Value and Later-Stage Principal Investing Blog: Analysis and Recommendation for Michael Kors Holdings Ltd.

Recommendation: Long
KORS is a ‘wide moat’ cash compounding machine w/ a ROIC > 25.0%+, EBIT Margins > 20.0%+, w/ ‘value oriented’ friendly capital allocation by senior management

Michael Kors Holdings

Associated Financial Valuation Model:

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Thesis

KEY SUMMARY METRICS:

  • Current Share Price (08/12/2017): $44.69
  • 3 Yr. Price Target: ~ $85.00+

  • % Upside (‘Margin of Safety’): ~ 67.0%+

  • Market Cap.: $7.32bn

  • Market Enterprise Value: $7.23bn

  • FY 2017 EV/EBITDA: 7.66x

  • 52 Week Price Range: $32.38 to $52.67

VALUATION:

  • FY 2017 Price / Sales : 1.61x
  • Price / Book Value (ttm): 4.29x

  • Price / Tangible BV (ttm): 6.47x

  • Price / Earnings Per Share: 12.7x (< 15.0x)

  • 10 Year (Prospective) Avg. ROIC: 31.5%

INVESTMENT THESIS (SHORT VERSION):

  • I recommend going LONG KORS equity w/ a 3 year price target of $85.00 intrinsic value (i.e. ‘Margin of Safety’ > 67.0%)

  • KORS is a ‘wide moat’ cash compounding machine w/ a ROIC > 25.0%+, EBIT Margins > 20.0%+, w/ ‘value oriented’ friendly capital allocation by senior management

TOP REASONS TO BUY KORS:

  • KORS has durable competitive advantage (i.e. ‘economic moat’)
  • KORS is a potential M&A / PE sponsor buyout target (i.e. trades at very low range of EV/EBITDA to peers)

  • KORS conversion rate from Rev. to Free Cash Flow is very high

  • KORS management uses ‘value oriented’ friendly capital allocation

  • KORS has ‘bullet proof’ Balance Sheet (w/ ZERO debt1)

  • KORS shows CONSISTENT 10 year track record of Y-o-Y Revenue increases and increase in Earnings

TOP RISK FACTORS FOR KORS:

  • High customer concentration in Wholesale segment
  • Sequential quarter-over-quarter declines in comparable store sales

  • Excessive reliance on contract manufacturer in China

  • Macroeconomic factors (possible eventual market correction in Tech affecting sales)

  • Possible border adjustment tax (due to Trump administration) affecting KORS imported manufactured goods

COMPANY BACKGROUND:

  • Michael Kors (‘KORS’) is a high end fashion brand that generates majority of its sales revenue from women’s handbags and accessories.

  • KORS has 3 operating segments: (1) retail; (2) wholesale; and (3) licensing

  • KORS shares have dropped in price from a high of $99.50 in Feb 2014 to $34.91 in Jan 2016

    1. This drop is share price appears to be due to factors such as (1) management oversupplying the retail and wholesale channels w/ its flagship women’s handbags (thus diluting exclusivity factor of  the brand); (2) excessive discounting / ‘markdown’ in wholesale channel resulting in Operating Profit margin deflation; (3) sequential quarter-over-quarter negative (high single digit) comparable store sales declines

  • KORS management has a strategic plan (called ‘Runway 2020’) where they plan to turn around declining comparable store sales trend and expand top-line revenue growth and Operating Profit margin levels to previous (historical) higher level

SPECIALTY RETAIL INDUSTRY BACKGROUND:

  • Specialty retail is a big industry, accounting for roughly 90.1% of the $4.9 trillion1 in US retail sales generated in 2016, according to the US Department of Commerce (DOC)
  • Within the Apparel sub-industry group, Women’s clothing stores consisted of $41.3bn1 in FY 2016 total North America sales volume; Men’s clothing store consisted of $8.6bn1 in FY 2016 total North America sales volume; Shoe sales consisted of $34.9bn1 in FY 2016 total North America sales volume

  • To keep up with the competition, specialty retailers are tapping new technology and adapting “omnichannel retailing” to reach out to their customers, expand sales, and spur growth

  • Retail construction declined 9.1% in 2016 to 68.4 million square feet compared with about 75.0 million square feet in the prior-year period, according to the latest “US Retail Outlook” report by financial and professional service company Jones Lang LaSalle

  • Favorable macroeconomic backdrop has helped specialty retailer industry; growth has come from increasing square footage of retail space in International Markets (primarily Asia)

  • Trend is for specialty retailers to increase leverage (due to low interest rates) to buy back shares and pay dividends to shareholders.

