smith and wesson holding corporation (swhc) … and wesson holding corporation (swhc) memo )))

Smith and Wesson Holding Corporation (SWHC) Memo

Important Company Financial Data 28 February Share Price: $9.34 Trailing PE: 11.3 EPS: 0.83 Market Cap: 619.48 M Forward PE: 9.37 Beta: 1.19 52 Week Range: $5.11-‐11.25 PEG: 0.29 Short % of Float: 24.3% 2012 Revenue: $500.52 M EV/EBITDA: 5.50 % Held by Insiders: 2.14%

Important Dates: December 14: Newtown Shooting January 15: New York State passes sweeping gun control legislation January 24: Municipal Employees Annuity and Benefit Fund (Chicago) Divests Febrary 15: New York City Teachers Retirment System Divests February 19: California Public Employment Retirement System Divests Thesis / Key Points

Ø X The demand for firearms in the U.S. is highly inelastic. Symbolizing individualism and self-‐sufficiency for a large portion of the population, guns are rooted in American values. For many, they represent a way of life. Katarzyna Celinska of the Pacific Sociological Association writes that the traits of a typical gun owner-‐ White, male, protestant, middle class and Republican, are also associated with individualism. As a result, changes in price or legal opposition are unlikely to impact the demand for guns as significantly as other goods. The firearms industry has a core customer base that is not going away.

Ø X Smith and Wesson has leveraged its brand name to capture market share and develop monopolistic pricing capabilities. Founded in 1852, Smith and Wesson has manufactured firearms and accessories for 160 years. During this time, it has attracted a loyal customer base and become the U.S market leader in firearms. According to SWHC’s February investor presentation, in a survey of current firearm owners and those that plan to buy a firearm within the next 12 months, the Smith and Wesson brand had a 92% aided awareness. This means that when offered a list of brands in the gun manufacturing industry, 92% of respondents were able to identify Smith and Wesson.

Ø X Smith and Wesson hedges risk by developing an innovative product portfolio with diverse sales sources. Smith and Wesson’s product portfolio includes revolvers, polymer pistols, metal pistols, concealed carry pistols, bolt action rifles, black powder rifles and modern sporting rifles. It targets both the consumer sector (sporting goods, hunting, personal protection) and the professional sector (international, law enforcement, government, military). This diversification hedges risk; decreased sales for one specific product or sub-‐section of the market will not have as large of an impact on total revenue.

Ø X Smith and Wesson has an experienced leadership team capable of driving both top line and bottom line growth. James Debney, CEO and President, has more than 20 years of experience in multi-‐national consumer and business to business environments. From 2006 to 2009, he served as President of Presto Products, a $500 million plastics extrusion business. Since taking over as CEO of SWHC in September of 2011, the stock price has appreciated 264%. Moreover, Debney has made some smart moves during his time as CEO. For example, SWHC donates a substantial amount of money to veterans returning from war. Moreover, he chose to pull SWHC from a gun show that didn’t want to display assault rifles, a move that fired up his customer base. Additionally, Debney has an experienced supporting cast. Jeffrey Buchanan, CFO and EVP, has more than 25 years of experience in financial management and law. Vice Presidents Mario Pasantes, Mark Smith, Robert Cicero and Mike

Name: Nikhil Khanna College/School: UVA/CLAS Year: 1st

Smith and Wesson Holding Corporation (SWHC) Memo Brown all have experience at major companies including Alcoa, Coca-‐Cola, and KPMG.

Ø X Insiders are buying shares of Smith and Wesson. On Dec. 11, Director John Furman bought $20,000 worth of shares for $9.78 per share, and, one day later, President and CEO James Debney bought $50,000 worth of shares for $9.76 per share. These share prices are significantly higher than the current share price of $9.34 per share. This means that from a purely fundamental perspective, insiders believe that the company is undervalued at about $9.78 per share, suggesting that at $9.34 per share, the company is very undervalued. Since the Newtown shooting on December 14, there has been no fundamental change within the company; if anything, the contention over gun regulation has and will continue to cause buying frenzies that drive up earning and make the stock even more undervalued at current prices (see market misperceptions).

Ø X Smith and Wesson repurchased shares worth 20 M in December, and has authorized an incremental 15 M to be repurchased before June, 2013. Smith and Wesson is a cash-‐rich company that is using some of that cash to buy back shares of common stock. On December 6, 2012, it released a press release, explaining that its board of directors approved a program to buy back 20 M worth of shares. On December 27, 2012, it released another press release, explaining that it subsequently repurchased all 20 M, and has authorized an additional 15 M for common stock repurchases through June 30, 2013. It explained that, “the amount and timing of any repurchases will depend on a number of factors, including price, trading volume, general market conditions, legal requirements, and other factors.” This means that if the stock begins to trade lower, SWHC will use some of the 15 M to buy common stock and buoy the price. This hedges against downside risk.

