Description

Smith and Wesson spun off their sports and outdoors division (American Outdoors Brands) in the past few years and has a cheap valuation due to a subpoena and destocking of inventories. S&W CEO Mark Smith refused to attend court hearing while CEOs of other U.S gun manufacturers showed up. Despite such negative news, S&W outpaced the market by over 28% in terms of production volume. Many of these gains were attributed to catering models to new firearms owners who are now loyal to the Smith & Wesson brand.

Mark Smith and management are good capital allocators— cash generated in 2021 was used to pay off 160M debt, return over 8M to shareholders through dividends and buybacks– outstanding shares were reduced by over 14%, all in the first 10 months since the spin-off.

There are a few reasons to invest in Smith and Wesson:

1.    S&W uses their flexible, third party manufacturing model to expand, while maintaining their fixed cost base during good years instead of employing leverage. This allows S&W to be at a level so that they’re profitable in any market conditions. Despite regulation and a cyclical industry, domestic growth has been steady.

2.     Production is moving from Massachusetts to Tennessee (assume 20-25M for normal CapEx and 90-95M in relocation CapEx) as this keeps assembly close to distribution. Tennessee has more lenient regulations towards gun control (machining operations are staying in Springfield, MA), while debt has been lowered.

3.     Capital allocation from CEO Mark Smith and his management team are shareholder minded— in terms of any further share buybacks authorization, the tax rules make it so that S&W will have to wait until August of 2022 which is the 2-year mark post-spin off from the parent (American Outdoors Brands).

4.    S&W is a strong brand name in a fragmented industry with innovative in products, specifically concealed firearms. This allows for the S&W to increase their ASP to absorb additional expenses from law suits, inflation, etc.

5.    Fundamental product line adjustments to embrace demographic such as new gun owners, women, and minorities shows that management adapts to customer needs. S&W ensures that products are always available at the retail counter, with a diverse product line catering to different preferences.

6.   The recent subpoena encountered will be dealt with as mentioned in Mark’s earning’s calls.

Total addressable market and competitors  

As of 2022, the total addressable market for the U.S. Guns & Ammunition Manufacturing (firearms) in the U.S is approximately 22-28B based on a volume of 6 to 9 million firearms manufactured a year. There are more than 80 million active gun owners in America.

FBI’s National Instant Criminal Background Check System (NICS) approximates the number and type of gun from background checks— providing insight into sales trends and consumer demand. However, NICS does not directly correlate to shipments due to inventory levels. NICS checks for new concealed pistol permits are currently outpacing checks for actual firearms.

Consumer demand among gun owners is cyclical— starting in 2009, Glock-type semiautomatic handguns, purchased for personal protection, began to outsell rifles, which have been typically used in hunting. Buyers capitalize on periods where there is loosening of gun restrictions by the Supreme Court, Congress and Republican-controlled state legislatures.

Please note the distinction between the U.S annual figures of firearms sold and manufactured.

From the graph above you can see that in 2019 approximately 7M guns were manufactured but 13.5M guns were sold. More than 11M guns were manufactured in 2020, but the gun industry had exceptionally high growth in sales in 2020 at 21.6M when 2019 had 13.5 million guns sold (60% increase). That number then fell slightly to 18.8 million in 2021 (a 12.96% decrease).

In 2020 alone, U.S. gun manufacturers produced 10 to 11M firearms, up from 5.4M in 2010. By 2021, 18.8M firearms were sold. While that was a 12.96% decrease from 2020, with 21.6 million guns sold, it’s still an 88% increase from 2010, when around 10M guns were bought. The growth rate is about 4 to 8% annually.

Gun manufacturers make more than the shop owners who sell to consumers. The markup on guns can be as low as 10%, leaving shop owners with very little profits. In addition, only a small number of gun-makers dominate the market. The top five pistol manufacturers alone controlled over 70% of all production in 2020: Smith & Wesson; Sig Sauer; Sturm, Ruger & Co.; Glock and Kimber Manufacturing. Four states – Texas, Florida, California, and Pennsylvania – had at least a million estimated gun sales in 2020.

According to a 2018 survey conducted by the nonpartisan Small Arms Survey, which monitors gun ownership, there are around 400 million guns in the United States. As of 2021, guns per capita in the U.S. reached a staggering 120.5 guns for every 100 residents. For a U.S population of roughly 300M, that’s about 393M civilian-owned firearms across the country, that means there are 67 million more guns in the U.S. than there are people.

