GIL: Stock Popped, but Model Has Not

GIL's stock has had a nice bounce since hitting its $23.75 low on the 5/2 preannouncement. Tough to explain away every tick, but one of the factors is likely the 6% drop in cotton prices and breaking through basic technical readings. Perhaps it gets a boost today with the positive mention in Barron's over the weekend. That's good, no doubt. But this story goes way beyond cotton folks. I'm extremely cautious on the fundamental model here. Here's why.

GIL Then . Gildan is coming off of a 7-year run where it radically altered its cost structure as it shifted production from North America to the Caribbean basin. Over that time period, GIL used its improved cost structure to double its share in the 'blanks' t-shirt business to 60%, grow share in fleece to 50%, and still have enough cost cuts left in the tank to improve reported Gross Margin rate from 25% to 33%. As always, I've gotta give credit where it is due. GIL has succeeded in offshoring where others have failed. But the rate of improvement is in its 9th inning. GIL has benefitted from 20%+ top line growth, 1 point/yr+ annual GM rate improvement, extraordinarily low levels of SG&A spend, and a tax rate close to zero. That equaled net income growing by 3x over 4 years. Not a bad story at all, and no surprise that GIL's cash flow multiple went from 10x to a peak of 26x (now down to a still lofty 16x).

GIL NOW : One of the nice things about GIL is that we have visibility on its new capacity, and can make assumptions about productivity and pricing to forecast revenue. Based on my math, I think that revenue growth in '09 and '10 will slow dramatically from the 30% rates we've seen recently. At the same time, I think that Gross Margins (which had been heading straight up) will reverse course due to cotton costs and a shift in mix to mass retailers. As a frame of reference, GIL needs to take up price by 1% to offset every $0.04/lb in cotton prices. At current prices, we're already looking at a 2% price increase needed in FY09. That's tough to bank on. Lastly, I think it is important to note that GIL has an SG&A ratio of only 12%, which is lower than just about any consumer goods company out there. Given that the retail-growth strategy requires SG&A spending to build the brands, I don't think that GIL can continue to spend at a rate less than half its competitors. The bottom line is that revenue is slowing, gross margins are peaking, and SG&A needs to head higher. This should take a 40%+ EPS growth rate towards something well below 20% (and perhaps even 10%) for '09 and '10.

In the Barron's article, Royce Associates notes that Gildan could be double its current size in five years. That's entirely possible. But I'd argue that it would be at a margin structure about 1/3 below where it is today, and not worthy of its current mid-teens p/e and EBITDA multiple.

Chart below shows sales slowing, GM eroding, and SG&A heading higher based on my model.