Michael Kors Holdings Limited (NYSE: KORS) is under limelight these days due to its disappointing results in the third quarter of fiscal 2017. The current fiscal year is proving to be disastrous for the company as its stock has declined more than 22% in the last one year as compared to 26% positive performance of the broader market. Despite its disappointing performance in the past year, it's still not a good investment for the short-term basis. However, the company's fundamentals are in support of the long-term investment case.
Source: Yahoo Finance
The retail environment is continuing to hammer on almost every company operating in the consumer goods sector. Consumer spending habits are largely affected by macroeconomic concerns including income levels, unemployment, slow growth rates, interest rates, and global economic and political uncertainties. These macroeconomic headwinds also have affected KORS recently as it is continuously reporting disappointing results since last few quarters. The declining trend in the results has put the company on the radar in the investment community as they seem to be less motivated to invest in the company's fortune despite its strong business fundamentals and attractive valuations.
According to the most recently announced third quarter financial results, total sales revenue dropped 3.2% to$1.35 billion from $1.39 billion in the comparable period last year. This drop in top line was 2.6% on the constant currency basis. The worst performing segments were the Licensing and Wholesale businesses as they declined 23% and 18% respectively from the same period last year. However, Retail sales increased 9% (10% on the constant currency basis) in the aforementioned period. The opening of 193 net new stores in the third quarter played a catalyst role in the retail performance. The major reason for the decrease in licensing revenues was the acquisition of previously licensed 143 stores in China and South Korea.
Source: Press Release
One very important issue that should be highlighted here is the huge customer concentration KORS is facing continuously. A small number of wholesale customers accounts for the significant portion of the company's net sales. Almost 26% of the company's total revenues belong to only five largest wholesale customers (10-K, page 6). If few of the largest customers go into problems, your business will be in a serious trouble. Unfortunately, this already has happened as Macy's is the biggest customer that accounts for almost 12% of KORS' total revenues and the retailer is facing serious headwinds these days. There is no information this customer concentration is going to ease in near future; therefore, the company will remain under the limelight in at the next at least one-to-two years until it seriously improves its business and brand loyalty.
The most alarming situation is that the company's same store sales (SSS) are consistently on the declining trend. James Brender nicely presented this phenomenon in his recent report on KORS. The company is facing a negative correlation between its stores' count and same store sales. KORS' store count is increasing every passing year while sales are decreasing. Most recently, the company's same store sales decreased 6.9% again, which has created serious doubts about the company's ability to utilize store space efficiently for the benefit of its shareholders. Below are few catalysts, among other factors, behind the worsening business environment:
The strengthening dollar negatively affected the customer traffic as it significantly reduced tourist activities. Heavy advertisement and promotional activities resulting from intense competition adversely affected the comps. Macroeconomic headwinds like unemployment, disposable income levels, economic conditions, inflation and interest rates, global political landscape, international terrorist activities, and weather conditions have their sever impacts on customer traffic and same store sales. Slow growth in China and its depreciating currency (yuan) greatly altered customer's shopping behavior. The shifting trend from store visit to online shopping (e-commerce) is another major factor that has adversely affected the same store sales. Now customers prefer to buy online as it is cost effective, easy way to shop, and time-saving decision.
On forward-looking basis, the company doesn't see this trend to reverse in near future. It is expected that the same store sales will decline in the high single digit range for fiscal 2017 with the total revenue of$4.48 billion as compared to $4.71 billion in fiscal 2016.
The bottom line was not the different too. The company reported diluted earnings per share of $1.64 as compared to $1.59 in the same period last year. Apparently, the net results look better than the previous ones but unfortunately, they are not. The most recent EPS is based on 165.2 million shares count as compared to 184.9 million weighted average diluted shares outstanding in the comparable reporting period last year. This is the result of the company's share repurchase program as it repurchased almost two million shares in the third quarter and five million shares in the second quarter of fiscal 2017. Well, share repurchase program is a good way to artificially increase the net results when they are reported on the per share basis. This strongly indicates that there is not much organic growth left that could become the reason for future performance. It would be a prudent decision if the company invests the cash reserves on building its brand equity by redesigning and developing trend-chasing products instead of repurchasing shares, which don't help much while you are in trouble. The EPS for fiscal 2017 is expected to be around $4.11 as compared to $4.44 in fiscal 2016, which don't bode well for the investment perspective.
