Summary
- Kontoor Brands has performed well fundamentally so far this year, but management has decided to reduce guidance for 2022.
- Despite that pain, shares have held up well in the current market environment and the future for the business looks promising.
- In all, this is still an attractive opportunity to pursue that should continue to deliver value for investors moving forward.
Although originally used to keep warm and to protect ourselves, clothing has, over time, evolved to also have a fashion component to it. Though perhaps not the most stylish, denim jeans have developed as a leading article of clothing. And one of the companies that has successfully built its business around the sale of these fashion products through its industry-leading Wrangler and Lee brands, is Kontoor Brands ( KTB ). Recently, fundamental performance for the company has been particularly robust. Even so, shares have taken a slight step back over the past few months. This is likely attributable to management's reduced guidance for the 2022 fiscal year. But given how cheap shares are currently, both on an absolute basis and relative to similar firms, investors should consider the enterprise a solid ‘buy’ opportunity at this moment.
An opportunity on market pessimism
Back in March of this year, I wrote a bullish article about Kontoor Brands. In that article, I called the company a favorable prospect given current industry conditions. I highlighted the two industry-leading brands that the company has, and I acknowledge that, while it did have a volatile operating history from a profitability perspective, recent performance had been promising. Shares were also priced at levels that many investors should consider favorable, but I did warn that investors should watch carefully just in case revenue starts to show signs of decline. At the end of the day, the low price of its shares and the recent fundamental performance of the business led me to rate the enterprise a ‘buy’, reflecting my belief that it would generally outperform the broader market for the foreseeable future. Since then, the company has outperformed the market, but it hasn't exactly performed exceptionally well. While the S&P 500 is down by 3.5%, shares of Kontoor Brands have pulled back just 1.7%.
Truth be told, if you had told me how the company would be behaving from a fundamental perspective now when I wrote about the firm in March, I would have thought that shares would have risen rather significantly. After all, sales growth for the business has been impressive. For the first half of the 2022 fiscal year, revenue came in at $1.29 billion. That represents an increase of 13.1% over the $1.14 billion generated the same time one year earlier. Growth for the company was particularly strong in the second quarter of the year, with revenue shooting up 25% from $490.8 million to $613.6 million. This rise in sales was driven by strong growth in the US Wholesale channel of the business. Revenue growth here was 44% year over year, primarily due to a shift in the timing of shipments from the second quarter to the first quarter of 2021 because of the firm’s ERP implementation in North America. However, it also said that it experienced growth in new business and saw nice upside associated with its digital wholesale operations. The performance of this particular segment is incredibly important since, at present, it accounts for roughly 77% of the firm's overall revenue.
This is not to say that everything has been great. In the latest quarter, the Non-US Wholesale operations of the company declined by 17% because of a shift in the timing of certain shipments and COVID-19 restrictions in China. Foreign currency fluctuations have also been a problem for the company. And when it comes to the Direct-to-Consumer operations of the company, sales globally decreased by 6% in the latest quarter because of a decline in retail store sales and a 3% impact associated with foreign currency fluctuations. One small bright spot here was the US side of e-commerce operations. Unfortunately, management did not say how much growth that part of the enterprise experienced.
The increase in revenue for the company has also brought with it strong profitability. Net income in the first half of the year came out to $142.8 million. That's significantly higher than the $88.1 million generated the same time last year. Just as was the case with revenue, much of this was driven by strength in the second quarter of the year, with net income of $62 million dwarfing the $23.6 million generated in the second quarter of 2021. So far this year, operating cash flow has declined, falling from $120.2 million to $99.4 million. This came in spite of the fact that operating cash flow in the second quarter totaled $24.6 million, which was up from the $1.8 million seen one year earlier. But if we adjust for changes in working capital, the metric would have risen from $133.1 million to $179.2 million, driven by a rise from $44.9 million to $77.6 million in the second quarter alone. Over that same window of time, we also saw some improvement in EBITDA, with that metric climbing from $193.8 million in the first half of last year to $212.9 million the same time this year. As with the other profitability metrics, this one also benefited from strength in the second quarter, where the metric jumped from $67 million to $95 million.
it is worth noting the reasons for this increase in profits. Yes, higher sales contributed to this. But there were other factors involved as well. The company's selling, general, and administrative expenses fell from 34.9% of revenue in the first half of last year to 29% this year thanks to the decreased costs associated with the company’s global ERP implementation and information technology infrastructure buildout. In the first six months of last year, that accounted for 4.3% of the company's revenue. Lower compensation-related costs were also a factor, some of which were offset by increased distribution expenses and other related factors. Some of the cost improvements for the company were also offset by higher costs of goods sold, driven by higher air freight expenses associated with expedited shipments that were required in order to meet demand and because of unfavorable geographic mix impacts. Strategic pricing did help to mitigate this to some degree.
Normally, I would imagine that the strength the company has seen this year would help to push shares up higher. Having said that, there was one negative for investors to digest. Because of current market conditions, management has decided to reduce their guidance for the 2022 fiscal year. Previously, they were forecasting revenue growth of 10%. But because of weakness expected for the second half of this year, with sales forecasted to be flat year over year, revenue growth should be a more modest 6%. Earnings per share have also been revised lower, from between $4.75 and $4.85 to between $4.40 and $4.50. Of course, this did not stop the company from buying back nearly 1.5 million shares for a combined $62.5 million so far this year. But I digress. Given the implied earnings per share expected for this year, the company should generate net income of roughly $253.7 million. If we assume that the year-over-year change for net income will be representative of the change in adjusted operating cash flow and EBITDA, then we should anticipate those metrics coming in at $368.2 million and $502.2 million, respectively.
Based on these figures, the company is trading at a forward price to earnings multiple of 8.5. This is down from the 11.1 reading we get using 2021 results. The price to adjusted operating cash flow multiple should decline from 7.6 to 5.9, while the EV to EBITDA multiple for the company should drop from 7.3 to 5.6. As you can see in the chart above, these trading multiples are also lower than when I last wrote about the business. As part of my analysis, I also compared the company to five similar firms. On a price-to-earnings basis, these companies ranged between a low of 5.2 and a high of 14.8. Two of the five companies were cheaper than Kontoor Brands. Using the price to operating cash flow approach, the range was between 5.5 and 14. And when it comes to the EV to EBITDA approach, the range was between 3.9 and 9. In both of these scenarios, only one of the five companies was cheaper than our prospect.
Company | Price / Earnings | Price / Operating Cash Flow | EV / EBITDA |
Kontoor Brands | 8.5 | 5.9 | 5.6 |
Canada Goose Holdings ( GOOS ) | 14.8 | 10.1 | 9.0 |
Capri Holdings Limited ( CPRI ) | 7.6 | 5.5 | 7.8 |
Oxford Industries ( OXM ) | 11.6 | 10.1 | 7.3 |
Carter's ( CRI ) | 11.2 | 14.0 | 8.1 |
G-III Apparel ( GIII ) | 5.2 | 7.2 | 3.9 |
Takeaway
Truth be told, I remain confused as to why shares of Kontoor Brands are as cheap as they are. Yes, the company has had a rocky operating history from a profitability perspective. And yes, the firm is forecasting weaker results this year than they previously anticipated. But outside of that, fundamentals remain robust and shares are trading at attractive levels both on a relative basis and on an absolute basis. In all, I expect the firm to continue to outperform the broader market and I do believe that attractive upside is still on the table. And as a result, I have decided to retain my ‘buy’ rating on the firm.
For further details see:
Kontoor Brands: Still An Attractive Play In Clothing