Smith & Wesson stock, modern sporting rifles

Smith & Wesson saw steep declines in sales of modern sporting rifles last quarter. Source: Smith & Wesson.

After Smith & Wesson (NASDAQ:SWBI) announced fiscal second-quarter 2015 results last Thursday, there were no shortage of headlines calling out the gunmaker's revenue "misfire" and wondering if gun lovers have left it for dead.

The bad
After all, skeptics noted, quarterly revenue plunged 22% year over year to $108.4 million, hurt most by a 50% drop in sales of modern sporting rifles. That translated to a 70% decline in income from continuing operations, to $5.1 million, or $0.09 per share. 

What's more, Smith & Wesson issued a weaker than expected fiscal third-quarter outlook, calling for net sales between $113 million and $118 million, along with generally accepted accounting principles earnings per share of between $0.09 and $0.11. Analysts, on average, had expected current-quarter earnings of $0.20 per share on sales of $129 million.

In addition, some expressed concern over leverage involved with Smith & Wesson's pending acquisition of firearms accessories and supply specialist Battenfeld Technologies. Smith & Wesson is taking on another $100 million in debt to fund the $130.5 million purchase, bringing its ratio of debt ($275 million) to this year's expected EBITDA ($114 million) to roughly 2.4. That's still well below the maximum threshold of 3.25 allowed by Smith & Wesson's existing bonds, but could be a concern should sales and earnings continue to fall.

Perspective is in order
Why, then, did Smith & Wesson stock climb 4% the day after its report?

For one, the second-quarter performance came in ahead of Wall Street's expectations for earnings of just $0.07 per share on sales of $105.3 million.

Next, investors are willing to forgive Smith & Wesson for its weak outlook because it is delivering on its long-standing promise to, as CEO James Debney regularly puts it, "manage our business for the long term in a way that gives us the ability to take market share, independent of whether the market is growing or shrinking."

Incidentally, I discussed this strategy last month after fellow gunmaker Sturm, Ruger, & Co. (NYSE:RGR) admitted it likely lost market share as it chose not to follow the aggressive discounting policies implemented by then-unidentified competitors. Sure enough, and likely much to Ruger's chagrin, Debney stated during Smith & Wesson's earnings conference call that both internal point-of-sale analysis and feedback from a major distributor indicate Smith & Wesson effectively held its market share during the quarter. That means the company remains the market leader in both handguns and modern sporting rifles.

A temporary blip
That said, Debney also noted that inventories remain elevated as distributors and retailers continued to hold an unfavorable product mix of "lesser brands and hard-to sell-products." He elaborated that "some independent firearms retailers are reluctant to spend dollars replenishing exhausted inventories of their most popular products, such as Smith & Wesson's firearms, choosing instead to promote those products that remain on their shelves."

As a result, Smith & Wesson plans to use "aggressive promotions" during the current quarter -- hence its light guidance -- to combat what should be a temporary lull in demand until channel inventories tighten. When that happens, and even if Smith & Wesson temporarily loses market share as retailers work to move products from those "lesser brands," Smith & Wesson will be set to rebound as sellers restock its firearms and the industry returns to more normalized levels.

Finally, with regard to Smith & Wesson's added leverage to acquire Battenfeld, the additional $100 million is being pulled from an existing line of credit after the company partially exercised an "accordion feature" to expand that line. This indicates Smith & Wesson is operating well within its leverage comfort zone. What's more, when the company announced the acquisition in November, it estimated the addition would provide incremental revenue in fiscal 2016 of $55 million and a healthy 27% EBITDA margin on that revenue, or roughly $15 million.

That's not to say there isn't risk in taking on this new debt, especially if Smith & Wesson sees fiscal 2016 EBITDA plunge back to its pre-surge 2012 level of about $68 million. Even including the extra $15 million expected from Battenfeld, that would bring it very close to violating the leverage terms of its existing bonds. However, this also assumes Smith & Wesson won't pay down any of that debt in the meantime, and such a drop in EBITDA seems increasingly unlikely considering the market share it has methodically taken from competitors since then.

The firearms industry certainly isn't perfect, and it's hard to blame investors for panicking as more normal demand resumes. But considering each point above, arguably no company in the space is better positioned for sustained success than Smith & Wesson. In the end, that's why it should be no surprise that this stock enjoyed a nice little bounce following the company's most recent earnings results.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.