Project Description

Kontoor Brands Spin-off Deep Dive

Overview

On April 1, 2019, apparel maker VF Corporation (VFC) filed its Form 10 registration outlining its planned tax-free spin-off of its jeanswear organization into an independent, publicly traded company. The spin-off was first announced on August 13, 2018. The new company will be named Kontoor Brands, Inc. and will include the Wrangler®, Lee® and Rock & Republic® brands, and the VF Outlet business. With estimated annual revenues of about $2.68 billion, Kontoor Brands’ goal to be a global leader in the denim category is ambitious.  This low expected growth spin-off is expected to be completed after the market close on May 22.

Holders of VF shares will receive 1 share of Kontoor Brands per 7 shares of VF held. A “when-issued” public trading market for Kontoor Brands’ common stock has now started under the ticker “KTB WI,” and will continue through the distribution date. The when issued price is now $40.50 per share. VF anticipates that “regular-way” trading of Kontoor Brands’ common stock will begin on May 23, 2019.

Why the Spin-off?

VF has had until the last few years, a fairly good record of consistent growth with an excellent average annual shareholder return of 17% since 2000. The company has been hampered, especially recently, by its slow growth jeanswear organization. In 2018, jeanswear revenue declined 4.6% whereas other VF business revenue advanced 21.4%. Jeanswear EBIT declined 14.2%, while VF’s other businesses EBIT advanced 36.7%. In 2017, VF unveiled its five-year growth priorities. These priorities include a reshaping of the brand portfolio to better position the company toward higher growth activity-based lifestyle brands. Since then, VF has acquired Williamson-Dickie, and the Icebreaker® and Altra® brands, and divested the Nautica® brand and the Licensed Sports Group, including the Majestic® brand. Through these actions, VF has sharpened its focus on activity-based outdoor, active and work lifestyles.  The slower growth jeans business was clearly an impediment to the new orientation; Wrangler and Lee are not premium brands and have experienced declining sales and market share over the last three years.

What to Expect in the Future

VF and Kontoor management believe that the jeans platform can be a successful, sustainable business with iconic global brands and a clear path to value creation as a standalone entity.  Kontoor, is expected to have a high single digit expected return with a relatively high dividend yield.

Recent results have been impeded by the confluence of several onetime events. The bankruptcy at Sears, destocking by Riders of Lee, India demonetization, the closing of the Argentina business and the non-branded optimization of the VF outlet business have accounted for about a $200 million reduction in revenues. Core sales have been stronger and now form a base for improvement going forward.

Kontoor Brands will have diversified geographic exposure and plans to further extend its geographic footprint with a sharp focus on Asia, building on its established presence in China. The company plans to expand its distribution to new customers and categories, with a focus on both their owned and wholesale digital partner channels. Kontoor expects to unlock significant scale and cost efficiencies by streamlining operations, and by providing flexibility to pursue strategic acquisitions over time. The company will be located in Greensboro, NC, VF’s current headquarters (VF is moving to Denver), and will move the Lee® brand from Kansas City to Greensboro. The following slide from a management presentation presents a good contrast between the jeans business as part of VF and as an independent company.

The following slides provide a good overview of their “Horizon 1” plans and how they will set the stage for “Horizon 2”.

Denim Market Overview

Zion Market Research estimates that the denim jeans market was a $66 billion market in 2018 and that the market will grow at a 3.6% annual rate to $85 billion by 2025. With about $2.7 billion in revenue, Kontoor has about 4% of the market. While the business would be negatively impacted by a recession (like all other consumer businesses), I was shocked to learn that revenue only declined from $2.9BN to $2.6BN during the Great Financial Crisis. Interestingly, margins and cash flow actually grew.

The company is particularly strong in U.S. men’s jeans with ~26% market share. The Asian and Middle Eastern markets offer the best opportunity for growth, with estimates as high as 10% per year through 2025. (Growth in the domestic market has been much lower, less than 1% in recent years and is estimated to grow by 3% going forward.) Kontoor’s Lee brand is #1 in China. Many people in these regions, especially style conscious woman, look to western fashion trends, and denim wear continues to be a staple in North America.  Kontoor Brands’ focus on China is an appropriate response to this reality. The “westernization” and the “casualization” of the workplace are important trends. The growing popularity of premium jeans supports pricing. Denim industry players are aggressively promoting innovatively styled denim garments. Further, growing middle class populations throughout the world are spending greater amounts on apparel.

