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Summary

  • Michael Kors has underperformed compared to the S&P 500 and has been downgraded by many industry analysts.
  • Too much expansion could make Michael Kors' brand ubiquitous and this would hurt the sales growth in the future and also negatively impact the gross and operating margins.
  • The elevated inventory levels have deteriorated Kors' liquidity position but its liquidity ratios are still better than the peers’ average.
  • On a price multiples valuation basis, Michael Kors’ stock is currently expensive for investment purposes.

Michael Kors (NYSE:KORS), which emerged as the biggest challenge for the apparel footwear and accessories market leader Coach (NYSE:COH), is now facing the same difficulties in its operations as Coach. In an attempt to squeeze its rival, Michael Kors has been aggressively expanding its operations and this has left an adverse impact on the company's margins.

The luxury retailer brand has recently been downgraded by many of the analysts who have cut down its price targets as well. On July 15, the brand was the biggest loser as its stock price fell decisively below its 200-day line. In the last month i.e. from June 16, 2014 to July 15, 2014 the stock has plunged by 12%, from $90.29 to $79.44.

Over-Distribution Could Hurt Sales and Margin Growth

Over the last five years, Michael Kors' sales have grown immensely at a CAGR of more than 550%, reflecting a significantly increasing market share. At the end of its fiscal year 2014, the company operated 405 retail stores, compared to 304 retail stores at the end of its fiscal year 2013. In the wholesale segment, Michael Kors continues to enhance its presence in the department and specialty stores by converting more doors to shops-in-shops, and through its continuous expansion in European market. The company is also busy expanding its revenue base in the Asian countries, especially in China through new store openings.

The expansion has undoubtedly brought humongous growth to Michael Kors' top line, but if we look at the margins it becomes evident that this top line growth is not effectively trickling down, indicating increasing margin pressure. Compared to the great year-over-year sales growth from the last five years, the company's gross margin has only improved by 8.39%, whereas the operating margin has improved by merely 3.56%. The figures indicate that Michael Kors' management is unable to effectively handle the immense sales growth and successfully transform that growth into its gross and operating earnings.

All Image Sources: money.msn, Yahoo Finance

The improvement in Michael Kors' net profits is quite impressive, as the company does not have any debt on its balance sheet, which reduces the interest expenses.

As Michael Kors is on its way to further expand its portfolio and its market presence through new store openings and a major extension in menswear, it looks like the company could be repeating the same mistakes as its rival Coach did in the past. Too much market presence would make the brand ubiquitous. The over-distribution of the products would frustrate the fashion-forward customers, the primary target of Michael Kors, who always want to look unique.

Therefore, to continue its sales growth momentum the company should look at whether or not its aggressive expansion strategy is in the right direction. It should then take an immediate step towards keeping a balance between the demand and its store penetration. This would help in keeping the brand image intact.

Liquidity Position

Another concern for the company is its elevated inventory levels. In fiscal year 2014, the company's inventory levels grew by 60% compared to the level in 2013, consequently deteriorating the quick ratio and affecting the company's liquidity position.

The higher inventory levels reduce the inventory turnover pushing the management to offer greater discounts and consequently hurting the margins.

Valuation

A number of industry analysts have downgraded Michael Kors from "buy" to "hold" while cutting the stock's price targets. Maxim Group cut the target by $29 from $109 to $89, reflecting a decline of approximately 18%. Eight other analysts at Barclays, Citi, and Sterne Agee cut Michael Kors' price targets for discounting its wares. Barclays cut its target from $85 to $82, reflecting a downgrade of 3.53%. Citigroup cut its target from $107 to $98, reflecting a decline of 8.41%, and Sterne Age cut its target from $100 to $92, reflecting a decline of 8%. Although the target price has been cut from the previous estimates, it is still above the stock's current price of $79.44, indicating that it has some upside potential.

The table below shows the calculations of the company's stock price based on its price multiples. The stock is quite expensive on the basis of price-to-sales, price-to-book, and price-to-cash flow ratios as these ratios are clearly above the industry averages. However, Michael Kors' substantial net earnings growth over the year has helped the company to maintain its price-to-earnings at a level below that of its peers' average.

According to this valuation, Michael Kors' stock is currently overvalued. The price-to-earnings and price-to-cash flow ratios have been given higher weighting as these are more refined measures of a company's financial performance compared to that of its price-to-sales and price-to-book ratios. The stock's fair value appears to be $73.40, reflecting a downside potential of 7.60% from the current stock price.

Final Thoughts

Michael Kors currently has strong fundamentals which are reflected in its sales and net earnings. However, the company's expansion strategies and the strategy of maintaining higher inventory levels would hurt the company's future comparable sales and margins growth and would deteriorate its liquidity position. The price-to-sales and price-to-cash flow ratios are negatively impacting the stock's valuation as well.

Currently, the stock does not pay any dividends right now and the only way to get profits by investing in the stock is the stock price appreciation. Therefore, I do not suggest buying the stock. I suggest waiting until the circumstances become favorable.

Source: Michael Kors' Aggressive Expansion Strategy