Lakeland Industries, Inc. — Q3 FY2014 Form 10-Q Summary
Business context and reporting period
Lakeland manufactures and sells safety garments and accessories for industrial protective clothing and homeland security markets. The report covers the three and nine months ended October 31, 2013, compared with the corresponding periods in 2012. The company is classified as a smaller reporting company. Financial statements are unaudited.
Key financial metrics
| Metric | Q3 FY2014 | Q3 FY2013 | 9M FY2014 | 9M FY2013 |
|---|---|---|---|---|
| Net sales | $22.8 million | $24.2 million | $69.2 million | $71.7 million |
| Gross profit | $5.0 million | $7.3 million | $18.6 million | $21.7 million |
| Gross margin | 22.1% | 30.1% | 26.8% | 29.7% |
| Operating profit (loss) | $(1.0) million | $0.3 million | $0.03 million | $0.4 million |
| Income (loss) before taxes | $(1.5) million | $(0.01) million | $(1.6) million | $(8.9) million |
| Net income (loss) | $(1.8) million | $0.3 million | $1.5 million | $(8.2) million |
| Basic EPS | $(0.31) | $0.05 | $0.27 | $(1.55) |
| Operating cash flow | Not separately provided | Not separately provided | $(3.0) million | $1.6 million |
The nine-month net income was substantially affected by reversal of a $4.5 million deferred-tax valuation allowance. The filing states that this benefit reflected management’s conclusion that the related deferred tax assets were more likely than not to be realized; it did not represent immediate cash taxes.
Balance sheet, debt and liquidity
- Cash and cash equivalents were $5.0 million at October 31, 2013, down from $6.7 million at January 31, 2013.
- Working capital was $39.6 million. Inventory increased to $40.4 million from $39.3 million, while accounts receivable increased to $15.0 million from $13.8 million.
- Total liabilities were $38.6 million and stockholders’ equity was $48.8 million at October 31, 2013.
- The company had $11.8 million outstanding under a $15 million senior revolving facility, with stated availability of approximately $2.3 million. The facility bears interest at 6.25% at the reporting date and matures in June 2016.
- Subordinated debt had a $3.5 million principal balance, shown net of approximately $2.0 million of unamortized warrant-related original issue discount. The subordinated facility matures in June 2018 and carries a 12% rate initially, increasing in later years.
- Other short-term borrowings included approximately $1.1 million in Brazil, $1.2 million in the United Kingdom and $0.8 million in China.
- Management stated that current credit availability, anticipated operating cash flow and its cash-management strategy were sufficient for liquidity needs over the next 12 months, but also noted covenant and default risks.
Material changes versus the prior comparable period
- Q3 sales declined 6.0%, primarily because Brazil sales fell $2.4 million, or 55%, following unusually large bid shipments in the prior-year quarter and weak current demand. Excluding Brazil, worldwide sales increased 4.6%.
- Nine-month sales declined 3.5%; Brazil sales fell $8.8 million, or 61.9%, while domestic sales increased $7.0 million.
- Gross margin declined sharply due primarily to Brazil’s negative margin, discounting, raw-material sales below cost and approximately $1.2 million of Brazil inventory write-downs. Total Q3 inventory adjustments were $1.886 million, including U.S. overhead-rate changes, a discontinued-product write-down and Brazil market-value and obsolescence adjustments.
- Operating expenses decreased 13.5% in Q3 and 12.9% for the nine months, reflecting lower commissions, payroll, equity compensation and certain Brazil-related costs.
- Interest expense increased to $0.6 million in Q3 and $1.4 million for the nine months, partly due to the new financing and approximately $138,000 of non-cash subordinated-debt OID amortization in Q3.
- Operating cash flow turned negative as inventory and receivables increased and cash was used for financing-related fees and working capital.
- The company sold its Qingdao, China real estate and an India property, generating cash proceeds, and continued to wind down discontinued India operations.
Guidance, outlook, management commentary and risks
- Management expected FY2014 capital expenditures of approximately $1.0 million.
- Brazil operations were reorganized during the quarter: the prior management team was replaced, a turnaround-oriented CEO was appointed, and the strategy shifted toward industrial and smaller governmental orders rather than large bid contracts.
- Management stated that Brazil sales may not improve and that the company’s results can vary materially from quarter to quarter.
- The senior facility requires, among other matters, a fixed-charge coverage ratio of at least 1.1 to 1.0, specified rolling EBITDA thresholds, and limits on capital expenditures and foreign-subsidiary investments. The company reported compliance with senior and subordinated debt covenants at October 31, 2013.
- The company remains obligated to make 21 quarterly settlement payments of $250,000 through December 31, 2018, with a remaining settlement balance of $5.25 million at October 31, 2013.
- Brazil VAT claims totaled approximately $7.7 million before the accepted amnesty adjustment. Management considered the largest claim probable but had not recorded the full amount; the company also accrued approximately $153,000 for an accepted smaller claim. A subsequent Brazil VAT claim of approximately $200,000 was identified in December 2013 and remained under evaluation.
- Brazilian tax authorities asserted approximately $1.0 million of tax, interest and penalties relating to goodwill amortization. Management believed it would prevail and recorded no provision.
- Foreign-currency exposure remains significant. The company resumed certain forward-contract activity through Wells Fargo but does not hedge its long positions in the Chinese yuan or Brazilian real.
- Management concluded disclosure controls were effective, but identified a material weakness in internal control over international financial reporting and review. Remediation efforts included restructuring international review procedures, management changes in Brazil and planned outsourcing of certain control testing.
Most important facts for investors to verify
- Whether the Brazil turnaround improves sales, margins and cash generation after the management change and strategic shift.
- Compliance with senior-lender EBITDA and fixed-charge covenants, particularly given negative Q3 operating results and only approximately $2.3 million of stated revolver availability.
- The cash-flow impact and ultimate resolution of Brazil VAT claims, the Brazilian tax audit and the $5.25 million arbitration settlement obligation.
- Whether the $4.5 million deferred-tax valuation allowance reversal is supported by sustainable taxable income rather than one-time transactions or financing effects.
- Inventory quality and the risk of additional write-downs following the $1.886 million Q3 adjustment and elevated inventory balance.
- Remediation of the material weakness in international financial reporting controls.
- Future dilution and financing cost associated with the subordinated lender’s warrant for up to 566,015 shares and potential interest payments in stock.