Takeaway: HAIN can’t cut G&A and be a company that is built to last.
HAIN in on the HEDGEYE Best Ideas as a SHORT!
Being short HAIN has been the pain trade for me.
That being said, the FY15 financial performance (negative earnings revisions and declining margins) over the past 12 months does not warrant a multiple expansion. Unfortunately, over the past 12-months the NTM EV/EBITDA multiple expanded from 13.6x to 16.8x today. At the time of our SHORT call we argued the company was overvalued because the international business (UK) was a slow growing, low margin food business that did not deserve to trade at a U.S. Organic food company multiple.
The exact opposite happened!
To that end, our thesis has not changed but has strengthened over the past six months. The company continues to provide little evidence that they have a sustainable business model, additionally management does not disclose the basic information analysts need to understand what the real organic growth rate is. We believe that there are structural impediments to future margin improvement, making the bull case even more suspect. The biggest impediments to margin expansion are:
According to the current sell-side models the HAIN business model will look very different in FY16 versus the past four years. Frankly, I have no explanation for the change in the sell-side logic other than they need to be bullish on the stock due to its Natural & Organic attributes.
The key components to the changes are:
The following is a look at why the current models are too aggressive in FY16:
GLOBAL DIVERSIFICATION LEADS TO LOWER MARGINS
Over the course of six quarters (to establish its international business), HAIN bought four international businesses for a total of $600 million.
Importantly, none of these businesses are organic or all-natural. This is in direct conflict to the U.S. business which is primarily Organic and the reason why the UK business should trade at a lower multiple.
Collectively HAIN’s new international businesses are producing low single digit operating margins, while the U.S. is running at 17%. Going forward, with the company now seeing 20% of its revenues coming from international with 1/3 of the margins and another ~12.3% from its latest protein acquisitions with mid-single digit margins it will be hard to grow overall margins. To summarize, HAIN can’t cut G&A to offset the gravitational pull of lower margins or it will sacrifice performance in other areas of the company.
GROSS MARGIN PRESSURE
For the past three years HAIN gross margins have been declining at a fairly steady rate. Since 2Q FY11 the company’s adjusted gross margins have declined from 29.3% to 26.6%, or 270bps. Gross margins are under significant pressure from commodity headwinds, mix shift and increased trade spending. We don’t see these issues abating in FY16. The current consensus sees a dramatic shift in HAIN’s gross margins in 1Q FY16. What has changed in order for management to guide to better gross margins in FY16?
MASSIVE CUTS IN G&A ARE CRITICAL AND UNSUSTAINABLE
Can any company cut G&A at the rate HAIN has and sustain critical mass? Does outsourcing G&A functions create sustainable long term advantage? I feel this is a big risk to the HAIN business model!
Prior to making the series of international acquisition in FY12 HAIN had not relied on G&A cuts to drive margin expansion. Obviously when they acquired lower margin business they need to cut significant amounts of G&A to prevent the overall margin structure of the company from collapsing. Until FY15 they have achieved the intended goal.
Prior to 2QFY12, over the previous five quarters HAIN had only cut G&A by 9bp. Since 2QFY12 the need to cut significant amounts of G&A has become critical to the overall story. From 2QFY12 to 3QFY15 the company has experienced on average 132bps reduction in G&A. Over that same time G&A has gone from 18.7% to 13.45%, or 496bps.
Over the past 12 months HAIN’s G&A has run has 13.75% of sales, as compared to 20% for most of HAIN non-organic companies and 23% for the biggest organic companies. Either HAIN has figured out a better mouse trap or this company is structurally set up to fail.
Now the company is in a very difficult position, the margins internationally have stopped improving and there is incremental pressure on the margins in the U.S. business. HAIN can’t cut G&A and be a company that is built to last.
OPERATING MARGINS HAVE PEAKED
Looking forward into FY16 the street consensus has HAIN returning to growth in operating margins. The improvement is entirely coming from improved gross margins, which seem counter intuitive to what is happening in the market place.
HAINS LTM EBIT margins have gone from 9.5% in 4QFY11 to 11.6% in FY4Q15. In FY15 LTM EBIT margins have gone from 11.8% to 11.6%. FY15 will represent the first time in 4 years that the company has not shown margin improvement. Why will the trajectory change in FY16?
Our bottom line for HAIN is that the margin story is over!
When the music stops it going to be real ugly!
