U.S. Markets close in 6 hrs 13 mins

How Levi Strauss Can Overcome Its Biggest Weakness

John Ballard, The Motley Fool

Levi Strauss (NYSE: LEVI) is the top jeans brand in the world, but it's been a rough outing for the stock since it began trading in March of this year, with the stock price down 25% since the IPO. One of the main reasons for investor pessimism has been the weakness in the wholesale market, which makes up about two-thirds of Levi's business.

The denim market is expected to grow modestly through 2023, but Levi Strauss is suffering from the wave of retail store closings in the U.S., which caused a drop of 2% in the U.S. wholesale business in the second quarter. This decrease weighed on sales in the Americas region, which grew just 3% year over year, versus 9% in Europe and 6% in Asia. 

The stock price has been under pressure, as market participants wanted to see better performance. But there are a few ways that Levi Strauss can overcome the near-term weakness in the U.S. wholesale business and deliver the growth that investors expect.

A group of distressed Levi's jeans.

Image source: Levi Strauss.

Direct sales channels are performing well

One of the most important ways Levi's can mitigate the reliance on wholesale is growth in the direct-to-consumer (DTC) channel, which includes e-commerce and company-operated stores. The DTC business is growing much faster than the rest of the company, up 14% adjusted for currency last quarter. This marked the 13th consecutive quarter of double-digit growth in the direct channel. 

The growth in the DTC business, which made up 35% of total revenue in 2018, reflects consumers who are choosing to go right to the source for their Levi's 501s instead of shopping a competing brand.

As long as the DTC channel performs this well, the company should be able to mitigate the softness in U.S. wholesale. The double-digit growth in both the direct and international business contributed to the currency-neutral revenue growth of 9% last quarter.

Expanding products and categories

Management is helping to fuel its brand popularity by introducing new products and categories. It offers a more extensive range of merchandise than just denim, including accessories, shoes, various styles of tops, and other branded apparel. Tops have been particularly successful, up 37% in 2018, and are now a $1 billion business for the company. 

Within denim, Levi's has successfully introduced new fits, such as the 502 and 512, which have grown significantly over the last two years. The company is also capitalizing well on its brand heritage with its Vintage and Made & Crafted collections, which feature premium-priced products based on popular styles from the company's rich history.

And it sees a tremendous growth opportunity in the women's category. Women's sales are a third of Levi's business, but the category saw sales jump 16% year over year in the last quarter. The recent growth was driven by tops and bottoms. 

New technology

Management is also excited about a new manufacturing initiative called Project F.L.X. It's an ordering system that allows buyers to customize their new jeans with any fit, fade, and other styling features. It's early for the new service, as it still seems somewhat limited in the range of choices, but this is a significant opportunity for Levi's.

The F.L.X. technology should help reduce operating costs and boost margins in a few ways. First, because the product is made on-demand, it reduces the need to carry inventory. It also cuts down on the number of chemicals needed to finish the jeans. And it helps respond faster to shifts in consumer tastes in the age of social media, where one tweet from a celebrity wearing a particular style can set a new trend. 

Now could be the time to buy the stock

Levi Strauss is the largest jeans maker in the world, and that brand recognition puts it in a good position to benefit from the growth in consumer spending for jeans. The global denim market is expected to grow 5.8% per year through 2023, according to consulting firm Prescient and Strategic Intelligence. 

The drop in the stock price has brought the valuation down to a more appealing forward P/E of 14.6 times next year's earnings estimate. Management has guided for single-digit growth on the top line this year, with a slight improvement in adjusted operating margin. 

All in all, I believe Levi's is in a better competitive position than its recent stock performance would indicate. One analyst with Bank of America upgraded it to a buy rating recently, citing the ability of the company's brand power to overcome the near-term weakness in the wholesale channel. 

More From The Motley Fool

John Ballard has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com