In the past four years the US civilian firearms market has experienced an unprecedented boom. Any participant in that market, whether it is a manufacturer or a retailer, has benefited tremendously. These companies include well known public entities such as Sturm, Ruger (RGR), Smith and Wesson (SWHC), Alliant Techsystems (ATK), Olin Corp (OLN) as well as Dick's Sporting Goods (DKS) and Cabela's (CAB). However, for the first time in years, we are starting to see outright signs of market exhaustion and the potential for incipient reductions in margins for the players involved.
None of these companies suffer from poor management, accounting issues, or any other company-specific failures. The companies in this industry are all well run with experienced managements. All have generally rebuilt their facilities to the most modern of specifications, increased their capacities, and come to possess robust and healthy balance sheets built from several years of massive sales, leading to higher share prices and dividends for shareholders.
So then what are the issues? Why, after four years of uninterrupted success, would we have a negative sentiment toward the US firearm industry? In our minds, gun sales have passed a peak level and political pressure has peaked. Meanwhile, new private gun companies and the competition brought on by internet sites are just gaining market share, which will start to trim margins for all players involved.
We would apply, in this industry piece, some of the work of Michael E. Porter, author and professor at Harvard Business School, who defines five forces analysis as such:
"…[it] is a framework for industry analysis and business strategy development. It draws upon industrial organization [IO] economics to derive five forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one in which the combination of these five forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven to normal profit." Porter 5 Forces Analysis
It is our belief that the gun companies are becoming unattractive due to four out of the five forces that Porter speaks of: new entrants (new manufacturers), bargaining power of the customers (reduced sales), bargaining power of the suppliers (internet based used gun markets) and the intensity of a competitive rivalry.
Guns are forever. Political will? TV fads? Not so much.
There are several points coming together now that we will review, but the first is simply time. In many cycles it is initially apparent that there is some element of a "bubble" being created. However, these cycles do not simply start and stop on a dime. Instead, they build up momentum economically, culturally and in social media, etc. New factories cannot overwhelm a "bubble's" demand in an instant, just as the housing boom could not physically overbuild in its first year. This momentum must turn before an investor can position himself to benefit from the downside. Had you positioned yourself short, for example, on RGR or SWHC a year ago, then you would have been rather brutally punished. However, at this point the gun rush has been in full swing for several years; from the end of 2007 right up to recent months.
Most civilian guns purchased, used and maintained in some reasonable manner should easily outlast their purchaser's lifetime. Therefore guns are an unusual consumer item, because they are not really "consumable". We believe that the sales spikes over the last half-decade have come from a series of horrific and highly publicized shootings like Tucson, AZ, Aurora, CO and Newton, CT in combination with an administration desperate to reinstate a similar Assault Weapons Ban of 1994-2004. These booming sales have not been drawn from some particular set of new capabilities in the products themselves. The nature of this product and the type of boom created have led to tremendous stockpiling of guns and ammo, far in excess of the amount actually "consumed" by the population.
Despite the highly publicized atrocities and political schism created by the likes of the Brady Campaign and the Obama administration versus the NRA and Tea Party, gun laws have largely remained the same. Socially speaking, the gun culture has become more widely accepted by the general public as can be seen by the myriad of highly rated gun programs that appeared over the previous 4 years. Shows like "Sons of Guns", "Top Shot", "Doomsday Preppers", "Doomsday Bunkers", "Doomsday Castle" and "American Guns" (canceled). All seem to have peaked in 2012 and are now going through some growing pains. Other than "Doomsday Castle" (which just began last month) and "Sons of Guns", many of these shows have gotten a bit long in the tooth and have yet to be renewed for another season. Perhaps this is a coincidence, but we believe the social frenzy to see anything 'gun related' is waning and if the 'couch potatoes' are full up on watching shows about guns, then we believe this could be the first indication that the gun boom is fizzling out. But let's not just use the nebulous world of TV ratings to make important judgments about an industry.
The Gun Glut.
What does the NICS show us? NICS or National Instant Criminal Background Check System "is a point-of-sale system for determining eligibility to purchase a firearm in the United States of America. Federal Firearms License [FFL] holders are generally required by law to use the NICS to determine if it is legal to sell a firearm to a prospective purchaser." NICS
Let us note three trends. For the past three plus years, background checks (which serve as an imperfect, but reasonable proxy for gun sales) have been almost continuously ratcheting up. Secondly, since the summer of 2012, when the Obama reelection became a focus, followed immediately by the gut wrenching horror of Sandy Hook Elementary School, gun sales began to hit numbers with no precedence in civilian history. Thirdly, the last three months reported are the first time we see where the background checks were consecutively lower year over year for several months together in quite some time.
