Capri Holdings Is An Intriguing, High-Reward, Bet On Management

|
About: Capri Holdings Limited (CPRI)
by: Vince Martin
Summary

CPRI shares trade at a seven-year low amid worries about the Michael Kors brand, and widespread pressure on the retail sector.

But management sees Kors stabilizing - while recently acquired Jimmy Choo and Versace drive growth.

Management targets imply a likely double in three years if they're hit.

Of course, investors don't trust those targets, or management - which needs to change for CPRI to rise.

If Capri Holdings (CPRI) hits the multi-year targets management laid out in its Q4 release last week, CPRI shares are going to soar. In fact, I'd argue CPRI likely doubles, at least, even assuming little or no change in the exceedingly negative sentiment surrounding retail at the moment.

Of course, that's kind of the point: the market is heavily discounting those targets, and has lost faith in CPRI management. The acquisitions of Jimmy Choo in 2017 and Versace last year look like potential overpays (though it's worth pointing out that investors liked the Choo deal at the time). Michael Kors' profits and margins have come down amid several missteps which continued into fiscal 2019 (ending March).

Sector sentiment doesn't help: almost any retail play at this point seems like a "show me" story. Investors listening to management at pretty much any company in the sector in the last five years or so could have modeled upside on paper - and in most of the stocks in the space (save a few high-end, high-growth names) would have lost money in practice.

That said, CPRI is a bit different. Those targets aren't based on Michael Kors, still by far the largest brand of the three, executing some sort of enormous tailwind: Capri management sees that business basically stabilizing. The growth is expected to come from Jimmy Choo and Versace - in part because both companies have overinvested of late. Simply normalizing spend should boost margins in those businesses - and drive solid earnings growth through fiscal 2022, at least.

Of course, an investor has to not only trust management, but be willing to take on retail exposure (or, in my case, more exposure). Tariffs are a concern, given sales in Asia are headed to 20%+ of total revenue. A cyclical downturn represents another near- to mid-term risk. There are reasons beyond what is close to a panic-level sentiment toward the sector why CPRI has fallen, and why it looks so cheap. Still, from here, CPRI looks too cheap - with room for upside even if performance over the next few years isn't quite as strong as management believes it will be.

The Case for CPRI

"We look at the health of the Michael Kors business and we see it is relatively stable. North America is a little softer than we would like, but in general, I think we see it as a relatively stable and a good foundation for us to really as a platform, and then the growth of Versace and Jimmy Choo that will reside on top of that."

That quote comes from CEO John Idol on the Q4 conference call - and it basically sums up the bull case for CPRI. If Michael Kors stays ~stable, Jimmy Choo and Versace can grow thanks to store count expansion, moves into adjacent markets, and leverage of operating spend (thanks in part to normalizing some of the investments made of late). With CPRI right now trading at ~6.5x EV/EBITDA, and less than 7x FY20 EPS guidance, any growth is going to lead CPRI higher - and likely significantly higher.

Indeed, the company detailed multi-year targets in the Q4 release which, if hit, suggest at least three years of growth:

Source: Capri Holdings Investor Day presentation, June 2019

By my numbers, the targets imply at least $6 in adjusted EPS come fiscal 2022. Deleveraging adds a catalyst as well: the company said at Investor Day that it planned to pay down some $500 million in debt each year over the period.

A 10x+ P/E to that $6+ in EPS gets CPRI over $60. The same 6.5x EV/EBITDA multiple currently assigned moves the stock to $52. Neither multiple suggests the current sentiment toward retail changes all that much; yet on a blended basis, they suggest CPRI over the three years could rise something like 70% from a current price of $33.50. Some level of multiple expansion on either basis - not unlikely if CPRI EPS grows 20%+ over the period - means the stock likely doubles.

That's the good news - but also, in a sense, the bad news. Again, blindly accepting management targets generally is poor investing - and that's been doubly true in retail. In the context of cyclical risk, tariff impacts, and sector worries, even a conservative measure of 70% upside over three years maybe isn't that compelling. There's no shortage of retail stocks that can double, or better, if only the underlying business starts showing any kind of growth whatsoever.

