Value Investors Club / HANESBRANDS INC (HBI)

Description

and a 7.5% EV FCF Yield, with plenty of opportunities to reinvest the cash generated in an accretive way.

Recommendation

- I joined the VIC in November 2010 on a Hanesbrands investment case. The stock was trading on $6.2

and rose to $35 by the summer of 2015.

- The shares have since come off 20%. Valuation multiples have declined 35% as earnings grew DD over

this period and consensus revisions remained positive. The FY1 P/E has fallen from 21x to 13x.

- There are a number of investor concerns that triggered this sell-off.

o Hanesbrands manufactures underwear and the US apparel industry had a difficult winter season.

o Half of Hanebrands’ US sales go through Wal-Mart, Target and Kohls. Investors worry about

legacy retail formats and have punished HBI by association.

o Gildan is taking market share in male underwear and Calvin Klein is turning around, which leads

to questions around the sustainability of Hanesbrands’ market share.

o And last but not least, we’ve reached the end of the steep margin expansion path that drove both

the earnings and shares from 2010 until 2015.

- Whilst the concerns above are genuine, investors seem to overstate the impact they have on HBI’s

fundamentals. The company will continue to grow earnings at a double-digit pace. Cash flows will remain

stable. And margins and returns will remain high.

- Therefore I believe that the current sell-off provides an opportunity to buy a compounder at an attractive

price. From current levels, I see 60-100% upside on a 2-3 year horizon.

Company

Hanesbrands (HBI) is a global manufacturer of innerwear and activewear apparel. The company reports

results along 4 segments:

- Innerwear (47% of sales, 60% of OP)

o Basic underwear, intimate apparel, t-shirts, socks, stockings, etc

o Key brands are Hanes, Playtex, Maidenform, Bali, L’eggs, DIM, Barely There and Wonderbra

- Activewear (27% of sales, 26% of OP)

o Athleisure apparel

o Key brands are Champion, C9 and Gear for Sports

- International (20% of sales, 11% of OP)

o 50% Europe, 20% Canada, 20% Japan, 3% Mexico, 3% Brazil, 4% the rest of Latam and China

o This breakdown excludes the $1bn in acquisitions announced over the past month. Those will

increase the international revenues by 50%, taking it to 1/3rd of company revenues.

- Direct-to-Consumer (6% of sales, 3% of OP)

o HBI owns a small number of outlet stores and websites used to dispose of excess/returned

inventory. Direct-to-Consumer is only used to manage working capital

o The traditional on-line sales through Amazon.com, Walmart.com, etc are included in

innerwear/activewear/international. CS estimates on-line sales are now 6% of total sales.

Competitive advantages

Apparel is a poor industry: ultra-competitive, fragmented, exposed to fashion trends, and very cyclical. Most

companies don’t last long. Yet Hanesbrands has held dominant market shares in its categories for decades

(around 20% in innerwear, 15% in outerwear). Cash flow generation has been stable. And the company

generates decent margins (15-20% OPM) and high returns (40% ROE, 17% CFROI). This anomaly is largely

the result of HBI having a number of competitive advantages.

Strong brands

- It might be hard to understand for UK investors who are used to buy generic underwear from Marks &

Spencer (I am a London based investor), but brands matter in other developed countries.

o People attach a high switching cost to underwear. It’s unpleasant to try on a new brand and find

the right size and fit. Think bras rather than plain male briefs, although the latter also show strong

brand loyalty.

o This explains why companies that have not invested in their product for decades have hardly lost

market share (Fruit-of-the-Loom, Jockey).

- Hanes is the #1 innerwear brand in the US, by a mile.

o 85% of American households own Hanes innerwear.

o The brand is popular across all segments of the population – young, old, rich, poor, men and

women.

o HBI also owns some of the strongest non-Hanes brands in the US (Playtex, Maidenform, Bali,

Wonderbra, etc), the #1 brands in Europe (DBA) and the #1 brand in Australia (Pacific Brands).

- Hanes is the #3 outerwear/athleisure manufacturer in the US.

o Nike is the #1 with 45% market share and Under Armour is #2 with 15%.

o Hanes has a similar total market share as Under Armour (15%), but split over its Champion, C9

by Champion and Gear for Sports brands.

o Champion might not have the same premium appeal as Nike, but it is the market leader in every-

day-athleisure at the better price point and has held this position for a long time. Its brand

awareness amongst the wider US population is 87%.

Stable inflationary category

- The economic sensitivity of basic underwear is quite low. Hanes charges $10-20 for a pack of underwear /

t-shirts and the world needs to get pretty grim before consumers stop buying the cheapest underwear.

- The replenishment character of the product adds to the cash flow stability. As does the low markdown

risk. There is no fashion risk and very little seasonal risk.

- The industry is fairly consolidated, which minimises competition and therefore also adds to stability. And

even when a lower end manufacturer tries to be price disruptive, retailers act as a stabilising factor.

o Retailers love underwear because it is one of the rare inflationary categories in their assortment.

- Innovation justifies moderate price inflation. And the price sensitivity of consumers is low

because of brand loyalty, the low starting price and the infrequent (but repetitive) nature

of the purchase.

