Monday, August 6, 2012

VF Corp is One Retail Stock Bucking the Trend

The mid-tier retail sector has definitely been a stock pickers market over the last couple of years. Some stocks have performed wonderfully, others have slumped. Most of the off-price and discount retailers have done well. Similarly, the high end has been very strong. However, mid-market retail performance has been mixed.

What makes the mid-tier stocks performance so variable is the pressure on middle class consumers to trade down. From the other perspective, they don’t sell the relatively price-inelastic products that appeal to the high net worth market. One company that bucks the trend is V.F. Corp $VFC. Although I think the stock is fairly valued, it can generate decent returns from here.

Who is V.F. Corp?

The name may be ambiguous but the brands are anything but! In fact, 70% of its revenues are generated by five household brands. In order of importance, they are The North Face, Timberland, Vans, Wrangler and Lee.

What I like about this company is that it offers a diversified product range, whose products all tend to offer utility to its users, rather than just being a fashion statement. When I look across the mid-tier competition I see things like Crocs, Inc $CROX which strikes me as being a highly faddish product. Similarly, something like Abercrombie & Fitch $ANF may well offer a unique customer experience, but shoppers can get bored of the novelty of buying goods from dimly lit outlets whilst perfume and loud music are being pumped around them. I’d argue that both these companies are significantly dependent on fickle customers' tastes. Even a company like Gap, Inc $GPS has suffered due to a loss perception over its fashionable status.

On the other hand, V.F. Corp offers a product range that appeals to consumers' core and ongoing needs. Rugged outdoor clothing, skateboarding fashion and jeanswear have far less variable demand than a lot of fashion.

I’m going to outline a few bull and bear points and, the develop upon them later.
  • Prices were not increased when cotton prices rose, so margins should increase now that cotton is falling
  • E-commerce initiatives in Europe with Vans and The North Face will produce secular growth
  • The Olympics will help the Sportswear division
  • Some of the key brands are underpenetrated in Europe and definitely so in Asia; this creates growth opportunities
  • US economic recovery will start to help the mid-tier market's comparables
  • The growing Jeanswear business in China is more profitable than any other in the world for V.F. Corp
  • New product initiatives should spur growth 
  • Despite international sales only being around 37% of total sales, Timberland  is a key brand and has 50% of its sales in international with its largest European market being Italy
  • Gross margins at Timberland in the last quarter were weaker than forecast due to a warm winter and the company learning how to manage the recently acquired business; aggressive action to remove inventories could come at more margin expense in the current quarter
  • Cost inflation from China is rising as wages go up there
  • Competitors may discount now that cotton prices are falling

Challenges and

In order to demonstrate the relative importance of the brands, here is a divisional breakdown of revenues for Q1.

The growth rate in Outdoor & Action (which contains The North Face, Vans and Timberland) was actually 60% but that includes the acquired Timberland business.

Timberland generated low single digit growth in Europe but strong double digits in Asia, on a constant currency basis. However, in North America revenues declined due to warm weather affecting winter boot sales. Whilst this is understandable, it comes in a brand that was only acquired last year, and the management admitted on the conference call that they are learning how to manage the inventory at Timberland. It is never a good sign to see a recently acquired business deliver lower than expected gross margins and the relatively high exposure to Europe is a concern.

Indeed, revenues at both Lee and Wrangler (Jeanswear) were lower in Europe for Q1, whilst they produced double digit growth in the Americas region. Both these brands produced good growth in Asia.  So a picture is emerging of weaker growth in Europe and I am a bit skeptical that the company will hit its double digit revenue growth target in this region. 

However, given that 63% of revenues are in the Americas region and Asia is an underpenetrated market for many V.F. Corp brands, growth opportunities are abundant.  For example, in China the company only has four currently active platforms -- Jeanswear with Lee, Outdoor with the North Face, Action Sports with Vans, and handbags and accessories with Kipling. There is plenty of room to introduce new brands and generate sales growth even if China's growth is slowing.

I would also be positive on prospects in its e-commerce initiatives. The North Face has launched e-commerce sites for Italy and Spain with the UK, Sweden and France already covered. Furthermore, Ireland, Germany, Austria and the Netherlands will follow later in 2012. Similarly, in short order, Vans will simultaneously launch e-commerce sites in the UK, Germany, Austria, Sweden, Ireland, France and the Netherlands. I like these initiatives because they cater to a fast growing sales channel and the products are exactly the kind of merchandise that does well with e-commerce. They appeal to a young demographic and can be easily understood by their customers.

This is not say that there might not be difficulties. As Nordstrom $JWN investors recently found out, e-commerce initiatives can have cost overruns. No matter, as with Nordstrom, the key issue is to get the investment done early. There is a new reality to retail and it lies in e-commerce.  I think that the early adopters who leverage their brands will benefit, whilst those who solely rely on continuing footfall and high street retailing will suffer. History is littered with high profile companies that stumbled because they did not adopt new technologies soon enough.

Guidance and Prospects?

Despite lower margins at Timberland, full year guidance was actually raised to $9.45 against analyst consensus of $9.48. At a current price of $139 this puts it on a forward PE of 14.7, which is attractive. I suspect prospects will be guided in the short term by running down the winter inventory at Timberland and by any cost overruns at the e-commerce initiatives. Meanwhile, US revenues look strong and new product initiatives will help spur growth. Cotton prices are falling and I think will give more margin expansion going forward.

In conclusion, V.F. Corp is currently generating 5.2% of its Enterprise Value in free cash flow, with analyst forecasts for 15.9% and 14.6% growth in the next two years. On balance, this makes it attractively priced, but investors will need to look out for the execution issues at Timberland and European sales across the whole product range. E-commerce will be a great long term driver but I wouldn't expect too much too soon from the new country site launches.

For these reasons, I suspect the next quarter’s numbers could be a bit weaker than many predict, but long term investors need not worry as long as the strategic direction is on track.

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