Shooting a Hole in the Outlook for Gun Stocks

When the Democrats swept into Washington in November, gun fanciers scrambled for 15-round pistols and tactical rifles equipped with grenade launchers, flash suppressors and bayonets -- in fear the new administration would reinstate a ban on the sale of such weapons. Gun makers Smith & Wesson Holding (SWHC: 5.15, -0.27, -4.98%) and Sturm, Ruger (RGR: 11.52, -0.04, -0.34%) have shown great sales gains the past couple of quarters. Their stocks have shot up as much as fourfold. But now the gun industry's leading indicator -- the Federal Bureau of Investigation's monthly count of the instant background checks it runs for gun dealers -- is settling back toward pre-election levels. While November background checks were 42% above the year-earlier level, last month's were up just 15%.

Gun shops corroborate the slowdown. "It was really big around the first of the year," said a Georgia gun dealer (who, like all we found, wanted to remain unnamed). "Now, it's starting to taper back off. It's not near like it was. Everyone is starting to relax."

If the recent sales burst turns out to be just a one-time pop, it won't be the first time...or even the second. Firearm sales spurted in 1993, before the federal assault-weapons ban. Yet within a few years, gun sales returned to the pre-ban trendline. Another rush for guns after 9/11 lasted only about three months.

MOST OF THE TIME, guns are a pretty flat business, with moribund sales and mediocre margins. You might not know it, however, from the recent trajectories of Smith & Wesson or Sturm, Ruger. Shares of the Southport, Conn.-based Ruger arced from 6.50 to near 14, before settling back to a recent 12.75. Smith & Wesson has shot from a pre-election 1.60 to as high as 7.50. Thursday, the Springfield, Mass., company reported a 20% jump in the latest quarter's revenue, and Smith & Wesson shares ended the week at 6. That's about 20-times Wall Street's estimate for current year earnings, more than double the outfit's typical multiple. Both companies are likely to disappoint investors who expect a continuation of post-election business levels. A return to normal for these companies could easily cut their earnings -- and stocks -- by half.

Firearms are a fragmented, competitive industry in which Smith & Wesson and Ruger square off against privately owned rivals like Remington, Sig Sauer and Colt, as well as European names like Heckler & Koch, Beretta and Glock.

Both of the publicly held U.S. companies have endured decades of highs and lows. Smith & Wesson was the lead supplier of handguns to America's police departments until the mid-1980s, when Glock got the drop on it with a line of light and powerful semi-automatics. In recent years, Smith & Wesson has been regaining share among law-enforcement agencies with its own new "military and police" models, and has further extended its brand into "long guns" -- that is, hunting rifles, tactical rifles and shotguns. Revenue grew about 50% in the fiscal year ended April 2007, then another 25% in the April '08 year to reach $296 million. But earnings in the April '08 year amounted to just $9 million, or 22 cents. That was a net margin of only 3.1%. Meanwhile, at Ruger, revenue fell 7%, to $157 million for the year ended December 2007, while profits on operations were all of $2.4 million, or 10 cents a share.

Before Obama's election, 2008 was shaping up to be a pretty lousy year for gun sales. Inventories piled up at gun dealers. The funky economy hurt demand for hunting rifles -- discretionary purchases, these days. Then voters elected a Democratic majority in Congress and a president who was partial to gun control. Bad news for the gun industry, right?

That's not how it's played out. After months of desultory activity at the FBI's National Instant Criminal Background Check System, or NICS, inquiries jumped 42% year-over-year in November, to 1.5 million transactions (which are dealer inquiries, and not necessarily firearm sales). December sales continued to roar, as purchasers grabbed for the kind of semi-automatics whose sale had been forbidden from 1994 to 2004 under the federal assault-weapons ban. These included pistols whose magazines held more than 10 rounds and rifles with two or more military-style features, such as a telescoping stock, pistol grip or flash suppressor. The post-election rush for AR-15 assault rifles was followed in 2009's first months by a run on semi-automatic ammunition. For most of this year, ammo was on back order. Says a Houston gun dealer: "Sales were blowing and going!"

The National Rifle Association reports a 30% rise in membership since November. About 65,000 folks showed up at its conference in Phoenix last month.

Sure enough, the gun-store activity indicated by the FBI's background checks for November and December presaged good quarterly results from Ruger and Smith & Wesson. Ruger's sales in its December 2008 quarter spiked 72% year-over-year to $58 million, and the company exhausted its finished-goods inventory. March period sales came to $64 million, and earnings quadrupled to about $6 million, or 30 cents a share.

At Smith & Wesson, sales for the January 2009 quarter jumped 26%, to $84 million, producing profits of $2.4 million, or five cents a share. The company will detail its results for the April 2009 fiscal year on Monday, but advised investors last week that April quarter sales had risen 20%, to $100 million.

Back in November, investors didn't seem to notice what the NICS background checks were prophesying; gun stocks didn't start moving until late February. By April, Ruger's stock-market value had reached $275 million, while Smith & Wesson's topped $350 million. The companies themselves seemed ambushed by the sudden demand. Ruger's last-reported backlog was more than $136 million, while Smith & Wesson's was $200 million. Those extraordinary levels reinforce the impression made by the NICS numbers charted above, which seem to be tracing the downside of a demand bubble that is reminiscent of the NICS numbers after 9/11.

Neither Smith & Wesson nor Ruger answered our inquiries. But the Houston-area gun dealer corroborated what the FBI numbers suggest: Sales started cooling in May. "It's just not as big as it was a month and a half ago," he says. And that shoots a big hole in the outlook for the stocks.

The Bottom Line
Gun shops and FBI numbers indicate that a post-election rush is subsiding for Smith & Wesson and Sturm, Ruger. Their earnings and stocks could fall back to last year's levels.