In this week's small-cap spotlight, we take a close look at Smith & Wesson (SWHC) . Shares were recently trading at $21.60, up 100% on the year, but does this gun manufacturer have more room to run or is it time to take some profits? Frank and Larsen take a closer look.
Curzio: Firing On All Cylinders
Shares of Smith & Wesson have been on a mind-bending tear lately, and most of the credit should go to management. In late 2004, Michael Golden stepped into the CEO role of a struggling company and just a few years later the handgun maker quickly transformed into a diversified growth machine.
Under his tenure, Smith & Wesson has been awarded contracts from the military, expanded its product base and has been active on the acquisition front. Some may argue most of this expansion is already reflected in the stock price, but I would argue that the company is in the early innings of a secular growth trend.
Starting with new products, Smith & Wesson entered the long-gun market in February 2006. This segment accounted for 13% of 2007 fiscal year sales and grew over 100% to $12.8 million from last year.
Also, the company expanded its presence in this segment with the purchase of hunting rifle manufacturer Thompson/Center Arms back in January. The hunting rifle market is estimated at $1.1 billion annually, and new products, including bolt-action rifles, are just beginning to arrive in retail outlets, which could add to revenue in the coming quarters.
Smith & Wesson's core handgun market provides a huge growth opportunity for the company. According to management, the company had a 98% market share of the U.S. law enforcement market over 20 years ago, and today, due to heavy competition, its share has reduced to just 10%. However, this trend seems to be reversing.
Its new military and police series of polymer pistols, which were introduced in April, are beginning to ramp and could help the company gain back market share in the law enforcement segment. This lightweight, high-firepower handgun with an interchangeable grip is now the gun of choice for 231 U.S. law enforcement agencies.
To put this in perspective, there are more than 17,000 police departments in the U.S., excluding federal agencies, giving Smith & Wesson huge growth potential. Management is fully aware of the products potential and said other departments are in test phases. This is great news considering that the pistol has an 80%-plus win rate when tested by law enforcement agencies.
On the military front, the U.S. Air Force is testing new pistols to replace its existing 9 millimeter with a more powerful 45 caliber pistol. Smith & Wesson is currently competing with several competitors for this contract that analysts estimate to be worth up to $500 million.
Smith & Wesson has recently won contracts from the U.S. government to supply the Afghanistan military with guns. Also, management believes its military and police 45-caliber pistol is more customized -- based on safety and performance improvements -- over its competitors. The contract could be awarded as soon as next year and an outright win will likely push shares significantly higher.
Based on valuation, Smith & Wesson is a little expensive. Shares are trading at 29 times next year's earnings, which is higher than its peers, but earnings are expected to increase 25% annually over the next three years, according to Capital IQ. Also, its debt-to-capital ratio is 65%, which is relatively high compared to the industry.
But I believe the high premium is warranted. Smith & Wesson is in its early growth stage, and we could see shares appreciate another 25% from the current level. Given the numerous catalysts that lie ahead, it's just too early to take profits in this stock.
Larsen: Don't Count Out the Competition
I knew Smith & Wesson was doing well, but when I saw the three-year chart for the stock I was nearly floored. Exactly three years ago, Smith & Wesson shares closed at $1.58. With no dividend and no splits (normal or reverse), Wednesday's close at $21.60 means that shares are up almost 1,300% in that time. While that performance is amazing, it doesn't necessarily mean that shares are overvalued. Investors need to look at why the stock has come so far, and what catalysts lie ahead that could drive shares to new highs.
As Frank mentioned, management has done a fine job of pushing the company into new areas. Smith & Wesson was traditionally the king of the revolver market, which is far from being a major area of growth for a maker of firearms. But over the last five years, the company has placed more emphasis on the pistol market, boosting its revenue in this area to 43% from 27%. The company also has retained its position as No. 1 in the U.S. revolver market, despite sales in this area falling to 27% of revenue recently from 42% in 2002.
Why are pistols so important to Smith & Wesson now? Quite simply, it's because the market leaders in handguns for U.S. law enforcement and the U.S. military are the Glock 22 and the Beretta M9 9mm, respectively. Smith & Wesson is giving both of these classic models a run for their money with the military and police series of pistols that Frank mentioned earlier.
The problem that I see with getting into Smith & Wesson now is that the gun market is a competitive scene. Traditionally, one model would overtake another model and remain in place for decades -- much as Glock overtook Smith & Wesson in the early 1980s.
Judging by its share performance and the comments of analysts, you would think that Smith & Wesson was turning the gun market into a monopoly. But many police officers have a choice of weapon today, making it much less likely that any one model will hold a truly dominant position in market share.
Meanwhile, the rapid rise of Smith & Wesson was most probably surprising to
(both European companies), but it would be foolish to not anticipate product improvements as well as additional sales force and initiatives from these two companies in the near future.
Smith & Wesson won a total of four U.S. government orders over the past two years to supply the Afghanistan military. Frank also mentioned the upcoming Air Force contract that Smith & Wesson is poised to win with its .45 caliber military and police model. Both of these points illustrate the company's momentum in the military channel, and I would say that investors already have very high expectations for this area of Smith & Wesson's business.
I believe a lot of the bullish news and upcoming catalysts are already priced into shares of Smith & Wesson. Meanwhile, the majority of the company's sales are still generated by the sporting goods channel, which posted an impressive 34% rise in sales last year. I see little reason to bet on any dramatic increase in handgun demand from retail consumers, and the number of hunters in the U.S. has been in a long-term secular decline, making Smith & Wesson's foray into rifles less than appealing.
In the end, shares of Smith & Wesson will be heavily linked to continuing momentum in the police and military areas. Winning the Air Force deal would be a major event, but I'm interested to see how much shares would move following the news, based on the fact that the win is somewhat expected. And although the company has executed very well in recent years, investors should keep an eye out for renewed competitive pressure from Beretta and Glock, as well as other competitors like
Heckler & Koch
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