Ø X Demographic shifts will increase proposals for gun regulation, which will drive SWHC sales growth. The strongest recent factor increasing civilian demand for guns is the fear of regulation and outright ban of certain types of guns. City-‐dwellers, who tend not to have a relationship with guns, support regulation of the industry. Individuals that live in more rural areas are more likely to have a relationship with guns, and are thus more likely to oppose regulation. According to the U.S. census, in 2010, a total of 80.7% of Americans lived in urban areas, up from 79% in 2000. Conversely, 19.3% of the U.S. population lived in rural areas in 2010, down from 21% in 2000. At the same time, the population of urban areas grew by 12.1%, much faster than the country's growth rate of 9.7% from 2000 to 2010. As more and more of the population shifts to urban areas, they will elect leaders that are more likely to bring the gun debate to the center of the political stage. This will augment fear of bans and spur buying frenzies, which will drive up earnings for SWHC. It is important to note that there is a dichotomy between the fear of regulation and the actual passage of regulation. Fear causes buying frenzies; passage of regulation limits buying altogether. I believe that demographic shifts will merely heighten the contentiousness of the debate over guns and the vigor with which each side argues. It is highly unlikely, however, that any meaningful regulation will be passed in the near future (see market misperceptions).

Ø More women are buying guns. One major demographic trend in the U.S. is that more women are leaving their traditional role in the home and becoming more independent. More so than ever before, women today are more likely to obtain higher education and enter the labor force. This independent, self-‐sufficient attitude is translating into higher gun sales among the women demographic. According to CBS News, the national total for female gun owners has doubled over the last decade, increasing to nearly 5 million women since 2001. According to a report by the National Shooting Sports Foundation, 80% of female gun owners purchased firearms for self-‐defense., 35% for target practice, and 24% for hunting (the categorical variables are not disjoint). Lately, gun sales for women have accelerated at an even higher rate. A Gallup study conducted in October, 2011 found that since the beginning of 2010, gun ownership among women has increased from 33% to 43%, which is a 30.3% increase. This demographic trend will boost Smith and Wesson’s sales.

Ø X On February 27, Sturm Ruger & Co., another firearms manufacturer, announced outstanding EPS and revenue growth. Adjusted earnings per share increased 26.58% to $1.00 in the quarter versus EPS of $0.79 in the year-‐earlier quarter. Revenue rose 52.05% to 141.77 million from the year-‐earlier quarter. By that measure, the company beat the mean analyst estimate of $0.94 for EPS and beat the average revenue estimate of 124 million. Since SWHC benefits from the same political tailwinds as RGR, it is likely that SWHC will report stellar growth as well when it releases earnings on March 5. It will be important to buy SWHC ahead of March 5 to reap the profit from a stock spike due to earnings.

Ø X Smith and Wesson is in a position to benefit from a short squeeze. Smith and Wesson is a highly shorted company, with short percent of float at 24.30%. If any of the market misperceptions are corrected and the share price rises, investors that are short SWHC will begin to cover their positions by buying shares. This increased demand for the stock will cause the share price to surge even more. MII can ride this wave.

Ø X Gun sales benefit from positive feedback. As more and more people buy guns, others feel the need to also buy guns to protect themselves. Chaudhri and Geanakoplos of Yale University write, “It seems like a reasonable conjecture that if one were to poll the members of gangs around the United States, they would favor a situation in which no gang had guns (this would likely raise the life expectancy of gang members). Clearly then, there is an externality effect on the demand for guns. That is, as more people have guns, the demand for guns increases (not only among gang members, but presumably, the perception of the need for protection amongst the general public increases).” This negative externality has an “arms-‐race” implication that drive up demand for guns, boosting Smith and Wesson’s earnings. Buying frenzies have positive feedback that can persist well after the buying frenzy ends.

