Sturm, Ruger accounting notes

Ruger is a rapidly growing company with incredibly high returns on capital (over 60%).  This is a follow-up to my original post on the company.

Generally speaking, their accounting is conservative.

Depreciation of assets (conservative)

From the YE2013 10-K:

In 2013, the Company revised its estimate of the useful life of machinery and equipment from 10 to 7 years. This change, which became effective December 31, 2013, resulted in increased depreciation expense of $0.7 million for the year then ended. The Company estimates that this change will increase depreciation expense for the machinery and equipment on hand at December 31, 2013 by approximately $7 million and $3 million in 2014 and 2015, respectively.

Reducing the estimated useful life causes Ruger to recognize its depreciation expenses earlier.  This will decrease reported profits in the short term.

Excess and obsolete inventory (conservative)

When Michael Fifer became the CEO, he inherited a company that had a very large amount of inventory.  He quickly steered Ruger towards “lean methodologies”, which in turn meant that Ruger would have excessive levels of inventory.  Ruger preemptively wrote down the value of its inventory.  As explained in the YE2006 10-K:

Excess and Obsolete Inventory—In prior years, the Company received one cancelable annual order in December from each of its distributors. Effective December 1, 2006 the Company changed the manner in which distributors order firearms, and began receiving firm, non-cancelable purchase orders on a frequent basis, with most orders for immediate delivery. In the past, the Company adjusted production schedules to consume on-hand raw material and WIP inventories, regardless of customer demand for the finished goods so produced. This practice led to increased investment in inventory, and an unbalanced finished goods inventory.

Consistent with the change in the manner in which distributors order from the Company, the Company significantly changed its production scheduling philosophy from an annual production cycle to a customer-demand pull system in the fourth quarter of 2006. Under the Company’s new system, production is driven solely by customer demand. The Company is committed to producing the firearms demanded by its customers and does not alter its production mix to achieve the short-sighted goal of producing finished goods in excess of customer requirements for the purpose of consuming excess or slow-moving raw material and WIP parts, components, or subassemblies, or absorbing overhead expense. This change to a customer-demand pull system should result in a better match between production and customer demand and is likely to result in further reduction in inventories.

As a result of this new production philosophy, it is apparent the Company has inventory in excess of its needs over the foreseeable future. Given ever-changing market conditions, customer preferences and the anticipated introduction of new products, the Company concluded that it was not prudent nor supportable to carry inventory at full cost beyond that needed during the next 36 months. Therefore the Company evaluated the adequacy of the excess and obsolescence inventory reserve and concluded that additional reserves were required to reflect the estimated recoverable value of excess inventories below LIFO carrying cost. The required reserve was estimated based on the following parameters, and resulted in an excess and obsolete expense of $3.2 million and a reserve balance of $5.5 million:

I would note that Fifer did not have to do this.  He could have avoided the short-term drop in reported earnings.  (*To be fair, sometimes conservative accounting could be construed as nefarious.  For example, management might “kitchen sink” a quarter and take lots of impairments so that future quarters will look better.)

LIFO inventory (conservative, hidden asset)

Investopedia has a good explanation of LIFO versus FIFO inventory accounting (it took me a while to understand).  Had Ruger used FIFO instead of LIFO, its earnings would be higher in most years.  Its current balance sheet would have an additional $38.5 in inventory (with an increase in book value and retained earnings).

ERP implementation

Many companies consider their ERP implementation to be a “one-time” charge and will add it to non-GAAP earnings.  Ruger doesn’t do this.  It also doesn’t capitalize a lot of software development and IT consulting costs (unlike JC Penney for example).

Impairment of bad investments

Ruger made small investments in a crossbow company and a pepper spray company.  It seems to have impaired these investments in a very reasonable timeframe, impairing these investments in the year after buying into these businesses.  (The aggressive thing to do would be to defer these impairments as long as possible.)

