This was a less than inspiring P&L quarter for HBI with the EPS upside and beat coming entirely from lower SG&A and the outlook for Q4 below Street expectations. That said, we have to give credit where it’s due – this is a business that’s been managed for cash flow and it delivered with $287mm used to retire $300mm of floating-rate debt, and posted an extremely impressive SIGMA performance. With another $500mm in debt targeted next year, HBI will have its debt burden down to ~$1Bn by the end of 2013 if it hits its operating margin targets – half of where it was in 2010.
But this is a business now exceeding peak margins and trading at 9x EBITDA benefiting from a number of near-term tailwinds. While HBI has the majority of its pricing locked up through 2013, it’s corresponding volume is not certain, and this is not a business without risk. HBI is not a raging short in the absence of a catalyst (valuation – even for an overpriced stock) is not a catalyst, but there just isn’t enough potential reward for us to get more constructive at these levels.
The company is looking to go up market driven by innovation (ComfortBlend underwear, slim fit t-shirts, and Smart Size bras) and that’s great if early shelf gains continue, but these initiatives cost money to support. HBI is now on its 3rd straight year of realizing $30-$40mm in supply chain savings one-third of which comes out of SG&A, which is noteworthy, but begs the question of just how much is left to squeeze. In addition, HBI will be reinstating its media spend next year ($10mm+), the benefits of which helped drive the beat this quarter. In reality, the investment should exceed what was simply held back in 2012 and will likely impact operating margins by -20bps-40bps next year.
Gross margin recovery driven by easing product costs and additional supply chain efforts will offset higher SG&A. A particularly strong SIGMA trajectory should support strong margins for the next two quarters, but we think operating margins beyond 10%-11% are simply not sustainable over time in this business. The only time HBI posted margins like that was when it was part of Sara Lee and preparing to go public. Now if HBI is willing to substantially ramp investment spending to drive double-digit top-line growth by taking pricing up with innovative basics while capturing shelf space resulting in top-line instead of cost reduction driven EPS growth then this story would be more attractive. But as it stands now, there is still uncertainty in the mid-tier channel and International is having execution issues that make it challenging to get above MSD revenue growth over the next two years.
At 9x and 8x F13 and F14 consensus EBITDA expectations, much of the potential reward scenario is already baked in at these levels. With the stock up +50% YTD and at 4-year highs, we need sustainable top-line acceleration or margin expansion to get more constructive – we don’t see it.