Description

LAWS is undergoing a transformative transaction from a sleepy, illiquid, sub-$500mln market cap with limited avenues to deploy capital to a $1bln+ specialty distribution holding company with a heavily invested majority shareholder who is looking to triple EBITDA over the next few years between organic growth and M&A. 

Historically, LAWS has been an attractive growing business that has struggled to gain an appropriate valuation as a result of its small size, minimal investor relations and sell-side coverage (only 2 small analysts covering), and limited ability to appropriately leverage its balance sheet via accretive M&A (net debt constantly near 0).

This transaction solves those problems by taking LAWS from a company that was forecast to do $36mln of adj EBITDA in FY 2021 to a company that is projected to do $108mln of adj EBITDA.  Furthermore, in a 5/17/21 13D, 48% shareholder Luther King Capital Management (LKCM) laid out a path to "accelerate cash flow growth over the next 5 years to approximately $300mln" through a combination of continued organic growth and accretive M&A as the three businesses continued to roll-up players in their respective end markets.  As a holding company, LAWS expects to have a large M&A pipeline that should allow for highly accretive deployment of capital.

Based on the achievement of that goal, I see a path for LAWS to trades at ~$140-170 per share which would be a 3-3.5x return from current levels and a ~30-40% CAGR over 4 years.  For nearer-term numbers, LAWS currently trades at ~10.6x FY 22 EBITDA, a discount to its pre-deal and merger valuation of ~13x.  At 13x 2022 EBITDA, LAWS would be worth $66 per share, a 35% return from current levels.

Transaction

On 12/29/21, LAWS announced a strategic combination with Gexpro Services and TestEquity, portfolio companies of LKCM.  Owners of Gexpro and TestEquity (LKCM and company management) will receive 7.0 and 3.3mln shares of LAWS respectively.  Additionally, they will have the opportunity for an earnout of 1.0mln and 0.7mln shares respectively based on accretion from acquisitions completed within 120 days of the transaction close and organic EBITDA growth in FY 22.

LKCM chose to solely receive LAWS stock for the contribution of these and will increase its ownership in LAWS to 64-65% depending on the results of a potential share earnout.  Management will own 9-10% of the holding company.

This transaction creates a holding company with 3 different verticals.  The verticals will be able to cross-sell product portfolios and customer bases and gain leverage through shared G&A.  The 3 companies would share skills including TestEquity's strong digital strategy and Gexpro's global sourcing capabilities. Customer facing activities would remain under existing leadership teams and there would be minimal overhead at the holding company level.

The enterprise values for the transaction were allocated at equal EV/21 EBITDA multiples of ~13.17x.  Publicly stated comps from the merger analysis were Applied Industrial Technologies, Fastenal, MSC Industrial Direct, W.W. Grainger, Watsco, and Wesco.  Their trading range was 9.4 to 26.9x 21 EBITDA with a mean of 16.3x and median of 15.4x.

The transaction is subject to the approval of a majority of LAWS disinterested shareholders at a stockholder meeting and is expected to close in Q2 2022.

As this transaction progresses, the company should expand their investor relations effort in an attempt to better tell the new story. It is also possible that we will get increased sell-side coverage given the banks that worked on this transaction and the potential for future M&A from the holding company.

Valuation and Projections

Assuming the payment of the earnout shares, LAWS has 21.3mln shares for a $1.05bln market cap at $49.01.  The company had 251mln of PF net debt at 9/30/21 and has committed to acquisitions for $62mln as of the proxy for adjusted net debt of $313mln (2.9x).  FY 22 adjusted EBITDA is expected to be ~129mln or 10.6x.

As part of the proxy, LAWS, TestEquity and Gexpro management put together financial projections until 2025 which include TestEquity and Gexpro current acquisitions that have not closed yet.  As we can see, the company expects 8% revenue growth and ~18% growth in adj EBITDA to 2025.  It should be noted that Unlevered FCF includes growth capital expenditures as well as working capital outflows due to revenue growth.

Upside

Near-term upside comes from LAWS returning to historic trading multiples.  The merger valued LAWS at 13.2x which was below median/mean peer valuation of 15/16x.  If we value LAWS at 13x FY 22 EBITDA, it would be worth $66 per share, or 35% upside.

However, more interesting upside comes from the long-term valuation.  In their letter to the board attached to the May 2021 13D LKCM laid out a path to "accelerate cash flow growth over the next 5 years to approximately $300mln" through a combination of continued organic growth and accretive M&A.  The proxy lays out a path to over 200mln of EBITDA on an organic (post 2021 acquisitions) basis.  Bridging the gap with further acquisitions to get to $300 mln paints a path to ~$140 per share at keeping the multiple constant (13x) and ~$170 per share with multiple expansion peer levels (15x).  With a 4 year time horizon, that would be a ~30-40% CAGR.  While this analysis is obviously not precise, it shows the potential for significant returns based on the publicly disclosed strategy for LAWS. Furthermore, I only assume the company gets to 195mln of organic EBITDA in 2026 as opposed to over 207mln of organic adjusted EBITDA forecast in the proxy.

