Shot Show 2018: Does Market Share Matter?

Summary

• A quick overview of the firearms industry.
• A deep dive into the topic of "market share" and whether it matters to firearms investments.
• A discussion of the latest inventory data for American Outdoor Brands and Ruger.
• A discussion of how various manufacturers are handling the slowdown as it relates to pricing and production.
• A back of the napkin outlook for AOBC stock.

I recently had the pleasure of attending the latest annual firearms and outdoor convention, the NSSF Shot Show, held in Las Vegas at the Sands Expo Center.

I recently wrote about the show and what it means for the firearms industry in my article, "Shot Show 2018 - The Sober Up Show?". In that article, I outlined five key questions I wanted to have answered by the industry in order for firearms and firearms-related investors to have the information that they need in order to make informed investment decisions.

While I have skipped ahead and written an article in the past few days which deals directly with Ruger (RGR), "Shot Show 2018: Ruger - The Right Mix Of People, Products And Processes," today, I wanted to take a step back and start looking at the bigger picture, addressing the five questions which I believe impact every firearms-related investment and company, from the production to the distribution end.

(Author's Note: I really thought I would be able to cover all five questions and speak broadly about the things which I have learned all in one article. Boy was I wrong. After over 3,700 words and 18 pages addressing just the first topic, I realized I would be better served breaking this down into multiple articles in order for the information to be digested and the importance of each point not to be diluted. I apologize for the novella but look forward to our continued discussion of the industry and the companies which we all love.)

Before we dive into the questions I want to point out that at least the firearms industry listens. And after publishing my previous article, I had two publicly traded companies and a number of smaller companies and financial analysts reach out in order set up a meeting while I was in Las Vegas for the show. I was simply blown away.

So, let's get into it!

After listening to numerous conference calls of American Outdoor Brands (AOBC), I was left scratching my head. We have heard management discuss how proud it was of picking up a few percentage points of market share as it was severely discounting brand-new firearms with dealer discounts and mail-in rebates. Yes, there were sales, but they were not exactly the shining example of profitability.

In my previous article, I asked and hoped to get answered at Shot Show:

1. Should the focus be on growing market share at depressed prices and expenses in order to increase revenues, or on preserving margins and not going deeper into the discounting game?

We have seen, time and time again, American Outdoor Brands talks about increased expenses due to its attempts at growing market share. But is it really necessary?

Source: "Shot Show 2018 - The Sober Up Show?"

Ideally, I wanted to ask this question directly of American Outdoor Brands management. But after two attempts and even extending my trip by an extra day, no one was able to entertain my questions. (Author's Note: After writing this article I was reached out to by the company, I hope to have some answers over the next few days.)

The second best thing to do would be to ask their competitors the same question to see their response.

The reason this had me scratching my head is that while I understand how and why market share is important to companies such as Apple (AAPL), General Motors (GM), or even Starbucks (SBUX), I have never understood why it would be as important to companies such as American Outdoor Brands, Ruger, or Vista Outdoor (VSTO).

Why is market share important to others?

The answer is simple... the company only begins to make money from you purchasing the product. There also is a lot more money to be made on the back-end of the sale.

For an automotive company, selling a car means a whole lot more years of selling you parts, service, and financing. To that, we also can add the billions of dollars you are worth as a customer when it comes to data mining your driving habits.

For Apple (AAPL) selling you an iPhone means you may end up purchasing an iPad or a MacBook. More importantly, however, you are now plugged into the Apple iTunes ecosystem and will likely spend hundreds if not thousands of dollars buying music, applications, or in-app purchases.

As a gun owner, I fully well know that when you buy a gun, the manufacturer is not making any more money off of you over the life of the product and in fact has significant liabilities knowing that the products are for the most part warrantied for life and subject to recalls, such as what we have seen over the last year or two with the Ruger Mark IV 22lr pistol.

Does buying a brand X firearm make you that much more likely to return to brand X in the future, especially if you purchased brand X for its price?

As a gun guy, I believe it is a resounding no. I am not tied into any particular brand.

Now, to be clear... there are brands with questionable quality... Taurus pistols are a prime example. Made in Brazil, even though many of their designs were copies of existing pistols, they had questionable quality. They did improve in time. A number of years ago, I did purchase a used Taurus revolver, and it has been OK, and I would be OK buying another Taurus pistol, but probably not new. However, I do not at all feel that just because I have one Taurus pistol, I would go out there and only buy other Taurus pistols.

I believe when you have such a well known brand like Smith & Wesson, you do not need to maintain market share, especially if it means selling pistols at cost or lower. Smith & Wesson has, in my opinion, near 100% brand recognition with gun owners. So, does market share matter?

