The Apparel industry has seen dire developments throughout the COVID-19 pandemic, and some operators within it have yet to come back to business activity levels reflecting those pre-pandemic. "Business is still slow overall. Customers have not yet picked up orders at pre-pandemic levels." this is what the respondents said about the apparel industry in the latest ISM manufacturing report on business, along with clocking in a contraction for March 2023. V.F. (NSYE: VFC)
It has seen the worst of these trends as the company deals with declining sales and excess inventory within its Vans brand segment, despite many positives still present, allowing for upside potential in the stock.
As many retail apparel operators like Ralph Lauren (NYSE: RL) and Lululemon Athletica (NASDAQ: LULU) have come to find out, the inventory levels that are currently being held by the average firm in the industry coupled with slowing consumer demand amid rising interest rates and fears of an economic recession, are driving the supply-demand dynamics on a negative tilt for retailers and wholesalers alike.
Management across different apparel firms has pointed to the shared pain experienced in the sector. Excess inventory and not enough demand are prompting marketing departments to push for inventory write-downs in the form of discounts and other liquidation sales to get working capital, well, working and investor hunger fed via healthier cash flows and renewed dividends.
Inventory Problems at VFC
The COVID-19 pandemic had a notable blow to be dealt for the Vans 'off the wall' brand, as sales declined significantly and inventory was stuck in the woodwork waiting to be marked down like the rest or even liquidated to other wholesalers. The Chinese consumer represents nearly 6-8% of the revenue for the firm, and the nation's aggressive COVID lockdowns only brought further declines to VFC's top-line figures. For the year 2022, The Vans brand delivered -13% revenue declines to its parent company, a brand that currently represents over a third of total revenue.
Markets did not take the news well, and further accentuated their bearish view toward the stock by beating it down to levels not seen since 2010-2012. It starts to become irrational for investors to think that the company is trading at the same price it was back when it had not owned faster-growing names like The North Face or Supreme, nor when it had divested slow-performing brands like Kodiak, Terra, and Work Authority.
One of the main concerns for analysts and investors in VFC is the current inventory levels. This excess can magnify discounts and write down effects adversely affecting future sales and margins. For example, in 2022, VFC reported earnings per share of $3.53; however, that same year reported free cash flow per share of only $1.58. The discrepancy between the net income driving earnings per share and the level of free cash flow (operating cash flows minus capital expenditures) can be attributed to inventory levels as USD 381 million in inventory value was written down to USD 357 million, or a 6% write down for starters.
Hidden Value, Reasonable Entry
Li Lu famously generated a monstrous multi-bagger return in Timberland stock before VFC acquired it. Lu's reasoning behind acquiring the company came down to its low price-to-book ratio and, ultimately, what that "book" was made of. So while Lu paid 1.3x book value for the individual apparel company, investors today can pick up VFC's portfolio of brands like (including Timberland) Vans, The North Face, Supreme, and Dickie's for a reported 2.5x book value.
If investors normalize the retained earnings of the company, whereby the total value of inventory can be taken rather than the discounted value, and debt levels normalize back to 40% of the balance sheet rather than the current pandemic-induced level of 64.6%, book value per share rises to $10. This adjustment thus brings the price to book value to a current 2.15x.
While this multiple is still higher than what Lu paid for Timberland back in his day, modern-day investors need to account for what today's "book" contains, and that is a pre-pandemic six-year compounded average growth rate (CAGR) of 17% and a projected 5% CAGR up to 2027, a 3% reduction in outstanding shares through the pandemic and a current dividend yield of 8.4% sustained to encourage investors to bet on management's ability to turn the Vans brand situation around and rectify the inventory issues faced today. Furthermore, this book is behind a company that generated 17.8% returns on invested capital pre-pandemic and is now back to 13.9% post-pandemic despite its inventory and global sales challenges.
Analysts agree with management cases, as they have assigned a near 48% upside target from current prices. In addition, the stock is trading at almost decade-lows and is the cheaper alternative in its peer group with a five-year average price to free cash flow multiple of 9.7x.