Description

Note: LAKE just reported earnings and AH trading suggests it may open down 5-10% from the closing price of $17.20. Even if it does, we believe this is a good short candidate. And, it will likely trade back up, as it has been locked in a range since February.

If your fund mandate or investment doctrine requires holding a short book, you've likely had a hard time navigating nasty technicals and trading values that might already be far below your normalized intrinsic valuation. We have had this problem with most single name shorts, and pair trades pose their own problems. Getting a short right nowadays depends heavily on having the correct view of COVID-19 lockdown duration, macro and/or public policy intervention. We like LAKE in this circumstance because you don't have to be right about much to win. In most states of the world, it should be an underperformer.

For much of its history, LAKE has been a sleepy manufacturer of disposable protective clothing for hazardous environments. A quick overview:

- Products are clothing for hazmat, high heat and clean room applications.

- Their core markets are oil, petrochemicals, auto and other industrial manufacturing, firefighting, utilities and clean rooms. Medical has not been a historical market for them and there is not even a link on their website for the medical vertical.

- They operate their own manufacturing facilities in China, India, Mexico and Vietnam.

- Their biggest competitors are Dupont and Kimberly Clark. 

- Their sales are approximately 50% US and 50% international.

Their latest investor presentation is here: https://www.lakeland.com/uploads/data-sheets/Investor-Relations/Investor-News-Events/Roth-Capital-32nd-Annual-Conference-March-16-2020.pdf

They caught a bid in January on the back of coronavirus in Asia. Their sealed seam suits (similar to https://www.safespec.dupont.com/tyvek/featured-products.corebrand$$TYVEK.html) were in demand as China's medical professionals all donned bunny suits and adult diapers. As just discussed on the earnings call, this benefit amounted to $1 million in incremental sales for the fourth quarter ending Jan 31, 2020 (3% of sales). However, these revenues only represented 2 weeks of sales from existing inventory. Since then, they have ramped up two underutilized plants to max capacity to serve ongoing demand, representing a "20% increase above their normal production pace" for just the sealed seam product. They also pulled forward a capacity expansion that had been planned for next year, with no more specificity provided.

Curiously, they traded up by more than 100% at one point in February on COVID-19 hope when they're not even really a COVID-19 play. The vast majority of their business is for industrial use and is therefore cyclical. Management has been circumspect in projecting exactly what the COVID-19 opportunity really is, even though they have put out a press release around the COVID-19 driven capacity expansion. We had waited for the earnings call to post on the hope they would provide some guidance on the opportunity. Based on their commentary, though, it seems likely they don't have much visibility into current or future demand. The best they can muster is that, after this wave, they are optimistic about areas such as COVID-19 disinfecting and corporates ordering ahead for the back half of the year. Also, management emphasizes that they are still focused on their existing industrial customers first and COVID-19 is a secondary consideration.

There will certainly be some benefit this quarter to their sales, but it is unclear what that benefit will be and how long it will last, because even management doesn't seem to know, despite just installing an ERP system. Based on management's reluctance to discuss in any detail, we suspect the magnitude of the financial benefit will be millions and not tens of millions per quarter. 

The situation we like here is that the two most likely COVID-19 event paths should both be winners:

A. COVID-19 is controlled = extra suits are not needed, this is no longer a story stock, stock lags the market

B. COVID-19 is not controlled = their key end markets suffer in a depression, stock suffers with market because competitors catch up on supply

In addition to a COVID-19 catalyst, there are a few other factors that make them an interesting short:

- Product is undifferentiated. On today's call, management replied to a softball analyst question by saying their only advantage was speed. Not customization, not quality, not price. Just the ability to retool their manufacturing facilility more quickly than the big competitors whom all use contract manufacturers with longer lead times. Seems like a temporary advantage due to a demand shock, which competitors will likely correct on the supply side in time. See https://www.nbcnews.com/health/health-care/dupont-expediting-production-tyvek-hazmat-suits-health-care-workers-n1169031

- As they own all of their own manufacturing, operating leverage works both ways. That said, much of their cost is labor and not machinery, so they're not necessarily capex heavy either.

- 20% of revenue tied to oil industry. Rest of industrial client base would also be hurt in recession.

- Management highlighted some potential pull-forward of distributor inventory stockup on supply fears. This may reverse.

- Material weakness in controls

- Actually actionable for small funds compared to many "COVID-19 is solved" shorts that are not consumer staples companies. Cost to borrow < 5%.

So, what is a no moat company that is benefitting from temporary tailwinds worth? They are trading at 22x P/E and 11x EV/EBITDA off HSD consensus revenue expectations for 2021. Although consensus is likely unreliable here, these multiples look too high. But, if you squint, that doesn't look terrible as they've traded at these multiples in the past. Guidance is nil, but while we can safely assume there's some surge of COVID-19 growth ahead in FY21Q1, their industrial demand is also likely to contract. Even if they are able to sustain some margin expansion from this episode, as they did in Q4, it will be short lived.

Putting aside the numbers, though, this is a thoroughly unsexy stock without the demand shock. Low single digit FCF yield, inconsistent revenue growth realistically in the normalized single digits at best, no moat, cannot ramp quickly because of facility constraints. At the conference where I first met them last year, they were so neglected that their outsourced IR was cold prospecting people at the registration line to try to fill 1-on-1's.

It is probably most fair to just say they should trade back closer to $10 when the hype dies down or they report bad numbers.

The company levitated on ebola sales in 2014 as well (https://www.wsj.com/articles/orders-for-protective-suits-flood-into-lakeland-industries-1414625473), but they didn't have to deal with a global recession back then. That episode did not result in them building a sustainable healthcare business thereafter, as they'd hoped. And investors quickly looked past the blip. Interestingly, management was similarly circumspect at that time. Not clear the ERP is quite there yet.

This writeup is on the shorter side, less detailed and does not rely on any alternative data. As some wise posters noted, being too clever with the data or exotic with the idea has had low correlation with good outcomes (something we're all too guilty of with our posts). To the detriment of the forum and ourselves, our best performing VIC idea by far would have been our membership application and we never posted it as an idea because we felt it was too ordinary and circumstantial. Hopefully, trying a different tack here will lead to better outcomes. 

Risks: 

- Has been nibbling share away from competitors and would have shown Q4 sales growth of 9% even w/o COVID-19

- No recession, bounce in oil and manufacturing (however, this would probably coincide w/ a cure)

- Positive operating leverage, pricing power in short term

- Buyback program supports share price

Catalyst

COVID-19 under control in x months

Pullback in petroleum sector comprising 20% of sales

Competition from larger players catches up

Prolonged recession