At Shot Show, I asked the above question of a number of firearms manufacturers both big and small. So what did they say?

With Ruger, it was absolutely no surprise and has been repeated time and time again on its conference calls, the focus is on profitable sales and maintaining margins and profitability, not chasing sales. I was told again that capturing market share is important but not if it means losing money on every gun you sell.

In my next meeting with Glock, I got an even more straight forward response. The executive I spoke with clearly stated that in their own experience, they have seen people buy other pistols based solely on price. What they found, however, is that after buying a cheaper pistol, many of those buyers went straight back to Glock in that "pursuit of perfection." They did not seem worried at all that having customers buy cheaper pistols and brands today would somehow prevent them from buying a Glock in the future.

With smaller manufacturers, it had to be different, right? They had to want to capture market share above all else, right?

Not quite.

One of my favorite small manufacturers is CZ. It makes some truly terrific firearms both as production guns and then as modified by the CZ Custom Shop. CZ firearms are typically priced around Smith & Wesson and Glock levels, and a bit below companies such as Sig and H&K. As per the CZ representative I spoke with, granted not an executive, CZ's main issue was not the lack of sales but the lack of inventory to sell. Needless to say, CZ has not had to drop prices all that much over the past year.

Good products sell themselves and will steal market share from others.

Well, what about those really small start ups? They must surely want to focus on market share?

Wrong again.

One of my favorite companies to keep an eye out in this space is Honor Defense and their founder, Gary Ramey. I previously highlighted the company in a previous article, "Shot Show 2017: A Warning Shot Across The Bow?" as a shining example of that "All-American Patriotism."

Honor Defense sells a quality concealed carry pistol which was designed and is assembled by veterans right here in the United States.

Source: Honor Defense booth at Shot Show Media Day 2018

Asked the same question, profitability was the central focus once again.

Does Market Share Matter?

In one of my discussions and I cannot recall a specific person to tie it to, we came to the conclusion that in the firearms business, that while having a large market share is nice, it is not the most important aspect.

Do we need to look at market share? I think we need to look at market share for firearms manufacturers the same way we look at our own body weight... it is merely a number. What's more important is how we got there.

I always giggle when I see a new study that shows that diet and exercise are effective at weight loss. DUH!

I think everyone knows that if you follow a healthy diet and lifestyle, your weight will not be an issue, and if you are over or under-weight, your weight will be where it should be (exception with some genetic situations).

I believe that very same way we should be looking at the manufacturers' firearms market share.

If the company produces a high-quality firearm and can read the market's demand, the market share will be a byproduct of all of that work. One shining example of that is Glock.

While Glock is the dominant player in the pistol market, I highly doubt that it loses much sleep (or market share for that matter) when customers can buy a brand new M&P 2.0 pistol for $399 (prior to any rebates) when an older Generation 4 Glock 19 is sold for $539 and a new Generation 5 is sold for $559.

Source: GrabAGun

Source: GrabAGun

In fact, like CZ, Glock was one of the few companies in the firearms industry that did not resort to throwing out major mail-in rebates or dealer-only deals.

At any given time at which I visited the Glock booth at the show, it was always packed, and there were people waiting to meet with someone from Glock in one of the eight conference rooms located above their booth.

Source: Author's picture from Shot Show 2018.

So, Does Discounting Work?

Yes, it does, for the most part, in the short term.

If it was not for the discounts I don't doubt that the M&P 2.0, Shield and BodyGuard pistols would be outsold by far wider margins than they already are.

For the "non gun" investors, the Smith & Wesson pistols are good, in particular, the M&P 2.0 line, but they are by no means any better in any meaningful ways than equivalent Glock 17/19, the Sig P320, H&K VP9, H&K P30/L, FNH FNS 9, CZ P10C, Ruger American, Springfield XD-M, Walther PPQ or the countless other competing polymer pistols and countless steel or aluminum frame firearms. Gun manufacturers copy designs, and within a year or two, every manufacturer has the same or equivalent features. Take for example the interchangeable grip panels that were found on the H&K P30L pistol. For a short time, the company was able to charge hundreds more for that pistol as it was with little doubt "the most comfortable polymer pistol out there." Today, pretty much every gun I outlined has some sort of a modular grip with interchangeable panels or a backstrap.

Smith & Wesson is surely selling pistols it would not otherwise sell, but it is not because people are lining out the door in order to buy a new firearm, it is because it is a good quality pistol at extremely low prices. Heck, that's why I bought my own M&P 9mm pistol, a dual tone, Cabela's exclusive which came with a holster and some extra magazines. It was too cheap to pass up. Do I love it more than my Sigs, H&Ks, CZ, Browning Hi-Powers or numerous 1911s? No, but, once again, it was too cheap to pass up. Would I buy it at the same price as the other pistols? Not at all, especially now that customers are used to the idea that an M&P 2.0 pistol is a $350 to $450 gun, and not a $500 to $600 firearm it once was.

