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Firearm manufacturers Smith & Wesson Holding Corporation (NASDAQ:SWHC) and Sturm, Ruger and Company (NYSE:RGR) had seen their share prices slide since the election, only to fall precipitously since the murders in Sandy Hook, CT. The reason is obvious: investors fear new gun control legislation will dampen future sales. It is difficult to know what form future legislation may take, if any at all. But presuming that the political capital for gun control legislation is at an apex, it is prudent to look to past gun control laws for indications on their potential restrictions. Then we need to assess how these restrictions could impact future sales for these companies.

The last major federal gun control law was Public Safety and Recreational Firearms Use Protection Act, also known as the Federal Assault Weapons Ban. This ban was a part of the larger Violent Crime and Control and Law Enforcement Act of 1994. The law was passed in 1994 and expired in 2004. This law defined assault weapons, and prohibited the sale of newly manufactured assault weapons to citizens other than law enforcement and military. It targeted three major subsets of semi-automatic firearms: rifles, shotguns, and handguns. For each subset it explained how Congress defined an assault weapon. For example, a semi-automatic rifle with both a telescoping stock and pistol grip was titled an assault weapon, and newly manufactured rifles of this type could only be sold to law enforcement and military. Nineteen firearms were specifically defined as assault weapons, regardless of their features or appearance. Magazines were limited in capacity to 10 cartridges. Following Sandy Hook I expect that we will see legislation similar to this attempted through the Senate within a week. It will likely pass the Democratic controlled Senate, and will have no problems with a Presidential signature. The House is the only potential roadblock.

For companies like S&W and Sturm Ruger, this will impact many areas of their business, but one product line primarily: modern sporting rifles. Modern sporting rifle is a category that describes semi-automatic rifles that are not traditional hunting rifles. If you picture a traditional 30-06 or 7mm magnum, it would not typically fit into this category. But any of the myriad of AR-15 rifles potentially would. Why? Most hunters don't use rifles with telescoping stocks or bayonet mounts, and they do not use .223 caliber ammunition for game. This product line will be the one that Congress targets, and it likely have nothing to do with the caliber of the firearms, but everything to do with their appearance and accessories.

To a lesser degree one could hypothesize that a restriction on magazine capacity could negatively impact semi-automatic handgun sales. I don't consider that a significant detriment. Most handgun enthusiasts are perfectly content with a 10 cartridge magazine, and for those that are not, higher capacity mags are readily available on the secondary market. Basically, magazine size restrictions have a negligible impact on handgun sales. Considering this, when looking at the potential impact of future legislation on firearm manufacturers, I want to focus in on their exposure to modern sporting rifles.

Smith and Wesson Holding Corporation (10-k, FY ending April 2012)

Product Line

Total Sales ($ MM)

Percent of Net Sales

Handguns

238.4

57.9%

Walther

32.3

7.8%

Hunting Firearms

27.3

6.6%

Modern Sporting Rifles

75.1

18.2%

Parts and Accessories

20.5

5.0%

Non-Firearms

18.3

4.4%

Total

411.9

100.0%

About 18% of their total sales were in the product line most likely to be targeted by legislation. 89.1% of S&W sales were to domestic citizens that were not law enforcement or military.

Sturm, Ruger and Company (10-k, year-end 2011)

Product Line

Total Sales ($ MM)

Percent of Net Sales

Rifles

83.4

25.4%

Pistol

150.0

45.7%

Revolver

69.9

21.3%

Accessories

20.2

6.2%

Investment Castings

4.6

1.4%

Total

328.1

100.0%

Sturm Ruger does not break out their long rifles to the same level of detail that S&W does. It is noteworthy that when the 1994 Assault Weapon Ban was enacted, all of their long guns were exempted by name. If new legislation is passed, Ruger may not be so lucky. In particular, the Ruger SR-556 will likely be a candidate for control. This is one of their more expensive firearms. While the 10-k does not specifically indicate what percentage of their sales it comprises, it does suggest that it is not significant.

Looking at the numbers we can see that S&W has potential legislation exposure of less than 20% of their total sales. Despite this, the stock has sold-off over 16% since midday last Friday. That kind of sell-off is anticipating a complete shut-down of their modern sport rifle sales.

With Sturm Ruger their exposure to this product line of firearms is significantly less. This stock has shed about 9% in the same period, anticipating more than a complete loss of the product line.

In the case of both of these companies, potential legislation has scared many investors into selling their shares too cheaply. This assertion considers everything else, fundamentally, is unchanged over the past week.

Prior to the enactment of the 1994 legislation, there was actually a rush from consumers to purchase modern sporting rifles before the ban took effect. In a perverse way, legislation could actually drive sales of this product category up in the short time. Over the longer time frame, the ten year period of the previous ban, manufacturers found innovative ways of marketing modern sporting rifles that were compliant with the law. In other words, the ban did not eliminate an entire product category, it primarily changed the physical appearance of many of the firearms, and minimally altered their user interfaces.

As I am authoring this article (noon EST 19 Dec 2012), it looks like the market realizes the oversold nature of these two stocks. They are still cheap, but yesterday was a fire sale. The President has already indicated that he will introduce gun control legislation. Watch to see if the Senate doesn't beat him to it within the next week. Also watch for larger, current owners to develop a social objection to ownership. Both of these could have the effect of accelerated selling. If that happens, I will likely be a buyer.

Source: Assessing The Impact Of Future Gun Control Laws