Description
Delta Apparel (DLA) is a simple, understandable company with a current market value at least 50% below its intrinsic value. Over 97% of DLA’s business consists of the manufacturing and selling of t-shirts. DLA was founded at the turn of the century and in the mid-80’s it was purchased by Delta Woodside. Delta Woodside mad made many acquisitions during the 80’s including Standard Knitting Mills and Royal Manufacturing to form Delta Apparel in its current form. In June 2000, DLA was spun off from Delta Woodside and began trading on June 30, 2000.
The following compelling facts support the recommendation of this company. DLA has a conservative balance sheet with long-term debt-to-equity ratio of less than 14%. It should report at least 16% return on equity, price/sales ratio is 0.38, price to book is 0.70, P/E ratio is 4.76, ongoing capital expenditures are approximately half of depreciation, and the company is repurchasing its shares in the open market.
DLA will report fiscal year earnings in mid-August of approximately $9.5 million, yet has a market cap of $44.5 million. Yes, it does have a very small market cap and is a thinly traded stock at this point. It may not appeal to the majority of money managers due to its illiquidity, however the smaller investor has a great opportunity.
OPERATIONS
The decision to spin off DLA was because management thought they could focus the business in a different direction and create a very profitable company. They have thus far been successful in this endeavor. The cotton is purchased and converted to yarn in their yarn facility in and then transported to their facility in North Carolina for the knit, dye and cut process. It is then shipped to either to a plant in Honduras, where they have two plants built in 1995 and 1997, or to a plant in Mexico, which opened in April 2001. The t-shirts are sewn in these plants and then shipped to either a facility in Knoxville, TN or to a new west coast distribution center in California.
DLA is expected to reduce operating expenses by over $1 million during the next year due to the opening of these new offshore sewing facilities. They closed a plant in the US this past year that had previously done a portion of their assembling.
The company has made a significant move in order to increase profitability by focusing the mix of product to more profitable segments. In the industry, approximately 50% of total demand is for white t-shirts. Historically, the company was focused on making a large percentage of white t-shirts; however over the past three years the percentage of white t-shirts manufactured has decreased from 63.5% to 56% to 43.5%. DLA makes over 40 different colors of shirts and makes primarily two different types of t-shirts. DLA intentionally made this decision to manufacture more colored t-shirts as they have a higher profit margin than the white t-shirt.
Management has also focused on increasing profits by changing the mix of who the product is sold to. Three years ago, DLA sold 40% to distributors and this percentage has dropped to 32% last year and 24% this year. Distributors historically provide smaller profit margins to companies and DLA is now doing business with distributors that it considers more of a true business partner. In order to increase profits, DLA has increased sales to private label and sales through its catalog. Both private label and catalog sales have higher profit margins and the decrease in sales to distributors has led to increased sales in their private label and catalog merchandise.
The company has a policy that prohibits them from having any one customer having more than 10% of aggregate sales. Their largest customer in the past year amounted to 7% of total sales. Even though DLA only began trading in June 2000, the company has begun to repurchase shares. As of a June 2001 report, DLA has repurchased 31,000 shares at an average price of $17.64. The board has authorized up to $3 million in share repurchases. They have stated they will continue to repurchase shares as the market price continues to be below the intrinsic value of the company. Various IRS regulations limit the amount of share repurchases that can take place in the first two years of spinning off a new publicly traded company.
INVENTORY AND DEBT
The largest selling season for DLA is April through September. Prior to this time, the company will have balances on its $25 million line of credit and its inventory will increase. Inventory will peak around April of each year and be at its low point around September of each year. After September of each year, it is anticipated by DLA that the line of credit will have a minimal balance and that inventory levels will again decrease. Going forward, due to the free cash flow generated, DLA will have even less need next year for its line of credit than it had this year. It is conceivable that DLA will not need to utilize its line of credit next year. Please keep these important items in mind when analyzing the financial statements.
