Research Reports

UPDATE COMMENTARY – With the recent sharp drop in the market through the end of November 2008, we wanted to revisit and update our thoughts on one of our favorite defensive ideas that has been beaten down to what we believe are ridiculous levels. In addition to macro market concerns, investors have company specific concerns for Hanesbrands which are discussed below. While we acknowledge the validity of some of these concerns, we believe investors are assigning excessively over weighted probabilities for them to occur due to the current emotional and fearful investment climate. We believe this has created an excellent opportunity for oversized investment returns over the next year or so.

When HBI was spun out, the historical trends and results were weak: poor top line growth; sub standard relative margins; a bloated inefficient manufacturing base; and excessive leverage (post spin out). In addition, there was a lack of analyst coverage which has lead to an inadequate understanding of the business by investors. We believe these issues will be resolved over the next few years which will help pave the way for substantial stock price appreciation once the catalysts mentioned below occur.

Our basic investment thesis for value creation is our expectation for modest single digit top line growth, 300+ basis points of margin expansion, and improved asset utilization. We expect an improvement in FCF generation over the suppressed level just after the spinout. The FCF will be used to substantially de-leverage the balance sheet. We believe the following catalysts listed below will unlock value and drive the stock price to our target valuation level.

APPRECIATION CATALYSTS - We believe there are identifiable catalysts that will push the stock price towards our target during the next several years. They are:

1. Independent, motivated, focused management team (time frame 2007+) – When HBI was part of SLE, they were treated as a cash cow and incremental investment to support growth was not a priority. For example, HBI never had a chief marketing officer while they were owned by SLE. They have hired a former P&G executive for this position and his sole focus will be to grow sales. In our conversations with management, in the past they felt somewhat handcuffed regarding the marketing of their products while under SLE and there seemed to be a disconnect between company performance and monetary rewards. Now that management has full control of their strategy, their financial rewards will now be more closely aligned with company performance. Profitable growth and ROIC will drive management’s total compensation.

2. Annual revenue growth of 2% to 3% (time frame = 2009+) – Overall, 2007 was a transitional year for the company as they began operations as a stand alone company. They have set a goal of growing sales 2% to 3% per year. In late 2007 and the beginning of 2008, they started to grow sales in the +3% area even with two negative industry trends that worked against their growth goals. First, there has historically been industry wide pricing pressure on apparel of approximately -1% per year (more on pricing later). Second, due to changing consumer tastes (less stockings being wore), industry wide hosiery sales have been declining 8% to 10% per year for the last 10 years. Using minus 10% as the average, HBI will see their hosiery sales drop by approximately $28m in 2008. (It is interesting to note that management has modeled for their $280m (#1 share) hosiery business goes to zero over time. (This is clearly an unlikely assumption because there would seem to be some solid base level of replacement annual sales that will eventually be reached.) These two negative sales trends have represented about a negative -1.5% annual sales headwind. The recent economic slowdown starting in the 2H08 has further hurt retail sales even though as much as 75% of their products can be considered non fashion orientated replacement demand items. HBI posted some weak sales due to the broad based slowdown in consumer spending. Management has identified several ways that they will grow sales by a net 2% to 3% over the long term. First, 44% of their sales are to the "mass" channel. The long term plan for these retailers such as WMT (31% of sales), TGT and KSS is to grow their store base each year by about 3% to 5%. Looking at the numbers, we believe that HBI’s mass channel sales are about $2b per year. Assuming that store square footage grows 4% per year, this should mean additional growth in organic sales volumes. Factoring in some cannibalization, we believe HBI can derive about $60m in new annual sales due to retailer store base expansion. Another driver of organic volume growth will be the efforts of the new chief marketing officer. He has a much larger (undisclosed) promotional budget to drive new sales. We believe it is reasonable to expect the new focus on marketing will help drive new annual sales growth by 1%. The final major volume growth initiative being pursued by management will be to improve the sales volumes by introducing new, higher price point products. We believe this could drive sales higher by another 1%. A good recent example of this is the very successful recent introduction of the "C9" line from HBI’s Champion brand which is sold exclusively at Target stores. This product is a high price point for HBI but a discounted version of performance athletic apparel sold by Under Armour (UARM) and Nike (NKE). This is a fast growing, billion dollar market that HBI expects to be an attractive new category for the company.

