2023-12-18 03:38:52 ET
Summary
- Activist investor Barington Capital targets Hanesbrands due to perceived cheap valuation and fixable business problems.
- Hanesbrands has three catalysts that could potentially double the stock price, including sales growth, gross margin expansion, and a strategic review of the Champion business.
- The company's strong performance in the innerwear market and commitment to innovation provide a positive outlook for future growth.
Investment Thesis
Hanesbrands ( HBI ) recently attracted an activist investor from Barington Capital , known for successfully driving changes at retailers and restaurant chains in the past. One of the reasons Barington Capital targeted HBI is its perceived cheap valuation and fixable business problems. HBI has three catalysts that could address these issues, potentially doubling the stock price if any of them materialize, with one of the catalysts possibly materializing very soon. Hence we have a Strong Buy rating for HBI.
The first catalyst involves sales growth. At the beginning of the second half of 2022, U.S. retailers grappled with excess inventory . While many have diligently managed their inventory in 2023, some are still working through surplus stock accumulated in 2022. In 2023, retailers, either due to caution regarding customer demand or ongoing inventory clearance, have reduced orders from HBI, creating headwinds for its sales figures. This affects HBI because third-party brick-and-mortar wholesale constituted approximately 69% of HBI's sales in 2022. A positive catalyst for 2024 is the anticipation that excessive inventories will no longer burden the industry. Retailers are expected to be more optimistic about customer demand, driven by the easing of inflation and the peak of rate-raising cycles.
The second catalyst involves gross margin expansion. HBI controls most aspects of its product lifecycle, from manufacturing and sourcing to distribution, with cotton being a primary raw material. In 2022, cotton prices surged to record levels , resulting in high input costs for their inventory and exerting pressure on gross margins in 2023. However, with cotton prices now returning to pre-pandemic levels and the high input cost inventory being cleared through 2023 , we anticipate gross margin expansion in 2024. In fact, their gross margin has shown a positive trend, climbing from the low end of 30% to the high end of 30% by the end of 2023.
The third catalyst pertains to the decision stemming from the strategic review of the Champion business. In 2023, the Champion business faced considerable pressures, with excess inventory still present in the market requiring clearance. To address this, the management is simultaneously taking two approaches for this brand: (1) driving product mix, channel segmentation, and overall brand improvement, and (2) considering the sale of this iconic brand. Regardless of the chosen path, it is anticipated that positive profits will be generated for the company following the strategic changes in this brand. If sold, it would also result in a substantial release of working capital, expediting the pace of deleveraging the balance sheet.
Business Introduction
HBI sells innerwear and activewear both in the U.S. and internationally. Hanes, their largest brand, is present in 90% of U.S. households with a range of innerwear products. Champion, their second-largest brand, is renowned for its athletic wear. The company also owns several smaller brands, primarily focused on intimate apparel. Hanes reports its business in three segments: Innerwear, Activewear, and International. The international segment encompasses innerwear and activewear outside of the U.S., representing 31% of its total business. Major international markets include Australia, Europe, Japan, China, Mexico, and Latin America.
Competitiveness Analysis
HBI operates in a highly competitive market, contending with various companies in its innerwear and activewear lines. In the innerwear segment, competitors include L Brands, known for the Victoria’s Secret brand. Mass retailers and department stores also offer basic apparel under private labels. In the activewear sector, Hanes faces rivals including NIKE ( NKE ), adidas (ADDYY) (ADDDF), PUMA (PMMAF), Under Armour ( UA ). This market is characterized by intense competition where brands typically lack significant pricing power, relying on factors such as brand reputation, comfort, style, and value to attract customers.
While the market remains competitive, the entry of new players has been limited. As long as existing players can keep up with the pace of industry innovation, they are likely to maintain their market share and grow alongside the industry.
HBI's innerwear brand has demonstrated strong performance in the industry. According to the management's remarks in the 2023 Q3 earnings call , their innerwear business continues to grow, even as the overall innerwear market experiences a decline.
While the total Innerwear market was down 3% in the quarter, our Innerwear sales were consistent with the prior year period as we gained market share driven by younger consumer-focused innovation, permanent retail space gains, a successful back-to-school campaign and better on-shelf availability as we leverage our data analytics capabilities to help our retail partners improve sales and working capital efficiency.
These strong performances stem from Hanes' commitment to innovation. In recent years, their innerwear segment has introduced several new products. Notable examples include the Hanes Total Support Pouch underwear for men in 2021, Hanes Originals in 2021, and the more recent M by Maidenform in 2023. The management team has outlined an innovation pipeline that is expected to support new product launches through 2025.
