This was a guest post by Value of Stocks.

VF Corporation

The first of the two Dividend Aristocrats we should watch in 2021 is VF Corp. VF Corp. (NYSE:VFC), focuses on high margin branded apparel, footwear and accessories. Their brand portfolio has managed to maintain popularity among individuals of various ages. This in turn allows the company to spend less on constantly marketing their products. Brand recognition has allowed for steady margins. Although the competition in the clothing industry is fierce, by choosing the right brands to include in its portfolio VF has been able to constantly increase revenues, earnings, and dividends. 

VF Acquires Supreme

Last year, VF announced the acquisition of Supreme for $2.1 billion. Supreme has probably been one of the most misunderstood clothing brands of the 21st century. Created in the 90’s in Manhattan, the clothing brand is associated with skating and has gained tremendous popularity among celebrities and the general public. By focusing on limited pieces, Supreme is able to charge very high prices for their products. Customers can only purchase Supreme items by signing up on their website, and waiting for instructions as to which store, they should visit to purchase the item. The company also limits the number of similar items that one customer can acquire. 

Source: Pinterest

Supreme stores are well known for its long lines of waiting customers. The obsession over their products, and the fact that they are limited in quantity explains the brand value. With the pandemic Supremes’ sales probably took a tumble. Given the business strategy, long lines of waiting customers are not an option now. That was probably one of the reasons VF was able to make the acquisition. Despite that over 60% of Supreme sales are digital. Supreme is expected to bring in an additional $500 million of revenue and $0.20 of adjusted earnings per share in 2022. The acquisition makes a lot of sense for VF’s brand portfolio. 

Source: VF Investor Presentation

Supreme is also known to launch items partnering with different brands and has done so in the past with VF. This can now be easily achieved, now that VF owns the brand and multiple other brands. Also, the resale market for Supreme items is huge. Some of the items can fetch higher prices when they are resold. A quick look at eBay shows some items selling for hundreds if not thousands of dollars.

Impact of COVID-19 on VF

Due to the pandemic sales have been anemic for the first two quarters, resulting in losses. As of Q2 FY2021 VF has been able to return to profitability even with revenues down year-over-year and lower adjusted gross margins. Even in this challenging retail environment, management was able to increase sales in China. The company recently reported Q3 FY2021 and companywide performance improved sequentially from Q2 FY 2021.

Source: VF Q3 FY 2021 Presentation

Despite the challenging retail environment the virus has created for VF, management is forecasting a fast recovery in 2021. The company upped guidance after the third quarter to $9.1 – $9.2 billion in revenue and over $650 million in free cash flow resulting in adjusted earnings per share of about $1.30.

Source: VF Q3 FY 2021 Presentation

Risks for VF

Unemployment leads to less consumption. Given the high level of unemployment spurred by the pandemic worldwide. Sales have taken a hit and should take some time before recovering to pre-pandemic levels. Given the nature of the coronavirus, businesses with a strong direct-to-consumer digital channels should be the ones to benefit the most. E-commerce sales rose last year and now represent 17% of all retail sales. VF has been able to increase its direct-to-consumer revenue. Revenues in that segment rose 10% in the 10 months prior to February 2020. Consequentially digital sales also grew 18%. Eventually, management should be able to regain this operational performance it has achieved in the past.

The second risk is decay of brand recognition. The biggest risk a clothing company like VF faces is the possible demise of the value of its brands. If for some reason, consumers decide to steer away from its brand portfolio it will be difficult for the company to maintain revenues and margins. Although it seems highly unlikely at this point that VF’s brand portfolio would lose its preference among consumers. It is an important risk to keep in mind, when investing in a stock in this sector.

Final Thoughts on VF

Concerns surrounding the impact of the virus on VF’s operations have now vanished. The company remains strong and has shown how it can sustain incredibly adverse economic situations. The company was not one of the retailers to cut or suspend its dividend. Given the current stock price, and expectations of earnings about $1.30 for the next year it translates into a price-to-earnings ratio of roughly 58X. No matter how valuable the company is and its brand portfolio. The future expected growth hardly justifies the high multiple price-to-earnings. It seems overvalued despite the great performance in the past. It would be wise and prudent to wait at this point for a pullback.

