Description

Investment Thesis

Sturm, Ruger & Company (NYSE:RGR) is a long. RGR designs, manufactures, and sells firearms under the Ruger trademark in the United States. The stock is down 30% from its 52 week high following a weak Q2 announcement and is cheap, trading at 5x EBITDA, a 40% discount to the stock’s average 7x EBITDA trading level over the last five years. RGR is heavily shorted, with 22% short interest compared to just 12% for RGR’s closest comp American Outdoor Brands (NasdaqGS:AOBC, formerly known as Smith & Wesson). The opportunity exists because many investors think gun sales will decline substantially in a Trump administration, depressing RGR’s multiple, and these investors ignore the secular tailwinds facing the gun industry.

RGR generated its strongest EBITDA ever of $195 million in 2013 and second highest of $171 million in 2016. EBITDA will be lower this year primarily due to retailers, having ordered too much inventory last year, and secondarily due to NICS background checks, a proxy for gun demand, being lower (YTD -9% as of August) than last year’s record of 27.5 million. We think EBITDA will likely end up in the $130-135 million range in 2017 before picking up to ~$150 million in 2018 as retailers clean through their inventory this year and their ordering picks up in 2018 amidst continued strong gun demand. We think normalized EBITDA for the Company is around the $150 million level, which can produce $80 million of FCF, and can grow 3% per year. In our DCF, we assume $80 million of FCF grows 3% a year, a discount rate of 10% and perpetual growth rate of 3% to get to a fair value of $64.08, or 36% upside from today’s price of $47.25.

Industry Overview

Analysts follow NICS background checks because they are one of the best gauges of purchasing activity. Although these checks do not always result in a sale, nor do they indicate how many firearms a person is buying or whether the firearms are being bought new or used, they are still an extremely important barometer of the health of the industry. We ran a correlation between RGR’s sales and NICS checks going back to 1999 and, not surprisingly, found a 95% correlation. From 2000 to 2008, NICS checks were steadily increasing, beginning at 8 million in 2000 and ending at 13 million in 2008. In 2009 they were 14 million, in 2010 they were 14.4 million, in 2011 they were 16.5 million, in 2012 they were 19.6 million, in 2013 they were 21.1 million, in 2014 they were 21.0 million, in 2015 they were 23.1 million, and in 2016 they were a record 27.5 million due to uncertainty regarding whether Hillary Clinton would be elected.

As of August, YTD checks are at 16.3 million, down 9% from last year’s figure of 17.9 million. That said, August represented the first month this year that checks were actually greater than last year (increase of 4% yoy). In fact, checks in August at 1.9 million were the highest on record for August. Perhaps the trend will return negative for the rest of the year, but we view it as positive that at least one month this year checks were greater than last year. Assuming 2017 checks end up being 9% less than last year would put 2017 checks at 25.1 million, which would still represent 8% growth over 2015 and 20% growth over 2014. Clearly there was a rush of buying ahead of the November election, but with Trump in office, if all of the buying was simply politically driven, why would 2017’s checks still be so strong, on pace to be the second highest ever?

While it’s true promotional activity at retailers is probably boosting sales a bit this year, we think this year’s strong activity is instead being driven mostly by secular tailwinds, namely that there are simply more people buying guns today than a few years ago. The first trend driving this is the recent shift from hunting being the number one reason to own a gun to personal safety. This trend is in part driven by several mass shootings in recent years like Sandy Hook and Orlando, and social media, which has increased coverage of such events and is very good at causing an emotional response in people which can lead them to feel unsafe and purchase guns. According to a survey by Pew Research, in 1999 57% of gun owners said the number one reason they owned a gun was for hunting and target/sport shooting versus 26% for protection. In comparison, in 2013 39% of gun owners said the number one reason they owned a gun was for hunting and target/sport shooting versus 48% for protection. Bears might point out the percentages have shifted due to hunting being in secular decline, however based on the data below, the number of hunters has actually been fairly stable to increasing. This would suggest there has instead been a large increase of first-time buyers who are buying for protection, more so than for hunting/sport.

