Acquisitions Are a Value-Enhancing Strategy for VF

Acquisitions have been a core component of  VF's (VFC) growth strategy and are likely to continue to be a strategic goal, given their inclusion in the company's 17x17 five-year plan. We have completed a scenario analysis to determine the impact they would have on our fair value estimate. Although determining any acquisition target and its value is highly difficult at best, we explore a few options that make sense considering the importance of the outdoor and action sports coalition, international expansion, and direct-to-consumer penetration to VF's strategic goals. We believe that a $1.5 billion acquisition, which would add approximately $1.2 billion in revenue and $130 million in operating income, could provide 11% upside to our current fair value estimate of $62.

In our opinion, VF's moat-building cost and brand advantages have uniquely positioned the company to make acquisitions accretive to earnings and are a quick way to expand into the higher-growth lifestyle space. As such, we think a scenario analysis should be a valid component in an investor's shareholder return calculation.

VF's Economic Moat Makes an Acquisitive Strategy a Good One
Acquisitions have long been core to VF's operational and growth strategy. Originally offering diversification from a core jeanswear and imagewear product-focused platform, acquisitions have been key to transforming VF into an international branded lifestyle apparel and footwear company. The company now operates more than 30 brands and expects nearly three fourths of its total revenue to come from the lifestyle coalitions (outdoor and action sports, sportswear, and contemporary brands) by 2017.

VF's manufacturing and distribution scale and its centralized procurement and logistics are competitive advantages. VF sources or produces about 486 million units annually across brands. It operates 32 manufacturing facilities and uses more than 2,000 contractor manufacturing facilities in more than 40 countries. Thirty percent of units are manufactured in VF-operated facilities at a lower cost and shorter lead time than contracted production. PVH, the closest competitor that we cover, outsources all of its manufacturing. This scale and global network afford VF synergies across its brands.

Brand strength and a deep bench of operational and brand-building expertise also play into VF's narrow economic moat and its success in growing through M&A. Each brand is managed within five coalitions, and management teams share and leverage best practices in areas including sourcing, manufacturing, inventory management, human resources, and information systems. We think these relationships are key to more quickly advancing a brand's capability to broaden distribution channels and to enter new markets.

In our opinion, strong brand management, superior operational expertise, significant economies of scale, vertically integrated manufacturing capabilities, and a unique organizational structure that fosters independent creativity and interbrand collaboration have made VF best in class at acquiring, integrating, and expanding brands in apparel manufacturing. Over the past three years, we estimate that VF achieved an average compound annual return on invested capital of 17%. When adjusted to exclude excess cash and goodwill, this return on invested capital increases to 22%. As heritage brands now account for only about 34% of sales, we see this as a testament to VF's ability to drive high returns through acquisitions. Acquisitions in the outdoor and action segment appear to have outperformed those in sportswear and contemporary brands, which we attribute to a lower exposure to fashion trends and a higher ability for product differentiation through innovation. We think this further highlights the importance of sustainable competitive differentiation in driving higher returns.

Future Acquisitions Likely to Speed Strategic Execution
In its 17x17 strategic plan, VF highlighted the importance to its growth targets of outdoor and action sports, international expansion, and direct-to-consumer distribution. We believe that each of these levers has significant room for penetration gains and will create further value, enhancing mix shifts. First, we see international and DTC as generating a higher top-line growth rate than heritage businesses. From 2007 through 2012, total revenue grew at a compound annual rate of 9%, aided by compound annual growth of 15% in international revenue and 17% in DTC revenue. Second, the outdoor and action sports coalition, international segment, and DTC channel each generate higher margins than VF as a whole. Outdoor and action sports possesses a gross margin approximately 4 percentage points above the overall VF gross margin, while the international and DTC businesses have premiums of 7 and 20 percentage points, respectively.

As such, we expect VF to continue to pursue acquisitions as a means to supplement organic growth and to speed strategic execution of mix shifts toward higher-growth and higher-margin businesses. In fact, the five-year plan incorporates acquisitions adding 2% compound annual growth to the overall 10% expectation. We see acquisitions in outdoor and action sports as being the top priority for cash.

With corporate cash balances remaining at all-time highs and with easily available low-cost debt financing, we see high demand for acquisition targets across the apparel manufacturing sector. Unfortunately for VF, we think this demand is outpacing supply, making attractive targets at a good value difficult to find. Last year was a healthy environment for initial public offerings, and PricewaterhouseCoopers reports that retail and consumer IPO proceeds more than doubled to $10.3 billion, a 220% year-over-year increase. PwC attributes some of this strength to sponsors' desire to profit from the robust equity markets through an IPO exit versus a traditional M&A sale. Deal value in the retail and consumer sector was up from 2012, but deal volume was down, resulting in an average deal size increase of 67% to $399 million.

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Cross-border deal activity was lower than prior-year levels but still represented 37% of retail and consumer deal volume and 33% of deal value in 2013, according to PwC. Outbound deal activity was more prevalent and composed 59% of cross-border deal volume. Europe was still the dominant region for U.S. investment, but it has fallen as a percentage of outbound transactions relative to other geographies. We expect these trends to continue as apparel retailers and manufacturers attempt to tap into high-growth international markets and the growing middle class in emerging markets.

