Undervalued Dividend Growth Stock of the Week: Hanesbrands Inc. (HBI)

February 19, 2017
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There was once a time when I believed that the traditional school-work-retire life path was the only one that existed.

You go through elementary, middle school, and high school. If you can afford it, college is next.

Then it’s a career where you punch buttons and/or push paper for 40 years.

At the end of it all, if you’re lucky, you have a modest retirement account bolstered by also-modest Social Security payments, whereby you’re able to pay for your bills and finally enjoy life.

Of course, by this time, you’re in the twilight of your life.

Your physical and mental capabilities have eroded significantly compared to what they were when you were in your 20s, 30s, and 40s.

Fortunately, I woke up a few years ago.

I learned of a totally different life path that’s available for most who want to walk it.

This path means you can fast-forward everything, putting yourself in a position to enjoy the end of the rainbow decades before most people.

It just requires making smart decisions.

You have to live below your means, intelligently invest your money, and remain patient.

But it does work.

I’d know: I put myself in a position to retire in my early 30s.

Living below your means is relatively straightforward: you simply have to stop spending so much money.

Once you’re able to create a gap between your income and expenses, it’s time to put that excess capital to work.

After studying every available investment strategy out there, I think dividend growth investing offers the most benefits at the expense of the least amount of drawbacks.

Said another way, dividend growth investing strikes me as the best investment strategy available.

This strategy involves buying shares in high-quality companies that pay and increase dividends to shareholders.

You buy these shares at attractive prices. And you hold for the long haul, assuming the business continues to hand out dividend increases and more or less operate as expected.

Almost 800 US-listed dividend growth stocks can be found on David Fish’s Dividend Champions, Contenders, and Challengers list.

It’s the best resource I know of for finding dividend growth stocks.

Once you’ve done the appropriate quantitative and qualitative analysis on a stock, it’s time to buy.

However, as noted above, you want to buy at an attractive price.

An attractive price is one that’s well below what the stock is worth.

That’s because price and value are very different from one another.

Knowing a stock’s price will only tell you how much that stock costs.

But knowing a stock’s value will tell you how much that stock is worth.

Value gives context to price. Without knowing the former, it’s impossible to decide whether or not the latter is appropriate.

While price is objective and easily discovered by pulling up a stock quote, value is more subjective and difficult to ascertain.

Fortunately, there are resources out there designed to make the process of valuation fairly straightforward and easy.

One such resource is fellow contributor Dave Van Knapp’s valuation lesson for dividend growth stocks, which is part of his overarching series of lessons on dividend growth investing.

Once you have an estimate of a stock’s intrinsic value, you’re equipped with an incredible piece of information.

See, buying a high-quality dividend growth stock for a price well below its fair value is very advantageous for the long-term dividend growth investor.

An undervalued dividend growth stock will usually offer a higher yield, greater long-term total return prospects, and less risk.

That’s all relative to what the same stock would offer at fair value or overvaluation.

Since price and yield are inversely correlated, a lower price will, all else equal, translate into a higher yield.

And that higher yield not only potentially benefits the current and ongoing income of the investment, it also benefits the long-term total return prospects, as yield is a major component of total return.

You then have to factor in the additional possible capital gain, as there’s upside that exists between the lower price paid for a stock and the higher worth of it.

While price can be strongly disconnected from value over the short term, value tends to matter over the long run.

And this upside turns into capital gain if the lower price eventually meets the higher worth.

Capital gain is the other component of total return, which means undervaluation can help total return from both angles.

This all means less risk for the investor, too.

If you’re able to pay significantly less for a stock and you’re buying a fixed number of shares, you’re investing less overall capital. That means you’re risking less money.

But even if you decide to instead invest a fixed amount of money, you’re still introducing a margin of safety.

If you pay much less than a stock is deemed to be worth, you have a cushion there.

So just in case the company doesn’t operate as expected, or if the company outright does something wrong, you have wiggle room before the investment becomes worth less than you paid.

As such, you can see why it almost always makes sense to buy a high-quality dividend growth stock when it’s undervalued.

And just to provide you readers even more value, I’m going to discuss a dividend growth stock listed on Mr. Fish’s CCC list that right now appears to be priced much less than it’s likely worth.

Hanesbrands Inc. (HBI) is an apparel marketer and manufacturer, with a portfolio of apparel brands across t-shirts, innerwear, casualwear, activewear, socks, and hosiery.

This is one of the world’s largest apparel companies.

Some of their key brands include Hanes, Champion, Playtex, Bali, and Maidenform.

About half the company’s revenue comes from its Innerwear (think bras and underwear) segment. About 25% of the company’s revenue comes from Activewear (think Champion basketball shorts). The remainder of the company’s revenue comes from its Direct to Consumer and International segments.

Warren Buffett has a famous quote: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

Well, this is an opportunity to literally invest in socks… when the merchandise appears to be marked down.

But before we get into that, let’s first consider the dividend growth pedigree here.

