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Hanesbrands Inc. (NYSE:HBI)

Q1 2012 Earnings Call

April 19, 2012 4:30 PM ET

Executives

Charlie Stack – Chief Investor Relations Officer

Rich Noll – Chairman and CEO

Bill Nictakis – Co-COO

Rick Moss – CFO

Analysts

Bob Drbul – Barclays

Eric Tracy – Janney Capital Markets

Susan Anderson – Citi

two things going on with Bras

David Glick – Buckingham Research

Eric Alexander – Stifel Nicolaus

Omar Saad – ISI Group

Steve Marotta – C.L. King & Associates

Scott Krasik – BB&T Capital

Andrew Burns – D.A. Davidson

Eric Beder – Brean Murray

Emily Shanks – Barclays

Carla Casella – JPMorgan

Operator

Good afternoon. My name is Mike and I will be your conference operator today. At this time I would like to welcome everyone to the Hanesbrands’ First Quarter 2012 Earnings Conference Call. (Operator Instructions) Thank you.

Mr. Charlie Stack, Chief Investor Relations Officer, you may begin your conference call.

Charlie Stack

Good afternoon, everyone, and welcome to the Hanesbrands’ Quarterly Investor Conference Call and Webcast. We are pleased to be here today to provide an update on our progress after the first quarter of 2012. Hopefully everyone has had a chance to review the news release we issued earlier today. The news release and the audio replay of the webcast of this call can be found in the Investor section of our Hansbrands.com website.

I want to remind everyone that we may make forward-looking statements on the call today either in our prepared remarks or in the associated question-and-answer session. These statements are based on current expectations and are subject to certain risks and uncertainties that may cause actual results to differ materially. These risks are detailed in our various filings with the SEC such as our most recent Forms 10-K and 10-Q as well as our news releases and other communications. The company does not undertake to update or revise any forward-looking statements which speak only to the time at which they are made.

Before we begin as a result of the reduce size of share hosiery and changing trends, Hanesbrands decided in the first quarter of 2012 to change its external segment exporting to include hosiery operations within Innerwear segment. Hosiery had previously been reported as a separate segment. Prior-year segment sales and operating profit results including other minor allocation changes have been revised to conform to the current year presentation.

With me on the call today are Rich Noll, our Chief Executive Officer; Bill Nictakis, one of our two Co-Chief Operating Officers and Rick Moss, our Chief Financial Officer. For today’s call Rich will highlight a few big picture themes. Bill will provide a sense of what’s happening in a few our businesses and Rick will emphasize some of the financial aspects of our results.

I’ll now turn the call over to Rich.

Rich Noll

Thank you, Charlie. Well obviously we are not pleased with the loss in Q1. We are tracking well relative to our expectations with sales, profits and cash flow running at or above our plans.

When you couple that with the visibility of our pricing and costs for the rest of the year we feel very good about our momentum and our ability to achieve our full year guidance. Let me give you a few specifics.

First our core categories which sustained price increases of more than 20%, such as underwear and panties, continue to perform well with both retail sales growth and our shipments being at or above our plans. Champion was also very strong with sales increases in the mid-teens.

Second we’ve made good progress repositioning our U.S. Imagewear to focus more on branded sectors and de-emphasized the low end commodity segments. And in fact we’re a little ahead of that schedule.

Third we executive the majority of our previously announced supply chain actions to adjust capacities and these actions costs us a little less than planned.

So we’ve had very good visibility for the remainder of the year for both price and costs as I said. Cotton costs are locked through December. And we’ve confirmed pricing with our retailers for over 95% of our expected U.S. volume. And finally we’re making good progress on de-risking our balance sheet.

Our inventories have peaked for the year and as they decline they will begin to generate substantial cash. We remain firmly committed to using that cash to pay down debt for the rest of 2012 and 2013.

So to sum up, the largest margin impacts of cotton inflation, the supply chain realignment and the operating losses associated with Imagewear are now behind us. Therefore, as planned our operating margins for the rest of the year should return to a more normal average of low double digits.

I’ll now turn the call over to Bill to give you a little bit more detail. Bill?

Bill Nictakis

Thanks, Rich. We saw a solid performance in our core domestic retail categories in both Innerwear and Outerwear segments during the first quarter. Our consumers and retail partners continue to prefer our leading brands as evidenced by retail sell through in the first quarter that was at or better than planned and the continued increases in shelf space that we have achieved across our businesses.

Let me touch on a few highlights for the quarter starting with Innerwear, and first let me discuss price. The short answer is that the pricing strategies and tactics that we have implemented are meeting or exceeding both our expectations and those of our customers.

Price gaps now appear to be moving within our historical ranges, and our customers acknowledge and are pleased with the positive impact that category prices have had on their business. We have now finalized the vast majority of pricing and package size changes for the balance of the year with retail pricing confirmed for over 95% of our expected U.S. volume.

