By The Valuentum Team
Michael Kors' Investment Considerations
• Michael Kors (NYSE:KORS) is a rapidly growing global luxury lifestyle brand led by a renowned, award-winning designer. The company operates its business in three segments-retail, wholesale and licensing. The Michael Kors name has become synonymous with timeless, luxurious fashion. The company is poised to take share in the growing accessories product category.
• Growth rates at Michael Kors have been incredible in recent years. However, soft consumer confidence expectations and the concerns over economic growth in China have led many to lose faith in retail sales. Increased pressure from Amazon in the apparel space is not helping.
• The firm's Michael Kors collection establishes the aesthetic authority of its entire brand and is carried in many of the finest luxury department stores in the world, including Bergdorf Goodman, Saks, and Neiman Marcus. Its other collection, MICHAEL Michael Kors, is carried in mainstream department stores such as Nordstrom and Macy's.
• The firm operates in the global luxury goods industry, which is estimated to be north of $275 billion. We like that the industry tends to be resilient during economic downturns. Michael Kors is targeting $6.5 billion in total revenue over the long-term, $4.5 billion of which is expected to come from North America.
• Michael Kors is growing like a weed in Europe. Revenue from the region is more than doubling on a year-over-year basis, and quarterly comparable store sales have been spectacular. It is targeting long-term sales in Europe of $1.5 billion. Performance in Japan is also strong.
• Shares of Michael Kors are downright cheap. Diluted earnings per share is expected in the range of $4.38-$4.42 for fiscal 2016, implying the company is trading at roughly ~11 times soon-to-be trailing twelve-month earnings with a ~$700 million net cash position!
Economic Profit Analysis
In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Michael Kors Hldg's 3-year historical return on invested capital (without goodwill) is 63.4%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Michael Kors Hldg's free cash flow margin has averaged about 12.9% during the past 3 years. As such, we think the firm's cash
flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Michael Kors Hldg, cash flow from operations increased about 139% from levels registered two years ago, while capital expenditures expanded about 197% over the same time period.
Through the first three quarters of fiscal 2016 the firm reported cash flows from operations of $961 million and capital expenditures of $290 million, resulting in free cash flow of ~$671 million in the period. This represents more than a 57% increase from the same period in fiscal 2015.
This is the most fashionable portion of our analysis. Below we turn our raw data assumptions into the most beautiful fair value estimate imaginable.
Our discounted cash flow model indicates that Michael Kors Hldg's shares are worth between $50-$74 each. Shares are currently trading at ~$49, just below the lower bound of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $62 per share represents a price-to-earnings (P/E) ratio of about 14 times last year's earnings and an implied EV/EBITDA multiple of about 8.4 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 4.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 26.1%. Our model reflects a 5-year projected average operating margin of 27.4%, which is below Michael Kors Hldg's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.9% for the next 15 years and 3% in perpetuity. For Michael Kors Hldg, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $62 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Michael Kors Hldg. We think the firm is attractive below $50 per share (the green line), but quite expensive above $74 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Michael Kors Hldg's fair value at this point in time to be about $62 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Michael Kors Hldg's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $84 per share in Year 3 represents our existing fair value per share of $62 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
We think there is plenty to like about Michael Kors. The firm's fiscal third-quarter (calendar fourth-quarter) release showed a company that is still growing revenue at a nice clip (~10% on a constant-currency basis) and one that put up $1.65 per share in earnings on a constant-currency basis during the period. For fiscal 2016, Michael Kors expects total revenue to advance at a "low-double-digit" pace, with the current quarter the last of the fiscal period, despite pressure on comparable store sales (+2% in Q3, however). Diluted earnings per share is expected in the range of $4.38-$4.42 for fiscal 2016, implying the company is trading at roughly ~11 times soon-to-be trailing twelve-month earnings with a ~$700 million net cash position! Given some of the exorbitant multiples (i.e. 20+ times) placed on "slow-growing," debt-heavy equities in this market, it's very easy to see why we liked the company from a valuation standpoint. Michael Kors is included in the Best Ideas Newsletter portfolio.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Michael Kors is included in the Best Ideas Newsletter portfolio.