Nevertheless, there are challenges ahead. Consumers have continued to transition away from traditional wholesale retailers to large online retailers like Amazon and others, where products are exposed to increased competition. As a result of demand moving online, many stores have closed and I expect continued consolidation going forward.  

Other channels, including vertically-integrated specialty stores and eCommerce sites, account for a substantial portion of jeanswear and casual wear sales. In some mature markets, these stores and sites have placed competitive pressure on primary distribution channels, and many of these stores and sites are a competitive threat. Kontoor Brands primary branded competitors are large, globally focused apparel companies that also participate in a variety of categories, including, but not limited to, athletic wear, denim, exclusive or private labels, and workwear. A select list of key competitors includes Calvin Klein, Carhartt, Diesel, Guess, Levi’s, Tommy Hilfiger, and Uniqlo. Additionally, there is a large and growing offering from private label apparel created for retailers such as Walmart, Amazon, H&M, Old Navy, and Gap.

Kontoor Brands’ Business Model

Kontoor manufactures approximately 38% of their products in owned and leased facilities, and distributes products worldwide primarily through both major brick & mortar and e-commerce retailers. The remainder of units sold are supplied by a range of third-party manufacturers. They focus on continuously improving what they consider the most important elements of their product, fit, fabric, finish, and overall construction, while offering an attractive price. The company has a presence in over 65 countries. Within the United States, where 73% of revenues were generated in 2018, they offer apparel and accessories largely through their wholesale channel, which consists of mass and mid-tier retailers, specialty stores including western specialty retail, department stores, and retailer-owned and third-party e-commerce sites.

They also sell products in the U.S. through direct-to-consumer channels, including full-price stores, outlet stores and their own websites. Digital Wholesale, Digital Direct to Consumer, and International offer the most promise currently. The ten largest customers accounted for 53% of revenues in 2018. Walmart alone accounts for about 33% of revenues. Outside the U.S., they operate through similar wholesale channels as in the U.S., and utilize distributors, agents, licensees, and partnerships along with their full-price and outlet stores and digital presence. Sales are made on a purchase order basis; there are no long-term supply contracts.

Management Guidance

Management has provided guidance that revenue will be down in 2019 to about $2.5 billion from the pro forma level of $2.7 billion in 2018, but that revenue growth will rebound (guidance is mid-single digit growth) in 2021 and 2022. Likewise, adjusted EBITDA will decline to the $350 million level this year from the pro forma level of $377 million in 2018.

They forecast that EBITDA should grow at a mid-single digit rate in 2021 and 2022. Capex will range between $55 and $60 million for each of the next 3 years. Historically, the EBITDA margin has ranged around 14-15%. Transition costs will be about $120 million over the next 18 – 24 months, and costs of being an independent company will approximate $10 million per year. Management looks to reduce ongoing operating costs by about $50 million per year.

Consequently, they are planning to expand margins over a five year period by 2-3%. The company plans to adopt a 60% payout ratio and has announced an initial annual dividend of $2.24. At KTB’s recent when issued trading price of $40, the dividend yield is 5.6%.

Gross leverage is targeted to be less than 3x (Debt/EBITDA). The company projects continuing operating cash flow of about $300 million over the next few years, and low single digit long term growth in earnings. Cash will be used to pay dividends, pay down debt, and make modest acquisitions. While they hope to offer investors a total return of 8-10%,  they suggest that multiple expansion, share repurchases, and acquisitions could add to the 8-10% goal.

Capital Structure

The company is borrowing $1.05 billion to fund a transfer of $1.027 billion to VF to extinguish the “parent company investment.” The debt consists of a $750MM senior secured term loan with a 5 year maturity and a $300MM senior secured term loan with a 7 year maturity. KTB also has a $500MM 5 year revolving credit facility. Moody’s Corporate Family Rating will be Ba2. The commentary from Moody’s is quite favorable, but they point out the constraints of the big concentration of revenue from Walmart, and an undiversified product line. Additional concerns include fashion risk, volatile input costs that could be influenced by tariffs, and foreign exchange risks. Total debt divided by EBITDA is about 2.8. Interest coverage is about 6.1 times (EBITDA of about $350 million divided by $57 million.) The weighted average interest rate will be about 5.1%.

