Description
We are following HanesBrands (HBI) insiders, who recently purchased over $850,000 of common stock on the open market at higher-than-current prices.
After its spin-off from Sara Lee Corporation (NYSE: SLE), HanesBrands Inc. (NYSE: HBI) became one of the largest publicly-traded apparel companies in the world with $4.5 billion in annual sales and a branded product portfolio that includes Hanes, Champion, Bali, L’eggs, Playtex, Wonderbra, Barely There, and Just My Size.
Winston-Salem, NC-based HanesBrands underperformed as part of the Sara Lee organization, as Sara Lee underinvested in the business and drained the division’s operations for its tremendous cash flow. In order to make the HanesBrands spin-off a tax-free transaction for shareholders, Sara Lee took a $2.5 billion one-time dividend from HBI and saddled the company with an enormous debt load. HanesBrands was spun-off on September 6, 2006 at $22 per share. Today, Sara Lee does not have an equity ownership or any other business relationship with HanesBrands.
Running an independent company, HanesBrands management has the opportunity to create significant value for its shareholders. Hanes owns strong brands with leading positions in categories that are considered “basics”. Despite its large U.S.-based manufacturing presence, HanesBrands is a low-cost branded supplier to this market. Sara Lee had not heavily invested in this business for some time, and HanesBrands management is investing to improve both profit margins and sales. Small expansions in revenue growth and operating margins would have tremendous effects on the company’s stock price.
I believe that the market is not giving HanesBrands enough credit for its sizable cash flow, brand equity, and considerable opportunity to improve its business. At current prices the company is trading at a 9.6% trailing free cash flow yield, and free cash flow should grow considerably from current levels.
Quick Background
HanesBrands began as a producer of men’s underwear in 1901. By the time Hanes was acquired by Sara Lee in 1979, the company sold a wide variety of products including women’s hosiery, swimwear, men and boys’ underwear, and cosmetics. Champion, a producer of professional-quality athletic apparel, and Playtex, a manufacturer of intimate apparel products, were later acquired by Sara Lee and integrated into the division. In February 2005, Sara Lee announced its plan to transform itself into a pure-play food, beverage, and body care company; the “non-core” businesses – namely, the HanesBrands businesses – were to be spun-off to shareholders in a tax-free transaction.
HanesBrands includes four business segments: Innerwear (59% of revenue), Outerwear (27% of revenue), Hosiery (7% of revenue), and International (7% of revenue).
The Innerwear segment ($2.65 billion in FY 2006 sales) is composed of women’s intimate apparel, men’s underwear, kids’ underwear, socks, thermals, and sleepwear. The key brands in this segment include Hanes, Playtex, Bali, Barely There, Champion, Just My Size, and Wonderbra. The Company also produces underwear products under a licensing arrangement with Polo Ralph Lauren. Intimate products are a $22 billion industry at retail or $11 billion at wholesale. The industry is fragmented and highly competitive. HBI’s main competitors are Fruit of the Loom (owned by Berkshire Hathaway), Warnaco, VF Corporation, Maidenform Brands, Gildan, Russell, and Under Armour. Specialty stores like Victoria’s Secret have been quite successful in gaining share in the undergarment category, and private label continues to gain momentum in most categories, excluding cotton basic undergarments.
The Outerwear segment ($1.23 billion in FY 2006 sales) focuses on casualwear and activewear markets under the Hanes, Champion, and Just My Size brands. With the fast-growing trend towards high-tech, performance materials (away from basic cotton) in athletic apparel, the Champion brand shows a lot of future promise. The brand has already demonstrated significant success with its C9 by Champion exclusive label at Target. This product line was heavily promoted at Target during this year’s Christmas season. Sales of Champion products are only 10% of total sales, but the proportion should increase over the next few years.
Hosiery ($306 million in FY 2006 sales) includes brands such as Hanes, Bali, L’eggs, and Just My Size. The company also maintains licensing agreements with DKNY and Donna Karan. Despite the fact that Hanes holds the #1 position in this category, the segment has experienced consistent 8-12% annual declines over the past decade. Consumer preferences have shifted away from hosiery, and it is unlikely that this shift is reversible in the foreseeable future. Accordingly, Hanes manages this segment primarily for cash flow, and it remains quite profitable despite the revenue declines. Segment operating profit has been flat for the last three fiscal years.
The International Segment ($388 million in FY 2006 sales) comprises all products sold outside of the United States. HBI’s largest markets are Asia, Canada, Latin America, Japan, and Mexico. The Company has recently opened sales offices in India and China.
The distribution of Hanes products is skewed heavily to the mass merchant segment. In fiscal 2006, breakdown of distribution was as follows: 44% mass merchants, 21% other retail channels, 19% national chains and department stores, 8% direct to consumer, and 8% international. The company’s direct sales were generated through its 229 outlet stores, catalogs, and the Company website.
Hanes owns operations in all parts of the manufacturing process, from purchasing raw cotton and synthetics to yarn spinning, cutting, sewing, packaging, and distribution. Roughly 70% of the finished goods sold in the United States were produced through facilities owned and operated by HanesBrands. This proportion is likely to continue going forward because management believes that an allocation towards ~70% self-production allows an appropriate balance between efficient production and reliable, prompt supply for its customers. Approximately 70% of the HBI workforce is located outside the United States, but 70% of the labor costs were related to its domestic workforce. Half of the domestic labor costs are administrative and distribution related and would not benefit from any overseas outsourcing activities.
