Dividend Investing

Spin off’s present one of the most interesting opportunity for investing. They might have some irrational selling which will move the stock price downwards. Both Joel Greenblatt from Magic Formula Investing fame and Peter Lynch in One up on Wall Street mention to keep an eye on spin offs for best opportunities to invest.  I believe there is something similar going on with Kontoor Brands, a recent spin off from VF Corp.

Allow me to introduce Kontoor Brands (KTB)

Kontoor Brands (KTB) is a newly created spin off from V.F Corporation (VFC). Its business is selling Wrangler, Lee, Rock & Republic jeans as well as operating VF Outlet business. VFC spun off this business in May 2019 to focus on their fast-growing adventure brands business. They wanted to focus more on them and decided to spin the jeans segment off as KTB.  So Kontoor Brands started trading on 23rd May for about 40$ a share and then fell to about 26$ a share by June 25th.

Why did Kontoor Brands fall so much?

Irrational selling. Just like most big stocks, VFC had lots of institutional owners of its stock. If you look at Morningstar’s ownership details tab for VFC, you will find a huge amount of Large cap/dividend growth-based funds holding VFC stock.

You can see above most funds are large cap based funds. When KTB was spun off and started trading, its market cap was about 2-2.5 billion dollars. It was not part of SP500, neither was it considered a large cap company, nor had they made any official dividend announcement. On the contrary, KTB was a very boring, small-mid cap, non SP500, high dividend yield company with not a fast growing dividend. These large caps, SP500 focused, or dividend growth funds, would have been forced to sell most/all of their KTB stock. Since the new KTB stock did not follow any rules set by the fund for their holdings.  I think this is the prime reason KTB stock took a dive after beginning to trade as an individual company. You can also see huge volumes of buy, sells in the first few days when mostly funds were selling:

The daily volume is far less now, 3 months after the spin off:

Management seems great and very shareholder friendly

KTB management has been touting the dividend policy of the company.  Even before the spin off, the management spoke about a very strong dividend policy. Focusing on dividends as a major factor in total shareholder return. They already said in their roadshow, they planned to maintain a 60% target payout ratio. They even mentioned they plan to initiate a 2.24$ per share dividend equaling about 5+% of their 40-42$ trading price when it was spun off. So, when the price kept falling and a dividend was not announced, investors became skeptic of the planned dividend. I believe this contributed to further falling of the price. However investor’s fears were disproved when KTB announced a 2.24$ dividend per share on July 23rd 2019. Yield around 7%+ as of close on Jul 23rd.

I think this really speaks about the quality of management. Management promised something and delivered! The dividend is always at discretion of the management and the board. Management could have reduced the 2.24$ payout they mentioned before the spin off. They could have kept it at 5% of 26-28$. However, they followed through and delivered on the 2.24$ amount as previously mentioned.

Most of the KTB management has come straight from their parent company. The CEO, CFO and VP of supply chain all worked for VF Corp before moving to KTB. I see this as a great sign and shows confidence of the leadership in Kontoor Brands.

Now let’s talk about financials

Revenues for Kontoor Brands have been decreasing over the past 3 years and was one of the reasons VFC wanted to spin off this division. Revenues have decreased from about 2.92 to 2.76 billion dollars since 2016. This was mainly due to challenges in NA over retailer bankruptcies (Sears in 2018), India demonetization and exiting business in Argentina. Management expects them to decrease to 2.5 billion dollars in 2019. But then from 2020 on wards they expect for revenues to start growing at low-mid single digit rate.

For the most recent Q2 2019 quarter, the adjusted EPS was .96$ a share. You can check out there Q2 earnings report right here.

The interesting thing you would notice is that they have the word adjusted mentioned at a lot of places. Adjusted EPS (0.96) is also higher than the GAAP EPS (0.67). But there is not much concern here. We need to remember that this is practically KTB’s first earnings report as an independent company. They are focusing a lot on restructuring currently. As part of Q2 2019, they ended up exiting business in Turkey & Argentina which were poorly performing. Changed business models to distribution from direct in Chile, Russia & Israel. Closing some factories in Mexico that used to produce goods for VFC.

All these steps cost money and KTB is excluding these costs and revenues from adjusted numbers as one time charges. They plan to continue investing in restructuring throughout 2021. This is kind of needed for a newly spun off company since this will eventually help them to cut a lot of costs which will reflect on the bottom-line soon. In fact KTB management expects to start seeing result from the restructuring program in second half of 2019 itself.

