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INVESTMENT THESIS

Here’s a terrible thought: Imagine inheriting your parent’s old stodgy jeans. Shareholders of VF Corporation are in exactly that position. VF Corp. (VFC) has just completed the spinoff of its jeans business, which is primarily comprised of the Wrangler and Lee brands. The new company has the catchy moniker of Kontoor Brands. (I dread to think how much the name consultants were paid for this one.) ­

That said, I believe that Kontoor at its current price represents excellent value, with the prospect of large capital gains, possibly more than 100%, over two or three years. While we wait for price appreciation, we will collect a hefty dividend that yields 7.3% at today’s price.

VFC has not invested in nurturing the highly profitable and cash-generating Wrangler and Lee brands in recent years, instead treating them as cash cows while focusing on its numerous other businesses and on acquisitions. This is reflected in the performance of its jeanswear division, with sales down about 10% over the last five years and operating income down from more than $500 million to less than $350 million over that period. During those five years, the parent invested less in cap-ex in the jeans business every year than the amount of D&A expense in that business. The division made aggregate net after-tax profits of about $694 million in the last three years, and I estimate that about $753 million of cash (i.e. more than 100% of profits) was transferred up to the parent during that time. And as part of the spinoff, Kontoor has taken on just over $1 billion of debt to make another payment to its now former parent.

In a situation like this, there is necessarily a leap-of-faith element that management can successfully execute to realize the potential that I see in the business. The higher the valuation, the greater the leap required. For this collection of assets, I believe that the stock price is cheap enough that the leap here does not have to be huge for this investment to work out well. The bad news (mature business, negative growth, aging brands) appears to have been priced into the stock, and there is now plenty of potential for pleasant surprises from an incentivized management team who can use the abundant free cash flow to create shareholder value through investments, dividends, and potentially stock buybacks down the road.

THE SPINOFF

Kontoor‘s spinoff from VFC was completed on May 23rd. VFC cited the usual reasons for the spinoff: it allows each management team to focus on their separate businesses, pursue growth opportunities, capital allocation, appropriate incentivization of management, etc. My guess is that another unspoken reason is that despite its strong profitability, the jeans business is mature, with sales not only not growing, but declining in the last few years, and therefore dragging down VF’s overall growth rate. VFC has retained the rest of its vast portfolio of products, which include North Face, Timberland, Vans, JanSport, and many more.

The when-issued stock traded in modest volumes at just over $40 immediately prior to the completion of the spinoff. Since then the stock has declined virtually every day, losing almost 25% of its value in very heavy volume, to $30.75 currently. I suspect that there are multiple reasons for this decline:

(1)   Dumping of KTB by institutional shareholders and index funds. VFC is part of the S&P 500 index. Vanguard and Blackrock owned a combined 13.1% of VFC at end-2018. So they would have owned about 7.4 million of the 56.4 million shares of KTB outstanding, most of which they probably had to sell. At the 1:7 spinoff ratio, a shareholder who owned 7 shares of VFC worth about $596 today would now also own 1 KTB share worth less than $31, a ratio of 19:1. (VFC’s market cap is about $34 billion, compared with less than $1.75 billion for Kontoor.) It’s not hard to imagine many other large cap or more conventional funds and investors rushing for the exits.

(2)   Although the two brands (Wrangler and Lee) have been around for over 70 years and 130 years, respectively, and are household names (at least in the U.S.), the Kontoor name is virtually unknown to investors. Despite being a small-cap company, it should gradually become better known in the investment community because of its well-known brands.

(3)   The trade war with China and the threatened Mexican tariffs are bad for Kontoor, since most of its products are manufactured in Asia (by outside suppliers) and in Mexico/Central America (at the company’s manufacturing facilities). Competitors are likely to be similarly affected. My guess is that this is probably a short-term issue, though making predictions in this crazy political environment can be dangerous to one’s wealth. Over the longer term, production can be shifted to more cost efficient locations if necessary.

(4)   U.S. equity markets have been volatile over this period, possibly precipitating some selling by nervous investors.

BUSINESS BACKGROUND

The bulk of Kontoor’s business is from the Wrangler and Lee brands, which together account for over 90% of the company’s revenues. The Lee brand was created in 1889, and was acquired by a predecessor of VF Corporation in 1969. Wrangler’s jeans were first introduced in 1947, though the Wrangler brand had existed for some years before that. In 1986, VF acquired Blue Bell, which owned Wrangler, JanSport, and other brands. (VF is keeping JanSport and not spinning it off into Kontoor.) In addition to jeans for men, women, and kids, both brands sell other apparel (pants, shorts, denim jackets, shirts, tops, outerwear) and accessories (such as belts and caps).

