RGR Sturm Ruger and Co

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except per share)

NOTE 1 - BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the results of the interim periods. Operating results for the nine months ended September 30, 2017 may not be indicative of the results to be expected for the full year ending December 31, 2017. These financial statements have been prepared on a basis that is substantially consistent with the accounting principles applied in our Annual Report on Form 10-K for the year ended December 31, 2016.

NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES

Organization:

Sturm, Ruger & Company, Inc. (the “Company”) is principally engaged in the design, manufacture, and sale of firearms to domestic customers. Approximately 99% of sales are from firearms. Export sales represent approximately 5% of total sales. The Company’s design and manufacturing operations are located in the United States and almost all product content is domestic. The Company’s firearms are sold through a select number of independent wholesale distributors, principally to the commercial sporting market.

The Company also manufactures investment castings made from steel alloys and metal injection molding (“MIM”) parts for internal use in its firearms and for sale to unaffiliated, third-party customers. Less than 1% of sales are from the castings segment.

Principles of Consolidation:

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All significant intercompany accounts and transactions have been eliminated.

Fair Value of Financial Instruments:

The carrying amounts of financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities, approximate fair value due to the short-term maturity of these items.

Use of Estimates:

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Reclassifications:

Certain prior period balances have been reclassified to conform to current year presentation.

Recent Accounting Pronouncements:

On November 20, 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-17, Balance Sheet Classification of Deferred Taxes (Topic 740). The new guidance requires that all deferred tax assets and liabilities be presented as a net noncurrent asset or liability on the balance sheet. Previously such items were presented as a net current asset or liability and a net noncurrent asset or liability. The new guidance was effective for fiscal years beginning after December 15, 2016 and interim periods thereafter. The Company adopted ASU 2015-17 in the first quarter of 2017 and applied it retroactively to all prior periods presented in the financial statements. The impact of adopting this change in accounting principle on the December 31, 2016 balance sheet was to reduce current deferred tax assets and working capital by $8,859 and noncurrent deferred tax liabilities by $8,526 from the amounts previously reported for these items.

On March 30, 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718). The most significant change in the new compensation guidance is that all excess tax benefits and tax deficiencies (including tax benefits of dividends) on share-based compensation awards should be recognized in the Statement of Income as income tax expense. Previously such benefits or deficiencies were recognized in the Balance Sheet as adjustments to additional paid-in capital. The new guidance was effective in fiscal years beginning after December 15, 2016 and interim periods thereafter. The Company adopted ASU 2016-09 in the first quarter of 2017. The impact of adopting this change in accounting principle reduced the Company’s effective tax rate by 2% for the period ending September 30, 2017. This did not have a material impact on the Company’s results of operations or financial position.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either a full retrospective or retrospective with cumulative effect transition method. In August 2015, the FASB issued ASU 2015-14 which defers the effective date of ASU 2014-09 one year, making it effective for annual reporting periods beginning after December 15, 2017. We plan to adopt the provisions of ASU 2014-09 on a modified retrospective basis. We do not expect the adoption of ASU 2014-09 to have a material impact on our consolidated revenue. We continue to assess the overall impact the adoption of ASU 2014-09 will have on our consolidated financial statements.

On February 25, 2016, the FASB issued ASU 2016-02, Leases (Topic 842), its long-awaited final standard on the accounting for leases. The most significant change in the new lease guidance requires lessees to recognize right-of-use assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease

payments are generally recognized over the lease term on a straight-line basis. This change will result in lessees recognizing right-of-use assets and lease liabilities for most leases currently accounted for as operating leases under legacy U.S. GAAP. The new lease guidance is effective in fiscal years beginning after December 15, 2018 and interim periods thereafter. Early application is permitted for all entities. The Company is currently evaluating the effect that the standard will have on the consolidated financial statements.

NOTE 3 - INVENTORIES

Inventories are valued using the last-in, first-out (LIFO) method. An actual valuation of inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs existing at that time. Accordingly, interim LIFO calculations must necessarily be based on management's estimates of expected year-end inventory levels and costs. Because these are subject to many factors beyond management's control, interim results are subject to the final year-end LIFO inventory valuation.

