VF Corporation: This Best-of-Breed Clothing Company was Built Piece by Piece

Investment Highlights

• Given a strategic advantage in acquisitions, the company is likely to announce a deal in the near future
• Strong sales and cash flow growth drive good cash returns to investors though the dividend yield has fallen below 2%
• Shares are relatively expensive and expectations may be too high, investors may want to wait for a better opportunity

Not familiar with VF Corporation (VFC)? You’re not alone but likely have the company’s products in your closet right now. Founded in 1899, the company is largely a middle-man with outsourced production in Asia and selling its branded clothing lines to retailers around the world.

Originally selling shares as Vanity Fair Mills in 1951, the company’s name was changed to VF Corporation in 2007 when the Vanity Fair brand was sold to Fruit of the Loom. The outdoor & action sports segment contributes the largest share with 53.9% of sales and strong brands like North Face, Timberland, Eastpack and JanSport. Jeanswear accounts for 25.6% of sales and includes the Wrangler, Lee, Riders and Rustler brands. Imagewear is nearly 10% of sales and sales the licensed clothing lines from the MLB, NFL and Harley Davidson.

VF Corporation is possibly the most adept company out there at the growth acquisition strategy. Its size has helped it succeed in an industry of razor-thin margins and management regularly looks for strong brands on the verge of bankruptcy. VF Corp bought the North Face brand for just $25 million in 2000 against annual revenues of $240 million as the winter apparel brand was facing bankruptcy. A bid to purchase Australian surf brand Billabong was dropped last year on price but I wouldn’t rule out a renewed bid.

Fundamentals

Sales have grown at a relatively strong pace over the past ten years, jumping higher on acquisitions. Growth in operating income has outpaced sales growth in each of the three periods shown below, a good sign for operational efficiency.

VF Corporation has very strong balance sheet and is likely ready to announce another acquisition. Current assets more than cover working capital needs and there have been no major acquisitions since 2011.The company paid off a ton of debt last year ($405 million) and now holds just 25% of its capital structure in debt.

Cash flow over the long-term has mirrored growth in operating income which is a good sign that management is not trying to manipulate the income statement. The company increased its capital expenditures by nearly 15% in 2013 and was still able to post a strong jump in free cash flow.

Dividends and Growth

Like other Dividend Aristocrats, the quarterly payment has failed to keep up with growth in the share price recently and the dividend yield has dropped to just 1.6% on an annualized basis. The company pays out 33% of its net income as dividends, in line with the three-year average ratio.

Despite the lower current yield, there is still good reason to like the shares. The company has paid a dividend since 1941 and has increased the payout every year for the last 41 consecutive years. The dividend per share has grown by an annualized 12.3% over the last five years, partly on an aggressive share repurchase program returning more than $350 million to shareholders through net repurchases in the last three years.

With the company’s strong cash flow and relatively little debt, I would expect a major announcement over the next year. Keeping with its strength in acquisitions, I would expect at least one acquisition over the next 12 months. If management is unable to find a suitable target, it could instead choose to increase the repurchase program significantly. I would also expect a modest increase in the December dividend as has been the case in previous years.

Valuation

The gain in the shares over the last several years has boosted the price to 23.1 times trailing earnings, well over the five-year average of 17.8 times but still below the industry average of 28.4 times earnings.

Analysts are expecting sales to increase by 8.1% this year and 8.3% next year to $13.4 billion. Earnings are expected higher by more than 13% each year to $3.51 in 2015, which would bring the price multiple closer to the long-term average.

The assumption for sales growth is pretty aggressive considering the company’s history and an acquisition would probably be needed to meet the target. The expectation for $3.51 in earnings would require an 11% net margin on expected sales, slightly above the 10.4% margin last quarter but not out of the question. The problem is that margins often come under pressure directly after an acquisition. This could make it difficult for the company to meet earnings estimates unless sales increase at a faster pace than expected.

While I believe there are a couple of catalysts that could send the shares higher, including an acquisition or an increase to the buyback program, VF Corporation is looking expensive and estimates for earnings may be too high. The dividend yield has fallen below 2% and no longer meets my yield requirement for dividend stocks.

I am going to call this one a neutral given the company’s strong track record for acquisitions and cash return against an overvalued share price. You could probably keep the shares you already own and wait for an acquisition announcement to analyze future sales and earnings growth. I would wait for a 5% pullback in the price to buy any additional shares or to start a position.