Levi Strauss Q2 Earnings: Stock Selloff Makes No Sense (NYSE:LEVI)

Investment Thesis

There is so much to love about Levi Strauss & Co. (NYSE:LEVI). The company released its earnings last week, and despite the challenging macro environment, the numbers were admirable. In this article, I highlight the catalysts that could drive LEVI’s growth in the future and outline why, from a valuation standpoint, there is considerable upside to the company’s stock.

A Snapshot of Levi Strauss’ Q2 Performance

Q2 Revenue for LEVI came in at $1.47 billion, up 15% YoY, comfortably beating analyst estimates by nearly $40 million. Diluted EPS came in at $0.29, up 26% YoY, beating estimates by $0.06. Just like Nike (NKE), Levi Strauss’s revenues were also driven by the strong performance of its direct-to-consumer business (DTC), which saw revenues jump by 22% YoY, thanks to increased traffic, store expansion, and continued gains in AURs.

Despite e-commerce sales down 2%, which was primarily due to a higher influx of customers into brick-and-mortar, sales across all digital channels were up 8% YoY and made up approx. 20% of the total Q2 net revenues. Geographically, the company saw weakness in Europe as both wholesale and revenues from digital channels declined. But strong performance in the Americas and Asia (excluding China) more than made up for the weakness in Europe. Overall, the company’s performance was so strong that the company reaffirmed its FY22 guidance.

Strengthening its Digital Business Without Undermining Brick-and-Mortar

One of the catalysts that should drive the company’s growth for the long-term is its adaptability and willingness to alter its business model to changing consumer preferences. This was evident from the management commentary during the Q2 earnings call when they outlined the company’s plans for strengthening its direct-to-consumer channel. More specifically, Levi Strauss, like Nike, is upgrading its Enterprise Resource Planning (ERP) system and plans to introduce the new ERP in the second quarter of FY23 in the U.S. Unlike the sneaker giant, however, it has already implemented the new system in other regions such as Mexico and Canada successfully, which should help it to make the necessary tweaks more effectively prior to launching it in the U.S.

The new ERP system and the subsequent growth of its Digital channel is a catalyst for the future. Where LEVI’s adaptability comes into play, however, is that it has not forgotten the present environment, which has seen a shift in consumer preferences from digital to brick-and-mortar. After witnessing a steady increase in brick-and-mortar sales coinciding with falling e-commerce sales, the company is now firmly focused on expanding its physical presence and plans to open 70+ doors on a net basis this year. Given that store traffic hasn’t gone back to pre-pandemic levels yet, the company sees further room to grow here and has adapted accordingly. Furthermore, there is the added benefit of securing property space at reduced rents given that it is one of the very few retailers who is focused on brick-and-mortar, thereby giving the company more bargaining power.

During the company’s Investor Day, the company did outline its plans of opening about 80+ doors, on a net basis, from FY23, which should further boost its brick and mortar sales and help it to scale its Direct-2-Consumer segment without having to overly rely on its Digital Channel. It is this ability to adapt that should help the company’s growth in the long term.

Wholesale Segment Continues to Deliver

Just because the company is focused on direct-to-consumer doesn’t mean that it has forgotten its wholesale segment. The company has already expanded its successful partnership with Target, where it sells its premium Red Tab jeans, and has also been deepening its ties with the likes of Kohl’s (KSS) and Macy’s (M) over the last two years. These partnerships have been more than fruitful, as evidenced from the 18% growth and improved profitability seen in Q2 for its wholesale segment.

And the good news is that LEVI’s wholesale segment looks set to further boost company’s revenues in the second half of FY22, especially in Europe, as evidenced from the strong pre-bookings seen from the wholesale retailers there.

Beyond Yoga: Levi Strauss Has Got This Right

There is no better proof to demonstrate that LEVI can diversify effectively than its acquisition of Beyond Yoga. The acquisition continues to show strong signs of growth and is providing an effective channel for diversification for LEVI as evidenced from the continued success of its dresses and Mommy & Me collection.

