Earnings Call Transcript - SWBI Q2 2020

Liz Sharp, Vice President of Investor Relations

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, believe, and other similar expressions is intended to identify those forward-looking statements. Forward-looking statements also include statements regarding revenue; earnings per share; non-GAAP earnings per share; fully diluted share count and tax rate for future periods; our product development, focus, objectives, strategies, and vision; our strategic evolution; our market share and market demand for our products; market and inventory conditions related to our products and in our industry in general; and growth opportunities and trends. 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 8-K, 10-K, and 10-Q. You can find those documents, as well as a replay of this call, on our website at aob.com later today.

James Debney, President and CEO

Thank you, Liz. Good afternoon, and thanks, everyone, for joining us. With me on today's call is Jeff Buchanan, our Chief Financial Officer. We are pleased with our second quarter performance, which includes several achievements that I will outline for you today. Among them was our work to finalize the plan to spin off our Outdoor Products & Accessories business as a tax-free dividend to our stockholders, a transaction we announced in early November that we expect to close in about 8 to 10 months. Because we plan to become two independent public companies at the spin-off date, I have organized my comments today to first address our firearms business, which will become Smith & Wesson Brands, Inc., and then our Outdoor Products & Accessories business, which will become American Outdoor Brands, Inc. After my comments, Jeff will discuss our financial results and our outlook, which will now include revenue guidance for each business for the balance of the year as we work to provide stockholders with enhanced visibility as we approach the spin-off date. As you know, we transfer firearms only to law enforcement agencies and federally licensed distributors and retailers, not directly to end consumers. That said, adjusted NICS background checks are generally considered to be the best available proxy for consumer demand for firearms at retail. In our fiscal Q2, background checks for handguns increased 14.8% year-over-year, while our units shipped to distributors and retailers increased by 14.2%. For the same period, background checks for long guns grew 7.8% year-over-year, while our units shipped to distributors and retailers declined by 30.3%. This decline occurred for two reasons. First, you'll remember that on our last call, I indicated we have proactively worked to reduce our inventory of a certain family of hunting rifles, with enough time for that inventory to clear out of the channel in advance of an upcoming major product launch. As a result, we believe consumer demand for our hunting rifles in Q2 was addressed with the inventory that we effectively moved into the channel during Q1. In a more recent update, November adjusted NICS increased 2.1% versus a year ago, following the expected seasonal trend line. Within that result, unadjusted background checks of Black Friday were brisk, delivering the second-highest Black Friday on record and indicating that the consumer is willing to wait for a great deal on their next firearm purchase. Distributor inventory of our firearms decreased sequentially from 178,000 units at the end of Q1 to 153,000 units at the end of Q2. This sequential decline is normal as Q2 takes us into the beginning of the fall hunting and holiday shopping season. Since the end of Q2, distributor inventories have further declined, but remain above our 8-week threshold. New product introductions in Q2 included the Smith & Wesson Model 648 revolver, featuring an 8-round capacity and chambered in .22 Magnum, ideal for target shooting and small game hunting, as well as the new M&P M2.0 Subcompact, the newest addition to our popular M2.0 family of pistols and ideal for concealed carry and personal protection. During the quarter, we also prepared for an exciting new upcoming major product launch. We seeded the channel with this new product late in Q2 in preparation for the official launch that will occur on December 12. The team also continued preparations for several exciting new product launches we have planned for the SHOT Show in January. While I won't share more detail at this point, I can tell you that we look forward to providing consumers with some exciting new products from the brands they know and trust. So please stay tuned. Turning now to Outdoor Products & Accessories or OP&A. Revenue for OP&A in Q2 decreased by about $8 million from the comparable quarter last year. The prior year quarter was a challenging comparison since it included large discounted orders from two significant customers, and those orders did not repeat in the current Q2. That said, the decline does not concern us because point-of-sale data continues to indicate strong consumer demand for our products at retail. In fact, and as Jeff will outline later, we expect full year fiscal 2020 revenue in OP&A to grow over the prior year. Our decision to organize our OP&A business into brand lanes continues to yield exciting results. Our four primary brand lanes are oriented around distinct consumer archetypes: the marksman, the harvester, the defender, and the adventurer, each containing 3 to 6 distinct brands. This focus has enabled our teams to establish clear positioning for each brand, which, in turn, defines where each brand has the consumer's permission to play in certain product categories. The result of this approach is evident in our new product launch plans. In January, primarily at SHOT Show, 15 of our 19 OP&A brands will launch a large number of new products, one of which is an entirely new brand, and many of which represent our entry into 6 completely new product categories. Those entries demonstrate meaningful progress towards our expansion into the $35 billion rugged outdoor market, while the remainder are introductions aimed at strengthening our position and taking market share within existing product categories. I look forward to sharing the details of those launches in the new year. Lastly, and before I hand over to Jeff, just a few comments on the planned spin-off of our OP&A business. We made the spin-off announcement just three weeks ago, so there are no significant new developments to share today. We currently have a dedicated project team in place that will keep us on track while we work to develop the various business arrangements that will need to be in place by the spin-off date. In the meantime, the rest of our organization will remain focused on continuing to effectively and efficiently run the company. As we approach the spin-off, we will continue to provide regular updates. We look forward to getting our new leadership teams out on the road, providing us the opportunity to meet with many of you. The first of these opportunities will be at SHOT Show in January, and we hope to see some of you there. With that, I'll ask Jeff to provide more detail on our financial results and our updated guidance. Jeff?

