Undervalued Dividend Growth Stock of the Week: VF Corp. (VFC)

September 11, 2016
By

If I could go back in time and tell the 18-year-old version of me anything, I’d tell him to save his money and invest regularly in high-quality dividend growth stocks at attractive prices.

I wouldn’t need to give him any other information on what’s yet in store.

No winning lottery numbers would be necessary, because investing this way is almost just like winning the lottery: my six-figure dividend growth stock portfolio is worth over $300,000, which is on par with a lot of lottery jackpots.

And this portfolio generates five-figure dividend income that’s growing, which is enough to cover a substantial chunk of my core personal expenses.

But check this out.

I’m only 34 years old.

And I didn’t start living below my means and investing my excess capital into high-quality dividend growth stocks until I was almost 28.

So just imagine what I could have done if I had started at 18.

Now just imagine what YOU can do if you were to save your money and invest that capital into great businesses that pay you growing dividends.

I’m talking about stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish has compiled information on almost 800 US-listed stocks with at least five consecutive years of dividend increases.

I love these stocks because you’re generally looking at wonderful businesses – it is, after all, just about impossible to pay and increase dividend payouts to shareholders for decades if you’re not producing the growing profit necessary to make sure those checks don’t bounce.

Plus, the growing dividend income itself is a fantastic source of passive income that can one day (when it’s enough) pay one’s bills, rendering that person financially free. They’re then able to go about their life on their terms, choosing to spend their time how they wish.

However, one should also make sure they’re paying the right price for any dividend growth stock they’re buying.

And by the right price, I’m saying you should always look to pay less than that which a stock is estimated to be worth.

Said another way, you should always attempt to make sure every dividend growth stock you acquire is undervalued at the time of investment.

That’s because the price you pay has a direct and lasting impact on your yield, long-term total return, and risk.

See, price and yield are inversely correlated.

All else equal, a lower price will always equal a higher yield.

Of course, that then means more income both now and later on your investment.

If one has a choice of more or less income, which would you choose?

This higher yield also impacts one’s long-term total return prospects, since yield is a major component of total return.

The other component, being capital gain, is also positively affected by virtue of the upside that exists between the lower price paid and the higher value of a stock, when you’re buying a stock that’s undervalued.

While price and value can diverge wildly over the short term, value matters over the long run.

Paying a lower price also reduces your risk.

That’s because you’re introducing a margin of safety, whereby a company could not perform as expected or do something wrong, causing its value to suffer, and you’d still be okay (assuming the value doesn’t completely collapse).

If a stock is worth $50 and you pay $50, you don’t have a margin of safety. It would only take a minor issue for you to be sitting on an investment that’s worth less than you paid.

But paying $40 for the same stock means you have a lot of breathing room there.

Thus, valuation is paramount.

As such, checking out fellow contributor Dave Van Knapp’s valuation guide (part of his overarching series of lessons on dividend growth investing) is a fantastic usage of your time.

Once you’re equipped with the tools necessary to have a good idea of what any dividend growth stock is worth, you’re in a fantastic position to make sure you pay the right price.

But I won’t just leave you there.

I’m going to share the name of and some information on a high-quality dividend growth stock that right now appears to be undervalued.

VF Corp. (VFC) is an apparel and footwear company that designs and manufactures or sources from independent contractors a variety of clothing including jeans, sportswear, outerwear, luggage, and footwear.

While apparel isn’t my favorite industry, due to changing trends and consumer tastes, VF Corp has weathered those changes for decades.

They’ve done this by focusing on value and the power of brands, the latter of which conveys just as much a lifestyle as it does a brand choice.

One one hand, they offer tremendous value through their Lee and Wrangler brands.

And on the other, they offer these top-tier lifestyle brands in The North Face, Timberland, Nautica, and Vans.

This strategy has provided not only staying power but also increasing profit and dividends for decades.

Indeed, the company has increased its dividend to shareholders for the past 43 consecutive years.

captureAnd we’re not talking tiny dividend raises just to keep a streak alive.

The 10-year dividend growth rate stands at 17.1%, which is just monstrous.

