“Risk appears to be at its greatest when measures of it are at its lowest.”
Keith and I have been on the road meeting with subscribers this week and spent the first part of the week in Winnipeg, so it seemed appropriate to start the Early Look this morning with a quote from Mark Carney, the current Governor of the Bank of Canada.
Setting aside the fact that Carney played hockey at Harvard, which raises some character questions in our minds, he has had a respectable tenure as the Governor of the Bank of Canada. In fact, even though we at times question too much government involvement, his actions are rightfully credited for getting the Canadian economy back to normal levels of output and employment quicker than the G-7 following the 2008 meltdown.
Personally, after reading the above quote from Carney, I was almost ready to forgive him for wearing the crimson colors of Harvard. To me that quote shows perhaps the most appropriate understanding of risk, which is that risk in the market is greatest when we least expect it. For us, a key measure of risk is volatility. As it relates to equities, a key measure of this is the VIX, or volatility index of the SP500.
Like much of modern risk management, the VIX is a relatively new creation. In fact, it was developed by Professor Robert Whaley in 1993 (courtesy of Wikipedia). The VIX is a weighted blend for a range of options on the SP500. More specifically, the VIX is the square root of the par variance swap rate for a 30-day term initiated on the current day. So, in layman’s terms, it is the expected movement of the SP500 over the next thirty days on an annualized basis.
As an example if the VIX is at 15, the expected return for the next twelve months is 15%. Over the next thirty days, the range of return is calculated by dividing the VIX by the square root of 12. Therefore with the VIX at 15%, there is 68% likelihood, or one standard deviation, that the SP500’s move, up or down over the next thirty days, will be 4.3%, or less.
In the Chart of the Day, we show the chart of the VIX going back five years. The takeaway of this chart, a point we have been hammering home as of late, is that when the VIX reaches levels around 15, it has been a contrarian signal to shift out of risk assets. In the course of the last two years, this signal has been reached three times – April 2010, May / June 2011, and now. (Incidentally, we are long the VIX, via the etf VXX, in our Virtual Portfolio.)
In our meetings with subscribers, the push back we often receive on the VIX discussion is that in the 2003 – 2007 period, or thereabouts, the VIX reached lower levels and stayed at these levels for sustained periods, which buoyed equity market returns. So, what’s different this time?
This is certainly a fair question. Our retort is that the economy itself is more volatile than it was in that period. This is due to the active management of the economy by Keynesian central planners, but also accelerating debt burdens of the economy. Think of the economy like a highly levered company, with more debt on the balance sheet a company’s earnings become much more volatile, so equity returns are inherently more volatile. (Not to mention, the “awash with liquidity” period of 2003 – 2007 was far from normal.)
In part, this is why we are long Canada in the Virtual Portfolio via the etf EWC and, if you think about, long Mark Carney policy. Canada’s debt-to-GDP is 83% (per the CIA Factbook), which while higher than we would like, is below the critical 90% bound which historically leads to slowing economic growth, and less than the United States’ ratio that is north of 100%. In Canada, the deficit is actually now in decline, which will lead to lower debt-to-GDP ratios in the future. This compares to the United States, which had the largest monthly deficit of any nation in history in February.
Another key discussion or debate point in our recent meetings with subscribers has been the outlook for economic growth, both in the United States and abroad. As we’ve stated repeatedly, we expect lower growth than many Wall Street 1.0 prognosticators. This is primarily driven by the math of our predictive algorithms and further supported by incremental data points.
For us, the price of oil is a critical data point when contemplating economic growth. As I wrote two weeks ago:
“Charles Hall, Steven Balogh, and David Murphy did an analysis of the connection between the price of oil and when recession can be expected, examining the Minimum Energy Return on Investment (EROI). In their assessment, recession is likely to occur when oil amounts to more than 5.5% of GDP. Logically, this makes sense. Even based on the very tainted calculation of CPI, the average U.S. consumer spends 9% of his or her income directly on energy, with the majority allocated to gasoline. This obviously also excludes the derivative impact of increasing energy costs, such, as we noted above, the increasing costs of food.”
Incidentally, Brent oil at $116 per barrel is equivalent to 5.5% of U.S. GDP based on current usage patterns. Brent is trading at $124 per barrel this morning.
The most recent data point supporting lower global economic growth came from the mining giant BHP Billiton this morning who said they are seeing signs of “flattening” of iron ore demand from China. It seems when China tells you they are going to gear down economic growth, they actually will.
T.S. Eliot once wrote:
“Only those who will risk going too far can possibly find out how far one can go.”
