Description

Hampshire Group (ticker HAMP) is an illiquid micro-cap stock that has been delisted, doesn’t have current financials, and whose former CEO and biggest stockholder is allegedly a crook.  For investors able to look past those minor issues, HAMP is an opportunity to buy a consistently profitable high-return business at an amazingly cheap price.  The stock is at around 19-20% of revenues, 2.6 times normalized EBIT, and a P/E of about 5 times normalized earnings.  While there is uncertainty about the current financials (no financials since spring 2006), the issues that make this cheap have nothing to do with the underlying business.  The risk is well controlled by the fact that HAMP is holding cash equivalent to over 50% of the market cap and the very cheap valuation being ascribed to the business.  The upside is substantial – the stock should double at a valuation of 8 times normalized EBIT, which should be achievable in a year or two.  Note that even though the market cap is only $135 million, the stock does trade – average daily volume is about $200,000 per day, and periodically there are days when $1 million or more trades.  Anybody running less than $200 million should have a little HAMP in their portfolio.  The financials should be up to date soon, and its possible that HAMP will buy a substantial portion of its stock back as part of the resolution of litigation with the former CEO.  Ultimately this business should just be sold to a larger branded apparel company, and the path to that happening will be cleared once the former CEO is out of the picture and the financials are current. 

 

HAMP has 7.85 million shares and a $17.15 stock price for a $135 mm equity market cap.  As of 12/31/06 the company had $70 mm of cash and no debt.  So enterprise value is about $65 mm.  In 2005, HAMP reported revenues of $324 million and operating income of $15.5 mm (which was a depressed 4.8% operating margin) – so on 2005 numbers the enterprise is trading at 20% of revenues and about 4 times EBIT.  Since 2005, HAMP has done a couple of acquisitions which should add at least $50 mm to revenues.  So if the normalized revenue run rate is now $350 mm (assuming some decline in the core business due to the loss of one private label customer, as discussed later) when HAMP returns to its normal operating margin of 7% (the 5 year average EBIT margin is actually 7.8%) the company will generate $25 mm of EBIT.  On a normalized basis the company is thus trading at around 19% of revenues and 2.6 times EBIT.  $25 mm EBIT would be $14 mm of net income, which over 7.85 mm shares is $1.78 of EPS.  Net of the cash, the adjusted stock price is about $8.25.  Financing all annual working capital build-up through a credit facility (versus the current cash balance) would likely cost about $2-$3 mm of annual interest, which would impact EPS by about $0.18.  That would result in about $1.60 in EPS from the business on a normalized basis, assuming no excess cash is held.  Thus the business is trading at about $8.25 / $1.60 = 5.2 times normalized earnings.  It could take a year or two to get back to this level of performance, but there is no reason to think this business is broken. 

 

HAMP is an apparel company, and is the largest women’s and men’s sweater company in North America.  Women’s sweaters are about 33% of revenues, men’s sweaters are about 23% of revenues, and women’s related separates are about 45% of the business.  These numbers will shift a bit due to some recent acquisitions.  Unless global warming accelerates dramatically, macro trends favor people continuing to buy sweaters (and clothes), especially since high energy prices provide an incentive for people to lower their thermostats in the winter and wear sweaters instead.  (That was a joke, but the point is that this business, while seasonal and subject to fashion and competitive risk, is unlikely to become obsolete.)  HAMP sells under a variety of licensed and owned brands.  HAMP designs and markets the products, which are sourced from third parties internationally (70% from China).  Key customers in 2005 were Kohl’s at 25%, May Company at 9%, JC Penny at 7% -- the five largest customers account for 54% of sales. 

