Don't Misinterpret Heidi Klum: Buy Michael Kors

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 |  About: Michael Kors Holdings (KORS), Includes: COH
by: Alex Pitti

Summary

Kors is a great investment for the long term and is not a fad.

The future growth will come from international expansion and into accessories.

Men's ready to wear is the X factor for the future growth of the firm.

When most investors look at Michael Kors (NYSE:KORS) stock they probably see a growth brand that is currently doing fantastically, but may fall out of favor with consumers at any point. It is rational to feel this way when looking at these types of fashion companies because fashion styles are short lived. As Heidi Klum says on "Project Runway", which the man Michael Kors was previously a judge on, "One day you're in. and the next day, you're out". The most obvious example of a fashion company losing touch with the consumer is Coach (NYSE:COH). The company had a tough fiscal 2014 with negative revenue growth. I believe that although fashion can be very difficult to compete in, Kors will thrive in the long term as its designer has been working in the industry for over 30 years and is now in the enviable position where he sets the fashion trends. Comparing Michael Kors to Coach is similar to comparing Facebook to Myspace. I am not implying that Coach will end up like Myspace. I am saying that the Michael Kors is poised to have success in the long term, even as its growth will inevitably slow as the company matures.

The reason why management likely wants to avoid comparisons with Coach can be seen in this chart.

media.corporate-ir.net/media_files/IROL/...

The firm is in a substantially different part of the marketplace than Coach; the Michael Kors line is much more expensive and fashionable and the MICHAEL Michael Kors line is more fashionable, while Coach is more on the classic end of the spectrum. The two separate lines give the company a competitive advantage. The Michael Kors line is a high end line of ready to wear items that appear in fashion shows. The MICHAEL Michael Kors line is in the affordable luxury category. Although in my introduction I stated that the company would eventually have maturing growth I was not implying that it was about to reach this phase in the near future. The company has many areas of growth in which it has just begun to scratch the surface.

Before looking into the firm's many growth areas, I would like to focus on the main issue that the skeptics of the stock such as Herb Greenberg have with the company. This issue is possible margin compression due to an overexposure of the brand. This is where the high end Michael Kors line gives the company a competitive advantage that I mentioned earlier. The company has done a great job with leveraging the brand by allowing consumers to wear accessories and clothing that are made by the same company that dressed Michelle Obama in her first portrait. The brand will not be tarnished or cheapened when you have top celebrities wearing the product. The fact that the brand has become enormously popular should not be treated as a negative. The only way the brand will be cheapened is by the product itself. If Michael Kors loses his design ability or the company suffers from quality concerns, only then will the brand lose its luster. In my opinion it is a safe bet to assume that Michael will continue to be among the most innovative fashion designers in the world. He has been working on the high end line since 1981 and will continue to churn out fantastic designs. It is important that the line is not couture; it is ready to wear making it easy to inspire the more affordable line. The quality of the Michael Kors product is best in class as it uses high end exotic leather and partners with great companies in its licensing business. The company has licensing agreements with Fossil for its watches and jewelry, Estee Lauder for its fragrances, and Luxottica for its eyewear. This jet set glamour company will not succumb to the problems that the high end retailer Lululemon had with quality

Specifically the company had a 330 basis point decline in margins in the licensing business because of increased advertising and increased expenses with the expansion of its European licensing business. In the retail segment the company had 199 basis points of lower margins. 150 basis points of this margin expansion had to do with the expansion of stores and the creating of its in house website. 50 basis points of the gross margin decline was related to a mistiming of a release of products in June and from a return to more normalized levels as the previous level was unsustainably high. The wholesale margins were up 100 basis points because of operating expense leverage. The margin guidance for the whole of fiscal year 2015 was for gross margins to decline 50 points and for operating margins to decline 100 basis points because of investments in the business. The analysts on the quarterly conference call used almost all of their questions to harp on the decline in gross margins as they feared a decline in the brand image and an increased amount of discounting. The company stated that it did not do significant discounts like other luxury retailers. The other part of the gross margin decline came from the company putting clothes for the fall in its stores too early. This slight timing issue was quickly solved as the company retracted its items after just a few weeks in June.

