Description

Gildan Activewear – they are a $3B market cap company. 2/3 of their business is making basic T-Shirts and activewear in the wholesale channel for screenprinters (they press ink based stencils onto GIL’s plain T-shirts).  1/3 of their business is selling branded T-shirts, socks and underwear in the retail channel. 80% of that business is socks. GIL started with less than 10% market share 10 years ago and now has 60% of the screenprint channel. They did it by being the lowest cost producer. They were the first to move production out of north America to take advantage of lower wages, tariffs, etc. The biggest competitors are HBI and Fruit of the Loom but both were underinvesting in this business and they still do so GIL’s advantage got bigger. GIL’s ROE is consistently over 20%, often over 30% with next to no debt. So it’s a quality business in a weak industry.

Why does GIL offer a good value? 2012 consensus EPS expectations were $2.60 in summer 2011 but are now $1.30. The stock declined from a high of $38 to a low of $16.50 and now trade at $25. GIL’ 2012 earnings reflect a one time inventory destocking issues in its distribution channel that the market is treating as a semi-permanent hit to margins.

-          Cotton was 75c in fall 2011 then rose to a high of early $2 in summer 2011 then promptly declined to 95c, with most of that decline occurring over a few weeks.

-          GIL was able to raise prices 20%, fully offsetting the rise in cotton, so their gross margins actually rose. But two things happened. First, GIL raises prices in increments, and distributors knew they would keep raising prices to match the rise in cotton so they accelerated their purchases. Second, the price of cotton collapsed suddenly. So distributors knew GIL would have to lower prices and they had the excess inventory to wait. So GIL had to cut its prices on its T-Shirts and took the hit all at once. FQ1 2012 EPS expectations declined 80c reflecting the inventory writedown.

-          The same thing happened in 2001 when cotton went from about 30c to 70c. GIL’s stock was hit and then rebounded within a year. Analysts downgraded the stock, saying it was unclear if GIL had margin sustainability and then they backtracked 6 months later.

The wholesale business can earn a normalized $2.00 per share in EPS in 2012, potential for $2.60-$2.85 in a couple of years - $1.3Bn in sales, with 25%+ EBIT margins before corporate expense. That results in $325M in EBIT less about $65M in overhead for the division. They pay minimal taxes because of the location of their facilities. That results in $2 in EPS.

-          I spoke with competitors and distributors and I’ve never heard such praise for a management team. They are consistently regarded as the “smartest manufacturing operators in the western hemisphere”. One competitor said, “you survive by learning not to compete with Gildan. You find a niche market where their scale can’t operate because you can’t compete with them on cost. It’s impossible”

-          In the domestic market - The long run potential is 70% market share up from 60% now and margins could rise another few percent. I explain why under the risks section. That would add 35c to EPS if margins are flat and 60c if margins expand so EPS could be $2.35 to $2.60. if you add some volume growth now that cotton prices are declining and assuming the economy continues to grow that could be $2.60 to $2.85 in EPS in a couple of years.

Growth in the international screenprint channel could add another 50c in EPS within a few years - less than 10% of GIL’s screenprint business is in the international market where they have 10% share. It’s unclear how high their market share can go but it can definitely double and likely triple. They get about $130M in revenue here now and I include that in the $2.00+ EPS noted in the prior paragraph. But I excluded growth in the international market. So that $130M in revenue could grow to $390M at 30% share assuming no growth in the market. The incremental growth is worth 50c or more in EPS.

Their retail business – moving from negative EPS to 75c or more in 2013. Their goal implies that this division will earn $2.50 in EPS in a few years.

-          GIL disclosed segmented margins for the first time this quarter. EBIT margins are negative in this segment. It’s important to understand why and why that will change.

-          80% of this business is socks $320M of $400M in 20011 revenues.

-          GIL needed two things to succeed in retail. distribution and a brand. They got distribution about 5 years ago when they acquired some small sock companies. But their manufacturing was high cost, in the US in old facilities. They needed to transition that to their low cost Honduras facility which took time to build. Then they acquired the Gold Toe brand. Now they can produce a recognized brand at the lowest cost. So margins should rise. GIL says that once they reach $600M in revenues, which is their target for 2012, that EBIT margins will be comparable to the screenprint channel. That could result in 75c EPS. I think their growth prospects are reasonable given that they have a good brand and the competition is weaker than in screenprint, socks are often produced in the US at a high cost.

