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Down 25% Each, Is It Time To Buy Ruger and Smith & Wesson?

August 29, 2014 | About:
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Magic Diligence

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The two Magic Formula gun stocks, Sturm Ruger (RGR) and (former Top Buy) Smith & Wesson (SWHC) have hit the skids as of late. After long, multi-year runs where both RGR and S&W saw their stock prices soar by over 500%, both have come crashing back to earth this summer. Since mid-June, S&W is down 32% and RGR 21% (-33% year to date). Both now trade near a 52-week low.

Those are some substantial short-term drops. Are we now faced with a buying opportunity, with a temporary lull in a hot market, or is this the beginning of a bubble popping? Let's take a look.

Guns Are Cooling Off

A little over a year ago, we had an article discussing the impetus behind the soaring domestic gun market. There were a few reasons for the unprecedented gun booms of 2008 and 2012-13, but the underlying theme was the same: fear of new gun control laws.

It has been almost 2 years since the awful occurrence at Sandy Hook elementary. Congress has failed to produce any substantive new gun control legislation, and indeed chatter about it has died down to almost nothing. The driving force behind the massive 2013 spike in gun demand is waning.

This can be seen in the numbers. Through July of this year, FBI background checks totaled about 7 million, down from the nearly 9 million a year ago. Ruger and S&W, after struggling to keep up with demand last year, now face an over-supplied situation. Respectively, the companies posted a 14% and 23% decline in revenues for their most recent quarters.

The key questions for a prospective investor to answer are: what will the trend be going forward? Will gun demand collapse, or are we just seeing a reset to a more normal demand level? And, of course, what are these stocks worth given the answer to the first two questions?

America and Guns: A Love Story

My opinion is pretty simple: gun demand probably was in a temporary bubble in 2013, but the trend of higher gun sales is a long, well-established one that is unlikely to change. I don't see anything approaching a complete collapse in the cards.

Even though background checks are down this year, they are still marginally higher than at this point in 2012. We saw a similar swell-and-sink pattern in 2009 after the first election of Barak Obama, where checks for this 7 month period neared 5.5 million before dropping back to 5 million in 2010 and then continuing steady growth from there. And the long-term pattern is undeniable. The same period in 2005 saw only about 3.7 million checks!

I believe the gun market is re-setting back closer to its longer term trend, with 2013 acting as a blip upwards, like 2009. Over the long term, I see the overall gun market holding around 2012 and 2014 levels, with moderate (3%) growth.

So What Are These Stocks Worth?

In the last review, we said Smith & Wesson was a better choice because of two reasons. One, it had better margin upside than Sturm Ruger. And two, its valuation was substantially cheaper.

That thesis played out relatively well. Since then, SWHC is up 25.5% vs. a 2.2% decline from RGR.

However, the tables have turned. Both companies now sport similar operating margins: 21.9% for SWHC and 23.4% for RGR. Both also have similar earnings yields too: 17.7% for SWHC and 16.9% for RGR. Ruger pays a decent dividend (3.6% yield) vs. none for Smith & Wesson. Lastly, Ruger may be holding up a little better than S&W given their relative revenue declines, although the reporting periods are not exactly comparable.

Overall, neither stock looks like a great bet currently. My target price for Ruger is $54, which represents mediocre 13% upside. Smith & Wesson, on the other hand, looks about right on fair value at $11.50. Again, this is assuming 2013 was a "blip" year and gun sales fall back into a roughly 3% growth rate from 2014 levels. Whether that assumption holds true is the real question mark behind these two stocks.

About the author:

Magic Diligence
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.2/5 (5 votes)

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Comments

z18wheeler
Z18wheeler - 3 months ago

9 year old accidentally shoots range instructor with UZI . Guns are going nowhere. They are like death and taxes, a sure thing.

chompinchuck
Chompinchuck - 3 months ago

Like Cisco in the late 1990's guns - like routers - will thrive for years to come. The stock prices however will not thrive.

pravchaw
Pravchaw premium member - 3 months ago

What drives the sale of guns in America? Are gun collectors the driving force here?

Gammastyle
Gammastyle - 3 months ago

I prefer RGR due to thier Balance Sheet. No debt and have rewarded shareholders with a dividend. Plus they authorized share buybacks. Thier dividend policy is interesting as well. They pay based on earnings and not a locked down number each quarter/year. This gives them the flexibiilty that other dividend payors do not have. The shareholder understand (or at least should understand) that the dividend could fluctuate.

Gun sales will continue to grow, just not linerarly as the author points out. The company has a balance sheet and a brand that makes them one with staying power. This isn't a home run stock, but it is a long term hold.

Disclosure: Long RGR

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