THE HEDGEYE EDGE
We added HBI to Investing Ideas as a short on 3/31/16. We don’t like the Brands, don’t like Management, and don’t like the Company, but that alone is no reason to short a Stock. What is, however, is the fact that we think earnings and margins are at peak. We’re 7% below consensus this year, -20% in ’17, -30% in ‘18, and -40% by year 3. Some argue that stock seems cheap today at a mid-teens multiple and 5% FCF Yield – though we really don’t follow that logic.
Once the dust clears from the acquisitions, special charges, and cotton prices normalize from the 7-year low, we think we’ll be looking at lower multiples on lower earnings and cash flow. A low double-digit multiple on our numbers gets us to a high-teen stock. Perhaps management agrees, especially CEO Noll who has cut his stake in half over four months.
HBI should release 1Q16 results around the 21st of April. This is not intended to be a call on the quarter, as it’s more of a margin and growth story that has run its course. For the most part, we expect earnings to be roughly in line with the Street this quarter. But unless HBI guides down, this might be the last beat/in-line quarter for a while.
INTERMEDIATE TERM (TREND)
After reporting weak revenue growth in 4Q15, HBI's stock price crashed 19% in 2 days. The stock has since rallied back 17% in line with the broader retail sector (XRT), yet the fundamental issues have not changed. Organic (core) growth slowed 800bps in 4Q, and organic compares are harder in 1Q and 3Q with 3Q being the toughest organic growth compare in over 2.5 years.
In addition, 1Q is the last quarter of top line help from the Knights Apparel acquisition in early April of 2015. The margin tailwind from cotton hitting 7 year lows is waning as much of the cheaper input costs have worked through the supply chain. Lastly, the sales to inventory spread sits at the worst level seen since 4Q11.
The risk over the trend duration is the announcement of new accretive acquisitions that will be followed by restructuring charges. That could cloak the slowdown in the underlying business, much like the Champion Europe acquisition announced this morning.
LONG TERM (TAIL)
Here are some longer-looking factors to consider…
1) Why? Can someone, ANYONE, explain to us why HBI has operating margins of 15%? That’s demonstrably higher than the following companies – UA, RL, PVH, GES, CRI, ANF, KATE, and yes – even NKE. It’s also well above its key retailers (WMT, TGT, KSS, JCP, AMZN).
Why should a company whose primary brand sells through mass channels and department stores have higher margins than the best brands in the business? As hard as we try, we cannot figure it out aside from over-earning due to a 7-year trough in cotton prices and the temporary benefit of being a serial acquirer and restructurer of companies in an effort to grow away from its core.
2) Let’s consider how the margin structure changed at HBI over the past 4-years. Cotton peaked in the market at about $2.00 in 2011, which ultimately flowed through and hit HBI’s margins in 2012. That was when the stock was at a split-adjusted $5. Overly penalized, for sure.
But we’d argue we are seeing the inverse today. Since the precipitous decline in cotton to the $0.57 level, HBI recouped seven (7) full points in Gross Margin. Over the same time period, how much did the company see flow through to EBIT margin? Seven. Ordinarily, we’d like to see a company invest more of the upside.
They’ll say they ‘innovate to elevate’. But we’ll bet there’s a direct flow through in margin downside if either a) cotton prices head higher, or b) if Wal-Mart and Target decide that HBI is making too much money.
3) Buying at the Top? HBI is buying back so much stock while margins are at all-time peaks (and management is selling) comes across as flat-out reckless. In fairness to HBI management, we see this behavior from most major consumer companies – they buy stock when they CAN and not when they SHOULD. This is not unlike Target, which is taking the incremental $1.2bn it gained from its pharmacy business and using it to buy back shares at $80. Our sense is that it will come back to haunt them if we’re right on earnings and this stock is in the high teens.
4) Acquisition Behavior Bothers Us. This company has acquired an average of a company a year for 5-years for a total of $1.5bn. It’s also taken $546mm in restructuring charges, or 25% of non-GAAP EBIT, since 2013 when HBI started its recent streak of acquisitions with Maidenform in October 2013.
5) As hard as the company might try, HBI cannot simply grow online. If there was only one statistic we could see for a consumer brand to gauge the health of its business, it would be the direct to consumer (DTC) sales of its product. DTC sales at HBI, however, have shrunk as a percent of sales over the past 5 years from 9.5% to 6.8%. We’ve never seen a company do that before.
Our sense is that WMT, TGT, the Department Stores, and Dollar Stores all would react severely if HBI tried to go direct. And yes, we understand that WMT and AMZN sell Hanesbrands online, which counts as a wholesale sale on the P&L but shows up online. It does not matter. Margins are better for a direct sale full-stop.
We refuse to accept the premise that underwear is not a category that lends itself to online sales. Tell that to Tommy John, Lululemon, and Under Armour, who all have 30-40%+ online businesses and are charging $30-$40 per pair (not package), and they can hardly keep them in stock.
It’s abundantly clear where the trend is going – and HBI can innovate all it wants, but it’s likely not going to be a player in this premium game.
6) When management buys a share of stock, we’ll step back and question our logic (though we’ve done that a few times already). We have seen an absolutely massive degree of selling from the management team over the past year – see CEO Rich Noll’s selling activity below. Specifically, he has sold $85mm in stock over the past 14 months, most of that +/- $2 of where it is trading today. Last time Noll's ownership % was this low (0.2%) was in January 2010.