Playing With Guns: Is There A Point Of Saturation?

| About: Smith & (SWHC)

Summary

The firearms industry has enjoyed an unprecedented period of exponential growth over the last decade.

Even with no forthcoming gun control legislation, it is unlikely gun sales can continue to maintain its current pace.

It's wise to avoid companies with sales tied to the boom - Smith & Wesson and Sturm, Ruger - and those understanding short-term risks may consider shorting them.

"My momma told me, son always be a good boy, don't ever play with guns."

- Johnny Cash

His lunch interrupted by a robbery across the street, a San Francisco police officer fires shots at the three perpetrators and then calmly walks to the lone survivor laying on the ground and says:

"I know what you're thinking. 'Did he fire six shots or only five?' Well, to tell you the truth, in all this excitement, I've lost track myself. But being this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you've got to ask yourself one question: 'Do I feel lucky? Well, do you, punk?'"

The legendary scene from Dirty Harry encapsulates a significant portion of the appeal of gun culture that has grown up in the United States: good guy with gun stops bad guy with gun, and he does it while defining the feeling of freedom that comes by refusing to play by anyone's rules but his own.

These days, though, the gun industry has been feeling luckier than Harry Callahan could have ever imagined. The industry has been selling a record number of firearms year after year, and blocked almost all attempts by politicians to restrict gun sales in any manner. This success has come despite, and perhaps even because of, sickeningly frequent mass shootings, which the Harvard School of Public Health estimates now occur about once every two months in the United States.

Mass shootings continue growing more frequent Click to enlarge

It was not always this way. The first gun control legislation was enacted in 1934 following widespread fear of gang-related violence. The terms were pretty mild, but it set up a decades-long debate on the meaning of the Second Amendment. Following the 1934 legislation, The National Firearms Act, the Supreme Court judged it constitutional, since the restrictions had no relation to the functioning of a "well-regulated militia".

More recently, though, the Supreme Court has ruled that the Second Amendment protects the right of individuals to keep and bear arms for purposes unrelated to the functioning of a militia. Or put more simply, that gun ownership is an individual and not a communal right. And over the last few decades, Congress has rolled back existing gun control legislation. Meanwhile, gun sales have been rising exponentially.

Quantifying Guns in America

One common method of tracking gun sales is the number of background checks made through the National Instant Criminal Background Check System (NICS) at the FBI. The available data reaches back to 1998 and shows a long-term uptrend, although that trend clearly accelerated in 2008.

Click to enlarge

A few spikes are clearly seen in January 2013, March 2014, and January, 2016. These spikes coincide with the mass shootings at Sandy Hook Elementary School, the beginning of concealed carry background check submissions in North Carolina, and Executive Action by President Obama that somewhat narrowed the number of guns that could be purchased at gun shows without a background check.

While tracking the number of background checks performed is a good proxy for gun sales, it is not a perfect one. Some people fail the background check, some people pass and do not buy a gun, and others purchase guns without going through the background check.

An alternative measure of long-term trends in gun sales comes from statistics published by the Bureau of Alcohol, Tobacco, and Firearms (ATF) on production, imports, and exports of firearms. The information lags by about a year, but is currently updated through 2014.

Click to enlarge

The ability to gather information going back to 1946 provides a valuable view of the context of gun sales in recent years versus prior periods. Starting in the middle of the 1960s, production of firearms rose from a level of about one per one hundred people to almost one for every thirty in 1975. The period of time was marked by bursts of social disunity, high-profile assassinations, and sharp increases in crime levels.

But after peaking in the middle of the 1970s, gun production slightly declined and then leveled off for two decades, excepting a brief spike in the early 1990s that was accompanied by President Clinton signing the Brady Bill into law.

The remaining data is unambiguous. Beginning around the time of President Obama's election, the number of guns produced or imported into the United States moved to levels never before seen, and recently grew to a level of about one gun for every twenty people.

Every category of firearms has grown, but handguns have increased the most at 172% since Obama's election, versus a 110% increase in rifles and a 45% increase in shotguns. The population has grown about 6% during that same period. Currently, a net amount of about 13 million firearms are produced in the United States or imported (net of exports), with handguns accounting for a little more than half of that number. That compares to only composing about 10% of total gun production directly after the Second World War, as the primary reason for the purchase of firearms has shifted from hunting to self-defense.

