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

There are certain inevitabilities in life.

Death.

Taxes.

Work.

There are probably a few others in there, but that’s a pretty solid list right there.

It’s tough to escape these three things.

But what if you could devise a system that at least minimizes one’s exposure to two out of three?

While immortality is, unfortunately, not possible, minimizing one’s exposure to the tedious and painful necessity of both taxes and work is indeed very much possible.

Better yet, avoiding the two can happen almost simultaneously.

I say that with firsthand experience, as I started aggressively saving and investing back in early 2010 for the express purpose of becoming financially independent and retiring from my career by 40 years old.

The plan worked so well, I was able to quit my full-time job back in early 2014, at only 32 years old.

Now the real-life, real-money portfolio I built generates five-figure passive and growing dividend income, which I can use to pay real-life, real-money bills.

This portfolio is built with high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

I invest in dividend growth stocks because I get to have my cake and eat it, too: I experience the upside that comes with owning great businesses, and I get to collect substantial and growing dividend income all along the way.

Now, one obviously needs to live frugally in order to escape the traditional 9-5 grind till 65 timeline.

The more you can save, the more you can invest. And the less you spend, the less passive income you need to live off of.

But once you cut those expenses down and get the passive income up to an appropriate level, it’s absolutely possible to avoid work, if you so wish, for the rest of your life.

While I don’t actually aim to avoid work completely – I just want to work on what I want, when I want – eliminating work from that aforementioned list can be done if one’s passive income is enough to cover their bills.

Living off of dividend income also works in one’s favor in regard to taxes, as dividends are taxed extremely advantageously.

If one is inside of the 15% tax bracket, they pay $0 on all qualified dividend income.

So a single filer could earn, say, $40,000 in qualified dividend income and pay $0 to the taxman.

Talk about killing two birds with one stone!

That’s what today’s article is partly about.

I’m going to discuss a high-quality dividend growth stock that appears to be undervalued right now, which could bolster one’s chance to kill those two birds with one stone.

Price is what you pay, but value is what you end up getting for your money.

And this truism is never more important than dealing with stocks, as valuation can significantly impact your investment in a variety of ways.

Undervaluation is present when a stock is trading at a price that’s below its intrinsic value. The further below intrinsic value price is, the better.

The reasons why undervaluation is pertinent are threefold.

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

This is all relative to what the same stock might offer if it were fairly valued or overvalued.

First, price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

Second, potential long-term total return is positively impacted both via the higher yield (resulting from the lower price) and the upside that exists between the lower price paid and the higher intrinsic value.

While price and value can become wildly disconnected in the short term, they tend to mirror each other a lot closer over the long haul.

Valuation correlates fairly well with operational performance over the long term: as earnings increase, the value of a business increases, which is more or less reflected in the price.

However, that relationship can be impacted by numerous factors in the more immediate sense, which can lead to undervaluation or overvaluation.

Third, one’s risk should be reduced when undervaluation is present.

One is paying less per share, which, in the most straightforward sense, is risking less capital per share. If buying a fixed number of shares, the total amount of money invested and risked is thus reduced.

But risk reduction is accomplished mainly via the margin of safety, or buffer, that is instituted when undervaluation is present, as there’s simply less potential downside when there’s more potential upside.

It’s obviously less risky to pay less than it is to pay more.

And just in case a company does something wrong, or the investment thesis doesn’t pan out as expected, you have a buffer there before the stock/investment becomes worth less than you paid.

The good news about all of this is that valuing high-quality dividend growth stocks isn’t a terribly difficult task.

Although valuing a stock down to the penny is not realistic, a system, or set of systems, can help an investor estimate the intrinsic value of just about any dividend growth stock out there, which can then further guide the investor in terms of what to pay.

One such system was put together by fellow contributor Dave Van Knapp.

It’s a lesson on valuation, which is part of an overarching series of lessons on dividend growth investing as a strategy.

It’s absolutely worth a read, if you’re at all unfamiliar with the process of valuation.

With all this in mind, an undervalued high-quality dividend growth stock can be an excellent long-term investment.

And I may just have found one for you readers…

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

I wrote about inevitabilities earlier.

Well, you know what else is inevitable in life?

You’re going to wear clothes.

You just can’t walk around naked in modern-day society.

As such, companies that provide quality garments at a great value can serve both their shareholders and their customers very well over the long term.

Hanesbrands is one such company, offering mostly undergarments and activewear through a variety of brands that include Hanes, Champion, Playtex, Bali, and Maidenform.

Their business breaks down as such: its Innerwear segment (bras and underwear) accounts for almost half of the company’s sales; Activewear (Champion sports wear) accounts for approximately 25% of sales; Direct to Consumer and International segments account for the remainder of sales.

These products are about as sure a long-term bet as one can find. People aren’t going to stop wearing bras and underwear anytime soon, and there’s almost no chance of technological obsolescence.

Hanesbrands also offers a surefire dividend.

They’ve increased their dividend for five consecutive years.

This might not seem like a very lengthy dividend growth streak for a company that was founded at the turn of the last century.

