Debt + Dilution = Delicious, why SWHC looks better than ever right now
May 07, 2009
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RELATED TICKERS: SWHC
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You want to get a bunch of Fools to vigorously nod their heads, and get a rise out of the crowd like a small town revival, shout into a crowded room, "Dilution is bad for shareholders!" -- "Right on!" they will shout! --- "Debt is terrible! All the time!"--- "You tell it!" they will encourage. "We should never buy a debt laden company diluting shareholder value!" --- "Preach it!" they will scream. And then you can run from the room as they storm the stage. And many times these doctrinaire beliefs are totally right. It's hard to go wrong limiting your investments to companies with solid balance sheets, with no debt, and who don't go around regularly diluting shareholder value by issuing new shares. But I think that SWHC's announcement today, of a 5.5Million share offering is actually great news.
A shaky past with questionable choices about debt
Smith and Wesson (SWHC) has never been afraid of some debt or dilution. And previously, this was bad news for them (and shareholders). At the top of the last hunting gun cycle in late 2006, Smith and Wesson issued $80M in convertible notes to finance the purchase of Thompson Center Arms, a major player in the black powder rifle market. Almost since completion of that purchase, the black powder market has been terrible, and Thompson's doors were shut as they waited for that market to come back.
That bad judgment hung over them into 2008 and the selloff in their stock got worse at the end of 2008 as the whole market paniced about consumer spending ever coming back, and companies being able to refinance or pay off existing debt. In the last few months, we've seen a strengthening in the consumer and a rapdi rise in gun sales. Because of both their debt and historical bad judgment, I've not been a fan of SWHC - instead choosing to invest in Sturm Ruger (RGR) - a slow steady grower with no debt and a strong enough cash flow to recently bring back a dividend after a 5 year suspension.
So why do I now like SWHC?
I like this share offering to raise cash. For one thing, they're doing it close to the highest stock price of the last 2 years. For another, I think it's going to enable them to ramp up quickly and take advantage of the current demand for firearms.
Firearm demand this year is coming from two places: 1) the consumer who is concerned that a Democrat in office and controlling the House and Senate will lead to increased gun laws, so they're buying like crazy, and 2) the economic stimulus package which will be getting funds to police departments who need to buy. My longtime favorite RGR can only take advantage of #1, as they don't really sell to police. SWHC can take advantage of both.
But again, why issue shares right now? Why the need for cash? (besides the obvious overhanging debt). A clue to that is in the Smith & Wesson press release about what they will do with the cash:
The approximately $32 million of net proceeds, after deducting underwriting discounts and commissions and estimated offering expenses, will be used for corporate purposes, which may include the purchase of additional equipment to expand manufacturing capacity to satisfy product demand, the purchase of outstanding debt, and strategic relationships and acquisitions.
OK, right, yawwwwn, you're thinking. So what jumped out at me? "expand manufacturing capacity to satisfy product demand" Why is this significant? These firearms companies are experiencing almost unprecedented demand. And you know if you've followed any company, from Nintendo to National Oil Varco, that demand and backlog are great to have - but if you really truly can't fulfill that demand *when* it happens, some of that demand goes away.
Now, my favorite managers at Ruger are managing their money and our expectations, and have spoken directly to shareholders about this danger in their recent letter to shareholders. Here's the relevant passage, where they let you know that *they* will not be able to meet demand and some of it *will* go away.
I caution our Shareholders not to place undue reliance on the size of our
backlog and current demand levels.
When demand eventually declines to more historical levels, and especially so if
the decline is precipitous, we will be very cautious to avoid over-supplying the
distribution channel merely because we have orders on the books. Our goal at
that time will be to manufacture to actual end-user demand plus some additional
units to slowly build safety stock inventory in our warehouse and in the
distribution channel. Doing so should help mitigate the impact of volatile
demand and help us preserve our workforce and the efficiencies we have gained in
our manufacturing processes. It will also help us maintain the quality of our
accounts receivable.Ruger letter to shareholders on SEC site
Who's going to pick up the slack? I'm thinking SWHC is going to be one beneficiary of Ruger conserving cash and the huge public and police demand for guns, ahem, firearms.
Smith & Wesson earnings are coming up mid-June, and I'm sure there wlll be a lot of analyst opinion jockeying and lots of press in advance of earnings. And post earnings, we should get some actual facts.
To further acquaint yourself with SWHC, take a look at their latest analyst/investor presentation from February of this year where they share their goal of basically doubling revenue in 3-5 years. Link to presentation on sec.gov.
Sarah - currently long RGR and SWHC
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