Description

I am recommending a long investment in Unifi ("UFI" or the "Company") with the potential to generate a return of 50% or more in two years or less.  For those who are interested, I suggest you review my first UFI posting to VIC on August 26, 2020 for some historical context and relevant details about the Company.  I will not repeat most of those details but aim to reinforce the core tenets of the long thesis in this VIC submission.  UFI appreciated by more than 140%, at its peak, during the past two years from my first VIC posting but the stock is now below the price from the first UFI posting. 

Since I anticipate ongoing weakness to the Company’s results during the first half of UFI’s fiscal year (“FY”), I do not expect that my thesis will be so evident in the short-term.  However, I believe that results should begin to improve during the second half of this fiscal year and during FY24 that will reinforce that the Company’s prospects for longer-term growth are intact.  In the near-term, there are significant headwinds for Unifi to overcome—specifically the lockdowns in China and ongoing inflationary pressures as well as the inventory glut across retail--and although these are well-documented and management has sought to manage near-term expectations prudently, one should size their exposure accordingly for potential volatility that could materialize around this relatively illiquid stock.  My recommendation is based on a two-year perspective that I find compelling given the stock is currently trading at ~40% discount to its tangible book value and ~3.5x my EBITDA estimate for FY25.  In two years, when the market will look towards FY25, at 5x my EBITDA estimate and implying 9.5x EBIT and ~7% FCF yield, UFI would be trading at more than 50% from today. 

For those having interest, I also suggest you review the comprehensive investor day presentation that management made during February when management communicated its FY25 EBITDA goal of more than $110M.  Although I do not expect such will be achieved as quickly as management communicated, I do believe the potential for such, at a later date, is very probable based on the Company’s competitive positioning and the secular growth trends ascribed to textile sustainability.  Based on management’s FY25 EBITDA goal, UFI is currently trading at ~2.5x FY25 EBITDA.  To achieve its FY25 goal, management estimates a gross margin of 14-15% and growing share from 29% to 40% in the Americas, from 3% to 8% in Asia, and from 12% to 18% in Brazil.

During the past two years, Unifi's stock price exceeded my expectations as to the pace of its appreciation from the time of my first UFI posting to VIC.  The stock closed up 47% in less than four months on December 15, 2020, by more than 54% in less than five months on January 6, 2021, and by more than 140% within seven months on March 12, 2021 when the stock closed at $30.44.  That price was the peak during the past two years.  The market was valuing UFI at 7.7x that year's (FY21 ending June 2021) EBITDA at that peak price.  At the current price, UFI is trading at ~5.5x FY23 EBITDA as recently forecasted by management at the low-end of their expectation.  At 6x my FY25 EBITDA estimate, absent any FCF generated, UFI would almost double in two years to trade at $22.50, a price that is less than 10% above the average price paid by insiders during the past four years. 

Management’s FY23 outlook anticipates numerous near-term challenges as evidenced by ~5% decline in EBITDA from FY22 at the mid-point of their forecast.  I believe FY23 will be a trough level of EBITDA for UFI. 

In my original posting, my target was based on 6x EBITDA that I was forecasting in FY23.  For Unifi, FY23 has begun and although the longer-term prospects continue to be very strong, my forecast for FY23 (at $65M during August 2020) will prove to be too high since management recently provided $48-57M as its FY23 outlook. That said, the $65M I was forecasting for FY23 was already achieved in FY21 which was well-ahead of when I anticipated the Company posting results of that magnitude.  The ~$65M generated in FY21 was almost 300% of growth from the ~$17M of EBITDA generated during FY20 which suffered from the onset of COVID.  At the beginning of this past fiscal year ended June, during the Q1 earnings call in October 2021, management provided an FY22 outlook of $65-67M.  This was a higher outlook from what management forecasted for FY22 during the Q4 FY21 call when management noted an expectation for EBITDA that would be “broadly consistent” with FY21.  However, pursuant to the Q1 results when management raised its FY22 outlook, the Company reduced its FY22 outlook during the following two quarters primarily because of the lockdowns in China and inflationary-driven pressures.  The Company recently reported $55M of EBITDA for the fiscal year ended June.     