 - Put differently, consumers don’t care if you take up the price of a pack of 5 briefs from

$10 to $10.50, especially if you mention that the new briefs come with an improved elastic

band. Consumers probably don’t even remember that they paid 50c less last time.

 - Similar to the producers, retailers benefit from the replenishment character and the lack of

markdown risk.

 - This all adds up to top-line inflation for the retailer and explains why innerwear’s floor

space has been stable to moderately growing.

o Hanes is the price setter as market leader.

 - Fruit of the Loom is the cheaper option, consistently priced a few dollars lower per pack.

 - Gildan is also competing on the low end (male underwear only) and gaining market share

as they offer better quality than fruit-of-the-loom or generic players.

 - State-of-the-art production facilities means Gildan even has a lower cost price for the

higher quality, and they sell to the retailer at this lower cost. However, the retailers are

pocketing the difference rather than passing it on to the consumer. They are not keen to

start a price war in one of the few inflationary categories in their assortment. This adds to

the stability of the category.

 - Relative to the lower end manufacturers, HBI benefits from the strength of the brands and

the ongoing innovation. Combining the two leads to higher priced products and therefore

higher dollar gross margins for the retailer.

o So in a world where retailers battle deflation, underwear stands out.

Proprietary low cost and scalable supply chain

- Most US apparel companies have spent the past 15 years outsourcing more and more to EM suppliers.

Hanesbrands has also closed its US manufacturing facilities, but opted to build its own manufacturing

hubs in emerging markets rather than outsource production. Its main hubs are Vietnam, Thailand, China,

Honduras, El Salvador and Dominican Republic.

- Building your own supply chain comes with higher initial costs but leads to a sizeable cost advantage

once established. The latter is the case today, with HBI saving around 10% on COGS relative to the

average retailer with a fully outsourced production base. In OP margin terms this provides Hanes with a

6%+ higher margin.

- It also provides the company with better cost insight (raw material fluctuations, EM wage inflation,

transportation, etc) which helps to accurately set prices and deliver stable margins.

- And vertical integration makes it easier to adjust the supply chain to accommodate for growth, organic or

acquired. Textile plants do not cost that much, especially for HBI as they own a lot of land around existing

facilities. The industry bottleneck is usuallythe ability to hire and train new staff quickly and secure more

fabric. Hanes’ decades of experience give them a competitive advantage here.

Sustainable low tax rate

- The other benefit of owning the EM supply chain is a lower corporate tax rate. HBI currently pays 11%.

- This is not driven by Starbucks-style accounting whereby profits are channelled through tax havens. HBI

simply creates most of its economic value in the production hubs, with end sales happening through

external retailers.

- The EM hubs are of course not randomly chosen. They are selected based on existing trade agreements,

local labour costs, sewing skills and the availability of raw materials. But the resulting tax is based on strict

transfer pricing regulations. The IRS just finished a 2-year detailed audit of HBI’s tax arrangements and

concluded that they are in fact too conservative. So Hanes received a rebate for excess tax payments in

recent years.

- The additional competitive advantage of a lower tax rate is that it makes it easier to achieve a higher

return on acquisitions.

Innovation

- HBI spends 1% of sales on R&D per year and 3-4% on advertising.

o Fruit-of-the-loom hasn’t invested for years and is run as a cash cow for Berkshire Hathaway.

Jockey hasn’t been investing either. The only other sizeable player focused on innovation is

Gildan.

o The main difference with Gildan is scale. HBI generates $4.5bn in underwear revenues. That is 4x

the underwear revenues generated by Gildan. Even if Gildan was willing to sacrifice its entire

margin, it still couldn’t match HBI’s R&D and marketing budget.

- Aside from the size of the budget, HBI believes a key competitive advantage is how the money is spent.

o Rather than invent new products and then try to build a market, they start by identifying consumer

needs first. Once the customers have told them what they want, they look to develop and test

product solutions. The fact that new products come with detailed consumer insight reports and

testing makes it easy to convince retailers to put new products on the shelves.

o Also, the 400 R&D people work closely with the manufacturing teams. HBI believes it is crucial

that new products can be produced at low cost. They call the whole process Innovate to Elevate

(I2E).

o So the goal of I2E is to create new products that 1) strengthen customer loyalty, 2) can be sold at

higher prices and 3) produced at lower costs. Recent innovations include comfortblend, flexible fit,

X-temp and tagless.

- Innovation provides pricing power. And Hanes believes that they have a long runway to increase prices

given that the nearest competitive product to ‘5 premium Hanes boxers for $20’ is ‘3 Calvin Klein boxers

for $30’. And research shows that customers attach the same brand quality to both.

- The next big innovation announcement is scheduled for 2H16. Management indicated that we will see

innovation in the basic underwear category.

Margins

The table below shows that HBI’s operating margin has expanded from 10% to 15% in recent years

- Hanesbrands was formed when Sara Lee put a number of its innerwear and outerwear divisions together

and spun them off as a new company in 2006. Typical Sara Lee, these businesses were run as individual

silos with separate supply chains, back offices, etc.

