Michael Kors: On the quest for Value

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May 18, 2015
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Michael Kors is a world-renowned fashion designer and retailer who Mr. Market has gotten depressed about lately. The company has great margins, and an equally great valuation. In the following, I will make the case as to why I think this company should attract considerable attention if you – like me – is a value investor looking to profit.

The company:

Michael Kors founded his company over 30 years ago, and is now a world-renowned designer specialized in ĂĽber-luxury apparel and accessories, such as jewelry, bags and footwear. Their two primary segments are retailing and wholesale which accounts for 48,1% and 47,6% respectively, while licensing accounts for the rest. They are located in some of the most illustrious cities in the world, and cater almost exclusively to the young, hip and affluent which has proven to be very profitable. Over the last five years, they have grown at the speed of light, with revenue increasing more than 7-fold, and profits more than eight times over. ROE, ROA and ROIC have consistently mostly every other retailer on the planet, and for the last 12-month period they stood at 44%, 36% and 86% respectively. Very respectable numbers indeed. Operating margin, Net margin, ROE, ROA and ROC are all better than at least 97 % of comparable companies. Those numbers speak volumes as to their quality of operations more than anything else.

Despite steadily increasing sales and profits however, the company has suffered a very severe drawback recently, going from USD 97 on may 16th 2014 to USD 61 as of this writing, representing a haircut of more than a third. The reason for this reason recent selloff, as far as I can gather, is the fact that investors are concerned about if Michael Kors’ expansion is happening too fast, thus compromising the brand value, as we saw it with coach. When you are selling something that is a luxury item, you don’t want everyone to own it. I find this to be a concern that is not completely unfounded, and I am willing to acknowledge that there is some risk of this happening if MK starts compromising their prices. As long as they don’t however, they should continue to grow at a reasonable clip. They will not maintain their current growth forever, but that won’t be necessary for investors to profit from this opportunity.

Senior management have a very solid track record, and have been with the company 10+ years. Michael Kors, who founded the company functions in a role as honorary chairman, and Chief Creative Officer, which is a highly influential and crucial role – and his track record and future accomplishments might determine the company’s success more than any other factor. In general the management seems highly regarded and the CEO John Idol has an 85% approval rating on Glassdoor.

The sector:

Retail is a notoriously fickle sector, where consumer’s taste vary widely over time, and this is even more so when it comes to fashion. In this industry most of the success stands and falls with the talent of the designers and especially the chief designers. They are much sought after, and as a result their talents are richly rewarded. The chief designer at Dior made four million dollars last year. Luckily Michael Kors has an in-house designer with a proven track record, who has a lot at stake in this company and is highly unlikely to leave – namely Michael Kors. If his track record is any indication – and it is the best one we’ve got – then this company will be successful in the foreseeable future, and will reward shareholders in the process.

The company is positioned as a high-end retailer, charging a lot of money for very fashionable clothing, and they are endorsed by some of the most admired people on the planet – Angelina Jolie, Gwyneth Paltrow and Michelle Obama to name a few. This translates in to nice, fat margins – 20% net margin for the trailing 12-month period. Similar companies both in terms of size and competitive positioning like Ralph Lauren, Burberry and Prada sport growth rates and net-margins that are not even close to Michael Kors’, while their valuation are remarkably higher.

Valuation:

The company comes across as financially very strong. They have 0 debt, almost half their equity is in cash, so they are well equipped to weather any future storms. Further they have initiated a 1 billion dollar share buyback program, which clearly signals that management thinks that Mr. Market is severely undervaluing the company.

On Gurufocus’ Financial Strength indicator, it scores 9 out of 10, while it scores an 8 out of 10 on their profitability and growth. With an earnings yield of 10,8 and a PEG of 0,23 (which is in the top 1% of comparable companies), and an EV-EBIT of 9,35 all valuation ratios are screaming to buy.

There is one red flag however, and that is the lack of free cash-flow. Free cash flow has been consistently below earnings, for every year since they started reporting, which doesn’t necessarily signals anything suspicious, but I would like to see management address this issue. Especially since in most retail businesses, it is very clear how the net income comes about.

Having said that however, I find the company to be an extremely attractive opportunity, with great fundamentals, which has a solid foothold in an attractive industry and are valued as if they are going to stop growing very soon. At the current price, the market factors in zero growth. This is highly unlikely, almost to the point of laughable and not exactly supportive of the efficient market hypothesis. I obviously think this is unreasonably low, for a company such as Michael Kors.

Because I wish to err on the side of conservatism however, I set the growth rate for the next five years at 15%, which is very conservative, considering they have grown earnings at an annual clip of more than 40% and are currently buying back shares, which will result in an increased stock price, all things equal. After this initial slowdown of growth, I model a terminal growth rate of 5% for 15% years, with a discount rate of 8%, and add in the tangible book value, which is most mostly cash and get a fair value of USD 116.94. This represents a margin of safety of 48%, and I have already started adding this stock to my portfolio. Supporting my own analysis is the fact that out of 22 Wall Street analysts who follow the stock, seven rate it a strong buy, and only one rates it a moderate sell.

It is not every day that Mr. Market presents you with the opportunity to buy a business of considerable proficiency, and future earnings potential at half its actual value. He seems to be quite depressed about Michael Kors, and unduly so. I will be happy to do business with him now, and then sell my part in the company back to him, when his mood brightens a bit. Probably at a reasonable profit.

Disclaimer: I am a value-investing student, doing independent research in order to hone my own skills, and get better at investing. Please do your own research before buying this stock.

Any and all constructive criticism is highly appreciated, as I consider Gurufocus’ participants very reliable experts in the field of value-investing and I will value the opinions of its members.