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Let’s give ‘em a golf clap on forecast accuracy this quarter. Despite losing a nickel less than the guide-down, we think the stock was looking for something better. All in, we still think that the company is in denial as to the risks to its revenue and/or margins in 2H12. We’re 30-40% below the consensus for the next 3 years.

This was a horrendous quarter for HBI. But relative to expectations, it was right in line. In fact, we’ve got to hand it to management; with such massive moves in its Gross Margin line and the pricing pressure in its screenprinting business, we’d think that its forecast accuracy would be sub-par at best. But they came in right in line with nearly every line on the P&L. In addition, relatively all aspects of guidance that the company said 9 weeks ago remain completely unchanged. When all is said and done, the company lost -$0.27, and while better than the Street at -$0.33, we don’t think that this is anywhere near what the stock needs to rally.

Why? Keep in mind that the company reported its 4Q a few weeks late (2/15), and reported this quarter a week early. In the end, there was only 8-9 weeks between reports, and we’d venture as far as to say that the company did more conferences and roadshows intra-quarter than it ever has. The tone of its meetings has been extremely bullish, about both the state of the current business and the prospect of hitting a $4 earnings number in the future. Recent conversations we’ve had with the investment community lead us to think that the real concern for anyone who is short HBI is that the company would come out and print a profit this quarter. But clearly, it did not. We’ll give ‘em a golf clap for its forecast accuracy. But not much more. In addition, in alluding to 2013, management again referenced a low $3 EPS assumption. On the Q4 call, Rich suggested “one could reasonably model 2013 EPS potential in the low $3 range.” There was slightly more conviction in the low $3 reference this evening- “10% to 11% operating profit run rate is still a good assumption resulting in 2013 EPS potentially in the low $3 range”… still not exactly a raging endorsement.

While comments on the business remained largely unchanged, there was a slight softening as to management’s tone on its ability to pass through pricing. Also, we continue to be puzzled about HBI’s bullishness on cost inflation. The company believes that the industry acted very rationally this quarter, supporting its own strategy as well. It thinks that there is a paradigm shift going on at retail where higher costs = higher consumer prices, and higher margins for the supply chain. That’s where we simply disagree. It’s the consumer that decides whether or not there is inflation, not the fluctuation in input costs. The retailers might seem fine now, but all we need is for one major party to break rank, and the ballgame changes very quickly. The consumer will have no problem blowing up a paradigm shift.

The biggest positive that I’m being hit with by the bulls is that the company is committed to repaying debt, and having debt down from $1.8bn to $1.0bn by 2014. That’s great, and we’ll be the first to admit it. But that also assumes that the cash is there to achieve the goal. If HBI’s business turns down or if margins compress, then net income comes down, working capital goes up, and there won’t be anywhere near enough free cash flow to achieve those debt levels. Remember, it was in 4Q11 where the company said it would generate free cash flow of at least $192mm to meet the low end of the full year guidance of $100-$200mm. As a result of the business underperforming in Q4, they only reported $174mm for the quarter and $82mm for the full year, falling $18mm short of the low end of the $100-$200mm guidance. That’s certainly a hit to credibility. And we’re going to give them the benefit of two years? This is not necessarily an HBI thing, as they definitely helped their credibility somewhat this quarter. But it’s tough to guage that level of confidence for any company with limited visibility, a consolidated customer base, and high operational and financial leverage.

HBI remains political about changes at JCP – that it’s excited about the change. They might lose a little hosiery business there, but that’s all that’s in their plan. That’s a binary outcome, in our opinion. JCP is about a 5%-6% customer for HBI. Family dept stores = 15%. Mass channel = 50%+. Ron Johnson at JCP is going to competitively bid out each section in the stores to see which brand wants it more. JCP might get the revenue, but it will be at a lower margin. PLUS, any special product workup is going to upset Kohl’s, Target, WalMart, Sears, Macy’s, Dollar Stores, etc… This will be a domino effect with or without HBI. Also, be sure to remember that price competition at retail in higher end categories is often funded by discounts in more commodity categories (ie discounts on Polo at Macy’s will be paid for by Jones Apparel Group, PVH’s Dress Shirt biz, and underwear vendors like HBI). If HBI is savvy enough to please all of its customers, the cost of the growth is likely to go up.

All in, we took our numbers up by $0.10-$0.15 for each of the next three years, which is ENTIRELY due to a lower tax rate (down 500bps each year). Management mentioned a $3+ EPS number in 2013.  We don’t have that in the cards until 2015 at the earliest. We think this stock is just flat out expensive.

HBI Management Credibility Check.

Here’s a quick check as to what the company said it would do when it reported 4Q results versus both 1Q actual and 2012 guidance.

Wholesale Orders:

-Wholesale order slowed substantially in Dec, expect sell rate and orders to normalize

Margin Pressures:

-Both sales and profits should grow for the full year but sales and margin pressures expected to cause a loss for Q1 $0.27 loss in Q1

-Beyond Q1, Q2 operating margins should return to MSD-HSD Unchanged-  2H Gross margins expected to be low 30s with OM LDD

-Q3 operating margins should be DD

Free Cash Flow:

-Guided to $400-$500mm for 2012 Unchanged- Half of the reduction from improved working capital primarily through better inventories

-“FCF should be strong for the next number of years”

-Debt reduction a priority- goal for debt to be at $1.5bn in December 12 Unchanged

Pricing:

-2012 innerwear pricing solidified Unchanged- 95% of US volume locked

-Price gaps have been closing to more appropriate long term levels Unchanged- Reaching more normalized levels

-As pricing comes back, HBI will tactically give back value to the consumer (5 pack for 12.46 today will be a 6 pack for 13.46 tomorrow)

-Have removed volume offers to create every day prices despite the industry offering volume initiatives as sales drivers

Miscellaneous:

- Gaining shelf space at retail primarily through Hanes Comfort Brand and socks as well as intimate apparel (trends encouraging) and hosiery Unchanged- Additional shelf gains in innerwear should help revs in 2Q and 3Q 

- Gear for Sports Operating profit expected to be $40mm in 2012 Unchanged 

- JCP: Have planned for an impact on intimates business which is included in guidance but not so much on the underwear business which is still set for expansion Unchanged- JCP’s goal for fewer more impactful brands said to fit right into HBI’s wheelhouse and plans for imagewear to be more quality focused vs. commodity

Guidance headed into the Call:

1Q12 Guidance: 

Sales: Estimating 1Q around $1bn BEAT

Excluding impact from outerwear, expect sales flat YoY through first 5-6 months Unchanged- sales ex imagewear and JMS expected to be flat through May with growth resuming with the help of shelf gains thereafter

Gross Margin: 900 bps of pressure primarily from screen print business Came in down 898bps

Expect flat SG&A in Q1 Came in down 1.7%

2012 Guidance:

Full year sales growth 2-4% Unchanged

Expect EPS $2.50-$2.60 Unchanged

Includes a $0.30 loss in imagewear (should occur half in Q1 and half in Q2) Unchanged- $0.18 impact in Q1 with the balance to take place in Q2

Interest expense should be down $15mm in 2012 Unchanged

FCF guidance: working capital headwinds should reverse and become tailwinds in 2012 Unchanged

Longer term prospects of the business:

Inherent long term guidance includes average operating margin of 10-11% in 2013 resulting in Low $3.00 EPS range Unchanged

Brian P. McGough
Managing Director