Michael Kors: Shrinking Margins Equal A Shrinking Share Price

Aug. 6.14 | About: Michael Kors (KORS)

Summary

Some analysts and investors are concerned that KORS has grown too fast and is becoming a victim to the discounting and tough environment affecting other retailers.

The company’s retail operating margins decreased as price cuts were needed to clean out fall merchandise that the company indicated was put on store shelves too early.

The company also forecast future margin declines and predicted that retail gross margins could drop for the year.

Extensive insider sales of KORS shares since their initial public offering by company founders and top executives are a strong warning sign.

Michael Kors (NYSE:KORS) recently announced revenues and earnings that exceeded internal and external estimates. The company's shares, however, sold off sharply the day of the earnings announcement as the company forecast slowing sales and weaker margins as well. Analysts and investors are concerned that KORS has grown too fast and is becoming a victim to the discounting and tough environment affecting other retailers. During the quarter the company's retail operating margin decreased due to price cuts that were needed to clean out fall merchandise the company said it put on store shelves too early. The company also predicted future declines and predicted that retail gross margins could drop for the year. (In our earlier article regarding KORS, we discussed potential concerns about the effects on discounting on the company's high-end product offerings.) Now is not the time to buy KORS shares.

Background

KORS designs, markets, distributes, and sells branded women's apparel and accessories, and men's apparel. The company has three divisions: retail, wholesale, and licensing. The retail division sells women's apparel including accessories such as handbags and small leather goods. KORS has retail locations in North America and international retail stores in Europe and Japan. KORS wholesale division sells accessories including handbags and small leather goods, footwear in department stores and specialty shops in North America and Europe. KORS licensing division licenses its trademarks on products, such as fragrances, cosmetics, eyewear, leather goods, jewelry, watches, coats, men's suits, swimwear, furs, and ties, as well as licenses rights to third parties to sell their products in specific geographical regions around the world.

Second Quarter Earnings

In early August 2014, KORS announced first-quarter fiscal 2015 earnings of per share of 91 cents. Earnings exceeded the company's own earnings guidance of 78 to 80 cents.
The company's quarterly revenues of $919.2 million and grew about 43 percent from the first-quarter fiscal 2014 earnings.
KORS' performance excelled across all divisions in all regions of the world.
Comparable store sales increased about 24 percent while gross profit increased 43.9 percent from the year earlier quarter to $571.6 million, while gross margin grew 20 basis points to about 62 percent. Operating profit increased about 40 percent year over year to $276.8 million whereas operating margin decreased 70 bps to about 30 percent.
The company's retail division net sales increased 47.5 percent year over year to $480.2 million aided by a comparable store sales increase of 24.2 percent along with 115 new stores openings over the past year. The wholesale division increased net sales by 40 percent to $406.8 million.
The licensing division revenues increased 30.5 percent to $32.1 million.
Revenues from the North American (U.S. and Canada) grew about 30.3 percent to $718.9 million.
In the European region, increasing brand recognition and demand led to a 128 percent increased in revenues to $185.5 million. In the Other Regions division (including the markets of Japan, Latin America and the Far East), revenue increased about 88 from the year ago quarter to $14.8 million.

KORS management raised fiscal 2015 guidance to the range of $4.25 to $4.35 billion in revenues as compared to earlier estimates of $4.0 to $4.1 billion. KORS also raised their earnings estimates to the range of $4.00 to $4.05 from earlier estimates of $3.85-$3.91 per share. KORS shares dropped almost 6 percent the day of the earnings announcement. The shares have recovered some of the losses from the sell off since the earnings date.

Competitors

KORS competes with multiple companies in the handbag and accessories space. Coach (NYSE:COH) and Kate Spade (NYSE:KATE), however, are thought of as KORS' primary competitors. COH effectively created the affordable-luxury hand bag market years ago. As KORS and KATE became increasingly successful competitors, COH, failed to continue to innovate and increasingly relied on discounting to increase their sales. Discounting has damaged COH's brand in the North American market in particular and COH's share price has sunk to multiple year lows as COH is putting in place a turnaround plan to repair their brand.

Pre-Earnings Fears of Discounting on Products

In the weeks leading up to the 2015 fiscal first quarter earnings announcement, some analysts began to indicate that KORS was engaging in price cuts for their more upscale products. Those analysts believed that the maker of premium hand bags and accessories may be losing its "luxury halo." In particular, those analysts continue to see the risk of brand dilution from KORS' large North American wholesale distribution network. As concerns about KORS' discounting increased, some analysts lowered their price targets for KORS shares. The change in opinion of some of the analysts in regard to KORS from just a few months ago had been so quick, a Barron's article featured a headline mocking such a rapid change in opinion. There were even commentators forecasting an imminent crash in KORS' stock price. As one commentator indicated about KORS:

...the brand is becoming ubiquitous, and that's the kiss of death for trendy fashion brands, particularly those positioned in the up-market younger consumer sectors. Its distribution is racing towards ubiquity, wholesale and retail (online, its own stores, outlet stores and internationally). Even worse, a rocket-propelled accelerant to ubiquity is its expansion into multiple product categories and sub- brands, so they can compete at all price points. Some would argue all of those segments will simply end up competing with each other, thus cannibalizing the top end of the spectrum.

The 2015 fiscal first quarter earnings announcement confirmed such fears and KORS shares sold off sharply. Another red flag we pointed out was that the same commentator stated that since 2012, KORS founders and top executives, including Michael Kors, Silas Chou and Lawrence Stroll, have decreased their share ownership from about 52 percent of KORS just prior to the KORS initial public offering in 2011 to just over 15 percent currently.

Analysts' Views and Our Views

Analysts with more negative opinions regarding indicated that their post-earnings announcement focus was on margins and the start of seeing the KORS' business model normalize to reflect markdowns and operating expense deleverage. The analysts who expressed concern in the weeks leading up to KORS' earnings announcement remain skeptical on the prospects of KORS shares given the shares higher price to earnings ratio along with ongoing margin concerns. Analysts who were more positive in regard to KORS fiscal 2015 first quarter earnings believed that KORS' product position, multi-product portfolio and fashion innovation was extraordinary. Those analysts believed that the KORS share price drop is a buying opportunity. They also believed that the impressive top-line expansion would help silence concerns of market oversaturation of the KORS brand. Such analysts believed, however, that KORS shares would continue to face pressure as expectations moderate. The analysts that are more optimistic on KORS prospects have price targets ranging from $87 to $103.

We agree with the analysts and commentators regarding continued discounting problems on KORS products and the effects on the company's margins and their KORS brand. There are analysts, of course, on both sides of the KORS discounting issue as indicated. However, with KORS price to earnings ratio at a higher level, the risk in holding KORS shares is too high at the moment.

KORS current price to earnings ratio is about 24.5 and their forward price to earnings ratio is 16.5 for fiscal year 2015 earnings forecast. In comparison, COH, which has experienced sharp share price and earnings estimate declines in 2014, has a price to earnings ratio of about 10. COH is already suffering from damaged brand issues from discounting and has set forth a plan to repair their brand. KORS has yet to experience the problems that COH has had but such problems seem to be emerging as KORS attempts to meet Wall Street's revenue and earnings estimates through increased discounting. We question, as some analysts do, the quality of KORS earnings and what they are doing to meet their earnings estimates. We believe that the company is meeting their earnings estimates by growing too fast and discounting too much. With the success that KORS has had, complacency arises. The higher price to earnings ratio of KORS as well as sharp insider sales by KORS insiders are strong red flags to not buy KORS shares now.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within 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.