Kontoor also inherited a third, smaller jeans and apparel brand, Rock & Republic, which is sold exclusively through Kohl’s in the U.S. Additionally, Kontoor also owns some smaller brands worldwide, including Gitano and Chic, though I think that both these brands are dormant. These are not important to my investment thesis.

The spinoff assets also include VF Outlet stores, which sell Wrangler and Lee products, other VF-branded and third-party products, and also serve as outlets for disposing of excess Wrangler and Lee inventory.

The table below provides a five-year summary of the financial performance of the businesses inherited by Kontoor, and a pro forma summary income statement for 2018, which adjusts for discontinued businesses and the debt taken on by Kontoor in the transaction. Pro forma EPS last year was $4.03, implying a P/E multiple of less than 8x 2018 earnings. Sales are expected to be lower in 2019 at about $2.5 billion. Earnings can be expected to decline too, and I expect EPS to be perhaps about $3.30 - $3.50. 2020 should be better.

Wrangler and Lee generated $1.6 billion and $960 million of sales, respectively, in 2018. The VF Outlet stores and other products accounted for the remaining $202 million of last year’s sales. The table below shows the revenues and operating profits by segment for the last three years. Sales have declined somewhat; operating profits have experienced a large decline, from $473 million in 2016 to $359 million In 2018. (Note: These numbers have not been adjusted for some spinoff-related accounting issues, so the numbers are not fully comparable to other tables in this report, but should give a good sense of the general magnitude, trends, and profit margins of the businesses.)

The longer-term financial history of VFC’s jeanswear business (which excludes the VF Outlet stores that are part of Kontoor) is summarized in the table below. Revenues increased at very modest rates until 2013, but have decreased every year since then, with somewhat alarming declines in the last three years. Also, while still solidly profitable, margins for Wrangler and Lee are down too, with EBIT margins for the company decreasing from over 19% to 14.3% in 2018.

Kontoor begins life with a fairly strong balance sheet. It has taken on about $1.05 billion in term loans to pay a dividend to VFC. There is about $100 million of cash on the balance sheet. Annual interest expense is expected to be about $52 million, which can be comfortably covered by $300+ million of operating income (EBIT). The table below summarizes the pro forma balance sheet (as of end-2018). Importantly, the business is relatively asset-light, with only $138 million of net PP&E supporting more than $2.5 billion of sales. This is partly because manufacturing for about 62% of the products sold is outsourced, primarily to manufacturers in Asia. (The remaining 38% is manufactured at company owned facilities in Mexico and Central America.) Receivables and inventories require more capital. The economics of the business look very attractive: with $1.1 billion of tangible assets and $692 million of tangible capital, the company has consistently produced over $300 million of operating profits.

U.S. wholesale sales (i.e. sales to independent retailers including third-party e-commerce retailers) accounted for 61% of last year’s sales. International wholesale accounted for another 22%. Other sales, including direct-to-consumer sales through the company’s websites and the VF Outlet stores, accounted for the remaining 17% of 2018 sales.

Walmart accounted for 32% of Kontoor’s 2018 revenues. Its ten largest customers (which also include Kohl’s, Target, and Amazon) accounted for 53% of revenues.

Management has plans for organizational changes to make the organization more efficient. They expect to realize cost savings of $50 million by creating a more centralized and streamlined global organization structure. For example, Lee’s North American headquarters are being relocated from Kansas City to Kontoor’s corporate headquarters in Greensboro, NC. The company is also transitioning the Central America and South America region to a distributor model.

They are particularly focused on growing international sales and direct-to-consumer sales, which they expect to become a larger percentage of the total. The company has a presence in more than 65 countries. The two brands, particularly Lee, have more cachet outside the U.S. than they do domestically. Wrangler is predominantly a U.S. brand, and Canada is Wrangler’s largest international market. Lee is stronger internationally, with 47% of Lee sales outside the U.S. China is Lee’s largest international market; it has been there since 1995. Management expects both China and India to be growth markets for Kontoor going forward. In particular they believe that China offers a significant opportunity to grow by offering a broader range of products across a wider range of price points.

