Please click on the following link to read our full report on trends in the firearms industry.

There have been few, if any bright spots in the consumer discretionary space over the past 12-18 months. The threat of job losses combined with an unprecedented shock to the net worth of most consumers has resulted in a seismic shift in consumer behavior. For the first time in decades, credit card debt outstanding is declining and the savings rate has increased. People are hunkering down – this is not a good time to be a company selling discretionary items at a high price point. There has been one bright spot in the consumer discretionary landscape – gun sales.

The “Obama Effect”: It Appears the 44th President’s Most Effective Economic Stimulus Has Been for the Firearms Industry

According to the FBI, the number of background checks completed for gun purchases under the NICS system has increased 27.8% YOY through April, on the heels of a record number of checks in 4Q08.

Keep in mind that a gun typically costs hundreds, if not thousands of dollars. The huge increase in sales in this economic environment is truly a stunning development. What has been the cause of this surge in gun ownership? In a word: Obama. Fears of increased restrictions being placed on gun owners under the Obama administration have sparked a “run on guns” of sorts. 100% of the firearm dealers we surveyed indicated that fears about gun control legislation have caused their sales to increase. Smith and Wesson and Sturm and Ruger (RGR), two publicly traded gun manufacturers have been direct beneficiaries and their stocks have more than doubled off recent lows. Backlog for both companies is at record levels and manufacturing capacity for certain product lines is maxed out.

However, we think the “Obama effect” has now peaked and we anticipate that it won’t be long before sales trends for SWHC and RGR begin to resemble those of other companies in the consumer discretionary space. Our thesis is based on the following:

• According to Compete.com, the number of unique visitors to the leading online gun dealers has declined almost 20% since December 2008 peaks. We view Internet traffic as one of the best indicators of current and future consumer activity. Presumably any consumer considering making a purchase of a high priced item will do research on the web before hand. The good news for gun manufacturers is that the number of unique visitors to the top five online firearm dealers was up in excess of 90% YOY. The bad news is that the sequential trends are not encouraging.

• Information from Google, aka “the database of intentions” suggests the level of interest in purchasing a gun is declining. In John Battelle’s excellent book: The Search: How Google and Its Rivals Rewrote the Rules of Business and Transformed our Culture, he characterized Google as “the database of intentions”. Keyword search terms are in effect indications of intention. Someone typing in “real estate broker” into the search bar on Google is likely looking to buy a house, while someone entering “gun dealers” probably is in pursuit of a firearm. We often look at charts provided by Google Trends as a real time indicator of consumers’ interests and intentions. Looking at the number of searches for three keyword search terms: “guns“, “buy a gun“, and “gun dealer” suggest demands for guns has already started to normalize or will do so in the next few months.

• Our proprietary survey of firearms dealers indicates that sales growth for SWHC and RGR could slow substantially in the second half of the calendar year. Most dealers have witnessed significant sales growth as a result of the “Obama effect”. Pistols and ammunition remain in short supply. However, we were surprised to learn that more than 60% of the dealers we surveyed have witnessed an INCREASE in inventories YOY thus far in 2009. Additionally, re-order intentions imply a growing degree of caution among dealers.

• SWHC and RGR stocks do not reflect the prospects that the Obama administration may eventually address gun control. We have no idea whether or not he plans to propose legislation this week, next month, next year, in his next term (if the case may be), or never. That being said, the impact of gun registration rules or other restrictions on demand according to the firearm dealers we surveyed would be sizeable. It is our view that the stocks do not yet fully reflect a level of regulatory risk commensurate with its potential impact.

We recognize that SWHC and RGR shares have been beaten down of late and are oversold. We recommend initiating a small short position at current levels and “sizing-up” on any moves higher. We expect SWHC to beat 4Q09 earnings expectations, which will be released in early June. We would use any strength in shares in response to earnings to sell shares. It should become increasingly clear over the next 3-6 months that demand is starting to normalize. Firearms have an extended useful life and there is no clear replacement cycle. In many respects, the strength in sales in the past six-months should only be viewed as demand from future periods that has now been “pulled forward”. We think SWHC and RGR shares should trade as if current street consensus for the next 12-months are peak EPS. Stated another way, we think the stocks should receive a market multiple on normalized earnings. In our view normalized EPS for SWHC in a depressed consumer environment would be $0.20-$0.25 and for RGR $0.45-$0.50, which would imply stock prices of $3-$4 for SWHC and $7-$8 for RGR (assuming a 15x mulitiple).

The “Obama effect” on firearm sales finally is waning. In a few quarters, the earnings prospects for SWHC and RGR might look similar to other consumer discretionary companies producing high priced goods.

Please click on the following link to read our full report on the firearms industry.

As always, please act accordingly…