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Sturm, Ruger & Company (RGR) – The Apple, Inc. of the Firearm Industry

October 07, 2010 | About:




Sturm, Ruger & Company (RGR) is one of only two publicly traded American manufacturers of firearms. The other company is Smith & Wesson (SWHC), and if you wish to read my analysis on it, click here. Sturm, Ruger & Company designs and manufactures pistols, revolvers, rifles, and shotguns, primarily for sporting purposes, but also for law enforcement and military agencies.

History

Sturm, Ruger & Company has very inspiring roots. It was founded by Bill Ruger in 1949 during the time when there were already four well established firearm manufacturers. With the odds stacked against him and everyone telling him that it could not be done, he succeeded anyway. In order to understand the company’s history and its culture, one has to learn about Bill Ruger himself. Without his passion for firearms, Sturm, Ruger & Company would have never become what it is today.

Bill Ruger was born on June 21, 1916. When he turned 12, his father gave him his first rifle. With this, his passion for firearms was ignited. He spent most of his early teens learning about guns. He joined the rifle team in high school and become a pretty good competitor. He read every single book in the New York City Public Library on the subject. He even bought two deactivated machine guns so that he could take them apart and learn about how they operated. By the time he was 18, he knew more about guns than some engineers at that time. He realized this when he visited Marlin Firearms Company in New Haven and found the chief engineer and other employees gathering around him to listen to him talk about guns.

When he was 20, he enrolled in the University of North Carolina. After spending two years there, he realized that college was not for him, so he dropped out to pursue a career in the firearm industry. Unfortunately, he was not able to find employment with any of the major gun manufacturers. Instead, he received an offer from the U.S. Government to take a position designing machine guns, which he immediately accepted. Even though he was gaining practical experience and learning more about the American firearm industry, the pay was not enough to support his family, and therefore, he left after several months of government employment.

He then took on a different challenge. During this time, the Army was looking to replace its machine gun as it was preparing for World War II. Consequently, it published specific requirements that Ruger used to build a prototype of his machine gun. Because he did not have any manufacturing capability, he shopped it around to different firearm manufacturers, such as Remington and Smith & Wesson. Even though none of the manufacturers were interested in producing it, some, like Smith & Wesson were impressed with Ruger’s engineering abilities and offered him a job.

Unable to find anyone to produce his machine gun, he accepted a position with Auto-Ordnance Corporation, firearm manufacturers with lots of government contracts. During his four years with his new employer, he learned valuable mass production manufacturing techniques and realized that product innovation was important to stimulate demand and gain an advantage over competitors. This experience served him well when he ventured out on his own.

In 1945, he Ruger left Auto-Ordnance and in 1946, he started The Ruger Corporation whose mission was to supply parts to the firearm industry, develop a hardware tool line, and produce an automatic pistol. Unfortunately, things did not go as planned and by 1949, the company went bankrupt and found itself in receivership. Even though the venture turned out to be a complete failure, Ruger learned a very important lesson that shaped the future of Sturm, Ruger & Company – when you borrow money, it is much easier to go bankrupt than if you have no debt at all.

During this time, Ruger met Alexander Sturm, a graduate from Yale University, who came from a wealthy family and was a keen firearm enthusiast. Together, they formed Sturm, Roger & Company to manufacture the automatic pistol that Ruger intended to produce under his failed company, The Ruger Corporation. This time, he said “no borrowing,” and the new company was seeded with a $50,000 investment that came from Sturm. Ever since this initial investment, the company never borrowed money and instead, grew by reinvesting internally generated earnings. Because Sturm died in 1951 of hepatitis, Ruger ran the company mostly by himself throughout the majority of its history.

