Move Over Cotton, Cash Is King!
Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Students of American history are probably familiar with “King Cotton.” The term came into use during the Civil War era to signify the enormous impact that the cotton crop had on the economy of the Southern States. Cotton no longer has singular importance to the fortunes of any particular geographic region, but there are still industries where cotton has a major impact and where the year to date decline of cotton prices has been meaningful. Companies in apparel manufacturing and retail have seen outstanding stock performance this year with the weakness in cotton (a primary cost input) contributing to expected improved results next year. Hanesbrands (NYSE: HBI), Gildan Activewear (NYSE: GIL), and Limited Brands (NYSE: LTD) have seen their shares rise 30% to 80% year to date, while Maidenform Brands (NYSE: MFB) has lagged the group, rising by about 3%. Because of the sharp rise in share prices, investors in these companies might be headed out the door, however, if cotton prices reverse course and go higher.
Because they are primarily engaged in the manufacture of apparel and clothing, Hanesbrands and Gildan are directly impacted by changes in the price of cotton. Hanesbrands disclosed in its fiscal year end 2011 10-K that cotton typically represents about 6% of their cost of sales but this figure rose to around 12% in 2011. The rise in cotton’s share of Hanesbrands’ cost of sales was a result of the company’s cotton costs increasing to an average $1.09 per pound in 2011 from just $0.69 per pound in 2010. Gildan does not disclose these metrics but the impact of cotton prices is likely similar to Hanesbrands because both companies indicate that a $0.01 per pound move in cotton prices affects annual raw material costs by approximately $4 million.
Hanesbrands and Gildan are expected to grow their EPS between 11%-13% and both companies trade at a forward price to earnings to growth (PEG) multiple of about 0.9x. Operationally, both companies have produced free cash flow of 5.6% of revenue on average over the past 9 years. Hanesbrands and Gildan share these investment attributes but they do differ in some key operating metrics, with Gildan having the better results.
Gildan has been able to turn over its inventory more quickly at about 119 days compared to Hanesbrands at about 152 days. Also, Gildan is the low cost leader with a long term average operating expense to revenue ratio of a little more than 14% compared to more than 24% for Hanesbrands. This cost structure advantage is critical in the commoditized apparel business and has allowed Gildan to generate returns on invested capital of more than 17% on average compared to slightly less than 11% for Hanesbrands. Finally, Gildan’s financial leverage position is much more favorable with equity at about 75% of total capital compared to just 20% for Hanesbrands.
Maidenform and Limited, as designers and retailers of apparel, encounter the risk of rising cotton prices indirectly through their inventory purchasing. With revenue of more than $10 billion, Limited, whose signature brand is Victoria’s Secret, dwarfs Maidenform’s revenue of only $600 million. A comparison of the companies’ operating metrics demonstrate that Limited has been able to use its scale to its advantage and has produced better returns on invested capital of about 14% on average compared to just 12.7% for Maidenform.
Limited’s scale advantage also shows up in superior profitability with average gross margin and operating expense percentage of more than 36% and less than 26%, respectively, compared to less than 35% gross margin and almost 28% operating expense percentage for Maidenform. Similarly, average inventory turnover of 69 days for Limited easily bests the 80 day average inventory turnover at Maidenform. One operating metric in which Maidenform exceeds Limited is average free cash flow as a percentage of revenue at 6.6% compared to 6.2% for Limited. However, this is a result of greater capital spending by Limited at 4.4% of revenue compared to only 1.0% for Maidenform. Limited is able to sustain its competitive position through greater capital spending because its cash flow from operations has averaged 10.5% of revenue compared to just 7.6% for Maidenform.
In its operations, Limited is the more appealing company and investors recognize this, making Limited the less attractive investment at recent share prices. Limited carries a forward PE ratio of around 14.7x compared to just 11.9x for Maidenform despite the fact that analysts estimate forward EPS growth of about 13% for Limited compared to about 14% for Maidenform. Putting these pieces together, Maidenform has a much lower PEG multiple at 0.9x compared to 1.2x for Limited. Because its operations are superior I prefer Limited over Maidenform and the PEG multiple, while higher, does not alter the assessment.
These apparel manufacturing and retail companies have enjoyed market beating returns this year as the price of cotton has fallen from its record highs. Investors looking to purchase these companies should be aware of this outperformance and also should consider the cyclical nature of the companies because if cotton prices go higher and earnings growth stalls, share prices could tumble. Tracking the price of cotton is a necessary task when evaluating these companies but “King Cotton” is a relic from another age and investors should instead pay homage to the Foolish idea that cash is king for long term investment success.
56Steve has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!