Explore the defining characteristics, past performance, current valuation, and future outlook of Sturm Ruger & Co (NYSE:RGR).

This post is part two of two in our RGR analysis:

  1. RGR – Lay of the Land
  2. RGR – How many guns has The Walking Dead sold, irl?

 

Marketing guns

Spoiler Alert: We’re not answering the question in the title, but it’s an interesting thought to ponder. Guns are cool. That’s the takeaway message from just about every movie, TV show, and video game in existence. Whereas in real life, firearms rarely make an appearance, they show up on the screen every few minutes. Even if the bearer is weak, the possession of a gun makes him/her a powerful figure. The normalization of guns has a profound psychological impact on prospective customers. It’s like an endless marketing budget for RGR paid for by entertainment companies. From an early age, people are exposed to guns in a way that acts as free marketing for the entire industry. Even slasher films that feature no firearms in their course of horror inspire a viewer to scream inside, “If only she had a gun!” Guns are seen as an equalizer. Guns in a drama are so ubiquitous and powerful than a drama principle exists called Chekhov’s Gun, one variation of which states, “If in the first act you have hung a pistol on the wall, then in the following one it should be fired. Otherwise don’t put it there.”

Capital structure

One of the reasons that RGR is our preferred starting security is that it carries absolutely no debt. None. That certainly makes analysis easier. Sturm, Ruger & Company has less debt on its balance sheet than you do, in all likelihood. Very few companies operate in this manner and for good reason. Debt is a critical financial tool that corporations use to expand their production, acquire other companies, enter new markets, or otherwise grow their business. Especially at a time when corporate debt is at historically low rates, the decision by management to avoid owing money to banks or bondholders is a bit perplexing. When we later analyze the unique political risks associated with the personal firearm business, this ultra-conservative capital structure begins to make sense. It’s extremely difficult to go bankrupt with a $0.00 debt load, but it is possible. If your business is legislated to a halt or a Supreme Court decision today cancels orders tomorrow, or if you’re hit with an enormous class-action lawsuit that dwarfs your market cap, then the business can still go bankrupt. Conservativism is the call when sailing in troubled waters, and RGR has certainly heeded that warning, perhaps a bit too cautiously for this author’s tastes.

Cash and access to debt for acquisitions

Multinational corporations such as Microsoft and Johnson & Johnson are stacking cash so high that they could build structurally sound sky scrapers out of 100 dollar bills, but there’s a problem. Much of the cash was earned and is stored outside of the USA. In order to deploy the full power of their accumulated currencies, these global businesses must repatriate money and face a devastating one-two punch of converting laggard global currencies into a historically strong dollar and then paying 35% tax before sending the money to shareholders, repurchasing outstanding shares, or acquiring accretive domestic businesses. Sturm Ruger & Co doesn’t have this problem; its cash is cocked locked and ready to rock. All of it was earned and is stored here in America. It has already been fully taxed.

From the 2016 annual report, “At December 31, 2016, the Company had cash and cash equivalents of $87.1 million.” The entire business is valued on the open market at ~$956 million. For every $100 you put into RGR, you buy $9.11 of cash.

Conservative share repurchase

On top of the juicy balance sheet and tantalizing cash flow, Sturm Ruger & Co has among the very best track records for share repurchases. When a company repurchases shares of its own stocks, investors hope to see management exercise discipline and patience. Sturm Ruger & Co executed one of the most impressive buybacks in recent history, for any publicly traded company. “In 2015, the Company repurchased 82,100 shares of its common stock for $2.8 million in the open market. The average price per share purchased was $34.57. These purchases were funded with cash on hand. In 2014, the Company repurchased approximately 680,800 shares of its common stock, representing 3.5% of the then outstanding shares, in the open market at an average price of $35.22 per share. These purchases were made with cash held by the Company and no debt was incurred.” After letting previously authorized share repurchase programs expire unused, management’s patience for a ridiculously low price allowed them to expand the slice of everyone else’s pie by retiring a big chunk of shares at rock-bottom prices:

From the 2016 10k, we see that more money is waiting on the sidelines for another such opportunity: “At December 31, 2016, approximately $59 million remained authorized for share repurchases.” With $87M in cash on hand and $59M authorized for buyback, the company could take advantage of the recent price drop to wipe out another 6.16% of the publicly traded shares. That would make everyone else’s slice of the RGR pie substantially bigger.

With buyback programs, it’s vitally important to evaluate the net effect on outstanding shares. Dilution happens, usually because of executive compensation. Let’s take a look at RGR’s net effect. From 2014 to 2016, the diluted share count dropped from 19,837,408 to 19,049,515, a 4% reduction in two years. During this time period, the company repurchased 1,046,256 shares. That’s a 75% rate wherein 3 out of 4 repurchased shares were fully retired from the market, not too bad. The repurchase programs are actually helping shareholders and not just lining executives’ pockets.

Peak Earnings Trap

The surprising results of the 2016 elections will have resounding impacts on Sturm Ruger & Co and the gun industry as a whole, both in the short term and decades down the road. Because the 2016 election was seemingly going to result in a President Hillary Clinton, with her push for gun control, many gun buyers rushed to the store to make preemptive purchases. This will absolutely have the effect of pulling demand forward in time. All investors in gun stocks should expect 2017 to be a down year when comparing YOY numbers. But how much will sales drop? And how long will it take to recover to the record-breaking 2016 waterline?

