Tailored Brands – Making Your Portfolio Look Good

People pass by a Men's Wearhouse store in New York

On July 27th I published a post outlining why I thought Tailored Brands was deeply undervalued. Since then, the stock has nearly doubled. The market is up about 4% over that same time period. I want to summarize the events that have happened since July 27th and reevaluate the stock as we move into 2017. My post from July 27th can be found here.

Tailored Brands purchased Jos. A. Bank in 2014 for $1.8B which turned out to be a horrible acquisition. The business was deteriorating when they bought it and the promotional model was not sustainable. TLRD did not have an earnout covenant so they ended up having to write-off $1.24B in goodwill from the acquisition in 2015. This write-off was overly conservative. The $1.24B write-off deemed Jos. A. Bank to be worth basically nothing as the business had $460 million in cash when they acquired it. The following is from my post on July 27th.

Although the deal was terrible for existing shareholders I believe there is value in the stock today. In 2015, Tailored Brands wrote off $1.24B of goodwill from the acquisition. They paid $1.8B. This would mean that they only received $560 million of value. I don’t believe the deal was that bad. Below is a screenshot of Jos. A. Bank’s balance sheet before the acquisition.

Jos BS

Prior to the acquisition, Jos. A. Bank had $935M in assets and only $200M in liabilities. To be conservative, I would write off half of the acquired inventory since we know business has been bad. After that write off, I calculate that $585 million in assets were acquired (935-200-150=585). So we know they acquired about $585 million in assets vs. the $560 on the balance sheet today. This would mean that TLRD’s financials indicate the actual business of Jos. A. Bank is worthless and there were no synergies. We know this isn’t the case. Comp store sales at Jos. have taken a hit but are beginning to recover.

What has occurred since July 27th

On September 7th the company reported Q2 earnings which beat on the top and bottom line. Men’s Warehouse reported 2.9% comparable store sales. Jos. A. Bank reported -16.3% comparable store sales which was worse than I had expected but was inline with the Company’s expectations. The company also gave an update on their transition plan which will achieve $50 million in cost savings. During the second quarter, they closed 86 stores, including 45 Jos. A. Bank factory stores and eight Men’s Wearhouse outlet stores. They remained on schedule to close approximately 250 stores during fiscal 2016. TLRD reiterated their previous full year guidance of adjusted EPS in the range of $1.55 to $1.85 per diluted share. Overall this quarter didn’t impress me all that much. However, the stock jumped 16% because expectations were so low.

On December 7th the company reported Q3 earnings which also beat on the top and bottom line. Men’s Warehouse reported a soft 0.1% comparable store sales. Sales since Father’s day have slowed and management said that trend had continued through December 7th. Management said that the Jos A. Bank turnaround is gaining traction. Jos reported a better-than-expected comparable sales decline of 9.8% in the third quarter. This third quarter number was up against the final “Buy-One-Get-Three Free” event in October. This number was inline with what I was expecting. Management updated full year 2016 adjusted EPS expectations to $1.70 to $1.85 per diluted share from the previous range of $1.55 to $1.85 per diluted share. Jos A. Bank is expected to post mid-to-high-single-digits comps in the fourth quarter with Men’s Warehouse posting a negative low single digit comp. The company also gave an update on their transition plan which will achieve $50 million in cost savings. During the third quarter, TLRD closed 83 stores, including 74 Men’s Wearhouse and Tux stores, bringing the total year-to-date closures to 187 stores.  They expect to close approximately 63 stores in the fourth quarter for a total of approximately 250 store closures during fiscal 2016. This quarter was better than I had expected. The turnaround in Jos A. Bank is on track. The stock soared nearly 40% on this earnings report.

Debt Situation

In my July 27th post I discussed the Company’s debt situation. The liquidity risk in the stock has dropped significantly. TLRD will be net cash flow positive in 2017 while they continue to pay down their debt. Just as a reminder, these are their debt deals.

  • $1.1B Term Loan due June 2021. Terms: LIBOR + 3.5%
  • $500M ABL Facility loan due 2019. Terms: LIBOR (No borrowings as of 10/29/16)
  • $600M in 7% Senior Notes due 2022.

In my last post, I mentioned I didn’t think the Company would be able to retire all of its debt timely. However, TLRD’s cash flow situation has improved in the second half of the year and it now appears probable that they will be able to retire all their debt on time without having to cut the dividend. Management continues to be positive on the trends they are seeing. I believe the Company will be able to achieve $20 million in net cash flow in FY17 while continuing CAPEX trends.

Valuation

The valuation has changed quite a bit since my last post with the large move in the stock. In the last two quarters, we have seen Men’s Warehouse comps begin to weaken while JOSB comps have been stronger than expected. In 2017, I expected MW to have a flat comp and JOSB to have a high single digit comp. Overall I think a TLRD 3.4% comp is achievable. In the July 27th post I valued the stock with the sum of the parts analysis below. Jos SOTP

As we approach my base case price target, I wanted to look at the valuation to evaluate whether the stock is still undervalued. The stock trades at about 13x forward earnings which seems cheap compared to the market at 17.5x. However, the balance sheet is still very leveraged so 13x times isn’t as cheap as it appears. The three year historical forward EV/EBITDA multiple is 7.6x. The stock is now trading close to 8x; about a 5% premium to the three year average. The stock is now pricing a lot of optimism around the JOSB turnaround. At this point, I believe this investment has transitioned from one with a positive skew to one that is now negative. 2017 should be a year where GDP growth is led by consumer spending. However, if that doesn’t transpire there may be limited upside in the stock.

Bottom Line

This stock has been a monster over the last five months. I will continue to hold it in 2017 while I carefully watch the JOSB transition. I am not sure this is a great opportunity to initiate a new position now that the stock trades at a premium to the three year historical valuations. Consumer discretionary stocks did not perform well in 2016 as a group but I think 2017 will be a better year. Management continues to do a good job in getting JOSB back on track.

Disclosure


Long TLRD

 

 

 

 

Restoration Hardware – Taking The Road Less Traveled

restauration-hardware2.0Overview:

Restoration Hardware Holdings, Inc. is a retailer in the home furnishings marketplace offering furniture, lighting textiles, bath ware, decor, outdoor and garden, as well as baby and child products. It operates an integrated business with multiple channels of distribution, including galleries, source books and websites. The company was founded by Stephen J. Gordon in 1980 and is headquartered in Corte Madera, CA.

RH Modern

This is an entirely new business that was unveiled at the end of last year. RH Modern has multi-distribution channels and has its own 540-page Source Book. The line will target the growing number of people who are drawn to modernist design, whether their aesthetic is rustic, classic, or contemporary modern. The depth of business spans to nearly every part of the home – from living rooms to dining rooms, bedrooms to bathrooms, and pools and patios. This assortment is the first brand to offer this groundbreaking breadth of furnishings. Most of the RH Modern is developed with some of the world’s most talented designers- including furniture collections from Barlas Bayar, Anthony Cox, and Thomas Bina; lighting from Jonathan Browning and Fortuny; modern rugs by Ben Soleimani; outdoor offerings from Leo Marmol and Ron Radzine. Gary Friedman said “From antiques to architecture, from the environments we work in to the devices we work with, there is a modern sensibility that is influencing what we see and how we live in the world. While the market for modern furnishings has always been somewhat small, the convergence of these trends creates an opportunity to develop a much larger market.”

To date, RH Modern has been more of a headwind than a tailwind due to a barrage of supply issues. The production delays have been big trouble throughout 2016 but seem to be worked out heading into Q4. The design of the new line is differentiated from current furniture offerings. Statement pieces include inviting platform and canopy beds; oversized ottomans; low, sophisticated sofas and sectionals with integrated accent tables; tactile carpets; dramatic sculptural lighting; floating lounge chairs and vanities; and stunning window and bath hardware.

The new brand has its own unique website and a significant physical presence, including a standalone RH Modern Gallery at the site of RH’s former gallery on Beverly Boulevard in Los Angeles, the entire ground floor of the Flatiron Gallery in New York, plus entire floors in the Company’s next generation Design Galleries in Chicago, Denver, Tampa and Austin. The freestanding RH Modern Gallery in Los Angeles is completely redone into a contemporary structure – indoors and out – featuring a modern sculpture garden with soaring palm trees. RH Contemporary Art – which has been integrated into RH Modern – will be showcased in each location with original works from a global roster of artists, creating the feeling of both a home and a gallery. RH has invested in integrating this brand into its existing portfolio. As most of the issues are behind the company this brand may provide a boost going forward.

