Takeaway: Numbers for '20 have come down too far as it relates to the de-stocking. We’ve seen this movie before, historically, this is when you buy.

After making the Street wait a painful 2 weeks since its pre-announcement with no conference call (which was an IR/PR gaffe), I actually give management credit for projecting a sense of calm on today’s call. Much of what we heard was what we already knew – that the slowdown in the quarter was isolated to screenprint, and was fairly broad-based (HBI echoed that this morning as well). Management noted that the pricing environment is rational, and that it is not losing share. Based on our calls over the past two weeks, I believe that’s predominantly true. That said, there’s a bit of a game of cat and mouse going on…when it talks about pricing, and that it won’t devalue inventory for its customers, it was talking to its customers – not to Wall Street. In the end, I think that we see some degree of price concession in order to get velocity churning again – something I think GIL can afford given that cotton is turning into a tailwind, and that the price points are so much higher in fashion basics without comparable increase in cost to make. There have been three de-stocking events in the past ten years in this business, and they have always proven to be the best times to buy the stock – even though it took a painful leap of faith at the time. In the end, we should see a meaningful reacceleration in revenue in 1Q20. We’re nearly $0.20 ahead of consensus for next year, with an upward bias to our number – pending what we learn when we go to Honduras in two weeks for the company’s analyst meeting. As growth reaccelerates, so should the earnings revision factor and the multiple. We’re looking at 17x our out-year estimate of $2.53, or a $43 stock in 12-18 months – which is 65% upside from here with very strong downside protection.

 GIL | Buy Ahead of 2020 Growth Reacceleration - 10 31 2019 GIL chart1

Responding to the downturn

Gildan reported Q3 EPS in line with the lowered consensus expectations of $.53. Management tried to project a sense of calm on the call. They said there has been a slowdown that was broad based, but it was limited to screen print. Management said past downturns have only lasted two to three quarters (which is true). They said the pricing environment largely wasn’t promotional and they aren’t losing share. Management does not see the downturn as something to cause alarm, but a time to do what they have done in the two previous downturns – get more efficient on costs and come out of the downturn better positioned than before.

In that context it is no surprise that the responses the company was taking to the downturn that were communicated on the call were all on the cost side. Gildan is going to cut its highest costs and become leaner. Management said they are going to close the Mexico facility that was acquired through the Alstyle acquisition. They will move the equipment to their plants in Honduras and the Dominican Republic in two phases over the next one to two quarters. The Alstyle facility in Mexico represents 8-9% of capacity or 20mm dozens and would produce roughly $300-350mm in revenue at full utilization. It hasn’t been at full utilization, because it was a higher cost facility. A good portion of Alstyle’s fashion basics production was moved to Rio Nance 6 over the past year as well. Gildan didn’t acquire Alstyle for the manufacturing facility, but before RN6 opened it needed the capacity. Shutting it down during a seasonal slow period should also help manage inventory levels while keeping production at the other plants better utilized. Management also said they are assessing fully phasing out the direct ship-to-the-piece imprintables business like Comfort Colors. Comfort Colors has revenue of $55-60mm that is sold directly to screen printers or through distributors. Gildan has probably already decided to get out of shipping directly to screen printers. It is probably assessing which distributors will be given the business and at what terms.

Don’t count out new business wins

There was no word on further private label wins, but we expect to see Gildan in new categories and doors at mass retailers in 2020. The timing of RFPs may not line up with a Q3 conference call. Mass retailers have clearly shifted to adding more private label in their apparel offering. Given all the advantages Gildan has over the competition the new tariffs going into place on List 4 imports may be the best opportunity to overcome the inertia of existing manufacturing relationships for retailers. Management will likely speak to new business wins when they address their 2020 outlook in more detail. At this share price new business wins are not priced in.

What’s still working

Fleece and fashion basics still grew in Q3. While sock sales declined the retail business was still in line with plans due to growth in activewear categories and new shelf placement. Global Lifestyle Brands still grew double digits. The business had always been held back by available supply while smaller and less profitable contracts were culled. We would like to learn more at the analyst day about what business Gildan wants to win as the US tariffs raise costs for the incumbent manufacturers.

