Highlighted Holding: PVH Corp.
Fourth Quarter 2022 Highlighted Holding: PVH Corp.
For Financial Advisor Use Only
We believe PVH’s management has a viable plan to spur meaningful long-term earnings growth; the stock’s valuation is such that even a marginal improvement in sentiment may lead to shares re-rating.
PVH Corp. is one of the largest brand houses in the world, with sales of over $9bn in 2021 generated in more than 40 countries. The bulk of the company’s earnings come from the eponymous Calvin Klein (CK) and Tommy Hilfiger (TH) labels, which are two of the most successful and well-known fashion lines in history. CK’s and TH’s underlying performance strongly suggests the brands are as strong as ever, but PVH’s share price—down over 33% in 2022 and trading at just 8.5x¹ its forward earnings estimate— implies otherwise. The factors underpinning PVH’s material valuation discount are, in our view, almost entirely temporary and unlikely to persist longer term. Investors are nonetheless valuing the company as if current recessionary conditions will be permanent, disregarding PVH’s long-term value proposition and potential for significant earnings normalization.
EXECUTION MISSTEP PRESENTS AN OPPORTUNITY
In 2016, PVH hired Dior’s reputable creative director Raf Simons, whose vision was to elevate CK’s status in the marketplace from premium to luxury. The strategy shift coincided with significant investment in the brand, pressuring margins. After a few fashion cycles, Simons’ designs were critically acclaimed and won several awards, but unfortunately, they were not commercially successful, and he left the firm in 2018. Beyond the CK fashion miss, the market believed PVH was ill-prepared to capitalize on the growing prevalence of e-commerce. Specifically, investors were concerned over PVH’s large brick and mortar presence and questioned whether its brands could command engagement and pricing power in a world of infinite online shelf space. Around the same time, U.S.-China trade/geopolitical tensions were boiling over and pressuring stocks linked to discretionary spending and tourism; these converging headwinds sent PVH’s stock into bargain territory, setting up a classic value opportunity.
Upon Raf Simons’ departure, PVH announced that CK would return to its roots as a premium apparel brand with a minimalist aesthetic. We made our initial investment in 2019 on the premise that CK’s timely transition would both reinvigorate the top line and improve margins given the discontinuation of luxury-related investments.
We also believed that macro-related pressures would prove temporary, and that PVH’s e-commerce initiatives were further along than investors were giving it credit for. PVH’s profitability began to improve, but the ensuing COVID-19 pandemic provided an unforeseen challenge for management.
PANDEMIC RESTRUCTURING AND PVH+
PVH acted quickly in the early months of the pandemic to bolster its liquidity position and cut discretionary investments. This afforded the company the financial flexibility to withstand prolonged periods of uncertainty and store closures, while its underappreciated e-commerce capabilities helped support sales. Under the leadership of CEO Stefan Larsson (who joined PVH in 2019), PVH has been using the downturn as an opportunity to enhance the company’s operating model and emerge as a stronger business. The new strategic plan, deemed PVH+, contemplates an end-to-end restructuring of the business, with investments focused on 1) demand generation, 2) channel optimization, and 3) cost efficiencies.
On the demand side, CK and TH plan to connect more closely with consumers, while repositioning supply chains to react more nimbly to demand signals. We believe this data-driven operating model should lead to structurally higher gross margins. PVH will look to augment this by a pruning the long tail of unproductive products at CK and TH and instead reemphasize core bestsellers.
On the channel optimization front, PVH is investing more to effectively reach consumers as they increasingly shift their purchases online. CK and TH’s ecommerce offerings (which account for 25% of revenue today versus 10% pre-COVID-19²) are being supercharged via demand-led initiatives in product assortment and consumer engagement. Additionally, fulfillment options are being expanded to meet consumer needs. These actions, combined with a store base of relatively short-duration leases, should allow CK and TH to rapidly follow consumers to their preferred shopping channels, however they may develop.
