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Standard & Poor's


07/28/14 10:21:46 AM



This week's Focus Stock of the Week is Michael Kors Holdings Ltd (KORS: $81.09), which carries S&P Capital IQ's highest investment recommendation of 5-STARS, or Strong Buy. Under the vision of fashion designer Michael Kors, KORS has evolved from an American luxury sportswear house founded in 1981 into a global accessories, footwear and apparel company with a presence in more than 85 countries. Accessories, including handbags and small leather goods, account for more than 80% of total sales. The company believes a focus on accessories aligns its business more closely with European luxury brands.

Through its two main collections, Michael Kors and MICHAEL Michael Kors, the company targets a broad customer base while retaining a premium luxury image. It also has three major product licensees, namely Fossil (fashion watches and jewelry); Marchon (eyewear); and Estee Lauder (fragrances). Also, KORS licenses distribution rights across Asia-Pacific and Latin America, among other emerging markets. In fiscal 2014 (ended March), the company generated about 84% of its total revenue in North America, 15% in Europe, and 1% in other regions (including Japan).

The company has three reportable business segments, namely retail (48% of fiscal 2014 revenue); wholesale (48%); and licensing (4%). As of March 29, 2014, it operated 288 retail stores in North America, as well as 117 international retail stores, including concessions, in Europe and Japan. It also had wholesale sales in 2,496 department store and specialty store doors in North America and another 1,232 doors in Europe. The company expects the retail segment to represent 70% to 75% of its business over the next three to five years.

In our view, the near-term outlook for worldwide spending on luxury goods is relatively healthy. According to international management consulting firm Bain & Co. and Italian luxury goods association Fondazione Altagamma, worldwide sales of personal luxury goods grew 6.5% in 2013 to more than 225 billion euros (on top of a 12% growth in 2012). Bain and Altagamma also projected that worldwide luxury goods sales grew 2% in 2013 (6% at constant exchange rates), including a 4% gain in the Americas, and project an average of 3% to 5% annually from 2013 through 2016.

We believe KORS is successfully executing on the key elements of its medium-term growth strategy. First, the company is on track to expand its retail presence in North America - targeting 400 stores with a two-to-one ratio of full price to outlet stores. Second, an ongoing conversion of department store doors into branded "shop-in-shops" has thus far provided a major lift to sales. Third, the company is building out its European business, which it believes could exceed $1 billion in revenues over time. Next, KORS is developing its relatively nascent Japanese business, while stimulating further brand awareness in other parts of Asia as well as in South America. Fourth, the company is investing in its men's business, which it views as a $1 billion opportunity. Lastly, KORS has made notable progress with establishing a global e-commerce business, which it believes could represent about 10% of North American retail sales over time.

In the near term, we see a potentially sustainable trajectory for a continued strong growth. From fiscal 2012 through fiscal 2014, KORS increased its revenue at a compound annual growth rate (CAGR) of 60%, EBIT at a 94% CAGR, and net income at a 109% CAGR. Meanwhile, gross margins attained a recent peak of 60.9% in fiscal 2014 (versus 47.5% in fiscal 2009), reflecting strong sales of higher-margin accessories and international expansion, as well as SG&A expense leverage, despite investments in new retail stores and brand marketing. In fiscal 2014, the company spent about $185 million on capital expenditures, which it plans to significantly increase to more than double to nearly $400 million in fiscal 2015 - including new retail stores, shop-in-shop installations, and further investments in IT infrastructure.

After a 52% advance in fiscal 2014, we expect consolidated net sales to increase approximately 27% in fiscal 2015, with high-teens low-twenties growth in same-store sales, and a potentially sustainable pace of planned 110 new retail locations across North America, Europe and Japan, with KORS benefiting from strong consumer demand for fashion handbags, small leather goods, and watches in its core U.S. market, an expanding product offering (including men's leather accessories and a new fragrance and beauty collection), and growing brand awareness in international markets. In fiscal 2016, we see net sales up 22%.

However, we expect a moderate contraction of operating margins, to 29.5% in fiscal 2015 and 29.1% in fiscal 2016 (versus 30.5% in fiscal 2014). Aside from potential promotional markdowns, we also see margins pressured by further investments in new retail stores and shop-in-shop conversions, brand marketing, and e-commerce initiatives, versus an enhanced product mix, lower retail markdowns, reduced wholesale discounts and allowances, and expense leverage. We forecast EPS of $3.97 in fiscal 2015 and $4.76 in fiscal 2016, versus operating EPS of $3.22 in fiscal 2014.

We believe the shares offer relatively attractive upside at current levels. Our 12-month target price is $100, applying a projected fiscal 2016 P/E multiple of 21X, which represents a 35% to 40% premium to the forward median multiple of peers within the apparel, accessories and luxury goods space - as well as a comparable premium to the S&P 500 Index. Against a backdrop of a projected long-term EPS growth of 24%, we believe this premium multiple is justified by expectations of continuing momentum in North America, combined with early-stage high growth in Europe and Japan.

Finally, we highlight some potential risks to our recommendation and target price. First, we think KORS may be vulnerable to changing consumer tastes in fashion accessories and luxury goods, or lackluster response to new products. Also, we note intensifying pricing pressures amid a very competitive retail environment - and potentially deepening promotional markdowns. This might result from a failure to keep inventories in line with sales trends, or an oversaturation of retail stores. Next, we see some macroeconomic vulnerability to a potential significant weakening in consumer discretionary spending on luxury goods. Lastly, our outlook could be adversely affected by significant delays in planned openings of its new store locations, or inability to lease sufficient space for new retail stores in prime international locations.

S&P's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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