The company's Chairman and Chief Executive Officer, John D. Idol commented on the results:
"Overall, we were disappointed with our North American and European comparable store sales performance during the quarter. We believe that headwinds in these markets will continue throughout the Spring season as we face reduced traffic trends in shopping malls, currency fluctuation, uncertainty surrounding certain political changes in European countries and the implementation of our reduced promotional cadence in North America. While we face certain challenges in the short term, we continue to believe that there is meaningful long-term growth ahead for the company as we focus on maintaining our luxury leadership position while expanding the Michael Kors brand internationally."
The most recent results show the trend set by first and second quarters of fiscal 2017. We can observe a similar performance if we look at the second quarter results as shown below. The company's wholesale segment is continuously disappointing with its undesirable performance as it accounts for almost 40% of the total revenues. This is mainly driven by the overall troubling retail sector resulting from the macroeconomic headwinds. I am not much worried about the Licensing segment as it only accounts for less than 5% of the total sales. Further, KORS has acquired the majority of its licensed business in Asia. The company's Retail business that accounts for more than 55% of total sales is posting a decent growth of above 10%, which is encouraging one for investors.
Source: Press Release
Some Key Fundamentals
Let's have a look at some of the company's fundamental measures in comparison to its competitors. KORS is fundamentally a solid business, which is a good news for the long-term value investors. Look at the below table that shows some key fundamentals of KORS in comparison to its competitors. Every fundamental measure of KORS is much better than industry peers' average measures. The company's operating and net margins are more than 2x than its peers' averages. Its free cash flow (FCF) margin is amazing that is almost 4x of the average margin for its industry peers. I believe, the economic moat of the company still prevails as the three most important measures to judge the economic moat (return on equity (ROE), return on invested capital (ROIC), and free cash flow margin) are substantially higher than the peers' average measures. This indicates that the company has more ability to add wealth to shareholder's capital than its peers. This is due to the fact that the company is using shareholder's assets efficiently as its return on assets (ROA) is 29.57% as compared to 7.64% average measure for its peers. However, the recent slowdown resulting from macroeconomic headwinds is a serious concern that will continue to impact KORS' profitability in next few more quarters. Fiscal 2018 would be a tough one for the company as it has to improve its business in many fronts especially, the worsening same store sale atmosphere.
Source: Author Calculations/ Stockrow.com
KORS have a solid financial position as well. It has $368.80 million cash on its balance sheet as compared to only $147.80 million debt, which is all short-term. This means the company can easily make its balance sheet debt-free and still left with more than $220 million excess cash to spend on its brand to make it a unique product to beat the competition. Moreover, KORS short-term financial position (liquidity position) and long-term financial position (leverage position) are in favor of the company's long-term future; therefore, the investors should not be worried about its sustainability.
Source: Seeking Alpha
The company's valuations look attractive at current levels. It is trading at only 5.5x EV/EBITDA multiple, which is much lower than the industry's average multiple of 9.93x, meaning the company could be the takeover target candidate in near future. Its current P/E ratio is 8.7x as compared to almost 18x for its industry. The company's forward P/E multiple is 9.5x as compared to industry's forward multiple of 18.30x, which indicates that the stock is undervalued. If we look at the last five years historical P/E multiple (shown in the PE Ratio graph below), the stock is trading at the lowest multiple. However, we have to look at the multiple critically before making any final decision.
The two important components that affect the P/E multiple are the earnings growth rate (G) and the investors' required rate of return (R). First of all, I discuss the G component. If the expected earnings growth is high, the high P/E multiple is justifiable. However, if the growth expectations are not good, then even the low multiple is unjustified. KORS' next year expected earnings growth rate is negative 3.30% and five years expected earnings growth rate is 4.01% as compared to industry's five years growth rate of 13.18%. This indicates that KORS' lower multiple is not justified because its growth expectations are much lower than the industry's.
The second component also affect the P/E multiple. Investors demand more return as the risk in the company's investment prospects increases, the basic principle of the risk/reward tradeoff. The high required return adjusts the P/E multiple downward because investors are not ready to pay high against per dollar of company's earnings. In the case of KORS, the risk has adjusted upward due to disappointing business performance as well as very low growth expectations, which has adjusted the P/E multiple downward. Therefore, the low multiple doesn't indicate that the stock is undervalued. The company has to show significant improvement in its business in order to justify its low multiple.
The above discussions bring me to the conclusion that we have to see KORS through two angles. As we saw at the start of the discussion, the company is facing some serious headwinds currently, and it is also expected to face similar headwinds in next few quarters as macroeconomic concerns are still over-hanging and new establishment's economic policies are not clear yet. This stock is not a good bargain opportunity for the short-term (less than one year investment period). However, if you are a long-term investor (more than two years of investment horizon), you can buy KORS as its fundamentals and valuations are in favor of long-term opportunity.
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.