There are lots of reasons for investors not to like Hanesbrands (HBI).
We don’t like the brands, don’t like management, and don’t like the company. Go out and short the $7.6 billion underwear purveyor right now? Yes, the company’s earnings and margins have just started to fall off their peak.
This isn’t a tiny inflection point either. I see material weakness in the business—that can’t be hidden by acquisitions and stock buybacks forever. The cracks are already beginning to show.
Hanesbrands has looked fishy to me since we added the company to our Best Ideas short list in May 2016. The stock has collapsed since then, down -31%. We still see considerable downside to $5 or a fall from current prices of 70%. If I’m right, this may prove to be the best short call of my 23-year career.
This could be a single digit stock by the end of the year.
The reasoning behind this short call is pretty simple...
The underwear business isn’t exactly booming. That was made crystal clear recently. In early February, the company reported fourth quarter earnings. Year-over-year sales growth for the quarter was down -5.5%. The company missed earnings per share expectations by 5 cents, reporting $0.49.
Most egregiously, Hanesbrands missed its annual cash flow from operating activities target by 22%, even though with two months left in the year management said they were “very confident” in the numbers. Also, neatly tucked away inside the company’s earnings release was its precarious debt position. Leverage backed up to 4.2 times – with 50% of operating cash committed to dividends – mitigating the company’s ability to do deals or invest in the business to grow.
A word of caution. Over the next couple quarters, the company can play with its reserves to avert breaching a debt covenant. Could it pop by 10-20%? Possibly. But I'm ok with that given the 75% downside with a complete revaluation on lower numbers.
In other words, this cash flow draw down was the first of many dominos still to fall. All told, Hanesbrands management offered flat to +2% organic revenue guidance in 2017. I think there is less than 10% chance it actually hits that.
Why? Hanesbrands’ accounting practices are about as aggressive as any other (solvent) company in retail. Regulators are seemingly aware and watching.
About two weeks ago, the SEC released several comment letters directed toward the company. Among other things, the SEC was interested in the company’s continual non-GAAP and acquisition-related charges. Hanesbrands provided satisfactory answers for the comments. While we don’t see any smoking gun here, it is notable that the SEC is scrutinizing the company’s accounting practices.
The SEC is sniffing around for good reason. Hanesbrands’ management has been quietly trying to paper over its problems via acquisitions. By our math, this company has acquired an average of one company a year, over the last five years, for a total of $1.5 billion. These have come at increasingly expensive prices. The most gem was Pacific Brands, which cost 10x EBITDA. In short, Hanesbrands is trading at 10 times EBITDA, but its most recent deal multiple is 20% higher. Why? Just asking…
When roll-ups come to an end, it’s an ugly picture. There’s more ugliness to come.
On the stock buyback front...
The company has spent $731 million over the last 18 months, just when margins were at their all-time peak. This comes across as flat-out reckless. Meanwhile, former Hanesbrands CEO Richard Noll sold $116 million worth of stock, before stepping down in October, taking his stake from 0.8% to just 0.2% of the company. That’s not exactly a vote of confidence. I think management sees the underlying issues here.
There’s more.
Distribution of Hanesbrands products is highly consolidated, with Wal-Mart, Target, Kohl’s, Penny, and Amazon accounting for ~70%. Question: Why should a company whose primary brand sells through mass channels and department stores have higher margins than some of the best brands in the business? Its customers are questioning this too. Both Target and Wal-Mart have indicated they plan to lower prices and pressure vendors like Hanesbrands.
As if it couldn’t get any worse, pricing pushback from Wal-Mart and Target will be compounded by the rising cost of cotton. The company has been the beneficiary of a 7-year low in cotton prices. Cotton prices fell 55% from the peak in 2011 and Hanesbrands saw about 700bps of gross margin expansion.
That’s changing.
Cotton is up about 36% from the bottom about a year ago. It takes about 9-12 months for these costs to flow through to the P&L. By our estimates, a 10% move in cotton equates to about 45-65 basis points of gross margin risk for Hanesbrands, or about a 4% hit to earnings per share. Who will likely take the hit of higher prices? Not Wal-Mart or Target. Or consumers. Well, you get where I’m going with this.
We see significantly more downside for shares.
Short the tighty whities!