Now looking at the specific category performances for the quarter, Innerwear sales were led by men’s underwear, women’s panties and hosiery with some increases of at least mid single-digits. These categories benefited from a combination of factors. In addition to price we launched several new products that are performing well, and we gained shelf which while having a positive impact in Q1 will have a more positive impact in the second and third quarters.

So overall our Innerwear business delivered to expectations. We took price to offset cotton, innovation is working, space gains are on track, and we’re successfully managing the price environment to our customers’ benefit.

Now turning to Outerwear, the core retail portion of this business excluding Imagewear performed well with sales up 4% in the quarter.

Our Champion brand continues to deliver strong results. It grew solid double digits in the first quarter led by our C9 by Champion line that’s sold to Target.

Our retail Casualwear category also showed positive momentum. Several new Hanes programs have performed very well and significantly beat retailers’ expectations. These program successes have enabled us to offset most of the loss of the Just My Size fashion products, with those losses now behind us. Also, Gear For Sports remains on track to deliver $40 million of operating profit in 2012.

Now, let me provide an update on our U.S. Imagewear business. As communicated on the last earnings call, we intend to focus our resources against those sectors of the channel whose end-users value leading brands, great quality, ultimate comfort and proper fit.

This means we’ll focus our efforts against unique products such as Champion Activewear, Hanes Beefy Ts, Tagless Ts and Ecosmart while deemphasizing the chief commodity products where brand, comfort, quality and fit are irrelevant. We’ve communicated this position to our wholesalers, and they now understand how and why we’re migrating our business model to be a more value-added branded partner.

As part of the Imagewear plan, we’ve made significant progress in unwinding our position in the commodities sector. In fact, we’re a little ahead of schedule and should have our commodity product inventory appropriately sized by the end of the second quarter, thereby significantly reducing our exposure to further price deterioration in that category. Longer term, we believe that going forward, this should be a smaller but more profitable and less volatile category that represents about 4% of our annual sales.

In our international segment the overall performance mirrored the domestic businesses as it was impacted by the same issues of its Imagewear business in Europe and the cotton inflation that’s working its way through the supply chain. In fact, international’s operating profit decline was very similar to the overall decline in the total company.

We expect to see its operating margin improve similar to the U.S. beginning next quarter, all of which was built into our guidance. More specifically regarding our Imagewear category in Europe, which is about 12% of our total international business, we’re undertaking the same thought process and analysis as we have with the U.S. category. As we fully formulate our plan, we’ll apprise both our customers and the investment community on our intentions no later than our next quarterly conference call.

Shifting to our global supply chain, we’re very pleased with our performance. Now that we’ve settled into our manufacturing footprint and have a more stable environment, we’re seeing the full benefits of our strategy take hold. So, this is our record levels, quality remains strong, inventory is being reduced at or ahead of plan and we should again deliver substantial savings. Our supply chain will continue to be at pillar for both near-term success and our longer-term momentum.

So to wrap up, our overall strategy is working as planned. We see a lot of good things in lots of places to give us more confidence in the balance of the year. Product innovation is working. We’re gaining space. Our supply chain is delivering cost, savings, service and quality.

As I reflect upon our first quarter performance, I think the biggest positive is how we and the entire retail community have managed pricing. Up until the dramatic cotton inflation of 15 months ago, the majority of the apparel world was stuck in a cycle of deflation. This was difficult for suppliers and difficult for retailers.

As the price of cotton doubled and then tripled, we all had to burst through the traditional apparel pricing paradigm and raise prices. And our retailers learned that some level of price increases can work to their advantage. I think this change in perception with regards to price has an ongoing benefit to our retailers, as well as to companies such as ours who have strong brands, quality and innovation.

I will now turn the call over to Rick Moss to discuss our financial performance.

Rick Moss

Thanks, Bill. Our first quarter financial results unfolded and a little better than we expected, and as a result our outlook for the balance of 2012 hasn’t changed. The worst of the margin pressure related to high cotton costs is now behind us, as well as most of the impact of Imagewear. So we continue to expect our margins to improve throughout the year.

First I’d like to review the financial results from the first quarter and then reiterate our guidance for 2012. Finally, I’ll talk about our continued focus on de-risking the business.

Sales in the first quarter were $1,800,000,000, in line with our previous guidance and down 3% versus last year. Our EPS loss of $0.27 was $0.08 better than our previous guidance. Our gross profit margin in the first quarter was expected to be in the mid-20% range and came in at 25.2%, down $100,000,000 or 900 basis points from last year’s first quarter.

As expected, about half of the gross profit decline came in Outerwear, impacted by the loss in our U.S. Imagewear category and the sales declines in Just My Size. In addition, we recognize $13 million of expenses related to supply chain adjustments as we discussed on our last call. The balance of the gross profit decline resulted from higher input costs, primarily cotton, net of price increases and cost savings.

Our first quarter SG&A dollars decreased $4 million from the prior year, driven primarily by lower distribution costs and lower media spending. Due to the lower sales, the SG&A rate increased slightly year-over-year from 24.4% to 24.6%. Interest expense for the quarter declined $4 million due to lower debt and the tax rate was 15%.

