Should You Follow Mr. Buffett Into the Underwear Business?

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Always on the lookout for value, Warren Buffett and his Berkshire Hathaway conglomerate bought a leading position in the underwear business back in 2002 when it acquired Fruit of the Loom out of bankruptcy protection.  It further solidified the unit’s operating position with the purchase of competitor Russell Corporation in 2007.  Most likely, the Oracle of Omaha was attracted to the consistently recurring nature of underwear purchases and consumers’ strong brand allegiance.  So, how can an investor play this "intimate" sector?

Leveraging an icon

Hanesbrands (NYSE: HBI) continues to get mileage from spokesperson Michael Jordan’s global popularity, despite the fact that he hasn’t played basketball for years.  The company has effectively used national advertising to build its brands, which include Playtex, Wonderbra, and Champion.  Hanesbrands also furthered its ambitions in the licensed sportswear business with its 2010 purchase of competitor Gear For Sports.

In FY2013, Hanesbrands has reported flat revenue growth, while its operating income has more than doubled versus the prior-year period.  The chief cause of the profit improvement has been lower cotton costs, which have stabilized below the elevated price levels of 2011 and early 2012.  Hanesbrands has also been gaining net space at its mass merchant and department store retailer base, thereby producing economies of scale in its administrative overhead.

On the downside, Hanesbrands has reported declining unit volumes in its women’s underwear segment, due to heavy competition from private label brands on the low end and premium brands, like Victoria's Secret, on the high end.  However, the segment is a focus area for future growth, which led the company to offer to acquire competitor Maidenform Brands (NYSE: MFB) in July 2013 for $23.50 per share in cash or roughly $547 million.  The purchase price of approximately 10 times adjusted operating income is a reasonable price to pay, as Hanesbrands saw an opportunity to leverage Maidenform’s brand while gaining cost savings from the elimination of duplicate operations.

In FY2013, Maindenform has reported weak financial results, with decreases in revenues and operating income of 12.2% and 60.8%, respectively, compared to the prior-year period.  Like Hanesbrands, Maidenform was hurt by low-priced competition in the women’s underwear business, causing it to have to reduce prices and increase promotions.  The company has also been late in adding full figure sizes to its product line, with plans to integrate the additional sizes into its collections later in 2013.  However, Hanesbrands should be able to reduce costs in Maidenform’s operations and distribute a greater quantity of the company’s popular product lines through its retailer network.

Making a fashion statement

Of course, both companies have been chasing L Brands’ (NYSE: LTD) Victoria’s Secret unit, which brought underwear out into the open with its lingerie collections and runway models.  The Victoria's Secret unit (as well as Bath & Body Works) is the heart of retail legend Leslie Wexner’s L Brands empire, after jettisoning the majority of its Limited and Express store chains in 2007.  Unlike Hanesbrands and Maidenform, Victoria’s Secret has primarily chosen the retail market over the wholesale market, with a network of over 1,000 stores around the world.

In its latest fiscal year, Victoria’s Secret has reported solid financial results, with increases in segment revenues and operating income of 7.4% and 9.9%, respectively, versus the prior-year period.  The unit’s top-line growth benefited from strong comparable store sales, up 6% for the period, as well as its continued expansion into additional product lines, including swimwear, fragrances, and accessories.  Like its competitors, Victoria’s Secret has generated a higher operating margin due to lower average cotton costs, as well as its ability to premium price its products.  After consolidating its Victoria Secret store base for the last two years, the unit is also on the growth path once again, with plans for additions to both its namesake and smaller Beauty and Accessories store bases.

The bottom line

Underwear is an apparel item that everyone has to buy, usually at fairly consistent periodic intervals.  Warren Buffett saw the value of the sector years ago, buying Fruit of the Loom at a fraction of its long-term value.  While uncertain cotton prices are always a wild card, the elimination of Maidenform Brands as a major competitor should improve the profitability of the industry’s remaining stalwarts, including Hanesbrands and L Brands’ Victoria’s Secret unit.  These two brands belong on investors’ watchlists.

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