Company, history and business
Kontoor Brands Inc. (KTB, Financial) is a spinoff that generates a significant amount of cash flow and has a long history of being a profitable, resilient business.
It is an apparel company that owns the Wrangler, Lee and Rock & Republic brands. The company also operates the VF Outlet stores.
Kontoor is currently undervalued at $27.37 per share (as of close on June 18) due to indiscriminate selling by institutions and investors who simply do not want exposure to the stock as a result of its differences with its parent company, VF Corp. (VFC, Financial).
Kontoor was spun off of VF, which owns brands like Timberland, Vans and The North Face, on May 22. Shareholders received one share of Kontoor Brands for every seven shares of VF they held.
Management said they spun off the company to employ greater strategic and management focus, deploy capital more efficiently and to provide investors a choice between the two companies. The third reason is the most telling as VF’s “big three” brands have been growing, while Kontoor's brands have not been. From 2014 to 2017, VF's revenues grew 2.93% per year when including the jeanswear business. Excluding the jeanswear business, revenue growth would have been 4.72%.
The Wrangler brand has been around for 70 years and the Lee brand has been around for 130 years. They both make up a significant portion of the U.S. jeans business (11%) and account for approximately 26% of all U.S. men’s jeans sales. Kontoor delivers value to its customers by providing brand name products at cheaper prices than its competitors through several outlets.
For more than 25 years, the company has had extensive relationships with its top three customers: Walmart (WMT, Financial), Target (TGT, Financial) and Kohl's (KSS, Financial). However, the recent widespread closure of brick-and-mortar stores has made these three customers a significant portion of the company's revenue. Its top 10 customers represented 53% of total revenue in 2018, with Walmart representing 32%. Kontoor's reliance on Walmart and other traditionals retailers is crucial. The long-standing relationships with these customers should prove to support revenue in the future.
The areas of focus for this energized management team are overseas, female customers and online sales. Lee is already a top-selling brand in China, but Wrangler has some room for growth. Management believes it can obtain a higher price point for these brands overseas, which would improve margins.
The company also plans to manufacture more products that appeal to women. If successful, this could be a significant driver of growth going forward.
Wrangler has also seen its direct-to-consumer sales increase over the past several years. More growth through this avenue should lead to higher margins. On top of these two strategic initiatives, Kontoor Brands has the secular tailwind of the growing jeanswear industry at its back. The global jeanswear market has a 5% projected compound annual growth rate. In the U.S., the jeanswear market is projected to grow at a 3% rate.Ă‚
Financial strength
The jeanswear apparel industry is characterized by low barriers to entry and high competition. Kontoor Brands’ competitors include Calvin Klein (PVH, Financial), Tommy Hilfiger (PVH), Carhartt, Diesel, Levi Strauss & Co. (LEVI, Financial), Guess (GES, Financial) and Uniqlo (FRCOF). Its most similar competitor is Levi Strauss, which recently went public.
Levi has grown revenues 4% over the past four years and trades at a significantly higher enterprise value-Ebitda multiple than Kontoor. While its revenues have been declining over the same period, Kontoor has been able to generate significantly more operating profit (15.5% on avgerage for Kontoor and 9.7% for Levi).
When looking at the pricing of its best-selling items with online retailers such as Target and Walmart, Wrangler is sold in the high-teens to low-$20 range. In comparison, Levi’s products are sold in the mid- to high-$20s. The fact Kontoor is able to generate a significantly higher operating margin while pricing its products at lower prices speaks to the efficiency and scale of its operations. The company seeks to improve operations by centralizing its management team in Greensboro, North Carolina and is currently determining the areas where distribution centers and warehouses would be better suited in order to better meet customers’ needs. Kontoor Brand’s competitive advantage lies in its ability to provide brand name apparel for lower prices.
