Description

Company Overview

Hanesbrands (HBI)  is a leading global consumer goods company that designs, manufactures, markets and distributes innerwear (underwear) & activewear (sports and exercise) apparel.  In 2006, Hanesbrands (which included the US innerwear and activewear brands: Hanes, Champion, Playtex, L’eggs, etc.) was spun off from Sara Lee’s as a public company.  As part of the transaction, Hanesbrands paid a one-time dividend to Sara Lee of $2.5 billion, financed by adding $2.5 billion of debt to its balance sheet.  On the day it went public, Hanesbrand market capitalization was $1.9 billion.  Uncomfortable with its heavy debt load, HBI management’s first order of business was to de-lever the balance sheet.  Starting in 2006 and continuing through the financial crisis in 2009, HBI closed down 12 production plants and reduced staff by over 10,000 people.  By 2012, with the help of its cash flows and cost reductions, Hanesbrands had reduced its debt from $2.5 billion down to $1.3 billion.

By 2013, with its net debt/EBITDA ratio nearing 2x (management’s sweet spot is between 2-3x), Hanesbrands’ focused on expanding its brand geographically through acquisitions.  Between 2013 and 2016, the company spent $2.4 billion and acquired 5 companies, expanding its footprint into Europe, Australia, and parts of Asia where competition amongst the top brands was fragmented.  These acquisitions adhered to managements strict criteria: 1) The acquisition must be within the company’s core competency, 2) complement future growth in a segment, channel or geography, 3) leverages production, global supply chain and/or its SG&A, 4) and must be accretive within 12 months (including integration costs).  Leveraging its global supply chain and in-house manufacturing allowed Hanesbrands to not only improve the acquired company’s gross margins but utilize its new foothold to distribute its established collection of brands.

By manufacturing 75% of its apparel in-house, either through its owned and operated production facilities or through its dedicated contractors, Hanesbrands has the ability to be both a low-cost producer while having the flexibility to manage changes in inventory through third-party outsourcing.  Hanesbrands does not receive purchase orders for its apparel; instead, it regularly refreshes customer inventories (spring, summer, back to school and holiday season), providing the company with good insight into its inventory needs for the upcoming year.  Unlike apparel that changes seasonally, innerwear and activewear styles and fabrics evolve over a number of years but remain relatively constant year in and year out.

The company’s sales are broken down into four segments: Innerwear, Activewear, International, and Direct-to-consumer.  Innerwear is the largest segment, representing nearly 45% of revenues and its highest operating margins at 23%.  Activewear and International represent 27% and 25% of revenues and operating margins of 16% and 13%, respectively.  International, with the acquisition and ongoing integration of DB Apparel (Europe) and recent purchase of Pacific Brands (Australia/New Zealand), is the fastest growing segment.  At less than 7% of revenues, Direct-to-Consumer, a combination of 252 retail outlet stores and a growing consumer e-commerce business, is the smallest segment but the area that has received the most investment on a percentage basis.  The US market represent nearly 75% of Hanesbrands overall revenues with mass merchants (WalMart & Target) representing over 35% of sales, and department (Nordstrom's, Macy’s, Kohl's, JCPenney, Sears, etc.), sports stores, dollar stores, grocery stores, convenience stores, and online making up the rest. Hanesbrands has consistently ranked number 1 or number 2 in the segments and geographies that it services.

Business Strategy

Hanesbrands business strategy is very straightforward: “Sell more, spend less, generating cash and acquisitions.”  This may seem overly simplistic but it is important to remember this company sells underwear.  To increase sales, Hanesbrands focuses on expanding its brand geographically, through innovation, advertising, and marketing.  With 80% of US households already using a Hanesbrands product (Hanes, Champion, Maidenform, Playtex), the company is one of the most recognizable brands in the United States but also has strong international recognition.  The US underwear market is highly concentrated with the top 5 brands representing 90% of the market share.  Hanesbrands recent acquisitions outside the US is deploying a “land and expand” strategy into more fragmented markets, creating a beachhead on which to broaden its global distribution.  Innovation is also a key ingredient in global expansion.  Underwear is a very commoditized product; the styles, fabric, packaging, and price, especially amongst mass merchandisers, is nearly identical.  To separate itself from the competition, Hanesbrands spends around $70 million a year on research and development.  Over the past 10 years, the company has spearheaded innovations like tagless apparel, odor and moisture control, and improved elasticity for better comfort and fit.  These may not appear to be disruptive changes, but for the staid underwear industry, these innovations differentiate Hanesbrands from its competitors.  The company has recently highlighted its growing social and environmentally responsible behavior (hanesforgood.com) by reducing its carbon footprint, increasing the use of renewable energy, minimizing the use of water in production, and providing a healthier work environment.  This responsible behavior connects with the millennial generation who, by 2020, will represent nearly 70% of all apparel purchases.  Combined with an ongoing advertising and marketing campaign centered around Michael Jordan (a global brand unto himself), Hanesbrands has positioned itself to maintain its number 1 or 2 ranking.

