Rare Quality Micro-Cap: LSI Industries, Inc. (LYTS) Long Thesis

Rubicon Capital Group's memo to investors for the month of June 2019, discussing if LSI Industries, Inc. (NASDAQ:LYTS) executes their turnaround plan successfully, the stock could see 75%+ upside.

LSI Industries Inc.

Price:  $3.51

Mkt Cap: $91 MM

Ent Val: $121 MM

EV / EBITDA:  8.4x LTM, 6.7x fwd

TD/ EBITDA:  2.2x

Price / Tang. Book: 1.0x

Div. Yield:  5.7%

Price Target:  $6 + (trading), $10+ (transaction)

Situation Analysis

• Rarely does one find a compelling turn around opportunity led by an institutional quality executive with aligned incentives to drive shareholder return in small cap land.
• Founded in 1976, LSI Industries (“LSI”, “LYTS” or the “Company”) is a manufacturer of outdoor and indoor lighting products, digital signage and screen graphics for customers that include retailers (Costco, grocery stores), automotive dealers, gas station / convenience store operators (BP, CVX, XOM, PSX), quick serve restaurants (Burger King, Dairy Queen, Taco Bell, etc). 30% of sales are to the petroleum/c store channel.
• LSI has a strong reputation in key niche market segments but lost its way in recent years due to a very bad acquisition (done in 2017) that diversified the business away into more competitive end markets while leveraging the balance sheet.
• Currently, a turnaround is underway led by a new CEO with impressive experience (PE and operations) and a track record of value creation. (PE turnarounds and exits, etc.)
• Management has embarked on a plan to streamline operations while improving profitability and leverage.
• At current levels, the stock does not reflect the true earnings power for the business thereby providing an extremely favorable risk / reward set up for the stock at current levels.
• If management is successful in their turnaround plan, we think the stock has at least 75%+ of upside from current levels ($6+) on a trading basis and could be sold for substantially higher in a transaction ($10+)
• One analyst covers the stock (Roth) but has not published since 1/24/19 and may potentially drop coverage. This coupled with the fact that the turnaround is only two quarters in presents an undiscovered opportunity.

Company Overview

• Lighting Segment (76% of sales) – Outdoor and indoor lighting and controls for the commercial and industrial applications. Focus Lighting fixtures, poles, brackets, LEDs, etc.
  • This segment has been challenged and experienced revenue declines over 10% 9 mo y/y with gross margins down 950bps during the same period.
  • Management is currently addressing the issues by consolidating facilities and addressing the sales organization.
• Graphics Segment (26% of sales) – Manufactures and sells integrated digital signage solutions (TV monitors at the gas pumps, interactive menu boards, etc. LSI manages and executes the implementation of large rollout programs which are used in petroleum / convenience stores, QSR menus, grocery stores, etc.
  • This is considered the “gem” segment. LSI has a strong reputation and relationships in this space.  Some speculate that if sold, this asset could sell for a substantial sum ($60-70MM).
  • A large driver of this segment is “image conversion programs”, where a corporation may roll out a new image to customers and franchise retail sites.
  • Strong top line growth of 24%, 12% and 16% over the last three quarters, respectively
  • Over the last two quarter, LSI has onboarded two meaningful customers which will drive revenue visibility. When customers are added, margins are depressed and grow as the program rolls out so this segment should experience some natural margin expansion.
    • One example of this involves a rebranding of over 370 stations in Mexico following the government liberalization of gasoline prices and the retail fuel sector

What Went Wrong?

• Over the years, the Company successfully grew through several acquisitions in the space over the years and established a strong reputation in key vertical markets (petroleum, QSR, dealerships, etc.) focused on made to order solutions with implementation times ranging from 3 months to 3+ years.
• However, in Feb 2017 LYTS altered course and flexed its balance sheet to acquire Atlas Lighting Products, a stock and flow distributor of commoditized products for $97.5MM.
  • This was a diversion away from LSI’s primary focus on providing customized products as Atlas was a stock and flow distributor (downlights, LED panels, floods & wall packs).
    • Pro forma for Atlas lighting LYTS rev mix is approx. 70% custom / 30% distribution
  • This detracted LSI from its core competency of providing specific solutions to key vertical markets.
• Since the acquisition of Atlas, competition in the market intensified for commoditized products with Chinese imports up over 300%.
• The cross currents of the markets and LSI’s eye off the ball on its core segments drove LYTS’ stock price from $9 pre-Atlas transaction to its current price of $3.40. Since, old management has been replaced by new executives.
• The industry is a fragmented one with multiple players offering multiple products. LSI’s foray to compete in the commodity arena against larger players was not a wise one.  The good news is that under the right leadership, the Company intends to focus on its core competencies.

