HBI’s 1Q came in below street expectations on revenue and earnings, but a bit better than we were expecting, mainly in International. Revenue down 17% and EPS down 82%, not much to like there especially as the company faces much greater demand pressure in 2Q, and potentially even 3Q, when compared to what was seen in the couple weeks of weakness in March. Management’s lack of transparency on business trends and pointing out of positives means the street is unlikely to re-base expectations low enough. With high leverage and crashing earnings, we think HBI remains a short here with 50% downside.
Business Trends
This was pretty poor disclosure from HBI management as it relates to helping investors assess the business trends and downside in earnings. This is actually what was provided in the FAQ on business trends…
Q: Can you provide an update on recent business trends?
A: “Comments reflect certain business trends as of April 30, 2020. While the majority of our stores and those of some of our retail partners remain closed, we have seen orders resume in April as consumers and retailers have begun to adapt. Online growth has rapidly accelerated each week, reaching triple digit growth rates across a number of our customers’ online platforms as well as on our Champion.com and Maidenform.com websites. Consumers are also buying our categories at stores within the mass, hypermarket, dollar store and drugstore channels. We are starting to see a new base line of orders within these channels. The Basics reset at a large mass retailer is progressing and we have received back‐to‐school orders from some of our large customers. In addition, we have ramped a new business line for cotton face masks as well as other personal protection garments. We believe this business has the potential to be a substantial contributor of incremental profit and cash flow over the next several years.
Our belief is driven by the anticipated change in consumer behavior (COVID‐19 pandemic driving increased usage of masks by consumers and businesses globally) as well as the sizeable interest from potential customers around the world, including governments, retailers, large corporations and individual consumers. We believe the combination of our trusted brands and large scale manufacturing could further enhance this long‐term opportunity. We are currently manufacturing cotton face masks for the U.S. government as well as launching a Hanes‐branded consumer program for several customers. Combined, we expect these programs to generate well over $300 million of sales in 2020.”
The commentary is focused on PPE production and ecommerce, what about the other $6bn (or nearly all) of HBI’s revenue?
It also makes it seem as if things are getting better in April, yet almost every other read from retail so far suggests April to be much worse. So nothing on actual April business metrics was provided, but thanks to more transparent and quality companies (like GIL and TGT) we know apparel POS is down in the area of 40% in April in the US vs the 20-30% in late March. When pressed at the end of Q/A management again gave no specifics but cited ‘ramping of POS’ and liking the trends seen there. Again this commentary seems misleading. Especially since during the call the CFO stated “Currently, stores that represent approximately half of our sales are closed”.
Even the comments on trailing results were not very helpful. The company noted through mid‐March, U.S. Innerwear revenue was down less than 1% over prior year, and U.S. Activewear revenue was up mid‐to‐high single‐digits driven by Champion and other activewear brands. Note, this commentary appears to be excluding the lost programs, which were 2% and 21% drags on Innerwear and Activewear, respectively.
And why not give precise Champion growth through Feb and for the quarter as a whole? It gave it in all the good growth quarters of the last couple years. Instead management simply states that Champion was down in US and international, and without Covid Champion would have been up 7%. Somehow management can tell what March looks like without Covid-19.
Management is highlighting the online demand across brands, yet consumer directed sales were still down 5% in the quarter. HBI’s stores were apparently closed sometime in late March, but the company announced it on April 7th.
An analyst also called out the listing of Champion product on Walmart.com, management said it was to position the brand better vs 3rd party sellers. We’ve also seen plentiful assortments of Champion inside Costco in 1Q. The brand has rapidly gone from the peak of fashion trends to commonplace in low priced retail over a few years.
Gross margins were down 257bps, for a decremental gross margin of 53% and op margin of 39%. We think something in the area of 35% is what we should expect this year, and with some incremental cost savings initiatives we probably settle around that number.
There was a lot of Q/A discussion of inventory, as it looked relatively clean down 12% YY. Working capital was a big cash help this Q. Though we should keep in mind, one of the biggest tailwinds to working capital has to be the exit of the C9/DKNY programs, collecting receivables on what was likely good payment terms for TGT. Management dismissed concerns about seasonal/fashion risk around inventory, which we don’t necessarily disagree with except perhaps for Champion product. Looking at the inventory makeup Finished goods were up $65mm vs 4Q despite exit of programs, work in process down $12mm, raw materials up $6mm. So despite the “clean” nature there is some underlying build.
The company took 29mm of non-GAAP charges above the line, mostly in supply chain investments, but also program exit charges and other restructuring.
This quarter HBI bought 14.5 million shares at a weighted average price of $13.83 using $200 million. If it could have waited to Q end the price would have been closer to $8.
Lastly the company is touting the personal protective equipment manufacturing. It expects $300mm in PPE sales this year, and when asked management said at will come at a company average margin. The margin of every business tends to be company average for this team in commentary, but not in real numbers. Maybe there is profit opportunity on this initial year's sales as governments pay above normal pricing for masks near term, but we think the opportunity is short lived.