INVESTMENT THESIS:

  • –I recommend to long Michael Kors common stock because its stock price has dropped significantly due to overblown, excessive short-term focus on recent declining comparable store sales. The company has a strong franchise value (i.e. durable competitive advantage) with an highly attractive valuation, and the

    ‘Runway 2020’ strategic plan should result in a turnaround story within 2 to 3 years from now (i.e. FY2020 to FY2021). KORS is a ‘broken growth story’ at an attractive value investor price right at an inflection point where the business is stabilizing and multiple growth initiative already underway.

    • (1) Consensus View: KORS has very high negative comparable store sales declines which makes it an unattractive investment

  • –My View: The market expects the negative comparable store sales declines to persist indefinitely because the trend has persisted for many sequential quarters now. However, the trend line has been improving from how single digits to low single digits. In fact, as of Q1 FY 2018, the declining trend has began to stabilize, and management has given explicit guidance that they expect the trend to reverse and turn positive FY 2019 or FY 2020. Hence the market is extrapolating this short term negative comparable store sales decline indefinitely into the future which is not the case. By way of an example, KORS Q4 FY 2017 same store sales comps were -13.6%…then in Q1 FY 2018 then improved to -4.9%, which was well above the market expectation of where same store comparable would be. This shows significant sequential improvement and best same store sales numbers in 5 fiscal quarters. KORS Runway 2020 initiative will close 125 retail store locations, and this should help reverse single digit negative same comparable store sales trend

    • (2) Consensus View: KORS traditionally high profit margins have compressed significantly due to consumer taste changing and KORS traditional line of women handbags no longer being considered desirable by customers

  • –My View: Listening to KORS earnings call transcripts and reading thru MD&A sections in KORS 10-Ks, the reason profit margins have compressed is not necessarily due to decreased desirability and demand for KORS iconic brand of  women’s accessories, but rather excessive promotional activities and price markdowns within the Wholesale segment. KORS management has identified this issue and already implements plans to decrease shipments to Wholesale segment, reposition towards more reliance on higher margin Retail segment store sales going forward, and much more strict control over promotional pricing and how often promotional weeks will take place. I expect this in turn to gradually result in the Operating Profit margins to gradually trend back upward towards historically higher levels. We are already 2 years into the Wholesale segment pull back. KORS is in the beginning stages of a stabilization in its Retail segment.

    • (3) Consensus View: KORS paid too high acquisition multiple for Jimmy Choo acquisition

  • –My View: KORS paid 2.7x EV/Rev. (and 17.5x EV/EBITDA) for CHOO, whereas Coach and other luxury M&A transactions took place at average of 1.8x EV/Rev. (and 13.0x EV/EBITDA). CHOO is a premium ultra luxury footwear iconic brand that deserves a premium acquisition multiple. CHOO will allow KORS to diversity its product mix and reduce its heavy reliance on women’s accessories product category (namely, women’s handbags). Luxury footwear is the fastest growing segment of the luxury fashion industry. CHOO will allow KORS to tap into a very high growth market in luxury shoes (especially men’s luxury shoes where KORS existed sales are very limited). CHOO has only 150 total retail store and its strategy is to open on 10 stores per year to enhance the luxury brand name. CHOO will allow KORS to further expand into Asia continent as there are many area in, for instance, China, where there are > 10mm people in population and there are no previously existing CHOO or KORS retail store footprint. Furthermore, KORS management believes that CHOO can generate ~ $1 billion in annual revenue contribution to KORS core business.

