Despite reporting a very strong first quarter, shares of Smith & Wesson (SWHC) ended flat-to-lower. The stock initially bounced 5%, but then retreated 6% from these levels, as an analyst downgrade weighed on sentiment. At a forward P/E of 12.9, SWHC looks cheap based on the fundamentals. However the stock has risen more than 70% in the past year, and there are fears that the gun industry has reached the peak of its latest cycle. SWHC is a fundamentally strong company but has a highly uncertain outlook, and the high risk premium is what keeps SWHC trading in the value range. We acknowledge the uncertainty, but think SWHC can go higher.
Revenues in Q1 increased 40%, beating estimates by $8.84 million, and non-GAAP EPS (adjusted for acquisition-related items) came in at $0.62 (compared to last year's EPS of $0.32). The combination of strong performance and the earnings accretion from two acquisitions lead to a boost in guidance. Management now expects FY16 sales of $900-$920 million and EPS of $2.38 - $2.48 (compared to consensus forecasts of $778.4 million and $1.94 respectively).
The revenue increase was driven by higher orders for handguns and long guns in the Firearms division, which grew 48%. This was the byproduct of "strong consumer demand as reflected in adjusted background checks from the National Instant Criminal Background Check System as well as market share gains", according to management. The growth also reflected two acquisitions the company made during the last year, which have so far gone smoothly. SWHC acquired Crimson Trace and Taylor Brands, and we believe these acquisitions will strengthen SWHC's market position and lead to new growth opportunities (both of these businesses have averaged organic annual revenue growth in the double digits over the past five years). We anticipate that purchase of Crimson Trace, a key supplier to Smith & Wesson and an industry leader in laser sighting and tactical lighting systems for firearms, will lead to long-term cost synergies (through backward integration and greater control over input) and revenue synergies (economies of scope through the cross-selling of Crimson's broad range of accessories and SWHC's guns). We also view the acquisition of Taylor Brands, an industry leader of knives and specialty tools and a long-standing licensee of SWHC, positively. Expanding deeper into the rugged outdoor products and accessories market will offset some the cyclicality inherent to the firearms business. The synergies from these acquisitions were evident in Q1: gross margin expanded from 39.8% to 42.3% while non-GAAP operating margin expanded from to 20.5% to 27.3%.
SWHC is a fundamentally strong company, and if you just look at the financials and valuation metrics it's difficult to understand why the stock is still cheap. SWHC has achieved strong growth in recent times through a mix of organic growth and prudent acquisitions, expanding margins in the process. The company's formidable market position, strong brands, and limited competition give the firm strong pricing power, and SWHC converts a high percentage of sales into cash flow (FCF as a percentage of sales has averaged almost 20% over the past three years). Working capital turnover has trended up thanks to strong demand for the firm's products, which has translated into improved liquidity and reduced the need for borrowing. Debt is manageable at 26% of assets (compared to cash at 33%).
But investors are hesitant to go long. The stock is up 70% in the last year and many investors worry the latest gun cycle has peaked. The gun industry is highly cyclical, and sales tend to spike on mass shootings and threats of government intervention. The upcoming elections introduce a wave of uncertainty, and the possibility of stricter gun control laws could be responsible for SWHC's strong organic growth (i.e. it is pushing demand forward into the current period). We acknowledge the risks of investing at the peak of a cycle, but we think SWHC can go higher. SWHC's market positioning and revenue diversification are much improved after the latest acquisitions, and we think there could be positive catalysts regardless of who ends up in office. A Clinton victory may imply stricter gun laws, but there would likely be more instances of terrorism/mass shootings given the easier immigration policies. On the other hand, while mass murder may decline under Trump, he might loosen gun laws. In either case, we could see gun sales going higher, and think SWHC remains an interesting choice for long-term investors.
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