Description

Smith & Wesson Holding Company (SWHC)

Smith &Wesson Holding Corporation (SWHC, S&W) hits the bull’s-eye for attributes one looks for in an undervalued situation.  The valuation multiples are exceedingly cheap, the brand is iconic, organic growth and margin statistics are outstanding, its industry is riding a secular growth trend that is accelerating, barriers to entry are high, the company is taking market share and management is very capable.  A few factual supporting highlights:

• At current prices, the market values the company at a bargain 4.7x 4/13 EBITDA and 8.8x 4/13 earnings. (On an LTM basis 5.6x and 10.5x respectively)
• SWHC has organically grown topline by a CAGR of 15.6% over the past 6 years while operating margins have expanded from 10% to
  21%
• No net debt
• The US consumer firearm market has grown at a CAGR of 11% from 2005-2010
• SWHC has a grown to 17% market share of the domestic consumer firearm market and is taking share in the fastest growing sub-segments

The bearish view rests on one primary concern: Aren’t the current sales figures simply driven by “political buying” ahead of potential new gun control laws?  Aren’t we at the top of an Obama induced “gun buying surge?”  Au contraire.  To be certain, the current robust sales figures contain some Obama buying, though numerical evidence points to a continued secular growth market in guns which I will address in detail below. 

At a more rational 8x EBITDA in line with competitor Sturm,Ruger and other branded consumer products companies, S&W would be valued at a $16.40, representing a 75% gain from current prices.  Since the current valuation already implies operating declines going forward, I believe the margin of safety is firmly in place should sales trends reverse.

Firearm market overview

The US consumer firearm market is approximately $1.5bn for handguns, $632mm for hunting firearms and $489mm for modern sporting rifles for a total of $2.6bn.  According to the ATF, it has grown at a CAGR of 11% from 2005-2010.  The biggest three players in the industry are Smith & Wesson, Sturm, Ruger & Company, Inc. (“Ruger”),  and the Cerberus firearm roll-up,  Freedom Group, Inc. Together they represent about half the market, while each currently maintains an approximate 16.5% share.  The balance is split by a variety of private manufactures the largest of which is the infamous Glock GmbH.  Sales figures are not disclosed, but they claim a two-thirds market share of the domestic law enforcement and represent a significant percentage of shelf space in gun shops.

The relevant political history and implications

The 1993 Brady bill required that all firearm sales be screened to deny those with criminal records or other ineligibilities from making a purchase.  The National Instant Criminal Background Check System (NICS) was officially launched in 1998 by the FBI and the data is subsequently compiled and released monthly, providing excellent insight into sales trends.  To put it mildly, the data has been good:

For a mature industry, the gun business has solid growth track record.  Beyond this obvious conclusion, a second salient point reveals itself.  The uptick in gun sales began in 2006.  Despite the popular media’s narrative portraying Obama’s (2008 and current) election as the catalyst for massive increases in gun sales, the growth began a full year before he even announced his candidacy and two years before he took office.  I believe the more meaningful political event aligned with the data was the expiration of the Federal Assault Weapons Ban (AWB). The AWB, signed into law in 1994 by President Clinton, limited the types of firearms available to consumers and limited the capacity of most magazines (including rifles and pistols) to 10 rounds.  Further, it severely handicapped the ability to sell civilian versions of military rifles known commonly as assault rifles, AR-15s, or tactical rifles.  Since the AWB was not renewed, the law’s sunset provision took effect toward the end of 2004.  Sales growth in tactical assault rifles (now using the gentrified industry term  “modern sporting rifles” or MSRs) have since been meteoric, driven by a generation of adults weaned on video games, veterans returning from active service, doomsday preppers going mainstreaming (http://channel.nationalgeographic.com/channel/doomsday-preppers/ ), aging baby boomers looking for home defense options, and a general increase in the acceptance of firearms.  According to the National Sports Shooting Foundation (NSSF), the modern sporting rifle category has grown at a 31% CAGR from 2004 to 2008.  According to Remington Arms (Cerberus roll-up Freedom Group), MSRs have grown at a 27% CAGR from 2007-2011.   At $500mm in annual sales, modern sporting rifles now represent about 20% of the consumer firearms market.  Handgun sales have also experienced strong growth trends since the expiration of the AWB with a CAGR of 17% from 2004-2011.  Further, if the growth was simply an Obama related event, wouldn’t the sales spike have ended soon after Obama’s election?  While it’s a more attention grabbing story for the media, the numbers show gun sales began a secular increase before Obama, and have accelerated their increase through today.

