Description

SUMMARY

Kontoor Brands currently offers a great opportunity to invest in a business with two global brands—Wrangler and Lee—at a very reasonable price. The business had languished under former parent VFC Corporation which had treated its highly and consistently profitable jeans business as a cash cow and underinvested in it. This resulted in both revenues and operating profits of the jeans business languishing over the last twenty-five years. Since KTB’s spinoff three years ago, the brands have been reinvigorated by an incentivized management, with clear improvements in performance and potentially years of continued improvement ahead. Trading at about 8.6x projected 2022 EPS, and paying a dividend yielding 4.5%, the stock appears compellingly cheap, and is likely to give us an annualized total return of more than 20% over the next three to five years, with little risk of permanent capital loss.

INVESTMENT THESIS

I previously wrote up Kontoor Brands on VIC in June 2019, just after it had been spun off by VFC. The price then was $30.75. In April 2021 I recommended exiting the position, when the price had roughly doubled, earning us a total return of about 110% (including dividends) in less than two years.

Enough has changed since then to warrant a new report.

Now I’m heading back to the trough, looking for seconds. In the 12 months since my exit recommendation in April last year, KTB’s stock price has dropped by more than a third while the fundamentals of the business have improved dramatically from pre-pandemic levels. (From its peak of $69 one year ago, the stock is down more than 40%.) Therefore, I once again recommend the purchase of Kontoor. Three years ago, I wrote, “. . . I believe that Kontoor at its current price represents excellent value, with the prospect of large capital gains, possibly more than 100%, over two or three years. While we wait for the price to appreciate, we will collect a hefty dividend . . .” The same words can be used today (though the dividend yield is now “only” 4.5% vs. 7.3% in mid-2019. The dividend was eliminated briefly in the early days of the pandemic, though it was subsequently reinstated at a lower level. More on this later). Having the stock double from current levels over the next two or three years is not hard to imagine.

If you’re still reading, I urge you to read my June 2019 writeup for background, much of which I won’t repeat here. [George Bernard Shaw: “I often quote myself. It adds spice to my conversation.” I don’t know if I could say the same for myself.] Also, do read the message thread that followed, and in particular puppyeh’s view, which is cynical of my conclusions. (Incidentally, I’m a fan of puppyeh’s work, and paid careful attention to his comments.) And while you’re at it, also read VIC member bdad’s recommendation to short KTB in May 2021. His timing was impeccable, almost perfectly catching the stock’s peak price.

Despite the views of these VIC members, I believe that KTB represents a very interesting opportunity today. I have no difficulty imagining 20% compounded returns over the next few years. Also, given the durability of the company’s two brands, their growth opportunities, the huge cash-flow generation, the relatively modest debt load, and the improving balance sheet, I think that the long-term downside risk is very limited.

Below is a chart showing KTB’s stock price movement from the time of the spinoff in 2019 to the present. Following a big downdraft in the early days of the pandemic, the price reached a high of $69 in mid-2021. The decline over the last year is probably because of supply chain concerns and worries about the impact of politics on their growing China business. [They have little exposure to Russia and Ukraine.]

FINANCIAL PERFORMANCE

With the 4Q 2021 earnings report in early March, management provided its outlook for 2022. Their projections are surprisingly strong and suggest that, despite the pandemic, the business has gained traction since the spinoff, with revenues set to increase to above 2019 pre-pandemic levels, and operating profits to be the highest since 2016, with indications of further increases to come. EPS in 2022 is projected to be between $4.65 and $4.75. Given the improvement in the business over the last three years, despite the pandemic, the stock seems remarkably cheap, trading at less than 9x 2022 EPS and at something like 8.0x projected 2023 EPS.

The table below shows the performance of the business since the spinoff in 2019. Sales and profitability dropped sharply during 2020, due to the pandemic, but the company was still very profitable using GAAP accounting and even more so using “adjusted” earnings. 2021 saw a strong recovery in the business. Management’s projections for 2022 are for sales of about $2.7 billion, the highest level since 2016, with operating margins (EBIT) at over 14%, higher than any year since 2017. At an analyst meeting a year ago, management projected that operating margins would exceed 15% by 2023, and EPS would exceed $5.00. My projections below for 2023 and 2024 assume 5% revenue increases in each of those years, and 15% EBIT margins. This results in EPS of $5.18 in 2023 and $5.57 in 2024, numbers that are not hard to believe. 

In the two tables below, we can see that, prior to the 2019 spinoff, VFC’s jeans business made operating margins of 16% - 19% in most years between 2010 and 2017. These numbers may have excluded some corporate overhead allocations of VFC, but suggest that further operating margin improvements, to perhaps 17%, are attainable. EBIT margins of 17% in 2024 (rather than the 15% I have above) would result in EPS of about $6.35 which could cause the stock price to exceed $100 two years from now.