Is The Strong Demand On Guns A One-Time Thing?

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Includes: CAB, RGR, SWHC
by: Jacob Steinberg

In the last year, many gun companies including Smith & Wesson (NASDAQ:SWHC) and Sturm, Roger & Company (NYSE:RGR) and Cabela's (NYSE:CAB) have seen great results due to historically high demand for guns. A lot of gun shops report having empty shelves and many others have huge wait lists that will take years to clear. While the gun companies have posted impressive growth in the last year, they still trade for cheap valuations and many people wonder why this is the case. After all, many gun companies trade at valuations as if they will post no growth in the next few years even though we know that they will continue to post growth because most of them enjoy huge backlogs that can keep them going for years even in the absence of any new orders. Interestingly enough, companies like Smith & Wesson even increased their guidance after beating past estimates and still failed to see a rally in its share price.

Recently, I heard an interesting argument regarding the matter. In fact, I have heard it from more than one person. It goes like this: "people are afraid that Obama will ban gun ownership so they are buying guns in a panic mode before the guns get banned." So this argument assumes that the booming demand we see in the gun industry is a one-time thing and it will not come back once the politics around the gun ownership issue settles down. According to this argument, either a bunch of guns will get banned and these companies will see a sharp decline in sales, or guns will not be banned but the panic buying will come to an end, resulting in decline in sales again.

I definitely don't agree with this idea and I will explain why. First, Obama can't really ban guns because it's not up to him to place such a ban on guns or not. The decision is up to the congress and the house of representatives. Second, even the most liberal anti-gun people don't support a model where all guns are banned. If we see any kind of ban on guns, this will be restricted to certain types of guns such as assault rifles. Third, the new laws might simply bring stricter background checks or other types of limitations rather than actually banning any type of guns. There are too many variables in the story to tell where things are heading right now; however, it is almost certain that only a small number of guns will get hit from the new laws if anything. Among Americans, the support for gun control is not very strong.

Before moving forward with the scenarios regarding the anti-gun laws that may or may not arrive soon, let's take a look at the chart below. The chart is taken from Smith & Wesson's presentation at the latest earnings conference and it shows the number of FBI background checks conducted for gun purchase purposes by month.

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It is evident that there has been increase on the number of background checks every year since 2009. These background checks can act as intend to buy guns, which means the trend is increasing. In 2012, the trend has increased much faster than the years before and the acceleration is expected to continue on in 2013. While some of the year-to-year increase might be due to panic buying, the growth can't be attributed to panic alone. As mentioned above, if gun control measures pass the senate and the house, most people expect it to be limited to assault weapons alone. If the increased demand on guns was only due to the panic related to guns getting banned, we wouldn't see an increase of demand across the board. We would only see a spike in demand for assault weapons and nothing else, since these weapons are most likely to be banned if anything. Notice the strong demand for handguns in the chart below (keep in mind that the year 2012 in this chart only represents the first 3 quarters whereas other years are represented by all 4 quarters).

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As you can see, the demand on guns started to increase even before Obama took the office in 2009. In 2006, 2.48 million handguns were sold whereas in 2011, 4.49 million handguns were sold. Also keep in mind that there is a great shortage of guns at the moment and if it wasn't for the supply limitations, the number of guns sold in 2011 and 2012 would have been much higher.

The new trends are favoring gun companies. A larger diversity of people than ever want to own and use guns. For example, historically, very few women used to own guns but this trend is changing as guns are becoming increasingly popular amongst women, which helps to keep the demand at historically high levels.

Now back to discussion of gun control. The best case scenario for gun companies would bring no changes in the current gun laws. This would be very bullish for the gun companies because they would continue to enjoy a strong momentum that started a few years ago. In that case, many gun companies would have to increase their production levels in order to clear their huge backlogs. A more realistic scenario would involve a ban on certain types of assault weapons or a more rigorous background checks for these weapons. This would hurt revenue growth some gun companies but that might not be a big deal for companies like Smith & Wesson that generate a small percentage of their revenue from assault weapons. In fact, if assault weapons were banned, this wouldn't stop gun enthusiasts from buying guns altogether. Many people would simply buy another type of gun if assault guns were banned. The worst case scenario would involve a ban on all weapons but there is no way this can pass the congress or the house because it would be against the second amendment of the US constitution which allows every American citizen the right to keep and bear arms.

In conclusion, the strong demand we see on guns in the US market is not a result of "panic buying because people fear that Obama will ban all guns." Rather, it is part of a trend that has been around for the last 6-7 years. Now more Americans are owning and using guns, including women and other minorities who historically had low rates of gun ownership. Investors can safely buy a gun company to enjoy nice valuations as the market is nearing a peak and good valuations are hard to find.

I personally own shares of Smith & Wesson. The company has a trailing P/E ratio of 10 and forward P/E ratio of 8. Recently, Smith & Wesson beat analyst estimates by a large margin and increased its guidance for the next year to reflect another year of double-digit growth. A company that posts double-digit growth year after year should not be trading for a single digit P/E ratio.

Disclosure: I am long SWHC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.