- The bulk of the margin expansion at Hanesbrands came from the integration of these separate

businesses, and from moving the production base from the US to emerging markets. This required a lot of

investments in the early years, which kept the margin low initially. Other factors pressuring the margin

were the global financial crisis and the cotton boom-and-bust in 2010-2012. But eventually the gross

margin expanded from 2012 onwards.

- The gross margin went up by 600bp to 38.4%, with management saying that at least 400bp of this came

from integrating the divisions and moving production abroad. Additional drivers were product mix (more

premium products), price inflation, increasing utilisation rates, and general cost savings. Corporate mix

was a headwind, with lower-margin active wear growing in the mix and the company frequently acquiring

lower margin businesses (before increasing the margin under HBI ownership).

- It is worth stressing that aside from short-term fluctuations, cotton was a neutral factor since the company

was founded (with cotton currently at similar levels as 2006-2007).

There is some scope for further margin expansion going forward, but not that much

- We’ve come a long way and management is guiding for a more moderate 10-20bp in GM expansion per

year going forward.

o Innovation/pricing and an ongoing focus on cost efficiency should drive this expansion.

o This might be conservative as management seems very confident that they can even achieve this

in FY16, a year with a 50bp GM headwind from reduced production utilisation rates. The latter is

the result so ofa poor winter for apparel retailers which resulted inexcess inventories. HBI

decided to keep the inventory given the absence of fashion risk and the low cost of carrying

inventory.

o I model a 10bp expansion per year

- Some operating leverage on the SG&A side

o Management is guiding for SG&A growth at half the pace of organic revenue growth

o Additionally we should see synergy benefits coming through from previous acquisitions (guidance

is for 100bp this year)

o And the international margin will increase with scale (9.5% in FY15 versus 16.0% in outerwear

and 22.5% in innerwear).

o I model SG&A to indeed grow at 60% of the organic revenue growth pace and a conservative

40bp expansion this year as opposed to 100bp because apparel continues to be weak.

- This results in the operating margin going from 15% last year to 16% in FY18

The resulting margins in our model seem reasonable from an ecosystem point-of-view.

- The innerwear margin (22.5% going to 23%) compares to 26% at Van de Velde (luxury lingerie) and 23%

for Gildan’s printwear business. L Brands generates 18%, but that includes athleisure products, overhead

costs and an outsourced supply chain.

- The activewear margin (16% going to 17%) compares to 14% for Nike and 11% for both Under Armour

and Columbia Sportswear. Again note that the peer margins include corporate overhead (which lower the

margin by 2% on average) and an outsourced production chain (which lowers the margin by 6%+).

- The international margin is scheduled to go from 9.5% last year to 13% in FY18. The FY15 margin was

pressured by acquisitions. Taking the supply chain of acquired companies in-house has indeed historically

led to a 6% margin lift within 1-3 years. The international margin was 11.3% in FY14 and should grow

over time on the back of scale.

What do investors underappreciate?

Accretive acquisitions and capital returns extend HBI’s growth path

With the scope for margin expansion significantly smaller from hereon, organic OP growth will slow down to

around 5% per year. This justifies some of the de-rating in the stock. However, we’re now reaching valuation

levels which indicate that investors do not appreciate that total growth will remain double-digit through high-

return capital deployment.

Acquisitions will double the top-line growth pace

- Funding is provided by the large and stable cash flows of the core business

o The existing business requires little investment. Management believes that 1.5% of sales in capex

spending per year should easily cover the next 5 years of growth. So roughly $100mn in capex

per year. The big cost of relocating and integrating the production base is behind us. Going

forward we should simply see some smaller expansions of existing facilities on company-owned

land, which typically cost $20-30mn.

o This means that the company will have around $800mn in free cash flow per year.

- Acquisitions are a fairly low risk strategy in the case of HBI

o Management is sticking to a category that they know well and these acquisitions are fairly easy to

integrate. HBI simply keeps the acquired brands, products and retailer relationships and moves

the production onto its own platform. Historical acquisitions have taken 1-2 quarters to integrate.

The exception was DB Apparel, a collection of unintegrated European innerwear brands which

took 2 years to integrated (unsurprisingly DBA was previously owned by Sara Lee).

o Synergies of bringing the acquired production in-house are significant. Usually between 6% and

10% of sales, meaning that HBI acquires SD margin businesses and turns them into DD margin

ones.

o The company has consistently paid pre-synergies multiples 2-4 multiple points below the HBI

valuation. Post synergy multiples have been around half the HBI valuation. Details per deal are in

the tables below. Essentially HBI has no competition when bidding for these assets. Gildan is the

only other player who could achieve similar margin and tax synergies, but they continue to focus

on integrating the printwear market (FY16 acquisitions have indeed been in printwear once

again). Other players do not own their supply chain.

o The integration costs are substantial, around 15% of sales on average. These reflect the cost of

closing and integrating production facilities, as well as taking the acquired company onto HBI’s IT

platform. Taking into account the longevity and stability of acquired cash flows and the low post-

synergy multiples paid, the return on investment justifies the spending. In essence, HBI is

applying the Inbev strategy to underwear.