-          The big question is how big this business could be. GIL’s targets are to make it a $1.6B business with 25% EBIT margins before corporate overhead. In such a case, it could add $2.50 in EPS.

-          I don’t think they will get  $2.50 in EPS but it is possible. I explain my reasoning in the risks section below

-          Retail should easily add 50c in EPS from a normalization of cotton prices alone. In the near term, Hanes is expected to see a 10% increase in gross margins as lower priced cotton flows through the retail channel, where prices never fully reflected higher cotton costs. Gildan should see the same benefit; although GIL’s retail margins are much lower than Hanes’ there is a clear correlation. For GIL, a 10% lift to retail margins would add about $55M in EBIT or 43c in EPS. Furthermore, GIL is moving away from private label which improves margins. If they can reach scale, then margins could be much higher but I am skeptical so I assume a 75c lift to 2013 EPS.

Further growth – they are underlevered and will likely acquire growth – GIL is underlevered with net debt of $250M. it makes up less than 10% of their EV compared to more than 40% at HBI. This debt capacity can help them in their retail strategy. As I detail below, they may need to acquire a brand to grow in retail and this is how they can do it.

So normal EPS in 2012 is $2.50, and potential EPS in 3 years is $5.75. a conservative forecast is for $4 EPS in a few years which assumes continued strength in the screenprint channel, success in the international screenprint market and very modest success in retail ($2.75 EPS from wholesale, $0.50 in international growth and $0.75 in retail EPS). They will likely exceed that if they acquire a retail brand and/or have success in persuading the end customer that their retail brands are worth trying (aside from Gold Toe which is on solid ground).

-          2013 EPS could be a bit lower if there is some crazy price competition with Fruit or if cotton takes a fast decline. Otherwise they could also be $3.00 since GIL is lowering costs and has more scale than before so they should see record margins in 2013.

-          The $2.50 forecast excludes the Anvil acquisition which should add 25c.

A breakdown of potential EPS under a few different scenarios

• Bull case - $6.00 EPS – this assume they reach their targets in the wholesale channel. I think they have a very good chance of it. It doesn’t assume a ton of growth. I assume 29% EBIT, slightly above their historic norm because they will have increased scale and a wider gap in costs compared to the competition. I assume they hit their retail targets and get slightly lower margins than in wholesale. GIL targets identical margins.
• Base case - $4.40 EPS – I think they come close to hitting their wholesale targets and will get back to normal margins. I wouldn’t be surprised if they do better. I don’t give them full credit for retail. I think they will have trouble building a brand given that HBI spends 10x as much. I actually think GIL can do it, but they have to recognize that their branding strategy is weak. I don’t see evidence that they will move aggressively to build share of mind. I think they underestimate how badly they need share of mind for a customer to adopt their product. I also assume they don’t hit the same margins. They say they can reach those margins at $600M in revenues and I forecast $850M but I assume they end up spending more to build a brand in order to reach $850M in sales.
• Bear case - $3.50 EPS. I knock them on wholesale, retail and margins.

Fair value for a high quality business with good growth should be 15x EPS, it’s historic norm is well above that. Assuming a 12x multiple on $4 EPS, this is a $48 stock in a few years, offering a 92% return and a 25% CAGR.

Risks

1)      Margins in the screenprint channel  and market share– I think 25%+EBIT margins are sustainable and market share can go to 70% -

-          Fruit of the Loom has been aggressively cutting prices in the screenprint channel – I spoke with several distirbutors and competitors. They are clearly bleeding cash in a big way and this is unsustainable. They had a new CEO who likely thought that since GIL was running on higher cost inventory that Fruit could underprice them and win share (GIL turns its inventory faster so they were running $1.70 cotton before competitors). Fruit did win some share, from 6% to 9% but all of that gain came at the expense of Hanes and small competitors. Hanes is now exiting 1/3 of the screenprint market (on their Feb 15^th call). this should make the industry more rational, but even if it doesn’t, Fruit is bleeding cash. They are now beginning to use their $1.50+ cotton inventory while GIL is priced to 95c cotton after the writedown. So while they could irrationally keep prices low, GIL will still get its 25% EBIT margin.

