Sara Lee Saddles Hanesbrand Spin-off With Excessive Debt, But It's Attractive Nonetheless

Sara Lee Corporation (SLE) is in the midst of a significant restructuring of the company. Part of this initiative is the spin-off of Hanesbrands (HBI). Hanesbrands is a good business. But it will also be a highly leveraged one when it is hatched in early September.

So that HBI can pay a large dividend back to its parent, Sara Lee has saddled the company with $2.6b of debt. It's a crafty and totally legal way for Sara Lee to extract value from the Hanesbrands subsidiary, without resorting to an outright sale. The debt laden Hanesbrands should be trading "regular way" in the first week of September.

Hanesbrands has the kind of business economics super investor Warren Buffett adores. In fact, in recent years, Buffett has bought two highly similar businesses, Fruit of the Loom, and Russell Corp. He loves steady boring businesses and Hanesbrands fits the description to a "T". ;-)

Hanesbrands, though, may be an even better business than the two Buffett already scooped up for his company, Berkshire Hathaway. Here's why. HBI gets lots of shelf space at Wal-Mart, Target, and Kohl's, three retailers that should continue to take share from other retailers year after year. Hanes, believe it or not, is the most recognized brand by female shoppers. The new Hanesbrands will include not only Hanes clothing, the dominant brand, but Champion sportswear, Playtex, and Wonderbra as well. These products are high volume items that are frequently replenished. Consumers make on average, 4 trips a year to places like Wal-Mart to buy exactly the kind of products that HBI sells.

Hanes sells undergarments! These items are far less subject to the whims of fashion. This is highly appealing to rational investors like Mr. Buffett. People are always going to need white T-shirts and undergarments, regardless of economic conditions. One question Buffett always asks is how much will this business change? T-shirts don't change. Underwear doesn't change (although we change underwear!). HBI has a formidable position in these stable slow growing markets. The spin-off should only help to focus and motivate management, which now has a great financial incentive to create value at this newly public company.

The market for Hanesbrands products should grow at about 4.5% per annum. For a variety of reasons, I estimate this business can grow its EBITA at 8% to 10% rates. Management has a plan to create more integration and focus at disparate units of the company, increase marketing spend, and optimize the supply chain. There is room for some moderate operating margin expansion from the 10% range. Management will have more financial incentive to improve HBI than they had when operating as a unit of SLE.

Although Hanes will be highly leveraged, management should, in the years ahead, have increasing flexibility to pay down its debt, even after funding necessary cap-ex, and paying the higher interest costs it is stuck with. Leverage works to the equity investor's advantage when there is more than enough funding to invest in operating expenses, and cap-ex, as well as pay the high interest charges. Value gets transferred from debt holders to shareholders as a highly leveraged company painstakingly pays down its debt. This seems the likely outcome at HBI. At the right price, Hanesbrands is the kind of business Buffett usually salivates over.

What is the right price for a business with the mouth watering characteristics of HBI? Luckily, all we have to do is go back a few months and examine what Buffett paid for Russell Corp. Russell has many of the same qualities as Hanesbrands. It was not as leveraged, however, and operating margins were a shade lower. Hanes has better brands, more scale, and a more diversified product line. It deserves a higher price tag. But how much higher?

Not long ago, Buffett paid about 7 x EBTIDA for Russell. By the numbers, this also works out to 10 x EBITA, or operating cash flow - maintenance cap ex. As stated earlier, Hanesbrands, as a better business capable of higher returns, deserves a higher multiple. What might a highly rational private buyer pay for Hanesbrands? My educated guess would be a price somewhere around 8 x current year's EBITDA, and 12 x current year's EBITA.

Here are some of the pertinent numbers. Hanesbrands will have 95m shares outstanding. It will have $2.6b of long term debt. Importantly, it will have an unfunded pension liability of about $360m, and $200m of cash. I add the unfunded pension liability to debt less cash, and arrive at net debt of ~ $2.8b. It looks like EBITDA came in at about $530m for 2006. 8 x ~$530m = $4.25b TEV. My proxy for operating earnings, EBITA, is about $440m for 06. 12 x ~$440m = $5.3b TEV.

The enterprise value range of HBI is $4.25b to $5.3b. But HBI is a highly leveraged company. The range for the equity values, therefore, will be much wider, as we will see. $4.25b (8 x EBITDA) - $2.8b = $1.45b/95m shares = $15.25 share price. The EBITA calculation is as follows. $5.3b - $2.8b = $2.45b/95m shares = $25.75 share price. In when issued trading, the shares are changing hands slowly for about $19. That seems just about right, for now, and provides a measure of confidence to this valuation work.

As a disciple of Warren Buffett and his investment methodologies, this business appeals to me. It would be a worthwhile portfolio addition at the right price. At first blush, however, the shares don't seem especially cheap. The stock could sell off in the weeks ahead though, as Hanesbrands may well be jettisoned from institutional portfolios for any number of reasons.

I plan to watch the trading of HBI closely and will consider buying the stock if it approaches the low end of the above calculated valuation range. Of course if it falls trough this range, all the better. Hanesbrands is one to watch, even in your skivvies. You can bet Mr. Buffett will be, although he will be wearing Fruit of the Loom. ;-)

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