Why Smith & Wesson Will Likely Prosper Despite Any Gun Control Law

Smith & Wesson Holding Corp. (SWHC) shares are down some 15% in the aftermath of the school shooting in Connecticut, as investors fear restrictive firearms legislation will adversely impact long-term profitability. A dispassionate analysis of available evidence suggests the current valuation of the U.S.-based gun manufacturer is compelling – acknowledged emotional and social sensitivities aside.

On December 7, the Springfield, Mass.-based company reported better-than expected results for its fiscal second-quarter ending October: sales grew year-on-year 47.9% to $136.6 million and share-net of 24 cents beat consensus estimates by one penny. Citing strong growth across all product lines and gains from recent cost-cutting initiatives, management also raised its fiscal 2013 outlook. Given consensus analyst estimates of $1.02 per share, Smith & Wesson currently sells at a 40% discount to the PE ratios of both publicly-traded competitor Sturm Ruger (RGR) and the S&P 500 Index, as seen in a stock chart.

SWHC PE Ratio TTM Chart

SWHC PE Ratio TTM data by YCharts

As of October 31, the order backlog stood at $332.7 million, up 150% from the comparable quarter last year. Before the Sandy Hook school shooting, overall industry demand grew 21% in the first nine months of 2012, according to disclosures by the (mandatory) National Institute Criminal Background Check System.

Looking ahead, bookings are likely to soar, and here’s why: In the months leading up to import restrictions on several models of assault rifles in 1989, the enactment of the Brady Handgun Violence Prevention Act (mandatory federal background checks) and the 1994 Assault Weapons Ban (also signed by then President Bill Clinton), pre-ban prices and sales surged due to speculative stockpiling. History is repeating itself -- Fox News has reported that sales of the popular AR-15 (and similar high-capacity models) are surging – “through the roof,” to quote one gun store owner.

Human behavior as it is – and irrespective of one’s position on gun control – 2013 will likely be a very profitable year for Smith & Wesson shareholders. Nonetheless, given the headlining visibility and public disgust over the paroxysmal spate of massacres still fresh in our collective memory (from the 1999 shootings at Columbine High to the crazed gunman slaughtering moviegoers in Aurora, Colorado this past July), investors are fearful that emotional momentum could force Congress to work with President Obama and enact a meaningful ban on the sale of assault weapons – common parlance, “sporting rifles.”

In first-half, fiscal 2013, sales of sporting rifles grew 109.4% to $61.3 million. And this is what worries investors: Sporting rifles are likely to be targeted for a legislative ban. However, this category of firearms represents only about 18% of Smith & Wesson’s total sales, according to regulatory filings. Additionally, built into this market-share number are many sporting rifles that hold magazines with a capacity of just 10 rounds (which would likely stay “legal,” assuming Congress looks back to its prior definition of “assault weapon” under the 1994 law).

The recent decline in Smith & Wesson’s stock price, in my opinion, already reflects this worst-case scenario -- the total ban of assault weapons with large ammunition clips. Investors should note, however, that historically, the largest driver of growth at the company has resulted from the sale of handguns in the U.S. sporting goods market. Handguns and hunting rifles (mostly bolt-action) accounted for 55% and 8% of first-half fiscal 2013 firearms’ sales of $265 million. Of note, both categories posted stellar 37% year-on-year revenue gains, too.

SWHC Revenue Quarterly Chart

SWHC Revenue Quarterly data by YCharts

Though management doesn’t specifically break-out what percentage of sales is derived from high-capacity pistols, it’s probably on the order of 15% of total sales. Popular nine-millimeter or 40-caliber handgun models, capable of holding 15 (plus 1) rounds could be grandfathered. Even if banned, shareholders could view this as an opportunity – leveraging the 160-year old name of “Smith & Wesson,” management could easily grow its share of the domestic handgun market beyond the current 18% through redesign modifications, taking share from Austrian rival’s Glock brand.

Given political uncertainties revolving around gun control, it’s important for investors to ascertain any firearm manufacturer’s ability to assess the longer-term unknown from potentially restrictive legislation. Smith & Wesson’s balance sheet looks healthy: As of October 31, the company had $61.3 million in cash, $60 million in unused credit, minimal lease obligations, and a manageable debt burden, with only $9.5 million in notes payable maturing in the next three years.

SWHC Cash and Equivalents Chart

SWHC Cash and Equivalents data by YCharts

When the 103rd U.S. Congress passed gun control legislation back in 1994, the Democratic Party controlled both the Senate and the House. This time around, the Democrats have a majority only in the Senate. And, given the current level of partisanship, it’s highly improbable that political leverage exists for comprehensive gun control this time around.

David J. Phillips, a contributing editor at YCharts, is a former equity analyst. His journalism has appeared in Bloomberg BusinessWeek, Forbes, and Kiplinger's Personal Finance. From 2008 to 2011, David was a reporter for CBS News Interactive. He can be reached at editor@ycharts.com.

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