There's not much debate about the quality of the brands that Hanesbrands (NYSE:HBI) owns. Names like Hanes, Champion and Playtex resonate with consumers, and when it comes to innerwear, a large percentage of shoppers stick with a single brand for decades at a time. This company has not always managed to convert that brand value into shareholder value, though the stock has rebounded sharply from the lows of 2009. Now the question is whether management can not only maintain the value of these brands, but also wring more expenses out of the operations and deleverage the business.

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Not Much Near-Term Momentum
While retail spending has started to perk up a bit recently, spending on clothing hasn't been smooth or even across the board. Particular retailers like American Eagle (NYSE:AEO) are doing better, but larger players like Walmart (NYSE:WMT), Target (NYSE:TGT) and Kohl's (NYSE:KSS) (which make up about half of Hanesbrands' sales) are seeing less robust growth. So while innerwear growth of 2.2% and overall sales growth of about 1% in the second quarter wasn't bad relative to Maidenform (NYSE:MFB) or Warnaco (NYSE:WRC), it's certainly not robust. Likewise, the four-point drop in gross margin and one-and-a-half point drop in operating margin aren't reasons for great excitement.

But Ample Scope for Improvements
I'm not all that bothered by Hanesbrands' quarterly performance, as this isn't the sort of stock where one quarter really changes the underlying thesis. That said, it does perhaps serve to reemphasize that the company's management needs to succeed with its ongoing improvement initiatives.

This past quarter's margins did not look great on a year-on-year basis, but that has to be viewed in the context of a "more than doubling" of the company's cotton costs (about 10% or so of COGS in normal times). While cotton prices have indeed come down substantially from last year's elevated levels, Hanesbrands processes those costs on a delayed schedule, meaning the company is going to start seeing the benefits of lower costs in the coming quarters.

But that's not all that the company can do. Hanesbrands' management should be able to wring nine figures of total cost savings through multi-year efforts to improve purchasing, optimizing the manufacturing/distribution chain and so on. Likewise, the company should be able to generate adequate free cash flow to start making a real dent in its leveraged balance sheet.

Rational Competitors, but a Shifting Retail Market
Various consumer surveys over the years have suggested that only about 10 to 30% of the innerwear market is really up for grabs, with the remainder pretty much devoted to one or two brands. That gives relatively little incentive to Hanesbrands and rivals like Warnaco, Maidenform and Berkshire Hathaway (which owns Fruit of the Loom, among other brands) to contemplate corporate murder-suicide with cutthroat pricing.

But that's not to say that Hanesbrands' business is steady as she goes. Retailers like J.C. Penney (NYSE:JCP) and Sears (Nasdaq:SHLD) are still trying to figure out a new retailing formula, and there's a lot of back-and-forth between mall-based retailers like J.C. Penney, discounters like Walmart and Target, warehouse clubs and "others" such as Kohl's. That offers up some challenges for promotion, merchandising and so on for Hanesbrands, but I don't think these will prove insurmountable.

The Bottom Line
This company has, in its past, reported pretty solid returns on capital and assets and solid margins. I believe that management is on its way back to doing so again. In my mind, the biggest risk to that goal is another sudden disruption to the cost structure (say, for instance, a bad cotton crop) or management going off-plan and making an expensive acquisition.

I'm a little concerned, however, that sell-side analysts have already raised the bar pretty high. I think it will be difficult (though not impossible or unthinkable) for the company to grow revenue much beyond a mid-single digit rate. While I think the company can get into the high-single digits with its free cash flow margin, I'm not sure it can go much beyond that. Accordingly, it's hard for me to see a fair value much beyond the high $30 range for these shares and that makes it difficult to recommend them as new buy.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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