Shot Show 2018: Deck Chairs On The Titanic?

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Includes: AOBC, BGFV, CAB, RGR, SPWH, VSTO
by: Maks F. S.
Summary

Continued discussion of the state of the firearms industry as confirmed by Shot Show 2018.

A deep dive into inventory and production levels for publicly traded manufacturers and distributors.

A look at the product development cycle.

Deep dive into the state of firearms dealers and distributors.

Discussion of the potential for international expansion for US manufacturers.

Over the last week, I have been writing about and we have been discussing the state of the firearms industry and what it means for investors. Combined with the information learned from the industry's largest firearms trade show, the NSSF Shot Show 2018, this set of articles is creating a nice primer for firearms investing for the foreseeable future.

If you have not done so already, please take a look at my previous articles in the series,

In our first article, we discussed my hopes for the show and the five areas where I wanted to get some more clarification.

In my second article, we skipped ahead and discussed Ruger (RGR) more deeply, including the new product introductions and my interactions with management.

In my last article, we started addressing the five areas, starting with whether chasing market share in the firearms business is even necessary for well known and iconic brands such as American Outdoor Brands' (AOBC) Smith & Wesson, Ruger, Glock, and others.

Today, I wanted to focus on the remaining four points discussed in "Shot Show 2018 - The Sober Up Show?"

The State Of The Firearms Industry

It is not any secret nor private information, the firearms demand in 2017 took a sharp downturn after the 2016 presidential elections, which gave gun owners and gun rights supporters peace of mind knowing that at least for the foreseeable future, gun rights would not be threatened.

The industry went from a high demand and high price environment to a 2017, which brought decade-low prices and multi-year-low demand.

As I wrote in my NICS series, "December NICS: Wrapping Up A Concerning Year", we saw an acceleration in the decline of background checks with a 13.6% year-over-year drop in the December Adjusted NICS data.

Looking at 2017 broadly gave us a year with 2012 like data. If we look at the "long gun" category, which includes shotguns and rifles, including the so-called "black rifles" or the "modern sporting rifles" gave us the lowest numbers seen since 2011.

Not surprisingly, the sales also suffered, and revenues and net incomes tumbled broadly, including the three publicly traded firearms and ammunition companies, American Outdoor Brands, Ruger, and Vista Outdoor (VSTO).

Chart AOBC Revenue (TTM) data by YCharts

While revenues did tumble, the bigger hit was taken in the net income numbers. In the case of Vista Outdoor, a major GAAP loss as they did the right thing and took impairment charges on their previous acquisitions that many thought were at extremely generous valuations, but more on this in a future article.

Chart AOBC Net Income (TTM) data by YCharts

As we know, a large factor to this slump has been the demand falling off of the cliff. What most don't realize, however, is that there are two other components here which are adding large amounts of fuel to this fire.

The first is that going into the elections, manufacturers, and other industry participants largely bet big, and they bet wrong on Hillary Clinton becoming president.

Going into the elections,

2. The industry has invested billions into increasing production capacity, in large part due to wrongly assuming a Clinton presidency. What happens now? As demand is returning to normal, are companies going to be idling production? Or will they continue production, thereby increasing inventories in hopes of liquidating inventories at lower prices (and margins)?

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

We often wondered whether or not the industry expected "President Trump" to be a reality.

While it was not at all a surprise for me, it seems now more than ever quite clear that on the whole, the majority of the gun executives I spoke with ran their business assuming that Hillary Clinton would become president.

It was a complete business certainty that IF Hillary Clinton would become President, she would likely be responsible for more gun sales than even President Obama was for the simple reason that she was certainly going to place gun control near the top of her agenda.

Furthermore, now more than ever, I am quite certain that many in the gun business were certainly hoping for Hillary Clinton to win as while gun rights would be trampled, at the very least they would be quite a bit wealthier as a result. Fortunately, that DID NOT happen, but it seems to me that at least a few companies did not change anything in the wake of Donald Trump winning the election.

At least a few of the companies I spoke with, both big and small, immediately cut production shortly after the election, assuming demand was going to return to normal.

More broadly, however, it was quite clear to me from my discussions with industry executives is that very few companies actually immediately cut production assuming demand would drop. Reading between the lines, it was becoming evident that even after the elections, many industry executives made the same mistakes that most financial analysts made, making 2017 projections off of 2016 base levels.

If we look at the public earnings conference calls, we see the slowdown in Q1 2017 explained as "seasonality" rather than a major trend reversal.