What has Changed? Why Now?

• In calendar Q418 Jim Clark became CEO. Clark comes from an impressive and relevant background having led turnarounds and sales of companies:
  • Former Pres. And CEO of Alliance Tire (a former KKR portfolio company which was sold in 37 months with a 30% IRR). Solid background with GE and other industrial companies.
  • https://www.linkedin.com/in/jclark5/
• Clark laid out a plan streamline LSI’s manufacturing footprint and to refocus LSI and its sales organization toward its core competencies:
• Facilities Consolidation
  • Going from 7 US-based facilities to 6 and potentially less.
  • In April LSI announced the sale NY plant for $12MM (no tax liab and to close in June) that will allow the Company to delever while ALSO gaining $4MM of ann. gross margins savings
    • This sale delevers LSI almost a turn (to 2.2x TD / EBITDA) while improving the overall GM profile of the segment as plant utilization goes from ~50% in two plants to over 90% in one consolidated plant. To summarize, this action will trigger a $12MM pay down of debt PLUS generate a $4MM run rate of annual savings which drives EBITDA improvement by 28% from this action alone.
  • Realignment and Refocus of Sales Organization
    • Realigned sales organization to focus away from commodity products and toward higher value-added applications and solutions that LSI is known for.
    • Focus on key niche segments that include Petroleum / C-stores, Automotive dealerships, QSRs, Retail, Warehouse and Parking / Area lights.
    • The Company added a temporary CMO position as well as more sales resources on the ground to improve customer service in a targeted fashion.
      • Better understand comparable pricing from competitors to improve sell through.
      • While this has been somewhat disruptive for the organization, the initiatives seem to be bearing fruit as the order book to bill ratio for the month of March was strong and backlogs are building into this next quarter

What is of Value? / Investment Case

• Strong reputation in key market segments (petroleum / C-store) with entrenched customer relationships.
  • Petroleum segment grew 27% y/y last quarter with two large programs which are in the early stages of their life cycle representing approx. 60% of the growth.
  • Lighting segment book to bill ratio increased the backlog as they entered this coming quarter (FY Q4).
• Cost opportunities seem reasonable (currently lagging peers) lead by an experienced CEO with track record in turning around businesses.
  • 5% EBITDA margins closer to 10% seems achievable.
    • Management believes that 10% EBITDA margins, longer term, are achievable with system optimization.
  • Important to note that even a 2.5% increase from here adds another 7MM of profitability or about $.20 of incremental earnings.
• Highly incentivized CEO with high equity award thresholds:
  • 250K shares on the 3^rd anniversary date.
  • 125K shares on 3^rd anniversary if stock price exceeds $9.50.
  • Additional 125K shares on 3^rd anniversary if stock exceeds $15.
• Strong free cash flow characteristics and deleveraging balance sheet
  • Currently trades close to a 9% FCF with ups if management executes.
  • Rapid deleveraging converts debt to the equity. Combined with a small share count can materially drive the stock price higher.

What Needs to Go Right?

• Company needs to demonstrably show progress in margin stabilization and subsequent improvement. Execution is critical for the stock to work.
• Economy and corporate spending needs to be stable
• Better understanding of China trade will help customer confidence and input costs

Risks / Catalysts

• Inability to execute
• Salesforce overhaul does not bear fruit
• Competitive threats
• Volatility around imports with trade war, etc (important to not however that ALL of LYTS’ manufacturing is done in the US).

Valuation Considerations

• Absolute Value Considerations
  • Even with depressed earnings the stock is cheap trading at an 9% LTM FCF yield.
  • Assuming margins stabilize and management executes on its plan to drive $4MM of costs out of the business, 9% turns into 12% FCF.
  • If margins creep closer to peers, LYTS is trading at a high to mid-teens free cash flow.
  • The market is giving very little credit to the pending $12MM of deleveraging that will occur from the sale of the NY plant.
  • Trades 1.0x TBV and pays a 5.7% dividend which mgmt is committed to paying out
• Relative Value Considerations
  • LYTS is cheap on most metrics – trading 8.5x LTM EBITDA (depressed number) vs peers in the 10-13x range
  • Assuming some multiple expansion and applying the same 8.5x multiple on improved earnings ($20MM vs $14.4MM LTM), the stock could be worth at least $5.50 a share (63% higher)

Catalysts

• Margin expansion
• Cash flow generation
• Research coverage
• ETNs upcoming spin of their Lighting Business will provide a solid comp
• Liquidity event / exit

Capitalization and Free Cash Flow

Article by Lee Lignos, Rubicon Capital Group