Transition from Promotional to Membership

In Q1, RH announced the introduction of the RH gray card. This is their new membership program. For a $100 annual fee, the RH Grey Card provides 25% savings on everything. This includes all brands – RH, RH Modern, RH Baby & Child, RH TEEN, and RH Contemporary Art. RH Chairman and CEO Gary Friedman said “We want to shop for what we want, when we want and receive the greatest value. So rather than navigating countless promotions, we’re changing things…because time is the ultimate luxury.” In addition to the 25% off all regular merchandise, Card Members will also receive 10% savings on all sale merchandise, complimentary interior design services, eligibility for preferred financing plans for the RH Credit Card, dedicated concierge services to manage orders, and early access to clearance orders. This Card is expected to make shopping with RH more simple. Gary Friedman added that “Our lives are filled with complexity – and we long to break through the clutter to find simplicity.”

I really like this approach by RH. Not only does it simplify the shopping experience, but also, it encourages repeat business. The Company is taking a page out of the Costco playbook. I believe this membership model will be a long-term success. However it has caused near team margin pressure. In Q2’16 the Membership deferral resulted in a 80 BPS margin deleveraging. This deleveraging showed up again in Q3’16 as the company will not recognize the revenue up front.

The Membership Card will encourage customers to spend a minimum of $400 in the store. This is where customers break-even. $400*(-25%) = $300 + (Membership fee $100) = $400. Pretty simple, although it becomes harder to understand the read on how this stacks up to the old promotional model. Obviously, there won’t be many product offerings that are on sale with the new model. If a Card Member spends $2,000, they will save $400 net, so this will equate to a 20% promotion in the old model. The discount that any customer can achieve on regular priced merchandise is capped at 24%.

SKU Rationalization

In the Q2’16 earnings press release, Gary Friedman mentioned the current headwind of SKU rationalizing. Over the next couple quarters, this will continue to result in margin deleveraging. However, in the long-run these expenses will result in a smoother shopping experience. Once the SKU count has been optimized, this investment will be a tailwind for operating margin.

Source Books

This year, RH decided to delay the roll-out of their Source Books from spring to fall. This decision has created a drag on the stock. This decision will likely continue to put pressure on sales in Q3 and early Q4. Last year the Source Books shipped in Q2 and this year they won’t ship them until late Q3 or early Q4. The last major marketing initiative from the Company was in Q2’15 when they shipped the 2015 Source Books. The new Source Books have been completely redesigned and rephotographed. The redesign was done by art director Fabien Baron, who also designed the RH Modern book. The new books present the brands in a completely new format.

RH Austin, The Gallery at The Domain

I visited RH’s Austin Gallery to better understand the customer experience. From the moment that you walk in, the experience is unique. The ascetics of the Gallery are completely different than any other store. The store was very fresh and bright. I was told that RH management has painted the walls in every store white (from grey) in order to make the furniture standout against the background and brighten up the store. It worked, it gives the furniture a good look.

One of the biggest takeaways from my visit was the fact that the Company is in the middle of a massive product refresh cycle. I was told that they are about half way there. In total, about 80-90% of the product will be refreshed. The rollout of Modern into Gallery’s is well underway. About one-third of the store will be made up of the Modern product. The Modern brand is differentiated from the legacy/core brand. The two-thirds of the store that will have the core brand furniture are also being refreshed. The new product has new looks and finishes that have not previously been in stores. The refresh should improve store productivity. The design team member that helped me said Modern has been very popular among customers.

This Gallery had its grand opening on September 16, 2016 and traffic has been steady. The product refresh is beginning to peak interest from customers and it is driving repeat business. Slowly rolling out the Modern and the core brand is resulting in customers coming in more frequently to see the new furniture. Once the Source Books are sent out at the end of Q3, RH expects traffic to improve.

Gary Friedman’s Vision

Restoration Hardware shows off its innovation every step through the shopping experience. The first step for RH management was to blur the lines between retail and home. When you are in an RH Gallery, you certainly do not feel as though you are in a retail store. It feels like you are in a home and you are more relaxed. The second step for management is to add an element of hospitality into the mix. RH Chicago has a courtyard cafe where customers can eat while they shop. The cafe sits in an atrium that is filled with natural light. The store also has a pantry and coffee bar where customers can get hand crafted coffee drinks.

Gary Friedman wants to activate all five senses (sight, sound, smell, taste, and touch) during the shopping experience. Traditional retail experiences are boring and offer no natural lighting. RH Gallery’s provide a unique experience that can not be replicated online or at any other retailer today. While RH is not the first retailer to have a cafe or restaurant, they are the first to integrate the restaurant into the shopping experience. This strategy has worked tremendously well and the Company will begin to integrate it into new Galleries. In 2017 RH will add it to RH San Franciso The Gallery at The Historic Bethlehem Steel Buliding, RH Nashville The Gallery In Greenhills, RH Palm Beach The Gallery At City Center, and RH New York The Gallery At The Historic Meatpacking District. This will make five locations with the next generation shopping experience. Gary Friedman calls it “The most significant retail transformation in the history of our industry.”

Below is a picture of the Saks Fifth Avenue at Cherry Creek prior to it closing. This is the location of RH Denver, The Gallery at Cherry Creek.

Saks

RH purchased the land, tore down the Saks store and built RH Denver, The Gallery at Cherry Creek. A picture is shown below. Which store would you rather shop at? Easy decision.

RH Denver

Traditional mall and anchor stores are windowless boxes that have no fresh air. RH believes that customers will shop at brick and motor stores but you must provide them with a differentiated experience. Current mall and anchor stores lack imagination and have not innovated.

Waterworks

On April 12th, RH announced that it had acquired Waterworks for approximately $117 million in cash. Waterworks is a luxury bath and kitchen brand with fittings, fixtures, furniture, furnishings, accessories, lighting, hardware and surfaces. It is comprised of the Waterworks, Waterworks Kitchen and Waterworks Studio. Products are sold through 15 showrooms in the U.S. and U.K., boutique luxury retailers and online. The premier luxury bath and kitchen brand was founded in 1978 by Barbara and Robert Sallick, and has been led by Chief Executive Officer Peter Sallick since 1993. This acquisition “creates the first fully integrated luxury home platform in the world – offering a complete collection for every room of the home, in every channel, to both design professionals and consumers” according to the April 12th press release. Peter Sallick and Ralph Bennett, President, will continue to lead the Waterworks brand along with the rest of the leadership team from their headquarters in Danbury, Connecticut.

Waterworks is the only complete bath and kitchen business offering fittings, fixtures, furniture, furnishings, accessories, lighting, hardware and surfaces under one brand in the market. Ralph Bennett, Waterworks President stated, “We believe RH is the most significant brand being built in the home market today, creating extraordinary opportunities for us to collaborate and benefit from their unique and growing platform. As a combined organization, we look forward to extending and expanding our passion, product offer and commitment to outstanding service to our incredibly valuable clients.” Gary Friedman shared the enthusiasm by saying “There are certain brands that define their categories, like Hermès, Tiffany, Apple, Range Rover and Ralph Lauren, and we believe that Waterworks is one such brand. We have long held great admiration and respect for the esteemed brand and business the Sallicks have built, and feel honored and privileged to be partnering with the entire Waterworks team, as we combine forces to further redefine the industry.”

RH’s Executive Compensation Plan

RH’s executive compensation plan is built around three pillars.

  • It’s closely aligned with the performance of the Company, on both a short-term and long-term basis;
  • linked to specific, measurable results intended to create value for stockholders
  • tailored to achieve the key goals of our compensation program and philosophy.

RH’s executive compensation programs are aligned with stockholders’ interests. Performance-based compensation is tied primarily to annual earnings before taxes and long-term stock price performance.

