Delta Apparel DLA
June 08, 2003 - 9:03pm EST by
grant387
2003 2004
Price: 16.25 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 65 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

I originally wrote this idea up in August 2001 and because there is no industry more exciting than the t-shirt industry I’m going to submit it again at this time. I’ve been buying DLA again in this price range and I believe it is still cheap by most measures. DLA is now a $65 million company that has a strong balance sheet, an intelligent business plan and is trading at reduced valuations.

I’ll attempt not to regurgitate the previous write-up, but instead to reinforce the specific qualities of DLA that I believe make this a terribly boring, profitable investment. I thought DLA was cheap when I last wrote it up to a collective yawn at VIC and even though it is up over 75% since then, I believe it is another good time to purchase more shares.

DLA has delivered on its business plan and I’d like to spend some time discussing their business and focusing on what has made them successful. No doubt that the t-shirt business is a typically a commodity type business and DLA has attempted to differentiate themselves from their competition. Their competition primarily focuses on selling t-shirts through distributors, who in turn sell them to retail outlets and various other end users. DLA has found that they are able to maintain higher margins and a stronger presence by focusing their sales on screen printers through their direct sales force. DLA has also continued to focus on selling a greater percentage of colored t-shirts as opposed to white t-shirts.

Their main product has always been a 5.5 ounce t-shirt. These aren’t the undershirts that all the suits wear, but instead shirts that you’d typically find with a logo on them or some type of embroidery work. Sales of the 5.5 oz shirt have increased 20% over the past two years and sales should continue to increase at least by 10% annually over the next few years. DLA appears to be the market leader in sales of 5.5 oz shirts. Two years ago they also introduced a heavier 6 oz t-shirt that has seen significant growth and from all indications will continue to realize significant growth in the next few years. Sales of 6 oz t-shirts increased 50% in FY02 versus the prior year. The 6 oz shirt should be a significant driver of growth going forward. Currently, DLA is #4 in sales in the 6 oz t-shirt market.

As mentioned earlier, the focus is on selling colored t-shirts. The industry average is about 50/50 white to colored shirts and DLA has been able to attain about a 40/60 ratio. Their real key has seemed to be their direct sales force and the introduction of their distribution centers. Their original distribution center was in Knoxville, Tennessee and almost two years ago they opened a new distribution center outside of Los Angeles. It is interesting to note that 80% of sales in FY02 from the Los Angeles distribution facility was new business. This spring, they opened a third distribution facility outside of Miami. It is this new facility in Miami that should have a great impact on sales going forward. They currently have two full-time sales reps working the Florida region. The financial statements will reflect additional inventory and work in process inventory that has been bumped up to adequately stock this facility.

DLA now has facilities in two of the largest areas of demand for t-shirts in the nation, covering Florida and California. With the addition of the latest distribution facility, they are able to provide two day shipping to the vast majority of the US. More importantly, DLA can deliver product within one day to all of South Florida and Southern California. I’d look for more strategically located facilities over time as they are able to grow their sales force and continue to provide excellent service to their screen printers. A true catalyst in this scenario is the opening of the Miami distribution center. Over the next few years, look for very strong sales increases out of this facility. DLA should realize new sales of between 50-60% from the Miami distribution center, which is less than the LA facility because they already have a significant presence from their Knoxville distribution center. Their direct sales staff continues to grow and the benefits are obvious. There are over 20,000 screen printers in the US, and DLA has barely scratched the surface in this market.

Pricing
The textile industry and especially the t-shirt industry has been subject to a significant and steady decrease in the revenue they can generate per shirt since 1996. This was directly caused by the move of the sewing facilities offshore. This move had a significant impact on operating costs and the savings were passed on to the customer. A virtual price war continued for years and the fact that a few companies ran into financial problems (ie. Fruit of the Loom, etc) also added to the decrease in prices. Companies were selling shirts at lower and lower prices in hope of gaining market share. It appears as though we may have entered a period of shirt prices stabilizing. The vast majority of companies have now moved their sewing facilities offshore and the reduction in operating costs are no longer being realized. The other aspect of this is that there has been an increase in the price of cotton during the past year, which will force companies to begin pricing at reasonable levels again. It has become very apparent to companies that this continued price cutting is pure economic suicide and has led to the demise of more than one company.

Financials
DLA’s fiscal year ends June 30 each year and they have a highly seasonal business. Their 4th quarter is their strongest quarter, followed by the 1st quarter, 3rd quarter and 2nd quarter. Inventories will typically rise during the 2nd and 3rd quarter, while cash will decrease and debt will increase. I’d like to look at the end of FY02 and attempt to make some assumptions about what we might see at the end of FY03 in order to analyze the numbers for DLA.

