Earnings Call Transcript - GIL Q2 2023

Operator, Operator

Good morning, everyone. Earlier, we issued a press release announcing our results for the second quarter of 2023. We also issued our interim shareholder report with the Canadian Securities and Regulatory Authorities and the US Securities Commission, which are available on our corporate website. Joining me on the call today are Glenn Chamandy, President and CEO of Gildan; Rhod Harries, our Executive Vice President and Chief Financial and Administrative Officer; and Chuck Ward, President, Sales, Marketing and Distribution. This morning, Rhod will take you through the results for the quarter and a question-and-answer session will follow. Before we begin, please take note that certain statements included in this conference call may constitute forward-looking statements which involve unknown and known risks, uncertainties and other factors, which could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. We refer you to the company's filings with the US Securities and Exchange Commission and Canadian Securities Regulatory Authorities. During this call, we will also discuss certain non-GAAP financial measures. Reconciliations to the most directly comparable IFRS measures are provided in today's earnings release as well as our MD&A. And now I'll turn it over to Rhod.

Rhodri Harries, Executive Vice President and Chief Financial and Administrative Officer

Thank you, Jessy. Good morning to all and thank you for joining us on the call today. This morning, we reported our second quarter results, which came in slightly ahead of our expectations for the top line and operating margin. We ended the quarter with $840 million in net sales with better-than-expected sales volumes in activewear, which offset weaker-than-expected product mix tied to current market conditions, which I'll speak about a little later. During the quarter, we believe we outperformed the industry in a challenging environment, supported by positive activewear POS trends and the breadth of our product offering, which provided flexibility in what appears to be an increasingly more price-conscious environment. This speaks to our strong competitive position and our ability to continue to drive market share gains. That said, while we continue to expect our revenues to grow year-over-year in the second half, we believe it is prudent to lower our outlook for the full year to reflect the impact of current market conditions on activewear mix as well as near-term uncertainty related to the broader macro environment. I will take you through the details of our revised 2023 outlook a little later, but first, I'd like to highlight that we remain fully committed to our capital allocation priorities, having returned $175 million to shareholders year-to-date supported by strong free cash flow, which we continue to expect will exceed $425 million for the full year. As such, with our existing NCIB program expiring, we announced this morning the renewal of our NCIB program to repurchase up to 5% of the company's issued and outstanding common shares over the next 12 months. Now let me turn to the specifics of our second quarter results. Net sales for the second quarter came in at $840 million, down 6% year-over-year, reflecting a decline in activewear sales of 9%, partly offset by 8% growth in the hosiery and underwear category. In activewear, as previously communicated, we faced a strong comparative period as we cycled post-pandemic inventory replenishment. Overall, the year-over-year POS trend for the activewear category was positive during the quarter, driven by performance in North America, which improved sequentially, largely as anticipated. On the other hand, international markets remain challenged with sales in the quarter down 2% versus the prior year, with POS trends softening sequentially, which fell below our expectations. Finally, good growth in the hosiery and underwear category for the quarter was mainly driven by underwear sales volume growth, reflecting the expansion of our private label offering and the rollout of new programs in the mass retail channel. Furthermore, while industry demand for men's underwear remained down year-over-year, it continues to improve sequentially, and we remain encouraged by the improving momentum for this product. Turning to margins. Adjusted gross margin came in at 25.8%, down 380 basis points year-over-year. This is largely a result of the anticipated flow-through impact on our cost of sales of peak fiber as well as unfavorable product mix in activewear related to shifting product preferences in this environment. SG&A expenses for the second quarter were $78 million, down $11 million versus last year, mainly due to lower variable compensation expenses and our continued cost containment efforts, which more than offset the impact of cost inflation. As a percentage of sales, SG&A of 9.3% improved 70 basis points despite the impact of sales deleverage. Consequently, we generated operating income of 21.7% of sales during the quarter, which included a net insurance gain of $74 million related to the two hurricanes that impacted the company's operations in Central America back in 2020, partly offset by restructuring charges of $30 million, which included the closure of a sewing facility in Honduras. On an adjusted basis, operating margin of 16.5% was up 190 basis points sequentially, slightly better-than-expected but down 310 points compared