How Sara Lee Left Hanes In Its Skivvies

The newly spun-off maker of underwear and clothing could now be hobbled by debt

Did Sara Lee (SLE ) steal a page from the private equity playbook with its successful spin-off on Sept. 5 of Hanesbrands Inc.? It sure looks that way. As part of the deal, Sara Lee Corp. loaded up the apparel maker with billions in new debt, then paid itself a big, fat dividend -- money it'll use to trim its own debt and buy back shares. Hanes, by contrast, will start life as a public company with a bond rating in junk status and a debt load so onerous some worry it won't be able to invest enough in its well-known clothing brands.

It's the sort of financial engineering that has more in common with the world of leveraged buyouts than with corporate spin-offs. And at first blush, from Sara Lee's perspective, the deal makes sense. Why should executives rely solely on the fickle stock market to recognize the worth of Hanes as a stand-alone company when they can grab some cold cash now and put it to work immediately?

But if Hanes can't sustain the debt over the long term, investors holding shares of both companies might be worse off for the maneuver. Analysts say the amount of debt -- as well as the dividend Sara Lee paid itself -- was considerably more than expected. To capitalize the spin-off, Hanes took on new debt totaling $2.6 billion. Most of those proceeds went to Sara Lee in the form of a $2.4 billion dividend.

Overburdening Hanes with debt leaves it in a weaker financial position than many of its rivals. Standard & Poor's (MHP ) has given the new company a B+ credit rating, which puts it in the bottom half of the apparel sector. The level of Hanes's debt compared with earnings before interest, taxes, depreciation, and amortization (EBITDA) is 4.52, the highest in its peer group, says Joseph W. Cornell of Spin-Off Advisors, a specialized research and investment firm. The ratio of its earnings to interest charges, at 2.65, is also weak.

Sara Lee executives declined to comment for this story. A Sara Lee spokesman says the company believes Hanes's level of debt is appropriate. A Hanes spokesman says the company generates enough free cash to fund investment as well.

The Sara Lee move didn't occur in a vacuum. It's part of a broad restructuring that CEO Brenda C. Barnes announced back in 2005. Her goal then: to spin off or sell some 40% of the company for around $3 billion and concentrate on well-known food brands. So far she has fallen short: Sales of units have brought in just $1.4 billion. Hence the need to get more cash out of Hanes.

Certainly, it's not unusual for a parent company to pull money from a unit it is spinning off. But the payment of so large a dividend out of freshly minted debt has raised eyebrows among analysts. Few spin-offs enter the markets so highly leveraged: Of the 16 companies spun off since the beginning of 2005 that have debt rated by Standard & Poor's, only three are rated lower than Hanes.

LOWER RETURNS?

Timothy S. Ramey, a former Sara Lee executive now at brokerage D.A. Davidson & Co., says the deal makes little sense from the perspective of shareholders of both companies: "They are raising high-cost junk debt to pay off low-cost investment-grade debt, and that will leave shareholders poorer overall." Like many companies that have gone through LBOs, Hanes will spend the next few years using its cash flow to pay down debt. For investors, that may dampen returns, at least for a while. Spin-Off Advisors' Cornell says Hanes's heavy leverage will keep it from outperforming the market, as many spin-offs do.

Don't expect that to discourage more such deals, though. As long as there are buyers willing to snap up high-yield debt like the stuff Hanes floated -- even when the benefits don't go to the company footing the bill -- more sellers will emerge. Says Tom Marshalla, a managing director of leveraged finance at credit ratings agency Moody's Investors Service (MCO ): "Companies do this because they can."

By Jane Sasseen

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