2023-03-11 05:00:32 ET
Summary
- In a market dominated by a handful of companies, Smith & Wesson has a strong position.
- They are very efficient in their use of capital and invest for the long term, which can lead to astonishing returns for shareholders.
- As a result of the fall in share prices as earnings have returned to more normal levels, you can now buy shares at a good price.
Thesis
There are some investors for whom it is worth checking their 13F filings to see if they have added a new company. Norbert Lou is one of them, as he has an incredible long term track record and a very concentrated portfolio with only a single digit number of holdings. If you are interested in the investment approach of one of the best investors of our generation, check out this 2011 interview with him.
And here you can see that he started building a position in Smith & Wesson ( SWBI ) in Q2 2022 and added to it in Q3 2022. This made me curious as to why he started this position and so I started looking at Smith & Wesson.
They operate in a highly regulated industry with high barriers to entry for new competitors, and they also have a competitive advantage because of their brand. They are also in a cyclical industry that has seen record sales during the COVID crisis + the social unrests in summer 2020. However, the decline in sales was quite dramatic and the share price fell as a result.
As a result of this fall, I think it could be argued that the shares are at a good price to build a position for the long term. Let me explain this in more detail in the next few chapters.
Analysis
If you compare the third quarter figures with those of the previous year, it would look like a really bad quarter, because sales and operating income were down sharply. But the last few years have not been normal, sales have gone up far too much because people were afraid. So the best comparison should be with the pre-pandemic years , and if you use them as a benchmark, they increased sales by 1.3% and improved the margin by 440 points. This is largely due to lower operating costs and higher ASPs. They also said on the earnings call that recent product launches had exceeded their expectations and that inventories were starting to come down. The company should therefore be in a better position than it was one quarter ago.
They also declared a quarterly dividend of $0.10 , payable on March 30th. So all in all, if you compare the latest figures with the 'normal' figures before the pandemic, Smith and Wesson is still a growing company, with some headwinds due to the relocation of its headquarters, but with all the tools in place to start returning cash to shareholders at the end of 2023.
As you can see from the chart above, revenues look like those of a company in a cyclical industry. In times of fear, people tend to buy more guns to feel safe. And as we saw with oil companies last year, if you buy these companies when revenues are depressed, you stand a good chance of making a nice return when they are back in favor. There is a long list of possible catalysts that could cause gun sales to rise again.
In the following you will see some graphs that might look outdated by they are based on the most recent publication from the Bureau of Alcohol, Tobacco, Firearms and Explosives from the 5/5/2022.
The Conversation, Bureau of Alcohol, Tobacco, Firearms, and Explosives
Smith & Wesson is the clear market leader in the pistol segment and has strengthened its position by meeting customer demand during the historic sales surge. Furthermore, in their 2022 annual report , they stated that they were profitable in 2022 even after demand declined, proving that they allocate capital efficiently to deliver good returns in any environment.
The Conversation, Bureau of Alcohol, Tobacco, Firearms, and Explosives
In this somewhat smaller market segment, there are 3 dominant companies and they are in third place.
The Conversation, Bureau of Alcohol, Tobacco, Firearms, and Explosives
In its latest annual report, Smith & Wesson said its 2021 market share was around 17% for handguns and 12,7% for long guns, and that the firearms manufacturing industry grew at a CAGR of 3,4% between 2015 and 2020. International sales represented only 2-4% of net sales. The main market is the US, and the forecast for global gun sales is a CAGR of 6.15% to 2027.
Small Arms Survey 2017 / Washington Post
This graph illustrates why the US is the largest market. There is now real competition in the number of firearms per 100 people. The United States alone accounts for almost 50 per cent of all firearms in the world held by civilians . And it is in such a market that Smith & Wesson is the market leader. For gun enthusiasts, the brand is really important. Names like Smith & Wesson, Sturm, Ruger, Glock and Sig Sauer are almost household words in the US. The major players in the market are also almost all based in the US. Only Beretta from Italy and Heckler & Koch from Germany are household names from Europe. Smith & Wesson, Sig Sauer and Sturm, Ruger account for 58% of all guns manufactured in the US. The surge in demand has added almost 10 million new customers and, with studies showing that most gun owners own 7-8 firearms , this should lead to an upward trend in sales over the next few years. Nevertheless, investors should expect margins to deteriorate in the coming quarters and perhaps even FCF to be negative, which could further depress the share price, but better entry points should favor long-term investors. The headquarters + operations relocation, which the company detailed in its 2022 annual report and last earnings call, is a cash drain, but once it's over, the company can start returning cash to shareholders.
An aggressive share buy-back program has significantly reduced the number of shares outstanding in recent years. We do not expect this to continue in the near future. But once the relocation is complete, they have said they will start returning excess cash to shareholders again.
Capital Allocation
Return on capital and return on equity are both in the 20%+ range over a 5-year period. So they allocate their capital efficiently and in normal times they have plenty of cash to reinvest or return to shareholders.
With a GAAP P/E of around ~6 and an EV/EBIT of ~4.5 , you are paying a reasonable price. Coupled with a cash position of around $44 million and low outstanding debt, you have a strong balance sheet. Once the move is complete, the balance sheet should become even stronger.
Risks
Federal and state laws are a risk factor. So they moved their headquarters to Tennessee. The laws in Massachusetts could have prevented them from making certain types of guns in the future. It was a necessary move to secure the company's future, and they plan to have the new facility ready by the summer of 2023. In the Q2 2023 earnings call they said that normalized cash would be $30 to $40 million higher than with the relocation costs. But all in all, the 2nd amendment should prevent a total ban on guns. Strangely, the stricter laws seem to benefit gun manufacturers. They make it harder for competitors to enter the market, and gun sales increase when the risk of regulatory intervention is strong. There are parallels with the cigarette industry, where shareholders have also benefited from legislation over the past 40 years.
Conclusion
All in all, in Smith & Wesson you have a company that can allocate capital efficiently, which you can buy cheaply, combined with a strong brand and a market that protects it from new competitors. In addition, they have aggressively reduced their share count in recent years and take a long-term view of their business.
For further details see:
Smith & Wesson Brands: Strong Brand Coupled With Good Capital Allocation Skills