Sturm & Ruger's Brief Burst of Value

Sturm, Ruger & Company (RGR) is a firearms manufacturer that makes and markets four different kinds of firearms: Rifles, shotguns, pistols, and revolvers. The company also produces investment castings for third-party sale when there is excess capacity not needed for its own products. Products are sold mainly to independent wholesale distributors, who then resell to retailers primarily in hunting and sporting markets. Ruger is basically a U.S.-only company, with less than 4% of sales coming via export.

Ruger's appearance on the Magic Formula screen is a classic case of fooling the parameters due to a cyclical situation - this time the widely reported "gun boom" that started in the forth quarter of 2008 right after the election of President Obama and has continued through most of 2009.

Many were worried that the new administration would re-enact the assault weapons bans of the mid-1990's. This fear combined with the prospect of another Great Depression leading to widespread crime and desperation created a perfect storm for firearms sales. Gun shows were packed, with lines wrapping out the doors and down the streets. Ammunition at many suppliers was sold out. Both Ruger and other public gun maker Smith & Wesson (SWHC) reported unit demand doubling from normal levels.

Certainly, Ruger has benefited greatly from these developments. Sales in 2009 are going to come in 60% above 2008. What's more, the company's recently announced SR-556 assault rifle has been a hot seller, and it is one of Ruger's most expensive and highest margin products. Average selling prices have been trending upwards and factory utilization is full-tilt. These factors show up in gross margins, which have been right around 30% for the past 4 quarters, vs. a 5-year average of 20%. Put it all together and the profit story is fantastic - Ruger has earned over $44 million in operating profits over the past 4 quarters, putting up big returns on capital (52% normal and 83% by MFI calculations). At the current price, with investors pricing in a bursting bubble, the trailing earnings yield is a massive 26%. Bingo, the "magic combination" for a spot on the MFI screens.

However, before we invest, we need to ensure that the earnings levels and returns on capital are sustainable going forward. Here, Ruger clearly fails any in-depth examination. There is ample evidence that the gun boom is coming to an end. Q3 orders plummeted, down 36% from a year ago (which represents a more normal level). Backlog has declined almost 50% from where it was at the end of Q1.

Signs of the boom ending are also evident in the moves by some noted private equity groups. Cerebrus Capital has been scrambling to IPO the Freedom Group, a firearms company containing some of the industry's best-known names such as Remington and Bushmaster. Clearly, they are looking to price it as high as possible, before this carpet ride ends.

With everything from economic stimulus to Afghanistan to massive healthcare reform on the administration's plate, the fear of gun bans returning is starting to wane. And, in any case, most folks who were worried about it likely have already outfitted their armory and are not looking to buy more at this time.

With this in mind, it is useful to value Ruger using a mid-cycle scenario for gun sales. Fortunately, this is fairly easy to do. The gun business in normal times is relatively stable, and Ruger has not diversified like Smith & Wesson has. Looking at the past decade, Ruger usually brings in revenue around $150 million a year, at operating margins in the 6-7% range. I believe with the SR-556 and a higher-ASP backlog, Ruger will do better on margins, but I also believe that the gun boom has pushed many normal sales forward, meaning that volume will lag behind historical levels for the next few years.

Therefore, my valuation assumes $160 million annual revenue at a 8.5% operating margin, giving me about $13-14 million in operating earnings. At the current $11-12 price, that's about an 8% earnings yield, which is slightly on the "cheap" side but not overly so. The company is in good financial health, with no debt, and currently pays a 3.3% dividend yield. However, MagicDiligence does not consider this a stable dividend - the company scales it to cash flow, and it has been an "on-again off-again" proposition over the past decade.

There are some things to like about Ruger, but in the long run this is not an exceptionally cheap stock and historical returns on capital have been a pedestrian 7%. Best to look at some truly good companies on the MagicDiligence Top Buys list.

Disclosure: Steve owns no position in any stocks discussed in this article.

Comments

[Chancer]

Whoever did the title should be told it is not like Smith & (AND) Wesson.