Walgreens Boots Alliance

The second of the two Dividend Aristocrats we should watch in 2021 is Walgreens Boots Alliance (Nasdaq: WBA). Walgreens Boots has an excellent track record of dividend growth. The stock has been trending down since it reached a peak in 2015. Since then, the stock has lost over 50% of its market cap, mainly attributed to reduced margins. Walgreens Boots has the distinction of being one of the three worst performing Dow Jones stocks in 2020 and also in 2019.

Source: StockRover*

Despite the reduced margins, management has still been able to raise its dividend by 2.2% in 2020 Q2. Gross margins and operating margins have been declining steadily in the past decade taking a toll on the company’s earnings. 

Source: Morningstar/ValueofStocks

As Walgreens Boots battles the shrinking margins, management has put in place a series of changes aimed at improving operations. Both in Walgreens and Boots. Management has defined a transformational cost program for both its operations in the U.S. and Europe. Optimizing operations and increasing efficiency, will allow the company to increase margins.

Source: Investor Presentation

Management estimates to deliver over $2 billion in annual cost savings by the end of 2022. The pandemic uncovered some of the biggest flaws in some businesses. For Walgreens, it was a wake-up call as to the under-investment in their digital sales. Management has stated their intention of continuing to invest in the e-commerce channel.

Source: Walgreen Boots Q1 FY 2021 Presentation

Source: Walgreen Boots Q1 FY 2021 Presentation

Alliance Healthcare Deal

As management implements these operational changes, it has also decided to divest some of its holdings. Namely Alliance Healthcare, Walgreens’ distribution business in Europe. After a potential deal to acquire AmerisourceBergen (NYSE: ABC) in 2018 of which it owns roughly 28% Walgreens is AmericsourceBergen’s biggest customer, and that has led both companies to explore possibly combining operations in the past. 

Both companies have agreed on the Alliance Healthcare divestment, from which Walgreens Boots will receive $6.75 billion. This will include $6.275 billion in cash and 2 million AmerisourceBergen shares boosting Walgreens Boots’ stake in the company from 28% to 29%. Given the attractive multiple of roughly 12X FY20 adjusted EBITDA, Walgreens Boots’ management seems to have made a good deal. The expected impact on earnings per share is -$0.02. The proceeds from the sale will be directed toward healthcare investments and to reduce the hefty debt load.

Competition for Walgreens Boots

CVS Health Corporation (NYSE: CVS) has been Walgreens’ biggest competitor in the past. Both companies have fiercely fought for market share. Combined they had more than 50% of the drug prescription market share. Rite Aid Corporation (NYSE: RAD) is a much smaller competitor, the number of its locations is roughly 25% of CVS or Walgreens. Besides Rite Aid, supermarket chains with their own pharmacies also compete in the space. Walmart (NYSE: WMT) and Kroger (NYSE: KR) also have a considerable percentage of the prescription drug market share estimated at around 7.8%, according to data from 2019. 

Recently Amazon (Nasdaq: AMZN) has also ventured into the pharmacy business. Allying its excellence in customer satisfaction and distribution expertise, to take a bite of both CVS and Walgreens market share. The announcement pushed the stock prices of the largest pharmacy chains down.

Risks for Walgreens Boots

Among the biggest risks Walgreen Boots faces is the hefty debt load. At over 2.0X times its equity. With over $40 billion in debt, the company will have to reduce it in order to improve its financial performance. The Alliance Health deal should help management deleverage the balance sheet. Another concern regarding Walgreens Boots is the fact that due to the poor financial results, which is a consequence of the pandemic, the payout ratio has skyrocketed to over 380%. This should be a short-term result of the operational impact spurred from the lockdowns. The payout ratio should return to levels of around 40% allowing management to reward shareholders and still have capital to deploy.

Final Thoughts on Walgreens Boots

Walgreens Boots is a recession proof company, offering a solid dividend of about 3.7%. Despite the operational challenges presented by the pandemic, the company was still able to generate over $4 billion of FCF. In 2020 the company was able to generate $4.90 of FCF/share. Once the company recovers the operational performance it has achieved in the past, we can expect earnings over $4 per share. In line with its forward price-to-earnings under 10.

In the short term the company might face some difficulties as the management puts its transformational changes in place. But the stock is bound to return to higher levels. As management reduces debt, the stock price should reflect the healthier balance sheet. Even during uncertain times, Walgreens Boots business won’t dramatically change. The investment thesis for Walgreens Boots is focusing on the long-term prospects of the company, which were not materially affected despite the deterioration of operations in the past and the high competition it will face in the future.