Sturm Ruger (RGR) has been down nearly 28 percent since it reached its 52-week high in January. It also has a short percentage of 34.53 percent. The company’s financials look great. It is a small cap company of $1.21 billion, has a low P/E of 11.20, and a dividend yield of 3.5 percent. What could be driving the stock down, and is it worth owning?
Company Background
Sturm Ruger is one of the leading manufacturers of rugged, reliable firearms for the commercial sporting market. The company was founded in 1949 by William Ruger and Alexander Sturm. They are the only full-line manufacturer of American-made firearms that includes rifles, revolvers, pistols, and shotguns. There are over 400 variations of more than 30 product lines.
The vision of the company is:
“Ruger focuses on serving our shareholders, our loyal customers and our employees. We strive to produce high quality products demanded by our customers as efficiently as possible, which provides long-term value for our customers and promotes the interests of customers, employees, and shareholders alike.”
Now that we know who Sturm Ruger is, let’s take a closer look at its financials and stock performance. From here I will refer to the company as “Ruger,” the name most people are familiar with when it comes to their products. It is also the name that is used on the company’s corporate website.
Income Statement
The company’s revenue has been increasing at a rate 23.7 percent over 10 years, 27.6 percent over 5 years, and 37.8 percent over the past year. The margins have also been expanding since 2008 from 4.78 percent to a current 16.17 percent. Although revenue has been expanding rapidly, it is difficult to see it continue at that rate. The number of NICS background checks increased at a disproportional rate in 2013 as compared to the past and is not expected to continue at a similar rate.
Its earnings have also been increasing at a rapid rate. They have increased at a rate of 71.4 percent over the past 10 years, 43.9 percent over the past 5 years, and 55.1 percent over the past year. The return on equity was 62.13 percent for 2013.
The company has a GuruFocus Profitability & Growth score of 9/10.
Balance Sheet
Ruger has a solid balance sheet with no debt. The current cash balance is balance is $55 million, and the company was able to close the purchase of a new manufacturing facility without the use of debt. The number of shares outstanding has increased about 3.6 percent since 2009. The increase in shares has ended and a share buyback program has been initiated. The current program allows for the use of $25 million to buy back stock. The company previously had a pension liability through the end of 2012. In 2013 the company migrated its retirement benefits from defined-benefit pension plans to defined-contribution retirement plans, utilizing its current 401(k) plan.
The company has a GuruFocus Financial Strength score of 9/10.
Cash Flow Statement
Both cash flow from operations and free cash flow have been increasing every year since 2010.
| Cash Flow from Operations and Free Cash Flow ($millions) | ||||
| Ă‚ | 2010 | 2011 | 2012 | 2013 |
| CFO | 32.5 | 57.4 | 87.2 | 119.7 |
| FCF | 13.1 | 35.3 | 59.9 | 65.1 |
Management
The company has a stable management team. Michael Fifer has been the CEO and on the board of directors since 2006. The year Fifer took over as CEO, earnings per share was at $0.04. For 2013 it was at $5.58. He was also the president from 2008 to 2014. The new president is Christopher Killoy. He previously served as Vice President of Sales and Marketing since November of 2006. During this time, he has been instrumental in executing the successful launch of many new products and in managing the company’s strong sales growth. The CFO, Thomas Dineen, has been in his role since 2003. Other than the CEO, the board of directors is independent of the company’s executive team. The board has been chaired by C. Michael Jacobi since 2010, and he has been with the board since 2006. Previously Mr. Jacobi served as the President, CEO, and board member of Katy Industries, and is the former President, CEO, and board member of Timex. Ruger still has the same team intact that helped them with their rapid growth in the recent years.