From a personal perspective, I’d agree with Eliot, from a portfolio risk management perspective, not so much.
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1, $122.96-127.19, $79.33-79.88, and 1, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
The Macau Metro Monitor, March 20, 2012
LABOUR CHIEF REPLACEMENT MAY OPEN THE DOOR FOR IMPORTED WORKERS Macau Daily Times
The government announced the replacement of current Director of Labour Affairs Bureau (DSAL) Shuen Ka Hung, by Wong Chi Hong, the head of the Human Resources Office (GRH). Apparently Shuen’s performance fell short of the Chief Executive’s expectations, and the speculation is that there will be a change of labour policies to rely more on imported workers.
The Secretary for Economy and Finance, Tam Pak Yuen said it is the government's top priority to improve the quality of local workers to help resolve the bottleneck situation in Macau’s economic development.
OKADA'S ROOM GIFT NO CRIME: TRAVEL EXEC Macau Daily Times
In defense of Okada's room comps Robert Lim Joseph, the chairman emeritus of the Philippines’ National Association of Independent Travel Agencies (NAITAS) told reporters, “the hotel accommodations, even if they were first-class and other freebies are very common in the industry. Of course, when gaming officials go here, we also would give them the best. We will not place them in a cheap hotel. It would always be first-class accommodations.”
The Chairman saw no reason to charge with Pagcor chairman Cristino Naguiat of wrong doing since Okada’s gaming license had already been approved before Naguiat travelled to Macau. “So there’s more reason to dismiss allegations that Naguiat was bribed to allow Okada to operate his business in the country,” Joseph said.
PAC ON MAY HAVE 3 NEW ROUTES TO HK AND MAINLAND Macau Daily Times
Within 2 weeks, the Maritime Administration will decide whether to add new routes proposed in 3 applications for new ferry operations in Pac On Ferry Pier. The new routes would depart from Taipa, to Zhuhai’s Wanzai, Hong Kong’s Sheung Wan and Shenzhen’s Shekou. There are currently eight ferry routes that depart from Taipa’s Pac On temporary ferry terminal, to Hong Kong and nearby Mainland cities.
14.5% OF MACAU'S WORKING POPULATION WORKS IN GAMING SECTOR AT END OF 2011 Macau Hub
At December 31, 2011 there were over 50,000 Macau residents working in the gaming sector, representing a 12% increase QoQ, according to DSEC Manpower Survey released yesterday. Almost half of those employees - or 22k worked as croupiers, a figure that also rose 16.7% QoQ.
In December 2011 the average monthly salary for full-time workers (excluding bonuses and profit sharing) working in casinos was 16,720 patacas, (US$2,090), up 6.5% YoY, whilst that of croupiers was 14,700 patacas (US$1,837). In December there were more than 2,000 vacancies for casino positions of which 1,500 were for croupiers.
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This note was originally published at 8am on March 06, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“The human mind does not deal well with non-events.”
When you are me, analytical life can get lonely. Every single major Growth Slowing call I have made since 2007 has been met with doubt, denial, and disdain. But growth still slowed.
Whether I’m out for a run, on a plane, or in the shower, I’m constantly trying to re-think better ways to communicate our process. What is it that we do? How do we model our assumptions? What are the risk management signals?
Ultimately, I’ve come to the conclusion that I can always do better, but I can’t make it any more simple than stating it each and every day before it occurs. I’ll call this Risk Managing Non-Events.
Back to the Global Macro Grind…
What is a Non-Event? You can ask Dan Kahneman for his definition – mine is that Non-Events are constantly occurring and tipping the slopes and probabilities of events becoming obvious.
Got tipping points? Consider the following Growth Slowing Signals in our globally interconnected Macro Model from the last month:
- Basic Materials Stocks (XLB) stopped going up on February 3rd, 2011 (now down -3.1% from YTD top)
- India’s Stock Market (INP) stopped going up on February 21st, 2011 (now down -6.8% from YTD top)
- Small Cap Stocks (IWM) stopped going up on February 23rd, 2011 (now down -3.1% from YTD top)
Those are obviously just leading indicators from big, liquid, stock markets. All the while, Copper, 10-year US Treasury yields, and Global Yield Spreads continued to flag what they started flagging immediately after the Ben Bernanke’s January 25thPolicy To Inflate to 2014 – Growth Expectations started falling as Inflation Expectations started spiking.
