Leatt Corp (LEAT): Exploring New Opportunities

DISCLAIMER (2021): This analysis is not an investment recommendation. The author is a shareholder since Leatt was a $30 million market cap company and his projections could be wrong. Please, do your own due diligence.

DISCLAIMER (2023): The author is no longer a Leatt shareholder as of August 2022. The reasons were detailed in the Q2 2022 portfolio update for paying subscribers.

Original Post:

• Market Cap: $97 million

• Ticker: LEAT

• Stock Exchange: US OTC

Companies with special stories behind them or a different DNA have always caught my attention. Leatt Corporation is one those examples.

Leatt is a company based in South Africa but with global revenue. The stock doesn’t screen well, has no analyst coverage, is practically inaccessible for funds exceeding 20 million AUMs (daily volume is $35,000 a day) and more than 60% of the shares are held between management and private investors who have been betting on this story for years. It kind of reminds me of XPEL two years ago when it wasn't talked about that much. Leatt has gone from being a mono to a multi-product company, with brand and intellectual property, which has leveraged its distribution network to sell something that works in a global market with a much higher TAM than the company's revenue.

I think that Leatt could be, if the management continues to perform well, a turnaround trading at 60 cents on a dollar that may become $5 - $10 in the next few years. The company is growing above 70% with ROIICs above 40% and it still has a wide margin to continue reinvesting capital in its own business, since its market share in most categories does not exceed 3%. It has net cash, operating leverage has room for improvement and is trading at 15x the FCF I estimate for 2021.

ORIGINS

Leatt was founded by doctor and surgeon Chris Leatt after having to go help in a fatal accident (broken neck) at a mountain bike exhibition of which he was a mere spectator. Due to the lack of alternatives on the market to protect himself against this type of accident, he decided to invent a neck protector. This protector, registered under patent and under the Leatt brand, ended up being distributed globally and accumulated $140 million in sales to date. This neck protector became a leading product worldwide with a much higher market share than consumers’ second choice.

Chris Leatt founded the company with capital from family and friends. Humble, he knows how to acknowledge his own mistakes, has a long-term orientation, knows how to delegate, still holds 40% of the shares and is the head of the R&D department (the most important leg of the company together with the marketing department). Management cut their own salaries by 20% in the middle of the pandemic so as not to fire any engineers even before the strong consumer demand for foreign products surprised them.

The company, whose revenue was entirely dependent on the success of the neck protector, was starting to find it difficult to keep gaining share in a market where they were already winners. The TAM for this market niche is very limited and the success of the product brings new alternatives from the competition. In addition, sports federations still haven’t made the neck protector a compulsory item to participate in tournaments. On the other hand, the community of riders ended up divided between in favor and against wearing a neck protector (mainly due to mobility problems and experience in practice).  7 years after the beginning of the global commercialization of this product, the annual revenue of the company was still stagnant at $18 million and the returns on the invested capital did not exceed 6%. 

CHANGE OF COURSE

In 2010, current CEO Sean MacDonald came into play, and together with founder Chris Leatt, announced a new strategic plan for the years to come. Leatt Corporation would take advantage of its already established distribution network and launch all kinds of products to become a brand with a much broader catalog (protections and sports accessories from head to toe). A win-win relationship was created between the company and distributors by cross-selling the new range of products. The brand generated loyalty and consumers ended up pivoting to adjacent products of the same brand. Leatt has gradually become a multi-product and multi-category brand with a global presence. Through the strategy of launching new products of different categories, they were introduced into sports and sports subcategories that would be impossible for them to tackle only with the neck protector. The company's TAM has multiplied several times with the change of course.  

Source: Author using company filings

Leatt is currently a global company, with a young but well-recognized brand and with diversified revenue in two large geographical areas (45% Europe and 36% USA) and through various sports categories, the most relevant being motocross, mountain bike, downhill or BMX. Country risk and product risk are significantly mitigated: only 3% of revenue comes from South Africa and the neck protector has gone from representing 100% of sales to 10% of the total.

SOMETHING SPECIAL

The current business model is interesting for several reasons. Leatt is in charge of the design, outsources the manufacturing to Asia and sells through leading global third-party distributors and only directly to the consumer through its online sales channel. The maintenance capex is negligible and the expansion capex is accounted for through income statement (through investment in R&D and marketing). The real value of the company lies in the strength of a brand that grows stronger with each new sponsorship the company has managed to sign with high-level athletes (Link 1, Link 2, Link 3). Cash flows are being reinvested in new agreements for recognized athletes to wear Leatt brand products. Thanks to Instagram, Facebook and YouTube, marketing campaigns can be successful regardless of the frequency of sports competitions (COVID has not significantly frustrated their ROI), as these athletes are expected to boost the power of the Leatt brand through their profiles on SNS.  