Compensation Committee

The Board of Directors has established a compensation committee that is generally responsible for the oversight, implementation and administration of the executive compensation plans and programs. The compensation committee annually reviews and approves RH’s corporate goals and objectives. The core function of the committee is to review annual salary levels along with short-term and long-term incentives. The committee ensures that appropriate overall corporate performance measures and goals are set and determine the extent to which the established goals have been achieved and any related compensation earned. The executive compensation plan is aligned well with both short-term and long-term incentives. However, it doesn’t look like the compensation committee is doing the heavy lifting in setting up this plan as they have hired Willis Towers Watson as a compensation consultant. Charlie Munger has said “I’d rather throw a viper down my shirt front than hire a compensation consultant.” In short, the compensation committee could probably do without a compensation consultant.

Leadership Incentive Program

The Leadership Incentive Program, or “LIP,” is a cash-based incentive compensation program designed to motivate and reward annual performance for eligible employees, including named executive officers. The compensation committee considers annually whether LIP bonus targets should be established for the year and, if so, approves the group of employees eligible to participate in the LIP for that year. The LIP includes various incentive levels based on the participant’s position with the Company. Cash bonuses under the LIP link a significant portion of the named executive officers’ total cash compensation to overall performance. The LIP bonus for named executive officers is based on achievement of financial objectives, rather than individual performance. Each named executive officer is provided a target bonus amount equal to a percentage of the eligible portion of such officer’s base salary. The target bonus amount is based on the Company meeting the target achievement level for the relevant financial objectives. The compensation committee and/or the board of directors establishes the target achievement level at which 100% of such participant’s target bonus will be paid (the “100% Achievement Level”), the minimum threshold achievement level at which 20% of the participant’s target bonus will be paid (the “20% Achievement Level”) and the achievement level at which 200% of the participant’s target bonus will be paid (the “200% Achievement Level”).

The compensation committee, either as a committee or with the board of directors as a whole, sets the financial objectives each year under the LIP, and the payment and amount of any bonus depends upon whether RH achieves at least a certain percentage of the financial objectives under the LIP (at least 20% for fiscal 2015). The compensation committee generally establishes such objectives for the Company at levels that it believes can be reasonably achieved with strong performance over the fiscal year. For fiscal 2015, the performance metric for the LIP was based on adjusted net income (“Adjusted Income”), which is defined as consolidated income before taxes, adjusted for the impact of certain non-recurring and other items that are not considered representative of ongoing operating performance. For fiscal 2015, the compensation committee approved the following targets under the LIP (based on approximately 30% earnings growth):RH A

The following table sets forth the bonus targets as a percentage of the eligible portion of the executive’s base salary under the LIP in fiscal 2015. For 2015, the compensation committee determined based on discussions with Mr. Friedman, to provide him increased bonus targets in lieu of increases in base salary in order to better align his compensation with our overall financial performance. Consequently, the compensation committee approved an increase to Mr. Friedman’s bonus target as a percentage of base salary from 100% to 125% at the 100% Achievement Level, and from 200% to 250% at the 200% Achievement Level. No changes were made to the bonus targets for the other named executive officers.

RH B

Adjusted Income for fiscal 2015 for purposes of the LIP was approximately $184 million, which reflected the compensation committee’s determination that certain other extraordinary or non-recurring items should also be excluded from determining Adjusted Income for purposes of the LIP. Accordingly, the compensation committee approved payment of the bonuses earned under the LIP for our named executive officers, other than Mr. Dunaj, as follows:

RH C

Equity Compensation

In 2015, the compensation committee approved grants of stock options and restricted stock units to the named executive officers, as follows:

RH D

The stock options were granted at an exercise price of $87.31 per share which was the price of the common stock on May 6, 2015, the date of grant. The options vest at a rate of 20% per year over five years on each anniversary of the date of grant, expire in 10 years. Management is really going to have to get this thing in gear for them to be able to exercise these options. The stock will need to nearly triple.

Gary Friedman’s Stake

Mr. Friedman, has consistently maintained a significant equity ownership interest in the Company and beneficially owns approximately 15.1% of the Company’s common stock. Today his stock is worth about $200 million. However, just one year ago his stake was worth more than $540 million. Tell me he isn’t motivated to turn this thing around.

Q3 Earnings Commentary

RH reported Q3 earnings on December 8th and beat on the top and bottom line. However, they guided down Q4 which caused the stock to sell off 18% on Friday. So is this an opportunity? I say yes. The reasoning for the guide down was a bit of a surprise. There was a mix of issues that contributed including bad holiday inventory, membership model transition, delay in source books, and SKU rationalization. As the Company moves into 2017 they will lap the issues related to the launch of RH Modern and move past the timing issues related to RH Membership. The SKU rationalization is causing a $0.40 hit to EPS, RH Modern production delays are causing a $0.30 drag, and the membership timing issue has caused a $0.25 headwind. However, I think the Q4 guidance is awfully conservative and Gary Friedman said so on the conference call. Friedman said “I think I’d characterize it, I think we’re being conservative in Q4 today. So, because we just don’t have visibility in the builds, right? It could be a little better, but today, based on where we sit, we thought it was right to take a conservative view based on how we saw the rest of December and January.” This didn’t stop analysts from slashing Q4 estimates and even 2017 numbers.

Bear Case

The bear case assumes a normalized growth rate in the low single digits, only slightly ahead of GDP growth. This case assumes management will have to continue to invest in their supply chain and will never get back to prior peak operating margin of 9.8%. This scenario suggests that RH would pull back on opening larger-format galleries and the rate of high-end income growth slows which would impact the amount of new customers entering its TAM. In this scenario, RH would have to lower price points due to a sluggish demand environment.

Valuation

As mentioned, the stock tumbled 18% on Friday and analysts have cut estimates. I also cut Q4 numbers but I didn’t move my 2017 estimates down as much as other analysts. As the source books have now been shipped, I think we will see some of Q4 sales show up in Q1.

IS Estimates

The DCF analysis I performed, suggests a stock price in the range of $35-$50. The scenario used implies a more normalized growth trajectory for the business relative to management’s current long-term plan to double revenue and reach a mid-teens operating margin over time. I assume a 5-year CAGR of 5.3% and a 9.0% operating margin in FY21 which assumes that RH will double EBITDA over that time period to $330M from $165M expected in FY16.

Enterprise

Per Share

Using a terminal EBITDA multiple of 7.5x, we are looking at a stock price in the range of $35-$50 and a $42 price target at the midpoint, implying 31% upside from current levels. I believe a 7.5x multiple is appropriate given its most direct home good peer, WSM, which is viewed as a bellwether in the space, has a five year historical EV/EBITDA average of 7.5x. I note that WSM is currently trading at a discount to its five-year average at a 6.5x EV/EBITDA due to a number of uncertainties regarding competitive threats to its long-term growth.

Bottom Line

RH is taking the road less traveled. In a time when retailers are shrinking their store counts, RH is looking on providing a differentiated shopping experience that can’t be replicated online. I believe it makes sense to shop online for many products. However, I don’t think home furnishings are in that category. RH’s stock is hated by pretty much everyone which makes it interesting to me. If you exclude the hedged shares, the stock has a 24.2% short interest. I believe RH will achieve its conservative Q4 guidance even if it’s from low quality liquidation sales. In my opinion, this might be enough to force shorts to cover and that could rally shares higher in 2017. In the next few weeks, I wouldn’t be surprised if the stock moves lower. I will add to my position below $30/share.

Disclosure


Long RH

 

 

Under Armour – Chasing Down Nike

UA store

Overview:

Under Armour, Inc. develops, markets and distributes branded performance apparel, footwear and accessories for men, women and kids. The Company’s segments include North America, consisting of the United States and Canada; Europe, the Middle East and Africa (EMEA); Asia-Pacific; Latin America, and Connected Fitness. Its apparel is offered in various styles and fits to improve comfort and mobility, regulate body temperature and improve performance. UA’s footwear offerings include football, baseball, lacrosse, softball and soccer cleats, running, basketball and outdoor footwear. Its accessories primarily include the sale of headwear, bags and gloves. Its accessories include HEATGEAR and COLDGEAR technologies. It offers digital fitness platform licenses and subscriptions, along with digital advertising through its MapMyFitness, MyFitnessPal, Endomondo and UA Record applications.

