2023-05-29 23:15:15 ET
Summary
- I believe the sharp overreaction to the company's margin contractions is a good opportunity to get in for the long term.
- The company’s “DTC First” initiative will be successful in the long run, which will increase margins in my opinion.
- The company has very solid financials that showed a very good bounce back since the '20 bottom.
- Even with what I believe to be conservative assumptions, the company is a good buy at these levels for the long-term investor.
Investment Thesis
With a huge drop in Levi Strauss & Co.'s (LEVI) share price after reporting Q1 , I believe that it was an overreaction to temporary gross margin contraction. I argue that Levi Strauss' strategy to prioritize its direct-to-consumer initiatives, opening up of China and strong sales outside the US will cushion the slowdown in demand in the main region. Temporary contractions of gross margins will improve in the next couple of quarters, and with what I believe to be conservative estimates, the company is attractive at these levels; however, there may be further volatility due to macroeconomic headwinds in the next year or so.
Outlook
The company is trying to get away from third-party distributors and is committing to the direct-to-consumer direction. This business segment is the most promising to me that may be able to deliver higher returns in the long run than the company has seen in the past. It’s not like they will completely stop distributing their merchandise through third parties, it will complement it.
In the latest reported quarter, the company said that DTC saw very solid growth y-o-y of around 16% and they are prioritizing building out this revenue segment over the next while, by opening up more and more stores around the world and also by enhancing the customer experience through their e-commerce website.
Generally, DTC will have higher margins than selling through third-party distributors, so the more the company expands, the higher gross margins it will achieve.
The company opened up 25 new stores in Q1 , so they are well on their way to prioritizing DTC over the long term.
In the same transcript, the company saw massive growth in its loyalty membership, reaching almost 25m customers as it grew at almost 40% in Q1. That is an impressive growth that will certainly drive higher sales overall, if the discounts, offers, or other benefits are very good.
Even though Asia is not the biggest revenue generator for the company, it is worth noting that sales in Asia excluding China grew over 22% in the quarter. This is going to be quite a substantial revenue generator in the future in my opinion, especially now that China is starting to open back up, which should further drive higher sales in the region.
In summary, I believe focusing on DTC is a great way to improve profitability and efficiency, which will lead to sustainable growth. Coupled with the other catalysts for revenues like loyalty membership and strong growth in the Asian region, Levi's has a solid future ahead of it.
The company continues to gain market share and is the leader in the 18–30-year-old target group. Women's denim is also doing well according to the management and is closing in on the number one spot.
Financials
At the end of Q1 '23, the company had slightly less cash than it did at the end of FY22. It had $321m compared to $429m at the end of FY22. The company also has $994m in long-term debt. That is not an issue in my opinion, because the company's interest coverage ratio at the end of FY22 was over 25x, which means that EBIT can cover annual interest expense 25 times over.
We can see that in 2020, during the peak pandemic scare, the company had a lot of problems but managed to recover very quickly.
The company’s current ratio was also pretty solid at the end of FY22, although in the past it was slightly better. Nevertheless, the company has no liquidity problems as it can cover its short-term obligations with ease.
Looking at the company's efficiency and profitability metrics, we can see that it recovered very nicely since the pandemic and has resumed efficient and profitable operations once again, with a slight dip in the latest yearly performance, which is not an issue yet. The company can use its assets and shareholder's capital very efficiently and is creating value.
The company’s return on invested capital shows a very similar picture also, where it recovered very nicely since ’20, then a slight dip in FY22, which is not a concern as of yet. This number suggests that the company has a decent moat and a competitive advantage.
Overall, there is a lot to like about the balance sheet and the company’s solid performance in terms of profitability and efficiency.
In terms of margins, at the end of FY22, these remained relatively stable with a slight dip, however, now we know that due to an aggressive advertising campaign in Q1 ’23 to lighten inventory levels, gross margins saw over 300bps contraction . This will not last long and I’m sure it will regain margins in the near future.
I would expect to see similar margins in '24 and even better margins beyond that.
Valuation
I approach all my valuations with a conservative mindset. It’s better to be safe than sorry and I would like to get a better risk/reward profile if possible.
The company grew its sales by around 6% a year, and much higher if we exclude the fluke pandemic, which brought down revenues by a whopping 23%. After that, the company bounced back 29% the next year, like the pandemic never happened. It would have averaged around 9% since 2015, but with ’20 included, it went down to around 6%. For my base case, I decided to be even more conservative, and I went with a 4.75% CAGR for the next decade. For the optimistic case, I went with 8.55%, which is pretty optimistic in my opinion, but still achievable, while on the conservative side, I went with 2.75%.
In terms of margins, I believe the "DTC First" initiative will be successful, and the company will see margin expansions over the long run, however, I still went with conservative estimates here also.
For the base case, in the first two years, I contracted margins by 150bps, or 1.5%, because the management said they expect to see a 50bps contraction for the full year, so I just decided to be even more conservative. In the following years after '24, the margins will begin to improve and by '32 these will have improved by 200bps from FY22 figures.
For the optimistic case, every period is 75bps better than on the base, while on the conservative case, I left them as of FY22 margins.
On top of these assumptions, I will add a 25% margin of safety, which is the lowest I give to a company that has a solid balance sheet, which LEVI does in my opinion.
With that said, the company's intrinsic value with these conservative estimates is $14.67, meaning there is around a 9% upside from current valuations.
Closing Comments
The company seems to be very relevant even after 170 years of being in business. It sells some quality clothing and the 501s are an absolute classic that never goes out of style, which is also going to bring in around $800m in total revenue alone. What this calculation above means is that the company is attractive at these prices for long-term growth in my opinion. The big overreaction to the company's short-term contraction in margins presented a good opportunity for a long position, however, the macroeconomic sentiment isn't very favorable at the moment. Inflation is still very sticky. High labor and raw material costs will keep retailers' profits somewhat lower for the next while, which can present an even better opportunity in the next 6 months or so because of volatile markets and uncertainty.
So please, do your due diligence to see if you would like to open a long-term position now or if you would like to wait a little while longer, either way, I believe the company has good long-term prospects.
For further details see:
Levi: The Overreaction Presented A Good Opportunity For Long-Term Investors