Smith & Wesson Brands, Inc. (SWBI) Q4 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 Smith & Wesson Holding Corporation Earnings Conference Call. My name is Jeff, and I'll be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Ms. Liz Sharp, Vice President of Investor Relations. And you have the floor, ma'am.

Thank you, and good afternoon. Our comments today may contain predictions, estimates and other forward-looking statements. Our use of words like anticipate, project, estimate, expect, intend and other similar expressions is intended to identify those forward-looking statements. Forward-looking statements also include statements regarding sales, margins, expenses and earnings for future periods, our product development and strategies and liquidity and anticipated cash needs and availability. Our forward-looking statements represent our current judgment about the future, and they are subject to various risks and uncertainties. Risk factors and other considerations that could cause our actual results to be materially different are described in our securities filings, including our Forms S-3, 8-K, 10-K and 10-Q. You can find those documents, as well as a replay of this call on our website at smith-wesson.com. Today's call contains time-sensitive information that is accurate only as of this time, and we assume no obligation to update any forward-looking statements contained herein. Our actual results could differ materially from our statements today. Now I will turn the call over to our President and CEO, James Debney.

Good afternoon. Thank you for joining us and for your interest in our company. With me on the call today is Jeff Buchanan, our Chief Financial Officer, who later on will provide a recap of our financial performance and an updated outlook. Fiscal 2012 marked a very encouraging year for Smith & Wesson and clearly demonstrated the strong positive impact that came from focusing intently on our firearms business. Our strategic objectives, designed to drive shareholder value, remain as follows: focus on our core firearms business; deliver truly exceptional high-quality products; grow with the expanding market, but more importantly take market share; and continue improving our gross and operating margin. In the process of executing our strategic plan, we have achieved a number of records in this past fiscal year. For example, we shipped well over 1 million units, a record volume. And we delivered record full year sales from continuing operations in the process. Our revenue growth over 20% was driven by strong sales in the consumer channel of our M&P polymer pistols and our M&P modern sporting rifles. This result is completely aligned with our strategic direction. Turning now to the fourth quarter. Our results reflect a material financial improvement and clearly demonstrate progress on a number of our key strategic and operational initiatives. Here some of the highlights: We exceeded the high end of our sales guidance, the result of a great job by the operations team of accelerating our planned increases in manufacturing capacity and outsourcing capability. Strong sales and capacity expansion contributed to improved gross margins and record level net income from continuing operations. We more than doubled our backlog sequentially to $439 million, setting yet another record. We launched the M&P Shield, a new polymer pistol with an easily concealed 1-inch profile. This was described in one industry publication of setting a new industry standard, and full credit goes to our engineering and marketing teams. We also completed preparations for the launch of our new SDVE line of polymer pistols, a replacement to the 18 year-old Sigma Series. We significantly improved operating and free cash flow versus the year ago quarter, allowing us to consider purchasing some of our debt on the open market, which we did after the end of the quarter. We worked with the NRA on a significant sponsorship deal to enhance the presence of our M&P brand, with both the professional community and the growing group of new female shooters. We entered into talks with Walther on the long-term viability of our strategic alliance. And finally, we made significant process -- progress with the divestiture of Smith & Wesson Security Solutions. Based on our recent successes, our strategic direction and our current outlook for the business, today, we are providing fiscal 2013 guidance that calls for double-digit growth in revenue and net income. So with that, I'll ask Jeff to review the financial results.

