Lawson Products

Source: Lawson Products Corporate Brochure

Disclaimer: The content below is for educational and entertainment purposes only and should not be construed as investment advice or a recommendation to buy or sell any security. I own shares of Lawson Products (NASDAQ:LAWS).

Summary

Lawson Products (NASDAQ:LAWS) is a niche industrial distributor of maintenance, repair, and operations (MRO) supplies. The business model is compelling and management is executing well in a difficult environment. Lawson is currently under-earning due to cyclical softness and growth investments obscuring steady-state earnings potential. I believe the stock has ~40%+ upside potential as revenue growth and margins begin to increase in the next couple of years.

Business Description

Lawson sells and distributes a wide range of MRO consumables (e.g. fasteners, cutting tools, chemicals, etc.) and specializes in Vendor Managed Inventory (VMI). The primary value proposition of VMI is a high-touch service component as Lawson sales reps visit customer sites weekly or biweekly to maintain sufficient inventory levels for these consumables. The reps essentially act as outsourced supply chain managers ensuring customers don’t run out of critical supplies needed to operate their businesses.

VMI is a ~$20–25 billion niche within the larger $150+ billion MRO industry. Despite low single digit market share, Lawson Products is one of the leaders in the space as the market is very fragmented with thousands of mom and pop competitors.

Although industrial distribution does not sound like a very sexy industry, I find Lawson’s business model and market opportunity very compelling. Below are some key advantages:

  • High-touch service offering: Distribution sounds like a commodity industry where the low-cost provider will ultimately win in a race to the bottom. However, due to the high level of service Lawson reps provide, customer relationships are actually quite sticky. Reps are on customer sites regularly (often weekly) and develop relationships with supply managers. This results in sub 10% annual customer churn, which is often the result of customers being acquired or going out of business. The service component also significantly mitigates the potential “Amazon threat” of disintermediation that many distributors face.
  • Low cost, high value products: Lawson provides customers with a compelling value proposition to help maintain sufficient inventory levels of consumables. It is very expensive for customers to run out of these products, which are often relatively low-cost compared to overall costs. For example, not having enough required fasteners can shut down a manufacturing line and lead to hefty express shipping costs. The low cost nature of the products also helps maintain price stability.
  • High private label mix: ~60% of the 300,000 products Lawson sells are private label. Additionally, these tend to be highly engineered, premium products that perform better than many of the branded competitive products. The high private label mix helps drive gross margins in the ~60% range and customer loyalty since switching distributors may result in alternative products.
  • Fragmented competitor set: Lawson rarely runs into the larger industrial distributors (e.g. Grainger, Fastenal, MSC Industrial, etc.) from a competitive standpoint. Instead, they typically compete with smaller mom & pop shops. The industry is very fragmented and is potentially ripe for consolidation.
  • Low customer concentration: In 2015, Lawson had ~70,000 customers with the largest comprising ~2% of sales. Most customers are regional or local but Lawson has been building a national account base as well. The many-to-many supply-demand dynamic within VMI allows for pricing and gross margin stability.

Company History and Evolution

Lawson Products was founded in 1952 and has a long-standing brand based on a service oriented value proposition and high quality products. The company operated profitably in the 1990s and 2000s but performance deteriorated coming out of the Great Recession due to (i) poor management, (ii) years of under-investment, and (iii) a $30 million settlement with the US Attorney’s Office related to sales reps providing improper gifts to purchasing agents, including government officials.

Lawson has restructured the business over the past six years and is now in a position to return to growth and margin expansion. The turnaround focused on five key initiatives, listed below:

Leadership changes

Michael DeCata (LinkedIn bio) was hired as President and CEO in September 2012. His background is impressive with both financial and operating experience. He previously worked at Hamilton Robinson Capital Partners (PE shop) and led a turnaround as President of The Chefs Warehouse (specialty food distributor). His prior experience also includes positions at United Rentals, Grainger, and General Electric giving him first-hand experience with roll-ups, industrial distribution, and operational excellence.

Ron Knutson (LinkedIn bio) was hired as CFO in November 2009 and has continued to take on more operational-related responsibilities since joining the company. Previously he was CFO of Frozen Food Express Industries, VP of Finance at Ace Hardware, CFO of Mascal Electric, and senior manager at KPMG.

