HBI | Manufacturing the print…until it can’t.

People ask me if I’m nervous heading into this HBI print. I wouldn’t say ‘nervous’ but OF COURSE I’m on high-alert – and the closest an investment process should get to ‘nervous’. I am for every company where I have an out-of-consensus call (the goal with all of our calls) and there’s a material risk of the company manufacturing a good print until ultimately – it can’t. Here’s what concerns me short-side…

1. The stock is off by 18% with the market up 5% and the company has been working the conference circuit playing up its cash flow for this year. This thing trades on cash flow – full stop.
2. Management will likely be optimistic about 2017. It has to after its optimism over the past 90 days. Need to give REASONS for cash flow optimism – not just bc management is bullish. It won’t be beared up this early in the year. That would give Noll a black eye. And while he left the CEO slot in October, he’s still Chairman, and runs that ship with a very heavy hand.
3. It’s done five (count ‘em – five) acquisitions in eight months. If there was ever a time to engineer a good number, this is probably it.
4. It just increased its dividend by 36% -- which at face value is pretty bullish.

BUT, there are two sides to every coin…

1. First off, there’s no reason why a big dividend increase is not setting the stage for a disappointment. ‘We’ll give you some cash before we deliver a steamer.’
2. The company probably has less leeway to manufacture the P&L in the fourth quarter. Accruals usually are made whole in 4Q – and our sense is that Noll used up most of the ammo when he was in his CEO seat.
3. The Street is already looking for 31% growth in EPS.
4. A good EPS number might not matter. This trades on cash flow – full stop (remember the 3Q print?), and it’s very difficult to manufacturer cash flow.
5. My strong view is that it won’t be enough for management to simply be bullish. It has to quantify WHY it is bullish instead of giving us the ‘trust me’ schtick.
6. When I think the underlying call is as powerful as this one is, I’m not going to back off just because of uncertainty around an event. When the call proves itself out, I’ll be there on that day. And there is a chance – albeit small – that the call plays out (again) on Thursday.

Ultimately, I think this stock gets re-rated on a much lower cash flow number.

1. Our model is calling for $375mm in operating cash in 2017 – which compares to $760-$775mm this year, and management’s (loose) initial guide of $1bn in ’17. This is where the rubber meets the road. If we’re right on the number, I can’t see how we’re wrong on the stock.
2. It is ‘over-earning’ its wholesale channel by the widest margin (3x) in the history of HBI. How much longer will WMT, TGT, KSS, etc…allow that.
3. Only 20% of the cash flow miss is attributed to an earnings miss. This is working capital squeeze, less factoring, pension contribution…
4. People forget that this is a vertically integrated manufacturer of commodity goods that is at peak margins while utilization in its plants has gone from ≈ 70% to 90%+. That’s almost never sustainable.
5. Shouldn’t this trade on Free Cash instead of operating cash? It’s capex went from 5.3% of sales to near 1% of sales over the course of this cycle. How I see it, the company will have to take up capex meaningfully (which would have hurt Noll’s comp), or risk missing top-line over and over. And at 3.5x leverage, it is probably done doing deals to perpetuate an obfuscated eroding core P&L.
6. While the dividend is nice, if our cash flow number is right HBI will be obligated to pay out 60% of OCF next year. And yes, that’s with capex at trough levels and no more room to do deals.
7. As a kicker, HBI spent nearly a decade moving its plants outside the US and taking its tax rate down from 20%+ to 6%. It is the biggest ‘anti-Trump’ trade if I’ve ever seen one.
8. We’re likely to see unit consumption of apparel go from 83 units today to something in the 70s under a border tax scenario (it was 30 units in the 1990s). This disproportionately hurts low-end commoditized basics. i.e Underwear.

Trades at over 10x EBITDA – buying weak assets at near 13x EBITDA. Warren Buffet buys these assets at 3-4x EBITA, and VFC sold its’ intimates business at 3.6x EBITDA. If the cash flow pans out as I think it will, there’s no reason why we can’t see a 5x-6x multiple on a lower cash flow number. That’s a $6-$8 stock.

I guess my biggest concern is that this ends up being like Quest or Jones Apparel Group back in the day – or Kinder Morgan was last year. The management team will bash the bear case – violently and personally if necessary – until it has to fess up and show the flaws in the sustainability of cash flow. Could that take several quarters to play out? You betcha. But I’m gonna be there when it does.

Brian McGough

McLean’s Take on the TREND.

Print Summary

We're at $0.55 with the street at $0.58, but we won't be shocked by an inline print – or even a couple cent beat.  We think management will pull every lever to at least get to the bottom of EPS guidance and hit the cash flow target, but the levers are becoming few and far between.  Being able to hit street numbers would be impressive, but leaves such a dangerous set-up.  Revenue up from acquisition, inventory way down, with utilization near peak, margins at peak, tax rate at trough, with a levered balance sheet, and negative trending organic growth rate.  All while 20% of EBIT comes via charges from acquisitions as long as 11 quarters ago. 

