Description

Levi Strauss & Co (LEVI)

Ticker: LEVI

Price: $15.55

Market Cap: $6.1B

Price Target: $13.00

Overview

Levi Strauss & Co. only recently became public in 2019, and since its IPO, the world has been in a global pandemic making it difficult to judge the company’s financial performance. While the stock underperformed the S&P500 in 2020 and 2021, it did appreciate in absolute terms. We believe that the next several months will prove to be very challenging for the company as it laps tough comps in 1H23, is pressured by margin headwinds, and at the mercy of a rapidly decelerating consumer. Thus, we think a near-term short position is justified.

Description

Levi Strauss & Co. is an American clothing company, known for its popular denim and apparel. Last year, the company did about $6B in revenue with 53% coming from the Americas with the other 43% split amongst international markets. Its business model has changed over the last few years and now offers an omnichannel experience for its customers as well as a differentiated apparel assortment.

LEVI has been able to successfully offer consumers both fashionable and quality products for over 100 years. As a result, it has retained its number one spot in denim market share for many years.

Business 

Levi’s is a global jeans wholesaler and retailer but has more recently branched out into adjacent apparel categories over the last several years. As of FY21, bottoms accounted for 75% of sales while 20% came from tops and the remainder coming from footwear and accessories. Approximately 53% of their revenue comes from the Americas, while 27% of sales comes from Europe, 15% from Asia, and the remainder coming from other brands and ventures. While the company operates under several different brands, the Levi’s brand accounts for 87% of sales, with the rest split between Signature, Denizen, Dockers, and recently acquired Beyond Yoga. As of FY21, it sold 64% of its merchandise through wholesale and 36% through DTC. However, like several other large brands, it is shifting more sales into its DTC channel.

Its DTC segment is broken down into brick & mortar stores and an e-commerce business. As of last year, LEVI’s 1,100 company-operated stores accounted for about 70% of DTC sales, while the remainder came from its e-commerce business. In its most recent Investor Day, management noted that they expect the DTC channel to be the primary driver of growth and account for over half of company revenues by 2027. The shift from wholesale allows the company to showcase the fullest expression of its brands, have complete control on merchandising, and own the connection with the customer. Additionally, company-operated stores have a high-teens ROIC. Despite its plans to focus more on DTC, the company is not fully abandoning its wholesale channel. LEVI plans to continue its evolution of the channel, meaning they will optimize their partners to ensure the best margin and brand alignment. While the company is margin focused in the long-term, we believe this strategy will harm them in the near- and medium-term as it sacrifices distribution and likely brand awareness.  

As of 2021, the global denim market was a $91B category with it expected to grow to $121B by 2026, representing a 5.3% 5yr CAGR. While LEVI has only been public for three years, the name has long been synonymous with the denim category. Since 2012, LEVI has held a commanding number one share position in the global denim market, almost 3x its next largest competitor. Although the global denim market contracted slightly since 2012, top market share positions became more concentrated. During this period, LEVI gained 60bps of share, far less than any of its competitors.

We compare LEVI to RL, PVH, and KTB. While each company is slightly different, they are all ultimately wholesalers/retailers that play in the apparel space. The graphic below shows some key operating metrics for the four companies as of 2019. We chose to use 2019 as a benchmark due to the impacts COVID had on the industry in 2020 and 2021.

While we believe that LEVI has the best brand equity, its financial profile is not as strong as some of its competitors. It has the second lowest margins, both gross and EBIT. At its most recent analyst day, management conveyed their intent to double down on initiatives laid out during its 2019 IPO roadshow. They mentioned that they are going to increase DTC sales and optimize their wholesale exposure, meaning greater emphasis on premiumization and less on off-price and lower priced outlets, which over time, will increase the company’s gross margin. However, this transition will give its brands a more premium price, likely alienating the lower to middle income consumer – a key demographic for the company. LEVI has also been investing in operational and digital programs that will help transform the cost structure. Although the incremental investments are long-term focused, they have caused numerous problems in the near-term – the most detrimental one being an abnormally large increase in inventory. The company is currently implementing an ERP system into its warehouses and that along with the current supply chain environment has caused the company to have an elevated inventory position.

Lastly, management also raised its long-term revenue growth outlook. At the IPO, their long-term algorithm was for topline to grow at a +4-6% CAGR from 2022 to 2027, but given their momentum and strategic initiatives, they raised it to a +6-8% CAGR in the same period. We believe that it was inappropriate for the company to raise its medium-term algorithm amidst an environment in which the consumer is slowing and promotions are rising. The company already had to cut its guidance once (Q3 earnings call) and demand is likely to slow even further. The immediate future looks pressured from both a cost and demand standpoint so we think the stock will underperform over the next several months.

