Canada Goose: Highly Conservative Estimates Show Shares Are Undervalued

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About: Canada Goose Holdings Inc. (GOOS)
by: Shravan Chinta
Summary

Conservative forecasts show shares are undervalued, giving investors a high margin of safety.

The company is fundamentally strong with an attractive ROIC and financial strength.

DTC segment should contribute to higher gross margin growth going forward.

Note: All numbers are in Canadian dollars

Canada Goose (GOOS) management recently updated their guidance with 20% revenue growth for 2020 and going forward. After Incorporating these assumptions into the valuation models below, shares are still undervalued by at least 20%. Recalling 2017 and 2018, management had maintained a similar stance where revenue grew by 40% each year vs. 20% management's forecasts. The recent drop of 30% should create an attractive risk-reward for long-term investors. On top of that, the company generates around 30-35% ROIC and is financially strong, making it even more attractive.

Revenue Forecast

The firm is shifting its channels of distribution from wholesale to direct to consumer (DTC). DTC is a higher margin segment, and selling directly to customers allows for a better relationship, takes advantage of impulse buys, and the company can gain access to customer shopping data, which provides a complete picture of consumer behaviour. GOOS is expected to launch eight new retail stores by the end of winter selling season in Italy, US, Canada, China, and one brand new digital concept store in Toronto. The firm is also releasing stores with 'cold room', which improves the customer shopping experience by allowing them to try the products in the environment for which they are built.

The company had produced 47% of its down-filled jackets in-house, instead of outsourcing it to third-party manufacturers. Also, GOOS opened up eight manufacturing facilities recently. In-house production not only adds value through increased profits and productivity but also improves scale production, efficiency, flexibility in terms changing clothing design, controlling quality to meet customer demands, and allows them to offer more product categories. This shows an expansion/improvisation of the company's vertical integration, which should accompany an increase in revenue and profit margins. Leveraging its well-known brand and product quality, GOOS has significant pricing power, which is evident with its jackets ranging between $400 and $1,600, while the company's products go on sale occasionally, protecting their brand image. Collaboration with Hollywood actors and filmmakers should further improve their brand image.

Based on the management's forward guidance for 2020 and beyond, and considering the factors mentioned above, I've used conservative revenue growth estimates for projecting revenue the next five years.

Revenue forecast

(Author's revenue model - in $CAD)

Management said revenue grows by at least 20% going forward. As you can see in the model, my estimates show that revenue gradually increases from 21% to 30% year over year by 2024. I believe this is a safe and conservative estimate and in line with the management's base-case scenario.

  • Canada region: High double digits with new store openings. Management says "we estimate that the populations of addressable Canada Goose consumers are much larger". This is also supported by broader luxury outerwear and increased apparel spending levels. Therefore, I've used 25% for DTC segment.
  • USA region: revenue growth could decline from 64% to 25% going forward, based on softening consumer discretionary purchases.
  • Rest of the World: primarily includes revenue from Western Europe and China. Western Europe is expected to slow down as a whole, evidenced by the continued QE by ECB, Brexit uncertainty, and with Germany's sharp economic slowdown. However, this will likely be offset by retail and e-commerce store expansion in high growth and skyrocketing middle-class market - China. With management's increased focus on DTC segment, I believe the Rest of the World sales should be around 50%, which is almost half of 2018 revenue growth - 93%. Moreover, Rest of the World, as a percentage of revenue, will more likely represent half of the entire revenue by 2024.
  • Wholesale segment: Grows at 9% YoY, based on management's forward guidance from the recent earnings report.

Margin Forecast

Margin Forecasts (Author's margin forecast, in $CAD)

Gross margins

  • Management says that "the primary drivers of our cost of sales are the costs of raw materials". Although raw material prices are increasing year over year, GOOS's pricing power should slightly offset it.
  • Gross margins improve over the next five years, and the cost of sales as a percentage of revenue declines as the high-margin DTC business contributes to a higher percentage of revenue.
  • Based on the historical gross margin percentage change, I have assigned a 2% increase for the next five years, which I believe is conservative. However, raw material price changes are challenging to forecast, and it could affect my 2% gross margin YoY growth assumption.

Operating Margins

  • Expected to spend more on SG&A in 2019 due to increased retail stores and e-commerce activity and normalise it going forward as the store operating costs are generally fixed in nature.
  • D&A: Expected to slightly increase in 2019/2020 as a percentage of revenue because the management is expected to increase Capex spending in new retail stores and manufacturing facilities.

