PVH Is Dressed for Success

 PVH (PVH) announced that it is in discussions to amend the credit facility entered into in February 2013 to increase the principal amount of the term loans. The proceeds of the increased loans will be used to redeem all of the outstanding 7.375% senior notes due 2020. The transaction is expected to close at the end of March. Additionally, PVH announced that during fiscal 2013, it repaid about $500 million of term loans under the credit facility, above our expectation of $400 million. Although none of these transactions will affect our fair value estimate of $140 per share or our Narrow Economic Moat Rating, we see these moves as evidence of good management stewardship and expect that this rebalancing will lower PVH’s overall interest expense.

Management reaffirmed its updated fourth-quarter guidance provided Jan. 10, calling for revenue of $2.06 billion and adjusted earnings per share of $1.40, in line with our estimates. Although we continue to believe that performance in the first half of 2014 may be muted given an ongoing promotional environment, turnaround efforts in the Calvin Klein jeans business and heritage brands retail business, and weakness in Southern Europe, we are bullish on the long-term outlook of this stock. We expect cost synergies of $100 million over the next four years from the Warnaco acquisition and think we will see signs of returns on the acquisition as early as the second half of the year. Overall, we think PVH can achieve a compound annual growth rate of 6% in revenue and 9% in adjusted operating profit (200 basis points of margin expansion to 13.8%) over the next five years.

Calvin’s Under Control and Tommy’s Growing
We think PVH will continue to capitalize on its leading brand portfolio--the basis for our narrow-moat thesis--and manage it strategically, culling brands with a declining market demand and developing or acquiring those that have true market potential. Following the $2.9 billion acquisition of Warnaco and sale of Bass, we think management’s focus will now turn to integration and internal growth, focusing on the Calvin Klein segment.

We think the Warnaco acquisition was strategically sound, giving PVH full control of the Calvin Klein brand, product quality, marketing, and distribution. Additionally, we see Warnaco’s international operations providing a boost to PVH’s top-line growth by offering Tommy Hilfiger and other PVH brands a platform in Asia and Latin America, where revenue growth and margin performance have historically been stronger for Warnaco. In the near term, we think top-line growth and margin expansion will continue to be hindered as jeanswear quality is improved, Warnaco distribution channels are shifted upmarket, and its systems and supply chain continue to be upgraded. However, PVH’s record of integrating acquisitions, such as Tommy Hilfiger in 2010, makes us think that management can deliver cost synergies of $100 million over the next four years, and we expect to see signs of returns in the second half of 2014.

We think the main focus at Tommy Hilfiger will be to broaden distribution globally with a particular focus on emerging markets. A joint venture in Brazil was started in early 2013, and we think the country remains an underpenetrated opportunity. Furthermore, we expect the brand to benefit from Warnaco’s Asia and Latin America platform over the longer term.

As a result, we have a favorable longer-term revenue and earnings outlook for PVH, but note risks including weakness in the turnaround of the Calvin Klein jeans business and heritage brands retail business, the ongoing promotional environment, and weakness in Southern Europe, especially Italy.

PVH Has Dug a Moat
Following the acquisition of Warnaco in 2013, we believe PVH has successfully acquired and developed its brands into a distinctive array of lifestyle products for which customers are willing to pay a premium, and it has thus developed a narrow moat. We now believe that PVH can sustain a return on invested capital above its cost of capital and project an 18% compound annual rate of return on invested capital over the next five years versus our 9% cost of capital assumption.

PVH possesses a varied portfolio of brands, which we believe are strong enough and have a high enough market demand to command an economic moat. Heritage brands have strong U.S. market positions, with neckwear topping a 50% share on a unit basis, dress shirts approximating a 45% share, woven shirts with a 19% market share, and knit shirts with an 11% share, according to the company. However, it is the Tommy Hilfiger and Calvin Klein businesses that really stand out as leaders in their respective lifestyle brand categories. Tommy Hilfiger was acquired by PVH in 2010 and did more than $3 billion in global retail sales in 2012 with its classic preppy-with-a-twist brand generating strong global brand awareness. The Calvin Klein brand was acquired in 2003 and was supplemented by the acquisition of Warnaco in 2013, which gave PVH the Calvin Klein jeanswear and underwear licenses, thereby reuniting the disparate parts of the brand and giving PVH full control of its image. Time magazine has cited Calvin Klein as one of the top 100 icons in fashion, style, and design, and the brand is the only one that ranked in the top 10 of each category in the WWD 100, a brand awareness survey spanning more than 1,000 brands in nine categories. We think this image and recognition will only be enhanced now that PVH has full control of product quality and marketing.

Brand strength has given the company pricing power. Through the acquisition of Warnaco, management has been able to decrease the Calvin Klein jeanswear presence in discount and off-price retailers and is expanding the full-price business. We think this repositioning has increased the strength of the brand. On Macy’s website, Calvin Klein dresses ranged from $99 to $250 and Tommy Hilfiger dresses from $80 to $150; this compared with Macy’s private-label brands like Alfani priced from $80 to $100, INC from $80 to $120, and Charter Club from $80 to $100.

Despite the current strength of the brands, we think a narrow moat rating is more appropriate than a wide moat rating. Fashion is by its nature a constantly changing force. It is redefined and adapted by each generation to reflect its unique lifestyle, values, and style. Few brands truly transcend the generations and remain valued by multiple generations, and most of those fall in the luxury category. In our opinion, Tommy Hilfiger and Calvin Klein are still too young to have proved their multigenerational staying power.

Global Economic Exposure Brings Risk
Apparel retail manufacturing is fraught with challenges, and we give PVH a high fair value uncertainty rating. Because of the global scale of its brand portfolio, PVH is exposed to numerous economies, some of which, including Italy, have yet to show significant recovery from the recession. This is likely to negatively affect both the volume and price points of discretionary apparel.

The company has also pursued large acquisitions as part of its growth strategy. Although we see the acquisition of Warnaco in 2013 as strategically sound, giving PVH extended control of the Calvin Klein brand and a significant footprint in Asia and Latin America, integration will be challenging. We think PVH will have to invest heavily in systems, supply chain, product quality, and distribution partners to gain the synergies it hoped for. We think it will take approximately four years before full value can be achieved.

We also think changes in trends and values can affect the strength of the brands over time. Apparel styles are constantly changing to reflect the mood and values of each period. Although a strong brand identity helps consumers differentiate products and remain true to a single, if evolving, lifestyle, there is the risk that the lifestyle will disappear altogether or be devalued by society in the long run. If American cool/preppy or modern/sleek loses its place in society, the Tommy Hilfiger and Calvin Klein brands could lose their equity.