Description

Executive Summary

We think in the high-50s, Sturm, Ruger & Co. (“RGR”) makes an excellent GARP investment as one is paying approximately 10x through-the-cycle UFCF for a high quality (albeit cyclical) branded consumer goods company that’s led by a very capable and shareholder-friendly management team. There is some evidence for a sales recovery in the near term, and (atypically for us) we’d be supportive of RGR management buying either Savage Arms or Remington, as RGR management has demonstrated great discipline towards capital allocation and acquisitions in the past. After the violent bounce in the market in January where a lot of cyclical names squeezed higher, we think RGR shares still offer great risk-reward for long-term investors.

Description

RGR is one of the two leading listed gun manufacturers (together with American Outdoor Brands, f/k/a Smith & Wesson, “AOBC”), and both have been written up several times over the past as longs and shorts. Mack885’s old write-up and cloud89’s old RGR write-up provide some good color on the industry and companies, whilst tychus’s well-timed analysis and ci230’s short call give you a good sense for the short-term dynamics that many followers of this industry trade on. We will not go into great detail on the business model – which primarily involves taking metal and working it into guns, mostly handguns but also rifles, and selling them to distributors and retailers – but instead focus on the fundamentals of the business and excellent long-run economics, which we felt have been underemphasized in previous writeups.

We want to make some high-level observations about the industry and RGR, which we think tends to get overlooked by people who exclusively treat the gunmakers as a short-term trading opportunity:

1. In the long run, this is a very profitable industry with high ROCEs, similar to many other branded consumer good companies, although

2. In the short run, this is a volatile and cyclical industry where sales swings get exacerbated by (i) distributor inventory swings, and (ii) operating leverage of the gun manufacturing business, and

3. RGR has an excellent management team that is very shareholder-friendly and has shown great discipline with regards to capital allocation.

Whilst RGR shares are not absolutely screaming cheap right now as AOBC was a few months ago, we think they still qualify as a GARP investment over many years, and for the short-term aficionados amongst us, we think there are good reasons to believe that RGR’s financial performance will start improving from relatively muted LTM levels.

Structural Growth & Short-Term Volatility

Before we get lost in details, we firstly need to note that this has been an industry that has seen structural growth over the past 20 years, although this may have been masked by violent swings in sales volumes driven by shootings and political events. 

One can have different theories around the drivers of the Obama-era gun sales increase, however, it’s hard to deny based on volume data that this industry has seen structural growth. Since the Republican candidate Trump won the presidential elections in November 2016, NICS has taken a dive but appears to have stabilized over the past 12 months since hitting the local low at 25.2mn in in Jan 2018 (on an LTM basis given the underlying retail sales are quite seasonal). This 25.2mn local low compares to 8-11mn during most of the 00s under President Bush, a 2.5-3x increase. RGR shipped 460k units in 2005, but shipped 1.6mn LTM after peaking at 2.2mn in 2013, which suggests market share gains on top of participating in general market growth. Whilst we may disagree on how far along in the downcycle we may be, we think few observers will deny that current market conditions are tough as evidenced by the venerable Remington undergoing a financial restructuring. Overall, we think that the industry is growing at around 2-3% annually via volumes only, although this gradual long-term trend has been vastly overpowered by shorter term swings that we will discuss next. 

In terms of short-term developments, NICS data so far suggests that we may have found a bottom. Most of you following this industry will be aware that NICS data prints have stabilized and exhibited a moderate uptick in January 2019 of 6.6%, but on top of this, we want to note that RGR’s company inventories have reached unseasonably low levels, which has gone hand in hand with higher order inflows and improving backlog levels over the past few quarters. To us, the combination of indicators suggests that RGR and distributors / retailers have worked through most of their inventories built in anticipation of a Clinton victory, and RGR sales and profitability should start increasing again over the next few quarters as they ramp production to meet recovering order volumes. RGR management cut headcount by removing most part-timers over the past 18 months, but now appear to be looking to increase staffing levels. For a management team that flat out refuses to provide forward guidance, we think this is as much of a hint that we’re going to get.

Management Team & Capital Allocation

RGR has one of the best management teams in our view, undoubtedly being very shareholder friendly and also being great operators, which makes RGR an excellent long-term holding in our view. Whilst disciplined, there may be additional upside if / when RGR management manages to find a suitable acquisition target at an appropriate price, which could be very value accretive if we are right about the secular trends and the current point in the gun cycle.

Operationally, we think RGR has a very capable management team that has managed the business for consistency and stability, which is no easy feat given the wild demand swings. Overall, one can have long debates on the merits and demerits of (i) managing inventory and product pricing swings as RGR does, whilst AOBC engages in much more aggressive promotional activity to clear inventory that leads to greater revenue and earnings volatility, (ii) pursuing an integrated operation encompassing guns, scopes, and other accessories as AOBC is doing as opposed to the more focused “we want to bring more than money to the [acquisition] party” mantra that RGR keeps preaching, and (iii) AOBC’s tacit move towards enabling more direct retailing, potentially cutting out the distributor middlemen whereas RGR has not made any noise on that front. We see what RGR management is doing and whilst we may not always agree with their strategy, RGR management is extremely direct and conservative and there is no reason to doubt their abilities to manage this company going forward.

Even more exciting, in our view, has been RGR’s shareholder-friendly capital allocation policies, which we believe makes RGR an excellent long-term investment even if they decide to make a big acquisition in the next 12 months. Since 2011, RGR has returned ~$400mn in dividends and share buybacks, and currently sports almost $140mn in cash on balance sheet and no debt whatsoever. Over the past 10+ years, RGR has not engaged in any M&A but instead thoughtfully and steadily increased production capacity organically. This has been great for shareholders, given that RGR has been clocking ROCEs through the cycle in excess of 30% (that’s post-tax UFCF over book equity and debt excluding excess cash balances over $50mn). 

Unlike AOBC, RGR has shied away from acquisitions in the accessories space over the past few years, citing concerns around valuation and fit. One can take different views on such strategic decision, but this has put RGR in pole position to acquire either Savage Arms from Vista Outdoors or Remington from its lenders today. We usually are sceptical towards M&A given management teams’ tendency to overpay, however, given how disciplined RGR management has been in the past, we think the odds are stacked in favour of a value accretive transaction. RGR management’s discipline has resulted in a debt-free balance sheet and almost $140mn cash holdings today, which they’ve explicitly stated is above operational requirements. In contrast, having spent almost $400mn in acquisitions since FY2015 on various accessory makers, AOBC has less debt capacity compared to RGR to stem a larger acquisition. Furthermore, AOBC management has been sending mixed messages around their intrinsic appetite for large-scale acquisitions recently, which bodes well for RGR, given we view AOBC was their prime strategic competitor. 

Catalyst

Frankly, there is no hard catalyst for RGR per se. Apart from our expectation of improving financials in the near term, one should look out for either (i) a major acquisition (which does come with its own set of risks), or (ii) management announcing a major return of excess cash holdings if they fail to make an acquisition.