Smith & Wesson Brands, Inc. (NASDAQ:SWBI) Q2 2022 Earnings Conference Call December 2, 2021 5:00 PM ET
Company Participants
Kevin Maxwell - General Counsel
Mark Smith - President and Chief Executive Officer
Deana McPherson - Chief Financial Officer
Conference Call Participants
Ryan Meyers - Lake Street Capital
Cai von Rumohr - Cowen
Rommel Dionisio - Aegis Capital
Scott Stember - CL King
Operator
Good day, everyone and welcome to Smith & Wesson Brands, Inc. Second Quarter Fiscal 2022 Financial Results Conference Call. This call is being recorded. At this time, I would like to turn the call over to Kevin Maxwell, General Counsel, who will give us some information about today’s call.
Kevin Maxwell
Thank you and good afternoon. Our comments today may contain forward-looking statements. Our use of the words anticipate, project, estimate, expect, intend, believe and other similar expressions are intended to identify forward-looking statements. Forward-looking statements may also include statements regarding topics such as our product development, objectives, strategies, market share, demand, consumer preference for our products, inventory conditions related to our products, growth opportunities and trends, and industry conditions in general.
Forward-looking statements represent our current judgment about the future and are subject to risks and uncertainties that could cause our actual results to differ materially from those expressed or implied by our statements today. These risks and uncertainties are described in our SEC filings, which are available on our website, along with a replay of today’s call. We have no obligation to update forward-looking statements.
I have a few important items to note. First, we reference certain non-GAAP financial results. Our non-GAAP financial results exclude costs related to the planned relocation of our headquarters and certain manufacturing and distribution operations to Tennessee. The spin-off of the outdoor products and accessories business in fiscal 2021, COVID-19 related expenses and other costs. Reconciliations of GAAP financial measures to non-GAAP financial measures can be found in our SEC filings and in today’s earnings press release, each of which is available on our website. Also, when we reference EPS, we are always referencing fully diluted EPS. Finally, when we discuss NICS results, we are referring to adjusted NICS, a metric published by the National Shooting Sports Foundation based on FBI NICS data. Adjusted NICS removes those background checks conducted for purposes other than firearms purchases. Please remember that adjusted NICS background checks are generally considered to be the best available proxy for consumer firearm demand at the retail counter. Because we transfer firearms only to law enforcement agencies and federally-licensed distributors and retailers and not to end consumers, NICS generally does not directly correlate to our shipments or market share in any given time period, we believe mostly due to inventory levels in the channel.
Before I hand the call over to our speakers today, I would like to remind you that any reference to income statement items refers to results from continuing operations unless otherwise indicated. Joining us on today’s call are Mark Smith, our President and CEO and Deana McPherson, our CFO.
With that, I will turn the call over to Deana.
Deana McPherson
Thanks, Kevin. Revenue for our second quarter was $230.5 million, an $18.3 million or 7.3% decrease from the prior year second quarter, with nearly $13 million of this decline coming from our discontinuation of the Thompson/Center product line. The decline also reflects an easing of demand, combined with a channel that has largely been replenished after an 18-month consumer surge that began in March of 2020. Although our revenue was lower than in the prior year quarter, the current quarter’s results remain remarkably strong, representing a 2-year compounded increase of over 140%.
Compared to the quarter ended October 2019, our revenue was up $116.8 million or more than double. Reports from our channel checks indicate that consumer foot traffic continues to be elevated above 2019 levels, but is lower than it was during late calendar 2020. Because of our ability to deliver in such large volumes, we believe that we have now fully replenished the channel for most product lines.
Gross margin in the second quarter of 44.3% was 370 basis points above the 40.6% realized in the prior year comparable quarter. This increase in margin was due to the impact of two price increases since the prior year second quarter, an increase in production volume as we were still ramping production throughout most of late calendar 2020, a favorable product mix, including the lack of low margin hunting products and reduced promotions as we were still fulfilling certain early calendar 2020 promotions late in the year. Margins were slightly negatively impacted by increased volume-related spending, some inflation impacts and payroll-related accruals associated with our impending move to Tennessee.
