UFI - The Painful Wait For A Volume Recovery At Unifi Drags On

2023-10-04 12:25:16 ET

Summary

• Unifi's stock has continued to struggle due to ongoing volume pressures tied to weak retail clothing volumes.
• With underwhelming demand, clothing retailers are still reducing inventory levels, leading to a prolonged period of under-ordering.
• Unifi is managing the downturn well, but weak volumes are devastating to profitability, and the company's capacity utilization is a significant factor.
• The shares look undervalued below $9 but an underwhelming Christmas season could further extend this painful customer inventory correction cycle.

When I last wrote about Unifi ( UFI ) I noted the risk that this stock would struggle to perform so long as there were ongoing volume pressures in the business and that the outlook for a sharp rebound in clothing volumes was not especially good. Such has proven to be the case. While I believe that Unifi’s team is managing this downturn about as well as could be reasonably expected, there’s no getting around the ongoing inventory destocking in the clothing sector and the operating leverage pressures this creates for the company.

Down another 25% since my last update, the story here remains basically the same – investors have to have confidence that this painful customer inventory correction process will end in the coming quarters, volumes and margins will recover, and Unifi can generate better results over the long term as clothing brands and retailers increasingly turn to more sustainable products (where the company’s leading REPREVE 100% recycled fiber brand can shine).

Retail Is Still Not Looking Especially Robust

Clothing retailers have been pushing hard to reduce inventory levels for some time now, and while there has been progress, that progress has been tempered by ongoing weakness in overall spending.

A few categories have done relatively better (athletic and specialty athletic), but overall clothing spending has continued to decline at a single-digit rate throughout 2023 as per Bank of America research (generated through the company’s credit card data). The rate of decline has been improving – from around down 8% in February to down 3% more recently – but this general malaise has led to a more protracted period of inventory correction and under-ordering. At the same time, a recent survey of discretionary consumer retail spending from Morgan Stanley has shown growth trending down from mid-single-digit growth for most of the year to the low single-digits in recent months.

The ongoing risk here is fairly straightforward – if the Christmas shopping season is soft and inventories aren’t further depleted, the lackluster re-ordering patterns will continue, further compromising Unifi’s operating leverage and profitability. At the same time, I note the recent decline in REPREVE as a percentage of total sales – I suspect that this is a byproduct of customers trading down (REPREVE is often used in higher-end prestige products) and being less willing to spend up for features like sustainable materials in a period of inflationary pressure.

Unifi Doing What It Can, But It Can Only Do So Much

As a manufacturer with relatively high fixed costs, weak volumes are devastating to Unifi’s profitability (the flip side being that when volumes are robust, incremental margins are quite attractive).

This is further exacerbated by the company having spent considerable sums in recent years to expand and refurbish its manufacturing capacity in the Americas, leading to meaningful under-utilized capacity. To that end I note that Unifi generated a gross profit margin of (3.8%) in FY’23 on revenue of just under $390M, while generating gross margins of 9.4% and 2.9% in FY’21 and FY’20 (respectively) on revenues of $387M and $380M. Not all of this is due to capacity or volumes (higher input costs are also a factor), but I do think capacity utilization is an important factor.

Likewise, I note that the asset-light Asian operations have seen a less pronounced deterioration in profitability. Gross margin actually improved 60bp in FY’23 (to 14.6%) on a 44% decline in revenue; likewise, Q4’23 segment operating profit actually improved by over a point (from 13.3% to 14.6%) despite a 35% decline in revenue (including a 34% decline in volume), as gross margin actually improved 110bp year over year.

Looking at the next few quarters, I expect management to be as careful as they can with spending. They’ve already made the decision to defer the remaining 25% of their capex expansion program in the Americas, holding off on further eAFK Evo machines from Oerlikon ( OERLY ) until perhaps as late as 2026, as the company looks to preserve cash and limit additional under-utilized capacity.

Management is also trying to better sync production to order volumes. While the company is not engaging in sweeping layoffs (instead relying on attrition to more gradually reduce headcount), it did close plants for a week around July 4 and I wouldn’t rule out similar moves in the future if orders don’t rebound.

While some investors may clamor for more aggressive headcount reductions, I think Unifi has to be careful – the North Carolina unemployment rate is below the national average, companies are establishing or expanding plants in the state, and I wouldn’t say it’s a guarantee that the company could just assume they’d be able to re-hire the workers they need when orders rebound (particularly if that rebound comes within the next year).

The Outlook

I’ve pushed out and stretched out my expectations for a recovery in Unifi’s business. I don’t expect a particularly sharp recovery in calendar 2024 for the clothing sector, and I’ve decided to go with a low single-digit volume growth estimate (3%) for Unifi’s America business as I think there will still be a very cautious ordering environment over the next few quarters. I do think business will pick up in fiscal ’25 and ’26, though.

A weaker volume recovery means weaker incremental margin recovery as well. I still expect a return to mid-single-digit adjusted operating margins (4%-5%), but it will likely take longer now.

A key ongoing unknown is the adoption curve for REPREVE. As I’ve said in prior articles, many of Unifi’s customers are targeting significantly increased usage of recycled fibers over the next few years, and Unifi is not only a leading provider of recycled fibers, but also has arguably the strongest auditing around those claims (many yarn producers make bold claims about their ESG compliance, but fail to substantiate them). This should be a positive for revenue growth and margins, but if customers continue to trade down in the face of higher costs, that adoption curve could get pushed out.

I’m looking for a rebound in the coming years, with a five-year revenue growth of over 7% that could yet prove conservative. Over the longer term, I expect revenue growth of around 5% (or a little over 2% using the prior high water mark), with that growth fueled by increased use of REPREVE and success in ongoing efforts to further penetrate non-clothing channels like automotive and upholstery fabrics as well as packaging and flooring materials.

On the margin side, I’m looking for a return to high single-digit EBITDA margin in three years and long-term margins in the mid-to-high single digits. Again, if orders recover more substantially, there should be stronger incremental margin leverage than I’m modeling. On the free cash flow side I expect a long-term weighted FCF margin in the low single-digits.

Between discounted cash flow and a forward EV/EBITDA (using a margin-driven target EBITDA multiple of 6x and my FY’25 EBITDA estimate, discounted back a year at a double-digit discount rate) I get a current fair value in the $9’s.

The Bottom Line

I can’t and won’t say that Unifi’s turnaround is inevitable and just a matter of time. A lower-for-longer down-cycle in orders could create further liquidity and operating cost pressures that would force more drastic action from management and likely permanently impair the long-term potential of the business.

I view that as a bear-case outcome and I do think there is upside from here, but it’s hard to feel great about the near-term prospects of meaningful order volume recoveries given the current state of the economy. I think there’s still a bull case here, and that patience will be rewarded, but there is definitely a point where patience becomes blind stubbornness and I can’t rule out the risk that Unifi is a value trap.

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