About 1 in 3 Americans report owning a gun, while 42-44% American households own at least one firearm— this means that most gun owners have more than one gun— of the 42-44%, 32% of those are personally owned guns and 10% shared among the household.

Pistols are the most common gun in America, accounting for 40-44% of guns produced. Pistols and rifles made up about 70-75% of the total firearms produced.

In 2019 alone, there were more than 3 million pistols produced in the United States. Pistols are common because they’re often less expensive, easier for beginners to use, and licensing is less rigorous.

Smith & Wesson is the largest pistol producer in the U.S., producing 1.2 million pistols and revolvers each year.

Smith & Wesson has 60% of its sales from pistols and revolvers with 91.2% of its firearms are sold to domestic consumers. Two manufacturers, S&W and Sturm & Ruger dominate the handgun market— Smith & Wesson accounted for 8.2M guns produced from 2016 to 2020, 17% of the overall market.

Despite S&W outperforming Sturm & Ruger in 2020, over 2016 to 2020— Ruger & Co. was close behind, with almost identical sales and production figures. Smith and Wesson, Ruger, and Sig Sauer cover more than half of all production volume. If you include Glock and Kimber manufacturing also—the top five pistol manufacturers alone controlled over 70 to 80% of all production volume in 2020.

The number of manufactured large-caliber pistols able to fire rounds greater than or equal to 9 mm has soared over the past 15 years, rising from just over 500,000 in 2005 to more than 4 million by 2022.

Rifles are the second most common gun type in the U.S., accounting for 25-30% of guns produced.

In 2019, there were just under 1.96 million rifles produced in the U.S. The production of rifles has also increased, doubling from 1.4 million in 2005 to 2.8 million in 2020, though down from a record 4.2 million in 2016. Of the 2.8M, the top 5 manufacturers produced 1.68M, or about 60% of all production. This is driven primarily by a higher demand for semi-automatic weapons, including assault rifles.

This is driven primarily by a higher demand for semi-automatic weapons, including assault rifles— selling at a higher ASP with lower volume than pistols.

The biggest rifle manufacturers in the U.S are— Ruger, Springfield Armory, Savage, Henry Rac and W.M Anderson.

Remington Outdoor and Sturm & Ruger are the 2 largest rifle producer in the U.S., producing over 700,000 each year, nearly double the number of rifles as S&W.

The U.S. has over 20 million AR-15-style rifles legally in circulation.

An AR-15, otherwise known as an Armalite Rifle, is an extremely controversial gun in the U.S., owing to the gun’s usage in more than a dozen significant American mass shootings. The AR-15 is widely misunderstood as an automatic assault rifle when it is actually a semi-automatic rifle. The AR-15 is restricted in states like California and Massachusetts.

Shotguns are the least common of the major gun types produced in the U.S., making up only 7% of guns produced.

There were around 480,000 shotguns sold in 2019; below even the 580,000 revolvers sold.

A breakdown of unit volume by manufacturer—The field and competitors

Sturm, Ruger & Co. and S&W are the two largest firearm manufacturer in the U.S— producing an average of 1.7 to 2 million firearms per year. Others among the top five largest firearm manufacturing companies include Remington Arms (1.2-1.7 million), Sig Sauer (500-600k), while Glock and Maverick arms are around (400-500k).

From the chart above, you can see that S&W is slightly weaker in production volume compared to Sturm & Ruger and Remington (396-400k compared to 700-760k). S&W dominates the revolver and pistol market with S&R. In addition, Sturm & Ruger acquired Marlin Firearms recently and updated their rifles with modern parts.

S&W has a duopoly with S&R on revolvers and pistols based on brand, efficient manufacturing and distribution, and product reliability.

Purchasing demographic and purchase drivers— why are these consumers buying firearms and how S&W can reach out to them?

What appeals to first time users?    Adaptable and innovative development team displayed— tailoring to fit the right demographic and customer preferences

90% of handgun owners own an average of 7 firearms. The first sale is the most difficult because of the process and learning curve.  For new firearms owners, a good first experience as a beginner is crucial— expect somewhere between 25 to 30% to purchase their subsequent firearms. S&W spends about 7 to 7.5M annually on R&D to anticipate and respond to trends and shifts in consumer preferences.