Downside

For downside, if we assume the company is unable to grow from 2021 EBITDA and the multiple shrinks to 10x, then the stock would be worth ~$39 or 20% downside.

That valuation would also be under 1x 2021 revenues which seems low for a multi-legged industrial company with attractive growth prospects, solid profitability, a comfortable balance sheet and a strong competitive position in high-retention businesses.

Further Information

Business Descriptions

LAWS is a provider of vendor managed inventory (VMI) of Class C parts for maintenance and repair industry.  VMI is a heavily service intensive business as LAWS 1,200 person salesforce visit their 90,000 customers frequently (daily/weekly) and manage their inventory needs for various high-turn, low $ consumables (ASP $0.90). 

Gexpro Services is a leading provider of VMI and supply chain services to manufacturing OEMs.  Gexpro specalizes in engineered commodities and complex manufacturing processes and helps these OEMs by providing lower procurement costs and total cost of ownership for Class C parts.  Gexpro serves almost 1,800 customers in 35 countries with 74% of the customer base under a contract or long-term agreement.  Gexpro works with ~2,250 suppliers for 60,000 parts. 

TestEquity is the leading independent North American Test and Measurement Distributor for the aerospace, defense, automotive, electronics, education and medical industries as well as VMI for the niche electronic manufacturing industry.  The company serves over 30,000 customers and 100,000 locations in the US, CAN, MEX and UK.  TestEquity has 70 highly technical sales representatives and a very strong eCommerce offering.  Key suppliers include Keysight, Tektronix, Keithley, Kester, Desco, and Chemtronics and purchases over 90,000 products from ~2,500 suppliers. 

These companies share similar business DNA and are all high ROIC businesses with market leadership in their core markets. 

1. Service-Based Business

1. LAWS- "We don't chart our customers sepately for the services, its built into the price of the product, but clearly, there's a value that they are willing to pay high 50%, low 60% from an overall margin standpoint."

2. GEX- Former employees noted that competition is "Service, 100%."

3. TE- Business is based on the technical capabilities and dedicated support of their highly trained sales force.

2. Low churn, high purchase frequency businesses- 90+% annual retention

1. LAWS management- "about 90% revenue retention and accelerating so we are very, very sticky.  Once we have a customer, we tend not to lose that customer."

2. GEX former employee- "once you've established what we call a vendor-managed inventory program, you're extremely sticky."

3. TE former employee- "once you're embedded in a big aerospace supplier…. They'd rather add to that program rather than move away from it."

3. Leadership in fragmented markets

1. LAWS competitor employee- "The top three/four would be Kimball, Lawson, Grainger and Fastenal."

2. TE former- Q- "Would you consider TestEquity to be the leader on the distribution side?" A- "Yes, I think  so, number one".

Financial Structure

As part of this deal, LAWS has a commitment letter from JPM for a $450mln financing agreement consisting of a $250mln term loan and a $200mln revolver. Covenants are minimum interest coverage of 3.0x and Total Net Leverage <4.0x with the ability to increase net leverage up to 5.0x for 1 year after an acquisition >$75mln.  As a result of this attractive facility cost of debt, future acquisitions have the potential to be highly accretive and the company is saving almost $4mln per annum from its pro-forma 2020 interest expense.

M&A

One of the key reasons for this transaction is to expand the M&A pipeline.  LAWS has completed 7 acquisitions since 2015 but still has barely managed to stay in a net debt position. Historical LAWS acquisitions like Partmaster in 2020 have been highly accretive.

Going forward, the company worries that LAWS acquisitions will become more challenging due to the limited number of meaningful targets in the MRO market.  TestEquity and Gexpro have a larger number of potential M&A targets which should allow for accretive uses of capital going forward.  The company notes that it has a "robust acquisition pipeline with active negotiants with several accretive targets likely to close in the next 6 to 18 months".  Former employees of TestEquity and Gexpro have supported this notion of an active M&A pipeline for those businesses

LKCM has been a LAWS shareholder for over 9 years and will only receive shares of LAWS in this transaction, significantly increasing their exposure to the company. Bryan King will act as the LAWS Chairman on an unpaid basis going forward so his only path to returns here is through share price appreciation.  LKCM will also not receive financial compensation for oversight activities and other efforts. 1/3 of LKCM Headwater's capital came from the investment team, affiliates and related parties so they are highly incented to make this deal work.

LKCM also has significant expertise in investing in distributors as you can see from the image below.  Here's a quote from a senior, former TestEquity employee about Bryan King. 

"Bryan knows these industries; I mean, you can get in conversations with Bryan and it'll last hours, because he's reazlly good at talking about midsized B2B distribution.  I mean he just knows it really well."

In the press release announcing their sale of Gexpro Services to LKCM, Rexel CEO Patrick Berard noted:

"Under LKCM Headwater, Gexpro Services will become core and will benefit from a new owner with extensive specialty, value added distribution experience"

Sources

5/17/21 13D

12/29/21 Press Release

12/29/21 Presentation

1/14/21 Prelimary Proxy

Expert Calls

LAWS filings and earnings calls

Rexel Press Release 12/29/21

Catalyst

Organic EBITDA growth

Accretive M&A

Increased IR effort post holding company transaction

New sell side analyst coverage?