Looking at the balance sheet, we’ve now passed the peak levels of our inventory and expect to consistently free up working capital over the next three quarters as inventory dollars and units continue to decline. Inventory at the end of the quarter totaled $1.6 billion and is tracking favorably to our plan. Basically the first quarter unfolded as we expected and therefore there have been no material changes in terms of our financial outlook. And today we’re reconfirming guidance for the full year.

We continue to expect sales growth of 2% to 4%, compared to fiscal 2011 and EPS for the year of $2.50 to $2.60. Excluding the impact of Imagewear, we continue to expect sales trends through May to be fairly consistent with the last three quarters. But as a result of our new shelf space gains and more normalized price gaps, we expect to see sales growth resume thereafter.

Turning to U.S. Imagewear’s impact on the P&L, the first quarter loss was approximately $0.18 per share. And we continue to expect that the loss for the year will be roughly $0.30 with the balance coming in the second quarter.

We’re making great progress repositioning our overall Imagewear category; however, as we continue to evaluate it, we may incur some noncash charges not included in our guidance. When we have more information around these items we will share them at that time.

For the total business we continue to expect our gross profit margin percentage to improve over the balance of the year. Second quarter gross profit margins should improve to the high twenties leading to operating profit margins in the mid to high single-digits. The back half of the year is still on track to potentially see gross margins return to the low thirties with operating margins in the low double-digits.

For the full year, we continue to expect to see SG&A flat to slightly down. For the year, interest expense should be approximately $15 million lower than 2011 and our tax rate should be in the low double-digits for 2012.

We’re also reconfirming free cash flow guidance of $400 million to $500 million for the full year, reflecting the unwinding of inflation working capital as well as reduced units in inventory. This free cash flow guidance includes pension contributions between $30 million and $35 million and roughly $45 million of capital expenditures.

As we continue to focus on de-risking the business we’re on track to pay down the remaining $300 million of floating rate notes at the end of 2012 with a goal of prepaying our 8% notes when they become callable in late 2013. In 20 months this will bring our total outstanding bonds to $1 billion and should substantially reduce interest expense versus historical levels.

Still inherent in our 2012 guidance is an average operating profit margin of approximately 11% for the second through fourth quarters. For 2013 modeling purposes, a 10% to 11% operating profit run rate is still a good assumption resulting in 2013 EPS potentially in the low $3 range. As Rich mentioned with the worst behind us, we now have good visibility and are focused on reducing debt de-risking the business and showing Hanesbrands true earnings power.

I’ll now turn the call back to Charlie.

Charlie Stack

Thanks, Rick. That concludes the recap of our performance for the first quarter. Now we’ll begin taking your questions and we’ll continue as time allows. Since there may be a number of you who would like ask a question I’ll ask that you limit your questions to one question plus a follow-up and then re-enter the queue to ask any addition questions.

I will now turn the call back over the operator to begin the question-and-answer session. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Bob Drbul from Barclays. Your line is open.

Bob Drbul – Barclays

Hi. Good afternoon. I guess I have two questions. The first one is around some of the pricing actions, what you’ve done so far, and you say you’re locked for the year. Can you just elaborate a little bit in terms of the pricing that you have logged for the rest of the year in terms of pack sizes or holding price versus price adjustments, maybe a little color on category.

And then the second question is I think you mentioned some shelf space increases if you might be able to like quantify that a little bit or detail that a little bit more. That would be very helpful. Thanks.

Rich Noll

Right. This is Rich. I’ll start with some of the high level and I’ll turn it over to Bill to give a little bit more specific. You know we’ve always talked about as we’ve gone through this to make sure that we’re adjusting our prices appropriate for the cost environment that we have. We’re doing that. We’ve done it; we’ve talked about it last call and the call before as cotton come down we’re adjusting our prices and all this inherent in our guidance and as it’s happening our margins are expected as we projected to increase to the low double-digit levels in the back half of the year.

We’re doing this through a number of different techniques. Some of the cases were increasing the pack sizes, in other cases we’re adjusting prices and other cases they’re sticking exactly where they’ve been. And Bill do you want give a little bit more specifics and then talk a little bit about some of those shelf space gains?

Bill Nictakis

Sure. I think exponentially as we go and talk to our customers about price, their biggest concern frankly is that we don’t muck up their entire category. Their business is doing well and I think we’ve helped them manage the price to their advantage for the category. And they’re concerned that we cause them a comp store issues, a deval issue, a margin issue down the road.

So, most of the conversations are how do we go and protect the gains that they’ve had because they have inflation and wages and benefits that they need to adjust too. And I think they’ve seen the benefit of some modest price increases on their overall business. So, we’re arm-in-arm, and that’s why we’ve had the conversation, and we’re pretty much set for the balance of the year in terms of where prices and pack sizes and things like that are going to be.

Second part of your question with regards to shelf space, we’re gaining space across multiple categories and multiple classes of trade. And I think part of the reason is we’ve had really good productivity on our new products. Our product innovations have worked extremely well for our customers. And I’ll give you a couple of examples.

