This Is the Best Indicator Yet That Analysts Were Wrong About the Gun Industry

Investors who were carefully watching knew Wall Street was missing something important.

Rich Duprey
Rich Duprey
Jun 13, 2017 at 3:18PM
Consumer Goods

Two years ago, the FBI reported that it conducted a record number of background checks on potential gun buyers in May, more than it had ever done before for that month. It would launch a 19-month-long streak that would culminate in more than 27.5 million background checks performed in 2016, 20% more than the year before and over two and a half times time the number conducted 10 years prior.

While the November elections seemed to gut that growth, as December's background checks dropped 16% from a year ago followed by a steep 20% drop in January, the numbers have been climbing since. Now that the FBI has reported results for May 2017, it looks as though the firearms industry is back, guns a-blazin'.

A woman receives instruction at a gun range.

Image source: Getty Images.

59 checks per minute

The law-enforcement agency says it once again conducted a record number of background checks for the month. Some 1.94 million investigations were processed through the National Instant Criminal Background Checks System, or NICS, almost 4% more than last year's record. The stocks of major gunmakers have responded in kind.

Shares of Smith & Wesson manufacturer American Outdoor Brands (NASDAQ:AOBC) have jumped 23% in the past three months, while Sturm, Ruger (NYSE:RGR) has surged 31% in the same time frame. Even troubled ammunition and long-arms maker Vista Outdoor (NYSE:VSTO) has risen 11%, though another ammunition maker, Olin (NYSE:OLN), is down 5%, but it's a more diversified company deriving most of its revenues from speciality chemicals.

There was a lot of speculation on Wall Street that the gunmakers would be the victim of the so-called "Trump Slump" -- the belief that a reputedly pro-gun president and Congress would obviate the need for further gun sales.

Chart showing year-to-date background checks compared to trendline

Data source: FBI. Chart by author.

Demand remains firm

What the pundits missed, of course, was that there was no real slump at all, just that gun buying wasn't running at the same white-hot pace it had gone at last year. Anyone who cared to look could see that even the supposedly low numbers being reported each month in 2017 were still running well ahead of 2015, which, as noted, was also a record year.

Fear of new gun-control laws doesn't create demand for guns; it merely affects the timing of the purchase. Thinking your right to buy an AR-15 might be limited in the next few months, you'll buy one now instead of waiting. Removing that concern doesn't eliminate the demand for the new firearm; it just takes it off the "must buy now" list. The demand remains regardless, a point analysts seemed to overlook in declaring doom for the firearms industry.

But that made it opportune for investors who correctly assumed reality would eventually catch up with the prognostications. Shares of American Outdoor Brands and Ruger had been particularly depressed, and considering their strong financial position and ability to generate substantial free cash flow, they were bargain-basement stocks. And while their shares have made some big gains in the past few months, investors might still consider them attractive.

A Smith & Wesson M&P 2.0 handgun, surrounded by bullets and lying on top of a target.

Image source: Smith & Wesson.

Still time to target gun stocks

However, of the two major gunmakers, American Outdoor Brands is the better deal. It trades at less than 10 times earnings and 15 times next year's estimates, but with analysts expecting it to continue growing earnings at 15% annually for the next five years, it's trading at just a fraction of its price-to-earnings-to-growth rate. Moreover, at less than eight times its free cash flow, the Smith & Wesson maker remains super cheap.

On a market multiple basis, Ruger looks good at just 14 times earnings and estimates, but at 47 times its free cash flow it seems expensive. Its bigger gains are probably predicated on its being the last pure-play firearms stock, meaning it will react more decisively to positive industry developments. That also means when things go south, it will fall harder.

American Outdoor Brands has tried to smooth out the volatility by entering the rugged outdoors market, being a seller of goods to consumers along the periphery of the firearms market, more like Vista Outdoor. Yet the upheaval of the retail landscape has put significant pressure on Vista, so while American Outdoor's strategy may smooth out the bumps of the gun market, it brings with it its own set of challenges.

Still, the FBI's May numbers show the elections didn't shoot the manufacturers in the foot, and while we might not get another 19-month record run, gun demand is healthy and the gun manufacturers remain good investments.