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Is Smith & Wesson Holding Corp (SWHC) A Value Trap?

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Smith & Wesson Holding Corp (NASDAQ:SWHC) released earnings after the market closes today, and Meson Capital Partners  expected some bad news. The company reported Q2 EPS of $0.09, $0.02 better than the analyst estimate of $0.07. Revenue for the quarter came in at $108.4 million versus the consensus estimate of $105.8 million. The hedge fund, which is shorting Smith & Wesson, cites falling demand, high fixed costs, and a history of poor asset allocation decisions as reasons to see this as a value trap instead of a buying opportunity.

“The best shorts, in my view, do not have crazy valuations that are liable to double – as it is well known that 2*Crazy = Crazy. Stocks that appear cheap but with predictably deteriorating earnings are far less risky shorts as the driving reason the bottom hasn’t fallen out already is an attractive valuation based on irrelevant, backwards-looking numbers,” Meson Capital wrote on SeekingAlpha earlier today.

Smith & Wesson

50% downside on Smith & Wesson, writes Meson Capital

The argument is that the gun industry has been a commodity business for decades, earning about 3% CAGR with demand tracking GDP growth. Citing statistics on background checks, Meson Capital says that demand went up after Obama became president and then peaked after the Sandy Hook school shooting as the nation debated gun control, but since then demand has been reverting to the longer term trend line.

Smith & Wesson

The problem is that Smith & Wesson Holding Corp (NASDAQ:SWHC) used the opportunity to gear up, buyback stocks, and increase capacity to the point that its maintenance capex is $25.5 million per year, which is only slightly less than the company’s five-year average operating income from 2007 – 2011 ($26.6 million per year), what Meson Capital calls the pre-gun bubble period.

“Even assuming no overcorrection to the downside, at normalized margins over the last decade (including Obama’s first term where firearm demand was already elevated), SWHC is worth maybe $5/share for 50% downside,” Meson Capital writes.

Smith & Wesson

Poor asset allocation decisions

Meson Capital also points out that Smith & Wesson Holding Corp (NASDAQ:SWHC) has a history of making bad asset allocation decisions. Former CEO and current co-vice chairman Michael Golden acquired companies for $102 million and $83.3 million respectively in 2007 and 2009, and then had to write-off about 90% of each in impairment charges. Current CEO James Debney borrowed money to finance buybacks and double production capacity, leaving SWHC with debt burden that Meson Capital believes is going to be a major problem in the next few years.

Smith & Wesson allocation decisions 1214

Smith & Wesson Holding Corp (NASDAQ:SWHC) is already having a hard time, and Meson Capital suspects that interest from value investors could be supporting its stock price already, but investors should be on the lookout for lowered guidance that could signal bigger problems down the road.

Smith & Wesson

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