Analysis of Sturm Ruger & Co (NYSE:RGR) – Part 1: Lay of the Land


 

Explore the defining characteristics, past performance, current valuation, and future outlook of Sturm Ruger & Co (NYSE:RGR).

Introduction

Welcome to the inaugural equity analysis at Duke of Dollars! We are excited to share with you an in-depth examination of a publicly traded business. We’re going to start our investment series with Sturm Ruger & Co: a well-known brand but a surprisingly small company by market capitalization. In Part 1, we’ll describe the state of the personal firearm industry and the political climate that has an outsized influence on the perception and performance of this business. Part 2 will dive into the financials, trends, and valuation.

If you haven’t already, please read about our investing philosophies. The information contained in that article is critical to fully understanding our stance with regard to all stocks and how we intend to present them to you, our valued readers. If nothing else, please note that this is not a recommendation to buy, sell, or hold the stock; it’s strictly an analysis of the business.

Overview

Sturm Ruger & Co makes and sells guns, mostly to private citizens of the United States of America via a network of distributors. Overall, Ruger was been the #1 US producer of firearms from 1986 – 2010, according to the Small Arms Survey, “Ruger leads with about 15.3 million firearms produced in all, followed by Remington Arms (about 14.2 million) and Smith & Wesson (nearly 10.5 million).” Despite its production prowess, the limited size of the firearm market has constrained RGR to a market capitalization of < $1B. The shares trade currently for an eye-catching ~$11.50 P/E ratio amid a market where the S&P500 costs more than double at a $26.00 P/E. The headline P/E ratio is salivating for value investors, but the Earnings denominator needs further examination before we can call the shares undervalued. First, let’s dig into Ruger’s place in the industry.

Ruger products and market position

Sturm Ruger & Co enjoys primary, secondary, or tertiary market position in all three of its primary product categories. According to the Small Arms Survey, from 1992 to 2010, Sturm Ruger & Co held the #1/#2 market share position among pistol makers, #1/#2 for revolvers and #1/#2/#3 for rifles. More recent data have shown that Ruger’s strength in these markets continues into 2017 despite intense competition. In its 2015 10K, the company states, “The principal methods of competition in the industry are product innovation, quality, availability, and price.” The Ruger brand is synonymous with quality among gun buyers, and the company’s lean manufacturing prowess helps ensure as much availability as possible, especially given that demand for its products can come in massive waves and troughs. On price, RGR is reluctant to discount its products as much as some competitors, although they’ve tweaked this practice in response to losses in market share spurred by its competitors’ fire sale prices in 2014-2016. That leaves product innovation as the last major feature in the firearm competitive landscape. Fortunately for Sturm Ruger & Co, innovation is an area of strength, and they’ve cultivated it into a competitive advantage.

New products and engineering teams

Gun enthusiasts know few greater feelings than handling a cool, new toy out on the range. RGR has latched on to this dopamine release with ferocious enthusiasm and intentional pace. No other firearm manufacturer is as dedicated to Research & Development (R&D) as Sturm Ruger & Co. Its closest competitor, American Outdoor Brands Corp (formerly Smith & Wesson) spent $12.5M in 2014-2015 and dedicated 56 employees to R&D; compare that to Ruger’s $16.2M investment and 115 employees for the same time period. Ruger releases new products frequently, averaging about 10-15 minor releases (think same rifle, new caliber) and 3-5 major releases (a whole new gun or an upgraded, reworked version) per year. The major releases are especially prone to massive fanfare. Just check out YouTube reviews for the Ruger Precision Rifle (announced July 2015), or search forums for opinions on the ultra-concealable Ruger LCP II (announced October 2016). In the months following retail availability of new releases, demand sometimes spikes so high that customers have troubling finding these items in stock.

Leading up to these major releases, management groups engineers into teams of about a half dozen men and women. Each team focuses its efforts on expanding an existing product line or introducing a new one. Generally, the team will remain intact and focused on this specific effort until the product is under production and for sale, at which point new teams are formed to engineer new ideas. Ruger has about 115 employees focused on R&D. Therefore, you can estimate that about 15-20 projects are simultaneously underway, at various stages of completion. In the past 4 years, new products have comprised between 16% and 36% of sales per year. 2014 at 16% was a low water mark for this composition of sales, and it’s reasonable to expect new products to drive 25-30% of sales going forward.  Product launches should be considered the backbone of continued revenue and EPS growth. While firearms are durable goods, especially well-made brands, Ruger uses novelty and variety to keep its products fresh and interesting for its customer.