 

Historically this has been a pretty good business – revenues have generally grown and it’s been consistently profitable.  Income statement highlights below exclude certain non-recurring charges and includes the impact of a recent financial restatement through 2005 (2006 financials have not been filed):

 

                                                2001       2002       2003       2004       2005                       Average

 

                Sales                       261         294         293         302         324

 

                Gross Profit           69           83           74           81           78

                Gross Margin        26.3%    28.3%    25.4%    26.7%    24.1%                    26.2%

 

                EBIT                      23           32           20           23           16

                EBIT Margin        8.9%       10.8%    6.8%       7.7%       4.8%                       7.8%

 

2005 was a difficult, competitive year which was negatively impacted by tough conditions in Q4, when operating income fell to $7 mm from $14 mm the year before.  From 2001-2005 the average operating margin was 7.8%, but excluding 2005 the average operating margin was 8.6%.  A 7-8-9% normalized operating margin seems respectable and reasonable for this type of business. 

 

Returns on capital invested in the business are pretty good – average equity in 2005 was $101 mm, but if you net out average cash of $78 mm, the average equity invested in the business was more like $29 mm.  The $15.5 mm of EBIT that year (which was a depressed year) therefore represents a pre-tax return on equity in the business of about 67%.  In 2004 (a more typical year), the equivalent calculation shows a pre-tax return on equity of over 100%.  Basically there are no fixed assets, so the investment here is in receivables and net inventory, and the value is created through HAMP’s design and sourcing capabilities, brand names, and customer relationships. 

 

A key to whether HAMP really is cheap or not is whether the cash HAMP is holding is truly excess cash.  Although HAMP had $70 mm of cash as of 12/31/06, the cash balance changes throughout the year as the company uses its cash balance to fund the inventory build-up for its big seasonal periods in Q3 and Q4 each year.  Cash was down to $57 mm as of the end of March 2007, and will continue to go down into the fall as the company builds inventory.  HAMP will actually use its revolver a bit for a short period to fund inventory in September-October.  Then the working capital is converted back into cash at the end of the year.  Even though HAMP’s average cash balance throughout the year is less than the $70 mm they ended 2006 with, we believe the excess cash in the business is close to $70 mm, since the seasonal working capital build-up could be self-financed.  Assuming credit availability based on 65% of inventory and 80% of receivables plus a normal level of payables, almost all the cash is really excess cash not needed for operating the business.   One can do an analysis of HAMP’s actual working capital quarter by quarter versus what should be financable and conclude that HAMP doesn’t need to carry this cash.  To argue that HAMP needs to carry this cash to run its business implies that any seasonal apparel vendor needs to carry a high cash balance to finance seasonal working capital, and that simply isn’t the case.  A good example is G-III Group (ticker GIII) which is very similar to HAMP in many respects – it is a smallish apparel vendor selling very seasonal apparel to major department store customers (GIII has historically sold mostly leather jackets and other outerwear).  Looking at GIII’s balance sheet over time clearly shows that GIII doesn’t have to carry a big cash balance – GIII holds a nominal cash balance and funds its huge seasonal working capital build-up through increased payables and usage of a revolver.  HAMP management acknowledges that the company is holding a lot of excess cash right now, and when questioned regarding how much cash HAMP really needs to hold to run its business, HAMP’s General Counsel suggested that the company’s “too conservative” CFO thinks they need to hold about $20 mm.  We agree that holding $20 million would be more than adequate, and that a realistic number would be materially lower. 

 

HAMP’s recent problems started in June 2006, when the Audit Committee began investigating issues relating to “the misuse and misappropriation of assets for personal benefit, certain related party transactions, tax reporting, internal control deficiencies, and financial reporting and accounting for expense reimbursements, in each case involving certain members of HAMP’s senior management.”  A new CFO joined the business a few months prior and may have uncovered this.  The CEO and 35% stockholder Ludwig Kuttner was put on leave, as was Treasurer (and former CFO) Charles Clayton and VP of Finance Roger Clark.  HAMP hasn’t released current financials during this period and SEC filings have been delayed.  In September 2006 HAMP announced that Ludwig Kuttner and the other two executives were terminated, as a result of the Audit Committee’s findings that Kuttner submitted expense reports for $1.45 million over a period of 10 years, a substantial portion of which were fraudulent or not substantiated in accordance with company policy.  Ultimately HAMP was delisted from Nasdaq for failure to file timely financials.  HAMP’s recently amended credit facility included deadlines to file 2005 financials by May 31 (HAMP met this deadline by filing the restated 2005 10-K at the end of May) and 2006 financials by July 30 – implying we are pretty close to getting the financials current. 

