Unifi Stock: Sharp Downturn In Orders Doesn’t Unravel Long-Term Story

Weaker retail sales and record-high retailer inventories has led to a sharp reversal in fortunes for Unifi (NYSE:UFI), as this leading producer of recycled polyester yarns has seen a sudden and sharp downturn in volumes this year. That downturn has not only thrown management’s guidance for FY’23 out of the window, but also likely put the company’s former FY’25 goals ($1.1B in revenue, 10%-plus EBITDA margin) out of reach.

This has had a massive negative impact on the share price, with the stock down more than 50% since my last update on the company. This is a huge setback, but I do note that the company is still leveraged to an ongoing trend among major retailers to shift to recycled polyesters and this inventory issue with retail and apparel customers will resolve over the next few quarters. Even with a sharp revision to near-term financials, I still believe there is a bullish case to be made for the shares, though it will take some time to recoup the losses seen in 2022.

Fiscal Q1 Results Bring More Pain

Unifi is barely followed by sell-side analysts, but I don’t think you need robust consensus estimate comparisons to see that it was a tough quarter for the company.

Revenue declined 7% in organic terms, after growing almost 18% in FQ4’22, 11% in FQ3’22, and 23% in FQ2’22, with price/mix up 14% and volume down more than 21%. REPREVE, the company’s higher-margin lead product line (made from recycled plastic bottles, among other sources), saw sales fall almost a third (to 27% of total sales).

Revenue from the Americas segment (a new category that includes the former Polyester, Nylon, and “All Other” segments) saw a 3% organic revenue decline on a 21% decline in volume. Sales in the Asian operations declined 31% on a nearly 40% decline in volume, and sales in Brazil rose more than 14% on nearly 17% volume growth, as apparel demand and overall activity has remained relatively stronger here.

Unifi is getting hit and squeezed by a combination of higher input costs, which the company is offsetting with pricing, as well as volume deleverage, leading to gross margin declining almost 10 points year over year and 470bp qoq to 3.7%. Gross margin in the Americas business went negative (-4.5% vs. 8.3% last year), and declined sharply in Asia (down 22pts to 17.5%), while rising slightly in Brazil (up 50bp to 14.1%).

Adjusted EBITDA plunged 88% from the year-ago level (to 2.3M, 1.3% margin), and operating income went negative (-4.7M versus 13.3M), with segment profits down across the board. The Americas business was just barely profitable this quarter (0.6% margin), while the Asia and Brazil operations saw 30%-plus profit declines, with margins up 50bp to 14.1% and down 1960bp to 18.7%, respectively.

Management rescinded its guidance for the year (which was a little higher than my estimates for the year at the time of that last article) due to the uncertainties in the end-market. Management did guide for further erosion next quarter, with revenue down 10% to 15% sequentially and adjusted EBITDA falling to a smaller loss ($0M to a loss of $5M). Management also said that they do expect volumes to recover once the destocking process is over, but the timing of this recovery is uncertain at this point.

Retailers Cutting Purchases As They Try To Work Down Inventories

Apparel retailers have seen their inventories shoot up to all-time highs, as correcting for prior stock shortages overshot the mark and consumers have started curtailing their purchases. As I discussed in a recent article on American Eagle (AEO), clothing sales have been declining for most of the past year (since March), with double-digit declines starting in October.

This year’s Black Friday promotional activity was higher than average, but not dramatically so and not really what you might expect given the record-high inventory levels. Average discounts have been a little higher this year (reportedly averaging out at around 40%) and a wider swath of merchandise has been marked down, but it doesn’t look like retailers are taking drastic actions to work down inventory, though promotions could ramp up again closer to Christmas as retailers and consumers play a game of chicken with each other.

Early reports on Black Friday traffic have been positive, but I do expect these companies to be cautious about orders/purchases until those inventories work down. Many of these retailers will want to have refreshed spring assortments, so I don’t think they can hold off on new purchases indefinitely, but they may be more cautious with their stocking levels for those spring assortments.

This inventory correction process is further complicated by the growing macroeconomic uncertainties for 2023/24. There’s a growing expectation of a recession in 2023 and if consumers cut back on spending even more, it will stretch out the inventory correction process and lead to a longer period of weak orders for Unifi.

It’s hard to corroborate Unifi’s results with other companies, as most of its peers are privately-owned. That said, Nan Ya Plastics (1303.TW) does offer a little bit of information, with the company seeing a sharp decline in polyester sales in recent months.

The Long-Term Story Still Works

I believe there are still positive long-term trends favoring Unifi, and most of that revolves around corporate sustainability initiatives.

Multiple apparel manufacturers and retailers have committed to significant recycled polyester use around 25%, with companies including adidas (OTCQX:ADDYY), The Gap (GPS), Hanesbrands (HBI), Kohl’s (KSS), Target (TGT), and Walmart (WMT) committing to 50% to 100% use of recycled polyesters by 2024/25. Around one-third of Unifi’s current sales include recycled content, so I do expect Unifi to see growing demand for its recycled products like REPREVE.

In addition to riding a tide of increased recycled content, Unifi has invested resources in transparency initiatives that provide its customers with assurances that the products are what they say they are – an area of increasing concern for many companies.

I also see longer-term opportunities for Unifi to expand the scope of its business. The bulk of its sales, including REPREVE, go into apparel and related products, but there are meaningful opportunities to grow the business in end-markets like automotive and furniture where there is likewise pressure on OEMs to use more recycled materials.

The Outlook

I’m expecting the next two quarters to see negative sequential comps, with a modest recovering in fiscal Q4’23. Where I was previously looking for around 4% revenue growth for FY’23, I’m now expecting a 7% decline ahead of recoveries in FY’24 and FY’25 that will help drive mid-single-digit growth over the next five years. For the longer term, I’m expecting around 5% revenue growth as Unifi continues to benefit from a shift toward recycled polyester yarns and growth outside of its core apparel end-markets.

Higher input and production costs combined with operational inefficiencies are going to hit margins hard for the next year, and I’m expecting sub-2% EBITDA margin in FY’23, around 5% in FY’24, and over 8% in FY’25, with long-term EBITDA margins in the high single-digits. Management had previously targeted 10%-plus EBITDA margins, and while I do think that’s possible, I still remain skeptical that it’s attainable/sustainable on a year-in/year-out basis. Over the long term, I expect this will drive FCF margins in the low-single-digits (in the 3%s) that does represent improvement over the trailing averages.

On a discounted cash flow basis, I believe Unifi shares are priced for a solid double-digit annualized return from here, but clearly there are valid questions about the long-term margins that the business can achieve. Using a shorter-term valuation approach that uses inputs like operating margin, ROIC, and so on to drive a “fair” EBITDA multiple, I believe it’s fair to value Unifi with a 6x multiple on FY’25 EBITDA and discount back two years – doing so gives me a fair value around $14.

The Bottom Line

Unifi has been hit hard by a sudden shift in behavior on the part of its apparel customers, but I believe this is an inventory correction cycle and not a Unifi-specific issue. Likewise, I believe apparel companies will continue to increase their use of recycled fibers and will turn to Unifi to get them, given Unifi’s superior documentation and transparency. Given all of that, I believe the current share price is overreaction, but I do see considerable modeling risk for the next 12-18 months, so investors should regard this as a high-risk proposition.