Investment Thesis

Like many of its competitors and the overall consumer discretionary space, LEVI has had a very volatile few years due to COVID. In 2021, revenue grew nearly 30% YoY but ended the year approximately flat to 2019. This year its is poised to finish the year with +MSD to +HSD topline growth, relatively in-line with its new long-term algorithm. The first half of this year benefitted from easier comps, government stimulus and a more confident consumer – it should not be looked at as a normal run-rate. The first half of next year will prove to be very challenging as we believe that the company will experience depressed topline numbers and face numerous cost pressures, thus creating downside to the current price.

The macro environment has been very unpredictable since February, when Russia invaded Ukraine. The picture became even more complex when the Fed started to raise rates to cool inflation. Regardless of one’s macroeconomic view, it is evident via Bank of America Credit card data, that spending levels have slowed significantly since earlier in the year. In May, total card spending, according to BofA, was +6% YoY, compared to +1.7% YoY in November. Furthermore, as the macro conditions continue, if not worsen, we believe that spending will continue to decelerate next year.

As a result of the deteriorating macro environment, the retail industry has also suffered. Most recently, the JWN CEO noted that the demand build in Q4 (holiday period) has been slower than they anticipated, and the promotional landscape has worsened compared to what they had initially expected. In September, the CFO of Kohl’s called out softening denim trends. Similarly, AEO, on their conference call called out weaker denim trends as consumers were shifting into non-denim bottoms. In early December, VFC negatively pre-announced earnings and noted that it was experiencing “weaker than anticipated consumer demand across its categories, primarily in North America, which is resulting in a more elevated than expected promotional environment as well as order cancellations in the wholesale channel.” Recall that wholesale makes up 64% of LEVI revenue and North America is 53% of sales and about a 33% of consolidated EBIT. While the company doesn’t specify the exposure to North America wholesale, it is significant to the overall picture. 

Current discretionary spending trends in Europe are very similar to those in the US. Spending trends have been deteriorating and as a result, the apparel category is greatly impacted. Europe is LEVI’s second largest geographic exposure, with 27% of sales and 25% of EBIT coming from the region. On their Q3 earnings call, management cut guidance due to the “significant incremental currency headwinds from the strong US Dollar” and to reflect “a more cautious outlook for North America and Europe due to macroeconomic conditions and ongoing supply chain disruptions.” Although they haven’t yet reported F4Q22 earnings (November-end), investors have turned their attention to 2023 guidance. We believe that management will have to guide below the Street as these conditions will continue to pressure earnings into 2023.

In 1H23, LEVI will be lapping very strong topline comps (+22% in 1Q and +15% in 2Q). Last year, retailers were restocking so they had outsized topline growth (a lot of pricing was embedded) and in 1H23, you will have a destocking impact. As a result, the likelihood of the company going from above-trend to trend sales is unlikely in this environment and will therefore experience below-trend sales. Due to a combination of the tough laps, volatile macro environment, decelerating consumer demand and a more promotional retail landscape, we believe that LEVI will report negative MSD% topline growth YoY in 1Q23 and 2Q23. Not only will they have topline problems, but also LEVI will experience pressure on the gross profit line.

LEVI’s headwinds in 1H23 include an increase in COGS and elevated inventory levels. In a meeting with management, Harmit Singh (CFO) noted that the company was purchasing cotton at $1.30 per pound, essentially the peak in cotton prices earlier this year. As a result, the majority of their inventory that they will have to sell through will come at a margin dilutive price. This is before the fact that they may have to mark it down due to the promotional landscape.

LEVI ended Q3 with +43% inventory growth YoY, significantly higher than their average growth (in-line with sales) and also higher than Q2 (+29%). With elevated inventory levels and a slowing demand environment, the company will likely need to mark down products to move them to return to a more normalized inventory state.

With the combination of a tough macroeconomic environment heading into next year, decelerating global spending trends, slowing consumer demand, and company-specific headwinds in 1H23, we believe LEVI will underperform over the next six months.

Valuation

In terms of the stock, the valuation has contracted over the last 24 months. While some of this is due to the broader market sell-off, some of it is also due to the fundamental framing. The stock is currently trading at 7.4x FY24 EBITDA, well off its peak multiple of 13.5x in May 2021. On a P/E basis, the stock is trading at 11.0x FY24 earnings, down from its peak of 22.5x earnings in May of 2021. We have valued LEVI using an equal-weight combination of P/E and EV/EBITDA valuations. We use an EV/EBITDA multiple of 6.5x and a P/E multiple of 10.5x to get a price target of $13, about 17% downside from current levels. However, due to its number one market share position, better brand health and revenue growth profile, we believe that LEVI should trade at a slight premium to competitors such as RL and PVH. While the stock (and general apparel industry) has underperformed over the last few weeks, our price target implies there is further downside in the near- to medium-term as margin and demand headwinds continue to pressure the fundamentals over the next several months.

Catalyst

Catalysts
· Macy’s or other wholesaler negatively pre-announces Q4 sales
· Negative commentary regarding retail sales at ICR conference (early January)

Risks
· Positive commentary regarding retail sales at ICR conference (early January)
· Pre-announcements regarding strong European sales trends