Gregory Emge
Professor Phillip English, PhD
31 January 2015
Case Analysis #3
Smith& Wesson: A Long Shot Predicting the Future
Executive Summary:
River Capital, LLC, a long/short hedge fund, has assigned investment analyst, Ben Mackovak, to evaluate Smith and & Wesson Holding Corporation (SWHC) after the firm’s acquisition of Universal Safety Response, Inc. (USR). Mackovak must decide if S&W’s stock price change ($4.93 to $5.58) following its acquisition announcement accurately reflects the value added to the firm in order to make a long/short recommendation; making a short recommendation if overpriced by over 30% and a long recommendation if underpriced by over 20%. With USR being a privately held company in a niche industry, assumptions will be difficult to make due to lack of available information. High growth, questionable revenue projections, and variability in acquisition terms will make NPV estimates a challenge to calculate. I recommend that Mackovak makes no recommendation; NPV analysis determines that implied stock values will neither be overpriced by over 30% nor underpriced by 20%.
Analysis:
Assumptions Needed For Evaluation:
Will the acquisition add value in terms of diversification? What is USR’s cost of capital? What will USR’s earnings and revenue growth rate be? How much will S&W ultimately pay for USR’s acquisition?
Diversification Strategy:
Over 93% of S&W revenue consists of firearm sales, while only 7% of revenue comes from other products and services such as handcuffs and law enforcement training. An acquisition would increase the proportion of non-firearm sales by 329%. This would make S&W less vulnerable to market changes in the firearm industry, as well as expand opportunities for growth. Additionally, an acquisition would put less reliance on the consumer market by increasing the proportion of commercial customers by 118%. See Exhibit 1. This will give S&W an unique opportunity to gain a customer base from military, government, and law enforcement (Investors – Press Releases).
Cost of Capital:
USR’s current cost of capital is unknown. S&W’s WACC is 10.6% and will change slightly after taking on USR’s debt and equity. Four firms have been chosen as comparables to USR; their WACC’s ranging from 7.2% to 12.7%, with an average of 10.8%. Without the knowledge of USR’s capital structure or bond rating, and considering it is in a slightly different industry, the assumption of USR’s cost of capital will be S&W’s WACC averaged with the comparables’ WACC, at 10.7%. See Exhibit 2.
Growth in Revenue and EBITDA:
USR is experiencing very high growth in revenue and EBITDA, with revenue averaging 142% yearly growth if using 2009 and 2010’s revenue forecasts. Growth is dramatically decreasing, however; therefore these averages cannot be used to forecast growth past 2010 (Exhibit 3). Additionally, much of the revenue projections are based off of backlogged sales that can be cancelled at any time; no information was given on the conversion rate of backlogged sales (Exhibit 4). The assumption will be the 2009 and 2010 forecasts are accurate due to its current high growth and backlogs. It is to be concluded that this is a short period of high growth; therefore an industry comparison is needed to forecast growth past these years. The EBITDA growth rate from 2011 and on is determined by the 5-year averaged compound annual growth rate of the four comparable firms; 25.9% (Exhibit 5). The revenue growth rate is no longer a required assumption because EBITDA growth is already established which will be used to estimate the NPV of the acquisition.
NPV’s and Stock Price
USR is being bought out based on an earnout contingency; meaning that the acquisition’s NPV and implied value price per share price depends on two factors; 1) EBITA at the end of year 2009 and 2010; 2) the trading price per share at the end of year 2009 and 2010. The NPV of the acquisition’s cash flows is $51.9 million (Exhibit 6). USR will
