Relax, Michael Kors' Margins Are Nothing to Worry About

Some investors and analysts believe that Michael Kors' fourth-quarter results contained troubling gross margin data. Are they right?

Jun 6, 2014 at 9:00AM

When Michael Kors Holdings (NYSE:KORS) reported stellar fourth-quarter results on May 28, investors weren't really surprised. A top- and bottom-line beat has become the new standard which investors have come to expect from the fashion icon.

Not everyone is impressed
Herb Greenberg commented on his blog that there are "cracks at Kors." Specifically, Michael Kors' fourth-quarter gross margin declined to 59.9% from 60.1% a year ago.  

According to Greenberg, this should sound some warning bells for investors given the fact that revenue rose 12.5% from the previous quarter.

Greenberg wrote, "If this were a genuine beat on revenue and earnings[,] the company, arguably, would have also beat on margins."

It's obviously very difficult to argue against one of the most respected and knowledgeable journalists on Wall Street, but nevertheless the case could be made that Michael Kors doesn't have a margin problem.

Kors is building a global brand
Michael Kors is building a global brand and is looking outside of the U.S. to fuel growth. In fact, in the recent quarter, North American same-store-sales, while impressive at 20.6%, lagged the 62.7% growth in Europe and 50% growth in Japan.

Michael Kors plans to open 45 new retail locations in North America, 55 in Europe, and 10 in Japan. The company is also raising the profile of its e-commerce site, however through management's own admission, e-commerce will not have a positive impact over the next two to three years.

Regardless of gross margin, Michael Kors continues to deliver impressive comp figures, especially compared to its competitor Coach (NYSE:COH), which reported a 21% drop in comparable-store sales in North America for its third quarter. In fact, analysts at Citigroup downgraded Coach to neutral given a lack of catalysts in the near term that could reverse comp expectations.

While Coach has guided for sales in fiscal 2015 to "moderate further," Michael Kors has guided for a 20% increase in total company comps for the first quarter of fiscal 2015.

Brand awareness for the Michael Kors name is improving worldwide. Based on a company study, 89% of consumers in the U.S. are aware of the Michael Kors brand, up from 82% in 2013. In Europe, brand awareness has improved to 49% from 39% over the same time period.

As consumers worldwide continue to recognize the Michael Kors brand name, the company appears to be on track to recognize its guidance.

So what about margins?
Shares of Michael Kors dipped around 5% after the company's earnings release due to gross margin concerns. Specifically, management has guided for the gross margin to be "slightly lower" than current levels in both the first quarter and throughout the entire fiscal year.

Management previously warned investors to expect a gross margin erosion as the level of markdowns normalized. During the company's second-quarter conference call back in November, Michael Kors' Chief Financial Officer Joseph Parsons said

We continue to caution you that very consistent with what we've said, our business will normalize, which means that our markdowns and allowances will normalize, which will have an impact on margins over the longer term. Our business structure is positive for margins, both because retail will be growing somewhat faster than the wholesale, Europe will be growing somewhat faster than North America. Then, ultimately, again, very long term, Japan will be coming online, which will have [a] strong gross [margin.]

The company hinted at gross margin erosion back in 2013 when the stock was still trading below $80 a share. Why didn't investors show any concern back then?

The answer is simple. Investors realized back in late 2013 and still today that Michael Kors is undergoing a dramatic shift in geographies as growth in Europe and Japan outpaces the U.S. Additionally, a product shift from apparel to accessories is under way.

Management noted during its fourth-quarter conference call that accessories such as small leather goods continue to outpace the handbag business in terms of growth. Accessories are very attractive gross margin drivers, which could offset the impact of price markdowns.

Bottom line
Michael Kors is making the necessary investments in its global infrastructure to support a global expansion. Management is making the right investments to support long-term growth, even at the expense of short-term gross margin concerns.

As long as Michael Kors continues to grow revenue and raise its brand awareness, the underlying business is set for a global expansion. Coach, the once dominant brand in fashion, is now playing catch up. The company has hired Stuart Vevers, a famed English designer, to turn the company around.  

As time goes on, investors should continue to appreciate Michael Kors' growth strategy and ignore shorter-term margin concerns. On the other hand, investors shouldn't show the same amount of enthusiasm for Coach based on its multi-year lifestyle brand transformation.

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Jayson Derrick has no position in any stocks mentioned. The Motley Fool recommends Coach and Michael Kors Holdings. The Motley Fool owns shares of Coach and Michael Kors Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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