Kontoor Brands, Inc. (NYSE:KTB) is a $2.25 billion small-cap stock that competes in the apparel and accessories market. While the stock has lost momentum following a great Q4 2022 earnings report followed by a dismal Q1 2023 earnings report. With returns of 149.90% over the last three years, KTB stock has outperformed its peers Levi (NYSE:LEVI), Guess (NYSE:GES), and previous parent firm V.F. Corporation (NYSE:VFC).

Despite missing its profitability and revenue predictions in the Q1 2023 profitability report, management remains confident about the Chinese market’s quick rebound. However, the company’s foreign wholesale performance has been negative this quarter. As a result, I recommend a hold rating until we see improvements in the Chinese market while keeping in mind the macroeconomic issues and potential negative impacts on the US market.

Introduction

Kontoor Brands was set off from V.F. Corporation in 2019 with a denim focus. Today, the brand wants its clients to be able to freely express themselves through a greater range of clothing options. With its roots in denim management, the company has expanded its categories to include casualization, comfort, and outdoor activities. Its income is generated by two segments: its Wrangler and Lee brands, which include denim, apparel, footwear, and accessories. The corporation operates in the United States, overseas markets, and direct-to-consumer markets. The company’s revenue is split down into regions and brands below, with Wrangler in the United States being the most significant contributor to its top-line growth.

A diverse business strategy has an impact on the organization. At the same time, US revenue increased by 2% to $518 million, while overseas sales decreased by 14% to $149 million due to a 32% reduction in China sales YoY due to COVID policy changes in China affecting Lee’s China wholesale business.

However, the company expects favorable growth results from its overseas markets in the second half of the year as China recovers at a faster-than-expected rate. On the other side, macroeconomic issues in the United States are likely to slow consumer demand. As a result, management has maintained its double-digit growth prediction for FY2023, with revenue expected to expand by 13 to 14%, adjusted EBITDA expected to rise between 17% and 18%, and adjusted net income expected to rise between 30% and 33%.

Highlights of Earnings in the First Quarter of 2023

We can see that, although missing EPS forecasts by $0.04 to reach $1.16 per share, Kontoor Brands has a strong track record of routinely outperforming expectations. We may also notice that EPS and revenue were lower than the previous year. Kontoor Brands’ revenue fell 2% year on year to $667 million in Q1 2023, owing to poor performance in the international wholesale business, which was principally driven by the ongoing effects of COVID-policy changes in China.

This quarter’s gross margin fell to 43.0% of sales due to increasing inflationary pressures on input costs and a geographic mix influenced by production downtime in China. When we compare Kontoor to its counterparts, we can see that its gross margin is much lower, which is troubling in a competitive climate where costs are rising due to inflation.

Over the last five years, Kontoor Brands has regularly generated positive free cash flow, but it now has a negative levered free cash flow of $82 million. The company has a dividend and share repurchase program, with $62 million remaining in the share repurchase program. Its dividend payment ratio is significant at 44.34%, accounting for over half of its earnings. The next Ex-Div rate is scheduled for June 8, with an FWD yield of 4.78%.

Examining the company’s balance sheet and comparing it to its counterparts reveals that it has less long-term debt, around $800 million. As of Q1 2023, the company has $53.68 million in cash, $50 million in outstanding borrowings, and $438 million in credit facility borrowing available.

Valuation

The stock is now trading below its average target price of $51.71. This is due to a drop in analyst optimism, as indicated by Barclays analysts cutting their price estimate to $45 following the Q1 2023 earnings results. These outcomes were influenced by persistent economic difficulties and poor international performance. The stock has lagged the S&P 500 over the last three and six months. It does, however, have an appealing price-to-earnings ratio of 8.97, which is lower than the consumer discretionary sector median and lower than peers Levi and V.F. Corporation. We recommend caution owing to a decrease in gross profit margins, which are lower than its immediate competitors, and lackluster growth. Nonetheless, the company expects double-digit sales growth in FY2023.

Risks

Kontoor Brands is a consumer discretionary stock that is susceptible to market fluctuations. If the economy suffers a downturn, the company’s performance may suffer as consumers become more cautious with their spending. Furthermore, the company’s success is heavily reliant on growth in the Chinese market, which is currently recovering. Because of the continuous uncertainties in the global economy, a downturn could have a detrimental influence on the organization as a whole.

Last Thoughts

Kontoor Brands saw a reduction in market confidence following a poor Q1 2023 performance, which was caused by a drop in sales in its China market and a failure to meet EPS and revenue estimates. Nonetheless, the management team expects double-digit top-line growth in FY2023 due to a faster-than-expected rebound in the Chinese market. Furthermore, there is an increasing trend toward direct-to-consumer sales, which results in higher profit margins. However, considering the potential negative effects on US and worldwide markets as a result of economic concerns, it may be best to wait and see how the second half of the year plays out. As a result, I propose a hold rating.

Featured Image: Pexels @ Edgars Kisuro

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