Description

Tapestry Inc (TPR) is a clothing and accessories design company with a portfolio of brands including Coach, Kate Spade, and Stuart Weitzman. The company’s current CEO executed a highly successful turnaround of its main brand Coach over the last few years. The company’s high cash generation and unleveraged balance sheet have allowed it to repurchase $2 billion of stock over the last 7 quarters, equivalent to 25% of the current market cap (up until the announcement of the acquisition of Capri Holdings (CPRI)). In addition, the company pays a ~4% dividend. 

Last August, on the back of the announcement that TPR was acquiring Capri Holdings (CPRI) for $57 per share, the stock fell ~20% in the days following the announcement before ultimately bottoming down ~37% at around $26 per share. While I believe this to be a very good deal for TPR both financially and strategically, Tapestry stock fell hard on the back of an optically high price (60% premium to the 30-day average price of Capri), suspension of the Tapestry share repurchase program and the concern over the financial leverage taken on by TPR to complete the acquisition. 

The drop in the TPR share price effectively wiped out most of the premium paid for Capri, given TPR's significantly larger equity market capitalization. In addition to being significantly accretive to earnings, I believe the acquisition will eventually drive a higher multiple for TPR with a more diversified, higher multiple set of brands in its portfolio. Furthermore, I believe the $200 million in announced cost synergies, while significant, substantially understates the potential and will be only a part of the ultimate synergies of this deal, as TPR’s successful experience turning around Coach, will help fix the issues plaguing Michael Kors. 

Beyond streamlining distribution, the combination will also improve the pricing structure in the accessories market, as the two leading affordable luxury accessories brands will be under the same umbrella post-closing. If the valuation multiple continues at these depressed levels post-closing, TPR could always sell Versace or Jimmy Choo and do a massive incremental share repurchase, given their significantly higher multiples. Luxury fashion houses like Versace often trade for 15-20x EBITDA. Last year, luxury stalwart, Kering, announced a non-control, 30% investment in luxury fashion house Valentino for ~16x EBITDA.

I view the bearish concerns regarding leverage as less concerning over the medium term. The leverage at about 3.6x net debt / EBITDA on a pro forma basis is manageable. Both TPR and CPRI are very cash generative with combined unleveraged free cash flow generation of $2 billion per year. While there is always a risk of consumption slowing down and hurting earnings, both companies will benefit significantly from the nascent recovery of travel in Asia, as the rolling lockdowns in Asia hurt earnings meaningfully over the last two years for both companies. Earnings power for the combined entity should be over $7.75 per share, and the company’s leverage should be below 2.5x within two years of closing. With a portfolio of brands offering better growth, more upside to margins, and more diversification than peers like Ralph Lauren and Abercrombie and Fitch, I believe a 15x cash EPS multiple to be quite reasonable. This implies a TPR stock price of $116.25. or 2.9x the current price. This multiple does not even consider the structurally higher multiple nature of its true luxury brands, Versace and Jimmy Choo.  While we wait for this to play out, I am happy to collect the ~4% dividend.

Risks

Regulatory Hurdles

Regulatory risk concerns have been raised by investors and analysts alike, particularly in the US where a combined Coach, Michael Kors, and Kate Spade would be a top player in accessible luxury handbags. However, according to Euromonitor data for the Handbag category, one can see that combined, Tapestry and Capri would hold ~24% of the US market – placing the combined companies in the top spot, but not excessively far from LVMH (~19%) and Kering (~17%). And on a global basis, The Tapestry/Capri combination would place its market share at ~9%, well below #1 LVMH (~16%) and #2 Kering (~11%).

As China’s State Administration for Market Regulation recently approved the deal, I expect that the FTC will likely conclude its in-depth review and approve the merger in Q1 of this year. Last November nearly three months after the announcement of the CPRI acquisition, the FTC notified both TPR an CPRI that they would be requiring a secondary review extending the HSR (Hart-Scott-Rodino) for 30 days after the companies have complied with the request. So, this is a binary outcome and I assert a very low-risk outcome for TPR holders.

FTC Does Not Approve 

If the FTC fails to approve the deal, TPR should gap up substantially higher (while CPRI likely falls quite a bit). Investors hated this deal from the start as can be seen by the beating TPR stock took falling from announcement to bottoming nearly 37% lower. This market reaction was consistently and uniformly described as due to the leverage the TPR would be undertaking. I have written about CPRI in the past, and my belief that the stock was undervalued and the TPR acquisition terms made sense and were a good deal for TPR shareholders as TPR would not only acquire Michael Kors which fits well with TPR brands but also two iconic luxury brands that could be further developed or potentially sold. Nevertheless, for investors who might have been concerned about TPR either being over-leveraged or paying excessively for CPRI (I do not share this view), then I believe a significant relief rally would ensue propelling TPR much higher. Without CPRI, the original investment thesis for investors would be back in place with a cheap, no debt company growing nicely and likely to begin buying back stock. 

FTC Does Approve

Assuming the FTC approves the transaction, I believe TPR management will be under extreme pressure from the board to demonstrate to shareholders that the deal was strategically important and a wise decision to make. If the TPR stock price recovers and investors return to the combined entity, I believe TPR will quickly pay down debt faster than analysts are assuming, and this will provide investors with increased confidence that TPR can pull off this merger. If the market fails to respond by rewarding TPR with a higher stock price, I think it is likely TPR would move quickly to sell Versace and Jimmy Choo, and there would be no shortage of interest in these iconic luxury brands. With the likely proceeds from separating true luxury brands from the affordable luxury brands, investors would likely applaud such a move, as TPR then could deleverage and resume a new stock repurchase program with the proceeds from such a sale.

Percentage Return for TPR and Various Comps a Day Prior to Acquisition Announcement

Catalyst

• FTC approves the acquisition of CPRI
• FTC denies the acquisition of CPRI
• Closing the CPRI acquisition
• Investors grow more comfortable with this combination
• Potential Sale of true luxury portfolio brands of Versace and Jimmy Choo following the close of the acquisition if the stock price does not respond well