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Fear and uncertainty about new firearm legislature following the 7/20 movie theater shooting and the 12/15 school massacre could provide opportunities for investors to start positions in firearm manufacturers over the next few months. As preparation, I decided evaluate the two major public companies in the firearm industry: Smith & Wesson (NASDAQ:SWHC) and Sturm, Ruger & Company (NYSE:RGR). My analysis includes a review of the industry, background on each of the companies, a review of the fundamentals, and review of current market evaluations.

Industry Outlook: Demand is still healthy

The battle raging in Washington over gun control policy has done little to assuage demand for firearms. Each month the National Shooting Sports Foundation (NSSF) publishes an adjusted account of the number FBI's National Instant Crime Background (NICB) checks conducted. These FBI NICB checks are required whenever someone purchases a firearm in the United States and are an indicator of current demand. This data can be purchased on the NSSF website, however I was able to extract the following graph leveraging the data from the Smith & Wesson December 2012 investor presentation.

(click to enlarge)

As you can see, demand for firearms from Oct. '12 to Nov. '12 grew more than 30% to the new four-year high and since Jan. 2009, the number of checks has increased at an average annual growth rate of 16%.

Company Profiles

Sturm, Ruger & Company first opened in 1949 and has since become one of the nation's leading manufacturers of high-quality firearms for the commercial sporting market, and a major producer of precision steel investment castings. The company offers products in four industry product categories: rifles, shotguns, pistols, and revolvers; in addition Sturm, Ruger & Company manufactures investment castings.

While the company's 2012 Annual Report has not been published, in 2011, 95% of the company's net sales came from sales within the U.S. Of those sales 99% were of firearms and the remaining 1% were investment castings. The percentages of sales by segment were as follows:

Segment

Percentage Net Sales

Rifles

25.4%

Shotgun

NS

Pistols

45.6%

Revolvers

21.2%

Accessories

6.1%

Investment Castings

1%

Source: 2011 Annual Report

For more information regarding Sturm, Ruger & Company check out the investor website.

Smith & Wesson is one of the world's leading manufacturers of firearms. The company produces a wide variety of firearms and firearm-related products such as: handguns, modern sporting rifles, hunting rifles, black powder firearms, handcuffs and other accessories. Smith & Wesson targets a diverse group of consumers including gun enthusiasts, collectors, hunters, sportsmen, competitive shooters, individuals desiring home and personal protection, law enforcement and security agencies and officers, and military agencies in the United States and throughout the world. Products are sold under the 160-year-old Smith & Wesson brand, as well as the brands: M&P, Thompson/Center, and Walther.

In 2012, 95% of the company's net sales came from firearm sales within the US. The percentage of sales by segment were as follows:

Segment

Percentage Net Sales

Handguns

57.9%

Walther

7.8%

Modern Sporting Rifles

18.2%

Hunting Firearms

6.6%

Parts and Accessories

5%

Non-Firearms

5.1%

Source: 2012 Annual Report

For more information regarding Smith & Wesson check out the investor website.

Fundamentals

The key metrics I looked in this analysis were:

  1. Gross Margin (the amount of revenue the company retains after paying the cost of creating the product)
  2. Expense Margin (the amount of earnings left after paying SGA, R&D, Depreciation and Interest Expenses)
  3. Net Margin (the amount of earnings retained per dollar sold after tax)
  4. Earnings Growth
  5. Current ratio (the amount of current assets to current liabilities)
  6. Ratio of Liabilities to Stockholder Equity plus Treasury Stock
  7. Ratio Capital Expense to Gross Profit

The following table summarizes the 10-year average for each of the metrics:

RGR

SWHC

Gross Margin

29.6%

31%

Expense Margin

56.8%

72.6%

Net Margin

9%

-5.5%

Earnings per share CAGR

24%

-9%

Current Ratio

3.04

1.98

Ratio of Liabilities to Stockholder Equity plus Treasury Stock

0.36

1.91

Ratio Capital Expense to Gross Profit

12%

13.9%

Gross Margin: If you look at the 10-year averages alone, SWHC looks slightly better with a gross margin 1.5% higher than RGR. Averages don't tell the whole story though. If you look at the 10-year trend, RGR saw its gross margin jump close to 10 percent after 2008 and has grown its gross margin consistently since. In 2011, RGR actually enjoyed a gross margin 3.4% higher than SWHC in 2011.

10-year Gross Margins

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

RGR

N/A

34.0%

32.9%

32.3%

23.6%

25.1%

16.7%

19.3%

20.5%

23.5%

22.4%

SWHC

31.1%

30.6%

33.4%

29.0%

31.0%

32.3%

31.0%

32.5%

32.7%

30.4%

-

Expense Margin: Sturm, Ruger & Company is better managing variable expenses than competitor Smith & Wesson. While 2005-2006 were difficult years for RGR, the 10-year average is 16% lower than that of SWHC. Since 2008, RGR has decreased its expense margin 16%. In the same period, SWHC's expense margin decreased only 9.5%. At just a little more than half the expense margin of SWHC in 2011, RGR shareholders will see more revenue translated into earnings than SWHC.

10-year Expense Margins

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

RGR

N/A

44.4%

47.8%

48.2%

70.3%

73.2%

99.7%

93.8%

76.5%

60.5%

57.1%

SWHC

64.9%

83.0%

66.5%

74.4%

74.4%

68.0%

76.9%

72.5%

85.1%

91.0%

-

Net Margin: Sturm, Ruger & Company, with a 10-year average net margin of 9%, is significantly better for investors. Over the last 10 years, RGR hasn't had a single year of negative earnings, unlike Smith & Wesson, which had large losses in 2009 and 2011 drive down the company's 10-year average net margin to -5.5%.