Short Squeeze

Because of the aforementioned expectation that RGR earnings will drop in 2017, RGR is among the most shorted companies in the entire world, ranking in the top 125 securities for short interest % of float. If and when the stock price makes an upward move, it’s likely to jump in leaps and bounds. Within a week, it would not be surprising to see a 15% gain as a result of a short squeeze, as investors betting against RGR will unwind their positions in rapid fire. The takeaway is that RGR has potential to move upward quickly.

Price outlook

We cannot predict short-term price movement, but if history is any guide, there’s a good chance that the next two years will present investors with an opportunity to buy RGR at prices significantly lower than the ~$50 per share price available today. Does that mean that now is a bad time to buy RGR? No, because investing in stocks is an activity with a minimum of a 5 year timeframe. In fact, a purchase today followed by a temporary dip in share price is the best case scenario for a long-term investor.

There are three ways that a drop can benefit your balance sheet after a buy order is executed. 1) You can reinvest the dividends deposits in your account at lower prices. 2) You can contribute new capital to buy more discounted shares. 3) You can rely on the superb management team at Sturm Ruger & Co to repurchase shares when the price presents a compelling opportunity. When the company takes these shares off the open market, your piece of the earnings pie gets bigger and the company itself needs to distribute less total dividends each quarter, allowing it to retain more capital for other investments.

Margin of safety

Five factors contribute to a significant margin of safety for investors:

  1. No debt – if RGR gets into financial trouble, they cannot go bankrupt to creditors if no creditors exist.
  2. Low P/E – RGR earnings could take a significant hit and still be in the fair value range.
  3. Variable dividend – because only 40% of earnings are paid out as a dividend, RGR management won’t feel compelled to impair its balance sheet in order to continue an unsustainable dividend policy. If investors are reinvesting dividends, this quarterly cashflow will help ease any price dips.
  4. Conservative buybacks – if the stock price dips too far, management has shown that it will accumulate cash in anticipation of this event, and when prices reach their bargain basement calculation, management buys back fistfuls.
  5. The 2nd amendment – consumer’s rights to purchase RGR’s products are protected by the law of the land. Furthermore, the Supreme Court is projected to lean more in favor of the company’s interests with each appointment in the next 4 years.

The margin of safety concept was introduced by Benjamin Graham and is meant as a backstop, in case one’s analysis of intrinsic value ends up being incorrect, whether for calculation errors, bad assumptions, or unforeseeable black swan events. Sturm Ruger & Co sports a robust margin of safety, enjoying favorable valuation, a remarkably sound balance sheet, and long term legal protection. The downside for RGR stock at $50 seems to be limited by these factors, whereas the bullish case offers a juicy opportunity.

Fair value

According to the NICS, which tracks background checks for firearm sales – a close proxy to the sales themselves – the number of background checks has increased by 19% YOY since the beginning of 2006, a trend that began a full 2.75 years before Barack Obama was elected. Let’s assume that 11% of that 19% growth rate was politically motivated and will disappear overnight going into 2017, leaving RGR EPS to grow at a 8% rate. Furthermore, let’s assume that sales immediately drop 20-30% from 2016 to 2017. Using the same data, it looks like 2015 earnings might be a good baseline for 2017 results, given that 80% of 27,538,673 is 22,030,938, pretty close to 2015’s NICS total = 23,141,970. Ruger’s EPS in 2015 was 3.23 diluted. Using the closing price on 2/23/2017, $50.15 / 3.23 = 15.52. This adjusted P/E estimate is probably more accurate than the values you’ll see on Yahoo Finance. And it still represents a very attractive price for a company sitting on $87.1M in cash, hindered by no debt, and growing at a 8%+ rate.

For 2017 RGR stock price, let’s plugin that immediate 30% dip from 2016’s diluted EPS of 4.62, dropping EPS back to 2015 levels, a less politicized year, and putting it around 3.23. A 15x multiple would put fair value around $48.45. With the S&P500 trading at a multiple above 26.5x, 15x seems to be inordinately low for a company with a decent cash hoard, no debt, and EPS growth > 18% annually for the past 8 years.  Given its political risks, an 18x multiple seems to be reasonable ceiling, which would put fair value at $58.14. If the 30% drop materializes to be substantially less, and if EPS growth in the next 5 years is > 8% after the election year burn-off, then this $48.45 to $58.14 range will seem laughably low.

Conclusion

All of the factors discussed in Parts 1 and 2 of our analysis of RGR coalesce into an interesting opportunity in a market where the pickings are slim. One business has its products protected by the US constitution, is in the mid/early stages of a decades-long secular growth trend, has nearly nil risk of bankruptcy, ad is sitting on a hoard of domestic cash representing greater than 9% of its entire market cap. Years of rock-bottom interest rates have led to a bubbly, frothy market where attempting to find value-oriented investments can be a fruitless search among barren trees. And yet off in a forgotten or detested corner of the publicly traded stock orchard, a golden pear is fat, ripe, and hanging from the lowest branch. It looks good from the ground, but are you willing to climb up the tree and take a bite? We did.

We revisited this analysis with a third post – check it out here!

Disclosure: Long RGR.