Description

Thesis:

KORS is trading at 10.2x this year’s calender year earnings and is in a transition period from several investments that we believe will reaccelerate growth next year.   Longer term there are several potential growth drivers that provide a lot of option value (e.g. International, Ecommerce, Men'swear, etc.).  Growth investors have left this for dead due to the recent weakness in North America as a result of a slowdown in the handbag category and increasing competition.  KORS is focused on growing its digital strategy as consumers shift sales online and see continued strength in international markets such as Japan and Korea.  KORS should grow revenue in the high single digits as it continues to take market share and grow units.  We think expectations are now low enough that any stabilization will quickly re-rate the share at least to a market type multiple.  At 15x our CY16 earnings of $4.65/share, we get to a $70 share price or over 50% upside from today.  Some stats to note that give us some comfort and a margin of safety – 1) the company is buying back 8% of the market cap; 2) the ROICs are over 40%, 3) Ebit margins are a healthy 26-27% and 4) the free cash flow yield on calendar 2016 is around 8% after growth capex. 

Business Description:

Michael Kors Holdings Ltd, (KORS), a global luxury brand, designs, markets and distributes apparel and accessories under two main collections, Michael Kors and MICHAEL Michael Kors.  KORS operates three segments retail, wholesale and licensing in North America, Europe and Asia, including Japan.  The retail segment has approximately 550 locations, which includes both full price and outlets, while wholesale penetration is just over 2,300 worldwide with shop n’ shop penetration at 2,132 at the end of FYE 2015.

Why now?:

KORS’ multiple has contracted significantly as a more intense competitive landscape, particularly in North America, and the poor results of competitor Coach have made investors skittish.  We think the story is not broken but in transition and expectations are now reset.  KORS forecasts a lower growth rate in FY 2016 but expects a return to double digit growth as it improves its ecommerce platform and grows the men’s and international businesses.  KORS’ growth rate has decelerated to high single digits, though it’s still above the industry growth rate as it continues to take share and is growing by expanding its square footage, both physically and in the digital world via its ecommerce sites.    

In addition, KORS forecasts wholesale growth as it transforms its remaining doors into shop n’ shops, along with both licensing and unit expansion (particularly in Korea and Japan) opportunities globally, which will further bolster sales.  Investors are concerned about sales growth rate deceleration in North America, but are discounting KORS’ market share gains, international and ecommerce growth and the emergence of its men’s business.  Additionally, a large portion of its investments, such as their digital flagship initiatives, infrastructure investments in Asia, corporate IT system investments and the buildout of their European distribution center, are at or nearing completion which should boost free cash flow and allow KORS to repurchase more shares, driving earnings growth. 

Investment Highlights:

·         Strong Competitive Positioning  - Rising Brand Awareness and Prominence

Michael Kors – The Designer; differentiation is powerful

At the crux of this story is really the strength of Michael Kors brand. No matter how many stores are built, sales and long term margin potential are really a function of how many people know about the brand and how they view it.  Unlike other brands, where the designer is hidden or unknown, KORS has the benefit of having Michael Kors as its lead designer and chief visionary. Mr. Kors has been in the business for over 30 years and has had his own line since the early 1980s.  The Michael Kors brand is more than just accessories, and while that is the area of growth and the largest part of revenues and profits, KORS still has a runway apparel collection, which gives it credibility as a luxury high end designer brand.  Mr. Kors’ celebrity connections and run as a judge on Project Runway through 2012 gave audiences the chance to know him as a person/personality, but also as a designer and how he views fashion and the world- a great marketing tool that further helped to broaden his brand awareness. 

Strong Online Brand Presence – grew 102% in the most recent quarter

KORS has transitioned its e-commerce site in-house, having added features such as mobile optimization which pair visitors with the nearest store.  It has a global social audience of over 24 million engaged fans and remains a highly popular and searched and followed brand on many websites including Facebook and Twitter. On Facebook, KORS has the second highest interactions per post, indicating higher level of engagement vs other brands.  L2 Digital IQ Index Fashion 2014’s, which highlights brands’ online strength, listed the Michael Kors brand in the top 10.    

·         Gaining Share In Growing Global Accessories Market

In North America, the combined premium women’s and men’s market for handbag and accessories is approximately $13 billion and continues to grow at a mid-single digit rate as consumers shift their spending from apparel.  KORS total North American performance (retail stores, wholesale on a retail basis and accessories business) grew at a low double digit rate, growing faster than the category in the most recent quarter.  This, along with KORS’ history of multi-year double digit comparable store sales gains, indicates it is taking share, particularly from competitor Coach who saw its share decrease from 38% in 2008 to 23% in 2014.  KORS’ innovation and growing distribution have given women reason to shop and make purchases particularly for affordable luxury according to our own surveys.

