Description
(Please note that this write up was originally posted as part of the Hanesbrands message thread on Sunday. With the approval of the VIC administrator, I am posting it as a separate idea.)
“The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.
For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old ones."
And Warren said, "Gee, I hope this doesn't work because if it does, I'm going to close the mill." And he meant it.
What was he thinking? He was thinking, "It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business."
And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.”
Looking for a third rate, levered business trading at a premium multiple to short? Look no further.
Blinded by the concept that it is a “spinoff turnaround story,” by headline EPS numbers, and by rising analyst estimates, investors have bid Hanesbrands to a price that simply makes no sense.
I believe that in the short term, Hanes is going to have difficulty making its numbers unless it simply chooses to stuff its working capital and in the long term, the business faces a substantial risk of bankruptcy as its competitors continue to nip away at its market share, leaving it with too large a debt burden to service. In this fashion, I expect Hanes to follow the path of other notable recent highly levered spinoffs such as Avis Budget, Idearc and Sally Beauty.
A long write up by Kalman in December describes pretty accurately the bull case with the business. I would refer reader’s there for the bull side of the story. It is well written and thus far, it has been a money making view of the Hanes story. If nothing else, it highlights that reasonable people can have very different perspectives.
I will grant that Hanes has done a great PR job of getting investors to focus on its positives while ignoring the obvious problem that Hanes is not in a capital position to compete with the companies building new mills, particularly Gildan and that if it attempted to get into that capital position, it would simply ruin returns industry wide rather than increase its own.
The dilemma that Hanes is in is best illustrated by its historic revenue numbers. The older numbers are available in the Form 10 that it filed prior to spinning off from Sara Lee.
|
FY2002 |
4,920 |
|
FY2003 |
4,669 |
|
FY2004 |
4,632 |
|
FY2005 |
4,683 |
|
FY2006 |
4,472 |
|
stub perid |
2,250 |
|
FY2007 |
4,474 |
(company changed from June year end to December year end when it spun)
Across this period of time sales decreased approximately 10 percent, despite such marvelous innovations as the “tagless tee” and the spokesmanship of Michael Jordan.
Management will say that the fall is revenue was simply the discontinuation of unprofitable product lines. I expect more profit lines to become unprofitable in years ahead.
It is also worth noting that Hanes’s diminished sales happened during a period when overall sales were growing. This slide was missing from the 117 page pack that was published at Hanes investor day in February of 2008 and the spinoff slides are no longer available on their website, but from the Form 10 document, we know that while Hanes’s revenue was shrinking from 2003 to 2005 that most industry areas Hanes participates in were growing rapidly, including 8.4% compound annual growth in T-shirts.
So where did all of this growth go?
As was mentioned in Kalman’s original write up, Fruit of the Loom, which is a very well funded Berkshire company is a fierce competitor, but its financials are not broken out in an analyzable way.
What we do know is that a Canadian competitor called Gildan during the years that Hanes’s revenue was declining posted the following revenue numbers:
|
FY2002 |
383 |
|
FY2003 |
432 |
|
FY2004 |
533 |
|
FY2005 |
654 |
|
FY2006 |
773 |
|
FY2007 |
964 |
During this period Gildan was able to steal share from Hanes by building low cost capacity and underpricing Hanes. Gildan is continuing along this strategy and currently has both a contract for boy’s underwear and for hosiery at Walmart, which as a customer is about 30 percent of Hanes’s sales. As I understand it, the only reason Gildan does not yet have a greater share at Walmart is that they are capacity constrained and there are more profitable opportunities elsewhere in the market place. As they invest and grow, I would expect Hanes’s share at Walmart to gradually erode.
As a spinoff, people have expected that Hanes should be able to get its costs down and consequently stem or reverse the hemorrhaging of its market share. It is true that Hanes when it was spun was a bloated enterprise and the current management is consolidating distribution centers, factories and so on.
The idea, however, that they will be able to become profitability comparable with Gildan is a pipe dream for two reasons:
- In order to get its cost advantage, Gildan needed to spend massively on capex. To get an idea for the magnitude of this spend, for the last 5 years Gildan has been spending 9 to 14 percent of its sales on capex. For Hanes that would be roughly 400 to 600 million dollars per year, or virtually all of Hanes’s ebitda. In the past 3 years, Hanes has averaged less than 100 million dollars a year in capital expenditures. While management pays significant lip service to offshoring and new plants, Hanes simply is not spending the money to walk the talk.
- If Hanes did spend the money to get to a competitive cost structure, it would likely result in a significant reduction in Gildan’s margins rather than a rise in Hanes’s. It is important to remember in an industrial relationship, who holds the power and selling to Walmart is a difficult business.
After a honeymoon year out of the box, where Hanes’s revenues actually went up for the first time in years, Hanes held a very bullish analyst day in February, where they claimed they would “sell more, spend less and generate dollars.” (They also had slides of a book about Hanes’s strategies that does not appear to be available on the web and which I suspect does not exist, see slides 37 and 52) By the time the company reported its earnings in April, the tone had changed markedly.
As CEO Rich Noll said in his prepared script:
“The one set of strategies not working in this quarter is sell more. Sales declined $52 million , or 5%. The sales decline was broad based across most categories and customers. The pervasiveness of the sales decline is one indication that the decline was more the result of macro trends and not specific tactics on our part. This belief was further supported by recent retailer’s same store sales results.”
