Description

SUMMARY

At $21, we believe shares of LAWS offer a compelling risk / reward dynamic. The US industrial economy appears to have stabilized, and with the company trading at ~11x LTM ebitda with a FCF yield of 7%, we believe shares offer reasonable valuation support at current levels, absent a further significant step down in the industrial economy. Downside also appears to be mitigated by strategic takeout potential, in part bolstered by a lead shareholder with a history of acquisitions in the space.

Upside looks promising. Even in a scenario where the industrial economy continues to be characterized by uninspiring capital investment, the company’s clean balance sheet and unfilled distribution network offer room for a doubling of ebitda margin over the near term. Should the company execute effectively on a recently emphasized initiative to drive growth via M&A, we believe shares could likewise double over the next two years.

All in, due largely to the fact that the company is in the final stages of a turnaround story, we believe LAWS offers investors a unique opportunity to invest in a high quality industrial distributor that is devoid of many of the characteristics that have dogged its larger peers for the last couple years.

COMPANY OVERVIEW

Lawson Products is an industrial distributor of MRO supplies. The company distributes 200,000 SKUs to 70,000 customers. It's largest end market is an auto repair business that constitutes ~20% of sales while a strategic accounts program comprises ~15%.

LAWS serves customers via a high-touch, customer-focused model of Vendor-Managed Inventory (“VMI”) in which company reps visit customer warehouses and plants to stock bins on a weekly or more frequent basis. Reps seek to maintain an optimal amount of small parts inventory to keep the shop running, cut down on unnecessary working capital for customers and reduce overall cost of procurement. This bin management program is similar in process to the Fastenal blue wall program, and it’s worth noting the VMI offering is at the forefront of the trends in the industrial distribution marketplace as distributors seek to get closer to and sticker with their customers. 

• Like its larger peers, they serve a highly fragmented market (~$25B as LAWS defines it) that fits the preferred many-to-many distribution industry structure. Minimal capex needs and high recurring free cash flow result in a high ROC business. The company has an impressive private label offering (60% of mix at a higher gross margin than third-party sourced products), which helps the company generate gross margins at the 60%+ range. However, unlike its larger peers as a result of an up and down corporate history that we’ll cover further below, it is operating well short of capacity and consequently generating subscale ebitda margins. Other positive company attributes include:
• o   Proven management team: Mike DeCata, CEO since 2012, comes from a distribution background having been President at Chef’s Warehouse (2006-09) and head of the eastern half of the US Grainger business (1997-2002)
• o   Clean balance sheet: ($2M net cash)
• o   Defensible variable cost driven operating model: strong ebitda performance +12% in ’15 despite oil and gas headwinds leading to sales down -4% for the year
• o   Cost conscious culture: driven by LEAN initiatives (Lean Six Sigma journey began 3Q13)

COMPANY HISTORY

Founded in 1952 by Sidney Port, Lawson has been publicly traded since 1970. Dr. Ronald Port, founder Sydney Port’s son, is the lead shareholder, has been on the board since 1984, Chairman since 2007 and owns 1.4M shares, or 16%. Family members together still hold 29% of shares outstanding.

Throughout the 1990s, the company’s core MRO business enjoyed mid to high single digits annual organic sales growth and double digit operating margins, peaking at 16% in 1994. In 2000, Robert Washlow, son-in-law of founder Sydney Port, took the helm guiding the company to an average operating margin around seven percent while completing five acquisitions. In 2007, Washlow stepped down and turned the reigns over to Tom Neri, the then current CFO. The company muddled through the financial crisis years. Then disaster really struck in the summer of 2012 as the company simultaneously embarked on a headquarter relocation, SAP installation and consolidated its back end operations from three distribution centers into one new, larger and more advanced distribution center in McCook, IL. Sales plummeted and goodwill and inventory were written down amid ineffective management and an inability to meet customer service obligations. Tom left the company in September of 2012.

Mike DeCata was hired in October 2012 and began the turnaround effort. Key milestones achieved include: converting the contractor based sales force to in-house full-time employees in January 2013; consolidation of inventory from three distribution centers to the new McCook, IL facility in 2Q13; successful execution on a $20M cost savings plan; and the successful onboarding of new sales reps, taking the total from 760 at 2012 yearend to 937 at 2015YE.

 The company has seen adjusted ebitda (adjusted for SBC due to large share price moves, severance and other turnaround related events) move from $10M in 2013, to $14M in 2014 and with another steady climb to $17M in 2015 even despite the oil and gas headwinds which directly impacted ~6% of their sales. Three analysts estimate 2016 ebitda to decline 8% year over year. Despite the analyst forecasts, we believe the company is forecast to resume the growth trend previously in place, especially if the industrial economy is indeed bottoming as much of the recent data seems to indicate.

