Smith & Wesson Brands, Inc. Q1 FY2024 Earnings Call

Good day, everyone, and welcome to the Smith & Wesson Brands, Inc. First Quarter Fiscal 2024 Financial Results Conference Call. This call is being recorded. At this time, I would like to turn the call over to Kevin Maxwell, Smith & Wesson's General Counsel, who will give us some information about today's call.

Thank you, and good afternoon. Our comments today may contain forward-looking statements. Our use of the words anticipate, project, estimate, expect, intend, believe, and other similar expressions are intended to identify forward-looking statements. Forward-looking statements may also include statements on topics such as our product development, objectives, strategies, market share, demand, consumer preferences, inventory conditions for our products, growth opportunities, and trends in industry conditions in general. Forward-looking statements represent our current judgment about the future and are subject to risks and uncertainties that could cause our actual results to differ materially from those expressed or implied by our statements today. These risks and uncertainties are described in our SEC filings, which are available on our website, along with a replay of today's call. We have no obligation to update forward-looking statements. We reference certain non-GAAP financial results. Our non-GAAP financial results exclude costs related to the planned relocation of our headquarters and certain manufacturing and distribution operations to Tennessee, the spin-off of the Outdoor Products & Accessories business in fiscal 2021, and other costs. Reconciliations of GAAP financial measures to non-GAAP financial measures can be found in our SEC filings and in today's earnings press release, each of which is available on our website. Also, when we reference EPS, we are always referencing fully diluted EPS, and any reference to EBITDA is to adjusted EBITDA. Before I hand the call over to our speakers, I would like to remind you that when we discuss NICS results, we are referring to adjusted NICS, a metric published by the National Shooting Sports Foundation based on FBI NICS data. Adjusted NICS removes those background checks conducted for purposes other than firearms purchases. Adjusted NICS is generally considered the best available proxy for consumer firearm demand at the retail counter. Because we transfer firearms only to law enforcement agencies and federally licensed distributors and retailers, and not to end consumers, NICS generally does not directly correlate to our shipments or market share in any given time period, we believe, mostly due to inventory levels in the channel. Joining us on today's call are Mark Smith, our President and CEO; and Deana McPherson, our CFO. With that, I will turn the call over to Mark.

Thank you, Kevin, and thanks, everyone, for joining us today. We are very pleased with our first quarter performance. Our top-line results reflected strong consumer demand for the Smith & Wesson brand at retail. Channel inventory of our products remained steady throughout the seasonally slow period this summer, indicating healthy pull-through of our shipments at both distributor and retailer levels. Innovation and our iconic brand's reputation for quality continue to be big drivers of consumers' preference for Smith & Wesson. Combined with healthy lean channel inventories as we enter into the traditionally busy fall season, we anticipate these tailwinds will allow us to continue delivering strong results. Our 35% growth in year-over-year revenue in Q1 was driven by unit volume and higher average selling prices (ASPs). ASPs were positively impacted by NICS due to the strength of several new product launches coupled with the seasonal factors relative to the demand for our core products. The team has been effectively managing a balance of innovation and promotions on our core line to grow market share profitably in a highly competitive environment. With firearm demand now steady and following normal seasonal trends, we anticipate that competitive promotional activity will continue, and we may experience some moderation in overall ASPs through the balance of fiscal 2024. Diving a little deeper into new products, they accounted for almost one-third of our first quarter revenue as we continue to see significant demand for our latest introductions. The Folding Pistol Carbine and the M&P 5.7 launches from late last fiscal year continue to dominate their respective categories, and the newest launch in July of the M&P 22 mag is exceeding our expectations so far, and our development pipeline remains robust, continuing to reflect the strength of our new product development team with additional products launching later this fiscal year. Turning to market conditions, we continue to see relatively stable demand and familiar seasonality. While consumers continue to be pressured by macroeconomic headwinds, firearms demand trends are following normal historical patterns. We believe our products are well positioned, reflecting the strength of our brand and innovation, and that we are gaining share. NICS was down about 13% on a year-over-year basis during our first fiscal quarter, while our units were up significantly in both handguns and long guns. I will note again that while monthly NICS trends moderated during the quarter, this is consistent with the normal seasonal pattern during the summer, which typically marks a low point for increasing as we move into the fall hunting season. And in spite of the higher shipments of our products into the channel during the quarter, distributor inventories remained steady during a period which traditionally marks an inventory build due to slower retail and stock up for the busy fall season. For context, our channel inventories are down over 35% versus this time a year ago. Again, this reflects the strong momentum we are seeing across our newest products and the success of a number of targeted promotional programs. We continue to work closely with key retail partners to ensure the channel is clean and closely aligned with SKU level demand. Finally, our balance sheet inventory is in a great spot, down mid-single digits versus a year ago despite the planned redundancy to mitigate any potential disruption caused by our move to Tennessee. A quick update on the Tennessee relocation: Inventory was moved in phases from our Missouri distribution center into the new facility throughout the second half of July, and we went live with our distribution operations in August as planned. Assembly and plastic injection molding operations will now begin to transition over the next several weeks and continue into calendar 2024. Construction on the headquarters building is in the final stages, and we're looking forward to the grand opening celebration on October 7. I want to thank our entire team of loyal dedicated employees who have been working tirelessly to ensure the success of the move, while all along maintaining the highest standards in our existing operations and simultaneously dealing with the personal impacts of the relocation. A project of this magnitude is not without its challenges, and over the past two years, our employees have consistently delivered on the values that underpin the culture of Smith & Wesson, overcoming each challenge and putting us in an even stronger position for the future.

