Sturm, Ruger: Long-Term Holding Is The Only Way To Go

Summary

• A closer look at gun control legislation on the cards reveals minimal impact on Ruger's future sales.
• The current depressed valuation stems from uncertainty around inventory levels, the political landscape, and the long wait to see Ruger-made Marlin rifles on shelves.
• This represents a great opportunity for long-term investors to get in at an attractive price point ahead of Q1-21 on May 5, 2021.

Photo by Ethan Miller/Getty Images News via Getty Images

At a time when most companies are looking to diversify their offerings to present a broader surface area to consumers, some industries are going even deeper into their niche and specializing even further in what they already offer. Sturm, Ruger & Company, Inc. (NYSE:RGR) is one such entity that I've been covering for a while on Seeking Alpha. With the November 2020 acquisition of Marlin Firearms, Ruger is even more vested in the firearms business in the United States. Is this a wise move considering the political forces currently at play?

Thesis: The political forces I refer to are actually part of the reason why Ruger makes a solid investment case. Uncertain times lead to fear, and the current uncertainty around the regulation of firearm sales will only serve to heighten that fear and force new consumers to join the ranks of gun owners. This article hopes to make a strong bullish case for investing in Ruger at the current depressed valuation level even as the aforementioned political forces coalesce around gun sales in what 'apparently' appears to be a chokehold but may actually benefit companies like Ruger and its peers.

Political Forces at Play

There are currently three important bills in the pipeline that relate to gun sales and related federal regulations. Let's see what each of them means if passed into law, what it would impact in general, and the implications for Ruger.

H.R. 8: Bipartisan Background Checks Act of 2021

This bill seeks to prohibit the transfer of a firearm by an unlicensed entity unless a licensed importer, manufacturer, or dealer first takes possession for the purpose of conducting a background check.

The broad impact of this bill, if passed into law, is that gun sales by anyone who is not a licensed entity will become illegal.

There is no impact on manufacturers such as Ruger since this bill only seeks to prevent unlicensed transfers. From the company's 10-K filing for FY-20:

The Company's firearms are primarily marketed through a network of federally licensed, independent wholesale distributors who purchase the products directly from the Company. They resell to federally licensed, independent retail firearms dealers who in turn resell to legally authorized end users. All retail purchasers are subject to a point-of-sale background check by law enforcement.

H.R. 1446: Enhanced Background Checks Act

This bill seeks to close a loophole that allows a 'default proceed' on a gun sale if the background check cannot be completed within 3 business days. The bill seeks to increase the time period "a minimum of 10 business days"; it also states:

If a submitted background check remains incomplete after 10 business days, then the prospective purchaser may submit a petition for a final firearms eligibility determination. If an additional 10 days elapse without a final determination, then the federal firearms licensee may transfer the firearm to the prospective purchaser.

The broad impact of this bill, if passed into law, will be that unlicensed gun buyers will need to wait longer to trigger a default proceed, and it involves filing a petition if the background check is not completed within the first waiting period.

With regards to Ruger, this could minimally impact sell-throughs, since 4% of background checks typically cross the three-business-days threshold. The bulk (96%) of checks are processed within that period, hence the assumption of minimal impact on gun sales for Ruger.

H.R.127 - Sabika Sheikh Firearm Licensing and Registration Act

Yet to pass the House, this bill seeks to amend Chapter 44 of title 18 of the United States Code and requires the implementation of a Firearm Licensing And Registration System by gun owners.

The broad impact of this bill, if passed into law, is that it will require all gun owners to register each of their weapons under the new system, even if the firearm was purchased prior to the bill being signed into law. The Attorney General will be required to issue a license to the individual registering their firearms following a process that involves a background check, a psychological evaluation, at least 24 hours of training, and the possession of an insurance policy. In addition, the bill also potentially affects the sale of ammunition and magazines that exceed specified limits.

By far, this is the most controversial gun control bill yet, and has significant opposition from gun owners, lobby groups, and even law enforcement personnel.

