Conclusion: The Punchline on the stock is that if you’re a longer-term holder and don’t mind seeing the recent weakness continue, then hang in there. If you like buying good quality companies at great prices, then wait. We think you’ll still get your chance.
VFC is always a tough company to bet against. It has a portfolio of better-than-average brands, managed by far-better-than-average-individuals who have an exceptional track record of managing the street. It’s got the size and scope of touch points in its supply chain that make it a great partner, a tough competitor, and dangerous target for vendors or retailers to go to looking to improve their respective cash cycles at the expense of VFC. It has a healthy balance sheet, and is one of the few apparel companies that is successfully growing outside the U.S.. The bottom line is that If you believe VFC’s plan that it can add $5Bn in sales and $5 in EPS – organically – over 5-years, then this stock is flat out cheap.
But 5-years is a long time. And we think most would agree with us in saying that making an investment decision in today’s market based on valuation would be both foolish and costly. Also, let’s not forget that VFC has a portfolio of brands, and it’s going to be very difficult for a company with a portfolio – even an above average one – to outgrow the industry – in a profitable way – 2-3x in this environment. Ralph Lauren? Yes. Calvin Klein? Yes. Nike? Yes. VFC? I dunno. And we think that the realization of margin outlook in this space will get worse before it gets better. VFC can’t sit that one out.
The Punchline on the stock is that if you’re a longer-term holder and don’t mind seeing the recent weakness continue, then hang in there. If you like buying good quality companies at great prices, then wait. We think you’ll still get your chance.
HERE ARE SOME OF THE BULL VS. BEAR POINTS IN THE WAKE OF 1Q01 RESULTS
Bull Case:
- Revenues were strong in the quarter up +12% coming in 2-3 points ahead of expectations. While both Outdoor & Action Sports and Jeanswear continue to drive sales and fall bookings remain strong, the three smaller coalitions (Contemporary, Sportswear, and Imagewear) all came in significantly above expectations. Combined, these ‘little three’ account for ~70% of Jeanswear revenues and have contributed little in terms of growth over the last several years. Further improvement here would take pressure off the two biggest segments and drivers of growth.
- One of the more bullish takeaways from the call is that initial price increases in Jeanswear have been taken by consumers better than anticipated and has impacted unit volume less than expected. While a select few in retail are planning for a 1-for-1 relationship between higher prices and unit volume impact, management noted during the March analyst day that they were planning for a 2-to-1 scenario whereby for every 10% increase in prices they expect a 5% decline in units. So far, this has proven conservative. To say we are in the early innings of this game is a massive understatement, but undoubtedly a positive change on the margin.
- Operating profit came strong against the toughest compare for the year. Now, there was a 40bps contribution from an accounting change (we’ll hit on below), but excluding that profitability was better than expected driven largely by better than expected Jeanswear margins. Importantly, it’s not just that domestic margins were down less than expected (still down -130bps), but that higher margin international sales were up 50%. VF’s international Jeanswear business is the company’s most profitable – to see sales up over 50% here in the quarter is very bullish as it relates to VF’s ability to offset domestic margin pressure. It also suggests that full-year expectations for margins to be down -100bps in Jeanswear could ultimately prove conservative.
- In the first quarter out of the gate since the company’s 5-year strategic growth plan was laid out, coalition performance is coming in on-track if not slightly above as noted above. Yes, 5% of the way into the plan is early indeed, but the precedent is important and positive.
- While definitely not a long term positive for anyone affiliated with the US Consumer, the fact of the matter is that 30% of VFC’s revenue comes from consumers outside of US borders, a crashing US dollar will continue to give VFC tailwind to offset commodity costs.
Bear Case:
- Management’s revised year-end guidance implies they’re taking down the back half. Despite beating the quarter by $0.23 and adding $0.10 of Fx contribution, guidance was only taken up by $0.15.
- Q1 was a lower quality beat. Half of which came from one-time items including $0.08 from more favorable tax adjustment. The other item embedded in the beat came from a change in inventory accounting to FIFO from LIFO ($0.04 in EPS) that will bring remaining coalitions into a consistent reporting structure. We can appreciate the need for establishing a consistent reporting standard across all businesses, but the timing of this change really bugs us. The net effect of it makes it such that VFC’s sales are booked at product cost that was set 3-6 months ago instead of 1-2 months (our estimate). In a rising raw materials environment, this FIFO is your friend. Again, we’re not beating VFC up for complying with this standard, but why not years ago when the businesses in question were acquired?
- Management cautioned that Q2 results would be the most challenging of the year. Pressures both on gross margin as well as SG&A are likely to lead to operating margin compression for the quarter. In addition to timing pressures between price increases and higher costs, the company also highlighted that it suffered the complete destruction of one of its Jeanswear DCs in Tuscaloosa, AL creating inventory disruption concerns. On the SG&A line, higher spend on both advertising and technology are going to make it challenging to leverage investments in the quarter. As a result, management is relying increasingly on 2H execution to meet year-end targets not something we like to see given the setup we have going into the 2H in retail. These guys will make it happen, and can execute through a tragedy like this better than almost anyone. But we still need to count the cost.
- Near-term, the top-line comp setup gets increasingly more difficult. The company has posted some impressive growth numbers recently on top of considerably easier compares (nothing more than +2%), but that shifts significantly as we look out over the next three quarters with a +7%, +7%, and +11% coming down the pipe. Is this insurmountable? No – especially with all the inventory on hand. But it certainly ups the ante for the core growth engines and requires the ancillary coalitions to also start picking up the slack.
- While not a major risk, let’s watch Levi’s even closer as a competitor as they’ll be introducing its Denizen brand to Target this summer. Originally launched last year specifically for the Chinese market, the brand will be priced at the lower end of its signature Levi line at $20-$30 adding more competition to the low-end denim market. VFC’s Wrangler line is currently the price leader at Target with opening price points at $12.99.
- Last, but certainly not least, is the a substantial negative change in the cash conversion cycle (see chart below), as a meaningful uptick in inventory more than offset nice improvement in payables. In addition, this is the third quarter of sequentially higher inventory growth. While this might give the company a cost advantage heading into the 2H, it also increases fashion risk as they need to ‘make the call’ on fashion that much earlier. It’s also worth highlighting that the last time we saw a deterioration in yy change in the cash conversion cycle of this magnitude back in Q3 of 2007, shares fell -17% over the following 3-months.
- This SIGMA Chart is NOT VFC’s Friend. It was heading towards the lower left quadrant, and took an uncharacteristic swing to the right. Usually we see companies of VFC’s caliber swing to the upper left, which get’s them into “manage the balance sheet” mode. VFC is clearly in investing mode by building working capital ahead of 2H. That’s cool, in fact most companies in this space HAVE TO do this given how low inventories have been drawn down over the past two years. But the only companies it will work for are those that have the process to a) ensure that they are ‘on trend’ with their designs, and b) are putting the appropriate marketing dollars to work in order to connect with their consumer.
All in, we’re pretty much in-line, shaking out at $1.05 for Q2 and $7.16 for the year, which has us a penny above and $0.04 below the Street’s revised numbers, respectively. In the end, we’ve got a name trading at 14.0x earnings, and 9.2x EBITDA, which we don’t find particularly compelling.
SIGMA: Not the move you want to see
EPS Sandbag History:
(Note: Original Expectations reflect consensus estimates 4-months prior to earnings; Company Led Expectations reflect consensus estimates 1-month prior to earnings)
