2023-09-11 09:05:28 ET
Summary
- Smith & Wesson Brands' Q1 2024 results show strong growth, beating estimates with a 35% year-over-year revenue increase.
- Smith & Wesson's normalized free cash flow and earnings are expected to be between $80 million and $100 million, providing a strong investment opportunity.
- SWBI's undervaluation and potential for future earnings growth make it an attractive choice for long-term investors.
Has my Smith & Wesson thesis changed?
Smith & Wesson Brands, Inc. ( SWBI ) is one of my favorite plays right now because it combines many favorable factors. It trades at a low valuation due to the one-time cost of moving its headquarters, which makes free cash flow ("FCF") and earnings look lower than they are on a normalized basis, and a management team that is willing to return that FCF to shareholders in the future via buybacks and dividends.
And the new results have not changed my mind. SWBI beat estimates and showed strong growth in a difficult environment. Therefore, I still see a strong buying opportunity for long-term holders, as I have outlined in the articles here and here .
Smith & Wesson Brands Q1 2024 results
SWBI released its Q1 2024 results on September 7th after the close of the market, and with 35% y/y revenue growth, they easily beat the estimates that had only predicted 19%. And what makes these results even more amazing is that NICS was down 13% year-over-year and SWBI still managed to grow sales by 35%, and what speaks for the great work of the R&D department is that 1/3 of the sales were from new products.
The investments in the Pistol Carbine, M&P 5.7 and M&P 22 have really paid off. In addition, there will be more new product introductions later in the fiscal year. Channel inventory was also reduced, and sales operations at the new location went live on schedule in August, and the big grand opening of the new headquarters is on October 7. So the one-time relocation costs, which were also responsible for the decline in gross margins to ~26%, are almost over. The long-term plan is to get back to 32%+, which seems achievable.
Furthermore, it should be noted that the second half of the fiscal year has the higher margins as more is produced, which improves unit costs. In this industry, there is a kind of seasonality where the summer and Q1 are usually weaker than the rest of the year and Q4 is usually the best in terms of revenue.
SWBI normalized FCF and earnings
After 2021 and 2022, when gun sales were unusually high, the industry has come back down to earth in recent months. So to get to normalized levels, we should compare it to the years before that boom and also factor in the temporary costs of relocation.
FCF for the quarter was $8.5 million, while CapEx was $32 million this year and $11 million last year. So if we say that on a normalized basis CapEx is less than $32 million and a little bit higher than $11 million because of increased costs due to inflation and all the other issues that we have right now, a $20 million CapEx would be a good choice for a conservation assumption.
So $40 million minus $20 million would be $20 million of normalized FCF this quarter. However, if we look at 2023 revenue, we can clearly see that Q1 is typically the weakest quarter.
- Q1 2023: $84m
- Q2 2023: $121m
- Q3 2023: $129m
- Q4 2023: $144m
- FY 2023: $479m.
Therefore, I think we can expect full year FCF to be higher than 4x Q1 FCF. So $20 million x 4 would be $80 million, but a range between $80 million and $100 million normalized would be achievable.
Smith & Wesson FY21 Report
The last year before the unusually high revenues was the year ended April 30, 2020. Here FCF was $67 million for the full year, with much lower CapEx than I used in my calculation, so CapEx for the next few years could be even lower, but I took it a bit higher to be more conservative. Here CapEx is only $12 million for a full year. So even if they can get it to $20 million for a full year, that would be a huge boost to FCF and a huge benefit to shareholders.
FY2020 net sales were $529 million and this year net sales are expected to be between $574 million and $622 million. That is the range that I am looking at because I think the revenue for the year will be up 20% to 30% versus FY2022 where the revenue was $479 million. So I think $80 to $100 million for FCF is a good normalized assumption that is also realistic after the one-time costs. If CapEx is lower than estimated, it could even exceed that projection. So the upside is huge.
With a current market cap of $535 million, SWBI would generate about 1/6 or 1/5 of the market cap in FCF. This is a really strong argument for an investment. The dividend they currently pay costs them 5,535 million per quarter, or ~$22 million per year. Even if we only take $80 million of FCF, that would leave a lot of room for dividend increases and share buybacks.
The historical CAGR of the shares outstanding is -11.79% , which is really high, but I think a CAGR of about -5% to -6% might be realistic going forward while increasing the dividend. That would be strong compounding for shareholders. And SWBI management always talks about the long term and their focus on capital allocation and returning cash to shareholders. So this is a real possibility after they are completely done with the relocation.
In addition, we have the opportunity for multiple expansions. Right now, SWBI is trading at a P/E multiple of ~14 because of the low net income last year, which was only $37 million due to relocation costs . On a normalized basis, $70 million would be possible if we look at the historical comparison where we exclude the boom years of '21 and '22 with $252 million and $194 million of net income. So on a normalized basis, that could be closer to a 7x P/E multiple, which would make this stock dirt cheap. A 7x P/E on 20% to 30% revenue growth this year?
Reverse DCF for Smith & Wesson
Assuming a normalized EPS of $2, which I think is realistic, and a 12x multiple combined with a 10% discount rate, EPS only needs to grow 2% over the next 10 years to justify this stock price. In my opinion, this shows the severe undervaluation of this investment. The EPS growth rate will most likely be higher than 2%. Maybe even double digits annually for the next 5 to 10 years.
In the boom years they had diluted EPS of $4.08 and $4.55 and last year was $0.8, so I think $2 is realistic on a normalized basis.
Risks
One factor influencing the valuation, apart from the fact that it is an overlooked small cap, is the risks associated with arms manufacturers. Last Friday, a governor in New Mexico suspended the right to carry firearms , and it will be interesting to see how this situation develops on Monday. Since almost all of SWBI's sales are in the U.S., this could have a strong impact on the investment case, depending on how this situation develops. Normally, SWBI investors hope that they are safe because of the Constitution and the law.
Conclusion
Smith & Wesson is simply a criminally under followed play that has great potential for outstanding long term results. The high barriers to entry, hopefully strong future FCF, and ample opportunity to reinvest in growth are a wonderful opportunity to deliver strong long-term results for shareholders.
Furthermore, the normalized valuation by any metric you like, be it EV/FCF, P/E or EV/EBIT, is dirt cheap compared to the earnings growth potential. So I think this is going to be an FCF monster with a strong management team that knows how to allocate capital while being shareholder friendly. A dream combination for small cap investors.
For further details see:
Smith & Wesson: A Free Cash Flow Machine After The Relocation Is Complete