SUM OF THE PARTS
The following charts are a look at the top line growth rate for the HAIN’s important regions. As you can see the two most important markets U.S. and UK are showing a significant slowdown in revenue growth. Importantly, the UK business revenue growth is estimated to slow 1% over the balance of FY16. What is the organic growth rate of a company with 1% revenue growth? And why should it trade at a premium multiple? Even the U.S. business is slowing to the mid-single digits. Again, the company organic growth will not be in the high-single digits in FY16.
What do you pay for a company that is seeing a significant slowdown in revenues and can only grow margins by cutting massive amounts of G&A?
I understand that my bearishness on HAIN ignores the roll-up story and all the hype surrounding the growth taking place in the organic market. At best the UK business is seeing low single digit organic growth of 1-2 and high single digit operating margins. We believe the UK business should trade at a significantly lower multiple than the U.S. business.
Our sum of the parts table is below:
Hedgeye Healthcare Sector Head Tom Tobin and Analyst Andrew Freedman hosted a live Q&A session in our studio today.
They discuss how the Affordable Care Act (ACA) will be an emerging headwind for Zimmer Holdings (ZMH) in 2015, and likely create a tough environment for the Healthcare sector as a whole.
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Please see below Hedgeye CEO Keith McCullough's refreshed levels for our high-conviction investing ideas.
Trade :: Trend :: Tail Process - These are three durations over which we analyze investment ideas and themes. Hedgeye has created a process as a way of characterizing our investment ideas and their risk profiles, to fit the investing strategies and preferences of our subscribers.
Anything longer than 3 years is unpredictable.
Takeaway: Current Investing Ideas: VNQ, EDV, ITB, TLT, MUB & HIBB
We added Hibbett Sports to Investing Ideas as a short this week. Retail analyst Alec Richards explains the rationale below.
In light of our increasing caution towards equities and the removal of many of our favorite names, last week we featured one of our analysts' favorite short ideas, Royal Caribbean. We received an overwhelmingly positive response from Investing Idea subscribers. The common refrain we heard was, "What took you so long?!"
To that end, this weekend we have chosen to showcase another stock we believe is massively overpriced. In fact, our Restaurants analyst Howard Penney says this company is 'egregiously valued' and poised to drop over 50% from its current sky-high perch.
Happy hunting out there on the long and short side.
Have a great weekend!
Below are Hedgeye analysts’ latest updates on our five current high-conviction long investing ideas, one short idea, and an additional new short idea from our Restaurants team.
We will send CEO Keith McCullough’s updated levels for each in a separate email.
We added Hibbett Sports (HIBB) this week.
As always, we also feature two additional pieces of content at the bottom.
For the most part, the Shake Shack (SHAK) growth story (business model) is predicated on the view that what works well in New York City will work well in the rest of the world. In our view, when it comes to operating a small cap growth restaurant company, NYC is not the center of the universe. Just ask the management team at DFRG.
The bull case for the stock centers on the brand’s unique beginnings and its “cult-like” status, which sets it apart from other better-burger operators. The company has guided the street to sustained, long-term EBITDA growth of +20%. This growth is expected to be driven by +20% domestic unit growth, execution on existing agreements for overseas licensed growth, low single digit SSS, and modest operating leverage.
The stock is reflecting a performance that assumes multiples of the aforementioned guidance. What the stock is not reflecting is the inevitable reality that, at the end of the day, it is just a restaurant company and the “cult-like” status will not last forever. We’ve seen many “cult-like” companies come and go and the vast majority of these stories have ended poorly.
To simplify the SHAK story, the only thing that will truly matter from here on out is the performance of new units.
There are currently 63 Shake Shacks worldwide, with about 49% of the store base company-owned. Most of the franchised stores are operated internationally, the majority of which are in the Middle East. Going forward, management is targeting at least ten company openings a year, and wants to triple its domestic footprint over the next five years. This translates to +32% and +27% domestic growth in 2015 and 2016, respectively. This would put SHAK’s growth rate at the highest in the industry and significantly above the more mature fast casual players that are growing in the +8-14% range.
Despite only having 63 units, management believes that Shake Shack “has become a beloved global brand with a power reaching multiples beyond [its] size.” Ah, a classic New Yorker’s view of the world. During the 4Q14 earnings call, CEO Randall Garutti went on to say, “The excitement we create during our openings and the ongoing connection we have with our fans through an intensive social media strategy, graphic design, and unique collaborations have together powered our voice and created a truly dynamic connection with our loyal Shack fans.”
