Smith & Wesson

(Smith & Wesson)

This Trend Could Spell Trouble Ahead for Smith & Wesson and Ruger

By Economic Indicators Fool.com

Firearms manufacturers have enjoyed a period of protracted higher production levels leading to increased profits, but the good times may be coming to an end. Photo: Smith & Wesson.

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The firearms industry has been producing more guns than ever: a healthy increase in output that has enabled manufacturers Smith & Wesson Holding and Sturm, Ruger to post some of their highest operating profits in a decade.

But after years of heady growth, the firearms industry could be entering a protracted period of decline.

Guns a'blazing

According to the Bureau of Alcohol, Tobacco, Firearms, and Explosives, more than 10.8 million pistols, rifles, and shotguns were produced in 2013 (the most recent data available), representing a 26% increase over the prior year and almost double the number made in 2010.

President Barack Obama has often been cited as the catalyst for the growth by providing cover fire for those who want to enact stricter gun control measures while giving ammunition to those who fear they would become a reality.

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Gunmakers everywhere were pumping out more firearms:

  • Glock produced almost 205,000 pistols in 2013, 55% more than it did in 2012.
  • Colt Manufacturing made almost 70,000 pistols that year, up from 52,000 the year before.
  • Smith & Wesson produced over 1.5 million pistols, revolvers, rifles, and shotguns in 2013, up 33% from 2012.

Demand was so hot that Ruger had to stop taking orders at one point because it simply couldn't keep up with all the new orders. It received more orders for units during the first quarter of 2012 than the total number it shipped during all of 2011.

In 2012, it made more than 1.6 million firearms, but it produced over 2.2 million the following year.

A cooling effect

But now the ardor has cooled considerably. The ATF's attempt to ban so-called "green-tip" ammunition last month momentarily raised fears that the Obama administration might try a backdoor attempt at gun control -- get rid of the ammo and the guns become ineffective -- but the agency quickly reversed course, keeping firearms owners and enthusiasts from flocking to gun dealers.

Sturm, Ruger said that while 2014 started off with a bang, sales and profit dropped off dramatically in the back half of the year as consumer demand fell. That left retailers with high levels of inventory that drove significant discounting in the industry. Full-year adjusted earnings for the gun maker fell 42% year over year.

Smith & Wesson's fiscal third quarter sales, posted last month, dropped 15% from the year-ago period as handgun sales fell 7% and rifle and shotgun sales plunged 40%.

We can see this trend as well in the number of FBI firearm background checks. The agency performed slightly fewer background investigations in 2014 than in the prior year, and firearms background checks are down 10.5% so far this year from the same period a year ago.

Sturm, Ruger remains hopeful for 2015, pointing to higher demand at independent retailers and distributors. But in looking at how production has matched background checks, we can probably expect gunmakers to scale back their factories.

A question of value

It is, of course, intuitive that without demand, production will fall. But the extent to which the gunmakers' operations are harmed by the pullback could affect their valuations. And that means Sturm, Ruger could fall more sharply than its rival.

Whereas Smith & Wesson trades at 13 times earnings and 13 times forward estimates, Ruger shares sell for 25 times earnings and 16 times forward estimates. Yet the former is more profitable across the board.

Source Data: Morningstar.com

The tougher times could hit all firearms manufacturers, but some might be hurt worse than others.

Worth a shot

I'm not giving up on the gunmakers yet, though. Obama could still take executive action to enact some form of gun control, and another tragedy could befall the nation that would energize those who seek more and broader legislation, such as what was seen after the Sandy Hook shooting in Connecticut.

The threat of either situation is still present, and while background checks for gun purchases are falling, the gunmakers themselves remain healthy. If I had to choose one over the other, I would lean away fromSturm, Ruger and toward Smith & Wesson, because of its superior financial position relative to its valuation.

The article This Trend Could Spell Trouble Ahead for Smith & Wesson and Ruger originally appeared on Fool.com.

Follow Rich Duprey's coverage of all the firearms industry's most important news and developments. Hehas no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.