Smith & Wesson Strategic Analysis: Porter's Five Forces

Company Overview and Financial Performance

Smith & Wesson (S&W) is the nation's leading manufacturer of handguns, hunting accessories, and safety equipment, and has one of the strongest brand names in the firearms industry, with a 153-year-old legacy to build on. The company is publicly traded on the NASDAQ exchange under the symbol SWHC, and at the time of this analysis had a market capitalization of $518M with a P/E ratio of 59.64. The turnaround strategy defined in this profile had been very successful, as quarterly results attested, with total revenue of $48M, gross profit of $16.6M, operating income of $5.8M, and net income of $3.37M.

With 854 employees producing pistols, firearms, accessories, and safety products across two manufacturing plants, Smith & Wesson is well positioned to move into entirely new segments of the firearms and weapons market. One manufacturing center is located in Springfield, Massachusetts, where revolvers and pistols are produced; a second center in Houlton, Maine manufactures handcuffs and pistols. The company's accomplishments include being the largest U.S. manufacturer of handguns, the largest U.S. exporter of handguns, and the largest U.S. manufacturer of handcuffs. In addition, S&W revolvers hold the number-one market share position in the U.S., and the company also holds the number-three U.S. pistol market share. Most significantly, Smith & Wesson has 87% brand awareness with the general public. Senior management's biggest challenge is turning this significant brand identity into greater growth in high-growth security markets.

A new leadership team was brought in during calendar year 2004, and their immediate results were impressive. There was more than 20% growth in sales, primarily driven by an aggressive new marketing campaign, a greater focus on core markets, and more aggressive selling and distribution strategies in the fragmented U.S. handgun industry.

The strategy of bringing in a turnaround team of senior executives, as directed by the Smith & Wesson Board of Directors, is working. The impressive turnaround is quantified in both total revenues and a gain of $3.4M in net income between 2005 and 2006. The most recent 10-Q filed by Smith & Wesson on July 31, 2006 with the Securities and Exchange Commission showed continued strength in sales, with quarterly net product and services sales of $48M, a gross margin of 35%, and net income of $3.37M.

The financial ratio analysis also shows the strength of the turnaround then in progress at the company. Return on Equity (ROE) continued to post very solid gains as the company moved into higher-margin, more in-demand pistols and security products at the regional, national, and global level. Return on Assets (ROA) had also turned around, mainly as the result of more efficient processes being put in place within the key manufacturing centers in Massachusetts and Maine. The most significant result of the turnaround team's efforts was the dramatic improvement in EBITDA. This came from rejuvenating the value of the brand, introducing better cost controls and distribution channel processes, and better management of the product mix as it related to high-growth customer segments — including state and local police departments, which had been a high-growth area for Smith & Wesson.

Markets Served

Smith & Wesson's revenue growth is attributable to more than 20% sales growth in sports, law enforcement, military and federal, and international markets, including new sales to the California Highway Patrol and the Afghan Army. Below is a brief description of each core market in which Smith & Wesson competes.

Sporting Goods: The turnaround management team abandoned an indirect sales force and moved to a direct sales force — sixteen salespersons at last count — to work with dealers and increase sales in high-margin segments. These segments include engraving, commemorative guns, and performance centers. The launch of the S&W 460 and 500 revolvers assisted the growth of this segment.

Law Enforcement: S&W had nearly lost this market during the 1970s to Glock, which had created a polymer revolver that was very popular with law enforcement agencies throughout the U.S. In response to declining sales within this segment, S&W hired two sales representatives away from Glock and expanded its sales staff by adding eight additional reps. With the introduction of the M&P pistol, S&W also gained more demonstration opportunities with police departments. At last count S&W had demonstrated the pistol at 150 departments and 33 law enforcement agencies.

Military/Federal: Through intensive lobbying and sustained outreach to Washington-based agencies — stressing the fact that the majority of U.S. government agencies were using foreign-manufactured pistols and firearms — S&W executives successfully secured four U.S. government contracts worth $20M to manufacture firearms for the Afghan Army. Executives were also working with senior U.S. government contacts to pursue the opportunity of selling weapons to the Iraqi Army and police forces.