Sturm, Ruger & Company under Bill Ruger’s Leadership (1949 to 2000)

Under Ruger’s leadership, the company went from nothing in 1949 to generating over $200 million in sales and $30 million in earnings by 2000, becoming one of the top players in the firearm industry. The return on equity ranged from 15.2 to 33.1 percent between 1991 and 2000. He achieved this phenomenal performance at the expense of his competitors. He could very easily be compared to Steve Jobs of Apple, Inc., when it comes to innovation and to Warren Buffett of Berkshire Hathaway, Inc., when it comes to integrity.

Because firearms are durable goods, innovation is key to stimulating demand. When a company offers more features, it gives buyers reasons to buy its new products. Over the years, Sturm, Ruger & Company became known for its innovative designs. The company always hired the best engineers and Ruger himself was involved in designing new products until his retirement.

Besides being the most innovative, the company became known for high quality as well as low prices. Because at the beginning, it did not have the kind of brand name that of some of its competitors had, Ruger was forced to figure out a way to produce high quality firearms at a lower cost, and that’s when he turned to a new technique called precision investment casting. This technique allows for the production of castings out of the highest strength alloys available at a reasonable cost. As a result of this, the company’s margins were the best in the industry.

Because the company provided a high quality product at reasonable prices, and it was not encumbered with debt, it was the only company in the firearm industry to show profit every single year. Competitors who were not as fiscally disciplined struggled during lean years or went bankrupt. Sturm Ruger, at one point or another, had a chance to purchase each of its four main competitors, Colt, Smith & Wesson, Remington, and Winchester.

Ruger was also known for his high integrity and ran his company in a way that Warren Buffett would like to see. For example, he did not spend money on fancy offices, personally owned more shares than anyone else, and paid out dividends because he believed that shareholders had better uses for cash than he had. He truly loved his work and did not see it as work. He said, “I’ve never done a goddam day’s work in my life.” In October 2000, Ruger retired at the age of 84, and his son Bill Ruger, Jr. took over the leadership of the company.

Sturm, Ruger & Company under Bill Ruger, Jr.’s Leadership (2000 to 2006)

When Bill Ruger, Jr. took over, the company experienced some rough years. It began facing problems such as excess inventory, congested factories, and outdated product lines. It reduced spending on research and development to cut costs, which is the last thing that should have been done because innovation is what stimulates demand. Competitors took advantage of it and stole market share, and consequently, the company’s sales began to decline. They went from over $200 million in 2000 to as low as $146 million in 2004. In 2005, the company barely broke even on earnings, almost ending the over 50-year record of positive earnings. Then in February 2006, Bill Ruger, Jr. stepped down and retired. Stephen Sanetti became the temporary CEO while the board of directors searched for a permanent replacement.

Sturm, Ruger & Company under Michael Fifer’s Leadership (2006 to Present)

On September 2006, Michael Fifer was hired as the company’s CEO. His transformation plan included modernizing the manufacturing through principles used by Toyota, strengthening research and development, monetizing under-utilized assets, changing the management style, improving the compensation system, switching retirement benefits, and simplifying communications with Wall Street.

To modernize the manufacturing, he aggressively reduced inventory, which was masking problems in the production process. This was a painful process because once inventory was reduced, all kinds of problems started to appear, such as line stoppages, and they had to deal with them as they came up. Then the management set up manufacturing cells, which allowed the company to transform raw materials into finished goods or subassemblies in one area. The advantage of cell manufacturing versus the old-style, batch process manufacturing was the improvement in material flow, which increases efficiency.

Bill Ruger, Sr. learned in his early years that product innovation drives demand, and this is why he was able to make his company successful. But when he retired, so did the company’s emphasis on new product development. Fifer knew this concept very well, and consequently, he hired new talent to strengthen the company’s innovation process. He also allowed the customers, through their “Voice of the Customer” program, to tell the company what kind of products they wanted.

To monetize under-utilized assets, the management sold off some real property assets, foundry equipment, titanium raw material, and art work. This allowed the company to bring in cash that otherwise would have been sitting idle.