Operating expenses of $36.6 million for our second quarter were flat to the prior year comparable quarter. The current quarter includes $4.5 million related to our relocation to Tennessee and $2.9 million of increased legal costs, which were entirely offset by spin-related costs in the prior year of $4.8 million and lower compensation-related costs of $1.6 million due to synergy savings realized from the spin. The decrease in revenue was more than offset by increased gross margin and a reduction in interest expense to result in a $1.8 million increase in net income. This increased profitability, combined with a reduction in share count of over 7.8 million shares resulted in GAAP earnings per share of $1.05 compared with $0.87 in the prior year and non-GAAP earnings per share of $1.13 compared with $0.93 during Q2 of last year.
Finally, adjusted EBITDA of $80.4 million was $1.6 million higher than the prior year and 34.9% of revenue. During the second quarter, we used $3.7 million of cash from operations, primarily as a result of investments in inventory and spent $4.4 million in capital equipment resulting in $8.1 million of free cash utilized in the quarter. We did not repurchase any shares of our common stock during the quarter and continue to have $50 million available for us to use through August 2022, the 2-year anniversary of the spin-off. We paid $3.8 million in dividends and ended the quarter with $159.4 million of cash and no bank debt. Our Board has authorized the payment of our $0.08 per share quarterly dividend to shareholders of record on December 16 with payment to be made on January 3.
Looking forward into our third quarter fiscal 2022, inventory in the channel began to replenish during our first fiscal quarter and continued to grow throughout our second quarter. As of today, our distributors have approximately 15 weeks of supply in the channel, representing a broad range of products. This growth in inventory in the channel and within our company is a good thing as there are often periods of increased consumer demand for which we cannot produce enough product. Inventory in the channel and internal inventory levels help us to provide our products to consumers whenever and wherever they need them.
That being said, however, the inventory levels in the channel indicate to us that our third quarter sales are likely to be quite a bit lower than what we realized in our third quarter of fiscal 2021. Last year’s third quarter was impacted by strong consumer demand driven by the height of the pandemic, a recent change in the presidency, civil unrest and virtually no inventory in the channel. None of these factors exist in our current third quarter. In response, we have reduced production rates by nearly 27%.
In addition, we expect that our internal inventory will continue to build during Q3 in our effort to restock after last year’s complete depletion of finished goods inventory and due to our mitigation of supply chain issues that all manufacturers have been dealing with over the last several months. In spite of the expected reduction in sales and approximately $3 million in expense related to our Tennessee move, we will continue to meet or exceed the target gross margin, EBITDA and cash metrics that we shared in June. Our strategy of investing in our business and returning capital to our shareholders has not changed, and we will continue to pay our quarterly fixed dividend and be opportunistic regarding share repurchases. Finally, our effective tax rate is approximately 23%.
With that, I’ll now turn the call over to Mark for a deeper dive into our results. Mark?
Mark Smith
Thank you, Deana and thanks everyone for joining us. Before I provide commentary on the quarter’s results and the outlook going forward, I’d like to quickly take a step back and reflect on the past 18 months. As you all know, we have seen a historic increase in firearms demand during this time. And as always, our team met the challenge by taking immediate action to increase our production to meet that surge in demand and we owe a great deal of gratitude for the tremendous success of the past 1.5 years to all of our employees and particularly those who have worked hard to keep our manufacturing operations going strong through some pretty difficult times.
At the same time and equally as important, we remain focused during the demand surge on positioning our business for long-term success knowing that while the firearms industry has experienced healthy long-term growth over the past several decades, and we expect that trajectory to continue, it can be cyclical, often coming in fits and starts. And so we always need to be thinking several moves ahead in anticipation and preparing to maintain our strong financial performance and industry leadership position in any market condition.
Our operating model is designed to deliver strong financial results in a range of market conditions. In the most recent quarter, for example, we experienced a decline in top line revenue, but actually increased our gross margin and net income. We are constantly investing in our operations to not just identify efficiencies in production, but also to continue making improvements to our flexibility in manufacturing. This continues to pay dividends by allowing us to rapidly adjust not just overall volume levels but product mix to meet changes in demand, positioning us to capture market share in any environment. We continue to invest in and see results from our marketing and consumer preference efforts. Initiatives like gun smarts and point-of-sale kiosks have resonated with our consumers and keep the Smith & Wesson brand at the forefront for new consumers and enthusiasts alike.