Smith and Wesson Holding Corporation (SWHC) Memo Misperceptions

Ø X Obama’s gun legislation will pass and will significantly harm SWHC’s earnings. In the wake of the Newtown shootings, much attention has been brought to President Obama’s attempt to regulate the gun industry. His three main proposals are a ban on assault weapons, a limit on high capacity magazines, and an extension of universal background checks. Prior to the Newtown shootings on December 14, SWHC was trading at $10.85 per share. I believe that the main reason that the stock is trading at only $9.34 per share is fear over this regulation. Yet this fear is misguided. Obama’s first two proposals (assault weapons ban and magazine capacity limit) will not pass both chambers of Congress. The House is controlled by Republicans. Most Republicans in the House of Representatives have top rankings from the National Rifle Association. Moreover, many Democrats in the House, particularly from the conservative south and rural west, are vocal supporters of gun rights. Even in the Senate, where Democrats control the chamber, Democratic leadership sources told CNN that passing any new legislation will be extremely difficult. More than a dozen vulnerable Democrats from conservative states will likely resist much of what the president is pushing. Even Harry Reid, the Senate majority leader, does not support the assault rifle ban and limit on magazine capacity, stating that a vote on these two proposals will be “largely symbolic.” The third proposal, universal background checks, will simply limit the secondary market for guns. Rather than buy through an intermediary, consumers will have to buy from a federally accredited retailer. Law abiding citizens, who make up almost all of SWHC’s market, will not be affected by this. Universal background checks are vehemently opposed by the NRA, but even if this measure does pass, it will not impact SWHC’s earnings in any significant way.

Ø X States are imposing stringent regulations on gun owners. Since December 14, state regulation of the gun industry has received a lot of attention. Specifically, New York state enacted the nation’s toughest gun restrictions on January 15. The measure, which received a ton of media attention, includes an expanded assault weapons ban, restrictions on ammunition magazines to seven rounds, and extensive background checks that even include the purchase of bullets. Other highly monitored state efforts to restrict the gun industry include Rahm Emmanual’s attempt to restrict the sale of assault weapons in Illinois and Jay Inslee’s attempt to do the same in Washington state. In addition to federal regulation, I believe that fear over state regulation is contributing to SWHC’s low share price. Contrary to popular belief, however, the impact of state legislation is more ambiguous. While 19 states have Democrat-‐controlled legislatures, 26 have Republican-‐controlled legislatures. In the other five states, no party has control over the legislature. States with Democrat-‐controlled legislatures have issued 35,168 gun licenses. States with Republican-‐controlled legislatures have issued 71,099 gun licenses. This means that more than 2/3 (when you include the five states where partisan bickering will yield no comprehensive gun regulation) of all gun owners will be unaffected by state gun regulation. Of the less than 1/3 that reside in states with Democrat-‐controlled legislatures, it is still unlikely that an assault weapons ban will be passed because many moderate Democrats are pro-‐gun. And even if an assault weapons ban passes, it will only affect one of SWHC’s products in its diverse product portfolio, and thus won’t hurt the company as much as people believe (see my third thesis point). Moreover, many states with Republican-‐controlled legislatures are trying to pass legislation that requires school teachers to carry guns to protect their students. Specifically, Alabama, Georgia, Mississippi, Arizona, Missouri, North Carolina, South Carolina, Tennessee and Texas have introduced measures to either allow school teachers to carry guns or to increase the number of police officers in schools. All of these measures will increase demand for guns, which will boost SWHC earnings. Lastly, eight states have already exempted themselves from federal gun regulation, and twenty-‐one other states have introduced similar measures. This means that even if federal regulation of assault weapons somehow passes, state law may prevent it from being enforced. This hedges against the downside risk of federal regulation.

Ø X Recent drops in share price represent fundamental, internal problems with Smith and Wesson. In addition to fears over regulation, a major reason that Smith and Wesson is trading lower is that many institutional investors, including state pension funds, have divested. Specifically, the Municipal Employees Annuity and Benefit Fund (Chicago), New York City Teachers Retirment System, and California Public Employment Retirement System have divested of all positions in gun stocks, citing “moral” reasons. Since stock prices represent the present value of future earnings streams, divestment for “moral reasons” will cause SWHC to become undervalued because it will trade lower despite no change in future earnings streams. Many instiutional investors do not want to own SWHC because they need to maintain an amiable public image, not because there is anything wrong with the company. This will create a great buying oppurtunity.