To fire the point home, here are a few more relevant data points supporting the current social acceptability of firearms in America:

• According to an October 2011 Gallup poll, self-reported gun ownership in the US is the Highest since 1993 to 47% percent of American adults. (not coincidently aligned with the beginning of the AWB)
• According to an October 2011 Gallup poll, a record low 26% of Americans favor a handgun ban
• In 2008 the Supreme Court made a landmark decision on gun rights for the first time since the 1930s, in the case of DC vs. Heller.  They ruled that individual citizens have the right to possess a firearm even if they are not in the military, thus removing a primary argument of anti-gun activists’ read of the second amendment.
• The number of states that must (shall) issue a handgun permit to a citizen versus may issue, where a citizen may have to prove need, has grown from 9 in 1986 to 41 in 2011; http://en.wikipedia.org/wiki/File:Rtc.gif
• This week, the Seventh Circuit Court of Appeals struck down Illinois’ ban on concealed firearms as unconstitutional.  It was the only state left with such a prohibition.
• According to Ruger, 90% of handgun owners own an average of 7 firearms.  The first sale is the most difficult because of the process and learning curve.  Hence the following data point is very important:
  • NICS checks for new concealed pistol permits are currently outpacing checks for actual firearms.
  • This is one of the most popular channels on youtube.com:  http://www.youtube.com/user/fpsrussia

Smith & Wesson Background and market position

Smith &Wesson is a branded consumer products company that has been designing, manufacturing and selling its wares since the 1850s.  The company invented, and is most famous for, cartridge based revolvers.  The best modern example is the .44 Magnum that Clint Eastwood made famous in “Dirty Harry.” (http://www.youtube.com/watch?v=u0-oinyjsk0 ).  While the popularity of the handgun market has shifted away revolvers in favor of semi-automatic pistols, SWHC has quietly and very successfully shifted its products to meet this consumer demand despite its synonymy with revolvers.  Revolvers only represent 18% of the handgun market today, which is in-line with the proportion they represent of SWHC’s sales.  Much of SWHS’s success comes from its continued introduction of new “hit products” and innovation.  In 2006, soon after the expiration of the AWB described above, the company successfully introduced a line of polymer based semi-automatic pistols (an homage to Glock) and modern sporting rifles. The M&P line, as they are named, has been a large component of S&W’s recent and future success.  While introduced only 6 years ago, MSRs contributed 18% ($75mm) of their FYE April, 2012 sales. In the six months ended October 2012, they have sold $61mm of MSRs representing over 100% growth from their prior year.  Today the company has over a 15% market share and continues to take market share of the fastest growing category in the industry.

While M&P pistols are not specifically broken out, they have contributed disproportionately to the growth of S&W’s handgun category.  Further, due to their injection molded polymer (plastic) frames, margins are significantly higher.  Comparable Glocks cost approximately $75 per pistol to manufacture, wholesale in the $300 range, and carry MSRPs of $550.  Given their similarity, it is not unreasonable to believe SWHC’s M&P pistols carry similar economics.

As a result of the popular M&P products, Smith & Wesson has been able to consistently grow gross margins from 31.8% in 2007 to 35.6% on an LTM basis. Management has guided the gross margin on the balance of the year to be over 36%.  Much of the growth in polymer pistols has come at the expense of Glock and there is still ample runway.  Despite their identical retail selling price points, M&P has some tangible benefits over Glock that they specifically highlight in their advertising including made in America, ambidextrous fire controls, improved sights and better ergonomics.  According to SWHC, Glock sales are more than 3x M&P pistols.  However, Glock has shown some cracks as their law enforcement market share has declined from 75% to 65%.  There has been no major innovation in their product line (really their one product) since their launch in the 1980s. While law enforcement sales are currently a small part of S&W’s business it penetration of the M&P line represents an obvious growth opportunity.  Further, consumers historically purchase what has been blessed effective by law enforcement.   

Revisiting the concept of a hit product, at April NRA show the company last year launched a new ultra-compact concealable M&P called the Shield.  To date, gun retailers have described it to me as a “unicorn gun.” Demand has been so strong relative to supply that few have been able to purchase it and retailers simply can’t get allocations.  As per the second quarter earnings call last week, the company expects to launch another splashy product at this year’s SHOT Show in January.  Hopefully their capacity investments come closer to fulfilling demand.

Competitive landscape

Smith & Wesson’s market share across handguns, modern sporting rifles and hunting firearms is approximately 18%, 15% and 5% respectively.  Like any consumer product, brand awareness, reliability, and innovation are significant factors in customer purchasing decisions.  All of its markets are highly competitive, with S&W, Ruger, and Freedom Group being the largest three, each currently controlling a 16.5% share.  The other half of the market is highly fragmented, though Glock is very strong in polymer pistols as is Springfield Armory.  Freedom Group controls the number 1 position in modern sporting rifles with a 48% market share between its Bushmaster and DPMS brands.  Freedom Group is Cerberus’ roll-up of the industry, consisting primarily of Remington, Bushmaster and DPMS, though company also manufactures ammunition which contributes over a third of its sales.  Freedom filed an IPO prospectus in October of 2009, but withdrew its offering in 2010 amid slightly slowing sales and the departure of its CEO.  Ruger is SWHCs closest competitor offering a very similar product catalog targeted to slightly lower price points.  Ruger has enjoyed similar growth with sales up 75% in the last 3 years and operating margins expanding from 16.8% to 23.1%.  Both companies have excellent growth prospects and solid management, though Ruger garners a higher valuation.  Adjusting for last week’s $4.50 special dividend, Ruger trades at 8.5x LTM EBITDA and 15x LTM net income, three turns higher on EBITDA and 4.5 turns higher on net income.  Should one desire a hedge against the concept of a “gun bubble”, Ruger makes a good short to pair against Smith & Wesson.

