September 2016 Hanesbrands Price: $26 Research Summary By Ryan Kinney, Check Capital Management (CCM)

Hanesbrands (“HBI”) is the world’s top basic-apparel company. It manufactures and sells essential clothing—underwear (for men, women and children), bras, socks, T-shirts, hosiery and active- wear—worn by hundreds of millions of people every day. HBI’s portfolio of leading brands includes Hanes, Cham- pion, Playtex, Wonderbra, Maidenform, L’eggs, Pacific Brands, JMS and BALI, with #1 or #2 marketshare in the firm’s core categories in numerous countries around the globe. Hanesbrands domi- nates the U.S. market, where eight of ten households own its products. The Earnings exclude nonrecurring gains and losses. | Here and company is organized into four opera- henceforth “E” means Estimated. ting segments:

• Innerwear (46% of sales; 61% of operating income): The Innerwear segment consists of frequently replenished products, such as underwear, socks and bras, featuring high brand aware- ness and stable consumption patterns. The U.S. market is large (~$21 billion), with steady low- single-digit annual growth and rational competitive dynamics. Operating margin: 23%.

• Activewear (28%; 26%): Activewear consists of branded outerwear products that are used often and for many purposes. The domestic market is growing at low-double-digit rates driven by the convergence of athletic and casual apparel. Operating margin: 16%.

• International (19%; 11%): The International segment includes products bought globally that span the Innerwear and Activewear segments. Operating margin: 10%.

• Direct-to-Consumer (7%; 3%): Direct-to-Consumer is entirely domestically based. Its opera- tions have two facets: 1) company-run outlet stores and 2) website activities that sell HBI- branded products directly to U.S. consumers. Operating margin: 7%.

A Stable, Predictable Business

The apparel industry, generally speaking, is hyper-competitive and filled with challenges. It is cyclical, plagued by fast-changing fashion trends and all too easy for new rivals to enter. But Hanesbrands is far from a typical apparel company. For over a century, the firm has specialized in “boring”, low-cost basic apparel that people need more than “want” and must be replenished somewhat regularly (see chart on next page). In fact, 85% of HBI products are purchased based on replacement cycles—because undergarments wear out and kids grow. Consequently, Hanes-

1 Check Capital Management Inc.  Costa Mesa, CA.  (714) 641-3579 (800) 710-5777 brands generates consistent, recurring cash- flow, with low fashion risk and minimal exposure to economic cycles. Consumers can postpone buying basic apparel, but they cannot put off such purchases indefinitely.

While there are almost no barriers to stop new competitors from entering the basic-apparel market, the industry remains dominated by just a handful of players. In U.S. men’s under- wear, for example, Hanes and Fruit of the Loom control 45% and 30% of the market, respectively, and have maintained their leader- Source: NDP Group ship for decades. The market for socks and intimates is similarly ruled by very few companies. This suggests that Hanesbrands, as well as other top basic-apparel firms, possesses a competitive edge that discourages potential rivals.

Brand. In the basic-apparel business, brand matters. In 2015, branded innerwear sales account- ed for 85% of the market (15% private label), up from 82% in 2010. According to a consumer panel conducted by market-research firm NDP Group, brand is the chief factor driving people’s innerwear purchases, followed by comfort, fit, style and price, in that order. With consumers overwhelmingly focused on brand over price, HBI enjoys considerable pricing power. This enables it to a) charge more for its products than competitors can and b) maintain margins by raising prices during times of inflation. To better understand the firm’s pricing capabilities, consider 2011: Poor weather in India and flooding in Pakistan and Australia caused cotton to spike from roughly 65¢/lb. in early 2010 to more than $2.00/lb. in 2011—among the highest cotton prices in history. In response, Hanesbrands hiked prices noticeably several times during the year. Yet, despite these higher prices, unit volume only declined marginally and, remarkably, overall sales and profits increased. (Cotton is the primary raw material used to manufacture HBI products; it accounts for approximately 7% of the total cost of goods sold.)

“When consumers find brands they like and trust, they tend to stick with them, buying them over and over again, literally for decades.”

–Richard Noll, Executive Chairman

Hanesbrands benefits from a captive customer base, thanks largely to the power of its brands. The firm “acquires” customers at a young age and continues to sell them products into their twilight years. Because basic apparel is fairly inexpensive and people, for obvious reasons, do not like trying on undergarments, consumers are rarely willing to switch brands to save a dollar or two. They typically stay with a company they know and trust. What is more, studies have shown that consumers prefer Hanes garments, which account for more than half of HBI reve- nues, to those of its competitors. Just how faithful are consumers in the basic-apparel category? In 2013, an NDP Group study on the men’s underwear market found that approximately 60% of sales are to customers considered “brand loyal” (i.e., customers who consistently and exclusively buy a company’s product irrespective of price), 30% are “bi-branders” (loyal to two brands) and only 10% are “brand-switchers”.

