Is Smith & Wesson Firing Blanks?

The P/E ratio on this stock looks good, but the cash drawer is almost empty.

Jun 24, 2014 at 10:12AM

A stock without strong free cash flow is like a gun without ammo. Source: Wikimedia Commons.

According to NBC News, America's love affair with guns is over, but investors need not fear. "Nimble stalwarts" like arms maker Smith & Wesson (NASDAQ:SWHC) can still dodge the downturn.

Citing a KeyBanc research report, NBC affiliate CNBC reported earlier this month that gun sales in the U.S. are estimated to have dropped 9.9% year over year from May. Individual manufacturers such as Freedom Group, which makes the popular Bushmaster line of rifles, are suffering even more, with Q1 sales said to be down as much as 20% year over year. Yet according to CNBC, trouble for the industry as a whole was likely to help the very strongest players -- S&W among them -- "to separate from the rest of the pack."

Except... that's not the way things are working out.

True, when Smith & Wesson released its numbers for the financial year just completed (its fiscal 2014), the company was able to boast of 6.7% sales growth for the year as a whole and "record" profits as well. But already the strain on the industry is beginning to show on this "stalwart" as well. In Q4, for example:

  • Revenues fell 4.6% to $170.4 million.
  • Operating costs spiked 350 basis points to 15.6% of net sales.
  • Operating profit margins dropped 90 basis points to 25.3%.

Meanwhile, S&W's net profits flatlined at $0.44 per share. So while CEO James Debney pronounced himself "very pleased" with the results and CFO Jeffrey D. Buchanan highlighted the company's "robust cash flows," it's already becoming apparent that business is not great at Smith & Wesson.

And it's about to get a whole lot worse.

Smith & Wesson tells investors to expect no more than $600 million in revenues for the full fiscal year 2015, with profits of no more than $1.40 per share. Even in this best-case scenario, Smith & Wesson's numbers will be down about 4% and 5%, respectively, from 2014 levels -- and management didn't rule out the possibility that the news might be worse.

Investors should be prepared for a very early shock. S&W management warned that Q1 sales could be as low as $130 million this year, with profits as low as $0.23 per share. In last year's Q1, the company did $171 million in business -- and earned $0.40 on it, according to S&P Capital IQ figures. So we're looking at a potential 24% fall-off in revenue and perhaps a 42% plummet in profit in fiscal Q1 2015.

Should you be scared?
When investors took a gander at these projections last week, they promptly proceeded to sell off the stock -- now down 10% from pre-earnings levels.

The shares may have even farther to fall. Despite reporting more than $89 million in GAAP "profits" for the past year, Smith & Wesson's cash flow statement clearly shows that the company really generated only $27.6 million in cash profits -- free cash flow.

Valuation matters
Smith & Wesson stock looks attractive on the surface, with a P/E ratio of just 11 times earnings. If analysts are right in their projections of 14% long-term earnings growth, that's not a bad valuation. On the other hand, with Smith & Wesson management now warning of imminent double-digit earnings declines, you have to wonder how much longer analysts are going to stick with that 14% consensus growth target.

Risk-averse investors may be best advised to look beyond the P/E, and think of Smith & Wesson as a company selling for more than 30 times trailing free cash flow. At that valuation, even if the 14% growth target proves accurate, the shares are arguably already overpriced. And if the 14% growth target goes away? Look out below.

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Rich Smith has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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