Shares of firearms manufacturers fell earlier this month after the FBI reported data for the final month of 2017. The number of criminal background checks performed on potential gun buyers in December dropped 13% year over year. It was the fourth consecutive month of declines and the ninth month out of the last 11 that they were down.
To put last year's decline in perspective, the drop-off in background checks, which are considered a rough proxy for gun sales, was the worst year-over-year decrease since the FBI began keeping records nearly two decades ago. Yet as gloomy as that all sounds, there remain more than a few silver linings.
The gathering storm
American Outdoor Brands (SWBI -0.29%), the owner of Smith & Wesson, admits the industry weakness is going to last longer than it anticipated. The company noted that while inventories were lower both internally and at retail for its products due to extensive discounting, inventory across the industry is still high. American Outdoor Brands was cutting its production, but other manufacturers were not. The current promotional environment will remain as companies jockey for market share.
And Sturm, Ruger (RGR 0.33%) shares American Outdoor's concern over inventory levels and discounting. It pointed out in November that over the first three quarters of 2017, it had reduced production by 17% and continued to manage its inventory as the year closed out.
Yet where American Outdoor was ready to jump into the price war and take additional near-term hits to its profitability -- Sturm, Ruger chose not to play that game. That mirrors how the company has operated in the past. Despite elevated promotional activity, Sturm, Ruger was not willing to engage in the wholesale discounting employed by its rivals, a strategy management feels is too short-sighted and detrimental to the business as a whole.
And if you look at others in the industry, the situation is no different. Vista Outdoor (VSTO -0.33%), the owner of Savage Arms and Federal Premium ammunition, reported adjusted earnings before interest, taxes, depreciation, and amortization fell 8% last year, and it forecast net sales in 2018 to decline 12%. Meanwhile, ammo maker Olin (OLN 0.54%) said sales of its Winchester brand were down 20%.
A different take
There is a lot of doom and gloom for the industry right now, but when you look at the background check data, December was still the fourth highest-volume month ever, and 2017 overall was second only to 2016, which increasingly must be seen as an outlier. Pre-election buying and other factors drove the gun market to dizzying heights in 2016. As I've noted before, on a two-year basis, the industry is running fairly even with the long-term trend.
Of course, that doesn't make the adjustment period gunmakers are currently going through any easier. After scaling up production to meet demand, they've since had to scale back, as Sturm, Ruger indicated it will be doing with its recent layoff news. The fact the industry notched big gains on Black Friday means it pulled forward a lot of sales that would otherwise have occurred in 2018. While there's still work to be done on dealer and manufacturer inventories, there will soon come the opportunity for a restocking.
The coming tailwinds
Demand is also likely to pick back up, perhaps sooner than even the gunmakers expect. Although there was little to no activity on gun control at the federal level, nearly 1,700 bills were introduced in 2017 at the state level, and there will be congressional elections this year that could tilt the balance of power once again.
The industry trades at a tremendous discount. American Outdoor Brands goes for just 11 times trailing earnings and forward estimates, and trades at only a fraction of its sales and its estimated earnings growth rate. Sturm, Ruger trades at nearly similar levels, while Vista Outdoor carries a valuation that's but a minuscule fraction of its sales and book value.
This is not the retail industry where large swaths of apparel companies and department stores seemingly teeter at the edge of solvency. Investors with an appropriate long-term outlook should view the gunmakers' valuations as a rare opportunity to buy into an industry that is not only still growing but remains financially sound with almost all of its players laying the groundwork for when the market turns once more.