The gun production industry is heavily influenced by the power shifts in the government in the United States.
The nature of the industry being what it is creates an interesting market dynamic for those firms participating, few of which answer to shareholders.
Sturm, Ruger & Company and Smith & Wesson are major players in the pistol manufacturing segment and are the only two publicly traded gun companies in the US.
The United States is one of the few countries where guns are not only readily available but are part of the national heritage. Because of this, the market for guns is diverse and massive in the United States and has hundreds of major players in production. In the past 30 years there have been significant changes to the gun industry in the US due to legislation restricting what one can and cannot own. I will not be taking a side on the issue as to whether it is right or wrong as it is a touchy subject for many people but I will discuss how it affects the industry and investment opportunities.
Gun laws enacted in 1986 outlawed the sale of automatic weapons and closed off a segment of the market for gun producers. This landmark law demonstrates how the government can shake the industry through legislation. Because this is possible, gun enthusiasts, hunters, sportsmen, and other gun owners are vigilant of the politics regarding guns. The two dominant parties in the United States government have very differing views on gun control laws. As a result of this, when the party, or person, who is pro-gun control, usually the democrats, is elected or it seems that there will be a power shift towards gun control, gun markets see rises in demand because it is perceived that the new leadership will "take away our guns." The following graph illustrates the change that legislation can have the industry. Between 1986 and 1989, production dropped 20%. The market also seem to fluctuate between three million and six million units, seeing support and resistance at the respective levels. Knowing this, not all serious fluctuations are due to legislation.
The only major publicly traded gun companies are Smith & Wesson (NASDAQ:SWHC) and Strum, Ruger (NYSE:RGR), hereafter referred to as Ruger. Both these companies operate in all price ranges of rifles and handguns,except super premium guns that exceed fifteen hundred dollars, however, Ruger is the only major producer that operates in all four segments, rifles, shotguns, pistols and revolvers. Though the gun production market is highly fragmented, the two companies in question are among the largest producers of rifles, just behind Freedom Group.
It can be seen from the above graph that the further fragmentation of the market has detracted from the dominance of the largest played in the industry. There has been a large increase in the amount of imported guns available in the United States that have affected the fragmentation of the market. Two of the major culprits in this phenomenon are Beretta (Italy) and Glock (Austria), both private companies. One of the primary drivers of these imports success in the United States is who buys them. The majority of police officers in the United States carry a Glock 9mm pistol as their standard sidearm. With police stations being fairly regular customers and being slow to change habits, they provide a reliable flow of income for Glock. Beretta has a similar luxury, the Armed Forces of the United States are given a Beretta M9 as their standard sidearm. In some instances, soldiers and police officers choose to carry their own weapon that is pre-approved by their superiors on a list of acceptable weapons. While both Smith & Wesson and Ruger weapons are on these lists, there is little incentive for a switch to be made by an individual given the relative quality of the imported standard weapons.
Now that the market in which the companies exist has been analyzed, we can inspect each of the companies or their viability as an investment.
Both Ruger and Smith & Wesson have healthy cash flows with an EV/Cash Flow of 9.3 and 7.8 respectively. Ruger maintains higher cash reserves than Smith & Wesson. Despite these higher reserves, Ruger is less liquid in comparison to Smith & Wesson according to their quick ratios, 1.39 for Ruger and 1.77 for Smith & Wesson. That being said, it is worth noting that Ruger has no long term debt weighing on its balance sheet.
Source: Google Finance
Ruger outperforms Smith & Wesson on the income statement by a sizable margin. Smith & Wesson sports disappointing margins and has posted losses in two of the last 5 years despite high levels of gun demand. Ruger on the other hand, suffering from the same high costs of production in gun manufacturing, has consistently grown its net income over the last 5 years, the geometric average of this growth is close to 60% since 2010 while Smith & Wesson's geometric average growth for the same time frame in around 35%. Despite the troubling earnings numbers, Smith & Wesson has outperformed the Dow Jones since 2010.
Source: Google Finance
As far as the value of each company, I have calculated the fair value of Ruger to be between 78 and 85, using the comparables method, at the time this article was written the company was trading at around 61 with a P/E of 10.95. This indicates that Ruger is undervalued and would be bought at a discount. Smith & Wesson's fair value has been calculated to be between 21 and 25. At the time this article was written, Smith & Wesson was trading at around 16 with a P/E of 11.07. At the same P/E ratio levels of Ruger and Smith & Wesson, I expect both of these stocks' prices to increase by 20% in the next year. However, given the volatility of the gun production market and the resistance it is facing at its current production levels, it is possible that these stocks could suffer within the next few years depending on the political climate and mid-term election results. With Ruger's balance sheet and income statement, and the added bonus of a dividend, it is a much more appealing investment prospect today compared to Smith & Wesson.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.