Smith & Wesson: Just ‘Good Business’ But Now A ‘HOLD’ (NASDAQ:SWBI)

Dear readers/followers,

Over a year ago, I bought a small position in, and initiated coverage on Smith & Wesson (NASDAQ:SWBI). The company is a market-leading firearms company with strong margins, low debt, and impressive profitability, despite its volatile revenue trends.

At the time, company results showed top-line revenue improvements, with a focus on the outdoor markets and several new products which saw good traction on the market. While I expected the company to continue to outperform at a good rate, I did not expect the company to nearly double the S&P500 in the meantime.

That is nonetheless what has happened.

The company since my article and my bullish rating has seen a TSR of over 41%, as seen below.

As such, we’re in a very nice position in terms of this stake, and may be looking to rotate at the right price. In this article, this is one of my primary goals – stating and communicating whether this is the time, and if not or if so, then why.

To many investors, Firearms remains a field where they don’t want to go in. My own stance on them isn’t as controversial as that. Smith & Wesson Brands was a minuscule “BUY” in my portfolio, and any company that outperforms the index deserves highlighting here. Also, i’m product/company-agnostic. It’s not the investor’s job, as I see it, to make these distinctions between what is right and wrong, but the respective law- and policymakers.

While there are of course funds and strategies that avoid this, I am not an investor that does so. I will invest in anything that is legal and makes me money if the circumstances are correct.

Let’s see what we have here.

Smith & Wesson – The upside here is no longer as compelling

Some are now stating and believing that there is plenty of upside left to Smith & Wesson. This is a sub-$1B market cap company without a real credit rating and what is a very relatively minor yield, especially when we see it in the context of what you could easily get on the market today.

However, Smith & Wesson remains market-leading – and by market-leading I mean exactly that, I mean that in terms of margins, the company is among the best in its field. In this case, we compare it to aerospace and defense, and its in the 60-80th percentile here, with less than 0.8x net debt/EBITDA, over 30x in interest coverage, and a superb ROIC net of WACC.

The things that speak against Smith & Wesson is really that the revenues are, or can be, fairly volatile – and the trends and history speak to this. Especially during periods after crises, such as GFC or COVID-19, the company went net income negative, only to then quickly bounce back.

Cyclicality and understanding of that cyclicality is key here. The company is a handgun & long-gun business, a market which has an estimated market size of just below $5B even just in the US, and has a number of very appealing brands under its wing.

For 3Q24, which is the latest quarter we have herre, the company once again grew. It grew sales by 6.5% to $137.5M for the quarter, however, with a decline in gross margins and a decline in GAAP net income and a slight decline in EBITDAS.

Reason for this drop and decline?

Well, shipments outpaced the overall firearms market, meaning that demand wasn’t the issue, and there is a continued demand expectation going into 2024 with the election cycle as well as other concerns currently ongoing. The company also has its relatively new and very modern Tenessee facility, which will be able to produce quality products for decades. It has a very strong balance sheet with which to meet these challenges.

Inventory cycled down in the distribution channels as well, implying very strong sales numbers and operational cash flow was actually up, not down in any way. The company also went ahead and repurchased 71,000 shares at market, using a small portion of its authorization, but not in any way a large one ($916k out of $50M). The dividend is at $0.12/share and remains so.

Like any cyclical products company, the inventory level at the distribution point and the cycling of this remains a very important factor.

So, the negatives come from new operational costs from the company’s new facilities in combination with inefficiencies due to start-ups, and what the company refers to as “inflationary factors”, which I bundle into both labor, materials/input, and probably some logistics as well – which could not be offset completely by a higher sales volume nor the January 1 price increases that the company managed to push through (Paywalled TIKR.com link).

Is this sub-30% margin the new normal for Smith & Wesson?

It’s possible – the next few quarters will give us a better indication, and I will keep an eye on this. The company has stated with clarity that TN is increasing costs at the margin level, but this is also due to geography P&Ls since the company is no longer in Missouri. Also, the company makes it clear that not all efficiencies and synergies of the new TN facility are yet captured – but whether this can make up for over 300 bps of gross margin difference, remains to be seen. Some automation changes are coming online which will show improvements, and the company has not yet closed Connecticut, which should provide another upside.