In regards to the $55M of EBITDA generated during FY22 by Unifi, it’s interesting to note that UFI generated a similar amount of EBITDA, ~$52M in FY18, and the stock traded (on a closing basis) above $30 for that entire fiscal year with the exception of nine days without closing below $29.59.  UFI’s FY22 EBITDA declined by almost 15% from FY21.  The Company’s FY18 EBITDA was 20% below FY17 but the market back then was not overly concerned.  On the day UFI reported its FY18 EBITDA of ~$52M, the Company was being valued at 11.7x LTM EBITDA and 20.3x LTM EBIT.  Today UFI is trading at over a 50% discount to those valuation multiples despite an attractive longer-term outlook, albeit FY23 is expected to be weak.    

We navigate markets that are frequently overly focused on the short-term.  If you are not willing to look beyond a year of performance, then an investment in UFI is not likely worthy of your deeper consideration.  The pace of the equity appreciation at UFI from my original posting exceeded my expectations but I would be more surprised if UFI worked as quickly again pursuant to this VIC posting.  However, I would be even more surprised in two years if UFI has not appreciated by 50% or more from today.  The market is being overly punitive to UFI as it was a couple of years ago pursuant to FY20 results.  The vaccine had yet to materialize that would lead to the “re-opening trade” so there was admittedly risk of the pandemic lasting longer but the market is now looking at the impacts from China lockdowns, inflationary pressures, and an inventory glut across the apparel industry as if those won’t abate anytime in the future. 

With the well-documented inventory glut now overwhelming so many retailers, management’s FY23 outlook reflects the anticipated near-term weakness across the Company’s largest mix of business as apparel/footwear and retail customers reconcile their inventory challenges.  Investors might be reluctant to get long some apparel and footwear-related companies given the inventory overhang that numerous retailers have highlighted but the order book will eventually resume and more importantly towards achieving sustainability-driven mandates which will drive UFI’s longer-term growth. 

The degradation to EBITDA in FY22 is largely related to the COVID-driven lockdowns in China and the adverse impacts from inflationary pressures.  The impact from lockdowns in China is most apparent from the 17% decline in Q4 sales in Asia from the previous FY.  The Asia segment would typically grow sequentially by 10-15% but because of the lockdowns in China, the segment suffered ~13% sequential decline.

The Company incurred inflationary pressures to virgin polyester raw materials during June that were ~20% above March levels which were already elevated from petroleum-related inputs.  There is a typical lag until Unifi recaptures higher inputs through customer pricing and therefore both working capital and profits suffer accordingly in the shorter-term from inflationary pressures.  Management was able to reset pricing for higher costs from March and April but not enough for the pressures that escalated into June.  Management recently noted that its pricing has increased almost every month during the past sixteen months.  The impact from inflationary pressures is most apparent from the gross margin compression in the Americas, Unifi’s largest geographic segment, which suffered 470bps of compression during Q4 and 430bps during all of FY22.  The gross margin for the Americas was worse than any FY during the past eight years other than the pandemic-driven FY20.  Overall gross margin was only 6.8% during FY22 despite the 10.8% delivered by the Company during the first half and management’s 11% estimate as of the February investor day.

The inventory glut is an additional headwind that will adversely impact FY23 results.  The volatility of raw material prices compounded by the inventory glut has created a difficult situation for Unifi which will be evidenced by a low gross margin during FY23 and especially the first half.  The CFO communicated the potential for an inventory write-down during the most recent earnings call.  Nevertheless, in spite of my expectation for near-term challenges, there is no fundamental deterioration to the core investment thesis that Unifi’s sustainability-driven textile material REPREVE will continue to grow significantly and eventually comprise more than 50% of the Company’s business mix.  

REPREVE comprised 36% of business mix in FY22 which was down from 37% in FY21 because of the lockdowns in China as evidenced by the decline in Q4 REPREVE mix from 38% in FY21 to 31% in FY22.  Over 80% of business mix in Asia is from REPREVE so the growth of REPREVE was marginalized by the lockdowns in China.  Nevertheless, the growth of REPREVE has been robust.  During the past three years, REPREVE has grown at a CAGR of ~18.5%.  Absent the lockdowns in China, thereby assuming that sales in Asia would have grown by at least 10% sequentially, REPREVE’s three-year CAGR would have calculated to over 19.5%.    