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The firm’s two largest units—Hanes and Champion—possess universal appeal. These brands are popular among men and women, young and old, rich and poor. This is a stark contrast to competitors like Victoria’s Secret, which predominantly caters to affluent women age 18 to 49, or Fruit of the Loom, which is more popular with baby boomers. It is hugely advantageous to own a brand that is for everyone. Said CEO Gerald Evans, “Our brands are our greatest assets, and we will continue to invest in them.”

Cost advantage. Unlike most of the competition, Hanesbrands controls its own low-cost global supply chain. At a time when most apparel companies were closing U.S. manufacturing facili- ties and subcontracting production to cheaper, emerging-market suppliers, HBI’s management team reasoned that instead of outsourcing, the firm could save even more money by building its own plants, run by its own employees overseas. They were right. The initial costs to move manufacturing plants from the U.S. to Central America, the Caribbean and Asia were substantial, but now the firm can produce basic apparel in high volumes (nearly two billion units annually) at 15% to 20% lower costs. Additionally, efficiency gains have resulted in average annual savings of $35 million to $40 million.

“What sets us apart from most apparel companies is that we own our supply chain. Our network of large-scale facilities and dedicated contractors gives us tremendous ability to manufacture at low cost and scale up production of our latest big ideas to enhance margins. And our deep understanding of the technical aspects of producing our products allows us to invent platform innovations like no one else. Our supply chain is a true competitive advantage.”

–Gerald Evans, CEO

There is also a large tax benefit in supply-chain ownership. Since the majority of sales are conducted through production hubs located in overseas jurisdictions with reduced taxes, HBI’s effective tax rate is very low: 9.5% in 2015 and 8.0% expected this year. The firm does not engage in artificial tax management—e.g., tax inversions or “earnings stripping” (domiciling in a foreign country with low taxes to shield earnings)—to minimize corporate taxes. A com- pany spokesperson states, “Our tax rate is the by- product of our global business model, which we believe is sustainable for many years to come.” Operating margins exclude nonrecurring gains and losses. Furthermore, the IRS recently finished a two- year audit of the firm’s tax structure and found that it was indeed sound. Not only was it proper, Hanesbrands received a tax rebate for overpaying in 2011 and 2012.

Potential Threats

Gildan Activewear. Hanesbrand’s market dominance is being tested by a relatively new basic- apparel player. Gildan, a longtime global leader in printwear (a commodity business selling

3 Check Capital Management Inc.  Costa Mesa, CA.  (714) 641-3579 (800) 710-5777 blank T-shirts, sweatshirts, etc., to printing companies), is aggressively pushing into the branded basic-apparel space. Like HBI, Gildan is fully integrated and operates its own overseas, state-of- the-art manufacturing facilities that enable it to mass-produce garments at a low cost. Gildan is well managed. Years ago it squeezed major players, including Hanes and Fruit of the Loom, out of printwear. HBI’s exodus from that low-margin business was to a great extent by design, so it could instead focus on high-return branded apparel. Nevertheless, Gildan can be similarly discerning. It began selling branded men’s underwear only three years ago and already reported- ly controls 8% of the market. Such progress is impressive, but it will likely be much more challenging for Gildan to continue gaining share.

Gildan Activewear appears to be selling its men’s underwear to merchants at a lower price point than other low-end brands, with stores selling it at prices comparable to other low-end brands, thereby improving retailer margins. This strategy has helped Gildan gain shelf space and grow its business. It is important to note, though, that while Gildan has increased marketshare, it has had no perceivable impact on Hanesbrands business, which suggests that Gildan is taking business away from private-label and low-end brands. It is unclear whether Gildan will succeed at stealing customers from perceived “premium” brands Hanes and Fruit of the Loom. But this scenario currently seems unlikely.

Remember that basic apparel—particularly underwear—is an industry driven by brand, not price. In fact, a decade ago Gildan tried to compete in the premium-sock trade but failed to gain traction, despite offering a comparable- quality product at lower prices. Why the flop? Because the brand was virtually unknown. (Gildan has since grown its sock business via acquisition, acquiring Gold Toe in April 2011 for $350 million.) And while Gildan has increased spending to heighten its consumer profile, a truly trusted brand simply cannot be built overnight. Hanes has interacted with Source: Kantar Media, 2014 | $ Figures in millions hundreds of millions of customers over the course of decades, spending billions of dollars on marketing and product development to cultivate interest in its brands. Only time will tell if Gildan is willing or able to match this commitment, given the financial strength and entrenched status of HBI and Fruit of the Loom.

