Description

Overview:

During periods of market disruption and dislocation, we have found investing in companies with strong brands and franchises to be a profitable endeavor. One such company that fits the bill in today’s market environment is Levi Strauss & Co. (“LEVI,” or “the Company”). LEVI has an extremely strong brand that has stood the test of time, enduring through numerous recessions, world wars, a great depression and even prior pandemics. ValueGuy featured LEVI within this VIC forum in December 2019 shortly after the Company’s March 2019 IPO and that write-up is worth revisiting. However, there have been several significant developments over the past two years and we believe now is an opportune time to revisit LEVI. After reaching a post IPO high of ~$30.50 a share in 2021, LEVI’s shares have declined by nearly 45% over the past year.

Successful Turnaround:

The Levi’s brand has been revitalized under Chip Bergh, the Company’s current CEO who took the reins about 10 years ago. Before joining LEVI, Bergh was an executive at P&G, where he was instrumental in growing a number of notable brands in the company’s portfolio. Under CEO Bergh’s leadership, LEVI has experienced growth and improved profitability as the Company has bolstered its presence in faster-growing and higher margin categories and distribution channels. These higher margin areas include women’s, which has increased to 33% of overall revenues (vs. 15% as of FY 2015) and direct-to-consumer (DTC), which now accounts for 36% of overall revenues (vs. 22% in FY 2011). 

Margin Improvement:

Thanks in part to growth in the aforementioned areas, LEVI has experienced meaningful margin improvement. During FY 2021, LEVI’s adjusted operating margin expanded by 180bps basis points vs. FY 2019 (12.4% vs. 10.6%), surpassing the Company’s 12% target on an accelerated time frame. Although the margin improvement is impressive, further expansion is likely with LEVI recently communicating (at a June 2022 investor day) a new adjusted EBIT margin target of 15% by 2027. Additional profitability improvement is expected as its higher margin areas are expected to become a more meaningful component of the overall business. By 2027 women’s is expected to increase further and represent 42% of net  revenue (vs. 33% today), while continued growth in DTC (includes both revenue generated from the Company’s own online sites and stores) is expected to increase to 55% of net revenue (vs. 36% today). Although wholesale still accounts for 63% of net revenues, the business generates strong cash flow for the Company and its net revenues (as a % of overall net revenues) will likely continue to decline as the DTC business continues to expand. Moreover, LEVI has done a good job increasing its exposure to wholesalers where it commands premium price points (Nordstrom, Bloomingdale’s, etc.)  and/or are faster growing (Amazon, Target, etc.), which should also bode well for future margin expansion. It should be noted that LEVI has achieved this margin expansion despite elevated commodity and supply chain costs. LEVI has successfully pushed through price increases to help offset/more than offset these cost headwinds. As recently as mid-2021, management stated that it believed that it was still in the “early innings” of pricing.

Pandemic Beneficiary:

Although Levi’s sales were not immune from the impacts from the pandemic (net revenues surpassed 2019 levels beginning in 3Q FY 2021 and for the full year FY 2021), the crisis has produced a number of near and long-term benefits. In the near term, LEVI notes that approximately 40% of consumers changed waist sizes (both up and down) during the pandemic offering LEVI the opportunity to participate as consumers update their wardrobes. The pandemic also helped accelerate casualization trends and LEVI’s is positioned as a key beneficiary with denim outpacing the overall apparel industry in recent quarters. The women’s jeans category has experienced a shift toward looser/baggier fits in recent years (as has the men’s category), which LEVI believes is still in the early innings. Denim cycles trends tend to be multi-year, if not decades, in duration, with the last denim cycle for women (skinny jeans) having commenced over a decade ago. The transition also helps to drive sales of other LEVI products (tops, T-shirts, etc.). From a longer-term perspective, the pandemic prompted LEVI to reset its cost structure with the Company reducing approximately 15% of its corporate workforce, producing $100 million in annual cost savings. LEVI also accelerated its investment in technology and DTC initiatives, which should have favorable long-term financial impacts with DTC sales producing higher margins for the Company. LEVI company-operated ecommerce sales were just ~$100 million in 2015 (~3% of net revenue), are currently ~$500 million (~8% of net revenue), and are expected to reach $1.5 billion (~15%) by 2027. Meanwhile, LEVI’s expects to open ~400 new stores by 2027 with its store count rising to ~1,550 by 2027 vs. ~1,150 today. While the store expansion is not without its risks, management has noted it has been a good environment to be looking for new real estate locations. 

