Gun Control: How To Profit From Increased Demand

We have written about investing in guns before (link) but it is time to take a deeper look at Smith & Wesson (SWHC). Right now the prices of semi-automatic AR's (ArmaLite rifle) are literally up 100%. We will be looking at how much exposure Smith & Wesson has to an increase in semi-automatic sales of AR style rifles.

Exposure to Semi-Automatic AR Rifles

Looking at the chart we can see that Smith & Wesson has 22.48% exposure to the semi-automatic AR market. Growth of the semi-automatic AR rifles segment is up 109.4% compared to last year.

_{(Source: 12/06/12 10Q, Note: % Sales Weight was created by the author)}

Demand

Demand for semi-automatic AR rifles is far outstripping supply. We can safely assume that the vast majority of retail AR weapons in the U.S. have been acquired. This is partly due to speculation -- if anyone can actually find one for sale they can flip it for a very handsome profit online.

Finding a semi-automatic AR style rifle at retail is extremely rare and even online many retail web sites are sold out or on allocated backorder. Smith & Wesson's website will redirect you to dealers to buy various semi-automatic AR style weapons, yet they are not in stock. Retailers are doing the best they can to restock but as soon as inventory arrives it is sold out in most cases.

Dennis Pratte, owner of My Gun Factory in Falls Church, VA talks aboutAR sales:

"They've sold out of just about every gun shop nationwide and just about every distributor is out of stock."

Gun manufacturers such as Smith & Wesson and Strum, Ruger & Co. (RGR) are experiencing unprecedented sales of the AR line of rifles. This translates into higher revenues and profits, something all shareholders love.

Parts & Accessories

Parts & Accessories are a big part of any modern sporting rifle. Smith & Wesson derives 5.6% of its revenue from this segment. Revenue in this area is about to increase though -- because with an increase in AR sales comes additional parts and accessories sales.

American Rifleman points out:

The survey reveals that 84 percent of MSR (AR) purchasers accessorize within 12 months: 22 percent at the time of purchaseand 62 percent within a year.

While this is not a huge segment for Smith & Wesson it is a positive event for the company and must be noted.

Concealed Carry

Smith & Wesson obtains almost 54% of its revenue from pistol sales. With an increase in demand for concealed carry permits, additional pistol sales will occur. Typically people who want to pack a concealed carry pistol opt for a compact pistol rather than a full size due to the bulk of a full size pistol. This means they have to buy a compact style pistol and this will translate into additional pistol sales for Smith & Wesson.

WNEP of Pennsylvania reports:

People seeking license to carry permits in Columbia County more than doubled, up 112%. Lackawanna County saw a 65% rise. Applications are up 55% in Luzerne County, 49%-percent in Schuylkill and Lycoming Counties, and 39% percent in Monroe County.

In those six counties, (concealed carry permits went) from 1329 last December to 2031 this December, an overall increase of 53%.

Parts of Washington State have experienced a rise on concealed permitrequests.

Concealed pistol license applications in Clark County quadrupled according to the Clark County Sheriff's civil department. On Dec. 14, "people were lined up out the door," said Nanci Collins, a sheriff's support specialist.

All of this bodes well for Smith & Wesson and the gun industry in general.

Share Buyback

On December 6th Smith & Wesson announced a $20 million dollar share buyback. A mere few weeks later the buyback was completed and the company announced they were going to expand the buyback by $15 million dollars. While we love and prefer dividends, buybacks are also good as it improves the earnings per share.

Conclusion

Smith & Wesson is a buy. Aggressive share buy backs on top of a buying mania will translate to higher revenues and earnings for the company. The financials look good with a trailing P/E of just 10.07 and a forward P/E of 9.07. The PEG ratio stands at .27 while the profit margin is 11.16%.

^{(6 month chart via Yahoo.com Finance)}

The risk the company faces is that if a gun ban went into effect, Smith & Wesson would lose a very productive product line and the stock would suffer in the short term. Some of this loss would be offset by a surge in pistol sales though due to fear of additional bans. To protect against a drop in share price an investor could buy put options to guard against a severe drop in share price. Buying a put allows you to sell your stock at a predetermined price to an investor. Of course you have to pay a premium for this option but it is worth considering.

We view Smith & Wesson as a strong buy. The share buy back and unprecedented sales of semi-automatic guns will result in an increase in revenue and earnings per share.

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4 Reasons Why Hartford Financial Can Continue To Rally

Shares of The Hartford Financial Services Group Inc (HIG), a leading provider of insurance and wealth management services, are up more than 33% over the past year. This move comes despite HIG taking significantcatastrophe loses related to hurricane sandy. There are four reasons why HIG can continue to rally.

