Guns: Jammed cylinder

Don't bet that the American gun rally is over just yet. This week gun manufacturer Smith & Wesson sharply lowered the sales outlook that it laid out just two months ago. Smith & Wesson and its listed peer Sturm, Ruger are down 15 and 30 per cent respectively since January. The simplistic explanation is that purchases of guns after the 2012 Sandy Hook school massacre have abated as it became clear that tightened gun control would not be forthcoming. But that is only part of the reason for the pullback in the share prices. The rest can be explained by the vagaries of the firearm supply chain.

There are five or so big retail chains that sell guns and Smith & Wesson (whose enterprise value is $700m) will deal directly with them. But most Americans buy guns from small shops which source their wares from 14 major distributors. Over two-thirds of Smith & Wesson revenues come from selling to such distributors. This distributor layer creates a lag between end-consumer demand and production decisions. For example, Ruger (with an enterprise value of $900m) says that the retail-level sales of its guns in the first quarter of this year were the second-highest ever, even though its own revenues (higher up in the supply chain) were weakening.

In June, Smith & Wesson had said that revenue in the current fiscal year would be about $600m, off 5 per cent from last year. This was not shocking, given the 2013 buying surge. But this week, based on its recent market observations, it brought down the revenue estimate to $530m at the low end. That reduction, according to the company, was less about thinning demand and more about the elevated inventory of deeply discounted competitor products which distributors held. A data point: distributors held 326,000 units of Ruger inventory at the end of the second quarter, up more than 50 per cent quarter over quarter.

Over the long term, Smith & Wesson is confident about its prospects because it believes in both the strength of its product offering (new models are constantly being introduced) and because it thinks demand for guns will continue to rise. The adjusted NICS volume - the number of firearm buyer background checks used as a proxy for demand - has risen 9 per cent on average annually for the past seven years. But the lesson from these recent events is that demand from the middlemen matters as much as demand from consumers.

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