Description

In March of 2019, Levi’s went public after 166 years as a private company. On roughly $5.7bn of 2019E sales (+5% y/y constant currency) the company will generate $300mm in free cash with EBIT margins of around 11%. Levi’s has less than half a turn of net debt (2.3x lease adjusted) on 414mm fully diluted shares and trades on a forward free cash flow yield of about five percent (10.9x ‘19E EBITDA). The stand-alone Levi's valuation story here is just OK, but Levi's stated that the creation of an acquisition currency was a key reason for the IPO. Coincidentally, this year, Kontoor Brands (KTB), which sells Wrangler and Lee Jeans, spun out of VF group. KTB is slightly less than half the size of Levi's, both by TEV and by revenue.

The top line at KTB $2.5bn ($1.5bn Wrangler, $900mm Lee, $100mm Rock Republic and VF outlet sales), EBITDA is roughly $350mm and TEV is $3.25bn (9.3x ‘19E EBITDA). EBIT margins are about the same 10-11% at both companies, though Kontoor has seen top line declines from the closure of US retailers, while Levi’s has maintained overall growth.

Bondo119’s five-star 2008 report on the Levi Strauss 8.625% Bonds explains the financial resilience of the core Levi’s franchise, and CNBCs engaging primer on the company https://www.youtube.com/watch?v=Z54JcslYQ_o walks the viewer from 1853 to IPO. Please take a look at both before continuing - they are pretty good. Like other national brands, Levi’s can resist pricing pressure from both online and brick and mortar retailers.

Levi’s pays a about a third of its free cash in dividends (~$110mm in ‘19E) and has an A/B voting class structure. There are about 47mm A shares and 346mm B shares, for a total of 393 million basic shares outstanding. In the IPO, they sold 15mm Class A shares at $17 for net proceeds of $235mm.  The B shares, held primarily by descendants of Levi Strauss (i.e. the Hass family), have 10 votes per share vs 1 vote for the Class A.  So, the Hass family controls the vote by a wide margin. The IPO lockup expires March 17^th, 2020. For the most recent company data see the presentation from this month’s non-deal roadshow: https://s23.q4cdn.com/172692177/files/doc_presentations/2019/12/Europe-IR-Deck-FINAL.pdf.

Aside from a recession, the bear case is that the company cannot continue to grow in the face of the closure of retailers that account for roughly half of US wholesale revenue (i.e. 15% of total company of sales).  Although the other half of US wholesale revenue does actually grow, it grows too slowly to offset the effect of retail store closures. For a sense of scale, Levi’s forecasts 300-500 third-party retailer door closures this year (matching the trailing 3-year average).

The wholesale channel accounts for 64% of sales and the direct to consumer channel (online and company store) accounts for the other 36%. Europe and Asia combine for roughly 48% of sales, and the US 52%. Europe (+15% YTD) and Asia (+13% YTD) are both rapidly growing. 87% of overall company sales are of Levi’s branded products.

From a regional perspective Levi’s believes they can open a sufficient number of direct to consumer stores to generate positive growth in the US market, where, again, third party retail closures are pressuring Wholesale revenue. In contrast, Kontoor brands has been struggling with its US wholesale revenue, but without the benefits of Levi’s branded stores, constant currency sales there were down 8% y/y last quarter.

The bear case has some problems.  First, if 15% of global sales decline 20% per year that would be a 3% point drag, at 30% per year that would be a 4.5% point drag; noticeable but hardly determinant. 15% of $5.7bn in sales translates to $855mm of exposure to US wholesale retail closures. Second, US wholesale revenue at 30% of total company sales is actually down from 40% four years ago while the top line has expanded in constant currency terms in each of those years (’15 +1.2%, ’16 +3.1%, ’17 +7%, ’18 +12.7%). As an aside, Levi’s total sales declined -1.4% and -2.9% in ’08 and ‘09, respectively, including 3-5% declines in Americas. Third, in the final analysis people still want to buy Levi’s in the US, the company faces an operational challenge to recreate shelf space – not a decline in organic demand.

