Lower Cotton Prices and Debt Will Lead to Re-Rating for Hanesbrands

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Bo Yang.
Firm: Guggenheim Partners. Hedge Fund.
Location: New York, NY.

Recommendation: Long Shares of Hanesbrands (NYSE: HBI)
Timeframe: 1 to 2 Years
Recent Price: $27.15
Target Price: $40.00
Strategy: Delveraging Play

Quick Thesis:
The Company’s flagship brand, the Hanes brand, has been performing fairly well with space gains of ~7% in 2010, ~2% in 2011 and a projected 2% to 3% in 2012. The Company is highly levered, with about $2bn of long term debt or a ~70% debt to cap and ~4.2x LTM leverage.

The story here is that Hanesbrands will be able to delever the balance sheet using the strong free cash flow it will generate over the next two years as cheaper cotton prices run through its cost structure and the Company realizes benefits from decreased inventory levels.

This should not only lead to healthy EPS growth of 27% through 2014, but it could also lead to multiple expansion as the debt overhang on the stock is removed and the Company possibly initiates a regular dividend or buyback, which will attract a larger, longer term investor base.

Hanesbrands guided 2012 FCF to $400mm to $500mm, with around $100mm of the FCF generated by favorable working capital. In 2013, I believe FCF could be around $350mm. This equates to a midpoint 15% FCF yield for 2012 and a 12% FCF for 2013.

Hanesbrands plans on using the roughly ~$800mm of FCF to reduce debt. In 2012, the company expects to pay down a total of $300M in debt, including the $150M of FRN Notes (L+375) just announced. In 2013, HBI will most likely pay down $500M of the 8.00% senior notes for a total of $1B. By the end of 2013, HBI will have $1.3bn of debt left and will save ~$52mm in interest expense, or an incremental ~$0.42 EPS. Hanesbrands might also sell non-profitable non-core assets to pay off even more debt. They recently sold their European imagewear divison for $20mm and have stated intentions to sell more non-core assets such as their Outer Banks brand.

Assuming the $300mm of FRN notes are paid off in 2012 and $500mm of the 8.00% notes are paid off in 2013, I believe 2013E EPS and 2014E EPS can reach $3.05 and $3.54 respectively. In roughly a year when the market starts trading off 2014 numbers, applying a 12.0x multiple to 2014E EPS will give you a target price of ~$42 a share. This share price also implies a 10% 2014 FCF yield, which I feel also supports the valuation.

While Hanesbrands has traded at an average of 10.0x P/E over the past five years, this multiple was depressed due to its highly levered capital structure and the fact that during the financial crisis, Hanesbrand’s P/E multiple hit as low as 3.0x as investors feared that they might trip debt covenants. Once Hanesbrands delevers and leverage goes from ~4.2x currently to ~2.2x in 2013, the debt overhang will be removed and it is possible that the Company will use its substantial FCF to buyback shares or pay dividends. In this case, I believe 12.0x P/E could be a conservative multiple.

Hanesbrands has a lagging exposure to cotton, which will account for an increase of $200mm in costs in 2012 (6.5% of 2011 COGS). The price of cotton usually takes about a year to run through the Company’s financials. Cotton prices spiked in the 2nd half of 2010 and throughout 2011 to record levels as floods in key cotton producing countries such as Pakistan and Australia decreased supply.

Since reaching $2.00 / lb, cotton prices have come down to around $0.70 / lb today. The cost of cotton doubled for HBI in 4Q 2010 and had a negative impact of $150mm in 2010. In 2011, rising cotton prices increased COGS by an estimated $200mm. Gross margins in the 1st half of 2010 were in the 34% range. Gross margin for the past two quarters have been 25% in 1Q 2012 and 29% in 4Q 2012 as peak cotton costs passed through their P+L. Starting in 2Q 2012, cotton costs should moderate but the Company has said current prices of $0.70 / lb won’t pass through the Company’s cost structure until 2Q 2013. The Company expects 2012 pricing to average $1.25 to $1.35 / lb, which is still significantly higher than the $0.70 / lb market price.

Another tailwind for gross margins is the Company’s decision to exit the imagewear business. The Company recently announced the sale of its imagewear business and its intentions US private label and Outer Banks businesses. Management has said that this will have a ~$60mm impact on sales, primarily 2H 2012, but an insignificant impact on operating profit. The implication is a ~30bps impact on operating margin in 2H, which I believe will most likely be in gross margin. I believe starting in 2013, gross margins will normalize in the 33% to 34% range.

Management guided to growth of 0.7% to 2.7% in 2012, despite the exit of its imagewear business. I think there could be upside to these numbers as the Company is lapping easy comps in the back half of 2012. Also, International sales accounts for 12% of the business and Management has said they expect this segment to grow over the next few years (ex. impact of the sale of the European Imagewear division).

In addition, the Company has been gaining shelf space with new products such as the ComfortBlend, which won’t fully hit the market by late 2Q 2012 and The Hanes Beefy Ts program, which won’t start shipping to Wal-Mart until the 2nd quarter. Management has said this should be a 7% tailwind for 3Q12-2Q13. Overall, I think Hanesbrands can conservatively grow through 2014 and achieve further success rerating thanks to its deleveraging efforts and eventual multiple expansion.

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