Pacific Textiles (1382 HK)

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Hong Kong activist investor David Webb just bought a 5.0% position in Hong Kong-listed Pacific Textiles (1382 HK － US$299 million).

Pacific Textiles is the preferred supplier of knitted fabrics for Japanese fast-fashion brand Uniqlo. It also sells knitted fabrics to lingerie companies like Victoria’s Secret, Calvin Klein, Triumph, and Maidenform.

When most people think of textile businesses, they picture factory floors full of young people cutting and sewing fabrics. But that’s only the downstream part of the industry, and it tends to be labor-intensive and commoditized.

What Pacific Textiles does is to run relatively automated factories producing fabrics from yarns. It’s a capital-intensive business that relies on machinery to run 24/7. But it also tends to be highly profitable, with Pacific Textiles earning 20-30% returns on equity for most of its history.

The only problem with fabric manufacturing is that it requires high utilization rates. Pacific Textiles was founded in 1997 and did well until 2015. But then, several issues emerged:

• Vietnam joined the Trans-Pacific Partnership, enabling it to import cotton from the United States and elsewhere at zero duties. That cotton continues to be roughly 30% cheaper than in China’s regulated markets.
• Reports of forced labor in China’s Xinjiang province and a US ban in 2022 caused several Western brands to switch away from Xinjiang cotton.
• China's costs have increased significantly due to the government pushing for higher minimum wages and stricter environmental standards. That’s been especially problematic for Pacific Textiles, which sells to Japan with its depreciating currency.

Since 2015, Pacific Textile’s share price has dropped over 80% despite having no debt during most of that period.

So why has David Webb taken a 5.0% position in the company? Analysts at Smartkarma have tried to untangle the story, and I think they’re spot on.

There are two parts to the earnings recovery story:

• In April 2024, Pacific Textiles just opened a massive new factory in Nam Dinh, Vietnam, with an expected capacity of 80 million pounds of fabric, adding 30% to the total capacity. And this new factory is likely to reach full utilization soon.
• Management is also guiding for a recovery in their legacy factory in Panyu, China. Pacific Textiles’ US customers have dealt with a post-COVID inventory build-up as customers moved their spending to services. But orders are now coming in again.

The transition to Vietnam will take years, and the Nam Dinh factory will only take them halfway there. In any case, fundamentals will improve as the new factory ramps up throughout the fiscal year 2025, which ends on 31 March 2025. If I’m right about the yen eventually strengthening, that will probably also help Pacific Textiles’ margins.

In my base case, I see Pacific Textiles ending up with a 2026e P/E of 4.4x. The company is targeting a dividend payout ratio of 70-90%. Historically, they’ve paid out 95% on top of share buybacks. My base case for the dividend yield is for it to end up at 18%, far higher than for most of its peers.

My initial concern with Pacific Textiles is that its controlling shareholder, Toray Industries － a Japanese conglomerate － might care more about scale than profitability. After Toray became a shareholder in 2017, profits have gone in the wrong direction.

But Pacific Textiles is not the only China-based fabric producer that’s suffered in the past few years. It’s been a multi-year trend. Except this time, Pacific Textiles is starting to be on the right side of it.

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