 

In late May 2007, HAMP filed its restated 2005 10-K, and the changes versus previously filed financials were immaterial.  The total multi-year cumulative pre-tax income adjustment was $2.0 mm, or $1.3 mm after tax, or about a $0.17 per share cumulative impact.  These adjustments were due to a number of small adjustments to items such as sales allowances, intangibles capitalization and amortization, expense accruals and non-income tax liabilities.  (When a company does an investigation as a result of fraud by an officer, as in this case due to the $1.45 mm expense report issue, the issue of materiality goes out the window, and minor accounting adjustments that would normally not need to be made have to be investigated and restated.)   In addition to the items mentioned above, there was also a cumulative $6.4 mm “income tax restatement adjustment” which relates to the company likely incurring “tax liabilities for deductions related to highly compensated executive officers of a publicly-held company related to Internal Revenue Code Section 162(m) for incentive compensation, deductions for non-deductible plan expense reimbursements under IRS regulations, certain executive compensation plans that may not have conformed to federal regulations due to actions by Former Senior Management, and certain other tax matters.  Additional tax liabilities which will likely arise were identified for deductions for intangible assets acquired and not capitalized, certain distributions from deferred compensation plans, state and local tax nexus issues and certain other tax matters that required restatement.”  The result of these tax adjustments is that the effective tax rates under the restated financials are very high – 47% for 2005, 49% for 2004, and 49% for 2003.  The bottom line driver of these high effective tax rates is the fact that certain pockets of executive compensation were not deductible for tax purposes.  We believe this relates to the $1.45 mm of expense reports and other additional issues.  Effectively the prior management team was overpaid to the extent that compensation above certain levels became non-deductible.  Note that the old management team is now out of the company, and the restated financials do not eliminate the amounts previously expensed for “excess compensation”.  So the restated financials understate EBIT, to the extent that EBIT was hurt by unnecessary and above market compensation for the now-departed management team.  Also, this tax rate issue should not affect the business going forward – HAMP’s General Counsel says there is no reason why HAMP shouldn’t have a normal tax rate going forward.    

 

The HAMP General Counsel also assures us that the restatement process hasn’t had any negative effect on the operating business itself.  The terminated CEO and other terminated executives were at the holding company level, and the business is operated through several divisions, each with their own operating managements.  Customer relationships are managed through divisional management, not by the terminated executives at the holding company.  When asked if anything has happened that would make HAMP’s historical level of roughly 8% operating margins unachievable, the General Counsel’s response was that he didn’t think so, but he did note that the business environment is difficult.  Suppliers want to raise prices due to labor shortages in China, while big retailers are always trying to push prices paid for product down.  In fact, HAMP’s last reported quarter was not so great – this was for their Q1 2006, which showed revenues up 17%, but down 16% on a pro-forma basis excluding two recent acquisitions.  This is a seasonally weak quarter in general, and the core HAMP business was hurt by HAMP losing a private label account.  HAMP implies that they are not distraught by that, since the private label business is a low margin business which they are de-emphasizing anyway, and since they quickly adjusted the cost structure for this lost business.  Our belief is that while this is generally a pretty good business that should do roughly 8% operating margins, 2006 was probably a tough year and performance won’t be at that level.  Also the company is in negotiations with the former CEO over his dismissal – he claims he is due some additional compensation, and the company is arguing he isn’t owed any additional comp due to his fraud and instead owes HAMP money for the prior fraud and for repayment of past bonuses.  He owns 35% of the stock, and we believe that part of the resolution may be for the company to use some of its substantial cash balance to buy back some or all of his stock.  After that point, we think this business would be ripe for a sale to a larger apparel company, and also ripe for targeting by some aggressive activist investors. 

