Why Hanesbrands Is Falling

Summary

• Hanesbrands has borrowed heavily to finance acquisitions, due to the company’s inability to grow organically and/or on a sustainable basis.
• The company has leveraged its balance sheet significantly; the current debt-to-equity ratio is 938%. Hanesbrands is effectively paying $180 million per year on interest expense.
• The company operates in a competitive industry with a below-median gross margin; Hanesbrands lacks differentiation or any real competitive advantage.
• Insiders (executives) are basically selling their shares. HBI stock will probably fall at least to $15, and possibly further.

On February 14, I briefly outlined some risks associated with investing in Hanesbrands. I was short. The stock ran up that day – alongside other retail stocks. However, since then, HBI has fallen over 15% (and by about the same amount from the start of 2018). The S&P 500 has fallen about a percentage point, for reference, hence HBI is clearly under-performing, even in spite of increased volatility in markets in 2018.

It is risky to take long positions on “cheap”, low quality stocks, but it is arguably even riskier to go short on companies that are “expensive but otherwise sound”. Further, shorting is difficult, and in my opinion should only be done to hedge against long positions (unless you buy puts to limit downside risk).

In any case, HBI isn’t even cheap on a valuation basis, and in my critical opinion it is a low-quality stock. Note that while I am no longer short HBI, I do foresee further downside, although I am now less confident about the extent of the downside. Therefore, I am no longer short. (If you went short in early 2018, you should be pretty happy.) Nevertheless, my reasons for believing there is future downside are as follows.

Firstly, nothing has changed since my last brief piece. Most of Hanesbrands’s assets are what I would call “high risk”; that is, goodwill, intangible assets, deferred tax assets, inventories, and other miscellaneous assets and receivables. These are largely the sorts of assets that only have value if the overall business is managed well, performs well, and remains competitive.

I have little reason to believe Hanesbrands is managed well. People point to the return on equity, but the return on equity is only so high because of the high debt load. Any management team with access to capital markets can over-leverage their balance sheet; this does not take skill.

Further, people challenge the idea of even caring about goodwill and intangible items on the balance sheet, yet these represent very significant transactions – literally billions in Hanesbrands’s case – which under a certain downside scenario would demand large write-downs – possibly even producing insolvency on a balance sheet basis (whereby liabilities exceed assets at book value).

And of course, once again, these represent large transactions – significant uses of cash that could have potentially been wasted, but which we are not certain have been wasted until some future date. This does not make them any less “real”.

The company’s return on assets has averaged around 6.5% over the past few years (if we average out the poor last twelve months, which include the tax charge). This is not especially bad, although it is not especially impressive either. The company’s historical EBIT vs. average total assets has historically been in the 11-12% range; however, the measure has dropped below 11% in the past twelve months.

Another concern is poor working capital management. Hanesbrands pretty much has the longest (i.e. worst) cash conversion cycle of all its comparables. This is the sum of: (1) the days it takes on average to collect in debtors, plus (2) the days it takes to shift inventories, minus (3) the days it takes to pay suppliers.

The company’s cash conversion cycle was 159 days as of recent (2018 Q1, TTM), which is an improvement on the first quarters of the 2016 and 2017 fiscal years, in which the cycle was 174 and 173 days in length, respectively. Nevertheless, the improvement has basically arisen from better terms with suppliers – days payable outstanding has risen by around 10 days since those comparable periods.

Without the boost from days payable outstanding – which I believe is likely unsustainable – Hanesbrands’s working capital cycle is barely improving. Indeed, in most cases, days payable outstanding of over 70 days is rarely sustainable.

Among its comparables, one that comes close to Hanesbrands’s large days payable outstanding is Under Armour Inc (NYSE: UAA). Aside from that, Hanesbrands effectively has one of, if not the highest (depending on who you compare it with) days payable outstanding and days inventory outstanding. In fact, it also has the highest days sales outstanding among most of its comparables.

In effect, Hanesbrands is finding it relatively difficult to convert trade receivables into cash, while little improvement is being made on the inventories front. The 180+ days inventory outstanding is frankly terrible. In effect, they take six months on average to shift inventories in aggregate. Raw materials and work in process as a percentage of overall inventories also continues to decline as finished goods continue to increase.

The slow cash conversion cycle of Hanesbrands is indicative of both poor working capital management and a lack of competitiveness – if not one or the other, then both. I like to think, somewhere out there, there is half a billion dollars’ worth of tighty whities sitting in the dark – not selling. Joking aside, this is a real waste; I find it very difficult to believe their inventory figure does not contain embedded losses that we have yet to see booked. Time will tell.

Although Hanesbrands’s valuation on a ‘pricing’ basis (e.g. using multiples, independent of capital structure, such as EV/EBITDA) is not “cheap” (we could say it is close to the median of around 10-12x), the company is itself a large and established business that could take advantage of its high free cash flows to build equity value.