On men’s underwear, one of our best performing categories over the last couple of years, we’re launching a new innovation ComfortBlend. It’s a synthetic cotton blended product. It’s actually a higher ring per garment.

So, it’s more profitable at a higher penny product for our customers as well as on our side. And we’re supporting that with some real and tactful marketing that’ll show up in late Q2, Q3. We’re getting space gains from accounts, and we’ve already gotten it from a couple of them. It’s in Target right now and Kohl’s. It’ll be going market-wide here late Q2.

Our bra business, Bali bras, we have a simple, sure sizing innovation that’s having extreme success in the marketplace, and we gained space with that too. So, lot of success is driving our space gains.

Bob Drbul – Barclays

Great. Thank you very much. Good luck.

Rich Noll

Thanks.

Operator

Your next question comes from the line of Eric Tracy from Janney Capital Markets. Your line is open.

Eric Tracy – Janney Capital Markets

Hey, guys. Good afternoon. Congrats on a nice quarter.

Rich Noll

Thank you, Eric.

Eric Tracy – Janney Capital Markets

If, I guess, Rich or Bill, to follow up on the pricing discussion here just in terms of retailer strategies in the back half in particular. Clearly it sounds like conversation to date have been really, really positive in wanting to hold on to. How do we think about the potential risk if one of the bigger retailers decides to go a little bit more aggressive on pricing as their costs roll off? Or is there enough structural cost to them that are going to be sustained that they’re going to want to hold on to the pricing?

Bill Nictakis

Yeah. I think there’s two things. One is, again remember we are adjusting prices down to reflect the lower cotton work into our P&L. So, that’s already in place, and that’s in our guidance, and that’s in the conversations and the pack sizes and things like that, that we’re bringing out summer and fall.

I think the second thing we all have to remember is while we’re all talking about cotton you look at what’s going on with polyester’s up 74%, wages over the last couple of years anywhere from 20% to 90% based on part of the world. Fuel is up 160%. So there’s a lot of other things that play here for us and for the entire industry.

Rich Noll

Yeah. And let me just – I think it’s important to put into perspective what the level of adjustment we’re talking about relative to the overall increase. Remember some of our prices are up 25%, 30%. We initially price for high watermark of cotton which would have been in that 30% range. Clearly even for today’s low price of cotton you’re still talking about price increases versus 12 or 18 months ago that are 25% higher, and that’s the appropriate price. So these adjustments have been relatively minor in the scheme of things. We don’t want to leave anybody with the impression that prices are coming down a lot.

Also as importantly, it was as all expected. I mean if we kept prices where they were and cotton came down our operating margins would probably be in the mid to high 20s. Nobody ever expected that to be sustainable, but with the price adjustments that we have locked in, with the certainty that we have, with the retailers that have indicated where they intend to price things we’re very comfortable with the visibility we have about getting our operating margins back to more normal historical levels or even up into the low double-digits that we’re talking about for the back half of the year.

Eric Tracy – Janney Capital Markets

And then maybe to follow on that just more sustainably on the out margin line. All the supply chain moves, offshoring the production to low cost, certainly been masked by first recession and then on the severe cotton spike, but it sounds like some of the supply issue is actually starting to show through again. Maybe just remind us, walk us through how we should start to think about that again for the longer term now that you’re managing, there’s starting to be sort of an underlying expansion driver.

Rich Noll

Yeah, and I think the best way to think of this is that we’ve had a lot of issues with cotton inflation working its way through and Imagewear working its way through, and it’s all showing up in this first quarter where we’ve got a loss. As Rick said, our operating margin for the next three quarters in our guidance it’s around that 11% level, and we have talked about that’s a reasonable operating margin level, that 10% to 11%, to think about into 2013.

That’s supported by the pricing that we have got. That’s supported by the supply actions that we have got and a whole host of things. So we believe that our run rate as you’re going into the next portion of the year is much more indicative of our true earnings power as we’re now getting this inflationary bubble behind us.

Longer term we have always talked about the supply chain continuing to deliver advantages, continue to go after our branded business and remix our business up and then operating margins in that 12% to 14% over time are definitely – be still achievable. So in 2013 we’re talking about sort of that rebound as we’re not going to have the bad first quarter that we’re having this year. Remember 2014 you’ve got huge interest expense savings that can drive earnings power, but you’re going to continue to see operating margins expand over time.

Eric Tracy – Janney Capital Markets

Okay, great. Thanks guys, best of luck.

Rich Noll

Thanks.

Operator

Your next question comes from the line of Susan Anderson from Citi. Your line is open.

Susan Anderson – Citi

Hi, guys. Congrats on getting through a tough quarter.

Rich Noll

Well thank you, Susan.

Susan Anderson – Citi

So if you look at some of the categories it looks like sales are trending pretty good. I think you had the men’s underwear mid single-digits, women’s panties double-digits. How do you think about kind of what’s driving the sales there? Do you think there’s restocking going on or are these trends that we can expect to continue throughout the year?