Current PE for KTB is 32.20/(.96*4) = 8.41 on an adjusted basis & 32.20/(.67*4) = 12.01 on GAAP basis.

Dividend Safety of Kontoor Brands (KTB)

According to adjusted EPS, payout ratio comes to be about .56/.96 = 58.3% for the quarter. According to GAAP EPS, payout ratio is .56/.67 = 83.5%. That’s a little high but as I mentioned, this reflects extra one time costs company has had to bear for restructuring. As we move forward into 2020 & beyond, cost savings will be realized and one should expect costs of operations to go down lower thereby improving the payout ratios on GAAP basis.

Based on free cash flow, its 53.39-9.3 = 44.09 Million in free cash flow. This results in (56.64*.56)/44.09 = 71% payout ratio on cash flow. Which is not bad at all and again this percentage should improve with the restructuring changes.

Interest Coverage ratio = GAAP EBIT / Annual interest payments which comes to about (52.15 *4)/60 million = 3.4 times.      I annualized the 52.4 million EBIT to get the annual. On adjusted basis its  (74*4)/60 million = 4.93 times.

This ratio just tells us if the company will have any extra money left after paying interest payments. Ideally 5 and over is better. I think on adjusted basis, KTB is almost there. On a GAAP basis they might take a couple of years to get there, but I am confident they will.

I expect all ratios mentioned above to improve with each passing quarter as Kontoor Brands management keeps executing on their restructuring plan. I will keep looking at their financials with each quarter to see if they improve or not.

Risks

Concentration of Revenues

Walmart accounts for about 33% of revenues in USA which is pretty huge considering they generate 73-80% of their total revenues in USA. In fact, 53% of revenues come only from 5 retailers in USA. So maintaining those relationships is very key to Kontoor Brands.

Lack of diversity

At the end of the day they mostly sell jeans. They do sell some shorts and some shirts, but most revenues are generated by the jeans segment.

Too much debt

As part of the spin off, 1 billion dollars in debt was taken out by KTB. That’s pretty huge. This is mostly long-term debt and company is in a very defensible industry selling jeans and related products. So the debt is a big concern with the juicy dividend yield. However only 20% of revenues in Q2 were from outside USA. So there is room for far more growth internationally where management said, they are now focusing. Lee is already number 1 jeans brand in China and KTB plans to introduce Wrangler in China in early 2020. Plus with all the operational efficiencies realizing over next 18-24 months, I can see the company focusing more on cash flow and bringing down the debt. They already paid off 50 million this quarter Q2 2019.

Still a new dividend company

Ideally most dividend investors like to look at multiple years of prior data. Dividend history, sustainability/safety, historical pe ratios etc. before making a decision on dividend stock. However KTB is still a very new company. They just declared their first dividend. So there is not much historical data to look at which might put off some investors.

Conclusion

Peter Lynch and Greenblatt do mention, special situations like spin offs create interesting opportunities to invest. They also mention there is huge imperative not just for the spun off company but also for the parent to see the spun off company succeed. If the spun off company fails it also reduces trust in the management of the parent company since it destroys shareholder value.  VFC has always mentioned spin off will unlock lots of value for both companies and would allow KTB to focus more on gaining operational efficiencies and growing in jeans segment. This is just what KTB has been presenting and speaking about since day 1 of spin off.

I think KTB has been way irrationally oversold. The company has already declared dividends as they had been saying. They also have a good plan to achieve efficiencies in operations and cost. This is already showing signs of good management quality. They operate in a very boring but defensive jeans wear segment. They only had 11% drop in revenues during the recession. Management has mentioned multiple times about focusing on dividends being major component in shareholder return. They even reiterated this during the most recent Q2 2019 earnings call. This is just the type of dividend income company investors should like for the long run.

I received a handful of shares of KTB as part of the VFC spin off. After studying the company, I decided to increase my position. I would add more if I see their financials improving  in another 2-3 quarters. Here is my proof of purchase which is also updated in my dividend investing portfolio.

UPDATE

Until February of this year, things looked pretty good on Kontoor Brands. It reached a high of 41.87$ and was giving out   dividends. However, the COVID pandemic resulted in them cutting the dividend. Most dividend based etf’s were forced to sell their Kontoor Brands holdings. So we saw the effect of forced selling for dividend cuts this time around. Stock went to as low as 14$. So far I have kept buying despite the cut. Management even spoke about possibility of reinstating dividends in Q4 of 2020 if debt and bank covenants improve by then. Listening to calls management does seem to be working towards reinstating dividends. Not sure when it will happen but I like what they have been saying so far. I also learnt about selling covered calls for income.  I did this with my Kontoor Brands stock position and I still own the stock.

