Necessity.
It’s one of my favorite words when it comes to long-term investing.
I love investing in businesses that provide some kind of necessity.
It’s simple.
If you’re providing necessary products and/or services, it’s practically necessary that your profit rises over time.
This idea is uncomplicated yet also incredibly powerful.
And it’s an idea that I’ve stayed true to over the years, building up my FIRE Fund in the process.
Indeed, this portfolio and the passive dividend income it produces allowed me to retire in my early 30s.
My Early Retirement Blueprint describes exactly how I was able to accomplish that.
Investing in the necessary has led me to investing in high-quality dividend growth stocks.
It’s a straightforward leap from one to the other.
Businesses are able to pay out reliable, rising dividends because they’re generating reliable, rising profits.
Hundreds of these stocks can be found on the Dividend Champions, Contenders, and Challengers list.
As great as these stocks can be for long-term investment, valuation at the time of investment is always important.
Price is only what you pay. But value is actually what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value. And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Buying a high-quality dividend growth stock providing the world with the necessary, and doing so when valuation is favorable, is a near-guaranteed way to make yourself wealthy over time.
Fortunately, finding those favorable valuations isn’t as challenging as you might think.
Fellow contributor Dave Van Knapp put together a series of “lessons” on dividend growth investing – one of which is Lesson 11: Valuation.
It provides a valuation template that can be aptly applied to just about any dividend growth stock.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
VF Corp. (VFC) is a worldwide apparel and footwear company.
Founded in 1899, VF is now a $27 billion (by market cap) apparel titan that employs more than 33,000 people.
Some of VF’s most important and recognizable brands include: Vans, The North Face, Timberland, and Supreme. The Supreme acquisition closed in late 2020 for $2.1 billion.
The company has three segments: Outdoor, 45% of FY 2021 revenue; Active, 45%; and Work, 10%.
Revenue geography is nicely diversified. 50% of FY 2021 revenue came from the US; 50%, international.
Channels are also diversified. Wholesale accounted for 55% of FY 2021 revenue, while the other 45% came from direct-to-consumer sales.
VF has multiple clothing types for multiple clothing settings locked down. Whether it’s for work or play, they cover it with high-quality options across their branded portfolio.
And with their large DTC channel, they’re already ahead of the e-commerce curve. They’re providing products on their customers’ terms.
Apparel is one of my favorite business models to invest in.
I say that because they’re providing a necessary product to society.
You can’t go around without clothing and footwear. And while you certainly don’t have to buy your clothing or footwear from VF, their brand strength gives them a leg up on a lot of the competition.
Providing necessary products to an ever-larger pool of global customers, at ever-higher prices, is a recipe for ever-higher profits.
And that should naturally lead to ever-higher dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, VF has increased its dividend for 48 consecutive years.
They’re a Dividend Aristocrat.
Actually, they’re a Dividend Aristocrat nearly twice over.
The five-year dividend growth rate is 9.0%.
We’re looking at a yield-and-growth combination that’s in the double digits here.
That 2.9% yield, by the way, handily beats the market.
It’s also 50 basis points higher than the stock’s own five-year average yield.
The dividend remains protected by a payout ratio of 61.3%, based on this year’s adjusted EPS guidance.
Great dividend metrics here.
Revenue and Earnings Growth
As great as they are, though, they’re looking backward.
Investors are risking today’s capital for tomorrow’s rewards.
As such, I’ll now attempt to build out a forward-looking growth trajectory for the business, which will later help in the process of estimating the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
I’ll then compare that to a near-term professional prognostication for profit growth.
Contrasting the proven past with a future forecast in this way should give us a pretty good idea as to where the company might be going from here.
VF’s revenue is basically flat over the last decade, moving from $9.459 billion in FY 2011 to $9.239 billion in FY 2021.
Meanwhile, earnings per share actually fell substantially over this period, from $2.00 to $1.04.
I won’t lie. These numbers are pretty ugly.
However, I think it’s important to properly frame this.
First, VF spun off its Jeanswear business in 2019. This spin-off, which is Kontoor Brands Inc. (KTB), is a $3.2 billion company on its own. This spin-off had the effect of immediately lowering VF’s sales in a material way.