Thank you, James. Please note that I will be giving the financial results for only our continuing operations. For results of discontinued operations, please refer to our 10-K, which will be filed this afternoon. Revenue for the quarter was $129.8 million, this is an increase of $28.1 million or 27.7% over the prior year. We exceeded our upwardly revised revenue expectations through excellent operational efforts in bringing forward capacity increases and managing outsourced suppliers. The gross margins were 36.1%, over 5 percentage points higher than Q4 of last year. Gross margin dollars were helped by onetime benefits, totaling $3.7 million, relating to reductions in inventory, warranty and product liability reserves. Even without those onetime benefits, however, we had solid margin gains. The higher volume of our production helped with our overhead absorption, and in addition, cost and saving efforts, reduced promotion costs and the favorable product mix also contributed to the improved gross margin. Our operating expenses in the quarter totaled $21.2 million or 16.3% of revenue versus $23.2 million or 22.9% of revenue last year. Thus, even though we had greater profit sharing and incentive expenses, actual SG&A costs were significantly lower because of the company-wide cost and saving efforts and reduced legal expenses relating to the DOJ/SEC investigations. Our tax rate for the quarter was 27.4%, primarily because of the tax losses relating to the move of our Thompson/Center business to Springfield and tax restructuring relating to the intercompany ownership of the Thompson business. Net income in Q4 was $17.8 million or $0.27 per share compared with net income of $4.4 million or $0.07 per share last year. Non-GAAP adjusted EBITDAS was $31.2 million compared with $14.9 million last year. Our definition of adjusted EBITDAS excludes cost we consider to be unusual or onetime. Reconciliation to GAAP net income can be found in our press release, which has been posted on our website. Now just a few quick comments on the year. Our fiscal year 2012 revenue was $412 million, a 20.4% increase over the prior year. Our gross margin for the year was 31.1% compared with 30.6% last year. Our diluted EPS for 2012 was $0.40 compared with $0.13 last year. And our adjusted EBITDAS was $68.4 million compared with $42.1 million last year. So now we'll discuss a few balance sheet items. At the end of the quarter, we had $107.4 million in working capital and no borrowings under our credits facility. Free cash flow in the quarter was $25.8 million, and our cash balance at the end of the quarter was $56.7 million. Capital expenditures for the year were $14.4 million, more focused primarily on capacity expansion. While fiscal 2013 CapEx will include some capacity expansion investment, it will also include a significant investment in the maintenance and health of our infrastructure and systems, especially in operations in IT. In fact, we'll be implementing a new ERP system in our operations over the next 18 months in order to improve our management's processes and systems. Thus, based on our current guidance, we expect capital expenditures to increase in fiscal 2013 and to be in the range of $27 million to $29 million. Based on our strengthened balance sheet, we went into the bond market after the end of the year and sought to purchase our 9.5% bonds. Although the market in our bonds is very thin, we have managed to recently acquire $6.4 million of bonds. We will continue to look for more bonds to acquire, but, of course, we will always continue to evaluate the best use of cash based on the relevant circumstances at any particular time. Now just a quick comment on our discontinued operations. As we have noted previously, we decided in the second quarter to divest our security solutions business and we engaged Wedbush to act as our adviser. We have identified a potential buyer with who we are negotiating. We expect that the purchase price will be less than $10 million. With that, I'll turn the call back over to James for a discussion of our operational results.

