Special Situations: Ecolab and Kontoor Brands
The S&P has almost fully recovered from its March plunge. Year to date, it is only down 6.5% (including dividends). Cheap compounders are once again in short supply (though we’re working on a few you’ll see in subsequent write-ups), so some special situations are naturally catching our eye again. This week there are two: the Ecolab exchange offer and forced selling in Kontoor Brands.
Ecolab Exchange Offer
Ecolab plans to combine its upstream energy business (named Nalco Champion) with Apergy in a tax-free "Reverse Morris Trust" transaction. First, Ecolab will spinoff Nalco Champion via an exchange offer. Immediately, Nalco Champion will merge with Apergy and the combined company will be renamed ChampionX. Ecolab shareholders will own 62% of ChampionX and Apergy shareholders will own the balance.
Ecolab is offering to exchange up to $111.11 of ChampionX for every $100.00 of Ecolab subject to a 24.6667 upper limit on shares of Ecolab to Apergy. There is no lower limit. The exchange has a built-in profit of up to 11.11% to incentivize participation.
This makes it likely that the exchange offer is oversubscribed and prorated. However, the transaction contains an odd lot provision which shelters investors tendering 99 shares or fewer from proration. This transaction is structured like the McKesson-Change Healthcare transaction we wrote up in February.
The precise exchange ratio will depend on the volume-weighted average price ("VWAP") of Ecolab and Apergy on May 27, 28, and 29th. Ecolab will publish the final exchange ratio by 9 AM EST on Monday June 1. It looks like the upper limit will be in effect, which substantially reduces the trades profit potential. The offer expires on June 3 (at 12:01 AM EST).
The trade would be to buy 99 shares of Ecolab for $20,500 and tender them. You'd receive 22,442 shares of Apergy (24.6667 x 99). Those Apergy shares are worth $21,400 currently, implying a $900 profit and 4.4% return.
Given recent market volatility, this isn’t a wide enough profit margin for us to participate. Shares of ChampionX could easily fall 4.4% by the time you get them. And ChampionX isn’t something we’re interested in owning long-term. Investors could sell short Apergy shares to lock-in a sale price ahead of time, but that has its own risks and complications. Buying stocks is hard enough, so we don’t mess around with shorting.
Kontoor Brands
Kontoor Brands has been our radar for about a year following its spinoff from VF Corp. We bought the stock last summer and sold it this winter for a tidy profit. It exhibited classic spinoff dynamics: V.F. Corp’s growth-focused investors sold the stock indiscriminately after they received shares in the spinoff. Then, when Kontoor declared a large dividend, yield-focused investors came in and bought it, causing shares to rally. We bought it for about $28 and sold it a few months later for about $40, which is about where we pegged its intrinsic value.
Since then we’ve continued to keep an eye on the stock as it has plunged. Today the stock trades for $14, only a hair above its $12.90 52-week low.
What happened? When V.F. Corp spun off Kontoor, they saddled it with about $900 in debt (2.9x leverage) and took the proceeds for itself. That’s a standard practice with spinoffs. Kontoor has a steady business selling Lee and Wrangler jeans, so normally this wouldn’t be an issue. However, we’re not in normal times.
In response to the pandemic, Kontoor drew down $475 of its $500 million revolver and preemptively amended its covenants. The company worried that under certain scenarios it would breach its 4x leverage limit.
The amended terms allow Kontoor’s leverage to run as high as 5.5x in Q2 and Q3 before tapering back to 4.0x by Q2 2021. The amendment also calls for Kontoor to maintain at least $200 million of liquidity and suspend its dividend.
That last item - suspending its dividend - is what makes the stock interesting again. Once again, Kontoor’s shareholder base is turning over, but this time the dividend investors are piling out. Kontoor doesn’t have many prospects for growth, so its dividend yield is the cornerstone of its total return proposition. The stock yielded over 5% even at its highs above $40.
Now that the dividend is gone, its yield-hungry investors are abandoning it. One of Kontoor’s largest shareholders is the SPDR S&P Dividend ETF (symbol SDY). SDY owns 17% of Kontoor.
The fund tracks the S&P High Yield Dividend Aristocrats Index which aims to own the highest yielding stocks in the S&P 1500. Per its prospectus, it will sell its holdings by the end of the month if a company cuts its dividend or falls below a $1.5B market cap. Kontoor is guilty on both accounts and the end of the month is today. Not surprisingly, Kontoor is down over 4% today (versus the market’s 1% decline).
SDY doesn’t strictly have to dump its KTB shares. Its prospectus allows holdings to deviate 20% from the index it tracks. However, large tracking errors aren’t good for business. Kontoor is less than 1% of SDY’s assets, so the fund will most likely sell the shares by today’s close at whatever price it can get.
