2023-06-07 22:39:34 ET
Summary
- Kontoor Brands, Inc. is a lifestyle apparel company that specializes in designing, producing denim, apparel, footwear, and accessories.
- Revenue has declined at a 2% annual rate, as the company has been unable to drive a material increase in interest.
- Margins are attractive but are slipping due to inflation and increased discounting.
- The coming 12-18 months look tough, as demand will continue to decline in our view.
- With Kontoor trading at a justifiable discount to its peers, we rate it a hold.
Investment thesis
Our current investment thesis is:
- Kontoor Brands, Inc. ( KTB ) is highly reliant on the Wrangler brand, which primarily deals in Denim. This leaves the company highly exposed to changing trends if Denim falls out of fashion.
- Revenue growth is poor and although there are avenues to improve this, execution risk remains.
- Margins are contracting due to current economic conditions.
- Kontoor's Q1 performance was poor, suggesting FY23 will be a tough year.
Company description
Kontoor Brands, Inc. is a lifestyle apparel company that specializes in designing, producing denim, apparel, footwear, and accessories. Its main brands are Wrangler and Lee, known for their quality denim products. The company also licenses and sells apparel under the Rock & Republic brand.
Kontoor is a spin-off from V.F. Corporation ( VFC ), a stock we have covered here .
Share price
KTB stock share price has traded sideways since listing, which is a reflection of the poor timing. The company was immediately impacted by the Covid-19 pandemic, the subsequent increase in demand post-lockdowns, and inflationary conditions.
Financial analysis
Kontoor financials (Tikr Terminal)
Presented above is Kontoor's financial performance.
Revenue
Revenue has declined by an annual rate of 2% across the last 6 years, reflecting what has been a difficult period for the business, with Management's priority being to deliver consistent returns.
The majority of Kontoor's revenue is from the Wrangler brand, which comprised 63% of revenue in Q1'23. A further 36% is from Lee. The fashion industry can change very quickly and we generally see trends and tastes develop over time, this creates a big risk for companies reliant on one or two brands. For this reason, Kontoor faces significant risks around remaining socially and culturally relevant. This is heightened as both Wrangler and Lee are denim brands.
According to Google Trends, Wrangler has maintained a strong level of popularity across the last 2 decades, with increased interest in the last 5-10 years.
This looks to be driven by an effective social media campaign, with Wrangler focusing on its core demographic to develop recurring sales and association with the culture. This is our preference for an effective marketing strategy as many retailers attempt to widen their reach too far, leading to ineffective conversion due to the lack of relatability. Further, if the company is good at what it does, it positively contributes to the wider public perception of the designs. A great example of this is Streetwear. Led by brands such as Stussy, Bape, and Supreme, the designs remained authentically Streetwear despite the level of interest, with no attempt to appeal to the masses. Over time, consumers developed an interest in Streetwear, making it one of the largest subgenres in fashion. The people came to Streetwear, not the other way around. Wrangler's DNA is American Denim with its Social media activities heavily reflecting this. There has been a noticeable increase in Denim interest on social media, which Wrangler is positioned well to tap into.
E-commerce has emerged as a dominant trend in the retail industry, driven by the widespread use of the internet and mobile devices in the last decade. This has forced many brands to adapt their current operations to focus on improving their market presence online. Although we like Wrangler's approach to social media, we are concerned with the company's level of reach. Levi ( LEVI ) for example has 8.6m Instagram followers whereas Wrangler has 0.8m. The market is substantially larger than what Wrangler is currently reaching.
Direct-to-consumer ((DTC)) is a trend impacting the fashion industry and represents an opportunity for Kontoor. This is due to the social media and e-commerce developments in recent years. It is far easier for brands to directly engage with consumers, which allows them to encourage direct purchases. Brands no longer rely solely on retailers to generate sales for them. DTC is preferable as it cuts out the "middleman", increasing sales and margins. This is one of Management's strategic initiatives, with DTC currently representing c.10% of sales (Q1'23).
Further, Kontoor is generating 25% of its revenues in international markets, with the vast majority in the US. This is a reflection of the company's core demographic, given its Americana style. This represents an opportunity from Kontoor as brands such as Ralph Lauren ( RL ) and Tommy Hilfiger have shown that the American style can be exported globally.
