Michael Kors Is on Sale

Over the last several years Michael Kors’ (KORS, Financial) revenues have grown at a CAGR of 54%. In the last few quarters, though, overall growth has slowed, and same-store sales have declined 5.8%, 9.5% and 8.5% (1.7%, 5% and 3.4% on a constant currency basis) in the last three quarters. The negative same-store sales and slowing overall revenue growth have caused growth investors to rush for the exits resulting in the stock price dropping ~50% over the last 12 months.

Negative same-store sales have also caused investors to question whether Michael Kors has lost its cachet with customers and could be in danger of losing business like Coach did. The company now trades at 6.4x EBITDA – MCX and a PE ratio of 8.7x (I use total shares currently outstanding to calculate PE). Assuming Michael Kors' growth does slow significantly, it still should trade in line with other slow growing peers such as Coach (COH, Financial), PVH (PVH, Financial) and Ralph Lauren (RL, Financial). These three companies have an average EV to EBIT of 13.2x and an average PE of 17.5x. Obviously 13.2x EBIT is a very high price to pay; I use a more conservative multiple of 10x my estimate of EBITDA minus maintenance capital expense ($226 million or 5% of sales) to arrive at a value of ~$60 per share.

Business overview

• Michael Kors is a luxury brand that primarily sells accessories such as purses and watches. These categories make up the majority of revenue but the company also carries an apparel collection. The company currently operates in three primary regions: North America ($3.419 billion or 78% of total sales in 2015), Europe ($885 million or 20% of total sales in 2015) and Asia ($68,000 or 1.6% of sales in 2015). Approximately 49% of total sales come from retail locations, 47% from wholesale stores and 4% from licensing.

Valuation

• KORS EV/EBIT of 6x is at a significant discount to the average comps EV/EBIT and the apparel industry median EV/EBIT of 14.2x. Other measures of value, including PE ratio (8.7x), price to free cash flow (9.1x) and EV/EBITDA (5.3x) also show how cheap the business is. Comparable companies such as Ralph Lauren, Coach, PVH and Vera Bradley (VRA, Financial) trade for an EV/EBIT of 9.4X, 16.1x, 14.3x, and 13.2x. For perspective, an increase in Michael Kors’ EV/EBIT ratio to 14.2x would increase equity value to $93.38 per share. Since 14.2x EBIT is a very high multiple to pay for any business, I only assume a 10x multiple of EBITDA-MCX to arrive at an estimated value of $60 per share for approximately ~49% upside.

Business quality and durability of business (moat)

• As a luxury retailer the price of the product Michael Kors sells is based on its perception rather than its actual cost. This allows the company to earn unusually high gross margins of 55% to 60% and net income margins of 20% over the last three years. In addition to high profit margins, the company also has low capital requirements since it leases its stores. The combination of high profit margins and low capital requirements results in an unusually high return on capital of 68%. Comparable companies Ralph Lauren, Coach, PVH and Vera Bradley have lower returns on capital of 22%, 25%, 31% and 18% respectively. Michael Kors' high returns have allowed it to grow very quickly with sales rising from $803 million in 2011 to $4.512 billion in the TTM period.
• The key to maintaining the high returns on capital is maintaining the company’s brand perception. The company has done a good job of this so far, but concerns have been raised that the brand has grown so quickly it has become ubiquitous and has lost some of its cachet with shoppers. Detractors point to the decline in same-store sales over the last three quarters as proof the company has become too ubiquitous and its brand is suffering. This is a big reason why the stock has dropped. This story is very similar to what happened with Coach which saw its sales drop from $5.075 billion in 2013 to $4.183 billion in the TTM. Michael Kors is in a stronger position than Coach, and there are several factors to consider that are negatively affecting same-store sales but have nothing to do with brand health.

1. Currency effects have played a big part. On a constant currency basis the negative same-store sales would actually have been down a cumulative 10.1% versus the reported total of 23.8% over the last three quarters.
2. On the Q2 2016 call CEO John Idol noted that average unit revenue (AUR) declined about 15% in the U.S. and ~60% of the decrease was “driven by smaller handbags and I’d say the balance of that is driven by additional promotional activity inside the stores.” Since the smaller handbags have lower price points they can still be selling the same number of purses but have a same-store sales decline. In fact, on the Q2 call management noted that in North America total units sold actually increased in the high double digits versus only a low single-digit increase in total sales. In speaking with the company, it would not provide hard numbers on the actual same-store change in number of units sold so it is difficult to quantify the effect of style change. However, the emphasis on this point does indicate that the number of units sold is at least flat or increasing on a same-store basis and not falling as the negative same-store sales might indicate.
3. The number of Michael Kors stores in North America has grown rapidly, increasing from 231 at the end of fiscal 2013 to 377 as of 2Q 2016. For perspective, there are only 116 cities in the U.S. with a population over 200,000 so as customers of Michael Kors have more stores to shop in their cities it is natural to expect that the average sales per store will decrease even as total sales rise. Management has stated that the build out of North American locations is virtually complete so new stores opening and cannibalizing the sales of existing North American stores should not be a factor going forward.

• One of the strengths Michael Kors has is that its chief designer, Michael Kors, is well known partially due to his appearance as a judge on Project Runway through 2012. Kors has been in the business for more than 30 years and has had his own line since the early 1980s. The stability of having Kors in charge also stands in stark contrast to Coach, which brought on a new designer in June 2013 to try and revitalize the company’s designs.

