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<DAILY TROUBLE>
Friday, July 30, 1999

Pillowtex Corp.
(NYSE: PTX)
Phone: 214-333-3225
Website: www.pillowtex.com
Price (7/29/99): $16

HOW DID IT FIND TROUBLE?

A year ago, investors were laying their heads on Pillowtex, a manufacturer of pillows and other home textile products, at $46 a share -- and feeling comfy enough to curl up and cut some ZZZZZZs.

What they've gotten instead is lots of tossing and turning, grinding of teeth, and Z%#Z)&^Z!*. Missed earnings and a rough upgrade of information technology systems fed into a continuing short-seller's story for this debt-laden company.

The December 1997 acquisition of broad line manufacturer Fieldcrest Cannon tripled Pillowtex's sales and offered lots of opportunities for consolidating operations, jettisoning non-core assets, and upgrading plants for low-cost manufacturing of sheets and towels. Pillowtex spent $133.6 million last year on such improvements.

The efforts appeared to be paying off, too, with manufacturing efficiencies and lower raw materials costs (mainly cotton) producing steadily improving gross margins, which hit 18.6% for the year versus 15.5% on a pro forma basis (including Fieldcrest) for FY97. Operating expenses increased to 9.1% of revenue from 9.0% in FY97, but Pillowtex decreased absolute pro forma selling, general and administrative expenses (SG&A) by $24.6 million to $137.3 million.

Yet, third quarter FY98 revenues came in low and fourth quarter earnings of $0.89 per share missed estimates by a penny. A far more disappointing first quarter followed. On March 22, the company warned that earnings for the period ended April 3 would come in at just $0.40 a share, while Q2 results would be just $0.50, both well below forecasts. The stock was slammed to a low of $11 3/8

Actual Q1 results announced May 3 were even worse: $0.31 per share, as gross margins sank to 15.3% from 16.8% a year ago. About $0.07 per share of the shortfall resulted from Pillowtex being forced to expense rather than capitalize $2.1 million connected to the shutdown of its spinning and weaving plant in Alabama. The rest was due to problems with its new computer systems, which forced the company to leave "unshipped orders on the dock at quarter end."

As fellow Fool Warren Gump has pointed out, management should have had a grasp on the quarter when it warned of a shortfall -- but it didn't. And despite the less than $10 million in unshipped orders that fell into Q2, management has now guided investors to expect $0.40 per share in Q2, as the computer system upgrade continues to cause a disturbance.

Due to its acquisitions, Pillowtex's balance sheet is heavily leveraged, with non-current long-term debt of $1.01 billion and equity of just $242 million. So investors have rightly begun to worry that missed estimates could lead to a liquidity crunch or at least higher dividend payments on its convertible preferred.

BUSINESS DESCRIPTION

Based in Dallas, Pillowtex is a leading manufacturer of home textile products. It markets towels, sheets, pillows, and blankets under brands such as Fieldcrest, Cannon, and Royal Velvet. Through licensing deals, it makes and markets bedding products under brands such as Ralph Lauren, Comforel, and Waverly.

Wal-Mart (NYSE: WMT) accounted for 24% of FY98 sales. About 61% of Pillowtex's overall revenue came from its top ten customers. It employs some 14,000 people, with about 15% unionized.

Acquisitions have helped Pillowtex grow from just $540 million in core revenues for FY97. In December 1997, it acquired Fieldcrest Cannon for $409 million in cash and stock plus the assumption of $199 million in debt.

Last July, it paid $41.8 million in cash plus the assumption of $32.5 million in debt for The Leshner Corp., a manufacturer of towels and terry-cloth products with FY97 sales of $105 million.

Pillowtex is in the middle of a three-year $275 million capital spending plan to improve production efficiency by increasing the use of information systems provided by Oracle (Nasdaq: ORCL). Management expects final manufacturing and warehousing systems to be implemented during the current quarter. Capital expenditures should hit $85 million this year.

Competitors include WestPoint Stevens (Nasdaq: WPSN) and Spring Industries (NYSE: SMI).

According to the latest proxy, insiders own 38.2% of the company, with Chair/CEO Charles Hansen holding a 17.5% stake. Significant outside investors include Apollo Advisers (16.0%) and Palisade Capital (8.9%), though Palisade has apparently cut its stake substantially since March 22.

FINANCIAL FACTS

Income Statement*
12-month sales: $1,512.1 million
12-month income: $40.3
12-month EPS: $2.50
Profit Margin: 2.67%
Market Cap:: $271 million
Enterprise Value: $1,383.4 million
(*Income and EPS based on earnings available to common shareowners.)