S&W has completely redesigned their website to improve ease of use and brand messaging with well over 16 million people visiting since 2021. S&W has recorded over 45 instructional videos viewed over 2M times for their Guns Smarts program, along with a professional shooting team on topics ranging from the basics of responsible firearms ownership, to finding local fire arms within your community, to becoming a proficient shooter.

Compact and subcompact 9mm pistols are also becoming more popular, where 25 or more states have constitutional permit-less carry for self-defense. The number of .38-caliber pistols – small handguns designed specifically for concealed carry – jumped to a record 1.1 million in 2016 and totaled 660,000 in 2020, compared with 107,000 in 2005.

Here are some new pistols catered to make it easier for novices and beginners:

S&W M&P Shield EZ in 9mm

At an MSRP of USD521, S&W is building the Shield EZ model to convince newbies to buy more than just one gun.  Weaker or older customers who cannot pull on a slide which requires a metric ton of force to rack a concealed carry gun will appreciate easy-to-manipulate line of pistols with the M&P Shield EZ.

45% of people and households who are 65+ years old own at least one gun. That’s slightly higher than any other age demographic, but they’re all fairly close. For instance, 43% of people and households who are between 18-29 years old and 50-64 own at least one gun.

The 9mm requires much lighter springs than the striker-fired options that presently dominate the market. In turn, this means less resistance to work the slide, thus opening up polymer pistols to a much greater range of the shooters. The Shield EZ is recoil is friendly for beginners and the cartridge comes in a .30 super carry with a capacity of 10 + 1 rounds.

New gun users love this gun and no pistol is easier to load, handle, and shoot. In Guns and Ammos’ pistol magazine, one of the author’s wife loves how easy the slide is to operate. After shooting 30 rounds at distances of 3, 5, and 7 yards, the author’s wife scored 293 out of 300 points.

Smith & Wesson made the springs lighter with Shield EZ, incorporating other such as aggressive cocking serrations and a flared section for a better grip. It’s also right-sized for carry, with a 3.575-inch barrel and weighs in at a manageable 23 ounces unloaded.

.30 Super Carry

.30 Super Carry is a rimless pistol cartridge introduced by Federal Premium in early 2022 that has an MSRP of USD1095. It was designed as a competitor to 9×19mm Luger and .380 ACP for use in semi-automatic handguns, where its smaller dimensions are intended to permit greater magazine capacity without increasing physical magazine size.

Smith & Wesson CSX

During 2022, S&W launched the CSX “chief’s special X”, an all-aluminum alloy for the frame, hammer-fired, single-action featuring a 12-round capacity and ambidextrous controls in a micro compact size with a 3.1” barrel. The pistol has a very low bore— there’s less muzzle rise when you’re shooting; think of a lever or fulcrum. S&W CSX uses an SAO system which requires the pistol to have a cocked hammer before pulling the trigger. This means that the trigger pull would be lighter and shorter, with more consistency.

Modern Rifles

S&W refreshed their modern sporting rifle line with the introduction of the Volunteer rifle series, which includes a number of custom enhancements, including handguards, adjustable stocks, hand grips, and muzzle brakes, and the first S&W shotgun in 20 years, the M&P 12.

Subpoena, regulations, and unreasonable fears of politicians temporarily beating down on S&W

In the gun industry, regulation always poses as a risk, but so far regulation has affected production volume short term. Overall, units sold and units produced keep on going up despite shootings.

Federal regulations that hamper gun sales to the public are the biggest risk to this company, but the 2^nd amendment, the right to bear arms, ensures that permanently banning guns would be almost impossible. Considering the electoral advantages given to rural areas in the makeup of the US Senate (2 senators per state, no matter how small the state), however, this seems very unlikely.

If compromise at the federal level is at all possible, a requirement of stricter background checks or higher age limits seems more likely. Statewide regulations (especially in states that already have strong regulations) may continue to firm up.

This was why S&W moved their facilities from Massachusetts to Tennessee over rising concerns over legislation recently proposed in Massachusetts that, if enacted, would prohibit S&W from manufacturing certain firearms in the state.

But these risks cause somewhat counter-intuitive behavior among gun customers. When the risk of regulatory action is high, gun sales tend to rise. Since nationwide legislation on this issue is difficult to pass, this often results in gun companies actually benefiting from higher sales when regulatory risk is at its highest.

Given so many high profile shootings in the U.S. recently, what are the risks of the assault weapons ban being imposed once again, and how would this affect the company?

