UFI - Weak Apparel Demand Continues To Unravel Unifi's Operating Results

Summary

• Excess inventories among clothing retailers is crushing near-term demand for Unifi's yarns, sending revenue sharply lower and pushing the company into losses as high up as the gross profit line.
• Retailer destocking should finish late in the spring, around the time orders are made for the holiday season, but it will take several quarters for reported results to recover.
• Weak near-term results don't yet threaten the longer-term story, and Unifi looks attractive below $10 given its strong position as a provider of yarns made from recycled materials.

For yarn producer Unifi ( UFI ), a relatively disappointing holiday season was the lump of coal that the company really didn’t need. Apparel retailers were caught flatfooted by a sharp reversal in consume apparel demand early in 2022, leading to unusually high inventories and weaker replacement orders that have flowed through since the holidays. While there was modestly elevated promotional activity during the holidays, clothing sales have continued to fall, leading to very weak orders to their apparel manufacturers and, in turn, weak orders to Unifi for their yarns.

Listening to apparel companies and manufacturers, it sounds like inventories will normalize around late spring – around the time that retailers make their holiday orders. That should drive a restocking cycle for Unifi, and better margins, but the next year and a half or so still look pretty lackluster from an earnings and free cash flow perspective.

The good news, if you can call it that, is that I had low expectations going into this recent quarter and the downside relative to sell-side estimates doesn’t really change my fair value. Unifi is likely not to draw much interest until and unless retail sales and inventory numbers improve and evidence of restocking emerges, but for patient value investors there could still be enough upside here to make the wait worthwhile.

From Bad To Worse

If Unifi’s fiscal first quarter was rough, the second quarter was a beatdown, as volumes plummeted and crushed operating leverage.

Revenue fell more than 32% year over year and 24% quarter over quarter as reported, with a nearly 35% decline in volume hardly offset by a better than 4% benefit from pricing and mix. Revenue was weak across the board, with a 25% organic decline in the Americas (volume down 27.4%, price up 2%), a 58% decline in Asia (volume down 53.4% and price up 5.3%), and a 13% decline in Brazil (volume up 8.1%, but price/mix down 21%).

Sales of REPREVE, the company’s signature recycled fiber product made from recycled plastic bottles, saw a 47% yoy and 12% qoq decline in revenue.

Unifi’s business model isn’t built to withstand that sort of volume pressure, and margins eroded significantly. Gross margin went negative, dropping from 8.4% a year ago and 3.7% in the prior quarter to a negative 5.9%. Margins held up relatively well in Asia (down 40bp to 14.4%), while margins declined sharply in Brazil (down 2,210bp to 5.2%) and the Americas (down 1,600bp to negative 15.3%).

Adjusted EBITDA swung to a loss (-$13M versus a year-ago profit of $11M) and likewise with segment profits (-$2.1M versus $22.3M) and reported operating profit (-$19.8M versus $4.6M). Both Asia and Brazil were profitable at the segment level (with Asia down 56% with a 14.8% margin and Brazil down 78% with a 6.6% margin), while profits in the Americas fell $13.5M to negative $7.5M.

Nothing To Do But Wait

There’s little that Unifi can do but wait out the apparel inventory correction cycle. The company does continue to work with partners in apparel and other markets to find new opportunities for REPREVE, and the company did see new launches from ASICS ( ASCCY ), Arcade Belts , Tom Tailor (TTI.HM), and H & M ( HNNMY ).

Management does expect to see sequential improvements in revenue and operating performance, and a “modest” recovery throughout calendar 2023. Orders for summer assortments would have gone out late in the fall, and given that retail sales were weak during last year’s summer, I wouldn’t expect particularly robust orders.

Brazil has stayed healthier from a demand perspective, but excess capacity in Asia is pressuring prices. Conditions should improve now that we’re past the Chinese New Year, but I expect buyers to be cautious. As far as positives go, though, I do think it’s notable that Unifi has managed to preserve double-digit margins in the face of a 50%-plus decline in volume.

As far as controlling what they can, management is cutting back on some of its variable costs – minimizing nonessential spending, minimizing overtime, slowing material purchases, and delaying new hires (as opposed to launching layoffs). I do see the opportunity to trim a few million dollars out of SG&A on a near-term basis, but that doesn’t really move the needle much in my valuation, and Unifi isn’t facing any immediate liquidity crunches.

The Outlook

With retail inventories still too high and retail sales still contracting, I’ve decided to cut my near-term estimates even further. I’ve cut my revenue estimate to a 19% decline for FY’23 (previously a 7% decline), but I do still expect a meaningful rebound in FY’24 (up 16% versus up 10% previously), as I do think there will have to be some restocking cycle for apparel retailers unless the U.S. is headed towards a severe consumer spending-driven recession.

I was already looking for an operating loss, but my numbers have fallen from a negative operating margin of around 2% to negative 5%, and my EBITDA estimate falls from about $13M to negative $10M.

Beyond FY’23/FY’24, not as much has changed. I still expect around 4% long-term revenue growth, with Unifi well-placed to leverage corporate mandates for increased recycled content in apparel (as well as more intense scrutiny of suppliers, which Unifi is well-placed to satisfy). I don’t believe management will hit its 10% EBITDA margin target, but I do see improvement into the high single-digits, and I likewise expect FCF margin to rebound into the 3%-4% range.

I still value Unifi on the basis of discounted cash flow and an EV/EBITDA approach using my FY’25 estimates. My FY’25 EBITDA estimate is now modestly lower (down 4% to $62.8M) and I’ve lowered my forward multiple to 5x in light of the much weaker near-term operating results, but the fundamentals I model for FY’25 would still support my prior 6x multiple.

The Bottom Line

I think Unifi should trade in the low double-digits based upon its longer-term prospects, but that’s likely off the table until there’s more evidence of a restocking trend among apparel retailers – in the meantime interested readers can watch the earnings reports from those retailers to monitor what they say about sales and inventory trends.

I expect the business to recover from this steep downturn, but it does underline some of the risks that Unifi faces – apparel is more cyclical than commonly believed and operating leverage cuts both ways, crushing earnings when revenues dive. For now, this remains a name that is likely only going to appeal to patient value investors, but I do believe in the longer-term trend of using more recycled materials in apparel, and I still believe Unifi is particularly well-placed to leverage that trend for improved results down the line.

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