During the nine month period ended September 30, 2017, inventory quantities were reduced.  If this reduction remains through year-end, it will result in a liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years as compared with the current cost of purchases.  Although the effect of such a liquidation cannot be precisely quantified at the present time, management believes that if a LIFO liquidation occurs in 2017, the impact may be material to the Company’s results of operations for the period but will not have a material impact on the financial position of the Company.

Inventories consist of the following:

NOTE 4 - LINE OF CREDIT

The Company has a $40 million revolving line of credit with a bank. This facility is renewable annually and terminates on June 15, 2018. Borrowings under this facility bear interest at LIBOR (1.787% at September 30, 2017) plus 200 basis points. The Company is charged three-eighths of a percent (0.375%) per year on the unused portion. At September 30, 2017 and December 31, 2016, the Company was in compliance with the terms and covenants of the credit facility, which remains unused.

NOTE 5 - EMPLOYEE BENEFIT PLANS

The Company sponsors a 401(k) plan that covers substantially all employees. The Company matches a certain portion of employee contributions using the safe harbor guidelines contained in the Internal Revenue Code. Expenses related to these matching contributions totaled $0.7 million and $2.5 million for the three and nine months ended September 30, 2017, respectively, and $0.8 million and $2.5

million for the three and nine months ended October 1, 2016, respectively. The Company plans to contribute approximately $0.7 million to the plan in matching employee contributions during the remainder of 2017.

In addition, the Company provided supplemental discretionary contributions to the 401(k) plan totaling $1.2 million and $4.4 million for the three and nine months ended September 30, 2017, respectively, and $1.4 million and $4.5 million for the three and nine months ended October 1, 2016, respectively. The Company plans to contribute approximately $1.2 million in supplemental contributions to the plan during the remainder of 2017.

NOTE 6 - INCOME TAXES

The Company's 2017 and 2016 effective tax rates differ from the statutory federal tax rate due principally to state income taxes partially offset by tax benefits related to the American Jobs Creation Act of 2004. The Company’s effective income tax rate was 30.3% and 34.0% for the three and nine months ended September 30, 2017. The Company’s effective income tax rate in the three and nine months ended October 1, 2016 was 34.8% and 35.7%, respectively. This reduction is primarily the result of the Company’s adoption of ASU 2016-09 on January 1, 2017, as previously discussed in the Recent Accounting Pronouncements section of Note 2.

Income tax payments for the three and nine months ended September 30, 2017 totaled $1.3 million and $18.6 million, respectively. Income tax payments for the three and nine months ended October 1, 2016 totaled $13.5 million and $34.4 million, respectively.

The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2015.

The Company does not believe it has included any “uncertain tax positions” in its federal income tax return or any of the state income tax returns it is currently filing. The Company has made an evaluation of the potential impact of additional state taxes being assessed by jurisdictions in which the Company does not currently consider itself liable. The Company does not anticipate that such additional taxes, if any, would result in a material change to its financial position.

The dilutive effect of outstanding options and restricted stock units is calculated using the treasury stock method. There were no stock options that were anti-dilutive and therefore not included in the diluted earnings per share calculation.

NOTE 8 - COMPENSATION PLANS

In May 2017, the Company’s shareholders approved the 2017 Stock Incentive Plan (the “2017 SIP”) under which employees, independent contractors, and non-employee directors may be granted stock options, restricted stock, deferred stock awards, and stock appreciation rights, any of which may or may not require the satisfaction of performance objectives. Vesting requirements are determined by the Compensation Committee of the Board of Directors . The Company has reserved 750,000 shares for issuance under the 2017 SIP, of which 727,000 shares remain available for future grants as of September 30, 2017.

In April 2007, the Company adopted and the shareholders approved the 2007 Stock Incentive Plan (the “2007 SIP”), which had similar provisions as the 2017 SIP. The 2007 SIP plan expired April 24, 2017. The Company had reserved 2,550,000 shares for issuance under the 2007 SIP, of which 2,181,000 shares were issued.

Compensation costs related to all share-based payments recognized in the statements of operations aggregated $1.0 million and $2.6 million for the three and nine months ended September 30, 2017, respectively, and $0.8 million and $2.2 million for the three and nine months ended October 1, 2016, respectively.

The aggregate intrinsic value (mean market price at September 30, 2017 less the weighted average exercise price) of options outstanding under the 2007 SIP was approximately $0.5 million.

