V.F. Corporation: Tailwinds Ahead Make It A Contrarian Investment Opportunity (NYSE:VFC)

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Investment Thesis

I currently view V.F. Corporation (NYSE:VFC) as a contrarian opportunity with the potential for significant upside and an outsized yield opportunity for investors willing to be involved in the retail space going into a widely expected economic downturn. I believe at my entry point of $26 there is significant price appreciation potential. I also strongly believe the board of directors will prioritize paying the outsized dividend allowing VF Corp to maintain its Dividend King status while the company rebuilds the balance sheet.

Company Overview

VF Corp is a global apparel and footwear company founded in 1899. The company owns a portfolio of popular brands, including The North Face, Vans, Timberland, Supreme and Dickies. It operates in more than 125 countries worldwide, with over 35,000 employees. At the time of this writing, VF Corp reported 1,300 company-run retail locations.

The main street consensus about VFC seems to be that of a broken company, with declining earnings per share, sporadic sales growth, and a negative cash-flow margin over the last 12 months. Looking at the challenges facing VF Corp may lead you to ask why I feel there are current opportunities in the stock.

The answer, my friend, is blowing in the wind – the tailwinds. The tailwinds of a company set to benefit from what I believe, the end of a difficult CEO run (which saw the stock price decline -34.28% over his 7-year tenure), the end of China’s zero COVID Zero policy, favorably warm weather in Europe, and an inventory glut in core products that will begin to be worked off in 2023.

Management Changes

VFC named Steve Rendle as CEO and Chairman of the Board in 2017. Mr. Rendle’s time as CEO led to two major brand transactions which didn’t work out as planned. The first was the $2 billion purchase of the streetwear brand Supreme. The second was a divestiture of the occupational portion of its workwear segment. The occupational workwear brands were sold to a subsidiary of Redwood Capital Investments. The sale included work apparel brands Red Kap, VF Solutions, Bulwark, Workrite, Walls, Terra, Kodiak, Work Authority and Horace Small. Interestingly, the divestiture deal did not include VF workwear brands Dickies or Timberland PRO.

In my view, the divestiture of the 9 workwear brands to Redwood Capital Investments was almost certainly related to the excess funding needed to cover the poorly timed purchase of Supreme. This segment of the business had been making meaningful contributions to VFC’s growth prior to the sale. In the fourth-quarter of fiscal year 2021, revenues at the workwear segment had improved 23% year over year (up 20% in constant currency) to $259.5 million.

It’s easy to understand why an ambitious CEO like Mr. Rendle fell in love with owning Supreme. As someone who worked with major apparel labels (adidas, Reebok, Converse, Mitchell and Ness, & ’47) and advised major apparel retailers for 2 decades, I know that for some brands the allure of gaining an access to ‘cool’ can be intoxicating. If you look at Q1-2021 (April-June) performance, Supreme’s contribution to VF’s results included $145.7 million in sales, $88.8 million in gross profit, and an operating income of $31.7 million – not a bad quarter’s work. The problem was these numbers were never going to be sustainable because the very act of a corporate company like VF purchasing Supreme changed the way the Supreme brand was viewed by the culture that had supported it. By the Q2 of FY23 (reported in Oct of 2022), VFC had taken a $422 million write-down at Supreme.

It’s clear in retrospect – and it should have been clear at the time – that over-paying to gain access to scarcity-based streetwear brand, while selling a profitable segment that fit into the manufacturing cycle of core remaining workwear brands like Dickies and Timberland was a mistake. The good news for VFC investors may be that Steve Rendle is out and, at least for the time being, Benno Dorer, former CEO of Clorox (CLX), is in. VFC would be expected to comment further on the status of their CEO position in their February 7, 2023 conference call. In the meantime, Mr. Dorer is the perfect steady hand to right the VFC ship. I believe replacing the growth-at-all-costs mindset of Mr. Rendle with a more cost-conscious CEO is the first of many tailwinds setting up for VF in the coming years.

Additional Tailwinds

I see two additional tailwind opportunities for VF in the next 12 months: a rise in European discretionary spending and the release of pent-up consumer demand in China.

