Image Source: Steven Depolo
Hanesbrands’ management set too high of a bar for itself to hurdle, and while the company put up strong free cash flow performance, we think it set investors up for a disappointment, shattering investor confidence in the executive team’s ability to accurately forecast future trends in its business. Hanesbrands’ stock, however, continues to look cheap by most valuation measures, and free cash flow is expected to remain robust in fiscal 2017, easily covering cash dividends expected to be paid in the year.
By Kris Rosemann
Highlights from Hanesbrands’ Fourth Quarter 2016 Press Release: “Record Net Sales, Operating Profit and EPS for Full Year; Record Cash Flow from Operations of $606 Million in 2016; Company Initiates Full-Year 2017 Guidance, Forecasting All-Time Highs for Net Sales, Operating Profit, EPS, and Cash Flow.” With those fourth-quarter headlines from its February 2 report, you wouldn’t expect Hanesbrands (HBI) to be trading down 15%+ Friday, February 3, but it is…incredibly. Targeted 2017 adjusted earnings per share from continuing operations in the range of $1.93-$2.03 implies shares are trading at roughly 10 times current-year earnings, and free cash flow expectations for the year in the range of $525-$635 million suggests the company’s free cash flow yield is ~7%. The company remains cheap by most valuation measures, and in a market where the average S&P 500 company is trading at more than 17 times forward earnings, things are out of whack.
From where we stand in trying to explain the sell-off, the market is either anticipating a near-halving of the company’s revenue and profits in the near term, which would better align its valuation with the average forward-market multiple for the average S&P 500 company, or that quite simply the market’s confidence in management has been shaken and investors are selling regardless of the underlying numbers (and what level of intrinsic value is implied by them). We think the latter is the likely case, though we admit that our confidence in management’s ability to accurately predict trends in its business is being tested, too. We certainly didn’t like the operating cash flow “miss” for 2016 (and that it was caused by receivables not inventories), but we also can’t overlook that it was still record performance. We might expect a stock price move like this from Netflix (NFLX), or Amazon (AMZN) or from another high-flying, high-beta equity, but the market activity in Hanesbrands February 3 is quite puzzling. There’s no other way of putting it.
We’re not happy with the market’s reaction to the report, perhaps better described as an “overreaction,” but the revised expectations do little to change our opinion of the company. In the area where it truly matters, we continue to see a reasonable valuation opportunity for shares coupled with the potential for ongoing growth in the dividend. To reiterate our view on the sell-off, the concern about the most recent quarter was not the company’s financial performance itself, but rather that management’s forecasts for the period had been too optimistic when considering the current US retail environment, and that investors have lost a bit of confidence in the team’s forecasting ability. That receivables caused much of the cash flow from operations shortfall (and not inventories) is a peculiarity that we’re watching closely in the event a key customer may be setting up to file for bankruptcy.
That said, Hanesbrands’ top-line growth in the quarter came in at 12% over the year-ago period, largely driven by acquisition-fueled growth in its international operations. Innerwear sales, down 8% year-over-year, was a key source of weakness in the fourth quarter as retailer inventory control strategies resulted in lower replenishment orders for Hanesbrands (it appears that one customer accounted for the vast majority of the shortfall). Hanesbrands experienced lower than anticipated traffic levels that are also being felt across US retail during the holiday season, but the destocking of what management described to be a single large retailer accounted for roughly 6 percentage points of the drop in Innerwear sales. This wasn’t expected, and we’ll be waiting to see whether receivables that weren’t collected in this quarter will eventually be collected. The market may have some concerns in this area.
Aside from the receivables consideration, the unexpected mid-quarter drop in replenishment orders in the fourth quarter was also a contributing factor to Hanesbrands’ “miss” on cash from operations guidance for the year, which had been targeted at $750-$800 million compared to $606 million reported. The company’s Direct to Consumer category was the only other segment to report a sales decline in the quarter as the company works to exit the legacy catalog business and reduce noncore offerings in outlet stores and online. Only 11% of US sales were made via the online channel in the fourth quarter of 2016, which is an improvement over 8% a year ago but we would like to see a more material improvement in this area moving forward.
Despite failing to deliver on expectations in the most recent quarter, Hanesbrands reported record net sales, operating profit, earnings per share, and cash flow from operations for the full year 2016, and it is forecasting another round of all-time highs for all four measures in 2017. However, the market is a game of expectations, and shares have been punished since the results were released as investors were hoping for a bigger and better record-setting performance in 2017. Management expects 2017 net sales of $6.45-$6.55 billion, adjusted operating profit of $935-$975 million, adjusted earnings per share of $1.93-$2.03, and cash from operations of $625-$725 million.
Hanesbrands lists four factors to support its confidence in its 2017 targets. First, last year’s acquisitions are not only expected to add meaningfully to the top line, but $15 million in synergies are expected from the purchase of Hanes Europe Innerwear alone with more synergies coming in 2018 from the Champion Europe and Pacific Brand acquisitions. Second, management is adjusting to new consumer preferences. It is expanding its assortments across all online channels and anticipates digital media to account for over half of its total media spend in the year. Third, the firm is confident in the momentum in its core business fundamentals as it gained market share in Innerwear and notes that its Activewear business should benefit on a comparative basis from bankruptcies in the sporting goods retail space in 2016.
Finally, Hanesbrands will be more conservative in its brick-and-mortar channels in 2017. Traditional retail traffic has not only been lost to online shopping, but it has become more centralized around key promotional events. As a result, management is going to be more targeted with its promotions while planning for tighter inventory management moving forward. Unlike the fourth quarter of 2016, when management may have been too hopeful to reverse retail traffic trends, we think the company is preparing appropriately for what will continue to be a generally difficult retail environment in 2017. Hanesbrands’ vertical integration, however, (it owns its supply chain) not only gives it an advantage in low-cost manufacturing, but also provides flexibility in navigating various economic and political environments.
All in, the recent 36% jump in Hanesbrands’ quarterly dividend puts its annualized payout ratio at the high end of its target range of 25%-30% when considering adjusted earnings per share guidance for the year. Management has indicated that it, too, feels its shares are being undervalued by the market–shares are trading at less than 10x the midpoint of 2017 guidance as of this writing–and it expects to buy back $300 million in shares in 2017. Though share repurchases are a competing capital allocation option relative to the dividend, it looks to be a value-add proposition at current price levels, in our opinion.
We’re reiterating our opinion that shares of Hanesbrands are undervalued. After factoring in the new guidance for 2017 and tempering our top-line expectations, we’ve tweaked our fair value estimate for the company to $27 per share from $30 previously, a rather minor move. The company’s Dividend Cushion ratio was also impacted by the lower guidance, but it, too, remains above parity. The largest concern as it relates to the dividend is its sizeable debt load, but free cash flow coverage of the payout shouldn’t be an issue in 2017 based on management expectations for free cash flow in the range of $525-$635 million (capital expenditures are expected to be ~$90-$100 million). We may be looking to add to shares, but we’re going to let Hanesbrands’ stock bottom out first. We’re in no hurry.