And certainly, one of our biggest opportunities as market demand levels ease from the historic highs will be our full pipeline of exciting new products. Our product and engineering teams remain focused during the surge and in addition to the successful launches of the M&P 10 millimeter, the M&P 12 Shotgun and the Shield Plus, we have several more new product launches scheduled for SHOT Show in a few weeks and even more scheduled shortly thereafter throughout the winter. Our loyal consumers are going to have plenty to talk about, and I’m very optimistic about Smith & Wesson’s continued leadership in the marketplace.
Turning now to our Q2 financial results and market conditions, our team adjusted to changing demand patterns and continued to drive historically strong results. Our Q2 sales this year were our second highest for the period in our history. And as I just mentioned, we actually achieved the highest second quarter profit level ever. And the efforts to reach our consumers through innovative marketing and product offerings is also paying off as we continue to maintain a strong leadership position in the industry, even as other manufacturers have begun to catch back up and brand selection has improved at the retail level. Consumers now have a choice, and we believe they are continuing to choose Smith & Wesson.
It is also important to note that while the overall firearms demand has certainly eased from the red hot levels we saw in the comparable quarter last year, we believe that the new consumers that entered the marketplace during the pandemic, growing interest in the shooting sports, a charged political environment and news events driving a continued desire for personal safety have kept the market healthy. As a matter of fact, adjusted NICS during our Q2 were their second highest ever, up 10% versus the last big surge in Q2 of FY ‘17. And the most recent November NICS results release just yesterday indicate that consumer interest in firearms still remains strong, while returning to more normal historical seasonality. That said, where last year, we essentially sold through every unit we produced, we have now fully replenished the channel in preparation for the busy winter season and have the ability to rebuild our internal inventories. And so we have begun adjusting production levels accordingly, as Deana mentioned.
So just a reminder on our flexible manufacturing model, this allows us to ramp up production to meet surges in demand without adding large fixed costs, and therefore, also allows us to delve back production in response to changing market conditions, without incurring any large absorption issues in our manufacturing operations. As a result, we believe that we will be able to maintain healthy levels of profitability in varying demand conditions and that we will continue to operate at or above the top end of our financial model that we provided during our call in June.
Finally, late last quarter, we announced our intention to relocate our headquarters and certain of our operations to Maryville, Tennessee in 2023, and work on this project has begun in earnest. With a successful groundbreaking ceremony held on November 5, we are excited about the opportunity to shape our company for generations to come. The new state-of-the-art facility will serve as our headquarters and will be the new home for our plastic injection molding, assembly and logistics operations and will solidify the future of Smith & Wesson, an innovative, nimble organization whose dedicated employees leverage the latest technology to produce products that set the standard for firearms enthusiasts around the globe. We would like to thank the state of Tennessee and the Blount County community for such a warm welcome, and we look forward to calling Maryville home.
With that, operator, can we please open the call to questions from our analysts.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question comes from the line of Ryan Meyers of Lake Street Capital. Your line is open.
Ryan Meyers
Hi, guys. Thanks for taking my questions. First one here, you kind of alluded to this on the call a little bit, but I just wanted to dive into the revenue slowdown a little bit more. Did you guys experience any shutdown or production-related delays? Or is this just kind of what you talked about with demand starting to normalize a little bit more and the inventory is starting to be refilled?
Mark Smith
Hey, Ryan, it’s Mark. No, it’s – our second quarter does have 1 week of shutdown from our summer shutdown. So there is a little bit of that in there. But the – as we talked about on the call, we were able to rebuild some inventory. So it’s – it was more related to the market coming off the kind of red hot historic levels of last year.
Deana McPherson
Right. The same – we had the same production days in Q2 of this year as we did last year.
Ryan Meyers
Okay. That makes sense. And it looks like we saw pretty healthy ASPs for both the handguns and the long guns. How are you guys thinking about this for the rest of the year? And if you’re thinking about any promotional environment heading in SHOT Show and the new product launches?