In my opinion the management was correct to get frustrated on the conference call because, as I will delve into further in a moment, the quarter was fantastic. Reinvestments in the brand are great way to build a long-term successful company and should not be harped on for hurting short-term margins. The company has repeatedly stated that gross margins would come down from the very high levels that it was at. The mistiming of the release of June product release was a short term blip for the company. It is important to state that company is being conservative in its guidance as the CEO stated that "we guide what we know we can deliver". Conservatism should not be mistaken for a brand image problem.

Looking at the situation that Michael Kors is in reminds me of Netflix because the company will soon have a maturing U.S. business, but the international growth potential is great. The company currently has 301 stores in North America with the goal of having 400 stores in total. It opened 13 stores last quarter in North America. In Japan and Europe the company has a goal of 300 stores while it only currently has 142 stores as of June 28th. This growth potential is impressive, but what makes the company's potential truly amazing its same store sales growth momentum. The company had 18.7% same store sales growth in America. This impressive metric is attributed to the increased awareness of the brand. This brand awareness went up from 82% last year to 89% this year. The CEO stated that the company is 50% through its growth potential in America. In Europe same store sales went up an astounding 54.2%. Brand awareness went up from 39% to 49%. When the brand awareness gets above the 50% the company expects to see even greater sales momentum as the brand really gains traction with the consumer. In Europe the company states that it is 30% through its potential growth. In Japan the company is in its infancy as it is only 10% through its growth in the country. It had 48.8% same store sales growth and reached 32% brand awareness in 2014.

As of last quarter, 3.5% of its revenues came from licensing. The company has 162 licensed stores with the potential of having 300. The only revenues that come from China currently are from licensing agreements. The company said that when these agreements expire shortly it will think about having company take backs or joint ventures. With regards to the expiry of license agreements, the agreement with Fossil, which makes its watches and jewelry, is ending at the end of next year. Currently the company earns a 10% royalty rate, but other companies that sell Fossil earn a 20% rate. Considering the fact that Kors has been responsible for 60% of Fossil's 2 year revenue growth, the company will have great leverage in these negotiations.

Besides store count growth the company is also focusing on shop-in-shop conversions and increasing the size of some stores that are over productive. Both of these strategies have to do with the company's expansion into new categories. As of the most recent quarter the company had 70% of sales come from handbags and small leather goods. 13% of sales came from men's and women's ready to wear. 10% of revenues came from footwear and 7% came from watches and jewelry. The revenue that comes from categories other than handbags is where the growth will be coming from. Stores that have been over productive, having about $3,000 per square foot, are being expanded to have ready to wear, footwear, jewelry, and watches sold in them. For context, the company is the 4th most productive in sales per square foot for companies in America; the company has $1,886 in sales per square foot according to Forbes. The shop-in-shop conversion gives the company clearer branding in its wholesale stores such as Macy's. Wholesale revenues increased 40% this quarter compared to last year's same quarter. This growth is coming from shop-in-shop, conversions, European expansion, and ready to wear accessories and jewelry. The company has 3,862 wholesale store doors worldwide and it is planning on having 750 conversions in the fiscal year 2015. It opened 30 jewelry and watch shop-in-shops bringing the total to 155. The long-term potential is to have 500 worldwide.

The men's business is another avenue that has growth potential in the future. The company will be releasing a men's fragrance in September. The store counts that I have previously mentioned exclude the potential for men's only stores. The first store of this type will be opening next year. Kors has the potential to open 500 in the long term. The firm showed its new emphasis on selling to men when it hired Mark Brashear, who is the former CEO of Hugo Boss, to run the men's division. Along with fragrances and ready to wear items the firm may be able to shift some of its watch sales to men by leveraging the brand. It currently has 90% of its watch sales in the women's category.