    • (4) Consensus View: KORS future growth potential is severely limited as its core market (i.e. women’s accessories) is already a very competitive and crowded industry at a full saturation point with limited additional growth potential in North America

  • –My View: The main future growth possibilities for KORS (as well as most other specialty retail / luxury fashion brands) is from international expansion, primarily in Asia and Europe. KORS has a very big growth opportunity within Asia… currently there are 100 KORS retail stores in Japan, and management believes this has a potential to be a $300mm annual revenue generating business. KORS brought back in-house the Greater China and Korea business; management believes these two areas have a $500mm and $100mm annual revenue potential, respectively. Furthermore, in Southeast Asia KORS management sees a potential $100mm annual revenue potential. In total, KORS management is targeting a $1 billion in total revenues business in Asia over time.

  • Acquisition of Jimmy Choo will allow KORS to diversity its product mix (from handbags and accessories to shoes as well) and breathing room from geographic expansion as well

  • KORS is currently a broken ‘growth story stock’; it had robust growth earlier this decade which averaged 60.0% top-line and 100.0% bottom line growth from FY 2011 thru FY 2014, w/ 4 years of 25.0%+ same store comp

  • Luxury Shoe market is growing at 11.0% CAGR (2013 – 2015) versus 7.0% CAGR for Luxury Apparel ex-footwear

    • 1. –CHOO acquisition will help reverse comparable store decline since luxury shoe is among fastest growing sub-industry w/in Luxury Apparel (i.e. tapping into expanding growth market)

  • Net Sales (in $) from Retail segment in FY 2017 actually increased (despite negative HSD comparable store sales figures)

    • 1. –New eCommerce channel added 304 basis points to comparable store sales (and this is expected to increase over time)

  • Specialty Retailer Industry Average P/E ratio in FY 2017 is 17.6x

    • 1. –KORS P/E multiple is lower that both its industry average as well as S&P500 P/E multiple

VALUATION:

  • KORS current trades at a 12.9x P/E multiple1

    • 1. –Specialty Retailer Industry Average P/E ratio in FY 2017 is 17.6x

    • 2. –KORS P/E multiple is lower that both its industry average as well as S&P500 P/E multiple

  • I used a Discounted Cash Flow analysis to value KORS common stock, using scenario analysis to come up with a Base / Upside / Downside cases. I used a 10.0% discount rate as a conservative measure (even though KORS WACC is much lower around 4.7%). Based on an Unlevered Free Cash Flow basis, the valuation range for KORS is approximately $70 per share for the Downside Scenario. On an Unlevered Free Cash Flow basis, the valuation range for KORS is approximately $80 for the Base Case Scenario. On an Unlevered Free Cash Flow basis, the valuation range for KORS is approximately $90 per share for the Upside Case Scenario.

  • For the Base Case Scenario price range of ~ $80 per share, that implies a ‘Margin of Safety’ of ~ 75.0% from the current share price of ~ $45 per share.

CATALYSTS:

  • HARD CATALYSTS

    • –(a) closing of approx. 125 retail stores as part of Retail Fleet Optimization Plan (i.e. ‘Runway 2020’ restructuring initiative)

    • –(b) remodeling of 100 existing stores

    • –(c) integration of Jimmy Choo acquisition (accretive to EPS in 2020)

    • –(e) e-Commerce website taken ‘in-house’ in FY 2015 and is seeing robust  growth

    • –(f) growth in International expansion (primarily Asia and Europe) from increased brand awareness

  • SOFT CATALYSTS

    • –(a) potential PE sponsor LBO ‘take private’ buyout prospect;

    • –(b) ‘subtle’ brand transformation from ‘iconic women handbags’ to ‘international luxury fashion house’

INVESTMENT RISKS:

  • KORS faces an image problem due to excessive focus on discounting their products

1. –This was due to the excessive promotional discounting in the Wholesale segment, which KORS management has already taken measures against

  • KORS has very high customer concentration in Wholesale segment

1. –Net sales to the 5 largest wholesale customers constituted 21.0% of total revenues in FY 2017 (and 25.8% of total revenues in FY 2016)

2. –Macy’s Inc is KORS largest Wholesale customer and constituted almost ~ 10.0% of FY 2017 total sales

  • KORS largest manufacturing contractor (located in China) accounts for the production of ~ 30.0% of KORS total finished products

 


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