Concentrated customer base. Hanesbrands’ 10 leading merchant relationships comprise 56% of sales, with Walmart, Target and Kohl’s accounting for 23%, 15% and 5%, respectively. This concentration of retailers could precipitate problems. What if Walmart or Target stop carrying Hanes? Or what if consumers abandon these retailers for “e-retailers” (e.g., Amazon)? First, the firm’s large retailers are extremely motivated to continue carrying the brand. They have longstanding relationships with HBI and treasure the innerwear category (whose floor space has steadily increased over the years), since basic apparel has proven to be stable, with healthy margins and consumer acceptance of price increases. Besides, Hanes—the industry leader—is prized by consumers, making Hanesbrands (with unit sales in the billions) invaluable to retailers.

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Second, the channels customers use to buy HBI products will look different in the future. For example, sales to the company’s eighth-largest customer—an “internet pure-play” with no brick- and-mortar locations—grew 70% in 2015. But where customers buy HBI’s products, whether in a physical store or online, is rather inconsequential. What does matter is that people continue to seek Hanesbrands goods (demand shows no signs of waning) and customers become increasingly loyal to all of the HBI brands.

Acquisitions to Fuel Growth

Some companies, when purchasing other firms, are merely trying to buy earnings. In contrast, Hanesbrands’ acquisition approach is very involved. HBI pursues leading apparel companies operating within its core categories. After completing a deal, the acquired firm’s manufacturing is painstakingly transitioned to HBI’s own low-cost supply chain, leading to considerable margin improvement and higher profits. By leveraging its existing assets and relationships, Hanesbrands often discovers opportunities to improve sales, too. The company’s management team is only interested in deals with an expected rate of return in the low-to-mid-teens.

Since 2010, HBI has initiated six major acquisitions, four of which are complete and generating solid returns. The firm spent $1.5 billion to purchase Gear for Sports, Maidenform, DBApparel and Knights Apparel. Collectively, they now earn over $250 million pre-tax annually, excluding nonrecurring integration costs, and are expected to generate an additional $40 million per year once fully integrated. This equates to an after-tax return of 15%. Once significant acquisition and integration costs (~$500 million) associated with these deals are factored in, the final return on capital computes to a satisfactory 11%. This figure is especially respectable when one considers that HBI typically issues low-cost, long-term debt to fund these deals. Borrowing money at approximately 3.6%—the present cost of its total outstanding debt—and investing it at 11.0% is an attractive proposition.

Acquisition/ Adjusted Year Acquisition Purchase Price Integration Costs Purchase Price 2010 Gear for Sports $227 $0 $227 2013 Maidenform $583 $200 $783 2014 DBApparel (Hanes Europe) $528 $268 $796 2015 Knights Apparel $200 $27 $227 Total $1,538 $495 $2,033

2016 Champion Europe $228 - - 2016 Pacific Brands $800 - - Total $1,028 $100* $1,128 *Based on management estimates ($53M expected in 2016)

HBI’s two most recent acquisitions, Pacific Brands and Champion Europe, cost about $1 billion total. Together, these firms earn around $70 million pre-tax, but after management overhauls the operations and shifts manufacturing to HBI’s low-cost platform, operating margins are expected to rise substantially, resulting in pre-tax profits of $125 million within three years.

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Management

Hanesbrands was divested from Sara Lee in 2006. Since then, it has been run by Executive Chairman Richard Noll and CEO Gerald Evans. These two men, plus the entire management team, deserve ample credit for the firm’s extraordinary performance over the last decade: Revenue increased from $4 billion to $7 billion (including recent acquisitions), operating profits grew from $400 million to over $1 billion and adjusted EPS (earnings per share) rose from 37¢ to $1.92. These impressive results were produced by following Noll’s and Evans’ simple-yet- effective strategy—“Sell More, Spend Less and Generate Cash.”

The company announced in June that longtime CEO Noll will relinquish that post in October, handing it to Evans while remaining as Executive Chairman. The transition should be smooth. Evans, who has worked at Hanes for 30 years, was chiefly responsible for creating/transforming HBI’s global, low-cost supply chain and integrating several of the firm’s major acquisitions

Not only has management proven to be operationally astute, but it is an excellent, shareholder- friendly capital allocator as well. It has consistently deployed excess cash to high-return projects and acquisitions. Also, the firm initiated a dividend in 2013 (with a target payout ratio of 25% to 30%) and, as shares languished over the last year, management opportunistically repurchased $731 million of stock, retiring over 6% of the total outstanding.