Michael and Ron have made substantial progress since joining Lawson and have navigated the company through the below restructuring initiatives. I have also been impressed with their long-term perspective and conservative approach, seemingly striking the appropriate balance between growth initiatives and cash flow / liquidity.

Significant infrastructure investments

In August 2012, Lawson opened a newly built, custom-designed distribution center (DC) in McCook, Illinois. Throughout the remainder of 2012 and 2013 the company consolidated their distribution network and transitioned customers from three smaller Illinois DCs to McCook. The 305,000 square foot facility features state-of-the-art technology and was designed for scalability as Lawson grows its customer base. The facility allows Lawson to purchase products from suppliers in bulk for delivery to McCook. Inventory is then either stocked or delivered to one of four regional distribution centers, located in Georgia, Nevada, New Jersey, and Ontario. Lawson and its customers have seen many benefits including increased fulfillment rates, enhanced product availability, and greater shipping options given the facility’s proximity to a UPS hub. The revamped distribution network can handle ~$100 million in additional revenue before maxing out capacity.

In August 2011, Lawson replaced outdated, legacy information systems with a comprehensive SAP Enterprise Resource Planning (ERP) system. The new technology provides increased visibility with regards to daily sales and profitability trends and allows management to use information as a competitive advantage. However, it’s important to note that during the transition period in 2011 and 2012 productivity suffered while bugs were worked out and processes changed.

Lawson Products spent ~$40 million in over-due capital investments from 2010 through 2012, the majority of which went towards the McCook facility and the ERP system.

Realigned sales force from independent agents to company employees

As was common in the industry, Lawson operated for decades with an independent agent sales force model. Sales reps are one of Lawson’s most valuable strategic assets and the contractor model led to some misaligned incentives and unwanted behavior. For example, in 2008 the company was forced to settle with the U.S. Attorney’s Office and pay a $30 million fine related to reps improperly providing gifts to purchasing agents, including government purchasing agents. Beginning in 2009, Lawson began to redefine the expectations of their reps and the company converted all U.S. agents to employees on January 1, 2013.

Despite a temporary reduction in the sales force, the transition has had many benefits. Lawson can now invest more in training and development, management can share market segmentation and other corporate analyses with reps, and new company technology is more widely adopted by the sales force. For example, Lawson rolled out Bluetooth scanners in early 2015 to help reps scan products and the adoption rate was high.

Additionally, upon DeCata’s arrival as CEO, the senior management team now accompanies sales reps on customer visits once per month. This allows leaders within the company to (i) have a better and more subtle understanding of the business, (ii) see opportunities for process improvements, and (iii) understand evolving needs of both sales reps and customers.

Non-core business and asset divestitures

From 2010–2014, Lawson monetized non-core business units and assets to fund the capital investments described above. In total, the company received over $60 million in cash and also re-focused all efforts on its core MRO consumables business. See Exhibit A for a more detailed description of the dispositions.

Cost savings and operational improvements

Lawson announced a restructuring in June 2012 to reduce its cost structure, improve operating efficiency, enhance revenues, and improve liquidity. The company eliminated 11% of its workforce, rationalized inventory, and reduced other miscellaneous costs. In aggregate, Lawson expected ~$20 million of annualized cost savings. Additionally, the company halted dividend payments in July 2012 and instead now reinvests all capital back into the business.

Subsequent to DeCata’s hiring, Lawson rolled out a Lean Six Sigma initiative in 2013. More than 70 employees have received training and various functional areas have been challenged to identify bottlenecks and drive waste out of the process. Some functions that have seen benefits include onboarding sales rep, accelerating new sales rep productivity, strategic sourcing & supplier relations, special order procurement, and warehouse efficiency. The focus on operational efficiency has led to a tremendous improvement in key operating metrics. For example, order fill rates have improved over 50% and back orders reduced by more than 80% since 2012.

Management has shown an aptitude for “continuous improvement” and they relentlessly search for additional efficiencies and cost savings. A few weeks ago the company announced they will further streamline their distribution network and close the New Jersey facility. McCook will assume ~80% of these customers with the remaining transitioning to the Georgia DC. Management expects the closure to result in annual savings of ~$1.2 million.