Rich Noll

Yeah, we suffered a lot of destocking in the fourth quarter; that has stopped but we have not seen retailers go back and try to bring back and restock that inventory. So I think the retailers by and large are ordering to replenish what’s going out the front door, but we haven’t seen, nor do we anticipate a big restocking going on. But driving our business has been the space gains and we just started a set that will really start showing up in Q2 and Q3 and some of our product innovations are working pretty well.

Susan Anderson – Citi

Okay, great. And then maybe if I could just nail down a little bit on the women’s side of the business if you could maybe give a little bit more color on Intimates. It sounds like panties were obviously pretty strong. Is that mainly at mass or also at the department stores? And then maybe just the trends that you’re seeing on that side of the business because I know it was a little bit weaker last year out of the department stores.

Bill Nictakis

Yeah, so let me just talk about Intimate Apparel. So we have our Bra business, our Panty business and Hosiery Shapewear. Our Panty business and Hosiery Shapewear business we’ve been focused on over the last 12, 18 months, we’re seeing good progress on those. Both of those categories grew for us in the first quarter, we’re gaining shelf space going forward, so we feel good about the direction we’re headed on those.

Bras is the big opportunity for us now and frankly our focus is to take the same approach that we did on Panties and Hosiery and apply it to our Bra business. And I think there’s two things going on with Bras

one’s macro and one’s ourselves.

On a macro basis, our core Bra business, Bali and Playtex, appeal to the over 35 fuller figured woman. She’s buying bras less often, she’s buying fewer bras when she does buy them, and that started in a recession and that behavior has maintained through the first quarter. So we’re just seeing less purchase frequency on our core business.

Important to note, though, our share in mid-tier and department stores on Bras is fine. We’re flat to up in terms of market share there, so it’s really a macro issue. I think where we’ve got to do a better job executing is on the mass channel. We haven’t kept up with what our customer’s expectations are and we’re working aggressively with both of our key but all three of our major mass customers on developing action plans to help them use our brands to re-energize their categories.

Susan Anderson – Citi

Okay, great. Thanks, guys.

Rich Noll

Thanks, a lot.

Operator

Your next question comes from the line of David Glick from Buckingham Research. Your line is open.

David Glick – Buckingham Research

Thank you. Good afternoon and congrats on the progress. Just a quick question. I was wondering if you could give us a better sense as to how you see the top line in operating margin progress from Q2 through Q4. I know you don’t give quarterly guidance, but maybe a little more color on the relative progress you expect to make from quarter-to-quarter. Obviously revenues down Q1 and operating margin, obviously a tough quarter given all the headwinds that you described.

But mid to high singles is a fairly broad range in operating margin. I suspect that the revenue trend should improve, you mentioned through May. So there is still a month where you have some shelf space gains in the end of Q2, maybe could drive like a low single-digit increase in revenue.

And then you’re coming up against some of the intimate apparel de-stocking, for example, in Q3 and some other things that could turn your trend around. If you can walk us through how the year might unfold. Help us understand how the earnings and margins are going to flow as the year goes on. That would be helpful.

Rich Noll

Yeah. David, this is Richard. And I think you’ve actually itemized a number of things on the revenue side, you know as you’ve talked about that are actually the drivers that allow growth to happen. The space gains, the starting to overlap some of the de-stocking, and the price gaps that were widening last year as we were driving prices up in the marketplace usually 3 to 4 months is a little bit faster than the overall competition.

So we’ve been relatively what we believe conservative in our top line planning saying that we’re only going to see growth when we’re starting to overlap some of the weakness that we saw last year. In terms of margin cadence and everything, Rick do you want to talk about some of those things?

Rick Moss

Sure. I think if anything, we’re more confident of the directions that we’ve given in terms of where margins are going than we were before. We’ve seen as a result of the successes we’ve seen in the first quarter. You should see gross margins, as we said, in the upper 20’s in Q2, as we continue to see the impact of higher cotton costs on our margins wane a little bit. And then as we get into the back half of the year, more normalized margins in those low 30’s. And that’s going to drive that growth of operating profit from the mid to high single digits to the low double digits in the back half.

David Glick – Buckingham Research

So it’s fair to say that you can see slightly positive revenue growth in Q2 and then as the year unfolds you progressively better top line and then the same for the operating margin obviously a single digit in Q2 but increasing as the year unfolds. Is that the best way to think about it?

Rick Moss

Yeah. I think one thing to remember when you look at our top line even for the first quarter when you take out the effect of Imagewear which was $38 million down and JMS which we told you was going to be – in the last quarter we told you it was going to be between $25 million and $30 million, that was down about $28 million, $29 million. You take those two out and the rest of the business was actually up 4% or pretty darn close to it. So, again, very encouraging in terms of giving us really good confidence going into the rest of this year.

David Glick – Buckingham Research

Okay. Great. Thank you very much. And good luck.

Rick Moss

Thanks.

Rich Noll

Thanks, David.

Operator

Your next question comes from the line of Eric Alexander from Stifel, Nicolaus. Your line is open.

