Innerware manufacturer HanesBrands (NYSE:HBI) has to contend with fierce competition, powerful retailers, and a balance sheet that is far less than ideal. Although apparel manufacturing is going to remain a tough business for the foreseeable future and HanesBrands doesn't look cheap by conventional metrics, investors who look no further than the P/E or EV/EBITDA ratios may miss an interesting free cash flow expansion story in its early stages.
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A Tough Quarter
For a variety of reasons, HanesBrands delivered another poor quarter. Sales were slightly negative, as the company had to deal with retailers clearing out cold weather inventories, aggressive competition in graphic tees and some turbulence with Wal-Mart (NYSE:WMT). At the same time, higher cotton prices thumped margins (gross margin down more than a point) and operating income fell about 8%.
Bad Trends Easing Up?
On first blush, it would look like a fair number of the negative trends bedeviling HanesBrands should be lightening up soon. It looks like Berkshire Hathaway's (NYSE:BRK.A) has dropped its attempts to gain and hold share with aggressive pricing. At the same time, retailers like Kohl's (NYSE:KSS), Target (NYSE:TGT) and Wal-Mart have moved through the worst of their inventory corrections, and order patterns should begin normalizing relatively soon.
Considerably More Cash May Be Coming
One of the more under-appreciated positive angles on HanesBrands is the potential for significant near-term free cash flow leverage. Admittedly, HanesBrands' historic free cash flow production has not been great; better than Gildan (NYSE:GIL) and Warnaco (NYSE:WRC) perhaps, but below Maidenform (NYSE:MFB), and just not all that strong in an absolute sense at below 5%.
In the coming years, though, the company should be reaping the benefits of declining capex needs, as well as the benefits of past efforts to optimize its supply chain. All told, capex could drop by about 50% and represent just 40% of the spending of recent years. That will not only boost the free cash flow conversion into the very high single-digits, but it will also throw off cash that the company can use to pay off its excessive debt load.
The Bottom Line
Although brands like Hanes, Champion and Playtex are well-known and do inspire some brand loyalty, investors should not kid themselves about the quality of this company. HanesBrands is in a brutally competitive business where uncontrollable price inputs and powerful customers squeeze margins from both sides.
That said, management has made a lot of smart moves to improve operating performance, and metrics like return on capital are moving in the right direction. What's more, the free cash flow outlook for the next few years is about as good as it as ever been, and the momentum from that improvement could push these shares higher.
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.