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Hanesbrands Inc.

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Msg  23 of 24  at  11/19/2022 1:05:50 PM  by


Although Market Conditions Have Worsened, Hanesbrandsí Investments Should Support Its

Morningstar Investment Research Center
Although Market Conditions Have Worsened, Hanesbrands’ Investments Should Support Its Brands 
David Swartz
Equity Analyst
Business Strategy and Outlook | by David Swartz Updated Nov 15, 2022

Narrow-moat Hanesbrands is the market leader in basic innerwear (60% of its 2021 sales) in multiple countries. We believe its key innerwear brands like Hanes and Bonds (in Australia) achieve premium pricing. While the firm faces challenges from inflation, the strong U.S. dollar, lower inventory levels at retailers, and COVID-19, we think Hanes' share leadership in replenishment apparel categories puts it in better shape than some competitors. In May 2021, the firm unveiled its Full Potential plan to expand global Champion, bring growth back to innerwear, improve connections to consumers (through greater marketing and enhanced e-commerce, for example), and streamline its portfolio.

As part of Full Potential, Hanes intends to build on Champion’s popularity in North America, Asia, and Europe. Although recent results have been rocky, we believe Champion has expansion opportunities as it and other activewear apparel have become more than just athletic apparel and are increasingly worn as lifestyle/fashion brands. Moreover, Hanes has plans to improve Champion’s footwear after recently taking control of the product. Hanes’ management forecasts Champion will reach $3.2 billion in global sales in 2024, up from more than $2 billion last year, but we believe the macroeconomic and industry challenges difficulties have probably put this goal out of reach by this time frame.

Another key strategy for Hanes is to improve the efficiency of its supply chain. It has already made progress in this area, having achieved a 15% increase in manufacturing output over the past four years. Hanes, unlike many rivals, primarily operates its own manufacturing facilities. More than 70% of the more than 2 billion apparel units sold by the company each year are manufactured in its own plants or those of dedicated contractors. We believe the combination of strong pricing and production efficiencies should allow Hanes to maintain operating margins around 20% for its American innerwear business despite somewhat inconsistent sales.

Economic Moat | by David Swartz Updated Nov 15, 2022

Our narrow moat rating is due to the strength of Hanesbrands' intangible brand asset. Hanes’ key apparel brands have leading market share in their categories in the U.S. and a few other countries. The popularity of its brands allows it to maintain strong retail distribution and premium pricing. We believe the company can generate returns on invested capital above its weighted average cost of capital over the next 10 years.

Hanesbrands serves the competitive but concentrated category of mass-market basic apparel. The COVID-19 crisis has had an adverse impact on Hanes’ results and may continue to do so but should not change its competitive position to any significant degree. The company’s brands have held up during many economic cycles and ownership changes. They have, in some cases, even survived years of mismanagement and neglect. Hanes’ brands have leading market share in multiple countries and multiple categories. For example, in men’s underwear in the North America market, Hanes’ 2021 share of about 32% was more than the combined shares of Fruit of the Loom and Jockey, the second- and third-largest manufacturers (Euromonitor). Similarly, in Australia, Hanes’ Bonds has more than double the share of the second-largest men’s underwear brand and Bonds has been gaining share (to 21.4% in 2021 from 13.9% in 2016, according to Euromonitor). A decline in consumer spending and store closures will hurt Hanes but, in most categories, not more so than peers.

We think Hanes’ brands are especially important in its primary innerwear categories (underwear, undershirts, bras, socks). Although private-label apparel has become a major factor in many categories, these products only account for 7% and 2% of men’s and women’s underwear sales (Euromonitor), respectively, suggesting a strong preference for branded underwear.

Per capita consumption of underwear, bras, and socks varies little from year to year. In the U.S., market growth is not much different than overall population growth of approximately 0.8% per year. But unlike other categories, much of this apparel is unaffected by fashion trends and is more of a replenishment product. While there is significant competition, consumers are reluctant to change innerwear brands. They are more concerned about comfort and fit than price. A 2017 Millward Brown report found that price was merely the fifth factor in consumers’ purchasing decisions. While basic apparel has limited growth, per capita consumption of athletic-inspired apparel has been growing. This is a benefit for Champion and other activewear brands. Activewear (U.S. and international) represented 40% of Hanesbrands’ 2021 sales, up from 34% in the prior year.

Hanesbrands has invested in product innovation, which should support its brand intangible asset. The company spends about 1% of revenue on research and development related to product development and intends to increase this investment under Full Potential. New products are important for Hanesbrands because they allow for product differentiation and premium pricing. As an example, both men’s and women’s Hanes Premium X-Temp underwear sells for as much as double the price of basic Hanes underwear at Target and other stores. Consistent innovation is important because brand extensions allow Hanes to expand shelf space. Hanesbrands also supports its brands and product introductions with marketing. The firm spent $209 million (3% of revenue) on advertising in 2021, up from $114 million (2% of sales) in 2020. Hanes’ larger revenue base allows it to spend more on R&D and advertising than rivals. Hanesbrands’ spending on measured media in the U.S. is more double that of direct competitor Fruit of the Loom. As increased investment is part of Hanes’ Full Potential strategy, we anticipate both marketing and R&D spending to increase over the next three years.

