2023-06-26 07:00:00 ET
Summary
- Smith & Wesson is expected to reward shareholders through share buybacks, rising dividends and multiple expansion as it returns to normalized FCF.
- SWBI stock has the potential to outperform the market as it is underfollowed and therefore represents a good opportunity for investors.
- Once the relocation is complete and all associated costs have been paid, management is likely to start rewarding shareholders even more.
Thesis
In a difficult situation where Smith & Wesson (SWBI) is relocating its headquarters and sales are down, they are still returning cash to shareholders through a further 20% increase in the dividend to $0.12 . And once they return to more normalized FCF, excluding all relocation costs and increased material costs, they are likely to reward shareholders handsomely through a powerful combination of share buybacks, rising dividends and, hopefully, multiple expansion as sentiment towards the stock improves.
Analysis
Smith & Wesson released its Q4 and FY23 results a few days ago, beating analysts' earnings and revenue estimates. However, year on year sales are still down 20.1% and the adjusted EBITDAS of $30.3 million represents a margin of only 20.9% compared to 31.8% and $57.7 million last year.
Gross profit margins are also only 29% compared to 39% last year. This is due to lower sales and lower production volumes, as reducing inventories was a big priority, which they have achieved, and of course rising labor and material costs due to inflation. Promotional programs to reduce inventories also had an impact on margins and sales.
On the positive side, however, they now have 5 quarters of inventory reductions and are at or even below target levels. And with Tennessee's building nearing finalization, where they expect to begin operations in August and the front office to be in place by the autumn, the big cost factor of relocation could soon be a thing of the past. Nevertheless, they expect the relocation to cost an additional $85-90 million over the next periods, so it will take some time to return to pre-relocation FCF.
So the guidance for FY24 is that margins are likely to remain under pressure as inflation continues to have its impact on costs and they will also be running some more promotions. Despite this, FCF was positive at $13m in Q4, of which $4.6m was used for dividends. So the 20% increase in dividends would put them at $5.52m in the next quarter, assuming the same number of shares. There is still a big puffer here, so the dividend should be safe, especially as Smith & Wesson's cash position is also more than adequate.
Cash and cash equivalents at 30 April 2023 stand at $53m and this, combined with future positive FCF, will be the main driver for returning capital to shareholders through buybacks and hopefully a lot of buybacks.
1. Reason: Smith & Wesson's Share Buybacks
Smith & Wesson's CAGR of shares outstanding is a whopping -12.53% from 3/3/20 to date. I do not think they can maintain this pace, but since the shares are cheap right now, I could definitely see them buying back shares aggressively once FCF is more normalized.
In the long term, I think it is safe to assume a 4% CAGR over the next 10 years due to share buybacks, which would result in a 1.48x multiple.
2. Reason: Multiple Expansion
Before the earnings and dividend hike and the subsequent 20% increase in the share price, the stock was trading at a single-digit P/E ratio, whereas it is now trading at a 16x multiple, which is not so cheap anymore.
Previously I would have said that a multiple expansion in the range of 2x was possible over a 10 year period from 8x to about where it is trading now. But we also have to keep in mind that normalized earnings should be higher than they are now, so the earnings multiple on a normalized basis should be closer to 10 times, which gives us the opportunity for some multiple expansion in the future in the neighborhood of 1.25 times.
3. Reason: SWBI Dividends
The dividend yield has increased in recent years due to falling share prices and also due to the continuous increase in dividends, and therefore I would say that the chances of dividends adding 2.5% annually to the total return of shareholders over the long term are good.
This would result in a 1.28x multiple for shareholders via dividends over the next 10 years.
Summary Of Drivers Of Shareholder Returns
The net income growth rate CAGR over the last 5 years is 12.87% , but this is likely to be high for the long term, so I would use a 5% CAGR as a conservative approach going forward.
This would lead us to the following assumptions:
- Earnings: 1.63x (5% annually)
- Multiple Expansion: 1.25x
- Share Buybacks: 1.48x (4% annually)
- Dividends: 1.28x (2% annually)
And the results would be the following 10-year return due to the powerful combination of several compounding factors: 1.63 x 1.25 x 1.48 x 1.28 = 3.86x or 14.46%
That's a return of almost 15% per year, without much earnings growth, and just by combining the above factors. And this is a conservative calculation, so the buybacks could be much more aggressive and the earnings growth could be higher.
Opportunities
A big advantage of Smith & Wesson is that it is relatively debt-free, so downside risk is very limited. However, as this is a very cyclical company and industry, it is always important to know where the company is in the cycle, as sometimes it is the right time to sell when earnings are at their peak. But now that earnings are near the bottom, it is time to buy and look forward to earnings growth in the other parts of the cycle.
The high barriers to entry in this industry also really help to protect earnings, and because of their capital structure, where they have a low cost of debt, they also have a wide spread between ROIC and WACC, which really helps them to generate cash that they can return to shareholders.
Smith & Wesson also invests in research and development and truly strives to be an innovation leader by regularly developing new products. Additionally, a big advantage for individual investors is that the company is relatively small and therefore has very little coverage and most hedge funds cannot own it because of the size of the company. So the interesting metrics are mostly known to people who like to dig or have seen an article about Smith & Wesson somewhere.
And aggressive share buybacks at attractive prices have been one of the best investments for shareholders, as evidenced by AutoZone ( AZO ) and Apple (AAPL). So, in my opinion, Smith & Wesson is a really attractive opportunity that could even return much more than I have calculated above.
Conclusion
The last time I wrote about Smith & Wesson was in March, and since then they have returned 26.25% to shareholders, while the S&P 500 has returned only 13.38% over the same period. And the outlook has not changed much, so I am still confident that they have a good chance of outperforming the S&P 500 over the long term. In fact, management has often indicated that returning cash to shareholders is a priority once the relocation is complete.
Last quarter also showed that they were able to maintain their leadership position in the industry, as they mentioned on the earnings call, and so here we have an investment in an industry with high barriers to entry that can generate significant ROIC and also has a strong brand and is shareholder friendly. So everything is in place to deliver total shareholder returns of 15%+ over the long term.
For further details see:
Smith & Wesson Brands: 3 Reasons That Speak For This Share In The Long Term