Heavy Debt Obscuring Hanes' True Earnings Power

Inelegant Investor has a post on Hanes. The post also links to a Stalwart post on the company.

Here are a few things to keep in mind with Hanes.

Two major players, Hanesbrands (HBI) and Fruit of the Loom (a Berkshire Hathaway subsidiary), control most of the U.S. underwear market.

Hanes considers itself to be in the "apparel essentials" business which is to say the "t-shirts, bras, panties, men's underwear, kids' underwear, socks, and hosiery" business. In 2005, the U.S. apparel essentials market was about $44 billion. Apparel essentials have been growing faster than the overall apparel industry – still this isn't a fast growing market. You're unlikely to see sales growth exceed 5%.

Hanes divides its business into four segments: Innerwear, Outerwear, Hosiery, and International. The company doesn't do much international business. Hosiery is a dying business with good margins. It generates cash; but, it's going the way of the Dodo – fast.

That leaves innerwear and outerwear. Together these two segments account for something like 85% of Hanes sales.

Innerwear is underwear – and yes, it's just as profitable by any other name. This segment is the heart of the company. It generates more than $2.5 billion in sales and plenty of free cash flow. Apparently, you can achieve low double-digit profit margins in this segment, which is impressive given the volume involved.

The innerwear business is a ridiculously high volume business. Looking at it solely in dollar terms doesn't make that clear enough. So, let me give you some unit numbers.

Hanes manufactures and sells a billion socks a year – literally. That's 500 million pairs of socks a year. Even the T-shirt business is high volume; Hanes produces about 400 million T-shirts a year.

The company's biggest customers have high volume needs. Wal-Mart (WMT) accounts for nearly 30% of the company's sales. Does Wal-Mart have leverage over Hanes? Maybe. Does Wal-Mart have many other options? No. Hanes supplies them with well over $1 billion in product each year. It's a cheap product that can only be produced in such volumes at competitive prices by a few companies on the planet. In the U.S., your choices are basically Hanes or Fruit of the Loom.

Furthermore, customers don't contract this stuff. They simply buy what they need. The excess inventory costs on these high volume products could easily eliminate all the profit for any company that isn't accustomed to producing on this scale. Hanes averaged total inventory reserves of just under $100 million a year over the last three years. That's the cost of guaranteeing you have enough product to meet your customers needs.

Hanes employs a lot of people – and the workforce isn't particularly cheap considering how cheap the product is to produce. Before the spin-off, Hanes employed close to 50,000 people worldwide. The vast majority of the company's employees were located outside the U.S.; however, the vast majority of the company's labor costs came from inside the U.S.

Using American labor to produce underwear isn't particularly economical. Since the spin-off the company has clearly been moving to reduce costs. This means closing plants and firing people. I expect the company will have to engage in a fair amount of globe hopping just to keep moving jobs further down the global wage scale as wages in some of these countries may grow fast enough to threaten price competitiveness. Of course, competitors are in the same boat. Absent prohibitive tariffs, each of the players in the industry should end up about where they started – though much of their current workforce will end up jobless.

Hanes has reduced its total sales in an attempt to eliminate some low margin product. Currently, sales are around $4.5 billion. The company hopes to use that number as the base to maintain and eventually grow. However, growth will be slow. Around the time of the spin-off, the company's "growth goals" set the bar at sales growth of 1-3%.

Hanes is highly leveraged (both financially and operationally), so single-digit sales growth can produce double-digit EPS growth – for a time. Again, this isn't a high growth business. In the long-run, it's a slow growth business.

The best margins are in the innerwear business. That's also the area where Hanes has its most important competitive advantages. However, the outwear business isn't a bad business and there's probably more growth potential there.

I'd like to see Hanes focus more on innerwear than I expect them to. However, management may surprise me. They didn't set particularly aggressive sales growth goals, which is a good sign, because chasing growth would lead the company away from its competitive strengths – which happen to be in a highly-profitable business.

Hanes wasn't a good fit at Sara Lee (SLE). This isn't a small business. It's a big business with a couple good brands and one terrific brand (Hanes). Hopefully, the brand will get more attention now than it did under Sara Lee. We've already seen some evidence of that.

Long-term I hope to see Hanes grow international innerwear sales. However, underwear is a very personal thing; you need to build up familiarity over time – it isn't an area where buying habits change rapidly or where there's a lot of comparison shopping – so, it's a hard market to break into. But, with a lot of time and a little skill, there is the potential for growth in the international segment. But, I wouldn't count on any such growth when valuing the business.

Overall, I like Hanes today much the same way I liked Energizer Holdings in early 2006.

This is a good business with a lot of debt and a lot of temporary, transitional stuff obscuring the company's true earnings power. Look at the company's record under Sara Lee, the information filed since the spin-off, etc. and try to come up with some reasonable EBIT estimates. Then, work back from there to get to a share price 3-5 years out.

With some good capital allocation decisions (or rather without some bad capital allocation decisions) the stock should perform nicely over that timeframe (3-5 years) without requiring any miracles from the business.

HBI 1-yr chart:

Comments

[Amit Chokshi]

HBI's debt is what makes the stock so appealing, it's one of my largest holdings. This is about as close to public LBO participation a public shareholder can have with a phenomenal company. WEB paid 0.5x salesand 11.1x EV/EBITDA for BK Fruit of the Loom and paid 0.7x sales, 6.8x EV/EBITDA, and 24.2x P/E for Russell. FOL was bankrupt and Russell in my view is a weaker brand than HBI. So you're getting a company with arguably the best brand in underwear and very tangible value drivers for a very fair price.

HBI's Champion/9 series is doing well at TGT too and the company is also getting into other store fronts (Family Dollar).

The reason I love this co is that irrespective of economic conditions, I expect this to be a top line inflation grower (3-5%) per year but it has some real value drivers in operationionally and financially. They have a lot of non-cash restructuring costs that are being recognized reducing GAAP income, they are offshoring as much labor as they can, they are addressing pension issues and were able to reduce about $70MM in healthcare related costs.

As for financially, this business cranks out about $500MM in EBITDA per year so leverage for a high brand, stable business is perfect to me. CapEx will be about $90MM per year so you're left with $410MM in cash flow to work with in terms of working capital and paying taxes. THat still leaves a lot of dry powder to delever and reduce interest expense.

The "risk" is market confusion and execution risk. There's going to be about $250MM in restructuring costs (total) over the next 3 years but we don't know how much will show up in each year so god forbid an analyst covering it has a lower number for a particular quarter resulting in EPS higher than what comes in on a GAAP basis and the stock can take a hit. Also, HBI's switch to a calendar year end will make prior year comps difficult and their exitign as you mentioned from certain lower margin businesses will curtail revenue growht, also making prior year comps confusion. If you can wait it out 2-4 years this will prob be an amazing stock. As for execution risk, obviously having 5.0x debt/EBITDA makes execution of the co's strategic plans important, one minor mistake in this capital structure could be much more significant. However, I feel having Noll and Lee have the RSU's and options at $19 or so keeps them pretty focused on making sure things go smoothly. The comp awards were set pretty fairly in my opinion.