Growth opportunities

• A business that produces a high return on capital is significantly more valuable if the company has growth opportunities that allow it to continue to invest at that high rate of return. Fortunately Kors has several avenues for growth that it is currently pursuing. Management has stated that the build out of stores in the U.S. is effectively complete, and its focus is now shifting to Europe and Asia, which will fuel growth going forward.
• The company reported total sales in Europe of $885 million in 2015 which was split 47% retail, 45% wholesale and 8% licensing. Going forward, management believes that this region will account for $1.50 billion of total sales.
• In Asia the company is still quite small with $68 million in total revenue, virtually all of which came from retail locations. The company projects that total revenue will grow dramatically to $800 million.
• Management also thinks it can grow the business in the U.S. an additional 23% from $3.42 billion in 2015 to $4.20 billion.
• These growth estimates were provided by management in a presentation on Nov. 1 at a retail conference. Hard deadlines were not stated during the presentation, but in following up and talking with the company afterward it expected these goals to be realized in the next three to five years. Assuming these targets are reached, Kors would have sales of $4.20 billion in the U.S., $1.50 billion in Europe and $800 million in Asia resulting in total sales of $6.50 billion – a 44% increase over the TTM period. This would result in an average annual growth of 7.6% if achieved in five years and 12.9% if reached in three years. Growth this strong is clearly not what the market is expecting. I’d like to point out that growth of this magnitude does not need to be realized to justify my valuation since I only expect Kors to trade in line with slower growing peers such as PVH, Ralph Lauren and Coach. However, it is positive to note that the company does have significant opportunities to reinvest in its business.

Capital structure

• Kors has a pristine balance sheet with no debt and more cash than it needs to run the business.
• Kors’ enterprise value = market cap $7.43 billion + debt $0 – excess cash $232 million = $7.20 billion.

• The company has $431.5 million in cash on hand, of which, I estimate $232 million is excess leaving $200 million for day-to-day operations. Assuming this excess cash is taken out of working capital, the company’s current ratio would drop from 4.2x to 3.6x.

Management quality/compensation

• Idol (age 56) has been the chairman and CEO since 2003. He was put in charge when the company was acquired by Hong Kong-based private equity firm Sportswear Holdings which is controlled by Silas Chou and Lawrence Stroll (they successfully backed Tommy Hilfiger). When Idol started with the company, it was losing money, and he helped turn it around and bring it public in 2012. Idol is an interesting combination of being relatively young for a CEO (in his mid-50s) and very experienced (having over 10 years of experience as CEO and 30 years of experience in the industry). His experience as the manager of KORS while it was a private company hopefully has trained him to have the mindset of an owner.
• Michael Kors (age 56) is the chief creative officer, honorary chairman and a director of Michael Kors which he founded in 1981. He is an important figurehead in the business since his reputation as a designer helps elevate the brand's perception in customers' eyes.
• Both Idol and Kors have options valued at $78.48 million and $18.60 million in addition to restricted stock worth $4.88 million each. The option and stock value significantly exceeds their annual salaries of $2.5 million and should align their interests closely with shareholders. The fact that both men have run the business while it was private should also increase the probability they will think and act like owners. Thus far their actions and statements have not given investors any reason to think differently.

Risks

• Brand losing its cachet with buyers due to oversaturation of the market place resulting in decreasing sales and more discounts on products. For example, Coach had this problem partially because it let its outlet store presence become too large, eventually making up ~70% of total sales in 2013. Michael Kors has said it will limit its outlet sales to about one-third of total sales. They also noted in the 2Q 2016 conference call that they are decreasing inventory in the wholesale channel so that their product isn’t heavily discounted.
• Competitive pressure from smaller companies such as Kate Spade (KATE, Financial) and Vera Bradley attempting to take market share. The rapid growth of Michael Kors demonstrates how quickly a company can move into this market and take share away as it did to Coach. The returns on capital are extremely good and other companies will likely want a bigger piece of the pie.
• Something happening to Kors or Idol who have been the architects of the company’s success. Kors would be especially hard to replace since he’s the namesake of the company.

Catalyst

• Share buybacks – The company generates a large amount of free cash flow that it has been using to repurchase its shares. Over the last four quarters the company has spent $1.25 billion to buy back 23.2 million shares and still has $432 million in cash on its balance sheet and no debt. The company amended its share repurchase program on Nov. 3, allowing it to buy an additional $500 million worth of shares and extending the program through March 2018. This increases the initial repurchase authorization previously announced in November 2014 to $2.0 billion, of which approximately $758 million is available for future repurchases. The company generated approximately $597 million in EBITDA – total capex – taxes in the TTM period. Management noted on Nov. 17 at a Morgan Stanley conference that its priorities for cash flow are: 1) Reinvest in the business, 2) Buy back shares, 3) Make acquisitions (such as license partners in Asia). Specifically on the buyback Idol said, “As long as we continue to believe there is a complete disconnect in the stock price versus what our industry trades at, and quite frankly given our own results, we are going to put our balance sheet to work in a very significant way.” Since Idol's compensation is heavily tied to the stock price he can be believed.
• Same-store sales results flattening out – the company has posted negative same-store sales over the last three quarters which has been attributed to currency changes, more stores in the same city, increased promotions and changes in style. As the company laps the negative comps performance which began in the fiscal fourth quarter, its same-store sales comparisons will get easier and may return to positive comps as soon as its fiscal fourth quarter 2016. The company’s perception in the investment industry has been beaten up so much that if it can simply begin posting flat same-store sales comps the sentiment could improve considerably.
• Growth of sales in Europe and Asia. International sales have grown from $119 million in FYE 2012 to $953 million FYE 2015. The company expects to grow sales in these regions to $2.30 billion in the next three to five years. As international sales become a larger portion of total revenue they will receive more focus from sell-side analysts and investors.