Jeffrey Buchanan, Chief Financial Officer

Thanks, James. Revenue for the quarter was $154.4 million, a decrease of 4.5% from the prior year. Revenue from our Firearms segment was $113.7 million, an increase of 1.8%. Note that we recorded $8.1 million of incremental Firearm revenue because of a change in how we record federal firearms excise tax. Without that change, Firearms revenue would have been $105.6 million, or a 5.5% decrease from the prior year. This decrease relates mostly to the decline in long-gun sales that James discussed. Revenue from our OP&A segment was $47.8 million, a decrease of 14.6%. The decline in our OP&A revenue was due mainly to a reduction in large discount orders from certain significant customers, as James discussed earlier in the call. Despite the decline, we expect full-year OP&A revenue to be up versus the prior year. Intercompany eliminations were $7.1 million. So now let me take a moment to explain the change in firearms excise tax. The Firearms segment is now required to record and pay that tax when we ship firearms from our Massachusetts manufacturing plant to our Missouri distribution center. Previously, we paid the tax upon shipment to our third-party customers and recorded the tax as a reduction of revenue at that point. We petitioned to continue with that same treatment when shipping firearms from our distribution center. The Tax and Trade Bureau, however, denied our petition and insisted that the tax be assessed and paid on the first transfer of a firearm, which is when we ship it to our distribution center. This means that our revenue will no longer be reduced by that excise tax amount. Rather, that amount will be included in our cost of sales. Obviously, this change does not impact our gross profit dollars, but it will artificially increase revenue and cost of goods sold, and it will correspondingly reduce certain percentages based on revenue, such as gross margin, operating margin, and EBITDA margin. I will detail the tax-related revenue increase for the remainder of the fiscal year when I provide guidance later in the call. Now turning to gross margin. In Q2, the total company gross margin was 32.6% as compared to 34.9% in the prior year. The decline was driven by both the change in excise tax as well as lower margins in our OP&A business. In our Firearms segment, the gross margin was 28.2% as compared to 28.5% in the prior year. Although the gross margin percentage was unfavorably impacted by the change in federal excise tax, it was favorably impacted by moving firearm shipping costs down to operating expenses, as we discussed in our last earnings call. In the OP&A segment, gross margin declined to 38.9% as compared to 45.4% in the prior year. This decline was the result of additional tariffs and unfavorable customer and product mix. We expect our gross margins in OP&A to rebound in the back half of the year to well above 40%. In the quarter, both GAAP and non-GAAP operating expenses were roughly equivalent to last year, even though Q2 marked the first full quarter of operation of our Missouri campus, which increased operating expenses by $3.2 million. That increase, however, was offset by savings from closing our Jacksonville location as well as reductions in compensation, bad debt, and other costs. Additional savings will occur when we close our original OP&A facility in Missouri and fully consolidate into the Missouri campus. For the second quarter, GAAP EPS came in above our guidance at $0.02 as compared with $0.12 last year. Our non-GAAP EPS was above our guidance at $0.09 as compared with $0.20 in the year-ago quarter. Adjusted EBITDA in Q2 was $20.9 million for a 13.5% EBITDA margin as compared with a 16.5% margin in Q2 of last year. Excluding the excise tax