to the prior year. After reflecting net financial expenses of $21 million and factoring in continued share repurchases, we reported GAAP and adjusted diluted EPS for the quarter of $0.87 and $0.63 respectively. Moving onto cash flow and balance sheet items. Cash flow from operating activities was $182 million in the second quarter, which includes the net positive effect from the insurance gain mentioned earlier. This compares to $210 million in the prior year, and the drop is primarily due to higher working capital and lower net earnings. We continue to maintain healthy inventory levels, ensuring product availability and depth. Furthermore, we expect our inventory levels to decrease sequentially as was the case in Q2 and end the year below 2022 levels. After capital expenditures of $56 million, we generated approximately $126 million of free cash flow in the second quarter. On the CapEx front, the progressive ramp-up of our new Bangladesh facilities is underway, which will continue through 2023 into 2024. We also bought back 2.6 million shares in the quarter, reflecting our strong commitment to return capital to shareholders. The company ended the second quarter of 2023 with net debt of $1.17 billion and a net debt-to-EBITDA leverage ratio of 1.8 times, in line with our 1 times to 2 times targeted debt levels. Moving onto the outlook for the full year. With strong comparative periods now behind us, we continue to expect our revenues to grow in the second half of the year, supported by the planned rollout of incremental retail programs. However, despite continued market share gains, we are seeing current market conditions negatively impact activewear product mix in both North American and international markets as customers focus on lower-priced products. Combined with the near-term uncertainty related to the macro environment, we believe it is prudent to temper our previous full-year 2023 expectations for revenue growth and operating margins, which now reflect the trade down occurring within our activewear product category. Finally, our full-year 2023 outlook is also factoring in the impact of higher than previously expected financial charges for the second half. Accordingly, for 2023, we now expect revenue for the full year to be flat to down low single-digits versus the prior year. We also expect full-year adjusted operating margin to be slightly below the low end of our 18% to 20% annual target range. Although this said, we continue to expect sequential quarterly improvement in operating margins through the second half of 2023. We expect adjusted diluted EPS in the range of $2.55 to $2.65, including the impact of assumed share repurchase of 5% of our outstanding public float in 2023. And finally, we expect strong full-year free cash flow generation above $425 million after capital expenditures, which we continue to expect to be at the lower end of our 6% to 8% target range. So in conclusion, while we faced some near-term headwinds driven by the macro environment, which we can see is driving customers to focus on lower-priced products and which has largely driven the change in our 2023 outlook, we are encouraged by our performance relative to our peers as we continue to gain market share in a difficult environment. Accordingly, we remain confident that as macro pressures subside, we will be positioned to fully capitalize on our market share gains and resume our growth trajectory. This, combined with our cost structure that we believe is well under control in which we continue to improve, positions us well as we work towards delivering on our financial targets and creating long-term shareholder value under the Gildan sustainable growth strategy focused on three key pillars of capacity-driven growth, innovation and ESG. Thank you and I will now turn the call back to Jessy.

Operator, Operator

Thank you, Rhod. Josephine, you may begin the Q&A session. Josephine, we're ready to take questions.

Jay Sole, Analyst

Thank you. I would like to ask you to explain the current market conditions that are negatively affecting the activewear segment. What is happening? Is this related to customer issues or consumer issues? Any additional details would be greatly appreciated. Thank you.

Glenn Chamandy, President and CEO

I'll start with that one. Look, I think what we're saying is that our market conditions are actually pretty strong ourselves. We're gaining share in the market. The overall market, we think is down low double-digits in terms of activewear in the North American market. But obviously, we're gaining share with a positive 2%. The real change and I think what we're looking at is that the customers that are buying products are actually changing the type of product they're buying. So they're buying lesser-value type products. So, for example, instead of buying a hoody sweatshirt, they're buying a crewneck sweatshirt. Instead of buying some of the fringe items that we sell, they're buying more basic items. And then one area we're seeing is a shift back to basic product from the fashion product as the price points are lower. So that's really what's happening. But the unit volumes are good. It's just a shift in the mix of product, which is reflecting the actual net selling prices that we sell to these consumers, but our volumes are on track. Our volumes are good. We're taking share in the market, although the market is weak and being challenged, that's really what's happened.

