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  • Smith & Wesson: Hitting The Value Bullseye

    Smith & Wesson (NADAQGS:SWHC)

    Overview (Current Price: $10.82)

    Smith and Wesson ("SWHC") engages in the manufacture and sale of firearms in the US and internationally. One of the most iconic brands in the firearms world, the company was founded in 1852, and is a market leader in the handguns and long guns markets. I am recommending a long position in SWHC as it hits the bull's-eye in everything you would look for in a true value investing scenario: the current price of $10.82 represents a great entry point due to its exceedingly cheap trading metrics, robust earnings growth, strong future outlook, and iconic brand in a growing industry with high barriers to entry. For all these reasons and more that I will discuss later, I see SWHC as a smart value play that presents a ~50% upside even with exceptionally conservative assumptions.

    Valuation is Exceedingly Cheap

    At the core of my investment thesis is the fact that SWHC is currently valued at both relatively and absolutely cheap levels. The unjustifiably low stock price and lower still valuation metrics present an investor with a strong margin of safety by being able to enter the stock at an appreciable discount to fair value. The company is currently being valued at 3.9x EV/ LTM EBITDA, which is far below the mean and median of its peer group (8.9x). Shifting to looking at P/E, the company trades at 8.1x P/E which is well below the peer group median of 14.2x. Sometimes low valuation metrics can signal weakness or a company whose stock priced has tanked recently, but in the case of SWHC, it is just the harbinger of pure cheapness; it represents value that can be realized by a patient investor. Even holding earnings static (an incredibly conservative assumption), a multiple expansion to the median of the peer group would propel the stock price to $18.50, representing a 70% premium to the current price. See below for a comparison of selected peers from the firearms and outdoor activity sector (note that RGR is probably closest comp, which trades well above SWHC despite near identical operational statistics).

    (click to enlarge)

    Growing Market and Market Share

    SWHC trades well below its peers, despite the fact that it is enjoys a comfortable market share that has actually been growing. The company sports a 17% share of the US handgun market as well as a 6.7% share in the long guns market (each ~$2bn in the US alone). SWHC has been able to capture more and more of the growing demand for firearms in the US. With continued media focus on the gun-related stories like the Newtown school shooting to yesterday's Nevada middle-school tragedy, potential gun control and self-defense fears are driving more and more consumers to buy guns. The below graphic shows the strong secular growth in the firearms market experienced over the past 5 years, which SWHC is best positioned to take advatnage of. (click to enlarge) (click to enlarge)

    Robust Sales and Earnings Growth Accompanied by a Healthy Balance Sheet

    While the US handguns market has grown by a CAGR of 11% over the past 6 years, the company has grown its top-line even faster with a CAGR of 15.6%. All of this has been accompanied by an EBITDA margin expansion of over 10% since 2009. As the overall market looks to continue to grow in the foreseeable future, expect SWHC to be able to continue on its trend of growing total revenues at a faster rate. This continued top line expansion will ultimately find its way into investors' pockets, as management has proven time and again to find ways to improve operational efficiency. Surprisingly, the company hasn't grown its revenues chiefly through price increases; rather it has strictly been growth in volume that has been driving top-line performance. Any incremental raise in prices will be all profit and will flow accordingly into the bottom line. Normalized EPS has grown steadily from $0.15 in 2011 to an LTM EPS of $1.35; this tremendous earnings growth isn't been fully appreciated in the current stock price and suggests further room to run even at depressed valuation levels. With continued sales growth and operational improvement, SWHC looks to continue to grow earnings and deliver exceptional financial results that will reward patient investors. Assuming a 20% earnings growth rate (which is less than the forecasted market expansion), the stock would trade at more than $13.00 with no multiple expansion, or $22.20 with expansion to industry wide P/E multiples.

    Looking to the balance sheet, SWHC has a negative net debt position and has been undergoing a calculated balance sheet optimization. The company successfully replaced all of its 9.0% debt with much more manageable 5.875% debt. With this conversion the company took an immediate $4.3mm hit of bond premium recorded in interest expense, that depressed this past quarters earnings but increased the outlook going forward as debt service costs will be reduced. From a liquidity standpoint, the company recently negotiated a new revolver facility that is expandable up to $175mm and sits with a healthy cash amount of $143mm, providing ample wiggle room for any tough stretch or potential capital return policies. In addition, the balance sheet is currently goodwill free and only has ~1% in intangible assets. In essence, the company is carrying its iconic brand and 150+ year legacy as a leader in the firearms industry at almost nothing. This represents an incredible off-balance sheet value that could be realized in a potential sale to a financial sponsor or other acquiring company.

    Shareholder Friendly Management and a Potential LBO Target

    Smith & Wesson's healthy margins and iconic brand make it a perfect takeover target. Although management has proved efficient at running the business, the company sits in the sweet spot for almost any potential financial buyer. With strong cash flows and a clean balance sheet, the company is easily able to be levered up substantially. SWHC's EBITDA margin of 27.0% indicates strong pricing power and provides for ample cash-flow generation for any debt servicing needs. Additionally Private Equity firms are further attracted by the allure of a quick buck to be made due to the current low valuation metrics, which can translate into instant shareholder value realization on the consummation of a buyout offer.

    Finally, management has proven itself shareholder friendly through its recent $100mm buyback program that was recently completed in September, upon which they immediately authorized another $15mm. Despite a healthy cash position and strong earnings, management has yet to initiate a dividend, which it very may well be forced to with the advent of this new age of shareholder activism/zealotry that we have been living in. Even if no dividend announcement is made, expect the board to authorize a substantial share repurchase in the near term which would result in a substantial uptick in price.

    Risks

    1. The company operates in a heavily regulated environment where legislative action is one bang of the gavel away from severely impacting financial results.
    2. This has been true of the firearm industry to years, and growth is actually accelerating.
    3. The increased focus on gun control has been cannibalizing future firearms sales, pushing all the future demand into today; the firearm industry is potentially at its peak now and could go down in the future.
    4. Gun owners rarely tend to be the owners of a single gun. Non-typical gun owner purchases today may actually create lifelong firearms customers for the industry, and thus actually building future industry sales.
    5. The company cannot pace its production with the rising demand and loses market share.
    6. SWHC has made tremendous strides in improving its capacity, and has actually been able to cut down on its order backlog. Even RGR, SWHC's top competitor, had to shut its doors in 2012 for weeks on end due to a lack of capacity. SWHC now has the chance to benefit from all of its previous capital expenditures on improving capacity, thus opening the door for outperformance of consensus estimates as the increased capacity hasn't been baked into production/sales estimates.

    Catalysts

    1. Announcement of a share repurchase or dividend
    2. Re-rating of valuation metrics to the mean after continued financial performance
    3. Significant earnings beat due to increased capacity not factored into analyst estimates
    4. Potential LBO / Acquisition Target
    5. Activist shareholder demands capital return, forces boards hands

    Conclusion

    Smith & Wesson checks all the boxes for a potential value investment.

    It has a strong financial position with robust earnings growth in a growing market with defensible competitive moats around it. The company is currently sorely undervalued in both absolute and relative terms. With a re-rating of valuation metrics to its peer group median, or to the company's closest peer in Ruger, the company would be valued at a minimum of a 50% premium to its current share price. Factoring in potential shareholder activism and the company's profile as an LBO target, there are multiple catalysts for the company to realize its true value and reward the investor who enters now at an appreciable discount to that true value at the current price of $10.82.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: SWHC, RGR, Guns, Firearms
    Oct 25 11:35 AM | Link | Comment!
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