Putting It Together

Even though market share is a good metric to look at, American Outdoor Brands in particular is chasing market share not through the so-called "diet and exercise" plan but rather by the quick gains "not eating or throwing up" plan.

The company has, over the last year, picked up market share in the pocket/concealed carry gun segment through severe price cuts and significant discounts, both direct to dealers and mail-in rebates.

On one hand, the company was able to grow revenues.

AOBC Revenue (TTM) data by YCharts

On the other hand, the lower sales prices have started to reduce the company's gross profit margins.

Secondly, and where I believe the rebates are really kicking in are in the operating margins which have been nearly cut in half over the last year.

AOBC Operating Margin (TTM) data by YCharts

Looking at the latest six months, through October 31, AOBC's gross profit margin has declined to 32%, down from about 42% a year prior.

Looking at the operating margins, AOBC's operating margin fell to 1.7% for the six months ending October 31st, down from 23.76% a year prior.

The biggest drivers of that decline? An increase in the sales and marketing expenses and a decrease in sales.

Source: AOBC Q2 10-Q

Now, plenty of people have taken out their anger in comments a year ago when I suggested people either trim or sell their positions on the concerns of extremely high inventories and declining demand.

We have seen the declining demand, but those high inventories have surely worked themselves through the system by now, right?

Not even close. In fact, the situation is worse today than it was a year ago.

You usually like seeing a chart going from bottom left to the top right. Unfortunately, it is quite concerning in our case.

AOBC Inventories (Quarterly) data by YCharts

This must be wrong?

I went back through the last two years of quarterly reports and looked at the raw data.

Here is the raw data in thousands.

	4/30/2016	7/31/2016	10/31/2016	1/31/2017	4/30/2017	7/31/2017	10/31/2017
Finished Goods	$ 26,574		$ 51,742	$ 60,666	$ 61,080	$ 90,312	$ 111,428
Finished Parts	$ 32,804		$ 40,762	$ 47,005	$ 51,177	$ 50,340	$ 46,371
WIP	$ 9,263		$ 10,512	$ 10,091	$ 9,379	$ 8,566	$ 8,057
Raw Material	$ 9,148		$ 13,481	$ 10,334	$ 10,046	$ 11,849	$ 13,090
Total	$ 77,789	$ 87,649	$ 116,497	$ 128,096	$ 131,682	$ 161,067	$ 178,946

Click to enlarge

Source: AOBC Quarterly Reports, Compiled by Author

The data for 7/31/2016 did not have a breakdown for the inventories.

The scary thought is this.

Inventories were up going into the elections because Hillary Clinton was supposed to win, demand would go through the roof, and investors would be handsomely rewarded while they cry about losing their gun rights.

This would explain an increase of finished goods from $26.5 million as of April 30th, 2016, through October 31st, 2016, showing it nearly doubled at $51.7 million.

More than a year later, however, those already high inventories have once again doubled to the current $111 million in finished products.

Source: AOBC Quarterly Reports, Compiled by Author

The company is flooding the market with cheap guns, hurting its margins and profits, yet the inventories are four times higher today than they were heading into the election season less than two years ago.

But it cut back on production now, right?

Source: AOBC Quarterly Reports, Compiled by Author

Maybe just a little?

Looking at the data above, finished parts are still high while the work in progress declined slightly. Raw materials however are still quite high and about 40% higher than they were 18 months ago. (Some of this increase can be attributed to the increase in costs of materials.)

Based on the current lower demand and still elevated production, I believe record high inventories will be here for a while.

Is AOBC alone?

Not really.

Ruger also has record-high inventories. While they are at a record high, they are not more than double from where they were a year ago.

Source: Ruger 10-Q

The good news with Ruger, however, is that the Work in Progress and Raw Materials have come down since last year and are at about the levels seen at the end of 2015.

Source: Ruger 10-Q

Bottom Line

I went to Shot Show in the hopes of understanding what I might have been missing regarding this focus on capturing and defending market share which I have been hearing about on AOBC's conference calls over the last year.

Going through the transcripts, I have yet to find an explanation as to why it matters. And seemingly, none of the analysts on the conference call have asked that question either.

Logically, why I understand it matters for Apple, Ford (F) or GM (GM), as a "gun guy" I could not at all come up with a reason, particularly as it relates to the civilian markets.

Unfortunately, I was not able to get an answer from the company at the show, but I was able to have plenty of conversations with the company's competitors and have come to the conclusion that I have not lost my mind. The company's market share has as much to do with profits and future sales as the M.S.R.P. has dictating how much the gun actually sells for at your dealer. (It does not and no gun owner in their right mind pays the M.S.R.P.)

