Michael Kors (KORS) handbags and accessories are very much on the rise. Sales grew 62% last quarter, trouncing more mature rival Coach (COH) which only managed 11%. But we need to delve a little deeper to decide which makes a better investment.
Those in favour of Kors point to its 60% annual revenue growth since going public, and the fact that it is taking share from rivals such as Coach. They point to strong same store sales at over 30% and remind us that they are at an early stage in their international expansion. They go on to point out that the Coach brand is weakening as do all fashion brands (eventually) and pricing pressure is eroding its margins (from +36% before the financial crisis to below 32% now). Furthermore its aspirational target market is sensitive to weakening economic conditions and is suffering from a tougher economy. They claim that Kors is a rising brand that is obviously still going strong, whilst Coach is a falling star and its selloff and current price is justified.
On the other hand, those in favour of Coach point out that Coach is a superior retailer (as evidenced by better margins and return on assets than Kors). They say that the brand is a classic (hence its premium pricing) whilst Kors is a flash in the pan fashion brand, that benefits from lower pricing and has less of a proven pedigree. Coach lovers go on to point out that Coach has excellent long term growth potential as a result of its superior Asia position, whilst its classic status will enable it to maintain its US market position. In addition they point out that it sells at a big discount to a conservative estimate of intrinsic value. What's more, its share buyback of about 2.5%, dividend yield of 2%, and dividend growth (44% this year - though don't factor that into the future) are good reasons to wait for the price to be reappraised. Whereas Kors growth can only slow from here, and its price (PE 42) assumes that it can maintain an unsustainably high growth rate.To buttress the point they remind us that its market cap of $10 billion is already close to Coach's $15 billion, wheras Coach has eight times its free cash flow.
Comparing Coach to Michael Kors
So let's do a Coach and Michael Kors head to head.
Coach appears to be a higher quality business. Both are fashion brands and both enjoy a weak competitive advantage as a result of some brand loyalty. Without doing a brand survey I would hesitate to make a definitive call on which is stronger, except to say that Coach has higher brand awareness and its higher pricing is suggestive of a stronger brand preference. My small sample of friends and family (which is neither definitive nor comprehensive) seemed to prefer Coach, but remarked that it's not an either-or decision - a girl needs quite an array of handbag brands to get through the urban and corporate battlefield and that each one has its part to play.
As far as earnings quality is concerned Coach beats hands down. It not only beats on return on assets, its free cash flow is off the chart in comparison to Kors (which bodes well for buy backs and future dividend increases).
(Coach: RoA: 35%; RoE: 55%; FCF/Earnings: $989m/$1,045m; Kors: RoA: 30%; RoE: 45%; FCF/Earnings: $110m/$249m)
They both have stellar balance sheets.
On the growth front, Michael Kors wins hands down. With $1.7B revenue compared to Coach's $4.9B the argument is that it is much easier for Kors to make favourable percentage increases. In addition growth is not only higher, but unlike Coach which is decelerating, Kors is accelerating. Coach is reaching saturation in terms of new stores in the US, whilst Kors perhaps has a little way to go. For the most recent quarter, Coach managed to achieve a decent 5.5% same store sales growth in the US and double digit in China. Whilst Kors achieved 37% overall.
Coach September quarter EPS was unfavourably impacted by the acquisition of some of its distributors.
Here again Coach wins. I value Kors between $45 and $50 (implied PE of 36 to 40) based on stable margins, 25% to 28% average revenue growth over next five years and 45% to 50% annual free cash flow growth. Many may argue that it will grow faster, but my view is that it would need to accelerate its growth quite a bit from current performance in order to be worth much more than $50. At its current price of $53 there is not much of a margin of safety and a lot of downside if it can't triple its revenue (from $1.7B to over $5B) over the next five years. In addition the market seems to agree and is keeping it in a $47 to $58 range.
Coach on the other hand I value around $70 to $75 (implied PE 19.5) based on 10% revenue growth and stable margins over the next 5 years. Coaches high implied PE reflects its high return on invested capital and cash generating ability. Its current price gives a good margin of safety and leaves me OK even if my valuation is on the high side.
From a technical perspective I would call a draw, it's an equally good time to buy either one of them. The market is in an uptrend which is generally good for buying stocks and both stocks are being accumulated.
So which is the better investment? It appears like the market is playing out an old theme. Michael Kors with its exciting growth has been bid up to full value and possibly beyond, leaving little super return for new investors. Whilst Coach with its decelerating growth has been dumped and sold off relatively cheap, offering the prospect of a 2% dividend, 15% annual dividend growth over the next five or so years, and a 15% margin of safety (which if it were to become fully valued over five years would be another 3% per annum). At these prices, I prefer Coach.
Disclosure: I am long COH.