Disclaimer: The above are just my opinions expressed in the article. I am not your fiduciary or an investment advisor. Do not consider this as investment advice to you. This article is just for informational and entertainment purposes. Also please note that this article was published on Aug 25th. Many numbers would have changed when you are reading it. 

References:

Q2 Earnings Release

Investor Relations KTB

Curreen Capital Q2 letter

Cisco Systems Inc. (CSCO) is one of the largest networking hardware and software provider in the world. It also started giving out dividends in 2011. I wanted to analyze the safety of the CSCO dividend and look at its future prospects. We will do an overview of what Cisco Systems does and then look at its financials.

Overview of Cisco Systems Inc.

Cisco Systems Inc. (CSCO) is large cap American multinational company that focuses on building hardware/software related to computer networking, security, applications & collaboration in cloud and on-premise environments. Think of them as someone in business of building infrastructure to help world of internet function & grow. They mostly build these tools and services for enterprise customers. You might go and buy a Wi-Fi router or modem to allow you to tap into internet connection provided by your ISP. Most big business need to do this but, at a much larger scale. Most companies have their own data center. They usually setup their own private internet which employees work on. This needs to be done across multiple sites across multiple countries. They need to make sure connection is secure and only legitimate employees can connect. Employees use various devices. Companies need to make sure employees can connect using these devices from workplace or while travelling etc. The complexity involved with so many factors is huge. Cisco essentially provides their own proprietary hardware/software to help business manage their users, devices etc. connect to their own network and the global internet in a secure manner.

CSCO in Cloud Era

However, times are changing. Cloud is the new jargon. Nearly every big company on earth is looking at implementing or has implemented some or the other cloud-based applications/solutions. Most big cloud providers like Amazon, Google & Microsoft do not use Cisco switches or hardware in their data centers. They prefer to use white box(open source) cheaper alternatives to do networking. Companies today are preferring to outsource infrastructure/networking/storage related tasks to these cloud providers. This gives them even more money/effort to focus on their core competency. So, this can represent a challenge to Cisco for future growth.

Software Defined Networking (SDN)

What is making it possible for public cloud providers to use white box hardware instead of Cisco’s hardware? A new software based approach to manage networks. Traditionally the data plane (responsible for moving data across hardware) & control plane (responsible for controlling flow) used to reside within the hardware itself. Changes in config had to be done physically at the device and by a human. However SDN separates the logic from data flow. You can now make any changes using software. The actual hardware switch/router will act on them. So, this leads to easy reconfiguration of hardware using software. Now the hardware can be by any company and the software is what matters. This is a big shift in networking industry.

I work on the IT programming side for a big company. I can safely say that not all applications are going to be moving to cloud anytime soon. Hence, you have a situation where 15-20% of the applications are in a public cloud, some in private cloud and rest are still on their own on-premise data centers. Moreover, cloud applications are also distributed among various providers like AWS, Azure, Google etc. I can already see we work with AWS, Azure, Oracle cloud products on top of managing our own data center. We now have requirements to make sure one application residing in one cloud can communicate with some other application in our private data center or some other cloud. This type of setup is known as a multi-cloud environment.

An Exciting Opportunity

Imagine the amount of challenges this will have across multiple applications/platforms/users for networking and providing a seamless user experience. Cisco is already positioning itself as the leader in this multi-cloud space. They are now creating more software to manage networking and communications between multiple cloud environments. Here are some examples of their products:

Domain	Product	Competitor
Infrastructure-switches	Catalyst 9000 switches with Cisco DNA software	Arista Networks, Huawei, HP
Infrastructure-routing	SD-WAN with Cisco DNA	Juniper, Riverbed, Alcatel Lucent, Fortinet
Infrastructure-wireless	Catalyst and Meraki based wireless access points	HP, Ubiquiti, Extreme Networks
Application-collaboration	Webex, Cisco telepresence	Microsoft, Zoom, Slack
Application-analytics	AppDynamics	New Relic, Dynatrace
Security-endpoint	AMP, Any connect VPN, Umbrella	Fire Eye, Citrix, Zscaler, Fortinet
Security-cloud	Cloud email security, stealth watch cloud etc.	Palo Alto Networks, Fire Eye, Symantec

I am sure I have probably missed many other Cisco applications in the above table. But Cisco has some or the other cloud feature for each of the above apps/hardware.