Restricted Stock Units

Beginning in 2009, the Company began granting restricted stock units to senior employees in lieu of incentive stock options. The vesting of these awards is dependent on the achievement of corporate objectives established by the Compensation Committee of the Board of Directors. Beginning in 2011, a three year vesting period was added to the performance criteria, which had the effect of requiring both the achievement of the corporate performance objectives and the satisfaction of the vesting period.

There were 125,400 restricted stock units issued during the nine months ended September 30, 2017. Total compensation costs related to these restricted stock units are $5.1 million. These costs are being recognized ratably over the vesting period of three years. Total compensation cost related to restricted stock units was $1.0 million and $2.6 million for the three and nine months ended September 30, 2017, respectively, and $0.8 million and $2.2 million for the three and nine months ended October 1, 2016, respectively.

NOTE 9 - OPERATING SEGMENT INFORMATION

The Company has two reportable segments: firearms and castings. The firearms segment manufactures and sells rifles, pistols, and revolvers principally to a select number of independent wholesale distributors primarily located in the United States. The castings segment manufactures and sells steel investment castings and metal injection molding parts.

Selected operating segment financial information follows:

NOTE 10 – RELATED PARTY TRANSACTIONS

The Company contracts with the National Rifle Association (“NRA”) for some of its promotional and advertising activities, including the 2016 “Ruger $5 Million Match Campaign” and the 2015-16 “2.5 Million Gun Challenge”. Payments made to the NRA in the three and nine months ended September 30, 2017 were insignificant. The Company paid the NRA $1.0 million and $3.0 million in the three and nine months ended October 1, 2016. One of the Company’s Directors also serves as a Director on the Board of the NRA.

The Company has contracted with Symbolic, Inc. (“Symbolic”) to assist in its marketing efforts. During the three and nine months ended September 30, 2017, the Company paid Symbolic $0.3 million and $1.3 million, respectively, which amounts included $0.3 million and $0.8 million, respectively, for the reimbursement of expenses paid by Symbolic on the Company’s behalf. During the three and nine months ended October 1, 2016, the Company paid Symbolic $0.4 million and $1.5 million, respectively, which amounts included $0.2 million and $0.7 million, respectively, for the reimbursement of expenses paid by Symbolic on the Company’s behalf. Symbolic’s principal and founder was named the Company’s Vice President of Marketing in June 2017, and remains a partner of Symbolic.

NOTE 11 - CONTINGENT LIABILITIES

As of September 30, 2017, the Company was a defendant in four (4) lawsuits and is aware of certain other such claims. The lawsuits fall into three categories: traditional product liability litigation, patent litigation, and municipal litigation, discussed in turn below.

Traditional Product Liability Litigation

Two of the four lawsuits mentioned above involve claims for damages related to allegedly defective products due to their design and/or manufacture. These lawsuits stem from specific incidents of personal injury and are based on traditional product liability theories such as strict liability, negligence and/or breach of warranty.

The Company management believes that the allegations in these cases are unfounded, that the incidents were unrelated to the design or manufacture of the firearm, and that there should be no recovery against the Company.

Patent Litigation

Davies Innovations, Inc. v. Sturm, Ruger & Company, Inc. is a patent litigation suit originally filed in the United States District Court for the Southern District of Texas, Galveston Division. Upon motion by the Company, the case was transferred to the United States District Court for the District of New Hampshire. The suit is based upon alleged patent infringement as the plaintiff claims that certain features of the Ruger SR-556 and SR-762 modern sporting rifles infringe its patent. The complaint seeks a judgment of infringement and unspecified monetary damages including costs, fees and treble damages.

Pursuant to the Company's Motion for Summary Judgment, filed on February 15, 2017, the Court dismissed the plaintiff’s claim of literal infringement, but allowed the case to proceed to discovery on alternate theories.

The Company management believes that the allegations in this case are unfounded, that there is no infringement of plaintiff’s patent, that plaintiff’s patent is invalid, and there should be no recovery against the Company.

Municipal Litigation

Municipal litigation generally includes those cases brought by cities or other governmental entities against firearms manufacturers, distributors and retailers seeking to recover damages allegedly arising out of the misuse of firearms by third-parties.