Risk
The big concern is a drop in demand. The latest background check figures show a drop in demand for the first quarter of 2014 compared to the first quarter of 2013.
| NICS Background Checks | |||
| Ă‚ | 2012 | 2013 | 2014 |
| Jan. | 920,840 | 1,790,154 | 970,510 |
| Feb. | 1,266,344 | 1,634,309 | 1,264,010 |
| Mar. | 1,189,152 | 1,501,730 | 1,224,705 |
| Total | 3,376,336 | 4,926,193 | 3,459,225 |
Background checks are not a perfect indicator of the number of guns sold in the United States, but is a good indicator for the trend. The abnormally high number of gun sales in the first quarter of 2013 was largely due to emotional responses from the results of the elections and fear of stricter gun laws. Background checks also decreased in the first quarter of 2010 compared to the first quarter of 2009, but the decrease was not as large as from 2013 to 2014. Here is a slide from the March Investor Relations Presentation from Smith & Wesson displaying monthly data on background checks:
In Ruger’s conference call on 2/26/14, it was said that orders to start 2013 were more emotionally driven and the market is returning back to a more rational state. Orders are still up significantly over 2012, and they are outselling their competitors.
Demand has not been an issue with Ruger. The issue has been the difficulty in keeping up with demand. The number of units on backorder has been increasing at a high rate since 2010.
| Ă‚ | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 |
| Units Ordered | 776,400 | 958,700 | 842,700 | 1,388,100 | 2,879,200 | 2,251,000 |
| Units Produced | 600,600 | 934,300 | 906,200 | 1,114,700 | 1,695,900 | 2,249,500 |
| Units on Backorder | 175,900 | 181,000 | 106,800 | 337,400 | 1,507,200 | 1,520,800 |
The demand has been so high that Ruger had to stop taking orders at one point in 2012. Since then they have been working on increasing production capacity. Therefore, at this point in time, production capacity has been the main limiter of the company. They have been able to increase capacity in 2013 and were able to produce 32.6 percent more units. Although the company was able to produce more units, more units were added to their backorder. Based on 2013 production, it would take Ruger eight months to produce the units on backorder without working on any new orders.
With the orders on backorder, Ruger has more than enough demand to produce the same number of units as they did in 2013. One question is “How can they increase earnings if they are producing near full capacity?” In September of 2013, the company finalized their purchase of a 220,000 spare foot facility in Mayodan, North Carolina. Production there has already begun. At this time they are only utilizing 20,000 square feet of the facility for production. This was the company’s first major expansion in over 25 years. The new facility will give the company the ability to increase the number of units produced and add to their earnings.
Guru Trades
Recent purchases of Ruger’s stock have been from Joel Greenblatt and Stephen Cohen. Cohen initiated his new position in the 4th quarter of 2013, and the position has a current value of about $487,000. Joel Greenblatt (Trades, Portfolio) has the largest position of the gurus. He is a hedge fund manager and the author of “The Little Book That Beats the Market.” He uses specific criteria for finding stocks and calls the strategy “Magic Formula Investing.” The formula involves ranking companies based on return of capital and earnings yield. Ruger has high values of both. The return on capital is 151.53 percent and the earnings yield is 15.10. His definition of earnings yield is EBIT/Enterprise Value. Greenblatt has been purchasing the stock on a quarterly basis since the 4th quarter of 2012.
Valuation
The average analyst opinion for Ruger’s 2014 earnings is for it to be down 25.10 percent compared to 2013. These lowered expectations are now valued into the price of the stock. Year-to-date it is down 15 percent and down 27 percent from its recent high. I think that with the backorder to work through and the extra capacity at the new facility, Ruger can actually increase its production in 2014, thereby increasing its earnings. Prior to 2012, the backorder was only at about 300 thousand units before it jumped to 1.5 million units. In 2013 the company actually limited its orders due to the large backorder, and at one point in 2012 the company had to stop taking orders. The problem is not demand, it is production capacity. The new plant will likely not be fully utilized for about three years. At that rate they can increase production by 15 percent per year without making any other changes. Although this is not the rate of expansion that shareholders have been accustomed to in the recent past, it is still more than enough to justify its P/E ratio of 11.20. According to the GuruFocus Reverse DCF Calculator, Ruger would only need to grow its earnings at an average rate of 5.76 percent to justify its current value. To be more conservative then a growth rate of 15 percent, I will adjust the calculations using a growth rate of 10 percent. In doing so, the fair value comes out to be $82.31, making Ruger undervalued by 24 percent. The value is very close to the Peter Lynch earnings line value of $84.00 per share. The company has given no guidance for the year, but is open to acquisitions to increase growth if they can find the right company and costing no more than 6.5 times EBITDA according to their latest conference call.