Under Armour is the first company that has been able to give Nike a run for its money. UA has already made tremendous strides into basketball and football. Two sports that have always been dominated by Nike. Over the last few years we have seen numerous big colleges switch from Nike to Under Armour. Last year the University of Texas’ Nike contract was up for renewal and as soon as rumors started spreading that UA was interested, Nike re-signed Texas to a massive 15 year $250 million contract.

Under Armour is run by founder and CEO Kevin Plank. He started the business after finishing playing college football with the idea of creating a microfiber t-shirt to replace the heavy cotton ones in use at the time. Today, most football players wear microfiber instead of cotton t-shirts. In its first year, UA had $17,000 in sales. The Company forecasts that it will have $7 billion in 2018.

Footwear Market

The global footwear market is a $275 billion market. Of this market, the athletic footwear portion of the market is $63 billion. This portion of the market is expected to grow at a 3.6% CAGR over the next decade. The athletic footwear market includes sportswear, trekking shoes, aerobics shoes, walking shoes, and running shoes. The initiative regarding healthy lifestyle that motivates people to engage into some kind of sports activity will drive the industry in the coming years. This has motivated leading brands to come up with innovative and comfortable sports footwear products. Growth in wholesale and retail business, efficient supply chain, consumers’ willingness and increased purchasing power have fueled the global athletic footwear market.

The athletic footwear market is very different than the overall global footwear market from a demographic perspective. Men account for 60% of athletic footwear sales and women account for 25% (Children 15%). In the overall footwear market, women account for 57% and men hold 26%. Today, women are buying more athletic footwear and companies are fighting for this market share. In 2005, women only accounted for 21% of the athletic footwear market. Men have continued to spend on shoes but women have grown their share at a faster pace.

The majority of men select an athletic brand of shoe as their footwear preference. The largest brands in this space include Nike, Vans, Adidas, Converse, Puma, and UA. Footwear sales has been a major initiative for UA and it now accounts for 20% of sales as they steal market share. This trend has been led by basketball where UA has 20% of the market. This is up from 16% of the market in the fall of 2015. Steph Curry is driving growth in basketball and he has been a terrific ambassador of the brand.

Footwear

Asia has been a particularly strong market for Under Armour. Asia now accounts for 40% of all athletic footwear sales and is expected to be the fastest growing global market over the next five years. Steph Curry completed his second Asia tour last month in an effort to build his Curry shoe line. The Curry 3.0 was just released and has high expectations.

Under Armour has a mere 1% penetration into the $63 billion dollar market. Nike has a lot to lose. UA is in the first inning of their footwear campaign and they have great products. The future in UA footwear is driven by the Curry franchise. In 2015, Jordan shoes brought in over $2 billion in sales. UA is looking to develop a multi-billion basketball franchise like Nike has with Jordan. Today, Nike is building LeBron’s franchise and it is going head to head with the Curry franchise. Basketball will be crucial for UA to penetrate as football is being viewed as being increasingly dangerous and responsible for long term health problems in athletes. As more research is performed in the next decade, we will likely see more athletes choose basketball over football if they are gifted enough to choose.

Under Armour is working on incorporating technology into the footwear space. At this year’s CES conference they introduced a shoe with an embedded chip that collects data. The data will be used by Under Armour to communicate to consumers when they need to purchase a new shoe. Their data thus far has indicated that when people have run more than 450 miles, there is a higher risk of injury with old shoes. This type of information will be beneficial for the health of UA consumers.

Under Armour Sportswear Line (UAS)

Last month the Company launched UAS. This is very different market for them. UA believes that it has not been servicing the total addressable market. They have noted that about one third of their key competitor’s sales are derived from lifestyle rather than a pure traditional performance product. The lifestyle product provides a halo effect to the other lines of the business. As such, they have decided to fill this product gap with Under Armour Sportswear (UAS). UAS will initially be offered in a limited number of domestic locations including the SoHo (in NYC) and Chicago Brand House venues, as well as Barneys and online retailer Mr. Porter. The new line should be available in Boston in the coming weeks.

The UAS is geared towards trendy millennials. It is combination of traditional UA performance product with more fashion. The collection has a performance component, with stretch and waterproof fabric’s but has a fashionable look. The collection also offers fashionable footwear. The women’s shoe is not a traditional UA sneaker in that it has some lift in the sole. They are also going after the fashionable boot consumer with this line. Most of the products in this new line are priced in the $129-$250 except for the t-shirts, they are priced in the $49-$89 range.

This collection will not have a material impact to the top line until 2018 at the earliest. As they learn and receive feedback they will expand the breadth of the product and distribution. CEO Kevin Plank has said that UAS is a $15 billion opportunity. In my opinion, this is a very optimistic target and it will take many years to scale. Last year, UA had revenues of $4 billion so there is a chance that it might begin to impact the FY’17 revenues.

Under Armour believes that they will successfully be able to convert existing male customers to buy the UAS product. The new collection will not compete with the existing performance products so there will be no cannibalization. While there is an existing male customer base, UA expects the esthetics on the women’s side to attract female customers. Under Armour has traditionally struggled on the women’s side. It is estimated that only 15% of UA’s revenues are generated by female customers versus 23% at Nike.

Female Customer Base

As previously mentioned, Under Armour has historically been a bit out of favor with women. However, in July 2014 they launched the “I will what I want” campaign with Misty Copeland. As the campaign continued, UA signed Gisele Bundchen.  The campaign was a tremendous success by driving 28% growth in women’s sales and a 42% increase in traffic to the UA website. Today, the Company continues to try to appeal to female shoppers. UAS is the most recent strategy rolled out to create a larger female customer base. Nike continues to have a better perception among women but Under Armour is seeing improvement.

UA recently signed a distribution contract with the retailer Kohl’s. This is a strategic distribution move in an effort to reach women. Kevin Plank noted “The female consumer is there, she’s shopping and she’s buying. We think there is a big opportunity.” The margin mix for these sales in this channel are expected to be in line with existing sales. Kohl’s sold $3 billion in activewear and accessories last year representing 15% YoY growth. It is estimated that $1 billion of these sales were attributed to Nike. Under Armour is now offered in all 1,160 Kohl’s stores. This new distribution channel will be a long term revenue source for UA. I have reason to believe that Kohl’s will add $200 million to UA’s top line next year. This new channel alone will generate 350-400 basis points of sales growth in FY17.

International Growth

Under Armour continues to push into international markets and is having tremendous success. In the most recent quarter, international revenues increased by 80% on a constant currency basis. The direct to consumer channel now includes 191 stores comprised of 161 factory houses and 30 brand house stores. The international segment accounts for 15% of total revenues and they are stealing market share from Nike. The strongest international market for UA continues to be China. UA generated as much revenue in Q3 as it did in Q1 and Q2 combined. The brand is growing quickly in and they now have more than 80 stores there.

Intl

As the company expands internationally, they will steal market share from companies in new sports. The growth in EMEA is targeting Nike as well as ADIDAS. UA has not made soccer a growth initiative yet but I expect them to make a run at ADIDAS in soccer in the future. Soccer is the most popular sport in the world and is ranked as the most popular sport among today’s teens. To break into this sport, UA will need to begin signing endorsement deals with young soccer elites. We have seen that one dominant player like Curry or Spieth can really move the needle for UA. Signing the right athlete will be crucial.

Under Armour will be growing internationally for a significant period of time. For a comparison, Nike generated almost $16 billion in international sales last year which is almost 50% of their revenues. Under Armour has yet to reach the $1 billion threshold. I expect them to have $1 billion of international sales in 2018. This will be another important year as it will be an Olympic year. The Olympics provided a boost to international sales in Q3 as a result of an excellent advertising campaign around the Olympics. Under Armour is fairly well known in the U.S but as a brand, it is still in its infancy on an international scale. Worldwide sporting events like FIFA and the Olympics give UA an excellent platform to introduce their brand to the world.