- This is not a new strategy

o Management has done 6 sizeable deals since 2010. And the track record actually stretches back

to the start of the company in 2006 as the integration of the different Sara Lee businesses was a

similar exercise. The current management has been involved since the start (all ex-Sara Lee) and

still have some way to go to retirement (most are mid-50s).

o Management originally considered taking the Hanes brand abroad. But they quickly discovered

that brand loyaltymeans it is too expensive to establisha newbrand in a market. Acquiring

existing brands and plugging them into the HBI supply chain is a much easier and higher return

strategy. The official acquisition strategy is that they look for companies with strong brands and

complimentary products, with an opportunity to increase margins, room to grow the business, and

a market backdrop of stable GDP growth.

o Hanesbrands has made some bold moves in recent years, acquiring the #1 underwear

manufacturer in Europe, the #1 in Australia and the #2 in US female intimate. There should be

plenty of additional opportunities, with broker research showing that there are over 50 innerwear

brands globally with sales over $200mn.

o Management has done 2 deals in April ($200mn and $800mn) and are likely to take a break for a

while. The company says they don’t want to take on more integration work than they can handle

at any point in time and stress that they have walked away from deals for this specific reason.

That being said, they also point out that that the April acquisitions should be fairly easy to

integrate and therefore we shouldn’t model too much of an acquisition break.

o I model an extra $100mn in acquisitions in FY17 and $300mn per year thereafter.

Share buybacks also help to sustain DD growth

- Management spent $300mn on buybacks last year and $380mn so far this year (3-4% of mcap). Rather

than guiding for less buybacks going forward given that they just spent $1bn on acquisitions, management

announced a new share price authorisation of $1.1bn (no time frame). They also told me that they would

be willing to use the balance sheet to step up buybacks. The business could easily accommodate being at

the high end of the targeted 2-3x net-debt / EBITDA range.

- I model no further buybacks for this year and $300mn per year going forward. This is covered by FCF

after acquisitions and dividends and therefore includes the assumption that management lets the leverage

ratio come down to the lower-end of the range over time rather than staying at the top-end. In other

words, my combined acquisition/buyback assumptions might prove too conservative.

- Buybacks add around 3% to earnings growth per year.

Other investor concerns and misinterpreted changes

The US apparel industry had a difficult winter season and momentum is deteriorating again

- HBI didn’t escape the poor winter season in apparel.

o The fact that the slowdown came so late in the year meant that they could not adjust the

production schedule in time and this resulted in a $300mn increase in working capital in FY15.

o 90% of the latter reflects HBI’s decision to keep excess inventory. The cost of carrying inventory is

small and given that there is no fashion risk it was a relatively straightforward decision to keep the

excess inventory and sell it in the next winter season rather than discount to get rid of it.

o This implies a 0.5% pressure on gross margins this year as the production pace is lowered to

accommodate for the extra inventory. Management believes that they can cut other costs to

compensate for this and guide for an overall increase in gross margins this year.

o So HBI was impacted by the tough winter apparel season, but less so than the average apparel

company. The nature of the business means less economic sensitivity and less need to discount

in troubled times.

- Management is guiding for an even smaller impact of the renewed apparel weakness in recent weeks

o There is even less seasonality in spring compared to winter (which carries some hoodies for

Hanes).

o They have seen not much in terms of recent weakness, aside from some ordering tweaking by

certain retailers.

o And we are much earlier in the year, it’s easier to adjust production if need be.

Investors worry about legacy retail formats and have punished HBI by association

- 50% of HBI’s US sales go through Wal-Mart (30%), Target (15%) and Kohls (5%). These retailers are no

doubt gradually losing market share, but I don’t think this implies slowing sales for HBI, for a number of

reasons

o Most people still visit a Wal-Mart from time to time. They go less often but you don’t buy

underwear every time you go to the supermarket.

o HBI will benefit from rising minimum wages in the US. The brand is popular with both the rich and

poor, there are as just more poor people. And unlike the retailers themselves, there is no

additional cost for HBI from minimum wage inflation.

o All that being said, Hanes is evolving with retail trends. They are for example the category leader

at Dollar General. And they are rapidly growing their on-line sales, through the websites of their

existing retailers (eg Walmart.com) as well as new ones (Amazon.com).

o And finally there is the international expansion which will dilute the exposure to the top 3 US

retailers over time, reducing investor worries.

- I also want to tackle customer concentration whilst we are on the subject.

o There is undeniably a risk in generating 50% of your US sales through 3 retailers. But I am willing

to take this risk because the retailers need HBI as much as HBI needs them. There is no other

brand that will drive traffic for these retailers to the extent that Hanes does. And there is no other

brand that will be able to deliver the same level of price inflation.

Gildan will take market share from Hanesbrands

- Some background on Gildan’s strategy

o Gildan has cornered the US printwear market over the past decade. Printwear is the wholesale

business of selling t-shirts and hoodies to printing companies, who then print a pattern on them

and sell the end product at a premium price through retailers.

o There is no branding involved in printwear (at least not for the t-shirt producers). So this is

essentially a cost game and Gildan is dominating the industry because

- It has built state-of-the-art facilities which allow Gildan to produce a higher quality product

than the competition, at a lower price.

- It has located these facilities in Honduras, which further lowers the cost base and similar

to Hanes provides a low tax rate. The Honduras location also has a competitive

advantage over other EM hubs as the proximity to the US apparel market makes it ideal

for the short lead times in printwear (a small batch business).