“Spend less” leverages the company’s global production and supply chain while managing its inventory needs.  Hanesbrands has established itself as the low-cost producer within the inner and activewear industry.  Surprisingly, it has done so by only spending less than 2% of revenues yearly on maintenance.  Over the next 3 years, the company expects to lower its production, SG&A, and inventory expenses by $150 million.  These reductions will come from increased volumes, improved sourcing and pricing, reduction of redundancies, better utilization, and inventory management.

Hanesbrands goal to generate cash and acquisitions is a direct result of selling more and spending less.  Management has designated a significant portion of its growing free cash flow to be returned to its shareholders.  Starting in 2013, the company began issuing a dividend which has been raised annually and currently yields slightly below 3%.  With its targeted payout ratio to be between 25-30% of earnings, Hanesbrands has returned over $730 million to its shareholders.  In 2015, management expanded the use of its free cash flow to include the buy-back of its shares, spending $1 billion in roughly 3 years.  Both programs are expected to continue into the future, with future acquisitions paid for primarily through debt.

Industry Overview

The global underwear market is $220 billion and growing steadily at 6-8% a year.  At $21 billion, the US is responsible for slightly less than 10% of the global demand with the top five brands controlling nearly 90% of the market share.  Outside of the US, the underwear market is less concentrated: top brands in Europe represent a 50-80% market share, while concentration in Asia falls into the mid 30’s.  

E-commerce sales currently represent roughly 15% of the $21 billion US underwear sales, with 80% of e-commerce ($2.5 billion) coming from established brick and mortar online retail.  The overall online segment is growing at 14% a year with e-commerce pure plays, like Amazon, growing at over 25% per year.  By the end of 2020, it is expected that online retailing will grow to represent over 21% of the US underwear market.

Since underwear is a commodity, its brand has the biggest impact on consumer purchases.  This is followed by comfort, fit, style, and then, price.  Once a consumer finds a pair of underwear that is comfortable, fits nicely, and is stylish, he/she becomes very loyal to that brand for an extended period of time. Building and preserving a brand is key to weathering economic challenges stemming from commodity price spikes, economic slowdowns and periods of inflation.  Maintaining a strong brand allows a company to confidently pass along price increases without the fear of negatively impacting its sales or brand. Over the last 2 years, the US apparel market has been negatively impacted by the decline in mall traffic leading to lower sales, store closures, bankruptcies, and inventory destocking at brick and mortar retailers.  Some of those sales have been replaced by online shopping, but it will take time for apparel consumer habits to adjust to the changing landscape.  For the underwear industry, the demand has not changed just point of sales.

Investment Thesis

The recent decline in US retail brick and mortar traffic is very likely to negatively impact Hanesbrands’ revenues and margins in the short-run.  Over time, the demand for inner and activewear apparel will return to its steady 6-8% growth, as Hanesbrands continues to expand its omni-channel presence both geographically and through e-commerce.  The company’s growing free cash flow will be returned to shareholders via dividends and share buybacks, while future accretive acquisitions will be financed primarily through debt.  Given a 10 year outlook, this company can provide 17.5% IRR to its shareholders by selling more, spending less, returning its growing cash to its shareholders, and creating value for the company through acquisitions.

Competitive Advantage

Hanesbrands, with its strong brand, global infrastructure, and straightforward management maintains a secure competitive advantage in the inner and activewear apparel industry.  In a commodity business like underwear, brands matter.  Research has shown that the brand is the most important decision driving a consumer's decision when purchasing underwear.  It takes years to develop a brand, and the good news is that Hanesbrands has been working on its brand for the past 116 years.  Even more impressive is that the company only spends on average 3% of revenue on its advertising and marketing, while it consistently holds the top or number 2 position in the segment and geography it services.  Other consumer apparel companies such as Nike and Underarmour, routinely spend between 10-15% of revenues.  

