In a nutshell
Michael Kors (NYSE:KORS) is in my opinion an attractive long at the current levels. The market is discounting a lot of pessimism on several fronts. On one side, the current price/earnings and discount to peers suggest investors expect earnings to fall for several years. On the other side, the recent correction is the result of concerns about the negative effects of the introduction of an import tariff. The extreme pessimism has set the stage for an attractive contrarian long, and several factors could unlock the company's performance and the stock price.
Michael Kors has been dividing investors for at least two years. I have been long for a few months and I still think the stock is a compelling buy. KORS has declined by more than 60% since February 2014, and has recovered only a very small part of the lost ground. It's now trading around $42, less than 10% above the historical low.
The weak performance was due to a combination of factors:
- A fast growth in popularity, followed by a deceleration and slight decline, which has led many investors to believe that the popularity of the brand is the result of a fad.
- An overall weak environment in the fashion industry, especially in the U.S., as a result of declining tourist spending due to recessions in the emerging markets and a strong appreciation of the dollar.
While the whole fashion and retail industries in the U.S. have been beaten down by macroeconomic weakness in the emerging markets and a competitive environment characterized by destocking and heavy discounts, KORS has also been affected by a negative sentiment about its future prospects. The idea that an excessive commercialization could harm the brand's status and make it less attractive has led many to abandon the stock, while short interest reached peaks close to 14%.
Investors who were scared by declining comps sold the stock fueling the decline, while investors who were attracted by the extremely low multiples started to accumulate shares. In the last 6-7 months, the stock price has shown an accumulation pattern, as many investors started to bet on a recovery of the industry in the next few years. With peer companies such as Coach (NYSE:COH) and Burberry (OTCPK:BURBY) (OTCPK:BBRYF) showing slightly improving comps, and Chinese consumers contributing again to strong quarterly results of luxury names such as Tiffany (NYSE:TIF), Hermès (OTCPK:HESAF) (OTCPK:HESAY) and Brunello Cucinelli (OTC:BCUCF)(OTCPK:BCUCY), many investors turned bullish and started to build positions in many stocks in the fashion and retail industries, expecting the improvement to slowly extend to the affordable luxury segment.
Nonetheless, fashion and retail stocks have crashed in the last few weeks as a result of fear that import tariffs under President Trump would hurt the industry. After all, the industry heavily relies on imports of materials, semi-finished and finished products. KORS posted a 16-17% correction, while other fashion stocks in my portfolio such as Ralph Lauren (NYSE:RL) or Fossil (NASDAQ:FOSL) suffered even more.
Why I remain positive
As I said in my most recent article about Ralph Lauren, I doubt the government will actually impose tariffs, which would cause more harm than good to the economy. Nonetheless, I am not concerned about the effects that a 5%-10% import tariff (these are the numbers they are talking about) could have on Michael Kors and I think the negative effects are already largely discounted in the stock price.
The stock fell by 16% in the last few weeks, which, according to my calculations, means the market is expecting earnings to fall by more than 20%. For this to happen, the cost of goods sold should increase by roughly $160 million, which means by more than 8%. If we consider that about 30% of Michael Kors' sales are generated outside North America, this means the market is fully discounting the effect of a 10% import tariff. Moreover I think many fashion firms would try to heap as much of the cost as possible on their customers. In Michael Kors' case, it would mean raising prices by 4%, which in my opinion would not lead to a proportionate decline in sales.
Michael Kors' margins are very strong, so it's obvious that the effect of import tariffs would not be the same we could expect for a company with lower margins, such as Fossil. Nonetheless, the market reaction was very negative and, in my opinion, exaggerated.
I think that the probability that the government will impose high tariffs is low, while the overall environment in the fashion and luxury industry is improving thanks to less volatile currency rates and rising tourists spending, especially from China.
There are clearly negative and positive factors affecting the attractiveness of the stock. The most significant risks are:
- The negative effects of import tariffs. Although I think the probability of such measures is not high, we should take into account the risk of higher cost of goods sold in the future.
- The possibility that sales in North America and some European countries could keep declining, if the brand lost attractiveness.
On the other side, some positive catalysts could help improve the company's performance and unlock the stock price:
- Expansion in China and other emerging markets.
- Success in other product categories such as wearables.
- Improving environment in the fashion industry (higher tourist spending, more stable currency rates).
These are the same factors I have talked about in some previous articles, but now we know that the environment is actually improving and that MK branded wearables are having success.
Trading at 8.9 times earnings, expectations on KORS are very negative and the discount to peers is significant.
At this multiples, the market is expecting earnings to decline for several years. At the same time, the magnitude of the recent correction suggests the market is discounting the introduction of a significant import tariff. While the market is discounting very pessimistic scenario, many catalysts could lead to better than expected results.
If the government does not introduce import tariffs, we could expect a quick 25% rally, since the stock would recover the lost ground, together with all the fashion stocks that crashed after Trump's words. If the decline in sales and margins is not as strong as the market expects, I think the stock will trade closer to its peer COH in terms of P/E and EV/EBITDA. There is still uncertainty surrounding KORS and the fashion industry, but at this valuation, I think the risk/reward is favorable.
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Disclosure: I am/we are long KORS, FOSL, RL.
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.
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