·         Global Expansion And Growth Continues

North America

KORS has grown over 30% annually in this region for many years, though sales have decelerated in the last 12 months as same-store sales declined due to weak mall traffic, growing online and a move to lower priced cross body and smaller bags.  FY2016 will be a transition year and KORS will hopefully see a return to double digit growth in this region as it works to improve its online conversion and introduces new and innovative products to its consumers.  In spite of recent weakness, KORS continues to gain share in North America as regional sales as a whole grew in high single digit rate in its FY1Q.  Longer term, KORS believes they can improve revenue an additional 30% to $4.5 billion, up from $3.4 billion at the end of FY 2015 by growing retail through ecommerce and square footage growth, grow wholesale through accessories and finally through other adjacent categories which are gaining traction now including footwear, women’s sportswear and in men’s wear. 

Retail Business

KORS has grown its store base significantly over the last few years, benefiting from Coach’s earlier efforts in creating a category and changing customers’ behaviors while helping to create the habit of buying multiple handbags/accessories per year.  That change in consumer behavior is well established at this point and, after over a decade with Coach, many customers seeking an aspirational luxury brand are looking for something different and have come to KORS.   Kors branded stores allow it to more fully showcase its products, which is important in conveying Kors’ aspirational and jet set brand message to its customers.  Retail is about 50% of KORS total revenue and is expected to grow to 60%.  As KORS reaches 400 locations (373 by the end of FY 16), it is refocusing its initiatives on driving productivity (versus over expanding like rival Coach) and converting consumers via its ecommerce channel.  While same-store sales have weakened and decelerated in the last 12 months, it is a function of declining mall traffic overall and a move towards lower priced cross body and small handbags which lower average ticket. As ecommerce becomes an increasing portion of consumers’ shopping habits, KORS’ omnichannel experience will allow customers to shop whenever and wherever they want. Comps will improve as online sales become part of the base.  In the most recent quarter, comps would have increased by approximately 300-400bps and that could be a catalyst for the stock when they report their comp including online sales in Fiscal Q3 2015.

Wholesales Business

To further increase its wholesale productivity, KORS has converted over 1,800 wholesale doors (out of its over 2,300) into shop n’ shops with plans to convert an additional 500 locations by the end of FY 2016. The creation of shop n’ shops is very accretive to KORS as these locations triple their sales/productivity after the remodel versus a regular department store.  We believe that an average wholesale location has approximately $200,000 in sales.  After a shop n’ shop is developed, that revenue is tripled to $600,000 or $45 million in annual incremental revenue – a huge boost to both KORS and the department store, so it’s a win for both parties. The shop n’ shops, similar to retail stores, provide an opportunity for KORS to better showcase its brand and products, which consumers continue to respond to favorably.  Department stores, particularly Macy’s and Nordstrom’s, where KORS has a strong presence, are extremely careful about which brands are marketed/displayed or that develop a shop n’ shop. Most recently, wholesale growth has benefited by the growth in accessories, men’s wear and footwear, as well as the ready-to-wear category. 

Licensing

KORS licenses its brands for watches, fragrances, jewelry and eyewear and has grown double digits. Most recently licensing has declined as watches (via a partnership with Fossil) as the latest watch cycle reaches maturity.  While some argue that wearables have caused decline, management believes it is more likely due to the release of the iPhone 6 which millennials use to tell time vs watches.  Going forward, KORS is focused on innovation and adding technology to its own watches which will be ready for next year.  We think that an introduction of a fashionable smartwatch could be a catalyst to revamp this business.  Interestingly, the weakness has only been in North America while international markets are still strong.  In FY2016, the licensing segment should continue to expand due to strong sales in fragrances and eyewear from strong customer response and increased distributions. 

Europe

Internationally, KORS also has a huge runway in which to grow its store base and wholesale penetration.  The growth of KORS’ footprint internationally is key to the long term story of the brand.  At over $800 million in revenue (up more than 8x since KORS went public)), we believe revenue will grow an additional 65% to at least $1.5 billion.  Currently there are 133 stores in Europe with the goal of reaching 200 locations by FY 2017.  Europe, a $6 billion market, continues to grow rapidly and remain very productive with strong double-digit same-store sales gains (in the mid-20s).  Wholesale penetration and the conversion to shop n’ shops is growing quickly with a 100 new shop n’ shops in 2016. Licensing has grown quickly up to $72 million in revenue up from $23 million in FY 2014, boosting operating margins in the region.  Learning from its North American experience, KORS is focused on gaining the omnichannel consumer, who tends to shop more frequently and spends more per visit, and will launch ecommerce sites in 18 countries in FY 2017.  This will be a huge opportunity for KORS to introduce the brand aesthetic to customers where it will not have a retail or wholesale location and capitalize on rising trend in mobile and online shopping.