We do not believe the current pandemic will have much impact on Hanes’ pricing. The company sells high-volume products with low price points. As an example, Hanes’ men’s underwear at wide-moat Walmart is typically priced 20%-35% more per unit than the Walmart brand. While a sizable difference in percentage terms, the difference in dollar terms is only around $0.50-$0.85 per unit. Innerwear is a sector based on low prices all the time and mass retailers run on lean inventory. This has been an issue for Hanes, which has had to adapt to Walmart’s unwillingness to hold inventory over the past few years. Also, Walmart and no-moat Target have put a priority on private-label apparel. Nonetheless, Hanes’ adjusted gross margins have improved to the high 30s in recent years from the low-30s before 2013 due to the introduction of innovative product with better pricing and low-cost manufacturing. Hanes owns factories in Latin America and the Caribbean and can produce basic apparel at least as efficiently as others because it has the greatest volume. As such, Hanes’ innerwear operating margins are typically in the low 20s, which is higher than the operating margins of some higher-priced branded apparel.

We anticipate Hanes will continue to generate ROIC above its WACC over the next 10 years. Its adjusted ROIC including goodwill averaged 17% over the past 10 years, well above our WACC estimate for the company of 8%. We forecast Hanesbrands' average annual adjusted ROIC including goodwill at 19% over the next decade. Hanesbrands has reported uneven results over the past four years due to store closures, lower retail inventories, weakness in intimate apparel, and, more recently, COVID-19. However, our view is that Hanes can overcome some of these issues and slightly improve margins in future years as cost-saving initiatives take hold. Also, it has sold its former European innerwear business, which was unprofitable in both 2020 and 2021.

We classify Hanesbrands’ moat as narrow rather than wide. The company’s brand portfolio is strong enough that we think it can maintain its premium pricing and shelf space over the next decade and its brands are supported by heavy advertising and innovation. In the long-term, however, Hanesbrands faces competitive threats from rising brands and copycat products, so we view a wide moat rating as inappropriate. Moreover, the company lacks other factors that would allow for a wide moat. There are no switching costs in its apparel categories, barriers to entry are low, and there is no network effect. While Hanes’ production process is cost-efficient, some competitors have similar production models, so we do not think it has a cost advantage over them.

Fair Value and Profit Drivers | by David Swartz Updated Nov 15, 2022

We are lowering our per-share fair value estimate to $22 from $24 after the release of Hanes' 2022 third-quarter report. Hanes is facing inventory reductions by retailers, an uncertain economic environment, unfavorable currency movements, and cost pressures, leading us to reduce our adjusted operating margin forecast for 2022 to 9.5% from 10.1% and our adjusted EPS estimate down to $1.00 from $1.20. For 2023, we forecast only modest improvement to $1.05 in EPS on 1% sales growth. These estimates could provide to be conservative if Hanes works through its problems faster than expected. Our fair value estimate implies 2023 price/earnings of 21 and an enterprise value/EBITDA of about 15.

Hanes intends to invest in its brands under the Full Potential plan, and we expect these investments will be successful. In the long term, we model annual organic innerwear growth rates of 2%-3%. Although long-term growth in domestic innerwear (40% of 2021 sales) is low, Hanes has been gaining share in some basics categories. Activewear (25% of 2021 sales) suffered a large (36%) sales decline in 2020 due to the virus and the loss of the C9 business at Target but rebounded 42% in 2021. We believe the category has good growth prospects for Hanes, reflecting geographic and product expansion plans for Champion. We model long-term growth rates of 3%-4% for activewear. Further, we forecast long-term innerwear operating margins are around 22% (like prepandemic norms), while operating margins for activewear and international (30% of 2021 sales) improve to 15% and 17%, respectively, from 14% and 16% in 2021. Our fair value estimate assumes moderate inflation in wage and cotton prices, resulting in a gross margin that stabilizes at 40%.

We anticipate Hanes will generate about $6.4 billion in sales and $720 million in operating profit in 2024, the target date for its Full Potential plan. The firm had targeted $7.4 billion in sales in the year, but we believe inflation and other challenges have disrupted its growth. Even so, we project the firm will produce approximately $3.1 billion in free cash flow to equity between 2023 and 2026 after a loss in 2022. Given uncertain timing, our estimates do not include any contributions from acquisitions.

Our upside fair value estimate for Hanesbrands is $30. In this case, annual organic growth in its innerwear business stabilizes at 3.5% after 2024, well above U.S. population growth (below 1%). Our bull case assumes that new products can gain some share of the market. Further, it forecasts organic activewear growth achieves long-term annual growth rates of 6% as this segment of the market expands at higher rates than most others.. Further, this scenario assumes long-term annual organic international growth rates of 5.5%. On the profit side, our bull case assumes that long-term innerwear and activewear operating margins settle at about 22.5% and 15.4%, respectively, at the high end of historical norms. Activewear profit improvement is possible if the Champion brand continues to expand as it has higher price points and better margins than much of Hanesbrands’ other activewear. Further, our bull case estimates that long-term international operating profit improves from the midteens to 17.5% due to the expansion of Champion and the disposition of the European innerwear operations. Finally, our upside case projects long-term gross margins to settle at 40.5%, slightly above historical highs. An improved gross margin is possible with further production efficiencies and lower input costs.

