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 six months ended June 30, 2018 may not be indicative of the results to be expected for the full year ending December 31, 2018. 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, 2017.

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 4% 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. Approximately 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.

Revenue Recognition:

The Company recognizes revenue in accordance with the provisions of Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (“ASC 606”) , which became effective January 1, 2018. Substantially all product sales are sold FOB (free on board) shipping point. Customary payment terms are 2% 30 days, net 40 days. Generally, all performance obligations are satisfied when product is shipped and the customer takes ownership and assumes the risk of loss. In some instances,

sales include multiple performance obligations. The most common of these instances relates to sales promotion programs under which downstream customers are entitled to receive no charge products based on their purchases of certain of the Company’s products from the independent distributors. The fulfillment of these no charge products is the Company’s responsibility. In such instances, the Company allocates the revenue of the promotional sales based on the estimated level of participation in the sales promotional program and the timing of the shipment of all of the firearms included in the promotional program, including the no charge firearms. Revenue is recognized proportionally as each performance obligation is satisfied, based on the relative customary price of each product. Customary prices are generally determined based on the prices charged to the independent distributors. The net change in contract liabilities for a given period is reported as an increase or decrease to sales.

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:

In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, an update to Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (“ASC 606”), which supersedes nearly all existing revenue recognition guidance. As more fully discussed in Note 3, the Company adopted ASC 606 using the modified retrospective method on January 1, 2018.

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. 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.

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 – REVENUE RECOGNITION AND CONTRACTS WITH CUSTOMERS

On January 1, 2018, the Company adopted ASC 606 using the modified retrospective method, applied to those contracts for which all performance obligations were not completed as of that date. Under the modified retrospective method results for reporting periods beginning after January 1, 2018 will be presented using the guidance of ASC 606, while prior period amounts are not adjusted and continue to be reported in accordance with the previous guidance provided in ASC Topic 605, Revenue Recognition .

The effects of adjustments to the December 31, 2017 consolidated balance sheet for the adoption of ASC 606 were as follows:

At December 31, 2017, the Company had accrued $4.0 million related to certain of its sales promotion activities that included the shipment of no charge firearms. Using the new accounting guidance, a deferred contract liability of $6.9 million was required at December 31, 2017 and an entry for $2.9 million to increase the deferred contract liability, increase deferred tax assets by $0.7 million, and reduce beginning retained earnings by $2.2 million was recorded on January 1, 2018 (the “transition entry”).

The impact of the adoption of ASC 606 on revenue recognized during the three and six months ended June 30, 2018 is as follows:

During the six months ended June 30, 2018, the Company deferred $9.4 million of revenue, offset by the recognition of $9.7 million of revenue previously deferred as the performance obligation

relating to the shipment of free products was satisfied. This resulted in a net increase in firearms sales for the three and six months ended June 30, 2018 of $2.6 million, and $0.3 million, respectively, and a deferred contract revenue liability at June 30, 2018 of $6.7 million. The Company estimates that revenue from this deferred contract liability will be recognized in the third quarter of 2018. As a result of the adoption of ASC 606, for the three months ended June 30, 2018 the gross margin percentage was unchanged and earnings per share increased by approximately 5¢ over the comparable prior year period. As a result of the adoption of ASC 606, for the six months ended June 30, 2018 the gross margin percentage was reduced by 2% and earnings per share was unchanged as compared to the comparable prior year period.

Practical Expedients and Exemptions

The Company has elected to account for shipping and handling activities that occur after control of the related product transfers to the customer as fulfillment activities that are recognized upon shipment of the goods.

NOTE 4 - 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 six month period ended June 30, 2018, 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 2018, 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 5 - LINE OF CREDIT

The Company’s $40 million revolving line of credit expired on June 15, 2018. Throughout 2018, the Company was in compliance with the terms and covenants of the credit facility, which was not used.

NOTE 6 - 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 $0.8 million and $1.6 million for the three and six months ended June 30, 2018, respectively, and $0.8 million and $1.8 million for the three and six months ended July 1, 2017, respectively. The Company plans to contribute approximately $1.6 million to the plan in matching employee contributions during the remainder of 2018.

In addition, the Company provided supplemental discretionary contributions to the 401(k) plan totaling $1.3 million and $2.6 million for the three and six months ended June 30, 2018, respectively, and $1.3 million and $3.2 million for the three and six month ended July 1, 2017, respectively. The Company plans to contribute approximately $1.3 million in supplemental contributions to the plan during the remainder of 2018.