For Ruger, this could have the greatest negative impact on future sales to new gun owners. It's hard to quantify the impact in unit sales or dollars, but it's safe to say that such a law will be prohibitive to gun ownership due to the cost and effort involved on the part of the licensee, not to mention the privacy issues that the matter of a publicly viewable database has raked up.

That being said, this hasn't stopped the American public from purchasing guns in millions of units per month. A quick look at NICS data for March 2021 and preceding months is enough to support that assumption:

Source: FBI

NICS checks are up at historical highs for the past several months (excluding February 2021), which is a validation of the 'uncertainty fosters fear' assumption. A quick look at Ruger's FY-20 results show that inventory levels are under tremendous pressure due to high sell-throughs.

Source: Ruger FY-20 10-K Filing

Ruger's Future Growth

Future growth, therefore, will come not only from the high level of demand but also from the backlogs that the company needs to fulfill in the coming quarters. Although the company has not provided any revenue or earnings guidance for FY-21, all indicators point to a very strong fiscal year of sales from new orders, backlogs, and the launch of the first batch of Ruger-made Marlin rifles in "late 2021." The timeline is unclear at this point but we should expect a launch sometime in Q4-21.

One of the reasons RGR is trading at such low valuations is a potential decline in FY-21 sales over the tremendous performance in FY-20. Consolidated net sales for FY-20 came in at nearly $570 million, which was a huge 38.6% jump from the year before. Although that looks like a hard-to-match figure, it's not the highest YoY growth that the company has posted so far. Revenue growth in FY-09 and FY-12 approached 50% on a YoY basis, and revenue growth in FY-13 came in at nearly 40%.

There's no concrete evidence to suggest that sales can't keep up with demand. However, we also need to recognize that sales at the moment are limited by production capacity and nothing else. On that front, the 30% increase in production capacity achieved in the back half of 2020 means production rates are already up, and we should see some additional support underneath flagging inventories over the next few quarters. Marlin, as CEO Killoy noted, isn't likely to go online until the end of 2021, and we should only expect to see the bulk of benefits from that line in FY-22. For now, any increase in production capacity will directly show up at the top due to depleted inventories across channels.

Overall, the bloated and ongoing demand we're seeing in the market is actually the biggest risk to inventories, and to production rates being unable to keep up the pace. That's a looming risk factor that investors will need to take into consideration. Long-term however, as demand settles to more normal levels and inventories grow, we should see sales stabilize as well. As of now, we can expect production capacity gains to directly contribute to revenue growth.

Current Valuation

Data by YCharts

I mentioned that RGR was trading at low valuations, but why is that the case? If the future is so bright, why aren't investors flocking to buy the stock? Again, the answer boils down to uncertainty, but of a different kind. My assumption is that the uncertain political landscape in terms of legislation has forced investors to take a hard look at their holdings and determine if the risk is worth the effort. The result of that has been the stock trading relatively flat for the past three months.

However, based on this analysis, it's clear that the impact of any new legislation (bar H.R. 127) on Ruger's ability to sell its products will be minimal. People continue to want guns, and the record-level NICS checks in the first calendar quarter of 2020 is proof of that.

Source: Seeking Alpha Charting

Calculations shown in one of my earlier articles on Ruger show that a valuation of 18x is sustainable for RGR. At the current consensus EPS of $4.58 for FY-21, that would put the target price at $82.44, representing an upside potential of nearly 27% from the as-of-writing price of $64.94. That's validated by the $81 and $82 median price targets from sell-side analysts. In my opinion, that's great value ahead of Q1-21 earnings, which will be announced on May 5, 2021.

That said, holding RGR long-term is probably the only way to profitably invest in this stock. Lower demand in the future could lead to price corrections that will impact your total return; however, the company periodically announces dividends based on operating performance, as it did in Q4-20. As a result of this long-cycle growth pattern complemented by dividends, the stock has a total return of +300% over the past decade. And all indications point to another decade of strong growth that's already off to a great start.

Analyst’s 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.