Description

Overview
A former textile company quietly sheds its economically challenged manufacturing operations and shifts its model toward lighter operating businesses whose cash flows the CEO can plow into his private investment wing. Sound familiar? Forget it. Think reasonable business at a compelling valuation and not a wonderful business, perpetually earning incremental returns on capital.

Hampshire Group (HAMP mc: $41mm) IPO’d in June of 1992 at $9.25 a share. From ’93 to the end of ’00, the business compounded per share book value at 17.43% per annum while the stock price languished, recently hovering just below(!) its 1992 IPO levels. In the meantime, Hampshire has gone from being a capital intensive, commodity manufacturer of sweaters and hosiery fighting a losing war against global labor iniquities, to a lighter, diversified marketer and designer of more general apparel and an ill-disguised RELP.

At its 1992 IPO, Hampshire’s two long standing businesses*: hosiery (1917) and sweater manufacturing (1956) were difficult but reasonable economic propositions. The domestic apparel manufacturing industry only worsened from there, as customers gained pricing power -- retail consolidation cut customer count from 2000+ to ~500 through the mid to late 1990s -- labor costs continued to be an Achilles’ heel relative to cheap labor employed by international competitors, and sky high exit costs (exits get more expensive when everyone’s rushing toward them at once) kept pitiful ROE competitors on the race course. Hampshire was not one of those pitiful businesses, and it managed to maintain profitability throughout, sans a 1993 impairment charge in the hosiery line, generating average operating income of $9.4 million for the seven year period of ‘94-‘00 (93 was the hosiery write down).

Hampshire’s model shift began to take force in 1997, selling its hosiery ops to part of the management team. Before the alarm bells deafen my write up, note that the hosiery business was sucking wind and that the business was recently (December 2000) auctioned off by management to a competitor in the face of poor performance. That same year, CEO and founder Ludwig Kuttner cut the ribbon on Hampshire Investments, created to “diversify the revenue base” by investing in equities and real estate under Kuttner’s direction. Meanwhile, Hampshire the apparel business became largest sweater manufacturer in North America.

1998 brought a third straight year of double digit operating income (excluding an inauspicious start to Hampshire Investments which included a $2.5 million reserve thanks to some Russian real estate exposure just in time for the Ruble’s crash and burn), with the sale of the hosiery business having little affect. ’99 saw a 10% decline in the sweater business, thanks primarily to the dropping of a single product line from a single customer and to continued price competition from international manufacturers with cheaper labor.

Last year was the turning point in the business model, as Hampshire both shed all of its manufacturing operations (they were not inflated on the books, btw - produced a modest gain sans exit costs) and acquired -- with cash -- a private designer/marketer of primarily women’s sportswear called Item-eyes (major brand names: Requirements, Nouveaux). The manufacturing divestiture instantly reduced net PP&E from $10.1 million to $2.6 million, and headcount from 1500 to 225 (unionized e’ees from 80 to 14). The divestiture will allow HAMP to globally source all of its textile apparel and eliminates an important operating and disadvantage of higher labor costs.

What’s left is a designer, importer, marketer and distributor of sweaters and sportswear apparel, under both proprietary brands like Designers Originals and private label brands like Geoffrey Beene, Eddie Bauer and Land’s End. The Item-Eyes acquisition adds a significant revenue stream - around $100 million a year - and was not particularly expensive. Hampshire paid $18.7 million (equity, not enterprise), which was 8.1 and 10 times Item Eyes’ pro forma (Item-Eyes was an S corp., these figures assume C corp. taxation) net income (including significant debt payments) in ’99 and ’98 respectively. The three Item-Eyes principals, btw, are staying aboard for a minimum of 5 years apiece. Item Eyes had similar net income levels (~$2-3 million) in both ’97 & ’96.

*Hampshire’s only been around since 1979; the businesses pre-date it.

Valuation

You value Hampshire by isolating its investment arm’s net assets and adding them to a DCF of its operating business, adjusted for net cash.