The company has increased its dividend for five consecutive years, which means it just barely qualifies for Mr. Fish’s CCC list. Nonetheless, the company has clearly adopted a dividend growth strategy, which is great.

As you often see with companies with newer dividend growth track records, Hanesbrands has aggressively grown its dividend since the inception of the payout: the three-year dividend growth rate stands at 43.1%.

Of course, this can’t continue forever. But it’s wonderful to know that Hanesbrands has made up for lost ground by getting the dividend up to an appealing level quickly.

With a payout ratio of 42.9%, there’s still some room for strong dividend increases for the foreseeable future. I just wouldn’t expect 40% dividend growth to continue.

CaptureBut what’s super interesting here is that the stock offers a very attractive yield of 2.88% right now.

That’s well above what the broader market offers. It’s also a rather high yield when you consider where the dividend growth is at.

The company is in a good position to hand out high-single-digit dividend raises for years to come, which means both great current income and solid, inflation-beating income growth for shareholders.

However, in order to get a better feel for what kind of dividend growth to expect moving forward, we’ll first want to see what kind of underlying operational growth the company is producing.

So we’ll look at what Hanesbrands has produced over the last decade in terms of revenue and profit growth, and then we’ll compare that to a near-term forecast for bottom-line growth.

Hanesbrands increased its revenue from $4.475 billion to $6.028 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 3.37%.

Meanwhile, the company’s earnings per share expanded from $0.33 to $1.40 over this time frame, which is a CAGR of 17.42%.

I don’t often see such a wide disparity between top-line and bottom-line growth.

Some recent acquisitions have simultaneously thrown off GAAP EPS and provided solid growth.

But there’s clearly a margin expansion story occurring here. I’m not sure how much more expansion is available there, which means future EPS growth may be more muted, especially considering where the top line has gone.

Looking out over the next three years, S&P Capital IQ anticipates that Hanesbrands will compound its EPS at an annual rate of 10%. While that’s a much lower number than what we see above, it would still be rather impressive.

The company’s fundamentals are otherwise a bit of a mixed picture.

First, we’ll go over the negative.

The company has quite a bit of debt.

The long-term debt/equity ratio is 2.87. And the interest coverage ratio is under 5.

These are relatively poor numbers. Overall, I find the debt level a bit troubling. Any sudden drop in profit could cause issues with their leverage, especially considering they don’t keep much cash on hand.

But now we’ll go over the positive.

The profitability is really robust.

Over the last five years, the firm has averaged net margin of 6.62% and return on equity of 33.38%.

While ROE has been boosted a bit by the leverage, the margin expansion is pretty amazing.

The net margin has gone from about 3% a decade ago to about 9% in the most recent FY.

The profitability is on par with many apparel companies with more premium offerings, while Hanesbrands focuses on the value side of the spectrum. That says a lot about the company.

I think the only issue you might have with the dynamics here in the fundamentals is that the balance sheet has a lot of room for improvement while the profitability probably does not.

All in all, I love the business model.

I mean, we’re talking about basics here. Underwear, socks, t-shirts, pantyhose. This is super easy to understand for any investor. There’s built-in demand here. People have to wear clothes. And they generally want a good deal for quality branded merchandise, which Hanesbrands offers.

The company has a couple areas for further growth potential in their International and Direct to Consumer segments.

With the way e-commerce continues to grow, it’s essential that Hanesbrands aggressively expands their e-commerce (DTC) presence.

So we see a lot to like for the business. But what about the valuation?

The stock’s P/E ratio is sitting at 14.88 right now. That compares extremely favorably to the stock’s five-year average P/E ratio of 22.9. That’s also well below the broader market, which isn’t growing as fast. So we might be getting more for less here. Moreover, investors are paying less for the company’s cash flow, book value, and revenue than they typically have, on average, over the last five years.

The stock does look cheap. But how cheap? What might the intrinsic value be?

I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 7.5%. That seems reasonable (and actually conservative) when looking at the payout ratio and near-term forecast for underlying EPS growth. In addition, the company is obviously committed to aggressive dividend growth. The DDM analysis gives me a fair value of $25.80 per share.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

So my analysis concludes that the stock is priced well below its worth. But what are some professional analysts saying about this stock and its valuation?

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates HBI as a 5-star stock, with a fair value estimate of $34.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates HBI as a 3-star “HOLD”, with a fair value calculation of $27.20.

Wow. So my valuation worked out to be well above what the stock is priced at. But I actually came in the most conservative. If you average out the three figures, you get a final valuation of $29.00. That would indicate the stock is potentially 39% undervalued right now.

HBI_chartBottom line: Hanesbrands Inc. (HBI) is a quality apparel company that has executed fabulously over the last decade. The margin expansion is nothing short of incredible. And the company is aggressively increasing its dividend. With the possibility of 39% upside on top of a market-beating yield, long-term dividend growth investors should definitely take note of this stock.

– Jason Fieber

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