The fashion industry is a fickle and difficult place in which to survive, much less proper, over a period spanning decades. You can probably count on just your fingers the number of recognizable brands that have withstood the test of time over 20 or 30 years and still prosper today. Many, if not most, of the brands that are popular today will be long forgotten in 5 years. Those that choose to become publicly traded entities do not tend to fare much better. But, as is the case with most anecdotal rules, there are exceptions.
When exceptions to survival rules come along in the stock market, they tend to bring with them valuations that exemplify how highly regarded these exceptions are. As value oriented investors, these are not businesses that normally come to our attention because of the high valuations the market assigns to them. Today, it appears that the market might well be presenting an opportunity to us that allows us to buy an exceptional brand with a 33-year track record of successful operations at a compelling price compared to present and future fair value. The business that has come to my attention today is Michael Kors Holdings Limited (KORS, Financial).
Who is Michael Kors and why should investors care?
Michael Kors is a designer, marketer, distributor and retailer of women’s apparel and accessories and men’s apparel who launched his namesake business 33 years ago in 1981. For the first 30 years of its existence, it remained a private entity. Thirty years is a long time on anyone’s calendar, but it represents an eternity in the fast-changing world of fashion tastes and choices. Michael Kors and his products have withstood the test of time and deserve our attention if for nothing more than achieving something very few brands have managed in this industry. Today, the business is divided into three operating units consisting of retail, wholesale and licensing. This is the who of Michael Kors and his business.
But I don’t analyze businesses to pass out accolades for surviving. I do it to find and seize investment opportunities that present compelling present value and exceptional potential for both short and long term appreciation of my allocated capital. So, now we are going to look at why we should care about Michael Kors the business. One of the early investing concepts I learned was that the safety of my initial capital was rule number one in making investment decisions. This belief dictates that even the best of businesses with the brightest future prospects are not worthy of my capital unless they are currently priced at a level well below what I believe to be the current fair value.
The first thing investors should like about KORS is the fact that the business has no debt. It used to have a small amount but chose to pay it off. Even better, the company is holding $1.125 billion in cash and cash equivalents on its balance sheet; a figure that equates to about 7.8% of the current market value of the business. Cash on the balance sheet is often overlooked by casual investors but should never be ignored when seeking safety and strength in a business. It positions management that was smart enough to build it up to take advantage of compelling business opportunities that might present themselves without the necessity of waiting to access credit markets. Sometimes, the party with cash in hand today can close a much better deal than the one who might be able to get financing tomorrow. This cash on hand also makes our other valuations actually 7.8% more favorable since it could be used to purchase shares in the open market or pay dividends to shareholders. But, is that what we would really want them to do?
The management team at KORS knows how to build up a cash balance, but do they know how to apply that balance and all of the other assets they control to the best advantage of the business owners, the shareholders? They appear to know how to do so quite well and this is why we should care about them.
Performance is what matters
Dr. Steve Sjuggerud likes to point out that “money flows to where it is treated the best.” This does not always happen right away, and there are even times when money can flow away from where it has been well treated. These are the situations where value-oriented investors can avail themselves of the opportunity to profit handsomely. Let’s take a look at just how capable the management team at KORS has been with its handling of the shareholders' capital. In other words, let’s see if the capital should really be flowing in or out of the business.
Shareholder equity is the portion of a business above and beyond the debts and obligations of a business that is owned by the stockholders. In the private equity world, high returns on equity are achieved in many cases by keeping the investors’ capital allocated to a low level and using high levels of debt to leverage the return on their capital. Since KORS has no long-term debt, we know the returns we can calculate on shareholder equity, assets and invested capital represent real numbers with little to no leverage used to enhance them. Growth rates in book value are also an excellent methodology for determining the effectiveness of management in regards to building real shareholder value rather than simply an emotional attachment to a brand.
Since 2011, Michael Kors has produced exceptional investment returns based on these four metrics as indicated by the table below.
| Metric | 2011 | 2012 | 2013 | 2014 |
| Return on Equity | 115.71% | 50.68% | 52.89% | 46.37% |
| Return on Assets | 36.3% | 27.44% | 40.49% | 37.73% |
| Return on Capital | 119.69% | 80.57% | 128.49% | 138.21% |
| Yr-Yr Book Value | Ă‚ | 339% | 114.52% | 70.11% |
These numbers are nothing short of astonishing for a business with a market capitalization of $14.4 billion. Clearly we have a business that is doing far more than simply surviving in a very competitive and rapidly changing industry.
Unless you believe that exceptional management can suddenly lose a proven ability to produce exceptional results as they have already done for years, then past results do matter. They should never be construed as a guarantee of future results, but they should also never be ignored.
Exceptional management with a track record of delivering excellent levels of performance for shareholders will always justify the time spent to analyze a business for potential investment. It is critical, however, for prudent investors to always remember that the price we pay for our entry into a position will be just as important in the end result we obtain as is the selection of the right business. If we buy a great business with exceptional management but pay 50% more than current fair value, our long-term results will almost certainly be compromised.
Assessing the current fair value of Michael Kors
When assessing the current value of a business like Michael Kors with such stellar growth numbers over the past several years, I believe it is only prudent to apply a skeptical view when applying those results to any future projections for performance. Excessive optimism over future rates of growth can result in dismal investment performance faster than anything of which I am aware, short of the discovery of financial fraud.
