Hedge fund pitch: Don't play with this gun stock

Anyone investing in gun companies may soon be in the line of fire.

That's the view of Ryan Morris, president of hedge fund Meson Capital. In a note recently posted on SumZero, a private network for "buy side" analysts at hedge funds, Morris argues that gun sales are bound to return to historic levels after recently surging. He said that the increase in gun sales in the last couple of years was driven mostly by fears of tighter gun laws and that demand will be much lower in the long run.

One company that looks especially vulnerable: Smith & Wesson Holdings. The company's stock surged from about $3 in late 2011 to $16 earlier this year as sales soared and the company booked record profits.

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File photo: A man trying out a handgun at the Smith & Wesson booth at the National Shooting Sports Foundation's 33rd annual Shooting, Hunting and Outdoor Trade (SHOT) Show.
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File photo: A man trying out a handgun at the Smith & Wesson booth at the National Shooting Sports Foundation's 33rd annual Shooting, Hunting and Outdoor Trade (SHOT) Show.

But the timing of the demand spike suggests it was one-time in nature rather than indicative of a structural change. President Barack Obama was re-elected in November 2012 and the following month a young man killed dozens of children in the infamous Sandy Hook shooting. Those events triggered fears among gun lovers that the government would impose tighter restrictions on sales of guns, particularly semi-automatic weapons such as those used by the Sandy Hook shooter. Smith & Wesson didn't respond to a request for comment from CNBC Digital.

If gun sales return to lower levels, S&W's profits would naturally decline as well. But it gets worse: S&W has increased production to accommodate the pickup in demand. The cost of keeping those facilities in operation could eat further into cash flow.

Indeed, S&W had about $60 million in property, plant, and equipment on its balance sheet in 2012, but that has since doubled to roughly $120 million. The company has said capital expenditure, which helps keep the new factories running, will be $35 million this fiscal year. Those expenditures are significant, considering the company only had about $25 million in operating profit on average between 2007 and 2011.

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There are already signs that gun demand has begun to normalize. S&W's sales fell 23 percent in the three months through July to $132 million. The company said that most of the decline was because of sales of long guns, which were hurt by lower consumer demand.

There's reason to believe the declines can extend much further. According to Scott Hamann, an analyst at KeyBanc Capital Markets, publicly available background check data have a very strong correlation with S&W's sales. Using that data, he estimates that retail gun demand remains 15 to 20 percent above long-term trend levels.

S&W may have put itself at further risk by increasing its debt load. The company will have $175 million in long-term debt at the end of the current fiscal year, according to KeyBanc estimates. If the company's profits wear thin, that leverage may prove to be unsustainable.

S&W shares have fallen significantly in the last few months and don't look terribly expensive at about 10 times consensus forward earnings. But with a good chance of lower profits for the next few years, the stock could be dangerous to handle.