Leveraging its global production, supply chain, and inventory management is another area where Hanesbrands has a significant advantage.  The company’s production process was designed to be a low-cost producer while providing the flexibility to manage its inventory.  By manufacturing 75% of its apparel in-house or through dedicated contractors, the company can leverage its global supply chain, lowering its global cost.  The more volume that flows through the system, the lower the cost per unit, and the more control the company has on quality, minimizing defects, and reducing time to market.  Inventory management also plays a role, as the company is able to control its SKU count and transportation costs.

However, its Hanesbrands’ management that I believe has had the most positive impact on the value of the company.  Having been battle tested over the past 11 years, the management team was forced to restructure its balance sheet soon after going public and amidst the financial crisis.  Two years later, in 2011, as cotton prices spiked over 200% in less than 6 months, management was able to lower expenses and limit price increases without negatively impacting the brand.  Over the past two years, Hanesbrands management is once again working to protect its margins as declining revenues from US brick and mortar retailers have caused bankruptcies, store closures, and inventory destocking.  Even during all this uncertainty, management remains focused on creating value for the company through its acquisitions and returning its growing free cash flows to its shareholders.

Valuation

Hanesbrands’ earnings are expected to be around $2.05/share for 2018.  Currently, the stock price is trading slightly below 11x earnings.  A bear case for the stock would see a continued decline in mall traffic, further store closures, inventory destocking and possible bankruptcies.  Hanesbrands revenues and margins would still be under pressure with earnings falling to the $1.90/share level.  Applying a 10 multiple would produce a stock price of $19/share.  The base case would witness a stabilization of the current bricks and mortar retail market.  Revenues and margins would not increase meaningfully and Hanesbrands would achieve the $2.00 - $2.10/share expected by the market.  Applying a 12.5 multiple would produce a stock price of $25.63.  In a bullish scenario, HBI would see a return to growth in both its revenue and margins.  Earnings could achieve a level of $2.40 and with a bullish multiple of 14 times, a stock price of $33.60. Based on these valuations and growth prospects, one could make the argument that the stock is not cheaply priced and I would not argue the point.  

However, what attracts me to Hanesbrands is not its short-term potential, but rather the disruptive and profitable combination of marrying a company that creates a significant amount of free cash flow with a management team that is focused on creating value for the company and its shareholders.  I fully expect that Hanesbrands management will continue to execute on its strategy to return its growing free cash flow to its shareholders through dividend and share repurchases while using its balance sheet for future accretive acquisitions.  Over time, its earnings/share will grow at 11% per year, partly because of earnings growth and partly from share repurchases.  Given its predictable earnings and yearly dividend, Hanesbrands P/E multiple will expand from 10x  to 20x, still lower than the 25 multiple achieved by other consumer brand companies and HBI at the height of its stock price.  I think it is very achievable for HBI to return 400% (including dividends) over the next 10 years or an IRR of 17.5%.

Risk

Besides operational risks that all companies face, Hanesbrands is subject to political, economic, financial and commodity risks.  Because all of its products are manufactured outside the US, the company faces changes in taxes rates, added regulations, tariffs and domestic strikes in countries where the rule of law is not always well respected.  However, Hanesbrands is not the only apparel manufacturer that faces these risks.  Financially, management has a done a very respectable job utilizing its debt and free cash flows.  If that were to change, the company actions could compromise the company and its future value.  Finally, 65% of Hanesbrands cost to produce its apparel comes from commodities like cotton.  A substantial spike in prices witnessed in 2011 or its ability to source its growing demand could have a negative impact on margins and its brand.

Summary

Growing globally at 6-8% a year, the innerwear and activewear market is not attractive to many investors.  But for Hanesbrands, this predictable market allows them to leverage their manufacturing, global supply chain, and inventory management to expand its free cash flow and pursue accretive acquisitions.  Marrying a company that creates a significant amount of free cash flow with a management team that is focused on creating and returning value to its shareholders is a very powerful combination.

Catalyst

Stabilization of the US bricks and mortar retail segment and continued expansion in the international market.