Smith & Wesson Investors Shrug Off MHS Contract Loss. Are They Wrong?

By Markets

Smith & Wesson will not make the Army's new official handgun -- and that's OK. Image source: Beretta.

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Two weeks ago, Smith & Wesson Holding Corp. (NASDAQ: SWHC) had some bad news to report: The U.S. Army had just cut it from the competition to manufacture a new "Modular Handgun System" (MHS) to replace the Army's standard-issue Beretta M9.

The news meant as much as $1.2 billion in potential revenue lost to Smith & Wesson -- presumably lost forever. In what may have been an effort to limit the fallout from this revelation, Smith & Wesson released the news after trading hours...on a Friday...ahead of the weekend.

Investors were not amused.

Fool me once?

By the time Smith & Wesson stock had resumed trading the following Monday, the shares were down 7.4%. But then, a miracle happened: The stock began to turn around. Bottoming at about an 8% loss, Smith & Wesson stock has since climbed to more than $26 and change, and currently sits within about $1 of its pre-press-release price.

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All of which gets a Fool to wondering: Are investors crazy? After all, according to data from S&P Global Market Intelligence, Smith & Wesson has less than $800 million in annual revenue. How can investors so quickly forgive the loss of an opportunity worth one-and-a-half-years' revenue?

Which is an excellent question. Now here's the answer.

Valuing Smith & Wesson stock

Smith & Wesson noted in its press release that "the MHS program has never been included in our financial guidance." And while that doesn't necessarily mean that Wall Street analysts didn't build it into their estimates, it seems instructive that no one on Wall Street has cut earnings estimates for Smith & Wesson since the bad news came out.

Accordingly, it seems likely that a near-14% rate of earnings growth, which analysts projected for Smith & Wesson before the Army's decision was revealed, will hold true even after the bad news has become fact. So what does this mean for investors?

Priced at 13.2 times trailing earnings today, Smith & Wesson stock appears favorably priced relative to the 14.5 P/E ratio at rival Sturm, Ruger & Co. (NYSE: RGR). With an expected growth rate just under 14%, Smith & Wesson stock currently sells for a PEG ratio (price-to-earnings, divided by growth) of 0.96. No Wall Street analysts have published an estimated growth rate for Sturm, Rugerand, for that reason, it has no reliable PEG ratio. But considering P/E ratios alone, Smith & Wesson stock looks to be slightly cheaper than Sturm, Ruger.

Near-peer Vista Outdoor (NYSE: VSTO), meanwhile, sells for 17.1 times earnings, and has a projected growth rate of 16%. That works out to a PEGratio of 1.07 on Vista Outdoor stock, which is again slightly more expensive than Smith & Wesson's ratio.

What it means for investors

At a PEG ratio just a whisker under the value investor's standard of 1.0, Smith & Wesson is not the most obvious bargain stock in the universe. That said, it does fit the definition of a "cheap stock" -- and it is verifiably cheaper than the two alternative gun stocks, Sturm, Ruger & Co. and Vista Outdoor.

Based on these numbers, I'm forced to conclude that investors are not wrong to be bidding Smith & Wesson stock back up again. Despite the MHS loss, this stock is cheap, and is a good candidate for investment.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 284 out of more than 75,000 rated members.

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