Description

Overview

I’m recommending Hanesbands at $4.47. For a brief background on the business and the setup for this idea, read rhubarb’s write-up from June 2nd of last year, where he championed the stock at $11.93 before things really began to unravel. At that time the bull case was that CEO Steve Bratspies, hired in 2020 when he was the CMO of Walmart, was leading a revitalization of the business that the market didn’t appreciate. If you read transcripts from that time, Steve appeared to be making progress with share gains, SKU reductions, supply chain simplifications, the exit of unprofitable businesses, and spending in marketing, analytics and other enhancements. Those improvements were overwhelmed by both the end of pandemic fueled sales and inflationary cost pressures. 

Hanesbrands today is no jockey bet. CEO Bratspies was fooled by the pandemic boom, especially in Activewear, and he rushed headfirst into 2022 with too much inventory as the consumer slowed and as inflation in cotton, freight and labor hurt margins. His handpicked CFO left for “family reasons.” He was forced to cut the dividend early this year and renegotiate credit agreements. I believe the stock is cheap because of this 180 in sentiment. 

There are reasons to be optimistic. HBI successfully refinanced looming maturities and looks to have inventory under control. More importantly, margins for products in the supply chain today, which won’t show up on the P&L until Q4, are said to have margins comparable to those of early 2022 and 2021. A look at the components of inventory as well as consistent comments in past calls support that claim. My thesis is that between the refi, the expectation of cash generation and debt paydown this year, and the margins of product currently in the supply chain, HBI is at a trough and is cheap on its earnings power. 

Recent Developments

I think it will be instructive to look at the quarterly developments over the past year with the chart and tables below as context. The company was consistent and clear in calling out the freight, cotton, and time-out effects on margins in the past four quarters, which gives me more confidence that margins exiting 2023 will be close to margins in 2021 and early ‘22. These products are not fashionable, and so the problem here is less that they had to blow out of last season’s inventory and more that they were hurt by inflation and by fixed cost absorption when they reduced manufacturing capacity (HBI manufactures 2/rds of what they sell in-house). 

1Q22:

- Sales grew 4.5% and management guided to 4% growth for the year. Management talked about Champion growing from $2.25b in ‘21 to $3.2b in ‘24. 

- Inventory was up 22% year-over-year, but this was portrayed as a return to normal levels from levels insufficient to keep up with demand: “The increase was driven by the combination of higher in-transit levels, the impact of inflation on input and transportation costs, as well as investments, particularly in Innerwear, to rebuild safety stock as the Company takes action to continue improving service levels on its high-demand SKUs.” 

- Management touted the operational improvements made by the new CEO alongside market share gains and lofty long term goals. 

2Q22:

- "...we ended the quarter with more inventory than planned..."

- Sales declined 14% and negatively surprised by over 10%. 

- The inventory increase was said to be half caused by inflation but they also blamed the early arrival of 3Q commitments. Note the huge jump in raw materials in inventory in this quarter. 

- Margins for the second half were guided down 350-400bps from higher input costs and deleveraging. 

- Buybacks ended this quarter, but the company paid its 38th consecutive quarterly dividend. 

3Q22:

- Things really hit the skids. Mark downs weren't the issue given the inflationary environment, but HBI was caught offsides by retailers rapidly reducing inventory and orders. 

- "In just six months, we've seen the consumer and retail landscape slip from one with too much demand and not enough supply to one with too much supply and not enough demand. Inflation is hitting consumers' wallets and slowing demand. Retailers broadly are sitting on too much overall inventory, which is impacting orders in different ways across our business."

- Sales were down 7%, inventory was up 30%, and the company guided down 4Q severely. 

- The gross margin hit of 460bps was caused by 400bps of commodity and freight inflation and 100bps of time-outs in their manufacturing facilities as they strove to reduce inventory. 

- They amended their credit agreement, and the call saw questions about near term maturities. 

4Q22:

- About a month before the call, HBI put out a press release announcing the departure of the CFO (who was brought in by the CEO) for family reasons (and he didn’t leave immediately). They also announced that sales were above the top of the guide and op profits were in the middle of the guide. 

- The dividend was cut and a refi of near maturities was discussed (and executed on March 9th). 

- Margins saw impacts similar to those in 3Q.

- There were signs that things were stabilizing. Inventory dollars are "...up about 25%. When you think about that difference versus units, it's about half inflation and the other half would be roughly mix. So, when you think about unit cost, you're probably up in the low to mid-teens, when you average all that out." Inventory units ended 6% lower versus last year. The composition of inventory saw all the growth in finished goods, with raw materials flat year-over-year. 

1Q23:

- We saw positive FCF of $20mm in the quarter. Q1 is typically a cash use: 1Q22 was -$250mm. Guidance for 2023, including CFO of $500mm was reiterated. 

- "...based on the commodity and freight costs that are running through our supply chain today, we're manufacturing product at gross margin levels that are in line with 2021 and early 2022."

- Cotton costs were down 25% year-over-year, and freight was down 40%. Raw materials and WIP inventory fell in the mid-teens even as inventories grew 8%. 

- Management said that while they had continued challenges in Activewear inventory, Innerwear saw balanced inventory and POS and the destocking appeared to be finished. 

- Leverage was 5.4x (vs. a covenant of 6.75x). 

Conclusion and Valuation

I find retail to be tough, but Hanesbrands produces products that are less susceptible to the whims of fashion. They manufacture the majority of their products in house which gives them a cost advantage over (and has led to share gains from) competitors. The private label threat is low, and Hanesbrands is trusted by consumers. 

HBI is a levered equity, but I’m betting that we’re through the worst of it. On flat sales from 2022, I see TTM EPS above $1.00, gross margins ~ 37.7%, and EBITDA above $800mm by ~2Q24. That would put leverage around 3.5x assuming some paydown. I get there by assuming that we move past the 500bps of cost inflation and time-outs in the past few quarters and that we hold the cost savings implemented. I’m also assuming that the underlying sales stabilize. HBI appears to have gained share, but in a bad recession things would get ugly. What is $1.00 worth in a levered equity? If we have a 2/3rds chance this is worth $10 and a third chance it’s worth zero, the equity is worth 50% more than the price today.

Catalyst

Survival.