Thank you, Jeff. The fourth quarter continued to see an enhanced demand for firearms as gauged by NICS background checks and by our own increase in backlog. Orders continued to outstrip our ability to supply for the majority of our product portfolio, most notably, our M&P polymer pistols, our M&P Shield, our BODYGUARD 380, our revolvers and our M&P modern sporting rifles. These accounted for over 70% of our backlog at the end of fiscal 2012. We believe that the strong consumer buying has been driven by a number of macro influences, including political, social and economic. Certainly, we believe the recent political environment has been favorable at both a state and federal level, highlighted by the upcoming presidential election. More important to our industry is the social element. We believe that the user base has expanded dramatically, and this is likely being driven by increases in female ownership and the entry of a younger generation of new owners. We believe this higher level of social acceptance is clearly demonstrated in the adoption rate to conceal carried firearms. This is a factor that we think could drive industry growth for years to come. Lastly, the economic environment appears to have resulted in a migration to lower price points, where the consumer seeks a combination of value and quality. As I said last quarter, increasing our production in the face of a strong demand for our products in Q4 was a primary objective. I'm pleased to say we continue to make good progress by increasing our demonstrated daily throughput by 9% when compared to the prior sequential quarter. We have achieved this through a hybrid model, which provides a balance between internal production and enhanced production from our critical component suppliers. In terms of unit sales of Smith & Wesson and Thompson/Center firearms into the consumer channel, upper rates for the fourth quarter on a year-over-year basis came in at 27.2%. This compares unfavorably to the unit growth of adjusted NICS or FBI background checks of 21.1% for the same period, showing that we not only kept pace with the rapid expansion of the market in Q4, but that we did, in fact, take market share. In terms of dollars, sales in our domestic consumer channel during the fourth quarter were strong at $107.4 million, which is 39.2% higher than last year. That growth was driven by increased customer demand, especially for our M&P polymer pistols and our M&P modern sporting rifles. In our professional channel, which includes international sales, but also have an element of consumer sales, fourth quarter revenue was $11.3 million, an increase of 3.6% compared with last year. Our sales to law enforcement and government agencies reflects our success with meeting the most demanding standards for performance, safety and durability. Our effort to satisfy the requirements of these professional users translates to higher product performance for our consumer users as well. We believe this strategy supports growth in the consumer channel. So now I'd like to move to a discussion of new products, which are vital to the health of our future financial performance. At the NRA Show in April, we launched the M&P Shield, our newest polymer pistol available in 9-millimeter and .40 S&W. The new M&P Shield delivered the professional grade features found in the M&P Pistol Series: simple operation and reliable performance all in a slim profile. Acceptance of the M&P Shield in the market has been tremendous. In fact, the May 29 edition of AmmoLand applauded the well-coordinated product launch, and in reviewing the M&P Shield, wrote that it set a new standard in the firearm industry. During the quarter, we also completed preparations for the main launch of our new SDVE line of semiautomatic pistols. This replacement to our Sigma Series is chambered in 9-millimeter and .40 S&W and is designed for personal and home protection. The SDVE combines attractive price points with enhanced features, especially the trigger bolt. Our product strategy remains the same, balanced growth from new products with growth from our existing high-value product portfolio, particularly our M&P pistols, where we see opportunities for market share gains. And now let me update you on Walther. We have had a long and successful relationship with Walther, one that began at the time when Smith & Wesson did not have a strong polymer pistol offering. We have 3 agreements: one, naming us as the exclusive U.S. distributor for Walther products; one, for our manufacturer of the M&P Series of pistols at our Houlton, Maine facility; and one for Walther's manufacturer of the M&P22. For many years now, this arrangement has been beneficial for both companies, but now we have a very strong polymer pistol family in our M&P line, and that family of the products has earned the respect of both the professional and consumer communities. As a result, our company's agreed that now is an appropriate time for us to modify our relationship. We will allow the distribution agreement to expire at the end of our fiscal 2013. However, we do intend to continue our respective manufacturing agreement for an additional 2 years. Lastly, turning to backlog, and I want to remind everyone as we often do, the backlog is cancelable until shipped. Backlog at year end totaled $439 million, an increase of $252 million or 135% compared with the end of the fourth quarter last year, an increase of $240 million or 121% over the prior sequential quarter. We work closely with our customers to anticipate orders for a rolling 12-month period. While this initiative has been tremendously helpful in planning our production levels, our backlog has continued to grow. We will continue to take the steps in operations that I've outlined today to address the backlog that exceeds our current capacity. And now I'll ask Jeff to provide our financial outlook.

Thank you, James. In our outlook for the upcoming full year, we expect net sales of between $485 million and $505 million, which would provide revenue growth of over 17%. Based on our operating margin assumptions, that level of sales should allow us to get EPS between $0.60 and $0.65. This assumes the continuation of robust sales in the fall prior to the election and then a return between a more normalized industry growth rate after that. For the first quarter of 2013, we expect net sales of between $125 million and $130 million, which would represent revenue growth in excess of 36%, with EPS expected between the range of $0.16 to $0.19. For both the quarter and the year, we estimate the tax rate of -- at approximately 38% with the number of shares at 67 million. As a reminder, we have our usual 2-week shutdown in August and multiple holiday shutdowns in November and December, reducing our capacity in each of the second and third quarters by approximately 12% to 15%. Finally, let me give you some color on our longer-term financial model. Given our current outlook, we are accelerating the time frame in which we expect to deliver on our improved business model. And here, I'm referring to the financial model in our investor presentation that outlined our goals over the next 5 years. We have now revised that model, which you can find in an updated presentation just posted on our website. In that revision, and while there may be some variability quarter-to-quarter, our operating margin goals are 15% or higher on a consistent basis in 12 to 18 months and 18% on a consistent basis in the next 3 to 5 years. We think we would need a revenue run rate that is about 20% to 25% higher than our 2012 net sales in order to achieve our 18-month goals. The longer-term goals, like we believe we need a revenue run rate, there's an additional 20% beyond that. And with that, I'll turn the call back over to James.