What is interesting about this comment is that as of February, Hanes was guiding for a significant increase in the number of units they could produce (see Slide 86 of the investor day presentation). In addition, part of the bull story, is that Hanes’s revenue should not be impacted particularly by a recession.
In the words of Omar Saad, a CSFB analyst, who is the stock’s chief bull:
“Because basic intimate apparel is such a stable category, we think HBI could also prove to be a defensive stock in a difficult consumer environment.” (Saad, initiaition note, September 2006, price target $25)
Following Hanes’s most recent results, Saad published a note with the title “Sales not recession proof but earnings are.” (Making Hanes the only company I know of to fall into this category) Saad’s target is now $40. Saad gives three reasons to hold out hope:
- retail trends have picked up in April. (On the call Rich Noll described sales trends as “a little less worse”)
- Q1 has historically been a difficult quarter (It is unclear why that should matter in a year over year comparison)
- “pent-up demand …could eventually result in an accelerated underwear replacement cycle” (I am not making the third one up. Perhaps it is legitimate but it strikes me like something out of Woody Allen’s Bananas. I also don’t see why if T-shirts and underwear have grown at a rate much faster than population growth, that they can’t shrink.)
Saad then raised his EPS numbers for 2008 and 2009 based on the company’s expanding gross margin.
There were several things missing from Saad’s analysis that I think are important.
- Inventories in the quarter swelled. Inventories in the quarter increased to 1.224 billion from 1.117 billion or $107 million dollars from the prior quarter. Lee Wyatt, the company’s CFO described the situation as follows: “Inventories were $30 million below the first quarter of 2007 and below expectations.” No analyst called him on this statement, but it obscured an important fact. Last year, the company trumpeted the fact that it was wringing out excess inventories. On a days inventory basis, inventory actually wound up higher than in was last year at this time. Perhaps more importantly, the quarter to quarter increase last year was $37 million dollars.
In other words inventories grew by $70 million dollars more than they did last year. The effect that swelling inventory can have on EPS should not be disregarded. For instance, supposing that 20 percent of cost of goods sold is effectively fixed (i.e. factories that can’t be shut down, workers that must be paid, cargoes that must be transported whether or not they are full.), then a 70 million dollar increase in inventory has the effect of suppressing cost of goods sold by about 14 million dollars. (According to the company operating profit excluding actions rose 4 million dollars and my 14 million dollar guesstimate comes very close to the company’s number for “operational improvements.)
Last year between December and June inventories were up only $20 million, which means to accomplish the same feat this year, inventories in the second quarter would need to fall 87 million.
- The company had inventory profits from its cotton hedge, which the company broke out as being $2 million dollars. Cost per pound was 54 cents in the first quarter but will rise to 76 cents by the fourth quarter.
- The vast majority of the year on year improvement in earnings came from debt reduction and lower interest rates. Six of the 12 cents of improvement came from cost of debt falling because libor was lower. Hanesbrands debt currently trades at 94.75, despite the fact that it is further from its caps, which suggests that when it needs to refund its debt, its rates may be higher. Libor is also abnormally low. Also, to continue the debt reduction that Hanes began last year, it will need to have operating cash flow. Despite the fall in debt and interest rates, HBI’s operating cash flow in the quarter fell to -19 million from flat the year before. If Hanes is going to start making real investments in Capex, debt is unlikely to fall precipitously (especially if sales are falling).
The question then is, what is the appropriate multiple for a company whose ebitda stream is likely to hold stable at best unless it chooses to spend aggressively in capex and marketing. Consensus ebitda estimates for this year are 576 million (which would be the best year Hanes had since 2004) and 2009 has average analyst estimates of 619 (which I think is very aggressive for the dynamics of the industry). Roughly averaging these at 600 and adding 2.2 billion of net debt (and ignoring its negative accounts payable vs. recievables), suggests an EV to EBITDA multiple of a little above 9 times.
In case that number doesn’t give you sticker shock, it is probably worth mentioning, that blue chip companies retail companies like Walmart and Walgreens trade at those sorts of levels while Carter’s (ticker CRI) which sells baby clothes (which really is arguably less cyclical and which just blew away its analyst estimates) trades at a little over 6 times trailing ebitda. At 6 times ebitda of 600 million, HBI would trade at $15 a share. Since the story is essentially a cost reduction one, it is unclear what provides any ebitda growth beyond 2009.
What is worse, if it turns out we are in a down cycle for retail, Gildan continues to expand, cotton prices continue to go up and other input costs such as shipping and energy continue to go up then HBI’s 600 million EBITDA may prove way too optimistic. The fed appears to be just about done cutting rates, so further help from libor declines seems unlikely. The extent to which Hanes’s earnings could be affected is downright scary. Every 1% of margin contraction is about 44 million dollars in operating income and every dollar in income has gross profit of about 33 percent so a 5 percent margin drop combine with a $300 million sales drop, would cut ebitda in half, leaving virtually no free cash flow except for debt service.
Hanesbrands is a stock whose valuation is full on the bull case and is poised to fall precipitously if the company is unable to strike an unbelievable and unlikely combination of execution and luck.
Catalyst
Overstatement of income because of overabsorption of overhead costs in inventory, rising input prices (including transport and cotton), increased competition, and financial leverage.