Kors - Cloudy Near Term, Though Valuation Remains Attractive

| About: Michael Kors (KORS)

Summary

The risk/reward tradeoff looks attractive for this name.

Q2 performance underscores the popularity of the brand.

New fully-priced products exceeded management expectations. This will ultimately be crucial to a reversal in fundamental.

Michael Kors (NYSE:KORS) saw its Q2 EPS beat by 7 cents due to in-line comps & tight cost control. However, the earnings report as whole was a disappointing one. Gross margin was 80 bps below expectation due to weak mall traffic, heavy promotions, soft tourism and continued wholesale pullback. Stock price fell on lowered FY17 outlook from management as they expect these headwinds to persist. FY17 sales outlook for Europe was also reduced and thus KORS anticipates gross margin coming in at 60% (vs. prior 60.5 to 60.8%).

I maintain the risk/reward tradeoff looks attractive for this name. KORS is trading at 10.6x P/E F12M, 6.5x EV/EBITDA F12M and 8% FCF yield. Looking at its peers (COH, KATE, VRA and RL), the average is 18.8x P/E F12M, 9x EV/EBITDA F12M and 5% FCF yield. The biggest detraction to the fundamental is a challenge facing all players in the industry: reduced mall traffic, slow tourism, popularity of smaller sized bags and transition from the promotional tradition. Yet I believe KORS is better positioned in the competitive field and we have seen early signs of improvement in fundamentals. First, comps decreased less, from down HSD in Q1 to MSD in Q2. We see units increased by +MSD, underscoring the popularity of the brand. Second, new fully-priced products in both the handbag and smartwatch categories are well received, exceeding management expectations. This will ultimately be crucial to a reversal in fundamental, delivering positive earnings surprise. We have seen a similar successful transition for Coach (COH). Having done a lot of field surveys on the traffic and products between COH and KORS stores, I can confidently say that KORS' popularity is much higher than COH's. Therefore, I have full confidence that given a sector reversal, KORS will be hugely benefited.

The Positives

  • KORS saw units increase by +MSD rate for its overall accessories business, indicating demand for KORS product still alive.
  • The company focused on driving average transaction value with higher levels of full-price sell-through: 1) the new fall lines exceeded expectations led by the Mercer and the Brooklyn and five new groups are planned for the spring; 2) growing active footwear business; and 3) building on the initial success of its smart watch line which has been selling out globally.
  • Macy's also called out the success of the KORS' smartwatch on its earnings call and stated that they planned to make the line a major focus for holiday.
  • In North America, digital flagships see strong DD growth. Retail comps are starting to improve, from down HSD in Q1 to MSD in Q2.
  • In Asia, China business contributed to 96% increase in sales. Japan saw MSD comp increase. The company still believes that Asia will ultimately reach $1B in revenue.

The Negatives

  • Despite a MSD increase in the number of units sold, average unit retail (AUR) went down due to promotional activity and the ongoing popularity of smaller bags. There are risks that higher AURs from full-price items may not offset the loss of sales to bargain hunters.
  • North America comps decreased MSD rate. Retail store conversion rates increased in the HSD rate but was offset by a continued decline in traffic. In wholesales, sales declined 22% as the company strategically reduces its exposure to department stores in order to protect its brand. This will continue through the reminder of the year as it reduces inventory flow and promotions.

From the Q2 reading, there are undoubtedly some secular challenges facing KORS. However, I remain optimistic on KORS' long term growth potential given ease of its product acceptance, new digital focus, geographic expansion, and attractive valuation. In the near term, close monitoring for further deceleration is needed.

Disclosure: I am/we are long KORS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Expand
Tagged: , Apparel Stores, Hong Kong
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here