Levi’s ($LEVI)

Company:

Levi’s is an iconic American company with a rich history of profitable growth, quality, innovation and corporate citizenship. Today they design, market and sell products that include jeans, casual and dress pants, tops, shorts, skirts, jackets, footwear and related accessories for men, women and children around the world under the Levi’s®, Dockers®, Signature by Levi Strauss & Co. and Denizen brands.

Revenue breakdown (Customers and products):

Customers: The company depends on a key group of wholesalers and retailers for a significant amount of their revenue. The 10 largest wholesale customers represented 29% of all revenue. The entirety of the wholesale channel contributed to 61% of total net revenues for the company. This represents a problem as some of their key wholesaler partnerships with Sears, J.C. Pennies and K-mart are facing bankruptcy.

39% of revenues were derived from DTC channels or direct to consumer channels. DTC sales are a priority for the company, contributing to higher gross margins and greater control over the customer experience. These channels consist of company owned retail stores and franchised retail stores. Increasing the revenue share from DTC channels is the current focus of the company- from 2011 to 2020 the DTC channel revenue stream grew from 20% to 40%. The goal is to elevate DTC channels to represent 60% of revenue over the next decade.

The company also has a goal of reaching gender parity in regards to revenue. Men’s products consisted of 64%, 67% and 69% of total revenue for years ending 2020–2018 respectively. The goal is to achieve an even mix of sales across genders by focusing on outsized growth in women’s apparel.

Products: The lion share of revenue came from Levi’s brand name products. 87% of revenue came from Levi’s brand. The Dockers brand constituted 5% of total revenue, down from 7% just two years earlier. The Levi Strauss and Denizen brand accounted for 8% of the revenue, which is up 1% from two years earlier. The company’s strongest brand is evidently Levi’s. Jeans and casual dress pants constituted the largest segment of revenue at 65%, down from 68% two years ago.

Quality of Earnings Analysis:

The purpose of a quality of earnings analysis is to determine how the company’s EPS was impacted by non-operational performance. For Levi’s we will go through the income statement to adjust the EPS to remove one off-expenditures as well as adjust for increases or decreases in operational line items as a percentage of sales to adjust for percentage deviations against historical averages. Screenshots of the quality of earnings analysis are provided on the next page.

From the quality of earnings analysis above, it is evident that earnings were highly impacted by an increase in SG&A costs as a percentage of sales as well as a one time restructuring expense. The reported EPS was $-0.32/share for 12 months ending November 2020. Realistically, from our analysis above the true EPS was around $-0.15/share. The increase of SG&A as a percentage of sales was left in the analysis because the expense was in line with historical expenditures of this line item. We did adjust the EPS for the one time restructuring expense incurred during the year which had a negative impact of about $-.17/ a share. On an operational level the company realistically earned $-0.15/share.

Opportunities

DTC (Direct to consumer) expansion:

The company’s most obvious opportunity for growth and expansion is to further invest in direct to consumer outlets. These channels are company owned retail stores and independently ran franchises. The reason this is pertinent for the growth of the company is because the company makes a higher gross margin from sales from their own outlets when compared to sales from traditional retail chains. Additionally, the company has higher control over the customer experience when they operate alone and not via wholesale partnerships. There isn’t a comparison of gross margins derived from owned outlets vs. retail chains.

The company has pursued an aggressive strategy for expanding their DTC outlets. This is evident based on the number of stores being opened across the world. During 2020, Levi’s opened 77 additional stores when compared to 2019 in the United States. Of all of their stores in the United states, 94% of the operations are open. 6% of their stores in the United States remain closed from COVID-19. Levi’s also opened 32 more stores in Europe when compared to 2019. Notably, only 67% of Levi’s stores in Europe are open as a result of COVID-19. Levi’s also opened 28 stores in Asia when compared to 2019. All of the company’s stores located in Asia are opened. This rapid opening of owned stores is aggressive to say the least. Before 2020, the company had 888 owned stores, the addition of these 139 stores represents a 15.7% increase in owned and operated stores YOY.

Non-denim products:

When people think of Levi’s, people think of denim jeans. The company has plans to move away from deriving the majority of their revenue from denim jeans. In 2020, Levi’s generated 65% of the revenue from denim jeans and pants. The company is looking to drive higher revenues from non-pant revenues such as tops, accessories, outwear, footwear and non-denim bottoms. These products currently consist of 35% of the revenue with the goal of making these items constitute 50% of the total revenues. The DTC and owned retail channels are symbiotic to this goal.

