Shares of Michael Kors (NYSE:CPRI) were hit hard after the company received troubling media and analyst coverage. The Wall Street Journal printed an article which hinted that the company could follow its competitor Coach (NYSE:TPR) into becoming an irrelevant, outdated, and troubled brand.
Almost at the same time analysts at William Blair and Maxim downgraded its shares and presented investors with a compelling bearish case, at least in the short term.
This weakness is a buying opportunity
One of the main issues troubling investors is Michael Kors' ambitious, rapid expansion. Motley Fool writer Andrew Marder explained:
The article in the Journal expressed concern about the rapid expansion that Kors has undergone, arguing that the downfall of Coach came on the heels of its ubiquity. If everyone can have it, then no one is going to want it.
The fact remains clear that Michael Kors is a leading brand with highly desirable accessories. With over 80% of the company's retail sales generated from accessories categories (such as handbags, watches, and small leather goods) the company is well positioned to satisfy the growing demand in the category.
Michael Kors should be able to sustain its growth profile over the next few years and could even double its annual revenue to $7 billion from $3.3 billion. Growth will come in the forms of retail expansion to 800 full-price stores, an expansion of wholesale outlets, and international expansion.
Over the past few years investors have benefited tremendously as Michael Kors has seen demand for its brand surge at a faster rate than the company has built out its infrastructure. As a result, it is only natural that markdown rates have been below normalized levels, and that could change.
Analysts are reiterating what Kors already told us
Analyst Ike Boruchow commented that Michael Kors is about to see significant margin implications. Investors appeared to take the warning seriously, as the company's shares fell nearly 7% on July 15. However, the analysts' view on margin erosion has been part of Michael Kors' outlook dating back to its second quarter in November 2013.
John Idol, Michael Kors' Chief Executive Officer, commented that "it's more important that we grow the top line and the overall dollars that we're creating for the operating margin" and that "if we can maintain or even if our margins are just slightly lower than where they are today, we're going to be very pleased with that."
Naturally, investors should have seen the writing on the wall for some time now in terms of margin pressures. Michael Kors is setting out a strategy to invest in its infrastructure, people, and brand and it needs to do this because of the high growth that it has experienced recently.
Kors is no Coach
Perhaps most importantly, Michael Kors has a superior revenue mix that is balanced across its channels. In 2013, Michael Kors saw a revenue mix composed of approximately 48.1% retail, 47.6% wholesale, and 4.2% licensing. This compares favorably with that of Coach which only sees 5% of sales coming from its wholesale business with the rest coming from retail.
Michael Kors' product mix will give the company the upper hand in capturing a larger set of customers as it is safe to assume the company will maintain a healthy channel balance.
Even when Michael Kors does see margin erosion its solid inventory turns (it has a ratio near 3.5) and 90-day cash cycle will result in the company generating excess cash, even with its aggressive capital expenditures that it could potentially use for share buybacks.
On the other hand, Coach is undergoing a much needed face-lift and using its cash to make significant investments in its transformation. Coach's management expects capital expenditure to peak in fiscal 2014 at $400 million. Heavy spending from a historical perspective is expected in the following years to combat depressed operating performance.
While Michael Kors is expected to generate additional cash flow, the fact is that it is uncertain if Coach can follow suit. As such, investors may expect Coach to suspend its share repurchase program.
Investors will also need to question how Coach's heavy spending fits into Coach's fiscal 2019 guidance of achieving a 30% operating margin. It may be reasonable to assume that this objective may be unfeasible given the necessary investments Coach will be making over the coming years.
Michael Kors is in an ideal position where it can leverage its momentum and grow its iconic brand to the next level. Coach recently outlined a strategy to fix its sales and margin trends through new product innovation through Stuart Vevers' refreshed and new design vision.
The bottom line is that brand turnarounds have been rare and typically take longer than expected. Investors looking for exposure to the luxury apparel and accessories market should go with Michael Kors which holds all of the momentum but keep an eye on Coach from the sidelines for any sign of a turnaround in the future.