Why I Bought More V.F. Corp Following an Ugly 1st Quarter

The company was negatively impacted by Covid-19, but has several factors working in its favor

Sep 06, 2020

As we are all aware, the Covid-19 pandemic has caused havoc throughout the economy. Retail has been one of the hardest hit sectors as social distancing directives forced the closing of non-essential businesses worldwide.

This will obviously have a severe effect on a company's business performance. With lowered earnings per share, the traditional method of valuing stocks using the price-earnings ratio would likely produce a somewhat artificially high valuation.

One method I've been using to identify stocks that I believe to be undervalued is to compare the current dividend yield to the 10-year average yield. Stocks trading with a higher-than-usual yield could mean that the market is pricing the security too low.

Of course, this method of valuing stocks can only work if the dividend is safe from a cut.

One company that appears to have a safe dividend and offers a yield that is above its long-term average is V.F. Corp. (VFC, Financial). Shares of the world's largest publicly held apparel supplier have increased more than 50% from the March lows. However, the stock still offers a yield that is superior to the average yield that the stock has had over the last decade.

This indicates the stock could still have plenty left to offer shareholders, which is why I added to my position in V.F. on Friday at a price of $68.96. Let's look at why I thought now was a good time to buy the stock.

Quarterly highlights

V.F. reported first-quarter results for fiscal 2021 on July 31 (the company's fiscal year ends the Saturday closest to March 31). Results were ugly as this period covers April and May, which saw the height of the Covid-19-related store closings. Revenue declined 48% to $1.1 billion, which was $102 million more than Wall Street analysts had expected. Adjusted earnings per share was a negative 57 cents compared to 30 cents in the previous year, but was 11 cents higher than expected.

Results were rough pretty much everywhere. Breaking results down by segment, the Active segment was down 54%. The Vans brand was lower by 52%. Revenues for the Outdoor segment decreased 44%, with the North Face brand declining 45%. The Work segment held up the best, but still suffered a 19% drop in sales. Dickies slightly outperformed the segment as sales were down 16%.

International revenues were lower by 39%, led by a 48% decrease in Europe. Direct-to-consumer, which had been a source of strength for V.F. in recent quarters, was down 37%. Inventories ticked up 2% to $1.4 billion, but this is likely only a short-term issue.

Due to the pandemic, V.F. isn't giving guidance for the year, but sees sales as down less than 25% for the second quarter. This is vast improvement from the percentage decline in the most recent quarter.

According to Yahoo, the analyst community expects V.F to earn, on average, just $1.08 per share in fiscal 2021. This would be a 60% decline from fiscal 2020. Analysts do see a rebound in the next fiscal year as earnings per share is expected to reach $2.56, which is close to last year's figure. The closing of stores had a tremendous impact on results during the quarter and will for the fiscal year. Despite the challenging quarter, there are several reasons that I remain optimism about V.F.'s future.

Reasons for optimism

First, the company's physical locations began to reopen during the quarter. In North America, two-thirds of locations had reopened by the end of the quarter and approximately 75% of direct-to-consumer stores were once again open for business. While more than 120 retail stores had re-closed between the end of the first quarter and the earnings report, this was more than offset by reopenings in other locations. The vast majority of wholesale stores had also reopened.

In the Europe, Middle East and Africa region, all offices had opened outside of Russia and the United Kingdom. This region had more than 90% of direct-to-consumer stores operating as well. Every retail store in the Asia Pacific region have also been opened.

With so many stores no longer forced to be closed, it is likely that V.F. has seen the low point for sales for the year.

Though most regions saw a steep decline in business during the quarter, Greater China sales were flat. Not the most impressive accomplishment in a more normalized environment, but this should be considered a grand achievement given the circumstances.

Within this region, Mainland China had a 5% improvement in sales. The most recent quarter marks a return to growth for the company in China. For context, China sales were down 33% in the fourth quarter of fiscal 2020. V.F. has made this region a priority with investments that should pay off this fiscal year. The company expects mid-teen growth for China in the second quarter with full-year growth of more than 20%. Again, this would be an outstanding development if this growth were to materialize given the circumstances.

Another reason for my bullishness on the stock is V.F.'s digital business. This channel had 78% sales growth. In the fourth quarter of 2020, digital sales grew just 8%. For the first quarter of 2020, digital sales grew 25%. What this means is that V.F. saw an immense acceleration of digital sales both on a year-over-year and a sequential basis.

