A Couple of Things to Think About from VF Industries

With a different company I’d probably do what I usually do; get down and dirty in the financial statements. Some of you like that. Some hit the delete key early in the article. A few tell me they fall asleep.

VF released its results for the quarter and year ended December 31, 2010 the week before last. I spent most of this week in Florida with my college roommates without wives playing bad golf and having an occasional beer. I don’t suppose you need any further explanation as to why this didn’t get posted sooner.

But I digress. I guess I could spend lots of time analyzing VF’s balance sheet, but basically what’s you’d take away from that analysis is that it’s big and strong with assets of $6.5 billion and equity of $3.86 billion. They had revenues of $7.7 billion for the year (up 6.7%) and $2.13 billion for the quarter (up 11%). Net income for the year rose 23.9% to $571.4 million. Cash flow was in excess of $1 billion. They have no debt due until 2017 and paid down $200 million of higher cost debt. Acquisitions remain at the top of their priority list.  Check out the press release yourself if you want more details.
 
So instead of my usual, and sometimes pedantic, financial analysis let’s look at how the actions sports components of their business did (to the extent they give us that information) and then review some of the things they discussed in their conference call. There are some lessons to be learned and some insights into how the industry is evolving there. 
 
Revenue for the quarter in VF’s Outdoor and Action Sports segment, which includes Vans, Reef and The North Face in addition to other brands, grew 20%. The Americas revenue was up 17% and international 32% on a constant currency basis. The North Face) and Vans businesses each grew in excess of 40% in the quarter internationally.” Not sure if that’s constant currency or not.
 
With revenues of $896 million for the quarter, Outdoor and Action Sports is the largest of their 6 segments. Direct to consumer (stores and internet) revenue rose 21% in the quarter in this segment, with Vans and the North Face experiencing double digit increases. Overall, VF ended the quarter with 786 stores after adding 85 during the year. “The strong top and bottom line growth [in the quarter] was fueled in part by a nearly 60% increase in brand-building investments and initiatives during the quarter, particularly in The North Face and Vansbrands.” Of additional selling, general and administrative expense spending of $100 million that occurred during the year, over the whole company $45 million was spent during the fourth quarter.
  
Revenue in that segment grew 14% for the year to $3.2 billion. The next largest segment grew 11% in the quarter and 5% for the year.
In 2011, VF expects their Outdoor and Action sports business to “…grow at a mid-teen percentage rate.” All their other segments are expected to in the “mid-single digits.” Outdoor and Action Sports is becoming increasingly important to VF. They expect a lot out of Vans and expect to grow North Face to $3 billion of revenue in five years. As they announced at a North Face conference last fall, they plan to “…reach new consumers by focusing on the unique needs of athletes and enthusiasts who participate in hiking, climbing, performance athletic, and action sports. We call this our Activity Based Model (ABM), which is designed to deliver technically superior and relevant products across four consumer segments: Outdoor, Performance, Action Sports and Youth.”
 
Pay attention to this. Action Sports is much less specific as a segment or industry than it used to be. This isn’t a new trend and it’s certainly not unique to VF. I’m sure you all saw Transworld Business’ recent announcement, as reported on Boardistan, that they would start covering wakeboarding, motocross and BMX.
 
Okay, that’s a very brief summary of their financial results and comments on the Outdoor and Action Sports segment. Let’s move on to other issues they discuss in the conference call.
 
I stopped dead in my tracks when the first question from an analyst was how much of the increased revenue for 2011 would be from price increases. I hadn’t heard that issue raised for a long time. The answer, by the way, was “a few percentage points” of the eight to nine percent projected revenue increase. Once you discuss price increases, of course, you also have to discuss the impact on demand of higher prices. Let’s spend a little time on the price of cotton, costs and cost management, and how VF is handling it. As VF notes, “We’re aware that we are entering a new environment here in terms of consumer reaction to broadly higher apparel prices and that some trade-off in unit volumes is likely.”
 