According to Statista, the yoga clothing market is expected to grow at a CAGR of 8.4%, to $39.91 billion by 2028. Beyond Yoga recently opened its first pop-up store at the Grove in Los Angeles and is on track to open its first permanent store in the fourth quarter of FY22. A combination of physical and digital presence should help the brand to capitalize on the booming yoga clothing market and should also help it to catch up with the likes of Lululemon. A stamp of approval from top celebrities like Jennifer Lopez and Gwyneth Paltrow doesn’t hurt, either.

Lack of Exposure to China is a Blessing in Disguise

Finally, unlike the likes of Nike, LEVI doesn’t have a huge exposure to China. The region represents only 3% of the company’s business, and this is expected to decline to 2% by the end of this year. The company is only just starting to build its e-commerce business there, and by the time it gets going in the region, issues such as the stringent COVID lockdowns should be a thing of the past.

The lack of exposure to the region may have benefited the company in Q2 as it was able to generate a sales growth of 21% YoY, on a constant currency basis, and an operating margin of 8.6% in Asia.

Valuation

Forward P/E Multiple Approach
Price Target	$28.15
2-year Historical Forward P/E Multiple	18.4x
Projected EPS over next 12 months	$1.53

So, overall, LEVI is a company that seems to have figured it all out and yet, the stock is down nearly 33% YTD and is down nearly 6% in the last one month. Therefore, is it worth investing?

The company is still expected to earn between $1.50 and $1.56 for FY22. Given the continued outperformance of the company and having earned $0.75 till date on an adjusted basis, I am assuming that the company will earn $1.53 over the next 12 months. Here’s how I arrive at the estimate:

1. I assume that the company earns $1.53 for FY22, the midpoint of $1.50 and $1.56. This implies that the company earns $0.78 for the next six months.
2. Given the current macro environment and the increased probability of a slowdown, I assume that earnings will not grow year-over-year in Q1 and Q2 of FY23. This implies that combined earnings for Q1 and Q2 of FY23 will once again be $0.75. Therefore, projected earnings for the next 12 months are $1.53.

The company currently trades at a forward P/E of 10x, which is significantly lower compared to its peers (Lululemon and Nike trade at a forward P/E multiple of nearly 29x, according to Refinitiv). On the basis of its consistent performance, LEVI is a stock that should easily be trading at least at its historical forward P/E multiple of 18.4x.

Based on this multiple, this stock should be trading at a little over $28, which represents an upside of approximately 67% to the closing price on Monday 11th July 2022.

Risk Factors

The company’s results are affected negatively by a strong U.S. dollar. The U.S. Dollar index is up 12% YTD and is currently trading at 106 levels according to Refinitiv. With the Fed continuing to hike rates at a pace last seen in 1994, don’t be surprised if the dollar continues its upward trajectory, which would be a major risk factor for LEVI. The company is already expecting a 100 to 150 bps headwind on revenue on account of FX and China. Don’t be surprised if those figures get worse as the year progresses.

Next, there is the supply chain issue that is plaguing every retail company, resulting in inventory build-up. LEVI is no different. Inventories jumped 29% in Q2, with 20% of it comprising of products in transit.

Finally, there’s the issue of increasing raw material prices. The company had to lock in the commodity prices at the higher end for the first half of FY23, which will have a detrimental impact on its future profits. While commodity prices are starting to decline, the impact of this decline won’t be seen at least until the second half of FY23 at the minimum.

Concluding Thoughts

I love Levi Strauss the company! In my opinion, this company has done a fantastic job navigating the hostile macro environment and is building the foundations for future growth without sacrificing its existing strengths. From a valuation standpoint, the stock has been heavily oversold. Although the macro environment is expected to be treacherous for retail stocks in the coming months, it should not overshadow what this company has achieved to the extent that it has. Its ability to consistently adapt and diversify makes it a winner even during these tough times. So, if you like the company’s jeans, nothing should stop you from liking its stock too!