Good Management

Historically, VF’s success has come from acquiring small unrecognized brands with big growth potential. They invest in them and grow them. They have a sharp focus on ROIC in contrast to their WACC. A good example is the acquisition of Vans. This company was a small California company focused on skateboarders. VF has broadened and refocused the Vans product line to appeal to a broader hip group that includes women and the “creative” set. Van’s still has huge potential to grow. On the other hand, they regularly divest under-performing brands, notably getting rid of Vanity Fair, their namesake, in 2011.

Scott Baxter, an executive who led the denim business at VF from 2011 to 2015, will serve as President & CEO of Kontoor. The VF culture and discipline should accompany Baxter in his new role. The full management team at Kontoor is as follows:

I’m encouraged by the continuity of the management team at Kontoor Brands (everyone except the General Counsel is a VF veteran). This continuity helps to create a more seamless transition to life as an independent public company. It also reduces the risk of an early operational hiccup.

Incentive Compensation

The KTB Form 10 does not explicitly note how many shares are reserved for incentive compensation, however, it does make the point that Kontoor Brands executive compensation and incentive compensation philosophy will be similar to that of VF Corp. As of 12/31/2019 VF Corp had 32.7 million shares reserved for options or 8.3% of shares outstanding. Applying the same 8.3% to KTB implies that ~4.7 million shares will be reserved for incentive compensation.

Thoughts on Valuation

The following table shows Kontoor Brands (at its current when issued trading price) as being attractive on a relative basis vs. all apparel stocks.

However, KTB has higher debt, less diversity of revenue, and lower long term EPS growth. I think HBI is probably the best comp. Compared to HBI, KTB looks reasonably valued.

One could argue that LEVI is the best comp for KTB, however, I would disagree. LEVI has grown revenue organically at a double digit clip for the past 6 consecutive quarters while KTB has been shrinking. Plus LEVI has minimal debt.

Management has noted that it expects KTB to trade at a ~5% dividend yield. This would imply a $45 stock and is an important reference point. The dividend yield is indeed juicy and should provide valuation support over time.

On a DCF basis, I think the stock is worth $2.3BN or $40 per share.

Key assumptions underpinning the DCF:

There is definitely the potential for indiscriminate selling. VFC is in the S&P 500 while KTB will be excluded. Thus, index funds and ETFs that track the S&P 500 will be forced sellers.

Risks

As expected, Kontoor’s Form 10 lists every imaginable risk that would normally be listed for a consumer discretionary company. It’s been a long time since we’ve had a recession and economic weakness would certainly negatively impact Kontoor’s business. Consumers always retrench in a recession, though Kontoor was fairly resilient during the last one. I agree with Moody’s that the Walmart (33% of sales) concentration is also a concern.

Conclusion

KTB is a stock that I would want to own at a certain price. At its current price ($40.50 in the when issued market), I’m not interested. If KTB were to trade to the mid $20 price range, it would get a lot more interesting. It is not uncommon to see small cap spin-offs sell off by 40% or 50% in the initial weeks of trading.

Company Resources:

Form 10 – April 30, 2019

Kontoor Brands Investor Presentation – April 26, 2019

Spin off information – April 26, 2018

Full year outlook – April 26, 2018

Investor Relations: Joe Alkire, 336-424-7711 Vice President, Corporate Development, Investor Relations and Financial Planning & Analysis Joe_Alkire@vfc.com

Other Resources:

The Motley Fool – Why VF Corporation Rose 18% Last Month – February 11, 2019

Seeking Alpha – V.F. Corporation: One Of The Best Apparel Stocks On The Market – March 26, 2019

Real Money – Levi Strauss Results Show Solid Macro Footing for V.F. Corp. Spinoff – April 10, 2019

Retail Dive – Is There Life After VF Corp for Wrangler and Lee? August 13, 2018