One of the value metrics I use is to take the average of past returns across equity, assets and capital and multiply that number by the trailing, current and next year’s earnings projected for the business. In cases where I am dealing with what I believe to be unsustainable numbers, I will apply a “reducer” to the calculation in order to produce a more conservative result. I will also review the projections of the analysts covering the stock and use their projections should they be more conservative than my own.
In the case of KORS, averaging the past year’s return on equity, assets and capital produces an average return of 74% which coincides closely to the growth rate of 70.11% in book value. Even if I applied a performance reduction factor of 50% to this number, it would still result in a current fair value figure for the stock of 35 times earnings. Based upon fiscal year 2014 results of $3.12/share and the projected earnings of $4.17/share for March 2015, this methodology produces a current range of fair value between $109.20 (35 X $3.12) and $145.95 (35 X $4.17). The 52-week high for the stock is $101.04 which is within 10% of the bottom of this projected range for the next 12 to 18 months which makes this result sound quite plausible.
I don’t need a concurring opinion; but I will accept one
When one spends as much time as I do analyzing a business prior to allocating my capital, we tend to develop strong opinions and confidence in our final conclusions. I do not base my investment decisions on the opinions of professional analysts covering a particular stock ,but I also do not choose to completely ignore them, either. After all, these opinions represent the work of people who are paid by investment firms to prepare what amount to position papers on public companies and their future prospects. Part of any serious analysis performed in anticipation of allocating real capital should always consist of reviewing all of the information to which one has access.
In the case of Michael Kors, I was able to access reports prepared by 9 of the investment firms covering the stock with ratings from “Underweight” to “Strong Buy” and the Thompson Reuters I/B/E/S Estimates which amounts to an average view of all of the analysts covering a stock.
A company called EVA Dimensions currently had the worst rating I found on KORS with an “Underweight” rating. Their view of KORS is that the stock was overvalued at the time they downgraded it to “underweight” on May 31, 2014. At that time, the stock was trading at $94.38 compared to today’s price of $70.74. It is also interesting to note that just over a year ago, on November 2, 2013, this same firm upgraded the stock to “Overweight” from “Hold” when it was trading at a share price of $75.43. Based upon the history, I don’t think it would be a surprise to see EVA upgrade this stock again in the near future. This report did not offer any estimate of current or future fair value for the stock at the time of the report preparation. This particular report was dated November 6 with a reference to a share price of $72.40, but research firms have been known to change opinions almost as much as politicians.
On the other end of the research opinion spectrum we find the folks at Ford Equity Research. On November 7, 2014, Ford Equity upgraded its rating on KORS from a “Buy” to “Strong Buy.” Their “Buy” rating had only been in place since October 18, 2014; giving further credence to my previous statement regarding how quickly research firms can change an opinion.
The Ford Equity report cites the precipitous fall in share price against a relatively favorable outlook for the company which has resulted in a very attractive scenario regarding the upside potential of the stock when compared to the downside risk. Based upon the historic P/E range within which the shares of KORS tend to trade, Ford Equity projects the top end of the price channel on this stock to be $130.54 with a mid-range price point of $84.71.
Thompson Reuters I/B/E/S Estimates reveals that there is an overall bullish sentiment among the analysts covering this stock. The rating they assign to the sentiment of the analysts covering the stock is 7.5 on a scale of 1 to 10. I don’t mind when analysts disagree with me as it leaves a lot of people who can change their opinion and create new buyers of the stock, but it doesn’t bother me when it exists in regard to a stock that I believe is seriously undervalued.
What do all of these numbers mean in total?
In estimating the low-end of a price range we can reasonably anticipate for this stock, I think using the mid-point of the historic range of the P/E ratio we know the stock has traded within multiplied by the training 12 months’ earnings is quite conservative. According to Thompson Reuters, that calculation produces an expected share price of $84.71 or 19.75% above the current price within the next 12 months.
The consensus earnings growth rate for the next 5 years among the analysts covering this stock is 22.5%; when looking for the mid-range of a reasonable price target for this stock, we can use the projected long-term earnings growth rate multiplied by the estimated earnings for the current year that will end in March of 2015. The consensus earnings estimate of $4.17/share mulitplied by the 22% projected growth rate produces an anticipated share price of $91.74. Using a PEG ratio of 1 is generally accepted to produce a relatively conservative estimate of fair value. This scenario would produce a 12-month return of 29.69% from the current share price.
Since the Ford Equity analysis produces a more conservative upper end price target than what is produced by my own high-end target projection, I will apply the lower number to calculate the optimistic case for the stock. This would be achieved if the stock were to rise to the high end of its historic P/E range based upon trailing earnings. In this case, we could see a share price of $130.54, representing a gain of 84.5% from today’s levels.
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Final thoughts and actionable conclusions
It doesn’t happen on a regular basis; but when the market presents a value investor with the opportunity to own a high growth rate stock at bargain basement valuations and huge short-term and long-term potential with limited downside risk, we should never be so rude as to refuse to open the door for it. I firmly believe that is the opportunity with which we are currently faced through the share price of Michael Kors Holdings. The combination of zero debt, strong past and projected forward growth and exceptional returns on equity, assets and capital delivered by management combine to make this a compelling opportunity.
Opportunities like this do not present themselves on a regular basis and do not tend to last long when they do. This is probably not a stock that is going to double in the next 12 months but can certainly deliver returns in excess of 20%/year for the next several years and have the potential to produce even better results. If you choose not to act soon, this will quickly become a missed opportunity that you will regret have let slip through your fingers.