During its investor day, management forecasted its goal that REPREVE would grow to 50% of total business mix in FY25.  During Q2 of FY22, REPREVE was 40% of total business mix.  Although I am not certain that UFI will grow REPREVE to more than 50% of mix in FY25, I am confident that more than 50% will be achieved soon thereafter if not by then.  My confidence regarding REPREVE growth is validated by the sustainability objectives of most major apparel/footwear brands and retailers.  Furthermore, this has been reinforced by much primary research with both apparel manufacturers and retailers. 

The demand for sustainable products is accelerating.  Management’s FY25 outlook from February imputes to over 22% CAGR for REPREVE from FY21.  REPREVE is well-positioned to benefit from the ongoing secular growth trend across apparel and other market segments as brands and retailers seek to address their own sustainability mandates that are increasingly sought after by consumers.   The importance and demand for sustainability is growing and consumer demand attests to that.  Approximately 75% of Gen Z and ~70% of millennials are willing to pay more for sustainable products.  This provides Unifi with more pricing power for REPREVE which generates a gross margin that is approximately 200-300bps higher than from virgin polyester.  This is the key factor influencing management’s 14-15% gross margin forecast in FY25.   

The Company reached a key milestone ahead of their expectation last November when management announced that more than 30B post-consumer plastic bottles had been transformed into REPREVE-branded recycled performance fibers.  The 30B milestone was 3x the 10B milestone that was achieved in 2017.  As evidenced by twice as many REPREVE hangtags from two years ago, REPREVE is growing its brand awareness and momentum with its customers.  More than 1,000 global brands use Unifi’s recycled performance fibers.  During May, Unifi recognized 90 global partners for their sustainability achievements with REPREVE.  Over 20% of the bottles recycled for REPREVE have been done so for Nike, Target, Polartec, Wal-Mart, and Texhong Textile Group. 

Since Unifi’s recycled brand received its Higg Materials Sustainability Index scores during July 2021, REPREVE is increasingly being sought after by more brands.  The Higg MSI study confirmed that U.S.-manufactured REPREVE reduces global warming potential by over 40% compared to virgin polyester and by over 20% compared to generic, mechanically-recycled polyester.  As described by the Company’s Sustainability Manager, “REPREVE manufactured in the U.S. has a lower global warming potential than standard rPET, providing our customers with a verified pathway to lower their environmental impact and meet their sustainability goals.”  REPREVE remains well-positioned to be the partner of choice for global brands seeking to meet their sustainability targets in a transparent, trusted and traceable fashion.

The growth of REPREVE is the key ingredient that should drive Unifi’s performance to be stronger pursuant to a challenging FY23.  The demand for REPREVE remains robust but FY23 will be a challenge as customers work down their excess inventories.  In addition to the benefits from REPREVE, the Company’s growth profile will benefit from its $100M capital investment in eAFK EvoCooler (“EVO”) texturing technology that is exclusive to Unifi in the Americas.  Unifi has already spent ~$40M and will invest another $25M during FY23.  The Company is expecting numerous benefits from EVO that include ~30% increase to productivity, ~25% reduction to direct labor, ~20% reduction to energy usage, and ~35% reduction to maintenance.  Like most companies, Unifi has confronted labor challenges this past fiscal year and management highlighted that sales would have been higher in the absence of such labor pressures.  It will take time for the full benefits of EVO to materialize but is worth noting that Unifi would have delivered higher sales during FY22 with EVO being fully-implemented since the new technology delivers higher output per person per hour.  The new equipment also enhances the Company’s manufacturing flexibility with product innovation capabilities.  The EVO is the first new yarn texturing innovation since the mid-1990s.  Unifi’s margin will expand over time with EVO replacing equipment that was more than twenty-five years old but realization of the full benefits is not expected until FY25 based on the phasing of the investment. 

