Description

Company Description: Spun out from Sara Lee in 2006, Hanes Brands is the dominant provider of cotton undergarments and casual basic cotton wear worldwide, operating in a duopoly with #2 player, Fruit of the Loom (Berkshire Hathaway), in its primary undergarment and basics categories, and smaller players including Maidenform (MFB), Gildan (GIL), others in intimates and silkscreened material.  Hanes undergarments are the premium brand sold by its two largest customers – Wal-Mart and Target (26% and 17% of net sales, respectively.)  Hanes manufacturers 63% of its finished goods itself or through a combination of in-house and contracted manufacturing using its 43 manufacturing facilities located in low cost places around the world.

Thesis:  We start with a low valuation.  If things play out as we expect, earnings will be above $3.00 and free cash flow above $4.00 in F2012.  Starting at $24 a share we expect some multiple expansion as concerns around pricing pressure and margin compression prove to be overdone as cotton prices roll off.  We expect working capital to turn from a significant use of cash to a significant source of cash.  At an 11-12x multiple on $3.25 of earnings we see 50-60% upside in 12-24 months.

 Hanes historically has had no top line growth and cash flow has been poor the last few years.  In 2011 they passed through the run-up in cotton prices, the cost of which are hitting the income statement hardest (FIFO lag) in 4Q11 (not yet reported) and 1QF12.  The stock has fallen from $32 + (11x P/E) last spring as investors anticipated that the company would not be able to sustain the 2011 level of earnings as margins compress due to HBI’s higher priced cotton inventory flowing through and fears that customers will begin to place pressure on HBI’s pricing.  Further, investors felt that the company’s unfavorable FCF over the past two years, high debt load, and historical lack of earnings growth merit the stock a low multiple.

 Many investors are concerned that WMT, in particular, will aggressively pursue price decreases over F12 due to cotton input cost declines and ask HBI to reverse its 20% price increases over the past year.  We believe that pricing pressure will be more moderate than anticipated as WMT is actively looking to categories where it can grow its topline through price increases (while being very price competitive in key price-sensitive, traffic-driving categories), and historically, WMT has been reasonable with vendors that occupy the “premium” brand position in each category and exhibit pricing power (think P&G – WMT is known for pushing all of its vendors to optimize their supply chain to give WMT the best price, but it doesn’t have a reputation for trying to run them out of business).  Importantly, according to HBI, HBI’s products sold through at an elasticity of -0.5 (5% less units sold for each 10% price increase at retail) despite a widening dollar price gap vs. Fruit of the Loom.  This suggests a favorable gross profit-dollar (and corresponding flat gross margin) benefit for WMT and others from passing through HBI’s price increases, which we believe will lead them to forego exerting significant pricing pressure as cotton prices decline. 

 Further, by the end of F12, we anticipate that HBI will experience over 500 bps in gross margin pressure vs. F10 levels from labor cost increases, independent of cotton.  As such, in order to maintain at least F10 gross margins (120 bps below our F11 estimate) HBI could only sustain a 7% price decline from today’s level.  Assuming that the retailers would be hesitant to push HBI to below F10 gross margins given the brand’s leadership position in their portfolio, HBI would still have the benefit of SG&A leverage on greater sales, and should still earn above $3.00 in F12 – well above the $2.30 it earned in F10 and above the $2.84 we estimate for F11.

 Note that the “surprise” 3Q11 revenue miss – a key source of HBI’s underperformance since early November – was primarily due to retailers cutting back purchases of intimates apparel after slow sell through to women 35+ all year, despite only 5% price increases in this non-cotton based category (vs. closer to 20% in the cotton intensive categories that HBI sells).  These purchase declines were not due to HBI losing share; Maidenform reported a similar trend during its 3Q call.  HBI did lose share at WMT in 3Q after gaining shelf space over several years when WMT decided to bring in house the design & marketing of the “Just My Size” brand which HBI had previously managed (but not manufactured.)   This will impact revenues into 1Q, but HBI has stated that WMT intends to increase purchases in other areas by 2Q, which should compensate for this loss.  Further, in other categories, it appears that retailers bought below the -0.5 elasticity that HBI has reported at retail in order to keep inventories lean given input cost inflation across apparel.  Given that the lower intimates purchase volumes appear to represent a one-time “catch up”, retailers have likely now destocked in the areas with favorable elasticity, and WMT apparently intends to replace JustMySize purchases by 2Q12, we anticipate gradually increasing unit volumes over the quarters ahead.

 Looking forward, we believe that HBI is well positioned to gradually increase its prices over time (after moderate price decreases at the end of F12 through increased pack sizes as HBI laps F11’s 20% y/y price increases).  For the first time in 30+ years, apparel is facing long term input cost inflation vs. the previous period of structural deflation due to wage increases throughout emerging markets.  As the largest global manufacturer of cotton-intensive undergarments and basics, HBI is the low-cost leader with costs reported to be on-par with private label.  The combination of HBI’s cost leadership and consumers’ willingness to pay a premium for the Hanes brand vs. competitive products in the channel position it well to maintain gross margins through moderate price increases over time to keep pace with input cost inflation.  Through maintaining gross margins on an increasing topline, HBI should experience SG&A leverage, leading to margin expansion. 

