How Much Will Smith & Wesson Lower Guidance Today?

| About: American Outdoor (AOBC)
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Summary

SWHC Full year Guidance was $530-540mm implies roughly $145mm for Q3 and Q4 which we view as impossible given the industry headwinds. Even recent acquisitions won't get SWHC there.

Better managed peer Sturm Ruger reported one month ago: -43% YOY revenue, -77% net income - Cabelas guided that excess inventory won't clear the system for at least a year.

SWHC stuck between rock and hard place: A) Don't discount and sales will drop 40%+ like Ruger or B) Discount heavily to maintain share and crush gross profits.

New acquisition appears to have dubious strategic rationale and now loads the company with nearly $300mm of debt vs estimated normalized EBITDA of ~$60mm: Could lead to chapter 11?

SWHC has a history of spending $100mm+ on acquisitions and writing them off 2 years later in 2007 (Thompson), 2009 (Universal Safety Response), and 2013 (stock buyback at peak).

We believe Smith & Wesson (SWHC) is a value trap with severe downside risk - debt piled on for large capex and stock buybacks during temporarily good business conditions that are now mean reverting

FAA investigators have a euphemism, "Controlled flight into terrain." I think a year from today, analysts will be using this to describe Smith & Wesson's decisions to massively increase their debt load to buy back stock and double the size of their factories in preparation for a new, permanently high plateau of gun demand.

The best shorts, in my view, do not have crazy valuations that are liable to double - as it is well known that 2*Crazy = Crazy. Stocks that appear cheap but with predictably deteriorating earnings are far less risky shorts as the driving reason the bottom hasn't fallen out already is an attractive valuation based on irrelevant, backwards-looking numbers.

Historically the firearms business has been a mediocre business - up until 2012, RGR, SWHC compounded at roughly a 3% CAGR over the last 20 and 10 years as public companies, respectively. Not terrible but basically commodity businesses. Have been around for a century, gun demand has basically tracked with GDP growth in America. Beginning with Obama's election but peaking with a confluence of events in 2012 and 2013 including the Sandy Hook School shooting drove fear of policy change by the Obama administration on future restrictions on gun purchasing.

This spurred a "gun bubble" causing a huge increase in demand for firearms through 2013 - a leading indicator of this is the National Instant Criminal Background Check System (NICBCS) which jumped to record levels. I won't go into great detail about the politics behind it but it is a widely discussed topic and I have not found any compelling evidence that there is a structural shift in gun demand and this thesis only requires mean reversion to the already historically elevated demand levels a few years ago.

The summary thesis for Shorting SWHC today is:

· Temporary factors resulted in demand spiking for firearms, peaking mid 2013 - these factors are already rolling over and year over year comparisons are impossibly difficult for manufacturers

· Firearms have historically been a commodity - quality (i.e. not great) business earning ~10% Return on Assets employed

· Due to shortages, EBITDA margins and ROA's have roughly TRIPLED at SWHC (and also RGR) for 2012-2013

· SWHC management has a history of terrible capital allocation, writing off 90%+ of their last two acquisitions in 2007 and 2009

· Flush with 'bubble profits', SWHC management massively increased their debt load to buy back stock at peak levels and increase production capacity (i.e. fixed costs)

· Massive increases in capacity (capex spending in 2012-2013 by SWHC and RGR roughly doubled PP&E for both) and channels stuffed with inventory of very durable firearms means there won't be an uptick in the supply/demand balance for years and it may overcorrect to the downside (e.g. the housing bubble still has still not worked through its excess inventory almost a decade later)

· Due to increased fixed PP&E, the Company estimates that maintenance capex is now $25mm/year - which is roughly equal to 94% of Operating Income (Avg $26.6mm/yr) for the 5 years 'pre-bubble' 2007-2011.

· Even assuming no overcorrection to the downside, at normalized margins over the last decade (including Obama's first term where firearm demand was already elevated), SWHC is worth maybe $5/share for 50% downside. Downside case could require restructuring the $175mm debt load.

· Insiders have aggressively sold most of their stock over the last 18 mos

· Recent Battenfeld acquisition at 9X EBITDA and >2X revenue (vs SWHC trailing 4X EBITDA and 1X revenue) appears to have little strategic benefit; takes any 'upside' risk of merging with RGR off the table; and loads the company with enough debt to potentially require restructuring next year.