Free Cash Flow Valuation Model

DCF model (Author's free cash flow model, in $CAD)

  • After inputting the revenue and margin forecast assumptions into the FCF valuation model, there is potential for a 22% price appreciation from the current price ($52), with a price target of $64.
  • NWC: Has been negative 4 out of 5 years since 2015. Thus, I left it blank going forward; in fact, NWC is challenging to predict and distorts FCF.
  • Maintenance Capex: Capex of 15m, that I believe is required to keep the firm competitive. The actual Capex figure includes acquisitions and new store openings, which distorts the company's normalised long-term Capex outlook.
  • D&A: 3% for 2019/2020 (with more store openings) and 2% beyond that.
  • Cost of Capital (COC): Average COC has been around 6.5% for the apparel industry. So, I've used 7% to be conservative. However, the cost of equity can change dramatically based on market conditions. As a result, I've included a variation analysis below that shows the sensitivity of the stock with changes in COC, assuming a 2% growth rate after the next 5 years.

COC variation (Author's variation analysis, in $CAD)

Comparables Analysis

comparables analysis (Author's comparable analysis, in $CAD)

  • Although GOOS looks expensive relative to other competitors, with 20% to 30% revenue growth for the next five years, it looks still cheap. This is further justified with the CAD$ 64 price target in the free cash flow model.
  • EPS estimates for VF Corp. (VFC), Columbia (COLM), Capri Holdings (CPRI) are from management's year-end guidance.
  • NWC: Has been negative for GOOS, VFC, and COLM for most of the last five years, thus left it blank going forward. For CPRI, however, it has been positive for three out of the previous five years with a positive change in working capital ranging from $81m to USD 160m. As a result, I gave $CAD 50m credit for it.

Risk and Reward Scenarios

Bull case:

2020 EBIT: $290.7m (assuming 40% revenue growth rate and 120 basis point decline in operating margin - 22.47%)

35x Multiple (EV/EBIT)

TEV: $CAD 9.15 Billion

+ Cash: $88.6m

Market Value: $9.24 Billion

Shares outstanding: 112.4m

Share price: $CAD 82 (54% upside from current price)

I have used EV/EBIT multiple of 35x (well below its 2018 multiple of 45x EV/EBIT) and assumed 40% revenue growth, which is the high end of management's revenue estimates. Management was very conservative in its 2017 and 2018 revenue growth estimates, where revenue growth was around 40% vs. 20% management guidance. Based on this, I believe 40% revenue growth in 2020 could be highly probable.

Base case:

2020 EBIT: $227.3m (Assuming 20% revenue growth rate and 120 basis decline in operating margin - 22.47%)

30x Multiple (EV/EBIT)

TEV: $CAD 6.82 Billion

+ Cash: $88.6m

Market Value: $6.9 Billion

Shares Outstanding: 112.4m

Share Price: $CAD 62 (20% upside potential from the current price - $CAD 52)

I have used current EV/EBIT multiple of 30x and assumed revenue growth of 20%, which is management's base-case forecast. Incorporating these highly conservative estimates still provides 20% upside.

Bear Case:

2020 EBIT: $205.2m (Assuming 10% revenue growth rate and 120 basis decline in operating margin - 22.47%)

25 x Multiple (EV/EBIT)

TEV: $CAD 5.14 Billion

+ Cash: $88.6m

Market Value: $5.23 Billion

Shares Outstanding: 112.4m

Share Price: $46 (12% decline from the current price of $52)

On the downside, the Canadian economy could slow down due to oil price volatility. China's debt problem could hurt consumer discretionary spending, and more than expected softness in the US economy could affect the company's revenue. In addition to that, there are still risks around the Chinese boycott of Canada Goose jackets following the arrest of Huawei's CFO. These issues could affect GOOS's bottom-line revenue. After pricing these in (with only 10% growth in revenue), shares could potentially decline by 12%. So, I would watch this stock very closely for any future developments and increase my position size as uncertainty around Chinese Boycott settles down.

ROIC and Financial Strength

ROIC

ROIC

(Author's ROIC analysis - in $CAD)

  • ROIC with goodwill and intangibles was at 33% and 30% in 2018 and 2019, respectively, which is very attractive. It shows that the company earns around 30% by reinvesting its free cash flow back into the business. ROA and ROE can be distorted easily by the management; ROIC gives a more accurate estimate.

Financial strength

  • 2019 Interest Coverage Ratio (Interest expense/EBITDA): 18.2x
  • 2019 Leverage (Total Debt/Adjusted EBITDA): 0.68
  • 2019 Quick Ratio: 0.8
  • 2019 Current Ratio: 3.02
  • With low leverage, high interest coverage ratio and abundant cash, GOOS is financially strong.

Conclusion

Overall, using conservative and management's base-case estimates in the valuation models provides at least 20% upside from the current price. Canada Goose is a high growth company with a lot of untapped market across China, US, and Western Europe. With strong ROIC, financial position, and improving fundamentals, shares could go well above 20%+, likely trading at around $82 (50% appreciation) by the end of 2020.

Disclosure: I am/we are long GOOS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.