  (Ruger adjusted for $4.50 special dividend in December) 

Management

It took a non-firearms, consumer products executive to figure out the gun business.  Prior management made some large mistakes including paying $75mm for an unprofitable perimeter security business in 2009 and paying $104mm for Thompson/Center arms in 2007. James Debney joined the company toward the end of 2009 and quickly determined SWHC should be a focused, consumer driven firearms manufacturer.  The security division was sold for a nominal amount and the Thompson manufacturing operations were sold for $3mm in favor of consolidating its manufacturing to its Springfield, MA facility.  It is important to understand that firearms are a hit driven business and Debney brought that culture with him from running Alcoa’s Presto Products unit (UK’s answer to ziplock/Reynolds wrap/plastic products).  Since his tenure the company has introduced a slew of new popular products including the concealable M&P Shield, the M&P Sport (a value oriented MSR) and .22 caliber versions of the M&P modern sporting rifles.  The business model allows for a high degree of operating leverage as SG&A and R&D increase nominally relative to sales.  Under Debney’s tenure, sales have grown 50% while operating expenses have only increased 14.5%.  Further, on December 6, Debney announced a $20mm buyback program along with stellar second quarter results.

Second quarter earnings review: backlog and production capacity

By all accounts Smith & Wesson produced an excellent second quarter ended October 31^st, 2012.  Sales were up 48%, significantly greater than the adjusted NICS checks of 20% implying continued market share growth.  Operating margins were 19.5% and EPS was $0.24 vs. $.01 in the prior year period.  These numbers were already known ahead the December 6^th earnings release since the company preannounced on November 19^th.  At the time of the preannouncement, the company maintained its prior FYE April 2013 guidance of $530-$540 sales and EPS of $0.85-$0.90.  Only two weeks later, with the full quarterly release, management increased its FYE 2013 guidance to $550-$560 sales and EPS of $1.00-$1.05.  The increase in guidance was made sense in light of the November adjusted NICS checks showing a 38.5% increase from the prior year making the largest gun sale month in history with Black Friday having the highest NICS checks in any day in history. 

The stock is off over 10% despite the spectacular earnings report due to an incorrect reading of the backlog figures.  The backlog represents purchase orders received and scheduled for shipment within six months. They are cancellable up until the time of shipment.  While they were up 122% over the prior year, they were down sequentially by 15.2%.  Analysts looking for support of the “political buying frenzy is over” thesis took this data point and ran with it.  Management did not do a very crisp job on the call only stating: “We believe the sequential decrease is due to our improved ability to address backlog through our increased production capacity, and therefore, our improved ability to ship products, combined with the influence of some seasonality.”  A few days later (December 12), management posted a new investor presentation that cogently defends and explains the seasonality and capacity argument for sequential backlog declines. (see page 10

http://www.sec.gov/Archives/edgar/data/1092796/000119312512497620/d449938dex991.htm ).

Anecdotally, I have support for management’s thesis.  Much like a hot IPO, there is more demand than S&W can produce.  Consequently, gun shops from Texas to Connecticut I have spoken to tell me they put in much bigger orders than they need since they know their allocation will be significantly less.  S&W has invested $20mm in capacity expansion this year alone and production is starting to catch up.  In Q2 factories were shut down for two weeks for maintenance, yet they were still able to produce the same as prior quarters.  Ruger has had similar backlog issues. In March of 2012, Ruger stopped accepting new orders and effectively had customers resubmit revised orders in May.  Bigger picture, I like the backlog disclosure, but having analyzed the numbers for the past few years, they are not a good guide for near term sales.  They bounce all over the place relative to sales and show no exacting near term correlation to my eye.  (I am sure someone smarter than I can run a regression to prove otherwise.)

Summation

SWHC continues to take market share in a growing industry with a superior product offering and excellent management.  Contrary to the media’s narrative that fear of re-regulation driving gun sales and hence coming to an end, evidence points more toward an enduring secular growth trend.  The valuation already baked in the former but should be valued at least in line with Ruger, implying 75% upside from current levels.

Risks

• While it would create a buying frenzy in the short term, if the Obama administration can successfully renew a more restrictive Assault Weapons Ban it could damage the most profitable growth segments of the industry, the modern sporting rifle.
• The consensus about the Obama gun surge is correct and the stock moves lower despite its inexpensive multiple

Catalyst