Date

SWHC Capital Allocation Decision

Result

Jan 2007

Spend $102mm cash to acquire Thompson/Center Arms gun maker

2 years later take $98.2mm impairment charge

July 2009

Acquire Universal Safety Response a perimeter security company for $83.3mm in cash and stock (stock ~$6/sh then)

2 years later dispose of assets for $8.3mm, roughly a 90% impairment vs purchase price

Mid 2012-2014

1) Borrow and spend $165mm to repurchase 18% of shares at ~$13.50/sh

2) Invest $146mm in capex (including $24mm to acquire a vendor) to roughly double production capacity

Prediction: 2 years later… 2015

$175mm debt load proves to be highly burdensome as EBITDA margins revert to historical levels around 12% vs 28% during 2012-2013 'Gun Bubble' peak demand & shortages

To give the benefit of the doubt to SWHC, the prior two acquisitions were under CEO Michael F. Golden who served as CEO from 2004 to 2011, who also hired a VP who was charged by the SEC… Current CEO James Debney has served from Sept 27, 2011. On the other hand, Mr. Golden remains on the board as Co-Vice Chairman. As an aside, speaking as someone who has been on a number of boards, the fact that there is 1) An independent Chairman, 2) A non-Chair CEO, and 3) TWO co-Vice Chairmen including a the former CEO leads me to believe that should the company get into a difficult situation, it will NOT be able to react quickly or decisively.

Buffett on Dynamics of Shortages in Commodity Businesses:

When shortages exist, however, even commodity businesses flourish. The insurance industry enjoyed that kind of climate for a while but it is now gone. One of the ironies of capitalism is that most managers in commodity industries abhor shortage conditions - even though those are the only circumstances permitting them good returns. Whenever shortages appear, the typical manager simply can't wait to expand capacity and thereby plug the hole through which money is showering upon him. This is precisely what insurance managers did in 1985-87, confirming again Disraeli's observation: "What we learn from history is that we do not learn from history."

Warren Buffett, 1987 Shareholder Letter

RGR Return on Assets 12% 1990-2011 vs 40% in 2012-2014

SWHC Return on Assets: 7% 2002-2011 vs 25% 2012-2014

The numbers are already rolling over and likely to keep getting worse:

SWHC Three months ended June 30,

 

($ thousands)

2014

2013

Y/Y % change

Net Sales

$ 131,869

$ 171,020

-22.9%

Cost of Sales

$ 82,751

$ 98,247

-15.8%

Gross Profit

$ 49,118

$ 72,773

-32.5%

Operating Profit

$ 25,770

$ 48,014

-46.3%

Net Income

$ 14,556

$ 26,477

-45.0%

EPS (diluted)

$ 0.26

$ 0.40

-35.0%

Normalized Valuation for SWHC

 

Best Case

Back to 2012 levels

Overshoot Negative

Revenue

$ 500

$ 412

$ 300

EBITDA Margins

15%

12%

8%

EBITDA

$ 75

$ 49

$ 24

Net Debt

100

100

100

Stock @ 7x EBITDA

$ 7.87

$ 4.56

$ 1.26

The Gun Bubble: Sturm Ruger (NYSE:RGR) provides preview for SWHC given one month earler reporting period:

swhc margins, source: capiq

Due to the numerous acquisitions and write-downs at SWHC, some charts are cleaner from competitor RGR to highlight how distinct the period in 2012-2013 was for gun demand and how it is clearly mean reverting already.

Gun manufacturing is a competitive space, there is some premium ascribed to the brands vs a purely commodity metal pouring and shaping operation but this has been true over time and is not a 'new' premium. Returns on assets will normalize at competitive levels.

SWHC return on assets and capital - CAPIQ

RGR ROA - capiq

Note that Ruger is already overshooting to the downside on normalized return on assets - RGR Q4 will report a very significant loss (though due in part to a pension payment). RGR does not have debt, SWHC does and with debt include covenants. If SWHC's EBITDA overcorrects below ~$60mm in 2012 vs $300mm debt, they could violate their covenants and even be forced to restructure or heavily dilute shareholders next year.

RGR 5 year revenue growth - capiq

RGR inventory - capiq

On Cabelas (NYSE:CAB)'s most recent earnings call one month ago, the company indicated that it would take far longer than expected to clear the excess firearm inventory from the distribution and retail channels: at least a year vs initial expectations of perhaps 3-6 months. This does not bode well for SWHC's guidance of a rapid bounce back to peak revenue levels.

Disclosure: The author is short SWHC.

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