The Gildan quarter came across as what we’d most appropriately call a ‘Gong Show.’ There is so much noise with this company, but the key issue is simple…its’ core category is under pressure, and GIL is losing share in that context. Efforts to make up the slack in other businesses – socks, most notably – are not coming at the margins needed to offset the core. That’s why management moved forward with the acquisition of Gold Toe – to add opacity to an otherwise troubling transparent picture. While the diversification to third party manufacturing and brands is nice, it adds an element of risk to a model that already has proved to be one of the more volatile businesses in retail. We still do not like GIL after the guide down, and think that risk remains to 2012 numbers. We’re at $1.97 vs the Street at $2.34.
With margin compression a clear and present risk, concerns over the company’s base business headed into the 2H were briefly muted when the Gold Toe acquisition was announced in April driving estimates higher. On one hand, greater diversification should improve earnings stability and ultimately the multiple the stock is awarded. However, a sharp deceleration in Q3 shipments to distributors (down -9%) and a reduced outlook for Q4 shipments down -5% vs. +3%E due to softness in the U.S. screenprint channel (roughly 60% of total sales) has rekindled concerns about the base business.
Both Gildan and Broder cited the likelihood of pre-buying ahead of July 5th price increases last year as the primary cause of weaker demand along with differed spending in an attempt to capitalize on declining cotton costs. But what’s more difficult to reconcile is the fact that Gildan lost 90bps of market share to 61% across all product lines in aggregate during the quarter as well. It’s likely due to more aggressive pricing, which was up +26% for activewear and underwear offset in part by a -4% decline in unit volume. In fact, second only to softer industry demand, GIL’s move to start promotional discounting to drive sales in the U.S. distributor channel was the next biggest callout of the quarter resulting in lower margins and a meaningful reduction to the Q4 outlook (EPS of $0.40 vs. $0.52E).
Moreover, just as margin pressure becomes a reality and the company anticipates a 900bps swing in sequential gross margin, management is becoming increasingly more opaque about the cost at which cotton is covered. Rather than providing a price, they simply confirmed that it’s covered through the 1H of F12. While GIL expects cotton to weigh on margins through the 1H, management has several initiatives (energy, supply chain, ramping Rio Nance IV, and distribution & transportation) underway that could drive material margin expansion over the next 12-24 months, but that’s a long way off for most who are hyper-focused on the next 6-months. Over the immediate-term TRADE (3-months or less) and intermediate-term TREND (3-months or more), GIL is faced with increasing volatility and further downside risk.
Cost induced margin risk can be challenging enough, but the threat of greater variability in the top-line can lead to highly volatile earnings near-term. With the stock trading at 13.5x our EPS fiscal '11 and '12 estimates and a buck a share in debt compared to two dollars in cash prior to the acquisition, there is little room for doubt. It’s one thing to operate a stable business model through challenging times, but Gildan is trying to transition its business from a full vertically integrated manufacturer into expanding both at retail and internationally at the same time the industry is becoming increasingly volatile exacerbating the near-term earnings risk in this name. GIL remains near the top of our short list along with JCP, HBI, and COH.
Notable management commentary from the call:
- “we have very good visibility and covered for the Q1 and Q2 of next year. And in each of those subsequent quarters, our cotton cost will be less than it was in, obviously, Q4.”
- The company raised prices to cover cotton costs at $1.50 – right now it’s at $1.05 plus ~$0.10 of basis. Considering it takes ~6lbs. to make a dozen shirts, there is roughly a $2 spread.
- Inflationary costs across the industry (energy, labor, transportation, dyes, chemicals, etc.) are up roughly $0.80 a dozen offsetting the positive pricing spread.
Volatility in the model picking up:
- “margins in Q3 were, obviously, over 28%, and we've reported and we've guided to 22% in Q4. That changes really because of the significantly higher cost of cotton that's being consumed in Q4 which negatively impacts margins in Q4 versus Q3 by about 900 basis points.”
- “Overall, industry unit shipments from US distributors to US screen printers declined by 9% during the quarter according to the CREST report, compared with our assumption in our May guidance, the industry demand will grow by 3%.”
- The company also guided Q4 down -5% vs. prior expectation of +3% - an 8 pt. swing.
- Based on weaker demand, the company has initiated promotional discounting in the U.S. distributor channel in order to simulate demand.
- “the quality of the inventory that's in the marketplace may not be as good as it should be.”
- Q: “you've covered cotton at dollar x or dollar y or you partially covered dollar x or dollar y into a given quarter. Are you still willing or able to give that degree of color?”
- A: “No, I don't think we want to provide any more details than what Glenn said. We will be initiating our guidance for 2012 when we report at the beginning of December”