In 2011, the Company made a $1.0 million minority investment in a pepper spray company for which it received a 12% interest. In 2012, the Company made a subsequent investment of $0.3 million in the same company and now has a 19% interest. At December 31, 2012, the Company recognized an impairment loss of $1.1 million in this investment.

In 2012, the Company made a $1.3 million investment in a crossbow company for which it received a 29% interest. At December 31, 2013, the Company recognized an impairment loss of $0.9 million in this investment.

Insider selling

The CEO has been a seller of shares in the past few years.  However, it doesn’t seem like he has pushed the CFO to make Ruger’s accounting more aggressive.  While I don’t like his insider selling, I think the lack of promotional accounting reflects positively on his integrity.

I would also note that he tries not to waste time pleasing Wall Street or to be conventional.  He doesn’t give earnings guidance (this likely has something to do with Ruger paying millions to settle a shareholder lawsuit due to a 2007 earnings miss).  He doesn’t do 1 on 1 meetings with institutional shareholders.

Self insurance (hidden liability)

The company’s 10-K states:

The Company self-insures a significant amount of its product liability, workers’ compensation, medical, and other insurance. It also carries significant deductible amounts on various insurance policies.

It is possible that the company runs into an adverse chain of events that could cause high losses that it is not insured against.  While there is a small liability here, I like that the company avoids insurance.  If the expected returns from buying insurance is negative, then Ruger is “making” money by avoiding insurance where possible.

Healthcare costs may go up

Healthcare costs are listed as a risk factor:

Certain provisions of the recently passed federal healthcare legislation, in particular the “unlimited lifetime benefit” which eliminated the practice of capping the amount of medical benefits available to an individual, could have a material adverse effect on the Company’s financial position. The Company self insures the cost of the medical benefits for its employees up to an annual and lifetime maximum per individual. It supplements this self-insurance with “stop loss” insurance for costs incurred above these maximum thresholds. In the past, the medical benefit costs for several Company employees each year have exceeded this maximum, in some cases significantly. It is the Company’s expectation that if it is forced to provide an “unlimited lifetime benefit” its medical costs would likely increase significantly, which would have a material adverse effect on its financial condition.

Defined benefit pension plans (hidden liability?)

Ruger took steps to move away from them in 2007.  In the next year or two, it will likely manage to get rid of its defined benefit plans completely:

The Company expects to satisfy all of its obligations under the frozen pension plans when market conditions are favorable. Late in the fourth quarter of 2013, 94% of the pension plans’ assets were allocated to money market funds to capture the investment returns in 2013. This was an initial step to prepare to fully fund and terminate the plans in accordance with Internal Revenue Service and Pension Benefit Guaranty Corporation requirements, which if successful, would not occur before late 2014 or early 2015. Plan participants will not be adversely affected by the plan terminations, but rather will have their benefits either converted into a lump sum cash payment or an annuity contract placed with an insurance carrier.

It is expected that the settlement of the frozen pension plans would have a material impact on the financial results of the period in which it occurs, and may have a material financial impact on the financial position of the Company.

I don’t understand pensions too well but it looks like Ruger will be able to get rid of this potentially nasty liability completely.  I don’t know what it will cost / what the material impact described above will be.

Closing thoughts

I don’t think that Ruger’s accounting has serious distortions that would make a meaningful difference as to its valuation.  The company does have excess cash and a $35M LIFO reserve.

Overall, I found their financial statements easy to understand and helpful to investors in understanding how the business is doing.  Ruger’s financials compare favorably to Smith and Wesson’s (SWHC) financial statements, which I find to be a little misleading.  Smith and Wesson has some segments which have seen declining sales.  In more recent 10-Ks, it has lumped its declining segments into other segments to hide the declines from shareholders.

As well, Smith and Wesson has stopped breaking out its “modern sporting rifles” into its own category.  Compare page 25 of its YE2012 10-K to page 34 of its YE2013 10-K.  I think that modern sporting rifles should be its own segment given that the category has the highest political risk and is prone to panic buying over fears of impending legislation.  In comparison, Ruger also doesn’t break out modern sporting rifles but Ruger has much less exposure to that market.