It is Sturm, Ruger NOT Sturm & (AND) Ruger.

2009 Nov 11 02:56 PM

[Gus McRae]

You have an error in your analysis. Steady state operating margins are closer to 15% (surge = 20%, sag = 12%), not the 7-8% you suggest. Also, 200mm is closer to the true base sale figure. Thus your yield is half of the true yield. RGR is an obvious long.

What your quantative approach is failing to pick up is that Ruger is a fundamentally different company from the one you reference historically. New mgt is doing everything right most namely its implementation of lean manufacturing which lowers lot size break even points allowing for more frequent and profitable new product production runs. RGR's new product development is cutting edge and is prime growth driver, not just the surge. Finally, margins are now structurally higher. Ruger is actually a true magic formula winner and you should debias your approach and the let the formula work for you. Your false reference point of 7-8% margins and 150mm in sales is causing your error.


Ruger is worth $15 minimum. $19 in a best case scenario.

2009 Nov 12 08:55 AM

[MagicDiligence]

ttm: 265.596mm, 44.144mm op profit, 16.6% op margin
2008: 181.483mm, 13.537mm op profit, 7.5% op margin
2007: 156.485mm, 10.258mm op profit, 6.6% op margin
2006: 167.620mm, 0.922mm op profit, 0.6% op margin
2005: 154.722mm, 1.837mm op profit, 1.2% op margin
2004: 145.624mm, 7.024mm op profit, 4.8%

This is all directly from SEC filings. I agree that new management is doing a good job with manufacturing, but I would argue vociferously that ttm margin improvement is more due to 100% utilization than any sustained lean manufacturing. I've accounted for improvements in my higher op margin assumption, as well as in a sustained revenue figure, largely due to high ASPs for the SR-556, despite what is sure to be lower volume due to pushed up sales.

There are no factual errors in the analysis, and margin assumptions are of course open to speculation. The gun business is not a secular growth market (in fact probably the opposite), so I believe it is difficult to justify $200mm in revenue. It is competitive as well, making it difficult to justify margin assumptions that are significantly and sustainably higher than historical averages.

2009 Nov 12 04:30 PM

[Gus McRae]

How does your historical average sales figure account for the market share gains RGR has experienced with the LCR and LCP blockbuster products that are still on allocation. I agree that 100% utilization played a role in pushing margins from 15% to near 20% but I suggest 14-15% steady state margins not 8%. Ruger is introducing new share gaining products every month so even if the market does not grow, RGR can grow its share from current 10% to 15% over the next couple of years. Some evidence for this share gain is 50%+ sell through at retail of RGR products while NICS data has been running +12% y/y.

Again, my point is that the mahic formula did its job to surface an undervalued business and you are overthinking it - which is the very reason the shares hit the screen.


On Nov 12 04:30 PM Steve Alexander (MagicDiligence) wrote:

> ttm: 265.596mm, 44.144mm op profit, 16.6% op margin
> 2008: 181.483mm, 13.537mm op profit, 7.5% op margin
> 2007: 156.485mm, 10.258mm op profit, 6.6% op margin
> 2006: 167.620mm, 0.922mm op profit, 0.6% op margin
> 2005: 154.722mm, 1.837mm op profit, 1.2% op margin
> 2004: 145.624mm, 7.024mm op profit, 4.8%
>
> This is all directly from SEC filings. I agree that new management
> is doing a good job with manufacturing, but I would argue vociferously
> that ttm margin improvement is more due to 100% utilization than
> any sustained lean manufacturing. I've accounted for improvements
> in my higher op margin assumption, as well as in a sustained revenue
> figure, largely due to high ASPs for the SR-556, despite what is
> sure to be lower volume due to pushed up sales.
>
> There are no factual errors in the analysis, and margin assumptions
> are of course open to speculation. The gun business is not a secular
> growth market (in fact probably the opposite), so I believe it is
> difficult to justify $200mm in revenue. It is competitive as well,
> making it difficult to justify margin assumptions that are significantly
> and sustainably higher than historical averages.

2009 Nov 19 05:29 PM