- Gildan has also taken the yarn spinning in-house, mainly because there was not enough

high quality yarn available in the US (traditionally a low quality market). This provides a

further margin advantage.

- And these days the company also benefits from scale (multiple times the nearest

competitors in size).

o Gildan is now gradually venturing into other branded innerwear.

 - The initial focus is on low-end male underwear. The state-of-the-art facilities and access

to quality yarn means that they can produce higher quality basic male underwear at a

lower cost than the competition, including Hanesbrands (at the low end).

 - The cost advantage is passed on to retailers in return for shelf space (the product is

priced on par with other low end brands and retailers pocket the cost difference). A

strategy which seems to work as this has quickly become a $0.5-1.0bn business for

Gildan. Initially retailers simply offered Gildan a bargain bucket at the end of the aisles,

but this is increasingly being converted into real shelf space. And customer feedback on

the product is positive.

 - The fact that Gildan has squeezed everyone out of printwear, including Hanes, is scaring

investors. Especially now that Gildan is rumoured to get substantially more shelf space at

Target over the summer.

- Differences between Hanesbrands and Gildan

o Hanesbrands is more focused on returns.

 - They don’t want the best plants in the nearest location. Instead they focus on the plants

that will allow them to produce a wide range of products (male and female innerwear) with

varying degrees of quality (they basics at a slightly premium because of the brand name

and higher end at a premium on the back of innovation / higher quality), for different

retailers, in different parts of the world.

 - Whilst Gildan is 100% vertically integrated, HBI does most of the production in-house but

not the yarn spinning. They actually exited this a few years ago because it was the lowest

return part of the supply chain (low SD according to them) and because it added

substantially to working capital volatility (the pressure on working capital and gross

margins from the recent winter season weakness would have been double if they still

owned yarn spinning according to management). The global presence and the fact that

high quality yarn is readily available in Asia and Europe is another factor in this. Gildan

has to source from the US as the Honduras trade agreements stipulate this.

o Ultimately Hanes and Gildan have fairly similar margins (20% and 19% Holt Operating Margin

respectively). But HBI’s margin and returns are trending upwards, while Gildan’s margins and

returns are trending downwards. The latter might reverse at some point as they grow into their

new plants. Gildan generates organic growth a few percentage points above Hanes, whilst the

latter generates more top-line and bottom-line growth once you factor in capital deployment. And

ultimately, they both stand out within apparel

- So will Gildan take market share from Hanesbrands?

o Probably a little. Gildan’s consumer proposition of a higher quality product for a private label price

is a strong one. Lower end brands who have not invested for years are probably most at risk,

such as Fruit-of-the-Loom and Jockey. But even Hanes might lose a little market share given that

they are the largest player in male underwear.

o However, this is not a repeat of what happened in printwear. I’m only expecting small losses, for a

number of reasons

 - There will always be customers that are willing to try the new cheap product. And given

that Gildan’s quality is better relative to other low end options means that these

customers will probably become repeat customers. But most consumers still shop based

on brand and Gildan is unknown and invests little in marketing.

 - Hanes’ basic range might not be as high in quality as Gildan, but it is still good. Definitely

good enough for consumers to provide positive feedback on their purchases and for them

to keep coming back. And their premium range is of better quality than Gildan.

 - Retailers will continue to support Hanes because of the brand name and the premium

product range, which both result in price premiums. Even if Gildan offers retailers a higher

profit margin, they can’t compete with the gross dollars earned on the higher priced

Hanes products. That is why any shelf space will likely come from private label brands,

rather than from Hanes or even Fruit-of-the-Loom and Jockey.

 - Gildan tried going after the socks market with a higher quality product 10 years ago. The

socks indeed had a higher thread count and were more comfortable, but Gildan failed to

gain real traction because they did not have a brand name. So in 2011 they changed

tactics and acquired Gold Toe. Ultimately I think the right approach for them would be to

buy Jockey or Fruit-of-the-Loom, but apparently they are not for sale.

o And any impact on Hanes’ results should be small

 - If Gildan has indeed already gained 7% market share over the past 3 years as they claim,

we should have seen the impact on Hanes’ numbers already. The next 7% will no doubt

be more difficult to achieve. And I do model future innerwear growth below the trend of

recent years.

 - And Gildan is still only targeting male underwear at a limited number of retailers (Wal-

Mart and Target). The rumour is that they have written a big cheque to get the extra shelf

space at Target and that JC Penny’s and Kohls have ended their trial with Gildan.

- So to conclude, I believe any fears of the competitive threat of Gildan for Hanes are overrated. That

doesn’t mean Gildan won’t be successful, but it won’t impact Hanes too much over the coming years. And

therefore it doesn’t justify the substantial multiple compression.

Hanesbrands (top) vs Gildan (bottom)

Expected growth

Top-line organic growth of 2-3%

- Innerwear grows 1-2% per year.

o US population growth + modest pricing – some modest market loss

- Outerwear grows 3-4% per year.

o The Athleisure industry is growing sales at an 8-9% pace. A rapid improvement in quality and

style of athletic wear combined with rising interest in health and wellbeing has turned the category

into a widely accepted form of every day wear. Today’s ‘role models’ such as Kendall Jenner are

constantly photographed in it.Athleisure now even makes it onto the catwalks. And I would also

not underestimate the support this trend receives from an ageing obese society who just wants to

be comfortable.

o With 11% market share in apparel there seems room for further growth. Recognising that

Champion is one of the more mature brands here, I model growth at half the pace of the industry.

