2023-03-23 05:18:13 ET
Summary
- Uncertain economic conditions and a shift to services spending may revenue stall growth in 2023.
- The company has its highest cash requirements in 2023.
- Even flat sales growth in 2023 may help improve operating cash flow, given that the inventory has peaked.
- The company's dividend is safe for now.
- Investors can consider selling cash-secured puts with a $13 strike to generate income and acquire Levi Strauss at a reasonable valuation.
Levi Strauss ( LEVI ) showed strong growth in 2022, but the growth tailwinds may be fading. The company faces an uphill task of increasing sales in a challenging retail and apparel market. Although the company's inventory has peaked, it must sell those products quickly to generate good cash flows. The company faces one of its highest cash requirements in 2023, so it must generate good operating cash flow to relieve pressure on financing requirements. The dividend should be safe in 2023, especially if operating cash flows return closer to its pre-pandemic year of 2019. The stock is richly valued compared to its peers, so investors may look to acquire Levi Strauss at a 10x valuation.
Stalling revenue growth in 2023
Overall Levi Strauss had a successful 2022, in which revenues grew by 7% y/y compared to 2021. But, quarterly y/y revenue growth slowed as 2022 progressed and turned negative in Q4, declining by 6%. The company saw strong growth in its direct-to-consumer business in the U.S. and Asia, but closing stores in Russia hurt sales. The company's wholesale business dragged its total sales, declining by 8% y/y in Q4.
The company saw quarterly y/y revenue growth of 21.9, 15.2%, and 1.3% in Q1, Q2, and Q3 2022, respectively. The trend is unmistakable; Levi's change may come under further pressure as consumer savings dwindle, they shift to spending more on services, interest rates increase, and inflation eats away at purchasing power. FY 2023 guidance calls for a 1.5% to 3% revenue growth.
The company has excellent gross margins, averaging 53.3% over the past decade (Exhibit 1) . It has managed to increase its gross margins from 49.2% in 20213 to 57.5% in 2022, an incredible feat. Its 2022 annual gross margins are among the highest the company has seen. Since the May 2020 quarter, gross margins have averaged 56.6% and touched a high of 59.4% in Q1 2022 (Exhibit 2) . But, since then, the margins have declined to 55.8% in Q4. These are still excellent gross margins, but investors should watch them closely for signs of stabilization in the coming quarters. Ignoring the negative operating margins during the May 2020 quarter as an outlier due to the pandemic-driven lockdowns and slump in sales, operating margins have averaged 11.2% since then.
Exhibit 1:
Exhibit 2:
Inventory build-up leads to reduced operating cash flow.
Inventory increased by 9.8% y/y in 2021 and 57.7% in 2022. The company had 198 days' worth of sales in its inventory, compared to its average of 125 days over the past decade (Exhibit 3) . The standard deviation is 31. So, Levi's current inventory level is two standard deviations above its mean, a very high number. The company's CFO, Harmit Singh, pointed out that some of the increase in inventory was due to stocking up for the ERP transition they were implementing to better serve their direct consumer business. Harmit Singh pointed out that their old ERP system running on SAP was more geared towards serving their wholesale business. They needed a real-time view of inventory for their direct-to-consumer business, and they decided to use a cloud-based ERP system.
Exhibit 3:
In my Garmin article , I pointed out the high inventory levels at that company. Not all inventories or products are created equal. In Garmin's case, its consumer electronics products may have a shorter shelf life than the longer shelf life of Levi's apparel. Harmit Singh pointed out that the company can sell its products over multiple seasons. Garmin's shorter shelf life could lead to heavy discounting, margin erosion, and decreased cash flows. From Levi's perspective, its inventory may have peaked, which is good news for its operating cash flows.
