Kontoor Brands (KTB; disclosure: long) is a recent spin-off from VF Corp (VFC). At today's prices, I think shares are too cheap, and I expect shares will "snap back" once the typical spin dynamics have played out and the company finds its investor base / announces its first dividend and gets onto dividend investor watch lists.
There's a lot to talk about with Kontoor, but let me start with the most obvious. Kontoor is an awful name. I normally don't care about corporate names (even Tronc didn't really bother me), but something about the way Kontoor reads and feels in my mouth when I say it makes my skin crawl. If an activist ran against this board purely on the thesis "they approved naming the company Kontoor", I would vote for the activist.
Ok, that very important bit of corporate name shaming out the way, let's turn to the investment thesis. It's actually pretty simple: Kontoor was spun out of VF Corp in late May, with VFC shareholders receiving one share of Kontoor for every 7 shares of VFC they held. VFC shares were trading at ~$85/share when the spin completed, so basically for every ~$600 of VFC an investor held they got 1 share of KTB worth ~$30/share.
Spin-offs have been very popular among value and event investors for the past ~decade. The reason is obvious: everyone's read You can be a stock market genius (a book I highly recommend!) and "knows" that spin offs outperform. And the logic for spins outperforming makes sense! Large investors indiscriminately sell small spin shares they hold (often because of index restriction; i.e. a fund benchmarked to the S&P 500 might not want to hold a small spinco that will not be in an index), and spinning a smaller company off can incentivize the spinco management to be a bit more entrepreneurial / invest in the business in a more productive way. Still, I think at some point ~five years ago companies realized there was an investor base that would invest in just about any spin off, and you started seeing companies use spin offs to get their worst assets out of their footprint knowing that there would be a ready investor base to buy any spin (note that's just my opinion and why I've been hesistant on spins recently; there have been plenty that have worked but in general I think spins have been a very disappointing bucket over the past ~5 years).
Anyway, I think Kontoor represents some combination of the above factors (both positive and negative). VFC clearly chose to spin KTB because KTB was the "worst" / slowest growth asset in their portfolio. Despite that, I think Kontoor's attractive: it should be a relatively stable business, and I think it shows a lot of traits of a typically successful spin: some more focus from management should let their brands stem their organic declines, and once the "sell the spin" dynamics are over I'd expect shares to rebound higher.
Alright, hopefully that gives a broad overview of the spin dynamics around KTB. Let's talk about who KTB is and why I think they're so cheap.
Kontoor has three main businesses: Wrangler, Lee, and Other (mainly VF Outlet store revenue). Other is small enough that it can be ignored, so the two big drivers here are Wrangler (which owns the Wrangler brand of jeans) and Lee (which owns the Lee line of jeans).
The main appeal of KTB is that these brands are reasonably stable and KTB's shares are quite cheap.
Let's start by talking about how cheap KTB is, since it's really the crux of the thesis. At today's share price of ~$27, KTB trades for just ~7.0x EBITDA. Given reasonably low capex requirements (most manufacturing is outsourced), KTB trades for just 8.5x unlevered free cash flow. There's reason to think there's some upside to those numbers: capex has historically come in <$30m/year and is currently elevated by some IT expenses; once those normalize in the next two or three years that would add another $30m in cash flow. In addition, the company has suggested they took $45m in charges prior to the spin that will result in $20-25m in annual cost savings going forward. If you factor in either of those (the cost savings or the lower normalized capex), KTB would look even cheaper.
7x EBITDA and 8.5x unlevered free cash flow is quite cheap in the absolute, and it's awfully cheap if you look at KTB relative to some peers. The best peer is probably LEVI, which just IPO'd earlier this year and trades for ~12.5x EBITDA. Now, Levi probably deserves a premium versus KTB: it's growing while KTB is shrinking, and it probably has a better brand, but to sport a multiple >5x higher than KTB's is implying LEVI's brand is in a completely different universe than Wrangler. A 2-3x multiple discrepancy would probably make more sense and would result in a huge boost to KTB's share price (at 9x EBITDA, KTB is worth ~$40/share).
The other thing I think is interesting about KTB is the consistency of their financials. The slide below is from the April 2019 spin deck and shows unlevered free cash flow has been above $330m every year for the past ten years. Given the low valuation, if this slide holds shareholders are going to do very well from today's prices.
I think the right hand slide of this slide also points to the possible bear case for KTB. Recent revenues and earnings have been declining, and 2019 will mark multiyear lows for revenues, EBITDA, and their "cash flow proxy" (all down somewhere between mid-single digits to low double digits, per their 2019 guidance). Q2'19 in particular will probably be a disaster; I counted three separate call outs for how bad it would be in their earnings release. This is where I think the spin dynamics could come into play in KTB's benefit: LEVI's has been reporting strong growth recently while KTB has been declining. Sure, Levi's is a better brand than KTB's, but that Levi's growing so strongly while KTB is declining suggests to me that KTB's issues are company specific, not structural issues (i.e. the decline of department stores will forever doom Wranglers. Department stores decline certainly creates near term headwinds, but Levi's continued growth makes me hopeful the brands can grow and survive in a more online world). With the renewed focus from the spin (i.e. the ability to invest in their own brands versus having VFC headquarter allocate the majority of resources to their core brands), KTB should be able to stem the bleeding and, eventually, return to growth.
The biggest risk here is that I'm wrong on the ability of KTB to stem the decline. Maybe I'm right that the issue is KTB specific, but I'm wrong that it's fixable (i.e. the brands are just completely wrecked and Levi's is growing because their brand is gobbling up KTB's share and KTB will never be able to come back). I've seen no signs of that these brands are un-salvageable (for example, I did the cursory look at reviews on Amazon and Walmart and so no huge difference between Levi's and Wrangler / Lee) and I don't know of any reason why they would be, but that's probably the worst bear case.
There are plenty of other risks here. Walmart is a ~a third of sales, so losing them would be a disaster. Direct to consumer and declining barriers to entry are an interesting risk (and somewhat tied to the "legacy retailers going bankrupt" headwind). It doesn't take much to launch a clothing brand these days, and a start up can micro-target their audience and offer clothing quality that is equivalent or better than legacy brands at equivalent pricing. How do major brands like Wrangler (or Levi's?) look as that trend continues to play out? I'm not sure, but I'd again note that this is a general industry risk so to the extent it hits Kontoor it would be hitting Levi's as well. In addition, there is some upside opportunity here as the world evolves: for example, I guarantee KTB's lowest margin revenue are sales through WMT. Over time, if more of KTB's sales shift online, that could be significantly margin accrettive for KTB. Of course, that assumes that the WMT business doesn't fall off, but I'm just trying to point out that the evolution of the consumer landscape isn't all negative!
Other odds and ends