International: After hiring a former Colt executive who subsequently revamped the sales channels for Europe, Latin America, Asia, and the Middle East, this segment declined during FY2003 and FY2004 but saw significant growth in FY2006, attributed mostly to sales in Latin America.

Licensing: Previously unstaffed at the senior management level, the licensing market and business development function is now managed by a senior executive with over 20 years of experience in the area. The result has been a $1.8M increase from licenses for hearing and eye protection, knives, safes, soft air guns, and branded merchandise.

Existing and New Products

At the time of this analysis, S&W was the market share leader in revolvers and pistols, yet did not participate in hunting rifles, tactical rifles, ammunition, or security systems. On November 16th, S&W announced its move into the shotgun market, valued at approximately $350M per year in sales and an integral part of the $1B per year long gun market. S&W planned to unveil two models at the January SHOT Show, with production taking place at a manufacturing center in Turkey. Particularly notable about their entrance into the shotgun market was the lifetime Heirloom Warranty offered on both shotgun models.

Existing products include the S&W line of revolvers and pistols. Revolvers in the lineup include the Scandium, Model 500, and Model 460XR. Pistols include the S&W 1911 Family and the M&P Pistol, launched in 2005. The company was also relying on the S&W 460 and S&W 500 to further penetrate the sporting goods channel and segment.

Several key differentiators emerged during the turnaround:

Porter's Five Forces Analysis

The five forces that comprise Dr. Michael Porter's model are industry competitors, pressure from substitute products, bargaining power of suppliers, bargaining power of buyers, and the influence of potential entrants. Each of these areas is discussed in the following sections.

Despite the fragmented nature of the handgun market, S&W faces strong competition from global competitors across all customer segments, with competition most intense in the federal and military market. In this segment, S&W competes with Beretta from Italy, Heckler & Koch from Germany, and Fabrique Nationale from Belgium. The most dominant competitor in this segment is Glock of Austria, which sold 50,000 Glock Model 19 pistols to Iraqi Security Forces without the consent and approval of U.S.-based coalition command or the U.S. Congress. By refusing to cooperate with the U.S. military, Glock opened a significant opportunity for S&W in government markets, given the conflict Glock created and the preference of Congressional members to purchase from domestic suppliers.

There is an abundance of substitute products, as the handgun marketplace is fragmented with nine different manufacturers each holding between 5% and 14% market share. Glock's innovation in polymer pistols and firearms revolutionized the industry in the 1980s, yet S&W was able to regain market share by working with distributors, dealers, and key channel partners to understand unmet needs and design pistols more closely aligned with what buyers were looking for (Smith & Wesson, 2005).

As of April 30, 2006, S&W had a backlog worth $42.1M in orders, the majority of which was for M&P pistol orders from the Afghan Army, in addition to the successful launch of the M&P15 rifle. This firm backlog — based on purchase orders already received — put pressure on S&W to manage key suppliers and inventory positions to fulfill these orders on time, particularly as Glock was increasingly viewed by the U.S. Government as an unreliable supplier.

In the Form 8-K filed by S&W with the Securities and Exchange Commission on September 19, 2006, President and CEO Michael Golden and CFO John Kelly discussed the implications of managing suppliers in light of the major turnaround in manufacturing process efficiencies. The impressive manufacturing performance described in the 8-K included guns-per-day output rising 40% year over year, on-time delivery of orders increasing from 60% to 85% of all orders, machine uptime increasing from 60% to 80%, and inventory turns up three times over the previous fiscal year.