While they have a lengthy corporate history, they were spun off from Sara Lee Corporation in 2006, and Hanesbrands started paying a dividend within a few years of being spun off into an independent publicly traded company.

They make up for that short dividend growth streak through a very high dividend growth rate: the stock’s three-year dividend growth rate stands at 43.1%, which is phenomenal.

And with a payout ratio of just 39.5%, there’s plenty of room left for strong dividend growth moving forward.

I wouldn’t expect future dividend growth to average out to anything close to 40%+, but double-digit annual dividend growth seems very likely for the near future.

On top of that massive dividend growth, the stock also offers an appealing yield of 2.47%.

That yield is certainly higher than the broader market. And within the context of both the demonstrated dividend growth thus far and the dividend growth potential moving forward, that’s a great yield.

But in order to really get a feel for what to expect in regard to the dividend growth, we must first see what kind of underlying profit growth the company is generating, as its really profit growth that will support future dividend growth.

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

When looked at in tandem, we should be able to determine what kind of overall earnings power Hanesbrands has, which will tell us a lot about its future dividend growth potential.

Revenue for the company has increased from $4.475 billion to $6.028 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 3.37%.

Not fantastic, but I will say that this growth has been almost completely secular. Other than a modest dip during the financial crisis, the company grows like clockwork.

Meanwhile, Hanesbrands grew its earnings per share from $0.33 to $1.40 over this same 10-year stretch, which is a CAGR of 17.42%.

This kind of excess bottom-line growth isn’t common.

Some of this can be explained by recent acquisitions, which have been accretive, but they’ve also distorted some GAAP numbers.

However, the bigger story here is really margin expansion.

The company’s net margin has essentially tripled over the last decade, which is nothing short of remarkable.

But how much more margin expansion is possible? It seems unlikely that this will continue, which could make future outsized EPS growth that much more unlikely.

That said, CFRA believes Hanesbrands will compound its EPS at an annual rate of 17% over the next three years, which would be right in line with what’s transpired over the last decade.

Buybacks, recent acquisitions, and cost savings from restructuring are all built into that assumption.

One major potential area for growth and further margin strength is the company’s Direct to Consumer segment, which still makes up a relatively small portion of overall sales.

Fundamentally, the rest of the company is solid, but the balance sheet is one area that I believe could be improved.

The long-term debt/equity ratio is 2.87, while the interest coverage ratio is a bit under 5.

This isn’t necessarily immediately worrisome, but the balance sheet is probably the one major weak spot I see for the entire company.

But the company’s profitability is very robust both in absolute and relative terms.

Over the last five years, they’ve averaged net margin of 7.25% and return on equity of 33.39%.

While the net margin is great, it’s gotten a lot better. The most recent fiscal year showed net margin of almost 9%. That compares to net margin of under 3% just a decade ago. Clearly, the business has improved materially.

Overall, there’s a lot to like here.

We’re looking at a consumer products company that is likely to keep on doing what it’s doing for a very long time to come. There doesn’t appear to be any notable roadblocks to the company’s success.

These are basic garments that are practically necessary in everyday life. And Hanesbrands focuses on value, which bodes well in a retail environment that continues to focus more on price. For Hanesbrands to maintain/grow margins in that environment is impressive.

While e-commerce is a threat, it’s also an opportunity for the company to grow its DTC business further.

The only real drawback I see is the balance sheet. But any improvement there would make this a pretty stunning long-term business. As it sits, it’s already fairly compelling.

And it looks even more compelling when factoring in the valuation…

The stock trades hands for a P/E ratio of 15.98 right now, which is well below the broader market, the industry average, and the stock’s own five-year average P/E ratio. Investors are also paying less for the company’s sales and cash flow than they recently have, looking at recent historical averages. And the yield, as noted earlier, is relatively high.

So this is a business with above-average growth selling for a below-average multiple. What might be a good estimate of its intrinsic value?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.

That growth rate is on the upper end of what I allow for, but the modest payout ratio, strong demonstrated historical dividend growth, and double-digit earnings growth should allow for this to manifest over the long haul.

The DDM analysis gives me a fair value of $25.80.

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.

This looks to be a fairly high-quality dividend growth stock available at a price below intrinsic value, based on where I’m standing. However, I like to compare my analysis and valuation with that of what professional analysts come up with, as it adds depth and perspective to the picture.

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.

CFRA 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.

CFRA rates HBI as a 3-star “HOLD”, with a fair value calculation of $33.30.

I came up with a much lower number, but I do often err on the side of caution. Nonetheless, averaging the three numbers out gives us a final valuation of $31.03, which would indicate the stock is potentially 28% undervalued here.

Bottom line: Hanesbrands Inc. (HBI) sells necessary products at a great value, earning gobs of profit in the process. In a world of uncertainty, wearing the kind of garments Hanesbrands sells is inevitable. This company not only earns a lot of money, but they continue to share an ever-growing slice of it with their shareholders. With the possibility of 28% upside on top of what’s likely to be very appealing long-term dividend growth, this stock should be strongly considered right now.

— Jason Fieber

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