De-stocking/devaluation

Management described the de-stocking at the distributor level as normal in a slowdown. Gildan expects restocking to resume in 2020 after the downturn ends and distributors position for growth again. Gildan has told the distributors to not expect an inventory devaluation – where Gildan credits the distributors for the difference in cost for the inventory and the current market price. Gildan has given the distributors a devaluation three times in the past (2009, 2012, 2015) after significant drops in cotton prices and would like to wean the distributors from the support. However, the devaluations worked very well in the sense that restocking immediately resumed, the industry started to grow again, and Gildan gained share. It is still yet to be determined if there will be a devaluation in the coming months despite Gildan’s stated intentions, but one should be viewed more like an inventory charge and not as an ongoing margin drag.

The most important question

The most important question as we see it from here is Gildan’s ability to compete in fashion basics with its Gildan, Gildan Hammer, Anvil and American Apparel offerings. We still believe screen print fashion basics is a commodity business like the cotton basics business. We don’t consider consumers purchasing the fashion basics from Next Level and Bella Canvas undecorated (like they used to purchase American Apparel several years ago) as a commodity business. Buying those items undecorated is not taking share from screen print cotton basics. However, we still believe screen printers will accept Gildan in fashion basics as its product development, marketing and pricing improves. It is our contention that consumers purchase screen print garments for the designs on them and not for the tag in the back that may or may not be removed. We expect to be able to best frame the future of fashion basics after the analyst day where we will have extended access to Gildan’s management. What makes success in fashion basics so important is the share it will take from cotton basics in the future while also being the highest margin category for the industry. Gildan did not announce any strategic changes in fashion basics on the conference call, but we would be surprised if Gildan has not already started making some changes.

Other possible actions

We can only be left wondering if Gildan would have seen much of a slowdown in screen print if it had purchased Bella Canvas or Next Level instead of Alstyle or American Apparel. Next Level sold a majority stake to private equity last year. The price to sales multiple at the time would have been at least 2x more expensive, but would probably be much closer today. Acquisitions are still a possibility with Gildan’s balance sheet, but management likely does not view it as a good strategic move. The point is if it does get worse from here it could quickly get better and that is not priced in.

Upside/downside

Shares still have the same upside they did prior to the revenue headwinds, but have been pushed out. We view upside at $43 representing the out year (2021) EPS power of $2.50 at a 17x multiple.

Shares have troughed at 13x forward EPS in the past when things looked a lot worse (great recession, largest distributor potentially filing for bankruptcy, a historic crash in cotton prices).  So the current multiple reflects to us 13x normalized for cotton costs EPS of $2. We think downside is $24 representing 14x EPS of $1.60.  

Estimate changes

To reflect lower revenues and gross margins in the 2H we are taking our 2019 EPS estimate to $1.67.

Our 2020 EPS estimate goes to $2.15 reflecting a lower base in 2019, continued screen print market weakness in the 1H followed by restocking and market growth in the 2H, and lower gross margins due to lower utilization.

Q3 detail

  • Sales declined 2% with activewear up 1.1% and hosiery & underwear sales down 15.1%. US and International sales both declined 1.6% while Canada declined 10.9%.
  • Lower sales in the imprintables channel was partly offset by double digit growth in Global Lifestyle Brands and growth in fleece and fashion basics.
  • Gross margin contraction of 160bps was worse than our estimates. Q3 consumed the last of the higher cost cotton and Q4 should still see a swing towards gross margin expansion after the lower cost cotton finally is sold through.
  • SG&A decreased $9.1mm and leveraged 100bps. Management likely reversed some bonus accrual from earlier in the year, so we are not projecting similar SG&A declines going forward.
  • The company did not repurchase any shares during the quarter.
  • EPS declined 7.5% YY.

GIL | Buy Ahead of 2020 Growth Reacceleration - 10 31 2019 GIL chart2