Mark Smith
That’s a great question. Yes, so you saw in there for our Q2 that we had some pretty healthy ASPs. And I think the way to think about that going forward is it’s really going to be – it’s going to be a combination of mix as the MSRs were pretty heavy as we – all the way through the pandemic and the surge, and that’s going to shift a little bit now towards – more towards the handguns so – but then we’ve also got a couple of price increases in there that are going to muddy the water. So I think probably just to give you guys a little bit of color on it, our overall average ASP will probably – going forward here, will probably be somewhere in between where we ended Q2 and where we kind of were in Q3 of last year.
Ryan Meyers
Alright, that’s helpful. That’s all I got guys. Thanks for taking my questions.
Mark Smith
Thanks, Ryan.
Deana McPherson
Thanks, Ryan.
Operator
Thank you. Our next question comes from Cai von Rumohr of Cowen. Your line is open.
Cai von Rumohr
Yes. Thanks so much. So have you seen any – now that the inventories have basically been replenished and – have you seen any change in the pricing because to follow-up on Ryan’s question, that looked like really pretty robust pricing that you had there?
Mark Smith
Yes. We haven’t – obviously, there is some activity going on to some kind of more normal activity as we kind of come into the typical shopping season for the holidays and Black Friday. But it’s really, Cai, been more focused for us and for a lot of our competitors as well, just really on providing more value in terms of offering different accessories with the firearm or maybe doing a promotion where it comes with a box of ammunition or it’s really not gone to pricing. And as I’ve said before, we’re going to do everything we can to stay away from that and don’t foresee any need to do that here in the near term.
Cai von Rumohr
Got it. That’s great. And then – let’s see. So as I recall, this quarter is the quarter where you really have – I’m trying to think, I’m looking at my model, where you have a big downtick in terms of days – work days. My numbers have like you usually do 56 versus 59 in the second and then you go up to the mid-60s in the fourth quarter. Is that fair?
Deana McPherson
Right. Let me just – 59 days, yes, it’s 59 days this – and Q3 is 59 days, Q4 is 64 days.
Cai von Rumohr
Got it. So, you mentioned you have 15 weeks of channel inventory. What’s the normal level? I mean what would – I think it was – it used to – I remember a number like 8, is that correct or…?
Mark Smith
Yes. So, we try to target 8, but you got to remember that the 8 is the average across the year. And right now, when you look at our inventory levels, you are coming out of a period of if you look at the normal seasonality of the firearms NICS, which is the best obviously, a measure of consumer activity, usually kind of ramps up into the winter, November, December, the highest. So, we are coming into the peak period. And so we expect that the supply will be a little elevated at this time and then bleed out as we go through the holiday season and into the spring.
Cai von Rumohr
Thanks. Last question, you mentioned the move to Tennessee and the efficiencies, but also there was sort of more difficult regulations in Massachusetts. And you also showed that, I guess the legal expenses are up to $2.9 million. Are you seeing any more legal challenges in any of your states that might require more legal expenses or potential litigation risks?
Mark Smith
No. I mean obviously, we have always got legal expenses and litigation risk, but it’s no different today than it was last year. We still don’t anticipate any changes. The difference there in the legal expenses really was kind of just timing. So, in terms of the overall long-term, it’s not a change to the model.
Cai von Rumohr
Excellent. Thank you very much.
Operator
Thank you. Our next question comes from Rommel Dionisio of Aegis Capital. Your line is open.
Rommel Dionisio
Yes. Good afternoon. Guys, I just want to ask about the new shotgun, the M&P 12. I know you launched in August, but there was a recall that I read about in October. I can’t imagine there was that many units in the cost of recall is all that significant. But more importantly, I mean this is an entry into a new category for you. And I just wondered, does this kind of throw a wrench in the works of plans to kind of expand the product line there? Are there any sort of longer term repercussions for your entry into the shotgun category? I imagine you would have launched different calibers and that sort of thing. And does this kind of slowdown that process or delay it or kind of change your thoughts about that category? Thanks.