But what makes CPRI at least intriguing is that its brands seem stronger than most retailers, particularly U.S.-focused, mall-based plays. Meanwhile, its plan hardly seems aggressive. Again, the company is expecting little from Michael Kors. Jimmy Choo and Versace are growing as is, with Choo's margin compression of late a management decision: "we purposely took it [operating margin] down," as Idol put it at the Investor Day.

From a broad standpoint, Capri's outlook looks possibly even conservative. And it's worth noting that the company's "Runway 2020" goals, detailed at the 2017 Investor Day, were largely met. FY18 was better than expected, and FY19 a bit worse (most notably in terms of Michael Kors comparable sales), but net/net Capri management was basically on point. If that's true this time around as well, CPRI almost certainly outpaces the market over the next 2-3 years.

Unit by Unit

Michael Kors

Again, investors at the moment do not appear to believe that will be the case. And there are some worries.

Most notably, as far as Michael Kors goes, even the modest expectations for low-single-digit revenue growth and flat margins do imply some improvement from recent trends. Kors same-store sales have been negative for four consecutive years, dropping some 16% over that span. Operating income dropped over 20% in FY17 (segment-level detail, to my knowledge doesn't go back that far, but assuming corporate expense was flat to FY18, EBIT declined 22%) and since has declined at a sub-1% CAGR.

Management is forecasting, per the Q4 call, ~flat comps in FY20 and similarly flat operating margins. There's likely some help in the same-store sales figure from store closings, which pull out the weakest stores from the comp base and which will continue into fiscal 2020. Gross margin for the unit is expected to be lower in the first half of the year, after a disappointing Q4, before recovering in the second half. Investors would be forgiven for not quite trusting that guidance: more than a few retailers in recent years have projected a back-half recovery, and amid lower traffic and intensifying competition many have been overly optimistic.

Meanwhile, Kors has struggled with a consistent headwind in jewelry, and particularly watches. The latter category accounted for half of the negative comp in Q3 - and same-store sales would have been positive without watch declines in Q4, per commentary. On the Q4 call, Idol wouldn't detail the overall contribution of watches to sales, but admitted "it's still a significant business for us inside of our stores". He added that declines in the category are "accelerating faster than historic levels." Given that watches and jewelry have been repeatedly called out in filings as driving lower comps in recent years, that headwind needs to be monitored heading into FY20, and looking out further.

The broader concern at this point, however, might simply be the external environment. Kors remains US-heavy: 68% of FY19 sales, according to the Investor Day presentation, came from the Americas. The goal is to get that figure to 60%, with Europe (currently 20%) and Asia (12%) splitting the remainder.

Even that goal leaves Kors reliant on a U.S. market that investors increasingly believe is headed for at least a slowdown from a macroeconomic standpoint. And it's hard to think of a brand more at risk in a cyclical downturn, selling obviously non-essential items (65% of revenue comes from accessories, mostly handbags) to a largely upper-middle class demographic.

There's also the potential secular risk of lower handbag demand in perpetuity (athleisure, millennials preferring experiences over goods, etc. etc.). Competition is an issue: Tapestry's (TPR) Coach has outperformed Michael Kors of late in handbags. And Kors still is dealing with the aftereffects of overexpansion in recent years, a key reason comps reversed from +40% in FY13 to -8% in FY17.

That overexpansion in part was driven by the "tightrope", as one analysis put it in 2017, walked by so-called "accessible luxury" brands like Kors and Coach. Price points have to be high - but not too high. Availability has to be broad - but not too broad. Kors quite clearly overshot on both fronts in the middle of the decade, particularly in terms of full-price selling, to which smaller handbag manufacturer Vera Bradley (VRA) too has been trying to return. Even if the economy holds up, does Michael Kors stumble again?

The bearish or skeptical case (by retail standards, CPRI has minimal short interest, just 4% of the float) is that it might seem simple or conservative for Capri to model stability for Michael Kors - but it's not. This is a brand that soared in the early part of the decade (revenue rose over 400% between FY09 and FY13) - but in fashion, it's easier to get big than to stay big.