Driving this digital growth were 8 million new unique customer interactions with V.F. brands. Most of the company's top brands saw high levels of new customers. For example, The North Face had a 274% in new digital customers, while Dickies had more than 25% new customers. The Vans Family loyalty program swelled to 12 million members, who just happen to spend more than 35% on average versus non-members.

Customers couldn't shop at physical store locations, but they still sought out V.F.'s brands through e-commerce. This speaks to a high demand for products that should translate to higher sales once all physical locations have been reopened. This should allow the company to work off its inventory levels as well.

Of course, Covid-19 is an ongoing issue and could remain a factor, particularly in the U.S, but the reopening of most stores around the world, the company's growth in China and digital performance should reassure investors that V.F. is one of the top names in apparel.

Dividend analysis

V.F. is no stranger to succeeding in a difficult business environment and has performed admirably during several recessions. The company's earnings per share fell just 6 cents, or 4.4%, from 2007 to 2009. The company rebounded the next year to make a new earnings per share high, something it has largely done over the decade since.

All the while, V.F. continued to raise its dividend. According to the Dividend Investing Resource Center, the company's dividend has survived four separate recessions and the dividend growth streak stands at 47 years.

The company has increased its dividend by an average of:

9.7% per year over the past three years.
12.8% per year over the past five years.
13% per year over the past 10 years.

The dividend did decrease for the payment made in September of last year, but that was due to the spinoff of the company's jeans businesses into Kontoor Brands Inc (KTB, Financial). V.F. raised its dividend in the fourth quarter of 2019, as it customarily does.

Future performance is by no means guaranteed, but looking at the company's balance sheet and cash flows should offer some comfort to income investors.

V.F. ended the most recent quarter with $12.5 billion in total assets, including almost $2.9 billion of cash and equivalents, against current liabilities of $1.7 billion, which includes just $20 million of current debt. The company also has $2.23 billion remaining on its revolving credit facility. This gives the company a total of more than $5 billion in available liquidity.

The company was cash flow negative during the quarter, which means it has to borrow or use its cash balance to distribute dividends. This isn't as big of a short-term problem as it sounds. V.F. paid out almost $187 million of dividends in the quarter, a slight uptick from the previous quarter. Assuming no share dilution, this would put the company on pace to distribute nearly $750 million of dividends for the fiscal year, on par with fiscal 2020. V.F. has suspended share buybacks so the total might increase somewhat, but it won't be an extravagant amount.

It would be unwise to do so, but the company could fund the dividend using just its cash and credit facility for almost seven years if it wanted to do so.

The company might have to use its cash balance to pay this quarter's dividend, but that could very well be the end of this situation as V.F. Corp expects free cash flow to be at least $600 million for the year. The astute reader will decipher that this free cash flow estimate would cover more than three-quarters of possible distributed dividends, meaning that V.F. Corp's dividend is likely safe.

Valuation analysis

V.F. trades with a forward price-earnings ratio of more than 64, which is an unsustainable valuation. Of course, this is because of depressed earnings expectations.

As stated previously, using the current dividend yield compared to the historical average can be a solid substitute for valuing stocks in situations such as this.

Using the annualized dividend of $1.92 and my purchase price, V.F. has a yield of $2.8%. Shares have averaged a dividend yield of 2.3% over the last decade. There are just two years during this period of time that saw a higher average dividend yield (2010 and 2017).

Reverting to the average yield would mean that the share price would have to increase $84. Reaching this price target would result in a 22% gain on my investment, not including the dividend yield.

Final thoughts

V.F.'s first-quarter results were ugly, though the company did better than the analyst community had expected. Sales were down in nearly all areas of the company, save for China and digital. These two areas saw growth. A quick return to growth in China was unexpected and the company believes this region will be a source of strength for the year. Digital sales were incredibly high, much better than previous quarters, as consumers sought out the company's products.

V.F. should reap the benefits of this demand as more stores open around the world. The company has already stated that the percentage decline in sales for the second quarter will be less than half of that for the first quarter, meaning we've probably seen the trough for declines.

The company is in a solid position in terms of liquidity and the dividend should be covered by cash on the balance sheet until free cash flow turns positive. And that should happen this year.

Since the dividend is covered, shares are undervalued when comparing the current yield to the historical average. I may have missed a large chunk of the gains in the stock, but there is still more than 20% upside using the dividend yield method to value the stock. The company experienced the worst possible case for a retailer in the first quarter, i.e., closed stores, but there were still some positives. I remain a bull on the name and believe that V.F. is a buy today.

Disclosure: The author has a long position in V.F. Corp.