Hanesbrands: Too Expensive, Even After A Nice Bolt-On Deal

| About: Hanesbrands Inc. (HBI)

Summary

Hanesbrands announces the purchase of Champion Europe, giving it full ownership of the global brand.

The deal fits within the long term growth strategy as the price makes sense.

Shares remain quite expensive as the company is fairly leveraged, as investors have fallen in love with the predictability and growth ambitions of the business.

While shares are down 20% from 2015 highs, I require a further pullback before getting enthusiastic.

Hanesbrands (HBI) is continuing its acquisition spree as it announced the acquisition of Champion Europe, making it the global owner of the brand. The bolt-on deal makes sense as Hanesbrands is very familiar with the brand, while the relative and absolute valuation multiples look appealing.

While the bolt-on deal makes sense, and underlines the long term growth strategy, shares of Hanesbrands have gotten a bit expensive in recent years. At the same time, the leverage position has increased substantially following dealmaking, creating few triggers to send shares higher in the future. The high margins, steep valuation and elevated debt load leave few triggers to send shares higher going forwards.

Adding it altogether, Hanesbrands is quality business which can be bought on serious dips, allowing investors to buy into this quality business at market-equivalent valuation multiples.

Becoming A Champion In Europe?

Hanesbrands announced that it will expand its European business through the purchase of Champion Europe. With this purchase, Hanesbrands will acquire the rights of the namesake brand in Europe, Africa and the Middle-East. The company is of course already very familiar with the business, being the owner of the brand in the Americas and the wider Asian region. Following this deal, Hanesbrands owns the global rights to this "American-style" athletic brand.

Hanesbrands is paying 10 times EBITDA for the business which amounts to a 200 million euro purchase price. This translates into a 1 times sales multiple, with sales amounting to 190 million euro in 2015.

Champion Europe operates both a wholesale and retail business which is active in the southern parts of Europe as well as in Scandinavia. If all goes well, the deal should close halfway during this year. While this purchase increases the overall sales by merely 3%, it marks a significant expansion of the international business which generates roughly 15% of total sales.

Contributing To The Growth story

In essence, Hanesbrands is a global collection of apparel brands for everyday essentials and athletic wear. The company sell items such as shirts, panties, underwear and stocks, among others. Besides Champion, Hanesbrands owns brands such as Hanes, Bali, Dim, Lovable and Zorba.

Besides strong execution with regards to organic growth and internal growth projects, Hanesbrands has been in part a product of aggressive dealmaking. These deals have improved the diversification of the business in terms of products, geographies and brands. Both organic initiatives and M&A activity have fitted perfectly within the strategy to "sell more, spend less, make acquisitions".

This deal, which likely meets the stringent acquisition criteria, follows a cumulative $1.5 billion being spent to acquire Knight, GFS, DBApparel and MFB in recent years.

If I include the revenue contribution from the purchase of Champion Europe, sales come in at $6 billion per annum. This indicates that revenues have increased by roughly a third from the $4.5 billion being reported in 2006, translating into growth of merely 3% per annum.

What Is The Appeal?

Apparel-related business are typically not very well-liked by investors. What I am trying to say is that valuation multiples are often quite modest, as fashion trends can have huge implications on margins, growth trajectories and even the fortunes for entire businesses.

While operating margins have improved towards 10%, and they have shown real signs of stability, the actual sales achievements have not been too impressive as discussed before. That being said, both positive sales and margin trends have translated into GAAP earnings of $429 million in 2015, equivalent to $1.06 per share.

This reveals that shares are not necessarily cheap, even as they have been lagging in 2015. At current levels around $28 per share, the company now trades at 26 times earnings. This is a pretty steep multiple, even for a predictable kind of business which warrants higher multiples compared to "apparel" businesses.

While the valuation is certainly not cheap, it should be noted that Hanesbrands has taken on quite some debt as well in recent years. The company ended 2015 with a debt load of $2.4 billion, or $2.1 billion if you take into account the cash holdings. This translates into a leverage ratio of 3 times as EBITDA amounts to $700 million per year. With the purchase of Champion Europe, leverage will remain elevated for some time to come, hovering around the higher end of the 2-3 times targeted leverage range.

Deal Makes Sense, Acquisitions Hurt Earnings

In all likelihood, the $200 million purchase of Champion Europe makes sense at 10 times EBITDA and 1 times sales. In comparison, Hanesbrands was valued at roughly $13 billion before the modest deal has been announced, translating into roughly 2 times sales and nearly 20 times reported EBITDA multiple.

Both metrics imply that Hanesbrands will be able to buy Champion at a 50% discount compared to its own multiples. This relative valuation gap would have been really imminent if Hanesbrands would have elected to pay for the deal in terms of stock, while in reality it is using cash to finance the deal.

While the deal makes sense on a relative basis, the stand-alone valuation of Hanesbrands remains very elevated. Fortunately, the reported earnings have been depressed as a result of its acquisition spree. This implies that the valuation might not be as steep as it looks based on the GAAP results. Hanesbrands reports that acquisition-related charges depressed earnings by $0.60 per share in 2015. If you exclude all of these costs, earnings would have come in around $1.66 per share, translating into a much more acceptable 17 times earnings multiple.

Final Thoughts

Shares of Hanesbrands have been on a multi-year momentum run as investors liked the acquisition strategy and focus on higher margins. At the same time, the investment community realized that higher multiples might attached to a predictable business.

While all of this has been true, I think that investors might have become too enthusiastic. Shares rose from levels around $6 in 2006 to their mid-thirties in 2015, on the back of enthusiasm surrounding the business model and corporate strategy. While shares have fallen some 20% from last year´s highs to current levels at $28, they are certainly not cheap yet.

The question which I have is whether current performances can readily be extrapolated towards the future, as margins have already improved a great deal in recent years. I am furthermore not willing to ¨blindly¨ accept a 17 times non-GAAP earnings multiple, as acquisitions are a structural cost of business for Hanesbrands with the current strategy.

If I take the midpoint of a 17 and 27 times earnings multiple, the valuation of 22 times earnings still translates into an earnings yield of just 4.5%. This might look appealing given the low interest rates, and predictability of the business, yet I have some concerns. This relates to the strong margin performance of the business and somewhat elevated debt load, leaving few triggers which can send shares higher in my opinion.

At a 17 times multiple for the blended earnings of $1.06 and $1.66 per share, I arrive at a targeted $23 entry price. This is still 15-20% below today's levels, although it should be said that we have seen these levels as recent as February.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.