The T-SHIRT BUSINESS
For the past 15 years, the aggregate demand for t-shirts has increased about 6-8% per year. The company has major competitors including Hanes, Russell Athletic, Gildan, Anvil and Fruit of the Loom. As you are aware, Fruit of the Loom has been going through bankruptcy proceedings and has long been seeing its market share decrease in the t-shirt business. DLA currently has about 10% of the aggregate t-shirt market and 6% of the decorated active wear t-shirt market, and looking to expand those figures. Due to the slowing economy in the US, the sales of t-shirts are down this year. According to independent market data provided by the S.T.A.R.S. division of A.C. Nielsen, measuring unit sales from U.S. distributors to screen printers, industry sales volumes for T-shirts sold through distributors declined by 10.4% compared with the third quarter of last year. As management at DLA states, the t-shirt business is typically recession proof. However, an interesting phenomenon happened this year. As you are aware, corporate spending has significantly decreased for various items in this past year. It seems as though DLA has built up a sizeable market in selling t-shirts that are eventually made for corporations and used as give-aways or for various corporate promotions. As we have seen in many industries, corporate spending has just ceased over that past months, and DLA has been impacted in this sense. The retail sales of t-shirts have remained relatively stable in growth, however the significant impact has come from the vast decrease in corporate spending. Who would think that t-shirts were vulnerable to spending in corporate America?
DLA figures that its competitive advantages include a superior inventory system, optimized distribution channels and the most efficient offshore sewing facilities in the industry. They have some of the most efficient operations in the market and were the first to predominately have their product sewn offshore. This has created a very good operating efficiency for DLA.
TAX LOSS CARRYFORWARDS
Over the past year, DLA has benefited from various tax-loss carry forwards that are expected to end following the June 30, 2001 fiscal year. The effective tax rate during fiscal 2001 has been less than 18% and it is expected that the effective tax rate going forward is projected to be 36-37% a year. With this normalized tax rate going forward, it is expected that DLA will have flat, or slightly lower earnings over the next twelve months. The offset will take place with lower overall operating costs as discussed above.
FUTURE EXPECTATIONS
The management at DLA is clearly aware of the discount of their market value to the intrinsic value of their business. They are seriously looking into various ways in which they can efficiently use their free cash flow to enhance value to the shareholders. Various alternatives are available to them including continued share repurchases (limited in the next year by IRS regulations), paying of dividends (let us hope they only pay dividends if they can’t reuse this capital at a higher return than what we can earn and given their current valuation, that should be an easy decision), a potential dutch auction, or perhaps to pay down long term debt (although long term debt is relatively small at this point).
It would seem the DLA could be a prime target for a takeover in this industry as they have very high quality assets and a business generating significant free cash flow, while being significantly undervalued. On an annual basis, it is expected that DLA should generate free cash flow very similar to their reported earnings.
The unit sales for DLA have done well this year. The problem has been they have faced pricing pressure. Gildan, a competitor, had recently put in overcapacity and between Gildan and Fruit of the Loom, the industry is faced with temporary low prices. The current prices cannot continue and should become normalized in the next twelve months, hopefully sooner. On an ongoing basis, the goal of the company is to have annual 10% sales growth and 15% income growth.
Over the next twelve months, it is entirely likely that sales will remain flat because of the current pricing environment. They will have significant savings in their operations and they will be taxed with a normalized effective income tax ratio. Taking these assumptions into account, they should conservatively have net income per share of $3.40 per share. That should provide them with free cash flow of approximately $8 million, on a company with a market cap of $44 million, numbers that would make Warren Buffett salivate. Doing a discounted cash flow analysis into the future, free cash flow should grow at 15% a year (and when the current pricing environment lifts, growth could be higher). Plug in your own discount rates and you’ll find a company with a value at least twice as high as its current market value.
SUMMARY
DLA is clearly an undervalued company that has recognized this fact and is repurchasing its own shares through free cash flow. DLA is trading at 4.76 times earnings, 0.38 times sales and 0.70 times book value. It is a simple, understandable business that does not have a need for significant capital improvements in the foreseeable future. It has a conservative balance sheet and is well positioned to be a company generating significant free cash flow into the future.
Catalyst
It will not take a great amount of buying pressure for the stock price to significantly increase. It is a conservatively financed company earning free cash flow and trading at a minimum of a 50% discount to its intrinsic value. With a market value of less than 5 times current earnings and 38% of sales, it has a very large margin of safety.