Summary

• Shares are down 60% from their highs.
• Considering the company's net cash position and consistent profitability, this is far too low.
• Enterprise Value to normalized estimated free cash flow is now under 8.

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The Company

Smith & Wesson (NASDAQ:SWBI) is one of the most recognized brands in the world, allowing the company to compete effectively as part of an oligopoly of gun manufacturers. The proof is in the financials, as while there is some cyclicality in revenues, the gun manufacturers generally generate excellent average returns on capital through the cycle.

The company sells its firearms (and related products) to military, law enforcement and individuals both through dealers as well as directly.

Recent Bubble

Last year, high demand and low supply caused dramatic increases in the shares of gun manufacturers. For example, Smith & Wesson saw its share price rise some 400% from its COVID lows as manufacturers were able to raise prices and sell everything they had.

As one might expect, manufacturers increased capacity and purchases subsided, causing the industry balance to tip towards oversupply. Share prices crashed back down. For example, shares of Smith & Wesson are down 60% from their highs, as dealers work through elevated inventories, causing Smith & Wesson sales to be down some 32% year-over-year in its most recent quarter.

Flexible Cost Structure

Sometimes, when an industry goes through a bubble, there is a tendency for individual companies to lever up in order to expand. It's hard to look past the short-term, so it feels like the good times will last forever. And if you don't expand, less conservative competitors will eat your market share.

In Smith & Wesson's case, management seems wise to this phenomenon and has, therefore, implemented a system to deal with it. The company has set up the outsourcing of some of its manufacturing in order to deal with situations where its own manufacturing is at high utilization.

In this way, it can ramp up production quickly when it needs to, and avoid losing market share when times are good. At the same time, it doesn't need to lever up in order to grow, keeping the balance sheet stable. When industry conditions return to normal, as they inevitably eventually do, they are not left with huge overcapacity and a ruined income statement either.

As a result, Smith & Wesson remains profitable even though sales are down 32% year over year. It was also able to transform its balance sheet by taking advantage of last year's strong industry conditions. The company flipped from a net debt position to a net cash position, with cash of over $100 million on its $630 million market cap.

Capital Allocation

The company's balance sheet is in pristine shape even though the company has also been dramatically reducing its share count. Outstanding shares have fallen from 55 million a couple of years ago to just 45 million today.

Based on comments on the company's most recent conference call, if the share price remains at this level, more share repurchases seem likely in August when the company is once again permitted to do so. In the meantime, the company pays a small dividend equivalent to a 2% yield at today's price.

Smith & Wesson Valuation

Based on comments in its latest conference call, management appears to expect annual free cash flow of around $75 million. I'm inclined to think this is conservative, as the company has averaged more than this over the last several years.

With the company's enterprise value at $570 million, this equates to an EV/FCF of less than 8. Considering the competitive position the company finds itself in (a recognized brand in an industry characterized by an oligopoly), this is far too cheap. A ratio of around 12 or 13 would result in a share price on the order of 50% higher than its current price.

The reason for the low valuation appears to be the continued popping of last year's bubble. As dealers work through their inventories, manufacturers are likely to continue to experience year-over-year declines in sales. But when industry conditions eventually return to normal, valuations should normalize as well.

Risks

In this industry, there is always the risk of regulatory action. As tragic school and other shootings continue to prematurely end the lives of children and other innocent victims, federal regulations that outright ban gun sales to the public are the biggest risk to this company.

Considering the electoral advantages given to rural areas in the makeup of the US Senate (2 senators per state, no matter how small the state), however, this seems very unlikely. If compromise at the federal level is at all possible, a requirement of stricter background checks or higher age limits seems more likely.

In addition, statewide regulations (especially in states that already have strong regulations) may continue to firm up.

But these risks cause somewhat counter-intuitive behavior among gun customers. When the risk of regulatory action is high, gun sales tend to rise. Since nationwide legislation on this issue is difficult to pass, this often results in gun companies actually benefiting from higher sales when regulatory risk is at its highest.

Conclusion

Smith & Wesson is a great brand with a flexible cost structure that is part of an oligopoly. Its EV/FCF multiple of 8 is far too low considering these factors along with its history of profitability and willingness to return capital to shareholders in the form of share buybacks.