Sturm, Ruger (RGR): I’m betting against the short sellers

I think that short sellers are right most of the time.  The most obvious shorts tend to have very high short interest and/or borrow costs.  I try to avoid going long heavily shorted stocks because the short sellers probably know something that I don’t.

The borrow on RGR is a whopping 80.5% (on Nov 2 it was “only” 62%).  If RGR was about to enter bankruptcy like ATPG or STP or CMEDY, I would understand the borrow being so expensive.  But I seriously doubt that RGR is about to enter bankruptcy anytime soon.  The company has been paying dividends since 2009.  At the end of 2012, it issued a whopping $4.5 dividend (about 8.74% of its market cap at the time).  Its products are real and are reviewed all over Youtube.  I think that the shorts are wrong to pay such a high borrow for this stock.  It is almost impossible to make money when the borrow is 80.5%.

Because the borrow is so expensive, the call options on RGR are trading at very low implied volatilities (mid 20s versus historical volatility of around 40).

Recent history of Sturm, Ruger and Company

On September 25, 2006 Michael Fifer was brought into the company as the CEO.  Since his arrival, the stock has gone up roughly ten times (without counting dividends).

RGR-stock-history-since-fifer

Fifer immediately began to implement what he calls “lean methodologies”.  Dealers now had to make firms orders and Ruger would only make guns if there was an order.  Fifer also began to slash inventories.  Unfortunately, this meant that there was no inventory buffer against supply and manufacturing issues.  When Ruger ran into issues with its suppliers, it could not build enough guns to meet dealers’ demand.  Earnings for the quarter dropped to negative 3 cents/share and the stock tanked.  Ruger was sued and ultimately settled the lawsuit out of court for $3M years later (court filing).

Over Fifer’s tenure, he has been a phenomenal operator.  Returns on equity are very high (around 60%), the company has no debt, and the company has been growing.  The capital allocation has been very good.  Excess cash has been returned to shareholders in the form of dividends and share repurchases.  The company has exercised discipline in repurchasing shares only when the share price is low.  The company has followed an unusual dividend policy in that the dividends are not steady.  The underlying business is volatile and the dividend policy reflects that.  The company doesn’t seem to make an effort in pleasing Wall Street by smoothing its earnings or reporting non-GAAP earnings.

Demand for guns

When somebody wants to buy a gun in the US, they have to go through a NICS background check.  Most people use the number of NICS background checks as a proxy for overall gun demand.  You can download a summary of the number of NICS checks from the FBI website.  The National Sports Shooting Foundation improves upon the NICS data by trying to remove cases where background checks do not result in a sale.  Their data can be found on their website by doing a custom search through Google (here is the June 2013 report).  While the press often argues that Obama is driving gun sales, gun sales have been going up even before Obama was ever elected.  The rising popularity of guns started around 2003-2006 while Obama assumed office in 2009.

I don’t know why the popularity of guns has gone up.  There may be some cultural dynamics that I don’t understand.  I live in a city (Toronto Canada) and have never fired a gun.  I know very few people who own a gun.  Where I live, there is some fear of guns, gangs with guns, and serial killers with guns.  Toronto has some liberal-minded people who are in favour of gun control as they believe it will reduce gun violence.  I believe that guns are much more popular in rural areas than urban areas, where the culture is completely different.

Here’s what I can figure out from watching Youtube and reading the Internet.  In some rural areas of the US, it is normal for women to learn how to shoot a gun and to carry one for self defense.  Gun sports and going to the shooting range are seen as a wholesome activity for kids (including young girls) and the whole family.  Gun shows will sell jewelry for women.  And apparently more visible minorities are getting into shooting too, so it’s not just redneck men.  In Toronto, people might freak out a little that little girls are shooting weapons like a 50 cal., AR-15 or MAC-10 as these are guns are derived from military weapons.  I believe that most journalists and financial analysts have always lived in cities and don’t “get” the appeal of guns.  The American press often portrays gun owners as people who want to exercise their Second Amendment rights, but I don’t think that’s the real reason why people buy guns.  Rather, many people buy guns (often more than one) because shooting is a fun hobby.

