Michael Kors: Luxury At A Discounted Price

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About: Michael Kors Holdings (KORS)
by: Joseph Harry

Summary

KORS is evolving, pushing past its namesake Michael Kors brand and more into the field of luxury.

It's an above-average firm with solid expected earnings growth.

KORS shares look cheap here on an absolute and relative basis.

Michael Kors Holdings (KORS) is evolving into more of a luxury and fashion conglomerate after recently acquiring Versace. This acquisition comes on the heels of the 2017 purchase of Jimmy Choo, and further elevates the firm's overall brand portfolio. After closing the Versace acquisition, the company will be changing its name to Capri Holdings Limited (CPRI), better reflecting its more diversified stable of brands.

After absorbing Versace, the new firm will look like this:

Source: KORS financial presentation on Versace acquisition

An above-average operation

I'd put KORS in the above-average bucket, because its earns wide economic profits, meaning its return on invested capital, exceeds its weighted-average cost of capital by a wide margin - reflecting a wide economic moat.

I'm using the company's adjusted, non-GAAP operating profit (which excludes one-time charges) in my below model, as well as the effective tax rate for fiscal 2017 provided by management in the fourth-quarter conference call.

Source: All 8-K and 10-K forms can be found here

There are some flaws in my model that I would like to point out. The first, and most obvious, is the negative cost of equity. This is a result of the company's negative beta, which illuminates one of the flaws in using the capital asset pricing model, or CAPM, in estimating an equity cost. I will adjust the firm's cost of equity, and overall WACC, after I point out some more issues I have with the above model.

The second issue I have with the above numbers revolves around "off-balance sheet" operating leases. KORS utilizes a lot of these leases (just like most companies with a large retail presence), so I decided to theoretically capitalize them to gauge their impact on not only ROIC, but also on the balance sheet.

Adjusting for operating leases

The first step involves estimating a present value of the leases, which I've done below by discounting them at the firm's pretax cost of debt.

Now we can get a rough estimate of their effects on the balance sheet, by injecting them into the firm's capital structure. This is also the denominator to the ROIC-equation.

We can see that our estimated value of the company's operating leases pushes the debt-to-equity ratio past 1x, a noticeable difference from the headline ratio of just 0.43x.

The leases also impact operating profit, and therefore net operating profit, after tax as well. NOPAT is the numerator in the ROIC-equation, which we will determine by first calculating an adjusted EBIT that accounts for lease-related depreciation and interest expenses.

We can now take taxes into account, dividing by the lease-adjusted capital base to arrive at adjusted ROIC.

The company's ROIC takes a steep dive, but still comfortably remains in the double-digit range. Now we can stack it up against the firm's lease-adjusted WACC, which I've re-run utilizing a range of different equity costs:

Michael Kors', soon to be Capri Holdings, earns wide economic profits after adjusting for its operating leases by my estimates, which is the quantitative evidence of an economic moat. I would expect its moat to increase over time as well, as it further integrates its higher-end brands into its portfolio. It's hard to duplicate a Jimmy Choo or an iconic brand like Versace.

Valuations

KORS shares have tended to trade at about 16.91 times earnings on average over the past five years, while the thirteen-year median multiple is 17.27 times earnings. The current price-tag placed on KORS shares is below both of these historical multiples - making shares look cheap relative to their historical range:

The company is also expected to grow earnings per share to around $5.03 for fiscal 2019, according to analysts, and then $5.34 in fiscal 2020. That's a touch over 11% growth for this year, and then another 6.2% of growth between 2019 and 2020, which is much more than what's currently embedded in the share price (assuming a relatively conservative discount rate in the 10% to 12% range):

Even assuming a discount rate of 15% implies only about 7.98% worth of growth, less than the expected 11% for fiscal 2019.

Conclusion

Assuming KORS hits estimates this year, shares look cheap here. If it earns the expected $5.34 in fiscal 2020 and the market re-rates shares, awarding them with a P/E of around 17 once again, then I could easily see a scenario where investors earn solid double-digit returns over the next few years. This is far from a guaranteed scenario of course, but I think that there's a decent margin of safety embedded in the current share price here - largely due to cheap multiples not only in relation to history, but also in relation to the overall market.

There are also some real risks, including the recent Versace acquisition, which was done at a very high multiple: 22x EBITDA and 2.5 times sales. If Versace "sandbags," it could become a thorn in the overall company's side, and the firm did indicate that it expects the Versace acquisition to be dilutive to EPS in the high-single digits in fiscal 2020. After that, it expects that it will be accretive to earnings in the low-single digits in fiscal 2021, and also accretive in the high-single digits in fiscal 2022, however.

The company has gotten off to a very strong start for fiscal 2019, beating big on both the top and bottom lines during Q1 of this year, so it will be interesting to see how it does during the second quarter. The company also raised guidance during its impressive first quarter, so it appears momentum might be in the company's favor - which bodes well for a firm that's currently trading at only about 13.83 times this year's earnings estimates.

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.