LAKE - Lakeland Industries: Inventories Loom Over Margins And Profitability

2023-03-30 00:51:46 ET

Summary

• In a previous article, I considered LAKE a good, profitable company, but also that it competed in a difficult market and that its growth prospects were slim.
• My model of the company's profitability is maintained, but gross margins may fall because of costs embedded in accumulating inventories.
• The company also has spent cash in the acquisition of a UK designer of fire protective equipment. The prospect of share repurchases is now smaller.
• Overall, the company is not necessarily going to suffer, but its stock price already embeds optimistic assumptions about profitability and growth.
• LAKE is not an opportunity yet.

Lakeland Industries ( LAKE ) is a global manufacturer of protective equipment.

In a recent article from September 2022, I issued a Hold rating on the company because its competitive markets and lack of growth before the pandemic did not justify the company's current premiums.

Today, LAKE stock trades at a higher price, but business conditions have not changed dramatically. The company initiated an acquisition using approximately one-third of its cash reserves.

Based on the new developments, I maintain my Hold rating. The company's price continues to be excessive compared to the profitability we can expect from it.

Note: Unless otherwise stated, all information has been obtained from LAKE's filings with the SEC .

Previous thesis recap

Competitive industry

LAKE competes in the protective equipment market with big names like DuPont, Honeywell, Kimberly Clark, and Ansell. These are much bigger companies with significant IP moats.

Still able to compete

Surprisingly, LAKE has competed in this segment, albeit not always profitable. I believe the reason is that LAKE chose strategic niches in which to compete, and has manufacturing capabilities in the cheapest locations (Vietnam, China, Mexico, India, and now Eastern Europe).

Enormous cash reserves

The company built enormous cash reserves thanks to the profitability generated by the record demand from the pandemic period (mostly in disposables for healthcare).

It has used cash for investments, acquisitions (more below), share repurchases, and building working capital.

Our cost model

In our cost model, the company maintained its recent gross margins of 40% (above the historic levels closer to 32.5%), it expensed $38 million in SG&A, had no interest expenses and an effective tax rate of 27%.

Recent developments

The cost model is maintained

Recent data shows that the company has maintained and even increased its gross margins above the 40% and that revenues did not grow substantially.

Further, the company has accumulated $29 million in SG&A expenses as of 3Q22 , a little above our expectations, with makes us correct the yearly target to $40 million. The effective tax rate was 33% for the 9M22 period when excluding the effect of withholding taxes in distributions from the Chinese subsidiary (which we have accounted for in our previous article), but we will keep the 27% used in the previous article.

Short-term problem with inventories

The company has been building inventories despite sales not picking up as expected. The level of inventories (both in absolute terms and relative to sales) is at record highs.

High inventories are normal for a company with many product lines and global operations. The problem, in this case, is cost capitalization. The company's manufacturing salaries and overhead are not directly expensed but rather capitalized in the company's inventories. Because the company uses FIFO, it is expensing the oldest (cheapest, given that we have inflation) inventories. Further, if the company produces fewer units, more overhead is capitalized per unit. We can approximate total production by subtracting cash used in inventories from CoGS (a negative value for cash used implies inventory buildups). Eventually, when these newer inventories are expensed, they could reduce the company's margins.

Acquisition and capital allocation

In my previous article, I assumed the company would use all the cash available for share repurchases, calculating the multiples from the reduced share count. Indeed LAKE has continued its share repurchase but has also continued investing in other companies.

LAKE acquired Eagle Technical, a fire and heat protective equipment designer from the UK. The company manufactures through subcontractors in Eastern Europe and sells in EMEA and Asia. Eagle was acquired for $11 million, and little financial information was provided. Still, the multiple to sales could be above 2x, given that Eagle's sellers have earnouts conditional on the company surpassing GBP 6 million ($7.8 million) in revenues.

This changes our capital allocation model, reducing cash available for share repurchases. Using 3Q22 data, the company has $24 million left, most of that located in China (meaning $21.6 million after withholding taxes for repatriation). The company could repurchase 1.5 million shares with those funds, reducing the share count to 6.2 million.

Rebalancing price to opportunity/risk

Considering a low seasonality year (the company's sales are tilted towards the first quarter, between February and May), we can annualize sales of $116 million from 3Q22 data. We can add $8 million from Eagle to reach $124 million.

Again considering gross margins of 40% and SG&A costs of $40 million, we arrive at $9.6 million in pre-tax profits or $7 million after taxes of 27%. Divided into 6.2 million shares, that is approximately $1.13 per share. With a current share price of $14.5, that leads to a P/E ratio of 12.8x

The above calculation includes several optimistic assumptions: that gross margins are maintained despite the inventory problems mentioned above, that SG&A is not increased despite the company's absorption of Eagle Technical, that its effective tax rate decreases despite the company increasing business in the UK (with a corporate tax rate of 35%), and that the company uses all cash for share repurchases.

In my opinion, the multiple already incorporates sufficient optimistic assumptions but is still relatively high. The multiple leaves no room for a more negative scenario, like lower revenues, margins, higher SG&A expenses, or lower share repurchases.

From a longer-term perspective, as expressed in the previous article, I do not believe that LAKE qualifies as a growth business because it could not grow for much of the past decade, despite a world that was growing and increasing trade. The new global trends of deglobalization and inflation are not great for LAKE's markets. The company has not yet demonstrated that it can maintain the new margins for a sufficiently long cycle. It is still working through the inventories generated during the pandemic high production period.

Conclusions

LAKE has somewhat maintained the profitability that it inherited from the pandemic (particularly at the gross margin level). Still, the company faces challenges, particularly lower sales, which will eventually affect margins as FIFO inventories are sold.

Using our updated cost model, the company promises a P/E ratio of 13x for this calendar year, but only under relatively optimistic assumptions. This already leaves more negative scenarios unpriced.

From a longer-term perspective, I do not believe LAKE commands a particularly high premium on earnings. Its markets or operational history do not prove otherwise.

For those reasons, I maintain my hold rating on LAKE and consider it not an opportunity yet.

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