Description

Ruger: A value trap with big forces pushing to 50% downside

Though RGR screens as a magic formula and great looking “value” stock with a TTM P/E under 10, great trailing 3 year growth numbers and top tier ROE, the underlying economics are deteriorating and I think about to get much worse.

America’s “Gun Bubble” appears to have peaked almost 12 months ago now and is in the process of unwinding. http://www.businessweek.com/articles/2014-08-28/america-has-hit-peak-gun-and-the-obama-gun-bubble-is-bursting

In summary – gun purchases skyrocketed over the last several years as people stockpiled ahead of fears that Obama would implement gun control making purchases more difficult or impossible.  This drove the stock price of RGR (and Smith & Wesson) ballistic, up 400% during Obama’s Presidency.  This dynamic appears to have peaked nearly 12 months ago and is now unraveling.  Unlike the housing bubble, this is not a debt-fueled bubble that will crash spectacularly due to forced liquidations but the durable nature of guns means that inventories will likely be backed up for some time and I expect things to overshoot to the downside.

I believe the normalized value for RGR is 2x P/B or about $22/share, for a downside of over 50% from current levels.  More importantly, it seems like a very low risk short in a charging market as the “mass” of negative business trends seems extremely strong.

This is not a ‘bad management’ short – in fact the company seems to be particularly well managed and they have consistently returned cash to shareholders via their dividend or stock buybacks in 2006-07 when the stock became quite cheap.  This has been shareholder friendly but also left their balance sheet relatively weak with only $47mm of cash (though no debt) vs a market cap of $1 billion.  They recently announced a $100mm share buyback which if they lever up to do this could find themselves in some trouble

Some bullet points:

-Spent $120mm+ on capex over the last 4 years to satisfy demand of this gun bubble.

-Have returned most cash to shareholders: only $47mm of cash left on the B/S (though no debt)

-Has historically traded around 2x P/B (BV/sh: ~$11/sh -> $22/share normalized price) vs 4.8X today

-ROE averaged 15% for the 15 years prior to 2012 when Obama won his 2nd term, since then it has been 62.6% or 4X higher than normalized levels.

-Order backlog has declined and they have responded to this by cutting back capacity but given the amount of capex spent over the last few years, there might be write offs required and they have already begun by lowering their expected asset life:

Key quotes from most recent 10Q ended June 30:

During the second quarter and first half of 2014, the estimated unit sell-through of our products from the independent distributors to retailers decreased 31% and 11%, respectively, from the comparable prior year periods.  The estimated sell-through of our products from distributors to retailers in the second quarter was adversely impacted by the following:

• the reduction in overall industry demand,
• the aggressive discounting of many of our competitors, and
• the absence of recent significant new product introductions from the Company. 

Net orders received in the first half of 2014 decreased 66% from the comparable prior year period and our ending order backlog of 1.0 million units at June 28, 2014 decreased 1.0 million units from backlog of 2.0 million units at June 29, 2013.  This decrease is due to the reduction in demand discussed above and the unprecedented level of orders received in the first quarter of 2013. 

 In 2013, the Company revised its estimate of the useful life of machinery and equipment from 10 to 7 years.

The Company reviews the estimated sell-through from the independent distributors to retailers semi-monthly in an effort to regulate production and mitigate increases in inventory.  As estimated sell-through began to slow, the Company managed its labor force by limiting the hiring of new employees, reducing overtime hours, and allowing attrition to reduce its total employee base.  The Company’s compensation structure, under which at least 25% of individual employee compensation was variable in 2013, allows for a more rapid reduction in labor cost.

What does the Gun Bubble look like?

I think a visual is better to show the magnitude of how far off things got and how far they have to correct:

(VIC doesn't allow including images so here's a PDF link:)

https://www.dropbox.com/s/delnzp9nkrmp7x8/RGR%20VIC%20write%20up.pdf?dl=0

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