Thanks, Jeff. I want to thank the entire Smith & Wesson team for delivering a year of growth, improved profitability and continued product innovation. We look forward to another successful year. That concludes our prepared remarks. So now let's open the call to questions from our analysts.

[Operator Instructions] Our first question comes from the line of Scott Hamann with KeyBanc Capital Markets.

Just a few questions here. Number one, on capacity utilization, I know you probably don't want to give a number but you're kind of -- with the addition you had sequentially in the fourth quarter and some of the things you've been doing in the outsourcing, I mean, where are we right now? How are you thinking about that as we're approaching fiscal '13 given some of the uncertainty in the back half of the year?

Sure. I would say our capacity utilization remains very high. That's something we stated very clearly on our last call. But how we're thinking about 2013 is we're looking, as Jeff said, at a range of CapEx of $27 million to $29 million. A large chunk of that goes to our ERP implementation, which everybody knows can be costly. The rest though does have an operations focus and that's where some of our capacity increases will come. And as we stated before, we have a hybrid approach to the capacity ramp. It requires a balance. Certainly, some of our CapEx will go to making sure that we don't over rely on outsourcing to satisfy the future growth. Also, by doing that, it gives us a favorable absorption opportunity so we have to think about our improving margins here. As we go on and think about some of the other uses of CapEx in the context of operations, it's the normal uses, retiring assets, some of the company end of their useful life; cost improvements, so again looking to some improved margins; infrastructure improvement, the building is approximately 60 years old; new products, obviously, we're very excited about the pipeline of new products that we have; tooling to increase our production flexibility within our base capacity; and of course, overall increase our base capacity so that we can meet our growth objectives that Jeff discussed earlier in the call. We do have one new use but we're not going to discuss any of the details but we're taking some of our first steps toward the vertical integration as well and again, that move is towards improving margins. That's pretty exciting for us, but as I said, too early to discuss details but we'll update on future calls. Everything I'm talking about here is obviously baked into our financial model that Jeff described earlier.

Okay, fair enough. And then, Jeff, just in terms of your fiscal '13 guidance, gross margin, can you kind of give us a sense of where you think that's going to be for the year and then what some of the bigger pockets might be when we're looking kind of year-over-year in terms of efficiency gains? Or is there going to be some price in there? Is it all volume driven? Just some thoughts around that, please.

Right. Well, as you can see, we're no longer providing a gross margin and operating expense on targets. Rather, we're just kind of doing top line and bottom line. But I think the best way for you to think about it is to look at the model because the model has all the targets for each line of coming down to 15%. So it has, for example, a 33% gross margin, it has a 18% OpEx. Now that's more of a, like I said, 12- to 18-month outlook but you can probably take that in -- based on our forecast, like for the first quarter, I think-- gain a idea of what we're -- I'm thinking about.

Our next question comes from the line of Cai Von Rumohr with Cowen and Company.

Could you kind of give us a little bit of color with the change in the Walther relationship? What should we -- how should we think about it when we model? What that will do to your sales in fiscal '13? And how should we think about the new replacement products that sum up, what that will do and how that will phase in?