At 57%, Wrangler made up a significant portion of Kontoor’s revenue in 2018. Lee contributed 34%. As a result, management should focus on pursuing a strategy to expand the Wrangler brand as it has higher margins (17.9% versus Lee’s 11.5% from 2016 to 2018).
When looking back at past financial performance, a dismal scene is painted. Sales have declined approximately 3% per year for the past four years. The decline can be attributed to the destocking of inventory (particularly the Riders by Lee brand) and loss of sales to brick-and-mortar stores that have closed their doors. This is certainly a problem. The company, however, has longstanding relationships with retailers who will likely survive the upheaval in the retail space.
On a positive note, direct-to-consumer and e-commerce sales have grown as Kontoor has invested in its online platform.
Over the long term, the jeanswear business has been extremely resilient. Sales decreased approximately 13% between 2007 and 2009, but the company managed to maintain a strong operating margin of over 14% in that same period. This speaks to the quality of the brand and the value the company provides its customers.
The brands' long history as well as the profitability of Kontoor Brands compared with competitors makes me believe Wrangler and Lee have staying power. People buy the jeans because they are extremely affordable and of high quality. I don’t see this changing in the near term. The business also has extremely low maintenance costs as capital expenditures have averaged around 1.32% of sales since 2010.
Kontoor Brands is heavily indebted compared to industry peers. The company has a Ba2 rating from Moody's due to its reliance on very few large customers, lack of product diversification and fashion risk. To put things in perspective, Levi was given a Ba1 rating. This is only one notch above Kontoor's score, though Levi doesn’t carry nearly as much debt. Moody’s must not think the company's debt is a major problem due to its ability to consistently generate significant free cash flow.
The company issued a $750 million term loan A facility and a $300 million term loan B facility to fund a $1.05 billion cash transfer to VF Corp. as part of the restructuring and to pay fees and expenses related to the deal. The weighted average interest rate at the time the form 10 was published was 5.1%. The term loan A is due in five years and the term loan B is due in seven years.
Management has said one of Kontoor's goals is to pay down debt. According to the debt repayment schedule, it will have a significant amount of leverage on the balance sheet for at least five years. The interest coverage ratio cannot be less than 3 times and the net leverage ratio cannot exceed 4 times adjusted earnings before interest, taxes, depreciation and amortization. If Levi and VF are of any indication, Kontoor’s debt-to-assets ratio of 0.87 is most likely not the optimal capital structure. Levi’s ratio stands at 0.28, while VF is at 0.27. Therefore, Kontoor’s optimal capital structure should be somewhere around 0.28.
Management
Management has an extensive record with VF Corp. CEO Scott Baxter had been with the company for 12 years and had previously served as group president of VF’s Jeanswear Americas business.
Another key member of the management team is Thomas Waldron, who has worked for VF for 29 years and made his way up from a replenishment manager in 1995 to vice president of Wrangler today.
Kontoor plans to adopt a similar compensation structure to VF's, whereby a significant portion of compensation is pay at risk (equity). Currently, management owns around 0.58% of the business, which translates to $8 million at risk.
Valuation
Management guided for a mid-single-digit sales decline for fiscal 2019 and low single-digit increases for 2020 and 2021. Given that the jeanswear businesses’ compound annual growth rate for the past 24 years has been effectively zero, I projected future revenue would not grow. I believe this to be a likely scenario over the long term and incorporated it in my valuation. However, I did consider a 5% drop in sales for fiscal 2019 within my model.
The free cash flow to the firm method was used for valuation purposes. The next two years are likely to be challenging for Kontoor Brands as it will need to establish certain administrative departments that VF previously took care of. As such, margins have been adjusted downward within my valuation.
After two years, management expects general and administrative expenses to increase by $10 million over what they would have otherwise been while operating as a subsidiary of VF Corp. Management expects there to be between $110 million and $125 million in costs and expenses associated with being a public company for the first two years as well. These numbers have been incorporated in my valuation.
