HanesBrands (HBI) is a new position added to the Value Fund this past spring. HanesBrands designs, manufactures, and sells primarily branded replenishment apparel goods including t-shirts, bras, underwear, socks and hosiery. Most of what the company sells is staple-ish in nature and, while consumers can defer purchases in the short-run, undergarments are generally the first purchases to be made following a period of deferment. Contrary to popular thinking, brands are important in the undergarment category as consumers are becoming increasingly brand loyal. For example, in men's underwear, we find 80% of overall US sales is represented by national brands (up from 74% just five years ago). HanesBrands is the captain (#1) or validator (#2) in most of the subcategories in which it competes, and the company's brands have shown solid pricing power during recent periods of input price inflation.
HanesBrands was spun-out from Sara Lee in 2006. Prior to the spin, it is our opinion that, Sara Lee maintained a high-cost, uncompetitive domestic manufacturing footprint for Hanes, underinvested in innovation, and basically milked the Hanes unit of its cash flows for reinvestment in other areas within Sara Lee. Since 2006, HanesBrands has:
• Moved its manufacturing to lower-cost geographies including the Caribbean, Central America, and Asia;
• Focused on innovation and reinvestment opportunities such as the C9 Champion line at Target and overseas expansion;
• Pruned and added to its product portfolio with strategic tuck-in acquisitions like Gear for Sports; and
• Paid down debt significantly.
HanesBrands' operating performance during 2011 and the first half of 2012 was negatively impacted by a severe spike in cotton prices, which occurred during late 2010/2011. As a result, margins compressed when price increases were unable to match increased input prices. We established our position in HanesBrands, both as an improving ROIC and a Free Cash Flow (FCF)/de-leveraging story that we expect will play out over the next two years. We forecast ROIC to improve by 200bps (20%) over our investment horizon driven specifically by the following:
• Over the course of the year, HanesBrands will be shutting down its commodity screen printing t-shirt business, which is generating approximately $40 million in operating losses during 2012. Management has decided this business is non-core to the company's branded strategy and is basically ceding market share to competitors Gildan and Fruit-of-the-Loom. Simply shutting this business down will improve operating margins by approximately 100bps and operating profits by 10%.
• Due to the rise in cotton prices in 2011, HanesBrands absorbed a roughly $250 million use of cash due to higher average unit costs (AUCs) for cotton-based inventory carried on the balance sheet. As this high cost inventory works its way off the balance sheet, it will become a major source of cash for HanesBrands – beginning in 2Q 2012 and continuing for the next 12 months.
• Bolstering the ROIC-improvement story is a meaningful deleveraging story. We believe HanesBrands will generate approximately $700-800 million of free cash flow over the course of the next 18 months. We expect HanesBrands will use all of this cash to reduce over 40% of its long-term debt, including a $500 million tranche of notes with an 8% coupon, by the end of 2013. Leverage will be reduced to less than 2X, annual interest expense will fall from $156 million in 2011 to under $75 million by 2014, and the company's financial flexibility will be greatly enhanced to initiate additional shareholder-friendly actions, such as dividends and/or share repurchases.
From RS Investments' RS Value Fund Third Quarter Letter.