Michaels Kors - Greater Appeal As Underlying Business Growth Remains, But Shares Sell Off

| About: Michael Kors (KORS)

Summary

Michael Kors reports very strong first quarter results, issues a big-time raise in the full year outlook.

Yet investors are disappointed as some worry about a built-up in inventories and margin pressure.

I think the combination of the recent sell-off amidst continued operational growth creates an appealing opportunity for a great entry point.

Michael Kors (NYSE:KORS) witnessed a big sell-off in its shares at the start of the trading week, even after its first quarter earnings and full year guidance was much stronger than anticipated.

Some investors appear to be worried about a built up in inventory levels as well as a guidance for margin pressure as the company is increasing the pace of its expansion in Europe.

Given the rapid growth and the current valuation, shares offer actually quite some appeal at current levels in my eyes.

First Quarter Headlines

Michael Kors announced first quarter sales of $919.2 million, a 43.4% increase compared to last year. Revenues came in far higher than analysts had been anticipating, as they forecasted sales of $851.7 million.

Reported earnings were up by 50.2% to $187.7 million. On a diluted basis earnings came in at $0.91 per share. This resulted in a ten cent per share earnings beat.

Looking Into The Numbers

Again, growth was driven across all segments of the business. Retail sales rose by 47.5% to $480.2 million which in its turn was aided by comparable store sales growth of 24.2% and 115 net new store openings. Wholesale sales rose by 40.0% to $406.8 million as licensing sales rose by 30.5% to $32.1 million.

The reported comparable store sales came in much better than the 20% growth rate forecasted by analysts.

Overall, the company posted a very modest 20 basis points increase in already high gross margins of 62.2% of sales. Operating earnings faced some pressure, dropping by 70 basis points to 30.1% of sales, for still very impressive operating margins.

In terms of the geographical division, it is of course the North American operations which continue to drive growth. North American revenues were up by 30.3% to $718.9 million. While the growth pace is less spectacular than the other geographic regions, North American still make up 78% of total revenues.

Revenue in Europe rose by a very spectacular 127% to $185.5 million. Revenues from other geographies rose by 89% to $14.8 million.

Second Quarter Guidance

For the current second quarter the company anticipates sales of $950 to $960 million based on the assumption of comparable store sales growth in the high teens. GAAP diluted earnings are seen between $0.85 and $0.87 per share.

Based on the guidance, earnings are expected to increase by some 29% for the quarter on an annual basis. Earnings per share are seen up by ¨only¨ 21% due to operating margin pressure. Furthermore, earnings are seen down on a sequential basis. The guidance was a bit light as well compared to consensus estimates which were looking for earnings of $0.89 per share on sales of $960.6 million.

For the full year sales are now seen between $4.25 and $4.35 billion, again based on the assumption of comparable store sales in the high teens. Diluted earnings are seen between $4.00 and $4.05 per share. The new guidance represents a hike from the previously issued outlook for revenues of $4.00-$4.10 billion and earnings of $3.85 to $3.91 per share.

Valuation

By the end of the quarter, Michael Kors held $1.1 billion in cash and equivalents while not having any debt outstanding, resulting in a comfortable net cash position.

With 207 million shares outstanding and shares trading at $76 per share, equity in the business is valued at $15.7 billion. This values operating assets at about $14.6 billion after backing out the net cash position.

Based on the revised full year guidance, operating assets are valued at 3.4 times annual sales and 17-18 times annual earnings.

Growth Worries After The Strong IPO?

It is hard to imagine, but as recent as its fiscal year of 2010, Michael Kors posted revenues of ¨just¨ $508 million. This revenue is set to increase by a factor of 8 within the space of just five years. Combined with margin expansion and limited dilution of a cumulative 10-15% over this time period, this has resulted in an earnings per share explosion.

Yet even as the first quarter sales report was very strong, and the accompany raised the full year guidance ahead of consensus estimates, some worrying signs might be emerging. For starters is the anticipated margin contraction resulting from the increased focus on expansion in Europe. This results earnings per share which are anticipated to fall in the second quarter despite steady topline sales growth.

Besides the expansion in Europe, the increased focus on shops within department stores like Bloomingdale's and Macy's (NYSE:M) could have a negative impact on margins as well. In specific terms, gross margins are seen down by some 50 basis points in the second quarter, but more importantly operating margins are anticipated to fall by 200 basis points. The impact of pressured operating earnings is quite substantial given that Europe only makes up about 20% of total revenues. This is as most of the anticipated margin pressure is anticipated to result from the expansion efforts in the continent.

Yet even after this margin compression, the company does not believe that long term operating margins of over 30% are truly sustainable. For now it targets operating margins of 28 to 29% going forwards.

Final Takeaway

Given the expected growth and the 25% sell-off from the highs of February of this year, the valuation based on fundamentals is rapidly becoming more appealing at the moment.

After backing out the net cash position, shares trade at just 17-18 times annual earnings which is equivalent to the general market valuation. At the same time, the company is guiding for comparable store sales growth in the high teens.

While the European expansion will hurt margins in the long term, it is an important growth business for the company going forwards. The company sees potential for $1.5 billion in revenues in Europe which compared to the current annual run rate of roughly half of that.

Besides margin expansion, another worry was the fear for discounts and the built-up in inventories. Inventories rose to $527 million for the quarter, being up by 65% on an annual basis. This is as inventories as a percentage of reported revenues were up by five percent points to 55% of sales.

As the company continues to display solid momentum, and downplays the concerns about margin pressure and inventories, I am comforted. Michael Kors continues to stress that these are ¨investments¨ in the business, creating short term earnings headwinds.

The significant correction from February's highs combined with great operational performance creates quite some appeal based on the simple current valuation and reported as well as guided growth rates. I might be initiating a position in the coming days.

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