Record Number of FBI Background Checks Might Not Mean Much to Gunmakers

With background checks at record levels once more, investors may think gunmakers will be on target for posting record results again. Photo: Gerold Schneider.

So far this year, the FBI has conducted more background checks on gun buyers than in any January-September period in the past, including 2013, when, for the year, an all-time record 21 million individuals were investigated before they were given permission to purchase a weapon.

But the latest numbers don't mean Smith & Wesson Holding (SWBI 0.77%) or Sturm, Ruger (RGR 0.30%), the two publicly traded gunmakers, are stocks to buy right now. While the FBI cautions that you can't draw a correlation between background checks and gun sales, you also can't say the gunmakers will see a lift in their earnings or in their stock prices because of any rush to buy firearms.

Make no mistake, the gunsmiths will realize some benefit, but it's not as large and not as quick as you might think, and it has nothing to do with politicians rushing to capitalize on tragedy by proposing stricter gun control laws.

The year in background checks got off to a slow start, with the FBI conducting 8% fewer investigations between January and April than it had the year before, and they were actually almost 16% lower when compared to 2013. But then in May, the law enforcement agency began racking up record numbers, and during the last five months, has investigated more people each month than it had previously since it began tracking the data in 1998.

Year to date, the FBI has probed the criminal history of more than 15.6 million individuals, almost 4% more than the record-setting pace set two years ago.

Data: FBI.

There will always be monthly fluctuations in the data, such as this past January, when more backgrounds were checked than in the prior year -- though they were well below 2013's numbers, which followed on the heels of the 2012 Sandy Hook killings. So May's number could be an anomaly, but perhaps it was in response to a thwarted mass shooting in Lacey, Wash., where a teacher tackled a student who had fired off several rounds before he could hurt anyone. Or maybe it was due to the Obama administration's attempt to ban a popular type of ammunition.

Since then, however, there have been several very high-profile shootings that attracted significant media attention, and moved politicians to talk once again about imposing gun control, including the murder of worshippers in Charleston S.C., the killing of military personnel in Chattanooga, Tenn., the slaying of journalists on live TV in Virginia, and now, the shooting at Umqua Community College.

Those types of incidents instill fear in law-abiding gun owners and enthusiasts that tough new restrictions will be enacted, leading people to buy more guns before that can happen. As noted above, following the tragic deaths of two dozen children in Connecticut in December, 2012, and public reaction to the slaughter, criminal background checks in January 2013, and all throughout the year, surged to new highs.

Even the gunmakers saw record sales that year. Smith & Wesson posted record revenues in its fiscal 2013 report, as did Ruger. But it would be a mistake to say there was a causal relationship between the two events.

In the two quarters that succeeded the Sandy Hook shooting, Smith & Wesson recorded revenue growth of 38% in each quarter, seemingly pointing to a nexus between that and the tragic events in Connecticut. But it ignores the fact that, in the two quarters preceding the shootings, revenues were even higher, actually soaring 48% higher than the prior year's sales.

Sturm, Ruger also had similar results, with sales up 40% in 2013. However, this was a slower rate of growth than the 50% increase it notched in 2012.

Both gun manufacturers also saw their results crater afterward. Last year, sales plummeted 12% for Smith & Wesson, and were down 20% for Ruger. And that's why investors need to take caution in thinking more background checks will be a simple straight line to higher sales and greater earnings.

If you look at Ruger's rate of sell-through from independent distributors to retailers, which it uses to plan its production levels, and compare them to adjusted NICS background checks, you'll find there's very little correlation.

Data: Sturm, Ruger quarterly SEC filings.

Yet eventually, demand will catch up with inventory. When the market for guns was at its peak in early 2013, Ruger actually had to stop taking orders for a while because it couldn't keep up, so an equilibrium was eventually achieved.

Despite the torrid pace of FBI background checks this year, we haven't hit the same level of demand for gun purchases. Even though sporting goods retailers like Cabela's are reporting strong performance in firearms sales, there's nothing to suggest existing levels of inventory at Ruger and Smith & Wesson is insufficient to meet it.

The record number of checks certainly bodes well for the future -- just not the immediate one. With gunslinger stocks some 75% to 85% above their 52-week lows, and trading at twice their sales or nearly so, it suggests that investors expecting further gains by either may be aiming wide of the target.