I love to find cheap businesses that provide products and services that are necessary to our way of life. Today, it takes just a little bit of a stretch to get there from here.
Now, the reason this selection is a “little bit of a stretch” is not that it is not cheap; it is. It’s not that it doesn’t supply products within an industry that we need to maintain our way of life. It is just that the specific products this business supplies are above the basic level required for survival.
Having said that, I guess I should make some allowance for the fact that our wealthy friends need food, shelter and clothing, too. They just get the best brands! After all, a Bentley or a KIA will both get you to the grocery store. But you won’t find me riding in a Bentley and you probably shouldn’t expect to see Donald Trump driving a KIA any time soon.
Meeting the basic needs of the merely well-to-do
I don’t think the average Michael Kors (KORS, Financial) customer will be riding around town in a Bentley either. But Michael Kors' targeted customers are anything but poor and certainly not interested in settling for the basic necessities.
Michael Kors targets the 25- to 54-year-old age group with annual incomes over $50,000. Quite often, these consumers will represent the newly affluent or established upper middle-class in the market. What we might even refer to as the poor rich people. These are people who have disposable income and a desire to have some of life’s amenities.
Michael Kors engages in the design, marketing, distribution and retailing of branded women's apparel and accessories and men's apparel. The retail segment is involved in the sale of women's apparel; accessories, which include handbags and small leather goods, such as wallets; footwear and licensed products comprising watches, jewelry, fragrances and beauty, and eyewear. As of March 28, this segment operated 343 North American retail stores and its U.S. ecommerce site. It also operated 183 international retail stores, including its stores in Europe and Japan.
The Wholesale segment sells its products to the retail industry outside of the company’s dedicated locations. The Licensing segment licenses its trademarks on products, such as fragrances, beauty, eyewear, leather goods, jewelry, watches, coats, men's suits, swimwear, furs and ties and licenses rights to third parties to sell the company's products in geographical regions, such as the Middle East, Eastern Europe, Latin America, the Caribbean, Asia (excluding Japan) and Australia. Michael Kors was founded in 1981 and is based in London.
How is the business currently valued?
As the chart below shows, Michael Kors is currently trading at $42.52 per share. These are levels not seen since mid-2012. But when the price was hovering around $40 per share then, the price-to-earnings ratio was over 40 – fully four times higher than where it is valued today at less than 10 times projected earnings for the period ending March 2016.
I like to review past earning performance for two reasons. The first is to help determine how much confidence we should have in the estimates of the analysts covering this business. I always like to consider the past performance over the previous several quarters.
The table below from Fidelity Investments shows that, over the last eight quarters, Michael Kors has delivered at or above the analysts’ projections. As they say in the financial disclosures: “Past results are no guarantee of future performance.” But the consistency of the business in meeting past expectations does provide some reason to have a bit of confidence in their ability to predict the performance of the business.
The second reason I like to review the quarterly earnings from the last few quarters is to determine how the stock is valued against the earnings for the most recent 12 months. For the four most recently reported quarters ended Sept. 30, Michael Kors has reported earnings per share of $4.26. Based on Friday’s closing price of $42.52 the stock is currently trading at a P/E of 9.98.
Michael Kors is a globally recognized brand and a favorite among upwardly mobile middle-class consumers who want to enjoy some of the benefits of their growing affluence but are not quite ready to enter the higher end range of the luxury goods market. This brand provides them with the status and prestige of a designer brand, without the exorbitant cost that comes with some other designers.
Why is the business so cheap?
In a market trading at nearly double the P/E of Michael Kors, a company like this with a global brand would seem to be priced very cheaply at the current levels. While I believe it is, I also believe I understand why investors have driven the shares down over 57% in the last three years.
Even though sales have increased about 544% over the last four fiscal years, growth for the current year is projected to be essentially flat to slightly lower than last year.
Earnings per share, which increased from 38 cents per share in fiscal 2010 to $4.35 in fiscal 2014, are expected to be virtually flat for the current year and next.
These projections are shown in the table below from Yahoo!Finance. Wall Street loves growth and hates even temporary pauses. This is clearly shown in the current valuation of the business.
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Now, I do not discount the importance of growth in a business when it comes to pushing share prices higher. Other than becoming an acquisition target, there are few other metrics to drive a share price higher than increasing sales and profits.
However, barring a new global recession, it is hard to understand how a business that has grown at the pace of Michael Kors over the past five years is suddenly going to shift to almost no growth over the next five years.
When a bull market has run as long and hard as the current market has, I start to look much more seriously at solid growth businesses that seem to have share prices that have already been subjected to extreme devaluation and pessimism.