Risks

Wholesale Partners:

Wholesale partners still consist of the majority of the company’s revenue (61% of the revenue in 2020). Wholesale partners are a risk because Levi’s doesn’t have control over the customer experience that these companies provide. Additionally, many brick and mortar wholesalers are facing massive industry decline with several wholesale partners (J.C. Pennies, K-mart and Sears) facing bankruptcy. Because Levi’s is not yet making the majority of their revenue from DTC channels, the reliance on third party retailers performance represents a major risk. Currently the largest 10 wholesale partners represent 61% of the entire revenue stream. Although no wholesaler represents greater than 10% of revenue individually, a failure of their wholesale partners will also negatively impact Levi’s.

• Share Conversion/ Dilution:
• Levi’s currently has two classes of shares, Class A (77,329,197) and Class B shares (320,730,620). Class A shares are the shares that are traded on the open market. Class B shares are shares that are held mainly by the descendents of Levi Strauss. Because of the massive amounts of Class B shares that have to be converted to Class A shares to be sold on the open market, there is a major dilution risk that is present to Class A owners.
• Brick and Mortar Expansion:
• The company is opening up new retail stores in order to become a stand alone retailer who doesn’t rely on wholesaler partners. However, when considering that their brick and mortar wholesaler partners are not achieving success, one has to question Levi’s ability to be successful where the larger retailers have not been. This is a huge risk, especially given the rate of expansion (139 stores opened in 2020).
• Lots of Leverage:
• I was originally attracted to this company because I saw that their cash balance from 2019 to 2020 increased by $562M dollars, a YOY change of + 60%. However after looking at the cash flow statements, this increase in cash is clearly not from operations. About $100 million is coming from a decrease in cash spent on operating activities and investing activities with the majority of the cash increase coming from debt financing. This is extremely worrying because in 2020 the company had a negative operating income figure (a pre-interest line item).

Financial standing

Cash/ Peter Lynch valuation strategy:

Levi’s has a cash reserve of $1,497,155,000. This indicates that the company has enough cash to continue focusing on the expansion of DTC outlets even if the company doesn’t report positive operating income. Although, it is probable that the company will generate positive earnings per share for 2021.

Currently the cash reserves equate out to $3.77 a share ( $1,497,155,000 / 397,315,117 shares = $3.77/share). After removing the $3.77 from the current stock price of $23.03, you get a fair stock price of $19.26 a share. If we use 2019’s EPS ($0.97) as a proxy to estimate a P/E ratio, we get that the stock is trading for about 19.8 times earnings. Given that the stock’s revenue is growing at 10% a year, Peter Lynch would say that this stock is not an attractive investment.

Debt:

The company has $1.6 billion dollars of debt as of November 2020. Most recently the company took on $500M of senior notes with a 5% interest rate on the debt. The company’s weighted average cost of debt is 4.75%. This year the company faced interest payments of $82,119,000. Moving forward it is likely that the company’s future interest payments will be inline with this years. ($1.6B X 4.75% = $80,000,000). The company isn’t in danger of bankruptcy due to their vast amount of cash on hand and the high probability that the company will produce a positive EBIT in 2021.

• Dividends:
• The company issued a dividend of $0.04/share to both Class A and Class B shareholders. This works out to a net cost of $16M. The company is expected to continue paying a $0.04/share dividend for the rest of 2021, bringing the net dividend payment to $64M. This is concerning that the company is paying a dividend this year when they were not profitable in 2020.

Opinion

I don’t believe that an investment in Levi’s will yield any meaningful capital appreciation. I also do not have a high degree of confidence in the company’s DTC growth strategy. Even if the company is successful in deriving the majority of its revenue from owned retail stores rather than from wholesale retail partners, the company is still making large investments into the dying brick and mortar retail industry.

Is there any clear answer to the following question. Why is Levi’s going to be successful with their brick and mortar operations while their wholesale counterparts such as Sears, J.C. Pennies and K-mart failed?

I was originally attracted to the company because it has $3.77/share in cash. After finding out that the majority of the YOY cash increase came from debt financing rather than a higher net income or more lean business operations, this cash figure doesn’t mean much. Especially if there is interest to be paid on it.

I also question the management’s decision to start paying dividends this year. Why would the company issue a dividend that is being paid for with debt? Also, it doesn’t make sense that the company would pay a dividend when they are focused on growing their business via opening owned operations. That costs significant money.

Discounted Cash Flow Valuation:

Base Case:

Bull Case:

Bear Case: