Starting the Year With a Bang: Are Gun Stocks Right for You?

As gun control takes up more and more of the political stage, the gun industry is benefiting from all of the attention.

In this episode of Industry Focus: Consumer Goods, Sean O'Reilly and Vincent Shen take a close look at the gun stocks -- who are the big players; how demand has fluctuated in the last five years; how politics affect the space; and why investors should consider investing in gun makers in the midst of this politically charged environment.

A full transcript follows the video.

 

This podcast was recorded on Jan. 5, 2016.

Sean O'Reilly: We're talking firearms on this consumer goods edition of Industry Focus.

Greetings Fools, I am Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. It is Tuesday January 5th, 2016. Happy New Year. Joining me to talk firearms is my comrade in arms, Mr. Vincent Shen. Happy New Year, man! How's it going?

Vincent Shen: Happy New Year Sean and Happy New Year to all of our listeners!

O'Reilly: How was your holiday?

Shen: Excellent.

O'Reilly: Was Santa good to you?

Shen: Yeah sure. If by that you mean I'm a little stressed from having a lot of family in town. Also got engaged last week.

O'Reilly: What?

Shen: Should have mentioned it to you earlier.

O'Reilly: Stop the presses. Ladies and gentlemen. Mr. Shen here popped the question apparently. Tell us a little bit before we talk about something totally different.

Shen: I fired it off so to speak to her last week. We were at a cabin out in Shenandoah and it was very nice.

O'Reilly: Was it like a New Year's thing or what?

Shen: No, it was in between Christmas and New Years.

O'Reilly: Okay, yeah. Wow! Congratulations.

Shen: Thank you. Thank you.

O'Reilly: I need to take you and Gina to dinner or something to celebrate.

Shen: I won't turn down that offer.

O'Reilly: We'll go to Korean barbecue.

Shen: Again, sure.

O'Reilly: Awesome. Well, long story short and if our listeners may or may not be aware, President Obama is currently in the process of signing an executive action for basically stricter gun control laws. It's kind of a, we're not going to get into politics here. That's not our thing, but it's happening. Surprising though, it's been kind of good for the gun industry.

Shen: Yeah exactly. Yesterday's trading, the market kind of greeted 2016 with a little bit of a chilly reception. The Dow was down 276 points, 1.6%. S&P shed similar, about 1.5%. One of the worst opening days for the market in history. One of the worst.

O'Reilly: It's kind of set off by a week of kind of amazing China. They have like a 7% sell off over there.

Shen: Yeah and it could have been worse too if it hadn't ... They implemented ...

O'Reilly: They have circuit breakers. We don't.

Shen: ... new circuit breakers. They kind of do what a lot of the American exchanges have now where if the sell off gets tripped by a certain amount they'll halt the trading, which is exactly what happened yesterday. Then you combine a lot of that uncertainty around China, manufacturing, the implications around that, the implications all over the world, plus some new tensions in the Middle East with a lot of countries stepping away from Iran and that basically combined for a very I guess bearish view at least for yesterday. That seems to have continued into today unless like you mentioned ...

O'Reilly: Well yeah, they're up again. The standouts yesterday amid the sell off were all these gun manufacturers.

Shen: Exactly. Specifically ...

O'Reilly: There aren't many.

Shen: Yeah, there aren't many options here in the sector depending on if you're looking for a pure play gun manufacturer. There's of course people who make accessories, ammunition. If we're looking at Smith & Wesson Holding Company (SWBI 0.36%), they were up 6% yesterday. Then, there's also Sturm Ruger (RGR 1.32%) up 3% yesterday and we can talk a little bit about Vista Outdoor (VSTO 0.56%). They're up 2%. They produce a lot of ammunition. Obviously still involved in that industry and tied to it.

As you mentioned, why these companies bucked the trend. We had these executive orders coming down the pipeline that are supposed to be announced officially today. It's around background checks, more spending on enforcement, mental health,things along those lines but what that has signaled for a lot of gun buyers in this country is these new regulations. We might not be able to get certain guns that are available now, so buy them now. We should buy them now.

O'Reilly: Get them while you can.

Shen: Exactly.

O'Reilly: Supposedly. They're up even more today. This is going to keep, this is very impressive.

Shen: Yeah, they're up even more. Maybe because today is the official announcement. Smith & Wesson is again up 13% today.

O'Reilly: Wow.

Shen: Last I checked Ruger is up 7% and Vista Outdoor is up 5%. Not all that surprising considering what we've seen in the aftermath of certain political moves. Also tragedies where people worry about what is going to be available. There's a huge surge in demand. Again, not trying to hit into the political side of this too much, but just looking at these companies, their businesses, how their stocks have performed. We could dive in on the two main players at least.

O'Reilly: Actually on that note before we move on I wanted to point our listeners to the newly redesigned Focus.Fool.com. There you'll discover a special offer to join the Motley Fool Stock Advisor Newsletter. Start your year off Foolishly. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two year subscription. Just go to Focus.Fool.com. Take advantage of this offer. Once again that's Focus.Fool.com. You can see my smiling face on one of the photos I think. I think Dylan is with me.