change, adjusted EBITDA margin would have been 14.3%. Turning to the balance sheet. In Q2, operating cash outflow was $5.5 million, and our CapEx was $5.6 million. Thus, our Q2 free cash outflow was $11 million as compared to free cash outflow of $13.1 million in Q2 of the prior year. Free cash flow in our second quarter is usually neutral to negative but is typically strong in the back half of the fiscal year. We continue to expect CapEx spending to be about $25 million for the full fiscal year, and that's related to IT, new products, and maintenance. At the end of Q2, we had $43.8 million of cash on hand. We had borrowings of a little over $200 million, comprised of $50 million drawn on our line of credit, a term loan of $78 million, and bonds of $75 million. As a result, total net bank borrowings at the end of Q2 were just under $160 million. Our one-year trailing EBITDA is about $95 million, so our net leverage ratio is approximately 1.7:1, and we expect that ratio to be significantly lower at the end of the fiscal year. After the end of the quarter, we modified our banking facility with respect to certain terms that will take effect upon our planned spin-off. Most importantly, the banks have pre-approved the spin-off so long as certain debt levels are maintained. We believe the amended facility will provide more than enough borrowing capacity for the Firearms business after the spin-off. As a result of that pre-approval and modification, last week, we used the amended revolving line of credit to repay our bank term loan that was due in June of 2020. We also called our 5% bonds that are due in August of 2020 and expect to close that transaction in early January, also using the revolving line of credit. These two transactions will have the effect of extending 100% of our debt maturities out to October 2021 and reducing our overall blended annual interest rate by 35 basis points. So now I will discuss our guidance. For our full year fiscal 2020, we are revising upward our total company revenue guidance to reflect two factors. First, we are estimating a slightly improved outlook for product demand for the remainder of the fiscal year. Second, the change in federal excise tax will increase our full year revenue by $34 million to $36 million. Thus, we now expect total company full year revenue to be in the range of $680 million to $700 million. As James indicated earlier, in connection with our planned spin-off, we are providing revenue guidance for each separate business for the balance of the fiscal year to provide stockholders with enhanced visibility for each business. Accordingly, we expect full year revenue for firearms to be $520 million to $530 million and full year revenue for OP&A to be $180 million to $190 million. Intercompany eliminations between the two businesses are expected to be approximately $20 million. Regarding EPS. We are maintaining our full year GAAP EPS guidance of between $0.41 and $0.49 despite the following impact items: one, the beat in Q2 and our improved demand outlook, which have a favorable impact; and two, the expenses associated with the spin-off, which have an unfavorable impact. It should be noted that the spin-off expenses will not be included in our non-GAAP EPS. Thus, based on our beat in Q2 and the improved demand outlook, we are raising our full year non-GAAP EPS guidance to between $0.76 and $0.84. So turning to third quarter guidance and applying the adjustments that I just discussed, we expect total company revenue of $180 million to $190 million, GAAP EPS of between $0.11 and $0.15, and non-GAAP EPS of between $0.20 and $0.24. All of these estimates are based on our current fully diluted share count of 55 million shares and a tax rate for the full fiscal year of approximately 30%.

