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Morningstar | Soft Innerwear Sales in Hanesbrands’ 3Q Overshadow Strength in Other Areas; Maintain FVE

We view narrow-moat Hanesbrands as attractive despite weak third-quarter results. Investors were disappointed by soft sales of U.S. innerwear, higher input costs, and a few one-time issues. Hanesbrands blamed some of the third-quarter weakness on timing issues (just-in-time ordering). Year-over-year innerwear sales declined 6.9% versus our expectation of a modest 2% drop. Much of the underperformance came from socks and women’s intimates (sales down 14% year over year) as men’s underwear sales grew 5%. We have had low expectations for women’s intimates due to competitive pressure in the category. Hanesbrands claims that point of sale data its women’s intimates turned positive in September after the release of new shapewear product.

We believe investors are overlooking good results in Hanesbrands’ activewear and international businesses. International sales (constant-currency) increased 15% and operating profit increased 31%. As-reported international sales growth of 11% exceeded our 8.7% forecast. Hanesbrands’ Champion brand was a key contributor to both segments. Constant-currency sales of Champion increased 30% in the third quarter despite a negative mid-single-digit contribution from the mass market channel. We believe Champion will continue to grow through greater distribution and store openings, especially in China and Western Europe.

Hanesbrands continues to trade well below our fair value estimate of $27, and we like the potential for cash generation. While the stock was hit on the third-quarter report, the reported operating margin of 13.9% nearly matched our expected 14.0%. We remain cautious due to the loss of C9 and uneven innerwear results. Our full-year 2018 sales, cash flow from operations, and operating profit estimates remain slightly below the low end of management guidance. Our estimates for EPS are roughly in line with management guidance of GAAP EPS of $1.50-$1.54 and adjusted EPS of $1.69-$1.73.

Hanesbrands’ third quarter was negatively impacted by a strong U.S. dollar (year-over-year negative impact of $22 million), a lower-than-expected contribution from acquisitions, and a (worst-case) $14 million bad-debt reserve related to Sears’ bankruptcy. We view Sears as immaterial as it represents just over 1% of Hanesbrands’ total sales and less than 1% of operating income. Hanesbrands’ management remains very positive on the Bras N Things acquisition, but sales came in about $8 million lower than our expectation.

We anticipate Hanesbrands’ innerwear sales will suffer a small 1% year-over-year decline in the fourth quarter. While this is slightly below guidance, it is a clear improvement over the third-quarter result of negative 6.9%. The company reports that point of sales trends for innerwear in the third quarter and October were very healthy. The company plans new innerwear product launches in 2019 and price increases that will go into effect in February. We view these price increases as indicative of the strength of its brands.

Overall activewear growth of about 7% exceeded our 1% expectation as we have been cautious due to the expected loss of the C9 contract at Target. Management believes it can replace much of the lost C9 business with other Hanes and Champion brands. We maintain our view that Champion will reach management’s goal of $2 billion in non-mass Champion sales in 2022, up from about $1 billion in 2017. While some see Champion as a fad, we view it as a legitimate brand in the fashion/athletic market.

We believe Hanesbrands has good potential for debt reductions, dividend increases, and stock buybacks. The company paid down approximately $115 million in debt in the quarter, but debt-to-EBITDA remains elevated at 3.8. We anticipate Hanesbrands will continue to prioritize debt reduction over stock buybacks and dividend increases for the next two years or so. Management expects cash flow from operations of $625 million-$675 million in 2018. We forecast more than $3.6 billion in free cash flow in the 2019-22 period. For comparison, its total enterprise value has dropped below $10 billion.