Description

Michael Kors is a fairly mature, highly cash-generating business with some inherent business volatility trading at an extremely cheap price, which more than discounts the risks associated with the name. The stock is trading at a 15% free cash flow yield, which is generally the terrain of quickly melting ice cubes (think paging company, long distance carrier, Blockbuster) or deep cyclicals at peak earnings. KORS is neither of those things, and is trading at the cheapest valuation it has ever traded at in the wake of an unpopular acquisition (yes, they overpaid) and a big retrenchment in retail stocks, and the market overall.

A Little History and Background

Michael Kors was launched by its namesake designer in the 1990s, but only received his primary attention after he concluded a successful stint at Celine in 2003.  At that time, he received financial backing from Silas Chou and Lawrence Stroll, who had already made fortunes backing Tommy Hilfiger in the 1990s (fun fact: Tommy was my first write up on VIC, shortly before its takeout). Like with Tommy, Chou and Stroll oversaw a rapid expansion of the brand. This rapid growth was aided not only by Mr. Kors’ design skills, but also his good relationships with celebrities, who he frequently dressed (for free media impressions) and the notoriety that he gained as a colorful judge on the very popular early 2000s reality series, Project Runway. At the time of its 2011 IPO, KORS the company was flying high. Starting from a relatively small size, it picked off the low hanging fruit of opening doors with all the major department stores, which led to high organic growth (strong double digit) with low capital investment. It remained an immature brand for the first few years of its life as a public company, and it went from around $1 billion in sales when it IPOd to around $4.4 billion in the year ending March 2014, with annual sales growth ranging from 32% to 68% in those first few years as a public company. It did this by exploiting the opportunity to open every department store door possible (just before department stores got hit by the secular move to online shopping in their primary categories of apparel, footwear, and home), opening its own retail stores, signing lucrative brand licensing deals, expanding into new categories, and building a solid presence first in Europe and then in Asia (initially KORS entered Asia through a licensing deal with an entity controlled by Chou – related party transactions are a hallmark of the Chou/Stroll playbook).

Like many, many aspirational/accessible luxury brands before them (including Coach, Ralph Lauren, and of course, Tommy Hilfiger), KORS made the mistake of over distributing. They opened too many doors – both in their retail and their wholesale divisions. The Kors product and brand became too omnipresent, which hurt its caché, as well as margins. Too much product inevitably led to discounting and promotions, which hurt gross margins, and too many owned stores led to cannibalization, and deleveraging on retail operations.  Adding insult to self-inflicted injury, around the same time, department stores started to see a real slowdown in traffic and same store sales, and some department stores (like Bon-Ton), just went away entirely. Shortly after, a bubble in watches, of which they were a major beneficiary, gave way, hurting licensing income. This perfect storm led the former highflyer to see sales go negative in Calendar 2016/Fiscal 2017. Sales were negative in FY17 (ends March) and would have been negative in FY18 as well, if not for the acquisition of luxury shoe brand Jimmy Choo in the summer of 2017 (organic sales were negative that year). During this time retail comps got as low as the negative high single digits. KORS ultimately took its medicine and attempted to turn around by pulling back on this over distribution, exiting low productivity wholesale doors and closing retail doors that were not seen as productive. From FY16-FY18, wholesale sales were down almost 25% as a result of this rationalization.

During this time of repositioning from FY16 to FY18, KORS fell from its early 2014 high of almost $100 down to the $30s twice. At its two prior price troughs, KORS traded at 8-9x forward PE, versus an S&P 500 that was 15-17x forward earnings. This is important context for where we are now.

Beginning in the second half of Calendar 2017, KORS began a period of stabilization, when wholesale planned exits anniversaried and 20% declines reduced to small single digits ones in wholesale, and comps in their own stores improved from being down high singles to low singles. These “less bad” results led the stock to run from the mid $30s to over $70 from summer 2017 to summer 2018. Along the way, it acquired luxury shoe company Jimmy Choo ($600+ shoes) for approximately $1.45 billion. The acquisition was not cheap, but also not terribly out of line with other M&A deals in the luxury goods space. They paid around 2.8x revenues and 17.5x adjusted EBITDA. At the time of the Choo acquisition, KORS indicated its interest in rolling-up accessories-heavy American fashion brands, a strategy also articulated by its close competitor Tapestry (formerly Coach), who acquired Kate Spade around the same time KORS bought Choo.

During this period of “less bad”, KORS also saw healthy improvements in gross margin as a result of inventory rationalization at the remaining doors, and a removal of cannibalizing doors. As promotions and discounting came down, gross margin came up. Margins still trailed historical peaks – which were buoyed by hyper growth – but the company is currently chugging along at an industry respectable, even enviable, 18%ish EBIT margin and 20%ish EBITDA margin.

Despite this stabilization, KORS has been basically cut in half since Labor Day. Some of this is because of a market that is down 20%ish, but the underperformance to both the market and the sector can be explained by the unpopularity of its deal to buy Versace, as well as comments on the second quarter call, where they indicated they will be raising inventories somewhat going forward to chase sales they believe they are missing (more inventory = a return to more risk).

Why now?