Remember, Shake Shack is in the nascent stage of growth with a business model that is largely based on how New Yorkers view the brand. With 63 units, and only 13 in the same-store sales base (new units take 24 months to enter the base), management believes it has covered all of the bases. Its “versatile real estate model is built for growth, already proven throughout the country in varied formats: in urban, suburban, mall, train stations, airports, and even ballparks.” With roughly half of its units in the US, it’s difficult to imagine that management believes they have it all figured out. The runway for growth can be a lot smaller than most imagine and there is significant room for operational risk along the way.
Bottom line: SHAK shares are egregiously overvalued and could fall over 50%, perhaps even more.
We added Hibbett Sports to Investing Ideas as a short this week. Retail analyst Alec Richards explains the rationale above.
We think that HIBB is one of the most structurally challenged retailers in all of retail.
The company grew up to 1,000 retail stores mainly in the Southeastern United states with most of its doors within spitting distance of Walmart. The strategy was simple, 1) leverage WMT traffic, and 2) sell higher ticket sporting goods, footwear, and apparel from national brands that one cannot find at a WMT. But, now growth is tapped in its core market (over 95% of WMT’s in the company’s home state of Alabama have a HIBB within 5 miles) and must look to new markets like PA and the Southwestern United States for growth.
The problem is that a) HIBB has no brand equity in these markets, b) an underdeveloped distribution network making it impossible to service these markets in a cost effective manner, c) now has to compete in markets with an existing competitive presence (Dick’s Sporting Goods, Academy + Outdoor, Sports Authority) and d) manage competition entering its core market.
Add to that the fact that WMT – the retailer HIBB is most dependent on as a traffic driver – has posted negative traffic metrics in 8 of the past 9 quarters as it looks to e-commerce for its next leg of growth. The only problem is that HIBB can’t put a store next to WMT online, and it is one of the only retailers today that still does not have an e-commerce operation. That development of e-commerce capabilities appears to be in the works, but based on what we’ve seen from other retailers building out e-comm capabilities it could mean 300-500bps of margin headwind as the cost investment needed to enter the online marketplace, that has been driving outsized growth, flows through the P&L.
Ultimately we see top line trends decelerating, costs accelerating, and capital requirements are going nowhere but up. Any form of growth from here on out – in existing stores, new stores, and online, will all come at a lower margin. This year will be a roller coaster (mostly down) but we think next year’s earnings miss becomes explosive. HIBB is one of our top short ideas.
The ITB turned in modest positive absolute and relative performance in the latest week as the advance in interest rates ebbed and the high frequency mortgage purchase application data continued to reflect improving housing demand trends.
Purchase activity was flat week-over-week but held at 23-month highs with demand growing +11.7% on a year-over-year basis. As it stands, 2Q15 is currently running +14.5 QoQ, +13.7% YoY, and on track for its best quarter in two years.
The Mortgage Bankers Association also released its Mortgage Credit Availability Index (MCAI) for April on Tuesday. The MCAI made a new cycle high, increasing +0.5% month-over-month with the Government and Jumbo indices leading the gains. The regulatory pendulum continues to swing towards credit box expansion in 2015 and should provide marginal support to transaction volumes, particularly for prospective entry level buyers.
Next week will offer a more comprehensive update on the state of activity in both the New and Existing markets with the NAHB’s Builder Confidence Survey (May Data), Housing Starts (April Data), and Existing Home Sales (April data) slated for release on Monday, Tuesday & Thursday, respectively.
Click to enlarge.
In last week’s newsletter, we asked the question as to whether or not interest rates can move lower in both a deflationary and inflationary environment:
“While history suggests long-duration fixed income works in a QUAD3 scenario which we are moving closer to hitting in Q2, the performance hasn’t been as strong as a QUAD 4 set-up. However if the debate is between QUAD4 and QUAD3, bonds work in both scenarios.”
The counter-TREND moves in the USD and commodities have been extensive and now confirmed:
As Keith wrote in Friday’s Early Look newsletter , the longer-term sequence events causing the respective TAIL lines in the USD and Commodities to continue is as follows:
The move in 10-Year treasury yields on Wednesday’s retail sales miss was a good exercise in markets front-running central-planning:
The reality is that we are in a #LateCycle slowdown and the jockeying around each incremental data point will continue to get more and more intense as the Fed’s only ammo for suspending the cycle that has unfolded many times over is to push out the dots on a rate hike. #LowerForLonger.
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ADDITIONAL RESEARCH CONTENT BELOW
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