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Morningstar | Gildan Takes Prime Shelf Space Away From Gildan; We Maintain our Overvalued View

No-moat Gildan’s third-quarter numbers were overshadowed by the news that it was awarded a men’s underwear private-label contract at its (unnamed) largest retail mass customer. Walmart fits this description. While a new contract is good news, Gildan also announced this private-label contract (which begins in second-quarter 2019) would replace its branded men’s underwear at the retailer. One silver lining is the company claimed the private-label deal would expand by its total shelf space at the retailer (from a small base). We view the loss of branded underwear at Walmart as affirmation of our view Gildan lacks strong brands or a moat.

We see some weakness in Gildan’s third-quarter report. The report was mostly in line with our forecast, but hosiery and underwear remain very soft. This segment suffered a 16.6% year-over-year decline and Gildan provided a poor outlook. The company estimated a $125 million drop in 2018 sales for this segment, significantly worse than its previous guidance of a $85 million decline. Gildan’s branded socks are losing shelf space to private-label product at Walmart, another sign that Gildan lacks strong brands.

Gildan’s reported sales ($754.4 million) missed our forecast by $21.6 million. Gildan claimed it lost about $30 million in total sales from disruptions due to Hurricane Florence. Activewear sales, nonetheless, increased 12.1% year over year. Gildan’s gross margin of 29.0% missed our forecast by 500 basis points and was impacted by higher input costs and disruption to its Central American supply chain. Gildan’s operating margin of 16.9% matched our forecast, and its adjusted EPS of $0.57 nearly matched our forecast of $0.58.

We plan to maintain our fair value estimate of $23 (CAD 30.50) on Gildan and believe the shares to be overvalued. The firm slightly lowered its full-year 2018 guidance due to the hurricane and weakness in branded socks. The adjusted EPS range was narrowed to $1.85-$1.87 (in line with our $1.86 forecast).

We view the substitution of branded for private-label underwear at Walmart as a setback to the company’s long-term strategy as the trends look bad. Gildan’s branded sales increased by $300 million from 2012 to 2015, plateaued for two years, and are now declining. Further, branded sales will fall hard in the second half of 2019 when Walmart replaces Gildan-branded underwear with Gildan-manufactured underwear that does not carry its name. Gildan did not provide any detail on the economics of the private-label deal, but it is likely that margins will be lower than for its branded underwear. Walmart is notorious for squeezing suppliers’ margins to maintain low prices.

Gildan continues to repurchase stock aggressively. It used $366.1 million in cash on repurchases in the first 10 months of 2018 and has already exceeded our full-year expectation. We view these repurchases as ill-advised at current prices as we rate the stock as overvalued. Note that Gildan changed its 2018 free cash flow guidance from greater than $425 million down to a range of $400-$425 million. Our estimated 2018 free cash flow to equity of $437 million may be revised downward.