Overlay immediate-term leading indicators (real-time market prices, yields, and spreads) with our long-term Fundamental Research View that:
A) Debt (when crossing 90% of GDP) structurally impairs long-term growth (Reinhart & Rogoff data supports this view)
B) Inflation, from a certain time/price level, slows real (inflation adjusted) growth
All the while, have a Keynesian economist promise you that they can centrally plan just the right amount of “inflation” for just the right amount of employment and economic growth.
And you have yourself an “event” (versus consensus expectations) in the making…
Non-events are the proverbial grains of sand falling on the pyramid of risk that is our globally interconnected Macro Model. One by one, price by price, data point by data point, they fall onto the sand-pile of expectations.
Then, one day… week… or month, they become “events.”
If the deep simplicity of Chaos Theory is this obvious, how do we almighty chosen ones from the Ivy League routinely get this wrong?
“A general limitation of the human mind is its imperfect ability to reconstruct past states of knowledge, or beliefs, that have changed.” –Daniel Kahneman (Thinking, Fast and Slow – page 202)
That’s why we have to humble ourselves and Embrace Uncertainty. The idea that going to Yale immunizes my mind from being human under pressure is as ridiculous as Bernanke not seeing inflation at $120 oil.
There may have been a day in this business, without internet connections or Twitter, that you could have legitimately had an information edge on a company and its implied valuation. A lot has changed since then. Today, my 4-year old son can pull up cash flow multiples with two clicks on Yahoo finance (provided that I give him the ticker!).
Risk Managing Non-Events is the next frontier of finance. Yes, it’s a lot harder to do than proclaiming our mystery of faith on the “right” earnings “multiple” for the SP500. That’s why we do it every morning. Risk never sleeps.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1691-1735, $121.12-123.98, $79.03-79.74, and 1356-1366, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP – March 20, 2012
As we look at today’s set up for the S&P 500, the range is 26 points or -1.76% downside to 1385 and 0.09% upside to 1411.
SECTOR AND GLOBAL PERFORMANCE
- ADVANCE/DECLINE LINE: 766 (1051)
- VOLUME: NYSE 721.40 (-56.23%)
- VIX: 15.04 3.94% YTD PERFORMANCE: -35.73%
- SPX PUT/CALL RATIO: 1.28 from 1.94 (-34.02%)
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: 39.74
- 3-MONTH T-BILL YIELD: 0.09%
- 10-Year: 2.34 from 2.38
- YIELD CURVE: 1.98 from 2.00
MACRO DATA POINTS (Bloomberg Estimates):
- 7:45am/8:55am: ICSC/Redbook weekly retail sales
- 8:30am: Housing Starts, Feb., est. 700k (prior 699k)
- 8:30am: Housing Starts (M/m), Feb., est. 0.1% (prior 1.5%)
- 8:30am: Building Permits, Feb., est. 686k (prior 682k (revised))
- 8:30am: Building Permits (M/m), Feb., est. 0.6% (prior 0.7%)
- 11:30am: U.S. to sell $40b 4-week bills
- 12:45pm: Bernanke lectures at George Washington U. (1 of 4)
- 4:30pm: API inventories
- 5:30pm: Fed’s Kocherlakota speaks in St. Louis, Missouri
- U.S. CFTC may vote on rule defining swap dealers under the Dodd-Frank Act, 9:30am
- President Barack Obama meets with Irish Prime Minister Enda Kenny, 10:10am
- FDIC board will meet to consider notices of proposed rulemaking on assessments for large banks and enforcement of subsidiary, affiliate contracts under FDIC receivership, 10am
- Republican primary in Illinois
- Deadline for presidential candidates, super-PACs to file updated finance reports with Federal Elections Commission
- Ron Paul to appear on Tonight Show with Jay Leno, 11:30pm
- House, Senate:
- Treasury Secretary Tim Geithner testifies to House Financial Services on global financial system, 10am
- Senate Environment and Public Works panel holds hearing on EPA’s mercury and air toxics standards for power plants, 10am
- House Oversight holds hearing on Energy Dept.’s stimulus spending, 10am
- Senate Banking holds hearing on Obama’s nominees to Federal Reserve’s Board of Governors, 10am
- House Armed Services Committee holds hearing on developments in Afghanistan, 10am
- House Appropriations subcommittee hears from Commerce Secretary John Bryson on the agency’s budget request, 10am
- Senate Commerce subcommittee holds hearing on commercial airline safety oversight, 2:45pm
WHAT TO WATCH:
- U.S. housing starts probably increased to 700k annual rate in Feb., a 3-mo. high, economists est.
