Gus McRae's  Instablog

Sturm RugerRGR
$12:50/share
Base case Price target: $19.50 or 15x 2010 trough earnings ($1 ex cash).  The Best case could be far more dear.

Tremendous execution:  Sturm Ruger continues to execute:  new, higher gross margin products, improved manufacturing and sourcing and sharper marketing.  While the peak of the gun buying "surge" is over, RGR continues to outgrow the healthy market by dominating the concealed carry personal defense segment and entering the lucrative AR segment.  While backlog will fade back to historical levels over the next year, RGR will continue to generate high returns on capital and high cash flow on the solid core (ex surge) sales growth.

Short Squeeze looks obvious:  Curiously, short sellers continue to pile into this potential short squeeze disaster with the "melt up" risk rising with each additional share sold short.  Currenty, nearly 27 days of current volume are sold short meaning the ability to cover and exit without price impact is impossible.  So the "surge" has ended yet RGR continues to put up some of the strongest numbers in its history.  Ruger screens as the highest short interest of any company with NET CASH and a sub 10x PE.  A very dangerous short indeed.

Strong Earnings:  My expectations for Q3 are 70mm in top line with a 22% operating margin yielding 15mm in operating income.  For Q4 I estimate nearly the same margins and top line as Ruger is running at full capacity.  Tax effected, the company should earn $.50/share or better.  Adding Q3 and Q4 together, Ruger will generate $1 of earnings in the back half of the year which yields $1.76 for the year.

Super Cheap Valuation:  Backing out the year end $3 in cash (or more) from the current 12.50/share price = 9.50/1.76 = 5.4x 2009 earnings.  My minimum expectation for 2010 is $1 (and could be far higher with extensions into new product categories such as military, police, and a renewed effort in shotguns).  Backing out the $4 in cash from ending 2010, the shares trade at just 8.5x post surge trough earnings.  This, all for a company that generates 20% returns on capital that has been successfully turned around over the past 3 years.  Additionally, the company has the ability to re-purchase even more of the remaining 19.1mm shares outstanding.  Over the past 3 years, the company has bought back nearly 30% of the shares outstanding.

Earnings Kicker:  In addition to a super undervalued stock and overshorted equity, there is a chance that Ruger uses it's cash horde to do an acquisition of another manufacturing turnaround target that could take future earnings potential well above even the most optimistic forecasts.

Political kicker:  While the shorts are focused on the end of the surge - which has already occurred without drama and a steady sales level - their is a good chance that the remaining hand gun bans in place in the country are repealed as most Supreme Court watcher expect.  While the shorts are focused on the negative political implications, the regulatory winds are actually far better than is understood.

Buy Ruger.  Price target $19-20.

Sturm Ruger
RGR
14/share
*price target increased to $20/share*


Ruger printed a perfect Q2 as revenues (+93% y/y), margins (19.3%, +400bps q/q), cash flow, and a dividend increase all well exceeded even optimistic expectations.  Operating margins of 19% were extraordinary as management has strived to reach 15% for 3 years.

Interestingly, backlog did not decline much and is still at effectively record levels due to Rugers strong new product sell through and demand.  Declining demand was a key piece of the weak short sale story that has been overwhelmed with top and bottom line performance by RGR.

I am increasing my full year 2009 estimates for Ruger to $1.40 which translates to 8.3x eps with the 2.42/share in net cash back out.  I am raising my 2010 estimates from $1 to 1.20.  Therefore, Ruger is now trading at less than 9x trough 2010 earnings.  Raising price target to $20/share.

Below are some some of the highlights from the company's release.  Great quarter, stay long Ruger.  - GM

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Sturm Ruger (RGR) is a compelling value below $12/share.  Price target $18. 

Long thesis:  While the company is rather small in market capitalization (225mm), it has been caught up first positively and now negatively in the "firearm surge" long and short hype - both of which miss the primary point that Ruger has transformed itself from an inefficient manufacturer with an undermanaged but highly recognized brand to an extremely efficient lean manufacturer with a renewed innovative energy and bottom line focus. 

Current management took over the company three years ago from which time it changed a culture, improved returns on capital dramatically, and bought back nearly 30% of the shares outstanding all while maintaining zero leverage and stockpiling $35mm in cash on the balance sheet.  Its lean manufacturing combined with its strengthening customer feedback loop allows the company to improve its current product line continuously while innovating higher gross margin niches and micro niches within its core firearm market.  The end result has been an increase in operating margins from 1% to 15% and an increase in ROIC from 2% to 20-25%.  Ruger has turned and now it enters the next stage of life cycle - sustained growth through core market share gains and potentially an acquisition.

Short Story is over-reaching: Separately, the company is experiencing the benefits of a demand surge in the firearm market which has many short sellers claiming the company is caught up in a "fad".  The "fad" thesis is a bit aggressive as the firearms market has been viable for over 200 years but - fair enough - the surge of gun buying by law abiding citizens certainly will not sustain at current levels.  However, the current valuation more than reflects the future end of the current demand surge.   

Current Valuation:  Given RGR has nearly $2/share of net cash, if the cash is backed out from the equity valuation (11.50/share -$2 = 9.50/share), RGR shares are currently valued at just 7.5x (pe) on this year's estimated 1.25 eps estimate and just 8.5x 2010 even when 2010 eps is cut to $1 (and $1 of cash generated is backed out). 

Cheap with strong fundamentals and a rock solid balance sheet:  So for 8.5x non-peak 2010 eps you get a company that has driven ROIC from 2% to 20%+, repurchased 30% of the company over the past 3 years, with a pristine balance sheet and a newly reinstated dividend.  The balance sheet could and probably will be used to acquire adjacent businesses if the capital market seize up again or the surge ends swiftly and some if its less well capitalized competitors are put up for sale.

Price Target:  At $15 my down year $1 estimate +$3./share in cash (over a lower sharecount due to an additional buyback), I arrive at a price target of $18/share.

Risk/mitigants:  To conclude, I should address the two central risks:  1) a potential abrupt decline in sales due to the ending of the current demand surge and 2) firearm regulation. 

On the first point, the current valuation more than fully reflects a decline in earnings next year and a return to trend line sales.  Even so, a massive backlog is in place for a business that rarely had any sort of a backlog in its past.  On the second risk factor, firearms regulation has taken a backseat in Washington during this congressional term given the more pressing financial and health care related topics du jour.  Further, if a ban on automatic weapons is reinstituted, and even greater temporary surge in demand will occur before enactment during which the Ruger will be able to sell through current channel inventory (of which there is none currently due a strong backlog) and rebalance its flexible manufacturing model for the appropriate level of demand.

Short Squeeze likely:  As a kicker to this story, the shares are now heavily shorted with the short interest ratio > 11days.  Often once shares become this heavily shorted, even weak results but better than the extreme bear case expectations, can cause a violent squeeze providing downside protection and possibly considerable upside.  Regardless, Q2 and Q3 at minimum should yield quite impressive earning results in the face of a market that may be starved for earnings growth of any kind - all for less than 7.5x current year earnings.

Full disclosure:  the author is long RGR shares