The size and scope of the fireworks around this print were remarkably ‘meh’. At face value it comes across as the mother of all in-line quarters. This event was slightly net negative – enough for bulls to believe, and enough for bears to think they ‘missed it’ short side. This name is on a path to breaking in 2H. Zero equity value within 3-years.
No meaningful changes to our model. Still 15% below consensus in 2H, and 40% below in 2018. Dividend cut in '18 after accelerated share loss, and the $1bn operating cash number HBI is hanging its hat on simply melts away. But not like ‘dropped on the floor’ melt (like Sears). More like ‘dropped in a pot of boiling water’ melt.
With nearly every ‘this company will implode’ call, as we know, the quarters leading up to the implosion include irrational cost cuts, channel stuffing, aggressive terms, and whatever a company (and Price Waterhouse Coopers) could do to push the needle on accounting – while staying on the legal side of questionable. This started in 4Q. It should accelerate this summer. Rev very likely to crack in 3Q and take cash flow with it.
One of the key factors here – and I’ve said it before – is that management is almost certainly not lying. It simply believes in its own business planning process, which ranks somewhere between Kohl’s and Jared.
Let’s Put Management’s CONFIDENCE into perspective.
Management seemed extremely calm and cool on this call. I told my team that it seemed like Evans was reading a naptime story to a class of 30 kindergartners. In case you counted, management used the word ‘confident’ 12 times during the call. It’s prior record was 9 times. It said that word (or some derivative thereof) 8 times before missing operating cash flow targets for the 4th quarter by 30%. Just before that huge miss, Evans said "So very confident, though, that we're going to get to the numbers that we've been talking about."
A few callouts…
- HBI missed on organic revs…down 3% when HBI is guiding to a big ramp in 2H – the biggest the company will have to have seen in the decade it’s been public. Revs down over 200bps sequentially on 2yr.
- In the second half, the company expects organic growth in each of the Innerwear, Activewear and International segments. Basically, it expects growth in every business. Never been done.
- Took up acquisition impact in guidance by $15mm, implying it's contributing another 25bps to rev for the year, but reiterates 0-2% organic growth while holding full year total revenue.
- HBI comes in at bottom of guide if it does 2.5% organic growth in 3Q and 4Q -- $6.45bn... guidance today implies 1.5% in 3Q, but managment said on call that it will grow 2.5% organically in both 3Q and 4Q? That feels like a revenue guidance revision to me.
- 2Q operating cash was DOWN $100mm. That includes NOT contributing $40mm to pension, and about $100mm+ in working capital timing. Believe management’s spin if you want…cash flow did not improve.
- ‘Inventories are finally in check’. Yah…they’re in check based on how the company is planning its revenue in 2H – and very high based on where revenue is likely to land.
- GM% was +100bps. In-line all around…BUT the international mix shift alone should have driven 100bps. There was another 170bp in Nanjing tailwind that was spent/competed away. Hardly bullish setup for 2H gross margins.
-- Brian McGough
McLean’s Puts and Takes
Acquisition Impact Revision
In 2Q acquisitions contributed about $20mm more than expected with revenue in-line, which meant organic growth missed by 200bps. At the same time 2017 acquisition impact was revised up to $440mm from prior $420-$430mm, yet full year revenue was held steady implying organic growth was revised down from prior expectation.
Mixed Commentary on Organic Growth
The company guided 3Q at $1.8bn, with $10mm still remaining in acquisition impact (side note, that $10mm number will be higher on the 3Q print). That implies organic growth will be about 3.8% in 2H to hit the mid point of 2017 revenue guidance. Since acquisition are lapped in 3Q, 3Q organic growth is implied at 1.5%, putting 4Q at about 6%. HBI hasn’t put up anywhere near that kind of growth in a quarter during this economic cycle.
Meanwhile, on the conference call management talked about doing 2.5% organic growth in both 3Q and 4Q. That would just barely get HBI to the bottom end of revenue guidance for the year.
Gross Margins
Gross margins were up 100bps, good, however since the mix shift from higher gross margin international acquisition should be about a 100-125bps GM% boost, organic gross margin was flat to down, which was evident in the weak Innerwear and Activewear margin performance.
...And the company gave no context on Nanjing closure. We calculate the potential tailwind at 170bps in 2H, but don’t see the company being able to recognize that whole upside. Even when asked about the potential to protect margins if organic sales continue to be negative, management gave no detail on how flexing plant utilization would impact margins. 
Cash Flow
Operating cash flow looks much better ytd vs last year at +$34mm vs -$129mm midway through 2016. However let's remember that essentially 100% of operating cash for this company is generated in 3Q and 4Q every year. Despite management noting cash flow has been good, 2H is all that matters.
Seemingly Ridiculous Charge Guidance
When asked about slowing rate of non-GAAP charges, management commented that we will be seeing a lower rate of charges. BUT that last year's acquisition charges won't be completed until the end of 2019! That's another 2.5 years, and the acquisitions closed a year ago!
Leverage
Our math on credit agreement leverage puts HBI at 3.9x. Covenant leverage limit will be 4.0x at the end of 4Q if the company doesn’t do another acquisition over $200mm.
4Q Set-up
Ultimately it looks like HBI is setting itself up for a big make or break moment in 4Q much like last year. An unprecedented organic growth expectation, guiding improved profitability, while needing improved working capital going against an inventory clean up at the end of last year while layering on 4 acquisitions and winding down operations at a major factory.