This could prove too conservative judging by the growth in recent years. And growth at Champion

is accelerating. Retailers were angry at Hanes for some time because they created the C9 brand

exclusively for Target. But the need for new products to satisfy the growing demand seems to

help to forgive and forget.

- Direct-to-consumer grows at 1%

o This is the discount channel used to get rid of excess inventory. Traditional on-line sales are

included in innerwear and outerwear.

- International

o 4-5% growth as Hanes has been acquiring faster growing companies (taking market share in

more fragmented markets). Pacific Brands in Australia for example has been growing revenues at

an 8% CAGR in recent years.

o Additionally, the international top-line benefits from revenue synergies on recent deals as Hanes

rolls out some of its products and recent innovations across the acquired brands.

Acquisitions add 14% to the top-line in FY16/17 and I assume 3-4% per year from FY18 onwards

- The 14% in FY16/17 is based on the $850 in sales that were acquired in April + I assume another $100mn

worth of acquisitions in FY17. Modelling only a smaller acquisition in FY17 might prove too conservative

as the April deals should be smooth to integrate and therefore management time for new acquisitions

might free up sooner than expected.

- I model $300mn in deals per year from FY18 onwards. This is an amount that the company can finance

through FCF generation. Brokers estimate that there are quite a few acquisition opportunities in this

range. And $300mn is at the lower end of HBI deal range in recent years.

- Adding organic and acquisition growth together leads to annual top-line growth of 10% in FY16/17 and 6-

7% thereafter.

Modest margin expansion takes EBITDA growth to mid-DD for FY16/17 and 8-9% thereafter.

Share buybacks add another 2-3% per year, leading to high DD growth in FY16/17 and low DD growth

thereafter.

How do my estimates differ from consensus?

I am 14% ahead of consensus on the revenue side, 9% on the FCF side and 4% on the EPS side by FY18.

The main difference with consensus is that I model future capital deployment, both through acquisitions and

buybacks. Organic revenue assumptions are roughly in-line. My margins are 1.0-1.5% lower by FY18, which

reflects some conservatism from my side but also the impact of my modelled acquisitions. Acquisitions tend to

be lower margin initially with that margin ramping up within 1-3 years as the supply chain is moved internally.

Also, deals come with substantial integration costs as existing production needs to be shut down and IT

systems need to be switched. I model exceptional costs at 20% of the acquired revenues, at the higher end of

historical acquisitions.

Earnings revisions remained positive over the past 18 months. Revisions did slow down substantially from the

pre-2015 period because 1) the opportunity for further margin expansion got smaller, 2) FX became a modest

headwind and 3) the FY15 acquisition of Knights Apparel was relatively modest in sizecompared to the FY

13-14 deals ($200mn vs $550-600mn in both FY14 and FY15). I expect to see further positive revisions on the

back of the April deals. Pacific Brands was announced just one week after the Q1 results, which explains why

only 5 analysts have revisited their model again since the announcement.

Balance sheet

Management guides for a longer-term net-debt / EBITDA range of 2-3x. With the share price at current levels

they feel comfortable levering up to the top of that range and using the proceeds for M&A and share

buybacks. The recent deals will take the ratio to 2.8x by the end of the year (company guidance).

I think this is a reasonable leverage target taking into account the stability of the business and the cash flows.

The leverage ratio in my model comes down to 2.3x by FY18, and that is after modelling dividend growth,

buybacks and future acquisitions. So despite being comfortably ahead of consensus, there should be room for

additional capital deployment if management indeed wants to be at the higher end of the range.

HBI has no problem accessing the debt market. The BB rating means they pay around 5% interest. Add the

stable cash flow generation to the high coupon and you understand why debt investors love Hanesbrands.

$1bn of senior notes mature in Dec 2020. These can be called early and given the high coupon (6.375%) I do

expect that this will happen. The company hinted that they might consider this as part of the debt negotiations

for the April acquisitions. The rest of the debt matures in 2024 ($900mn) and 2026 ($900mn) and has an

average coupon of 4.7%. I model that they will raise an additional $600mn of debt for the acquisitions (no

guidance yet, but that takes me to the leverage target for the year). And that they will refinance the FY20 debt,

taking the entire funding cost down to 4.7%.

There are no off balance sheet liabilities. The pension fund was fully funded at the start of 2016 and the

assumptions are reasonable (5.6% long-term rate of return, 4% discount rate of obligations).

Cash flows

The company should generates around $800mn in operating cash flow per year.

- Capex requirements are $100mn

- The dividend consumers $166mn growing to $200mn

- The remainder is evenly split over buybacks and acquisitions

- And the leverage ratio comes down on the back of EBITDA growth

As discussed, there was an exceptional $277mn working capital outflow in FY15. This was 90% driven by the

company’s decision to keep the rising excess inventories in Q4. Additionally there was some pressure from

Wal-Mart asking suppliers to carry more inventory.