Ø X The gun bubble will pop soon. Seeking Alpha author Larry Trefz published an article on February 6, 2013, warning investors of the “Great American Gun Bubble.” The crux of his argument was that the current gun frenzy is unsustainable, and that eventually, people will be unable to buy more guns, even in the face of heightened threats of bans. He specifically cited low, per capita annual income in rural America, which has the largest gun-‐buying demographic, as well as rising taxes, gas prices, and house/rent prices. There are several problems with this argument. First, the author assumes that Smith and Wesson’s AR-‐15, which costs about $1500, is most popular in rural America just because it is gaining popularity in the U.S. as a whole. This is simply not true; handguns are most popular in rural America. Even if it were true, rural Americans that couldn’t afford the AR-‐15 would buy the more affordable handgun, which would still boost SWHC’s sales. The second problem with the argument is that the author does not account for cost of living differences. Just because annual per capita income is lower in rural America does not mean that rural Americans necessarily can buy less. Prices are lower as well. Even if guns have standardized prices, other goods are cheaper for rural Americans, meaning that they can devote more disposable income to firearms. Third, refer to my first thesis point that demand for guns is largely inelastic. Guns represent a way of life rooted in American values. At the very least, people will be reluctant to give up guns even as they become more expensive (relative to income.) Fourth and most

Smith and Wesson Holding Corporation (SWHC) Memo convincingly, handgun and long gun sales for Smith and Wesson have been steadily rising since 2006, even during the recession, when per capita income for rural Americans was falling. As the economy recovers, even in the face of rising prices, rural real income will rise (or it at least won’t fall at the rate it did during the recession). Claiming that a gun bubble will pop “soon” is absolutely arbitrary. It hasn’t popped for the last seven years; there is no reason it will pop in the next couple of months, especially since rural income is rising.

VAR

Ø For my first part of VAR, I wanted to gain a better understanding of Smith and Wesson’s brand equity. I considered conducting a survey of UVA students and their opinions of Smith and Wesson, but I felt that since the survey conducted by Smith and Wesson that tested aided awareness had a larger and more randomized sample (my survey would suffer from more voluntary or nonresponse bias), Smith and Wesson’s survey should be sufficient. I have been perusing gun forums online and the consensus seems to be that Smith and Wesson is the gold standard, both in terms of reliability and features.

Ø I think that my most conclusive VAR will come from talking to representatives of SWHC. Consequently, I have left several messages for the investor relations department in the last two weeks, but still have not heard back. I want to specifically ask them about the police force potentially replacing the M9 pistol with SWHC’s M&P product. I also want to discuss a potential acquisition of parts of Freedom Group next year, another firearms manufacturer. Due to recent pension fund divestment, I think that the investor relations department has their hands full. I wanted to get this memo out well before the March 5 earnings release, and I will provide VAR to the MII managers as soon as I hear back from the investor relations department.

How It Plays Out

Ø When 3rd quarter financial results are released on March 5, EPS will be well above estimates, and the stock price will rise. This seems to be the consensus of every article I’ve read on rifle and ammo shortages. FBI estimates indicate 2.78 million gun checks occurred in the last month of 2012, up from 1.86 million one year earlier.

Ø Only universal background checks will pass Congress. Obama’s other two initiatives, an assault rifles ban and magazine capacity limits, will not pass the Republican-‐dominated House of Representatives. Fear will be quelled and the stock price will rise.

Ø Some states will follow in the footsteps of New York and pass more gun regulation, but others, where guns are more prevalent anyway, will augment gun sales by increasing security measures.

Ø More pension funds may exit positions, causing the stock to fall, but individual investors, recognizing that no fundamental change has occurred within the company, will subsequently buy the stock, pushing the price back up. An example of this occurred from February 20-‐February 22, as the stock price fell but then subsequently rose (California pension fund divested on February 19).

Ø SWHC will be short squeezed, pushing the price up even more. Note

Ø It is important to note that much of the downside risk, especially from political catalysts, is hedged. If sweeping federal legislation is not passed (which I believe is very likely), a major threat to SWHC’s earnings is removed, meaning the price should rise. If the sweeping federal legislation is passed, but the twenty one states pass measures to exempt themselves federal legislation (in addition to the eight states that already have such legislation), then the impact of the federal legislation will be mitigated, meaning that SWHC’s earnings will not be significantly affected. If federal legislation passes and the twenty-‐one states cannot pass exemption legislation, then there will be a huge spike in gun sales as people try to stock up on guns before the ban goes into effect. This translates into higher sales for Smith and Wesson, at least in the short term, which could spur an initial spike in price (after at which we could exit the position). Remember that the assault rifle is only one of Smith and Wesson’s products, and that the civilian market is only one of Smith and Wesson’s targeted markets. Even if a ban does pass, it will not be as catastrophic as people seem to believe. Lastly, remember that SWHC’s board of directors has authorized 15 M in share repurchases. If the stock begins to fall, shares will be repurchased, pushing the price back up. All of these reasons hedge downside risk.