Under Armour has been rolling out their international growth plan and entering new countries. This year alone, they entered into France, Turkey, North Africa, South Africa, Indonesia , Vietnam, Paraguay, and Uruguay. Next year they will enter into Argentina, Eastern Europe, and Russia. UA announced at last year’s investor day that they expected a 50% international CAGR through 2018. Thus far, it looks like they might even exceed that impressive expectation. UA is planning to have operations in over 40 countries by 2018, taking its total international locations to over 800. By the end of 2018, 80% of its global door count would be located outside of the United States, up from 41% currently. Most of the new stores will come via partnerships with distributors, especially in China, Japan, and Korea. UA expects to own and operate only about 30% of the total number of locations worldwide, or about 300. Charlie Maurath is UA’s President of International and he has done a terrific job rolling out their strategy. He has communicated that UA will strive to be the premium brand in every market that it enters. The premium strategy will be consistent regardless of the method that UA exercises to enter a market.

Applications

Under Armour has invested billions into their Connected Fitness strategy. The way that people consume media has dramatically shifted in the last five years from traditional channels like TV to new channels like mobile. The company is using its apps to integrate the brand with users. E-Commerce growth over the next five years will be driven by its MapMyFitness, MyFitnessPal, Endomondo and UA Record applications.

UA also sees strong growth from mobile devices. Mobile traffic grew to 59% of total e-commerce traffic in 2015. That’s up from 5% in 2011 and 28% in 2013. The company is looking to raise mobile traffic fourfold over 2014–18. Total business generated from mobile was up 128% in 2015.

Under Armour’s Connected Fitness platform has over 190 million registered users. Athletic engagement implies more use of its gear and therefore more sales. Going by the current rate, Connected Fitness would have about 385 million registered users by 2018. The Connected Fitness platform allows UA to gain exposure to the $2 trillion food and nutrition market and the $8 trillion health and fitness market. These two markets make the $250 billion sports apparel market look small.

The global wearables market has turned into a battleground for many companies like Fitbit and Apple in recent years. UA is attacking the market from the software side which is probably the only way they can. One in five wearable devices is able to sync to UA’s fitness platform which helps drive sales.

Q3 Earnings Report

The Company surprised investors on their Q3 conference call and updated their long-term guidance. Management indicated that EBIT would be about $200 million lower than they had previously guided. The top line revenue growth guidance was in line with expectations. I believe that half of this $200 million is the result of unfavorable expected currency headwinds and the effects from the Sports Authority liquidation which were not baked into previous guidance. The other half will be used for accelerating infrastructure build, people, and Connected Fitness. I expect CapEx to move towards the 8% mark next year and FCF to swing positive in 2019. I believe the long term growth opportunity in Under Armour remains healthy.

In Q3, UA saw footwear up 48% Y/Y and international was up 74%. These two drivers remain key focal points going forward. In fact, management indicated that during the back-to-school timeframe UA’s footwear market share nearly doubled. In addition, management highlighted that while they sold 30MM pairs of shoes last year, they anticipate selling 40M pairs this year-still well below the 500M pairs that Nike sells. During the quarter, running was highlighted for footwear and the Company has continued to make inroads with women’s footwear. In basketball, the Curry 3.0 were released two weeks ago. This follows the tour that CEO Kevin Plank and Steph Curry made through Asia in September.

Valuation

So how much do you have to pay for all of this? In short, a lot. This is another one of these story stocks that you have to pay up for to get involved. However,the valuation has come down quite a bit since the stock dipped after their Q3 miss. The question is, what is a fair price for the Company?

IS Estimate Pic

IS Product Estimate Pic

After this most recent pull-back, shares are trading at 46x next year’s reset number and about 40x my FY18 estimate. Historically, shares of UA have traded at an average three-year forward P/E multiple of 59.3x (peak: 73x; trough: 40.1x). Since the Q3 miss, the P/E has been more in focus vs. P/S (given that earnings are revised down with higher investment). On a P/S basis, UA is trading at 2.5x FY’17 estimates. Historically, shares have traded at an average three-year average forward P/S of 3.4x (peak: 4.2x; trough: 2.5x). Today the shares are trading at the trough P/S valuation.

Conclusion

UA is a terrific business and a great story. However, the valuation is difficult for me to get comfortable with. The stock may go much higher from here but I can’t buy UA at 46x forward earnings. There is too much risk if the Company were to guide down again. The expensive valuation is pricing in continued robust growth in athleisure. Short seller Jim Chanos believes that athleisure is a bubble. He might be right, he might be wrong. I know there are some value guys that are buying the stock right here. However, if growth in athleisure slows, you do want to be stuck in a stock that trades at 46x forward earnings. I would love to own this name at a more reasonable valuation.

Disclosure


 

No Position

Hain Celestial – Is It Your Cup of Tea?

Hain Logo

Overview:

The Hain Celestial Group, Inc. (HAIN) produces, distributes, markets, and sells various natural and organic foods as well as personal care products with operations in North America, Europe and India. The company offers popular better for-you groceries (non-dairy beverages and frozen desserts, flour and baking mixes, cereals, condiments, cooking oils, infant and toddler food, etc.), snacks (potato and vegetable chips, organic tortilla style chips, whole grain chips and popcorn, etc.), and tea (include herb teas such as Lemon Zinger, Peppermint, Mandarin Orange Spice, Cinnamon Apple Spice, Red Zinger, etc.).

The Hain Celestial Group is the largest manufacturer in the natural foods segment and has several leading brands. Some of the prominent brands are Celestial Seasonings, Earth’s Best, Ella’s Kitchen, Terra, Garden of Eatin’, Sensible Portions, Health Valley, Arrowhead Mills, MaraNatha, SunSpire, DeBoles, Casbah, Rudi’s Organic Bakery, Hain Pure Foods, and Spectrum.

The company also provides natural personal care products under brands such as Avalon Organics, Alba Botanica, JASON, Live Clean and Queen Helene. The products of the company are principally sold to specialty and natural food distributors and are marketed nationwide to supermarkets, natural food stores, and other retail classes of trade including mass-market retailers, drug store chains, food service channels and club stores.

The company completely acquired Hain Pure Protein Corporation (HPP), which processes, markets and distributes antibiotic-free chicken and turkey products. The company also has a 50% stake in a joint venture, Hutchison Hain Organic Holdings Limited (“HHO”) with Chi-Med, a majority owned subsidiary of Hutchison Whampoa Limited.

 Markets:

Healthy Snack Foods

The Healthy Snack Food Production industry, which creates goods such as healthy chips, pretzels, roasted nuts, peanut butter, popcorn and other similar snacks, benefited from increased demand over the past five years. As the economy has continued to strengthen, discretionary income levels have climbed. In turn, renewed consumer spending has boosted sales of healthy chips, along with nuts and seeds. The price of key ingredients such as corn and wheat has also fallen for much of the period, reducing costs and expanding profit margins. Overall, industry revenue is anticipated to increase at an annualized rate of 5.8% over the next five years. This includes anticipated growth of 6.8% during 2016, bringing total revenue to $16.0 billion.

Shifting food consumption trends have affected the strategies of snack food producers. Specifically, growing health concerns about eating foods high in sodium, fat and sugar have made some consumers wary of consuming traditional snacks. Companies like Hain have entered the market with innovative products such as kale chips and roasted chickpeas. Demand for nuts and seeds have also grown as Americans have increasingly reached for trail mix and other healthy snacks. Additionally, as consumers demand more healthy versions of existing snacks, producers are expected to introduce a wider variety of products. The array of nontraditional ingredients currently used for snack production, such as taro root and butternut squash, indicates creativity will also be a key factor in future success. Hain has an extraordinary portfolio of brands that continue to innovate this industry.Snack Brands

Tea

Growing health awareness among Americans, coupled with new studies touting the healthful, antiaging benefits of tea, has bolstered industry demand considerably over the past decade. The tea industry is growing nearly twice as fast as coffee. According to the Tea Association of the USA, Americans drank over 80.0 billion servings of tea in 2015, representing a 10.0 billion serving increase from the 2014 figure. The overall industry is expected to grow at an annualized rate of 2.8% over the next five years.

Consumers are changing their dietary patterns to incorporate low-fat and low-sugar products, such as tea, as alternatives to staples like soft drinks and coffee. This dietary change is in response to the wave of publicity encouraging healthy eating and living habits; scientific findings and media reports are constantly reminding consumers to adopt healthier lifestyles. The increasing age of the population represents a potential for growth in the industry. While the aging baby boomers are usually not in the market for ready-to-drink iced teas (e.g. Arizona or Snapple), they are the main drivers of specialty teas like Hain produces.