Our downside, or bear-case, fair value estimate for Hanesbrands’ stock price is $14. Our bear case forecasts innerwear sales decline slightly over the next decade. This weak result is possible if Hanesbrands loses shelf space to other innerwear brands or private-label items. Our bear case estimates organic long-term activewear growth settles at just 1% per year, below market segment growth and historical results. This scenario is possible if the Champion brand loses popularity in the United States. Our bear case also forecasts long-term international growth of 0.5% per year. This weak growth is possible if Champion fails to gain popularity in China and other growth regions, or if Bonds loses share in Australia. On the profit side, our downside case assumes average long-term operating margins around 11%-12% versus around 13% in our base case. Finally, our bear case projects a long-term gross margin of 39.5%, 50 basis points below our base-case assumption. Hanesbrands’ gross margin can be hurt by an increase in input expenses, such as higher cotton prices, and/or increased promotional activity to aid sales in this intensely competitive environment.

Risk and Uncertainty | by David Swartz Updated Nov 15, 2022

We assign a High Uncertainty Rating to Hanesbrands. Like many others, Hanes has struggled with pandemic-related shipping delays and supply issues. Moreover, the firm is exposed to input costs, such as cotton, energy, and wages, that have been on the rise due to the crisis and the war in Ukraine. While Hanes can push through price increases to offset some of the impact, inflation could reduce consumer spending on apparel.

Hanes’ operations have suffered disruptions from store closures by wholesale partners (such as Sears and Kmart) in the U.S. in recent years, and this issue will probably continue to affect sales. No-moat Macy’s, for example, is closing more than 100 stores. Some key retail partners of Hanes in the U.S., such as Walmart (17% of 2021 sales), are more stable. Still, there has been some turmoil as Walmart and others have reduced the amount of apparel inventory that they carry in their stores as competition from e-commerce has had an impact on store visitation.

Champion has benefited from the “athleisure” fashion trend and could suffer from a change in consumer behavior. Also, Champion faces huge competition in the sportswear business from wide-moat Nike, narrow-moat Adidas, Puma, and many others. Our growth estimates are partially based on expansion of the Champion brand.

Hanes’ free cash flow has turned negative in 2022, which could force it to eliminate its dividend payments unless it improves soon. Moreover, the firm has more than $3.6 billion in long-term debt, including about $1.4 billion in maturities in mid-2024. Hanes has had to renegotiate its debt covenants to avoid a violation and must refinance its 2024 debt.

We believe Hanesbrands faces minimal environmental, social, and governance risks. However, like most international apparel manufacturers, it has faced controversies over the environmental impact of clothing production and the wages and the rights of workers in its supply chain.

Capital Allocation | by David Swartz Updated Nov 15, 2022

We assign a capital allocation rating of Standard to Hanesbrands. Former CEO Gerald W. Evans Jr., a Hanes lifer, retired from the company in August 2020 and was replaced by Steve Bratspies, a former executive at Walmart. We anticipate that Bratspies will continue to prioritize dividends and debt reduction while implementing the Full Potential investment plan.

Hanesbrands has a fair record of returning cash to shareholders. The company instituted a dividend in 2013 and has maintained it at $0.60 per share per year since 2017. Hanesbrands has also bought back a significant amount of stock. Management did a poor job with these buybacks, however, as repurchases have often occurred at prices above the current market price. In 2017, the company repurchased 19.6 million shares of stock at a cost of $400 million (average price of $20.35). In 2016, it repurchased 14.2 million shares at a cost of $380 million (average price of $26.65). Hanes concentrated on debt reduction and did not repurchase any shares in either 2018 or 2019. However, it repurchased $200 million in early 2020 before the virus spread (average price of $13.83) and has resumed them on a limited basis in 2022. We believe repurchases are favorable to shareholders at current prices.

Hanesbrands’ acquisitions have expanded the company’s portfolio and generally generated good returns for investors. These acquisitions have expanded the company’s activewear business and expanded the business in Europe and Australia. Hanes began its acquisition spree with its 2010 purchase of Gear for Sports and subsequently bought another seven companies. Management claims that every acquisition has generated an internal rate of return of midteens or higher and that each has met or exceeded original IRR expectations. However, it does appear that some of them were expensive to integrate as Hanes reported total integration charges of $1 billion between 2013 and 2019. Moreover, the firm sold its (unprofitable) European innerwear operation for the nominal price of EUR 1. While it is disappointing that this business did not add value, Champion and some of Hanes’ other brands have more growth and profit potential, so it makes sense to concentrate on them.

Hanesbrands’ capital expenditures are low, having averaged just 1.2% of sales over the past five years. However, we forecast capital expenditures will increase to 2.3% of sales in 2022 as the company invests in its supply chain and e-commerce capabilities under the Full Potential strategy. Even so, Hanes’ owned supply chain is largely built out, which we view as an advantage over some rivals.


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