Click to enlarge

It is much more difficult to obtain reliable information on the actual number of guns in the United States at any given time. The Graduate Institute of International Studies in Geneva estimated the figure to be 270 million in 2007. Starting from this point, it is possible to construct estimates of the total number of guns in circulation by using the yearly production and trade numbers from the ATF, along with some estimate of the number of guns that fall out of use. The chart below estimates this "gun attrition" rate at 1% per year.

Click to enlarge

The familiar pattern of a sharp increase beginning in 2008 continues. Viewed from this light, the number of firearms per household in the United States has risen by 18% during the Obama presidency, from 2.3 guns per household to more than 2.7.

But even these figures do not do justice to what has actually been occurring, because not all households own a gun, and the number that do is either declining or flat, depending on the polling that you prefer.

The General Society Survey, a sociological survey from The University of Chicago, has shown the steepest declines in gun ownership, with gun-owning households falling from around 50% in the early 1980s to about 30% today. The CBS News/New York Times polling shows a very similar pattern, but Gallup's survey results have not, with gun ownership rates falling from 45% to 40% over the same time frame.

While some point only to the Gallup polling as showing a level rate of gun ownership, even Gallup shows a gently declining trend, and an average of all three surveys shows a decline from 48% to 36% since 1980 and a decline from 39% to 36% since 2008.

Click to enlarge

This means, without a doubt, the surge in gun sales has not come about from new customers, but mainly from the same customers purchasing an ever-greater number of guns. Combining household surveys with estimates of the aggregate number of private firearms yields a current estimate of about eight guns per gun-owning household, up from five (+60%) in the 1990s and six (+33%) since 2008.

Click to enlarge

What is Behind Surging Gun Sales?

The simplistic answer to the question of "Why?" is to say that the election of President Obama is directly responsible for the steep rise as gun owners worried that gun control legislation would be enacted, making it more difficult in the future to purchase firearms. The rise since 2008 makes it too difficult to ignore this piece of the puzzle. Still, it's only a partial explanation.

It is impossible to disentangle guns in the United States from the activities of the National Rifle Association (NRA). The NRA came into existence after the Civil War, when two northerners felt a need to instill shooting skills in the public after watching the typical northerner display poorer skills than a typical southerner because of the greater urbanization in the north.

There are many outlines of the entire history of the organization, but suffice it to say that the modern NRA came about in 1977 when a group wishing to focus the NRA on protecting Second Amendment rights wrested control of the organization from a group that wanted to continue the traditional focus. The seeds of this change were planted in The Gun Control Act of 1968, which arose partly as a reaction to the large number of assassinations that were occurring, starting with John F. Kennedy in 1963 and including both Martin Luther King, Jr. and Robert Kennedy in 1968. There was a clear ulterior motive to the act as well. The Civil Rights movement had splintered, with some groups - like the Black Panthers - among the most vocal proponents of the Second Amendment, while also advocating resistance. The Act made it illegal for the mentally ill or drug addicts to own firearms (felons already could not), set a minimum age for gun purchases, required serial numbers on guns, and prohibited the movements of guns across state lines without a license. The new guard at the NRA took on the mission of rolling back this legislation.

By 1986, they largely succeeded by getting the Firearms Owners Protection Act passed. That law prevented the ATF from inspecting gun dealers and forbade the creation of a gun registry. Over time, the legislative power of the NRA grew as it became increasingly skillful in mobilizing its membership and lobbying Congressman. By 2000, many gave significant credit to the NRA for putting George W. Bush over the top in the election. Most discussions of the NRA focus on its power in Washington, which is large. But there is another aspect to the organization that has evolved from the 1970s: its relationship with the industry.

The NRA often acts as representatives of gun manufacturers in the same way as any trade group would. Getting pro-gun legislation passed is one aspect of this. But the NRA also serves a valuable entity in deflecting criticism from the gun companies themselves. If another mass shooting were to happen, it is likely that the NRA would take the heat and the protests, and not the manufacturer of the gun used.

The NRA also promotes the sale of firearms. It does this directly by selling advertising in its magazines and passing along discounts to its members who pay $40 per year to join. But besides its lobbying efforts in Washington, the biggest favor the NRA does for the industry is keeping fear stoked to encourage more gun purchases. The NRA, primarily through its Executive Vice President Wayne LaPierre, gets the message out to both its members and non-members that the world is filled with terrorists, murderers, rapists, and drug dealers, and while owning guns is the only way to stay safe, the government is just waiting for a chance to take them all away.

