- Delta Apparel is trading at a mid-single digit multiple of normalized earnings providing significant upside potential for value investors, additionally Delta Apparel trades within 15% of liquidation value.
- Management has taken a proactive approach to rationalize underperforming business units and unlock earning power.
- Recently acquired brand Salt Life is worth almost the entire market capitalization providing a free call for Delta Apparel shareholders.
"It always seemed, and still seems ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the...net current assets alone…the results should be quite satisfactory. They were so in our experience, for more than 30 years." -Benjamin Graham
In today's low interest rate environment, such deep value investments as described by Graham are rare; however, after announcing a low-awaited cost restructuring program and a reset of street expectations, shares of Delta Apparel (NYSE: DLA) have become an attractive value investment.
DLA is an asymmetric investment opportunity: a business trading at $10.30/share with $9.50/share in tangible book value, $17.50/share in GAAP book value, and with the potential for $2+ share in earnings power within the next 18 months (5x earnings).
Background
Delta Apparel operates an international apparel business for the design, manufacture and distribution of both branded and unbranded apparel products. DLA is organized in two segments: Branded which includes the Soffe, Junk Food, and Salt Life brands among others; and Basic which sells unembellished knit apparel to screen printers and major retailers. Delta has manufacturing facilities in the US, El Salvador, Honduras, and Mexico and has strategic distribution facilities in the US, allowing for same-day delivery of basic apparel in many markets. Wall Street has largely abandoned Delta Apparel, and shares trade near multi-year lows and currently offer investors an opportunity to invest in a company with limited downside and the potential for 80-110% upside over an 18-month holding period. The basic investment thesis is as follows:
Downside is limited by $9.50/share in Tangible Book Value.
Much of TBV is comprised of assets that are easy to liquidate including basic t-shirt inventory, and accounts receivables, so TBV is representative of economic liquidation value. In addition to DLA's stated balance sheet, certain assets are understated, primarily Soffe real estate, as well as several trademarks. Less than one year ago, a sell-side firm stated in an initiation report that the aforementioned assets have been appraised and are worth $5/share in excess of their stated value; however, for conservatism I do not include these assets in my valuation.
(click to enlarge)
Source: June quarter 10-Q
While DLA will likely generate a GAAP loss this year, it trades at a depressed mid-single digit multiple of recent historical earnings.
In FY2013 DLA earned $1.08 per share, and in FY2011 DLA reported $1.98 in earnings. Just several months ago, DLA management guided to $2/share in earnings for FY2014. Delta operates in a cyclical business buffeted on one side by the cotton cycle and the consumer spending cycle on the other. As a result, I value DLA shares by taking a normalized margin over the past 10 years and apply it to current revenue levels to take into account for expansion in capacity.
(click to enlarge)
By applying the 10-year average net margin to TTM revenue of $467m we arrive at a normalized profit of $16m or ~$2/share (5x earnings). However, given that the 5-year average is lower than the 10 year, due to recent volatility in cotton prices and the weak economy following the financial crisis, for conservatism we can use the 5-year average to arrive at a downside case normalized earnings of $1.12/share.
Additionally, Delta trades a trough multiple of book value.
As seen in the below diagram, if DLA shares revert to recent historical multiples of book value, there is significant upside for investors.
(click to enlarge)
Delta's management recently implemented a profit improvement initiative aimed at rationalizing non-performing business units that has the potential to significantly increase earnings power.
Management outlined their commitment to improving profitability in their June 10-Q (emphasis mine):
We have begun a reorganization of our administrative structure at all levels to streamline decision-making and information flow, as well as reduce duplicative and excess fixed costs. Workforce reductions are taking place designed to de-layer the management structure, leverage back-office functions, and streamline departments through the use of information technology systems that have recently been, or are currently being, implemented. The headcount reductions should result in approximately $7 million in annualized savings, with about $5 million recognized in fiscal year 2015.
While $7m does not sound like much, it represents a 9% yield on DLA's current market cap and ~$.90 in pretax earnings per share. Additionally, the removal of these fixed costs will allow DLA to operate at a higher level of normalized earnings. While $2/share was our 10-year estimate of normalized earnings and $1.12 represented the 5-year average in period of volatile cotton prices, it is safe to say that with this restructuring has raised normalized earnings from $1.12 to $1.85/share assuming a 20% marginal tax rate in line with DLA's historical tax rate. Put another way: it's likely that the restructuring will involve elimination of corporate waste that crept into DLA's operating model over the past few years as they grew revenue, and thus these cuts should enable DLA to return to positive earnings in 2015 and to historical earnings levels within the next 18 months as the retail environment normalizes.
Delta has a hidden jewel of an asset in growing brand Salt Life that alone is likely worth more than DLA's entire market capitalization.
Salt Life is a salt water lifestyle brand expected to grow 50% in 2014. DLA owns Salt Life outright and thus represents a unique opportunity to invest in one of the fastest growing brands in North America. Salt Life is on track to produce $30m in revenue this year, and management has guided to a double digit operating margin.
source: Delta Apparel May 2014 investor presentation
It is not a stretch to say a brand growing at 50% y/y is likely worth at least 20x EBIT or in this case $60m or $7.60 per DLA share. Management acquired the Salt Life brand in August 2013 for $39m, and after delivering two strong quarters I believe the value of this business unit has risen. Another key point is that Salt Life is not reflected in the historical earnings power of Delta's base businesses given that it was only just acquired, so our estimate of $1.50-1.85 of post restructuring normalized earnings does not include the earnings power of Salt Life.