Here we have a business with an exceptional history that is expected to suddenly turn into a zero growth future and is priced as if that is a fact. This seems to me to be a typical overreaction by the market that creates an exceptional long-term opportunity for patient, value-oriented investors.
That is what Michael Kors has put on our plate today.
Where is the 'risk insurance' for Michael Kors?
Regular readers of my work know I always like to feel as if I have some sort of protection for my capital when I allocate it to a new investment. My favorite place to find this kind of protection is in balance sheets.
A company’s balance sheet is a great place to look for protection or risk because of the straightforward manner in which everything financial about a business is laid bare. As a successful friend of mine in the acquisition business once told me: “I like balance sheets because cash doesn’t lie.”
For my purposes as an individual investor seeking assurance that my capital is safe, the first thing I want to be sure of is that the business is not going out of business.
The first thing I review in a balance sheet are the current assets. The reason I review current assets instead of long-term assets is that I have always believed it is easier for accountants and managers to overstate the value of plant, property and equipment that are normally a large part of long-term assets.
Without visiting a company’s facilities and actually assessing the condition and marketability of their equipment and real estate, I cannot hope to estimate its fair market value.
Also, if a business finds itself having to liquidate assets essential to producing and distributing its products, it would hardly be of any interest to me.
In the case of Michael Kors, at the end of September, the company had Cash and Short-Term Investments (usually considered equivalent to cash) of $432 million.
The company was owed $354 million by customers. Quite often, I will only assign a 50% valuation to the accounts receivable since there will always be some customers who don’t pay, and I want the most conservative approach possible for this type of business. That would assign a liquidation value of about $177 million to the receivables.
Since the fashion industry is notoriously trendy, I am going to apply the same 50% valuation discount to the inventory that I did to the receivables. Since inventories are carried at actual cost but reduced at wholesale cost, the 50% discount should provide a massive margin of safety on our valuation. This would value the liquidation of the inventory at $357 million.
Using the valuations discussed below, the immediate liquid value of the business should be no less than $966 million without assigning any value to the noncurrent assets of the business. The company currently lists the value of Property, Plant and Equipment at $672 million. Keep in mind that these items are carried on the books at the current depreciated value. This will generally overstate the market value of the equipment and understate the value of property and plants.
The next step in the process is to review the liabilities on the balance sheet. For this step, I take a somewhat different approach. It is still going to be very conservative. It's just that, when building a conservative evaluation of the liabilities on a balance sheet, you count everything that appears.
So not only are we going to look at the current liabilities, we are going to consider Total Liabilities when assessing the safety of the business.
The table below, from the company’s most recently filed quarterly results, reveals that it had $387 million in current liabilities and $144 million in long-term liabilities at the end of September.
When we subtract the total liabilities of the business from the conservative liquidation value of the current assets, we are left with a surplus of $435 million in truly free and clear current liquid value.
Michael Kors currently has 184,050,000 shares outstanding. This represents $2.36 per share of liquid current value beyond all outstanding liabilities, 5.56% of the total valuation.
This means that investors today have the opportunity to buy the long-term assets required to run the business and the brand for about 9.2 times earnings, free and clear of all liabilities.
For a brand with Michael Kors'Ă‚ global footprint, it is almost insane to be able to purchase it at this kind of valuation with virtually no risk to its survival.
What is the fair value of the business?
If the analysts are correct and the business will expand earnings at only 3% to 4% annually over the next five years, then the stock is probably currently valued at an appropriate level.
However, it is just very difficult for me to believe that will be the case with the brand identity Michael Kors has built and the growth of middle-class consumers around the developing world. Even a return to modest growth, which I see as the most likely eventuality, going forward should produce shareholder returns of 10% to 15% annually over the long term.
As a potential bonus for new investors, there is always the possibility that the stock would become valued in line with the broader market at about 16 to 19 times earnings. This eventuality would result in additional capital gains of 60% to 100%.
The risk is that the valuations of the overall market will correct. However, as long as Michael Kors is to be valued on an equal basis with the broader market, there is a tremendous amount of downside protection already built into the share price.
Final thoughts and actionable conclusions
Shares of Michael Kors, as priced in the market today, are not for everyone. However, I think they offer a compelling long-term opportunity for serious value investors who have the patience to wait for the ultimate reward.
The business is obviously on very solid financial footing and already appears priced for a worst-case scenario with very little value being assigned to a valuable brand franchise.
Should management decide to do the right thing and return some of its massive liquid value to shareholders by instituting a regular quarterly dividend or even a special one-time payment. I would prefer a regular dividend and believe it would unlock more value for long-term investors.
With the stock priced where it sits today, a large buyback would also serve the interests of long-term investors.