 Poultry/Protein

In recent years, adverse health effects associated with red meat consumption have driven some consumers toward alternative protein sources. Among these sources are poultry and meat alternatives. New consumer trends have emerged around livestock feed and how those animals live their lives. Poultry and meat producers have responded by increasingly differentiating their products (e.g. grass-fed beef, free-range or caged chickens and organic products). The poultry and alternative meat industries are set to grow at an annualized 4.1% over the next five years.

Disease outbreaks are becoming social concerns which are pushing people towards organic meats. Concerns about the use of antibiotics and chemicals in meat production are leading some consumers to shift into new products. As customers move away from red meats, meat substitutes like seafood and eggs are also gaining market share.

The primary risk in this industry for Hain is around the cost of feed. Current forecasts expect poultry feed costs to rise over the next five years. These cost increases could be worse than forecasted if competition and demand for organic feed rises. However, Hain’s poultry and protein segments are positioned well in the marketplace to take advantage of social trends.

Personal Care

The cosmetic and beauty industry is a mature industry that will grow in line with US GDP growth. Hain’s primary focus in this market is in skin care products. Skin care is the largest product segment within this industry, accounting for an estimated 28.9% of total revenue. This part of the market has grown faster than the rest with anti-aging creams and other facial creams. This category includes facial creams and cleansers, functional products (products that serve a specific purpose, such as anti-acne or wrinkle-reducing agents) and men’s skin care products. Skin care products can command some of the highest price tags in the industry, with two ounces of some skin products selling for upwards of $200.00. A focus on antiaging treatments has boosted this segment’s visibility in the past five years. Companies looking to gain market share often invest in the creation of new products aimed at preserving a youthful appearance.

In the last five years, research has linked certain cosmetic ingredients to long-term health problems like cancer, which has led many consumers to shy away from traditional makeup. As a result, products featuring natural and organic components are increasingly gaining favor in the market. This will be a huge tailwind for Hain going forward.

Mergers & Acquisitions

Since its founding in 1993, the company has used acquisitions to drive growth. Revenues quadrupled from 1998 to 2000, when Hain and Celestial merged. Since the financial crisis, Hain has been on a buying spree. In the last five years, they have made 19 acquisitions that have expanded their product offerings into new markets. Hain has posted a 24% CAGR since 2010 and revenues are expected to be close to $3 billion this year. Irwin Simon, CEO and his team have done a terrific job with creating synergies and shareholder value. They have a superior knowledge base and understand consumers better than their competitors.

Brands

Greek God’s

Greek God’s produces all natural, Greek-style yogurt, which is sold in natural and grocery retailers. Greek-style yogurt sales have grown over 400% in the last five years. I use a company like Chobani for the comp. Chobani has grown Greek-style yogurt sales from $78 million in 2009 to a projected $1 billion in 2016. Greek God’s had sales of $25 million in 2010. I expect them to reach $125 million or more this year. The Greek-style yogurt industry is expected to grow another 120% over the next five years.

Hain purchased Greek God’s in 2010. The terms of the deal were not disclosed. However, even if Hain paid 4x revenues, this has still be a terrific acquisition. The industry continues to grow and the move by Whole Foods to drop Chobani in 2013 has benefited Greek God’s. A conservative sales estimate of $125 million for 2016 and a 2x revenue multiple translates to a valuation of $250 million. As the Greek-style yogurt industry continues to grow, this brand could be worth $500 million in the next five years.

Ella’s Kitchen

Ella’s Kitchen is a manufacturer and distributor of premium organic baby food under the Ella’s Kitchen brand and was the first company to offer baby food in convenient flexible pouches. They perform research that indicates sensorial interaction with food is the key to cultivating positive attitudes towards eating, which in turn can create healthy eating habits that will last a lifetime. The organic baby food industry has experienced dramatic growth in the last five years. It is expected to continue to grow as more research indicating potentially harmful effects of chemicals and pesticides on children. Organic baby food sales are expected to grow at an annualized 20% over the next five years.

Hain purchased Ella’s Kitchen in 2013 for an undisclosed amount. Ella’s generated $70 in sales in 2012. I expect Ella’s to make $110 million in sales this year.

Spectrum

Spectrum is a California-based manufacturer and marketer of natural and organic culinary oils, vinegars, condiments and butter substitutes under the Spectrum Naturals brand. They also sell essential fatty acid nutritional supplements under the Spectrum Essentials brand, sold mainly through natural food retailers. Spectrum is also a supplier of natural, organic and non-genetically-modified oils to food manufacturers in the United States through its Spectrum Ingredients Division.

Spectrum was purchased in 2006 for a mere $34.5 million. Spectrum is likely to reach $125 million in sales this year as their products are sold in broad array of retail stores. The company has expanded their product mix and entered new markets since the acquisition. The Spectrum brand is worth as much as $250 million today.

Revenue Recognition Issue

On August 15th, Hain Celestial filed a press release disclosing the Company had identified concessions made to certain distributors in the US that they would be reviewing. The review is around the timing of the revenue recognition. The Company is currently evaluating whether the revenue associated with these transactions were recorded in the correct period and is evaluating internal controls over financial reporting.

While I have not spoken to the company directly, I am fairly confident that the issues called out surrounding concessions and revenue recognition are minor in nature. The language used in the press release is challenging to understand at best. Based on what was disclosed, there are a couple of different accounting questions surrounding concessions/deductions and the pass-through of final discounts Hain makes to retailers. In the press release, Hain noted questions around whether revenue associated with distributor concessions was accounted for in the correct period, as historically, the company “recognized revenue pertaining to the sale of products to certain distributors at the time the products are shipped to such distributors.” My interpretation, although with no specific guidance from Hain, I believe this is related to sales to distributors that are eventually pushed to retailers with some form of growth rebate and/or charge-back accounting estimates.

ASC 605-10-25-1 is the revenue recognition standard that outlines the two factors that must occur for revenue to be recognized. 1) Must be realized or realizable. To be realized, products, must be exchanged for cash for the right to cash. 2) Being Earned. Revenue is not recognized until earned, revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. This standard is fairly straightforward. The wildcard is the concessions/deductions and pass-through of final discounts Hain makes to retailers. To be recognized, the amount of revenue must be determinable. In this circumstance, this would not occur until the distributor has sold the product to the retailer. Historically, the company “recognized revenue pertaining to the sale of products to certain distributors at the time the products are shipped to such distributors.” A screenshot of their revenue recognition practices from their 10-k is below.Rev Rec 10-K

In Hain’s 10-K filing, it notes sales incentives and promotions are used to support the sale of product but the expense recognition is estimated. While Hain noted these alterations are normally insignificant and generally in the same period, when factoring in two layers of selling the accounting treatment becomes difficult.

Financial Statement Impact

The Company has already indicated the amount of revenues will not change, only the timing of revenues. The change in timing will have some effect on margins. Assuming concessions make up 10% of revenues would imply a mere 1% revenue timing impact. I assume “concessions” refer to manufacturer charge-backs (MCB’s) deductions, growth rebates, and discount terms. There is a bit of a difference in the accounting treatment between rebates and manufacturer charge-back (MCB’s). For rebates, a company earns a “growth” rebate, earning extra bps of purchases for the year if they reach a growth target. If they are targeting 7% and they grow 2%, the customer doesn’t accrue rebate (works opposite way also). For charge-backs, Hain might say to a retailer “You earn X% off every case you sell”, If they estimate 60 cases and sell 100 cases, an accrual needs to be based on 100 cases now, and visa-versa. The ending charge-back is sometimes a waiting game which creates the timing issue. Assuming that 10% of Hain’s total revenue is associated with “concessions”, the timing issue should be small in nature.

Result of Review

I believe the outcome will be a revision to previous financial statements. This would be much better than a restatement of previous financial statements. I have reason to believe the probability of a material weakness in controls or a material misstatement in previous financials is remote. I think it is likely the concerns around revenue recognition are overblown.

Project Terra

Over the next three years, (FY17-FY19), Hain indicated it expects $100 million in global cost savings from its project Terra in addition to the $50 million in cost saving initiatives in FY16. Hain has retained Boston Consulting Group (BCG), and hired new COO Jim Meier’s to support the initiative.

