Smith & Wesson Offers A Compelling Opportunity

| About: American Outdoor (AOBC)
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Summary

Shares of Smith & Wesson have declined significantly since the election & earnings.

With their move into non-firearm related businesses Smith & Wesson is preparing for the future.

I conducted a stressed valuation to account for a decline in gun sales.

Shares of Smith & Wesson (NASDAQ:SWHC) have been in a free fall ever since the Election, having fallen 26.57%. Investors are worried that sales of firearms will slow down during Donald Trump's four-year term. In addition, Smith & Wesson just reported earnings last week and crushed revenue and EPS estimates. However, investors dumped the stock because they gave disappointing guidance for the current quarter. They guided for revenue between $230M-$240M vs. $238M consensus, EPS $0.52-$0.57 vs. $0.59 consensus. The two factors of Donald Trump winning the election and disappointing guidance are the two reasons why shares have fallen, however, they have fallen to a point where the valuation is compelling and given their history of beating guidance, they will likely do so once again for the fourth quarter. Below I will look three fundamental factors and the valuation for Smith & Wesson.

Likely to beat Guidance

The guidance for the quarter that was just reported as I noted above came in below the consensus. However, Smith & Wesson has a tendency to under promise and over deliver on guidance. For example, after Smith & Wesson reported earnings at the beginning of September, they gave guidance of sales of $220M-$230M and non-GAAP EPS of $0.53-$0.57. Smith & Wesson reported sales of $233.5 and EPS of $0.68, which were $8.5 million and EPS of $0.13 above their respective guidance midpoints. Given their history of repeatedly beating guidance, I believe Smith & Wesson is likely to beat their guidance in the current quarter. The reason I believe this I will explain in the next two sections.

High Firearm Sales

Everyone expects that firearm sales during Donald Trump's presidency will be lower; however, I believe there is the potential for sales to remain strong. The FBI announced that they had a record number of background checks on black Friday. In my opinion, this shows that gun sales are still very strong even after the election. If sales were to stay strong, this would be a positive for Smith & Wesson and would likely help them beat their guidance.

Diversification

The final item I will be looking at is the expansion into non-gun related businesses for Smith & Wesson. This is a long-term positive for Smith & Wesson; however, it will cause small hits on earnings in the short-term. For example, Smith & Wesson recently purchased UST Brands for $32.3 million, which provides survival and camping equipment. In the deal press release, they noted UST Brands' trailing twelve months revenue was approximately $24 million and that from 2012 to 2015 revenues grew at 49%/year. The trend of Smith & Wesson making more of these small acquisitions to build their non-gun portfolio will likely continue because Smith & Wesson recently increased their credit facility from $225 million to $500 million. With $500 million at their disposal, Smith & Wesson can clearly close the gap and lower their dependence on firearms. As I have shown below, just by adding a $32 million acquisition, Smith & Wesson lowered the percentage of firearms revenue just over 2%. If Smith & Wesson makes further acquisitions that fit this mold, [$32 million purchase/ $6 million in quarterly revenue=5.33x] theoretically if they used all $500 million of their credit facility for non-firearms related acquisitions they could add $93.75 million in revenues [$500/5.33=$93.75 million], which would put the split between firearms and outdoor products at 58% & 42% respectively. This also assumes that firearm sales do not decline, if sales were to decline then the split would be even closer as firearms revenue would be lower.

Revenue MRQ

% Of Revenues

Firearms

$194.48

83.28%

Outdoors Products

$39.05

16.72%

Total Revenue

$233.53

Revenue MRQ

% Of Revenues

Firearms

$194.48

81.19%

Outdoors Products +UST TTM Rev/4

$45.05

18.81%

Total Revenue

$239.53

[Table data from SWHC 10-Q]

Valuation

I conducted a stressed discounted cash flow calculation (table below) and found that shares of Smith & Wesson have a fair value of $20.33, which is only 2.66% below the current price. For my calculations, I used data from Smith & Wesson financials on Gurufocus, and to determine the discount rate and terminal growth rate, I used the following calculators.

Discount rate calculator

Terminal Growth calculator

For my calculations for growth, I assumed that CFFO would drop as firearm sales could potentially decline over the next five years. Therefore, I looked back at CFFO over the last two years and found that the lowest rolling TTM CFFO was $158.6 million. If in 5 years time CFFO were to revert to $158.6 in five years time, which would be a growth rate of -5.21%/year. I used that stressed growth rate in my DCF calculations below.

Q1 2015

Q2 2015

Q3 2015

Q4 2015

Q1 2016

Q2 2016

Q3 2016

$84.90

$16.60

$6.10

$51.00

$94.80

$38.10

$23.30

Trailing TTM Totals

$158.60

$168.50

$190.00

$207.20

*Growth Rate to go from $207.2 to $158.6 in 5 years*

-5.21%

  • CFFO/Share:$207.2/57.1 shares = $3.63 CFFO/share
  • LT Debt/Share: $188.3/57.1= $3.30 LT Debt/share
  • Stressed Long-term growth rate: -5.21%
  • Terminal growth rate: -9.07%
  • Discount rate: 6.55%

Assumptions

  • Cash flow grows for next five years.
  • After that, growth levels off to the terminal rate for 15 years.

SWHC

DCF Calculations

CF/Share

PV

Year 1

1

3.44

$3.23

Year 2

2

3.26

$2.87

Year 3

3

3.09

$2.56

Year 4

4

2.93

$2.27

Year 5

5

2.78

$2.02

Year 6

6

2.52

$1.73

Year 7

7

2.30

$1.47

Year 8

8

2.09

$1.26

Year 9

9

1.90

$1.07

Year 10

10

1.73

$0.92

Year 11

11

1.57

$0.78

Year 12

12

1.43

$0.67

Year 13

13

1.30

$0.57

Year 14

14

1.18

$0.49

Year 15

15

1.07

$0.41

Year 16

16

0.98

$0.35

Year 17

17

0.89

$0.30

Year 18

18

0.81

$0.26

Year 19

19

0.73

$0.22

Year 20

20

0.67

$0.19

Year 1-5 Growth Value

$12.95

Terminal Growth Value

$10.68

LT Debt/share

$3.30

Value

$20.33

Current Price

$20.89

Upside/Downside

-2.66%

Closing Thoughts

In closing, I believe shares of Smith & Wesson are compelling at this level given their history of beating guidance, the potential for firearm sales to remain high, their diversification into other businesses and the stressed valuation is appealing.

Disclaimer: See here.

Disclosure: I am/we are long SWHC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.