Sturm, Ruger & Co: Strong Cash Flow + Peak SI Ratio (Squeeze) + Low Valuation = Strong Long

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Includes: AOBC, CAB, RGR
by: Gus McRae

Sturm Ruger (NYSE:RGR)
$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 P/E. 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. And 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 its 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 - there is a good chance that the remaining hand gun bans in place in the country are repealed as most Supreme Court watchers 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.