On KORS’ last print we called it ‘the unshortable stock’ – something which still holds true. But the problem is that there are so many ‘knowns’ in support of owning KORS. We know that a) KORS is eating Coach’s lunch, b) every single part of the business is on fire – and that’s whether you look at product, channel, or geography, c) management completely sandbagged 4Q guidance. We’re got to think that much of this is embedded in the multiple. When so many things are going so well, we think that the better question to be asking is “what do you need to believe to be buying KORS now, and what could go wrong if you do?”.
What you need to believe today to buy KORS here.
1) That KORS can continue to grow its’ wholesale business at 30% or better for the next 2-3 years without margin degradation. With 15-20% growth in the US, we think the addition of Europe and Asia can make this happen.
2) Retail can get halfway to management’s goal of 75% of the total mix. In order for that to happen on top of 25% wholesale growth, our model suggests that we need to see about 175 stores added over 3-years – which we think is doable – on top of comps averaging in the 20% range (we’re at 25%, 15%, and 10%, respectively for FY2014, 2015 and 2016). That gets us to sales/square foot of $2,400 by the end of year 3 versus $1,730 today. That’s the higher end of what we think is reasonable.
3) With appropriate leverage on the top line growth numbers needed to hit these goals, we’re modeling margins between 31-32% (vs 27-28% today) over 3-years. Interesting in that this is precisely where Coach is today, and we think that in 3-years, Coach will be lucky to be where KORS is today.
4) An increasing proportion of profit will come from lower-tax jurisdictions, which will take the aggregate tax rate down by 100-150bp per year.
5) Starting in FY14 (i.e. in April) the company starts to use excess cash to buy back stock. In small amounts at first – about $100mm in year 1 – but ultimately building to $400mm by year 3 to prevent ROI from rolling over due to too much cash.
6) When all is said and done, you’re looking at a global luxury goods brand with EBIT margins on their way to 31% that turns its operating assets once a month (as opposed to industry norm of 3-4x per year) that should have earnings power approaching $5.00 in three years. Yes, the stock is on fire. But even on today’s pop a $63 stock on $5 in EPS power in 3-years is hardly excessive. Over a 2-year time period, giving even a 20x p/e we’re looking at a stock close to $100.
What could go wrong?
The obvious problem would be loss of brand momentum. Let’s look past that one for the sake of this exercise. If there is one thing KORS is doing it is spending money – and lots of it. The company will have added around $140mm in SG&A dollars and another $130mm in capex this year on top of a $1.3bn revenue base. We’re ok with that. Other factors that we need to watch…
1) ‘Ready-To-Wear’ Margins: The company highlighted on its call how well its women’s ready-to-wear apparel is performing and how the line will get greater real-estate in some of the company’s retail locations. With accessories now at 80% of the total business for KORS (vs 62% 2-years ago) it’s pretty safe to say that this shift is nearing its end. Initially RTW might be high margin, but the reality is that it is a business where there is a greater penalty for missing fashion trends, as excess inventory will need to be marked down greater than sunglasses, shoes, watches or eyewear.
2) Rent Expense: When the company is comping 41%, its ability to leverage occupancy expenses is seemingly irrelevant. But keep in mind that KORS has been employing one of the most aggressive real estate strategies to secure prime locations than any company we have seen in a very long time. It’s no secret that not only are these locations expensive, but the rent escalators work as a compliment to stated rent/square foot such that they allow a company to get into an expensive storefront today but pay for it tomorrow. It is not transparent yet how KORS is handling this. On a 41% comp – it does not matter. On a 20% comp it probably does not matter (at least, it has not in the past). On a 10% comp, we think it probably matters.
3) Licensing Looking Toppy: Licensing EBIT is about 14% of the company’s total. We’d be surprised if it grew much form there – kind of like we saw from Ralph Lauren over the past 8-years as it took control of its own distribution. Licenses like Watches will forever be outsourced, but on the margin the company will look to grow incrementally from within. This is not a risk, really, in that it will allow KORS to consolidate a greater portion of revenue, albeit at a margin less than the 64% is has today in Licensing. As long as it churns more EBIT through its P&L, we’re ok with it. But keep an eye on this.
KORS SIGMA: Margins Looking Solid. Keep An Eye On Inventories