Surprisingly, only 5% of total company sales are through the website, 10% including online partner sites. Perhaps people like to try on their jeans before buying, thereby limiting online as a percentage of total sales.  Though even by the company’s own reckoning today, they could be doing more with their online channel. Recall that online and company store (including franchise) sales account for 36% of total company sales. That means 26% of sales relate to company stores.

If 26% of sales are via company stores then $5.7bn x 26% = $1.428bn / 3,000 stores ~ $500k/year in sales per store. This calculation ignores the difference between larger stand-alone retail and smaller footprint shops-in-shops. Levi’s has 3,000 brand dedicated stores including shops-in-shops in some of their 50,000 retail locations spread across 110 countries. Of the 3,000 brand dedicated stores 888 are company operated standalone and 500 are company operated shops-in-shops, implying ~1,600 franchise stores. The company operated standalone stores are spread across 32 countries 1/3 Americas, 1/3 Europe and 1/3 Asia, approximately.

Thanks to improved data analytics, the Levi’s believes it can cut the footprint of new stores from 6-7k sqft to 2-4k and better focus the merchandising mix to local tastes. I am not a retail expert, but it occurred to me that if Levi bought KTB and used newly found square footage in Levi’s existing retail stores, this might stem the sales decline at KTB and perhaps lead to growth. Again, I am not a retail expert, but I buy Levi’s only, to the exclusion of Wrangler and Lee, and would simply walk past the other brands if they were in the same store (i.e. limited cannibalization of Levi’s sales from consumers like me).

M&A

In a bear case, Levi’s could overpay, botch the integration, find no revenue synergies and cannibalize Levi’s sales. Worse yet, this would amplify exposure to the, previously manageable, declining US wholesale segment. In the end, one would have to have a view on the compatibility of the big three jeans brands in the same footprint – though arguably that experiment has already been conducted in certain department stores over the years that may have carried all three brands on the same menswear floor. See the link for more from an FIT professor on the Levis, Wrangler, Lee “trinity” https://www.forbes.com/sites/pamdanziger/2018/08/18/vf-spinoff-means-return-of-the-denim-jean-triumvirate-wrangler-lee-levis/#54d162a91d44.

In the bull case, Levi’s could begin putting Wrangler and Lee through their 888 company operated stores (and ~1,600 franchises) and also stop KTB from spending approximately $90mm on a new ERP system. If Levi’s has figured out how to optimize their company operated stores so that their products only take up 1/3 the previously required square footage (as they claim), perhaps that frees up remaining space to offer Wrangler and Lee.

In an all stock deal, the combined company would have roughly $8.2bn in sales, $1.1bn of EBITDA (ex-synergies) and $1bn of Net Debt equivalent to another turn of Net Debt on the pro-forma Levi’s balance sheet. VF only has about 70 outlet stores, so any lease adjustment to the leverage ratio would be comparatively minor.

Using round numbers (roughly right rather than precisely wrong), if Levi’s has 400mm fully diluted shares outstanding at $20 and KTB has 60mm fully diluted shares out at $40, then to get to a 15% premium Levi’s would have to pay $46 and issue 138mm shares. A $46 take out price x 60mm shares = $2.76bn and $2.76bn/$20 per Levi’s share implies 138mm shares required. Then 138mm shares / 400mm existing Levi’s shares would further imply about 34.5% dilution that would need to be offset for the deal to be breakeven from a GAAP earnings perspective (insofar as that may be a relevant standard).

Said differently, a six dollar per share premium today implies $360mm of value that would need to be offset in economic terms to justify the deal, or about 4% of combined company sales. 4% of combined company sales is not an outrageously high figure for expected merger cost savings, setting aside the potential revenue synergies from putting Wrangler and Lee into Levi’s stores.

Overall, I like Levi’s here as storied franchise trading around fair value with limited leverage. As US retail gets turned upside down, Levi’s appears equipped to make sure customers maintain access to their products. In addition, there is a decent rationale for an all stock M&A of a competitor that is not managing the shift in the retail channel very well. After 166 years, it’s time to get long.

Catalyst

IPO lockup ends March 17^th, 2020