The Market is Undervaluing This Apparel Maker's Enormous Profit Potential

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Hanesbrands (NYSE: HBI) owns some of the most recognizable brands in the United States. Its brands include Hanes, Champion, and L'eggs. Most of its products are essential apparel that everyone needs to buy, which makes it less prone to fashion risk and gives it stable margins even in a downturn. Its gross margins remained steady even as companies like Limited Brands (NYSE: LTD), Gildan Activewear (NYSE: GIL), and Maidenform Brands (NYSE: MFB) struggled with margin sensitivity.

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The relative steadiness of Hanesbrand's gross margin has a lot to do with its product mix. Limited Brands, Gildan Activewear, and Maidenform Brands try to ride trends to profitability, whereas Hanesbrands produces items that people are in the habit of buying and do not require much thought before purchase.

Debt Burden Will Decrease

Hanesbrands bears agree that the business model is sound and should do well over time. However, their main concern is the high debt burden that the company was saddled with when it was spun out of Sara Lee. But management has been working diligently to reduce debt on the balance sheet. In addition to using free cash flow to repay debt, the company has been lowering interest payments and pre-paying debt. Earlier this year, it repurchased nearly $300 million in floating-rate notes and pre-paid $250 million of its $500 million 8% notes due 2016. Taken together, these moves have reduced interest payments by nearly $100 million.

Margins Will Increase

Hanesbrands margins should increase as input costs decline and the product mix moves to higher-margin items. In 2010, cotton prices -- the company's largest input by volume -- reached a 140-year high. However, the pressure put on margins should subside as cotton prices come back down to a more normal range. In addition, the company has moved most of its manufacturing plants overseas and has shrunk the number of facilities from over 130 to just 54 locations. The savings from this shift to overseas production have largely offset the commodity price increases. Once the input costs  come back down, investors will be pleasantly surprised by the enormous cost savings created by this initiative.

Hanesbrands is also making a strong effort to expand into emerging markets. For instance, it moved some of its manufacturing plants to China. If it can recreate its U.S. distribution network in China, it can dominate the highly-fragmented Asian markets.

Valuation

At a price-to-sales of 0.78x and a net margin of 4% to 5%, the stock is trading in a normal-to-slightly-rich range based on the company's historical performance. However, there is plenty of reason to get excited about Hanesbrands' future. The remarkable staying power of the company's products, even during the worst economic downturn since the Great Depression, is reason enough to buy the stock at its current price. However, the company has significantly improved its operations by shifting production overseas and by expanding internationally. These improvements have been hidden by high input prices over the last few years, but when input prices fall again, Hanesbrands' enormous profit potential will finally show through.


titans8904 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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