There is only one remaining lawsuit of this type, filed by the City of Gary in Indiana State Court in 1999. The complaint in that case seeks damages, among other things, for the costs of medical care , police and emergency services, public health services , and other services as well as punitive damages. In addition , nuisance abatement and/or injunctive relief is sought to change th e design , manufacture , mark e ting and distribution practices of th e various defendants. The suit alleges , among other claims , negligence in the design of products , public nuisance , negligent distribution and marketing , negligence per se and deceptive advertising. The case does not allege a specific

injury to a specific individual as a result of the misuse or use of any of the Company's products.

After a long procedural history , the case was scheduled for trial on June 15 , 2009. The case was not tried on that date and was largely dormant until a status conference was held on July 27 , 2015. At that time , the court entered a scheduling order setting deadlines for plaintiff to file a Second Amended Complaint , for defendants to answer , and for defendants to file dispositive motions. The plaintiff did not file a Second Amended Complaint by the deadline.

In 2015 , Indiana passed a new law such that Indiana Code §34-12-3-1 became applicable to the City's case. The defendants have filed a joint motion for judgment on the pleadings, asserting immunity under §34-12-3-1 and asking the court to revisit the Court of Appeals' decision holding the Protection of Lawful Commerce in Arms Act inapplicabl e to the City's claims. The motion was fully briefed by the parties.

On September 29, 2016, the court entered an order staying the case pending a decision by the Indiana Supreme Court in KS&E Sports v . Runnels, which presents related issues. The Indiana Supreme Court decided KS&E Sports on April 24 , 2017 , and the Gary court lifted the stay. The Gary court also entered an order setting a supplemental briefing schedule under which the parties addressed the impact of the KS&E Sports decision on defendants ' motion for judgment on the pleadings . A hearing on the motion for judgment on the pleadings is set for December 12, 2017.

Summary of Claimed Damages and Explanation of Product Liability Accruals

Punitive damages , as well as compensatory damages, are demanded in certain of the lawsuits and claims. In many instances , the plaintiff does not seek a specified amount of money , though aggregate amounts ultimately sought may exceed product liability accruals and applicable insurance coverage. For product liability claims made after July 10, 2000 , coverage is provided on an annual basis for losses exceeding $5 million per claim , or an aggregate maximum loss of $10 million annually , except for certain new claims which might be brought by governments or municipalities after July 10 , 2000 , which are excluded from coverage.

The Company management monitors the status of known claims and the product liability accrual , which includes amounts for asserted and unasserted claims. While it is not possible to forecast the outcome of litigation or the timing of costs , in the opinion of management , after consultation with special and corporate counsel, it is not probable and is unlikely that litigation , including punitive damage claims , will have a material adverse effect on the financial position of the Compan y, but may have a material impact on the Company’ s financial results and cash flows for a particular period.

Product liability claim payments are made when appropriate if, as, and when claimants and the Company reach agreement upon an amount to finally resolve all claims. Legal costs are paid as the lawsuits and claims develop, the timing of which may vary greatly from case to case. A time schedule cannot be determined in advance with any reliability concerning when payments will be made in any given case.

Provision is made for product liability claims based upon many factors related to the severity of the alleged injury and potential liability exposure, based upon prior claim experience. Because the Company's experience in defending these lawsuits and claims is that unfavorable outcomes are typically not probable or estimable, only in rare cases is an accrual established for such costs.

In most cases, an accrual is established only for estimated legal defense costs. Product liability accruals are periodically reviewed to reflect then-current estimates of possible liabilities and expenses incurred to date and reasonably anticipated in the future. Threatened product liability claims are reflected in the Company's product liability accrual on the same basis as actual claims; i.e. , an accrual is made for reasonably anticipated possible liability and claims handling expenses on an ongoing basis.

A range of reasonably possible losses relating to unfavorable outcomes cannot be made. However, in product liability cases in which a dollar amount of damages is claimed, the amount of damages claimed, which totaled $0.1 million and $0.1 million at December 31, 2016 and 2015, respectively, are set forth as an indication of possible maximum liability the Company might be required to incur in these cases (regardless of the likelihood or reasonable probability of any or all of this amount being awarded to claimants) as a result of adverse judgments that are sustained on appeal.