Champion Boosts Undervalued Hanesbrands

Hanesbrands HBI slightly exceeded our sales and earnings expectations in the first quarter. Sales of $1.59 billion beat our forecast of $1.53 billion despite an unexpectedly high year-over-year negative $46 million impact from foreign currency. GAAP and adjusted earnings per share of $0.22 and $0.27, respectively, both exceeded our forecast by $0.01. The sales outperformance was led by Champion, which experienced a 75% worldwide year-over-year increase in constant-currency sales, excluding the winding-down C9 business at Target. We believe Champion will continue to benefit from the casual athletic fashion trend. Hanesbrands’ first-quarter international operating margin of 14.4% exceeded our forecast of 11% as higher sales from Champion as well as Bras N Things, acquired last year, allowed for expense leverage. We forecast a 2019 operating margin of 15% for the international segment. We do not expect to change our $27 fair value estimate as our 2019 adjusted EPS forecast of $1.76 remains in line with Hanesbrands’ guidance of $1.72-$1.80. We view Hanesbrands as significantly undervalued.

We believe Hanesbrands has leading share and pricing in basic innerwear in multiple countries thanks to the strength of its brands. We think its international acquisitions add to its brand intangible asset. While the U.S. innerwear channel has been affected by store closures and inventory reductions, we think the Hanes brand still achieves premium pricing and shelf space. Hanesbrands’ first-quarter U.S. innerwear operating margin of 22% matched our estimate, and we forecast an operating margin of 24% for the segment in 2019, up from 22% last year. We believe the strength of the Hanes brand will allow it to maintain prime shelf space at Walmart despite the imminent launch of new private-label men’s underwear from Gildan, which we believe will largely replace Gildan-branded underwear.

Champion Brand Is Key Hanesbrands is the market leader in multiple countries in basic innerwear, which provided 63% of its 2018 sales. Its innerwear has more than double the market share of its leading competitor in U.S. mass-market retail. It has successfully launched brand extensions at major retailers and grown through acquisitions. However, we believe that Hanesbrands must find new areas of growth because innerwear is a replenishment product with limited prospects.

Hanesbrands’ Champion brand, which contributed 26% of 2018 sales, is key for the company. We view management’s goal of $2 billion in Champion sales in 2022 (excluding the mass channel and up from $1.36 billion in 2018) as attainable. It expects growth from Champion despite the loss of the C9 label. While the overall apparel market in the United States grows less than 1% per year, NPD reports that activewear has grown at annual rates of 2%-4% over the past four years. Further, NPD reports that activewear represented 24% of U.S. apparel sales in 2018, up from 22% in 2017. Champion and other activewear apparel have become more than just athletic apparel and are increasingly worn as lifestyle/fashion brands. This trend is favorable as lifestyle brands have good growth and attractive price points, which underlies our forecast for 3% segment growth longer term.

Hanesbrands has improved its production efficiency over the past 10 years. The company claims a nearly 90% increase in per-factory output by both units and weight since 2008. Further, it claims a 33% increase in manufacturing efficiencies over the same period. In the first quarter of 2017, Hanesbrands announced a cost-efficiency program that aims to reduce annual expenses by $150 million by the end of 2019. While Hanesbrands can continue to take excess costs out of its system, we do not believe that it has a permanent cost advantage over rivals. It owns 50 or so factories in such low-wage countries as Honduras, El Salvador, Slovakia, and Vietnam, but competitors operate production facilities in many of these same countries.

Premium Pricing and Shelf Space We maintain a narrow moat rating on Hanesbrands due to the strength of its intangible brand asset. Its 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 Hanesbrands to maintain strong retail distribution and premium pricing. Supporting our moat contention, we believe that the company can generate returns on invested capital above its weighted average cost of capital over the next 10 years.

Adjusted return on invested capital fell to about 14% in 2018 from 18% in 2015. One reason for the decrease is an increase in the company’s tax rate to 14%-15% from the 12% average over 2009-16. The new federal tax law includes provisions on foreign earnings that have increased Hanesbrands’ tax rate. We expect Hanesbrands’ adjusted return on invested capital to remain in the midteens over the next decade. Hanesbrands has reported uneven results over the past three years due to store closures (Sports Authority, Kmart, and so on), lower retail inventories, and weakness in intimate apparel. However, we believe that the company has worked through some of these issues and will slightly improve margins in future years. Organic growth has returned to the innerwear segment after a period of negative comparisons. Also, Hanesbrands has expanded its international business through acquisitions and reduced its dependence on mass-market innerwear in the U.S. Our assumed weighted average cost of capital for Hanesbrands is 8.0%. This estimate is in line with long-term guidance from the company.

The company’s brand portfolio is strong enough that we think it can maintain its premium pricing and shelf space over the next decade. The brands are supported by heavy advertising and innovation. In the long term, however, Hanesbrands faces threats from private-label products and the decline of physical retail. We do not classify Hanesbrands’ moat based on brand strength as wide. Also, the company lacks other factors that would allow for a wide moat. There are no switching costs in its apparel categories, and barriers to entry are low. There is no network effect. While its production process is cost-efficient, competitors have similar production models. Economies of scale are limited, given that apparel production is a labor-intensive business, and rivals operate factories in many of the same countries as Hanesbrands. Our view is that Hanesbrands does not have a cost advantage over competitors.