Image Source: Hanesbrands 2016 Annual Report.
We’re looking to increase the equity exposure in the Dividend Growth Newsletter portfolio. Let’s take a quick look at our most recent idea.
By Kris Rosemann
The Dividend Growth Newsletter portfolio is sitting at 30%+ cash as of the release of the January edition, and we’re expecting 2017 to be another good year for equity prices in general, “5 Shocking Stock Market Predictions for 2017.” As a result, we’re actively looking for uses for the dry powder, and that’s where Hanesbrands (HBI) comes in.
Hanesbrands is the largest basic apparel company in the world and has a history that stretches back more than a century. Its brand strength is undeniable with a lineup that includes Hanes, Champion, Playtex, and Bali, to name a few, and it boasts leading market-share positions in key categories around the world. Along with such a portfolio of brands comes pricing power, which helps the company combat potentially volatile input costs such as cotton. We’re expecting Hanesbrands’ pricing power to help it continue growing its top-line at a mid- to high-single digit rate in coming years, while the underwear giant has an annual target of double-digit earnings per share growth.
Hanesbrands looks compelling from a valuation point of view. Our fair value estimate for shares currently sits at $30, and its stock is changing hands at ~12 times expected fiscal 2016 earnings from continuing operations as of this writing. Due to such an attractive valuation profile, we’ve had our eyes on the company for some time. However, after it hiked its quarterly dividend January 24 to $0.15 from $0.11 (a 36%+ jump), we now feel the time is right to establish a 3% position in the Dividend Growth Newsletter portfolio (as the increase pushes the firm’s dividend yield to ~2.5% from previous levels below 2%). After the large dividend hike, Hanesbrands’ Dividend Cushion ratio is still a healthy 1.8, and it brings its dividend payout ratio to ~30% on expected 2016 numbers (based on the high end of management’s adjusted earnings per share guidance), which is roughly in line with management’s target payout ratio of 25%-30%. Looking into 2017 and beyond, we’re expecting healthy bottom-line growth to translate into meaningful income generation for shareholders.
Though we like Hanesbrands’ investment opportunity a lot, let’s cover a couple risks to its dividend growth potential. As of the third quarter of 2016, the company’s net debt load was more than $3.4 billion, which translates to a net debt-to-annualized EBITDA ratio of ~3.2 times on the basis of our estimates (management is targeting adjusted operating income of $955 million at the high end of its provided guidance range and a good estimate for D&A is ~$100 million for the year). In the future, management is planning to reduce net debt-to-EBITDA to the range of 2 to 3 times, meaning it will have to allocate a portion of its free cash flow to deleveraging in coming years. Though we prefer a net cash position on most of our dividend growth ideas, we think management is aware of the risks that come with leverage, and we hope to see progress toward debt reduction in coming periods.
Let’s cover free cash flow. Free cash flow generation came in below cash dividends paid during fiscal 2015 (due to a sizable inventory build), but sales initiatives and inventory reduction efforts have been bearing fruit as of late, and we expect a return to previous years’ free cash flow performance (and even better!). Cash flow from operations during fiscal 2014 and fiscal 2013 came in at ~$508 million and ~$591 million, while capital spending was ~$64 million and ~$44 million for those years, respectively, good for average free cash flow generation of ~$500 million during 2013-2014. Hanesbrands’ updated 2016 guidance calls for record net cash flow from operations performance in the range of $750-$800 million on capital spending of ~$90 million, translating into expectations of free cash flow generation in the range of $660-$710 million for fiscal 2016. We estimate run-rate annual cash dividends paid after the hike to be ~$220 million revealing material coverage by free cash flow, to the tune of over 3 times.
In light of its valuation opportunity and improving free cash flow generation, we don’t expect Hanesbrands to continue being punished by the market. It had been one of the worst performing stocks in the S&P 500 in 2016, even as its top- and bottom-line performance marched steadily higher, and while we’re not ignoring the company’s exposure to a struggling retail environment (or its exposure to cotton costs), we view a good deal of its products (innerwear accounts for ~45% of sales) as borderline consumer staples, and its diversified geographic exposure helps mitigate risk associated with the current US retail space. No investment is ever perfect, and while we’ll be watching its debt load, inventory movements and cash flow trends closely in coming years, we’ve added a 3% position in shares to the Dividend Growth Newsletter portfolio at $23.77 each.