Eric Alexander – Stifel Nicolaus

Okay. Thank you. How you guys doing? Sitting in for Jim today. Good job on weathering the plan or ahead of plan. Definitely good progress. So, looking at the – as far as international goes you guys had noted the sluggish European Imagewear sales, and it was going to be under review similar to the U.S. review. Do you guys foresee a future charge to this that maybe isn’t captured in guidance today? Or is that captured? If you could just help me with that, that would be appreciated.

Rich Noll

Yeah. And I’ll just talk about the strategy and, Rick; I’ll let you address the other part of the question. Overall the European Imagewear business comprises about 12% of the international segment. It’s feeling the same kind of pressures as we’re feeling in the U.S., same types of competitors, Fruit of the Loom, Gildan are both in Europe. So, a lot of the same types of cotton inflation working its way through international.

So, it’s almost like a mirror image of what’s going on here. Obviously we wanted to focus on the big piece of our business, the U.S. Imagewear business first. We’re now undertaking a review exactly how to reposition that European business, and as soon as we finalize those plans we’ll make sure that we share them with both the customer groups over there as well as the investment community. So, we’ll have more about that – to say about that in a later – next quarter.

Rick, on the other?

Rick Moss

Yeah. And as we undergo those reviews that Rich just talked about European Imagewear and other parts of Imagewear business there may be some charges. They’ll all be noncash associated with some balance sheet items that have been on the balance sheet for a while. But again, I would emphasize they’ll be noncash charges.

Eric Alexander – Stifel Nicolaus

Okay. That’s helpful. And then a couple of questions on inventory. With inventory levels where they are, do you guys expect to see any sort of a distribution savings that you saw in the first quarter? Or are you lapping more difficult comps or easier comps I guess in the first quarter that we shouldn’t expect to see maybe the savings on air freight? And then also, do you still expect to be through your higher cost inventory by the end of second quarter?

Rick Moss

Yeah. I think – let me take a crack at that. We were very pleased with the progress in our distribution cost reductions in first quarter, that group is a very important part of the supply that, as Bill mentioned, is doing very, very well, and as this gels and the footprint solidifies. So yeah, we expect to continue to see that group perform very well. The second part of your question was?

Rich Noll

With overall distribution how it’s going to anniversary for the rest of the year, and I think you just go back to the SG&A guidance and it will be flat to slightly down.

Rick Moss

It should be flat to down. Yeah.

Operator

Thank you. Our next question comes from the line of Omar Saad from ISI Group. Your line is open.

Omar Saad – ISI Group

Thanks. Good afternoon, guys.

Rich Noll

Hi, Omar.

Omar Saad – ISI Group

I wanted to ask a question about department stores. I know it’s not as big of a channel for you guys as some of the mass channels, but there’s some dislocation going on. JCPenney is going through kind of a reorganization and restructuring, just the moving pieces across that channel. How do you guys see that channel playing out for your business? How do you feel that you’re positioned? Are basics really kind of – the basic categories that you guys specialize in, are they really kind of steady as she goes? Are any of those changes having impact on you?

Bill Nictakis

Yeah. I think we’re well positioned for that mid-tier department store because they seem to be more focused than ever on moderate-priced brands and really the power of big brands. You mentioned JCPenney. Their strategy has got three components. Right? Fewer bigger national brands, fewer SKUs into assortment and then this whole simplified pricing.

And that really, the whole thing about fewer brands, bigger more impactful brands that can drive traffic to their stores, they plays to our real house. That’s what Hanes is, that’s what Bali and Playtex is. I think that strategy works well for us, and I think as others are looking and say, hey, there’s dislocation and how can they possibly seize on it? They come back to brands are the key thing that they can leverage to drive traffic to their stores and let customers know that they sell the best brands at a great value. I think it plays well for us.

Omar Saad – ISI Group

Great. And a quick follow up on the international piece too. I know some of the similar business in the Imagewear side of it internationally obviously under pressure there, and you’re taking a look at that. What about the commercial businesses internationally? How have they been trending this quarter and last quarter compared to what looked to be pretty robust growth over the last year or two? Which markets remain strong? Are you seeing any softness out there ex the inventory piece? I’m talking about the commercial business.

Rich Noll

Right. So let me first hit it. On the profit side obviously they’re all facing the same kind of inflation and pricing issues that we’re feeling in the U.S. So that trend is exactly the same everywhere in the world to be honest.

From a top line perspective, which I think is where you’re more focused, in the quarter we actually saw a little bit of softness across the board throughout the Americas and Asia, but to tell you the truth it looks more likes it’s temporary than something that is actual structural. For example, Brazil is actually relatively soft in the quarter, but it’s already snapping back and looks like it’ll trend to be relatively strong in Q2. So I don’t want to over read into that and say that we’re starting to see softness in all of those countries. It may be more just coincidental tactically in a quarter than it is something that is systemic and a trend.

Omar Saad – ISI Group

Got you, Rich. Thank you. I appreciate it. Good luck, guys.

