WWW - Wolverine World Wide: Macro Factors Give Me Pause

2023-05-17 05:08:13 ET

Summary

• Wolverine World Wide is making strides in margins, inventory management, and its brand focus on growth.
• Shares have had a very strong start to 2023, and yet the valuation remains conservative on price/earnings and price/operating cash flow basis.
• However, the broad macro retail consumer spending trends are showing real weakness in the clothing and department store categories.

I used to the be the one in my family to hold the distance running crown, having done multiple half marathons from my late twenties into my mid-thirties, and generally improving my finishing time and fitness with each event. However, I have now been officially displaced by my younger sister, who qualified last year to run in this year's 127th Boston Marathon. She joyously did so last month, meeting her goal to finish in under four hours, have fun, and high-five as many kids along the running route as she could, and I am simultaneously proud and slightly jealous of her. I doubt I'll dethrone her in our friendly family competition, but I am trying to get back into half-marathon shape, and in fact participated in one earlier this month with a friend. What I found is that the shoes I wore didn't do me any favors - my left ankle is still a little sore as a result of a poor fit. For serious and semi-serious runners, having the proper shoe is probably the single most important decision, and for my sister, she ran Boston wearing Saucony Endoprhins, a choice also made by a handful of the most elite runners, though adidas ( ADDYY ) ( ADDDF ) and NIKE ( NKE ) clearly dominate this particular niche market for professional runners.

Saucony is one of multiple brands owned by Wolverine World Wide ( WWW ), which is primarily a footwear company selling products ranging from Caterpillar branded work boots to hiking shoe brand Merrell. In a choppy market since the start of the year, shares in Wolverine have outperformed some other general clothing and shoe brands, and appear to be navigating the current environment fairly well. First quarter results were released earlier this month, and the market reacted positively, and Wolverine's shares are clearly outperforming some peers since the start of the year.

With that relative outperformance, is the trend setting up to continue, or if you'll pardon the pun, will the metaphorical shoe drop and Wolverine's shares behave more like the others?

Looking at the chart, it is conceivable that in fact it already has dropped, with a sharp decline earlier this month that temporarily had the shares performing in-line with peers, but has quickly bounced back to be measurably ahead of athleisure brand Skechers ( SKX ) and the Weyco Group ( WEYS ) that focuses on men's dress shoe brands like Nunn Bush and Stacy Adams. Deckers Outdoor Corporation ( DECK ) may well be the most comparable company in terms of diversity of brands, with its lifestyle boots brand UGG and high-end running shoes Hoka, as well as a couple of others smaller names. Though clearly less direct in terms of competing head-on in the footwear space, I've included denim and clothing brands Levi ( LEVI ) as well as V. F. Corp. ( VFC ), which owns the shoe brand Vans, but also has outdoor-focused clothing brands like Dickies (for work) and North Face and Timberland. My rational is simply that from a consumer standpoint, shoes and other clothing items are generally categorized together, so I was interested to see if there was a correlation in share price returns, and clearly these two particular apparel providers are under performing the footwear segment generally (although in VF Corp's case, the share price is impacted heavily by a dividend cut while the company works out its own inventory problems). I've elected to leave out sporting heavy brands like NIKE, Under Armour ( UA ) and adidas due to their more narrow consumer focus, although the case could be made for including them.

Inventory Management and Working Capital Picture

The big story across retail for the last year or so has been about the mismatch between elevated inventory levels and cooling demand, a condition that could stretch to the end of 2023. In the case of Wolverine, the inflated inventory relative to peers has not been detrimental to the share price, but does set the stage for thinking about the potential that margin pressures erode the company's ability to generate free cash flow in the near to medium term. CEO Brendan Hoffman addressed it first thing in the Q4 investor call back in February; literally the third sentence of his prepared remarks is simply "Our gross margin performance in the quarter was impacted by our efforts to more swiftly clear inventory to position the Company for improved performance in the year ahead." In other words, this has been top of mind for several months now, and he knew it needed to be addressed first thing back then. With Q1 results for 2023 now announced, there is some clarity emerging around the inventory and margin trends.

Although there is still work to be done in cleaning up inventory as retailer partners work out what they have on hand, the signs are pointing in the right direction. Sequentially in Q1, inventory declined by $19 million to $726 million total, an additional 2.5% decline in inventory compared to year-end 2022 (not including $11 million in the "held for sale" category, presumably Sperry branded inventory and leather). Guidance for the end of 2023 is towards inventory levels to end at $225 million less than year-end 2022, so the expectation is to see those comps really accelerate in the coming quarters, which may keep some pressure on margins through the end of the year. Brendan Hoffman, Wolverine's CEO, took several questions on inventory on the Q1 earnings call, including the final question from a UBS analyst on pockets of softness in being able to get those levels back to a normalized status. Mr. Hoffman's response to that question in particular stated:

On the inventory side, I'd say in terms of where we're a little heavier on inventory, it's in the areas where the business has been the softest. So with Sperry, we have a little more inventory in that business than we would like. But overall, we're working through the inventory right on schedule. Our inventories at the end of the third quarter will actually be down over 30% year-over-year. And so obviously, much different than what we expect our growth rates to be, but obviously working off of elevated inventory. So that's the progress that we're seeing as we -- not only as we sell through the core inventory that we own today, work through the end-of-life inventory, but we've obviously adjusted our supply chain and the inflow of new product on core merchandise in the back half of the year to get the inventories rightsized by the end of the year.

