Is the Market Underestimating PVH?

 PVH (PVH) appears to be on the brink of a turnaround, but the market seems to have its doubts. Management guidance calling for over 15% adjusted earnings-per-share growth in the second half of 2014, following a 9% decline in the first half, does seem optimistic at first glance. However, we think numerous data points back up this forecast. With Tommy Hilfiger solidly on track, Heritage Brands facing what we think are only short-term headwinds, and Calvin Klein poised to finally begin realizing some returns on Warnaco investments in the back half of this year, we think now is an excellent time to consider buying.

We continue to think that the company's brand intangible assets yield more-stable demand and pricing power, compared with many competitors (the basis for our narrow moat), and that current earnings pressures are due to acquisition integration and poor execution, both of which are correctable, rather than a broken brand and declining consumer loyalty. Furthermore, we think guidance for over 15% second-half earnings-per-share growth in fiscal 2014 is based on already collected data points regarding planned pricing and square footage increases and early order books--not simply a blind hope that the product resonates better with consumers or that macroeconomic conditions improve.

Tommy Hilfiger Performance Seems Solidly on Track
Accounting for about 42% of revenue in fiscal 2013, Tommy Hilfiger is very important to PVH's performance. Tommy Hilfiger has been a steady performer for PVH, having posted 6% average top-line growth over the past two years and almost 8% growth in the first half of 2014. Furthermore, operating margins have remained strong, rising 30 basis points to 13.9% in fiscal 2013. We see a number of drivers backing up our belief that Tommy Hilfiger can sustain 7%-8% annual revenue growth over the next five years and achieve a slight margin expansion of 80 basis points to 14.7% within that same time period. In the near term, Europe order books indicate holiday sales up about 5%, and spring season order books look to be running up roughly 5%, with wholesale accounting for 63% of Tommy Hilfiger Europe revenue in 2013. Retail comps improved in August, with comp sales in Europe and North America up midsingle digits, leading us to believe that, when combined with retail square footage expansion, the business can achieve full-year mid-single-digit top-line growth.

We see emerging-market expansion as a significant contributor to top-line growth. On a global reported revenue basis, geographies outside of Europe and North America account for only roughly 5% of reported sales, and we see the potential to bring some of these joint ventures and licenses back in-house. Tommy Hilfiger Asia is principally a licensed model and is about a $550 million business today. Some of the business is in China through a joint venture with 45% ownership. Management has commented on the promise of Tommy in Brazil, where it could see growth from about $35 million to between $100 million and $150 million over the next three to five years. The Mexico business is about $150 million.

As the Calvin Klein business has direct operations in many of those markets, we see the potential, in the long run, to bring some of these in-house and to operate them directly as license terms expire. We also see room for market expansion in Europe, including underpenetrated countries such as Russia, Eastern Europe, the Middle East, and France, and further penetration in Germany, Turkey, Scandinavia, and the United Kingdom. As we think that Tommy Hilfiger's brand intangible asset is even stronger in international markets than in the United States, we think this expansion will carry significant pricing power and strong demand. We think slight annual margin expansion will be gained through leveraging fixed costs on strong retail comp and wholesale growth.

Despite Near-Term Headwinds, the Heritage Business Is a Strong Cash Generator
Heritage Brands (including IZOD, Van Heusen, Arrow, Speedo, Warner's, Olga, and Dress Furnishings) don't account for much of PVH in the way of income. In 2013, they composed less than 15% of adjusted operating profit. However, they have strong market-share positions and are relatively consistent cash generators. According to company measures on a unit basis, Heritage Brands have over 50% market share in neckwear, 43% share in dress shirts, and 16% share in woven shirts. Over the past three full years, retail sales of continuing Heritage Brands grew at a 10% compound annual growth rate, making us comfortable with our assumption that reported revenue growth will average 3% annually over the next five years. At that rate of top-line growth, we see no reason why operating margins in the range of 7%-8% wouldn't continue.