Balance Sheet*
Cash: $13.8 million
Current Assets: $776.2 million
Current Liabilities: $270.0 million
Long-term Debt: $1,126.2 million
(*Debt includes $1,011.8 million in non-current long-term debt, $51.3 million in other long-term liabilities, and $63.1 million in preferred stock that converts into common at $24 per share.)

Ratios
Price-to-earnings: 6.4
Price-to-sales: 0.18
EV-to-sales: 0.91

HOW COULD YOU HAVE SEEN IT COMING?

Highly leveraged companies often attract short-sellers, and heavily shorted companies need to be investigated closely. Market Guide indicates that 1.46 million of the 4.3 million shares in the float had been shorted as of July 8, producing an extremely high days-to-cover ratio of 17.4 based on average trading volume of 129,000 shares a day.

Some of that short interest is probably related to preferred holders hedging their investment, meaning it doesn't represent a bet the stock will fall.

Yet there is a short story, and it entails more than the company's debt, according TheStreet.com's Herb Greenberg. Textile makers receive subsidies from the U.S. government for buying homegrown cotton rather than imports. Greenberg reported last December that Pillowtex's cost of cotton might be about to rise since these subsidies were ending.

Though Pillowtex doesn't detail such subsidies in its filings, the shorts reportedly produced documents suggesting that such gimmes amounted to more than $4 million, or 1% of sales in Q3 FY98. For a textile maker with thin profit margins, that represented the difference between making and missing earnings.

WHERE TO FROM HERE?

Worth Online recently noted that Steve Romick, manager of the UAM FPA Crescent Fund, put Pillowtex's fair value at just $10 a share, suggesting that even low P/E stocks can be frothy.

On the flipside, Prudential analyst John Pickler maintained his "strong buy" on Pillowtex in May, even after the Q1 ugliness, and held out a target price of $25 a share. Countering the short-sellers, Pickler indicated that market prices for cotton have fallen below even the subsidized price of a year ago. So materials costs shouldn't be a major negative for gross margins, as the shorts assert.

In any case, management's significant stake in Pillowtex should make them quite motivated to run the company well. A number of insiders also took advantage of the March collapse to buy shares on the open market at prices ranging between $11.75 and $12.31 per share. That's exactly the kind of management confidence that investors like to see. It also helped that on March 23, the board authorized the repurchase of up to 1 million shares.

Still, Q1 revenues were nearly flat, reaching $368.5 million versus $366.3 million a year ago. Meanwhile, inventories soared 25.2% to $481.4 million from $384.4 million in the period. That's not what you want to see. It begs the question of whether the company is making too many towels and sheets that customers don't want, or whether there's a plausible management-friendly explanation.

Management says the extra inventory was caused by a planned product buildup to avoid hiccups during the systems upgrade at several plants; new product rollouts scheduled for Q2; and the one-time glitch that delayed late period orders from being shipped.

Yet, these explanations suggest we should see an inordinate increase in finished goods inventory relative to work-in-progress, raw materials, and supplies. That's not the case. Finished goods actually represented just 47.1% of total inventory last quarter versus 48.5% in the year-ago period.

According to I/B/E/S, Wall Street expects FY99 earnings will dip to $2.45 per share, with an uptick to $3.14 next year. That projected increase reflects Pillowtex's opportunity. With its enormous revenue base, tiny improvements in manufacturing and operating expenses produced by consolidation and the installation of new systems can lead to outsized increases in profits, or your basic operating leverage.

Still, dividend payments on the outstanding preferred stock will rise from 3% to as high as 10% if FY99 earnings come in below $2.34 per share. And frankly, debt-heavy companies often appeal to analysts searching for work for their firms' investment bankers, meaning one should eye their estimates with increased skepticism in this case.

While the company is operating within the terms of its debt covenants, that could change quickly. Its senior credit facility, for example, allows for a maximum leverage ratio (total debt to EBITDA -- or, earnings before interest, taxes, depreciation and amortization) of 5.25 now, but just 4.75 starting next January. Total long-term debt as of May 14 stood at $1,042.3 million while trailing 12-month EBITDA as of April 3 was $200.4 million, good for a leverage ratio of 5.2.

A debt-laden company like Pillowtex, then, can find itself in a bind that produces sleepless nights for investors. Yet, most of the company's enterprise value is captured in its debt, making the equity unbearably light, like a feather in one of Pillowtex's down comforters. Add that to the high short interest, and this stock could fly if the company can turn the corner on its recent troubles and boost net margins to 3.5% or better.

Given the risks, though, the current enterprise value to sales ratio looks a bit rich. Interested investors should take a close look at the Q2 results. A further disappointment would not be a total surprise.

-- Louis Corrigan (TMFSeymor@aol.com)

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