However, for Q1 gross margin was 39.4%, versus the extreme low in Q4 of 2022 of 33.7%, and returning to being in line with the gross margins historically around ~40%, and 2023 guidance for gross margin is for continued improvement, up to 42%. This is an optimistic sign that working capital concerns are nearly over along with its correlated spillover into pressuring margins.

Outlook

Wolverine is going through some significant changes by offloading some of its assets, having completed the outright sale of the Keds brand to Designer Brands ( DBI ) in February this year, along with licensing of the Hush Puppies brands, and still is seeking buyers for its leathers business. Furthermore, the Sperry brand (think boat shoes, loafers, and sandals) has been identified as a non-core asset and the company is looking for ways to exit this brand as well. Essentially, Wolverine is choosing to focus on its best drivers, which are found in its Active Group and Work Group reporting segments, which include active brands like Saucony athletic shoes, Merrell hiking shoes, Sweaty Beaty active wear, and work brands like Wolverine and Caterpillar boots, and a few others.

The Lifestyle Group is Sperry, Hush Puppies and Keds, all brands the company is de-emphasizing or unloading, while the "other" category captures leathers and some licensing revenue. Management's outlook takes those variables into account, with their specific assumptions being based on full divestment of Keds and the Hush Puppies licensing, and further excludes the leathers business. Any proceeds from a sale of Sperry will be used to pay down debt, according to management, with a year-end 2023 debt leverage ratio of 2x.

With those caveats in place, management is guiding for 2023 revenue midpoint from ongoing business of $2.55 billion, versus $2.68 billion total achieved in 2022, with about 55% of revenue recognized in the third and fourth quarters. Q2 is expected to present some challenges, with revenue coming in fairly light at $580 million, versus $718 million in Q2 a year ago and $599 million in Q1. However, with a leaner and more focused portfolio of brands that are performing at a higher level, especially Merrell and Saucony. The low end of the range for adjusted EPS is $1.40, exceeding the $1.37 achieved in 2022. Between earnings growth, debt reduction, and slowly but steadily improving inventory levels, the relative outlook is positive, although it could be clouded by the potential of consumer spending slowdown should there be a significant recession.

The management willingness to focus its energy on its best assets is a good sign, both in recognizing where its own strengths lie and in strategically moving now to make the needed changes. The "Active Group" reporting segment is not only the largest segment, but also holds the best growth potential, with Saucony and Merrell in particular achieving solid growth in Q1 (21% and 18% respectively versus prior year), while Sweaty Betty declined in sales, though less than anticipated.

Valuation

The shoe business can be considered a pretty mature sector, although disruption has made waves with the likes of Zappos.com twenty year ago selling shoes online, Under Armour with its massive growth into a sportswear power house, and more recently Allbirds ( BIRD ) with its sustainability angle. Generally speaking, though, any sustained double-digit percentage sales growth lies with the up-and-comers, not the established brands represented by Wolverine, so looking at valuation from the lens of price relative to earnings power and cash flow generation are reasonable metrics to apply.

Comparing Wolverine to its peers on P/Earnings, P/Operating Cash Flow, and dividend yield, reveals a valuation that is attractive.

An investor in Wolverine today is not facing a stretched valuation, although an investment in Levi's or Weyco could be equally appealing with a higher dividend. In spite of having a terrific run since the start of the year, there is some modest potential to continue going higher, although all of these could come under pressure if consumer discretionary spending drops severely as the year plays out.

The April 2023 retail sales estimates were released this morning, showing an overall increase in consumer retail spending of 1.6% compared to 2022. However, the specific trends in clothing and department stores is a different story, with year-over-year declines of 2.3% and 1.4% respectively. This trend could be concerning for investors expecting to see sales or earnings growth in a company like Wolverine.

Conclusion

Even though I like the overall valuation the market is giving to Wolverine relative to several of its peers, I am not personally taking a position due to having exposure to similar retail and consumer spending trends from other holdings in my portfolio, in my case Kontoor Brands ( KTB ) and Newell Brands (NWL). Broadly, I think the long-term downside risk is fairly minimal at these levels, and management is pulling the levers they have available to fix the inventory and keep the company on a growth path. However, looking out over the next 12 months, I think the clouds of recession appear to me to gathering more strength and the hoped for "soft landing" is more remote. Therefore, in spite of several positive aspects, I consider Wolverine a hold for the moment, based more on macroeconomic factors than on company specific fundamentals.

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