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.
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.
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 Glock and Beretta (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 SIG Sauer and Heckler & Koch. Want to hear the guys' take on your favorite small-cap? Email