Branded Apparel and Footwear: Navigating a New Paradigm
In our May 2016 Industry Perspective, I highlighted the rise of e-commerce and the consequent shaping of a new paradigm for the retail and branded apparel and footwear industries. This new model has been extremely disruptive to retailers; it has been somewhat less so to brand vendors that have the flexibility to sell into all channels yet still struggle to counter severe attrition in their brick-and-mortar wholesale businesses. Amazon and other third-party e-commerce platforms present a higher growth avenue for most brands, but this opportunity does not come without risks. And still we are faced with the challenge of navigating a perennially fickle consumer and the volatility in sales and earnings trends their changing preferences typically produce.
Identifying attractive long-term investment opportunities in the industry remains challenging. Although valuations have compressed, dramatic shifts are underway and the range of potential normalized outcomes is broad. We realize the limitations of our ability to accurately forecast negative secular developments and the rise and fall of the next big trend. We thus maintain a conservative approach to investing in the industry. We generally avoid mono-brand companies and look for businesses positioned to withstand—and eventually benefit from—a challenging environment. In pursuing this approach, we are reminded of the wisdom of Charlie Munger, who said, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
Over the last two years we invested in just one new name in the industry: Hanesbrands, Inc. (HBI). We continue to maintain positions in V.F. Corp. (VFC) and Carter’s, Inc. (CRI), and we still have negative exposure to the athletic brands through our short position in Under Armour, Inc. (UA).
Why We Still Like V.F. Corp.
We favor V.F. Corp. primarily for its multi-brand portfolio. While not immune to difficult industry conditions and despite revenue growth that has decelerated more than we anticipated, the company’s fundamentals have been more resilient than most other mono-brand companies. V.F. Corp. is the most diversified U.S. apparel and footwear brand company. It caters to a wide range of consumer categories: segments of the outdoor and action sports markets through The NorthFace, Vans, and Timberland; the western and casual jeanswear markets through Wrangler and Lee; and the workwear market through various other brands. Although demand for any one of its brands can fade, we rarely see an instance when all of the brands are underperforming at the same time. V.F. Corp.’s margins have held up well as a result, and its growing exposure to the direct-to-consumer and third-party online channels—where growth trends are still healthy—will continue to reduce the company’s exposure to weaker brick-and-mortar wholesale channels.
With resilient cash flow trends and a strong balance sheet, it maintains the flexibility to pursue strategic M&A opportunities. Four years after its last acquisition, V.F. Corp. recently acquired Williamson Dickie Manufacturing, a private company that will expand its workwear product. Workwear is an area that V.F. Corp. targets for future growth because margins are high and the products balance the company’s exposure to more trend-oriented brands. As valuations become more attractive across the industry, additional acquisitions could be on the horizon.
Basic Vendor Categories
Hanesbrands and Carter’s are also positioned to consolidate a fragmented industry and accrue share from weaker competitors. Although these companies sell most of their product under just one or two marquee brands, we are comfortable with more concentrated brand exposure when the product is a basic with limited fashion risk like Hanesbrands’ core underwear and Carter’s baby and children’s products. Acquisitions, the potential to expand abroad, and partnerships with Amazon also present opportunities to accelerate the companies’ lower organic growth rates.
Hanesbrands was early to partner with Amazon, while Carter’s announced a distribution agreement with Amazon this year. These and other partnerships (V.F. Corp. and Nike, for example) are sparking a lively debate on the advantages and disadvantages of working with Amazon. Potential risks include: damage to the integrity of the brand and ultimately to margins as Amazon is notorious for emphasizing volumes and share gains over profits; and Amazon could eventually introduce its own competitive product.
We certainly appreciate and closely monitor these risks, but there are mitigating factors and even some positive offsets. First, when Amazon enters into a formal agreement with a vendor, the terms are similar to those with any other wholesale customer. V.F. Corp. and Hanesbrands management note that once the product distribution teams are formed and they reach a certain amount of volume, the margins on sales to Amazon are similar to traditional wholesale margins. For products like t-shirts and underwear that have historically had large exposure to the mass channels, increasing sales to third-party online vendors like Amazon reduces customer concentration, which is a good thing for any vendor. For example, Hanesbrands’ exposure to Wal-Mart Stores, Inc. (WMT) has decreased from nearly 30% of total revenue to 20% of total revenue over the last five years as Hanesbrands has grown in international markets and expanded its sales on Amazon.com, which is now Hanesbrands’ fifth-largest customer.1 In addition, a formal arrangement with Amazon enables vendors to place more rigor around minimum advertised pricing for their products. It can also lead to restricted distribution of their product by third-parties, which helps the company control where and how their product is distributed. For example, shortly after Nike partnered with Amazon, a number of vendors reportedly received notice that many of the Nike products they sell are now restricted.
