Wall Street is going to be surprised by the level of gun buying demand next month because they misread FBI data, and Smith & Wesson's beaten down stock ought to shoot higher as a result. Image source: Getty Images.
No matter how you look at Smith & Wesson Holding (SWHC 1.46%), its stock is cheap. Even though it reported some monster first-quarter results this month, analysts say there's a slowdown in demand that warrants the stock pulling back. Although the gunsmith doesn't see any indication of demand easing up for its firearms, who are you going to believe, Wall Street or your own lying eyes?
Analysts' assessment of demand is wrong, though. They're mainly relying upon FBI criminal background statistics that seem to show an ebb in the number of people wanting to purchase firearms, but they really don't.
Still a really big number
According to numbers from the National Instant Criminal Background Check System, or NICS, the FBI conducted 1.85 million investigations on individuals wanting to buy a gun in August. That's just 6% more than it did in the year-ago month, and since it had been performing background checks at double-digit rates beforehand, it suggests demand is weakening. Except they (and just about everyone else) missed a key clue.
A contributing analyst on Seeking Alpha who goes by the name Fund Manager discovered an anomaly in the monthly data. The financial planner and options trader examined the state-by-state numbers and found Kentucky recorded an abnormal drop in the number of background checks it conducted. Where it normally performs some 300,000 or so checks each month -- in July, more than 363,000 were reported -- August saw just 29,700 investigations reported.
Not only that, the difference between what Kentucky typically reports in a month and what it did last month makes up for the entire decline seen in the national statistics. Add back in those missing investigations, and you no longer have a low single-digit increase, but rather a healthy 23% year-over-year jump. In fact, that's almost twice the rate of increase of last year's rise (12%) and is the single largest increase for the month of August going all the way back to when the FBI started keeping records. Demand isn't weakening, it's as strong as ever, maybe even stronger!
Everyone is under the microscope
As the Seeking Alpha article noted, Kentucky's numbers are already strange, even without the massive underreporting. The state has reported 320,000 monthly background checks on average in 2016, which is almost twice as many as any other state: California is second, with 191,000 monthly investigations conducted on average, followed by Illinois with 163,000 and Florida at 118,000. No other state performs more than 100,000 average monthly criminal background checks.
Data source: Federal Bureau of Investigation. Chart by author.
I contacted the Kentucky State Police Department to find out the reason for the anomaly. Turns out, Kentuckians didn't suddenly develop an aversion to buying guns, rather the FBI's NICS computer system underwent a major upgrade and the state police chose to only report new permit applications.
Kentucky is unique in that each month it does a criminal background check on every single concealed carry permit holder in the state because people involved in felonies are not allowed to own a firearm. As a result, the police regularly scan their database to find a match between a permit holder and a crime. Those numbers weren't reflected in its August report, but the State Police assured me they will be included next month, which means Wall Street will express "surprise" at the sudden level of renewed interest in guns.
In the bargain-basement bin
This is why Smith & Wesson is a buy right now. After reporting earnings on Sept. 1, the gunmaker's stock has fallen nearly 9%, and it's 15% below the all-time high it hit a month ago. The stock trades at just 13 times earnings and 11 times estimates, making it cheaper than industry peer Sturm, Ruger, which has also posted strong numbers, though not nearly as robust as its rival.
On just about every metric you'd care to look at -- from price-to-sales to price-to-earnings-to-growth -- Smith & Wesson looks cheap. And when you take into account that the gunslinger's enterprise value trades at a dirt cheap valuation of just nine times its free cash flow, it ought to mean that when September's NICS numbers are reported, and they're substantially higher than what they are today because of the Kentucky anomaly, Smith & Wesson's stock is likely to shoot higher.