Smith & Wesson’s M&P15 semiautomatic rifle, an AR-15-style firearm, was used in

1. A mass shooting at the Highland Park, Illinois Independence Day parade;
2. Similar rifles made by other manufacturers were used to kill 19 children and two teachers at Robb Elementary School in Uvalde, Texas on May 24, 2022,  
3. 10 shoppers at a Tops grocery store in Buffalo, New York;

In response to these shootings, the House Oversight Committee (“HOC”) sent letters to gun manufacturers seeking information about the sale and marketing of AR-15-style rifles and similar firearms and calling them to appear at a public hearing on July 27, 2022.  The CEOs of Daniel Defense and Sturm Ruger appeared, but Smith & Wesson CEO Mark Smith “abruptly withdrew” five days before the hearing.

In light of Smith & Wesson’s refusal to comply voluntarily with the Committee’s inquiry, Chairwoman Maloney issued, on August 2, a subpoena to obtain key information necessary to the investigation, including the revenue and profits Smith & Wesson is making from AR-15-style rifles, internal analysis and assessments, and internal communications involving the CEO and other top executives.

Smith said S&W “will never back down in our defense of the Second Amendment” and through the National Rifle Association, Smith wrote, “A number of politicians and their lobbying partners in the media have recently sought to disparage Smith & Wesson.”

Smith, said politicians have “vilified, undermined and defunded law enforcement for years, supported prosecutors who refuse to hold criminals accountable for their actions, overseen the decay of our country’s mental health infrastructure, and generally promoted a culture of lawlessness, Smith & Wesson and other firearm manufacturers are somehow responsible for the crime wave that has predictably resulted from these destructive policies.”

“We are proud of our 170-year history. We are proud of the commitment of our employees to making a quality product. We are proud to provide law-abiding citizens and law enforcement—our customers—with the tools to provide for their security and independence. We are proud of our responsible business practices. We will continue to work alongside law enforcement, community leaders and lawmakers who are genuinely interested in creating safe neighborhoods. We will engage those who genuinely seek productive discussions, not a means of scoring political points. We will continue informing law-abiding citizens that they have a Constitutionally-protected right to defend themselves and their families. We will never back down in our defense of the Second Amendment.”

Beneficial Regulations—'Stand your ground' laws flourish

Despite adverse regulations, there’s also beneficial laws to S&W such as widespread adoption of state "stand your ground" laws which explicitly allow people to use guns as a first resort for self-defense. Utah enacted the first "stand your ground" measure in 1994. The second law wasn't adopted until 2005 in Florida. A year later, "stand your ground" laws took off, with 11 states enacting one in 2006 alone. Another 15 states have passed such laws since then, bringing the total number to 28.

Flexible Manufacturing & Relocation to new facilities

Total cost of sales fluctuates from 350 to 600M, which brings in a gross profit of around 200 to 350M. With the new Tennessee assembly warehouse and third party contractors, S&W should be able to control both inventory levels and cost. CapEx is similar to Sturm at 20-35M, but Sturm has steadier operating cashflow over the last decade of near 100M. In the last 7 years on an aggregate basis, 60-65% of S&W’s operating earnings were converted into FCF.

S&W leverages their subcontractor manufacturing and outsourcing to react rapidly to the shifts in demand, to deliver an impressive 70% increase in unit shipments during the year, which led to 2021’s revenue to be just under 1.1 billion, but normalized in 2022 with 864M. S&W has held fixed costs largely flat despite doubling top line revenue which subsequently drove net income for 2021 of nearly 244M and generated over 317M in cash from operations.

S&W has the following manufacturing facilities:

A 575,000 square-foot facility located in Springfield, Massachusetts;

2 facilities totaling 44,000 square-feet located in Houlton, Maine;

A 150,000 square-foot facility located in Deep River, Connecticut.

A production facility being finished in Tennessee

In 2022 April, bill HD 4192 / SD 2588 filed Tuesday would prohibit Massachusetts companies such as Smith & Wesson from manufacturing assault weapons and high-capacity magazines covered under the state’s existing ban on their purchase and possession. Anything manufactured to be sold to law enforcement, the military or foreign governments would be exempt from the newly proposed ban, and handguns — which are used in a vast majority of gun violence — would not be affected.

Massachusetts first implemented a state ban on assault weapons in 1998, when a similar federal law was already in place. In 2004, Republican Gov. Mitt Romney signed a permanent ban into law shortly before the federal policy expired.