Part of the issue which makes the situation worse, however, is that while some companies do both design and manufacture their firearms, many have parts created through outsourcing. As such, even if they wanted to slow the demand there would still be a lag time as more than likely, parts were already ordered and waiting to be received. This is one issue that other companies may not have.

Looking at the three publicly traded manufacturers, we can see varying levels of inventories.

Chart AOBC Inventories (Quarterly) data by YCharts

Vista Outdoor, even though it has other issues, which we have previously discussed and will discuss in a future article, and while its inventory levels in absolute terms are still exceptionally high, it is THE ONLY one which meaningfully reduced its inventories since the elections.

In the beginning of 2017, we can see Vista was sitting on record high finished inventory and raw materials.

Source: Vista 10-Q

Looking at its latest quarterly report shows a 12.8% drop in finished goods inventories since the start of the year, and while we are not back to 2016 levels yet, it is a good start.

Source: Vista 10-Q

One of the drivers in this reduction in inventories, in my opinion, is the heavy, unprecedented rebates we have seen offered by Vista for its Federal and American Eagle brand ammunition. With the rebates gun owners saw the lowest ammunition prices in at least a decade!

Furthermore, we do see a significant reduction in both raw materials and work in progress further suggesting that Vista has cut back on production. This would bode in line with comments I received from the company stating they made significant reductions in the workforce.

As for the two firearms manufacturers, there was no such reduction in inventory in 2017, and in fact, inventories continued to climb to all-time high levels.

As discussed in our previous article, AOBC's inventories have more than doubled over the last year or so and finished inventory is now 4 times higher than it was going into the elections.

AOBC Inventory Levels

Source: AOBC Quarterly Reports, Compiled by Author

For Ruger, while the inventories and finished goods are also at all-time highs, they were at least not a four-fold increase.

Source: Ruger 10-Q

As I pointed out in that previous article, it does seem like finally, they have started to lift their foot off of the production pedal.

Looking at the retail inventory levels there is not much data, especially since Cabela's was taken over.

What we do have are Sportsman's Warehouse (SPWH) and Big 5 Sporting Goods (BGFV). Much like with the manufacturers, we also have record inventory numbers at these firearms and firearms accessories retailers.

Chart SPWH Revenue (TTM) data by YCharts

Of course, the 800lb guerrilla in the room are the inventories held at the distributor levels.

As we have discussed previously in our speculations, large manufacturers will often exert their pressures on the distributors to take up more inventory than they would perhaps be comfortable with. In turn, those distributors then try their hardest to get their dealers to pick up extra inventory.

Where I had more supporting evidence for this is in my discussions with both distributors and local dealers.

One distributor with whom I spoke was all too happy to discuss with me their pricing and specials knowing that I was there in the media capacity. One number which was shared was that they had about $85 million in inventory today, and that number came down from around $95 to $100 million heading into elections.

If we adjust our valuation of that inventory to the new lower prices, I would assume the unit levels are actually the same if not higher today than they were previously.

Speaking with a number of dealers and one in particular, one thing that became crystal clear was that he was constantly being called on by multiple distributors offering incentives and deals to take up more inventory. One common incentive being offered was longer credit terms and higher credit limits, all in the name of taking up more inventory.

All in all to answer our question, even though production levels have seemingly been lowered, the industry is collectively sitting on record inventories throughout the distribution channels that have not been reduced, even with the massive discounts offered to dealers and consumers.

All of this seems to confirm the three-pronged problem, the industry is sitting on record inventories, record production capacities, and selling into multi year low demand.

Increasing Demand

As we have discussed in our NICS article series and as confirmed at Shot Show, the demand for firearms is in a slump and in what I believe is a broader move to return to normal. My third area of focus for the show was to figure out what if anything can be done to increase the demand for firearms.

3. What will it take to increase demand? Even in light of the largest mass shooting in our history (to which there are still no answers), firearms sales are significantly lower. Do companies and investors need to look forward to another Democrat for increased demand? Or can the firearms industry spur demand themselves?

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

This was one area which I made sure to discuss with everyone I met at the Show.

My own suspicions were that there is nothing that the industry could do in order to meaningfully increase the demand for firearms over the next few years. The vast majority of the industry executives and dealers I have spoken with agreed with that sentiment, even a number of executives in the publicly traded space.

By and large, anyone who ever thought about purchasing a firearm has already purchased a firearm in the last few years over the fears that they would not be able to after another a mass shooting or under a President Hillary Clinton.

Of course, you do have a number of people who gave the "salesperson" response of increasing the demand through introduction of new, desirable firearms.

Yes, new products such as the Ruger PC Carbine, Glock 19X pistol, and the Tavor TS 12 shotgun will spur some new gun sales. They will in reality predominately steal market-share dollars from competitors rather than meaningfully spur sales to new gun owners.