Just to be clear on Walther, there are 3 agreements. The one that is about to expire is the distribution agreement for products made in Germany. The one we continue with is the agreement we have to manufacture the PPK at Houlton, Maine. And the other one is the agreement for Walther to manufacture the M&P22 in Germany. For Walther overall, as I stated, it's been a good relationship, it's been beneficial to both companies, but it's a shrinking piece of business. It peaked in fiscal 2010 at $44 million. And fiscal 2012, it's $32 million, so you can see there's been a significant erosion in the top line there. Certainly, as we think about fiscal 2013, it will be no more than last year. And you really must think about backing out the PPK revenue, which remains with us for another 2 years and that was approximately 15% of last year's revenue when it just comes to Walther. So we have a piece of business here, which really is smaller than the revenue generated by our BODYGUARD 380, a single SKU, just to put everything into perspective. It's really the result of the space becoming very crowded in -- on a competitive environment, and to be perfectly honest, we compete against Walther. Please remember that it is our lowest gross margin business. We said that on the last call, as we made a relative statement about gross margins. And certainly, life without Walther in the future is already baked into the financial model that Jeff described.

Terrific. And then the question about the Sigma replacement?

Yes, I mean, it's really -- Cai, it's really just a straight replacement, to be honest. We wanted to replace the Sigma. It's been a long-standing product for the company. It did have some opportunity to make an enhancement to that product and that's what we did, and we do highlight the trigger pull. It does have some other significant benefits there. We really searched from the SD range of polymer pistols that we did discontinue last year and have transitioned both over to this replacement of the SDVE for the Sigma series.

And just one other quick one. You mentioned twice the reception for the Shield was fantastic. Can you put some more specifics behind that?

No, not at this time, Cai, sorry. We will look to in the future. I mean, what I can say is, obviously, we continue our ramp through this first quarter. It's really a product that's very, very early in its product life cycle with us. So we're obviously well towards the end of what we would say is the launch process. And now is -- taking over is the capacity ramp. We will look to accelerate it where we can given the tremendous reception we've had from the trade and the consumer, especially, which is most important to us.

Our next question comes from the line of Rommel Dionisio with Wedbush Securities.

Is it possible to quantify the percentage of componentry you sell outsourced compared to maybe where it was a year ago? And also what steps have you guys taken to ensure that the product quality of the components that you're outsourcing to third-party providers is on par with what you guys are producing internally?

Sure, Rommel. We don't break out the split between in-house production and outsourced components. It's something we really don't want to reveal because, obviously, of the competitive nature of it. As regards to incoming inbound components, they are subject to 100% incoming inspection process, which is very, very rigorous and very, very robust. We also do a number of orders and you have to remember going right the way back to a whole selection process for the vendors that we selected to -- which is very strict, and there was a selection process for these vendors to make sure that they can produce the quality and deliver the products on time.

Our next question comes from the line of Reed Anderson with Northland Securities.

One question on -- getting back to the -- on to the Shield to Cai's question. I guess, where are you at specifically with that product in getting more out in the marketplace because just, anecdotally, the buzz is incredibly good, but very difficult to find. I'm just curious if you -- where are we at in getting that product more available so that we can really see the sales cycle ramp there?

Yes, I mean, it's really -- all I said earlier is we're in the ramp. We see the buzz, we think it's fantastic. The guys did a great job in the launch process. We are exceptionally happy with the response by the consumer and other customers. So it's just a ramp process and we can't really go into the detail of that ramp process. It's just too new, too early in it. Depending on the volumes that we do achieve with that product going forward, then we may carve it out as a separate cash equivalent way.

And just to follow up on that, James. I mean, when you look at the person who is buying that product, and again, it 's very early, but is that someone who's a hard-core firearms owner and is adding this because of -- it's such a new feature, a new gun for you folks? Or is it bringing in a new buyer you didn't have in the past? Just some color on what you're seeing with the initial purchases there.

Yes, Reed, it's really both. I mean, we talk with dealers on a regular basis, with some recently, just a couple of weeks ago. And they were saying they're seeing very different types of customers coming in and purchase it from the first-time buyer. We had one story where somebody came in, the first firearm they purchased happened to be in the M&P Shield. They came back just over a month later, I believe, and then said they wanted to upgrade to a full-size polymer pistol and they ended up buying 2 M&P full-size pistols. So it's definitely the first-time buyer. It's also definitely what we would describe as your more hard-core firearms collector who is adding to that collection. A lot of interest.