Part of leveraging this brand equity that the company has comes from the celebrity of Michael Kors and his high end line, but what should not be ignored is the social media expertise with which the company operates. Although this info graphic is a year a little over a year old it does an excellent job of showing how Kors is keeping fans engaged on Facebook.

pivotcon.com/4-reasons-michael-kors-is-t.../

The company has expanded its social media reach by launching various contests that involved users posting their favorite Michael Kors products. It was the first company to advertise on Instagram last year. 68% of Instagram users are female; this is the perfect demographic for Kors. Although the users are mostly younger than the 35 year old woman that the company tries to sell to, I still believe that the visual nature of the application is perfect for its ads. It currently has 2.2 million followers, which is very important as the average user spends 257 minutes on Instagram. This compares to only 442,000 followers for Coach. This is an example of a Kors ad on the mobile app.

instagram.com/p/qsEEmFHLuD/?modal=true

Michael Kors will be launching a new website in September which is expected to make the company's e-commerce sales grow. This portion of the business, when it is mature, will make up 10%-20% of the firm's sales. The website is being developed in house which is making it have high costs. These high costs should be worth it as the branding on the site will improve. The CEO stated that the branding on the current website is a 3 out of 10 and will improve to an 8 or 9 out of 10 once the new website in finished. The Canadian website will be launched along with the American website, while the rest of the world's online presence will be released by the beginning of fiscal year 2016.

Now that I have explained the initiatives that the company is focusing on I will explain further how they will impact Michael Kors' profits in the future. The website is very important to the future prospects of the company because it is currently the weak point in the company's presence on the internet. Since the company has been so successful in the social media space, it needs to complement its great ads with an equally great website to showcase its products. The company estimates that 1 out of 5 customers shop on the site and 3 or 4 out of 5 customers are pre-shopping online. A website with better branding will make a customer more likely to buy Michael Kors products when she physically walks into the store.

The impact of expanding into fragrances, watches, jewelry, footwear, and ready to wear allows the company to diversify its sales. As I previously stated, handbags make up a huge portion of sales. This can hurt the company in the future if it loses its dominance in the category. While the company stated that it is looking to sell multiple bags to the female consumer, it is much easier to sell her a new pair of shoes because she likely has yet to purchase any from the company. If a woman is wearing multiple items from Kors it makes her more engaged with the brand. It makes the company truly epitomize jet set luxury instead of simply being a handbag company. Michael was able to leverage the brand to create the MICHAEL Michael Kors line, so it shouldn't be difficult to leverage it further with new product categories.

Selling to men has an obvious long-term impact as it doubles the potential customer base. The possible creation of men's stores allows the company to build out more stores and have greater distribution within department stores without running the risk of over saturation and cheapening of the brand. Coach has been able to reach $700 million in sales to men. Based on Michael Kors' success in selling to women and out competing Coach, it is safe to assume that Kors can have even greater sales to men. The fact that Michael Kors himself is a man will make him a great ambassador for the brand as he has been for his women's line.

The international initiative provides the company with balance. The torrid growth rates in Europe and Asia are complemented by a maturing American business. The worldly jet set lifestyle is global in nature so the expansion into other countries throughout the world will further strengthen the brand in America. Clearly the spectacular same store sales growth shows that the company has momentum in the space which will drive future profit growth.

Looking at the stock, it recently has had a substantial correction after earnings were released. It has had somewhat of a recovery, but I believe that it is not too late to buy the stock as I expect it to make new highs by the end of the year.

KORS Chart

KORS data by YCharts

As of the August 20th close the stock is trading at 20.46 times consensus 2015 estimates. With the company having a 22.12% long-term growth rate estimate, this multiple is too low. The company's correction made it trade as if it is in between being a growth stock and a value stock. I believe that it will remain a growth stock because of the points I made in this article. Therefore, the stock will go much higher.

The risks that company has in the long term are execution of the proposed strategies by management and the continued popularity of the brand among consumers. The growth in brand awareness shows how well the management is executing, so I don't think this will be a major issue. The brand popularity is much more of a concern. Although the company is adept at social media and will likely experience growth from sales from international stores, men's stores, and in watches and jewelry, the main portion of its sales which is handbags in America has the potential to be faddish. If you simply look around in NYC the amount of Michael Kors handbags that you will see women wearing shows the dominance that the company currently has. This may not continue forever, as new fashion trends are always happening. If the company diversifies these sales into fragrances, ready to wear, and other accessories it will be able to weather this storm and still remain a strong company with growing sales.

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.