Capital Allocation 2010 2011 2012 2013 2014 2015 H1 2016 Capital expenditures $106 $90 $41 $44 $64 $99 $27 Dividends $0 $0 $0 $59 $120 $161 $84 Share repurchases $0 $0 $0 $0 $0 $351 $380 Acquisitions $223 $9 $0 $560 $360 $193 $193 Total $329 $99 $41 $663 $544 $804 $684 “H1” denotes First Half.

Hanesbrands’ debt remains both sensible and very favorably structured. It is low-cost (~3.6%), over 60% is fixed rate, and 95% of it matures in more than three years (76% in five or more years). Furthermore, the firm’s abundant cashflow readily covers interest expenses. As of July 2, 2016, HBI’s balance sheet had cash of $661 million (some will be used to pay for the Pacific Brands acquisition, which closed July 15, 2016) and debt of $3.8 billion.

Valuation

Check Capital’s investment strategy is to identify consistently outstanding companies and patiently wait to buy shares at highly favorable prices. Hanesbrands seems to fit the profile. HBI has declined roughly 25% from its high of nearly $35 in 2015. This drop was mainly due to “multiple compression”—its price-to-earnings (“P/E”) ratio fell from 21 to 13—not a decline in earning power: 2015 adjusted EPS of $1.66 is projected to reach $1.92 this year and around $2.24 in 2017.

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Several investor concerns are weighing on the shares, but most appear largely unjustified, such as 1) increased competition from Gildan that threatens marketshare; 2) a generally weak retail environment, particularly for retailers like Walmart and Target, which account for much of HBI sales; 3) the realization that HBI’s margin-expansion initiatives are mostly exhausted, limiting future earnings growth; and 4) perceived insufficiency of adjusted earnings. The latter two points require further discussion.

First, even though Hanesbrands will no longer grow EPS at 20% per year, the firm is entirely capable of growing earnings at a double-digit clip. So, while circumstances warrant a degree of multiple compression, HBI still merits a multiple that reflects its superb economics, competitive position, management team and growth prospects. At present, the S&P 500 trades at a P/E of 18 (based on 2016 earnings estimates), well-above the P/E of 13 that HBI currently fetches.

Second, some investors are skeptical of the firm’s adjusted earnings, which is heavily influenced by nonrecurring acquisition and integration costs, because a) the bulk of the charges are a real cash expense, and b) the costs seem to recur every year. If an investor uses the firm’s 2015 reported EPS of $1.06 instead of an adjusted EPS of $1.66, the earnings multiple changes considerably from a P/E of 24 to 15. The reason we are comfortable using the adjusted figure is that we believe it more accurately depicts HBI’s true earning power. The charges may seem to be recurring, but that is only because Hanesbrands continues to make acquisitions and it takes a couple years to integrate/overhaul the acquired firm’s manufacturing process. Moreover, future integration costs should decline materially. It cost HBI approximately $500 million to integrate its first four acquisitions (purchased for $1.5 billion), while it will spend less than $100 million on its last two deals (acquired for $1 billion). Management explains: “1) We have become more efficient at integrating acquired businesses; 2) we are benefiting from our prior foundational information and technology investments; and 3) these two integrations are less complex.” If we use 2016 estimates, the difference between reported and adjusted EPS is a P/E of 17 versus 13 (EPS of $1.49 and $1.92). Clearly, the gap is narrowing, and this trend is expected to continue.

2010 2011 2012 2013 2014 2015 E2016 Operating profit $404 $447 $440 $515 $564 $595 $775 Nonrecurring losses (gains) ($23) $0 $0 $81 $199 $266 $180 Adjusted operating profit $381 $447 $440 $596 $763 $861 $955 $ Figures in millions

Hanesbrands is on track to generate roughly $700 million of free cashflow in 2016, and that figure will likely approach $1 billion in the next two years. In our opinion, owning a predictable business with a near-impregnable competitive position and a talented, shareholder-oriented man- agement team—a business generating lots of excess cash at a free-cashflow yield of 7%—is a worthwhile investment.

[See “Executive Summary” and footnotes on next page]

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Executive Summary: HBI POSITIVES NEGATIVES

 World’s largest basic apparel  Concentrated customer base company  Gildan a rising threat  A predictable business, with  Limited future earnings growth; recurring, annuity-like cashflow nominal opportunity for further  Minimal exposure to fashion risk margin expansion and economic cycles

 Portfolio of trusted, high-quality brands; captive customer base

 Low-cost supply chain

 Value-added acquisition strategy

CCM Research Reports are for informational purposes only and are not an offer to sell or a solicitation to buy. They are not personal recommendations for any particular investor and do not take into account the financial circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities discussed and may purchase or sell such securities from time to time. CCM Research Reports are created using third-party data. While Check Capital believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness.

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