With a payout ratio of 53.2%, there’s still plenty of room for future dividend increases.

In fact, that payout ratio is pretty close to what I consider a “perfect” payout ratio of 50% – a rather harmonious split between retaining profit for growth and returning cash to shareholders via a dividend.

The only potential drawback regarding the dividend is the fact that the stock yields only 2.48% right now.

So one is perhaps giving up a little income now in favor of more growth later.

There’s always that dynamic between yield and growth to consider.

However, that yield is almost 70 basis points higher than the stock’s five-year average yield of 1.8%.

Investors buying this stock today are locking in a lot more yield than what was typically otherwise available, on average, over the last five years.

This is already a good indication of undervaluation, but let’s take things a bit further.

We’re next going to see what kind of underlying revenue and profit growth VF Corp. has generated over the last decade. And then we’ll compare that to a near-term forecast for profit growth.

This will tell us where the company has been and where it’s going, which will later immensely help us value the company and its stock.

Revenue has increased from $6.216 billion to $12.377 billion, looking at the period from fiscal years 2006 to 2015. That’s a compound annual growth rate of 7.95%.

Meanwhile, the company has generated a compound annual growth rate of 10.29% for its earnings over this time frame, increasing earnings per share from $1.18 to $2.85.

We’ve got really solid top-line and bottom-line growth here.

I’ve noticed that a lot of firms have had trouble generating revenue growth over the last decade, but VF Corp. has driven almost uniform, secular-like revenue growth over this stretch, even straight through the financial crisis.

And the bottom line has been helped by a combination of regular share buybacks and increasing profitability across the board.

Looking out over the next three years, S&P Capital IQ expects that VF Corp. will compound its EPS at an annual rate of 12%, which would be a bit stronger than what has manifested over the last ten years. Additional store openings and e-commerce sales are cited as the underpinning of that forecast.

The rest of the company’s fundamentals continue the high-quality theme, with the balance sheet another fine example.

Sitting on a long-term debt/equity ratio of 0.26 and an interest coverage ratio over 18, VF Corp. has a rock-solid balance sheet.

Profitability is also robust.

Over the last five years, the company has averaged net margin of 9.69% and return on equity of 21%.

I think there’s just a lot to like here.

You have decades of dividend increases, well-known brands across the value spectrum, a focus on lifestyle offerings, and great fundamentals.

In addition, I think the valuation also offers a lot to like at this point in time…

The P/E ratio for the stock is sitting at 21.78. That’s roughly in line with the five-year average. However, investors are paying markedly less for the company’s cash flow than what they usually have, on average, over the last five years. And as noted above, the current yield is significantly higher than its own recent historical average.

We definitely have some indications of undervaluation right now. But what’s a good estimate, then, of the stock’s intrinsic value?

I valued shares using a dividend discount model analysis. I factored in a 10% discount rate and assumed a long-term dividend growth rate of 8%. That growth rate is less than half that of which the company has produced over the last ten years. With a near-perfect payout ratio and a forecast for continued double-digit EPS growth, I think this is a solid baseline expectation. The DDM analysis gives me a fair value of $79.92.

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.

This stock looks cheap right now. If the company is able to generate dividend growth greater than what I’m expecting, it could be really cheap. But what do some professional analysts have to say about this?

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 4-star stock, with a fair value estimate of $74.00.

S&P Capital IQ 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.

S&P Capital IQ rates VFC as a 3-star “HOLD”, with a fair value calculation of $60.60.

I like to average these three numbers out so as to come up with one final number. This should help improve the accuracy a bit, since we’re blending the highs and lows together. That averaged valuation is $71.51, which indicates that this stock is potentially 19% undervalued right now.

scBottom line: VF Corp. (VFC) is a high-quality dividend growth stock. Great brands, decades of dividend growth, and excellent fundamentals are hallmarks of any great dividend growth stock, and VF Corp. checks all the boxes. With the possibility of 19% upside on top of a yield that’s well above its recent historical average, I’m thinking about increasing my position in this great apparel firm. You may want to consider the same.

– Jason Fieber

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