Admittedly, this assumption reflects an expected rebound in growth from the first half, when revenue for Heritage Brands was down 1% year over year, excluding the revenue related to the Bass business, which was sold in the fourth quarter of 2013. The decrease reflected relatively flat sales in the wholesale business and a 7% decline in retail comparable-store sales. However, PVH is entering the back half of the year with cleaner inventory levels, and we think the launch of IZOD at Kohl's will be a strong driver. It's also important to note the outsize impact of the Bass sale on growth. Full-year guidance calls for Heritage Brand revenue to decrease about 7%; however, if Bass is excluded from the prior year, this guidance implies revenue growth of 2%. Bass is estimated to have contributed $176 million in revenue in 2013. We estimate that its impact shaves roughly 200 basis points off total PVH full-year revenue growth for fiscal 2014.

The Warnaco Acquisition Looks Poised to Deliver Returns
We think the biggest overhang on the stock is doubt regarding the timing and number of returns that can be achieved from the Warnaco acquisition. The acquisition was completed in February 2013, and it was a large one, increasing total 2013 Calvin Klein revenue (net of the reduction in licensing revenue) by $1.525 billion and accounting for roughly 55% of total Calvin Klein revenue in 2013. In our opinion, the acquisition was strategically sound, uniting control of the struggling jeans and underwear business with the existing Calvin Klein business, and increasing PVH's presence in emerging markets.

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However, the acquired jeans and underwear business needed a lot of work. PVH has spent the past 18 months heavily investing in the company to correct product issues, reposition distribution channels, and upgrade technology systems. The jeans business should be one of the more profitable categories, with a big electronic data interchange (EDI) replenishment business. In our opinion, it should be more profitable than the sportswear businesses, which tend to operate in the 12%-13% operating profit range, according to management. For comparison's sake, the Jeanswear Coalition at  VF Corp. (VFC) achieved a 19.4% operating profit in fiscal 2013. Calvin Klein jeans are far from this level, thanks to poor investment and management on the part of Warnaco, resulting in subpar product development and overexposure to discount channels.

In Europe (approximately 20% of Calvin Klein global reported revenue in 2013), the business is losing money. And in North America, approximately 50% of Calvin Klein global reported revenue in 2013, the business is only at roughly the 1%-2% range. Conversely, operating margins in Asia (about 20% of global reported Calvin Klein revenue in 2013) and Latin America (about 6% of global reported Calvin Klein revenue in 2013) averaged in the high teens. We think PVH has the relationships and systems necessary to invest in better product and to gain entry to more upmarket distribution channels, a key part of the scale advantages underlying PVH's narrow economic moat.

PVH had targeted $100 million in annual run-rate synergies over four years. We still think this is reasonable and expect about $25 million per year. All-in, we think Calvin Klein can regain about 4-5 points of top-line growth through the anniversary of old merchandise clearance and the rationalization of the off-price and club business in jeans and underwear after the first three quarters. In Europe, the Calvin Klein jeans business has been down in the double-digit range, but it was planned that way as management hoped to clean up the business for fall deliveries expected to hit in July and August. Department store regular price growth, in our opinion a better indicator of future performance, has been strong, with the order book up double digits. The off-price channel that is being significantly reduced is offsetting that growth. We see this shift in distribution channels supporting not only top-line growth, but also margin expansion.

Management is looking for low-single-digit growth in the second half of the year. In North America jeans, management is looking for a 35% increase in square footage on the women's side (about 25,000-30,000 square feet) and a 50% increase on the men's side (about 65,000 square feet in A and B+ department stores). PVH is also investing about $15 million-$18 million in shop presentations. Finally, with new improved product (now designed with a regional approach for Europe, Asia, and North America, and upgraded fit, packaging, hangtags, and branding), we think PVH can slowly get pricing back to a level more similar to competitors'. Over the next three years, management hopes to increase the average unit retail (AUR) for jeans in North America from $25 to $40, with about a 10% increase starting this fall season. In Europe, the goal is to move average pricing from EUR 45 to EUR 80.

In the long run, we think Calvin Klein can achieve mid- to high-single-digit top-line growth through pricing increases, square footage increases in existing markets, and growth in underpenetrated markets such as Northern Europe, where the brand can benefit from Tommy Hilfiger's presence. We think margins will expand from the 14% operating margin expected this year to the 16% range over the next five years through Warnaco synergies, shifts away from off-price club distribution channels, shifts to high-margin and growth markets, and AUR increases.