This is also visible on the operating expense side – up almost half a million due to D&A increases and legal costs.

Overall, SWBI is now a sub-3% yielding firearms manufacture and leisure products company at a sub-$1B market cap trading at a P/E multiple that is significantly above its standard operating range.

The company’s significant cyclicality causes some issues in the forecasting and valuation, which we’ll look at in a moment. But aside from this, I would say that operationally, Smith & Wesson remains a relatively safe play with a good customer base, strong demand, proven market outperformance, and a market looking to purchase its products. The company also happens to be the #1 Firearm brand in America.

Valuationally speaking, we have the following case to look at.

Valuation for Smith & Wesson – high in the short term, the upside on the very long term

The paragraph title says it all. When we look at the company from say, a 5-year valuation average, Smith & Wesson trades at no more than a 10x P/E. If we assume that 10x P/E is where it’s at, then the company is most definitely not a “BUY” here. The company would then have a potential downside to that 10x, even with significant EPS growth, of 28% until 2025E.

But if we look at the longer term, say a 20-year average, things look very different, because then the P/E goes up to around 20x. We then have a 1-year upside of around 58%, which is well beyond market beating. Also, the fact that analysts are forecasting 44% growth this year due to a mix of new facilities and election cycle trends should provide, despite the recent “rocketing” up, some cushion for the valuation.

Also, there is the quite simple fact that Smith & Wesson has, historically speaking, quite often outperformed the average here. More than 65% on a 1-year basis with a 10% margin of error, the business has seen significant outperformance to these forecasts – which again gives some credence to a positive thesis here.

It becomes a question of where we align our expectations. I say neither on the high end nor on the low end. Smith & Wesson deserves some outperformance consideration but has already gone up 40%. More is possible, but the higher we go, the more careful I become.

I would put the company at an average of around 13.5-14x, which is around a 15-year average, which I believe includes the company’s potential annual outperformance, but takes into consideration that things actually may go down as well.

Because of this, we find ourselves, even with a 44.79% EPS growth estimate (Paywalled F.A.S.T Graphs link), at no higher than a 0-10% annualized upside for the company.

And that, dear readers, is not enough to interest me in buying more.

What’s more, and looking back to my last article, the company is now significantly over my conservative PT of $13.5/share. And while I with the outperformance in mind, and forecasts in mind, would be willing to raise the bar to around $15/share to account for this, making a 15-17x P/E a valid forecast, I would be no higher than this, or expect no more than that.

For that simple reason, I say that this company is now a “no go”, and I changed my rating for Smith & Wesson to a “HOLD” instead of a “BUY”.

I would still use long-term sales and revenue/book multiples as an indicator of the overall attractiveness of the company, and at the current price being below my PT, these now look no longer as good as they did at the time of my last article.

My following thesis for Smith & Wesson is now as follows.

Thesis

• Like other firearms manufacturers such as Ruger, SWBI is a volatile and cyclical company with ups and downs but found in a fundamentally attractive segment in the US market. The company has no credit rating, but also extremely low debt, and produces products that are extremely unlikely to go anywhere in the short, medium, or long term, at least in the US market.
• I give the company a conservative PT of $15, up from a previous PT of $13.5, which implies a flat upside at today’s valuation. It’s no longer significant, as in the last article, and we’re no longer above 15% annually. I do not believe a material outperformance potential is still possible here, and for that reason, I consider this one a no go.
• The company should be considered cyclical, however, and you should look at what other potential investments are available to you at this particular time – because there are better ones out there.
• I say “HOLD” – and being careful here, but I am not selling the company’s shares just yet.

Remember, I’m all about:

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

The company’s flaw is its dividend and valuation at this time. I won’t consider it less than qualitative for the credit rating, because it’s low debt. I consider it a “HOLD” here, no longer cheap.