James Debney, President and CEO

Thank you, Jeff. With that, operator, please open up the call for questions from our analysts.

Jeffrey Molinari, Analyst

James and Jeff, this is Jeff Molinari on for Cai today. Yes. To start off, can you update us on what your guidance assumes for negative impacts from tariffs on Chinese imports? And specifically, what are your assumptions around the potential Phase I deal, if that's going to provide any relief? And then I have one follow-up after that.

Jeffrey Buchanan, Chief Financial Officer

Well, an easy answer is that the forecast assumes that tariffs in place right now stay in place. So we're not making any guesses as to what's going to happen or not happen.

Jeffrey Molinari, Analyst

And what is the negative impact that what otherwise would mean? Could you quantify that?

Jeffrey Buchanan, Chief Financial Officer

Part of the reason that the gross margin, for example, in outdoor products was lower this quarter was tariffs. We haven't got into specific numbers on tariffs. But in general, obviously, some of those tariffs are in inventory. And as the products are sold, it's reflecting a lower gross margin. And the forecast assumes that everything in place stays in place.

Jeffrey Molinari, Analyst

Okay. That makes sense. Can you remind us what percentage of outdoor products is manufactured in China, roughly?

James Debney, President and CEO

Yes. It's 80-plus percent.

Jeffrey Molinari, Analyst

Okay. Let's switch topics to the other segment. The major new product launching on December 12, is that a long gun? It seems you hinted at that when mentioning that you were allowing old inventory of a previous product to be sold through. Should we expect that? Or can you share anything else about it?

James Debney, President and CEO

Yes. I'm really not going to comment much. But when we were talking about the inventory that we had, let's say, pushed out into the channel in the last quarter because we wanted that inventory to move through before the new product launch, that was referencing a different product launch that will actually take place in January at SHOT Show.

James Hardiman, Analyst

A couple of questions from me. So let's start with outdoor. It seems like there's a lot of moving parts there. You talked about big purchases from discount retailers that didn't repeat in this year's second quarter. But coming into the quarter, there also seemed to be at least what I thought was going to be a benefit because if memory serves, there were some delayed shipments that moved from Q1 to Q2. So is there any way to think about the outdoor trajectory, excluding those unusual items?

James Debney, President and CEO

Yes. I mean, I think you should think about it in terms of our guidance. As you can see, we've guided for the balance of the year. We haven't broken it down by quarters. We've just given what we believe we'll do in the second half of the year. And as you can see, we believe that it's going to show growth over the prior year. That's largely as a result of the new product introductions that we'll be making for the balance of the fiscal year. We are set to launch over 300 new products, which includes entering six entirely new product categories. This expansion is aimed at tapping into the $35 billion rugged outdoor market that we have been discussing for a while. The introduction of these new products is expected to drive significant organic growth. Additionally, we have developed a new brand that we believe will connect well with consumers in this category. We're quite optimistic about the remainder of the year, as we are gaining traction with consumers and achieving a good level of brand awareness. I need to clarify that we currently have 20 brands, and with the introduction of our new brand, we will reach 21, all of which resonate with consumers.

Jeffrey Buchanan, Chief Financial Officer

And James, if you look at the guidance, we gave guidance for the first time for the whole year for outdoor products, which we said $180 million to $190 million. Well, we only did $81 million in the first half, which means that the second half is $100 million at the low end. And if you look in past years, just to show you how impressive that is, is it typically, like Q3 and Q4 are down. So if you put in $100 million in the last half of the year, you're talking about an increase over the prior year of over 30%. So just in terms of a trajectory, everything that James talked about, with the new products and brands, we're very positive on the second half of the year.

James Hardiman, Analyst

That's helpful. Please continue.

Jeffrey Buchanan, Chief Financial Officer

No. It's all right. It's all right. Go ahead.

