Tuesday, 7 February 2017

Michael Kors is out of fashion


I recently initiated a 20bp position in Michael Kors (KORS US @ $41.09) – the global luxury goods company run (Chief Creative Director) by its eponymous founder. My entire research process took less than an hour, and illustrates nicely one of the investment philosophies I have developed over the years – that more information does not necessarily lead to better decisions or better investment outcomes. One doesn’t have to know everything or even a lot to make money in markets in my view – only what is important. Indeed, it is arguable that being able to block out irrelevant noise is equally essential.

First things first – KORS screens very well using Joel Greenblatt’s ‘magic formula’ – the stock is trading on a 9x trailing PE ratio, and generates an extremely high ROE of approximately 40-50%. Indeed, the stock screens in the top 5% of companies in the S&P500 on this measure. Greenblatt has argued that a mechanical quantitative approach to buying stocks that screen well on these two combined metrics – using earnings yield as a proxy for ‘cheapness’, and ROE as a proxy for ‘quality’ – has historically trounced the market. It is always comforting to know, when selecting your preferred bottom up picks, that you are selecting from a pool of potential opportunities where the odds are likely skewed in your favour. That certainly does not guarantee a good outcome, but it does increase the probability of one materially.

Secondly, the basic story here is pretty simple. Going back 2-5 years, KORS was growing sales and earnings very rapidly. EPS went from 78c in 2012 (diluted) to 197c in 2013, and then 322c in 2014. The market likes fast growing companies, and at the time, also liked luxury goods companies. Emerging markets were growing fast, and luxury goods companies were prospering. The stock 4-bagged during 2012-14, reaching almost $100 a share and 40x trailing earnings.

Alas, as is often the case in markets, the future proved much less predictable than those paying 40x felt it was back in 2013, and during 2015-16, grow slowed, first to 428c in 2015, and then to 444c in 2016. Sales have started to comp negatively (mid single digit declines this year), and after reduced guidance following KORS's first-half result late last year, EPS is currently expected to come in in the 400-450c range in fiscal 2017 (and the stock could well be cum downgrade).

The USD has strengthened, impacting translated offshore revenue and reducing inbound US tourism. Emerging markets have sharply slowed, impacting formerly rapidly-growing demand for luxury goods from Moscow to Sao Paulo. And conventional retail – particularly department stores, in which KORS have many concessionary stores – have been experiencing declining footfall. There is no visibility on how long sales will keep comping down and how severely. The stock has accordingly tanked 60% and now trades at about $41, or 9x trailing earnings, and is currently sitting right on its 52-week lows.

So why do I like it after less than one hour’s research? Several reasons. Firstly, the stock is now very cheap, trading at only slightly more than 5x EBITDA (KORS’s market cap is US$6.7bn, and its net debt of US$200m is very modest). This is very cheap for a capital-light, highly cash generative business. Indeed, even in its somewhat deflated state, the company remains a FCF machine, and the company is using a relatively high proportion of that FCF to buy back stock.

Secondly, I have no visibility or view on when sales bottom (or if they bottom), but I don’t think I need one, because nobody else appears to have such visibility either, and the answer may well be unknowable. Investors nevertheless feel as sure now that sales will keep dropping as they felt a few years back that sales and earnings would surely continue to grow rapidly well into the indefinite future.

If sales and earnings were showing a positive delta of say 10% and were expected to continue to do so, it is very likely this stock would trade at 15-20x earnings. Instead, because the recent delta has been negative and is expected to remain as such, the stock trades at 9x. This offers a margin of safety, because it means earnings can halve from current levels, and if trends then turn positive (or are expected to turn positive), the stock would likely trade at about current levels (although no doubt, the stock would have traded lower in the interim).

Will earnings halve (or worse?) from here. I have no idea. But neither does the market. It is unlikely months of research would shed much light on this issue, because the future is very hard to predict. If there were existing signs of improvement out there to be discovered, we would likely already be seeing some evidence of it in KORS’s stock price (we aren’t). The market is already assuming things remain very tough for an indefinite period, and that is all I really feel I need to know at this point to take a small position. Because the future is less predictable than people think, and because investors already have very low expectations, they are probably being too pessimistic on a probability-weighted adjusted basis.

It will be interesting to see how this investment goes. As noted, it is a small position (20bp). I like taking small positions in stocks like this where I have no particular reason to have any conviction that this particular name will do well; I merely have conviction that the average stock in KORS’s present circumstances is likely to be an attractive risk/reward proposition. A small position size also offers flexibility to average down if the stock gets materially cheaper.


LT3000

5 comments:

  1. You know your projects stand out of the herd. There is something special about them. It seems to me all of them are really brilliant!
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  2. This reminds me of LPPF in Indonesia. Low P/E + superb ROE + net cash position + ~4% dividend yield at current price.

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    1. Hi there. I'm not sure I entirely agree. I've looked at LPPF several times & have met the company. Although it has derated 50% it still does not look that cheap to me.

      It still trades at 15x PE, and more importantly, that is based on operating margins that are significantly above what are likely sustainable long term (low-mid teens operating margins on grossed up sales). Department stores globally usually do closer to mid-single-digits, and that number is falling. If you normalise margins to mid-high single digits, the stock is still on 30x earnings.

      Department stores are also amongst the most challenged retail formats globally. While it will take a lot longer for the full force of the e-commerce threat to be felt in a market like Indonesia, it will eventually happen, and the de-rating that has hit the sector globally will likely eventually hit LPPF as well.

      MLPL is a much cheaper way to play it, although it comes attached with some of the governance issues associated with that counter. I have a small position in MLPL.

      Best,
      Lyall

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  3. Wondering if you have looked at BBBY for reasons quite similar to the above - share price in the doldrums, margins compressed, amazon threat etc but trades near 52 week low at 7x p/e, 3% dividend yield with significant share buyback in place?

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    1. Hi Pete,

      Yes indeed - I happen to own BBBY as part of a small basket of depressed retailers I purchased late last year, when negative sector sentiment appeared to have reached extreme levels. My average entry on BBBY is about US$23 and so far it's been my least successful retail investment. I also bought DKS at $25, FL at $30, and TRS AU at $4, and KR at $21, and have done much better out of these (I sold TRS at $6.60 and KR at $28). I also recently purchased some MHJ AU at $1.10 also.

      However, I don't hold BBBY with any degree of conviction. They have an uphill battle ahead & Amazon is a formidable competitor. But BBBY is exactly the type of value stock that on average tends to do well due to the asymmetry involved if the consensus proves wrong (compare how BBY has done - everyone thought they were going broke 5yrs ago also and the stock has multi-bagged).

      Part of my thesis for owning BBBY is (1) the purchaser is not always the income earner (e.g. wives spending hubby's cash while shopping); (2) a segment of the retail market is likely to continue to like to go (experiental dimension) out and inspect products in person; (3) will benefit from reduced competition and 'last-man-standing' effect, as well as reduced rentals over time; (4) will likely migrate more to proprietary merchandise with omni-capabilities; (5) margins already depressed on account of ramping up e-commerce sales (approaching 10% of total sales I believe).

      BBBY online sales are already has some 50% of Wayfair's total sales if memory serves, and yet BBBY gets punished because its ecommerce sales lose money, while Wayfair's share price sores because people don't care about losses for pureplay tech companies - only revenue growth. It's a double standard that is creating an opportunity IMO.

      I have about a 20-30bp position in BBBY and continue to monitor it.

      Cheers,
      Lyall

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