Since 2021 was a solid year with work-from-home and stimulus-driving sales, the company's profitability and cash flows may not be repeatable. The year preceding the pandemic's start, 2019, is a good reference year for comparison. In 2019, the company had $412 million in operating cash flows, with an operating cash flow margin of 7.1% (Exhibit 4) . The 2022 operating cash flow was 44% below 2019. In 2022, operating cash flow dropped to $228 million from $737 million in 2021, mainly due to an increase in its inventory. With inventories peaking, investors should see operating cash flows improve in 2023. Inflation and the strong dollar headwinds in 2022 are fading, hence providing tailwinds in 2023. Harmit Singh pointed out that the company is taking advantage of the lower cotton prices and locking it in for the second half of 2023.
Exhibit 4:
If inflation and the dollar headwinds are fading, the biggest unknown is the strength of the economy and the consumer. The banking crisis in the U.S. may hurt lending in the coming months curtailing capital expenditures and reducing employment. If unemployment jumps, a recession may take hold in the U.S. and hurt discretionary spending. The company's revenue growth may continue its decline in the first half of 2023. But, even with a weakening consumer and declining revenues, the company's cash flows can improve, given that its inventory has peaked.
The dividend is likely safe, but the company has high cash needs in 2023
The company paid $174 million in dividends in 2022 (Exhibit 4) . The company generated negative operating cash after accounting for CapEx and dividends. The company had $500 million in cash and short-term investments at the end of 2022. The company has a total debt of $996 million and has about $1.1 billion in material cash obligations, including debt and interest, in 2023 (Exhibit 5) . The company has the highest cash obligations this year. With the inventory build-up behind it, the company's operating cash flows should improve in 2023, bolstering its ability to maintain its dividend.
Exhibit 5:
Rich valuation compared to peers
The company is trading a forward GAAP PE of 12.1x. Comparable consumer discretionary companies such as PVH Corp ( PVH ) and Capri Holdings ( CPRI ) trade at 10.8x and 8.2x, respectively. V.F. Corporation ( VFC ) trades at a P.E. of 10.3x. Given the economic uncertainty, it may be best to value Levi Strauss close to PVH's and V. F. Corporation's valuation of 10x. The company is forecasting adjusted diluted EPS of $1.30 in 2023. A 10x P.E. would put the price at $13; the stock is trading at $16.50.
Surprisingly, the Vanguard Consumer Discretionary ETF ( VCR ) companies are trading at a PE of 20.9. Since Amazon ( AMZN ) and Tesla ( TSLA ) are its largest holding, with 70x and 49x, respectively, the ETF's P.E. is skewed towards this high end. Together, these two companies account for 30% of the portfolio. Apparel companies make up just 3.9% of the assets in this Vanguard ETF. This large concentration in just two stocks is one of the risks of investing in the Vanguard Consumer Discretionary ETF.
A discounted cash flow model estimates the equity value of $18 per share . A 10% discount rate puts the equity value at $11.40 per share . But this model assumes a low discount rate of 8%, but given the current risk-free rate, a discount rate of 10% may be more appropriate for the company.
Exhibit 6:
The company is projected to grow its revenue and cash flows at a low-single-digit pace. It also faces headwinds in 2023 which could pressure revenue growth and profits. Paying about 10x forward P.E. or at or below $13.50 per share may be appropriate. At that price, the dividend yield will also be above 3.5%.
Investors could sell a cash-secured put at a $13 strike price to acquire a stake in Levi Strauss. The April 21 expiry $13 strike price puts last traded for $0.10 with an open interest of 274 contracts, a good number of outstanding options. But, the put premium is 0.76%, which may be low. Less than a 1% options premium can be considered low. Investors could sell a put when the market's volatility increases, which may yield a higher premium.
Levi Strauss is an iconic American brand with timeless products. But apparel stocks have taken a beating in this market downturn, and uncertain economic conditions remain. Consumers have also shifted to spending less on goods and more on services, which may be another sign of weakness for apparel stocks. The stock price will have to be lower if Levi Strauss is valued in line with its peers. A cash-secured put option strategy may be a good way for investors to generate income and buy LEVI stock at a reasonable valuation.
For further details see:
Levi Strauss: Lower Valuation Required