Apparel Valuation

Sweaters. Revenue growth has slowed recently -- after more than tripling revenue from 1994-1998, this division has recently grown 1%-2% per annum, with a run rate of $153 million. (Sweater revenue in 2000 was $153 million. Average revenue from 97-00 was also $153 million). Operating margin in that division have averaged 8.2% over the last four years and should gain stability from the newer model without a commensurate drop in expected value. NOPAT’s a reasonably sustainable FCF proxy with the manufacturing business gone, as cap ex drain (and working capital, to some extent) is minimized. Revenue growth is likely to pick up as outsourcing manufacturing will allow them to leverage customer relationships with more available product, and margin benefits from shedding the labor disadvantage should outweigh added procurement costs. However, I conservatively use a flat (zero) growth assumption and operating margins of only 7.5% going forward. Discounting at 15% (6.7 multiple w/ no growth) and applying a tax rate (ignoring NOLs for now) of 35% brings a conservative $50 million valuation for the sweater business, with real upside from even inflation-based revenue growth and flat operating margins. Using only average operating margins of 8.2% and expecting 3% revenue growth values the division at $68 million (discounting @ 15 percent again), leaving a more usual mature designer/distributor PE of 8.5

Item-Eyes. This business is harder to value because information is limited to the 8-K. Over the last three years, Item-Eyes has averaged around $100 million in revenue with slim operating margins of around 5%. While early results appear to confirm management’s contention that synergies are likely, a conservative estimate would again flat-line revenues and margins, valuing the division (15% COC - PE 6.7) at $21.7 million after tax.

That leaves the two apparel divisions with a conservative, but unlevered combined value of $71.7 million, with slightly more optimistic assumptions offering $90-$100 million.

Investments

Hampshire investments should be treated like a closed-end fund - valued at a discount to NAV. The portfolio is 80% in real estate, with 75% of that in the US (both commercial and residential) and the remaining 25% in Russia and Eastern Europe (mostly the Czech Republic). The Real Estate at book is around $25 million with another $5 million in investments (mainly REITs). Valuing those at 75% for valuation and agency uncertainty brings a net value of $22.5 million in net investment assets. While some of the commercial real estate in the portfolio may face valuation risk, assets like Merrick Properties (Huntington, NY residential development) may in fact offer NAV upside.

Capitalization

The balance sheet was leveraged in the Item-Eyes acquisition but debt/equity remains quite reasonable (interest bearing debt/tangible equity is 0.42), and improved year over year. The company continues to pay down debt Net debt at the end of March stood at $13.9 million.

Sum of the parts

The low end $71.7 for the unlevered apparel business + $22.5 million for the discounted investment assets, less $13.9 in debt (unadjusted for deductions) leaves a market value of $80.3 million. Using the somewhat less conservative apparel assumptions and valuing the investments at market suggest $130 million in value. This intentionally ignores $5.4 million in NOL carryforward (after-tax PV ~$1.6 million) that will likely be realized due to the sale of its Puerto Rico manufacturing facilities. The conservative figure of $80.3 million is approximately double recent market prices of $40 million. Stock options and pension liabilities are not a material factor.

Risks

The company has become an apparel marketer without any overwhelming franchise or a dominant position in the supply chain. While these worries ought to be tempered somewhat by Hampshire’s commendable ability to remain consistently profitable even while saddled with now disadvantaged textile production through a cutthroat industry cycle, there is reason to doubt the depth of the moat. Second, Ludwig Kuttner is reinvesting your free cash flow into Romanian Real Estate, and the Real Estate investment business is difficult to handicap from available disclosure. A third, related concern is one of agency/management. While management has certainly shown some value friendly signs by shedding under-performing assets, remaining stingy with equity capital and maintaining reasonable debt levels, Kuttner’s salary structure (bonus of 7% of net income, which may along with debt repayment help explain why HAMP is not repurchasing), the recent switch from PwC to Deloitte and the general specter of the murky Investment arm create agency questions. Notably, management has a large (34%), but not controlling stake in the enterprise.

Catalyst

The catalyst will be the one or two suckers who read this and buy shares, since anemic volume presents huge price impact problems. There’s a real liquidity problem here and size will have trouble entering. Because I think there’s little sign of a short term catalyst, I won’t manufacture one to fit the format. I will point out that the 9-year flat performance since IPO has not been one of market apathy, but marked solid returns from 94-98, and then a sharp drop off the radar in ’98. I believe Hampshire’s shift into a lighter, better capitalized and more diverse business have occurred beneath the radar, and offer an value opportunity before the integration is finalized and capitalization improves on what will soon be a profitable $250 million run rate business. According to the company, customer orders have been better than expected so far this year, but the benefits from that won’t emerge until the second half of the year.