Hunting, long thought to be in secular decline, has actually been fairly stable and in recent years has even shown growth. For example, according to the U.S. Fish and Wildlife Service, the number of certified paid hunting license holders decreased fairly regularly from about 15.8 million in 1988 to 14.5 million in 2008 before rebounding to 14.6 million in 2014, 14.8 million in 2015,  15.4 million in 2016, and 15.5 million in 2017. Hunting is a discretionary activity and therefore depends on the strength of the overall economy. We think the growth in the last several years has been driven by an improving economy, an increasing number of people purchasing guns for the first time, and the ongoing trend of more women buying guns and starting to hunt. On this last point, The National Sporting Goods Association suggests female participation in shooting sports increased 52% from 2001 to 2011.  In addition, a 2014 poll had women’s opinions on guns doing “more good than harm” increasing 11% from 2012.  A Crime Research Prevention center report showed a 270% increase in female concealed-carry permit holders from 2008 to 2015. Lastly, anecdotally many gun retailers across the U.S. have reported seeing more female customers in stores. We believe the increased participation by women is a positive trend for the industry and believe firearm sales for hunting and sport shooting will remain strong in the coming years.

Americans’ views on guns have also changed. In 1959 roughly 60% of Americans supported handgun bans, while today 73% are against such bans and only 26% favor handgun bans. This fundamental change in firearm perception, along with the increased number of female gun owners (up dramatically from 13% in 2005 to 23% in 2012) will drive strong gun sales going forward. These changes have been driven by The National Rifle Association, The National Shooting Sports Foundation and other gun-rights groups who have been rallying for Second Amendment rights, increased participation in shooting sports, teaching people how to shoot and store firearms safely, and other things. The NRA has also been lobbying all over the country and growing its membership and attracting more Americans to shooting sports. The NRA has helped make shooting sports safer and taught more people how to shoot and defend themselves.

Importantly, the NRA was a major backer of Trump’s campaign, and at the NRA’s annual convention Trump pledged “As your president, I will never, ever infringe on the right of the people to keep and bear arms.” While fear-driven gun sales will be reduced now that Trump is in office, we think Trump’s pro-gun stance will help firearm manufacturers increase their sales through new revenue streams such as firearm silencers, which currently require their purchasers to pay a $200 tax and go through an extensive registration process. The NRA has been pushing to deregulate silencers, arguing they could protect participants in shooting sports from hearing loss. Given the NRA supported Trump, we think he will be loyal to the NRA and help gun manufacturers like RGR increase their sales through methods such as deregulation.

Overall, we think these secular factors will result in continued tailwinds for the gun industry. While it’s true that existing gun owners certainly stocked up on guns during the Obama administration, as evidence by the average gun owner increasing the number of guns he/she owns from 4 guns in 1994 to 8 guns in 2013, we think increased participation in hunting and shooting sports, especially by women, will result in continued strong demand for guns. In addition, we believe that a number of recent first time gun buyers, who purchased due to fears around changes in gun legislation, will end up turning into gun enthusiasts, which will also serve to propel gun sales going forward. Certainly gun sales will be volatile year-to-year as they always have been, but for patient investors who can take a multi-year view, we think the future is bright for gun manufacturers like RGR. While RGR is trading at a depressed multiple, we think one of the catalysts to multiple expansion is seeing gun sales remain strong over the next year or two, even in a Trump administration, refuting the point bears make that the surge in gun sales was just due to political reasons, rather than more fundamental positive changes in the industry.

Financial Overview

RGR reported Q2 earnings below estimates, resulting in an 8% share price decline. Q2 sales of $132 million declined 21% versus prior year and 1H’s sales of $299 million declined 12% versus prior year. Q2 EBIT of $15 million was 42% less than last year due to high fixed costs and an 8% average sales price decline, while 1H’s EBIT of $49 million was 32% less than prior year. Q2’s EBIT margin was 12%, compared to 22% last year, while 1H’s EBIT margin was 16% compared to 21% last year. Clearly Q2 was ugly, but we think the negative situation is more short-term in nature and will normalize itself over Q3 and Q4 in time for 2018. It’s worth noting that AOBC had even worse Q2 results, with its sales down 38% compared to prior year and generating negative EBIT in the quarter, causing AOBC’s share price to decline 15%. Therefore, the recent underperformance is not limited to RGR.

