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The following segment was excerpted from this fund letter.
Gildan Activewear (NYSE:GIL)
Gildan is another company with a business model we believe is misunderstood by the market. Like Steven Madden (SHOO), it is also a company whose historical success is based upon its supply chain; in this case, however, Gildan manufactures their own products, whereas Steven Madden sources the vast majority of its products from third-party producers.
Although Gildan spent the first several years of its existence manufacturing textiles and finished fabric, it changed its operating strategy approximately thirty years ago to focus on selling activewear (primarily t-shirts, later fleece and other products) to the North American screen printing market. As you may know, screen printing is the process used to transfer artwork to apparel with end markets anywhere from fashion apparel to t-shirts for your family reunion. The traditional screen printing industry, as Gildan has focused upon it, consists of thousands of generally small individual print shops, which are served primarily by a handful of large screen print distributors. These large distributors make up the majority of Gildan’s business in the screen printing channel.
There are a few quirks to this business that make it very different than most apparel, shoe, or retail businesses. First, this business is basically the exact opposite of a fashion business, such as Steven Madden’s: a significant portion of this business consists of manufacturing blank white t-shirts. They do not go out of fashion, and they do not expire. Second, and most importantly, Gildan’s big customers in this business, the screen print distributors, win by having inventory available when their thousands of small customers need it. However, as distributors, these customers’ economics depend significantly upon their ability to turn inventories. In plain English, this means that they need to have inventory on hand when their customers want it, but they also don’t want to hold excess inventories.
Gildan built a very successful business over time, with excellent growth rates and healthy levels of profitability, by building a business to serve these screen print distributors perfectly. The Company accomplished this by building manufacturing capacity in low-cost regions in Central America and the Dominican Republic – areas in much closer proximity to the North American end markets than competitors with Asian manufacturing bases – as well as constantly reinvesting cash flows in further capacity expansions and upgrades. This provided a steady stream of incremental modern, high-quality capacity that could serve the screen print distributors with very short lead times – exactly what their customers needed to run their own businesses successfully. Gildan has vacuumed share of this market for a long time. While the Company rarely comments on their market share, we believe their share of the U.S. and Canadian industry now stands over 60%.
Interestingly, for years Gildan stayed within this corner of the industry. Looking back approximately 10-15 years, however, the company made a few strategic changes to pursue new markets and new growth opportunities. As the Company felt it was approaching the maximum share it could expect in the screen print business, it started building capacity to deliver branded Gildan products to mass retailers, such as Wal-Mart and Target. Gildan also made a few acquisitions to break into what it viewed as complementary products in areas such as socks and underwear.
Both moves put them head-to-head versus a fairly entrenched competitor, Hanes [or Hanesbrands], which had long specialized in supplying branded products to mass market retailers. Gildan also was going to market from a different competitive position, as the #2 or #3 player in a market dominated by two or three giant customers, rather than as the far and away #1 vendor in the screen print market.
In our view, this foray into mass-market retail customers hasn’t been their best strategic move. Eventually this culminated in a significant restructuring, resulting in the company attempting to pursue a much smaller, more basic business in underwear, in particular. In fairness, however, the company has fared better in its traditional activewear categories (tshirts and fleece) than it has in underwear, and they have also fared reasonably well in socks, although this is a very low growth category.
It’s worth pointing out that Hanes, around the same period Gildan was trying to move into mass market, spent several years migrating their manufacturing base for its North American business to the western hemisphere, very much like Gildan’s strategy. Hanes also attempted a few sallies into the screen print market, just as Gildan was trying to make an entry into mass market retail. Hanes, even after imitating Gildan’s manufacturing footprint, still found it could not beat Gildan in its screen print market – just as Gildan was struggling to dislodge Hanes in mass market. Hanes eventually exited the screen print market, just as Gildan, now, has stepped back from some of its branded mass market business.
We have ended up with a very healthy separation of the two businesses, in our opinion. The Hanes brand name, and the company’s long experience managing a mass market brand, as well as the management of categories more complex than blank white t-shirts, give it the dominant position with the mass market retailers, whereas Gildan’s advantages in cost and speed to market in the less concentrated screen print market give it the dominant position there. Furthermore, after the migration of its manufacturing base for North America, Hanes has eased up on capacity expansion, and it seems happy to grow at the modest pace of its large mass market customers. Gildan, on the other hand, continues to invest in new capacity as they always have done. We note the Company’s capex as a percent of revenue is nearly 4X the same metric for Hanes. This allows the Company to serve the growth of the screen print market while still playing in mass market as it mops up demand growth that Hanes is not serving with new capacity.
Moving on to the company’s stock, we purchased our initial position in Gildan this past summer, after it had taken a roughly -40% hit from its early-year highs. We believe the market has been spooked by two related issues: the well-publicized inventory corrections at large mass-market customers such as Amazon, Wal-Mart, and Target; and the fact that the Company has begun to build additional capacity after a Pandemic-era pause. We believe the basic thinking is “these idiots are building capacity in a shrinking market.” The problem with this is that mass market is Gildan’s smaller and relatively less important business; the larger screen print business has remained strong. Many of the drivers of that portion of the business (i.e., travel, events, sports) are still recovering from the Pandemic. We suspect the market attributes abnormally large importance to the mass market business because that is the part of the business most people understand. It is much easier, especially for observers who are not specialists in the apparel industry, to track how Wal-Mart and Amazon are doing than it is for them to understand an odd business serving thousands of little print shops. As for the capacity growth worries, the company already has secured business for both 2023 and 2024 with their new capacity; they are not just tossing up some new factories and hoping for the best. We believe the inventory corrections at large retailers will be easing over the next couple of quarters. We already have seen Wal-Mart make considerable progress on their inventory adjustments through their third quarter report, and we expect to see further evidence emerge from the industry as fourth quarter retail earnings are reported. Once these worries are lifted, we expect the market to reward Gildan with more realistic estimates for growth as well as a more normalized valuation.
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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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