Management notes in its opening remarks that it’s already taken some price increases across its brand portfolio in recent months to offset product cost inflation, and that they will continue to implement further increases during 2011, more in the second half than the first. These increases will be focused on products, especially jeans, where the cost of cotton is most critical. VF’s overall product costs will rise a projected 7% in 2011 and “Price increases and other factors positive to our gross margin comparisons will not entirely offset the pressure from higher product costs.”
 
Jeans represent about 20% of VF’s revenue and “…for these jeans products, costs are expected to rise by mid-teen percentages for the full year…” “Now while price increases will partly offset higher costs, gross margins for these businesses in 2011 will come down from 2010 by over 350 basis points.”
 
That’s quite a decline. Jeans operating margins, however, are expected to decline by less than 100 basis points. How are they managing that?
 
Well, by expense management of course. And by “reengineering” their products. That can mean removing features, using different materials, or just be smarter in how you make things.
 
VF also has an advantage is dealing with rising cotton prices because they make 65% of their U.S. jean products in their own plants. That doesn’t help them with price increases in denim, but they believe they can keep their labor costs flat by bringing more volume into their own plants. Most of you who are reading this and sell jeans or other denim products don’t have that advantage.
Another thing they note is that VF purchases 50% more denim to carry into 2011 than they normally would. Obviously, that’s to stock up before price increases. It’s a great idea if you have the balance sheet to pull it off, and I’m sure VF isn’t the only large company doing it. But that increases demand and stocking up has some impact on prices all by itself. If you aren’t one of the companies that can do it, you’ll face even higher prices when you do your purchasing.
 
Here’s another way VF thinks about the impact of price increases: “On the domestic front where we are so heavily penetrated, particularly in our Jeanswear business in the mass and mid-tier, an increase in cost of denim has a much more severe inflationary impact on our pricing to consumers. In Europe and in Asia, where products are so much more expensive to begin with at a base level, the percentage increase from the inflation is relatively minor and relatively easy to pass through. This is a much lower percentage of higher priced products.”
 
So the percentage increases in Europe and Asia are smaller and, therefore, less noticeable to the consumer because the average retail price there is 50% to 75% higher there than in the U.S. But they note that the gross margin impact of higher costs not offset by higher prices will still be around 200 basis points.
 
VF management is, I think, very realistic about what’s going on in the U.S. “You raise a real issue that particularly American consumers face is cost inflation across their lives. And that comes home particularly strongly in the mid-tier and mass channels, where as consumers pay more for food and for gasoline, for their cars and for their apparel, it’s going to put pressure on what they spend their money on.”…“That’s what gets us to the mid-single digit unit declines in our Jeanswear business, which we just haven’t had. But that’s why we’re seeing that is we expect great cost pressure to really influence how much consumers can afford to spend on apparel.
 
I think VF is right, and if they are thinking about the impact of inflation on demand for their products, we all need to be thinking about it.
 
Overall, then, what does VF see that we might want to focus on as well? First, cost inflation that isn’t going to be easy to pass on and will impact consumer spending because food, gas, and other necessities come first. Second, that there’s more opportunity internationally than domestically. They plan to open 100 new stores in 2011. 60% will be opened outside of the U.S. due to the strength of the operating performance they are achieving internationally in their stores. Hardly a surprise since that’s where incomes are rising and more “middle class” consumers are popping up. Income has at best stagnated in this country over the last ten years.
 
Third, they see great opportunities in direct to consumer, and it seems that the distinction between brick and mortar and on line is blurring. I think they’re right and that’s probably worth a separate article. Fourth, making their own product in their own factories is an advantage in an inflationary environment. And the inflation they are talking about ain’t just in cotton prices.
 
Finally, the push they are making with The North Face tells us something about how they think about the action sports market. It’s outdoors and it’s youth culture and not nearly as exclusive as we use to think.
 
Your business is probably a bit smaller than $7.5 billion, but those are all issues that will impact it anyway.