Earnings Power

Below is a summary of Lawson’s financial performance:

Sources: Company filings and presentations, Barrington equity research, Steve Vafier estimates

A few questions arise when reviewing recent financials. First, you may be skeptical that gross margins are sustainable, particularly when benchmarking against the industrial distribution comps in the ~30–40% range (See Exhibit B). However, I believe the industry leading gross margins are sustainable and demonstrates Lawson’s service-oriented value proposition. For instance, VMI competitor Barnes Distribution North America (described in more detail below) had ~60% gross margins in 2012 before being acquired. It’s also worth noting that higher margin private label products comprise ~60% of Lawson’s sales, which is significantly higher than other industrial distributors. For example, Grainger and Fastenal have ~22% and ~12% private label mix, respectively.

You may also wonder why recent financial performance has continued to languish despite the fact that the restructuring was largely complete by year-end 2014. Lawson is simply under-earning, primarily due to a cyclical slowdown and GAAP accounting requirements.

  • Cyclical slowdown: Lawson has faced a variety of cyclical headwinds the past couple of years, including (i) a dramatic slowdown from oil & gas customers, (ii) Canadian FX headwinds, and (iii) general MRO industry weakness. Sales directly to oil & gas customers comprised ~10% of the business a few years ago and has been cut in half resulting in a low-single digit percentage headwind to revenue. Canada makes up ~9% of Lawson’s business and therefore the strengthening US dollar has also resulted in a low-single digit headwind. Lastly, the industrial economy has been soft the past couple of years (See Exhibit C). If manufacturing customers are utilizing their machines and equipment less often, fewer repairs are required which decreases demand for MRO consumables. Exhibit D shows rep productivity by tenure over the past couple of years to hone in on the cyclical impact excluding the mix shift to newer, less productive reps.
  • GAAP accounting: Management is investing heavily in growth by hiring new sales reps. This will likely generate future market share gains and topline growth but it typically takes ~18–24 months before new reps are accretive to earnings. The company actually loses money in year one and 100% of those losses hit the income statement since the costs are primarily recruiting, training, and employee compensation expenses. Alternatively, you can think of each net new hire as a one-person acquisition. Lawson may spend ~$100K to hire and retain new reps but the return on investment is ultimately very attractive. If these losses for the ~70 net new reps hired in 2016 were capitalized instead of expensed, EBITDA would be ~$7 million higher, or ~2.5% of revenue. See Exhibit E for an illustrative example of hiring unit economics.

As a long-term investor, I’m not concerned by the recent income statement headwinds. The growth investments should ultimately benefit shareholders and I’m focused on through-cycle earnings power a couple of years out.

Revenue is driven by the size of the sales force and sales rep productivity. Although the hiring pace has been lumpy the past couple of years, Lawson has been organically growing the sales force ~7–8% annually. Sales rep productivity is also likely to rebound over the next couple of years as cyclical headwinds subside and newer reps mature. I expect the company to eventually get “sales per rep per selling day” back to the $1,300-$1,400 levels they were at in 2012–2014 (shown in the financial summary above).

Additionally, Lawson has recently started to make small acquisitions. Management has said they do not want to enter new business lines or expand beyond North America and therefore the targets are very similar to Lawson, just at a smaller scale. The main assets Lawson receives via these acquisitions are mature sales reps and their existing customer base. The acquired reps also have a chance to increase productivity post acquisition as they get access to Lawson’s private label products and their business is shifted into Lawson’s distribution network. As shown in Exhibit F, Lawson has made four acquisitions in the past 15 months and each one has been slightly larger in size. Management has indicated they wanted to be cautious to ensure the initial integrations go smoothly but eventually they plan to look for larger targets. As shown in Exhibit G, these tuck-in acquisitions have the potential to generate very high returns. Given Lawson is the largest independent player in VMI and they have net cash on their balance sheet, I believe there is a tremendous long-term opportunity to consolidate the industry. Although certainly not required for an attractive investment result, this would be the long-term compounder, home-run scenario.

In terms of profitability, management has set a 10% EBITDA margin target but they ultimately believe they can do better. For comparison, VMI competitor Barnes Distribution North America (described in more detail below) was operating at low double digit EBITDA margins at ~$300 million of revenue prior to being acquired in 2013. Lawson clearly has a ton of operating leverage as current EBITDA margins are in the mid-single digits but incremental revenue will flow through at ~25–30% margins. Additionally, the company can increase revenue by ~$100 million before maxing out capacity in their distribution network.