Smith and Wesson Holding Corporation (SWHC) Memo Risks / What Signs Would Indicate We Are Wrong?

Ø X On 2/25/2013, Forbes author Abram Brown published an article discussing the judiciary’s role in determining the constitutionality of concealed carry laws. In Denver, last week, the court decided that concealed carry laws aren’t protected by the second amendment. In Chicago, during the same week, the court reached the opposite conclusion; it declined to reconsider a ruling that found the state’s ban unconstitutional. Handguns represent a relatively significant chunk of Smith and Wesson’s product portfolio; consequently, instituting stricter concealed carry laws could impact earnings. In Columbia v. Heller and McDonald v. Chicago, the Supreme Court failed to provide a concrete decision on the constitutionality of concealed carry. It will be important to be cognizant of court rulings around the country, as well as any new Supreme Court ruling on this issue.

Ø X If Federal legislation banning assault weapons somehow passes, no state exemption laws pass, and investors recognize that any initial spike in earnings from a gun frenzy is temporary, then the stock will trade lower in the long-‐term. For this to happen, though, all three of the conditions must be true; if any condition is false, we will still be able to make money by going long SWHC.

Signposts / Follow-‐Up

Ø X March 5 earnings report Ø X Whether Congress passes all of Obama’s gun

legislation, parts of his legislation, or none of his legislation.

Ø X Whether Republican-‐dominated and Democrat-‐dominated state legislatures are able to pass the bills they have introduced.

Ø X Whether more pension funds divest. Ø X How demographic shifts impact the demand for

guns Ø X Whether SWHC is able to win the contract to

replace the army’s M9s with M&Ps Ø X Share repurchases by Smith and Wesson Ø X Changes in insider ownership

Company Description Smith and Wesson Holding Corporation (NASDAQ: SWHC) offers firearms, handguns, sporting rifles, hunting rifles, black powder firearms, handcuffs and restraints, and firearm-‐related products for safety, security, protection and sports in the United States and Internationally. The company sells its product under the Smith and Wesson brand, the M&P, the Thompson /Center, and the Walther brand name. Smith and Wesson Holding Corporation sells its products through commercial, law enforcement, federal, and military distributors, retailers, and dealers in the United States, as well as through distributors and manufacturers’ representatives internationally. It also operates an online retail store to sell its products. The company was founded in 1852 and is based out of Springfield, MA.


Sturm Ruger Smith & Wesson

Forward P/E 21.99 9.34

PEG N/A .29

Price/Book 5.89 3.89

EV/EBITDA 8.36 5.50 Price to Free Cash Flow 39.80 16.42

Cash per Share $5.49 $.88

ROE 39.47% 45.92%

EPS Q/Q 57.79% 1574%

Short % of Float 36.8% 24.3%

SWHC has a diverse product portfolio.

Individuals with little disposable income are not the only ones purchasing firearms; instead, individuals across the entire spectrum of income are driving sales growth.


During 2008, gun sales rose even as rural income fell.


The number of gun households is increasing.

Most gun households are located in the South and Midwest, where Republicans control the state legislature.

In the past few years, gun ownership among women has increased significantly.


Gun Licenses By Party Dominance of State Legislature

Democratic States Licenses California 7,177 Colorado 2,295 Connecticut 1,561 Delaware 301 Hawaii 256 Illinois 4,103 Maine 856 Maryland 2,261 Massachusetts 3,165 Minnesota 2,606 Nevada 1,160 New Hampshire 969 New Jersey 491 New Mexico 1,005 Oregon 2,317 Rhode Island 432 Vermont 526 Washington 2,340 West Virginia 1,347 SUM 35,168 Total States 19

Republican States Licenses Alabama 2,050 Alaska 988 Arkansas 1,744 Arizona 2,641 Florida 5,995 Georgia 3,234 Idaho 1,265 Indiana 2,541 Kansas 1,699 Louisiana 2,179 Michigan 4,059 Mississippi 1,340 Missouri 5,500 Montana 1,414 North Carolina 3,757 North Dakota 601 Ohio 4,218 Oklahoma 2,104 Pennsylvania 5,446 South Carolina 1,758 South Dakota 678 Tennessee 2,952 Texas 8,383 Utah 1,032 Wisconsin 2,757 Wyoming 764 SUM 71,099 Total States 26

** “Democratic States” are those states where Democrats control the legislatures, while “Republican States” are those states where Republicans control the legislatures.

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