HBI: Don’t Bet Against HBI

Top line momentum + transparency on the cost side are factors few companies have in this environment.  The market has figured it out – but in this instance, the market is right.

Investment Conclusion

It’s tough to bet against HBI at this stage. The company has solid top-line momentum and a high degree of transparency on the cost side – unlike almost every other company in retail (sans GIL). As it relates to revenue, there’s still three quarters of the Gear for Sports acquisition that give the model implied growth, but also continued organic growth due to considerable momentum with several marketing campaigns (ie watch Oprah today). Let’s not forget that this company is not afraid to miss top line targets; its done it plenty of times in the past.  But don’t bank on it in reported numbers until January ’12. On the cost side, this is a company that has the luxury of directly procuring nearly all raw materials instead of relying on another partner in the supply chain to look out for them. Anyone that is beholden to someone else in the chain immediately exposes themselves to risk of the unknown. In this business, ‘the unknown’ is far worse than severe fluctuations in costs. At least the latter can be managed proactively by nearly any management team. In the meantime, you’re looking at a name trading at 8.2x EBTDA, 9.5x earnings,  and that throws off enough cash to pay down its considerable debt burden within a 4-year time period. We’ll keep a sharp eye on the overwhelmingly positive sentiment factors right now (8 out of 9 analysts have Buy ratings, and only 6% of the float is short), but we think that – at least for the time being – that the consensus has this one right.

Overview of the Quarter and our Model

Solid quarter for HBI with Q1 EPS of $0.49 topping our estimate of $0.34. The beat was broad-based coming in better than expected on every line item. Strong top-line results (+12% vs. our +10%) driven by the Outerwear and International businesses coupled with less significant gross margin contraction and greater SG&A leverage drove 60bps in operating margin expansion in the face of the toughest compare of the year. The Street was also looking for $0.34.

On the margin, we’ve adjusted several lines in our model to reflect the traction that’s clearly evident in the business as well as the company’s ability to successfully mitigate higher costs. The bottom-line here is that following Q1 results, increased full-year guidance of $2.70-$2.90 up from $2.60-$2.80 actually looks conservative.

• First, our consolidated top-line assumptions remain little changed for the year up +12% taking into account stronger growth than we expected in the company’s International business and a modest ramp in Outerwear driven by early success at Gear offsetting more modest growth assumptions in Innerwear due to less meaningful from timing related space gain contribution.
• GMs contracted -108bps in the quarter 100bps less than expected in the face of the toughest compare of the year +460bps proving the company can mitigate higher commodity costs. With supply chain efficiencies of $8mm-$10mm, or 75-100bps a quarter, offsetting less onerous commodity costs as we look out to the balance of the year, we’ve taken up margins modestly in the 2H to flat and down -25bps in Q3 and Q4 respectively from down -50bps in each quarter.
• SG&A leveraged better than expected with dollars coming in below our expectations with added distribution costs to handle higher sales volume coming in much lighter than anticipated. Additionally, despite the perception of increased marketing spend given a multitude of new campaigns, the company confirmed that marketing spend will stay in-line with historical spend of $90-$100mm annually.

All in, given the $0.15 beat in the quarter and approximately $0.08 of added benefit attributed to both gross margins and SG&A over the balance of the year, we are taking our numbers up to $2.95 and $3.40 for this year and next ahead of what amounts to conservative guidance. While inventory growth of +30% (+26% ex Gear) is higher than we’d like to see at this point in the year, taking inventory early may in hindsight be an opportunistic move with retailers potentially looking to take stock earlier than usual heading into BTS.

Few Key highlights from the call:

Retailers/Inventory:

“what is interesting is that retailers are taking very different approaches to managing inventory as cost increases start to hit them throughout their entire apparel floor. Some are extremely conservative, some are pretty aggressive using as an opportunity to gape share, they will start to normalize later in the year, we clearly did anticipate in our guidance somewhere during the year we would see unit levels drop on in aggregate for retailers.”

Consumer:

“We are seeing a pickup in spending and confidence that help may help mitigate that a little bit. We are seeing consumers actually start to travel back up scale in terms of retailers and show a predisposition to begin spending higher prices per unit, that bodes well for the economy throughout the year.”

Re Pricing

“We got the lion's share of pricing secured. We feel fine about it and remember we price on a run rate basis, not to try and make a fiscal year and so we look at what we think the go forward rate is from a inflation stand point, both with cotton, oil and wages, as we put in prices, that should take care of not only 11 but cascading in to 12. We are fine from a pricing perspective”

HBI 1Q FY11 Earnings Call

P&L Notables:

• Sales Increased 12%Reflecting:
  • o Innerwear: (Flat)
    • Innerwear Operating Margin -400bps
    • Deterioration Reflects:  higher cost cotton and commodity cost throughout the quarter and price increases that were not implemented until mid quarter
      • o Outerwear segment: +37%
      • o Hosiery:  -6.9%
      • o International segment sales: +24%
      • o International Business
      • o Direct to Consumer: -2%

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    •  The fact that price increases were only in place for two months in the quarter contributed to a 23% decrease in operating profit.