 HBI is just beginning a concerted effort to expand into emerging markets, which still remain highly fragmented (apparently the largest cotton undergarments manufacturer inChina has only 3% share.)  The company’s recent hires of executives from successful consumer packaged goods companies as well as Hanes highly efficient manufacturing facilities in many emerging markets (including China) should help to position it well to succeed, though progress is likely to continue to be slow given the highly fragmented distribution channels. 

 All together, we anticipate that HBI’s price increases over the past several quarters combined with its supply chain benefits should more than compensate for 800 bps gross margin pressure from cotton inflation and 300 bps headwind from labor cost inflation in 4Q11, and nearly compensate for the increases in 1Q12, the quarter which will see the highest cotton prices.

 Further, we expect to see significantly improving free cash flow.  Over the past several years, HBI’s inventory levels have grown as the company has worked to ensure a lack of inventory disruptions while relocating its supply chain offshore.  With this process now largely complete, the company anticipates raising its inventory turns towards 3.0x (vs. ~2.2x today) – we model them getting to 2.7x turns by 2013 - while still meeting retailers’ just-in-time inventory needs.  This should release over $200M in FCF, or half a turn of inventory.  As another way of looking at the dynamics, another $260M+ of HBI’s $400M inventory increase over the past year has been due to cotton-price inflation, which has reversed by 70%.  As this inventory is sold through, HBI will receive the cash flow benefit.  Net this against the company’s investment in inventory to support growth.

 Overall, we anticipate ~$400M - $500M in annual FCF in F12 and F13 due to 15-20% EPS growth combined with HBI working down its inventory to more normalized levels. 

 Based on our conversations with the company, HBI is likely to use much of this FCF to pay down its $2B of long term debt, thereby allowing the company to reduce its total debt to EBITDA to around 2.6x by the end of F12, or near an investment grade level, from ~3.5x today.  Given HBI’s significant FCF generation ahead, we believe that investor concerns regarding the company’s high leverage ratio are ill-founded.  Further, HBI’s new CFO, Richard Moss, had a history of focusing on FCF generation driven by exceptional working capital at his previous CFO position at Chattem.  Of note, HBI has stated that it doesn’t intend to pay down debt much further than this level as it would like to use excess cash for small, strategic acquisitions such as Gear for Sports (which has proven to be a great investment) and potential share buy backs.   We have modeled debt paydown for 2012 and half the FCF going to repurchase stock in 2013.

 Risks

• Recent retailer destocking in intimates, in particular, (~15% of total sales) continues at a greater than anticipated rate; Hanes missed its topline significantly in 3Q after retailer buys dropped sharply at the end of the quarter for intimates, in particular, which have been suffering sell through all year as women over 35 have delayed purchases. 
• WMT (26% of sales) and TGT (17% of sales) change vendor allocations; recently WMT in-sourced the more fashion-forward lines for “Just My Size” for which Hanes had previously managed merchandising and sourcing.  (Note that this was not a line that Hanes produced in-house.)  HBI has said that WMT plans to add additional Hanes lines by 3Q12 to compensate for the lost sales, but any change in WMT’s decision making could depress Hanes’ sales longer than anticipated.
• Hanes’ customers push back on price as cotton deflation takes hold.  Given the concentration of Hanes’ customers in highly cost conscious retailers such as WMT, TGT, and Kohl’s, there is a risk that Hanes and its competitors will experience push back on to lower prices as cotton inflation rolls over.  Given the retailers’ willingness to accept significant price increases on the way up and their own desire to maintain or increase pack sizes to maintain their own retail ASP’s, we anticipate that this will materialize in retailers requesting increasing pack sizes rather than price decreases, helping to mitigate the bottom line impact through SG&A leverage.
• New competitors create margin and shelf space pressure.  T-shirt and silk-screen manufacturer Gildan has been increasing its focus on sales through the retail channel, and success in this area has the potential to pressure Hanes shelf space and margins. We believe that it would take Gildan many years to achieve Hanes brand credibility, limiting the near to medium term impact.  However, if we are incorrect, success by Gildan or others could lead to lower-than anticipated revenues and margins.
• Longer term price increases are unable to keep pace with labor cost inflation.  Apparel labor cost inflation is currently running at around 20% a year abroad, and conversations with Hanes and analysts suggest that more moderate labor cost inflation is likely to continue.  Should consumers be unwilling to accept ~1-3% price increases annually to help mitigate these cost pressures, this could pressure margins over the long run.
• Working capital trends remain unfavorable.  Hanes has experienced unfavorable working capital trends over the past several years as its changes to its supply chain and rising cotton prices have led to temporary elevated inventory levels; further accounts receivable have been drawn out, due to retailers trying to better manage their own inventory turns, and accounts payable terms have shortened, perhaps to get better terms with suppliers. We anticipate that the inventory trends should reverse over the next 12 months and the other terms stabilize, but should this not come to pass, Hanes will generate much less cash to pay down debt and lower interest payments. 
• A meaningful disruption in the credit markets could increase interest expense and raise concerns around eventual debt refinancing  given its $500M debt at Libor + 3 5/8%, and lead to a significant stock price correction as occurred in 2008. 
• Re-setting of Hanes tax rate could significantly impact profitability.  Hanes has a 20% tax rate, far below theUS statutory rate, due to claiming the majority of its profits in overseas jurisdictions.  While Hanes structure should allow it to maintain this tax rate, should Hanes ability to tax its profits overseas become reduced, it could have a meaningful impact on earnings.

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.

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