NOTE 7 - INCOME TAXES

The Company's 2018 and 2017 effective tax rates differ from the statutory federal tax rate due principally to state income taxes. The Company’s effective income tax rate was 24.2% and 24.4% for the three and six months ended June 30, 2018, respectively. The Company’s effective income tax rate for the three and six months ended July 1, 2017 was 35.0%. This reduction is primarily the result of the Tax Cuts and Job Act of 2017, which reduced the statutory Federal tax rate from 35% to 21% effective January 1, 2018, partially offset by the loss of tax benefits available in the prior period related to the American Jobs Creation Act of 2004 that expired effective December 31, 2017. The reduced effective tax rate resulting from the Tax Cuts and Job Act of 2017 increased earnings per share by 12¢ and 24¢ for the three and six months ended June 30, 2018.

Income tax payments for the three and six months ended June 30, 2018 totaled $8.0 million and $8.0 million, respectively. Income tax payments for the three and six months ended July 1, 2017 totaled $16.2 million and $16.3 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 9 - 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 543,000 shares remain available for future grants as of June 30, 2018.

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.

Restricted Stock Units

Beginning in 2009, the Company began granting performance-based and retention-based restricted stock units to senior employees in lieu of incentive stock options. The vesting of the performance-based awards is dependent on the achievement of corporate objectives established by the Compensation Committee of the Board of Directors and a three-year vesting period. The retention-based awards are subject only to the three-year vesting period. There were 184,200 restricted stock units issued during the six months ended June 30, 2018. Total compensation costs related to these restricted stock units are $8.8 million.

Compensation costs related to all outstanding restricted stock units recognized in the statements of income aggregated $1.5 million and $2.7 million for the three and six months ended June 30, 2018, respectively, and $0.9 million and $1.6 million for the three and six months ended July 1, 2017, respectively.

The aggregate intrinsic value (mean market price at June 30, 2018 less the weighted average exercise price) of options outstanding under the 2007 SIP was approximately $0.3 million.

NOTE 10 - 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 11 – 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 six months ended June 30, 2018 totaled $132,000 and $211,000, respectively. Payments made to the NRA in the three and six months ended July 1, 2017 were $127,000 and $302,000, respectively. 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. Payments made to Symbolic during the three and six months ended June 30, 2018 were de minimis. During the three and six months ended July 1, 2017, the Company paid Symbolic $0.3 million and $1.0 million, respectively, which amounts included $0.1 million and $0.4 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 the president of Symbolic.

NOTE 12 - CONTINGENT LIABILITIES

As of June 30, 2018, the Company was a defendant in three (3) lawsuits and is aware of certain other such claims. The lawsuits fall into three categories: traditional product liability litigation, non-product litigation, and municipal litigation, discussed in turn below.

Traditional Product Liability Litigation

One of the three lawsuits mentioned above involves claims for damages related to an allegedly defective product due to its design and/or manufacture. This lawsuit stems from a specific incident of personal injury and is based on a traditional product liability theory such as strict liability, negligence and/or breach of warranty.

The Company management believes that the allegation in this case is unfounded, that the incident was unrelated to the design or manufacture of the firearm, and that there should be no recovery against the Company.

Non-Product Liability

David S. Palmer, on behalf of himself and all others similarly situated vs. Sturm, Ruger & Co. is a putative class-action suit filed in Florida state court on behalf of Florida consumers. The suit alleges breach of warranty and deceptive trade practices related to the sale of 10/22 Target Rifles. The Company filed an Answer denying all material allegations and a Motion to Strike the putative class representative’s claims. That motion remains pending.

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 was held on December 12, 2017. On January 2, 2018, the Court entered an order dismissing the case in its entirety. The City filed a Notice of Appeal on February 1, 2018. The matter is in the process of being briefed by the parties.

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 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, 2017 and 2016, 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.

As of December 31, 2017 and 2016, the Company was a defendant in 3 and 5 lawsuits, respectively, involving its products and is aware of other such claims. During 2017 and 2016, respectively, 0 and 3 product-related claims were filed against the Company, 0 and 1 claims were settled, and 2 and 0 claims were dismissed.

The Company’s product liability expense was $0.4 million in 2017, $2.1 million in 2016, and $0.9 million in 2015. This expense includes the cost of outside legal fees, insurance, and other expenses incurred in the management and defense of product liability matters.