Adjusted NICS checks are calculated by the NSSF and subtract out NICS checks that are not directly related to the sale of a firearm, resulting in a more accurate picture of current market conditions. Adjusted NICS checks are disclosed in RGR’s filings. Adjusted NICS checks were down 7% in the first half of the year, in line with RGR’s volume decline, suggesting RGR has maintained market share. Management indicated sales have been down this year due to a combination of reduced purchasing by retailers as they try to reduce their inventories and aggressive price discounting by competitors which RGR does not engage in (RGR engages in more limited promotions). It’s important to note that unlike some of its peers, RGR does not sell directly to retailers and only sells to distributors. What happened in 2016 is that retailers ordered more guns than were needed to meet demand, resulting in distributors over-purchasing guns from RGR, which is why we view RGR’s earnings last year as having been too high and naturally set to decline this year as both retailers and distributors work through their inventories.

At the moment the whole system, from RGR to its distributors to retailers, is flush with inventory. RGR discloses its inventory for itself and its distributors (based on units, not dollars). RGR does not have data on inventory held at retailers so that is not disclosed. We calculated inventory days for RGR and its distributors on a quarterly basis since 2011 as shown in the chart below (note RGR’s inventory days are plotted on the LHS while inventory days for its distributors are plotted on the RHS). It’s clear that there is a lot of volatility, some due to seasonality (inventory days are typically highest during Q2/Q3 as inventory builds for the fall and holiday season), but the volatility is mostly due to the capricious orders from retailers over the past several years due to fears around legislation changes. With Trump only in his first year in office, we think the next few years will result in smoother orders given the runway the Republican administration has in office. As a result, we forecast smaller working capital swings in the business over the next couple years compared to the last several.

The other observation from the chart is that RGR’s inventory days are less than its distributors’ inventory days. Since 2011, RGR’s inventory days averaged 15 days compared to 47 days for its distributors. During peak sales of 2013, inventory at both RGR and its distributors turned extremely quickly before inventory days substantially began to climb in 2014 when retailers were oversupplied with inventory. Since Q1 2016 there has been a steady increase in inventory days across RGR and its distributors from 14 days for RGR and 42 days for its distributors in Q1 2016 to 31 days for RGR and 73 days for its distributors in Q2 2017. Since 2011, Q2 has averaged 15 days for RGR and 49 days for its distributors, so the current days represent a 105% premium for RGR and 50% premium for its distributors, indicating a situation of excess supply.  The current inventory days are near all-time highs and therefore not likely to worsen from here. We think retailers will clean through their inventories by the end of the year, driven by promotions and fairly resilient gun demand (i.e. gun demand is not going to fall off a cliff from last year). This in turn will help distributors and RGR clean through their inventories. As the chart shows, when inventory days are high, within two to three quarters they can return to normalized levels, which we think will happen with RGR and expect Q3 2017 days to still be elevated but for Q4 2017 and Q1 2018 days to return to more healthy levels.

We can also monitor the health of the supply chain by analyzing the number of units sold from RGR’s distributors to retailers as reported in RGR’s filings and compare this to the adjusted NICS checks. For example, RGR estimates 362,400 units were sold from its distributors to retailers in Q2, compared to adjusted NICS checks of 3.1 million, implying RGR effectively had 11.6% of the market. The ratio of units sold from RGR’s distributors to retailers divided by adjusted NICS checks averaged 13.0% from 2012-2016. Since 11.6% is less than 13.0%, this would further support the view that retailers are not buying a lot of new inventory from distributors, which in turn implies that until retailers can clear through their inventory, distributors are not going to be buying a lot of new units from RGR. We think over the coming quarters this ratio will return to the 13% average, implying distributors will be selling more units to retailers (assuming NICS checks and demand remain strong which we think they will) and therefore buying more units from RGR, which we view as positive and indicative of higher earnings in 2018 compared to 2017.

It’s also useful to analyze RGR’s units ordered by distributors, units shipped to distributors, and units shipped from distributors to retailers, alongside RGR’s revenue and EBITDA, as shown in the two charts below. We analyzed these metrics since 2012 and found that over the last five years, each year RGR has on average received orders representing 1.96 million units and has shipped 1.90 million units to its distributors. We also analyzed the data quarterly since 2016 and clearly Q2 2017 was a tough quarter as not only did RGR’s revenue and EBITDA decline, so did new orders.