Anyway, so we're talking about share price performances. I mean I don't want to say the word bubble, but just like I'm always suspicious when a stock goes up because of something in the news like this. Like right after 9/11 Taser was the stock to own. I don't know, but apparently we can dive in a little bit more here, they've actually been making a lot of money. Real money.

Shen: Absolutely. Smith & Wesson, we'll talk about them first. They are up almost 200% since the end of 2012. I feel like that timeframe in particular is important. That was the last time President Obama I feel like made major calls for more gun control.

O'Reilly: Right.

Shen: This was after the Sandy Hook tragedy of course. In 2013 just ended up being a huge boon year for these companies. Just to give you a little bit of context, the FBI, they have their NICS background check system. While it's not a perfect proxy for gun sales in the US, it does give you an idea.

O'Reilly: Ball park.

Shen: Exactly. At least their trends for example. The system has been in place since 1998. They've been tracking this data and just to give you an idea ...

O'Reilly: These are people applying to buy guns ...

Shen: Each application could be for more than one for example.

O'Reilly: Okay. All right.

Shen: It doesn't cover all purchases. Some being private party sales, things along those lines.

O'Reilly: Gun shows, stuff like that. Yeah.

Shen: Five of its top 10 highest days that recorded the most checks were in late 2012.

O'Reilly: Wow.

Shen: Okay, so five of its highest days were in late 2012. By far the biggest week in terms of checks that they've logged, the FBI has logged, was between December 17th and December 23rd of 2012.

O'Reilly: Merry Christmas!

Shen: Over 950,000 checks.

O'Reilly: I was about to say, was it a million? How many was it because I had no idea.

Shen: 950,000 for that week.

O'Reilly: Wow.

Shen: Then the second record is actually a recent week, from last month. It's like 860,000 maybe. It's a huge difference.

O'Reilly: Right.

Shen: You also have to keep in mind and we'll touch on this a little bit in terms of the prospects more recently is the fact that people were talking about Black Friday, biggest day ever in terms of new background checks being submitted.

O'Reilly: Buy one, get one free.

Shen: Smith & Wesson, along with much of the firearms industry, they rode that surge of demand into about 2014. Everybody was worried.

O'Reilly: Yeah, then nothing happened, right?

Shen: No, nothing happened. The stock peaked at about over $16 per share. That was up 90% from end of 2012. Once the panic buying essentially had tapered off, the stores or a lot of the dealers or distributors, they saw their inventory building up quickly because the fears were gone.

O'Reilly: Everybody calmed down. Yeah.

Shen: Exactly. Those quickly rose and as a result the stocks struggled actually and ended up losing almost all of its gains from that prior two year period in 2014.

O'Reilly: Which is my concern again. I'm just like (sound effect). Anyway.

Shen: Yeah. The inherent thing that we'll get to later is the volatility of these companies, but not long after it started, the stock bottomed out, six months later gun control reemerged as a major political issue in 2015, especially with the presidential campaigns kicking off for a lot of candidates. 2015 again became a big boon year for this company where the stock rebounded 132%. For the new year as you've seen with these executive orders coming down 2016 is looking very, very good for them as well.

O'Reilly: What were their revenues doing? I took a quick glance and in these years where the stocks go up it's like revenue is around 50% year over year in a quarter.

Shen: I'm looking at it quarterly. In 2013 quarters for example, total revenue up 40% year over year, 26%. Then after that 2013 surge it quickly subsided. It was down to single digits. Then it fell, so by 2014 you were looking at like a 23, 24% year over year drop in revenue. Again, you see ...

O'Reilly: Giving up most of the ...

Shen: You've seen this big swings in demand based on honestly not necessarily business fundamentals, but ...

O'Reilly: Fair.

Shen: Exactly. Now the company in its most recent quarter announced its fiscal 2016 second quarter results last month around this time. It boasted 32% year over year revenue growth. Gross margin was up 7.1 percentage points.

O'Reilly: This is a growth tech company we're talking about. That's what those numbers are.

Shen: Adjusted earnings were up 150%. Just yesterday probably contributing to the huge surge day where the stocks up 12, 13%, the company raised its sales and earnings guidance for the quarter and full year. Fiscal 2016 revenue which ends in April I believe, it's expected to come in between $650 and $660 million while adjusted earnings will be between $1.36 and $1.41 per share. That represents about 19% top line growth and 36% bottom line growth if you use the middle of those ranges compared to 2014. Full year that is.

O'Reilly: Obviously you've got Sturm, Ruger. Smith & Wesson is kind of a bellwether for industry. How are things looking for them going forward?

Shen: Sure, sure.

O'Reilly: Did you come across anything?

Shen: Looking forward I think the company honestly it's going to benefit from a lot of this uncertainty around this presidential election because basically the way it comes down is if you have a democrat ...

O'Reilly: Right. That's ...

Shen: ... take office ...

O'Reilly: ... one thing that I was about to chime in with. I was like it's crazy to me sometime show much a presidential election can effect a stock. I remember I bought a stock because Buffet owned it, but it's USG, this is like my first stock I ever bought. I was 16. They make drywall, it's sheet rock. It's gypsum. They were being sued for $2.1 billion for asbestos litigation. This is the 2004 election. The stock went up double the day Bush got reelected just because they figured that a republican administration would be kinder to a company ...

