Description

Hanesbrands (HBI) - Short

Stock Price: $21.50

Price Target $15

Market Cap: $8.0 b

ADV: $115 mm

Short interest: 10%

Thesis

Hanesbrands (HBI) is a bad business that is shrinking organically and is at the end of its levered roll up strategy. The CEO left last year and sold most of his stock, and last month the CFO also announced he was leaving/retiring at the end of the year. The current management team has low credibility with question marks on recent top line execution and significant quality of earnings issues. While the stock screens cheap on adjusted numbers, it is a value trap as GAAP earnings and free cash flow are 10-20% lower which means HBI trades at a low-teens levered earnings multiple for a business that is secularly challenged.

Business Description

HBI sells innerwear and activewear under the brands Hanes, Champion, Maidenform, Playtex and others. US is ~75% of sales, OUS is 25% (mostly Europe and Australia). 90%+ of sales are to large brick and mortar retailers with WMT and TGT accounting for 35% of total company sales (20% and 15% respectively) and 45% of US sales. Apparel is primarily manufactured at company-owned plants in Central America.

HBI is a no-growth but stable FCF generator given that innerwear demand is more replacement rather than fashion led. HBI’s strategy since 2013 has been to leverage this base business and roll up other innerwear apparel companies, in-sourcing inventory manufacturing and increasing margins. HBI has consolidated the US market and has begun acquiring companies internationally such that OUS has grown from 10% of sales in 2013 to 25% today.

What has the Short Thesis been and why has it worked

HBI went up from $5 to $33 from 2012 to 2015 as the company embarked on their levered roll-up strategy and Adj EPS ~tripled while the Adj EPS multiple ~doubled. From mid-2015 short interest increased from 3% to 10% as skeptics pointed out that:

·         Organic growth – negative due to pressure in the bricks and mortar channel from online.

·         Accounting shenanigans - significant use of 1-time items created a wide spread between adjusted and GAAP financials coupled with a deterioration in cash flow.

·         The CEO architect of the roll-up strategy announced his retirement and has sold the majority of his stock.

The short was a winner in 2016 as HBI grinded lower throughout the year from $29 to $22 as organic growth and GAAP EPS disappointed (although adjusted EPS held in as the magnitude of add-backs increased through the year).

The Q4 16 earnings release last month (2/3/17) was an important event for the debate in the stock as Q4 was supposed to be a big quarter for free cash flow as they unwound a bloated inventory situation. Instead the company missed wildly and guided 2017 lower on free cash flow and printed a negative 4% organic growth rate for the quarter, including a negative 8% for their core innerwear business in the US. Then two months later the CFO announced his retirement. Yet the stock is only down marginally from the February blow up, having bounced nicely from the lows of $19 in February to the current ~$21.50.  

What is the Short Thesis Today?

·         The biggest pushback to the short thesis is what’s the downside from here and isn’t everything in the stock at ~11x 2017 Adj EPS guidance. I believe that the weak Q4 cash flow results confirm that the management adjusted figures overstate the true FCF of the business and it is appropriate to use GAAP earnings or FCF to value the stock. On those metrics, HBI trades at ~13x true earnings/FCF based on management 2017 guidance. Also note that the company is levered 3x with a low tax rate so low tax shields from interest expense thus a 13x EPS multiple is a more expensive 16x unlevered earnings multiple. Given the thesis below, I believe the the stock can de-rate to 10x a real EPS that is less than 2017 management guidance, creating material downside to the stock.

·         What was once thought of as a stable no-growth business appears to be turning into an unpredictable declining business due to the pain we are seeing in the bricks and mortar channels. Online distribution (primarily AMZN) is now 20% of the US innerwear market making it the 4^th largest seller of innerwear in the US (behind WMT, TGT, and KSS) and continues to grow quickly. The mix shift from bricks and mortar to online is terrible for HBI because:

o   HBI’s moat was the real estate they controlled in the retail stores shelf space. The internet erodes that moat.

o   HBI has 40% market share in physical distribution, but much less than that in online, which means they are losing market share over time.

o   Innerwear is not a destination shop, so declining traffic in physical stores is a headwind.

o   Inventory turns are lower for online retailers than bricks and mortar due to centralized DC’s vs. hub and spoke models for retail stores. There is an effective “de-stock” headwind as retail loses share to online.