One final analysis we conducted to determine the health of the industry was to compare the volumes RGR shipped to its distributors (which are a proxy for revenue as RGR recognizes revenue upon shipment) to the adjusted NICS checks (which are a proxy for demand). As shown in the table below, we calculated the ratio of RGR’s volumes to the adjusted NICS checks from 2008 to 2017 Q2 to get a sense for whether or not RGR was over-supplying its distributors relative to demand in a given year. Assuming RGR’s market share did not change over the period, a high ratio would indicate RGR was over-supplying the industry, which would result in inventory build ups at distributors and retailers. 2013 represented the Company’s highest sales on record, and it’s no surprise that the ratio of RGR’s volumes to background checks was also the highest at 15.1%. Over-ordering occurred in 2013, leading to retailers carrying too much inventory in 2014, resulting in RGR’s share price declining from $76 at the end of 2013 to $40 by the end of 2014.

From 2008 to 2016, the average ratio was 11.5%, and from 2012 to 2016 the average ratio was 13.3%. The ratio in Q1 and Q2 this year was 14.1% and 13.9%, respectively, which is above the long-term average and suggests that RGR’s sales probably need to decline further into Q3 and Q4 versus last year in order for the industry to normalize itself.

Assuming demand decreases 7% this year would imply 14.6 million of adjusted NICS checks, or an implied 7.8 million adjusted NICS checks for 2H 2017. Assuming a volumes shipped to background checks ratio of 12.0% for 2H 2017 would result in RGR shipping 0.94 million units in 2H 2017, for a total of 1.9 million units for the year, which at an assumed $302 average unit price (same as Q2) would result in 2017 revenues of $571 million, down 14% from 2016’s revenues of $664 million. At an assumed 23% EBITDA margin, 2017 would generate $131 million in EBITDA, down 23% from 2016’s EBITDA of $171 million.

For 2018, we forecast a 3% increase in demand to 15.1 million adjusted NICS checks. At a ratio of 13.0%, this would imply RGR sells 1.96 million units in 2018. At an assumed average unit price of $305, this results in 2018 sales of $597 million, which at a 25% EBITDA margin results in EBITDA of $149 million, up 14% from our 2017 estimate but still down 13% from 2016’s actual EBITDA.

Valuation

RGR has a market cap of $835 million, no debt, and $44 million of cash, resulting in an enterprise value of $791 million. Over the last five years, the Company has averaged EBITDA of $150 million and FCF of $80 million (not including changes in working capital). In our discounted cash flow model, we assume EBITDA of $150 million and FCF of $80 million in 2018, growing at 3% per year thereafter at a 10% discount rate and 3% perpetual growth rate, resulting in a fair value of $64.08, or 36% upside from today’s price of $47.25. We note that our share price target of $64 is a discount to RGR’s 52 week high of $68.

The Company is currently trading at 5x forward EBITDA, which we view as too low. Our fair value is based on a 7x forward EBITDA multiple. Similarly, the Company is currently trading at 11x forward P/E, and our valuation is based on a 15x P/E multiple and 14x FCF multiple. We believe a market leader like RGR, who operates in an industry with secular tailwinds, has a strong brand with significant consumer awareness, high margins, strong cash generation, and zero debt should trade at these higher multiples.

In particular, we like management’s disciplined approach in not aggressively promoting its products or offering overly generous payment terms like some of its peers. We also like management’s capital allocation strategy. Management has not made an acquisition in over 25 years and prefers to grow the Company organically. RGR expects to invest $35 million in capex this year, much of which will be toward new product introductions, which we view as positive. RGR generates significant free cash flow, which is used to pay dividends (RGR has a variable dividend, which is currently a high 4%) and buy back shares. During the first 6 months of the year, RGR repurchased 1.1 million shares for $54 million (average price of $49.73). As of July 2017, $100 million, or 12% of the Company’s current market cap, remained authorized for future stock repurchase, which we view as a catalyst and we think now would be a good time for the Company to buy back shares given RGR’s depressed valuation. RGR’s share count has decreased from 18.7 million at the end of 2015 to 17.7 million today, a 5% decline which we view as encouraging. Importantly, RGR only began repurchasing large amounts of shares in 2014, which is fairly recent and we think goes underappreciated by bears as a value creating catalyst going forward. Note RGR’s closest comp AOBC does not pay a dividend and is much more acquisitive (AOBC has diversified into outdoor products and accessories and is therefore no longer a perfect comp). In fact, today RGR is the only pure play public firearms manufacturer, which we think creates scarcity value.

Catalyst

Continued strong NICS background checks, indications retailers are cleaning through their inventory and inventory days are improving across the board, further share buybacks