With KORS announcing that insiders are selling $1.24bn in stock in a secondary after a meteoric 148% rise in 3 months since the IPO, we’d like to shed some light into what you’re buying from management.
First off, we can argue all day that KORS is expensive. In looking at earnings and cash flow, there’s no way to justify where it trades. But great brands with incredible earnings momentum and conservative expectations will always look expensive. We have about another three quarters where yy compares will make fighting the tape a difficult battle for anyone on the short side here. But for anyone really buying it here, take a look at relative value. The comparisons are clearly out of whack to us.
With an Enterprise Value of $9.4bn, KORS compares to…
1) COH at 21.2bn (44% of COH Value, with 16% of its’ cash flow)
2) Both LIZ and VRA at about $1.5Bn respectively
3) TIF’s $9.1bn (KORS is 3.3% ABOVE TIF EV!)
4) UA at $4.8bn (UA offers better long term growth with less competition and lower risk)
5) LULU at $10.1bn (I view this almost identical to UA in many ways. All Blue Sky here. UA looks better to me at this value dispersion)
6) RL at $15.4bn. You believe that KORS is at 61% of RL’s EV? C’mon…
In an effort to shine some light on the composition of KORS’ runway, here is a look at how we see the KORS story playing out over the next few years:
We see KORS growing revenues at a 28% CAGR over the next three years as the company shifts its mix increasingly towards retail distribution and into the Handbags/Accessories category (see tables below). With the company still in the early stage of growing its store base at 231 currently and plans for 600+, retail will be the key driver of growth in addition to multiple drivers within each channel of distribution.
The key to our expectation for a 36% CAGR over the next three years in retail revenues is predicated primarily on new store growth as well as increased productivity from both product expansion and extensions as well as a favorable tailwind from KORS’ store maturity/productivity curve.
- Compared to other high growth concepts and established luxury apparel brands, at $1,280 per sq. ft. KORS already ranks among the most productive brands.
- In looking at KORS’ long-term store growth targets, there are a few important considerations. First, the number of mall/lifestyle center locations available, and second, the COH roadmap.
- There are nearly 1,300 U.S. malls and lifestyle centers over half of which are considered A or B locations. In addition to these 600+ mall/lifestyle locations, there are plenty of free standing stores available as well. After 15+ years, COH is up to 488 stores in the U.S.
- As part of their long-term planning, KORS has targeted 400 stores domestically just over 2x its current base of 188. Our sense is that KORS has no business being in a ‘B Mall’. So we think that their 400 US store target sounds about right. Keep in mind that existing stores are on ‘Main and Main’. Translation – as it relates to new store productivity, we’re inclined to think that this number trends down, not up. This is not to say that incremental dollars, ,or comps, will come down. But very simply that there will be a shift on the margin to a less productive asset. As long as the rent per sq/ft is in check, we’re ok with that.
- Take a look at the store growth trajectory for KORS in conjunction with COH’s own store historical store growth footprint. Combined with the store productivity charts below, one can see the acceleration in store growth, and category expansion coupled with higher priced product that drove a 6-year period of 20% revenue growth from 2003 to 2008.
- Given the breadth of product assortment not only in accessories (e.g. handbags, small leather goods, watches, jewelry, etc.), but also apparel, in addition to its smaller store format (KORS at ~2,000 sq. ft. vs. COH at ~2,500 in Year4) we think KORS can ultimately achieve similar levels of productivity ASSUMING NO MEANINGFUL DEGRADATION IN STORE LOCATION PROFILE.
- We think this highlights the key issue with KORS. Category expansion will likely get it the comp it needs. New stores will get the growth – optically – that it needs. But does channel fill related to less desirable locations ultimately take down aggregate sales/square foot at a rate faster than its lease agreements allow it to lower costs? We have to wait a year – at a minimum – to find out. But this is very key.
- Our model has KORS coming in over $1,350 in sales per sq. ft. in F12 reflecting an accelerated path compared to COH at this stage due to its aggressive product expansion strategy early on, which played out for COH years later
- In addition to square footage growth another key consideration is the store maturity curve, which is at an inflection point and will provide a multi-year tailwind to store productivity. Aside from a modest store base, the incremental store growth over the last two years will result in an acceleration in the maturity curve as illustrated in the chart below.
- Based on typical industry peak productivity timelines, we assume that the average KORS’ store reaches maturity in its third year of operation after which it becomes mature.
- Assuming new store productivity at its current rate of approximately 80% in Year1, 90% in Year2, and 95% in Year3, the base of mature stores operating at 100% productivity will increase from 32% in F12 to 59% in F15. This will result in a blended productivity rate of increase from 90% to 95% over that timeframe.
- All in we’re looking at a 36% CAGR over the next three years in retail revenues driven by new store growth, increased productivity from both product expansion and extensions as well as a favorable tailwind from KORS’ store maturity/productivity curve.
At 46% of total sales, the wholesale channel is still a sizeable business for KORS. While we think retail will account for the majority of incremental revenue growth (65%-75%) over the next three years as noted in the table above, we expect wholesale to account for a meaningful 25%-30%. Our revenue contribution from this channel is driven primarily by new door growth and conversions. Consider the following:
New Wholesale Door Growth:
- Over the last three years, wholesale door growth has averaged 345 per year ranging from 287 to 432.
