The Bottom Fishing Club: Smith & Wesson

Summary

• Gun sales to individuals in America continue to run at a high rate in early 2021.
• Economic and social instability could be the new normal for America, the result of an unsustainable debt load, pandemic disruptions, and higher inflation rates than the government will acknowledge.
• Smith & Wesson is ripe for further sharp gains, if the stock market turns bearish, inflation spikes unexpectedly, and/or a double-dip recession appears this year.
• A strong balance sheet, high profit margins, an undervalued stock quote, and improved equity trading momentum make the bullish argument.

Smith & Wesson Brands (SWBI) has been a gunmaker in the U.S. since 1852. The company designs, manufactures, and sells firearms worldwide. The company’s product lineup includes revolvers, pistols, modern sporting rifles, bolt action rifles, along with muzzleloaders, handcuffs, suppressors, and related items.

My investment thesis is turmoil in American politics will continue; social upheaval will not be a limited function of the Trump administration’s time in power; and, demand for personal protection items like guns will continue to run at above-normal rates into the future. Why do I believe such? Answer: Because Trump’s election was a “symptom” of America’s declining prosperity, especially in the middle income and working classes. And, today’s economy is even more leveraged and backwards-focused on work incentives than before Trump’s surprise 2016 election. If finances continue to decay for the average citizen, an elevated level of socioeconomic trouble is coming, maybe sooner than expected by the Wall Street boom euphoria of early 2021.

[Sermon Aside: The “moral hazard” of former FED Chairman Bernanke’s QE Ponzi money printing started in 2008 has been the well-heeled continue to accumulate riches owning real estate and stocks, while wages for the typical citizen have stagnated vs. under-reported inflation. The 2020 pandemic-induced “unlimited money printing” scheme by current FED Chairman Powell is Bernanke’s insanity x10. I am sure that will work out in the end? Not! The Federal Reserve’s ultra-low, suppressed interest rate policies have regularly taken purchasing power from savers earning next to zero, and worker incomes year-in and year-out rising low single digits, in favor of wild borrowing and asset speculation by businesses and the rich. I have been screaming about the long-term insanity and ruinous results of strangling free-market trading in bonds since 2008.]

A strong balance sheet and profit margin picture, alongside improving technical trading in the stock point to further gains for Smith & Wesson in 2021.

Image Source: Company Website

Business Headlines

During the summertime, COVID-19 lockdowns and the eruption of racial injustice protests led to a monster rise in small arms sales to American consumers. Fear and frustration encouraged both first-time buyers and existing gun owners to stock up on weapons and ammunition, as a precaution against social instability.

Smith & Wesson completed a restructuring, spinning off its American Outdoor Brands (AOUT) division in August. The new publicly-trading company focuses on selling hunting, fishing, camping, and shooting accessories. Management is hoping renewed attention on gun manufacturing will increase margins and profitability over time.

Since the November U.S. election, the threat of a Democratic push to restrict personal-defense weapons sales has been an excuse for higher gun demand, front running this potential outcome. With the big pickup in demand for personal firearms, on December 16th management announced a major stock repurchase authorization of $50 million, representing about 5% of shares outstanding. Both of these events helped the stock to a nice price increase into early January, measured from October.

Then, Smith & Wesson’s price spiked around the insurrection and attack on Congress during January 6th, by Trump supporters. All told, Wall Street is projecting a doubling in operating business earnings for 2021-22 vs. the 2019 level.

Strong Fundamentals and Valuation

In many respects, today’s balance sheet setup, high profit margins, and growth outlook mirror Sturm Ruger & Co. (RGR), another small gunmaker in the U.S. Below is a graph of expected EPS growth trends into 2022 and the similar gross margin picture vs. Sturm Ruger. The fundamental setup slightly favors Smith & Wesson.

Smith & Wesson has been able to largely sell out its inventory of guns at better pricing than usual. So yes, the spike in gun demand during 2020, as social unrest and COVID-19 fears ran amok, has benefited shareholders. Below is a chart of the resulting huge increase in earnings and cash flow during the summer and fall months, into the last reported operating period through October. I have circled in red the massive 6-month upside changes vs. 2019.