Management believes that it will experience continued pricing pressure going forward, which could be offset if the Company is able to successfully migrate a greater portion of its production to lower cost locations like Central America, the Caribbean, and Asia. Hanes intends to continue self-manufacturing products where it can protect or gain a significant cost advantage through scale or through propriety production techniques. Over the past year, the company has recognized $109 million in restructuring charges, and, over the next two years, HBI intends to take $140 million more in one-time restructuring charges as it rationalizes its production facilities. Half of these charges will be non-cash expenses.
In conjunction with the spin-off, HBI took ownership of its pension plan, which at the time of the spinoff was underfunded by $225 million. The company has been making contributions to its pension plan over the past year, which is now underfunded by just $25 million.
Recent Performance and Guidance
During the most recent quarter, sales increased 3.1%, which was the strongest sales growth that the company has realized in three years. At the same time, its competitors like Gildan and V.F. reported business slowdowns. In all likelihood, Hanes is likely to perform well in the current retail environment as its major customers are focusing on getting back to basics as consumers pull back on spending.
The company’s operating profit increased 12.6% during Q3 2007. Excluding restructuring charges, the company’s operating margin was 10% for the quarter and 10% during the first nine months of the year. The company’s $250mm restructuring program is slightly ahead of schedule; thus far the company has announced $120mm in charges and recognized $109mm.
The Company does not provide revenue and/or earnings guidance. However, management’s three long-term operating goals for the company include the following:
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1-3% revenue growth
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6-8% operating profit growth, excluding restructuring expenses.
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Double-digit EPS growth, excluding restructuring expenses.
Investment Positives
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HanesBrands management should increase company revenue. Since 2001, Hanes has experienced a 2.3% compounded annual sales growth decline. Under Sara Lee control, Hanes was managed largely for cash generation and withstood a number of years of underinvestment. It is likely that Hanes as a stand-alone company should be able to grow revenues, especially because its top two customers continue to increase their square footage.
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Market leadership position in undergarment brands. According to the NPD Group, HanesBrands holds the #1 or #2 positions in most of the product categories in which they compete and enjoy high awareness among customers. Hanes is the most recognized apparel brand among women in the United States. It also is the largest undergarment brand available at the mass discounters. Following years of underinvestment by Sara Lee, Hanes Brands plans to increase both its marketing and capital spending. In the mass merchant channel, Hanes brands have the 2nd largest retail presence after private label. 60% of Target undergarment sales and 25% of Wal-Mart undergarment sales are dedicated to in-house brands. Even still, its branding, low price points, and wide product array allows Hanes to retain a strong presence at retail.
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Undergarments are somewhat of a clothing staple. Unlike other typical branded apparel, basic undergarments do not experience dramatic seasonal shifts and rapidly changing fashion trends. The lack of fashion risk in undergarments causes business forecasting to be simpler. Accordingly, it makes sense for HBI to largely own its production facilities to keep costs low.
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The company’s margins should expand. There is room for Hanes to improve its profitability. Additional manufacturing can be moved out of the United States to the Caribbean and Asia. Sara Lee’s decentralized operating structure also caused excessive duplication of many corporate functions, which are in the process of being rationalized. The company’s publicly traded competitors have operating margins which are 35% to 65% higher than HanesBrands. We expect this discrepancy to decrease during the next few years.
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Insiders are buying stock: Compared to outside investors, management has better insight into both the business opportunities as well as the business risks of HanesBrands. We are encouraged that five different insiders have purchased over $850,000 worth of stock on the open market.
Risks
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Private label. Hanes retail customers can always eliminate Hanes as a vendor if private label products become more attractive from a price/value perspective. However, we believe this risk is limited and that a role for Hanes will continue to exist, given its brand strength. Target already sells a very high mix of private label, and Wal-Mart’s merchandising strategy is to rely more heavily on leading brands (and on basic clothing).
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Concentrated customer base. The mass merchant channel is 44% of sales, and Wal-Mart alone represents 31% of sales. Target is HBI’s #2 customer at 11% of sales, and Kohl’s is the company’s #3 customer, representing 5% of sales. The company’s top ten customers accounted for 64% of total sales.
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Debt. After the $2.5 billion dividend to Sara Lee, Hanes was left with a burdensome debt load. The ample cash flow of HBI’s business should help to mitigate this risk, and management’s proposed first priority to invest free cash flow is to pay down debt. The company’s net debt/EBITDA is about 5.8x, and over 80% of the debt is due after 2013.
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Commodity Risk. The price of cotton, HBI’s primary raw material, can affect margins materially. The Company does not break out what percentage cotton represents in cost of goods sold. However, HBI does estimate that a $0.01 per pound change in cotton prices would affect annual raw material costs by $3.5 million (or 10 basis points).
On a trailing twelve month basis, the company’s free cash flow yield is 9.6%. In addition, free cash flow per share should expand at a rapid rate as revenues and operating margins increase, as debt is paid down, and as the share count goes down through share repurchases. Our discounted cash flow valuation, which assumes a 7.1% WACC, 2% revenue growth, and gradual operating margin expansion in-line with management’s goals, suggests that the company should be worth $40 per share.
Catalyst
Continued execution in terms of revenues and operating margin growth