When President Bush was in office, this narrative was not able to gain a great deal of traction, since no one believed he would be coming for anyone's guns. But with the infrastructure built and the message fine-tuned, all that was needed was a foil. When Barack Obama said that Americans "cling to guns and religion", the NRA was ready to take advantage. After Obama's first term passed without major legislation, LaPierre was sure that was because the president had a secret plan to be implemented after re-election.

All of the available evidence strongly indicates that the reasons for gun ownership have been shifting from hunting to self-defense. A Pew Research poll finds that 48% of gun owners cited protection as the reason they owned a gun, up from 26% in 1999. It would be logical, then, for some correlation between gun sales and crime to exist, but it appears there is not a very strong one.

Click to enlarge

Source: The homicide rate was taken from the Bureau of Justice Statistics.

There was some relationship between rising crime in the 1960s to the increase in gun sales, but obviously, no such relationship exists today.

There are certainly other factors at play as well. For example, one well-documented fact is that more and more women are purchasing guns for their safety than ever before. However, looking at the timing of the significant increases makes it pretty clear that the primary reasons for the spike in sales since 2008 has been due to the marriage of Barack Obama's presidentship with the pre-existing narrative of the NRA.

The NRA, in turn, receives generous support from the industry, which often donates a percentage of its sales to the organization and offers free memberships to firearm purchasers.

The Industry

Of the ten largest firearm manufacturers, four are publicly traded. But one of those four is part of a larger company, and another is based in Brazil. That leaves Sturm, Ruger (NYSE:RGR) and Smith & Wesson (NASDAQ:SWHC) as the companies in the industry for which there is the most information.

Source: Mother Jones, guns sold and revenue in millions.

Not surprisingly, both companies have prospered of late, with Sturm, Ruger's revenues about 3½ times its 2008 level and Smith & Wesson's 2½ times.

Source: RGR and SWHC SEC filings.

Stock prices have followed suit. Smith & Wesson's stock is up an astounding 13 times its 2008 price, working out to a return of almost 40% per year, and is 35 times its 2002 price. Sturm, Ruger is up 11 times its 2008 price.

Source: Google Finance

Is There a Play?

With gun sales having risen at an unsustainable pace, a strong argument could be made for shorting one or both of the two large, publicly traded gun manufacturers. But that begs the question, "What is a sustainable level of sales?"

Prior to 2008, around five million guns per year was typical for a long period of time. Even allowing for growth in the industry, it is not at all inconceivable that gun sales could fall 30-40% over the next several years. With operating leverage working against them, profits at gun manufacturers would fall further. Current valuations are not excessively stretched on typical criteria, with RGR at 19x earnings and SWHC at 18x earnings, but nor are they cheap enough to absorb a contraction in business of that scale.

It seems Smith & Wesson is already aware of the downside risks, and is pursuing a strategy of making acquisitions to reduce reliance on the business of selling guns and further diversify into accessories. But with so much of its business continuing to be firearms-related and the remainder still tied to the firearms market, it is difficult to see how the company could be unscathed by an industry contraction.

Still, shorting these stocks do pose risks. For one, it is very difficult to fully grasp all of the factors playing into gun sales during an election year, and if Hillary Clinton is elected, a similar phenomenon to Barack Obama could take place. While it is easy to see a scenario where gun sales do not immediately decline, it is difficult to see one where they continue rising at the pace that they have been. As a result, while there is a possibility of a steep decline in the shares of RGR and SWHC, there is less of a chance of a steep rise.

It is important to clarify something before concluding. A prediction of a decline in gun sales is in no way a means to express simply what I wish would occur. My personal views probably parallel what could be described as a typical person's views: there are likely things that can be done that can intelligently limit gun violence, such as universal background checks, a ban on assault rifles, and efforts at limiting straw purchases. But anyone who would like a gun for self-defense or hunting should legally be able to buy one. The decline in future sales is more a matter of arithmetic than anything else, and a product of the school of "what cannot go on forever will end".

I have enough humility to admit that my thesis may not play out. But those staying long SWHC or RGR should ask themselves one question: "Do I feel lucky? Well, do you punk?"


Disclosure: I am/we are long SWHC PUT OPTIONS.

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.