Michael Kors's Profitability Analysis

Aug.16.13 | About: Michael Kors (KORS)

Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component in deciding whether to invest or to remain invested in a company. In this article, I will look at Michael Kors Hldgs (NYSE:KORS) earnings and earnings growth, profit margins, profitability ratios and cash flow. In addition, I evaluate which institutional investors bought the stock in the recent quarters.

Analyzing Michael Kors's Profitability

Kors markets luxury apparel, accessories and footwear under the Michael Kors names.

If you go back through the history of the stock market, there is a recurring theme among those stocks which have had some of the strongest price appreciation and it's related to their earnings growth. If you plot a chart of earnings growth versus a company's stock price, there is usually a strong relationship between the two. So, the first step when analyzing Michael Kors Hldgs is evaluating its earnings potential.

KORS increased last quarter EPS at 79% compared to the same quarter in the previous year. Some investors are bullish on the idea that the company will improve its quarterly EPS growth in the near future.

I like the fact that KORS generated more than 15% quarterly EPS growth. This shows that the business is growing organically and the company's products generate solid demand. In fact, management sounded optimistic in the last earnings call.

It is important to highlight that analysts just upgraded its estimates for the current year, increasing projected EPS at 40%. In addition, Michael Kors Hldgs generated 3 year average annual EPS growth of 111%.

It is encouraging to see that Michael Kors Hldgs generated more than 15% EPS annual growth in the past 3 years.

In addition to analyzing EPS growth, I focus on evaluating KORS's top line or revenue growth. The value of common stocks is, of course, closely tied to the sales power of the company, so an understanding of the company's growth potential for both the near and long-term timeframes is required in making a sound investment decision.
KORS generated 54% quarterly revenue growth compared to the same period last year. This shows that Michael Kors generated strong quarterly growth levels. I am confident on Michael Kors's continued success in emerging economies. When investing in a company, an investor wants to see sales grow or improve over time, not just the last reported quarter. Looking at the financials in comparison to previous years will give participants a much better idea of how well a company is doing. Michael Kors Hldgs generated a 3 year average annual sales growth rate of 63%. I require a minimum 3 year annual sales growth above 15% and Michael Kors certainly meets that criteria.

Gross Profit Margin = Gross Income / Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that operates with higher profit margin than its competitors is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

In reviewing Kors's gross margin over the past five years, an investors can see that the company's gross margin has been decreasing. In fact, the 5-year low for the gross margin was reported in 2008 with a margin of 52.5%. The 5-year high for the margin was in 2012 with a margin of 59.9%. The 2012 gross profit margin of 59.9% is below the 5-year average of 60.3%.

As the gross margin is below the 5-year average, this implies that management has not been more efficient in improving this key profitability metric.

Operating Margin = Operating Income / Total Sales

Operating margin is a measure of the proportion of a company's revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

Over the past 5 years, the operating margin has been volatile. For example, In 2008, the company reported an operating margin of 11.1%. In 2012, the company had an operating margin of 28.9%.

The 2012 operating margin of 28.9% is below the 5-year average of 32.3%. This implies that there has been less of a percentage of the total sales left over after paying for variable costs of production such as wages and raw materials compared to the 5-year average.

I always stress that it is essential to find companies with improving profit margins. While a declining margin does not prevent me from investing in Michael Kors Hldgs, I do not like the fact that its operating margins have declined.

Net Profit Margin = Net Income / Total Sales

A ratio of profitability is calculated as net income divided by revenue, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings. Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Over the past 5 years, KORS's net profit margin revealed a dip compared to the 5-year average. In 2012, the net profit margin of 18.22% is below the 5-year average of 18.85%.
As the 2012 net profit margin of 18.22% is below the 5-year average of 18.85%, this implies that there has been a decline in the percentage of earnings that the company is able to keep compared to the company's 5-year average.

I think it is important to look for stock with current net profit margins above the five-year average margin. Basically, almost all my stock market winners were companies with above than average margins.

ROA - Return on Assets = Net Income / Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."
The 2012 ROA of 40.49% is slightly above the 5-year average of 39.74%. As the 2012 ROA of 40.49% is above the 5-year average of 39.74%, this implies that management has had the ability to use the company's assets to generate earnings compared to its 5-year average.

Free Cash Flow = Operating Cash Flow - Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

Michael Kors Hldgs generated a ratio of cash flow from operations/total sales of 10.38. The higher the percentage, the more cash available from sales. If a company is generating a negative cash flow, it shows up as a negative number in the numerator in the cash flow margin equation. This means that even as the company is generating sales revenue, it is losing money

Institutional Sponsorship

I also evaluate recent institutional activity in the stock. In other words, which hedge funds bought the stock recently.

It is important to know that both Bruce Kovner and Jim Simons invested in the stock in the past quarter at an average price of $56.85. As explained in a blog post, I think that investors should track hedge fund holdings every quarter.

Analyst Outlook

Currently, many analysts have a good outlook for Michael Kors Hldgs. Over the next few years, analysts at MSN money are predicting Michael Kors Hldgs to have an EPS of $N/A for FY 2013 and an EPS of $2.76 for FY 2014. Analysts at Bloomberg are estimating Michael Kors Hldgs's revenue to be at $2.97B million for FY 2014. In August, Deutsche Bank gave Michael Kors Hldgs a rating of "Buy" with a target price of $85.00. A $85.00 price target signifies significant upside potential from this point.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KORS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.