If we project 25% growth for Salt Life in 2015, well below 2014 projections, the unit should produce $0.45 in after tax earnings per share.
The Salt Life acquisition was recorded on DLA's balance sheet as 100% goodwill and intangibles, and as a result it is not accounted for in DLA's TBV as seen in the below table from the June 10-Q:
(click to enlarge)
Why value DLA using P/E instead of EV/EBITDA given DLA carries debt?
Many investors likely consider DLA to have a heavy debt load in relationship to its market cap. While this is superficially true, I believe it is best to net debt against working capital for a company like Delta because the debt is used to simply improve DLA's working capital situation. Delta uses a covenant light asset based facility. As you can see from DLA's last 10-Q they have plenty of availability under their revolver (emphasis mine):
As of June 28, 2014, we had $106.2 million outstanding under our U.S. credit facility at an average interest rate of 2.6%, and had the ability to borrow an additional $30.8 million. Our credit facility includes a financial covenant requiring that if the amount of availability falls below an amount equal to 12.5% of the lesser of the borrowing base or $145 million, our Fixed Charge Coverage Ratio ("FCCR") (as defined in the Amended Loan Agreement) for the preceding 12-month period must not be less than 1.1 to 1.0. As availability was above the minimum, we were not subject to the FCCR covenant at June 28, 2014. At June 28, 2014, and September 28, 2013, there was $8.6 million and $9.9 million, respectively, of retained earnings free of restrictions to make cash dividends or stock repurchases.
Based on the asset-rich nature of DLA's balance sheet and the extremely low levels of interest and covenants on Delta's debt, the best way to view Delta's debt is netted against inventory and working capital, and as a result we utilize a P/normalized earnings and P/TBV valuation matrix.
Risks
The largest risk in the short term is that the market reacts unfavorably to a Q4 that is burdened with restructuring charges and produces a large negative earnings number. I believe that downside is buffered by the current low multiple of tangible book value. A more existential risk is that some of the t-shirt inventory is currently marked above net realizable value. Given that the 2011 spike in cotton prices has now fully been worked through inventory, I believe that current inventories could be sold at cost in liquidation given that DLA is currently earning a 15-20% gross margin. Management reaffirmed that inventory levels are conservatively marked on the Q2 conference call.
A final risk is that CEO Bob Humphreys, despite owning 456k shares or ~6% of the company does not act quickly enough to rationalize costs and position DLA to produce attractive returns on equity. I am encouraged by his initial steps to rationalize costs as discussed above. That said, if Humphreys falters, I believe that the 13Gs recently filed by Aegis Capital and Franklin Resources might re-file as 13Ds and advocate a replacement of the current management team with one capable of unlocking the significant value of DLA's assets.
Valuation
In our base-case scenario Delta shares are worth at least tangible book value of $9.50 per share and ~50% of GAAP book value based on significant inventory and accounts receivables mostly related to the basic apparel segment. Over the next 18 months, assuming the apparel market recovers from its current cyclical low, and management can produce the $7m in cost cuts they have laid out, it is safe to assume that Delta could deliver earnings power of $1.50-1.85 per share. Assuming a conservative 8x multiple on the low end of that range, Delta's core business is worth $14/share. Additionally, Salt Life is a recent acquisition that is likely worth at least as much as management paid for it ($39m or $5/share) with the potential to be worth as much as $8 per share in the near future. As a result we see upside in DLA shares of $19-22 within the next 18 months for an 80%-110% return. It is noteworthy that as recently as September 2013 DLA shares traded as high as $19, and they have a 52-week high of $18.82, so while our price target represents an outsized return it simply suggests DLA shares return to a price level realized less than 1 year ago.
In addition to our base-case values, we will seek to determine liquidation value in the event of adverse industry or economic developments that occur within our investment horizon; given the interchangeability of DLA's inventory of blank t-shirts, as well as the ease of factoring accounts receivables with healthy collection history like Delta Apparel's we believe DLA could liquidate for close to tangible book. That said, for conservatism we estimate that DLA can get 70% tangible book value, and sell the Salt Life Brand for half of what they paid for it less than 1 year ago (remember, DLA paid $39m for the Salt Life brand, with the entire purchase price being allocated to goodwill and intangibles so there is no overlap in the value I am ascribing in this calculation to Salt Life and DLA's TBV). Performing this calculation gives us a downside value of ~$9 per share or 12% downside from the current share price of ~$10.30.
Conclusion
Based on Delta Apparel's extremely asymmetric risk reward with 80-110% upside and only 12% downside to a conservative liquidation value, we believe patient value investors can earn differentiated positive returns with well below average risk by owning DLA shares over next 18-24 months as management unlocks historical earnings power and the recently acquired Salt Life brand continues to grow.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
Disclosure: The author is long DLA.
No comments:
Post a Comment