There are real risks here - and even though Capri paid over $3 billion combined for the other two brands, Michael Kors remains the story here. By my numbers, even if targets are hit, suggesting impressive growth for both Jimmy Choo and Versace, Kors still would drive roughly 80% of the company's segment-level profit in fiscal 2022. Put another way, if Choo and Versace perform to expectations, and Kors stumbles, Capri's consolidated growth can be zero or even negative. And in that scenario, CPRI stock probably trades sideways at best, depending on the degree of erosion in Kors profits.

That said, Michael Kors does have two growth drivers. It's looking to build out a men's business that drove just 5% of revenue in FY19. And, as noted above, the company is going to invest dollars (and add stores) in Asia, looking to target that potentially more attractive market. (We'll see whether that region remains more attractive if the trade war continues.) Neither initiative is necessarily transformative, but at the least Michael Kors is playing a bit of offense after staying essentially on defense for the last few years. Corporate synergies (back office, sourcing, etc.) can provide some help to consolidated EBIT as well, and offset any modest weakness in the brand.

Kors is still the driver of the story here, even after the acquisitions and the corporate name change. And its outlook is a bit of a 'feel' exercise. Stability in terms of comps and margins probably isn't quite as simple as the word suggests (indeed, many apparel plays have more unlikely hopes of getting back to flat at this point) - but there should be some modest tailwinds in the next couple of years. And it's important to remember that, particularly if Choo and Versace work out, stability, or close, means substantial upside for CPRI shares.

Versace

Capri paid up for Versace, paying $2.1 billion for a business that generated roughly $850 million in revenue during fiscal 2019. The market didn't seem to like the deal: what was then KORS stock dropped 8% when Reuters reported a deal was imminent, suggesting at the time a nearly $1 billion loss of market value. The fact that Blackstone (BX) was on the other side, and cashed in its 20% stake in Versace, likely didn't help.

But what Capri paid isn't all that material at this point - and the strategy behind the deal is intriguing. Capri sees a path from that $850 million in revenue to some $2 billion. EBITDA margins should expand nicely as well, thanks to both operating leverage and a plan to dramatically increase the brand's presence in accessories. On the call after the deal was announced, Capri targeted high-double-digit EBITDA margins - which is below the profit levels of other high-end businesses (and actually below Michael Kors itself).

Given a plan to increase the store count from under 200 to ~300, and the potential impact of accessories and footwear, the plan doesn't seem quite as audacious as it might at first glance. The company has had early success with sneakers priced at 1,000 euros. Revenue has grown ~12% annually this decade, per commentary on the post-acquisition call, including a solid Q4 under Capri ownership. Store count growth of ~50% provides a top-line tailwind. There seems little reason why one of the world's best-known fashion brands can't have margins in line with other high-end players.

And this does seem like an attractive business. Almost 50% of revenue, surprisingly, comes from men's. Price points suggest perhaps more limited cyclicality than Kors or Jimmy Choo; many Versace customers presumably aren't going to change their spending patterns should a modest recession arise. (To be sure, that may not be the case if the rapid wealth accumulation being seen in Asia starts to slow.) It might be the case that $2.1 billion was too high a price. But that's a concern that's largely immaterial at the moment, particularly looking at the next 2-3 years, during which time Capri seems unlikely to make another deal.

The key risk here, however, should be obvious: does Capri management wind up doing to Versace what it did to Michael Kors? Management cited a big opportunity in wholesale, notably luxury department stores. There does seem to be modest potential for the brand to suffer overexposure, even if those department stores are going to be luxury outlets like Harrods of London and Neiman Marcus.

Still, this seems like a strong, high-end brand, and one that could benefit from expanding its reach, particularly in Asia, and branching into newer categories. Expecting continued growth and margin expansion doesn't seem particularly aggressive.

Jimmy Choo

From an investment standpoint, Jimmy Choo seems much the same as Versace. Capri/Kors may have overpaid: a $1.2 billion acquisition price is over 2x FY19 sales and 25x+ FY20 operating income. Capri sees a path to expanding revenue from $590 million in FY19 to over $1 billion, in part due to a store count expansion (~250 to 300).

