Norwest Equity Partners agreed May 13 to sell gun maker Savage Arms to Alliant Techsystems (NYSE:ATK) for $315 million. While firms like Norwest and Cereberus are bailing on the gun industry, others like Alliant are lining up to buy in. Who's right? That's going to take some time to determine. In the meantime, I'll decide whether this deal makes Alliant's stock more attractive or less so.
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Guns Are Profitable
Ask the shareholders of Sturm Ruger (NYSE:RGR) how they feel about guns and you'll likely get a very positive answer. That's because its stock's achieved an annualized total return of 51% over the past five years which compares very favorably to the -7.5% per annum for Alliant Techsystems. Best known for providing ammunition to law enforcement, military personnel and sport enthusiasts, the purchase of Savage will add to the $1.2 billion in revenue its sporting group generated in 2012. More importantly, it will reduce its dependance on the U.S. government, which accounts for 65% of its overall revenue.
In recent years as gun demand has increased so too has Sturm Ruger's operating margin. In 2008 it was just 7.5%, about 280 basis points less than Alliant. Fast forward to 2012 and Sturm Ruger's operating margin was 22.6%, more than double Alliant's at 10.7%. While Alliant's barely budged, Sturm Ruger's went through the roof. I tell you this not because I think you should buy Sturm Ruger's stock, but because it points out how profitable the manufacture of guns can be when done well combined with an attractive operating environment. Approximately 42% of American households possess at least one gun. With 270 million guns in the country, the average house possessing guns has 5.6 of them. That's an extremely attractive audience.
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Companies like Altria Group (NYSE:MO) and Lorillard (NYSE:LO) have some of the best margins anywhere. They would have to be given the legal liability tobacco producers continue to face. Gun manufacturers don't face nearly as much of a problem thanks to the passing of the 2005 Protection of Lawful Commerce in Arms Act, which prevents lawsuits against firms like Savage Arms, where the product worked as intended in the commission of an illegal act. In other words, you can't sue someone because they bought a particular brand of gun and then went out and shot someone with it. Congress implemented this legislation to prevent tobacco-style legislation by the states. So, although gun makers, like cigarette manufacturers, are politically incorrect, there's far less risk involved.
While revenue numbers for Savage Arms weren't revealed, I estimate they're around $285 million annually based on a 20% operating margin and Alliant Techsystems having paid approximately 5.5 times EBITDA. Their addition brings Alliant Techsystems annual revenue to around $4.9 billion with its sporting group accounting for 31% of that. My guess is that the acquisition will add a one or two basis points to ATK's operating margin. At the end of the day though, you're looking at a business whose enterprise value is 5.3 times EBITDA. By comparison, Sturm Ruger's enterprise value is 6.7 times EBITDA. With continued growth in higher margin businesses it could garner a higher multiple around six times EBITDA, which would suggest a stock price around $145. That's the best case scenario. A more likely scenario suggests a 24-month target price of $125 or 5.25 times EBITDA.
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Alliant Techsystems' fiscal 2013 ended March 31 was a good news, bad news, situation. The good news was its sporting group achieved a 15.3% increase in revenue to $1.16 billion and a 29.7% increase in operating profit to $118.3 million. Most importantly, the sporting group had an operating profit increase of 167% in the fourth quarter due to higher volumes combined with higher prices. The bad news is that its aerospace and defense groups both saw significant sales decreases year-over-year.
Its sporting group continues to grow in importance. With revenues that are more consistent than its other two segments, the acquisition of Savage Arms represents a concerted effort by the company to bring more balance to its operations. Long-term I see this a winning move for shareholders including First Eagle Investment Management, its largest, who own 15.9% of its stock.
At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.