Shen: More business friendly.

O'Reilly: Yeah. I was like what? I did not anticipate that at all. I'm almost wondering if that's going to happen again in a year with these guys.

Shen: Yeah. People are going to come down really hard lines. Whether or not there will be a time of new regulations depending on the president, it doesn't even matter. It's what's perceived. 2016, until the run-up, until they announce or until the results are announced there's going to be a lot of uncertainty and I think the company will benefit from that at least for the next year or two. Then beyond that if you're looking at just more of the fundamental business ...

O'Reilly: It's a coin flip at that point though.

Shen: Exactly. Consumers though make up about 90% of the Smith & Wesson business.

O'Reilly: Do they sell to the government at all?

Shen: They do have a huge opportunity there to increase some of their selling with government contracts because ultimately ...

O'Reilly: Ten percent isn't ...

Shen: The US government is still one of the biggest buyer of firearms in this country, if not the largest. That's definitely an area of opportunity for them looking forward.

O'Reilly: Cool. Okay, talk to me about Sturm Ruger.

Shen: Okay, so I want you to look at this very closely as a mirror image.

O'Reilly: Okay.

Shen: In terms of a lot of that performance in 2013 how things dipped in 2014 and how they've recovered last year, all of that is almost exactly the same. Maybe a shift in terms of the exact timing, but overall very similar. For example Sturm Ruger shares gained 17% in 2013 when revenue was up 40% over the previous year. Again, after the fears from the Sandy Hook tragedy. The stock peaked in early 2014, so a little bit earlier than Smith & Wesson. In that year sales fell 21%. Very tough comparisons.

O'Reilly: Yeah, same story.

Shen: Very tough comparisons. The stock plummeted, reversed all of its gains, lost about 60%. More than the gains it made. It lost 60%. In 2015 again it roared back 70% on the surge in demand. Last November the company recorded its third quarter results. Recorded third quarter results and sales were up 23% year over year to $120.9. Earnings per share up 82%. Sound familiar? It's new products which include all of its major new offerings from the past two years made about a fifth of total sales in the first nine months of 2015. Obviously ...

O'Reilly: They're still there, yeah.

Shen: ... their product pipeline is coming in. It's doing quite well. It's very popular.

O'Reilly: Cool. All right, so I'm a value guy. Talk to me about where these guys are trading.

Shen: Sure, sure. I know you're going to ask me at the end of the show which I think is better.

O'Reilly: Of course I am.

Shen: I'm going to pre-empt that question and cover it a little bit. Sturm Ruger ...

O'Reilly: Which stock would Dirty Harry buy?

Shen: Smith & Wesson obviously, but Sturm Ruger pays 2.5% dividend so it's a little different because where Smith & Wesson doesn't pay one at all. Valuation-wise they're very similar. I calculated this based on their prices this morning with the surge they've seen recently because that's likely to continue and based on expected 2015 calendar year earnings. Twenty-two times for Sturm Ruger, 21 times for Smith & Wesson. Keep in mind that Ruger has a really strong balance sheet, no debt, they have very strong free cash flow.

O'Reilly: Are these family controlled? I'm reaching into the cobwebs here. Do they have a big ...

Shen: I do not recall.

O'Reilly: Anyway.

Shen: They have really strong free cash flow to cover the dividend payouts. Honestly both companies have a very strong name reputation in this industry. Like I mentioned Smith & Wesson 21 times, no dividend, but similar strong cash flow. If you were to ask me to pick, I think it's really tough.

O'Reilly: It sounds to me like you'd be both and be fine.

Shen: I think you should look not at the companies separately necessarily if you're first considering investing in this industry. You need to look at the volatility and the fact that these companies are not necessarily going to be driven by business fundamentals and things along those lines. A lot of it is going to rise in lockstep with each other and a lot of it is going to be driven by headlines, what happens in the political landscape. It's just tons and tons of volatility. If you're OK with that ...

O'Reilly: This has a speculative feel to it.

Shen: Exactly.

O'Reilly: It really does.

Shen: I think for a stock like this or for an industry like this taking a truly long term view is your best bet because trying to, I think anybody who's trying to bet off the election ...

O'Reilly: Right, so do you want to own these guys regardless of what happens in the next year? Or presidential or anything.

Shen: Then between the two companies you can look at that income component that Ruger offers.

O'Reilly: Yeah, that's a surprise. It's very reasonable.

Shen: Mm-hmm. Otherwise considering either of these, definitely take that long term view and also just consider the fact that it might get hit whether you think that this is doing well or not. Just with the way events can take place, the presidential election and everything else.

O'Reilly: Awesome! Thank you for your thoughts and I'm sure on behalf of our audience once again congratulations on the engagement.

Shen: Thanks Sean.

O'Reilly: If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again that [email protected]. As always, people on this program may have interest in the stocks that they talk about and Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based only on what you hear on this program. For the newly engaged Vincent Shen, I'm Sean O'Reilly, thanks for listening and Fool on!