Arbitrage is when two assets that should have very similar valuations trade at widely differing prices. Hence a profit can be made by going short the high valued asset with a long position in the undervalued asset.
A P/E arbitrage opportunity is when two companies that operate in the same sector and are subject to the same market fundamentals trade at widely varied P/E multiples. Two companies that are an example of such an arbitrage opportunity are Michael Kors (KORS) and Phillips Van Heusen (PVH). In this article, I will try to explain why arbitraging the P/E multiple difference between these two companies will probably be a highly profitable trade.
Michael Kors trades at roughly 50X P/E while PVH's multiple is around 18X. Both of these companies are fairly high end. They are quite concentrated in the North American market.
So why is the discrepancy in the valuation? As usual, growth is the culprit for the high multiple of Michael Kors. However, the real underlying reason for the high valuation of Michael Kors is that it is a newer company. It is marketed to investors as a company still in its major growth stage.
While I concur that Michael Kors is a solid company that does have a good growth plan, I do not agree that the valuation is justified, especially compared to PVH's valuation multiples. Based on that premise here are some reasons why a short KORS, hedged with a long PVH trade would be profitable:
- Both of the companies operate in almost exactly the same sub-market, which is mid to high-end. Although one company might be more successful than the other, there is a limit to how much a company can detach itself from the fundamentals of the market it operates in. Therefore, one company valued at almost 3X the P/E multiple of the other company is not very realistic.
- The insiders at Michael Kors have unloaded an unusually large amount of their holdings to the market (the SA market current is below). That indicates that even the insiders are of the opinion their stock is way overvalued."Tuesday, March 20, 6:37 AM Michael Kors (KORS) insiders plan to sell over $1B worth of stock in an offering, with founder Michael Kors due to offload 3M shares and CEO John Idol 1.7M. The offering will come just three months after the fashion company's IPO after banks waived the 180-day "lockup" restrictions."
- Michael Kors' stock has established a downward price trend even when the market was strong. On the other hand PVH's stock price has consolidated even in the weak market in May 2012 and the stock seems to be ready to rise back to its rising trend.
- The fact that PVH is a more stable company than Michael Kors, is an advantage in the volatile market environment. While Michael Kors has to use its operating cash flow for new investments to keep its growth (which increases risk), PVH does not have the same constraint on how to use its cash.
- PVH is almost 5X larger than Michael Kors in terms of revenue. Yet the enterprise value of both companies are the same. Investors simply get 5X more revenue per share with PVH which completely negates the Michael Kors's growth argument.
The best way to take advantage of this P/E arbitrage is the following trade, in my opinion:
- Long PVH August' 17th 2012 80 call option
- Short KORS common stock in the amount 5X the option value of the PVH options stated above.
The implied volatility on KORS put options is very high so I have avoided using them in my arbitrage trade.
I will try to post a follow-up article to this trade about how it has performed, when the option stated above is close to expiration.
Disclosure: I am long PVH.