- Senate Banking Committee to hold hearing on Fed nominations of Jeremy Stein, Jerome Powell
- Glencore said to near Viterra acquisition with Agrium, Richardson, deal may be announced within 24 hrs
- GE Capital’s Aa2 rating by Moody’s may be cut below its parent; both are under review
- Berkshire Hathaway directors, including Warren Buffett, won dismissal of shreholder claims over challenged stock trades by former Berkshire executive David Sokol
- Fed Chairman Ben Bernanke to give first of four lectures at George Washington School of Business
- Facebook CEO Mark Zuckerberg is said to take low profile in early IPO marketing
- CVC said to hire Goldman Sachs to explore a possible sale of a stake in Formula One in an IPO
- House Republicans will call for overhauling U.S. tax code by reducing rates, brackets
- China’s vehicle sales this yr may miss industry group’s growth forecast as economic conditions damp demand
- No IPOs scheduled
- JA Solar (JASO) 6:02am, $(0.63)
- Tiffany (TIF) 6:55am, $1.42
- DSW (DSW) 7:00am, $0.50
- Jefferies Group (JEF) 8:00am, $0.29
- Oracle (ORCL) 4:00pm, $0.56
- SAIC (SAI) 4:02pm, $0.33
- Jabil Circuit (JBL) 4:02pm, $0.58
- Cintas (CTAS) 4:07pm, $0.52
- Laredo Petroleum Holdings (LPI US) Post-Mkt, NA
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
GOLD – rising UST yields is bad for Gold on the margin. Period. Gold’s intermediate-term TREND line of $1691 remains broken as 10yr yields remain comfortably above my intermediate-term TREND line of 2.03%.
- Record Cotton Harvest Seen Cutting Prices for Gap: Commodities
- Copper Falls as Stockpiles Expand in China, Biggest Consumer
- Gold Declines on Concern Strengthening Economy Will Cut Demand
- Nickel-Ore, Bauxite Exports From Indonesia to Drop on Ban
- Oil Drops From Three-Week High on Speculation Supplies Rising
- Shipping Targets for Bears Dwindling After $99 Billion Plunge
- Corn Declines a Second Day on Early U.S. Planting, Wheat Slips
- Jewelers in India Extend Strike Seeking Withdrawal of Taxes
- Palm Oil Declines to One-Week Low on Soybean Planting Prospects
- India Seen Increasing Raw Sugar Exports Ahead of Brazil Harvest
- Ship Owners Losing After $11.4 Billion Battle for Boxes: Freight
- Australian State Says Uranium Prospects Attracting China, India
- Oil Supplies Climb to Six-Month High in Survey: Energy Markets
- China Increases Fuel Prices as Crude Gains
- China Steel Growth Has Flattened as Economy Shifts, BHP Says
- Less Grain Means More Gain as Export Prices Rise: BGOV Barometer
- Gold Stocks Due for Rebound Versus Metal Price: Chart of the Day
US Dollar – our intermediate-term TREND line of support of $79.33 is once again under assault by central planners who are absolutely hooked on the inflation policy born out of it (Obama’s % chance of winning the election just shot up to another new high of 60.5% in the Hedgeye Election Indicator (+200bps wk/wk) - stock market inflation is a big factor in our back-test).
CHINA – got Growth Slowing yet? Interestingly, but not surprisingly, the Hang Seng (-1.1%) snapped its immediate-term TRADE line of 21,255 overnight, joining India’s Sensex as the 2nd major Asian Equity market to break a significant line of momentum.
The Hedgeye Macro Team
KORS’ Q4 preannouncement after the close hardly came as a surprise. We expected another blowout quarter and so did the market as reflected in the stock. While consensus estimates were at $0.13 compared to revised guidance of $0.14-$0.16, the stock is not trading on what earnings will do this quarter, or the next, but what the real earnings power of this company is 2-3 years out.
We’re at $0.16 in our model for Q4, which could prove conservative. The key difference is our expectation for +100bps of gross margin expansion relative to Street estimates assuming -40bps of margin contraction. With sales outpacing inventory growth this past quarter in addition to an increasing shift towards retail, this is/was the biggest variable near-term and is likely to be the source of further upside in the quarter.
With the runway ahead including robust store growth, regional expansion, product extensions and expansion driving 20%+ revenue growth and 30%+ earnings growth, we think KORS could approach $2 in EPS over the next three years. As highlighted in our note “KORS Light” last Monday, we think a brand like this with incredible earnings momentum and conservative expectations is likely to look expensive for some time to come.
Below is our note from Monday (3/12) for further detail:
“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 229 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 $1,240 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 4-7% 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 +91bps 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.
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