Five Key Areas

Procurement & Logistics

Set up a procurement group in Lake Success with will oversee global purchasing and cost reduction. Will rebid freight lines and revisit transportation routing guides and contracts.

SKU Optimization

Identify low volume SKU’s to rationalize and replace with high-volume SKU’s. To date, Hain targets brands representing a total $30M in sales to package for divestment.

Optimizing Co-Packing Network

Reducing the number of co-packers, rebidding key categories and identifying joint purchasing opportunities with vendors and suppliers.

Facilities Rationalization

Reevaluating make versus buy across entire network or facilities

Reduce Spoilage & Discards

Reinvesting in systems, processes and reevaluating spoilage allowances.

Margin Effects

With the anticipated savings from Project Terra, I believe Hain could return its US segment operating margins to FY15 levels (17.1%) with limited investment efforts. The cost savings are expected to be reinvested to generate growth in US brands. If Hain can achieve US segment operating margins in FY17 of 17.1%, then, even with no revenue growth, Hain would generate EPS of $2.13 (consensus $2.15). If they can achieve these margins and also hit their goal of mid-single digit revenue growth, I believe they can generate EPS of $2.20 or higher.

Risks

There are several risks to my thesis primarily because this is a competitive and growing market.

Increased Competition

Retailers have added investments in natural/organic private label offerings. Food retailers across channels are slowly adding natural/organic private label products. Furthermore, many large CPG competitors are shifting strategic focus towards expanding their natural/organic food portfolio either through M&A or strategic shifts in brands. Either of these strategies could place potential market share pressure on Hain’s portfolio.

Change in Tastes

A slowdown in consumption of natural/organic foods caused by an economic slowdown, or consumer trends is a risk to the company. A change in consumer tastes away from healthy foods or another negative event resulting in a decrease in demand for natural foods.

Organic Food Supply

A tightening in organic food supply could cause sourcing issues. 95%+ of Hain’s portfolio is non-GMO. Both organic and non-GMO products have experienced supply tightness as demand has outpaced supply at times. While Hain has operated in this environment for over 20 years, unfavorable input prices and/or product shortages could impact Hain.

Goodwill Impairments

Hain has created material goodwill on its balance sheet from historical M&A activity. Unexpected impairment of goodwill would adversely affect the price of the stock.

Valuation

The Company is trading near 52-week lows today at about $35. The stock traded down to where it is today back in January before running to $55. Due to the Company delaying its earnings announcement, it has made a round trip. As I have mentioned previously, I am not relying heavily on forecasts or valuations. My forecasts are biased and therefore, often wrong. The biggest advantage I have is understanding a particular business better than most and focusing on pieces of information being overlooked by the market. I have looked at Hain several different ways.

DCF Model

The Company has a fiscal year end of June so they are well into FY17. My income statement estimates are shown below. Results from Project Terra begin to show up in FY18 as margins begin to widen. From a financial perspective, the company was operating better in FY14 than today. Notice how they have cut SG&A to keep income margins 7-7.5%. However, current initiatives from the company will boost margins.

IS Estimates

Using the inputs above we get to the valuations in the chart below.

Hain Stock Valuation

In a normal growth valuation, a 9% growth rate was used. This is significantly slower growth than the 24% CAGR the company has posted since 2010. Project Terra will allow the Company to operate more efficiently and most importantly cut down on SKU’s. The median value of the stock is about $45. This represents about 29% upside.

Sum of the parts

Hain SOTP

A sum of the parts valuation indicates the stock is worth about $55. This represents about 55% upside. The sum of the parts story is tough considering this would be an M&A price. Today, the company might have too many SKU’s for a Craft Heinz or a Mondelez to be interested. However, if Project Terra cuts SKU’s, Hain will become more attractive. As the Company executes Project Terra, it may find groups of brands that would be attractive to a General Mills or Craft.

Bottom Line

The Company should be wrapping up their accounting review soon and will release delayed earnings. I believe the probability of a material weakness in controls or a material misstatement in previous financials is remote. I anticipate a revision to previous financials. I think it is likely the concerns around revenue recognition are overblown. Once the accounting review clears, investors will once again focus on the business. I have bought some HAIN near $35.

Disclosure


 

Long HAIN

 

 

 

Tribune Media Continues To Trade At Massive Discount

TRCO HeadlineOverview: I like Tribune Media Company at $36. I’ve owned it for almost a year and I continue to believe that it is trading at a substantial discount. Tribune is asset rich and is beginning to monetize its real estate assets. The company continues to build WGN as the total audience is up 51% y/y. WGN has three very promising original series’ which will drive audience growth. The potential monetization of spectrum could represent a cash flow boost, although there is much speculation about demand and price per market. The company operates in markets such as New York and Hartford where demand is likely to be strong. A sum of the parts valuation shows lots of value.

Market Overview

The United States broadcasting market has produced moderate growth in recent years and is expected to produce slightly lower rates of growth over the next decade. The United States is easily the largest global market for broadcasting and much of this is due to the investment in content and the popularity of this content abroad. Growth is driven by advertising and subscriptions growth, with advertising being very strong despite the trends which are moving advertising revenues into digital spheres. The broadcasting TV market has produced a 2.2% CAGR over the last five years. It is expected to slow to 1.2% over the next five years.

The value of Tribunes 42 owned or operated broadcast television stations is largely dictated by the quality of the content. Content quality is determined by total audience to make the product marketable to advertising businesses. WGN is thriving in this area with their Outsiders and Underground original series’. The rise in popularity of downloading programs, both legally and illegally, is having an impact on the market.

Cable networks are direct competitors of television broadcasters for viewership, advertising dollars and TV ratings. Cable television programming has historically been the largest rival to major broadcasters in terms of total viewership. Viewers who subscribe to the expanding range of alternative television content providers, which include basic and premium cable packages consisting of hundreds of unique programming options, are likely to reduce viewership of traditional broadcast programming. The number of cable TV subscriptions is expected to decrease in 2017. However, this negative trend will likely not have a large effect on broadcasters. Many people, myself included, have cut the cord and have purchased an HD antenna enabling us to watch traditional broadcast programming.

Economic Drivers

The major driver in broadcasting growth is disposable income which is affected by labor market growth, unemployment and interest rate changes. In addition, disposable income is a key determinant of retail sales and expenditures on other goods and services which can directly influence advertising expenditure on TV. Per capital disposable income is expected to increase in 2017.

Changes in the Market

In the last five years, operators in the television broadcasting industry have undergone structural changes to contend with stagnating revenues. Broadcast revenue is largely dependent on sales of advertising spots, which are determined by their advertisers’ corporate profit and the disposable incomes of their viewers. Although advertising expenditure has increased along with rising disposable income and corporate profit in the last five years, the media landscape has become increasingly competitive. Consumers are shifting towards online media for their news and entertainment, prompting advertisers to shift their spending away from traditional television broadcasting. In addition, platforms like Hulu and Netflix directly compete with industry broadcasters to provide new content.

Media Fragmentation

Advertising expenditure has recovered strongly since the financial crisis. However, advertisers now have a wider range of channels to reach their audiences. Historically, advertising and marketing has been spread across broadcast television, radio and cable, print media, and direct mail marketing. The advent of the internet and social media has dramatically boosted media access through social networks, streaming platforms, RSS feeds and podcasts. Advertisers have realized the power of online media, which allows for targeted ad campaigns that were impossible with previous forms of broad-based advertising. Social media networks can tailor ads to specific demographics, attracting a greater portion of advertising budgets. Over the same period, people have adopted digital video recorders (DVR) and on-demand programming. Together, they have decreased audiences attention to TV commercials which has lowered the price that advertisers are willing to pay broadcast networks for ad time. Services like Netflix, Hulu and cable-free subscription packages from HBO and Showtime enable more content variety and viewer control. The accelerating media competition will be a headwind to the broadcast industry’s growth prospects.

Broadcast TV Networks

Broadcast TV networks are composed of TV stations that release the same programming through several stations (i.e affiliates). This strategy saves time and cuts costs associated with programming for separate stations which allows broadcasters to negotiate better prices for advertising to a mass audience. The bulk of airtime is made up of programming developed for national broadcasting but certain time slots are designated for local or regional programming.

