SWHC: Intrinsic Value $31.04
Overview: Smith & Wesson Holding Corporation is a manufacturer of firearms and a provider of accessory products for the shooting, hunting and rugged outdoor enthusiast. The firearms, handcuffs and other related products are sold through a distribution chain and direct sales to consumers and international, state and federal governments. The company sells its products under the Smith & Wesson, M&P, Thompson/Center Arms and Wheeler Engineering, among other brands. We like SWHC for the following reasons:
1. Appealing growth potential in a still fragmented Industry: SWHC estimates that the domestic non-military firearm market based on industry shipments is ~$2.2 billion for handguns and $1.5 billion for long guns, excluding shotguns, with the company’s market share in calendar 2015 being ~ 19% and 5%, respectively. In addition, SWHC estimates that the domestic firearm accessories and equipment market based on hunting-related expenditures is approximately $1.5 billion. SWHC’s accessories net sales for FY15 were just $65.3 million. Despite being an industry leader, there is still a lot of more market share SWHC could grab via production innovation, portfolio extension, and potential acquisitions, etc.
2. Iconic brand catering to multiple end customers: Established in 1852, Smith & Wesson’s brand has achieved an iconic status. It has the highest brand awareness with the consumer in the US, on both aided and unaided awareness. In the past years, the company has also acquired other brands to appeal to a broad group of firearm owners, which helped the company differentiate from competitors. SWHC, for example, owns M&P, which stands for military & police and offers higher tech polymer pistols that the company sells to both the consumer and to law enforcement. The company also owns a hunting brand called Thompson/Center, which is focused on muzzle loaders and bolt action rifles.
3. Industry enjoying robust growth: From 2007 to 2012, the US consumer fire arm manufacturing industry grew 17% CAGR. Taking out the surge periods, when consumers actively buy firearms in fear of increased legislation, the industry over the last 8 to 10 years grew 6% to 8%, with SWHC growing faster than the market. Going forward, the company expects 6-8% to be the base line for its organic growth, a strong growth target most other consumer companies would envy.
4. Building flexibility in manufacturing: Smith & Wesson operates in an industry that has seasonality and longer cycles of ebbing and flowing demand. Therefore, it is important to have a flexible supply chain which can adapt to changing demands quickly. SWHC deploys an outsourcing initiative, which outsources the manufacture of certain components such as slides and barrels. This layer of outsourcing on top of its own internal capacity allows the company to flex up and down manufacturing volume more easily to cater to different demand. In addition, the company also introduced flexibility between product categories internally within its manufacturing plants. If the revolver product category is growing and another category is shrinking, for example, the company can flex its base capacity to meet that change in demand quickly.
5. Conducting sensible Acquisitions: The company has made acquisitions to expand into adjacent markets. More recently in 2014, it acquired BTI and entered the firearm-related and outdoor lifestyle accessories business. In 2016, it acquired Crimson Trace and entered the electro-optics business. The acquisition ambition will continue with targets being strong brands and strong product portfolios in the fire arm and rugged outdoor space, which enjoy good market share, and ideally are ranked number one or two in where they operate. In addition, the company is also interested in vertical integration to expand gross margins and to mitigate risks in the supply chain. It acquired Tri Town Plastics, the primary supplier of polymer frames to the M&P polymer pistol family, for example. The M&P polymer pistol family has been core to the company’s growth strategy for the last few years. SWHC will explore other vertical integration opportunities as they arise, especially regarding certain manufacturing technologies the company doesn’t currently own but uses to a high degree.
Catalyst: There is the potential for a politics-driven bump in gun purchases as the US election will be held in a month. If Hillary Clinton wins the white House, and the Democrats retake the majority of the Senate, which have decent odds of happening, fear of an infringement of the 2nd Amendment Right could drive increased gun purchases before any law limiting the gun purchases actually takes effect. Though the actual impact of legislation on gun purchases is minimal for the foreseeable future, the perceived threat could be material.
In late September, SWHC was eliminated from replacing the Army’s M9 by the Department of Defense. In addition, there is some heightened fear that consumer demand for fire arms is decelerating, evidenced by the smaller y-o-y growth in FBI’s background checks for firearm purchases. These negative events have caused SWHC to lose nearly 20% of its market value lately, and in our view, removed lots of the downside risk to the SWHC stock in the near term.