Gildan earnings appear threadbare
The apparel market is a competitive one, and Gildan Activewear Inc. (GIL.N) is, compared to rivals Hanes (owned by Hanesbrands Inc. (HBI.N)) and Fruit of the Loom (owned by Berkshire Hathaway (BRKB.N)) brands, a smaller player. To gain market share against these brands, Gildan has slashed prices on everything from its fleece tops to its socks (it’s now the world’s largest sock manufacturer, after purchasing Gold Toe Moretz Holdings gave it 40% of the market), a strategy that has had mixed results but significant costs. Hanes has forfeited some of its market share (although it now is pursuing a differentiation strategy), while Fruit of the Loom has simply continued to gain further. Gildan’s aggressive approach to price-cutting has taken a toll on its margins in an industry where the margins are already razor thin; Gildan’s operating margin now stands at 9.4%, below the industry median for the first time in five years. As if that weren’t enough, the company has also had to contend with volatile cotton prices: after cotton prices surged last year, Gildan ended up with high-priced inventory, contributing to its first quarterly loss (for the period ended Jan. 1, 2012) in more than a decade and only the second since the Montreal-based company went public in 1998.
So it’s not surprising that Gildan is one of the companies identified by the StarMine Earnings Quality (EQ) model as having poor earnings quality. Indeed, its score – only 7 on a scale of 1 to 100 – signals that the company’s earnings are coming from sources that may not be sustainable in the future.
StarMine uses computer-driven models to analyze the financial statements calculate these proprietary StarMine Earnings Quality (EQ) scores for each security; companies like Gildan, with low StarMine EQ scores, are likely to have difficulty in sustaining past earnings. (For a more detailed explanation of this model, please refer to the recent AlphaNow discussion of American Express). This look at Gildan Activewear is the next installment in our series of articles examining companies across North America that rank either especially high or low in terms of earnings quality, as measured quantitatively by the EQ model.
In the chart below, the red bars represent quarters in which Gildan’s free cash flow (FCF) lagged its net income; earnings that are sustainable tend to be those that they are backed by strong FCF. In Gildan’s case, however, FCF trailed net income in three of the last four quarters. In the most recent quarter, not only was net income negative (the company reported a loss of $46 million), but the company’s FCF also turned negative – amounting to an outflow of $137 million.
The charts below show that, in the latest quarter, inventory days increased to 192 and A/R days increased to 50 days. Together, that led to an increase in the cash cycle to 162 days in the December quarter from 106 days in September 2011, meaning it is taking longer for Gildan to collect cash from disbursements. Poor control of the company’s working capital could lead to a near-term drain on cash flows, and eventually deterioration in earnings, since these accrual items tend to reverse.
Another reason Gildan scores so weakly on the StarMine EQ model is that operating efficiency measures have shown signs of weakening. The company’s net operating asset turnover is at 1.2 turns, returning to lows not seen since the recession of 2009. The industry median is 2.5 turns, which means that the competitors like Hanes and Fruit of the Loom are using their assets more efficiently as well as putting downward pressure on margins. Together, these warn that the company may have a hard time sustaining earnings in the coming quarters. Given the company’s weak EQ score of 7, that recent quarterly loss – as noted, the first since 2001 and only the second in its history as a public company, may not be an exception but the beginning of a new and problematic trend, regardless of what happens to cotton prices.
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