Last week, Herb Greenberg's new firm Greenberg Meritz wrote cautionary words about Hanesbrands (NYSE:HBI), which is the top holding in my portfolio. The following morning, Credit Suisse reiterated that the stock was a favorite idea in the market. Hanesbrands is the top holding within my portfolio and is my favorite stock within the consumer sector (although as I have mentioned on other occasions I continue to like stocks which are benefiting from the trade down effect while avoiding those who are prone to it).
Greenberg Meritz in their report questioned Hanesbrands' sales growth which they termed uninspiring along with the quality of earnings and economic headwinds that the company is facing. They also mention that Hanes continues to be involved in a restructuring (due to their spinoff from Sara Lee a couple of years ago) and that the balance sheet and operating cash flows are deteriorating at fast rates while the company faces increasing costs and intensifying competition. I thought I would address each of these points individually.
Sales growth- The company recently guided to 1-3% revenue growth (excluding any acquisitions) but at the same time guided profit margins higher than anticipated. If Greenberg is looking for a 20% top line revenue grower, then they are correct that it is uninspiring. However, for a business which is established and is shifting from lower margin to higher margin sales, a slower growth rate is not surprising, but this should be for the benefit of the bottom line and cash flows.
Balance Sheet- With nearly any spin-off it takes time to clean up the balance sheet as these companies are often spun off with significant debt loads. I would point out that the company has paid down nearly $300 million in debt over the past two years bringing down their debt to EBITDAR level consistently every quarter. The company's first traunche of long term debt is not due for another four years. In addition, the rating agencies agree as in May, S&P raised the credit rating for Hanesbrands to BB- and said that the company's restructuring is on target.
Much of Hanesbrands' interest expense has also benefited from lower interest rates as LIBOR has declined. Any improvements in credit markets should help Hanes in refinancing their debt (especially as their credit rating has improved), while deteriorating economic activity would likely result in steady or declining LIBOR rates allowing the company to continue to operate with a lower interest expense.
Operating Cash Flows- Hanes did exhibit a decline in operating cash flow in the first quarter after several quarters of very strong operating CF growth. The entire reason for this was due to an increase in inventory which is common for this company during the 1st quarter and which should be brought down somewhat in the next couple of quarters. I would also point out that FCF for the firm is close to $3 per share, which means the stock is only trading at 9x trailing free cash flow.
Costs- Hanes is actively cutting costs by shifting manufacturing facilities to lower-cost regions of the world (Vietnam, Thailand, El Salvador, etc.) from higher cost areas including facilities in the United States. The one area that is at least somewhat out of the control of Hanesbrands (although they do hedge in the near-term) is in the price of cotton. If cotton prices were to substantially increase from current levels, it could impact some of the cost savings that the company experiences from their manufacturing shifts, but in my opinion, the potential is already priced into the share price of the stock. SG&A has not shown any noticeable increase, and interest expense is declining.
Competition- Hanes does face competition in their sector, however, Hanes along with competitor Fruit of the Loom have significant brand recognition and economy of scale advantages over competitors. The cost of production of undergarments significantly declines with volume, and Hanes' use of partnerships with companies such as the 10-year agreement with Disney will only help.
Economic Headwinds- I agree with Greenberg on the point that the company does face increasing economic headwinds. However, I would argue that the company operates in a portion of the consumer market that is less cyclical and more recession-proof as people are always going to buy socks, underwear and shirts. Will sales be a little slower if economic conditions significantly deteriorate? Probably, but at the same time I would not expect a large decline and it would likely be very temporary in nature.
Also, Hanes has discussed the increasing importance of international sales going forward (only 10% of sales are international today) which could continue to help lift overall sales even with a weak U.S. economy. Greenberg did not address it in great detail, but bottom line growth should continue to be very strong due to the reasons listed above. In addition, Hanes has a return on capital in the 10% range along with healthy margins and a strong management team.