And then just one quick question, probably for Jeff. Your comments on gross margin, you had mentioned mix is kind of the last item mentioned as a positive. I'm just curious, just clarify what you mean by that. Is it mix of specific product, new product, or is it brand? I'm just curious what you meant by that.

I just said -- I mean, basically, obviously, what I meant is a mix of higher margin, that we sold more higher-margin products. So we haven't, like, typically identified what the margin is on various project -- on products. So I can't really go into that. But what I'm basically saying is the products that have higher margins, we sold more of it.

Our next question comes from the line of Jim Barrett with CL King & Associates.

James, you mentioned that post the elections, that the growth will return to, at least for the market, return to more normalized levels. What are the assumptions in that regard?

Well, when you think about the historical growth rate that we've observed from 2005 to 2010, which is an average of 11%, there's no doubt, as you think back to the election at the end of '08, that, that played a part there. I mean, an election certainly has an influence. We all know that. But people do tend to focus on just discussing the perceived short-term impact. The long-term impact is actually more exciting. It's new users and owners of firearms driving the expansion of the user base. So it really does act as a catalyst to increasing the social acceptance. It's a very dynamic environment. And when we think about the future, it's the social acceptance of firearms that we get most excited about as we act and behave and think like a consumer products company. So over and over at the moment, we still hear the same story. People are coming in to the store for whatever their reason, it could be politically related, or they're buying for the first time but they could become a repeat purchaser. Our research validates this. It's great for the industry and it's even better for a firearms company who focuses on strengthening their brand and bringing exciting new products to the consumer.

Agreed. Now in terms of your current sales growth, are there any major differences between independent dealers and sporting good -- large sporting good retailers?

I would say no. They're both -- in terms of their growth, if we were just to talk about their growth, that both groups are growing and doing well when it comes to firearms sales. We see Cabela's, for example, use them as the example for the big box, they're certainly adding more stores. You go to talk about -- some of the larger independent retailers are either adding more stores or refurbishing existing stores by making additions or moving premises to larger stores. You see a lot of them also adding shooting ranges. That's becoming key as people want to actually experience shooting a firearm for the first time, as well as purchasing one.

[Operator Instructions] Up next, we have Mr. Mike Greene with Benchmark.

Where do you see growth in MSRs in the future? Is it the adoption of the rifle by existing shooters that previously stopped for more traditional rifles? Is it new shooters? Or is it possibly stemming the product offering by Calbert [ph]? Is that second or third MSR into a shooter's state?

Growth will come on multiple fronts, we believe. Certainly, as you think back to the launch of our M&P15 Sport, we took -- we -- here, we've created an offering at an extremely attractive price point for the consumer. And there's no doubt that the economy is a factor in terms I mentioned before with consumers migrating to lower price points, but still looking for value. That certainly met that consumer need, and that's been a great vehicle of growth for us when it comes to MSRs. Certainly, in terms of recreation, the rifle -- the modern sporting rifle is extremely popular. And we do see the use for hunting ever expanding and that's quite an exciting one and one that we're monitoring closely.

Great. And then switching to the Shield. Could the existing design be adapted to a larger or smaller caliber pretty easily?

I mean, it really -- it comes in a 9-millimeter and a .40 S&W already. So were you saying, could it be a .45, for example?

Right, or a 380.

Yes, it wouldn't be -- the frame size is not actually suitable for a .45, it's not big enough.

Okay. And just one last question. I may have missed it in your earlier comments. Do you still have the USR business in the quarter?

Yes, we still own it. We are currently negotiating with a potential buyer. So we've identified the buyer and are in current negotiations with that buyer.

Ladies and gentlemen, that concludes the Q&A portion of the call. I'd now like to turn the presentation over to Mr. James Debney for closing remarks.

Thank you, operator, and thanks, everyone, for joining us today. We look forward to speaking with you next quarter and seeing some of you tomorrow. Thank you.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.