Below are illustrative sensitivity tables to help summarize potential 2018 earnings power. I have assumed the sales force grows at ~5% annually over the next two years. This will likely prove to be conservative given organic growth has been high-single digits the past couple of years and the company is also likely to make additional acquisitions.

Valuation Framework

It is somewhat challenging to come up with an appropriate valuation multiple target for Lawson. The publicly traded industrial distributors generally compete in the non-consumable space and are therefore more focused on product breadth and delivery speed vs. Lawson’s service-oriented approach. I actually prefer Lawson’s business due to that distinction — the revenue is more recurring in nature and there is less risk of market share losses and/or declining margins due to online disintermediation. Despite the caveats, industrial distribution trading multiples are shown below:

Industrial Distribution Public Comps

Source: CapitalIQ as of 12/24/2016

However, current multiples appear lofty compared to historical averages. Here are the multiples over time, which have averaged ~9–10x forward EBITDA and ~17–18x forward P/E.

Historical Industrial Distribution Multiples

Source: CapitalIQ as of 12/24/16; Median multiples include GWW, FAST, HDS, MSM, WCC, AIT, and DXP (as available)

Perhaps the most relevant comparable is a 2013 precedent transaction in which MSC Industrial acquired Barnes Distribution North America (BDNA). BDNA competes directly with Lawson in MRO consumables (specializing in VMI) and was at a similar scale. Below is a comparison of BDNA pre-acquisition and Lawson today:

Sources: Company filings and William Blair equity research

The transaction multiples are shown below:

Given the above comps, 10x forward EBITDA seems like a reasonable standalone multiple. The below sensitivity tables show illustrative YE 2017 price targets and implied P/E multiples. At the midpoint of the table, there is ~40% upside potential from the current stock price.

Lawson is also an attractive take-out candidate for one of the large industrial distributors (e.g. Grainger, Fastenal, MSC, etc.) if they want to beef up their respective VMI offerings. In fact, some industrial distribution competitors have been approaching Lawson about partnerships to outsource VMI to Lawson. Aside from confirming Lawson’s value proposition, these inbounds are also indicative of potential strategic interest.

Risks

Given (i) Lawson’s steady-state earnings power, (ii) the sticky, service-oriented value proposition, and (iii) state-of-the-art infrastructure, I believe Lawson has limited downside. However, below are a few key risks:

  • Economic cyclicality: As mentioned above, I believe Lawson is currently under-earning. However, financials may decline further if economic conditions deteriorate or the thesis may just take longer to play out if conditions remain soft. The cyclical nature of the business is why Lawson’s unlevered balance sheet is a key competitive advantage. Prolonged softness may allow the company to steal market share and potentially acquire smaller competitors at attractive prices.
  • Management execution: I believe Michael and Ron are top tier executives. However, the biggest long-term risk to the investment thesis is that they fail to execute. Poor execution hiring new sales reps or failed acquisitions are two potential examples that can ultimately destroy shareholder value. In addition to management’s track record, two hedge funds (Luther King Capital Management and KDI Capital Partners) own ~32% of the company in aggregate and will likely track execution closely. Additionally, Luther King has experience in the industry as they led the acquisition of Industrial Distribution Group in 2008.
  • eCommerce disintermediation: The service-oriented value proposition and high mix of private label products mitigate this risk. However, it’s possible some pockets of Lawson’s business will be disintermediated, leading to revenue headwinds and gross margin pressure.

Exhibits

Exhibit A: Non-Core Business Unit and Property Dispositions

Source: Company filings

Exhibit B: LTM Gross Margins

Source: CapitalIQ

Exhibit C: Producer Price Index — Total Manufacturing Industries

Source: https://fred.stlouisfed.org/series/PCUOMFGOMFG

Exhibit D: Annual Sales Rep Productivity by Tenure

Source: Estimated based on company investor presentations

Exhibit E: Sales Rep Hiring Unit Economics — Highly Illustrative (1)

Exhibit F: Acquisition History

Sources: Company filings and press releases

Exhibit G: Acquisition Economics — Highly Illustrative (1)

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