Image Source: FY Q2 SEC Report

Price to forward 1-year earnings and sales estimates are similar to Sturm Ruger right now, if not slightly cheaper for new investment dollars in Smith & Wesson. I have these ratios pictured below, alongside Smith & Wesson’s stronger price to trailing cash flow history.

After its reorganization, the remaining company held more current assets (like cash and receivables) of $215 million vs. total liabilities of $174 million at the end of October. Including net-cash plus property & equipment, Smith & Wesson holds a solid book value of $226 million, and tangible hard asset book value of $202 million, representing about $4 per share on an $18 stock quote. The price to tangible book value multiple is roughly the same as Sturm Ruger.

Overall, Smith & Wesson’s balance sheet is more liquid and conservative than the majority of other U.S. equity choices, while multiples of underlying business fundamentals are priced at a steep discount to the S&P 500 large cap and Russell 2000 small cap indexes. The valuation for the stock typically sells at a small discount to the market averages, because of heightened lawsuit risks, changing American views of gun ownership, and the lurking potential for more government regulation on the business model. However, my research suggests a 12x 2021-22 P/E, 1.7x valuation on forward sales, 4 to 5x price to cash flow, 5x tangible book value reading represents a larger-than-normal 50% discount to the average U.S. company. My conclusion: if you are willing to accept the risk side of the gunmaker investment equation, the upside story is quite compelling today.

Technical Momentum

I have drawn a 12-month chart below of daily price and volume changes, alongside some of my favorite momentum indicators. You will notice today’s price has once again risen above its simple 50-day and 200-day moving averages, with both in uptrends. In terms of upside momentum characteristics, Smith & Wesson has bested the S&P 500 price advance by almost 97% over the last year. You can see the positive price effect from a large summer rise in gun sales, inspired by fear over COVID-19 lockdowns and the appearance of racial injustice protests across America’s big cities. Again, you can review the price spike around the U.S. Capitol riot on January 6th. However, price trends overall have been consolidating since July, and could be ready for another substantial move higher in the coming weeks.

The Negative Volume Index and On Balance Volume indicators have zig-zagged higher in fits and starts. Yet, their patterns are relatively healthy the past year. Better NVI numbers in January-February could be a real signal of accumulation, from my work, potentially leading price to the upside.

Final Thoughts

My thinking is a stock market debacle, resulting from a tanking dollar valuation in exchange markets and rising inflation rates into late 2021, could keep gun sales high. Continuing unease about individual economic futures will not help social stability. I also worry about the repercussions of ending free-money stimulus checks (after a third round in March-April) that millions are using to plug deteriorating finances. FED Chairman Powell relayed to Congress last week that the honest unemployment rate is still well north of 10% in February, far above the official government stat closer to 6%. If the stock market drops hard in 2021, and the economy does not recover as quickly as optimists are forecasting, will new economic stresses lead to a falloff in gun demand? Likely not.

The current 50% discount valuation to the U.S. stock market generally, and elevated revenue/profit levels for Smith & Wesson could support another 30-50% rise in the stock quote soon. At the very least, I believe the stock will outperform the S&P 500 and Russell 2000, even under a significant bear market scenario. The fact gun sales often increase when the economy turns down also gives this name some hedging characteristics inside a diversified portfolio design.

The most important downside risk to an investment in Smith & Wesson revolves around the new gun control and regulation appeals being made by Democrats sweeping to power in Washington DC. Several days ago, President Biden called for tougher gun controls on the anniversary of the horrific 2018 high school shooting in Parkland, Florida. My feeling is greater use of background checks and the potential outlawing of mass-killing assault rifles a year or two from now would put a dent in sales, but not end the company’s profitable business model.

In the meantime, given the current legal sales of guns manufactured by Smith & Wesson, and a world that feels like it is falling apart, I rate the stock a Buy in late February 2021.

A final support for this stock vs. Sturm Ruger could be the extraordinarily high short interest position approaching 12% of outstanding shares in the middle of February. While Sturm Ruger’s 5% number is down from 10% in September, initially a bet on protest rallies disappearing and the pandemic ending, Smith & Wesson shorts remain stubbornly high. This additional fuel for a rally, as shorts cover borrowed shares through buybacks in the marketplace, is another bullish differentiator between the two gun companies.

Thanks for reading. This article should be a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.

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