Comparison of Apparel Companies

Earlier this year, I looked at a bunch of apparel companies. Sometime during my research, I compiled the following table to take a cross-sectional view of the space.

Untitled

NKE at $90B+ market cap is the big kahuna. It has stable growth of nearly 8%, high ROIC. Not surprisingly, it commands a premium price.

Adidas is also quite large. It seems to be getting its act together. Historically ADDYY has been a laggard in terms of ROIC, margins, and growth.

LULU and UA had spectacular growth spurts that seem to be slowing. LULU has delicious margins, and ROIC, but view from the wind-shield is not as rosy as that in the rear-view mirror. Unlike LULU, UA’s margins and ROIC have been okay, but not great. LULU is more expensive than UA.

VFC is a mature, boring, slowing, and solidly profitable company. Operationally, HBI seems the lousiest of the lot. However, it uses leverage and tax shields to play in the big leagues.

Note that good companies (growth, margins, ROIC) are more expensive than so-so companies. This is the free market at work.

Advertisements

Hanesbrand

One thing leads to the next. I started looking at Under Armour, stumbled into VF Corp, before landing on Hanesbrand (HBI).

All three stocks have been beaten up, and are trading near their 52-week lows. While S&P is up 15% and near its all time highs, VFC, HBI and UAA are down 20%, 30%, and 50% from a year ago, and are trading near 2-year lows.

Naturally, I had to take a look.

HBI was spun out of Sara Lee in 2006. It sells basic innerwear and activewear apparel in the Americas (US accounts for more than 3/4 of sales), Europe, Australia and Asia/Pacific. It owns many popular brands as listed in their 10-K.

brands

Sales have grown from $4.5B to $6B  from 2007-2015, even as EBIT margins have improved from 7-8% to 10-13% over the period. The ROIC has been a respectable 12-13% since 2013. The EPS has increased steadily from $0.33 in 2007 to $1.40 in the past fiscal year.

Their secret sauce has three ingredients:

  1. Acquisition and Integration of Brands: Over the years they streamlined their manufacturing and distribution capability to the point where they could acquire brands, plug them into their manufacturing and distribution pipeline, and end up with EV/EBITDA ~ 5 in a couple of years. Measured against its historic appetite to gobble up new brands, the last two years have been outliers. HBI spent nearly $1.3B acquiring Pacific Brands ($800m), Champion Europe (€200m), and Knight Apparel ($200m). For a company with a $7.5B market cap, this is serious!
  2. Turbo-charged with Debt: How has it been able to finance these acquisitions? The total number shares has remained somewhat stable (385m). HBI has always employed a lot of debt; currently, debt accounts for 75% of capital. This leverage obviously juices the return on equity. It allows HBI to lower the cost of capital, and reduce taxes. Leverage might be okay,  if cash flows are dependable. Since HBI sells a staple rather than a fashion product, it is somewhat shielded from unpredictable swings. As of the last filing, debt was about 3.5 EBITDA, and interest payments ($200m/year) were amply covered by operating income ($775m).
  3. Low Tax Rate: Finally, HBI benefits from a low tax rate (single digits to teens). I don’t understand why this is so. On their IR site, they have a FAQ which addresses this question:

Q: Do you believe a high‐single digit to low double‐digit tax rate is sustainable?

A: Yes. Assuming no changes to various global tax laws, we believe a high‐single digit to low double‐digit tax rate is sustainable for many years to come. Our tax rate is the by‐product of our global business model. We do not use artificial tax management, such as inversions or earnings stripping. Our accounting and tax strategies are sound. In fact, we were recently audited by the IRS (see our third quarter 2015 Form 10Q) and the audit was closed with no adjustments.

I can’t pretend I understand this answer.

Valuation

Let’s look at this in different ways.

Once the current acquisitions have been digested, a conservative estimate of normalized earnings is say $500m/year. FCF has hovered between $450m and $550m since 2012. The new acquisitions are expected to increase this historical number by about 10%. Using an 8% cost of capital, the  no-growth EPV estimate would give us something like $500/0.08 = ~$16/share.

However, this assumes no growth. Over the past 5 years, HBI has grown revenues, EBIT, and net income at a CAGR of 5%, 10%, and 15%, respectively. Let us see the effect of a small but non-zero growth rate (say, 3%). Now the EPV = $500/(8%-3%) ~ $26/share. This suggests a reasonably conservative range of $20-$25 for HBI. If it can grow faster than this, then the value may be much higher.

Let us look at this another way.

S&P estimates 2017 and 2018 EPS to be ~$1.90 and $2.30. Suppose HBI trades at 15x (approximately where it is trading now) at the end of 2018. This would imply a  15*2.30 = $34.50 stock price. If we buy the stock at current prices (~$20) and sell in two years, the CAGR return would be about 30%. Not too shabby.

The stock pays a nearly 3% dividend, which may be a suboptimal cash distribution strategy, but makes it easier for people like me to wait for the market to rerate the company. Furthermore, although HBI does buybacks, it seems price insensitive; thus, I prefer dividends over buybacks.

Risks

There are many obvious risks. Any disruption of the three secret sauce ingredients can jeopardize the investment. Taxes are low, and one might be able to argue that HBI is not paying its fair share in taxes. If one can make that argument persuasively enough to change current policy, HBI could be in trouble.

However, it won’t be in mortal danger because of increased taxes. It is the high debt load that has me worried on this count. Sure, currently it doesn’t seem like a problem, but if for some reason earnings start falling, then debt can present an existential threat. Cash flows may be predictable, but Fruit of the Loom (now a Berkshire subsidiary), which is a competitor, did go bankrupt.

Overall, I believe that HBI, like VFC, is modestly undervalued in the 20-25% range. It may be a decent buy, in this otherwise overvalued market. But one has to keep an eye out on the debt/EBITDA ratio and tax rates (and they may end up being correlated).