Although the firearms industry continues to see year-over-year declines in the adjusted number of monthly background checks conducted on potential gun buyers, it may finally be nearing the end of one of the longest downturns ever. The decline in the adjusted number of background checks recorded in April eased substantially from the double-digit rates recorded in the two months prior, indicating we may be approaching a state of normalcy again.

An anomalous bulge

The National Shooting Sports Foundation adjusts data from the FBI's National Instant Criminal Background Check System (NICS) to account for administrative checks such as those of existing permit holders to see if they're still eligible to carry a gun. These numbers are seen by the industry as a proxy for gun demand because by removing such checks, they get closer to actual gun sales, though it's not a one-to-one ratio because an individual may buy more than one gun or none at all.

Background checks fell less than 7% in April, a substantial improvement over the back-to-back declines of more than 12% in February and March.

Chart of adjusted background checks on gun buyers

Data source: National Shooting Sports Foundation. Chart by author.

The shooting tragedy in Parkland, Florida, in February 2018 caused the number of background checks performed late in that month to rise sharply a trend that continued into the next month, where NSSF data shows they spiked 11% nationally.  

People's reaction to the shooting artificially raised the number of checks performed last year, making this year's more normalized numbers seem worse, but now that we're cycling past those elevated levels, we may get a truer view of the industry, one that shows we have reached a bottom. 

AR-15 on an American flag

Image source: Getty Images.

A long way down

Gunmakers including Sturm, Ruger (NYSE:RGR) and American Outdoor Brands' (NASDAQ:SWBI) Smith & Wesson long expected that the industry would revert to the mean after gun purchases ratcheted higher for years during the Obama administration, particularly in the months leading up to the 2016 presidential election. It is the length of the slump following President Donald Trump's election that surprised many. NICS (unadjusted) data show 25.2 million background checks in 2017 and 26.2 million in 2018, both down from the 2016 number, which was a sharp rise from the 2015 number.

Chart of FBI background checks of gun buyers

Data source: FBI. Chart by author.

Storied gunmaker Remington Arms ended up in bankruptcy court in early 2018, while outdoor-gear retailer Cabela's ended up merging with Bass Pro Shop as a result of the downturn. As Christopher Metz, CEO of Vista Outdoor (NYSE:VSTO), the owner of Savage Arms, told analysts last quarter, "All of the best minds predicted that the recovery would take 18 to 24 months, and here we are at well over two years without the market rebounding."

There is plenty of softness that remains in the business, with Ruger, for example, reporting that sell-through of its firearms from independent distributors to retailers tumbled 32% in the first quarter because it didn't engage in the kinds of promotional activities Smith & Wesson and others did during the period.

Yet discounting and bundling items together allowed American Outdoor to report that firearms revenues rose 5% for the period, and even Vista, which is trying to sell Savage Arms, said firearms sales were higher in its quarter that ended March 31.

Where it was seeing weakness was in ammunition and shooting accessories, which is similar to the experience of Winchester ammunition owner Olin (NYSE:OLN), which saw ammo sales fall 8% for the period.

Signs of green shoots

Gun buyers are still in the market, but it seems they're mostly motivated to make purchases based on fear of rising crime rates or more restrictive laws being passed, or to take advantage of manufacturers offering good deals. As the market for guns regains equilibrium, however, the gunmakers should see their fortunes improve as demand normalizes and pricing stabilizes. We can see that happening already with manufacturer profits.

While Ruger's firearms revenue fell 13% in the first quarter, gross margin was down only 10%, and Smith & Wesson, despite the promotional environment, enjoyed a 30% gain in gross margin from the year-ago period. Vista says even margin pressure on ammunition has bottomed out.

Many of the gains they're experiencing come from new product introductions, which tend to be the driving force for gun sales. American Outdoors' new products represented 15% of total sales this past quarter, lower than in previous years, but they still favorably affected firearms revenue by a full percentage point. New products amounted to 20% of Ruger's sales.

The time to act

It's obvious the industry won't make a sharp upturn anytime soon, maybe not even until the 2020 presidential election gets closer, as there is a repeat of candidates holding starkly opposing views on gun control. But the stocks of gunmakers themselves still represent good opportunities now because they have been badly beaten down and should soon begin reaping the benefits of increased gun sales.

Sturm, Ruger trades for 18 times trailing earnings and less than twice its sales, while American Outdoor Brands appears to be a better buy at 11 times this year's earnings and a fraction of its sales. It also trades at a bargain-basement nine times the free cash flow it produces. And though Vista Outdoor trades at severely depressed valuations, because it is selling Savage Arms and going through a transformation process that is experiencing bumps and bruises that will last for some time, it is difficult to recommend now.

Still, investors looking for beaten-down stocks with the potential for long-term growth might use this opportunity to take a position.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.