Management is guiding for this to largely reverse this year. I conservatively model only a $100mn increase in

WC and assume a further $40-50mn headwind annually as I don’t expect to see much of an improvement in

the apparel retail environment or the tougher stance of retailers.

Have management been good stewards of shareholder funds?

The stock is up 506% since the company listed in 2006, which is roughly 9x the S&P500 performance.

Obviously management was given strong brands by Sara Lee. But I believe a large part of the stock

performance can be attributed to the success in integrating these brands into 1 company, relocating the

production to EM, and expanding the portfolio internationally. Therefore I believe we can largely credit

management for the stock performance. There have been some management changes since the IPO, but the

current C-suite has been involved in Hanesbrands from the start.

Compensation is reasonable: $10mn for the CEO and $2mn-$4mn for senior management.

- 10-30% of compensation is fixed salary.

- 20-30% is a short-term bonus based on revenue growth (20%), cash flow from operations (40%), and

adjusted earnings (40%).

- 30-70% is long-term compensation. Half of this is linked to the same targets of the short-term bonus, and

half is up to the discretion of the remuneration committee. The committee takes into account HBI

performance relative to a pre-determined peer group. Half of the long-term compensation are PSAs and

half are RSUs, which provides an additional link to share price performance.

Whilst there is room to improve the compensation (eg less discretion to the committee), the structure seems

aligned with shareholder interests. The only issue I reallyhad was the fact that the CEO has sold around

$100mn worth of shares over the past 3 years. All of that has gone through pre-determined 10B51s, with the

pace of selling accelerating from 30k blocks in 2012-2014 to 100-200k blocks in 2014-2015.

The company just announced that the CEO will retire and take over as Chairman. The COO, who has been

with the company from the start, is stepping up to become the new CEO. The old CEO still has a $40mn stake

in the company. The COO / new CEO holds a similar amount. And the rest of management has another

$50mn combined. As long as the new CEO does not sell down his stake, I am comfortable on this issue.

Valuation

I set the base case target at $43 (59% upside + dividends) based on the following FY18 multiples

- 17x P/E

o This is in-line with the 3-year average (range 14-21x, chart below). I use a shorter historical

reference period because the multiples in its initial years as a listed company were depressed by

HBI being a restructuring story coming to the market just before the financial crisis, followed by

the cotton boom and bust in 2011-2013.

o This implies an ongoing discount to peers, despite HBI outgrowing them on both the top-line and

bottom-line and HBI generating substantially higher returns (see tables below). Gildan trades on

19x FY1 P/E, Nike 27x, Under Armour 58x, VF Corp 20x and L Brands 17x. Only PVH and RL

trade at a multiple below my target multiple. And their FY1 multiple of 14x is in-line with HBI’s

current multiple.

- 5% EV FCF Yield

o Roughly in-line with the current yield

o And a reasonable target given the stability of cash flows

- 2.5x EV/Sales

o This is the most punishing valuation metric as it includes the recent increase in debt and the

higher leverage compared to fashion apparel peers, whilst not rewarding for the higher margin

and lower tax rate.

o That being said, 2.5x still looks reasonable versus Gildan’s 2.9x, Nike 3.0x, Under Armour 3.6x,

VF Corp 2.2x and L Brands 1.9x.

- Holt has 40% upside to $38 in its standard model (which puts HBI at the 94th

percentile). Note that this includes a fade in CFROIs, a slowdown in asset growth and a tax rate going back to 20%.

The more bullish target would be $54 (100% upside).

- I keep the same numbers, but roll forward my target year to FY19 and use multiples at the higher end of

the 3-year range and closer to peers

- 19x P/E, 4.5% EV FCF Yield, 2.9x EV/Sales

P/E and EV/EBITDA (top), EV/Sales (bottom)

Risks

Is the company exposed to material ESG risks?

Hanesbrand receives a AA rating from MSCI. The company scores an exceptional 94

th percentile on supply chain labour standards, and 70-76th percentile for raw materialsourcing,

chemical safety and product carbon footprint.

MSCI does give HBI a low governance score (24th percentile versus the industry, 36

th percentile versus US companies). The only real issues are the combined chairman/CEO role and concerns about ‘extreme values

on asset-liability valuation ratios’. There is no detail on the latter and I can only assume they refer to the

accrued liabilities in relation to the restructuring of acquired businesses. These reflect severance pay and

other costs related to closing acquired production sites. The governance teamdouble checked with ISS, who

do more thorough work on the governance side and have no real issues (HBI scores second decile).

What are other material risks to our investment case? What is a plausible downside valuation

scenario?

Hard to predict a turnaround in the lacklustre share price momentum

The HBI share price chart looks uninspiring. The stock rolled over in the summer of FY15 and has been

struggling to break that pattern since, despite good results and announcing $1bn of acquisitions over the past

month. The stock went up 6% on the Pacific Brands deal, but came back down in the following weeks.

As discussed, I believe there are various things weighing on the stock.

- Some are industry wide issues, with peers such as Gildan indeed also showing a lacklustre stock trend

over the past 6 months

o General market weakness. The peak in HBI shares coincided with the peak in the S&P500.

o Investors worrying about US apparel. A shaky Q4 on warm weather was followed by a decent Q1.

