Description

Garan (Amex: GAN) makes Garanimals -- you know, the kids clothing with giraffes or elephants on the pants and shirts, so the tykes can make sure that their outfits match. Mentioning Garanimals is sure to bring a snicker from anyone hip enough to not have his name on his belt buckle, but the company’s rock-solid financials, compelling valuation ratios and history of earnings growth are no laughing matter.

Numbers:

Share price: 42.80
Market Cap: 182 M
Long-term Debt (exclusive of lease obligations): 0
Cash and US government obligations: 37 M*
EPS: 4.60^
EBITDA: 49M
Current ratio: 3.35
ROA: 14%
ROE: 18.5%

(Numbers are from Garan’s 10k; I haven’t updated them for Garan’s recent 10q).

*This is misleading because Garan’s business is seasonal; the average cash balance is less.
^This is misleading because it is based on average-shares-outstanding, and Garan
executed a large tender offer during the course of the year. Based on current shares outstanding, EPS is about 5.00.

On a static basis, then, Garan looks cheap, with a PE of about than 9, EV/EBIDTA of less than 4, and P/B of about 1.5. The closest comparable I can find is OshKosh B’Gosh (GOSHA); others are First Years (KIDD), and Gerber’s Childrenware (GCW). The following table indicates that Garan is reasonably priced relative to comparable companies:

PE EV/EBITDA P/Book P/Sales
GAN: 9.3 3.2 1.49 .82
GOSHA*: 14.94 7.43 6.4 1.06
KIDD^: 15.78 6.64 1.92 .88
GCW`: 8.48 3.26 0.99 .60

* OshKosh B’Gosh also has retail operations.
^ First Years is a toy-maker/baby-supplies company.
` Gerber also has a hosiery segment.

Garan has grown EPS at 27% a year over the last five years, driven primarily by revenue growth of 12% a year, gross margin increasing from 22% to 27%, and a reduction in shares outstanding from 5.07 million to 4.5 million.
Garan also generates cash; in 2001, free cash-flow (earnings + D/A - cap ex) was over $25 million. This cash has been used to support a dividend of $1.80 per share ($1.00 regular, $.80 special), and to repurchase about 850,00 shares over the past two years.

Story:
So why is a company with a great balance sheet, stellar earnings growth and shareholder-friendly management selling at around 3 times EBIDTA?

Over the past five years, Garan has transformed itself from a manufacturer of a diversified line of of branded, licensed and private-label clothing selling to a (somewhat) diverse customer base to a company that is increasingly focused on selling Garanimals and Bobbie Brooks children’s wear to a single customer: Wal-Mart. Almost 90% of Garan’s sales are to Wal-Mart; 60% of its sales are Garanimals and Bobbie Brooks. This all-eggs-in-one-basket strategy has clearly been successful, but also poses risks. I think these risks are overestimated and misunderstood, and that one needs to get a clearer picture of the Garanimals brand and the company’s relationship with Wal-Mart in order to understand the investment opportunity.
Wal-Mart is an 800-pound gorrilla. Its power to dictate its suppliers’ margins is well-known. Garan admits that “If for any reason there were a substantial reduction in the amount of the Company's business with Wal-Mart, the effect upon the Company's business, operating results, and financial condition would be significant.” Isn’t it dangerous to be so dependent on one customer?
On the other hand, isn’t it a sign of operational excellence to increase gross margins while selling to Wal-Mart? And doesn’t a 30 year relationship with Wal-Mart say something about management ‘s integrity and ability to deliver? And doesn’t dealing with (basically) only one customer simplify life, and allow greater S/G/A leverage? Small technology companies would kill for that kind of relationship with a major player (except, of course, with Microsoft).So the question is whether Garan is _dependent_ on Wal-Mart, or _in bed_ with Wal-Mart -- whether the relationship should be treated as a risk-factor, or as big hunk of off-balance-sheet goodwill.
I lean toward the latter view, because I think that Garanimals is a strong brand that offers a reason to shop at Wal-Mart. Sure, there’s negative brand-equity after a certain point; no twelve-year-old would want to be caught dead in Garanimals. But the brand was introduced in 1972. Kids who grew up in Garanimals are now buying Garanimals for their kids. There are three kinds of responses to the brand: people make fun of it, take it for granted as a part of their day-to-day life , or wish that there was Garanimals for Grown-ups. I don’t think the ones who make fun of it shop much at Wal-Mart. Garanimals has become a timeless macaroni-and-cheese kind of comfort brand with considerable appeal for the Wal-Mart demographic. I also think that the brand and balance sheet are strong enough so that if, God forbid, worst should come to worst, the company would continue to prosper in the long run.

Valuation/Estimates/Catalysts/Risks --

There are a wide range of valuations for Garan. The company would be a double from here if it sold at a reasonable EV/EBIDTA; it would probably suffer a 50% drop if the relationship with Wal-Mart blew up, at least until new distribution channels were established and proven.
I estimate 2002 EPS to be about $5.50, based 6% revenue growth (50% of Wal-Mart’s projected revenue growth), lower average-shares-outstanding and a slight improvement in gross margin. A modest PE expansion to 10 over the next year would thus provide a 29% total return. A case can be made that Garan deserves a higher multiple. Garan could reasonably trade at a PE of 14, equal to to its return on assets.
Assuming no growth, a floor for the stock should be around $35, or seven times earnings, because the company has demonstrated its willingness to take in shares at this level.
As for catalysts -- I just think this is a good time to be in reasonably priced, easily understood, dividend paying stocks with good balance sheets. The K-Mart bankruptcy is also likely to help a bit.
The main risks are the dependency on Wal-Mart and illiquidity. Garan trades in the thousands of shares per day, so it could be difficult to establish a position. On the other hand, the company has shown itself willing to repurchase blocks from institutions.

Catalyst

Valuation; anti-Enron; large buyback hitting average shares outstanding; K-Mart bankruptcy;