-          GIL is out-investing everyone. Fruit is treating the business as a dying one and not reinvesting much. They still have US capacity so they are a high cost producer. Hanes (HBI) is focused on deleveraging and building their brand. So their capex which was $100M in 2011 is dropping to $45M in 2012 and flat-lining at $40M thereafter. They are GIL’s closest competitor on cost and GIL’s position against them will only grow.

2)      GIL’s capital allocation – they are all about growth

-          All my conversations indicate that this is a management team that doesn’t believe they can’t win. One mantra of theirs is that great companies can grow. So if retail turns out to be a problem, they probably will keep trying to succeed rather than return capital to shareholders. Personally, I would rather see them add some debt and use the proceeds plus FCF to buyback shares. But the stock is so undervalued there is enough margin of safety that if they don’t succeed in retail, the stock still works.

3)      Could retail be a disaster, or reflect poor capital allocation

-          EBIT Margins could be 15% to 30% before corporate overhead - As a benchmark, Delta Apparel (DLA) said on their last call that they can earn 11-12% EBIT in branded apparel, before corporate overhead,  and they are a high cost producer with terrible brands. Hanes earns a 10% EBIT margin after corporate overhead, so maybe 15% before those costs. They believe they can raise margins to 11-12%, implying 16-17% margins before corporate overhead. GIL has a big cost advantage that will only widen. So if they can get HBI’s pricing, they can likely exceed their 25% EBIT margin target, possibly reaching 30% before corporate overhead. I think if they fail, they should at least be able to get 15% margins, ahead of DLA that has weak brands and high costs.

-          I think a floor is 75 c in EPS based on the Gold Toe brand - I spoke with different people in retail, manufacturers of branded apparel, brand managers, distributors, apparel buyers. I still have more work to do, but it’s clear that Gold Toe, which is a $320M business and 80% of 2011 retail revenues, has a strong shot at achieving good margins. So I think 75c in EPS is doable.

-          But GIL’s plans for bigger growth will rest on branding in my view – brand power is what will drive both sales and margins – GIL can easily bribe the channel and likely get 20% margins before overhead. But the question is whether the consumer will buy their product. It seems that they will need to build a brand which is tough to do when the competition has entrenched share of mind and bigger ad budgets (think Hanes, Jockey, Fruit, Calvin Klein). Furthermore, it seems that purchases are routine and people need a reason to switch. Jockey won share recently by introducing Outlast technology that makes for more comfortable/breathable clothes. So GIL could innovate. But they likely need to buy a brand and build off of that. I am currently researching this aspect of the thesis but it is clear that companies can enter this market if the brand is known, think Under Armour underwear.

-          GIL is planning to extend Gold Toe into underwear which seems odd to me.

-          But they still lack a brand for T-shirts. They plan to use the Gildan brand, but I think they would be better off acquiring a brand.

-          In conclusion, I assume minimal success aside from Gold Toe socks.

4)       Are cotton costs a risk?

-          I grew up in family that ran a yarn dyeing operation. So I’m familiar with cotton demand. When it rose last year I ended up investing in Carter’s (CRI) as their margins were temporarily hurt. As part of that investor process I reached out to people my parents knew in the apparel business, former customers, associates etc. what is clear is that there is substantial substitution in cotton. So if prices rise, demand declines. You saw that in 2011 where retail sales volume declined and the % of cotton in each shirt for many apparel companies declined as well.  so high cotton prices are never permanent.

-          More important, GIL can pass on higher prices as they did in 2011. The risk is a sharp drop in prices.

-          I Spoke with distributors about the potential for another inventory writedown now that cotton declined from 90c to 74c. it seems very unlikely. You need excess inventory in the channel to get a writedown. You had that in late 2011 because there was a lot of buying in anticipation of a big price increase so distributors had a lot of excess inventory. If GIL didn’t take a writedown then the higher cost product would have moved through distribution slowly and that would have resulting in lower production run rates at GIL.  Currently, distributors no longer have excess inventory. So there should be no need to write down their inventories to get product moving.

Catalyst

Catalysts 1) evidence that they can return to normal margins (already underway, that’s why the stock is $25, not $16). 2) margin expansion in retail, 2012 will be a key test to see if they are on the right trajectory 3) growth in the international market. They are already at 10% share in short order. 4) execution on retail (maybe they buy a brand, announce a new brand or a marketing strategy that seems compelling).