With production efficiencies being a major part of S&W's turnaround, there is a need to closely integrate all these activities with suppliers and build comprehensive supplier relationship management (SRM) strategies so that manufacturing operations can have visibility multiple layers deep into the supply chain. As Wainwright (2006) notes, competitive pressures are not simply about having a given supply of raw materials — they are about which manufacturers can attain a specific level of supply chain visibility and synchronize their production efforts with the incoming series of materials from suppliers. This integration between suppliers and manufacturers is defined by strategic partnerships between S&W and selected materials suppliers, enabling the company to attain its production efficiency goals. Suppliers in the firearms marketplace are more tightly integrated with manufacturers than in many other industries and, as a result, exert a much greater influence on manufacturer profitability. With many sales made today on a project-by-project basis, both suppliers and manufacturers have recognized the value of a stable and integrated SRM strategy. The balance of power is consequently shifting toward suppliers and their ability to provide visibility into their own supply chains, making it possible for manufacturers to quote accurate delivery dates for large orders — as is the case with S&W today.

S&W customers and the broader buyer population of rifle, revolver, and pistol purchasers across all served segments have a wide selection of manufacturers to choose from, including several dominant international brands. As the firearms market is highly fragmented and has seen single-digit growth over the preceding three years (Cowen & Company, 2006), buyers are in a position to choose from multiple manufacturers. Cowen & Company (2006) also estimated the total U.S. gun industry market size at $2B in 2006, with no single manufacturer dominating all segments. While S&W holds approximately 40% of the revolver market and the market leadership position in pistols, its entrance into the rifle market — aimed primarily at the sporting goods channel — places it in one of the most competitive segments. Buyer influence is high across all segments, and most notably in the sporting goods market where many competitors and alternatives exist.

The difference for S&W has been its strong focus on building channels and markets rather than merely participating in them. This is evident in the 19.4% revenue growth in the sporting goods channel and a 250% increase in the engraving, performance center, and commemoratives market, where aggressive pull-oriented growth strategies — including a NASCAR sponsorship, shooting events in Hawaii, and an aggressive PR campaign — all led buyers in this segment to become much more aware of and receptive to S&W for their recreational and collecting firearm needs. The effort the company made in this specific segment exemplifies the level of commitment required to gain new customers in a slow-growth market (DataMonitor, 2006). Despite strong brand loyalty, S&W still had to work harder than ever before to attract buyers in the sporting goods segment. Awareness had not instantly translated into sales; buyers across all segments were becoming more discerning and price-sensitive.

Over the preceding three years, S&W had developed stronger barriers to entry in its core markets through relationships, lobbying, and strong market-segment-focused selling organizations, in addition to greater production efficiencies and manufacturing accuracy. The combination of stronger relationships in the government market, better sales teams across the sporting goods, law enforcement, military and federal, international, and licensing segments brought greater synchronization to S&W's marketing and selling efforts (DataMonitor, 2006). As S&W continued to gain market share and brand momentum, all these factors — together with the dominance of their brand — would become significant barriers to entry. Production efficiencies in the form of shorter order-to-ship, quote-to-order, and guns-manufactured-per-day cycles, driven by just-in-time inventory, also served as significant barriers to entry for any new entrant into the firearms market. Creating these levels of efficiency requires seeking out process re-engineering expertise and making an internal commitment to change production processes — a very difficult task for many firearms manufacturers to undertake.

S&W faces different competitive dynamics in each of the key markets it serves, some requiring a predominantly brand-centric response while others are more focused on product development and relationship-building, as is the case in the Military & Federal market. The aggressive product development plans and product introductions S&W completed were the best competitive strategy the company could have undertaken to initiate a turnaround, in conjunction with bringing in key sales personnel with expertise in each segment.

This combination of selling expertise and new, unique pistols and revolvers generated a major increase in sporting goods sales throughout FY2006 and significantly increased sales into the Law Enforcement market as well. Relationship-building, lobbying, and unique product designs aligned with customers' specific needs also bore fruit in the Federal & Military market, where S&W won four contracts worth $20M. International sales increased using the same strategy.

From a five forces perspective, S&W's ability to generate and capitalize on customer demand across all sectors also influenced both supplier and buyer power, making both more manageable as the voice of the customer defined the need for cooperation. In terms of the threat of new entry and the threat of substitution, the production efficiencies S&W had gained and their brand dominance would make it difficult for new competitors to enter their markets or for existing ones to displace them in larger accounts and among loyal sporting goods customers.