LSI Industries: Progress Despite The Volatility

Nov. 11, 2019 10:45 AM ETLSI Industries Inc. (LYTS)LGRVF1 Comment
Carlton Getz, CFA profile picture
Carlton Getz, CFA
2.74K Followers

Summary

  • LSI's new management is executing on its objectives and exceeding our initial expectations.
  • The potential sale of the North Canton manufacturing plant would provide additional funds for debt reduction.
  • The company's free cash flows continue to support the dividend, debt repayment, and investment in the business.
  • The focus going forward will shift to management's ability to grow revenues and improve gross and operating margins.
  • LSI remains attractive for risk tolerant investors focused on the company's long term potential.

LSI Industries (NASDAQ:LYTS) has proven a challenging portfolio position during the year since our initial article on the company. The view that the company was undervalued was perhaps rather early as the company’s shares continued to decline well into the year. In addition, our projection of annual operating results proved quite wide of the mark as our optimism in the company’s ability to stabilize the lighting segment last year was mistaken. Nonetheless, despite the interim challenges, we maintain our broader view that the company has significant potential (especially under current management), remains undervalued, and presents an attractive opportunity for more risk tolerant investors regardless of whether the company remains an independent operator or is ultimately acquired by a larger lighting manufacturer in the consolidating lighting industry.

In this annual update, we review our prior estimates, actual results, and current projections in the context of the company’s most recent quarterly financial report.

Inaccurate Projections

First, it’s necessary to recognize that the financial projections presented in our initial article on the company a year ago proved inaccurate by a wide margin even on an adjusted basis excluding impairment and restructuring charges. The primary driver of the difference was the sharp decline in lighting segment revenues over the course of the year versus our projection of stabilization or even modest growth. It’s difficult to assess how the company’s gross and operating margins would have been impacted had revenues tracked more closely to our expectations, but in any event the company’s actual gross margin fell below our low case projection while the company’s SG&A expense as a percentage of revenue matched our high case projection. In essence, the company underperformed our expectations on gross margin and outperformed on operating expenses. The result was that while the company’s operating margin fell short of our expectations, the shortfall was not quite as large as could have been the case. The much higher than anticipated interest expense related to higher interest rates on the company’s variable rate debt contributed to the gap.

However, the first quarter results suggest that some of the assumptions we had made for the prior year may be more reasonable for the current year. Revenues are growing, gross margins have improved, operating expenses remain under control, and the significant reduction in debt in combination with lower benchmark interest rates (at least in the near term) will reduce interest expense for the year.

Accordingly, we’ve updated our projections for the current year (excluding as before nonrecurring items such as impairments, restructuring costs, etc.) based on the first quarter results. The current year projection is, roughly speaking, close to a hybrid between our earlier low and middle outcome scenarios, as presented below:

Source: Winter Harbor Capital

Clearly, there is a wide range in our earnings per share estimates which reflects one of the primary challenges in creating financial projections for the company – the high sensitivity of earnings per share to relatively small changes in the gross margin and operating expense ratios. A change of a tenth of a percentage point in either metric, for example, changes the company’s earnings per share by a penny. In our view, this sensitivity tends to obscure rather than illuminate the company’s financial position and potential.

Indeed, we don’t believe earnings per share is the correct metric on which to focus as the company proceeds with its turnaround efforts. Instead, we are more interested in the company’s operational performance (especially trends in gross and operating margins) as well as the cash flow generated by the business as this drives the company’s ability to reduce debt, invest in growth, and pay dividends in a challenging business environment.

The volatility in earnings per share, largely due to the company’s currently narrow operating margin, does not appear as significant when considering the company’s projected earnings before interest, taxes, depreciation, and amortization (EBITDA) and free cash flows. By comparison, the company’s operating results appear far more consistent. In terms of EBITDA, we presently project this figure ranging from $12 million to $18 million for the current year while we project free cash flows of between $8 million and $11 million. A change of a tenth of a percentage point in gross margins or operating margins for both metrics results in a change of roughly $245,000. The ranges are still quite large given the degree of uncertainty but the implications are quite different. The key takeaway based on these figures is that even under a low case scenario the company’s free cash flows more than support the present dividend as well as debt repayment even after considering capital expenditures. In other words, only a significant deterioration in the business would place the company’s debt commitments or dividend at risk.

