Price: 18.20 NIS or $4.64 (9/22/11)
This is a post about another "magic six" stock, but based on some feedback from the post on Molins I want to take this post in a different direction. In the previous post the issue was raised in the comments that it would be unusual to find a great company trading so cheap and there must be a reason for the cheapness. This comment really honed in on the heart of the matter for these stocks. We already know they are cheap, and a magic six isn't a net-net where I'm worried about the tangible book value. The most important thing is knowing why the stock is cheap and if the reason for the low price are justified or not. So instead of digging into the components of a magic six (P/E < 6, P/B < 60%, Div > 6%) I'm doing to look at the reasons why Delta Galil is trading at a low price. A low prices doesn't always equal a cheap stock.
Delta Galil is a Israeli company that designs and manufactures intimate apparel for both men and women. Based on their site I would say they tend to focus more on women's apparel. The company sells most of their goods through major retailers worldwide such as, Marks and Spencer, Carrefour, Victoria's Secret, GAP, J Crew, Banana Republic, and JC Penny among others. Clothes are sold both as private label and with their own brand. The company is one of the largest undergarment manufacturers in the world, and the largest textile manufacturer in Israel.
As with all magic six stocks on a valuation basis the stock is very cheap, a P/E of 4.98, 53% of book value, and a dividend yield of 13% on a TTM basis.
Why is it cheap?
There are a lot of potential reasons for Delta Galil to be trading at a depressed valuation, I'm going to quickly go through each and discuss whether the issue is a driver for true undervaluation or an issue that doesn't really affect the business value.
Mideast violence - This is the first reason I think most western investors might take a flyer on Delta Galil, the company operates in a very volatile part of the world and the volatility has affected company operations in the past. During the Arab Spring the company's factory in Egypt had to be shut down for a period of time due to unrest. While this is a real risk I view it as a headline risk, the company is used to operating in the environment has has found a way to be successful. I don't see why this would change going forward. Side note, there is a great article in Businessweek about the Palestine Stock Exchange and how they are able to operate with constant disruptions.
Small cap, illiquid - This is a favorite reason for undervaluation, a neglected un-tradeable stock, and I have to admit I've used it as justification a few times myself. Delta Galil has a $108m market cap and trades in an emerging market which means not a lot of visibility to foreign investors. With that said the company operates globally and is part of the Tel Aviv market index. As for illiquidity the US ADR shares are pretty illiquid, but the ordinary shares traded in Israel seem to have a decent amount of volume.
Family owned and controlled - The CEO owns 54% of the company which could scare off potential activist investors or investors who hope to push management for change. I tend to prefer family held companies because I feel that my interests are aligned with the management. My number one interest is safety of capital, which for most tightly held companies is a priority for them as well. If a closely held company is a fantastic business the market will reflect that with a P/E higher than 5, I don't think this is a reason for the undervaluation.
I believe there are actually two very big reasons that the shares trade at such a low price.
The first is that the company doesn't have a very good track record of profitability. The company has been profitable recently stating that they have had nine straight quarters of increasing profitability in a soft market. It is good to see an upturn in business but investors might not believe the upturn is sustainable. The company recorded a loss in both 2007 and 2008 on revenues similar to the current run rate. In addition to this the US market segment has been operating at a loss for the year 2011, the company states they believe this will turn, but who knows.
The company is currently operating profitable the biggest component of their expenses was on a tear most of this year, the price of cotton. The price has dropped recently but it is still above the long term "normal" price range. Cotton accounts for 30-50% of the cost of goods sold. In the past they have tried to adjust their product lines to accommodate higher cotton prices, but this introduces a fashion risk. An apparel item that uses less cotton might not be as desirable to consumers.
The second major reason the shares are at a low price is that the company is very sensitive to currency fluctuations, both in USD and EUR. I have included the two charts the company uses to show the potential impact of currency changes in USD and EUR:
The first thing to notice on this chart is that fair value is 1.425 EUR/USD, at today's mark the EUR/USD was 1.346 which puts the company in the 5% decrease category from the balance sheet presented. This results in a loss of value on the cash and receivables mostly.
This second graphic shows the impact of the USD/NIS exchange rate on swap contracts the company holds to hedge their NIS debt in USD. As of today the USD/NIS stood at 3.72 which is in the 5-10% increase range. This will result in somewhere between a $3m and $5.8m loss if the exchange rate persists. To put this in perspective in 2010 net income was $22m, which means the swap loss at this point is about a 20% hit to net income.
Are these real reasons?
Are any of the reasons I presented above legitimate reasons to avoid investing in Delta Galil? I think any of them potentially could be but realistically the variability of the company's operating performance on the price of cotton and currency markets is enough for me to avoid an investment for now.
The reason I say this is that I have no idea if the price of cotton falling recently is due to macro-economic trends which could be temporary or if it's some sort of mean reverting change which would help the company going forward on a permanent basis. What's clear is that Delta Galil doesn't have much if any pricing power which means they could get squeezed if cotton rises again and their buyers refuse to pay higher prices. I should note that both of those things mentioned in the last sentence happened at the end of 2010, it's just at the moment they've reversed.
Contrary viewpoint
This post wouldn't be complete without the bullish viewpoint which I think I could probably sum up in a few bullets:
-The company is trading at a big discount to book value.
-The price of cotton has declined almost 50% in the past few months
-The company has restructured after the 2007/2008 losses and turned a profit in a tough economy
-Most of the profits are paid out as dividends giving a shareholder a cash return
-The company's bonds are trading very close to par or at par depending on the day meaning bondholders believe their investment is safe.
The bottom line
If Delta Galil was a net-net where all I was worried about was the quality of the balance sheet and a return to NCAV I would probably feel somewhat comfortable investing in the business. But that isn't what this investment is about, this is about a low margin textile business that is trading at a low price due to very volatile and uncertain inputs to their business. I think the price is probably too low, but I'm not sure what the exact level of discount should be given the risk factors. So while Delta Galil is cheap I don't think it's safe, and there are many other safer cheap stocks available to pick from.
Talk to Nate about Delta Galil
Disclosure: No position
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