Most likely SDY will do a large block trade with a bank or broker to get the shares off its books by the close. That counterparty will buy the shares at a discount and work out of the shares over the coming days. This could put pressure on Kontoor’s share price for reasons entirely unrelated to its fundamentals.
Kontoor is a good but not great business. It earns mid-high teens on its tangible equity and produces consistent free cash flow (approximated by Adj. EBITDA-Capex).
The chart above shows that free cash flow was stable in 2008 and 2009 but has declined recently. I chalk up much of that to neglect under VF Corp, who milked Kontoor for cash to reinvest elsewhere.
Now that Kontoor is independent its management is incentivized to improve the business. Last year management focused on improving quality of sales, which meant exiting unprofitable channels. This reduced revenue along with retailer bankruptcies, like Sear’s. Now, Kontoor is focused on increasing distribution. In Q3, 2,000 new locations will begin selling Lee and 400 will begin selling Wrangler. This should help to regain some of the sales lost last year and at a higher margin to boot.
The company’s digital sales were strong last quarter, growing 41%, but from a very small base. Kontoor is still highly dependent on its US wholesale channel which runs through retailers like Walmart. The good news is that these retailers are still open and selling, which mitigates some of the pandemic's impact versus other apparel companies. There's no doubt, though, that more retailer bankruptcies (like J.C. Penney's) will cancel out much, if not all, of Kontoor's growth elsewhere.
One piece of good news is that Kontoor owns about a third of its manufacturing. This lets it more tightly control inventories and will allow it to ramp up quickly when the time is right. In Q1, inventories grew $30 million or 7%. However, some context is needed. Working capital and inventories are usually lowest in Q4 following holiday sales. They build in Q1 and peak in Q3 as Kontoor ships holiday product. This quarter's inventory build was in line with history and actually smaller than 2019's 10% build. This is a subtle, but not insignificant, sign that Kontoor is managing reasonably well through this downturn.
Kontoor’s inventory is largely evergreen. Jeans don’t change much season to season. Some inventory is seasonal and will need to be liquidated. Kontoor owns its own outlets which will allow it greater recoveries than if it liquidated through the usual channels every other retailer will be stuffing this summer.
Brands seem to have more staying power in denim than elsewhere in fashion. Case in point: Levi, which has been around for 167 years doing essentially the same thing. That’s exceptionally rare for a business. The few businesses that have lasted that long have had to reinvest themselves multiple times (American Express comes to mind). Lee and Wrangler are almost as old as Levi, founded in 1889 and 1904, respectively. These brands have already survived two world wars, the Spanish Flu, Great Depression, inflation, deflation, booms and busts.
Another mark in Kontoor’s favor is anecdotal evidence that consumers are turning towards tried-and-true brands amidst the pandemic’s uncertainty. That should favor incumbents like Lee and Wrangler, especially because they are sold at approachable price points that consumers may trade down to.
To value Kontoor, I assume that after a few years sales recover to $2.5 billion, 2019’s levels. 12-year average free cash flow margins are 14%. Margins were 14.7% in 2017, 13.4% in 2018, and 13.6% in 2019, so I'm anticipating some reversion to the mean here.
Interest should run about $50 million per year and taxes should run at 22%. Putting it all together, Kontoor should earn about $235 million in a normalized environment.
Kontoor should be capable of growing a few percent per year, but I wouldn't call it a growth stock or necessarily even bet on it. Using a 10% discount rate and no growth suggests capitalizing Kontoor's earnings at 10x. This would value Kontoor shares at about $41, which is near where the stock peaked before the pandemic.
Kontoor's goal was to pay out 60% of earnings as dividends. It used to pay $2.24 per year, which is about 55% of my estimate of normalized earnings. This is a good double check for reasonableness with management's expectations.
At $14 per share, Kontoor is worth $800M, which is only 4x normalized earnings. This looks much too low if the company can survive long enough to make it to a normalized environment. If the stock does re-rate from 4x to 10x over five years, investors will earn 20% annually.
That’d be a wonderful result, so what’s the catch? Liquidity. Kontoor needs to maintain $200 million per its amended credit agreement. That gives it $300 million of firepower. But, Kontoor has $490 million of commitments due in 2020, per its 10-K. That means it needs to earn about $190 million of free cash flow. Said differently, free cash flow can’t decline more than 45%.
This gives Kontoor a decent amount of room, but not so much that I’d say survival is a no-brainer. If things really get back, Kontoor can likely amend its credit facility again to tap the remaining $200 million of cash on its balance sheet. Banks don’t want to sell jeans, afterall. Kontoor will most likely reduce some commitments and reduce SG&A, providing a further buffer. How much room this buys is impossible to predict.
Overall, Kontoor is an interesting special situation but definitely not a compounder. It looks like a levered bet on a recovery. Shares could easily shoot back to $40 in a “V-shaped” recovery scenario. At the same time, while unlikely, it is not unimaginable that the company’s equity is permanently impaired by a slow recovery.
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