Last year I wrote a short article about Sturm, Ruger & Company (NYSE:RGR) in which I concluded that, while the company is a good company and is delivering a good return on its capital, the price of the stock was higher than I thought it was worth. A good company bought at a bad price can spell disaster for any investor.
Since publishing that article, RGR moved from $60 to $80 and then back down to $50 - quite a ride! A drop in earnings brought on the final decline in price, which in turn was due to a drop in overall gun demand. In last year's article, I mentioned the fact that the gun market was saturated and that the demand for guns would not continue to grow at double-digit rates. Not only did gun sales slow, they declined.
In this article I would like to explore another facet of Ruger and how it will affect their earnings and stock price for some time to come - depreciation. That's right - boring depreciation.
I can hear the groans coming from you readers. After all, who cares about depreciation? Isn't it just another non-cash expense that can be ignored?
There are already numerous articles on SA and on many other sites explaining the importance of depreciation. The most one can do when adjusting depreciation is to use capital expenditures instead. This is why many investors use FCF instead of reported earnings, a method I personally use. There are even some investors who work out how much of CapEx is spent on maintenance as opposed to growth and use the maintenance CapEx as the depreciation expense. However, using EBITDA is a definite no-no. See what Warren Buffett has to say about EBITDA here.
Putting aside the fact that management at Ruger uses EBITDA in their reports as a metric (button up those wallets), something Warren Buffett opines to be misleading, they also tell us what useful lives they estimate their assets to have in determining the depreciation expense. This is important for our topic.
Before going further let's make sure that we all have a general understanding of depreciation. According to Investopedia depreciation is defined as -
A method of allocating the cost of a tangible asset over their useful life. Businesses depreciate long-term assets for both tax and accounting purposes.
Since depreciation is determined by the useful life of the asset and that estimate is left to management, this logically leaves management to determine the depreciation expense. This means that depreciation is one of the items that management can fudge or tweak. In other words, it's an expense that has no hard number, allowing management more leeway in accounting for it.
When reading the annual report for Ruger last year, I noticed that they depreciated their building over 15 years. I noted that 15 years for a building was a bit too fast but didn't give it much more thought. However, since then I've read Security Analysis by Benjamin Graham and David Dodd. In Chapter 34 entitled "The Relation of Depreciation & Similar Charges to Earning Power" (Security Analysis, 2nd Ed., 1940 pg. 445) Ben Graham teaches the reader to determine if the depreciation expense is adequate, too small or too large. He notes that this is important in determining the true earnings of the enterprise in question.
While reading this chapter, I found myself thinking of RGR and their 15-year life for their buildings. Does 15 years really reflect the useful life of a building? Walking down 5th avenue in NYC you will see many building that have been standing for well over 50 years, some even knocking at their 100 yr. mark. Sure some improvements have been made and repairs have been needed. But these are capital expenses that have been added to the assets value and depreciated over the time of their useful lives! Other manufacturing companies that I have looked into all seem to depreciate their buildings over a period of ~40 years.
Graham continues and points out that not only will depreciation affect how we determine profits but also how we measure the earnings against assets or capital. If a company uses a smaller number of years to depreciate its assets then, in later years, it will appear as if the companies ROA or ROC is greater than it really is, thus misleading investors.
A look at Ruger can confirm this. Using their 5 yr. averages RGR has a ROC (EBIT/Working Capital+Net PP&E) of 74%. I wonder what this number might be if Ruger's depreciation policy matched its peers.
The fact that in the last 10 years RGR's earnings have gone up tremendously isn't surprising when you learn that they bought their last building about 20 years ago. Couple the fact that gun sales have shot up over the last 6 years with the fact that RGR depreciation expense for their buildings went to nil and you will end up with a nice boost in earnings.
A better way for investors to try to gauge just how well RGR is really doing would be to use the average FCF for at least the last 5 years. (Since their depreciation expense is inadequate we have no way of calculating how much of CapEx is for maintenance. Therefore the best solution is to use the average FCF to arrive at a more realistic ROC.) Using Ruger's average FCF and average capital for the last 5 years we arrive at a ROC of 21%. While this is still a good ROC, when compared with their reported 5 yr. avg. ROC of 74%, a drop of ~5,300 basis points, we begin to see how big of a difference these adjustments can make.
(The above calculation is based on the reported PP&E. However, since Ruger's depreciation has been inadequate it is very possible that their PP&E is understated. If that is true then even the ROC we calculated above may be too high. If one goes back far enough they may be able to calculate what the PP&E would be if more realistic useful-life estimates had been used. However, such an endeavor would be extremely time consuming and beyond the scope of this article.)
Quickly depreciating assets is a double-edge sword. Now that RGR has a new facility in Mayodan, NC, their depreciation expense will shoot up and create a sense of falling earnings even if they do well. For the next few years (about 15) we can expect RGR to have a harder time showing growth in their earnings, even if we see a rise in gun sales. This is due to the bigger depreciation expense they will have to recognize due to their purchase of their new Mayodan facility.
In my opinion Ruger is misleading investors. They know that most people don't pay attention to small details such as the rate of deprecation. Investors should be aware that it is these small accounting details that can make all the difference. And even in the case that such adjustments don't change the numbers significantly, there is still the matter of management trying to pull the wool over shareholders' eyes.
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.