Jay Sole, Analyst

Got it. And then Glenn, can you just talk about just the factory closure and maybe put it in context for us how that decision came about and sort of what the implications are?

Glenn Chamandy, President and CEO

Look, I wouldn't take that factory closure as anything but the continued optimization of our whole manufacturing supply chain and optimization in terms of really focusing on our Back to Basics. So it's not a capacity-driven thing. We're still running our capacity relatively at the same levels we were in Q1 and Q2 and where we are today. So we haven't changed our capacity. We're just continuing to optimize in these markets. I mean, we're not running at full. Like what we said last time is we're running between 85% and 90%. We're still at those levels, but we're constantly optimizing our structure, our cost structure and positioning ourselves to be low-cost as we move forward into the future. So it's more of a Back to Basics approach than anything.

Jay Sole, Analyst

Okay. Thank you so much.

George Doumet, Analyst

Yeah, thanks. Good morning, Glenn and Rhod. Glenn, I think last quarter, you mentioned we're seeing pretty good yielded POS for fleece. I think you mentioned high single, low double. Can you just talk a little bit about how that's been trending now?

Chuck Ward, President, Sales, Marketing and Distribution

Good morning. Yes, fleece is still trending well, although not as strongly as before. The main point that Glenn mentioned is we're observing a change in the mix between hoods and crews, with hoods being sold at a slight premium compared to crews. So, we're seeing a shift in that mix, but fleece is still performing well.

Glenn Chamandy, President and CEO

And the mix shift is significant. Like just to put things in perspective, the price difference is in the neighborhood of 40% differential in price between a hood and a crew. So we're selling the unit volume. The share is going up. We're still in mid-single-digit type growth in fleece. But the thing is that the price point of the items from a crew to a hood is significant. It's in the neighborhood of 40% difference between a crew and a hood. So they're just buying a lesser-priced item, but we're still selling the unit volume.

George Doumet, Analyst

Okay. That's helpful. And maybe on the 380 basis points of contraction on the gross margin, can you talk a little bit about how much of that was cotton? And just how should we think of maybe Rhod, how should we think of the second half that recovery in the margins driven by lower price cotton? Anything you can maybe help us out there just to model that out. Thanks.

Rhodri Harries, Executive Vice President and Chief Financial and Administrative Officer

In the second quarter, our margins exceeded our expectations. We projected an increase of 100 to 150 basis points compared to the first quarter, and we actually performed better than that. We're very pleased with our results. Though mix dynamics caused a decline of approximately 170 basis points in our margin, our strong cost management in SG&A and other areas allowed us to achieve an operating margin of 16.5%. For the fiber impact, we faced a challenge in the first half, but as we move into the second half, this will shift to a positive impact. In the third quarter, we may continue to encounter some pressure related to fiber costs, but it should stabilize as the quarter progresses. By the fourth quarter, we expect this to become a positive factor. Overall, we had a solid performance in the second quarter, and we anticipate a sequential improvement in our margins for the third quarter. We expect to be slightly below the low end of our target range for operating margins in the third quarter, but we aim to reach the high end of our target range in the fourth quarter. Our cost structure remains well-managed, positioning us strongly for the latter part of the year and into 2024. We're confident in our cotton position and overall cost management as we advance.

George Doumet, Analyst

Great. Thanks for the color.

Stephen MacLeod, Analyst

Great. Thank you. Good morning, everyone. I want to revisit that last question regarding the insights you provided on the margins. I know you were specifically discussing the operating margin. Can you share any additional details about the gross margin and how the relationship between gross and SG&A contributes to the consolidated margins you mentioned?