Growth Opportunities:

In addition the promising initiatives discussed above, LEVI has several other meaningful growth opportunities that should favorably impact its share in the coming years Including:

Beyond Yoga: In 2021, LEVI acquired Beyond Yoga, a fast growing athleisure brand, for ~$400 million. LEVI is not a very acquisitive Company, but the Beyond Yoga is one of the biggest it has ever made. The Beyond Yoga business is margin accretive to LEVI’s overall profitability and should enable the Company to participate in the large and rapidly growing athleisure/activewear category which is currently pegged as $50 billion-a-year global category (5x the size of the jeans market). Beyond Yoga should benefit from LEVI’s brand expertise, while its recent expansion into the men’s category has generated favorable initial response. 

Dockers: The Dockers brand has struggled in recent years, but there are early signs that the brand has been reinvigorated. LEVI recently reclassified Dockers in its Other Brands segment to give the business more independence (not sharing resources with Levi branded products) and an opportunity to continue grow again. After years of challenges, the business has experienced good revenue growth (up ~30% in the past two years) and the business is expected to generate annual net revenue growth in the mid-teens % through 2027 with expanding levels of profitability.

China: LEVI continues to remain underpenetrated in China relative to other branded retail businesses. China accounts for just ~2%-3% (Nike generates ~20% of its sales from China) of the Company’s sales, but management believes that the country represents a “huge” opportunity. LEVI has been closing unprofitable franchisee locations and moving toward a Company-operated footprint. During 2022, ~70% of sales are expected to come from DTC (the balance derived from franchise), which is the reverse of where the business was positioned in that country just 3 years ago. The timing of the opening of its flagship China store in Wuhan was not great (it opened in 2019 shortly before the pandemic), though LEVI noted in April 2021 that the store had returned to pre-pandemic revenue levels. Admittedly, China is not something that is going to move the needle in the near term, but could be viewed as an attractive long-term call option for LEVI investors. 

Improved Share Liquidity:

When LEVI came public in 2019, just ~11% of its shares were publicly traded with the majority of the balance held by descendants of Levi Strauss, the Company’s founder. However, due to selling by family members, ostensibly for diversification purposes, ~25% of the shares are now publicly traded. We would expect family members to continue selling their Class B (super-voting) shares (which convert to the lower vote A shares upon sale) in the coming years, increasing LEVI’s public market liquidity and enabling LEVI to attract a wider investor base that could translate into an expanding multiple. 

Strong Balance Sheet Provides Optionality:

LEVI maintains an extremely strong balance sheet with just $243 million in net debt including cash/cash equivalents of $777 million and long-term debt of $1 billion. Although many investors would prefer companies to optimize their balance sheets to pursue shareholder friendly initiatives (outsized buybacks, etc.) LEVI’s strong balance sheet helped it navigate the challenges of the pandemic extremely well even as a few peers (True Religion, Lucky Brand, etc.) filed for bankruptcy during the pandemic. As noted previously, LEVI’s strong financial position allowed it to accelerate investments in its DTC initiatives, which should bode well for future growth and profitability. Going forward, LEVI’s strong balance coupled with its improved operating results will result in an outsized amount of value returned to shareholders in the form of dividends and share repurchases. At its investor day earlier this month, management stated that it is targeting returning 55%-60% of its free cash flow to shareholders in the form of dividends and repurchases. The Company is targeting a dividend payout ratio of between 25% and 35% (dividends expected to increase in line with net income) and we note that the Company’s current dividend ($0.40 a share; 2.3% yield) is now above pre-pandemic levels. A new $750 million repurchase authorization (~11% of LEVI’s current market cap) was recently authorized as part of its plan to accelerate returns to shareholders. 

Valuation:

LEVI has an enterprise value of $7.3 billion. Considering the ~$1 billion in EBITDA the Company is expected to generate this year LEVI is trading at just 7.3x  on an EV/EBITDA basis. We view this as a deeply discounted valuation for a branded consumer apparel company. Precedent transactions of branded apparel companies have taken place at ~11x EBITDA. We believe that LEVI would command a meaningful premium to these transactions if it were to be acquired. Although LEVI is unlikely to be sold in the near term due to its large family ownership and the associated super-voting stock, we would not rule one out over a longer term basis especially as shares controlled by the founder’s descendants continue to be sold. 

Risks: 

Reduced consumer purchasing power due to inflation impacts and/or a recession appear to be the most significant risk on the horizon. However, we note that with an ~45% decline in the Company’s shares from 2021 all-time levels, much of these concerns may be more than priced into the Company’s shares, which are trading at just 7.3x on an EV/EBITDA basis.

Catalyst

• Continued profitability improvement

• Benefits of a new denim cycle (looser/baggier fits)

• Continued growth in higher margin areas (women’s, DTC, etc.)

• Beyond Yoga growth

• Acceleration of returns to shareholders (higher dividends and outsized buybacks)

• Improved public market liquidity due to share sales by Levi Strauss descendants