They can either be found on app stores of biggest cloud providers or can be used as SaaS solution from Cisco themselves. Cisco is aggressively converting many of their hardware contracts by providing some cloud software to manage the underlying hardware. Again, this has been possible after moving logic and hardware into different layers in first diagram. Software to manage networking hardware and security is becoming more important. Then bundling this as subscription-based solution instead of customers buying the hardware & paying a one-time fee. Historically, Cisco has been a bit cyclical and there is some drop off revenues after every few years. But by moving into subscription style sales, they will address this in few years.

Cisco Systems seems to be on right path

Cisco provides application/hardware over most networking sub-categories. They do not have to be the best at everything or even one thing. Most of their products are in top 3-4 in every category. That is all they need. For any business looking for their networking needs for multi-cloud, Cisco can probably cater to everything. Provide support for everything under one roof. That is a big usp for most of their customers. Being in similar position at my job, I realize support is very important. If one company can provide me support for multiple solutions, I would like that instead of chasing customer support for 2-3 different vendors. Its not just me saying this, check out a post from reddit where multiple system and network admins talk how important support is in big companies:

Point is, it seems like Cisco is again trying to become one stop shop for everything you would need to manage multi-cloud environment at any enterprise. Cloud is immense opportunity to grow, has lots of challenges and Cisco Systems seems to be well equipped in all fronts.

Cisco Silicon One

On 12th Dec 2019, Cisco Systems announced it was getting into the business of selling chips. Historically, Cisco has been making and designing its own chips that go into its routers and switches. However, only way to get them was by using Cisco’s own hardware. As I mentioned above with increasing adoption of cloud, Cisco had not been able to sell its hardware to Google, Microsoft, Amazon or any big cloud provider. However, white box chips/hardware needs a lot of R&D and investment. Cisco Systems is now starting to sell these chips to any customer who wants them separately. They will do the R&D and make chips that will work in any white box router, switch or other networking hardware and design it to be more efficient. This move really helps them to start selling to these big cloud providers I mentioned above. Its a completely new business line for Cisco Systems and brings them in competition with Broadcom, Juniper which used to have their chips in this white box hardware so far.

Financials (Cisco Systems)

Here is a financial snapshot from Valueline with last 15 year results:

Revenues

It is important to note that CSCO’s fiscal year lasts from Aug-July of every year. Keeping that in mind, in recently concluded Year 2019 in July, CSCO made about 51.9 billion in revenues. This was 5% growth as compared to fiscal 2018. Services grew by 2% and products revenue by about 6%.

If we look at revenues by different segments Cisco operates in:

Security is going to be massive in the multi-cloud world. So Cisco growing 16% in that and another 15% in cloud applications segment is great to see. Switching and Router products come under the infrastructure platforms which also grew by 7%.  This segment is most challenged by SDN and good to see that Cisco grew revenues in this segment. I think this is where they are probably bundling some controller UI or software to manage routers and switches. So Cisco is already on the offensive to make sure they remain relevant in multi-cloud world.

However, in Q1 2020 ending in Oct 2019, CSCO only had a 1% increase in revenue and guided down to -4% revenues in Q2 2020. They attributed this to the weak macro environment. With Brexit and trade war between US and China still unresolved, its possible many of its customers are holding back on investing in networking equipment. Additionally, most telecoms are currently only using 4g equipment to demo 5g networks. So, less revenue on that side as well. Another reason might also be them converting one-time payments customers made, into deferred revenue subscription model. So, upfront revenue would be less as compared to previous years. But, it will be realized over the life of the contracts (multiple years).

Dividend Yield & Safety of CSCO Dividend

Dividend per share as of Nov 2019	$1.4
Price as of Nov 22 2019	$44.85
Dividend Yield as of Nov 22 2019	3.12%
EPS as of Jul 2019	$2.61
EPS Payout Ratio as of Jul 2019	.5363 or 53%
Cash flow per share as of Jul 2019	14.922/4.273 billions = 3.49
Cash flow Payout ratio as of Jul 2019	(1.4/3.49)=40.11%
9-year DGR	23.02%
5-year DGR	13.146%
Latest dividend increase in 2019	6.06%

Cisco Systems pays a 1.4$ dividend annually at 3.12% yield as of Nov 2019. Moreover, the payout ratio based on eps and free cash flow both seem relatively safe as compared to other tech companies. I think Cisco has some wiggle room during this period of transiting their business to cloud and subscription base. Looking at the latest dividend increase of 6% and the 9-year average of 23%, it looks like CSCO has tempered down their raises a bit. Although, I am still expecting mid to high single digit raises going forward. 3% starting yield with 6-9% yearly increases can still help return about 10% return on dividend income every year which is great!