3. Recent product price increases introduced (time frame – 2009+) – With the rise in commodity and energy costs relative to prior historical levels, for the first time in many years, HBI along with other industry players have pushed through a price increase starting in 2009. HBI has successfully negotiated a 4% price increase which will help offset any volume weakness and cost pressures in the coming quarters. This also highlights a very positive and we believe, unrecognized attribute for the company – the strength of their brand. Retailers accepted the price increase because of the strong brand loyalty consumers have for personal undergarments. Even with the 4% price increase, we don’t expect the cheaper private label store brands to make a big dent in HBI’s market share because the relative price differential between HBI products and private label products are too small to cause any meaningful switching.

4. At least 300 basis points of EBIT margin expansion (time frame = 2007 to 2011) – In our opinion, HBI has very large, easily attainable cost saving opportunities that will amount to at least an additional net 300 b.p. EBIT improvement within the next 4 years. (This is net of the additional 1.5% in expense for marketing and promotion we have factored into our model) Most of HBI’s US labor is non-union. The net savings will come primarily through moving labor offshore. Currently, 20% of HBI’s workforce is located in the US but it accounts for 70% of the company’s total labor expense. Labor accounts for 20% of COGS (The remaining costs are: raw materials (50%) and overhead (30%)). The total estimated labor cost for 2007 equates to approximately $600m ($3b COGS X 20%). Of this amount, 70% or $420m is for the US workforce. This $420m is split evenly between distribution $210m (will NOT be off shored) and supply chain $210m (100% off shored over the next 5 years). The wage differential between US and Non-US is substantial. In the US including benefits, it is about $16/hr versus $1.50/hr in the Caribbean basin and $.50/hr in the Far East (blended rate across several countries). To be conservative, we have assumed that the current hourly wages of $16 drops to only $5 in 4 years. Our expected potential annual cost savings would equate to $147m or about an additional 300bp of EBIT. In addition to the labor savings, HBI has been exiting low growth, low margin product categories (such as men’s private label fleece and thermals). The exit has also hurt top line growth the past few years but will benefit margins going forward. Additional low growth/low margin products will be eliminated going forward.

5. Improved asset utilization and ROA (time frame = 2007+) – Along with the labor off shoring and product category rationalization, production assets are also being rationalized. Management intends on changing their mix of asset ownership away from the low return, capital intensive assets such as US based production facilities to more low capital intensive assets within distribution. For example, HBI currently owns 7 textile production facilities of which 5 are located in the US. All 5 of these plants will be closed within the next 3 years. The production will be shifted to their 2 remaining underutilized non US facilities. Expansions and new more efficient non US facilities will be built to accommodate the production shift. The company had over 110 facilities at the end of 2007. They expect to reduce the number to approximately 60 facilities by 2012. Overall, management expects the asset rationalization will reduce capex and working capital needs and help give them more control over their margin growth goals.

6. FCF generation and de-leveraging of the balance sheet (time frame = 2009 to 2011) – Prior to the spin out, HBI was able to generate over $400m in annual FCF. Immediately after the spin, the increased debt load caused annual interest expense to be about $200m. Approximately 16% of that debt was at fixed rates. Management has prepaid almost $300m in debt and completely funded outstanding pension obligations from FCF the last few years. With the sharp drop in interest rates recently, the company has wisely locked in 86% of their remaining $2.3b in debt at fixed rates which will lower 2009 annual interest expense to a range of $145m to $160m. Management has stated that they will continue to look to lock in their remaining variable rates and reduce the level of debt going forward. We believe the catalysts mentioned above will enable HBI to grow FCF from an estimated negative ($100m) in 2008 to a positive $280m in 2012. (Note: The -$100m in FCF in 2008 is primarily due to a $200m planned increase in inventory levels for the purposes of creating a cushion for the transition of the supply chain from onshore to offshore). The primary use of FCF will be to de-leverage the balance sheet. Management wants to optimize their capital structure and will retain some debt. According to their long term capitalization goal of 2.5x debt to EBITDA, we believe they will pay down over $1b in debt over the next few years. The debt situation is currently a key concern of investors and is discussed in more detail below.

7. Extremely low investor expectations (time frame = 2008+) – We expect the final catalyst to be a positive revision in investor expectations. Due to recessionary fears, all stocks have been hit hard especially ones related to consumer spending and the retail industry. HBI’s stock is down over 60% for 2008. Short interest is 7.5m shares which is over 8% of the shares outstanding and represents 6 days of average trading volume. The 3 sell side analysts as a group has the stock rated as a "weak buy". For us, the silver lining to this share price carnage is an increased downside margin of safety in stock price at the current level. We believe as market meltdown fears ease; as redemption and margin call related selling subsides; and as investors begin to look beyond the recession, HBI will look increasingly attractive. We expect increased positive expectations for HBI to be reinforced when the company produces strong relative and absolute financial results in the coming quarters.