Thanks, Mark. Our first quarter results once again demonstrated the power of our flexible model. Bottom line profitability remains strong as disciplined cost control offset temporary headwinds from seasonally lower production volumes and inflationary factors. Net sales for our first quarter of $114.2 million were $29.8 million or 35.4% above the prior year comparable quarter with inventory in the distribution channel showing only a slight increase over April 30 level. As you will recall, throughout fiscal 2023, we experienced large sequential declines in channel inventory that negatively impacted our sales. We believe that our fiscal 2024 sales will more closely match consumer demand for our products at the counter. ASPs were stronger than anticipated due to the mix of product we sold, with new products making up nearly one-third of our total sales. Gross margin of 26.6% was negatively impacted by manufacturing cost absorption and inventory reserve adjustments. We believe this drop is temporary, reflecting seasonal factors, adjustments to production and inventory levels, as well as one-time costs related to our Tennessee relocation. We remain comfortable with our published financial model of annual gross margins of at least 32%. Operating expenses of $26.1 million for our first quarter were $1.5 million lower than the prior year comparable quarter due to lower profit sharing, lower legal expenses, and a reclassification of sublease income from other income to operating expense, partially offsetting these decreases with a $2 million impairment of distribution equipment during the quarter that we recognized as we began to decommission our Missouri operations. Net income of $3.1 million in the first quarter was $200,000 lower than the prior year comparable quarter. GAAP earnings per share of $0.07 was equal to the prior year first quarter, while non-GAAP earnings per share of $0.13 was up $0.02 over Q1 fiscal 2023. Cash from operations was $40.6 million, more than $33 million above last year, reflecting lower inventory due to strong pull-through of our products at retail in spite of the industry's seasonal slow period and a seasonal reduction in accounts receivable. With capital spending of $32.1 million, we generated net free cash of $8.6 million during the quarter. We paid $5.5 million in dividends and ended the quarter with $55.5 million in cash and $25 million in borrowings on our line of credit. During our first quarter, we received our certificate of occupancy for our new manufacturing facility in Tennessee and began receiving product in preparation to begin shipping to customers in the second quarter. We will continue capital spending to bring our assembly and plastic injection molding operations online and complete construction of the headquarters part of our building. The majority of the $70 million to $75 million that we plan to spend this fiscal year on the relocation will be completed in our first half. Therefore, we are likely to increase our borrowings on our line of credit during the second quarter, and we expect to fully repay it during our second half. Finally, our Board has authorized our $0.12 quarterly dividend to be paid to stockholders of record on September 21, with payment to be made on October 5. Looking forward to our second quarter, we expect consumer demand to be similar to last year with a normal summer seasonal slowness beginning to pick up as we move toward cooler weather and fall activities. Although we expect a slight increase in units shipped over last year's second quarter, we will likely use promotional dollars to drive some of that volume and therefore, anticipate a 5% to 10% drop in ASPs versus what we saw in our first quarter. We expect margins to continue to be pressured by promotions and higher costs due to inflation and higher interest rates, although we anticipate margins being up slightly in Q2 compared to Q1. The opening of the Tennessee facility will also include one-time costs in Q2 that will result in margin pressure that we expect to alleviate in our second half. Operating expenses will likely be 5% to 10% higher in the second quarter versus Q1 due to increased marketing costs associated with the start-up of our new facility, including our grand opening festival, increased hiring costs, increased promotions, and increased profit sharing. Finally, our effective tax rate is expected to be approximately 25%. With that, operator, can we please open the call to questions from our analysts.