Asia-Pacific

The growth of KORS’ footprint internationally is key to the long term story of the brand and Asia-Pacific will be the largest source of that growth.  We believe the Asian accessories market, including Japan, is over $12 billion with men’s and women’s accessories split fairly equally. Same-store sales have been extremely strong in the region with a majority of the growth currently coming from Japan.  Asia has been growing at 61% CAGR with revenue of $68 million in 2015.  The longer term opportunity is over 5x ($500 million) with about 60% from Japan, 20% each from Korea and wholesale sales.  There were 50 company owned stores in Asia in FY 2015  but can grow over three times to 175 with 100 stores in Japan (up from 60 at the end of FY 2016) and 75 locations in Korea.  This estimation does not include any other licensees that KORS may bring in house. 

Licensing is a major opportunity for KORS, particularly in China.  Coach believes that China alone could be a market as large as North America for handbags and accessories.   Other retailers have also stated that the number of concessions could be in the thousands. Retailers tend to be able to charge a significant mark-up on their products boosting their segment margins and overall company margins.  KORS should be able to do the same which would further push up its operating margins in the long term.  KORS is adding approximately 200 licensed stores in the region in FY 2016.    Longer term as the brand becomes better known, the impact of having a strong presence in China will resonate throughout other regions, such as Europe, as Chinese out-bound tourism returns to levels seen in recent years. 

·         Ecommerce Channel Is An Opportunity

Given KORS’ growing brand recognition, the online business has significant potential from a revenue and margin perspective, as well as a marketing tool as well as it is another platform to show nature of the brand and the depth of product.  The brand is already one of the most searched for luxury brands and having a more user friendly ecommerce site should increase the brand’s online stickiness.  According to American Express Business Insights, “The new focus on full-priced online fashion shows that giving consumers a taste of luxury will undoubtedly help build brand loyalty over time,” [and] “With Gen Y leading the way -- and even Seniors’ growing interest in flash sales -- online retail is certainly becoming a critical touch point for customer acquisition.”  Longer term, KORS expects 20% of sales to come via its online channels.

Digital Flagship and Kors Concierge

Digital flagship is KORS strategy to capitalize on the secular shift away from retail only shopping. As more and more purchases begin at home via internet or mobile, it is imperative that the shopping and consume experience for a KORS consumers begins there.  To further optimize the consumer experience, KORS is introducing Kors Concierge, which should boost same-store sales over time as more in-store customers are converted into sales. Through Kors Concierge sales associates will be able to enable mobile sales via iPhones or IPad which will further leverage KORS entire inventory (versus what is just in the store) and will lessen lost sales (if a particular style or color is physically out of stock). Even better, customers will have access to KORS’ full product line in the store, as currently only 40-50% of the assortment fit in the 2,500 square foot physical store    

Online Retail/Mobile Commerce Sees Significant Growth

In addition to marketing and brand presentation, KORS ecommerce site allows it to take advantage in the surge of retail spending online and via smartphones or mobile apps. KORS really missed out and was late to the online push because they really didn’t have control of their e-commerce platform, having only brought it in house in September 2014 (from Neiman Marcus).  It’s only single digit sales now but is growing rapidly and there is no reason why it couldn’t be 20-25% of sales over time.  They have since invested heavily in this channel and the 100% plus growth last quarter shows that they may have been at a disadvantage for not having such a robust platform that is a necessity for their consumers’ preference.

·         Serving Under Penetrated White Space in Market from $400 to Ultra Luxury Pricepoints

As an aspirational luxury brand, KORS is accessible to customers on the lower end trading up while also filling a niche or white space between accessible luxury and ultra-luxury, where price points are often multiple thousands ($2000-$3000+ per handbag.)  Coach has continued to see improvements in its sales in the over $400 category as it looked to fill the void between aspirational luxury and the ultra-high end. After the last decade, with consumers focused on newness and innovation, there is a great opportunity to for KORS to play in that $400-$1000 category. 

·         Development of Men’s – an upside optionality

We believe KORS has significant store growth potential globally as current estimates do not include the development and growth of the men’s concept.  Men’s could add at least another 500 stores, either freestanding or annexed to existing locations according to management.  Men’s could also increase penetration in KORS’ over 2,000 wholesale doors, which would further boost brand awareness and traffic.  Ultimately, the management believes the business could be $ 1 billion in revenues driven by accessories, men’s leather and sportswear. 

Risks:

o    Continued deceleration of growth in the handbag and accessories category

o    Current macro-economic conditions, particularly in Asia/China, and any general negative news about consumer discretionary spending, could weigh heavily on the share price.

Catalyst

o    Improvement in comparable store sales, particularly in North America

o    Improving GDP and consumer spending in China

o    Growth of the men’s concept and other licensed categories