Competition in the jeans business is intense. I think of Levi Strauss as being the most similar competitor, though the Levi brand is far more iconic globally than Wrangler and Lee can hope to be. Levi Strauss, which has been privately owned since 1985, became a public company again in March of this year. Levi’s also owns the Dockers and Denizen brands. Other large jeans brands include Gap, Tommy Hilfiger, Pepe, Diesel, True Religion, Calvin Klein, Guess, and Lucky, to name a few.

Unlike Wrangler and Lee, Levi’s has managed to grow sales in recent years, particularly in the last two years. Levi’s attributes this to having “significantly increased the level of marketing support for our brands” and “disciplined investment in brand-building” starting in 2017. Kontoor’s operating margins are higher, perhaps because of inadequate dollars spent on building their brands. I think it likely than money spent today to nurture the brands can result in a big payoff over time through higher sales. The marketing dollars being saved today are costing the company in future lost sales.

VALUATION OF KONTOOR BRANDS VS. LEVI STRAUSS

Levi deserves a premium valuation to Kontoor, but the difference today appears excessive. Levi is a more valuable brand and has been growing, while Kontoor’s sales and profits have declined in the last few years. Using actual 2018 numbers, the valuation difference is stark. Levi will probably gain more ground over Kontoor this year, and I have used rough projections in the table below for 2019. In my view, the valuation gap based on 2019 estimates, while narrower, still appears to be unwarranted.

DIVIDEND POLICY

The company has announced a target dividend payout ratio of 60%. The initial dividend rate is $2.24 annually, resulting in a 7.3% yield at the stock’s current price. (I assume that the 60% payout ratio and $2.24 dividend is management signaling that they believe the current per share earning power to be about $3.70, versus pro forma of $4.03 in 2018.)  My guess is that the first dividend payment of $0.56 will be announced with the second quarter’s earnings report, probably in late July or early August. When announced, this could attract some attention to the stock.

I have mixed feelings about the dividend policy. On the one hand, given that management’s capital allocation skills are unproven, I’m very happy to have a large part of earnings paid out to me as dividends rather than retained and possibly misused in poor acquisitions or other investments. But while a 7.3% dividend yield is a thing of beauty if well covered by current earning power, paying out such a large portion of profits has me wondering whether management believes that there are attractive investment opportunities for the business, and whether meaningful top-line growth is possible. (That said, if they maintain this dividend not much stock appreciation is required to produce a decent return.)

If they demonstrate their ability over the next couple of years to stabilize and streamline the organization, and improve margins by cost cutting or other efficiency methods, we can hope for higher earnings, and they can use the increased retained profits for acquisitions, stock buybacks, etc.

(For what it may be worth, they’ve also indicated in their presentation (see link below) that they expect the dividend yield to be about 5%, perhaps signaling that they think the stock price should be about $45. If that’s indeed the case, there should be meaningful insider buying happening right now.)

Presentation dated 4/26/19

https://www.sec.gov/Archives/edgar/data/103379/000119312519120774/d737654dex992.htm

Existing VFC stock options and other equity awards of the Kontoor management team have been converted to equivalent awards of KTB stock. The VFC options which were granted in the last few years and have been converted to KTB options have exercise prices ranging between about $22 and $31. Scott Baxter, the CEO, has about 550K Kontoor options, giving him plenty of incentive to work for a higher stock price. I’m sure that more options will be awarded directly by Kontoor to its management team.

ENDGAME?

The outcome I’m hoping for is stabilization of revenues in the short term (one year), followed by modest growth over the next few years. I think it’s too much to hope for anything approaching double-digit topline growth. Similarly, they need to stabilize and then improve operating margins over the next couple of years. 2018 pro forma EBIT was $351 million; this will decline this year. With their cost-cutting and streamlining plans, it’s not hard to visualize $400 million of EBIT in 2021 or 2022, which would translate to EPS of about $4.50. What’s that worth for a slow-growing company with well-known global brands and huge free cash flow? At least 10x earnings, I would think, and possibly as much as 15x in a low interest rate environment. Including dividends that would translate to total gains of about 70% to 150% over three years.

Eventually, I could see this company being attractive to both financial and strategic buyers. I believe that tax laws for spinoffs would preclude this from happening for at least two years in terms of management-initiated transactions.

RISKS

·      Management fails to execute on improving the business, and sales and profit margins continue declining.

·      Poor capital allocation by management.

·      Slowdown in U.S./global economic growth.

·      Trade war with China and Mexican tariffs increase cost of goods for an extended period.

Catalyst

(1)   Stabilization and Improvement in financial results over the next couple of years.

(2)   Kontoor becomes better-known to the investment community.

(3)   Dividend payments commence next quarter.