HBI's activewear, in contrast, is facing challenges in this competitive market. In its latest 2023 Q3 earnings report, activewear sales declined by 19% compared to the previous year. The Champion brand, a significant component of the activewear segment, is currently under strategic review by the management team.
Sales growth catalyst
HBI sells its products throug h third-party brick-and-mortar stores as well as its own e-commerce site. In 2022, third-party brick-and-mortar wholesale accounted for 69% of its sales. The top 10 customers collectively represented approximately 45% of total sales , with the largest customer, Walmart, contributing 16%. Hanes has maintained long-standing customer relationships, with key retailers such as Walmart ( WMT ), Target ( TGT ), Kohl’s ( KSS ), Macy’s ( M ), and Nordstrom ( JWN ), spanning a decade or more.
All these brick-and-mortar retailers entered the second half of 2022 with excessive inventories and approached 2023 with a cautious outlook regarding consumer demand for discretionary spending, particularly in apparel. The combination of lingering excessive inventory from 2022 and the conservative consumer demand outlook has led these retailers to reduce orders, inadvertently impacting sales for Hanes' brands.
Here are few examples using the FY2023 Q3 earning results of retailers; it is evident that sales have been impacted.
Retailers | FY2023 Q3 Inventory Level |
Nordstrom | total inventory is down 9% YOY |
Macy | total inventory is down 6% YOY |
Walmart | total inventory is down 4.8% YOY |
target | total inventory is down 14% YOY |
(Analyst compiled data from various earning reports)
On a positive note, the majority of retailers have successfully cleared excess inventories from 2022. The current inventory management practices align with a cautious outlook on consumer demand. Therefore, I anticipate the inventory levels from these retailers to remain steady or experience slight growth in response to a more positive consumer spending outlook in 2024.
On December 13, 2023, the Fed signaled the completion of rate increases , and the market anticipates a potential lower interest rate by the end of 2024. This may change the outlook for consumer spending from negative to positive. As a result, retailers could ramp up spending for their inventory, providing a sales tailwind for HBI.
Gross margin expansion catalyst
Over 60% of the apparel units sold by HBI are manufactured in-house, with these manufacturing facilities located outside the U.S. in low-cost labor areas. Additionally, cotton is the primary material for its manufacturing activities . As a result, Hanes' business is susceptible to the risk of inflation in freight rates and cotton prices. In 2022, the company faced historically high freight rates due to the Covid-19 pandemic and a sudden spike in cotton prices, resulting in a high input cost inventory.
As mentioned earlier in the competitiveness analysis section, these retailers typically lack pricing power, especially in a sluggish consumer spending environment. Consequently, Hanes's gross margin has suffered since the beginning of 2023. In 2023 Q1, the gross margin declined by 470 basis points year-over-year to 32.4%.
That being said, we anticipate HBI's gross margin to fully recover in 2024 as both cotton prices and ocean freight rates have returned to pre-pandemic levels. The following are key points from the management team's statements during their FY2023 Q2 earnings call .
In fact, input costs have come down significantly. For example, cotton costs, they're down nearly 40% year-over-year and have been stable since the first quarter. Freight costs, they're down enough significantly. For example, ocean freight, the container lanes, were down 80% year-over-year. And you can also see that on the balance sheet, raw materials, work in process, balances are down about 26% year-over-year. So, we're seeing that play out in what we're seeing in the manufacturing facilities and also seeing on the balance sheet. So it's really just a matter of time before that flows through the P&L.
We closely monitored HBI's gross margin throughout 2023 and observed a gradual recovery as the company worked through its high input cost inventory.
(In thousands) | 2023Q3 | 2023Q2 | 2023Q1 |
Net sales | 1,511,306 | 1,438,980 | 1,389,410 |
Cost of sales | 1,040,995 | 956,243 | 939,717 |
Gross profit | 470,311 | 482,737 | 449,693 |
Gross margin | 31% | 33.5% | 32.3% |
Adjusted gross margin | 35.5% | 33.6% | 32.7% |
(Analyst compiled data from HBI's earnings report)
Notes on the adjusted gross margin on 2023 Q3 from the earnings release :
Adjusted Gross Profit, which excludes certain costs related to the Company’s Full Potential transformation plan and its global Champion performance plan.
The management expects to conclude FY2023 Q4 with a gross margin in the high 30s and aims to maintain that level throughout FY2024. This implies a straight incremental $200M in gross profit for its bottom line, assuming the sales numbers don't change.
