Michael Kors: A Brand Worth Betting On

Summary

You do not have to like the Michael Kors (KORS, Financial) brand. But there is no reason to not like KORS stock at this price.

Details

KORS just reported Q2 FY 2016 earnings, and the numbers are by no means stellar. Same store sales were still down 8.5% and 3.4% ex FX. Outlook for the second half is weak. Management guided mid single-digit decline in same store sales and low single-digit ex FX for H2 and FY2016. But on the positive side, the company is still growing on both top line and bottom line. The outlook for H2 sees improvement in same store sales. In addition, the company bought $400 million worth of stock during the quarter. Management continued to talk about expanding to different categories such as men’s wear and eyewear.

As I am writing this update, the stock is up about 7%. Not because there is renewed hope on the stellar growth of the company, but because the stock was simply too cheap.

I have read a number of articles this year about how Michael Kors would be in trouble because it expanded too much. It should not get into the lower price points. It should not make every woman above 20 years old (maybe some younger ones, too) on New York commuter trains carry bags with big gold MK logos. It should not have outlets to dilute its brand, etc.

KORS stock is out of fashion. When a stock is out of fashion, there are opportunities.

Almost no U.S. specialty retailer did well so far this year. But why has KORS performed far worse?

1) Peers have had earnings downgrades. KORS does not appear so bad.

2) Peers have had negative same store sales.

3) Peers have had some sort of de-rating. But KORS had the most and it is now among the cheapest brand name specialty retailers in the U.S. No wonder the company spent close to $400 million buying back stocks in Q2 alone.

4) Peers also saw their stock price decline, but KORS was down the most

What are we so afraid of?

We are afraid of the brand having nowhere to go but down. When that happens, the profit of the brand can come down pretty quickly. We have also seen this in Coach, Abercrombie, Crocs and other brands.

Fair enough. Let’s say KORS is among them. The company was a big fad, passed its heyday and is riding into the sunset. But brands do not die within a year or two. KORS as of the second quarter has $1 billion in cash on the balance sheet and has been generating $400 million a year in free cash flow for about two years, while they more than doubled store count during the same time period. Their profit margin is now the highest among all major luxury retailers. The operating efficiency, return on invested capital, all look among the best, if not the best. With the high starting point, KORS can at least buy time.

KORS’ closest peer is probably Coach (COH). KORS is the contender in COH’s lucrative handbag business, which COH used to be thought of as the the only game in the “aspiring” or “affordable luxury” brand category. Like KORS today, COH a few years ago had fantastic margins that were higher than most other luxury brands. COH just didn’t seem to fare very well in the last several years. What if KORS is another COH?

Just from looking at the financials, KORS today looks somewhat similar to COH in 2007 and somewhat similar to COH in 2013 (table below). Since 2007, COH saw its number of stores double, and sales almost doubled. But profit margin dropped 20+ points and net income dropped more than one-third. Thanks to the good profitability and cash flow that did not go away overnight, management made the share count shrink 25%, which avoided EPS from turning ugly.

*Note, KORS and COH financials and store counts for “Today” are as of FY 2015 year-end.

Making the bold assumption that the brand will not die, let’s say we have two possible scenarios for KORS.

1) KORS today is like COH in 2013. Earnings went downhill in a year without share reduction.

2) KORS today is like COH in 2007 and repeated COH’s path with good earnings numbers for at least several years.

It is all hypothetical. I guarantee the future is not going to happen like either one of these two scenarios. But I think the chance is that the future lies somewhere in between these two. Things could be either worse or better, but I believe these two scenarios cover a good spectrum of what is likely to happen.

In scenario 1, in FY2017 KORS would earn $2.78 per share (compared to $4.28 per share in FY 2015 ending in March), applying the 17x (trailing) of COH, KORS should be a $47-stock versus the stock price of $43. In other words, the market seems to assume KORS is already another COH. Anything sustainably better than $2.78 per share EPS is not in the price, including the option that KORS continues to reduce the share count. If KORS reduced the share count like what COH did, the normalized EPS in scenario 1 would be $3.76 rather than $2.78.

In scenario 2, let’s keep in mind that even though COH’s margin came down from the all-time high in 2007 of 41% all the way down to today’s 23%, the net income actually grew from $640 million to $1 billion in 2013 before it halved since then. Therefore, it is possible for KORS to have lower margins, but still grow sales and profit. KORS has 78% sales in U.S. versus COH's 57% today and 76% in 2007. International business could have fantastic growth if the brand is managed well enough. And there are other categories to break into. If that is the case, the earnings could double, then the multiple could double as well, and the stock could be a four-bagger. In fact, COH in 2008 was at about 10x earnings and then peaked as a four-bagger in 2013. 2008 to 2013 was by no means a great period for the global consumers, as we all know. Going forward, we actually have some hope that the consumers would be in a better shape than before.

Conclusions:

1) KORS seems to have been unfairly punished in the middle of a very weak industry trend.

2) KORS’s valuation seems to imply that the company would have one-third of earnings eroded in a straight line. The upside potential is material.

What the company’s true path is, only time can tell. But at the moment, expectation is quite low. To me, risk is on the upside. There seems to be a decent chance and reason for the stock to re-rate to a reasonable valuation level of about 15x. We never know exactly what the future will hold. But the odds seem to be in favor of KORS stock to appreciate.