Source: Glock 19X, taken by Author at Shot Show 2018 Media Day

Where most conversations unilaterally met was that the only likely catalyst in the near future that would help turn firearms demand would be the next presidential election, either in 2020 when a Democrat would have a chance to take back the oval office or more than likely 2024 at which point based on pure statistics, the Democrats would have the best opportunity to take back the executive branch.

Most people I spoke with also agreed that even if Democrats recapture the Senate or the House, there is a very low probability the measure would be signed by President Trump or have enough votes to overturn an executive veto.

Need more supporting evidence?

As we discussed in our October NICS article, "October NICS Data - Gun Sales Failed The Test," not even the largest mass shooting in our country's history was able to turn gun sales around, not even for a month.

On this question, I believe we will have to wait at least 2 more years for gun sales to rebound, and before then, there is plenty of opportunity for companies to fail.

One other question which I was asked by readers was if I believed that American companies could do anything meaningful to grow their sales internationally. My own opinion was a resounding "no."

My opinion was also confirmed by people in a myriad of positions, particularly at the top levels.

Essentially, there are two issues. First, international firearms sales are predominately to law enforcement and military. Civilian gun rights are more or less restricted around the world, and in any case, the United States market is the largest firearms market. One of the only changes which would make me constructive on global firearms sales for domestic companies is if China, India, and Indonesia adopt the same level of gun rights as the United States.

The second issue which is related is that globally, once we take out the civilian demand for firearms and focus on military and law enforcement, the world has their own home town player which they would wish to support. Beyond that, they are far cheaper to produce overseas.

Simply put, it would be a very difficult thing to image German, Austrian, Czech, Russian, or Chinese military and law enforcement carry Ruger American or Smith & Wesson M&P pistols.

The one area where I believed there was opportunity, however, is in suppressors, with companies such as SureFire and Gemtech being the leaders in their space. Once again, however, one executive quickly pointed out that while they would love to sell more suppressors overseas, what is a $600 suppressor in the United States is a $50 suppressor overseas, where in many countries, suppressors are actually required for hearing safety.

Needless to say, on the foreign distribution of American firearms, I am not optimistic especially since there is very little to nothing proprietary to many firearms designs today such as the 1911, CZ-75 and Hi-Power pistols along with AR-15, FAL and AK-47 rifles.

The story is very much the same on the ammunition side with ammunition being a commodity with very little protect-able intellectual property.

Product Innovation

Even though we largely addressed this point already, perhaps there are trends that can help stem the decline?

4. Are there any truly market-moving products being announced? Or is it more of the same evolution?

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

I have already named the three top products that I ran across at the show, the Ruger PC Carbine, the Glock 19X and the Tavor TS 12.

These products are once again a newer take on an existing idea.

The Ruger PC Carbine is certainly an awesome product, but the idea is not new. In fact, a number of years ago Ruger had the PC9 which was also a pistol caliber carbine. The PC Carbine, while being a completely new design, is not a new idea by any means.

The Glock 19X is also a terrific firearm, but in reality, it is a full size Glock 17 frame with a slide from the compact Glock 19. By combining the full size frame and a compact slide, you have an extraordinarily quick cycling firearm that is quite easy to control. Once again, while it is a new firearm, it is not a new concept. Because it was the concept which was submitted for the US Army pistol contract competition, aka the XM17 Modular Handgun System, and regarded by many as THE best pistol for the job, it will sell absurd amounts, all while being a different way of putting together existing parts.

The Tavor TS 12 shotgun is perhaps the biggest leap on the evolutionary scale, but it is, in my opinion, just another take and building up on the new tactical shotgun trend started by the Saiga 12 and the KSG 12 shotguns.

Are they all absolutely terrific firearms?

YES!

BUT... unless those firearms become popular in a movie or a video game, they are not likely to attract any new gun owners in any meaningful numbers, at the very least any numbers to substantially stop the 13% year over year drop in adjusted NICS for 2017.

The truth on innovation in the firearms industry is that more often than not, the major manufacturers are NOT the ones who come out with truly innovative ideas, and it is rather the small start ups manufacturers and gunsmiths who design around a need, typically brought up by competitive shooters.

Take for instance a few years ago, the major trend of putting red dot optics mounted to the frame of the pistol.

It was a trend first noticed by the broad gun owner community on the "tactical" guns carried by the specialized military and law enforcement units and then made broadly available by Glock, Smith & Wesson and others.

Remember these?