S&W announced to relocate headquarters and significant operations to Maryville, Tennessee in 2023. As of April 30, 2022, S&W begun the construction of their new facility in Tennessee with the intent of seeking to minimize inventory costs through an integrated planning and production system.

All facilities operate under SAP, a fully integrated ERP system. This relocation will enhance S&W’s efficiency and nimbleness due to assembly operation’s proximity to distribution operations. This allows S&W to take a lot of steps, such as work in process inventory, out of the system.

All machining operations or flexible manufacturing will remain in Maine at the Holton facility and Springfield, Massachusetts. The Houlton facility is a machining center only with no assembly, finishing, or small parts operations for firearms. Handcuffs and restraint devices are produced in Maine also.

S&W will vacate and sublease or assign to a third party the lease related to their Missouri distribution facility. In addition, when S&W’s Connecticut building lease ends in May 2024, S&W intends to relocate a portion of plastic injection molding operations to Tennessee and will evaluate selling the remaining molding operations (custom plastic injection molding services, rapid prototyping, and tooling) used in Connecticut’s Deep River facility.

Valuation and Conclusion—

S&W has a strong balance sheet and financials – Temporary Inventory Problems with reversion of revenues and cashflow to pre-covid levels

Sturm, Ruger & Co’s revenue fluctuates annually from 450-650M, while S&W’s revenue is closer to 650M to 1000M or a billion with 50-60% of sales coming from pistols and revolvers. S&W properly incentivizes employees to achieve a higher sales volume—1.9M in accrual related to special bonus paid to employees for achieving 1 billion in sales.

Of the approximate 210M in working capital, 110M comes in the form of cash, 182M from inventory, and 23M from receivables, 110M of current liabilities comes from accrued expenses and payables. About 15M of dividends are paid annually and a 55M buyback which is 8% of market cap was recently taken into action.

S&W’s business model of using third parties allow them to rapidly react to upswings in market demand, but it also maintain strong profitability during periods of sharp declines in revenue by keeping fixed costs low and manufacturing cost absorption rates high.

It is likely that S&W will have a depressed valuation by the market which may last until 2023, but revenue and gross margin improvements with increasing ASP means that business economics have not been tarnished. Given the cheap valuation, the bad sales performance of a decade is only cyclical and inventory levels will have to revert— destocking won’t be a permanent theme.

As of July 2022, inventory days outstanding is 131 days. Days payable for suppliers is around 20 to 60 days. As shops, distributors, and S&W both clear off their inventory, days outstanding should normalize to a range of 55 to 85 days. S&W’s cash conversion cycle should be closer to 70 days instead of 100.

With demand normalizing and manufacturer’s added capacity, the industry is returning to pre-pandemic levels. This has led distributors and retailers to adjust inventory level targets to be more in line with the normalized demand. The worst of inventory destocking-related news has past— inventory levels of distribution drop from approximately 18 weeks in March to approximately 13 weeks during this time, which is still considered slow, despite distributor inventory being comfortable at current 14.5 weeks of supply. While still above the average target of 8 weeks, the number of weeks varies based on seasonality and many other factors.

As volume recovery takes hold S&W will benefit from operating leverage— most likely it will generate a cash flow of 75 to 120M, gross margins of 32% to 42%, and EBITDA at 20% to 30% of revenue. This can be attributed to S&W having a much more nimble cost structure now thanks to the cost take-outs over the last couple of years.

A strong balance sheet with no long term debt and 100M in cash with meaningful pricing power means that S&W won’t disappear off the map in the next decade or through fear or regulations from mass shootings or lobbies. While unit volume may be going up in a cyclical and slow rate, S&W’s ASP is going up at a linear and predictable fashion. Despite inflation, consumers are willing to pay up for a brand like S&W. They definitely have pricing power.

Management will opportunistically allocate capital through buybacks, new products, or acquisitions to benefit shareholders. S&W used free cash flow to repurchase 4.8 million shares of common stock for 90 million and paid 15 million in dividends recently. Since S&W completed the spin in August 2020, they have repurchased nearly 10.9 million shares and reduced share count by nearly 20%.

https://www.zippia.com/advice/firearm-industry-statistics/

https://www.pbs.org/newshour/nation/analysis-how-firearm-manufacturers-influence-american-gun-culture-in-6-charts

https://theconversation.com/6-charts-show-key-role-firearms-makers-play-in-americas-gun-culture-183900

Catalyst

- Destocking of inventory

- Subpoena and regulations subside

- huge buybacks