Our first question will come from Mark Smith from Lake Street.

First question for me. Just as we look at the NICS, can you talk at all about maybe revolvers versus polymer pistols and any impact that may be had on ASP? And kind of how the demand is shifting for each of those lines? Yes, of course. Demand for revolvers is typically quite stable since it's a category we always see high demand for, and we often face capacity constraints in that area. The change in NICS you're observing mainly reflects seasonal trends—historically, summer is a slower period for our core product line, which experiences lower volumes. Recently, we introduced several new higher-end products, which contributed more significantly to our overall sales volume, resulting in higher average selling prices during that period. This is particularly noteworthy given that it’s one of the slower times of the year, and the strong performance of these new products had a notable positive effect on our average selling prices over the last three months. Okay. And as we think about the new products, I think you called out the 5.7 and the Folding Carbine. Are those the primary tiers or is there anything else to call out that's really driving? Yes, I recall we launched the 22 mag in July as well. When we introduce new products, we ensure that they are ready and available to ship at the time of the launch. This means there will be a significant initial distribution. The 22 mag certainly had an impact too. Okay. Great. And then as we think about you made a comment about the promotional environment, what's kind of your outlook for that, especially as we move through the holiday season? And then it sounds like you're willing to or planning on competing a little bit in price, but maybe walk us through some of your thoughts as we move through the important fall and then positive season. Yes, that's a good question. We currently have the advantage of being quite strategic about our approach. We'll respond as needed. As I highlighted earlier, our inventories are in a favorable position as we head into the busy season. We worked diligently to clear out channel inventories during the second half of last year and entered the summer in a strong position. Our shipments throughout the summer have performed well at retail, thanks to our sales team and various promotional efforts. As we look ahead to the fall and the busy season, we are not faced with excess inventory that we need to move. This allows us to be strategic and focused. We intend to participate in the market strategically, aiming to maintain and gain market share in specific categories. We'll react as necessary to any competitive activities that we identify as threats. So, we will be targeting our participation and remaining in a wait-and-see mode. Okay. And the last one for me, and I don't know if you want to take this or Deana, but what kind of gives you confidence in the 32% gross profit margin expectation?

A lot of the changes we’re seeing in the first half are related to our accounting reserve adjustments, including capitalized variance and lower production compared to last year. This involves an amortization process that impacts the first half and gets spread out over our inventory turns. Although it may not seem exciting, it has its own cycle in the first half. Looking to the second half, which usually experiences higher volume and production, we typically have around 65 production days in Q4 without holidays, unlike the first three quarters. This allows us to produce more during those times. As a result, we will benefit from absorption and increased volume, leading us to expect a significantly higher margin in the second half compared to the first half.

Yes, Mark, it's been some time since we've been in a typical environment. Just keep in mind that the first half of the year generally sees lower margins compared to the second half, which is typically a higher margin period.

