Smith & Wesson Holding (NASDAQ:AOBC) is about to shoot a huge hole in the efficient market theory that says stock prices always reflect all relevant information available. The gunmaker's stock is down 18% from the all-time highs it hit in August as Wall Street insists gun buying demand is slowing. Another analyst recently downgraded the company from "buy" to "hold", because he believes FBI background checks had "meaningfully decelerated". Fortunately for investors, he couldn't be more wrong, and they can still profit from his call.
Shooting himself in the foot
Wunderlich Securities analyst Rommel Dionisio cut his rating on Smith & Wesson and downgraded its price target from $36 per share to $29. "Following a strong, multiyear run in the stock price in the wake of record consumer demand for firearms, we believe shares of Smith & Wesson will no longer see significant near-term outperformance given certain fundamental headwinds," he wrote, pointing to the supposed decline in demand, an early start of the hunting season, and the U.S. Army dropping the gun maker from consideration for its handgun replacement contest.
In particular, the analyst highlighted how criminal background checks of potential gun buyers grew only 6% in August and 10% in September from the prior year after running at double-digit rates all year long. That suggested to him that demand had been pulled forward, while Smith & Wesson faces difficult comparisons come December.
Yet as I recently explained, August background checks were abnormally low due to a computer upgrade at the FBI that led the state of Kentucky to underreport its numbers. They also did not come back online with the federal law enforcement agency until after the first week of September, which meant a whole week of data was again absent that month. When correcting for the missing data, firearm sales appear to be as strong as they have ever been, and any "slowdown" can be explained by typical seasonality than a fundamental drop in demand.
Examining FBI records, you can see that almost every year for the past six years, the number of background checks performed have been lower in September than they were in August. Only last year were the number of investigations higher, but if you look at what was happening then, it quickly becomes understandable why that was the case.
In August 2015, terrorists blew up a shrine in Bangkok that was popular with tourists; there was large-scale civil unrest in Ferguson, Missouri that led to a curfew being imposed and hundreds of rioters arrested; and three Americans thwarted a terror attack on a Paris train. Fear for personal safety was running high at the time, so it's not surprising that demand for firearms was also elevated.
Investors should expect demand to bounce back sharply when the FBI reports its numbers for October, as history shows NICS demand has always been higher in that period, no doubt influenced by national elections. Going all the way back to when the law enforcement agency began keeping records, October criminal investigations have increased on average 13% over September and continue rising strongly through the holiday shopping season.
Otherwise, when it comes down to it, the FBI has reported 17 consecutive months of record numbers of background checks.
Not only has Smith & Wesson indicated that demand shows no sign of abating, but Sturm, Ruger also agrees it remains white hot. President and CFO Christopher Killoy said demand continues to exceed its production capacity even as the company continues to expand.
While an early start to the hunting season could be a problem for some gun makers, Smith & Wesson only has a small presence in the long gun market for hunting. It may be working to change that, particularly with its introduction of the affordable Compass bolt-action rifle and hunting accessories through its Battenfeld Technologies division, but the hunting season, early or late, should have a limited impact on the company.
As for being dropped early from the U.S. Army pistol replacement contest, it was disappointing but will have no impact. Beretta is the current supplier and arguably has the inside track to hold this position, and Smith & Wesson never included potential revenue from winning the contract in its guidance, so the significant increase in sales and earnings it has forecast is still on track.
Wall Street has gotten it wrong on gun demand all year long, and that trend should continue. Investors can use this opportunity to capitalize on the weakness in Smith & Wesson stock.