Ability to Service Debt and continue paying dividend

Total Debt at end of fiscal 2019	$24666 million
Total shareholders equity at end of fiscal 2019	$33571 million
Debt/Equity	24666/33571 = .734 or 73%
Operating Income as of end of fiscal 2019	$14219 million
Annual Interest payments	$859 million
Interest Coverage ratio	14219/859=16.55

Cisco’s competitors have a lower d/e ratio. JNPR is at 40, ANET is at 3% & HPE is at 59%. Cisco is a highly acquisitive company. Here is a list of about 200+ acquisitions they have made since 1984. I think they’re just being very opportunistic in such a low interest rate environment. Making smart acquisitions and with a huge history, making those work. Having a interest coverage ratio of 16 means they have enough earnings to pay interests and service their debt. Cisco generates a lot of cash even after dividends and can pay debt down if it wanted to within 3 years. Thus, having debt/equity ratio a bit on the high side shouldn’t be much of a problem for a cash cow like Cisco Systems.

Trends

There is a very popular reversion to mean theory.  It says that most stock metrics tend to hover around the mean of its lifetime average. So if the PE of a stock increases to very over-valued, over time it will fall back to its mean PE ratio. Hence, I also like to look at average PE ratio and dividend yield of stock I am looking to purchase as compared to its historical values. This plays a small part in my decision-making process. Cisco only started paying dividends 8 years back in 2011. Using Macrotrends, we can see the current yield of 3.12% is higher than the overall average yield of 2.67% over 9 years.

The fwd pe ratio as of Nov 2019 is 13.77. Average annual PE over last 11 years is about 13.37. Ignore the spike in 2018, its from tax reforms and them paying taxes to bring cash back into USA.

As you can see both pe ratio and dividend yield seem higher or close to the average in last 9-11 years.

Risks

Cloud

As mentioned earlier, Cisco faces threat to its core hardware business which made more than 50% of it revenue in 2019. With more enterprises looking to move applications to cloud to reduce operational costs, less Cisco hardware gets purchased. But with Cisco trying to move to more subscription based business and getting into chip selling business, I think they are moving in right direction. Move to cloud is definitely happening but it will take time and till then we will be in a multi cloud environment for which Cisco seems well prepared.

Trade War

Cisco’s sales in China fell a whopping 26% from the 2018. Just as US is trying to eliminate Huawei equipment from its upcoming 5G network, Chinese government is making sure it avoids equipment from US based vendors. Although Chinese sales only comprise of about 3% of overall revenues for Cisco. However this could be a long term trend. Secondly impact of tariffs on Chinese goods also increases price of Cisco hardware coming into the US. So at least a resolution in trade war could help Cisco on one of these issues.

In Conclusion

Cisco in its most recent fiscal Q1 2020 guided revenues to be down in its fiscal Q2 by about 3-5%. They attribute it to their slowdown of sales in China, general macroeconomic environment and less investment in buying products by cable & telecom companies. With 5g standards still being finalized, slowdown in cable and telecom industries can be explained. Trade war can explain slowdown in sales in China and rest of the world as many customers seem to be delaying investments in technology improvements. They want to wait and watch because of the uncertainties. Eventually, 5g will be here. Companies won’t be able to keep delaying investments in upgrading their networking and cloud infrastructures. ANET & JNPR have both given lower guidance between SEP-NOV 2019. So, it does look like this is a broad industry issue and not just CSCO doing something wrong.  The macro economic weakness may go on for a few quarters. But, Cisco Systems CEO Robbins did mention they expect fiscal Q1 2021 to be better.

In the meanwhile, we get a cash cow paying 3+% safe yield and maybe even growing it mid-high single digits every year. This could be a good time to at least start a position for the long term in a tech stock that pays dividends. I am long CSCO.

Please check out my complete dividend portfolio and analysis of other dividend stocks.

I am by no means an expert on networking technology. So, I will also love to hear your opinion on the analysis in the comments below. Is Cisco Systems on the right path on the way to Cloud future?

References:

SDN Explaination

Cisco investor relations

Forbes article on CSCO

Disclaimer: The above are just my opinions expressed in the article. I am not your fiduciary or an investment advisor. Do not consider this as investment advice to you. This article is just for informational and entertainment purposes. Also please note that this article was published on Nov 26th. Many numbers would have changed when you are reading it.