New product revenue % of revenue Period
$58M 36% 3Q2016
$54M 33% 2Q2016
$50.3M 29% 1Q2016
$115.4M 21% 2015
$89.4M 16% 2014
$195.8M 29% 2013

Source: RGR Investor Relations SEC filings

 

Not only is it logical to expect Ruger to continue releasing popular new models, but its R&D efforts also convey a figurative lottery ticket with each share. From this annual capital investment, a new product might emerge that is so popular or so novel that it effectively creates a new market. In the previous few decades, two mega products have revolutionized the firearm industry: modern sporting rifles and polymer pistols. As a leading innovator, Ruger has as good a chance as anyone at intentionally stumbling into the next big thing in the gun world. Like tech companies investing in so-called skunk works and moon shots, it’s conceivable that Ruger could be first to market or fast follower of a new wave of gun tech.

The customers

Gun owners may be best described as collectors, and there’s a nearly endless list of reasons for a person to buy a new gun. A typical collection is incomplete without a full-size handgun for the nightstand, a concealable EDC option, a big game bolt action rifle, a trusty .22LR for the squirrels digging in the garden, great-grandpa’s cherished war relic, at least one shotgun of the five major types, a pistol capable of taking down a grizzly just in case, a modern sporting rifle for ultimate badassity, that pink muddy girl monstrosity that the girlfriend just had to have, etc. And if a gun malfunctioned one too many times, felt too heavy on that long hunting trip, or just doesn’t fit your hand perfectly after all, then it’s time to get a replacement. Our point is that people who buy guns will continue buying guns. They’re repeat consumers, not like people who buy deodorant so they don’t stink, but more like wealthy individuals with a wristwatch or fine jewelry obsession. Think of a situation, and a gun owner will think of an appropriate gun for the scenario. Next time you see your redneck or suburban survivalist buddies, suggest a game called “Best Gun for the Situation” and you’ll see what we mean.

In the past decade, the demographics of gun buyers have shifted. Although hunting is steadily declining, ownership of firearms for personal protection or sport is increasing. Anecdotally, new customers who aren’t exposed to hunting culture as children are often introduced to guns as the ultimate means of self-defense. While poking holes in paper targets at the local range, new gun owners quickly discover just how fun shooting is as a hobby. If it’s enjoyable to slowly line up the dot sights and chuck a relatively small 9mm bullet at traditional bullseyes, the freshly minted gun owner might start to wonder just how fun it is to unload a 30-round magazine of 7.62×39 hollow points into overripe jumbo watermelons. And thus starts a new collection.

Consequences of the November 2016 elections

Perhaps more valuable than a four to eight year presidency, for better or worse: the November 2016 election determined the political leanings of at least one future Supreme Court justice, who serves his or her life time. The court currently sits at a 4-4 stalemate on most issues. Trump has nominated Neil Gorsuch for the tie-breaking seat, a move heavily applauded by the NRA. Presumably a champion of the 2nd amendment, Gorsuch would tip the balance in favor of gun rights 5-4. He’d be the youngest justice by 7 years. With two liberal-leaning octogenarians currently seated, the Trump administration may have an opportunity to stack the court even more conservatively before its term(s) expire. As long term investors, we consider these political happenings to be enormously accretive to the value of gun makers. For the gun industry, the risk of adverse judicial opinions in the next two or three decades decreases with each supreme court justice that Republicans are able to seat.

The share price of RGR has dropped nearly 22% since Election Day, which on the surface, would appear to contradict the analysis in the previous paragraph that a Trump election is a long term boon for gun makers. We believe that the three-month drop is indicative of Mr. Market’s myopia. This price decline seems to be symptomatic of shorttermitis. In a nutshell, the thesis for shaving off nearly one quarter of RGR’s value is that the demand for guns and therefore EPS were both artificially inflated by 8 years of Democrat control of the White House. Prior to the election, the price of RGR shares reflected an assumption that the blue team would continue to be in charge, pressuring 2nd amendment rights and encouraging gun sales based on an imaginary deadline whereby purchasing firearms would be prohibited or severely restricted.