The anticipated gross margin expansion is poised to generate increased cash flow from the business, consequently accelerating the ongoing efforts to deleverage the balance sheet. HBI has already made significant strides, having paid down $270 million in debt, and is on track to further reduce debt by over $400 million in 2023. With the additional $200 million expected from gross margin expansion in 2024, we anticipate the company will allocate further resources to debt repayment.
Champion business catalyst
Champion business is currently pressured with no signs of the business turn around very soon. The management team has made several structural changes to its Champion such as segmenting, establishing a globalized product design, and streamlining its supply chain. The management team also announced that they are evaluating strategic alternatives for this business. Management mentioned the following in regard to the strategic review during the FY2023 earnings call:
While still very early in the process, we continue to evaluate the right path forward as we received strong initial interest from a broad group of global partners. We do not intend to provide continual updates on this process. However, as always, we'll be transparent and update you as appropriate when there is news to share.
Irrespective of the outcome of this evaluation, we are leaning into and executing our detailed Champion plan for product, marketing, distribution and operations. We remain highly confident and committed to reaching the significant global potential of the brand.
The activist investor from Barington Capital has a track record of successfully advocating for changes at retailers and restaurant chains, including L Brands before it broke into Victoria’s Secret and Bath & Body Works. Barington Capital has recently appointed three board members to HBI to guide the company toward shareholder value creation. Therefore, I believe that either the current management will succeed in the turnaround for the Champion brand, or it will be separated from HBI to unlock good value. The proceeds from such a separation could be utilized to expedite the deleveraging of the balance sheet.
Valuation
We will evaluate HBI's valuation through the lens of Price/Cash Flow and Price/Earnings, given its position in a mature industry.
HBI is anticipated to generate approximately $450 million in free cash flow and is currently trading at around 3.5X its FCF. In comparison, the sector's median Price/Cash Flow is 8.69 . HBI's low multiple is attributed to declining sales numbers and lower gross margins. With the expected gross margin expansion and favorable sales tailwinds, there is potential for the market to reevaluate these multiples. Using a Price/Cash Flow of 8 and free cash flow of $450 million, we derive a valuation of $3.6 billion, which is 2.5X the current market valuation of $1.4 billion.
We have analyzed three catalysts for HBI, with the gross margin most likely to materialize in 2024 and the other two catalysts potentially taking an additional 1-2 years to materialize. To project HBI's potential market value further into the future, we examine the estimated EPS.
Currently, analysts project an EPS of $1.46 with revenue of $6.01 billion. These estimates seem reasonable, especially if all three catalysts materialize, and HBI has demonstrated similar performance in the past.
The sector's median P/E value is 17.96 . Applying this to the projected EPS for 2026, we arrive at a stock price of $26, translating to a $9 billion market cap. This represents a 6X increase from the current market value.
Risk
HBI's current balance sheet reflects a challenging situation. The leverage ratio stands at 5.5 at the end of FY2023 Q3, with $3.3 billion in long-term debt. While it holds $1.2 billion in liquidity, only $191 million is in cash, and the remaining $1 billion is in available credits. If economic conditions do not improve in the coming year, the likelihood of sales growth is low. Additionally, if input costs spike again, navigating another round of input cost inflation could be challenging for HBI given its current balance sheet.
Having discussed valuation through both Price/Earnings and Price/Cash Flow, it's essential to consider EV/EBITDA and EV/Sales. Currently, HBI is trading at 12.88 in EV/EBITDA, above the sector median of 11.02 . In terms of EV/Sales, it stands at 0.93, below the sector median of 1.25 . From an enterprise valuation perspective, it is not trading at much a discount. The three catalysts discussed earlier aim to deleverage the balance sheet, and the successful execution of these strategies will be crucial. If the company struggles to achieve significant deleveraging, the market may continue to value the company at its current multiples.
Summary
HBI has three catalysts built into the company: sales returning back to growth, gross margin expansion, and a strategic review of its Champion business. These factors are expected to boost its earnings per share, deleverage its balance sheet, and consequently prompt the market to reevaluate its earnings multiples. Hence, we think HBI is a Strong Buy.
Editor's Note: This article was submitted as part of Seeking Alpha's Top 2024 Long/Short competition, which runs through December 31 . With cash prizes, this competition -- open to all contributors -- is one you don't want to miss. If you are interested in becoming a contributor and taking part in the competition, click here to find out more and submit your article today!
For further details see:
Hanesbrands Has Three Business Catalysts To Catapult Its Earnings Multiples