Liquidity
The CFO outlined a stress test on HBI's liquidity stating “We have modeled several different financial scenarios driven by the timing of these doors reopening. In our base case, we assumed these doors gradually reopen beginning in late May. In our downside scenario, we assumed doors began gradually reopening in early July. We even ran a stress test scenario that assumed these doors did not reopen until early October.” The test indicated positive 2H cash flow in each scenario.
The CFO did not identify expected store traffic trends within that opening cadence, hopefully it was far from back to 100%. The test also assumed 30% decremental operating margins (despite 39% on an adjusted basis in 1Q), 14.5% tax rate, extended payment terms on half of receivables and neutral working cap.
We assume this math guided the covenant negotiations, as HBI negotiated its leverage covenant to be suspended for 5 quarters. This comes with a fee that does not appear to be disclosed but states “During the Covenant Relief Period, the applicable margin and applicable commitment fee margin will be calculated assuming the leverage ratio is greater than or equal to 4.50 to 1.00.”
For some reason the company remains focused on a dividend, so as a condition of the agreement it can pay $215mm in dividends. You’d think it you are breaching a debt covenant you’d just temporarily suspend the dividend.
Within the updated terms of the covenant agreement are some specific hurdles related to LTM EBITDA… “a minimum last twelve months EBITDA covenant of $625,000 as of June 27, 2020, $505,000 as of September 26, 2020, $445,000 as of January 2, 2021, $435,000 as of April 3, 2021 and $505,000 as of July 3, 2021”
This is perhaps a tell of where management sees profits going. It's interesting that the company’s model appears to be indicating YY decline in 1Q 2021. Let’s say that is a little conservative, which it may or may not be, we see a decline to about $450mm in EBITDA. The company finished the quarter with $4.5bn in debt, $1.1bn in cash, looking to raise another $500mm. On that ~$450mm in EBITDA and ending debt balance, it implies the stock is now around 15x EBITDA. At 7.5x that EBITDA equity value is zero. What EBITDA multiple makes you comfortable on the stock here? Sure EBITDA should bounce back, but we don’t know how fast, and we don’t know to what level. We suspect it will be much lower than prior EBITDA levels given program losses and doors of distribution losses.
Management noted it sees $200mm in spending reduction opportunity, which we assumed is baked into the EBITDA’s above.
Management
Now if we may go on a little rant...
- On April 7th, HBI announced it would Wages were cut pay for executives and salaried employees from 10% to 30%, it furloughed all store employees plus another 575 employees, cut spending in many parts of the business, and raised a lot of cash via credit facilities.
- Then the company has to pay up to suspend debt covenants.
- If taking all those precautions to preserve cash/liquidity, why not suspend the dividend?
- What gives this worse optics is that even though the CEO took a 30%? salary cut (one of the smaller one's we've seen in consumer land) it seems the more significant cash consideration is $1.25mm annualized in cash he can expect from the dividend to his shares.
- Meanwhile the company is on the call touting its cash generation this Q and cash generation in all ‘stress tested’ scenarios. If your cash is so good that you can keep the dividend, maybe you should pay your employees their fair rate.
- But the CEO is retiring at year end, so no need for him to be accountable to the employees.
This, along with lack of transparency indicated above screams of poor management to us. But wait there’s more…
In the 10-K management had the update saying “Under the direction of our Chief Executive Officer and Interim Chief Financial Officer, management conducted an evaluation of the effectiveness of our disclosure controls and procedures and internal control over financial reporting. As a result of this evaluation, management identified control deficiencies that constituted a material weakness in our internal control over financial reporting with respect to the accounting for the existence and accuracy of income taxes.”
That likely drove the update this Q on taxes of “it is reasonably possible that the amount of uncertain tax benefits may decrease by approximately $25,318 in the next twelve months based on approvals of certain filings by tax authorities with approximately $15,261 of the reduction impacting the effective tax rate”
Long Term
Listening to the call, it sounds like HBI management is ready to become a mask company. The CEO actually touted the long term multi-year opportunity. We get that Hanes makes cotton goods, but does anyone really think it is going to compete in mask manufacturing longer term? It talked about some potential retail mask programs (already in its $300mm plan), how many masks are consumers really going to need come summer 2021? Won’t the ones they are making at home or buying now tie them over for a while? We don’t think its going to become a hot new fashion accessory.
Anyway, what matters for HBI long term is the basics apparel business. We think the COVID-19 disruptions will rapidly accelerate the losses in distribution we expected to see over the next several years. That means lower run rate cash flow sooner.
Then we have to question what the state of the Champion brand will be on the other end of this. Maybe it will have some growth left, but it could also see big declines as the last resort distribution channels have pretty much been tapped and growth appears to be stagnating.
With a new CEO expected next year, perhaps the company can reinvest in its core brands, clean up dying distribution, and get revenue stable or growing again, but that would have to be at much lower margin profile than what has been seen for HBI in the past, and well below the mid-teens expectation the street has.