Rich Noll

All right. Thanks.

Operator

Your next question comes from the line of Steve Marotta from C.L. King & Associates. Your line is open.

Steve Marotta – C.L. King & Associates

Good evening, everyone. You mentioned that inventory is expected to decline each quarter for the balance of the year. Can you give a little bit of guidance on where you expect inventories to end the year, either in a dollar range roughly or a percentage decline in a year-over-year basis?

Rich Noll

Yeah. Let me answer it this way, Steve. You know we’ve set our goal to or we’ve said that our guidance for the year on free cash flow is $400 million to $500 million, with about half of that coming from capital improvements, primarily in inventory. So you’re going to see significant inventory improvement beginning in Q2 and continuing on through Q4.

Steve Marotta – C.L. King & Associates

Got you. And my only follow-up question is did the marginal strength in the first quarter that you guys experienced affect your promotional cadence at all in the coming quarter? In other words, have you pulled back at all on perhaps planned promotions because things have been so good and your inventory levels are a little bit less than expected?

Bill Nictakis

No. We’ve locked those promotions in with our retail partners at four to six months in advance. So we’ve been set for the key back-to-school timeframe for a while.

Steve Marotta – C.L. King & Associates

Okay. All right. Thank you very much.

Rich Noll

Thanks.

Operator

Your next question comes from the line of Scott Krasik from BB&T Capital. Your line is open.

Scott Krasik – BB&T Capital

Hi, guys.

Rich Noll

Hey, Scott. How are you doing?

Scott Krasik – BB&T Capital

Good, Rich. Thanks. Just a couple of clarifications, did you say, Rick, that excluding both JMS and inventory sales are 4%? Or was that just ex-Imagewear?

Rich Noll

I said that Imagewear and JMS, the combination of the two. They were both, the two together, were down a little over $60 million from prior year.

Scott Krasik – BB&T Capital

Okay. And just to get a sense of what the gross margins in your Outerwear business may have looked like excluding the Imagewear particularly?

Rich Noll

Well, Scott, we don’t really talk about gross margins at the segment level. Operating profits margins are what we look at.

Scott Krasik – BB&T Capital

Okay. And then just to confirm as you restate numbers here. Can we just add together the Hosiery and the Innerwear numbers for historical quarters? Or would we be pulling out some sort of filing on that?

Rich Noll

No, Scott. It’s as simple as that. You hit the nail on the head. Take Innerwear and Hosiery, put them together and you got the new Innerwear.

Scott Krasik – BB&T Capital

All right. Thanks, guys. Good luck.

Rich Noll

Thanks.

Operator

Your next question comes from the line of Andrew Burns from D.A. Davidson. Your line is open.

Andrew Burns – D.A. Davidson

Good afternoon. I just wanted to confirm what I think I heard thee. In terms of your view on retail inventory levels, it appears that they’ve normalized and going forward sell in should closely follow sell through across most categories and channels. Is that correct?

Bill Nictakis

Yeah. I think that’s right. I think that’s what we’re anticipating.

Andrew Burns – D.A. Davidson

Okay. And then just a question, a nice start for Champion Outerwear for the year. You mentioned the C9 program. Was the strength that you’re seeing there, is that just improving sell through? Or is that a program gain in floor space? Any color there would be helpful. Thanks.

Bill Nictakis

Yeah. I think if you look at the growth in C9 for the first part of the year it’s a lot of sell through and a little bit of space and distribution. That business is doing exceptionally well working hand-in-hand with the Target folks.

Andrew Burns – D.A. Davidson

Great. Thanks. One last one for you. I haven’t heard about the Graphic T growth initiatives in a while. I was hoping you could update us on that, how that’s tracking, and what that opportunity looks like these days. Thank you.

Bill Nictakis

Yeah. And Graphics is a big part of our business now. Remember we bought Gear For Sports. So, we’ve really built our capabilities on Graphics over the last 15, 18 months. And that synergy of combining the Gear For Sports organization and their capabilities along with our core capabilities here in terms of on the retail side, we’re really starting to see some nice progress and some very good synergies across both businesses. So, we’re pleased with the performance. We’re probably more pleased with what we think we can do over the next 18 months or so on that business.

Operator

Your next question comes from the line of Eric Beder from Brean Murray. Your line is open.

Eric Beder – Brean Murray

Good afternoon.

Rich Noll

Hi, Eric.

Eric Beder – Brean Murray

You’ve talked before about inflation, and let’s just look beyond the ups and downs of this year and last year. Going forward what do you think – how do you think inflation’s going to play going forward beyond 2012?

Rich Noll

Yeah. Let me just give you my overall thoughts on how it’s likely to play out rather than – obviously we can’t predict it specifically. But clearly there’s a lot of wage pressure in the developing world with the apparel supply chains including ours is where they’re located. There’s not a lot of other low cost countries that have a billion people in them like China was.