Source: Glock - Glock MOS pistols

Source: Smith & Wesson - M&P CORE Pistol

The reality is USPSA and Steel shooters have been mounting such optics to their slides for years and gunsmiths have been doing so for a long, long time prior to it being adopted by the mass market.

Companies such as Zev Technologies have been taking stock guns and modifying them for accuracy and reliability for as long as I can remember, and over time, those innovations make it into production guns. Take for instance the below firearm.

Source: Zev Technologies

Immediately, you can see 4 or 5 major changes from a stock Glock.

First, you can see the stock Glock frame was heavily textured, aka stippled and a common point of complaint, the finger grooves were removed.

Secondly, you can see a flared magwell which aids in reloading the firearm more quickly.

Next, you can find a slide mounted optic, more aggressive slide cuts for improved grip and an upgraded barrel.

What you will not be able to see is an upgraded trigger in the gun.

Why do I bring it up?

As I wrote in my summer article, "As If Gun Stocks Haven't Been Hurt Enough?" Glock recently released its 5th Generation pistols.

What are the major changes?

A flared magwell, improved stippling for better grip, an improved trigger, removed finger grooves, and of course, the modular system for mounting the optics of your choice.

If you want to learn what may be coming to a production gun in the near future, visit a local shooting match or follow the smaller firearms companies, you will likely see it there first.

So How Bad Is It?

My last area of interest was for the distributors and local dealers,

5. What are the thoughts and experiences of the industry's distribution partners, namely the firearms dealers and range operators? Are they seeing any signs of a decline in the drop? What are their customers saying? Are they buying less? Are gun stores stocking less firearms? Are any of them closing down or considering closing?

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

Being the last area, we have naturally covered a large part of this question. Therefore, I will hope to give some extra color and clarity with points we have yet to discuss.

Starting at the distributor level, there is surely pressure for them to take inventory. We have heard from a number of earnings calls of manufacturers offering extra incentives for distributors to take on more inventory. The incentives come not only in the form of lower prices but also extended credit terms and free products (i.e. guns) to offset the drop in inventory values for firearms previously purchased that are now selling at lower prices.

In turn, the distributors are trying to offload inventory onto the dealers with those same types of deals.

In one "Shot Show Special" I have seen, a distributor was offering free guns with the purchase of others.

In most cases, it was "Buy 5, Get 1 Free" almost universally across the board, products from companies such as Ruger, Smith & Wesson, Beretta and others. One deal on a pistol we previously discussed was "Buy 3, Get 1 Free."

Source: A firearms sales catalog picked up by Author at Shot Show 2018

The one that was notably missing or different from the "Buy 5, Get 1 Free" was Glock. In the case of Glock, it was "Buy 20, Get 1 Free."

How is that for pricing power?

Add to these discounts the direct to consumer deals such as the massive mail in rebates we have seen in 2017 and we can begin to imagine just how much those margins are compressing. This is how we have brand new Smith & Wesson Bodyguards for under $150 as reported by one of our Seeking Alpha readers.

Speaking with the dealers, you certainly had A LOT of doubt and uncertainty about the immediate future. This is of course not surprising considering many of these dealers acquired too much inventory on credit and are now working through it. Now that the dealers are in a better position, they are understandably much more caution with adding significant new inventories beyond the demand they expect for the newly launched products.

One thing to consider is that in a declining price environment very few will be comfortable expanding inventories at higher costs just to see their inventory devalued when the manufacturer drops the price in the future.

This is precisely what happened with H&K recently dropping the sales price on the very good H&K P30 pistols from a street price of about $850 down to $550 or so!

With the demand slowing, a number of firearms dealers I have followed have ended up closing their doors in 2017.

While many "kitchen table FFLs" survived fairly well as they do not stock large inventories, retail shops who went "happy" with their demand projections in 2016 are in far worse shapes, either with excess inventory which they were working through or trying to recover and pay off the debt they acquired adding new inventory.

The group that was perhaps hurt the most however are the numerous "5 Star Ranges" which have opened up over the past 2 to 3 years.

Spurred by the influx of new shooters and a general lack of high quality shooting ranges, many wealthy individuals, many of whom were new shooters themselves, got the idea to invest in a shooting range.

Perhaps much like many of the same people who invested in Florida, Arizona, and Las Vegas real estate in 2004 and 2005, brand new people invested heavily into opening up new facilities and are now in trouble.

Ranges I have spoken with all noticed meaningful declines, particularly amongst new shooters.

One of the things I discussed is my perception of the typical life-cycle of a new gun owner.

Typically, once you hand someone a firearm, they will more than likely end up purchasing one.

