Buy, Sell or Hold: Now Is the Time To Target Smith & Wesson

When it comes to the firearms industry, throw out everything you know about investing.

In this industry, sales, cash flows, margins, 50-day moving averages and volume indicators just don't seem to matter.

When the Second Amendment is involved, high emotional responses are on full display.

So why should it be any different when it comes to a legendary firearms maker like Smith & Wesson (Nasdaq: SWHC)?

But old habits die hard, so before I go into what is truly driving the share price of Smith & Wesson, I can't possibly skip the boring stuff.

With gun sales going through the roof, let's take a look at whether or not this company has enough firepower to be part of your portfolio.

Fundamentals Shoot Up While Technicals Aim Down

This is actually the easy part...

In fact, try to find fault with the blowout numbers the company reported in its most recent quarter:

  • Net sales of $136.2 million, an increase of 38.8% from the year earlier.
  • Gross profit margin of 36.8% versus 30.6% one year ago.
  • Income of $17.5 million, or $0.26 per diluted share, versus income of $5.4 million, or $0.08 one year ago. That's more than triple!
  • Free cash flow of $20.4 million in the quarter.
  • 2013 guidance for gun sales raised to between $575 million - $580 million (up 40% year-over-year).

And although the stock currently offers no dividend, Smith & Wesson does return value to shareholders through share buybacks. The company purchased $20 million of its own stock in December and an additional $15 million by the end of the fiscal year in June.

Suffice it to say, these fundamentals have handily beat Wall Street's expectations. And you would think that such great results would drive the stock price to new highs and make Smith & Wesson the darling of fund managers.

But one look at the chart would tell you that's not the case.

Since the latest quarterly earnings report in early March the stock has dropped about 11%.

Source: Google Finance

Admittedly, in anticipation of those earnings, the share price did manage to break above the 50-day and 200-day simple moving averages. But soon after, a "sell-the-news" wave took effect and the share price couldn't hold above those levels.

As a potential buyer, that's a red flag to me.

In fact, usually I would like to see the share price move above those technical levels (approximately around $9.50) and establish a bit of a base before I'd be willing to buy.

But in the case of Smith & Wesson, I'm actually willing to "bite the bullet" and be a BUYER of this one rather than miss out on a nearly 10% up-move to those levels. Of course, a more conservative approach would be to purchase half a position now and add another half when the smoke has cleared.

Here's why I don't think I'm jumping the gun on this one.

Politics Drives Demand

When it comes to gun sales these days, the 2nd Amendment debate is never far behind. Back and forth -- the discussions never end.

In the meantime, whenever this issue is on the front page and legislation is on the table in Congress and in local governments, the demand for guns spikes.

Smith & Wesson and its main competitor, Sturm Ruger (NYSE: RGR), have now seen demand skyrocket to the point where Strum Ruger had to stop taking new orders because they couldn't keep up with demand, and both companies have missed out on sales because they couldn't produce the firearms quickly enough.

In the most recent quarter, Smith & Wesson's backlog was at an astonishing $667.8 million -- 43% higher than a year ago. Although quite a spectacular number, it is unknown how much of it will translate to sales. The truth is, the company may still not be able to crank out the firearms fast enough. Or worse, the orders from their distributors may be inflated and taper off once cooler heads prevail.

So, now we have to ask ourselves a few questions and make some educated guesses on how this will all shake out.

First, how likely is it that there will be a ban on certain types of firearms?

The short answer is: Very unlikely despite what you read in the news.

In fact, just last week the Senate voted down the background check expansion amendment to the gun bill, which means that any serious changes to the gun laws from the federal government are actually quite slim.

The only hope for the larger piece of legislation to survive now is if Senate Majority Leader Harry Reid, D-NV, introduces new amendments in the future - a very doubtful scenario.

Second, what would happen to Smith & Wesson sales if certain guns were banned?

The conventional line of thinking (and what is most likely hindering the stock price) is that if guns are banned, Smith & Wesson sales will crater.

But I completely disagree with that assessment.

Here's why.

If restrictions on the sale of certain guns were put into place, they would more than likely be focused on the semi-automatic class, like the AR-15, which accounts for 20% of Smith & Wesson's overall sales.

This 20% may sound dramatic, but the company is experienced enough to adapt to any new laws. For instance, it already has rifles for sale that are compliant to the stricter California laws. Plus, Smith & Wesson is making headway into procuring more Military and Law Enforcement contracts.

In the meantime, let's not forget the molasses-like way the government operates. To get any possible new laws on the books takes time - time enough to plow through all the pent-up and ongoing consumer demand.

Next you have to ask yourself, how long can the gun-buying frenzy continue?

According to data from the National Shooting Sports Foundation, the number of FBI background checks through the National Instant Criminal Background Check System (Adjusted) is not slowing down. In March there were 1,501,730 background checks, up from 1,189,152 in March of 2012 - an increase of 26.3%. This is the 34th straight month that the figures have increased from the same month the year prior.

That's just part of long-term trend of new gun buyers that is still on an upward slope. It can easily be argued that the "American gun culture" is growing instead of declining.

And one little-known tidbit is that there is a new super-macho class of buyers out there - women. In fact, both Smith & Wesson and Strum Ruger are increasingly focusing marketing efforts toward women and developing new designs and accessories that may be more appealing to them.

To sum it all up, Smith & Wesson is operating within the best of both worlds at the moment.

If there are future gun restrictions and the gun-buying passion continues, Smith & Wesson is a BUY because the fear that a ban will cripple the company's business in the long-term is exaggerated.

And if there is no gun ban and business returns to usual, Smith & Wesson is still a BUY because the huge cloud hanging over it and its share price will slowly dissipate.

That makes Smith & Wesson a juicy target right now for investors.

[Editor's Note: If you have a stock you would like to see us analyze in a future issue, leave us a note in the comments below and we'll add it to our list.]

About the Author: David Mamos brings nearly 15 years of analytical experience to the table with a background ranging from big-picture fundamental analysis to highly technical trading decisions. He began his career working as a financial advisor with Royal Alliance in 2001 and helped clients with portfolio management as well as buy-sell decisions before transitioning to the development, implementation and execution of trading strategies for aggressive investors.

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