Rhodri Harries, Executive Vice President and Chief Financial and Administrative Officer

Yes. Look, if you look at effectively what's going to go on, it's all really going to flow through for the gross margin, right, as we go into the back half because all of that cost structure, improvement in cost structure will be reflected in gross margin. We will have the weaker mix, right, that effectively will continue in the third quarter and the fourth quarter, as we called out for the second quarter. And really, if you look at our full-year outlook, our total outlook and you look at our sales outlook and the way we've moved it, it's all being driven by weaker mix. So the real move from our prior guidance to where our current guidance is flat to down low single-digits. If you go to the midpoint, it's all being driven by weaker mix. So weaker mix that is flowing through in the back half very definitely. But our cost structure is really improving as we move through the year. And effectively, that will offset it. We get the improvement in margin, as I said. And again, as we go into 2024, we'll see what happens from a macro perspective. We'll see what happens from a mix perspective. But because of that strength in cost structure, we feel very, very good that they set up at the end of the year and as we move into '24.

Stephen MacLeod, Analyst

Thank you. Glenn, you mentioned that the overall market is down in the low double digits, but Gildan is up. You've seen a 2% increase in activewear. Can you elaborate on where you're gaining market share? Is it partly due to your strong position in basics, allowing you to benefit from consumers trading down, or are there other factors at play?

Chuck Ward, President, Sales, Marketing and Distribution

Well, Stephen, I'll take that. This is Chuck. Yes, I think we're seeing gains in multiple places. I mean we're seeing gains in the basics. But we're still gaining share in the fashion ring-spun area as well. The ring-spun is not moving as fast as it was up a few quarters ago, but we're continuing to gain share against those competitors. Also, we're seeing more in the national accounts that service retail customers. They're more up mid-single digits as retailers have continued to experience improvement in sell-through and they're doing continued replenishment.

Glenn Chamandy, President and CEO

Our fashion sales may not be as strong as before, though they are still showing high single-digit growth. Meanwhile, our basics have turned around to achieve low single-digit growth. This shift indicates that customers are opting for basics, which is encouraging. The price difference between basics and fashion items is substantial, around 30% to 35%. Similar to the fleece category, we see customers seeking value. Importantly, even as buying preferences shift from hoodies to crewnecks or from fashion to basics, our manufacturing facilities remain flexible enough to accommodate these changes since everything is produced using the same equipment. We have adjusted to these market trends and continue to meet customer demands effectively.

Stephen MacLeod, Analyst

Great. Thank you.

Luke Hannan, Analyst

Thanks. Good morning, everyone. I just wanted to ask a question on what the promotional environment is like. It sounds like the change in guidance is more related to, as you mentioned, Glenn, the fact that people are trading down. It sounds like volumes are still fairly healthy. I'm just curious to know if you are seeing anything from your competitors on the promotional side of things, whether now with consumers trading down, do you expect there to be a little bit more competitive pressure to be able to capture that customer?

Glenn Chamandy, President and CEO

Well, we've seen some pricing action, particularly from some of the brands in the fashion category. However, even after they've adjusted some of the pricing, we're still significantly below them to the tune of 20%, 25% in certain cases, right? So we're positioned well on price. And with our product portfolio and all the different price points that we have, we think we're well-positioned that we'll see our price deteriorate on mix, we won't see it deteriorate because we're lowering prices. I mean, I think that's the way to look at how we're positioned.

Luke Hannan, Analyst

Okay. So then in other words, if you look also at the rest of the competitive set, I know you've mentioned before in the past that there's been this lever where you guys can take price because you're seeing inflation, not just on fiber costs, but on a variety of different cost buckets. As it stands today, are you seeing any evidence of competitors more broadly looking to take price as a result of those that cost inflation abating?