Despite this more difficult M&A environment, we believe there are enough acquisition targets available for VF to meet its five-year plan. With the firm's strong cost advantage over competitors given its economies of scale and manufacturing capabilities, in addition to a well-diversified brand portfolio, we think VF is better positioned to drive synergies with targets, making it more capable of paying a higher price without sacrificing returns and a better option for target management teams looking for a collaborative yet independently operated brand environment. Given VF's stated goals, we believe all acquisitions have an extremely high probability of being in outdoor and action sports and increased exposure to international markets or DTC channels will be prioritized over other options.

Organic Growth Potential Significant but Well Understood
Through exposure to the growing performance and actionwear markets, an underpenetrated DTC channel, and the potential to expand into developed and emerging international markets, VF is positioned to post organic top-line compound annual growth of 8% and average annual operating income growth of 12% over the next five years, in our opinion. Because we think outdoor and action sports apparel is differentiated on the basis of performance instead of easily replicated fashion designs, and because economies of scale and a broad brand portfolio should ease the expense and the difficulty of penetrating new distribution channels and markets (the basis of our narrow Morningstar Economic Moat Rating), we have a higher degree of confidence in our performance expectations than with highly volatile, no-moat companies. We also think stock performance can benefit from significant growth in dividends, with the company targeting a 40% payout ratio by 2017, an increase from 34% in 2013. Thus, our estimate calls for roughly 20% compound annual dividend growth over the next five years.

We expect the outdoor and action sports coalition (currently 56% of revenue) to increase revenue organically at an 11% compound annual rate to $10.1 billion in 2017. Although this might seem aggressive for organic growth in apparel, a deeper look shows that much of the boost comes from expansion opportunities rather than simple comparable sales. Based on data from the top three brands (North Face, Vans, and Timberland), we think DTC accounts for roughly 25% of the business, conservatively. With penetration increases, we expect this to grow at a 15% compound annual rate. International market penetration will also aid top-line growth. Assuming that international revenue has a similar breakdown by coalition as overall revenue, we estimate that it accounts for approximately 38% of coalition revenue and can grow at a 16% compound annual rate. Overall, we see international revenue growing to 43% of revenue by 2017 and DTC growing to 27% of total revenue. Although some double counting is probably involved, this would imply that our estimate assumes only low- to mid-single-digit compound annual growth in the core U.S. business, which we think can easily be achieved through pricing and market share gains.

The other large percentage of revenue is generated by the jeanswear coalition at approximately 25% of revenue. We see jeanswear increasing revenue at a 4% compound annual rate to $3.2 billion in 2017. Although this coalition has suffered because of a weak core consumer and a shift away from denim, among other things, we think it is poised to benefit from cleaner inventory levels, innovation in fabric and design, more doors with Wrangler moving into the midtier and Lee into additional department stores, and international opportunities (we estimate it is roughly a third of the business). This would imply that the remaining coalitions would grow at a 5% compound annual rate to meet our estimates.

We see margin expansion providing another 4 points to earnings growth on average annually, driven by mix shifts to outdoor and action sports revenue (gross margin is roughly 4 percentage points above total), international (gross margin is about 7 points above overall), and DTC (gross margin is roughly 20 points above overall).

Although we consider the top-line growth and margin expansion opportunities to be among the best in the apparel sector and have increased confidence in execution because of VF's narrow moat, our discounted cash flow analysis demonstrates that much of the upside has already been priced in to the stock. Using a 10% cost of capital and the aforementioned growth assumptions, we arrive at a fair value estimate of $62.

Acquisition Possibilities Create Potential Further Upside
We normally do not use potential acquisitions in our discounted cash flow analysis to determine fair value estimates, as it is almost impossible to predict the acquisition target, timing, price, and synergies. However, acquisitions have been core to VF's strategic growth plans and are a continued component, as evidenced by their inclusion in the 17x17 five-year plan.

Although organic growth seems fully priced into the current share price, we think the potential for acquisitions yields upside. VF expects acquisitions to contribute 2% compound annual growth to its $17.3 billion 2017 revenue target, implying that acquisitions will add more than $1 billion to the top line by 2017 (given our roughly $16.1 billion organic revenue forecast). To model an acquisition scenario in line with the company's five-year plan, we assume that VF will complete an acquisition valued at $1.5 billion in fiscal 2015, adding $1.2 billion to the top line and $130 million to operating income, implying roughly a 12 times enterprise value/EBITDA multiple (about the same as the Timberland acquisition). We then assume that top-line growth returns to the original organic growth rate of 8% on average annually and the acquisition operating margin increases from 11% to 15%, which is management's stated goal for acquisitions. Assuming no other future acquisitions (although we in fact believe that M&A will be an ongoing component of VF's growth story), our fair value estimate increases to $69 from $62 and implies 10% upside from current trading levels.