Second, and more importantly, the pandemic gravely harmed the company’s revenue and profit in calendar year 2020.
While that second issue is the more pertinent one, it’s also the temporary one.
Investors cannot and do not invest in the past. We’re risking present capital for future rewards.
And so, as we move past the pandemic, the question becomes: How will VF perform over the coming years?
Looking forward, CFRA is anticipating that VF will compound its EPS at an annual rate of 31% over the next three years.
That’s kind of an eye-boggling number, especially when you put it up against the last decade. But the last decade looks so bad only because of last year. FY 2021 was an aberration, and not indicative of this company’s true earnings power.
I don’t think it’s unreasonable to expect huge growth numbers off of an earnings trough as the business fully recovers.
To that point, VF is expecting adjusted earnings per share to be at least $3.20 this fiscal year. That would represent 144% YOY growth compared to FY 2021 adjusted EPS.
Moreover, the Supreme acquisition didn’t complete until December 28, 2020. This is a big brand that’s growing faster than VF as a whole, and VF has stated that they expect this acquisition to be immediately accretive.
When you combine an exciting, accretive acquisition with a strong recovery, VF is positioned to bounce back aggressively.
While EPS growth could very well be well into the double digits for the foreseeable future, I don’t think the dividend will necessarily grow at the same rate.
I believe that VF will responsibly manage the dividend and continue growing it at a high-single-digit range. That’d be right in line with their long-term history.
With the near-3% yield, that should be more than enough to make shareholders happy.
One last point here that I’d like to make is that VF didn’t cut the dividend during 2020, even though business results temporarily collapsed. I think that really shows just how committed to the dividend this company is.
Financial Position
Moving over to the balance sheet, VF’s financial position is good.
I will say that the numbers here look worse than they really are, due to the most recent fiscal year seeing both the closing of a major acquisition and a large drop in EBIT at the same time.
The long-term debt/equity ratio is 1.87, while the interest coverage ratio is slightly over 4.
I think the latter number will improve markedly over the next year or two as earnings normalize.
Profitability is robust.
Over the last five years, the firm has averaged annual net margin of 6.81% and annual return on equity of 19.61%.
I think profitability will also improve as we move forward and see the business recover. In addition, Supreme has better margins than VF as a whole, so the acquisition should put upward pressure on margins.
I see a lot to like about VF as a long-term investment.
And the company does have durable competitive advantages that include brand strength, global distribution, a multi-channel business, and economies of scale.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
There’s integration risk with the large Supreme acquisition, although VF has a long history of successful acquisitions and integration. Vans, The North Face, and Timberland were all acquired.
VF has some exposure to struggling B&M US retailers through the Wholesale channel.
Brand strength is something that has to be continually managed and marketed, so VF will have to properly maintain these brands moving forward.
Fashion trends are highly changeable. The company must stay on top of trends to continue growing.
Overall, I see these risks as fairly low.
Yet, with the valuation being so appealing after a 25% drop from its recent high, the possible rewards are very high…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 34.0.
That ratio is artificially high because of depressed earnings. Even so, it’s still lower than its own five-year average of 35.2.
The P/CF ratio of 19.1 is also well below its five-year average of 22.6.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
That DGR is on the high end of what I ordinarily allow for, but I think this Dividend Aristocrat deserves the benefit of the doubt.
It is below the company’s demonstrated five-year and ten-year dividend growth rates, respectively. So I’m being somewhat conservative here. It’s also quite a bit below CFRA’s near-term EPS growth forecast.
I think VF can properly balance a business recovery (which should result in double-digit EPS growth over the next few years) with growing the dividend at a level that’s not far off from (but perhaps slightly below) their long-term average.
The DDM analysis gives me a fair value of $84.28.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I don’t see my valuation model as all that aggressive, yet the stock looks cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates VFC as a 3-star stock, with a fair value estimate of $66.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates VFC as a 5-star “STRONG BUY”, with a 12-month target price of $80.00.
I came in a bit high this time around. Averaging the three numbers out gives us a final valuation of $76.76, which would indicate the stock is possibly 13% undervalued.
-Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is VFC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, VFC’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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