Glenn Chamandy, President and CEO

Well, I don't know if it's so much cost inflation, but I think that from we say, like I said, some of our fashion competitors have lowered prices, but are still significantly above us. It may not be because of inflationary reductions, but it's maybe more from business to business. I mean, I think that they're losing significant share. We're gaining share in this market. So one of the things that we just mentioned earlier is that the market is down it was low double-digits, and we're positive low single-digits. I mean, so we're obviously taking share, and there is a reaction. But we're positioned ourselves perfectly because of our product portfolio, the different levels of pricing, basics are coming back now. We're diagnostic of what's being sold. I mean hood or crew, we really don't care, and we're taking share. So I think we're well-positioned. And I think more importantly, even one of the things that Rhod said that even with this mix, which is factored into our forecast, we'll be at the high end of our operating margins in Q4. And we would have been higher than that if the mix obviously would have been better because you got to add a couple of like Rhod said, the impact is 200 basis points or 170 for example in Q2. So we would have been higher than even the high end of operating margins in Q4, but we're still there. We're well-positioned. We have a good cotton position. We have good visibility on our manufacturing. So as we continue to move into the future, despite the mix change, I think we'll be well-positioned to move into '24.

Luke Hannan, Analyst

Okay. Thank you.

Vishal Shreedhar, Analyst

Hi. Thanks for taking my question. Just on the comments about being down 12%. Can you maybe elaborate on that? Is that industry units? Is that industry sales? And how does that reconcile with what you saw last quarter when the April trends were down, call it flattish to slightly down? And maybe you can give me the time period of that particular data point that you mentioned.

Glenn Chamandy, President and CEO

Well, I think, last quarter, we said we were slightly down. This quarter we're positive mid low single-digits. But what we're referring to is that the overall market is down low double-digits basically. So I think that's the question. It's the actual market itself and the conditions within the market. So we're gaining share within this market. And that answers your question.

Vishal Shreedhar, Analyst

Yes. Is that market in units? And is that for?

Glenn Chamandy, President and CEO

Yes, that's all units for the quarter.

Vishal Shreedhar, Analyst

That's units for the quarter.

Glenn Chamandy, President and CEO

Units for the quarter.

Vishal Shreedhar, Analyst

Then how is the trend in July? Is it worse or stable?

Glenn Chamandy, President and CEO

July is showing improvement for us. Our activewear products are experiencing mid-single digit growth. With our new launches in underwear and socks, we are currently seeing low double-digit growth, which we expect to increase to high double-digits as we enter Q1, Q2, Q3, and Q4, driven by the momentum of our new products. Mid-July has also been around mid-single digits for us, and as we approach Q4, we anticipate easier comparisons which should lead to additional growth. We are continuing to capture market share, and it seems that we are gaining more share in the beginning of Q3 compared to Q2.

Vishal Shreedhar, Analyst

Okay. And with respect to the mix shift, is that something that you deem to be more of a base that we should reflect permanently in our earnings forecast? Or is this more of a transient thing, and next year, that mix might come back a little bit? Or have to lap that in Q1 and Q2 kind of thing, and we should build our earnings off this new guidance provided.

Glenn Chamandy, President and CEO

I believe the current situation is not structural and will eventually improve. We're experiencing a risk-averse environment where consumers are prioritizing purchases that seem to carry less risk, especially considering potential impacts on margins related to final pricing. In our case, we sell T-shirts through a distribution network, where the average shirt priced at $2.50 ultimately reaches a selling price of $25 as it passes through various channels. People are cautious about holding inventory, especially with items like tank tops or hoodies that carry higher risks. This cautious purchasing behavior is driven by the overall macroeconomic uncertainty, but I am confident that things will stabilize over time, and consumers will return to their usual buying patterns as conditions improve.

Vishal Shreedhar, Analyst

Thank you.

Brian Morrison, Analyst

Thanks very much. Question for Glenn or for Chuck, the dichotomy here of your market share gains relative to the decline of low double-digits for the industry. How is the channel inventory looking for both your products and maybe the industry in general, is there more destock that has to take place or are we now in a pretty lean position?

Glenn Chamandy, President and CEO

Well, look, the inventory at the end of Q2 was flat to Q1. It was slightly higher than we anticipated. And we believe there will be some destock in the back half of the year in our plan.

