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Smith & Wesson faces a double-barreled threat: Weak weapon sales and leverage.
The gun manufacturer said Thursday night that sales fell 22 percent in the quarter through October because of weaker sales of a variety of firearms. In turn, the company cut its full-year sales target to a range of $504 million to $508 million, down from $530 million to $540 million.
Why the sales swing? After concerns that President Barack Obama or other politicians would impose strict gun controls, many firearms lovers stocked up. Now that those fears have subsided, demand is returning to normal. That has left inventories elevated, prompting gun companies to offer discounts to clear their stocks.
But Smith & Wesson's worries don't end there. The company announced in late November it was buying hunting and shooting accessories company Battenfeld Technologies for $130.5 million. As part of the deal, the company will take on an additional $100 million of debt and fund the rest with cash. Adding that to Smith & Wesson's $175 million in existing debt, the company will have $275 million in debt.
That's a potential concern because Smith & Wesson has a covenant on its existing bonds requiring that its debt be no more than 3.25 times earnings before interest, taxes, depreciation and amortization (EBITDA). For now, Smith & Wesson might appear comfortably below its leverage limit. Before Thursday's statement, analysts expected the company to generate $114 million in EBITDA in the year through April. That would suggest a leverage ratio of about 2.4 times, or even lower, assuming some additional earnings from the acquisition.
But if sales and profits continue to fall, leverage could creep higher fast. Indeed, the company had EBITDA of just $68 million in fiscal 2012 before the big surge in gun demand. That would be low enough to violate the debt covenant. A spokesperson for Smith & Wesson told CNBC that the company took its "expected future financial situation and the covenants into account" when it borrowed more money.
There are signs that Smith & Wesson's profits will remain under pressure. With demand soft, the company's inventory has continued to rise. At the end of October, it held $99 million in inventory, up from $76 million at the same time a year earlier.
The company also said it plans to offer "aggressive promotions" in coming months to protect market share. It acknowledged that gross margins could take a hit as a result.
Unfortunately, margins are already looking depressed. Gross margin for the quarter was 32.1 percent, the lowest level since the quarter ended in January 2012.
Of course, the company expects to generate an extra $15 million in EBITDA next fiscal year as a result of the recent acquisition, and it should have over $30 million in cash left on its balance sheet after paying for the acquisition.
But Smith & Wesson has expanded its manufacturing capacity significantly recently, adding to fixed costs. If gun sales keep sliding back toward levels from a couple years ago, investors should keep Smith & Wesson's debt covenants in their sights.