Let’s face it – every HBI print is its’ own full contact sport. This one will be no different. I’m bearish – very. This is my top short. The only thing that gives me pause is the fact that its core customers in the US just benefited from a 6% retail holiday comp. The stock is only +11% since November in one of the biggest retail rallies since the Great Recession. That’s likely because its 4% tax rate precludes it from participating in any form of benefit from tax reform (in fact it gets hurt). Consensus estimates only look slightly high this quarter – and if the company was wildly off we’d likely have seen a preannouncement before it announced its reporting date. We’ll get initial guidance for 2018, and the chance of management guiding down from its fictitious $1bn in Cash Flow is minimal. I still think that I’m more likely to see a BigFoot wearing a thong by the end of ’18 than see $1bn in CFFO potential from HBI. Do I think that management is being dishonest? Not in the least. HBI’s problem isn’t the lack of a clear and defined plan – it’s that this management team actually believes it. I think 2018 is finally the year when 10-years’ worth of misaligned incentives (stemming from Sara Lee spin-out circumstances) results in REAL cash flow generating power of $500mm or less becomes a reality, and the stock is violently revalued accordingly. Will it happen on Thursday? Probably not. But I don’t see how we don’t get evidence that the day of reckoning is approaching.
-- McGough
Here’s McLean’s tear down of the model...
High Level on the Print:
HBI is reporting about a week later than normal. Perhaps this is driven by wanting more time to understand tax reform's impact on financials.
It's also reporting before close for the first time; we're not sure what to make of that.
There was no pre-announcement this quarter, that skews as a bearish read given the company historically likes to get good news (in-line or beats) out early.
We're modeling $0.51 vs street at $0.52.
Revenue:
The company guiding to $1.625bn to $1.65bn, we're coming out at $1.63bn, just $10mm below the street.… the growth tailwinds this quarter are outlined below.
Let’s not forget that HBI has missed revenue on 12 of the last 15 earnings prints.
Champion
Champion makes up about 16% of sales (with about 65% in Activewear, 25% in International and 10% in Innerwear). To put it in perspective, 20% growth (aggressive) would mean about $50mm in incremental revenue in 4Q.
Things are definitely better at Champion – you don’t get into Urban Outfitters by accident. But the brand is also showing up to a greater extent in Costco and Off-Price – similar product at dramatically different price point spreads.
Given the wide (over)distribution we are seeing, we'll give it credit for a mid to high teens growth rate in 4Q globally, with international skewing higher.
The next question is how much of that sales growth comes at the cost of other HBI product cannibalization. Despite a Champion growth rate in the low double digits over the last 4 quarters, the US Activewear segment has failed to grow better than 3%, even on easy comparisons. We'll assume about half is cannibalization in the US in 4Q. That equals about 3-4% growth in Activewear.
The International segment growth contribution (assuming no cannibalization) is about 300bps.
We don't think Champion will have a material impact vs the general Innerwear trend.
Alternative Apparel
Alternative Apparel was acquired on 10/13/17, so it contributes about 85% of a 4th quarter which should be more heavily weighted than other fiscal quarters given its a retail heavy operation. Alternative was disclosed to do about $70mm in revenue in 2017. That means about $17mm in revenue contribution going into Activewear in 4Q, or 440bps of growth.
Best Macro Retail Environment in Five Years is a Big Plus
No doubt retail saw improved strength in 4Q vs 3Q. Let's break it down as it relates to HBI:
Based on comp results of HBI US distribution, the implied weighted average comp for 3Q17 was about 1.6%.
With estimated 4Q results, the weighted average comp accelerates to 2.5%.
That 2.5% is likely a best case US comp for HBI and that's not factoring YY store closures.
Most of all, this analysis assumes no additional market share loss – which would be one of the first quarters this cycle that Hanes has not lost share. In other words, +2.5% would be aggressive – very.
Source: Factset, Company Reports, Hedgeye Estimates
FX
FX is a clear top line tailwind. After a 70bps benefit in 3Q, we estimate FX is accelerating to about 160bps of help in 4Q. That's $25mm or 500bps bump for International segment growth.
