Smith & Wesson - Appeal Is Increasing After Another Big Sell-Off

Aug.30.14 | About: Smith & (SWHC)

Summary

Smith & Wesson disappoints investors big time again, the second time in as many quarters.

Shares have, however, lost already a third of their value since June.

As such, fundamental appeal is showing up despite operating in a dismal environment.

Investors in Smith & Wesson (NASDAQ:SWHC) have been very disappointed with the company's results for the start of the fiscal year of 2015.

It was not necessarily the weak quarter which disappointed investors. Analysts and shareholders have been disappointed with the severe cut in the full-year guidance. This came so quickly after the release of the already disappointing guidance back in the fourth quarter of last year.

That being said, shares have quickly shed a third of their value, factoring in quite some bad news already. Shares might offer appeal in my eyes at current levels, especially if the company can maintain the guidance which calls for quite an improvement in the second half of 2015.

A Soft Start To 2015

Smith & Wesson posted first-quarter sales of $131.9 million, a steep 22.9% decline compared to the year before. Analysts anticipated a slightly less steep fall in sales towards a level of $134 million.

This kind of fall in revenues had huge implications on reported earnings which fell by 45.0% to $14.6 million. Investors should take notice that the company has retired about one in every six shares outstanding over the past year. This has limited the fall in reported earnings on a per share basis to 35%, or $0.26 per share.

Earnings beat consensus estimates by about a penny.

A Look Into The Softer Performance

Much of the revenue fall, or actually 87% of the reported revenue decline, was attributable to the lower sales of long guns which include sporting rifles. Lower consumer demand hurt sales of these guns, while handgun sales were solid for the smaller concealed pistols and revolvers. This was again offset by lower sales of larger handguns.

On the back of the lower sales and production, gross margins have been under significant pressure, as they fell by 540 basis points to 37.2% of sales. The absorption of higher fixed costs over fewer guns obviously hurt margins, as did the fact that the quarter had three fewer production days.

At the same time, operating expenses increased by some 320 basis points to 17.7% of sales, providing a double whammy in terms of pressure on operating earnings. Despite the 860 basis points decline in operating margins, they still came in at a very healthy 19.5% of sales.

Despite the negative developments as outlined above, CEO James Debney notes that the entire industry is dealing with high inventories following a previous surge in consumer demand. This environment, with big changes in consumer demand, is having a real impact on Smith & Wesson's capacity to run the business effectively.

The high inventories will really hurt operations in the current second quarter, although Debney expects a more normal operating environment in the second half of the fiscal year.

The Subsequent Lower Outlook

Based on the disappointing first-quarter results and the soft outlook for the second quarter, Smith & Wesson is less optimistic about the immediate future.

Second-quarter sales are seen between $100 and $110 million, representing a 25% decline in sales year-on-year at the midpoint of the range. Earnings are anticipated to largely vanish, expected to come in between just $0.04 and $0.08 per share.

Full-year sales for 2015 are seen at $530 to $540 million, with earnings anticipated at $0.89 to $0.94 per share.

The outlook implies that second-half sales are seen at around $300 million, down just about 5% compared to the second half of 2014. Earnings for the second half are seen around $0.60 per share, still down by a quarter compared to the comparable period in 2014.

Note that the company previously anticipated annual sales of $585 to $600 million, as earnings at the time had been forecasted to come in between $1.30 and $1.40 per share.

Valuation

At the end of the quarter, the company held some $83 million in cash and equivalents. This was actually up compared to last year despite the huge share repurchases in recent time, as the debt position has increased towards $175 million. More cash was held in the form of inventories as well which rose from $87 million last year to $101 million, as demand for guns is under significant pressure.

This results in a net debt position of about $92 million, a still very much manageable amount compared to the profitability of the business.

With 56 million shares outstanding at the end of the quarter, equity in the business is valued at around $620 million with shares trading just above $11 per share. Based on the full-year guidance for the fiscal 2015, shares are valued at 1.2 times annual sales and about 12 times annual earnings.

A History Of Boom And Bust

There are few businesses being so much impacted by public debate and policy changes as the guns business. These have been very well reflected in the historical share price.

Trading at just about $2 in the middle of the 2000s, shares have jumped to $20 in 2007. This was amidst worries about the economic crisis, resulting in the fear of higher crime and potential gun control legislation following the election of President Obama.

This did not play out and shares have fallen all the way back to $2 in 2008. After stagnating at those levels amidst losses in a generally favorable operating environment after some bad deals, shares have seen a big run-up again. Shares have risen from just $3 in 2011 to highs of $17 earlier this year. The terrible events in 2012 like the Connecticut school shooting only pushed up demand for guns.

The latest worries about falling demand amidst a lack of news surrounding legislative action has resulted in a fierce correction of about 35%. While this sell-off is steep for any kind of stock, notice that shares in the company have historically seen even greater volatility.

It should be noted that the company is quite a bit bigger now compared to recent years. At this time, it generates about 4 times as many sales compared to 2005, although the share base has risen by some 60% as well. Despite the greater size, the same underlying playing field exists.

Final Recommendation

Back in June of this year, I last had a look at the prospects for the company following the fourth-quarter earnings report. I concluded that despite the correction following the earnings report, shares were no obvious buy as I have been awaiting a greater sell-off before potentially initiating a position.

While the company managed to meet its first-quarter outlook, the full-year outlook in terms of both revenues and sales for the fiscal 2015 is rather weak. While the valuation based on past price-earnings ratios is very appealing, earnings are coming down fast as 2014 has been an exceptional year driven by fears about gun controls.

Yet shares have corrected significantly by now, although I realize that the company has seen even greater sell-offs in its history. As such, I am a cautious buyer in the $10-$11 region, although there are significant risks related to an investment given the poor predictability of the business, even for management. That being said, the improved conditions in the second half for the upcoming year should provide some stabilization and appeal as comparables become easier next year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.