Although we consider DTC and internationalization to be key growth opportunities, we are disappointed by Kontoor's penetration so far. The company is highly reliant on wholesaling in the US, which leaves the business susceptible to margin contraction and overstocking.
Economic considerations
Current economic conditions represent a key risk for the business. With heightened inflation, consumers are reducing discretionary spending where possible as a means of protecting their finances. This is contributing to a slowdown in retail spending, especially when considering volume.
Our expectation is for inflation to remain elevated for most of the year, before returning to a normalized level in 2024. For this reason, we expect Kontoor to struggle in the coming 12-24 months, as softer retail spending contributes to greater competition.
Q1 results
Kontoor performance Q1 (Kontoor)
Presented above is Kontoor's most recent quarterly results.
Kontoor had a poor quarter. Revenue declined (2)%, with GPM down 180bps compared to the prior year.
The decline in revenue is a reflection of economic conditions in our view, as consumers reduce spending. The company is also partially impacted by the impact of Covid-19 in China, which should subside in the coming quarter.
Margin contraction is expected in our view. During periods of slowing demand, we generally see greater discounting and price competition from peers. Further, the company is facing inflationary pressures in its supply chain. The concern here is that we do not believe Kontoor will easily win the margin back.
Much of the underperformance is driven by Lee. Wrangler's revenue grew 3%, with profits down (6)%. Whereas Lee experienced a (9)% decline in revenue and a (24)% decline in profitability. This suggests investors are potentially buying a 1 brand company, with everything else unattractive. Despite the weak conditions, the Lee brand's performance is extremely disappointing and disproportionately bad compared to its peers.
Margin
Kontoor's LTM GPM is 43%, EBITDA-M is 15%, and NIM is 9%.
The company has seen volatility in margins during the historical period, which is a reflection of its inability to achieve consistent growth and reliance on wholesale sales.
On an absolute basis, our view is that the margins are quite good. The company has little noise, which allows for EBITDA profits to translate through to NI.
Our concern, however, remains the continued risk of dilution in the coming quarters, which Kontoor may be unable to win back.
Balance sheet
Kontoor's inventory turnover has declined to 2.8x, and its CCC cycle has increased to 122 days in the LTM period. This suggests the slowdown in revenue was not wholly forecast by Management, contributing to an accumulation of stock. The risk here is that Kontoor begins discounting further in order to move stock in the coming year. This is the reason for the negative FCF despite the strong LTM profitability.
Kontoor is conservatively financed, with a ND/EBITDA ratio of 2x. For this reason, we are not concerned with solvency.
Distributions to shareholders have come in the form of both buybacks and dividends, with Management expending the majority of cash. Using FY22 FCF as a proxy, we would expect distributions to fall in the coming year.
Outlook
Kontoor (Tikr Terminal)
Presented above is Wall Street's consensus view on the coming 5 years.
Kontoor is expected to grow at a mild 2% p.a., reflecting difficult trading conditions for the business and no evidence to suggest outperformance is possible. This looks reasonable as nothing the business has done suggests a superior level is possible.
Margins are expected to remain flat, which currently looks racy in our view. We believe another 2 quarters of marginal dilution is possible due to discounting and inflation, which would suggest FY23 comes in under.
Valuation
Valuation (Tikr Terminal)
Kontoor is currently trading at 7.2x its NTM EBITDA. This is a discount to other US Brand retailers such as VFC and Levi.
Our view is that Kontoor is justifiably trading at a discount to these brands:
- Highly reliant on Wrangler, which despite being a quality brand, leaves Kontoor exposed to changing fashion trends.
- Lack of DTC and international penetration.
- Margin contraction risk which brings Kontoor in line with, if not below, its peers.
- Weak revenue growth.
Final thoughts
Wrangler looks to be a strong brand that can consistently maintain its cultural relevance over an extended period of time. Unfortunately, this is the only positive we see. One key concern is that Kontoor is reliant on Wrangler, faces margin risk, and requires a significant transformation process to make it more attractive (increased DTC, international expansion, etc.), with execution uncertain. Our view is that investors are better off with other businesses if they are seeking exposure to retail.
For further details see:
Kontoor Brands: Concentration And Margin Risk