Strong Brands Widen VF's Moat

We have always believed that  VF's (VFC) existing brands have high demand and significant pricing power, which was the basis for our narrow Morningstar Economic Moat Rating. However, we now think that the company's capabilities in selecting acquisition targets that are slightly broken but still possess an underlying respected brand, divesting itself of brands that do not make strategic sense to the whole, and having an operating structure capable of absorbing newly acquired companies and quickly plugging them into its supply chain and back-office functions give VF a wide economic moat with sustainable brand intangible asset strength and scale cost advantages.

The company bases its acquisition strategy and brand positioning on intense consumer research and reviews its brand portfolio annually to cull any brands that do not make strategic sense for the overall portfolio. We think these two practices will ensure that the overall VF brand intangible asset will remain strong over a significant period as the brands and products it owns will be adjusted to maintain value. Furthermore, through a thorough review of the company's most recent acquisition, we think that almost all of the supply chain and back-office management of acquisitions is plugged into the VF platform, which yields very significant cost advantages. As we see acquisitions as core to VF's growth strategy, we think this will be an important contributor to long-term returns. We expect VF to achieve an average adjusted return on invested capital of 23% over the next 10 years, well above its 9.8% weighted average cost of capital.

Shared Platform Provides Pricing Power, Cost Efficiencies
VF is best in class of the apparel manufacturers we cover in terms of pricing power and scale efficiencies. VF has a portfolio of more than 30 brands in five categories that drive above-market returns. Three of the largest brands are in the outdoor and action sports category. The North Face is the number-one outdoor brand in a $25 billion market. Vans is a leader in the $28 billion global action sports and classic/sport-inspired category. Timberland is the largest outdoor lifestyle brand and has a 2% share of the $75 billion men's global nonsports footwear category (market share estimates based on NPD global sports market estimates and Euromonitor International data). The jeanswear category has two long-standing brands in Lee and Wrangler. Lee Jeans has a history that stretches back to 1889 and generates more than $1 billion in sales. Wrangler is an iconic American brand associated with the West. The Western specialty channel is healthy and growing, with a 70% share in men's bottoms and a 40% share in women's bottoms.

These market leadership positions have yielded impressive pricing power. Of the apparel manufacturers we cover, only PVH (PVH) tops VF's gross margin; we attribute this to differences in channel and product mix. As VF increases its mix of higher-margin lifestyle apparel brands and direct to consumer through organic growth and acquisitions in the outdoor and action sports coalition, we believe its margin will reach if not surpass that of PVH. In our opinion, this supports the strong pricing power VF exhibits through its differentiated offering.

VF Has One of the Highest Gross Margins in Apparel Manufacturing

VF's manufacturing and distribution scale and centralized procurement and logistics are competitive advantages. VF sources or produces about 500 million units annually across 35 brands. It operates 28 manufacturing facilities and uses about 1,800 contractor manufacturing facilities in 60 countries. Twenty-seven percent of units are manufactured in VF-operated facilities at a lower cost and shorter lead time than contracted production. This scale and global network afford synergies across its brands. The only apparel manufacturers with operating margins close to VF's are Gildan (GIL) and Hanesbrands (HBI), both of which manufacture basic apparel and undergarments in mostly owned manufacturing facilities. Gildan owns and operates efficient large-scale manufacturing facilities primarily in Central America and the Caribbean Basin. Hanesbrands produces more than 80% of products through its network of large-scale facilities and dedicated contractors. In contrast, PVH products are made in more than 1,300 factories and over 50 countries, and Guess (GES) sources all of its products through numerous global suppliers.

VF's Operating Margin Is on Par with Peers'

Divestitures, Due Diligence Strengthen Portfolio
Through regular reviews of its brand portfolio, management assesses not only the strength of brand intangible assets, but also synergies with the rest of the brands in the company and returns on investment versus those presented by other brands. In this way, we think management preserves the strength of the overall brand intangible asset and cost efficiencies. VF has no qualms about ridding itself of noncore brands, most notably shedding namesake brand Vanity Fair in 2007. The sale of the intimates business to Fruit of the Loom significantly changed the corporation, with lifestyle brands accounting for 40% of revenue after the divestiture, up from 30% in 2005.