Ultimately, of course, we will see whether our projections for the current year prove more accurate than those for last year amongst the company’s ongoing transition.

Incremental Improvements

LSI continues to take steps towards streamlining its operations, eliminating underperforming assets, and improving operating performance. The announcement of the closing of the sale of the company’s New Windsor, New York, manufacturing plant for cash proceeds of $12.4 million was a welcome development. The use of essentially all of the proceeds to reduce debt – one of our larger concerns given the company’s potentially uneven free cash flows and high dividend yield – will not significantly boost earnings per share due to the low applicable interest rate but nonetheless reflects good judgment on the part of management. The annual savings of around $500,000 in interest expense alone will boost results but the projected annual reduction in operating expenses of $4 million will have a far greater impact.

Management is also exceeding our expectations in other areas where we had expected more incremental improvements, especially in the realm of working capital. The company’s net working capital declined by around $10 million year over year for the first quarter largely due to a significant reduction in inventory as well as reductions in accounts receivable and other current asset items. The reduction in inventory is notable despite lower revenues in the lighting segment as the company improved efficiencies without experiencing a buildup in unsold inventory. In addition, the company suggested that further reductions in working capital – notably accounts receivable and inventories – could be possible. In the event the company can indeed push days sales outstanding and days inventory into the range of 55 days, the company could theoretically squeeze an additional $3 million to $8 million out of the working capital account. In our view, this is an aggressive though not impossible goal and every additional dollar would be a welcome outcome for a company which has struggled with operational consistency and efficiency in the past.

The improvement in selling, general, and administrative expense as a percentage of revenue despite the revenue decline is another positive sign of management’s efforts to improve the business. Gross margin, on the other hand, was disappointing although a portion of the decline was related to manufacturing plant closing costs and, likely, the need to eliminate excess inventory. The company’s first quarter gross margin result suggests incremental improvement, however, at an adjusted 24.9% versus an adjusted 23.2% for the prior year. Ultimately, improving gross and operating margins will be the indicator that management has gotten the company on the right track and the turnaround efforts are yielding results.

On the whole, we’re seeing the incremental progress we expected to see with the company’s new management. The individual steps may prove uneven at times but the overall trajectory is, so far, promising.

Manufacturing Consolidation

In addition to the sale of the company’s manufacturing facility in New Windsor, New York, we were expecting further consolidation of at least one more of its smaller remaining manufacturing facilities, in particular the company’s smallest manufacturing facility which is located in Columbus, Ohio. The business still has excess capacity and while the proceeds from a sale of such a property would yield significantly less than the proceeds from the far larger New Windsor plant, any additional influx of cash would be beneficial.

Instead, management’s focus is instead on the company’s North Canton manufacturing plant located further to the northeast outside Akron, Ohio. North Canton is owned by the company and currently the company’s third largest facility at just over 212,000 square feet – roughly 25% larger than the recently sold New Windsor property. The company is reportedly targeting a reduction of at least 70% of the square footage – the equivalent of nearly 150,000 square feet – leaving around 62,000 square feet of manufacturing and distribution presumably to be relocated to other facilities. A reduction in capacity of this scale surprised us and indicated there is more slack than we’d anticipated in the company’s manufacturing base.

In fact, further research on the North Canton property indicates that it has actually been listed for sale with commercial brokerages since May at an asking price of $8.75 million. A sale of this facility and transfer of the remaining operations to other facilities, possibly including the company’s expanded plant in Independence, Kentucky, would provide quite a bit of additional financial flexibility. James Clark, the company’s chief executive officer, was predictably vague on first quarter conference call about the exact future of the plant but suggested additional details could be forthcoming within the next few quarters.

Lighting Segment Concerns

The lighting segment, as noted above, performed poorly in the prior year with revenues declining by slightly more than $25 million, or 9.8%, offsetting decent revenue growth in the company’s graphics segment. The decline was disappointing in that we had expected the company to at least maintain if not slightly grow revenues in the lighting segment over the last year resulting in our revenue projections being far too optimistic. The scale of the lighting segment makes this segment critical to the success of the company despite ongoing focus and growth in the smaller graphics segment and, in some respects, is a key component to our view on the company’s eventual potential as an acquisition target. The performance of the lighting segment is thus important to our overall view on the company’s potential.

