3 Things Michael Kors Investors Should Consider

Analysts have turned cautious on Michael Kors, but when you consider these three things, its long-term outlook couldn't be more clear.

Jul 22, 2014 at 5:30PM
Kors Store

Source: Michael Kors.

Michael Kors Holdings (NYSE:KORS) has now lost more than 10% of its valuation over the last month as analysts caution the company's margins have likely peaked. While potentially true, is Wall Street over-thinking this possibility, and does Michael Kors remain a solid long-term investment opportunity relative to peers like Coach (NYSE:COH) and The Gap Inc (NYSE:GPS)?

What is Agee's conclusion?
On Tuesday, shares of Michael Kors saw a 7% decline after Sterne Agee put the company's margin concerns in full focus. The company noted that in key e-commerce websites, they have noticed far more markdowns than last year. Agee also mentioned that with inventories up 60% to end last year, Michael Kors is likely trying to rid itself of product. 

Agee's conclusion was maintaining its neutral rating while lowering its full-year 2015 and 2016 EPS targets by $0.05 and $0.15, respectively, to $3.95 and $4.55.

Two things investors should consider
First, investors are often quick to react to an analyst's call, but they sometimes fail to put such information into perspective. For example, Michael Kors has 203.63 million shares outstanding. Therefore, $0.05 equals just $10.2 million to the company's bottom line, which is the degree that Agee expects the company to be affected by lower margins this year.

Second, inventories were especially higher to end last year versus 2012. However, is it possible that higher inventories are planned for the company's global expansion? During Michael Kors's last quarter European sales increased 62.7% on a comparable basis, and by exceeding $500 million, Europe now account for 10% of total revenue. 

Because of this explosive growth and the company's plan to enter new markets, it makes sense that it would need higher inventory levels to handle the demand it has seen in the infancy of its expansion program.

Here's the one big thing
With those things considered, after five consecutive years of margin expansion, it's no surprise analysts are expressing some concern at the first sign of problems for Michael Kors. The company's gross margin declined to 59.9% from 60.1% year over year during its last quarter, and a slew of analysts immediately issued bearish notes. However, relative to its peers, it's imperative for investors to realize that such performance is not that bad!

In fact, Credit Suisse stated that Michael Kors could eventually experience a 300 basis point decline to its 30.5% operating margin. However, the company also said global expansion and an increased focus on men's clothing could easily double the size of the company. Therefore, investors have to give and take, or decide whether growth or sky-high margins are most important at this point in time.

Is an eventual 300 basis point operating margin decline, or 27.5%, bad if Michael Kors grows to become a retail juggernaut, or is it bad when you consider the state of others in this space? For one, Coach saw its operating margin decline 540 basis points during its first quarter. Not to mention, while Michael Kors grew total revenue by more than 50% year over year, Coach saw considerable weakness, including an 18% decline in North America alone.

Furthermore, even the retail/designer juggernaut The Gap has seen margin weakness as of late. Gap's operating margin declined 250 basis points during its last quarter, and in the month of June, its comparable sales fell into negative territory as well, falling 2%. Therefore, other retailers have far worse problems than Michael Kors, yet the possibility of some margin weakness seems to be in full focus in recent weeks.

Foolish thoughts
The Gap at 12 times next year's earnings is cheap, but with comps falling and its margins under pressure, there is a reason it is so cheap. On the other hand, Michael Kors' operating margin of 30.5% is an industry leader, and its 20% plus comparable growth is untouchable among large companies in its space.

Therefore, it's mind boggling that shares trade at just 17.5 times next year's earnings, which is actually cheaper than Coach at 18 times forward earnings. In other words, fears of margin pressure have made shares of Michael Kors very cheap, and a great long-term opportunity as the company plans for global expansion. 

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Brian Nichols owns shares of Michael Kors Holdings. 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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