Although the brand is still young, it is starting to be recognized by consumers. With growth outpacing the industry, Leatt is beginning to gain ground against established and long-standing brands such as Bell, EVS Sports, Alpinestars and Fox, which have 10 times Leatt’s market share. The amount of capital is not the key to dominate the industry, but intelligence in capital allocation and strategy execution.

Leatt's business model is asset-light, with a flexible structure to adapt to the market’s needs, and operating leverage is yet to be fully exploited. The headquarters in the Western Cape from where global operations are directed are just 968 sq. ft. Finance, sales and R&D departments work there and rent barely exceeds $4,600 per month. COVID has accelerated remote work and Leatt has been able to take advantage of such trend to find talent in other geographies without expanding facilities. In 2016 with $16 million revenue they needed 55 employees worldwide. They will end 2021 above $50 million in revenue and the workforce has risen to 87 employees (incorporating more product development engineers, marketing and sales agents). The power of a brand with traction allows for SG&A cost with linear growth to be converted into profits with exponential growth. This way, Leatt recorded a growth in revenue in 2020 of 36.3% while costs increased by 5.2%. With the transformation of the company thanks to the team’s performance, returns on invested capital have gone from 6% to 45%, supported by an operating margin that has expanded from 2% to 18%. 

OUTLOOK AND OPTIONALITY, BUT NOT WITHOUT RISK

Leatt is focusing its strategy on a world market of almost 50 million riders (motocross, MB, downhill… excluding road cycling). Although there are no official numbers yet, I think this TAM has grown with the arrival of COVID and the increasing interest in outdoor sports and activities. The pandemic has accelerated the demand for Leatt products and they are having problems meeting orders due to lack of stock (delivery times, from when the order is placed to when product arrive are usually around 2 to 3 months). The 36% growth in sales in 2020 would have been higher if this golden age for outdoor activities had not caught manufacturers and distributors off guard. The management’s remarks suggest that demand will be just as strong this year and that Leatt's own growth will be significantly higher than in 2020, as they hope to finally meet those orders that were backlogged in previous quarters.

Although I think the pandemic has strengthened the brand, it is very difficult to distinguish what percentage of the growth of this demand is sustainable in 2 or 3 years from now. What can be defended is that the company's sales grew above 20% CAGR before the pandemic broke out.

Source: Google Trends

On the other hand, the company intends to continue increasing the product catalog and aims to position itself as a reference brand for protective helmets. Currently this leg of the business accounts for 10% of the total and they plan to raise it up to 40-50% in the medium term. The strategy makes sense for different reasons: helmets are by far the most visible item, the average price is higher than any other accessory or protection (usually around $400) and their usage is mandatory. Keep in mind that this plan is a double-edged sword and I am not particularly enthusiastic about how much they are willing to prioritize it over the rest of the business. This niche market is very competitive and some previous designs have already had a poor reception. The new line of helmets has arrived in 2021 and the management consider themselves satisfied with the feedback received. If results are as good as expected, we could see significant growth since the comps for this business segment are easy to beat.

I estimate that the company will close the year generating a FCF per share of $1.2. For a company growing 70% in sales and 400% in operating profit, with net cash and ROIC of 45%, I consider that 15x FCF of this year is a valuation with a substantial margin of safety to assume that post-COVID growth will be lower. The market generally underestimates positive optionality and in this case the company's ability to pivot to adjacent sports categories without needing to make large prior investments. The management team has already stated they intend to gradually get involved into winter sports. If they are able to succeed in this new vertical, the company's TAM would expand $11.5 billion, something that would be well received by the market.

The gap between value and price could be filled in the coming years when Leatt gains traction and goes public on the Nasdaq. Such a proposal is on the table and the board plans to carry it out. It will be at that time when they raise capital only to give more liquidity to the shares and allow institutional shareholders to get in. I have no doubt that analyst coverage will help this business to trade at a more reasonable price.

Leatt is the story of an emerging-moat company which takes advantage of its global presence and brand name to enter an industry with significantly less entry barriers than there were 30 years ago. I think the valuation coupled with the company's own scale (less than $50 million in annual revenue) is what offers leeway for this story to grow into something significantly larger. 

Thanks to @OlivierColombo for letting me know about this company in mid-2020.