At the end of the day, an increasing number of customers are going to shop on Amazon. It’s a reality that all vendors have to address. They can choose to work directly with Amazon and better control what and how product is presented on the site, or they can choose to forego the sales. Amazon is no different from any other retailer in its ability to compete directly with private-label product. Retailers have been doing it for years in many apparel categories, and still the market share for the leading brands has stayed fairly consistent.
Athletic Apparel and Footwear
Athletic brands used to compete on quality and performance innovation. However, the rise of the athleisure trend introduced a significant fashion element to the athletic brands and invited more competition to the category. During this transition, the leading brands were still enjoying strong average selling price and unit growth. We were concerned about the sustainability of these trends, yet valuations were still elevated. We established short positions in companies where we saw the largest disconnect between our outlook for fundamental trends and valuations: Under Armour and Lululemon Athletic. We covered our position in Lululemon when it reached our estimate of intrinsic value, but we maintained our short position in Under Armour. Under Armour’s stock price fell sharply over the last year, reaching our initial estimate of intrinsic value. However, since the company’s fundamentals and industry conditions deteriorated even more than we expected, we lowered our estimate of intrinsic value and—with still a large margin of safety—added to our short position.
Recent comments from management at both Dick’s Sporting Goods and Foot Locker capture the current environment well. “Pricing has gotten really competitive…we think it’s going to be…promotional and at times irrational going forward, particularly in athletic apparel,” said Dick’s CEO on the company’s second-quarter 2017 earnings call. The CEO of Foot Locker, which sells primarily higher- to premium-range athletic footwear, commented during the most recent earnings call, “The old multi-season seed, ignite and roll-out of key platforms doesn’t work as effectively anymore…the high level of promotional activity affected us more this quarter than in the past.”
Recent data points corroborate these comments: on a two-year basis, Nike’s North American footwear and apparel growth rates are at multi-year trough levels; and SportScan data from July and August 2017 reflect extreme pressure in Nike’s North American footwear (down mid-teens) and apparel (down low single digits) average selling prices. These weak Nike metrics can’t be good for Under Armour, which has higher exposure to the North American market (80% of revenue compared to Nike’s 50%) and far less scale, margin, and balance sheet capacity to absorb negative trends.
The one athletic brand that is doing well and taking share from Nike and Under Armour is Adidas. Adidas is realizing strong demand for its retro styles (Stan Smith) and lifestyle lines (anchored in the appeal and image of Kanye West), as well as the more performance-oriented Ultraboost style. However, the Stan Smith craze is already starting to reverse and the hype around the lifestyle shoes is likely to fade. Adidas may have secured more sustainable demand for its Ultraboost product since it has a performance element, but with much of its sales growth spurred by fashion trends, strong demand for Adidas products could stall sooner rather than later.
With Under Armour struggling and Adidas’ growth likely to moderate, Nike could regain share. Its research and development capabilities and athletic endorsements remain top-notch, but we still view a misalignment between Nike’s higher valuation and the potential for further deterioration in its fundamental metrics.
In conclusion, I borrow once more from Munger: “Opportunity meeting the prepared mind, that’s the game.” At Diamond Hill, focused industry coverage along with a long-term investment horizon enhances our understanding of cyclical and secular trends. While we maintain low exposure to the apparel and footwear industry at this point, we are prepared to act on additional investment opportunities when our research and valuation discipline informs us that the time is right.
1 Hanesbrands, Inc. 2016 Annual Report
As of August 31, 2017, Diamond Hill owned shares of HBI, VFC, and CRI.
As of August 31, 2017, Diamond Hill held short positions in UA and WMT.
Originally published on September 20, 2017.
The views expressed are those of the research analyst as of September 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.