AR-15 assault rifle meets Hello Kitty.  (I just find the combination amusing.) [source]

More guns and Hello Kitty.  There is demand for cute T-Shirts too. [source]

Fun for the whole family:

There are many short sellers that are targeting publicly-traded gun stocks on the idea that gun demand will plummet.  One argument is that gun demand has run up over fears that Obama will enact stricter laws.  Once this panic buying wears off, demand will drop.  Another viewpoint is that future government legislation may decimate the gun market.  I believe this macro-driven thesis is the reason why the major publicly-traded gun stocks are heavily shorted:

  • RGR – 80.5% borrow; 33.6% of float short
  • SWHC (Smith and Wesson) – 4.125% borrow; 28.9% of float short
  • CAB (Cabela’s is a gun retailer) – 0.44% borrow; 15.2% of float short

I think that the shorts are wrong to bet against the increasing popularity of guns and increasing social acceptance of them.

Is management ethical?

Regulation FD (good)

The company’s communication policy is unusual and in my opinion should be commended.

  1. No individual meetings with investors or analysts.
  2. No financial forecasts or guidance will be given under any circumstances.

It seems to me that the company takes Regulation FD seriously.  I think that one-on-one meetings with financial analysts, mutual funds, and hedge funds are bull****.  If the analysts are getting useful information, then it’s a violation of Regulation FD.  If they aren’t getting useful information, then why is management wasting time with these meetings???  More companies should adopt policies similar to Ruger’s.

Director and officer liability insurance (bad)

The DEF 14A filing states:

Directors are covered under the Company’s business travel accident insurance policy for $1,000,000 while traveling on Company business, and are covered under the Company’s director and officer liability insurance policies for claims alleged in connection with their service as a Director.

I don’t like companies that use D&O insurance.  Directors and officers should not be engaging in unethical practices in the first place!  There should be no need for this insurance.

On the other hand, the directors and officers were sued in the past.  I don’t think that insiders were clearly in the wrong and deserve to be sued.

Insider compensation (bad)

It seems fairly high.  See Morningstar’s summary.  In YE2012, compensation of directors and key officers was $8.59M and roughly 9.0% of the company’s book value ($95.03M).

Insider trading (bad)

Fifer was buying shares at low prices in 2006-2007 on the open market.  Since 2011, he has gradually sold over 192k shares on the open market for proceeds of almost $10M (see this list of his trades).  He does not have high ownership in Ruger stock.  He currently owns 79,292 shares (form 4 filing), which is around 0.4% of the company.

Is management promotional?

For the most part, I would say no.  The company doesn’t issue optimistic forecasts or any forecasts for that matter.  Fifer doesn’t talk to analysts.  It seems that Fifer is very much focused on operating the business and isn’t going to waste his time talking to Wall Street.  During the annual shareholder’s meeting (transcript), he was blunt and direct:

Unknown Analyst

I just wanted to try to reconcile your comments about a good manufacturer achieving 50% margins with the inventory turns that you think you might be able to accomplish over time. The balance would seem to indicate that you could do a lot better on margin than the 24% that you’re doing now.

Michael O. Fifer – Chief Executive Officer, President and Director

You sound like my Board of Directors. Ask a specific question. I don’t know what you’re asking.

During the meeting, he also stated: “I think we are good investment.”  This could be construed as promotional and a little hypocritical given that he was selling shares before and after the shareholder’s meeting on April 30, 2013.

Overall

The CEO strikes me as straight-shooting and to the point.  The transcript of the annual shareholders’ meeting was actually very informative and is definitely worth reading.

I don’t think that he cares too much about shareholders or himself as a shareholder.  It’s odd that he sells his shares.  At the shareholders’ meeting, he states that the company is a good investment and gives his reasons.  I get the feeling that he doesn’t think about making money as a shareholder or making money at the expense of shareholders.  He seems more passionate about guns, gun rights, and lean methodologies/Kaizen.

The operating business

The Ruger website has an informative presentation on the Ruger Business System.  It seems to me that Fifer is obsessed with generating efficiencies everywhere in the organization.  The presentation has many metrics that measure the amount of waste (time and resources) in Ruger’s manufacturing operations.  Fifer is also concerned with the integration between R&D and manufacturing.  He wants R&D to design guns that can be manufactured in a cost-effective manner.  He wants the engineers’ offices to be in the same building as manufacturing to so that the mechanical engineers understand production issues.

