SMITH & WESSON BRANDS, INC. annual report, FY2012

Business context and reporting period

Smith & Wesson Holding Corporation’s Form 10-K covers the fiscal year ended April 30, 2012 (fiscal 2012), with fiscal 2011 as the prior-year comparison. The company manufactures firearms and related products; firearm sales represented 95.6% of fiscal 2012 net sales. Its security solutions business, SWSS, is reported as discontinued operations after the company committed to divest it in October 2011. The filing also presents fourth-quarter results, but this is an annual report, not a standalone quarterly filing.

Financial performance and liquidity

The company had no balance drawn on its $60 million revolving credit facility at year-end and reported compliance with debt covenants. It reported $50 million of 9.5% senior notes due in 2016; interest expense rose to $7.5 million from $5.7 million. In May and June 2012, it repurchased $6.4 million of those notes and paid a $550,000 premium. Management said existing capital resources and credit facilities should fund operations, debt and other commitments for the next 12 months, excluding major acquisitions.

Material changes versus the prior comparable period

• Sales increased 20.4%, principally on higher demand and production of polymer handguns and modern sporting rifles. Handgun sales rose 25.1%; modern sporting rifle sales rose 94.1%.
• Hunting firearm sales fell 29.1%, reflecting lower black-powder orders, constrained bolt-action rifle shipments during the Venture rifle recall, and disruption from moving production to Springfield.
• Operating income improved as higher sales lifted manufacturing absorption and lower legal and consulting costs and cost-cutting helped offset expenses. DOJ/SEC-related legal and consulting costs were $4.0 million, $5.9 million lower than the prior year.
• Fiscal 2012 net income included a $10.3 million after-tax loss from discontinued operations, including a $5.5 million non-cash estimated loss on the SWSS sale. Fiscal 2011’s $82.8 million net loss included a $90.5 million non-cash impairment charge related to SWSS.
• Backlog rose to $439.0 million from $186.7 million, but orders may be cancelled and demand exceeded available production capacity.
• Fourth-quarter sales were $129.8 million and continuing-operations income was $17.8 million, versus $101.7 million and $4.4 million, respectively, in fiscal 2011’s fourth quarter.

Outlook, risks and unusual items

The filing provides no specific fiscal 2013 revenue or earnings guidance. Management planned further new product introductions and capacity increases through capital spending and outsourcing, while warning that capacity constraints could limit shipments. It expected no material additional fiscal 2013 costs from the completed hunting-production consolidation. Management’s liquidity outlook is qualified by the exclusion of major acquisitions.

• Product recall: The November 2011 recall covered Thompson/Center Venture rifles made since the product’s 2009 introduction. The company had incurred $512,000 by year-end and estimated another $1.0 million in costs; fiscal 2012 warranty expense was $6.3 million versus $3.5 million.
• Investigations and litigation: The DOJ investigation into potential FCPA violations and SEC inquiry into potential securities-law violations remained unresolved. The company was not charged in the DOJ indictments described, which were dismissed in February 2012, but disclosed possible penalties, contract restrictions, added costs and reputational effects. It also reported derivative, product-liability and municipal lawsuits.
• Environmental exposure: The company recorded a $2.1 million environmental reserve, including $1.5 million for the Rochester, New Hampshire site, and indemnified the prospective buyer for certain environmental losses. Additional remediation costs remain possible.
• Operating and market risks: Demand can be affected by economic, political and regulatory shifts; the business depends heavily on sporting-goods distribution, has customer and supplier concentration, and faces capacity, raw-material, competition and product-liability risks. The top five commercial distributors accounted for 37.9% of sales.
• Other exposures: A 10% weakening of the U.S. dollar against the euro could reduce gross profit by approximately $2.3 million on the identified €-linked inventory exposure, absent offsetting price changes. A new ERP system was scheduled for full implementation in fiscal 2014.
• Controls and audit: Management and the independent auditor concluded that internal control over financial reporting was effective as of April 30, 2012; the auditor issued an unqualified opinion on the financial statements.

Important facts for investors to verify

• Whether the $439.0 million backlog converts into shipments and revenue, given cancellation risk and production constraints.
• Final costs and customer response related to the Venture rifle recall, and any subsequent warranty developments.
• Progress and proceeds from the SWSS divestiture, including remaining obligations and transition-related costs.
• Developments and potential financial consequences of the DOJ and SEC matters, litigation and environmental remediation.
• Cash generation, capital spending, covenant headroom and the effect of repurchasing senior notes on liquidity and interest costs.
• Whether demand and margins remain resilient as product mix, consumer demand and manufacturing capacity change.