Capri will be more heavily focused on Asia (particularly Southeast Asia), which already accounts for nearly 50% of store locations. Accessories should grow, lessening the business's reliance on footwear. And margins are expected to expand.

The risk of that expansion seems greater here than with Versace, given that the brand isn't quite as established and that Asian economies have more than a few potential stumbling blocks ahead. And the opportunity isn't quite as big, with the company targeting $1 billion in revenue - half that of Versace - and mid-teen EBIT margins.

But in both cases, there should be some near-term help even if the concepts disappoint somewhat from a mid- to long-term standpoint. For Jimmy Choo, in particular, simply normalizing spend will add 100-200 bps to the segment's EBIT margins, per commentary at the Investor Day. Assuming accessories growth and store expansion adds revenue, there's a nice path for Choo to start contributing to profit, after driving just a fraction (roughly 2%) of FY19 earnings.

Valuation and Risks

There's some good news from a consolidated standpoint, too. Capri is more diversified both in terms of demographics (moving mostly toward the higher end - which seems like a good thing) and geography. The Americas - where retail seems toughest at the moment - is heading toward, and likely at some point below, 50% of sales. Synergies could be as much as $50 million, per Investor Day commentary, a nearly $0.30 per share boost (admittedly only about 6% of FY20 EPS guidance).

A stable Michael Kors and growth in the acquired businesses should lead earnings steadily, if not quite spectacularly, higher. My estimates based on targets suggest FY21 EPS of $5.31 and $6.03 in fiscal 2022. Synergies can add a few pennies as well, though the tax rate might be a wildcard (I'm assuming the 15% guided for fiscal 2020 holds through that period.)

Meanwhile, at the moment, CPRI looks reasonably cheap on a peer basis:

Stock P/E Multiple EV/EBITDA Multiple
CPRI 6.8x 6.5x
GIII 7.8x 5.2x
HBI 8.5x 8.4x
OXM 15.4x 8.4x
PVH 8.6x 6.7x
RL 14x 7x
TPR 11.2x 7.1x

source: author calculations based on company guidance (midpoint if available) for next fiscal year

There's certainly a case for CPRI to at least trade in line with Ralph Lauren (RL) and Tapestry in terms of P/E - and a sense that at these multiples its brands aren't really being treated as all that valuable, permanent, or high-end. It's worth noting as well that, of this group, only G-III Apparel (GIII) has performed worse over the past year. (That's all relative: the group as a whole has fallen by one-third.)

If management is right from a broad standpoint, in that Kors can stay reasonably stable and Versace and Jimmy Choo can grow, the stock likely rises at least 50%. A high single-digit P/E and ~$5.50 in EPS gets the stock to $50. If management is really right, and Kors drives modest profit growth while Versace and Choo start moving toward the goal of $3 billion in combined revenue, the upside is enormous. Surely at that point, the three brands are seen roughly in line with the Oxford Industries (OXM) portfolio of Tommy Bahama, Lilly Pulitzer, and Southern Tide. By my numbers, 15x FY22 EPS and 8x FY22 EBITDA suggest ~$95 and ~$75, respectively - at least 120% upside and perhaps something closer to a triple.

Those are big "ifs", however. Kors still is headed in the wrong direction from a comp standpoint. Much of the same management team that overshot with that brand is in charge of Jimmy Choo and Versace. Retail/apparel sentiment seems unlikely to improve any time soon. Multiples, particularly in terms of EV/EBITDA, can get lower with many U.S. plays trading at 4x or in some cases less.

Still, the risk/reward looks in favor of CPRI at this point. There's a case here that goes beyond "look how cheap the stock is," which can be applied in one form or another to pretty much every stock in the space. CPRI is cheap - but it has room for growth under seemingly reasonable assumptions. More notably (particularly in the context of the space), those assumptions don't require a massive turnaround, a brand shift, an immediate end to the trade war (Capri's businesses appear to have little direct exposure), or other massive changes. Kors simply needs to get better, and management needs to be on point with the newer brands. That may not be turn out to be the case - but if it is, KORS is likely to double.

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.