So, a lot of them move towards lower cost country are now over, and those costs of wages, fuel, polyester, all of those things are going to continually work their way through on a more consistent basis. You’ll always have the fluctuations with cotton up and down. But you’re going to see those other things go up and they tend to be relatively sticky.

I wasn’t running these businesses, or some of them back in the 1990s and that was an environment where it was the same kind of thing. And prices and apparel tended to go up at about three-quarters of the rate of the overall consumer price index in the U.S. And so what you might see is a 3% to 5%. Maybe not every single year, but maybe every other year where you would see a couple of percent per year.

If I had to guess what apparel’s going to look like in terms of inflation over the next decade, it’s probably going to be on the order of that. Retailers feel their own pressure, with their own costs going up, and now the apparel supply chain is going to have those same types of things. And that’s more likely the environment we’re going to be in. That bodes well for companies that have brands, because they’ve got more pricing power than those that don’t.

Eric Beder – Brean Murray

Great. And could you – we haven’t talked about it in a while, the marketing spend you guys have continued to be a lead marketer in terms of the Innerwear segment. I know you’ve talked before about taking that to 100 million plus market. Where is the marketing spend now, and where do you want to see it go going forward?

Rick Moss

In terms of overall spend this year, we talked about, we have in fact pulled back for two reasons. One is there was some spending that we were doing primarily in the Bra category that really didn’t have the payback that we really demand of marketing spend. So we actually pulling that money back and deploying it elsewhere.

Some of the other spend we’ve also felt in this great margin constrained environment, we did pull back on, which we’ll want to make sure that we restore next year. Now we’re talking in the 10’s of millions of dollars, we’re not talking about huge numbers. But don’t get me wrong, we’re still supporting everything we need to.

And in fact the underwear launch that Bill had talked about earlier is getting all the traditional support that we would have done in good years or in bad years. So we’re feeling that we’re spending the right amount, maybe a little bit less given the margin constraints that we have. But that will quickly snap back.

Operator

Your next question comes from the line of Emily Shanks from Barclays. Your line is open.

Emily Shanks – Barclays

Hi. Good afternoon. Thanks for taking the question.

Rich Noll

Sure.

Emily Shanks – Barclays

It really relates to the existing covenants in your bank facility, and specifically the total leverage covenants. I just had a housekeeping item. I was curious, is the reported EBITDAX in the press release, the EBITDAX that’s used to calculate the maintenance covenant? And secondarily, what is your calculation of total leverage at this point?

Rich Noll

We broke up a little bit there Emily, but let me – I think I got the jest of your question. First of all, we don’t generally disclose the exact difference between the EBITDA and the adjusted EBITDA for the leverage covenant, but it is substantially different. And so it provides us with a pretty significant cushion in the leverage ratio as defined in the credit agreement.

So, Emily, I’m not at all worried about our covenants this quarter or next, and I’m certainly not beyond. So I feel very comfortable with where we are. We’re not going to have a problem.

Operator

Your next question comes from the line of Carla Casella from JPMorgan. Your line is open.

Carla Casella – JPMorgan

Hi. One question on Imagewear. Your goal to get to 4%, did you say where that is today and how much of your Imagewear is U.S. versus Europe?

Rick Moss

Yeah, when we talked about the Imagewear and the 4% that was specifically U.S. Imagewear. Imagewear ended last year at around 8% of our overall business and we’ve talked about as we sort of remix it and pull back over the long-term, it’ll probably get down to that 4% level. We’re probably moving in that direction this year, but we’ll probably continue to unwind pieces of it through 2013. So it’ll be more of a gradual change.

Operator

Your next question comes from the line of Todd Harkrider from UBS. Your line is open.

Rich Noll

Todd?

Operator

Your next question comes from the line of Eric Tracy from Janney Capital Markets. Your line is open.

Eric Tracy – Janney Capital Markets

Hey, guys. Just a quick follow up, Rick, for you. As we think about the gross margin, the back half, kind of low thirties is what you suggest for each, but certainly fair to assume that cotton, it terms of being rocked in 3Q versus 4Q, definitely should still be up, I don’t know, to the tune of 20% to 30% in 3Q, correct? I just want to make sure I’ve got the cadence of 3Q 4Q on a cotton cost basis is accurate.

Rick Moss

Well cotton costs in Q3 will be, the focus of the P&L, will be a little bit higher than they were in Q3 last year. Is that what you were asking?

Eric Tracy – Janney Capital Markets

Yeah, I just want to make – because I mean obviously they were significantly lower in 4Q. But yeah, I just wanted to make sure that I was thinking about that still...

Rick Moss

Yeah, let me just say this here. The bulk of the – as we’ve said before, pretty much all the cotton that we’re carrying on the balance sheet at the end of the year flows through in the first half of the year and after that it’s really not significant.

Eric Tracy – Janney Capital Markets

Okay. Thanks, guys.

Operator

There are no further questions at this time. I turn the call back over to the presenters.

Charlie Stack

We’d like to thank everyone for attending our quarterly call today and look forward to speaking with many of you soon.

Operator

This concludes today’s conference call. You may now disconnect.

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