But data points in recent weeks point towards renewed weakness (SSS of retailers, intermodal

data from railroads).

- And some issues are stock specific. These include

o Worries about the decline of HBI’s largest retail partners

o Worries about the competitive threat of Gildan

o The fact that an investment case based on capital deployment is not as strong as an investment

case based on margins doubling.

If this was March, I would have predicted that the announcement of the acquisitions would break the share

price pattern, but that is now clearly not happening. Therefore investing today means we invest based on the

value opportunity in the stock without being able to pinpoint the catalyst that will unlock this value. It might

take better macro / retail data.

It is worth adding that both PVH and RL bottomed at around 12x P/E (with P/E being the key focus according

to analysts). HBI will reach that valuation in FY17 following the recent acquisitions, and the company is

delivering results ahead of expectations.

Cost inflation

- Cotton is only 7% of COGS. Oil is also 7% (synthetics). Labour is twice as important (mid-teens).

- Fundamentally I don’t worry about cost inflation. EM labour inflation is the biggest problem, but HBI has

been managing this well for years. Having a branded product and retailers who are keen to see inflation

helps to offset rising cost.

- So the bigger worry is sentiment. Despite cotton being a small part of total costs, people think t-shirts

when they think cotton and therefore hedge funds easily short the stock in times of substantial cotton price

inflation.

- The outlook for Cotton is to remain around the current $60c/lb level. The price has been stable since

2013. Supply growth is slightly lower than demand growth (100 bales vs 110 bales), but inventories

remain elevated. The stock -to-use ratio is 95% which compares to a historical average of 50%. China’s

inventories are even higher at 197%. Some of that might need to be written-down as cotton only ‘keeps’

for around 3 years. But it seems unlikely that inventories will fall below the historical average any time

soon. And speculative non-commercial positions in cotton are short. It would take an exceptional natural

disaster such as the Pakistan flooding of 2010/2011 to see substantial cotton inflation.

Supply chain disruption

- HBI’s manufacturing capacity is concentrated in a number of hubs.

- The fact that it’s more than one gives the company some flexibility in the event of a disruption, but at a

cost. A natural disaster in for example Vietnam would no doubt weigh on the stock.

Quarterly results fluctuations

- Investor worries about the bigger picture (apparel decline, Gildan competition, etc) can lead to excessive

reactions to short-term fluctuations.

- Top line fluctuations can be driven by macro, weather, stocking/destocking cycles, and FX.

- Margin fluctuations can be driven by mix, commodity prices and acquisitions (initially lower margin)

Customer concentration

- 50% of HBI’s US sales go through Wal-Mart (30%), Target (15%) and Kohls (5%). These retailers are no

doubt gradually losing market share, but I don’t think this implies slowing sales for HBI, for reasons

discussed earlier

o Most people still visit a Wal-Mart from time to time. They go less often but you don’t buy

underwear every time you go to the supermarket.

o HBI will benefit from rising minimum wages in the US. The brand is popular with both the rich and

poor, there are as just more poor people. And unlike the retailers themselves, there is no

additional cost for HBI from minimum wage inflation.

o All that being said, Hanes is evolving with retail trends. They are for example the category leader

at Dollar General. And they are rapidly growing their on-line sales, through the websites of their

existing retailers (eg Walmart.com) as well as new ones (Amazon.com).

o And finally there is the international expansion which will dilute the exposure to the top 3 US

retailers over time, reducing investor worries.

- I’m also not too worried about the customer concentration risk.

o There is undeniably a risk in generating 50% of your US sales through 3 retailers. But I am willing

to take this risk because the retailers need HBI as much as HBI needs them. There is no other

brand that will drive traffic for these retailers to the extent that Hanes does. And there is no other

brand that will be able to deliver the same level of price inflation.

Changes to trade agreements

- Nothing on the horizon, but you never know if Trump gets elected.

Downside scenario

- It is hard to see downside on a 3-year horizon absent a recession

o In a more bearish scenario, I lower my FY18 EPS by 13% to $2.22 by assuming top-line growth

which is a few percentage points lower, no margin expansion and halving the acquisitions

o I set a target multiple in-line with where PVH/RL got

- 12x P/E, 6.5% EV FCF Yield, 1.8x EV/Sales

o This still leads to a TP $27, in-line with today’s valuation

- So we need to model a repeat of the financial crisis to get to substantial downside.

o Modelling assumptions in-line with the financial crisis leads to $1.6 in EPS in FY17

 - A 20/10/10% decline in innerwear/activewear/international on de-stocking

 - A 1% decline in the gross margin

 - A $100mn cut to SG&A

o Gildan recession multiples of 10x P/E and 1.5x EV / Sales

o This results in a black sky target price of $16 (41% downside)

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Quarterly results confirming the investment case

show sort by

			2016	2017
Price:	26.00	EPS	1.94	2.26
Shares Out. (in M):	389	P/E	13.4	11.5
Market Cap (in $M):	10,103	P/FCF	13.3	15.1
Net Debt (in $M):	3,096	EBIT	980	1,109
TEV (in $M):	13,199	TEV/EBIT	13.5	11.9