If this thesis holds true, the result is that the 3Q2015-3Q2016 period will contain the highest ever earnings for the company, for at least the next 4 years. Potential investors will see an 11-12 P/E ratio on their stock screeners, which makes the stock look like a bargain, but earnings in 4Q2016 and beyond will collapse, saddling buyers with a crippled investment that they bought because of a classic Peak Earnings Trap or a Value Trap. This argument is a strong one and merits careful consideration.

Spectators of the firearm industry sometimes quip that former President Obama was the greatest gun salesman of all time. There’s little doubt that during his tenure, this industry’s consumers participated in a frenzy of buying and hoarding, largely from fear that easy and legal access to a bevy of different firearms might be curtailed in the near future. Precedence from the 1993 – 2001 Clinton administration lent credence to this fear, and Obama’s combination of executive orders with post-crisis press conferences especially spurred Americans to high tail it over to the gun store. While this politically motivated shopping spree has acted as a tail wind for gun sales, we believe that the effect may be overstated and that the growth in gun sales has a robust and secular underpinning. In part 2, we’ll take a shot at estimating the true growth rate of RGR EPS, independent from the shifting political winds.

Domestic design and production

“America first!” “Make America Great Again!” We’ve all heard the refrains a few too hundred times. One would think that a company whose flagship products include the American Pistol and American Rifle might stand to benefit from such a nationalistic administration, but for a plethora of reasons discussed here, the market price of RGR has plummeted since America’s Election Day hangover. President Trump has consistently pledged to protect and bolster American manufacturing. You won’t find more of a pure-play USA producer than Sturm Ruger & Co. In respect to RGR’s business, beneficial government action may include tax breaks for domestic manufacturing and tariffs on imported goods, directly harming Ruger’s competitors.

Pressure from institutional selling

Institutional investors place such large orders that their purchases and sales move markets, and this is doubly true in lightly traded securities. In the aftermath of the Newtown massacre, many institutional investors disavowed their holdings in firearm related businesses. RGR, SWHC (now AOBC), and OLN (the manufacturer of Winchester Ammunition) were among the tickers subject to market pressure from the big movers. CalSTRS – a California teacher’s union, socially responsible ETF’s, and the NYC Employee’s Retirement System, among many others, all divested in response to collective moral decisions by the fund representatives that the manufacture of firearms eschews their moral compass. Whether or not you agree with the moral and ethical justification, there’s no question that large Sell orders dominating sparse Buys will send a stock’s price plummeting.

High volatility

Single-week price movements in excess of 10% are not rarities for Sturm Ruger & Co. For a long term investor, a highly volatile ticker symbol is not much of a concern except in two circumstances: 1) finding an attractive entry point and 2) withstanding substantial paper losses psychologically. A prudent investor will exercise patience when considering a stock that tends to swing wildly in price. After one has determined an intrinsic valuation range, simply set up a stock alert and keep cash on standby; eventually, the threshold is likely to be crossed and an investor can make a confident purchase. That’s the easy part, where volatility works in your favor. The difficulty comes when you’ve already established a position and Mr. Market boldly claims that your shares are only worth 50% of what you paid. If you entered into the investment fully informed and look to a distant horizon, then you can rejoice in the markdown as an opportunity for both you and the business itself to accelerate returns on invested capital. All stock purchases are subject to these pricing considerations, but small cap companies that frequently find their way into news headlines are especially sensitive to Mr. Market’s crazy eyed bidding.

Sneak preview of Part 2

To combat the price fluctuations, knowledge is power. When you think of yourself as a business owner – because you are – you become more concerned with the balance sheet and income statement than you are with the new headlines or per share price. We’ll talk about how to value a RGR, with its $0 in debt, $101M+ in cash, decade-long burst of growth, variable dividend, share purchase program, and the potential to complete acquisitions or even be bought out itself. Now that we’ve described the state of affairs for RGR, the type of discussion you’d hear from the talking heads on money TV, let’s focus on what really matters. Is this a worthwhile investment at its current prices? Let’s dig into the numbers in Part 2, coming soon!

 

Full disclosure: one of the authors may be long RGR indirectly through small cap index funds, and the other author is long RGR.

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