Firearms Stocks: "Are You Feeling Lucky, Punk?"

Smith & Wesson (Nasdaq: SWHC), Sturm Ruger (NYSE: RGR), and Olin (NYSE: OLN) are three venerable firearms manufacturers that could add firepower to your portfolio. However, before you pull the trigger on any of these stocks, you should protect yourself with some homework. Call it "risk mitigation." Simply put, you need to determine the earnings quality of the company under consideration.

"Go ahead, make my day"
Movie watchers will remember Dirty Harry's (played by actor Clint Eastwood) famous phrase while pointing his Smith & Wesson .44 caliber magnum -- "the most powerful handgun in the world" -- at the punk lying on the sidewalk after a failed robbery attempt. S&W has been making firearms for sportsmen, governments, and law enforcement since 1852. More recently, the company began manufacturing perimeter security solutions.

Source: Yahoo Finance.

The first step in determining earnings quality is to review the income statement and look for trends -- good or bad. Also, avoid getting caught up in seasonal peaks and valleys. From the table, the company's revenue metrics look healthy, with revenue rising slightly and the gross margin falling slightly, year over year. Administrative costs are steady but low as a percentage of sales. The operating margin has increased by about 9% over the last year.

Next, look at metrics that affect cash flow. Accounts receivables as a percentage of revenue have fallen 78% to 48%, while days sales outstanding has dropped from 71 days to 44 days, both positive trends that show strong improvement in cash inflows. S&W's cash conversion cycle -- a measure of how long it takes to convert resource inputs back to cash -- has dropped from 125 days to 89 days as a result. Smith & Wesson's operating cash flow margin -- a measure of cash generated per dollar of sales -- has risen from 3% last year to 12% most recently. This increased cash generating efficiency is an excellent measure of earnings quality.

Smith & Wesson's stock price has risen more than 55% since January. Although it has a trailing P/E above 100, its forward P/E is less than 15, indicating that Wall Street expects a large earnings jump. Based on the EQ analysis, this stock could be a bull's eye.

Sturm Ruger

Source: Yahoo Finance.

While not made famous by Dirty Harry, Ruger is another firearms company; it has been making quality firearms since 1948. Ruger's income statement metrics are better than Smith & Wesson's -- revenue is rising at a faster pace, and Ruger's costs are lower than its competitor, which produces better margins.

Ruger is missing the mark on cash collections, however. Ruger's receivables as a percentage of revenue have increased from 40% to 44%, while days sales outstanding has risen from 37 days to 40 days, year over year. Ruger's operating cash flow margin is a healthy 16%, but Ruger should take better aim at receivables.

Ruger's inventory metrics read like a fast food chain, with days in inventory at only 10 days. You can't eat firearms, but buyers appear to be taking the phrase "a belly full of lead" too seriously.

Ruger's stock price has risen about 25% since January. The company pays a dividend of $1.30 per share to yield 2.9%. Due to rising revenue and margins, healthy cash flow, and a lightning fast draw inventory, this stock rates as a serious buy.

Olin
Olin manufactures Winchester firearms, a name that is synonymous with the old west and repeating rifles. Olin mainly sells chlor alkali products in the United States and internationally, so Olin is not a pure play on firearms.

Olin's quarterly revenue grew 16% year over year to $507.2 million. The operating cash flow margin equals 12%, an increase over last year's 7%.

But inventory management seems to be Olin's main issue. As as a percentage of revenue, inventory is high at 55%, and inventory levels are rising. Also, inventory shows a divergence between raw materials and finished goods at 177% versus 138% last year, meaning that anticipated sales have not occurred as quickly as estimated.

Since January, Olin's stock price has fallen about 7%. The stock offers a nice dividend play, with a 4.2% yield right now.

Of the three, Ruger offers the best combination of earnings quality and a reasonable dividend yield. The company's solid inventory controls and quality cash flow management provide a buffer around the stock.

One of the great things about companies like Ruger or Olin is the great dividends they pay, but there are even better ones out there. You can read about them in our special free report: Secure Your Future With 9 Rock-Solid Dividend Stocks. To see which dividends made the grade, click here now.