James Hardiman, Analyst

Okay. So along those same lines, sales guidance is up $50 million versus the previous guide. You talked about the excise tax issue being $34 million to $36 million. So I get to about a $15 million increase in the underlying business. Can you help us think about which side of the business that $15 million increase is coming from? Obviously, NICS were much better than expected. So I would assume it's more weighted towards firearms, but you also sound pretty positive on the outdoor side, even though it had a decline in the first half of the year. How should we think about that?

Jeffrey Buchanan, Chief Financial Officer

Yes. The $15 million increase you mentioned is primarily related to firearms, although it does include some outdoor products. We have always anticipated a strong second half for outdoor products, and it has exceeded our expectations. However, the majority of that increase is indeed tied to firearms.

James Hardiman, Analyst

Okay. And for my last question while we are putting together our models, I believe you provided the excise tax impact for the second quarter and the full year of 2020. Could you also share what that number would be for the third quarter? Additionally, what remains for next year, fiscal 2021?

Jeffrey Buchanan, Chief Financial Officer

Yes. The excise tax applies to the sale of a completed firearm and is around 10%. However, not all of our firearm sales are affected by this tax. If you consider roughly 8.5% to 9% of our firearm sales, it will give you an idea of the impact for Q3, which is likely between $11 million to $12 million.

Scott Stember, Analyst

James, you mentioned the positive trajectory we saw with NICS during the quarter, but then in November, things seemed to level off, and you noted that consumers are waiting for a good deal. Does this suggest that a significant portion of the strong NICS numbers from the previous months was largely influenced by discounts?

James Debney, President and CEO

Definitely an element of that. I mean, there's a lot of promotional activity still going on. We've talked about that for some time. And we have a strong promotional strategy as well, which we think is very appropriate in this environment. And we continue to invest in those types of promotions going forward. So as we think about the balance of the year, we're going to continue with the same strength of promotional activity that you've seen from us in the past.

Scott Stember, Analyst

Got it. Regarding inventory, you mentioned last quarter that inventories were slightly up due to strong demand. As we approach SHOT Show, it seems like you're building up inventory. In this quarter, we need to understand the disconnect. Is it that you managed to sell off older inventory more quickly than anticipated, leading to a decrease in inventories sequentially?

James Debney, President and CEO

You're heading into that busier period that we've always spoken about. So you've got full hunting, for example, which really does stimulate the consumer to go back to these stores, where most of our product is obviously sold. And then we're into the holiday season. And that obviously, we've seen that before in terms of adjusted NICS, just continues to strengthen as you move from November to December. So that's the reason that you start to see more sales velocity, let's say, where our inventory mainly sits, which is largely with our two-step distribution partners.

Scott Stember, Analyst

Got it. And then last question regarding the excise tax. Can you provide a bit more detailed information? I'm trying to understand the implications. I know that it's essentially a transition from sales to cost of goods sold, which means the overall gross profit dollars remain unchanged. However, could you discuss the timing? It seems like it applies immediately from when products are shipped from the factory to the distribution center, whereas previously it was from the distribution center to the endpoint. What are the timing differences we should consider? I'm trying to grasp how these changes will affect us.

Jeffrey Buchanan, Chief Financial Officer

Yes, it depends on how long the firearm product remains in inventory. Previously, when we shipped from the Springfield factory to a customer, it was assessed and paid at that moment, which we accounted for as a reduction in revenue. For example, if the product was priced at $100, we reported $90 in revenue. Now, when the product is sold to the distribution center, it is assessed and paid, but it remains in our inventory. The tax payment is reflected in the cost of goods sold, which means that when the product is eventually sold, we recognize the full $100 instead of the $90 we reported before.

Steven Dyer, Analyst

Just kind of touching base on the inventory question again. It seems like kind of the overall industry and the inventory in the channel has been above that 8-week level, for probably since before Trump got elected. Is that just sort of the level? I mean, are DCs, distributors just more comfortable carrying more inventory now? Is that sort of the new level, do you think? Or any color around sort of how you anticipate that looking going forward?