10-year Net Margins

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

RGR

N/A

12.2%

11.1%

10.1%

4.8%

6.6%

0.7%

0.6%

3.3%

8.4%

57.1%

SWHC

3.9%

-24.2%

9.1%

-19.2%

3.1%

5.5%

5.4%

4.2%

0.7%

17.2%

-

Earnings Growth: Similar to what we saw with analysis of the net margin, RGR has a better history of rewarding investors with earnings than SWHC. RGR has seen significant growth in earnings since 2005, while SWHC has been on a bit of a rollercoaster with two years of negative earnings. With a 10-year CAGR of 24% RGR has returned more earnings to investors than SWHC, which over the last 10-years had a CAGR of -9%.

10-year EPS (basic)

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

RGR

3.12*

2.12

1.48

1.44

0.43

0.46

0.04

0.03

0.18

0.46

0.31

SWHC

0.25

-1.37

0.56

-1.37

0.23

0.33

0.24

0.17

0.03

0.58

-

*12mo. trailing

Current Ratio: This one is especially important to me given the current discussion over new gun control legislature. While I believe any legislature will take significant time to be implemented, if something were to make it through Congress quickly, I want to make sure that the companies have enough current assets to cover current liabilities in case revenues decline. In this case, both companies look to have sufficient coverage, however RGR is safer with a current ratio greater than 3.

10-year Current Ratios

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

RGR

3.18*

2.95

3.16

2.98

2.50

3.63

3.85

5.53

5.72

5.70

4.76

SWHC

2.29

1.66

1.90

2.16

1.93

1.83

1.68

1.83

1.65

2.12

1.99

*Based on Sept'12 Q3 Report

Ratio of Liabilities to Stockholder Equity plus Treasury Stock: As I outlined in my article for identifying companies with competitive advantage, the ratio of Liabilities to Stockholder Equity plus Treasury Stock helps us understand how the company is financing growth. A higher ratio indicates the company is primary financing growth through debt, rather than cash made by the company from the initial equity offering. As you can see below, the lower ratio of liabilities to stockholder equity plus treasury stock for RGR indicates it largely financing growth with earnings generated in the business. This is more likely to reward shareholders because it means the company doesn't need to take on debt in order to grow. In contrast, SWHC has a much higher ratio of liabilities to stockholder equity plus treasury stock because it has had to carry debt equivalent to 3 times net income in order to continue operations.

10-year Liabilities to SE plus Treasury Stock Ratios

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

RGR

-

0.39

0.29

0.37

0.49

0.27

0.34

0.25

0.22

0.22

0.33

SWHC

1.25

1.90

1.13

2.80

2.52

3.19

1.29

2.03

4.20

6.09

-

Ratio Capital Expense to Gross Profit: If companies have to invest more than 25% of the earnings back into the company to continue to operate, I started to get worried as an investor whether not I'll ever see a return; how can they pay me if they have to reinvest so much to keep the company going? In the case of these two companies, both meet my criteria with 10-year averages less than 25%. At first glance, SWHC looks more appealing with lower capital expense to gross profit ratios, however this is largely due to them using more debt to finance operations than RGR.

10-year Liabilities to SE plus Treasury Stock Ratios

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

RGR

-

19.5%

23.1%

15.7%

22.0%

-20.5%

5.9%

14.9%

17.9%

-19.9%

7.8%

SWHC

11.1%

19.4%

14.1%

9.7%

15.2%

20.5%

31.4%

20.3%

14.4%

11.3%

-

Current Market Valuations:

Sturm, Ruger & Company is currently trading at 52.48 a share with a quarterly dividend of 0.38 per share and has increased almost 20% in the last month. At this level, the P/E of 16.82 is lower than the 2011 high of 18, but appeals over valued relative to the five-year mean and median of 15.6 and 11.5. As you can see from the chart below, the current P/E is far from the five-year low of 4.

As for Smith & Wesson, the company is currently trading at 9.02 a share with no dividend. The stock has seen an increase of just over 9% in the last month bringing it to a P/E of 10.3. Smith & Wesson may appear undervalued at it current level since it is lower than the five-year mean and medians of 19.0 and 14.8, but that is only because P/E moves towards infinity if earnings go negative, which happened twice for SWHC in the past 5 years.

Conclusion:

While the firearm industry is under scrutiny from the press and Washington continues to debate control laws, I'm inclined to agree with the Forbes article, "Want Less Guns? Support Policies That Reduce The Demand For Guns". As shown in the chart above, demand for firearms in this country is the highest it has been in the past four years and I do not think Washington is going to introduce programs that will reduce demand for the item, but rather programs that will make it more difficult to acquire. I also think that any new legislature will take significant time to be agreed on and implemented since it involves a constitutional amendment, thereby limiting the potential for investors to be surprised by new legislature. For these reasons, I would consider a position in the firearm industry.

From my analysis, Sturm, Ruger & Company is the better investment from a fundamental perspective. The business has been improving its fundamentals ever since the Mark T. Lang become vice president in 2008 and could make for a good long term investment if purchased at a fair price. At its current market price I think RGR is overvalued; I think a fair P/E with sufficient margin of safety is closer to 13. At current earnings this values the company at about $41 a share. I think that as the debate goes on in Washington, fear will hit the market and RGR's share price will drop closer to $41 per share providing the perfect entry into this long position.

Source: Forget Smith & Wesson, Sturm Ruger Is The One To Watch During Gun Control Debate