When you add these potentially P/E expanding tailwinds to a new cost-focused CEO at the helm I can’t help but look at VFC as a contrarian buying opportunity, even with a difficult macro environment.

Europe

While the Vans brand was down 11% (Q2 2023 earnings) in the US, all of VFC’s brands increased 10%+ in EMEA (Europe, the Middle East, and Africa), led by Vans. The EMEA increases came in spite of a “deterioration in consumer confidence and the corresponding impact to traffic levels.”

Consumer confidence in Europe has been significantly impacted by the war in Ukraine as well as the expectation of surging energy costs throughout the winter, related to the war. However, unusually warm temperatures have helped keep energy costs under control and left the European consumer with stronger household savings than was expected. This is shown below in the flattening of the household savings trend line heading into the winter season.

The European consumer having excess spending capacity is certainly a tailwind for the discretionary brands of VFC.

China

China in many ways could be viewed as a bright spot in Q2 FY 2023, as stated by management in the earnings presentation.

“The performance in Greater China improved to down 10% in the quarter, in contrast to down 30% in Q1.”

Obviously down 10% YOY in a major cash-driving region isn’t the ideal situation. VFC significantly under-executed in China during the COVID lockdowns, and listening to the Q2 2023 earnings call made it pretty clear that the company didn’t have the solutions necessary to overcome these government-imposed challenges. This tailwind is a bit of luck, China decided to end its zero COVID policy, releasing VFC from the necessity to create an operational solution for this region. Asia as a whole is an incredible growth driver for VFC with the rest of Asia (excluding China) growing 30% during Q2 2023. To add to this, VFC will have ultra-soft YOY comparisons in the region, which could also benefit from China’s post-COVID pent up spending demand. I view the end of China’s zero COVID policy as a major tailwind for VFC in 2023 that is being grossly overlooked.

Inventory

One last tailwind note, and this is a bit of detail that was more or less hidden in the Q2 2023 conference call. In an attempt to “right-size” the inventory Mr. Rendle’s team significantly overbought core (evergreen) products in an attempt to never miss a sale in the Van’s and Dickies U.S. market. Unfortunately, this supply chain shortage over-correction happened in-step with a slowdown in the US economy. The excess inventory landed as North America’s economic slowdown began accelerating wholesale order cancellations, causing inventory to pile up. While this isn’t ideal, it can work out if the economic winds in North America change. On the Dickies side, the product glut is related to Walmart (WMT) purchase orders. With core inflation cooling in the United States, and food prices easing, we can look for the US consumer to once again return to more discretionary goods.

Matt Puckett, Executive Vice President and Chief Financial Officer, commented on this business segment with Walmart during the Q2 2023 Fiscal quarter.

We also know is that inside the business and inside even that retailer, our brand continues to perform on the floor better than the competitive set. So as that business goes away pretty quickly at times when they pull back on inventory, they can shut the brakes pretty quickly. At the same time, they can hit the gas pretty quickly as well.

As Matt stated a major North American retailer like Walmart hitting the gas on core (and now overly stocked) goods could easily add to the 2023-2024 tailwinds. One further note here, it’s been widely reported (including on Seeking Alpha) that the inventory is up 88% YOY. This is inaccurate, in my view. The inventory represented on the balance sheet has increased by 88% compared to last year, but this included an accounting shift of $510 million in in-transit inventories due to a supply chain financing program VFC entered into in 2022. Without this shift in accounting, the inventories have risen by 58% over 2021, which was a historically low inventory year due to supply chain shortages. When excluding the in-transit inventories and comparing to pre-pandemic Q2 of 2020, gross inventories have increased by 35%.

I don’t love the current inventory position at VFC as I believe it is at least 35% higher than it should be, but companies like Nike (NKE) had similar inventory gluts that were swiftly corrected in 2022. Nike’s management significantly outexecuted VFC’s management in 2022 having already taken steps to decrease their forward inventory supply in the back half of the year. By decreasing their inventory purchases for the second half of 2022 and prioritizing inventory management in the marketplace, Nike is about one year ahead of most retail brands in the space. VFC will likely have a longer and most steeply discounted promotional environment as they look to play catch up the industry-leading Nike.