This is where things begin to get interesting. Three months in a row is a trend in our opinion. It is very difficult to claim such a data series is a "one off". So, if that is the case, then this means that the US civilian gun market has shown that it does in fact have a limit for its sales and that limit seems to have been reached in 2012.
The nine month period beginning on September 1st, 2012 and ending April 31st, 2013, represents the peak sales in all civilian history. Sales during that period are near the number of small arms produced by the US during the entire course of WW2! The corresponding period, which begins September 1st of 2013 and ends April 31st, 2014, will confirm the previous quarter's failure to exceed the YoY trend of higher gun sales. Given the size of the previous peak, we believe that the discrepancy will grow larger going into 2014. But these are not the only issues facing the industry at this potential turning point.
The Pressures Come From All Sides.
Looking forward, the structural cracks in the industry's recent super margins are worse than just a simple peaking of sales. The incredible sales rates have brought dozens of new, highly capable manufacturers into the market or have resuscitated old ones. This has not been a very large problem until recently as the time to setup gun manufacturing facilities is not trivial. While Smith and Wesson , Freedom Arms, and Sturm, Ruger are still the big three in the US, there are now dozens of manufacturers fully operational that will be in position to fight for consumers if sales have in fact peaked, a condition that did not exist even three years ago.
A few domestic examples would be companies like Windham Weaponry, a company launched in 2011, which went from non-existence to fully operational with 70 employees manufacturing a line of semi-automatic AR-15 rifles in just a few months due to the intense demand. Recently, they have expanded to a second facility in Arizona to help produce more arms and accessories.
Daniel Defense, another private manufacturer of AR-15 type rifles, once occupied a single facility around the turn of the 21st century, but now has finished expanding into a second 90,0000 square foot facility in 2012. The new facility represents a near tripling of the space the company had previously occupied. If the industry experiences even a slight slowdown, then this enormous new capacity to produce firearms will help to create a domestic over supply. But the supply story does not end at the water's edge.
Internationally, many manufacturers have begun selling into the US civilian market at rates never before anticipated or encountered. For brevity, lets us single out, as an example, the expansion of SAR arms of Turkey into the US civilian market noted by no less than the NRA's own monthly magazine. One quote we found particularly interesting:
Bernkrant, who has spent a lifetime scouring the globe for firearm designs he believed Americans would connect with, justified the latest trip to Turkey as an opportunity to convince a small group of writers that Sarsilmaz is at the forefront of firearm manufacturing. And, true to his word, the plant proved to be a showcase of the latest examples of CNC equipment, including seven-axis mills and fully automated and robotic equipment. And although much of the floor had not yet been occupied at that time, Bernkrant reported recently that new equipment is being added continually. During the tour, he pointed out one particular example, saying, "[The plant] has one of only two machines of its type in the world-the other being at Ferrari. Here it is used to cut aluminum shotgun receivers in only 12 minutes." The machine's robotics allow it to shuttle between carefully inventoried bins of tooling cutters in order to carry out each step necessary to the receivers' manufacture. Further, said Bernkrant, the plant makes and maintains its own tooling, ensuring quality control and quick turnaround times on engineering changes.
In short, even in countries that may themselves not be first world, the competitors certainly are.
Another example of international competition is Russia's national arms maker Izmash. This quote, from the company that made almost all the Russian AK-47s the US faced during the Cold War, stands out glaringly to us:
The main market for the company's guns is the United States, which accounts for 83% of its civil exports, the company's acting CEO Alexander Kosov told journalists on 29 November.
These are just a few examples of the new sources of guns that are not as as well known as the more ubiquitous arms used by US military and law enforcement agencies such as Glock, Beretta, Colt, H&K, FNH and Sig Sauer. Many have expanded their capacities to meet the demand. Some international players, like Walther Arms of Germany, experienced such a ramp in demand that they started their own full US subsidiaries. Walther, once handled exclusively in the USA by Smith and Wesson up until last year, has now separated into a standalone US company. Walther is now in direct and open competition with the company, who used to represent them and profit from those sales. These types of developments (new entrants, new factories, redirection of exports) take several years and it seems that they have finally come to bare fruit. The only common thing between these manufacturers is that they all now directly compete with the handful of large publicly listed US manufacturers of firearms, namely Sturm, Ruger and Smith and Wesson.
What will happen to the margins in the industry when all the manufacturers who make similar (in some cases identical) guns have their greatly expanded total capacity meeting a slowing demand for the first time?
Here Comes the Internet!
