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Gildan gets its foot in a lot more doors Add to ...

Who knew socks could be so exciting?

Gildan Activewear Inc.'s purchase of Gold Toe Moretz Holdings is one of the rare deals where the acquiring company sees its shares zoom on a deal's announcement. As my colleague Boyd Erman noted on the Streetwise blog last week, while analysts were "cranking up" their target prices for Gildan, "investors are pushing up the share price even faster." Shares jumped 11 per cent last week and closed on Monday at $34.33, up 20 cents.

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At first blush, it seemed to be too much enthusiasm for a $350-million (U.S.) acquisition. But a closer look at the deal's economics suggests the analysts who are adding 25 cents or more to their Gildan earnings estimates are being conservative - and the investors bidding up the shares fully understand the sweet deal the company has struck.

In buying Gold Toe Moretz, the product of a 2006 merger, Gildan gets a sock maker with its own Gold Toe brand as well as exclusive licences to make socks bearing the Under Armour and New Balance brands.

Gold Toe Moretz rang up $280.1-million in sales in 2010, but it produced profit of $2.3-million. The chief culprit for the profitability problem? The company's owners, a collection of leveraged buyout firms, coughed up $32.4-million in interest expense because they loaded up the company with double-digit-rate debt.

Look at EBITDA instead of profit and Gold Toe Moretz produced about $38.5-million in earnings last year. (Gildan prefers an "adjusted EBITDA" figure of $48.6-million that leaves out even more expenses, but we'll stick to a more traditional measure.)

Gildan pointedly notes it's not assuming any of that expensive debt. Instead, the company's pristine balance sheet provides the rewards: Gildan will pay about $150-million of the purchase price from cash on hand, and borrow $200-million from a line of credit that has, the analyst team at CIBC World Markets says, an interest rate of 1 per cent, rising to 2 per cent next fiscal year.

Why It Works

What makes the deal such a boon for Gildan is its relatively small shares outstanding count of 122 million, which will not increase thanks to the all-cash consideration. Spreading Gold Toe Moretz's earnings over that share count - even allowing for depreciation, amortization, and taxes - adds roughly 25 cents to Gildan's earnings per share, a boost of 15 per cent over fiscal year 2010's levels.

And Gildan management promises cost-saving synergies of $10-million to $15-million over the next 24 months; the midpoint of that range suggests another 10 cents added to EPS.

It becomes clearer, then, why the analysts following Gildan had to bump their earnings estimates and target prices up - it was a matter of simple math, not speculation, as Gildan struck one of the most immediately accretive deals you'll see this year.

There is room, however, for more sunny prognostication. Surprisingly, says Mark Petrie at CIBC, Gildan did little to no business at department stores such as Macy's, Dillard's, JC Penney and Kohl's; sporting goods stores such as Dick's and Foot Locker; wholesale club stores like Costco; and mass merchants like Target - outlets that are regular customers of Gold Tore Moretz.

RBC Dominion Securities Inc. analyst Tal Woolley led his report on the Gold Toe Moretz deal with his view that it "materially increases" Gildan's retail distribution network. "With control of established brands and relationships now across the entirety of retail, Gildan believes it can put together better assortments for retailers and win more business by offering: 1) a complete brand suite that covers all price points; 2) a choice between private label or branded solutions depending on a retailer's preferred strategy; and 3) a complete offering of basics (T-shirts, socks and underwear)."

But...

Now, let's sound a note or two of caution. Gold Toe Moretz completely outsources its production, mostly to Asia, while Gildan manufactures in-house, from same-hemisphere operations in Central and South America. Another wrinkle: Gold Toe Moretz operates 29 retail locations of its own, something Gildan does not do. The combination of the two increases operational risk, although Gildan believes it's mitigated it by bringing on Gold Toe Moretz executives who managed its overseas production and retail stores.

More importantly, for investors, Gildan remains one of the priciest stocks in the apparel business. Mr. Woolley of RBC says Gildan trades in New York at 14 times the consensus 2012 estimate, while basic apparel makers such as Hanesbrands Inc. trade at an average of 7.4, and branded apparel companies like Warnaco Group Inc. and Volcom Inc. trade at an average of 11.6.

However, if you were willing to buy into the Gildan growth story a week ago at the old prices, you should be even more willing today. Last week's runup failed to capture the reasonable estimates of EPS growth from this deal, to say nothing of the possibilities for top-line growth from new retailers.

Suggest Gildan has gotten ahead of itself? I'd rather stick a sock in it than say such a thing.



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