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”. 2 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777 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.