James Debney, President and CEO

Yes, I think it really is a new level. It's certainly our two-step distribution partners are comfortable carrying our inventory. As you know, we have some of the strongest brands, which means that they have a lot of confidence that they'll be able to sell our products. So we're relatively low risk compared to some of the lesser brands. So you're going to see that weeks of cover; it's going to fluctuate all the time. It depends where we are in seasonality. And obviously, over the summer, it's low velocity. The velocity starts to increase as we are into full hunting and into the holiday season. So it ebbs and flows, to be honest. So we don't get too hung up on it, and we're not concerned by the level of inventory that we see out there right now.

Steven Dyer, Analyst

Okay, that's good. And then you talked about seeding the channel, I guess, a little bit with a new product at the end of the second quarter. I guess, first, are you willing to sort of talk about how much revenue you recognized from that at the end of the second quarter? And is the launch of that sort of in line, the timing of that sort of in line with your expectations at the beginning of the year?

James Debney, President and CEO

I would say that everything is on plan. If I were to provide more details, I would say that we're slightly ahead of plan, which we're very pleased about. We're obviously not going to disclose how much revenue has been generated from that new product to date or what we anticipate it will generate for the rest of the year. We just don't provide that level of detail. However, I can say that we're extremely excited about the product. We truly believe it will be very well received by consumers and is something they will want to own.

Mark Smith, Analyst

First, just a housekeeping item. As we break down average selling price on handguns and long guns, I assume that, that is higher due to the excise tax?

Jeffrey Buchanan, Chief Financial Officer

Yes, that certainly impacts it.

Mark Smith, Analyst

Okay, perfect. And then even if we kind of back that out, it looks like long guns, maybe we saw a little higher price? Are we not seeing as promotional activity in long guns as maybe we are in handguns?

Jeffrey Buchanan, Chief Financial Officer

Well, as James mentioned, we sold out of a particular long gun product. We sold all the remaining mostly in Q1. It's a lower-priced product, so not having those sales in Q2 probably helped the ASP.

Mark Smith, Analyst

Okay, perfect. And then can you guys walk through the impact of the holiday season and maybe promotions around Black Friday and how that impacted this quarter? And any that maybe flows into the next quarter?

James Debney, President and CEO

It's too early to provide updates regarding Black Friday as it just occurred in the current quarter. However, we have been planning our promotions around Black Friday in advance with our customer base, and this is always factored into our guidance. And we have another follow-up from James Hardiman with Wedbush Securities.

James Hardiman, Analyst

A follow-up from me, and I don't think you've answered, certainly, versus the way that the Street was modeling this, the implied sort of fourth quarter numbers, both in terms of sales and earnings, much better. Some big growth rates in the fourth quarter. Is there any way to think about sort of, I don't know, any breadcrumbs you can give us in terms of how to think about the distribution between Firearms and OP&A sales or earnings between Q3 and Q4? Or even just how to think about the drivers of those two things?

Jeffrey Buchanan, Chief Financial Officer

I would say that the significant increase from Q3 to Q4 is in Firearms. We anticipate a rise in outdoor products, but Q3 and Q4 are generally not peak sales months for outdoor products, whereas they are for Firearms. Consequently, Q4 is always the largest month for Firearms. Based on the new products that James mentioned earlier, I believe much of the sequential growth in Q4 can be attributed to Firearms.

James Hardiman, Analyst

Okay, that's helpful. And then last question from me. So you talked about OP&A revenues during the first 12 months being $200 million to $210 million. Is that comparable to the $180 million to $190 million that you've guided to today for 2020?

Jeffrey Buchanan, Chief Financial Officer

That is comparable. That's apples to apples there.

James Debney, President and CEO

Thank you, operator. I want to thank everyone across the American Outdoor Brands team for their commitment and dedication to excellence. Thanks, everyone, for joining us today, and we look forward to speaking with you next quarter.

Operator, Operator

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