Geoff Gannon July 23, 2007

On Hanes

Inelegant Investor has a post on Hanes. The post also links to The Stalwart.

Here are a few things to keep in mind with Hanes.

Two major players, Hanes Brands (HBI) and Fruit of the Loom (a Berkshire Hathaway subsidiary), control most of the U.S. underwear market.

Hanes considers itself to be in the “apparel essentials” business which is to say the “t-shirts, bras, panties, men’s underwear, kids’ underwear, socks, and hosiery” business. In 2005, the U.S. apparel essentials market was about $44 billion. Apparel essentials have been growing faster than the overall apparel industry – still this isn’t a fast growing market. You’re unlikely to see sales growth exceed 5%.

Hanes divides its business into four segments: Innerwear, Outerwear, Hosiery, and International. The company doesn’t do much international business. Hosiery is a dying business with good margins. It generates cash; but, it’s going the way of the Dodo – fast.

That leaves innerwear and outerwear. Together these two segments account for something like 85% of Hanes sales.

Innerwear is underwear – and yes, it’s just as profitable by any other name. This segment is the heart of the company. It generates more than $2.5 billion in sales and plenty of free cash flow. Apparently, you can achieve low double-digit profit margins in this segment, which is impressive given the volume involved.

The innerwear business is a ridiculously high volume business. Looking at it solely in dollar terms doesn’t make that clear enough. So, let me give you some unit numbers.

Hanes manufactures and sells a billion socks a year – literally. That’s 500 million pairs of socks a year. Even the T-shirt business is high volume; Hanes produces about 400 million T-shirts a year.

The company’s biggest customers have high volume needs. Wal-Mart accounts for nearly 30% of the company’s sales. Does Wal-Mart have leverage over Hanes? Maybe. Does Wal-Mart have many other options? No. Hanes supplies them with well over $1 billion in product each year. It’s a cheap product that can only be produced in such volumes at competitive prices by a few companies on the planet. In the U.S., your choices are basically Hanes or Fruit of the Loom.

Furthermore, customers don’t contract this stuff. They simply buy what they need. The excess inventory costs on these high volume products could easily eliminate all the profit for any company that isn’t accustomed to producing on this scale. Hanes averaged total inventory reserves of just under $100 million a year over the last three years. That’s the cost of guaranteeing you have enough product to meet your customers’ needs.

Hanes employs a lot of people – and the workforce isn’t particularly cheap considering how cheap the product is to produce. Before the spin-off, Hanes employed close to 50,000 people worldwide. The vast majority of the company’s employees were located outside the U.S.; however, the vast majority of the company’s labor costs came from inside the U.S.

Using American labor to produce underwear isn’t particularly economical. Since the spin-off the company has clearly been moving to reduce costs. This means closing plants and firing people. I expect the company will have to engage in a fair amount of globe hopping just to keep moving jobs further down the global wage scale as wages in some of these countries may grow fast enough to threaten price competitiveness. Of course, competitors are in the same boat. Absent prohibitive tariffs, each of the players in the industry should end up about where they started – though much of their current workforce will end up jobless.

Hanes has reduced its total sales in an attempt to eliminate some low margin product. Currently, sales are around $4.5 billion. The company hopes to use that number as the base to maintain and eventually grow. However, growth will be slow. Around the time of the spin-off, the company’s “growth goals” set the bar at sales growth of 1-3%.

Hanes is highly leveraged (both financially and operationally), so single-digit sales growth can produce double-digit EPS growth – for a time. Again, this isn’t a high growth business. In the long-run, it’s a slow growth business.

The best margins are in the innerwear business. That’s also the area where Hanes has its most important competitive advantages. However, the outerwear business isn’t a bad business and there’s probably more growth potential there.

I’d like to see Hanes focus more on innerwear than I expect them to. However, management may surprise me. They didn’t set particularly aggressive sales growth goals, which is a good sign, because chasing growth would lead the company away from its competitive strengths – which happen to be in a highly-profitable business.

Hanes wasn’t a good fit at Sara Lee (SLE). This isn’t a small business. It’s a big business with a couple good brands and one terrific brand (Hanes). Hopefully, the brand will get more attention now than it did under Sara Lee. We’ve already seen some evidence of that.

Long-term I hope to see Hanes grow international innerwear sales. However, underwear is a very personal thing; you need to build up familiarity over time – it isn’t an area where buying habits change rapidly or where there’s a lot of comparison shopping – so, it’s a hard market to break into. But, with a lot of time and a little skill, there is the potential for growth in the international segment. But, I wouldn’t count on any such growth when valuing the business.

Overall, I like Hanes today much the same way I liked Energizer Holdings in early 2006.

This is a good business with a lot of debt and a lot of temporary, transitional stuff obscuring the company’s true earnings power. Look at the company’s record under Sara Lee, the information filed since the spin-off, etc. and try to come up with some reasonable EBIT estimates. Then, work back from there to get to a share price 3-5 years out.

With some good capital allocation decisions (or rather without some bad capital allocation decisions) the stock should perform nicely over that timeframe (3-5 years) without requiring any miracles from the business.