At current rates 1Q18 will see about 250 to 300bps of FX topline help, and 2Q18 about 200-250bps.
Margins:
Increased Marketing
We're modeling SG&A growth accelerating to 7% in 4Q. The company signaled it is increasing marketing spend. We would agree as it pulled down advertising spend by $13mm in 2016 while layering on 5 acquisitions.
Given its manufacturing weakness relative to Gildan, it cannot compete on price. Therefore, the way to drive incremental sales is to make more consumers want to buy it. That requires significant marketing investment.
Cotton
The cotton price increase from mid 2016 to mid 2017 is flowing through the P&L now. HBI has not signaled that cotton will be a drag in 4Q, but we think the pressure is there to the tune of 50-75bps, it just may be offset by utilization benefit (see below).
Gildan guided cotton pressure going into 4Q. Delta Apparel yesterday noted its 4Q gross margin was down 250bps, driven primarily by cotton price increases.
Utilization
The Nanjing factory closure is driving near term margin upside. We calculate the total cost tailwind to be about 170bps. However, the company would only be able to recognize a portion of it since it would imply a utilization rate in the high 90s range. We think the actual benefit flow through is about 50bps hitting this quarter as well as last Q. The company is likely using this to help offset cotton pressure.
Below the Line (Tax Guidance)
There has been much debate around what the tax reform impact will be for retail. To date 2018 tax guidance been about as expected. US retailers are seeing the rate drop from mid/high 30s to mid 20s. Multinationals like RL and TPR seeing 200-300bps rate reduction. However, HBI at a TTM 4% tax rate is the wild card.
It dosen’t take a CPA to make the (likely correct) assumption that HBI’s 4% tax rate is headed higher. How much higher is the question.
There are items in the tax reform bill that would seem to put clear pressure on HBIs rate, given that a 4% rate is only possible by shifting earnings to low/no tax jurisdictions, like via HBI's Grand Cayman subsidiary. We are comfortable modeling a 10% rate going forward as we think this is conservatively low.
Here are some items of the new tax law (per KPMG) that lead us to believe that HBI's tax rate will be heading higher, i.e. 10%+.
-Minimum tax on “global intangible low-taxed income” (GILTI) – this is broadly the excess income of foreign subsidiaries over a 10% rate of routine return on tangible business assets. The US taxable GILTI amount is subject to a 50% GILTI deduction allowance (up to the end of 2025, thereafter the GILTI deduction reduces to 37.5%) and is subject to tax at 21%. If nil tax is paid on the foreign pool of GILTI profits, the GILTI US effective tax rate in 2018 is 10.5%.
-Foreign-derived intangible income (“FDII”) regime – 13.125% effective tax rate (increase to 16.4% starting in 2026) on excess returns earned directly by a US company from foreign sales (including licenses and leases) or services
-A base erosion anti-abuse tax (BEAT). This applies to certain large taxpayers (with worldwide revenues in excess of a defined threshold) and will generally impose a minimum tax on certain deductible payments made to a foreign affiliate, including payments such as royalties and management fees, but excluding cost of goods sold.
Cash Flow:
Lapping Inventory Clearance
Guidance implies about $120mm in working capital benefit in 4Q. It seems difficult given that inventories have already been cleaned and the company is working against a significant inventory cleanup in 4Q of last year while winding down the Nanjing facility operations. That's when we saw raw materials and work in process as notable drivers of inventory reduction. We think inventory and working capital are reasonably likely to miss.
The impact of Alternative Apparel should be small, but the company has a history of acquiring cash flow to help the CFFO line. Perhaps Alternative was sitting on excess inventory that can be used to drive some working capital benefit in 4Q.
Capex/Deals
We expect capex to be in-line with guidance at $90mm for the year. Though we would note, that since the company does not properly invest in its business for growth, we treat ongoing acquisitions as capex. Therefore with Alternative Apparel, we are modeling $435mm in FCF in 2017.
Bon-Ton
A reminder, it’s not huge, but with Bon-Ton filing Ch.11 $3.6mm in HBI receivables is at risk, presumably this was provisioned for already.
Hat Trick?
Can HBI complete the hat trick with 3 calls in a row that go dead in the middle of Q/A?