Revenue

HBI's current revenue guidance of 21% growth implies  about 4% organic growth in the 4th quarter. This is positive on a standalone basis, but considering it is comping against a -10% number last year, it means an ugly 2 year trend after 3 quarters of improvement. Total revenue was down 7.4% in 4Q of last year, with 2.6% ($39mm) in growth coming from the Knights apparel acquisition.

The rest of the expected growth, about ~$250mm (18%) will come from the 5 acquisitions done this year. The acquisitions include Pacific Brands, Champion Europe, Champion Japan, and the 2 disclosed quietly in the 10-Q, GTM Sportswear, and Universo Sport.  $250mm seems like a reasonable estimate from our calculations, though we do have to recognize that management just revised its 2016 annual revenue impact from new acquisitions to $440mm from $365mm over the course of about a quarter's time.

Partner Pressures

Let's not forget the holiday results posted so far in the mass retail space.  After all WMT, TGT, KSS, JCP, and M account for about half of HBI's revenue.  The comp results:

TGT: -1.3%

KSS: -2.1%

JCP:  -0.8%

M: -2.7%

WMT: TBD

In 4Q last year when HBI sales tanked, only one of those comped negative which was M at -4.8%

HBI's direct to consumer growth has been negative for 7 straight quarters, and was down 11% in 3Q.  Where exactly is this organic growth going to come from?  Amazon is growing reasonably well, but that still only 1% of sales.

In all, not a good read-through to 4Q topline.

Margins

Gross margin comparison's are tough as last year's 4Q gross margin was up 152bps benefitting from 100bps of charges, and manufacturing/product cost savings, while Knights apparel consolidation was a slight gross margin drag. 

There are 2 main factors influencing gross margins in 4Q. 

• The first is cotton.  We've been saying this since we first went short, but the direction of cotton prices will be a clear margin headwind going forward.  Cotton price changes take 9-12 months to flow through to the P&L, and that means the increase we saw starting in March should start hurt gross margins.  A 10% move is about 50bps in margin pressure, and prices are up about 30% from the lows. If bulls think that HBI will simply pass along the cotton cost to the retailer and end consumer, we say good luck when your EBIT margins are about 900bps above your major wholesale partners.  Walmart probably wants to keep some margin, especially when they have an alternative low cost brand competing for space in their stores in Gildan.
• The other factor is mix shift from new acquisitions. Pacific Brands has a higher gross margin at about 49%, which at roughly 10% of revenue means potentially a 100bps in gross margin upside in the quarter. If Champion Europe is similar to DBA, which we believe it is, then that will also be higher margin.  Both will be EBIT Margin dilutive in the near term at least on a GAAP basis.

SG&A is a tough comparison as well. Last year SG&A was down 8.8% on revenue down 7.4%, leveraging 37bps. Restructuring and foundational charges reduced the sum by 10%. 4Q16 Total non-GAAP charges are expected to be about $45mm vs $56mm last year.

Cash Flow

The operating cash flow guide, though reduced slightly on the 3Q print, is still an impressive number at $775mm. Guidance assumes inventory is down about $100mm y/y even including the impact of acquisitions.  That means getting rid of about $300mm net in inventory in 4Q.  This seems like a big number, and it is, but we think they hit it simply because they have to.  Management has reiterated their confidence in this number throughout the fiscal year if they don’t hit the goal, not only have they missed the most important expectation line for the stock, but they lose all credibility just two releases into new CEO Gerald Evans' tenure.

We still see CFFO getting cut in half in 2017, with the big driver being inventory. The 2017 inventory reversal to a more normalized level makes up $321mm less in CFFO in our model.  We also see some increased pension contributions to catch up after the lowered contribution this past year.

The Dividend Raise

Ultimately the 36% increase in the dividend flies in the face of our call.  But it’s a near term positive, that we think is a longer term risk.  This increase is larger than last year when the company was preparing for overpriced acquisitions (which gets management paid) and raised it 10%, and about in line with two years ago (+33%). 3 years ago it was +50%.  Perhaps it means that there are no acquisitions on the horizon, as the company would likely save the cash to pay for growth.

But here’s what we really care about. The percent of operating cash flow paid out since the company instituted its dividend is as follows.

2013 = 10% of OCF

2014 = 24%

2015 = 71%

2016 = 22% (assuming guidance is met)

2017E = Implies 23% on Noll’s ‘$1bn in operating cash’ number (ie very bullish at face value).

But based on our $375mm cash flow estimate, this dividend obligates the company to pay out $228 or 60% of operating cash.  This is so dangerous for a company at peak utilization, peak margins and trough capex (especially in a Trump protectionist environment).

Lets put the yield into context looking at HBI, NKE, SBUX and MCD. HBI's yield has been essentially in line with that of NKE and SBUX over the last few years.  MCD is the only one that has crossed above a 30 year treasury yield over that time frame.

HBI was already among the highest dividend payouts as a % of cash flow, if we're right on the 2017 model, they are heading to over 2x the average of 25%.