Next Ten Years

Broadcasters are now receiving monetary compensation from cable operators through retransmission fees. Demanding payments for the retransmission of content has forced cable operators to charge more for their packages. This revenue stream has reduced volatility for broadcasters because cable contracts are typically renewed annually.

Rising advertisement spending and disposable income will support the industry over the next decade. Total US advertising expense is expected to grow at an annualized 4.4% over the next decade. Competition from new media that allows advertisers to target specific audiences for less will make attracting TV broadcasting ad revenue more difficult.

The major development in the industry over the next decade will be interactive TV. This change will customize viewing experiences for audiences. By making TV interactive, broadcasters will be able to offer advertisers a more direct way of selling products and services to targeted audiences. Broadcasters will have features that allow a viewer to order a product in a commercial just with a click of the remote. Features like this may not be received well by online streaming audiences who prefer zero commercials. This opportunity has the potential to boost ad revenues and could possibly take market share away from social media platforms.

Tribune Media Segment Overview

Television and Entertainment

This is the larger of the two segments and includes Tribunes 42 broadcasting stations. This segment accounts for 85% of Tribunes revenues. A breakdown of this segment is shown below.

TRCO TV Seg

The primary drivers of the business are advertising and retransmission fees. As Tribune operates in some of the best quality broadcasting markets, it supports advertising revenue to grow modestly going forward. TRCO owns or operate local television stations in each of the nation’s top five markets and seven of the top ten markets by population. Tribunes stations and local news reach is approximately 50 million U.S. households in the aggregate, representing approximately 44% of all U.S. households.

The business owns a national general entertainment cable network, WGN America, which is distributed to more than 80 million households nationally. In 2013 the company created Tribune Studios to source and produce original and exclusive content for WGN America and local television stations. Tribune Studios provides alternatives to acquired programming across a variety of segments. WGN has three hit series’, Underground, Outsiders, and Salem. These three are helping drive retransmission fees and audience growth. The table below presents WGN’s lineup of series. This table does not include Salem as it is their newest series.WGN

Digital and Data Segment

The Digital and Data segment is comprised of a company named Gracenote. The company provides music, video, sports, and auto metadata to users who are often brands.

Gracenote Music

Gracenote Music is one of the largest sources of music data in the world, featuring music data for more than 235 million tracks, which helps power over a billion mobile devices including smart phones, tablets and laptops and many of the world’s most popular streaming. Music data includes a variety of content such as artist name, album name, track name, music genre, origin, era, tempo, mood, as well as album cover art and artist imagery. Gracenote Music derives the majority of its revenue from licensing its music data, software and services in the B2B segment to music services and to Tier 1 suppliers to the world’s leading automakers.

Gracenote Video

The video segment provides data around TV shows and movies, such as descriptions, genres, cast and crew details, actor long- and short-form biographies, imagery, TV schedules and listings, TV episode and season information and unique program IDs. Gracenote Video derives the majority of its revenue from cable, satellite, online, consumer electronics and other business-to-business (“B2B”) channels.

Gracenote Sports

The sports segment provides live data and statistics from over 4,500 leagues and competitions, such as the National Football League, Major League Baseball, National Basketball Association, National Hockey League, Premier League, F1, Bundesliga, Tour de France, Wimbledon and the Olympics, among others.

Gracenote Automotive

Gracenote Auto provides Automatic Content Recognition (ACR) technology into any car’s audio system to identify music playing from various sources including AM/FM and satellite radio, CDs or streaming services and deliver relevant metadata and cover art. In December 2015, Gracenote launched its first audio technology, Gracenote Dynamic EQ, designed to help automakers and OEMs automatically tune connected car audio systems to the optimal equalizer settings for individual songs based on genre, mood and release date.

Today, data powers the algorithms that make movie and music recommendations possible for popular on-demand video and streaming music services. Demand for data has grown from consumers, and therefore distributors. Gracenote has a large variety of distributors including companies that deliver music, video and sports content to consumers through devices, platforms and applications. Gracenote is uniquely positioned to take advantage of this increased demand for entertainment data as it provides data on a large scale in the four largest entertainment categories – TV, movies, music, and sports.

Real Estate

Tribune owns the majority of the real estate and facilities used in the operations of the business. The real estate portfolio comprises 74 properties after its recent sales. In April, TRCO entered into an agreement to sell a property in Pennsylvania. On May 5th, TRCO entered into agreement for the sale of the north block of the LA Times Square property and the Olympic Printing Plant facility in LA. (A previously agreement for the sale of the LA Times Square property was terminated in Q1’16). It is estimated that the entire real estate portfolio is worth between $1 billion and $1.1 billion. Management has estimated it at $1 billion and said on August 30th that the recent sales are in line with this valuation.

Investments

Tribune holds a variety of investments in broadcasting and digital assets. The two large investments that produce the most cash flows are in the TV Food Network and CareerBuilder. Tribune owns 31% of the TV Food Network and 32% of CareerBuilder.

TV Food Network

The TV Food Network has two television networks, The Food Network and the Cooking Channel. TRCO’s partner in TV Food Network is Scripps Networks Interactive, Inc. (“Scripps”), which owns a 69% interest in TV Food Network and operates the networks on behalf of the partnership. Food Network programming is divided into a daytime block known as “Food Network in the Kitchen” and a primetime lineup branded as “Food Network Nighttime”. “In the Kitchen” is dedicated to instructional cooking programs, while “Nighttime” features food-related entertainment programs, such as cooking competitions and reality TV shows. As of February 2016, Food Network is available to approximately 97,652,000 pay television households (83.9% of households with television) in the United States. The Cooking Channel focuses on providing content around food information and instructional cooking. As of February 2016, Cooking Channel is available to approximately 63,772,000 pay television households (54.8% of households with television) in the United States.

CareerBuilder

CareerBuilder.com, is the largest job website in North America on the basis of traffic and revenue. CareerBuilder offers a variety of services including talent management software, recruiting platforms, and employee retention solutions. CareerBuilder operates in over 65 markets and operates websites in the United States, Europe, Canada, Asia and South America. Tribune’s partners in CareerBuilder are TEGNA Inc. and The McClatchy Company, which together own a 68% interest in CareerBuilder.

Financial Overview

On February 24, 2016 Tribune announced a massive $400 million buyback. As of August 5, 2016 they had purchased $96 million. Once completed, this buyback program will allow management to repurchase over 13% of the company. Repurchase programs of this size cannot go unnoticed by investors due to the sheer size. Actions speak louder than words and management is taking advantage of an undervalued stock. Additionally, shareholders are getting paid to wait for the market to understand the story. The stock yields about 2.8% which is very generous.

Tribune’s broadcasting business will be supported by the strong markets they operate in. Owning or operating affiliates in seven of the top ten markets will help generate continued advertising growth.

TRCO Estimates

The broadcasting business provides a stable operating environment. However, political spending drives advertising revenues which is reflected in the 2016 and 2018 estimates. The amount of political spending as been a bit disappointing during the presidential campaigns. Neither candidate is spending as much as anticipated. The distribution between traditional media and social media is as expected.

Tribune Media is a sum of the parts story. The company has two primary segments in broadcasting and digital but also holds many valuable assets. These assets are being undervalued by the market. As the company begins to monetize some and grow others, I believe the market will notice the massive discount the company currently trades at.

TRCO SOTP

A sum of the parts valuation indicates the stock is worth $64. This represents 80% upside. There is an ongoing FCC spectrum auction that should be over in the next 6 weeks. The spectrum market has support from cord-cutters purchasing HD antennas to watch broadcasting stations. There continues to be a lack of spectrum in the market and I expect this to continue. The outcome of this auction could be a near term catalyst for the stock.

I have owned the stock for almost a year and as of today, it is a loss (Average price about $37). I continue to believe the stock is trading at a massive discount. I am comfortable with the valuations of their investments and the real estate portfolio. It doesn’t appear that they have many level 3 investments which gives me confidence in the $1 billion valuation they have placed on the real estate portfolio. I continue to like the 2.8% dividend yield and the large repurchase program in place. I believe the market will begin to see the value in this company in the next 12 months.

Disclosure


Long TRCO