Mark Smith
Hi Rommel, a great question. No, the short answer is no, it doesn’t change our plans at all. I think we have a very, I will call it, strict approach to our products, to the quality of our products, and we want to make sure that everything that we are putting out is of the utmost work. So, we are going to probably have a little bit more conservative approach. And if we see any issues whatsoever, we are going to do a recall. And I think our consumers understand that about us and actually ends up and believe it or not becoming a bit of a marketing positive for us is that there is a lot of trust in our products because our consumers know that if we ever see a problem that we are going to let them know about it. That recall, frankly, as recalls go, went off without a hitch. I mean maybe in large part, as you just mentioned, because it was a fairly low number of units in the channel. We got those back and immediately corrected the problem, and they are actually – most of them already back out in the channel again and really hasn’t caused any issues, whatever is fairly in the rearview mirror and fairly minor bump in the road. So – and again, frankly, if you look at the recalls in consumer goods in the firearms industry, they are unfortunately not uncommon. And I think the consumers just expect that as long as you take care of it, they will appreciate that you will let them know about it.
Rommel Dionisio
Sure. And Mark, while around the topic, just prior to that – those first few weeks of sale. Could you just share with us how that had gone, or was it well received in the market? Thanks.
Mark Smith
Yes, extremely well received. And I think our consumers are pretty excited about us coming back into that category to the hunting category. I think as Deana mentioned in the prepared remarks, top line was off a little versus last year and a large part of that was the hunting products, but also a large part of our ASP increase was the hunting products. And so we were off on the top line, but actually on the gross margin and on the bottom line, we were up. And so I think that’s – amongst other things, that’s a reflection of our strategy to kind of exit out of that kind of lower end and hunting market and come back in with the products on the Smith & Wesson brand and it’s going to be a lot more profitable for us. And frankly, that should be a lot more successful.
Rommel Dionisio
Great. Thanks very much.
Mark Smith
Okay.
Operator
[Operator Instructions] Our next question comes from the line of Scott Stember of CL King. Your line is open.
Scott Stember
Good evening guys.
Mark Smith
Hi Scott. How are you?
Scott Stember
Deana, you were talking about, I guess production in the third quarter, down about 27%. I guess that was year-over-year. Should we be looking at the commensurate decline in revenues as well when we look at modeling?
Deana McPherson
Yes. I think you should. We were talking about unit capacity. You have to keep in mind that ASPs will be as Mark kind of walks through where ASPs will be. But the overall unit production will be down 27%. But keep in mind also that we said that we would be adding to inventory. So, production is a piece of it, but if that doesn’t all go through in sales, which by building inventory, we are telling you that it’s probably not going to go all through sales. So, there will be some level of inventory build. So, it’s kind of a complex calculation for you, but just based on what we are seeing right now that we expect a reduction in unit produced, an increase in units into inventory and then the ASP in the range that Mark gave you.
Mark Smith
Yes. Scott, I think just to give you a little help on that. I think if you think about our ASPs versus last year, you can’t just do a price increase because there is a lot of noise in there in terms of mix I just mentioned. So, think about ASPs last year. And I think last year, you can pretty much assume as you guys probably well understand that everything we sold was – everything we made was sold through. So, there is a pretty nice tight correlation there. And then this year, I think you can probably expect just in terms of dollars, we will build maybe a little less than inventory in finished goods than we did in Q1 to Q2. So, it should give you enough there to kind of get there.
Scott Stember
Got it. And with regards to, I guess your flexible cost structure, I guess we are right now the rubber hits the road and you can really start to show in a declining production environment how your margins will hold up. Could you just give us, at least for the back half of the year, assuming that we see a similar decline in the fourth quarter, your ability to hold on to these gross margins in this mid-40% range?
Mark Smith
Yes. If you remember back to our model we shared back in June, as I said in the prepared remarks, I mean the most amount of color I can probably give you there is that we will continue to operate at or above. That said, our margins as we kind of come into a little bit of a slower timeframe, they are going to come down a little bit. But we will still be very, very healthy margins, and we will be at or above those – that model that we shared back in June.
Scott Stember
Got it. That’s all I have. Thank you.
Mark Smith
Alright. Thanks Scott.
Operator
And I am showing no more questions. I will now turn the call over to Mark Smith.
Mark Smith
Thank you. And thanks everyone, again for joining us today. Once again, I do just want to thank all of my fellow Smith & Wesson team members for yet another strong quarter. Everyone, please stay safe. Have a merry Christmas, and happy holidays to everybody.
Operator
This concludes today’s conference call. Thank you for participating. You may now disconnect.
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