Kontoor’s cost of capital will be relatively low for the first five years of operation as a standalone company due to the amount of debt in its capital structure. As stated previously, the effective interest rate on the debt was about 5.1% at the time the final form 10 was submitted to the Securities and Exchange Commission. The cost of capital will increase over time as the company pays down debt.
After considering these factors, I arrived at a fair value of $38.50. At the current price of $27.37, this represents a margin of safety of roughly 40%.
When comparing Kontoor to Levi, there seems to be a chronic mispricing. Levi shares are trading at 13.4 times 2019 enterprise value-Ebitda, while Kontoor is trading around 7.8 times. As a result, Levi should absolutely demand a higher multiple in the market due to its past growth. However, the discrepancy is far too wide. A $38.50 price target implies a 2019 enterprise value-Ebitda multiple of 9.35.
In regard to the the dividend, management said in the form 10 Kontoor plans to dish out a $2.24 annual dividend. This currently represents an 8.1% yield. This seems steep for a company that has minimal capital expenditures to cover the dividend quite easily. Management plans on delivering a dividend based on a 60% payout ratio going forward. A dividend has yet to be declared, though.
The reason for undervaluation is simple. VF Corp. is widely held by institutional investors. There was a large market cap discrepancy between VF and Kontoor, forcing those funds with a large-cap mandate to sell the stock. Along these same lines, Kontoor isn’t included in the S&P 500, but rather the S&P Small Cap 600. Those institutions that have a mandate to hold only S&P 500 funds were also forced to sell. For other investors, this stock simply isn’t as appealing as VF Corp. A value jeanswear manufacturer that has had declining sales for the past four years doesn’t quite get investors excited, whereas “the big three” brands VF still owns do get people excited.
Risks
Some risks Kontoor Brands currently faces are related to the trade war. It may be difficult for the company to penetrate the Chinese market with its Wrangler brand and Lee may see a decline in sales in that region. In addition, roughly 85% of the company’s manufacturing facilities are located in Mexico. While President Trump did not go through with implementing tariffs on Mexico, it could still happen in the future, which could increase production costs.
Another headwind the company faces is the closure of more brick-and-mortar stores. As a result, a greater portion of Kontoor’s revenues will come from fewer retailers.
Catalysts
Several catalysts could push the share price up to fair value levels. Three analyst reports have come out since the spinoff, so more positive analyst coverage would likely propel the stock higher. However, the opposite is also true.
Bank of America gave a price target of $24 on June 6. The analysts cites multiple contraction of 6 times 2020 Ebitda to get to this valuation. Interestingly enough, the bank set a 12 times 2020 enterprise value-Ebitda multiple for Levi. I’d like to hear how the analyst reconciles these two valuations.
Susquehanna assigned a price target of $36 on June 13. Stifel set a price target of $46 on May 28.
On the fundamental side of things, any reversal in the revenue story should send a positive signal to investors that management can turn this ship around. With an 8% dividend yield, there clearly isn’t much growth priced into the stock.
The final catalyst is the declaration of a dividend. Some investors seem skeptical of the annual $2.24 per share dividend. I see no reason to be skeptical of it at all. It has the free cash flow to cover this amount and more, and it is blatantly stated in the form 10 the company intends to pay out 56 cents per quarter. When the dividend is announced, not only will you be receiving an attractive yield at current levels, but you should also see some price appreciation to reflect an appropriate yield.
Kontoor Brands is currently undervalued due to indiscriminate selling by institutions. The business is not very appealing and has not been growing. Regardless, it has solid long-term relationship with its customers and pricing power over its competition. The company provides customers with brand name jeans at a great value, just as the stock does for its current investors.
Disclosure: Long Kontoor Brands.
Read more here:
- Value Idea Contest- CenturyLink: A 10% Yield Deep Value Play
- Value Idea Contest: Vantage International Holdings Ltd.Ă‚
- JPMorgan Still Undervalued
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