That one firearm ends up being the first of about 3 or 4 purchased within a very short time frame. What starts out as a typical Glock 17 or 19 is followed up with a pistol in 22lr as it is far cheaper to shoot. That is followed up by a rifle, for most an AR-15 variant and then either a 22 lr plinker such as a Ruger 10/22, a 308 bolt action rifle such as a Remington 700 or a home defense shotgun purchase such as a Remington 870.

From there, gun owners either halt their purchases or perhaps go down the rabbit hole of a niche such as action shooting like USPSA, IDPA or steel, western themed SASS leagues, 3 Gun competitions, the myriad of rifle matches or the really deep hole of clay shooting where some shotguns can easily cost as much as a good 3 bedroom 2 bath home in parts of the country! (If you have not done so already, visit a local "Beretta Gallery." Then, do a search on Holland and Holland, Peter Hofer, Fabbri, James Purdey & Sons, or William & Son)

For most, however, the excitement of becoming a gun owner wears out after 3 to 6 months, and those guns end up stored in the safe or closet and pulled out once a year or so for cleaning to keep the rust off of. Simply put, going to the range is not cheap and "gun owners" spend multiples more on ammunition than they do on firearms, something that new gun owners easily overlook.

Let's say, for example, someone purchased a Smith & Wesson Bodyguard pistol for $150 after rebates.

The Bodyguard pistol shoots 380 ACP ammunition. Most gun owners will start out purchasing ammo either at their local gun range or go to a big box store chain like Cabela's. There they would find a box of 380 for about $19 per box. At the range, it would be in the area of $20 to $25.

Source: Cabela's

A typical trip to the range will include 2 to 3 boxes of ammunition for an individual or 3 to 4 if they go with a friend. Assuming that, our new gun owner will spend $36 to $72 for the ammunition.

As the person is new, they also likely do not have a range membership (it is "too expensive") and are likely paying "walk-on" fees which here are about $20 for an hour.

Right there is $56 to $92 for an hour at the range... more than one-third the cost of your brand new pistol.

Once our new gun owner sees the expense, they will likely go online and look for ammo. One of the places I used to buy ammo from (before I started reloading) is Aim Surplus where 380 ACP is $12.95 per box.

Source: AimSurplus

Needless to say, even if you purchase ammunition online, it is still a $45 to $70 proposition to go shoot.

With many new shooters diving deep and shooting once or even twice per week, it is easy to see how these expenses add up to more than what you would spend leasing a brand new BMW 3 series.

This relatively high cost of firearms ownership is why I believe we have that very short 3 to 6 month life cycle of the "firearms hobby" for most new gun owners. Once again, buying a gun is cheap, it is the actual shooting which is expensive, much like skiing becomes.

What does it all mean?

As bad as 2017 was, I believe 2018 may be worse as there will no longer be that natural life cycle of new gun owners buying additional guns and ammunition as they did through the first half of 2017.

Source: Pexels

Bottom Line

In the next two articles, we will take a deeper dive into the specifics insights I learned and conclusions I came to for both American Outdoor Brands and Vista Outdoor. My hope for the last two published articles however was to share both my insights and thoughts about the broader industry and where we are in this post election cycle.

If there is one thing that I can leave with fellow readers and investors with is that unlike employees and company executives, investors have a choice.

The industry may just have scratched the that proverbial iceberg on the surface and has failed to take into account how much bigger it is below the water line.

Unlike the employees, executives and owners, however, investors do not need to stay with the sinking ship like the captain does!

Your first chance to get on the life rafts was a year ago when President Trump was elected, and I wrote about the industry after attending Shot Show 2017. Unfortunately, it seems just like on the Titanic, most people did not believe the ship could actually sink.

Today, a year later with many stocks being down more than 50%, the situation resembles the Titanic taking on water with half the ship submerged. Still it seems many people are listening to the music waiting for a bail out (Mid Term elections) which may not come in time or at all.

American Outdoor Brands, Vista, and Ruger are all awesome companies with iconic brands Americans grew up with. On one hand, we would not want to see any of them failing. However, investors also need to separate the brands from the stocks.

Just in the previous few years, retailer Gander Mountain went through bankruptcy and Cabela's struggled its way into being taken over by Bass Pro Shops. Remington is on the verge of bankruptcy while the iconic Colt emerged from bankruptcy. All of this during a time when things were still "not so bad."

Serious gun owners will go through defensive audits, looking at their strengths and weaknesses with the goal of creating a strategy and an actionable plan for when things go wrong. I believe now is as good a time as any for any remaining investors to do the same.

I hope you found this article insightful, and I look forward to continuing our conversation.

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.