Our next question will come from the line of Steve Dyer from Craig-Hallum.

Ryan on for Steve. Maybe just in on that last point, can you quantify how much that accounting reserve was or amortization, either in basis points impact, gross margin or dollars or both?

No, it's several percentage points, but it's not something that we've disclosed, but it is a couple of percentage points impact.

Yes, Ryan, I want to emphasize that as a manufacturing company, when we operate our facility at full capacity, it naturally reduces absorption. Like any other manufacturing firm, this approach allows us to achieve very high gross margins. From the perspective of fixed costs, I can assure you that they remain quite stable and consistent. We pay close attention to this aspect, ensuring that regardless of market conditions or throughput, we keep our fixed costs in both operations and operating expenses flat. So, I’m providing you with some insight here; this is a significant factor. Therefore, increased production results in higher margins.

So, I guess when I look year-over-year, sales were up 35%, gross margins down 1,000 basis points. So I guess it seemed like those impacts would have been last year in Q1 or not necessarily?

No, because you remember, last year in Q1, we built inventory. The way that our flexible model works is that we allow our supply chain to continue producing until they're able to slowly take their volume down. That's what makes us so successful when we go back to the well later and need them to increase their volumes when a surge happens; we allow them to bring their volumes back down slowly. So we were still producing. We were growing inventory internally. So we were producing significantly more units in Q1 last year than we produced in Q1 this year. So it's not a function of revenue. It's a function of production. And so by driving inventory down, we no longer have suppliers. We're a year past the surge where we're no longer having suppliers who are still outproducing demand, and we are no longer building inventory. So as production curtails, inventory comes down and the absorption of that fixed overhead, and like Mark said, it hasn't increased significantly from one year to the next. It's just fewer units going across the same level of fixed overhead.

We will revisit this as we assess the inventories. Our internal inventory is aligned with our goals. It's important to consider a long-term perspective; we don’t have to react abruptly to fluctuating market conditions, which can be quite unpredictable. Instead, we take a longer-term approach, allowing us to adjust our pace accordingly.

Yes. If you think about the production days, we're in the 57 days in Q1, 61 in Q2, 58 in Q3, 64 in Q4; so more production, more volume. And we're not trying to play like a quarterly game where we need more production to make our margins higher, growing inventory. We are managing the business for the long term. We're managing for shareholder returns. And so there are times where you turn production down, your margins go down because your fixed overheads don't really change. Over time, it all levels out because you turn that inventory into cash, you're able to do more with it. So this is really a long-term goal here. This is not a quarter-to-quarter goal. We're going to do the right thing for our investors by managing this cut-back on inventory now that we're able to work beyond the third.

Yes. Helpful. Switching over to NICS, the end customer demand. I guess you've seen a deceleration here over the last couple of months. I get it, it's seasonally slow, but we're still comping into those same seasonal slow periods in prior years, and it still feels like there's been a bit of a deceleration here recently. I guess are you guys seeing anything in the underlying metrics or conversations with distributors, retail partners, the end consumer, et cetera, that gives you the confidence that this is just a temporary kind of summer lull and things are going to turn back up?

Yes. I suggest that you take a step back and look at a 10-year chart of NICS. You'll notice that it may ease your concerns, as it appears to be reverting to levels seen about four or five years ago. We all anticipated that the spikes during the pandemic in 2020 and 2021 were not sustainable. Now we are returning to normalcy, and that's where we currently stand. I recommend examining the firearms trends over the past 10 to 15 years; when you stack this year's data on top of that, you'll observe a predictable slowdown in the summer followed by a rise in the fall. Additionally, if you conduct your own channel checks, you will probably find that activity is starting to pick up now and will continue to improve in the fall.

Now I'd like to turn the conference back to Mark Smith for closing remarks.

All right. Thank you, operator. Thanks, everyone, for joining us today. I look forward to seeing as many of you as we can in our grand opening celebration on October 7, and everybody enjoy the rest of the evening.

This concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.