Safety check: Why Wedbush downgraded SWHC

February 15, 2016 12:00 PM

President Obama doesn’t plan to stop discussing guns during his final year in office, a factor that likely eliminates the possibility that politics’ influence on demand is set to wane.

But another risk exists to the sector that requires greater examination: Too much sales success during short-term spikes in demand and the impact on future production forecasting. 

The day after Smith & Wesson jumped 10% on news of the President’s executive actions and the company’s positive forward guidance for 2016, private financial firm Wedbush Securities downgraded the company’s stock from “outperform” to “neutral.”

After SWHC shares gained 131% in 2015, analyst James Hardiman announced that his firm was “taking money off the table and downgrading.”

The decision came down to one primary question: Was the recent surge in gun purchases fueled by new ownership or by the large number of American gun owners who were simply boosting their current arsenal. Without reliable data sources on the buying patterns, Hardiman appeared willing to take gains off the table and wait until a clearer picture presents itself.

A lack of reliable data

“As much as I have searched there isn’t a ton of good data on who is buying guns, which is by design,” Hardiman says. “Whenever someone tries to compile information – the reaction from activists is that the government is trying to take away their guns or aim to create a gun registry where owners are cast as bad people. That’s why available data is pretty limited.”

Even when it comes to simple data that might suggest the average number of guns per household, a simple Google search indicates several different answers. 

“If we see numbers flatten out and go negative – which has happened – that some if not most of these sales are demand being pulled forward,” Hardiman says. 

The analyst says he has seen this pattern before. “When you have a big surge, typically that’s demand being pulled forward. The stock surged over the last year. The NICS data is not going to climb 38% each month. Smart investors are not going to just sell the gun stocks. But when we have a major surge, gun sales eventually pull back.”

Hardiman points to the wake of the post Sandy Hook purchasing surge as evidence of how a short-term sales spike can cause significant problems for a manufacturer’s operations. The boom-and-bust cycle created a wealth of challenges that affected its research and development and hindered proper allocation of capital.

“In 2013 to 2014, there was a lot of inventory sitting at retail that became a major problem,” he says. “Companies created too much inventory and the calendar year 2014 was a throwaway year as it was all about clearing out retail level inventory.”

In 2014, IBISWorld reports that year-over-year revenue declined by 6.4% in the gun and ammo manufacturing sector. Meanwhile, gun and ammo store revenues fell by 5.2%, year-over-year. Following the lessons of that down year, Hardiman expects manufacturers to do a better job  of managing inventory levels and production.

“SWHC has made it their goal to change their manufacturing so that they will not be in the same position again,” he says. “So they can benefit from a sales surge and not be sitting on inventory and leave themselves in a tough position.”

A political upgrade

Over the long-term, gun ownership is on the rise, fueled by the liberalization of conceal carry laws, a primary driver of growth in the last decade. But politics remain the core influence of the analyst’s previous optimism for the stock. 

 “The reason for the original upgrade of SWHC stock to outperform was the political landscape,” Hardiman says. “We are focusing on the political landscape and what is likely to happen. A few things were pretty clear heading into this election cycle: One, gun rights and gun legislation would be a very hot topic among Democratic candidates. Even Obama a few months ago underscored gun control as one of his most important positions. Two, we know that when people discuss legislation, it drives hardcore gun owners to buy guns for fear that they could be taken away.”

Obama’s political stance was on full display during a January town hall meeting on CNN where he said he would not campaign for any Democrats who opposed “common sense” gun control efforts.

The long-term outlook is also driven by a lack of confidence that any bipartisan Congressional action like those witnessed during the Reagan or Clinton years will occur. (The two deciding votes – one Republican, and one Democrat - on the 1994 Assault Weapons ban were influenced by Reagan himself in letters to the Congressmen. The bill passed 216 to 214.) 

Hardiman doesn’t expect Congress to work with Obama or any presidential candidate on structural reform, which may fuel increased executive orders and regulatory efforts by government agencies in the future.

“I don’t think that anything will come of it. Without a full reshaping of Congress, there isn’t going to be any political will to alter how we manage gun sales,” says Hardiman. “Even a number of Democrats – they wouldn’t be willing to vote for it because they live in states where gun rights are critical. Bernie Sanders is a perfect example. Hillary Clinton is left of Bernie Sanders on gun rights.” 

To put that into perspective, Sanders, a self-described socialist from the hunting state of Vermont, has a “D-” rating on gun control issues from the National Rifle Association. Clinton has vocally supported efforts to reverse gun manufacturer immunity and enable lawsuits against the manufacturers. In 2000, she supported a national gun registry before reversing that position in 2008 during the election. 

A boon to gun sales?

Looking forward, James argues that the recent Presidential executive orders could be very positive for public manufacturers. 

“What Obama did [with his executive actions in early January] helped companies like Smith and Wesson,” he says. “The new law manages the process of purchasing used guns. Previously, the only way to avoid a background check is to buy a used gun. Now that more used guns will require a background check, the benefit of buying a used gun is lessened somewhat, which could in theory drive more business toward new gun sales.”

Given this logic, any person who was looking to purchase a gun without a background check from a table dealer would now lose the legal capacity to do so. However,  Hardiman acknowledges that anyone seeking to purchase a used gun illegally will still be able to do so.

With an eye on sales data, Hardiman acknowledges that the last seven years of sector growth have been driven by the influence of the National Rifle Association and the President’s rhetoric. 

“It’s not an enormous industry in terms of dollars, but the sway that the NRA has is pretty enormous,” he says. “The NRA feeds off [anti-gun rhetoric]. If there were not threats of new gun regulations, the NRA would struggle, and industry sales would be somewhat less than they have been. Barack Obama has been extremely good for the gun industry.”

However, Hardiman raises concerns that other analysts are ignoring fundamentals and long-term influences on the market. 

“I can’t argue for the upside that some of my peers are calling for,” he says. 

On average, Smith & Wesson has traded at about a 14x year-forward price to earnings multiple, and yet you now have many that are calling for a 20x multiple. That doesn’t make much sense in the absence of a structural change to the industry, and despite the current surge in gun sales, there’s really no evidence of such a change over the past few months.”

Hardiman argues that many analysts are not considering the uncertainty of the next political cycle and what Washington politics – the primary driver of industry growth for nearly a decade – will look like in 13 or 14 months. 

“Absent a surge of sales and manufacturing, we have to ask: What will the end of fiscal 2017 year look like when we have a new president?” he says. “We’ll be in the first 100 days and we’ll have to see if gun legislation is part of the initial plans. Given that uncertainty, why is someone willing to assign a growth type multiple on next year’s numbers? I struggle to come up with that answer.” 

Aside from the short-term threat that new owners may not be the primary drivers of recent growth – and the 40% surge in SWHC shares after the San Bernardino attacks, Hardiman plans to keep an eye on the progress of the 2016 election cycle – another obvious risk. 

“If a Republican gets elected, gun stocks will go down,” he says. “Going from a Democrat to a Republican doesn’t help – or create that urgency. Going from the Republican to a Democrat, it shoots up. There will be a bit of poll watching over the next few months.”

According to Thomson First/Call, SWHC stock has an average price target from 10 analysts of $25.60. The low-end estimate sits at $16, while the high-end currently is at $31.

About the Author

Garrett Baldwin is the Managing Editor of the Alpha Pages and the Features Editor of Modern Trader. An author and Baltimore native, he earned a BS in journalism from the Medill School at Northwestern University, an MA in Economic Policy (Security Studies) from The Johns Hopkins University, an MS in Agricultural Economics from Purdue University.