VF appears to carefully screen acquisition targets to ensure that they can or will fall within targeted growth and operating margin ranges. It has also been known to walk away from the deal table when terms or due diligence findings are not palatable, having done so with Timberland before the final successful conversation in 2011 and also with Billabong in 2013. This gives us confidence that management isn't aggressively pursuing acquisitions to bolster top-line growth.

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We are also impressed by the due diligence that goes into acquisition targets. VF completed consumer research of 18,000 consumers in eight countries to affirm the strength of the Timberland brand and to drive brand strategy. From this research, management positioned the brand to the outdoor lifestyle target market and realized that while consumers loved the brand, it needed to up the style/modernity quotients. Since 2011, revenue has grown from $1.5 billion to an estimated $1.7 billion in 2014 and operating margin has climbed 500 basis points from 7.9% to an expected 12.9% this year. Management believes it can increase the margin another 500 basis points over the next five years to 18% on increased full-price selling, pricing increases, and growth in the direct-to-consumer channel. We think this target is achievable and more in line with North Face and Vans.

Market Appears to Underestimate VF's Growth Potential
Our $78 fair value estimate implies 11% upside from current trading levels. Through exposure to the growing performance and actionwear markets, an underpenetrated direct-to-consumer channel, and the potential to expand into developed and emerging international markets, we believe VF is positioned to post organic top-line compound annual growth of 9% and average annual organic operating income growth of 13% over the next five years. Because we think outdoor and action sports apparel is differentiated based on performance instead of easily replicated fashion designs, and because economies of scale and a broad brand portfolio should ease the expense and difficulty of penetrating new distribution channels and markets (the basis of our wide moat rating), we have a higher degree of confidence in our performance expectations than with highly volatile no-moat companies.

We also think the 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. With more than $800 million in cash expected on the balance sheet by the end of this year and free cash flow growth excluding acquisitions estimated to be north of 12% on average annually over the next five years, we think this goal can be funded. Thus, our estimate calls for roughly 20% compound annual growth in dividend levels over the next five years.

We expect the outdoor and action sports coalition (currently 56% of sales) to increase revenue organically at a 13% compound annual rate to $10.2 billion in 2017. Although this might seem aggressive for organic growth in the apparel space, 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 direct to consumer accounts for roughly 25% of the business, conservatively. We expect this to grow at a 15% compound annual rate as a result of penetration increases. International market penetration will also aid top-line growth. Assuming that international revenue falls in 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 direct to consumer growing to 27% of total revenue. Although we acknowledge some double counting could be involved, this would imply that our estimate assumes only 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%. We see this coalition increasing revenue at a 3% compound annual rate to $3.2 billion in 2017. Admittedly, this coalition has suffered because of a weak core consumer and a shift away from denim, among other things. However, 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 opportunity (we estimate it is roughly a third of business). This would imply that the remaining coalitions would grow at a 4% compound annual rate to meet our estimates.

We see margin expansion providing another 3 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 direct to consumer (gross margin is roughly 20 points above overall). Although we acknowledge that the direct-to-consumer channel is likely to need increased selling, general, and administrative investment, we think the business will still result in overall higher operating margin.

VF expects acquisitions to contribute 2% compound annual growth to its $17.3 billion revenue target for 2017, implying that acquisitions will add more than $1 billion to the top line by then. 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 $122 million to EBITDA, implying roughly a 12 times enterprise value/EBITDA multiple (slightly more than the Timberland acquisition). We then assume that top-line growth returns to the original organic growth rate of 9% on average annually and that the acquisition operating margin increases from 8% to 15% in five years. 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 is $78 per share.