THE OPPORTUNITY

The investment opportunity lies in the company’s ability to meet its two principal goals of filling its unused distribution center capacity and leveraging its existing scale to grow cash flows and expand ebitda margins. 2015 ebitda margin was 5% and compares to the company’s goal of 10%. The McCook facility holds capacity for expansion to a $400M annual sales run rate, which is quite a bit of runway from FY15’s $276M. LAWS cites three principal growth drivers:

1.       Grow sales reps

·         Rep count was 937 at 2015YE

·         Management has communicated a target of 1,100 reps (prior peak was 1,600)

·         Sales reps are said to typically approach breakeven levels in the 12 – 18 month time horizons and approach the corporate average around 3+ years

2.       Drive sales rep productivity

·         Productivity (sales per rep per day) was $1,148 in Q1

·         This figure is temporarily depressed due to macro softness and the bolus of 110 greenfield rep adds in 2014; it compares to the $1,379 figure from 2013 which seems a reasonable near term goal as reps begin to scale the maturation curve

·         Industrial production growth would improve the existing market growth, but is not required for a successful investment; however, continued or increasing negative industrial production levels would be a deterrent to the company’s ability to drive earnings and increased cash flows

3.       M&A

·         LAWS has now done a total of three small deals (one in September 2015 and two more since March 2016); as the company perfects the integration process it is likely to do more and larger deals

·         Deals can be highly accretive as the company is effectively buying mature reps and folding them into their operations; it’s akin to buying a greenfield/startup rep who is already operating at the mature rep average of $400K per year

o   Significant cost synergies exist as the acquired company operations fold into existing Lawson operations or are eliminated entirely

o   Acquired reps can sell the Lawson private label product line at a higher GM than their prior lines

o   SKU assortment expansion creates additional sales opportunities for acquired reps

CURRENT OPERATING ENVIRONMENT

A few words on the current operating environment are probably useful given the recent struggles of LAWS’ larger peers. The bigger players have been facing a number of headwinds, many cyclical and some arguably secular. Some of the causes are interrelated but include limited inflation/commodity deflation, oil and gas related weakness, gross margin headwinds, industrial/capital spending malaise, expansion into less profitable business and customer mixes, capacity constrained back ends and an inability to leverage recent company investments given the soft macro environment. To be sure, Lawson shares the same operating environment and isn’t immune to these factors.

However, three factors have come together that have allowed LAWS to show financial results that are quite differentiated. The first and most critical is that the company is in a dramatically different stage of its life cycle. In short, because the company has only recently rightsized itself and is operating at such low capacity levels, many of the easy, first-order operational improvements (read: low hanging fruit) are only now being effected. Thus, incremental sales dollars fall easily to the bottom line. Second, a 60% mix of company sourced private label products on low dollar value, small parts inventory items serve to obfuscate pricing transparency on items that are not overly important on a per part, per dollar level in the first place. Finally, the company’s largest single end market is the steady, underpenetrated and highly fragmented auto repair/body shop business (at ~20% of the mix) where the company has achieved stable, mid-single digit type topline growth in recent history.

VALUATION / RETURN

Today LAWS trades at $21, or 11x LTM ebitda; 10X our current FY17 ebitda estimates implies a $27 share price, or a 29% near term potential return. Oher quick notes:

• -          The company’s closest peer, formerly known as Barnes Distribution North America, was acquired in 2013 by MSM for 13x ebitda (excluding tax synergies).
• -          The 10% ebitda margin and $400M run rate imply close to $2.00 in earnings power, which with effective M&A to expedite the path towards these goals, looks achievable by FY18 and suggests a doubling in share values is realistic over that time frame.

RISKS

• -          Further industrial or economic weakness
• -          Deflation
• -          Strong dollar (spurring both factors immediately above)
• -          Operational missteps

Disclaimers: The views expressed herein are for informational purposes only, and are not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision for any purpose. The author makes no representation as to the accuracy or correctness of the information contained herein. The information and the views contained herein are provided as of the date this summary was posted and present the views of an investment firm that currently holds a long position in the company’s securities. The author has no obligation to update any of the information provided herein. The author reserves the right to decide to purchase, sell, or engage in any other transactions involving the company’s securities as it deems appropriate based on a number of factors. These factors may include its ongoing evaluation of the company’s financial condition, business prospects, conditions of the stock market, general economic and industry conditions and other relevant factors. Past performance is neither indicative nor a guarantee of future results. 

Catalyst

• Earnings beats. These look quite achievable given the current projected topline growth of 1% and year on year ebitda contraction of -8% in 2016. Already announced M&A itself looks likely to contribute 1-2% to topline in FY16 and does not look to be in estimates. Additionally, the company has easy comparisons in the back half of the year, thanks to the oil and gas softness of last year.
• -          M&A takeout by a strategic or PE. See above regarding Barnes’ purchase by MSM. Also, note that large shareholder Luther King owns nearly 20% of the company and has a history of acquiring middle market industrial distributors (IDG in 2008). On 12/3/15 this shareholder filed paperwork indicating it had placed ownership of all of its shares in a special purpose vehicle named PDLP Lawson, LLC, potentially indicating future action.
• -          Greater investor discovery and enhanced trading liquidity. Currently only three sellside analysts cover the name. Hand in hand with greater attention comes potentially greater liquidity, often an issue for microcaps.
• -          The future M&A opportunity does not appear to be a focus and is quite significant as a way to further expedite the company’s dual goals of hitting its 10% ebitda margin target and filling the McCook facility capacity.