The market share should be a byproduct to be proud of as a result of creating products that your customers love, taking dollars away from your competition.

The market share is however a mere bragging right that does not mean much for the actual profitability when the company is essentially giving its product away nor will generate any revenue off of it in the future.

I often like to explain hard-to-grasp concepts by breaking them down to the absurd, so let's try this with a gun company.

Yes, a company can generate record revenues and have 90% or more in market share by giving away its guns for $50 or less. The company will dominate the market and generate billions in revenues.... yet it will also mean billions in losses as it would be losing money on every sale. Furthermore, there are no back-end sales to follow, no subscription fees, nothing... only the company's liability for future LIFETIME warranty claims and potential recalls.

Does market share matter in that case? Or even the record revenues?

Not at all. Of course, there will be people who claim that the company can turn around and increase prices, etc.... but we know that is simply not true.

What I believe is happening is that AOBC and others in the past are merely trying to generate revenue in order to hit numbers in a slumping market.

While this slowdown in firearms was supposed to be seasonal, in reality, it is turning into a normalization to the natural organic growth levels having taken out the threat of immediate gun control legislation.

The industry and the companies we deal with as investors are still sitting on record inventories. And the problem is, unlike a temporary sale, "gun guys" are getting used to the promotional rebates which are now the norm.

A comment that sums this up is one which I heard from a Smith & Wesson representative at the show. After I asked about the pricing on one of the pistols, I got a classic response: "The rebate ended at the end of last year BUT it does not mean we will not have another rebate soon."

My main concerns are the following:

As a "gun guy", I see the icon brand being diminished and watered down when the company is essentially giving away the gun. Having purchased a normally priced $550 pistol which is now available for $400 or less, brand new is not anything any gun owner wants to see, especially when that means your gently used pistol is now worth half of that or less.

As an investor, I would be concerned that once the company devalues its products, it is much more difficult to justify higher prices, especially when more premium brands have now come down in price to where the products were originally priced.

A prime example of this would be H&K and Sig now producing pistols in that $500 to $600 range where the Smith & Wesson pistols were originally aimed for. Simply put, being the "un-Glock" will no longer work for Smith & Wesson and I know very few people who would pick a Smith & Wesson pistol over a Glock, H&K or a Sig at the same price level. It would be like picking a Buick over a Lexus, BMW, Mercedes, Volvo, Acura or an Infinity at the same price... a few people would I'm sure but not the majority.

Why is American Outdoors leading the race to the bottom?

My belief and reason as to why this is happening is related to another question which we previously discussed, and it is related to the merits of either being a publicly traded or a privately held firearms company.

While a number of privately held firearms manufacturers and businesses severely cut production when President Trump was elected, I believe the publicly traded companies simply could not pull the plug, even if they were advised to.

I believe as investors, we put too much energy and focus into figuring out revenue. Thanks to non-GAAP numbers, we can more easily forgive a company missing on net income. After all, there is always a "one time" excuse.

A severe drop in revenue however would send investors for the doors, even if it meant maintaining profitability in the long term.

Unfortunately, what we have seen over the past year is still a decline in revenues and significant hits to the operating margins all of which once normalized would mean significant hits to the price/earnings multiples and thus lower stock prices.

As of the latest earnings call, the company, AOBC, provided full-year guidance of between $.33 and $.43 GAAP EPS. Even if we apply a very generous 20x multiple to the midpoint $.38 per share, we are left with a $7.60 per share target.

Applying a current 11x P/E multiple gives us a target of about $4.18 or so per share. This also is once again where the stock was for most of its trading history and prior to the latest gun control fears.

AOBC data by YCharts

Before anyone really freaks out and starts typing out "you are crazy" responses keep in mind we have seen this in the past.

Source: TradingView

From 2004 through 2007, the stock ran up from about $1.50 per share to $22. It then fell back over a very short period back down to $1.50 per share or so once again. And NO... this was not related to the Great Financial Crisis. (The fall was nearly a year prior to the S&P crashing.)

From the trading perspective, AOBC can easily get back into that gray zone between $2.50 and $8.50 per share.

Call me crazy, and I was for looking at $12 to $15 per share a year ago with the stock trading in the mid $20s, but I don't believe we have seen the entire story yet play out.

Bottom line, investors need to stop looking at how much they weigh and focus on how they and the company got there. While AOBC and a few others (private) have been able to soften the blow to revenues with massive discounts and rebates, the inventories have continued to pile up and the demand has continued to decline.

In my next article, we will discuss the rest of the questions and focus on what, if anything, the industry can do to adjust to what I believe is a return to normal.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.