CFFO in FY02 for DLA was $26.5 mil and cap ex was $5.3 mil, providing FCF in FYO2 of $21.2 mil (which is equivalent to an EV/FCF of approximately 3.1X). The results for FY02 don’t completely paint an accurate picture. By the end of FYO2, DLA was light in their inventory by somewhere in the range of 5MM to 8MM. The first six months of FY02 really were terrible with a pronounced slowdown of the dotcom parties and post 9/11 economic issues. Due to having another distribution center open this year and increasing inventories to a more normal figure, I’d expect to see inventory levels increase year over year, probably by $8 - $10 mil at the end of FY03.

Just as the results for FY02 didn’t accurately reflect the free cash flow because of the abovementioned reasons, the free cash flow of FY03 won’t be accurately reflected either. I’ll expect in the neighborhood of only about $4-6MM in FCF in FY03 and this is on approximately $8.5MM in net income. This isn’t a highly capital intensive business, so the changes in working capital, namely inventory changes, have had a significant impact on free cash flow.

To figure enterprise value, I’d like to use estimates for debt and cash similar to those at the end of FY02, which I believe is being conservative as they’ll be FCF positive this year. At the end of FY02, short and long term debt was about $1 mil more than cash and being conservative, I’ll use this same estimate for the end of FY03. Thus EV will be approximately $66MM.

Management has goals of increasing bottom line growth by 20% annually for the next few years. Even though I can picture a response of laughter, I believe this it is attainable to grow earnings at a minimum of 15% a year for the foreseeable future. If you adjust for past NOL’s, they’ve increased annual earnings by over 25% the past few years. They should earn approximately $2.05 a share this fiscal year, which gives us a P/E of just under 8 and with DLA having another distribution center fully operating for all of FY04, I’d expect to see a minimum of 15% bottom line growth, which would give them a P/E multiple of about 6.9X forward earnings. Should management continue to attain their earnings growth goals and continue to repurchase shares, we’ll see a much lower multiple. I’d also expect to see DLA strategically add additional distribution centers in the next few years. My impression from conversations with management is that we’ll see at least one new distribution center open per year over the next 3 years.

Buffett looks for a company to generate pretax earnings of at least 10% per year on invested capital. DLA should generate at least a 20% pretax return on capital.

Shortly after I wrote my initial recommendation, DLA announced a dutch auction and they’ve been a significant purchaser of their own shares since, given that the stock has consistently been undervalued. In an attempt to broaden the shareholder base, they had a 2-1 split in September 2002. Will DLA grow earnings at 20% a year, the next 5 years? It may seem unlikely to some, but not impossible and importantly this is the goal of management. However, they will see an increase of about 50% earnings in FY03 vs FY02, and I’d anticipate seeing earnings growth closer to 15-20% thereafter.

Management has delivered on what they said they’d do. They’ve exceeded all of my expectations. I won’t be shocked to see earnings and cash flow grow significantly higher than their 20% goal over the next few years and see FCF figures in the midteens. They’ve been candid in their mistakes and they’ve been prudent with their use of cash. The one exception I’ll provide to this prudent use of cash is the high salary the CEO receives, a carryover from his Delta Woodside days. Although, he might gain forgiveness because he’s led the company to a 250% price gain since its spin off in June 2000. They’ve repurchased shares at undervalued prices and they’ve purchased a manufacturing facility at a very reduced price. They’ve been discussing lately that an acquisition may be in the future, especially if they are to purchase undervalued assets or companies. Management has stated that an acquisition will be unlikely unless they are able to find a business to purchase that is valued at even less than the current price of DLA. They pay attention to their EBIT multiple and they have no enthusiasm to pay a higher multiple for an acquisition if they can continue to repurchase their own shares at these values. Management has been evaluating acquisitions as a means to further boost growth in earnings, but they maintain that they shall be very selective as to both price of the acquisition and the business being acquired


DLA is trading at less than 8X FY03 earnings, 1X book, 50% of sales, 7X normalized FCF and they should be able to grow earnings at 50% this year and in double digits, thereafter.

Far from an exciting, complicated trade. This is a solid company that just keeps continuing to deliver strong free cash flow and growing earnings. Yes, it is a rather illiquid stock and still has a very small market cap. But, all in all, the current price is significantly undervalued.

It is also interesting to note the five 13G filings that have taken place in 2003, including Royce & Associates.

Catalyst

Catalyst

1) Increased earnings from new Florida distribution center
2) Future openings of distribution centers
3) Continued stock repurchases
4) Stability of unit pricing
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