The first quarter report offered a glimmer of hope in that lighting segment revenues actually grew on a year-over-year basis by about 3%, suggesting the company has at least for the moment arrested the decline. In addition, segment operating margins expanded thus boosting overall performance. We suspect that a portion of last year’s decline may not be directly associated with challenges in the company’s end markets, referenced in the company’s financial reports as the primary driver, but instead to changes implemented by the company’s new management to clear inventory and focus on more profitable business at the expense of less desirable lines. We would, in fact, be quite accepting of such changes despite the short term impact as a conscientious decision to streamline the lighting segment.

In any case, it remains to be seen whether the first quarter performance can be maintained much less expanded in future quarters and this will be one area on which our attention will be focused going forward.

Acquisition Potential

We continue to believe the company represents a compelling – and still quite inexpensive – acquisition opportunity in the consolidating lighting manufacturing industry. Legrand (OTCPK:LGRVF) remains our preferred acquirer as the company has continued to purchase well known independent brands in the United States. Earlier this year, Legrand acquired Kenall, a well-regarded manufacturer of light fixtures used primarily in more specialized applications with extensive product lines serving medical, prison, and similar environments requiring specialized lighting. The Kenall acquisition reflects the company’s ongoing preference for higher end manufacturers (including OCL Lighting and Pinnacle Architectural Lighting) but still leaves the company’s product portfolio devoid of the commodity fixtures necessary to provide a complete lighting package for typical building projects. LSI’s product line of more common commodity indoor and outdoor lighting products would, in our view, inexpensively and quickly fill out the lighting portfolio Legrand is building at a rock bottom acquisition price. The potential for significant cost savings in any acquisition only adds to the allure.

Moreover, consolidation across the industry continues, most notably with Eaton’s (ETN) sale of its Cooper Lighting subsidiary to Signify (OTCPK:PHPPY), formerly known as Philips Lighting.

Conclusion

It’s been a rough ride since our last article as the company’s share price continued to fall – ultimately bottoming just below $2.50 per share. We used the decline as an opportunity to add further to our holdings in the company based on our view that the company’s new management has the experience and expertise to execute a turnaround with the view towards an eventual sale of the company.

In this regard, our core views remain essentially unchanged from our last article. The significant reduction in working capital, the apparently ongoing consolidation of underutilized manufacturing and distribution facilities, as well as the repayment of debt with cash proceeds all indicate that management is executing on its objectives. The proverbial lower hanging fruit being the easiest to reach, however, our focus will remain on revenue performance in the company’s operating segments as well as the company’s gross and operating margins to evaluate management’s effectiveness over the longer term. So far, we remain confident that management will continue to execute going forward.

Nonetheless, LSI Industries remains a work in progress. A full reversal of the company’s trajectory and any return to growth will take time and patience will be warranted in the process. The company’s new management is focusing on the operational challenges the company faces and taking specific and discernable actions which reflect the seriousness of those challenges. In addition, even if the company closes only a portion of the performance and valuation gap with its larger competitors, our valuation continues to suggest a significant margin for improvement in the share price going forward. In the meantime, the company’s free cash flow continues to support the current dividend yield while also allowing for ongoing debt repayment and investment in the business.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

This article was written by

Carlton Getz, CFA profile picture
2.74K Followers
The author writes on behalf of Winter Harbor Capital, a private fund, and oversees private portfolios for individual and institutional clients. The author founded an investment company in 1995 with the view that a value oriented investment philosophy focused on intrinsic value and long term opportunities could generate superior absolute returns over time, leading to portfolios with unusual investment tenure sometimes exceeding 10 years. In addition to stints in micro and small capitalization research at Wasatch Advisors in Salt Lake City and in private banking with J.P. Morgan Private Bank in New York City, the author is a registered investment advisor, licensed professional engineer, and graduate of the Darden School at the University of Virginia.

Disclosure: I am/we are long LYTS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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