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Smith & Wesson: Begging For An LBO
Aug. 14, 2014 1:33 PM ET | 8 comments | About: Smith & Wesson Holding Corporation (SWHC)

Disclosure: The author is long SWHC. (More...)
Summary

The latest NICS numbers imply stronger handgun sales YoY offset by weaker rifle sales.
Smith & Wesson's recent issue of debt at 5% along with its repurchase of shares is lowering the company's cost of capital.
The current market valuation implies an EV/EBITDA multiple of 2.5.

Latest NICS Numbers

The latest FBI statistics on adjusted firearm background checks , the best predictor of gun sales were down 4.5% in July versus 2013, by far the best year on record. Nonetheless, the checks were higher than in 2012, a better comp for the longer term growth trend. The mix in terms of checks shifted in Smith & Wesson's (NASDAQ:SWHC) favor with a 4.5% increase in handgun checks versus a 17.5% decrease in long gun checks. The data from the most recent NICS release supports CEO James Debney's prediction of sustained 5% long-term industry growth. As the smaller player in the field, Smith & Wesson also stands to gain from market share capture, a new focus of the company.
Capitalization Adjustments

Over the past few years, as cash flow has rebounded off of a bad acquisition, Smith & Wesson has taken a number of steps which have led to a better-capitalized company. The first step the company took was a debt exchange about a year ago. In that exchange the company replaced 9.5% notes with 5.875% notes lowering the interest rate by a full 38%. At the same time the company authorized the repurchase of $100 million of shares. By October, the company had completed to repurchase and authorized the repurchase of an additional $15 million of shares. Considering the company's sub-$700 million market cap, these repurchases are significant.

At the end of March 2014 the company had exhausted its repurchase funds and authorized another $30 million of repurchases. Then, in July it placed another $75 million of notes paying just 5%. In the interim the company also purchased one of its component suppliers for $23 million, a move which will be accretive in the 2015 fiscal year, and which should boost gross margins above 40%. In just a year the company has reduced the number of shares on the market, made the company more efficient, and refinanced all of its debt at a favorable rate. The company even renegotiated its revolving credit facility at a low interest rate.
Valuation

Even after taking all these steps to form a better company, Smith & Wesson trades at a forward P/E of 8.8 and at a 4.3x EV/EBITDA ratio. With a 12.5% cash flow yield and consistent growth, the company remains one of the most attractively valued companies on the market. Over the past five years it has returned close to 20% on equity and 10% on assets annually. And still, about a third of the company's shares are sold short.

As Debney, the CEO, has mentioned, 5% industry growth is sustainable over the long term. With the culmination of a CapEx cycle this year, and the vertical integration of the supplier, 45% margins are attainable in the medium term.

At the current time, the company has a cost of equity of 17.9% and a weighted average cost of capital of 15%. Until the cost of equity dips below 6%, share repurchases will remain accretive.

Even assuming 11% market returns going forwards and an exit EV/EBITDA multiple of 4.25, the shares have an implied value of close to $19. Just to give you a view of how the share could be valued in the case of a LBO I included a 5-year modeled DCF valuation table. The top row represents an EV/EBITDA multiple and the left column are costs of capital.

Implied values:


2.25


3.25


4.25


5.25


6.25

13.0%


$ 13.72


$ 16.89


$ 20.06


$ 23.23


$ 26.41

14.0%


$ 13.29


$ 16.32


$ 19.36


$ 22.39


$ 25.43

15.0%


$ 12.88


$ 15.78


$ 18.69


$ 21.59


$ 24.50

16.0%


$ 12.48


$ 15.27


$ 18.05


$ 20.83


$ 23.61

17.0%


$ 12.11


$ 14.78


$ 17.44


$ 20.11


$ 22.77
The Case For An LBO

I strongly believe that if S&W's share price remains depressed they will either be bought out or take private. LBO sponsors look for a set of characteristics in a company, all of which S&W possesses. The company is small enough at under $1 billion of EV to be taken out by a single sponsor with under $300 million in capital necessary. It also produces steady free cash flow which can be used to pay off debt. With $175 million of debt outstanding, it would not be too difficult to pay off existing debt in order to reissue it once take private. The multiples are low enough for buyers to profit both from cost cutting and multiple expansion, providing a margin of safety for the buyer. And in terms of exiting there are plenty of potential buyers in the defense sector which could be interested in taking S&W under their arms.

LBO or not, investors are getting great value in S&W. Aside from growth overseas, the company has barely penetrated international markets and the defense sector. It commands a reputable brand and has a sustainable business model which will continue to create value for shareholders or acquirers over the long term.

http://seekingalpha.com/article/2423435-smith-and-wesson-begging-for-an-lbo?uprof=44