The August data for the number of background checks conducted under the National Instant Criminal Background Check System (NICS) was released this morning. Overall, the total number of background checks increased 12.3% on a YOY basis and increased 11.2% on a month-to-month basis to 1,074,757.  This represents the first month-to-month increase since March of this year. Overall the number of background checks in the month of August was still 30% below the peak witnessed in November 2008. The chart below shows the trend in the number of background checks over the past 18-months.

Source: FBI

The August traffic to the top five leading online gun dealers tells a similar story.  According to Compete.com, the number of unique visitors to the top five online gun dealers increased 10.1% from July to August.  On a year-over-year basis, the number of unique visitors increased 45%, still quite robust, but well below the levels of growth witnessed earlier in the year.  Total traffic to these sites in August was down 23% from the peak levels witnessed in December 2008.

Source: Compete.com

We do not want to draw too many conclusions from one or two data points, but we would be remiss if we didn’t acknowledge that we are somewhat surprised by the resilience in the level of gun sales suggested by the NICS data or traffic to the leading online gun dealers.  The most difficult comps for firearm sales will occur starting in October. Over the past 6-9 months, both SWHC and RGR shares have become increasingly sensitive to the NICS data, which is why we find today’s trading action somewhat perplexing.  Based on recent trading activity, we think investors are increasingly discounting a decline in the “Obama effect” on gun sales.  SWHC and RGR now trade at 13.3x and 9.3x FY1 EPS, which certainly suggests that investors now view current year earnings as a peak, or that investors think there is material downside to consensus estimates.  We maintain the view that firearm sales are poised to decline, potentially precipitously.  However, we always want to remain vigilant to what the market is implying relative to what is fundamentally happening.  Perhaps, the August NICS data is a blip in what will be an otherwise consistent downward trend in firearm sales, but if it is something different both SWHC and RGR shares could head higher. 

Key Questions for SWHC’s 1Q10 Results

SWHC will report 1Q10 results tomorrow after the market  close.  Over the past 6-9 months, the company’s management team has been far more bullish on the sustainability of current sales trends than has RGR’s mangement team.  Here are a few key issues and questions we are focusing on:

• Has there been any change in end-market demand in the past 2-3 months?
• Has the scarcity of ammunition supply remained a bottleneck on sales growth?
• Are dealer inventories starting to increase as suggested by RGR management?
• Have their been any signs of stability in sales trends for hunting firearms?
• Has SWHC resolved manufacturing capacity constraints for its revolvers?
• At lower production levels what is a steady state gross margin objective given the increase in manufacturing capacity in the past 12-months?
• The company had one product recall during the quarter, are warranty reserves sufficient and will there be any increases to reserves in coming quarters?
• Inventory at the company level was incredibly lean in the back half of FY09, will the company start to build inventory meaningfully in FY10?
• How is the USR integration progressing and does the company still expect $50 million and $100 million in revenues from USR in FY10 and FY11, respectively?

Overall, we forecast revenues of $92 million (vs. $94 million consensus), gross margins of 32.4%, and EPS of $0.09 (vs. consensus of $0.10).  This will be the last quarter before USR’s full results will be included in SWHC’s.  The single biggest issue for the stock will be the level of backlog ($268 million as of 4Q09) and management’s characterization of inventory at retail.  To the extent, SWHC management tells a similar story to RGR, shares could trade materially lower.

It is difficult to tell how much demand has been “pulled forward” over the past 6-9 months, but it appears more and more likely that firearms sales will start to decline on a year-over-year basis in the fourth quarter of the year. Now that evidence continues to mount that the “Obama effect” on gun sales has peaked, we expect investors to increasingly look at normalized earnings for both RGR and SWHC. In the case of SWHC, we view normalized earnings power as $0.20-$0.25, applying a 15-17x multiple would imply a stock price of $3.75-$4.25. For RGR, we think normalized EPS is closer to $0.45-$0.50, which would imply a price of $6.75-$7.50 using a similar valuation.

As always, please act accordingly…