Dividend

The final consideration for me around VF Corp is their current massive dividend yield, which was at 7.18% at the time of this writing. This is not a technical review of VF Corp, but there are obvious issues that need to be worked through before the company can return to its profitable ways. Re-adjusted earnings per share for the full year are expected to now range from $2.00 to $2.20, down 14% from $2.40 to $2.50 in prior forecasts. This earnings range places the dividend payout ratio at around 100%, and this is well above VF’s target of 50%. The February conference call will shed important light on how committed the company is going to be to their Dividend King status. I’m betting the board will heavily prioritize the dividend using the more than $500 million of cash on hand and over $800 million of remaining borrowing capacity under its credit facilities to cover any short-term cash flow deficit.

Valuation Thoughts and Peer Comparison

My investment thesis for VFC sees a significant medium- to long-term opportunity. I expect nearly a 30% price appreciation from my entry point of $26 (in December of 2022) over the next 2-3 years. This is a fairly conservative estimate using a multiple expansion more towards historical norms. VFC has risen from its 52-week lows but still only trades at 13.6 times earnings, well below the 5-year historical P/E of 23. Using the most conservative current earnings estimate of $1.94 and a historically low but closer to average 5-year P/E of 19, VFC’s stock price should expand towards $36.86, which is a very conservative but sizable 29.3% increase on top of the massive quarterly dividend payments.

Expanding upon the valuation opportunity, VFC currently trades at a price to sales ratio just below 1 (at my entry point of $26, this ratio was at 0.86). In comparison, Nike trades at a P/S of just over 4 and the industry average is 3.64. The last time VFC’s P/S was below 1 was in 2010.

Price to book value is a similar story, with VFC significantly off its 2020 high of 9.88 and half of where it was at the start of 2022, currently sitting at 3.84.

Gross margins for VFC have been relatively flat since 2018 resting between 51% and 54%. In comparison, Nike’s gross margins have been between 43% and 46% during that same timeframe. In contrast to Nike, VFC’s net margins were significantly compressed in 2022, falling from just over 12% to just over 3.5% in their latest quarterly report. This was a reflection of the more promotional retail environment and over-hiring during the pandemic. In August of 2022 VFC reduced its workforce by 600 office based employees (or 1.7% of the total workforce). It will admittedly take more than a 1.7% workforce adjustment for the net margins to recover. This is why I view Benno Dorer as the perfect man for the leadership role at VFC. His time running the Clorox brand in the commoditized cleaning products space gives him great experience with leveraging established brands and cost controls as levers for driving shareholder value.

I’m more than happy to collect the oversized dividend while I wait for new management to better leverage their umbrella of brands into the awaiting tailwinds of a stronger-than-expected European consumer, pent-up consumer demand in China, and the return to VF’s largest North American wholesale account buying on-hand core goods.

In Conclusion

VFC hasn’t been firing on all cylinders as of late, and that has been reflected in the 12-month share price tumbling from $69.48 to the high $20s where it sits today. It’s never ideal when a CEO suddenly retires the Monday after an earnings call, your inventory is up 35% and your macro environment is devolving into a recession, but I believe these risks are baked into the current share price. The market punished VFC for its poorly timed decisions in 2022, but I view a more conservative CEO, the opening of China, and the potential for stronger-than-expected sales in Europe as underappreciated tailwinds over the next 12-16 months. These tailwinds will have the added benefit of weak YOY comparisons. I also see the excess of core Dickies and Vans inventories in the US being cleared out quickly, once demand returns to normal levels. Over the next few years, VFC’s profits should return to normal, and easily cover the dividend with a healthy margin of safety, while building free cash flow back onto the balance sheet.

There are plenty of challenges that VFC needs to overcome in the next several years, but I believe the market has priced these risks into the stock price. If I wasn’t already invested in VFC I would use any weakness after the February 2023 earnings report as a potential entry point into VFC.