Additionally, fulfillment options are being expanded to meet consumer needs. These actions, combined with a store base of relatively short-duration leases, should allow CK and TH to rapidly follow consumers to their preferred shopping channels, however they may develop.
Lastly, on the cost efficiency side, PVH has undertaken holistic restructuring initiatives by divesting minor brands, which were unprofitable distractions, and reducing headcount and office space. The latest endeavors are expected to cut $100M in costs (~10% of operating profit)³.
While we do not dismiss management’s ability to execute on PVH+, we also do not account for it in our model. We do believe these actions will create a stronger, more profitable PVH, but our model assumes the company reverts to its pre-COVID-19 trajectory—which effectively implies a normalization of today’s irregular operating environment. We assume revenue grows at roughly 2% per year (in line with the historical average) off 2019’s base, with operating margins expanding to 11% from 9–10% today. On that basis, PVH is trading at just 5.5x our normal earnings projection4. For context, management believes PVH+ will manifest in sustainable margins of 15% and revenue of $12.5bn by 2025, and shares are trading at just ~3.1x their long-term earnings estimate5.
It is also important to note that in Europe, CK and TH are already executing at or above the operating model contemplated by PVH+. Case in point, both TH and CK’s international sales—which are highly exposed to Europe—are up from pre-COVID-19 levels (Figure 1), lending credence to management’s strategy of sharing best practices between its European, North America, and APAC units.
MACROECONOMIC FEARS DOMINATE SENTIMENT
For the better part of 2022, shares of PVH have largely fluctuated around macroeconomic developments. Arguably the event most damaging to investor sentiment was Russia’s invasion of Ukraine. Notwithstanding PVH’s direct sales exposure to Russia/Ukraine, which is fairly de minimis, investors’ main trepidation was the war’s negative impact on the European consumer, to which nearly half of PVH’s sales are levered to. Additionally, Europe’s economic stress has a knock-on effect for PVH via a weakening Euro, which was solely responsible for the recent revenue declines at both TH and CK International.
If that was not enough, up until very recently, the Chinese government’s strict adherence to zero-COVID not only hurt PVH’s direct sales there, but had a more pronounced effect on its North American business—the reason being that an estimated 30–40%6 of PVH’s North America sales typically come from inbound tourists to the U.S., and tourism is still materially below pre-COVID-19 levels, principally due to Chinese lockdowns that are only just starting to be scrapped (Figure 2).
To be sure, the global economic slowdown and COVID-19-related disruptions have caused financial pain for PVH, but even under these severely stressed conditions, the company is free cash flow positive and slated to generate over $1bn in EBITDA and $8 of EPS for 20227. Even with European recessionary conditions, elevated raw materials prices, minimal North American tourism, etc., the stock is still trading at 11.2x8 its current earnings that incorporate this pain. While it is certainly possible that the environment does not meaningfully improve in the short term, we do not believe it is rational to extrapolate current headwinds in perpetuity.
It seems unlikely that today’s global macroeconomic conditions will remain indelibly, but even in that dire scenario, PVH’s current multiple is roughly 25% below that of its pre-COVID-19 average9, implying years of future earnings degradation instead of any sort of improvement. If the environment begins to normalize, and at least some of the systematic pressures impacting PVH’s bottom line abate, we estimate earnings upside of 55%10. The stock is trading at just 5.5x that projection and appears cheap on virtually any valuation metric (Figure 3).
. Source: FactSet Jan. ‘23E consensus EPS of $8.28
. Source: Company filings, Pzena analysis
. Source: Company filings, Pzena analysis
. 12/30/22 closing price of $70.59 and Pzena NEPS estimate of $12.90
. PVH Investor Day 2022 presentation
. PVH Company Filings
. Source: FactSet Jan. ‘23E consensus estimates
. TTM diluted EPS of $6.30
. Monthly average of PVH’s FY1 P/E ratio between Jan. 2010 and Jan. 2020
. Jan. ‘23E consensus EPS of $8.28 versus Pzena NEPS estimate of $12.9
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