Brian Morrison, Analyst

Okay. And then I guess two small questions. The sub-10% SG&A margin, is this achievable on an annual basis? And if so, is that sustainable? And then, Rhod, maybe free cash flow, what's your working capital assumption with your free cash flow guidance? Will this be positive for the year?

Rhodri Harries, Executive Vice President and Chief Financial and Administrative Officer

Yes, if you look at SG&A, our target is around 10%. We achieved 10% last year, and we expect to finish this year at a similar level. This quarter, we recorded 9%. Going forward, we will aim to maintain those levels. However, due to overall sales activity, there might be some deleverage. Long-term, we aim to bring SG&A below the 10% mark. We believe that as we grow and based on our business model, we can achieve operating leverage on SG&A, which gives us a competitive edge. We're focused on this area and confident we can manage it effectively. Regarding free cash flow for the full year, we're projecting it to exceed $425 million. We had negative free cash flow in the first quarter, but we've seen positive cash flow in the second quarter and expect to continue this trend in Q3 and Q4. Last year, we experienced inventory growth, but that is no longer the case as our inventories are decreasing, which supports free cash flow. We are positive about our free cash flow, which reinforces our competitive position. Our balance sheet remains strong, allowing us to return capital to shareholders. We had a solid return last quarter and plan to continue offering good returns with the new 5% NCIB program.

Brian Morrison, Analyst

No, that's very helpful, Rhod. Just a question, you have $325 million of negative working capital in the first half of the year. Where will that end up by year-end? Will that be flat, positive?

Rhodri Harries, Executive Vice President and Chief Financial and Administrative Officer

If you look at working capital basically this quarter, we are around 45%, 46% of sales, right? If you look at it on an LTM basis. What we called out in prior calls and we're still focused on it is effectively working capital at around 35% by the end of the year. So we'll drive that working capital basically to the, I would say, closer to our target level as we get to the end of the year. And so we do feel good about the way that's unfolding.

Martin Landry, Analyst

Hi. Good morning. I want to revisit the guidance revision. Your sales for the quarter exceeded expectations, and your point-of-sale trends were positive in Q2 in North America. I'm curious about what is causing the change in the outlook. Is there a slowdown in July that prompted you to lower your guidance? Any insight you can provide would be helpful, considering the positive trends you've experienced recently.

Rhodri Harries, Executive Vice President and Chief Financial and Administrative Officer

The main takeaway, Martin, is that the changes in our full-year outlook are primarily driven by the mix of products. We exceeded our Q2 expectations, mainly due to volume. We've observed positive point-of-sale trends in activewear, and while point-of-sale in underwear and hosiery has been flat, it's showing improvement as we head into the second half of the year. Glenn mentioned that distributor inventory levels were flat but slightly exceeded our expectations, and we anticipate this will normalize in the latter part of the year. Ultimately, it's the mix that's influencing our forecast. For the full year, the adjustments in our outlook are due to this mix, which we expect to continue in Q2 and Q3. The point-of-sale data is looking strong, and we're capturing market share in volume. Overall, our performance is in line with our expectations for the year. While there is a market shift toward lower-priced products that we're addressing, our diverse product range and cost structure position us well as we approach the end of the year and move into 2024.

Martin Landry, Analyst

Okay. And then just a follow-up, just to better understand that mix shift. Is it happening across all your end markets because you do have end markets that have very different dynamics. You have some that are more recession resistant and some that are more cyclical. Just trying to understand a little bit, is this across the board or in certain end markets?

Chuck Ward, President, Sales, Marketing and Distribution

Martin, I would say it was across the board. It's pretty consistent across the markets and categories.

Martin Landry, Analyst

Okay. That's it from me. Thank you.

Operator, Operator

Okay. Once again, we'd like to thank everyone for joining us this morning and we look forward to speaking to you soon. Have a great day.

Operator, Operator

This concludes today's conference call. You may now disconnect.