LAKELAND INDUSTRIES INC annual report, FY2016

Lakeland Industries, Inc. — FY2016 Form 10-K Summary

Business context and reporting period

Lakeland manufactures and sells protective clothing and accessories, including disposable garments, chemical suits, firefighting and heat-protective apparel, reusable woven garments, high-visibility clothing, gloves and sleeves. Products are sold through distributors and directly to industrial, governmental and emergency-response customers in more than 40 countries.

The filing covers the fiscal year ended January 31, 2016, with comparative FY2015 information. FY2016 benefited from Ebola-related orders in early fiscal 2016 and bird-flu-related demand in the United States. Lakeland exited its Brazilian operations effective July 31, 2015; Brazil is reported as discontinued operations.

Financial performance and liquidity

Metric	FY2016	FY2015	Change
Continuing-operations net sales	$99.6 million	$93.4 million	Up 6.7%
Gross profit	$36.3 million	$31.7 million	Up 14.6%
Gross margin	36.5%	33.9%	Up 260 bps
Operating profit	$11.8 million	$7.0 million	Up $4.9 million
Operating margin	11.9%	7.5%	Up 440 bps
Income from continuing operations	$7.8 million	$11.1 million	Down $3.3 million
Net income	$3.9 million	$8.4 million	Down $4.5 million
Diluted EPS	$0.53	$1.33	Down $0.80

FY2016 net income was reduced by a $3.9 million loss from discontinued Brazilian operations. FY2015 included an approximately $9.5 million tax benefit from a worthless-stock deduction related to Brazil, which makes the year-over-year decline in net income and EPS less representative of underlying continuing operations.

Fourth-quarter FY2016 continuing-operations sales were $20.5 million, gross profit was $6.0 million, and net income from continuing operations was a loss of $78,000. Q4 gross margin was 29.4%, compared with 37.7% in Q4 FY2015.
Cash and cash equivalents were $7.0 million at January 31, 2016, compared with $6.7 million at January 31, 2015. Working capital was approximately $43.7 million.
Operating activities used $0.5 million of cash, investing activities used $2.7 million, and financing activities provided $3.7 million. Year-end cash increased by $0.3 million.
Inventory increased to $40.8 million from $37.1 million, principally because management built a strategic stockpile for future pandemic-related demand.
Capital expenditures were $0.8 million, primarily for U.S. enterprise-resource-planning implementation and Chinese manufacturing equipment. FY2017 capital expenditures were expected to be approximately $1.0 million.
Total assets were $88.3 million and stockholders’ equity was $67.5 million at January 31, 2016. Total liabilities were $20.7 million.

Debt and liquidity

The company had $9.5 million outstanding under a $15 million revolving credit facility, leaving $5.5 million of availability at January 31, 2016. The facility carried a 4.25% annual interest rate and matured June 28, 2017.
Other borrowings included approximately $3.0 million in China, $0.7 million of long-term Canadian debt and $0.2 million in Argentina. Total debt in the filing’s payout schedule was approximately $13.4 million.
The revolving facility is secured by substantially all U.S. and Canadian assets and pledges of foreign-subsidiary equity. It contains fixed-charge coverage, minimum EBITDA, capital-expenditure and foreign-investment covenants. Management stated that the company was in compliance at year-end and expected liquidity to cover the next 12 months.
The company has not paid cash dividends and does not anticipate paying dividends in the foreseeable future. Dividend payments are restricted by the credit agreements.

Material changes versus the prior comparable period

U.S. external sales increased 12.9%, driven primarily by disposable and chemical products sold in response to bird flu and Ebola-related demand. U.S. operating profit increased from $7.3 million to $11.4 million.
China operating profit increased from $4.1 million to $4.7 million, while external China sales were approximately flat at $14.1 million.
Gross-margin expansion reflected higher-margin crisis-response sales, improved operating efficiency, and production shifts to Mexico and China. U.S. chemical-product margins increased to 51.8%, and Mexico margins increased to 35.5%.
Operating expenses declined 1.0% to $24.5 million, partly because FY2015 included a one-time $1.0 million restricted-stock compensation charge. Freight and customs costs increased because of expedited shipments related to bird-flu orders.
Interest expense declined to $0.8 million from $1.7 million, primarily following repayment of subordinated debt in FY2015.
Brazil was transferred to an existing local manager for nominal consideration, with Lakeland providing funding and retaining certain contingent obligations. The exit generated a $3.9 million discontinued-operations loss in FY2016.
Management identified and remediated prior material weaknesses in Brazilian and entity-level controls following the transfer of the Brazilian subsidiary. Management concluded that internal control over financial reporting was effective at January 31, 2016.

Guidance, outlook, risks and unusual items

Management did not provide formal revenue or earnings guidance. It expected U.S. demand to benefit over the following two years as infectious-disease preparedness funding from the 2015 Omnibus Appropriations Bill was allocated and put out to bid. Management also planned to add sales personnel globally, expand marketing, increase research and development, and use flexible international manufacturing capacity to pursue event-driven opportunities.

Management expected FY2017 research and development expense of approximately $300,000, compared with $165,000 in FY2016.
Q4 FY2016 demand softened worldwide because of U.S. industrial-production weakness, energy-sector job losses, the strong U.S. dollar, slower Chinese growth and near-zero European growth. Management cautioned that pandemic-related sales would remain significantly lower until government preparedness funds became available.
Results may be volatile because of crisis-driven demand, seasonality, government purchasing cycles, product mix, currency movements and economic conditions. The company historically experiences higher sales during spring industrial-maintenance periods.
International sales represented approximately 43.3% of FY2016 sales. Currency weakness in Canada, Europe, Russia, Kazakhstan, Argentina and China could reduce reported sales and margins.
The company depends on international manufacturing, particularly in China and Mexico, and faces labor availability, political, regulatory, trade, corruption, supply-chain and currency risks. Its largest supplier represented 9.5% of total purchases.
Former Brazilian operations remain subject to potential labor and tax exposures. Labor claims sought nearly $8.0 million in aggregate; management estimated remaining liability at less than $278,000, with a reasonably possible amount of up to $500,000. A $2.3 million receivable related to Brazilian VAT funding was reserved as doubtful.
The approximately $9.5 million U.S. tax benefit from the Brazil worthless-stock deduction could be challenged by the IRS.
The company competes with substantially larger businesses, including DuPont, Honeywell and Kimberly-Clark, and has no long-term commitments with many customers or suppliers.

Most important facts for investors to verify

Whether demand and margins remain sustainable after the Ebola and bird-flu response orders normalize, particularly given the weak FY2016 fourth quarter.
The collectability of the Brazilian VAT-related note and the ultimate cost of remaining Brazilian labor, tax and other contingencies.
Compliance with the revolving-credit facility’s fixed-charge coverage, minimum EBITDA and other covenants, as well as refinancing before its June 2017 maturity.
Inventory aging and potential write-down risk following the $40.8 million strategic pandemic stockpile.
The extent to which currency movements and Chinese labor-cost increases affect international sales and gross margins.
Whether government preparedness funding converts into recurring orders and whether the company can grow without materially increasing working-capital needs.
The validity and realizability of the approximately $9.5 million Brazil-related tax benefit and the company’s substantial deferred-tax assets.