- We expect incremental annual door growth over the next three years to be in the range of 275-325 driven primarily through international expansion (2/3) as well as domestic additions (1/3).
- As such, We think KORS can double its European store base over the next 2-3 years growing to over 1,000 doors.
- We assume domestic doors will operate at a productivity level similar to new conversions (~$500k/yr) and international doors to operate at a rate of ~$150/yr. This lower rate of productivity is due in part to more limited category representation in many of these new locations which include specialty shops that typically carry only KORS’ ready-to-wear apparel for example instead of accounts/doors that carry apparel and accessories.
- This would suggest a global wholesale door count of 3,250 by F15. As a point of reference, Ralph Lauren sells through nearly 10,000 wholesale points of distribution domestically and in Europe combined suggesting substantial opportunity for further growth.
- We estimate that new wholesale door growth will account for 7%-12% growth in the wholesale business and 5-7% of incremental growth in total revenues.
- There are approximately 1,800 doors in North America, roughly 1,000 of which are conversion targets. With ~250 conversions already completed there is an opportunity for at least another 750 wholesale door conversions.
- The productivity of wholesale doors that are converted typically run 3x pre-conversion sales levels. With wholesale door productivity running at ~$200k annually in 2010, we assume new conversions are generating close to $600k per door.
- Despite a target of at least 100 conversions per year, we expect that figure to be considerably higher and are assuming 150 conversions per year over the next three years - a rate that is likely to decelerate thereafter.
- We estimate that wholesale conversions alone will account for 6%-10% growth in the wholesale business and 3-5% of incremental growth in total revenues.
- Another thing to keep in mind is KORS’ e-commerce business, which is currently operated in partnership with Neiman Marcus and accounted for as wholesale sales. KORS sells product to Neiman’s at wholesale, which is in turn sold through michaelkors.com.
- The company has been taking steps to bring the e-commerce business in-house. We estimate that KORS online sales are $30-$40mm at retail accounting for $15-$20mm in wholesale revenues. This implies e-commerce accounts for ~2.5% total revenues (at retail) slightly below where COH’s e-commerce business stands currently.
- When the company brings this business in-house it will shift revenues from wholesale to retail, but improve profitability as well. While we do not have the exact timing of this eventuality accounted for in our model, we will adjust our numbers accordingly when this change is made.
Licensing accounts for only ~5% of KORS revenues, but ~17% of F12 EBIT. While not a key revenue driver, KORS has multiple avenues with which to grow its licensing business.
- In conjunction with Fossil, watches is KORS’ most significant licensing business currently at approximately $300 in revenues at retail.
- The other licensees of note are Estee Lauder for fragrance and Marchon for eyewear both of which are more modest businesses.
- Fossil is also the exclusive licensee of KORS’ fashion jewelry line, which is the business with greatest upside potential in our view aside from watches. We think this could be another $300mm+ business for Fossil at retail.
- We think the long-term opportunity for these four businesses could reach over $1Bn in retail revenues equating to $180mm+ in revenues for KORS. Assuming consistent ~60% profit margins, the license business alone could account for over $0.30 in earnings, or over $8/share in value over time.
- The shift towards retail as a percent of total distribution will be a natural tailwind for gross margins over the next 3-5 years at a minimum. Here is a look at the magnitude of this tailwind assuming constant margins for retail and wholesale isolating the mix shift.
- Sales growth outpacing inventory growth this past quarter is gross margin bullish despite what appears to be management conservatism in looking out to next quarter. We are modeling margin expansion to continue next quarter (+100bps) and for the next three years up +98bps in F13, +75bps in F14, and +50bps in F15 driven largely by this significant mix shift tailwind.
- We expect SG&A growth to remain at accelerated levels relative to revenue growth over the next three quarters due primarily to growing corporate costs including added headcount to build out an e-commerce team, higher rent expense related to store expansion, wholesale conversion costs, new warehouse management system expenses, and increased international marketing to raise brand awareness.
- We expect one of the more variable pieces of SG&A spend over the next two years will be international marketing spend in an effort to raise brand awareness. As noted on the latest earning call, sales hit an inflection point when brand awareness broke through 50%-60% domestically. In Europe, KORS brand awareness currently stands at ~35%. We think the company will invest aggressively to grow awareness overseas.
- As higher productivity rates and new store growth continues to leverage KORS’ existing infrastructure, we expect the company to realize SG&A leverage in the 2H driving modest leverage in F13 as well as the following two years.
With gross margin expansion and SG&A leverage, we expect KORS to expand EBIT margins by 4pts over the next three years from 17% currently to over 21% by F15 resulting in 30%-50% earnings growth during that timeframe. We are modeling EPS of $1.01 for F13, $1.37 for F14, and $1.77 for F15.
Free Cash Flow:
Capital spending is higher in F12 at ~9% of sales relative to a more normalized range of 6.5%-7.5% in recent years to support the transition of a new warehouse and related equipment, store growth, and additional investment in IT infrastructure. As a result, we expect FCF to be ~$25mm in F12. We expect additional capital spending related to the new warehouse and international corporate infrastructure to keep F13 CapEx elevated (~8% of sales) as well before returning to a more historical rate thereafter. As a result, we expect KORS’ FCF yield to rebound to 5% in F13, 6.5% in F14, and over 8% in F15.