 

The biggest risk here seems to be the potential for 2006 and 2007 operating results (and thus implied future results) to be significantly different than HAMP’s historical results.  While there have been no financials published for a year, it appears the business is basically okay.  We have made store visits to each of the major customers, and have confirmed that HAMP’s major brands are still being carried by these customers.  This includes Requirements women’s separates and Docker’s men’s sweaters at Kohl’s, Hampshire Studio women’s sweaters at Dillard’s, Mercer Street Studio women’s sweaters at Macy’s, and RQT women’s separates, Designer Originals women’s sweaters, and Docker’s men’s sweaters at JC Penney.  HAMP’s General Counsel says that the company has not had any significant changes in customer relationships the last few years, other than the loss of the private label business at Kohl’s which impacted the Q1 2006 results, and HAMP has adjusted its cost structure for the loss of that business.  The General Counsel says that while the Federated/May merger resulted in the loss of 100 doors, HAMP’s business with Macy’s has actually been quite strong and HAMP has maintained its overall volume with Macy’s.  We’ve spoken with the acting Chairman of the Board, who says the business itself is performing fine and is in very good shape.  While the business basically seems to be okay, we obviously don’t know precisely how it’s doing.    

The longer term strategic issue is whether the retailers need the small, often “exclusive label” brands that HAMP provides.  There is certainly risk that retailers replace these lines with either their own proprietary private label brands or major national high volume brands.  HAMP believes the retailers continue to buy the HAMP brands because these smaller brands provide variety and diversification, and because the customers recognize these lines as real brands that provide value.  The Requirements line of women’s separates is small for Kohl’s – typically presented in 3-4 racks versus what seems like 30-50 racks for each of the mega-brands at Kohl’s which are Sonoma, Apt 9, and Chaps.  However, HAMP says that Kohl’s considers Requirements a “real brand” and intends to keep carrying it, and values the diversity it adds to the store.  A saleswoman at Dillard’s believes that Dillard’s will “always” carry the Hampshire Studio line because it is wonderful product and the customers really like it.  Per HAMP, JC Penney eliminated the Designer Originals women’s sweater line a few years ago, but JC Penney had so many customer requests for the product that they decided to bring it back, and since then the business has been on an upswing at JC Penney.  We’ve spoken with a ladies apparel buyer at a major national department store chain, who had nothing but positive things to say about HAMP and its products.  This important customer says HAMP is a good partner who is very responsive, and that the HAMP product line is a consistently good seller that generates good margins and turns.  This customer says there no reason to think about changing their business relationship with HAMP, since HAMP is a good partner and it’s a good piece of business.  While these comments are very anecdotal, this shows that HAMP and these small brands do seem to have a place.  However, we do believe that long term this issue is a risk, which is one good reason why this business should be sold to a larger apparel vendor whose objective is to provide a menu of options of different brands to major retailer customers.  

 

While there is some hair on HAMP, such as the lack of current financials, some historical fraud, and 2006 results likely not being great, it seems obvious this is a very cheap business.  Viable consumer-oriented businesses that generate mid to high single digit operating margins just don’t trade at 20% of revenues.  If the operating business is not impaired (and obviously we don’t think it is), there is clearly a lot of room for upside in this stock.  A very reasonable valuation of 8 times EBIT based on a normalized operating margin of 7-8% on $350 mm in revenues, plus the cash, results in a value of $36 per share, which is about a double.  (GIII, mentioned above as a very similar company, trades at about 8X EBIT, 50-60% of revenues, and a P/E of around 18.)  Even if all the business ever does is a 5% operating margin, 8X EBIT would result in a $27 stock, up almost 70% from here.  Even with the hair (or perhaps because of it), the risk-reward here seems very compelling. 

 

 

Catalyst

Getting financials up to date. Getting back on Nasdaq.
Getting Lutwig Kuttner litigation resolved and potential buy-back of his stock.
Uses of cash for additional acquisitions of small apparel companies or stock buy-back/dividend.
Sale of HAMP to a larger apparel company.