On the product side, it seems that Fifer wants to enter markets where Ruger can deliver excellent value to the customer.  For now, Ruger has largely stayed out of the super hot “modern sporting rifle” market for AR-15 style guns (these are assault rifles and have the highest regulatory risk).  Fifer doesn’t seem to think that Ruger can do a much better job than the existing products on the market and has stayed away for that reason (with the exception of the high-end Ruger SR556, whose production is constrained by the availability of parts).  Ruger has also exited the shotgun business, so Fifer isn’t afraid of being disciplined in Ruger’s product line.  There is an excellent discussion of these product issues in the shareholders’ meeting transcript linked to earlier.

Growth prospects

Ruger is in the process of opening a third factory and finding the mechanical engineers and factory workers to staff it.  The company currently has a massive backlog of orders that production can’t keep up with.  I believe that Ruger’s short-term growth prospects are excellent.

Accounting

Depreciation rates

The company depreciates buildings over 15 years.  This seems too conservative to me.  A building can last much longer than 15 years.  This accounting practice predates Fifer’s appointment as CEO.

As a point of reference, Smith and Wesson depreciates buildings and improvements over 10 to 40 years according to its 10-K.  Presumably Smith and Wesson is depreciating its buildings over 40 years.

Defined benefit pensions

Fifer was quick in transitioning the company away from defined benefit plans to defined contribution.  This is a very smart move because defined benefit plans can grow into massive liabilities.

The Bottom Line

I don’t particularly understand the gun industry well.  It seems to me that Ruger is a management-driven business and that Ruger should be able to maintain its excellent performance as long as Michael Fifer continues to be the CEO.  This seems to be a wonderful business.  The return on invested capital is absolutely phenomenal (over 60%)… there are very few businesses with such high returns.

In terms of the macro picture, I have a suspicion that the shorts are on the wrong side.  Cultural attitudes towards guns are shifting (depending on where you live).  Gun demand has been going up for several years now.  Why would you want to bet against that?!  The trend doesn’t seem to be a fad.  Even if they are right, it is unlikely that they will make money after paying the interest on the borrow (currently 80%).

The integrity of insiders is ok.  It could be better.  The insider selling is odd.

As far as the stock’s valuation goes, the price is fair.  A P/E of around 15 is reasonable for a company with extremely high growth.

As far as the call options go, they are definitely cheap because the high borrow rates cause put/call parity to break down.  I wouldn’t touch the common unless you can get a very good rate on lending the shares out.

*Disclosure: Long 1 RGR call option.  I may add to my position in the future.

Links

CNN Money Interview with the CEO

Blog post “On Guns Becoming More Popular and Mainstream”

A Seeking Alpha post by Volte-Face Investments outlining their short thesis on RGR and SWHC.

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12 thoughts on “Sturm, Ruger (RGR): I’m betting against the short sellers

  1. Pingback: Guess the short thesis | Glenn Chan's Random Notes on Investing

  2. I think you have a strange source for borrow rates (I would guess a retail source such as IB or similar). Remember most funds/pro short sellers will have a PB. You will pay a far lower rate with a proper PB. The short thesis is predicated on the fact that: (a) retailers, having overreacted to the presidential election when there was a run on guns and they had insufficient inventory, over-ordered following the second election and subsequent Sandy Hook tragedy; (b) firearms sales cycle is peaking; (c) competition is intensifying for its main products; (d) end consumer sell through is far lower than compared to wholesale. RGR’s last results were down sequentially (Q on Q). If the sales cycle has peaked, there is a long way down.

    As a broader observation, short sellers are just market participants – they accordingly are not generally right nor wrong.

    • Thanks for the excellent reply (I use retail IB/Interactive Brokers).

      I find that the most obvious shorts (e.g. pump and dumps) out there tend to be heavily shorted. Short sellers tend to pile onto the worst stocks out there. Maybe the markets have been a little weird in the past two years because going long high short interest stocks has been a good strategy. But I think that short sellers will ultimately be right about the not-that-obvious shorts collapsing, even if they don’t make money.

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