*Disclosure:  Long RGR call options.

5 thoughts on “Sturm, Ruger accounting notes

  1. Interesting Post. – I had missed the initial post a few months ago.

    One side question: do you have an estimate on how much of sales are de facto foreign sales? E.g. guns sold in El Paso to be smuggled into Mexico.

    In general it is challenging to figure out how to think about product liability for a gun manufacturer.

    On the accounting side, I’d note that there is a major tradition in the US market place for a new CEO to come into power and the first or second thing that is done is to take impairments on assets, partly to distance himself from the old CEO, and partly to lower the cost and capital base to show higher earnings and / or ROE (or ROIC) going forward. The change in inventory methodology may be viewed in this light.

    A final note on LIFO accounting is– I believe you have it right that in an inflationary world, companies using LIFO will generally report less pre-tax earnings than companies using FIFO because inventory ‘creation’ costs go up over time due to inflation. (Obviously the length of time that something sits in inventory plays a role here too.) However, if my memory serves correctly, this is one of the rare cases in the US where GAAP methodology must equal tax methodology. Hence if a company uses LIFO for inventory on its GAAP books– showing a lower pre-tax profit– then it will also use LIFO for inventory when reporting to the IRS — and since it is showing less pre-tax income to the IRS, it will ultimately result in a lower tax bill.

    • Hi, I never considered gun smuggling into Mexico. This is not something that appears in Ruger’s 10-K as a risk factor and I am guessing it does not appear in the US media much. The current political issues seem to be microstamping and possibly banning assault rifles (or other forms of gun control).

      2a- From skimming through SWHC’s 10-K, product recalls seem to lead to high product liability charges.

      2b- Ruger does not have an explicit warranty policy (or any written warranty for that matter). However, they behave as if their guns have a (lifetime) warranty and they stand behind their product. Users seem to report excellent customer service.

      I don’t think that they will have a huge product liability issue that other companies don’t have. If they release a flawed product, I think that they would likely eat the cost and replace the flawed product just to protect their brand and reputation (like what Intel did for Pentium CPUs with a very minor error). I don’t think that they could buy insurance for that kind of scenario.

      Ruger makes a wide variety of models so I don’t think they would be hit hard by a defective product. They aren’t concentrated in a single design like Intel. (And Intel prospered anyways.)

  2. Thanks for the info on product liability. Here are a couple of news articles that seem relevant. (I seem to have missed out on the trend for people posting masked links.)

    Part of me thinks that having nearly 90 guns per 100 people in the US would indicate that current domestic sales trends are unsustainable.

    • I don’t think that gun count per capita is a good indication of future sales. A lot of sales are driven by gun hobbyists/enthusiasts who may own one or more guns. Of course, I don’t think that I’m any good at making a macro prediction about where the gun market is headed. However, Michael Fifer may be able to grow Ruger’s sales anyways by introducing new models and taking market share. Ruger has been releasing many new products where the value proposition is better than the competition. Ruger has intentionally stayed away from some markets unless it could offer better value than its competitors. It has stayed away from the low/mid-end modern sporting rifle market until recently. It is working its way down from the high-end.

      • Right. In the Economist article they mention that it’s estimated that 5% of gun owners own most of the guns in the US– a Pareto Power Law variant. The point remains that annual gun sales in the US increased considerably starting in the mid to late 2000s (if you agree with the chart in The Economist’s article); the reasons for this phenomenon aren’t fully understood. Naturally RGR’s annual sales, earnings, etc. increased considerably during this time as well.

        In the event gun sales decrease:
        (a) RGR seems to be reasonably well managed and Buffett’s maxim about the tide going out seems to apply here.

        (b) The task of growing sales/cash flows in a declining market is wildly different than one of growing sales/cash flows in a declining market.

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