While I do not find the company’s fundamentals convincing (HBI is not a low or even medium-risk investment), the stock could perform very well by virtue of its high-debt capital structure. If it is able to actually pay down its debt, the company could de-risk and actually grow its equity valuation into its enterprise value, if you follow. By de-leveraging its balance sheet, the company wouldn’t even need to grow to create returns for shareholders (although it would likely need to not shrink).

The problem with this idea is that (1) the balance sheet does not look particularly healthy, and (2) the company is finding it difficult to return even zero (rather than negative) organic growth sustainably, and management appear to be poor allocators of capital. Therefore, this alternative scenario – in which the stock performs like a kind of publicly-traded leveraged buyout – is probably not likely. I am still looking to further downside here.

Nevertheless, let’s look at the Hanesbrands’s free cash flow numbers. If we look at the company’s past five years’ worth of free cash flow, calculated as below, we find an average free cash flow per annum of circa $530 million (which is basically a free cash flow yield of about 8%). Here I have used a simple calculation: operating cash flow, plus interest expense (adjusted for tax, based on a five-year average effective tax rate), minus capital expenditures.

Free cash flow has been quite variable in past. For example, in the twelve months ended April 1, 2017, it was approaching $1 billion. Yet the comparable period a year before – ended April 2, 2016 – free cash flow was about $200 million. In any case, with over $6.5 billion in sales (TTM basis), and a gross margin of over $4 billion, the company has a large revenue and gross profit base from which to produce net income and cash flow.

Margins are not especially high however they have generally improved over the past five years, which is obviously positive. Yet a gross margin of 38.55% in the past twelve months is not indicative of a competitive or high-margin business; Hanesbrands products are mostly lower-cost, undifferentiated items.

Hanesbrands’s main strength continues to be limited to its size, scale and distribution – it’s simply not easy to tear down over $6 billion in revenue. Nevertheless, it is not impossible, and in fact over the long term it is most probable, in a world in which brick-and-mortar retail is declining and ecommerce is becoming increasingly competitive and efficient.

Still, if we assume that Hanesbrands is able to grow its $530 million of average free cash flow per annum at a long-term rate of 2% (from that $530 million FCF base), we could potentially ascribe an enterprise value of circa $8.8 billion to the company. The problem is that the high net-debt of over $4.1 billion in the first quarter of FY 2018 provides us with an equity value of “only” $4.7 billion. Over 360.4 million outstanding shares, we would find an equity value of around $13 per share.

Note that the long-term growth rate of 2% per annum to perpetuity is built on the assumption of organic growth, not acquired free cash flow. My capital expenditure numbers did not account for any of the net cash outflows that occurred with respect to acquisitions (as is standard for calculating free cash flow).

Yet this inorganic use of cash is important – these omitted net outflows (acquisitions minus proceeds from disposals) totaled over $2 billion over the same five-year period between 2013 and 2017. (This is the cash flow value only.) It is not difficult to generate free cash flow by buying it. The questions to ask are, “is this sustainable?”, “what about organic free cash flow?”, “is this business fundamentally competitive, or is it becoming a publicly-traded private equity firm?”.

If we take growth out of the picture and simply assume zero long-term growth, you are looking at a single-digit stock (possibly between $8-10 per share). If you were more conservative and additionally built a loss of EBIT margin into your assumptions – say, from around 12% to around 8% of sales – you are looking at a per-share value of less than $5 over the long term.

On the flip side, if Hanesbrands can refrain from buying more companies, and perhaps invest more in actual innovation (research and development, new products, marketing, etc. – R&D as a percent of sales is only about 1% currently), then perhaps it could sustain a long-term FCF growth rate of 2% or more. But can it exceed this? How can Hanesbrands grow, expand its margins, and generate more cash flow? How can it do this while sitting on six months’ worth of inventories, with already stretched suppliers?

I do not think Hanesbrands is an acquisition target. However, should it become “cheap” enough, it may well become a target of private equity. Until then, I am erring on the side of caution here. Being long is at least extremely risky.

The dividend yield is probably one of the main supporters of HBI’s stock price, providing somewhat of a ‘price floor’. Even if net income falls, Hanesbrands can probably continue its dividend for some time, even if it necessitates an increased ‘payout ratio’ (i.e. dividends paid vs. net income). The dividend yield of over 3% is attractive. However, so is the 27.25% interest rate in Argentina – this does not mean you should stick all your savings in Argentine pesos. The rate is high for a reason.

HBI is a risky stock, and I believe it still has further room to fall. Even insiders are selling their shares.

Finally, while the stock is about twice as volatile as the overall market, if you give any pay any attention to technical indicators (only for the purpose of finding an entry), you can see the moving averages currently lined up for further downside (although these trends can of course reverse at any time).

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I was short prior to this article, but I am no longer exposed in any way to HBI stock.