In addition to the fundamental challenges that Unifi confronted during FY22 that caused some of the decline in UFI’s stock, one should also recognize that part of the decline is related to the substantial volume that was sold by a smart insider that was the second largest shareholder a year ago.  The substantial volume was sold by Impala which is led by Robert Bishop who served as a Director at Unifi since 2016 until his resignation this past March.  The reduction of Impala’s position by over 80% since the beginning of 2022 is notably interesting since Impala had purchased a substantial amount of stock above $30 (as high at $36.50) in the past five years.  In fact, from early-2017 through mid-2020, Bishop’s insider filings showed ~$12M purchased by Impala at $28.  A year ago, Impala was the Company’s second largest shareholder (after passive-driven Blackrock) and given aforementioned purchases by a smart insider, it’s not surprising that the selling by Impala’s Bishop would qualify as a “red flag.”  However, if one reviews Impala’s recent 13F filing, it’s quite obvious that Bishop had decided to move on from managing institutional capital (during June, he announced his intent to focus on his family office) and therefore one should not interpret the near liquidation of UFI by Bishop as being indicative of a loss of fundamental confidence in Unifi.  Nevertheless, the fact that over 110 days of volume (assuming Impala represented 15% of average daily) loomed as an overhang this year did not help the stock’s performance.  The negative signaling first appeared during November 2020 and then followed during June 2021 but intensified during 2022 as witnessed by a filing in February. 

In regards to the near-liquidation by Impala, I think what is more relevant is that the Company and insider Inclusive Capital (founded by well-regarded value investor Jeff Ubben of ValueAct) each purchased 500,000 shares from Impala for ~$13.60.  Unifi’s CEO noted, “This repurchase demonstrates the strong conviction we have in the future of Unifi and our commitment to driving long-term shareholder value.  We will remain opportunistic in our repurchasing efforts going forward.”  The CEO’s confidence was further demonstrated in May as he purchased stock above the current price and added to his Q3 2020 purchase; in total, the CEO has invested ~$375K.  The CFO also demonstrated his confidence in May by investing at ~$14 which was his second purchase since Q1 2020 when he invested at ~$20; in total, the CFO has invested almost $300K.  Unifi’s buyback authorization is ~$39M (almost 25% of the float which excludes the 3.6M shares held by Inclusive Capital and Ken Langone from outstanding shares).  During the past three years, including the 50,000 shares that he bought directly from Impala at ~$13.60, Ken Langone has purchased ~$6M of UFI stock at ~$18.

Despite the Company's prospects for profitable growth having been proven from a pre-COVID period, the stock has been decimated this year, down by over 50%.  At UFI’s current valuation, I believe the market is being overly short-sighted in regards to the adverse impact of the lockdowns in China coupled with the ongoing headwinds attributed to higher raw material costs and the expected near-term pressure ascribed to weakness in the apparel industry.  Those issues are all well-documented and more than discounted by the current price which is trading at more than a 40% discount to the Company's tangible book value.  The Company's profitability has and will likely continue to suffer from some well-documented challenges but the trajectory of the mix shift to higher-margin REPREVE is not likely to abate.  

Selected Risk Considerations

·         Inflationary pressures from raw materials and labor continue to be a headwind

·         Asia segment continues to grapple with the effects of the headwind of the lockdowns in China

·         Americas segment will struggle during the first half of FY23 as the customer inventory glut challenges volumes and this will be compounded by inflationary pressures that has driven higher unit costs that will compress gross margin; management noted the potential for an inventory write-down

·         Fundamentally expect the first half of FY23 to be weak (not clear if this is already discounted despite management trying to clearly communicate near-term challenges).  With near-term results not likely to be strong coupled with tax-loss selling pressure for a stock that doesn’t look attractive on a technical basis (for the passive-driven algos and chart-followers) in a market that might be primarily focused on shorter-term catalysts to drive near-term momentum, UFI could underperform through year-end.  

Catalyst

·         Second half results demonstrate notable improvements from what is expected to be a challenging first half of FY23

·         Profitability profile improves as higher-margin REPREVE business grows to exceed 50% of total mix

·         Inflationary conditions ease

·         End of lockdowns in China

·         Inventory glut across retail, specifically with apparel, gets worked off

·         Unifi works through its higher-priced inventory such that gross margin expands

·         Buyback authorization (~$40M) is prudently executed near current levels

·         Productivity improvements from EvoCooler capital equipment as implementation scales against improving volume

·         Non-apparel mix grows as source of diversification and towards higher margin

·         Benefits from on-shoring and near-shoring enhances utilization for the Americas

·         Industry-related challenges in the shorter-term could enhance UFI’s longer-term share potential as smaller competitors become attractive tuck-ins or are cannibalized