·         HBI is over-earning both on an adjusted and GAAP basis. Before the roll-up started in 2013 HBI consistently earned 8-10% GAAP EBIT margins. Fast forward 4 years and $2 b spent on acquisitions and today margins are 15%. When the stock was working the market believed management’s explanation that their vertically integrated manufacturing allowed them to acquire other apparel companies and realize significant cost synergies. The reality is that adjustments pulling out 1-time expenses is worth 200-250 bps and cutting advertising spend accounts for another 150 bps, and given that excluding the acquired revenue the top line has been actually declining there are significant questions about whether the company needs to reinvest through the cost line to stabilize organic sales. A margin re-set to stabilize the business could occur; every 100 bps of margin is 16 cents of EPS, such that a reset back to 11% GAAP EBIT margins would result in $1.37 of EPS.

·         Weak accounting – see summary section below, with the takeaway being that there is a chance of a blow up as management cannot keep the accounting balls in the air as the actual business continues to be under pressure and they have maxed their ability to do further acquisitions to keep the games going due to their weak balance sheet.

·         Risk to 2017 guidance – after printing a negative 1.7% organic growth number last year  management is guiding to 0-2% organic growth in 2017. We know based on the Q4 debacle that management does not have the visibility into their business that they used to, and Q1 was guided to then pre-announced for a negative organic growth quarter, creating a back-end loaded FY guide. We also know that management’s forecasts did not assume the accelerated pace of store closures announced from their distribution partners nor any potential bankruptcies that could happen in 2017. Finally, after the FY guidance Target (14% customer) blew up and channel checks confirm they are pulling back significantly on apparel purchases.

Management

Rich Noll was the long-time CEO of HBI since it was spun from Sara Lee in 2006. While he was well-regarded by HBI investors given the stock went up 6x as he executed his roll up strategy, he is known for having a big ego and being promotional in his communication with the market. Noll announced his retirement from the CEO seat in June 2016 although he remains non-Executive Chairman. Importantly, Noll has sold $100 mm of stock in the last 3 years, leaving him with ~$30 mm of remaining stock. The CEO-architect of a levered roll-up returning and selling his stock right at the end of the roll-up as organic trends are negative was a big red flag.

Gerald Evans was COO and Rich Noll’s right-hand man since the spin and was promoted into the CEO role on Noll’s retirement. Rich Moss has been CFO since 2011 and recently announced his retirement at year end 2017. Evans and Moss are unimpressive in meetings and currently have little credibility with the market given the bad 2016 results.  

Summary of Accounting Issues

·         Excessive use of acquisition and other charges has distorted the adjusted financials vs. GAAP and cash flow.

·         Weak cash flow as working capital and other continue to be a significant use of cash.

·         Elevated inventory levels (steadily increasing inventory days). Management explanations about backing out acquired inventory are not rational (apples/oranges comparison).

·         Declining allowance for doubtful accounts boosted margins by ~50 bps but retail BK’s are becoming more frequent..

·         Increased selling of accounts receivable which makes it hard to calculate a clean days sales but implication is that they may have had to jam Target with inventory in Q4.

·         Changed pension assumptions in 2016 that helped earnings.

Valuation

On 2017 consensus estimates, HBI currently trades at 11x EBITDA, 11x Adj EPS, 12.5x GAAP EPS, and 14x FCF.

Downside price target is $14 which is 10x 2017 real FCF of $1.38 that assumes a modest miss vs. management guidance (assumes negative 1% organic growth vs. 0-2% and 14.0% Adj EBIT margins vs. 14.8%). I am using 10x as the target although you could argue if the business is declining given the leverage it could trade through 10x.

Upside price target is $26 which is 12x consensus 2018 adj EPS of $2.15. This is a re-rate from the current 10x NTM EPS which assumes that the company doesn’t shrink and current negative sentiment around missing numbers is alleviated over the next few quarters.

Risks To The Short

·         The stock is already down a lot, sentiment is bad, and there is 10% short interest. If HBI just hits their guidance through the year the stock should be higher as it re-rates. We need the company to miss numbers for the r/r to be attractive here.

·         A Gildan/Hanesbrands merger would solve HBI’s current problems as it would have strategic logic (best in class manufacturing with best in class brand names) and have a lot of cost synergies, and if it was done with stock would de-leverage the company. The risk to a merger for GIL/HBI are revenue dis-synergies as WMT is unlikely to have one company supply ~80% of their innerwear business and will give some of HBI’s current sales to Fruit of the Loom. Culturally a deal may be difficult as well as the two companies have competed aggressively against each other for years, with GIL having taken the Printwear market away from HBI and refers to themselves as the “Hanes-Killer”.

Catalyst

Reduction in FY17 guidance