Margin Gains in Store for Hanes

We have a high degree of confidence in the defensibility of

The company operates 50 manufacturing facilities, mostly in Asia, Central America, and the Caribbean Basin. In 2017, more than 70% of units sold were from its own plants or those of dedicated contractors. When Hanesbrands can internalize high-volume styles, we estimate that it saves as much as 15%-20%. Utilizing this manufacturing platform, Hanesbrands has been successful in making acquisitions to drive earnings growth.

Hanesbrands’ top line has come under pressure from secular trends to online sales; only 11% of the company’s global revenue was online in 2017, and retailers were hit with bankruptcies and downsizing. However, Hanesbrands is distribution-channel-agnostic, and we think these trends affect only the near term and create an attractive entry point for investors. The transition to e-commerce is proceeding well, with the online revenue growth rate hitting 22% in the fourth quarter of 2017. As online sales increase as a mix of business (we model penetration reaching a midteens percentage of total sales in 2018), we think total company growth will rebound. We expect 1% organic revenue growth in 2018, versus a slight decline in 2017, as well as contributions from acquisitions.

Brands Are the Bedrock We assign Hanesbrands a narrow economic moat rating, as we believe the strength of its intangible brand asset and manufacturing capabilities will allow the company to achieve returns on invested capital above its weighted average cost of capital for at least the next 10 years.

We believe brands are the bedrock of Hanesbrands’ business. Hanesbrands is the intimate apparel category leader in the United States, with the Hanes, Maidenform, Bali, Playtex, JMS/Just My Size, Donna Karan, and DKNY brands, and the leading manufacturer and marketer of men’s underwear and children’s underwear in the U.S. under the Hanes, Champion, and Polo Ralph Lauren brands. In international markets, Innerwear brands are market leaders across Australia and Western and Central Europe. In the intimate apparel category, Hanesbrands holds the number-two market share in France, Italy, Spain, and Australia. It is also the category leader in men’s underwear in Australia, France, and Spain and in hosiery in France and Germany. We think consumers value comfort, fit, and consistency over price, especially in undergarments, which carry the switching cost of having to try on multiple other brands to find the right fit and size, a task most people consider unpleasant. The innerwear segment was about 38% of Hanesbrands’ business in 2017.

We believe Hanesbrands leverages extensive manufacturing capabilities to produce quality products and charge an economical price. The company owns and controls a global supply chain with balanced production between the Eastern and Western hemispheres, which we think allows it to maximize low-cost production and international distribution. It has 50 owned facilities. Because it is owned and operated, a research and product design and development team works on manufacturing processes to find the lowest-cost production method for new product innovations. The production process is as much a priority as the new product itself. This integration in development and the benefits of scale afforded a synergistic brand portfolio are a competitive advantage.

We think these manufacturing capabilities also allow Hanesbrands to deliver high returns on acquisitions. Given the success Hanesbrands has achieved in integrating prior acquisitions like Maidenform and DBApparel, as well as the steady pace of acquisitions (roughly one or two a year), we think acquisitions will be a core driver of returns for shareholders going forward. Although there is some risk that management may be biting off more than it can chew, we believe this team is capable of execution. Overall, we see acquisitions as a way for the company to leverage its manufacturing platform to drive cost savings and to increase exposure to high-growth, high-margin product lines.

The pricing power Hanesbrands can achieve from its brands is somewhat limited by a variety of factors. The innerwear and activewear categories in which it competes are highly commodified, and we think consumers have a limited threshold for brand premium pricing, given the availability of almost identical products from other strong brands. Competitors include Fruit of the Loom BRK.B, Jockey, Warner’s PVH, Victoria’s Secret LB, and Gap GPS. Not only is Gildan GIL a direct competitor in both the innerwear and activewear categories, but the company also has a highly vertically integrated manufacturing capability. That being said, consumers have shown a willingness to pay up for innovation, which plays to Hanesbrands’ strength.

We think adjusted return on invested capital will average 15% annually over the next five years versus 19% over the past three. We expect earnings growth will be driven by innovations in innerwear such as FreshIQ, Tagless T-shirts and bottoms, and ComfortBlend underwear, which will drive price per unit and margins up, through growth of the activewear market and further fabric and fit innovation, as well as through supply chain leverage, scale, efficiency innovations, and capacity additions. These investments should keep return on invested capital well above the 8.1% cost of capital.

Vertically Integrated Supply Chain Is Both Advantage and Risk The apparel manufacturing trade is exposed to fluctuations in consumer spending, retailer inventory management, cotton prices, and the geopolitical environment. We think Hanesbrands is slightly better positioned than other players, as much of its business is driven by moderate-price-point replenishment innerwear products and also because of its vertically integrated manufacturing processes. Because of these characteristics, we assign Hanesbrands a medium uncertainty rating.

Walmart and Target accounted for 18% and 13% of total sales in 2017, respectively. In the innerwear segment, Walmart accounted for 34% of sales and Target for 17%, while in activewear, Target accounted for 25% of sales and Walmart 16% of sales. Retailers may cancel orders, change delivery schedules, or change the mix of products ordered with minimal notice.

Although we think operating a vertically integrated supply chain gives the company competitive cost advantages, it also exposes Hanesbrands to other risks. Changes in political relationships, taxes, or trade laws, increases in energy, cotton, or shipping costs, or natural disasters in any hemisphere could interrupt production and raise costs. Hanesbrands would probably need to assume the majority of the impact of these changes.

Even though we believe consumers will continue to replenish innerwear items even in an economic downturn, they may demand lower prices or be willing to trade down to a different brand. They may also delay purchases, making performance choppy. We think this scenario may pressure merchandise margins if offsetting cost savings cannot be found in the manufacturing process.

The company has significant leverage and adjusts operating profit to exclude many acquisition-related expenses. If its adjustments prove to be too aggressive, this could hurt the stock’s value.

We expect the company to use its free cash flow in three ways. First, we think it will strategically continue to reduce debt within its targeted range, but likely at the lower end, to retain some financial flexibility for opportunistic acquisitions. Second, we think it will seek acquisitions in core categories with synergies to existing products or target markets. Third, we think the company will increase its dividend and repurchase shares.