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    • Across-the-board strength in Gear For Sports, wholesale casual wear (Hanes), retail casual wear (Just MySize andHanes), and retail active wear (Champion).
    • 19% was due to Gear for Sports Acquisition

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    • Strength in all geographies - Canada, Latin America, Asia and Europe. Operating profit increased 86 percent (75% Constant Currency).

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    • Sales from Brazil, China and India all saw 40%+ revenue growth

• Gross Margins 34.2% down 108 bps
  • o Spoke to GM in Q&A

• SG&A up 4.5%
  • o Spoke to SG&A in Q&A

Balance Sheet:

• Inventories up 30%
  • o Reflects the normal seasonal build for back-to-school, Gear for Sports acquisition, and higher Cotton and Commodity costs.
• Continue to have a priority of deleveraging and will continue to pay down debt with free cash.

2011 Guidance

• Expect Sales for FY 2011 to be within the rage of  $4.9 billion to $5 billion
• Expect free cash flow to be between 100-200 million
  • o Expect to reduce year-end debt levels by the amount of free cash flow
• EPS  for 2011 at $2.70- $2.90

Q&A:

• International Business Drivers
  • o Strong positions in Canada, Mexico and brazil. Overall you will see continued strength in the teens in International .
  • o China: All of the major developing markets have a long term growth potential. Our categories are used all around the world. As middle class grows HBI benefits. Focused on developing china, Mexico, brazil and India.
  • o In china focused on building the basics business first. Intimate apparel will be built out later.
  • o International up 17% on constant currency. Believe that international should be able to deliver low teens. All geographies are performing well.

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    • Only weak region is Japan. It is a 75-80 million dollar business.

• Gear For Sports/ M&A environment/ Gold Toe:
  • o Acquisitions are not a major part of our strategy. Three are a lot of opportunities to grow business. Clearly tuck-in acquisitions are helpful. On the look out for acquisitions but acquisitions are not necessary for success of HBI.
  • o Gold toe has been perennially on sale. They have passed on the acquisition in the past.
  • o Low profit quarter for Gear for Sports when seasonality is taken into account.

 

• Innerwear /Elasticity
  • o Weakness in Innerwear growth due to tough comp
  • o "From a profit perspective its simple we are starting to see the impact of inflation. Price increases have not hit innerwear yet. Will begin to see rebound in second and third quarters."
  • o Company has embedded a substantial unit fall off in guidance for FY 2011.
  • o 400bps of EBIT margin deterioration

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    • Last year there were huge space gains and fixture fills (approximately 30 million).

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  •  
    • Higher commodity prices
    • Price increases not passed through yet

• SG&A

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  • Was unplanned. Still in marketing mode (Marketing expected to be 90-100 million for the year). Bulk of SG&A dollars went to G4S. Might see SG&A  dollars go up.
  • Through the remainder of the quarters SG&A will be leveraged. Rate will continue to improve (dollars up but leverage as a % of sales up)
  • SG&A dollars were up about $11 million.  Gear  represented ~$12 million of SG&A in the first quarter (Excluding Gear, SG&A was relatively flat in dollars)

• Elasticity

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  • From retailer perspective, retail  inventories are where they should be. Interestingly however, retailers are taking much different approaches to managing inventories. Some are being conservative, others are using this time period to take share.

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    • Unit levels have dropped off in the aggregate for retailers.

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  • No consumer elasticity impacts as of yet.
  • Seeing a pickup in consumer spending and confidence. Seeing consumers travel back to upscale merchandise.

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    • As there is better visibility feel more secure in negotiating with retailers and feel more comfortable with position.

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    • "It is the end of the deflationary environment in retail"

• Pricing/Cotton

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  • Have the lion share of their costs locked in.

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    • Use run-rate pricing

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  • Work directly with merchants who become involved in the futures market.

• Gross Margins

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  • Excess service costs spilled over very little but was not material.

• Inventory

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  • Inventory in 11 will be up 50million

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    • Inflation costs +100
    • Turns will improve by +50

• Competitor Responses to price Increases

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  • Every single company is having to deal with huge inflation. No one is immune. Every company is going about inflation differently. There are a few big global players who have been surprised by the increased.

• Average Interest Rate on all debt?

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  • 7.5%

• Outerwear

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  • Overall increase was driven by G4S.  Even so, everything was up excluding G4S (~18% Excluding g4s)

• Direct -Sales Segment

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  • Down about 2%. Comps were up 2%. Internet business was soft. Attribute softness to a mid quarter change in mailing strategy and timing.  Believe it will turn around later in the year

• Transportation and Energy Prices

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  • Built into guidance is oil at 100

Brian McGough

Casey Flavin
Robert Belsky