Maidenform Brands, Inc. (NYSE: MFB) is a distributor and retailer of intimate apparel under the Maidenform, Flexees, and Lilyette brands.Though the company has been in operations for nearly 90 years, its history as a public company only began in 2005 as the culmination of a restructuring process that included the transition to 100% third-party manufacturing. The company sells its products primarily through third parties, such as department stores (42% of revenues) and mass merchants (28%). However, the company does operate outlets and a website which account for approximately 10% of sales.
After the company reported its last quarterly earnings in mid November, the company’s shares fell 26%. The company reported a 20% drop in Q3 earnings due to weak customer traffic, a 420bp contraction in gross margin year over year, and a somewhat alarming growth in inventory from 97 days to 110 days year over year. Obviously these are poor results, but are they so weak as to justify that kind of price decline?
For the long-term investor, this type of price action may present a good investment opportunity, as the short-term focused market tends to overreact in the mistaken belief that one or two weak quarters signals a downward spiral into Chapter 11. The key, of course, is identifying which businesses are likely to recover. Is MFB one of these? Let’s start by considering its past performance.
Here we see that over the company’s short history as a public company, it has generally enjoyed strong, double digit returns. Moreover, these returns have not been weakened throughout the recession and have generally grown over the last three years. Also, it is a good thing to see general agreement in direction and magnitude among a variety of returns calculations, both cash and accruals based, and both with capital structure neutral and equity based. On a quarterly basis, we see expected volatility in the cash-based CROIC.
Here we see rapid growth in the company’s revenues despite the recession. From what I can tell, MFB’s products are not priced at the luxury end of the market and sales may have benefited as consumers move down market to save money. Worth noting here is that the company’s gross margins have been trending downward for several quarters now, which may be also be contributing to the increased sales as the company increases market share (something it has been doing consistently since 2008).
Here we see the most worrying issue, which is the dramatic growth in the company’s cash conversion cycle over the last six quarters, led by a rapid increase in inventory (exceeding the rapid growth in revenues). According to the recent conference call, this is largely driven by reduced purchases from mid-tier department stores and one mass retailer. Though this is a concern, it is important to consider the long-term performance of the company. Thankfully, management clearly recognizes the problem and has suggested that reducing inventory to more reasonable levels is a top priority over the next three quarters.
It would be very easy for management to blame all of the performance problems on the macro environment, and I like it when, as in this case, management clearly states where they screwed up and what they are doing about it. Listen to the conference call if you want to hear the list of changes they have enacted (unfortunately, there isn’t a transcript available, otherwise I would include sections here).
As this chart shows, the company’s operations are not very capital intensive (a result in part of their 100% third party manufacturing), which allows for free cash flows to closely track cash flows from operations. Since going public, the company has had positive free cash flows every year, but the absolute level of free cash flows is merely good rather than great. We’re talking about a sub-10% yield given the current market cap.
Here we see that the company has rapidly reduced debt since going public, from $124 million in 2005 to a negligible $17 million in the last quarter (and likely to be erased after the all-important fourth quarter completes at the end of December). This move has left the company with significantly more financial flexibility that may come in handy as the macro environment continues to impact consumer confidence (and ultimately, we assume but do not witness, impact actual consumer behaviour). Though the company does have a share repurchase program, it has just $17.6 million left to its authorization. Additionally, of the $32.3 million already spent, the net effect on the shares outstanding has had almost no real effect as repurchases have largely compensated for the dilutive effect of options. It would be nice to see the company repurchasing shares more aggressively (especially with the company’s low debt level and relatively low cost of financing).
In summary, here’s what seems to be happening: the company has capable management that got sideswiped by the rapid macro deterioration (didn’t we all?) which had the effect of causing its customers to hold off on new orders and cease replenishment orders as they reduce their own inventory on fear of further weakening of consumer demand. In the short term, the company expects continued deterioration in department store demand. Essentially the entire supply chain is going to have to reduce inventory, and MFB will accomplish this in line with its customers (which will free up even more cash), but this will take several quarters. In the meantime, it is anyone’s guess what the macro environment will look like a year from now (or two or three), which will play a big role in future revenue growth. The company is also working diligently to eek out every spare cent out of its operations and has made two new high profile hires to help in this regards.
So where does this leave us? In valuing MFB, I assumed revenue to decline over the next two years, followed by a relatively tepid recovery. I model a reversion to longer-term average COGS over the next two years, and SG&A being elevated next year and then moving toward long-term averages. I include inventory liquidation as a source of free cash flow, and I assume they are able to accomplish a return to normal inventory levels next year. I think I’ve used fairly conservative (even pessimistic) assumptions, and this is my nature; I would rather be pleasantly surprised than disappointed. The result shows MFB to be undervalued, but unfortunately not by enough to satisfy my required margin of safety.
What do you think of MFB?
Author Disclosure: No position.