How does the internet (the human race's most efficient retail margin killer) affect the gun industry a reader may reasonably ask? In the gun industry, websites like www.gunbroker.com now provide anyone in the US a legal, safe way to sell any firearm (used or new) to anyone else. This is done via shipping to a FFL-licensed middle man and bears no legal risk to the seller or the buyer, because the dealer charges a small fee to handle the process at the point of delivery, much in the same way a new gun would be sold in a store.
Cognizant of more than a decade's worth of hard work by the folks at Gunbroker, we believe that the internet has finally reached a point where it can be the main "middle man" between overstocked civilians looking to unload their surplus and opportunistic buyers exploiting the drop in prices caused by the gun bubble's retreat. This efficiency will reduce margins across manufacturers, wholesalers, large retailers and many local shops. Prices of guns on Gunbroker have been unmistakably dropping over the past 5 months, corresponding with the above slowdown in YoY NICS checks. Guns that were sold for over $1,000 in February of 2013 are now selling for $850 or less on the site and offers above the lowest prices are having a tough time getting bids. In 2009, Gunbroker hit a milestone of $1 billion in sales after its first decade of business, 3 years later (just 1/3rd of that time), Gunbroker's sales doubled to $2 billion. While some of the retailers have their own web presence and could conceivably go after this trading marketplace, gun and ammunition manufacturers will have no such avenue.
However, it's not just guns receiving the attention of the internet's baleful, margin-eroding gaze. The newest internet player on the block is Gunbot, which tracks dozens of online ammunition sellers and allows a potential ammunition buyer to instantly compare ammo prices of a given caliber across the entire US. Gunbot, once a hidden treasure trove among stockpilers, is slowly becoming the number one source to track ammunition costs. As early as March 7th, 2013, one commenter on a popular gun blog complained that Gunbot was getting so much notoriety that he would have to refresh the site constantly in order to buy ammunition or else the stock was gone in minutes.
In addition, new ammunition suppliers are constantly popping up on the site, including many based in countries not normally encountered in our surveys (Australia, Sweden, Switzerland, etc), but whose producers obviously can no longer ignore the massive US civilian boom. Prices on Gunbot have been strongly dropping from peak numbers six months ago, in some cases by as much as 40%. They continue to weaken in real time as we write this article. Supplies, which were tight to the point of unavailability just months ago, are now easily available from any number of retailers. While we do not doubt that spot shortages will be noticed in physical retail shops, the internet reaches all corners of the US and it will address them in the near future.
Overall, these websites provide the path for the stockpilers to buy or sell their guns and ammo easily and rapidly into the market. A marketplace that has gained the confidence of the shooting community over the past few years. There will be no "stranded" arms caches out in some distant corner of the US, with local gun stores unable to deal with the influx sold to them. Used firearms, unlike used cars, are often indistinguishable in function from new guns except in price. If our prediction of a continued drop from the peak of sales materialize fully, coupled with a softening of industry prices from greatly expanding total supply capability, a stockpiler will be incentivized to release some of his or her surplus into the market to avoid further depreciation. This would only serve to further glut the market from its peak sales, reduce margins and challenge producers and retailers across the industry spectrum.
In conclusion, we have seen evidence from the FBI itself that gun sales are failing to hit new highs for the first time in years. Over that same space of time, many new world-class manufactures, both domestic and overseas, have sprung up to compete with the entrenched gun and ammo makers like Smith and Wesson, Sturm, Ruger, Olin, etc. A market that a few players had to themselves for decades is now open across the world with countless new entrants. This condition has been meaningless while the buying spree in the US exceeded all capacity. However, we believe the evidence now shows that gun sales will struggle to maintain the high levels of the past few years due to a lack of new political catalysts and more simply sated demand. Without a new catalyst, these additional entrants to the market, all of whom are now well funded and equipped, will be chewing on the larger manufactures in an environment decreasing sales and margins. While it is wildly improbable that the major firearm industry players will face actual business failure, it is our opinion that going forward, they will face further negative YoY comparisons, persistently tougher competition for market share, and shrinking margins from internet based trading of used and new guns. Stocks are not priced for historical victories, but rather future success. The past several years were, in our opinion, aberrations that are showing their age and finally beginning to decay due to the aforementioned factors. For these reasons, we are negative at this time on the US civilian firearms industry, and see these structural headwinds as insurmountable to its players. Their best days, despite their own efforts and excellence, are now behind them.
Additional disclosure: We have no plans to transact on any other equity mentioned in this article over the next 72 hours. Our existing positions mentioned in this article may change at any time. This article is not a solicitation to participate in any of Volte-Face's strategies or funds. Volte-Face Investments does not accept clients nor is it soliciting readers to buy or sell any equity.