As mentioned before, the company was founded by two individuals, Bill Ruger and Alex Sturm. But Sturm died two years later, so Ruger was at the helm for over 50 years utilizing a top-down management style. When Fifer became CEO, he changed the management style from top-down to one that allowed lower level employees to have more decision-making power and be responsible for their own performance. Fifer also changed the compensation system that rewarded employees for performance and shifted the retirement benefits from defined-benefit to defined-contribution plans.

To better communicate with the investment community, he adopted a “plain English” presentation of the MD&A section of the 10-Q and 10-K filings and eliminated the narrative portion of the quarterly financial press releases, which were too complex to be explained in short press releases.

What Were the Results?

When Fifer took over as CEO, the company’s sales were $168 million and net income was a little over $1 million. By 2008, sales and net income increased to $181 million and $9 million, respectively. By 2009, sales and net income increased to $271 million and $28 million, respectively. While it might be easy to quickly assume that the improvements in sales and earnings were caused by the initiatives previously described, it is important to discuss another phenomenon that occurred at the end of 2008 and during the first half of 2009.

You might recall that this was the time of the presidential election and Obama is a well-known gun control advocate. As a result, people rushed to the stores to buy guns, fearing that he would tighten gun regulation (which he did not). However, because of this short-lived boom, the company’s 2008 and 2009 sales were higher than normal. Consequently, some investors argue that because of it, sales were stolen from the future. With that being said, I do not believe that it is this simple, and here is why. The hardest step for a gun buyer to take is to make the first purchase. Afterwards, the person is likely to purchase the second, third, or fourth gun. During the time when consumers were uncertain about what Obama would do, many made their first purchases, thus creating new customers that will bring the company more business in the future. Because of these occurrences, it is very difficult to say what the new normal will be other than that there will be a new normal.

Analysis

Let’s for a moment assume that the 2009 results are normal and ignore the Obama effect. As I said before, the sales were $271 million and earnings were $28 million. The current market capitalization of the company is $267 million, which means that the stock is trading at a price-to-earnings multiple of 9.5. This looks pretty cheap to me.

Now, the question is whether relying on these sales is prudent. At first, I thought it was not, but as I learned more about the company, I changed my mind, and now I believe that the 2009 sales and earnings are achievable, and here is why.

Before Bill Ruger, Sr. retired, this is what the sales and earnings looked like from 1996 to 2000.

1996 1997 1998 1999 2000 Average
Sales 223,295 209,383 211,580 241,664 202,654 217,715
Net Income 34,385 27,750 23,426 33,734 27,040 29,267
Sales were over $200 million every year and earnings fluctuated between $23 million to $34 million. The average sales and earnings were $218 million and $29 million, respectively. It is also important to realize that this was before the current CEO’s modernization of the company’s manufacturing processes. If from 1996 to 2000, the company had had a lean manufacturing process similar to the one today, net income would have been much higher than what it had been.

Today, considering the fact that the company has an excellent management team that made some very important changes as I previously discussed, I do not think that it is unreasonable to think that the company can generate sales and earnings that are on the same level as they were from 1996 to 2000. Look at the first six months of 2010 – sales were $133 million or $266 million annualized. Or, look at the second quarter of 2010 – sales were of $64 million or $256 million annualized. Even though the Obama surge is supposedly over by now, sales are still high.

In addition to this, margins are getting better because of the modernization of the manufacturing process. For example, even though sales during the first half of 2010 were lower than during the same period last year, earnings improved as margins expanded.

Based on this, I believe that the 2009 levels are not very far from the new normal, and therefore, the stock is cheap. Plus, seeing the company buying back its shares at this price makes one feel more comfortable.

Disclosure: The Author Does No Own RGR or SWHC

About the author:

Mariusz Skonieczny
Mariusz Skonieczny is the founder and president of Classic Value Investors, an investment management firm. He is also the editor of Ultimate Value Finder, a monthly newsletter that features three underfollowed, unknown, and undervalued companies ignored by Wall Street.

Visit Mariusz Skonieczny's Website


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