This company has never been cheaper. In addition to its 15% free cash flow yield, it is trading at just under 7.5 PE using the year ending 3/19 and around 5.5x EBITDA. In its time as a public company, it had never seen these multiples before, even when wholesale sales were trending down 20% and their own retail stores were comping down close to 10%. Its PE relative to the S&P 500 has never been this low. The last time it was at this actual price, it was going to earn in the $3s, but earnings for the FY19 year are likely to be around $5.  The last two times it got to a high single digit PE and an almost 50% discount to the index multiple, it was up 60% in 2 months (Jan to March 2016) and over 100% in 13 months (July 2017 to August 2018).  Yes, this is a trading call. You have a margin of safety down here, and history would say you will be rewarded for wading in when everyone hates it. And it is actually performing pretty well versus the other times it got close to this low on valuation.

So how bad was this Versace deal?

KORS is paying $2.1 billion for Versace, which equates to 2.5x TTM revenues (not outrageous) but 22x their adjusted EBITDA number. The EV/EBITDA multiple was very full, especially for a brand that has been around since the 80s, so may not offer tons of avenues for growth (some would also say the Versace look is dated, but we can argue that in the comments if you want). By my calculation, the deal will be about 25c dilutive to earnings, or about 5% of FY18 earnings. Their rationale for doing the deal was that Versace is under penetrated in shoes/bags/other accessories at 35% of sales, versus the Michael Kors brand closer to 80%. Accessories are higher margin than apparel, tend to be less deeply discounted, and are generally a better business model. KORS also thinks there is an opportunity to open more Versace stores. Even as a total skeptic on this deal, with the stock cut in half, I think the deal is beyond priced in, and you are basically getting Jimmy Choo and Versace for free at this price for KORS. Please note my numbers in the summary box are not pro forma for Versace, as the sellside has not adjusted their numbers yet and I wanted my summary numbers to be compariable. Also, with an unknown closing date, it's hard to know how much dilution ends up in FY20, as opposed to the tail end of FY19 or beginning of FY21.

Was there anything good about the Versace deal?

Following closing of this deal, Michael Kors will rename itself Capri Holdings. The new Capri Holdings has a revenue mix that is approximately 75% Michael Kors brand, 15% Versace, 10% Jimmy Choo. Luxury brands tend to trade at a higher multiple than accessible luxury brands because they are viewed to be more evergreen, carry higher gross margins, are less susceptible to discounting, and cater to the 0.01% who tend to have less spending volatility. So if KORS successfully integrates Choo and Versace, and they are able to execute on their plans to accelerate growth for both companies, then KORS could see multiple expansion on the company level. I am not banking on this, but it is a free option.

Is there anything good happening at the Michael Kors brand?

Management has done the right things to stabilize the Michael Kors brand. You can see it in recent results. The brand is mature in the US and Europe, while growth opportunities do remain in Asia and the rest of the world. Accessories (handbags, small leather goods, tech accessories, etc. and to a much lesser extent, shoes) are a pretty good business, and a superior business to apparel. Initial margins/mark ups are healthy, leading to realized gross margins around 60%, barring a major fashion miss or mistake with buying levels. Handbags aren’t growing as fast as they once were as a category, but they aren’t contracting dramatically like some other consumer categories are.

Other opportunities for KORS

The company has a large buyback authorization and there is $542 million remaining on it, equal to almost 10% of their market cap. Because leverage will rise from 0.5x EBITDA to around 2x with the Versace deal, I don’t anticipate them directing their $700-800 million of free cash flow to stock buybacks in the near term. They will eventually use that authorization, but in the next couple of years are more likely to direct free cash to paying down the Versace debt. These debt repurchases should be accretive, and help engineer modest earnings growth, even if the core business fails to grow.

Logo apparel is very in style right now, which is supportive of the Michael Kors business (which features logo product in both handbags and shoes, about 20-25% of sales is logo apparel) . The Versace brand also heavily features logo.

Key Risks

A dramatic recession in the US and/or Europe could cause KORS to return to more negative comps. A recession would also lead to a further contraction in wholesale sales. I think this macro risk can be hedged out with shorts in the US consumer retail sector.

There is some key man risk to Michael Kors. While there is an entire design infrastructure beneath him that could carry on in his absence, his personality and celebrity are assets to the company.

Almost half of EBITDA comes from the wholesale business, which is dependent on department stores, which remain secularly challenged.

Valuation

I arrive at a $58 price target, using a an equal-weighted blend of PE, EV/EBITDA, and Free Cash flow yield, applied to earnings pro forma for the Versace deal.

Pro forma for the Versace deal, my FY20 eps estimate is $5.06. At the historical 14x multiple for KORS, the expected price is $71.

Pro forma for the Versace deal, my FY20 EBITDA estimate is 1259. I apply a 7.75x multiple (which is 25% a 10 multiple for the luxury brands, and 75% a 7 multiple for KORS), and get a target of $46.

Pro forma for Versace, my FY20 free cash flow estimate per share is $4.65. At an 8% free cash flow yield, my target is $58.

Equal-weighting these three targets, my blended target is $58.

Key assumptions for FY20 are:

·      $40 mm in pretax losses at Versace

·      Retail division grows 3% with flattish comps

·      Wholesale division is down 2%

·      Licensing is down 5%

·      Jimmy Choo grows 10%

·      Gross margins decline 20 bp, as higher inventory levels lead to more discounting when SKUs miss the mark

·      Modest increases in annual SG&A costs

Catalyst

• Doesn't miss numbers
• Return to flat/low single digit positive comps in retail division
• Versace deal closes and sellside analysts adjust their models for the dilution, so that event is "fully known" and no longer feared
• Accretive paydown of debt followed by accretive buybacks of stock with their ample cash flow
• Free call option on growth acceleration at Jimmy Choo or Versace