1. Valuation

Despite trading close to a 52-week high, HIG remains a compelling value play based on price/book. As shown by the chart below, in the past, HIG has traded at significantly higher valuations based on price/book. Of course, HIG is unlikely to revisit its price/book valuations prior to 2008 but, given the current macro environment, the company should be able to move back to valuations seen in 2010 close to 0.75 times book value, a big improvement from the current 0.428 times book value.

2. Short Interest

Despite the rally in HIG shares, short interest remains robust. Currently, short interest stands at 42 million shares or 10.6% of the float. The high short interest indicates that many are still skeptical of HIG despite the move higher. Thus, many potential converts to the HIG bull case remain to drive the stock higher. Additionally, the high short interest means that, given any positive news, a short squeeze could develop.

3. David Tepper Increases Stake By 236%

Noted hedge fund manager David Tepper recently added significantly to his position in HIG. Of course, Tepper's endorsement alone is not reason enough to buy HIG. That being said, it is a positive that Tepper, usually a value investor, not a momentum player, (think about his purchased of Bank of America (BAC) for $3 in 2009) is buying HIG after a significant move higher, not selling.

4. Sector

Right now, the financial sector has the momentum. As shown by the chart below, the financial sector as a whole has been performing very well compared to other key market sectors, and this trend shows no signs of changing. There are a few fundamental reasons why the financial sector has been so strong: the improvement in the European debt situation, the improving housing market, and the prospect that the government will allow banks to increase dividends and buybacks in 2013. As an insurance and wealth management company, HIG is well positioned to benefit from the ongoing rotation into financial shares.

Potential Risks

In his piece To Hartford Management: I Wish You Wouldn't Do That, Seeking Alpha author Tom Armistead outlines some risks facing the company including the notable increase in CDS issuance. I agree with Tom that this has the potential to be a problem for HIG and the increasing CDS exposure is something of a red flag. That being said, the current bullish momentum behind the macro bodes well for HIG as the company should actually benefit from risky selling of CDS. However, if the macro environment were to change significantly HIG would likely face significant losses on this part of its business.

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Citigroup's Deep Value Makes A Great Entry Point

With the recovery continuing for the financial stocks, Citigroup (C) looks like a strong investment for the long term. The U.S. and world economyis slowly chugging along. The U.S. housing market has turned around withprices on the rise again and record low interest rates to entice buyers. These conditions are positive for Citigroup as the company's services will be increasingly needed.

The compelling thing about Citigroup is its undervaluation. The stock is currently trading with a forward PE ratio of 8.51 and a PEG of 0.91. The most attractive valuation statistic is the fact that the stock is trading 38% below its book value per share (stock price of $39.56 vs. book value per share of $63.58). Most stocks trade above their book value per share. Many of Warren Buffett's stocks trade between two to four times their book value per share. Citigroup's stock will eventually rise above its book value per share as its fundamentals continue to improve.

The stock price overshot to the downside as a result of the financial crisis. The price should continue to rise as earnings continue to grow. Citigroup is expected to see an 18% increase in earnings for 2013. The company is expected to grow earnings annually at 11% for the next five years. As the economy improves, the need for Citigroup's loans and other financial services for individuals and businesses will increase. This will allow the company to meet or exceed its expectations.

(click to enlarge)

Although there are short-term risks with the stock, I think having a long-term investment perspective will prove successful. In the short term, if the U.S. entered another recession, Citigroup's stock could lose 50% or more of its value. However, if that happened, the subsequent economic recovery would bring the stock back up quite rapidly. Therefore, when I'm talking long term, I'm looking 5 or more years into the future.

Financial stocks have had a nice run in 2012 and unless we see a recession in 2013, I think the bull run will continue. The long-term potential rewards should outweigh the risks for Citigroup. With the stock selling under its book value per share, it has some catching up to do. Stocks selling under their book value per share can rise quite rapidly. Bank of America (BAC) doubled in price in 2012 and still trades well below its book value per share. It's not too far-fetched to say that Citigroup could double in the next year or two, given its low valuation and strong earnings expectations.

I think that a healthy string of exceeding earnings expectations will continue to propel the stock higher. The company has already put together 3 straight quarters of exceeding earnings expectations by 10% or more. If this continues, the stock will continue rising.

Overall, Citigroup stock should perform better than the S&P 500 for at least the next five years. The average company in the S&P 500 is expected to grow earnings annually at about 9% for the next five years. Citigroup is expected to grow 11% annually over the same period. The stock should beat the S&P even if it was fairly valued. However, since Citigroup is trading so far under its book value per share, I think the stock will crush the performance of the market.

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