(This idea is not liquid as it involves LEAP options expiring Jan 2017.)
KORS is a luxury goods company with extremely high growth (44%+) and returns on capital (86%).
The trade I am interested in is going long KORS call options and long COH put options. I think that both trades are compelling by themselves. See my old and brief writeup on COH for my thesis on that company. This post will focus on KORS. The reason to go long KORS call options are:
- Implied volatility is reasonably low (around 34-35).
- Given the company’s ridiculously high growth, there is a good chance that the stock may see a lot of volatility on the upside.
- The P/E ratio is around 16.6 and the PEG ratio is 0.84. Arguably, the company is reasonably cheap from a GARP perspective.
Valuing the options
To break even on the calls, there only needs to be a small chance of something good happening. In the past 5 years, revenues per share have grown 44.2%. If this continues, the calls will make a lot of money.
I think that the Black-Scholes(-Merton) options pricing model can be useful if you modify the volatility parameters to account for flaws in the model.
- In the long run, stock prices tend to move towards intrinsic value. Growth stocks tend to have larger variances in their future intrinsic value. There is a tendency for companies with high growth to continue their high growth. They have above-average chances of growing intrinsic value dramatically. They also have above-average chances of ending badly if their growth were to reverse (if the high returns on capital were due to some bubble or economic cycle). So, I think that options on hyper-growth stocks should trade at higher implied volatilities than average stocks.
- In other cases, the options are reasonably priced but the underlying stock is mispriced. In those situations, the options may be a better idea if they magnify the mispricing of the underlying.
For the KORS call options, I think that #2 is more relevant than #1. My gut feeling is that the expected volatility on the KORS options should be somewhere around 40-60. The current IV is around 34-35 so the under-forecasting of future volatility is not that significant.
Implied volatility of similar LEAPs
KORS and FOSL have track records of consistent profitability and growth while COH, GES, and KATE have not. On that basis, I would say that KORS and FOSL are the most comparable. Clearly KORS grows much faster than FOSL. 5-year revenue growth per share is 44% versus 25%. The disparity in growth is greater for earnings, EBITDA, and free cash flow. Fundamentally I think that the KORS calls should be more expensive than the FOSL calls.
The simplest way of thinking about it
To value the call options, you simply have to estimate the chances of good things happening versus bad things happening. The bull thesis is simple: the future may resemble the past. If KORS continues to grow at something resembling its historic rate, then it is likely that the share price will go up a lot and the call options will be worth a few to several times their purchase price.
To determine the expected return, we need to figure out the chances that the options go to zero.
There are multiple scenarios where the options might go to 0.
- Fashion / fad / brand risk.
- The CEO may leave. It is unlikely that the next Kors CEO will be as good as John Idol.
- Market risk.
- Growth slows down due to market saturation.
- Macro risk. Luxury goods are a cyclical business. It has been several years since the recession of 2008/9 (6-7 years).
- Some type of disaster such as Lululemon’s see-through yoga pants, Joe Fresh sweatshop workers dying from a building collapse, etc.
- Risks that I haven’t thought about.
Fashion / fad / brand risk
I think that this is the most important risk. Unfortunately, my understanding of the probabilities is not very good.
Historically, many hot brands do not last long. While Michael Kors is a hot designer today, he may not be hot in the future. While some brands like Louis Vitton have been resilient over long periods of time, other high-fashion brands have not been.
Here are some ways in which Michael Kors puts its brand at risk:
- Sell products directly to outlet stores.
- Make lower-quality products specifically for outlet stores.
- Sell lower-priced products that aim at mass market appeal.
- Wholesale their products in department stores and online retailers.
- Manufacture their products in China and other countries where labour is cheap. There is the perception that these products are lower quality even though these countries produce amazing Louis Vuitton knock-offs that are pretty much identical in quality. Because branding is all about perception, this hurts the brand. Mass-market brands try to hide the country of origin by making it difficult to see the “Made in” tag (you have to flip the bag inside out).
I believe Coach has taken slightly more risks with its brand than Michael Kors. It has discounted more heavily than Michael Kors and has been substituting in lower quality products. Both companies engage in all of the practices above. Louis Vuitton does not do any of these things.
Michael Kors is trying to mitigate its brand dilution by differentiating its brand into the high-end “Michael Kors” brand and the lower-end mass-market “MICHAEL Michael Kors” brand. From what I can tell, this gimmick does not seem to work. Consumers seem to treat the brands as one single brand. The high-end brand seems to have lost some of its lustre because of the wide availability of “Michael Kors” product even though it is “MICHAEL Michael Kors” product that is widely available. Design-wise, the cheaper MICHAEL products tend to have much flashier logos (larger and more blinged out).
On the high-end couture side, I think that the Kors brand will suffer a lot and has lost its appeal. Fundamentally, Kors cannot do well in the high-end market if it also sells mass-market products. There is a niche of people who want to own quality handbags that are not owned by everybody. However, the money is made in the bigger mass-market products that the MICHAEL line is going after. I don’t know if the company will be able to build/maintain a strong brand there. It has certainly been drawing down its brand equity given that it is selling low-quality product specifically designed for outlet stores.
Here’s what I think the argument in favour of this strategy is… the CEOs of these companies have recognized a market segment that was poorly served in the past. Nobody has executed a strong branding approach to the middle market of $150-500 handbags (and other luxury goods). To build a strong brand in that market, these companies are trying to use the halo effect of their high-end goods, celebrity fashion designers, celebrity endorsements, etc. etc. These companies are transforming themselves into mass market brand companies. Yes, Coach and Kors have received a lot of negative comments from consumers about their ubiquity, tackiness (the big blinged-out logos), and lower quality. However, like reality television this might actually be what people actually want despite saying how awful it is. This strategy worked for Coach up to around six hundred stores in North America, though its current struggles make it unclear as to whether or not the strategy is sustainable at that level. Maybe I’m crazy but I think that John Idol could pull it off (assuming that he doesn’t get bored once he has reached the pinnacle, which is what happened to Lew Frankfort and Reed Krakoff).
CEO risk and operations risk
CEOs frequently leave their company to do other things. However, companies tend to exhibit some inertia after the CEO leaves. It often takes a while for the company to deteriorate under the new CEO. (On the other hand, Ron Johnson managed to destroy value very quickly at JC Penney.)
The track record of a CEO isn’t always a good indicator of future performance. Here are some examples of CEOs that fared poorly despite a long run of initial success:
- Tuesday Morning / Kathleen Mason
- The Gap / Mickey Drexler – He was fired after The Gap’s international expansion efforts did poorly.
- Crazy Eddie / Eddie Antar – The electronics chain later went bankrupt.
- Michael Jeffries / Abercrombie and Fitch
If the stock market crashes, almost all stocks will fall with the overall market. Growth stocks tend to fall more than the market. This risk if not a big deal if you have short positions. I am long COH put options.
Many retailers see their growth slowly grind to a halt as they saturate their domestic market. Kors will likely saturate at the same point as Coach. Currently, Kors has roughly two-thirds the stores as Coach in North America so it has not reached its saturation point.
- As of Dec 2014 Kors had 337 retail stores and concessions in North America and 509 globally (source: 10-Q).
- As of Sept 2014 (source: press release), Coach had 540 stores in North America and 1019 globally. At its peak, Coach had a higher store count in North America.
EDIT (2/23/2015): On the latest conference call (transcript), management stated: “At the end of the quarter, we operated 509 Company-owned retail stores, and see potential for 700 stores worldwide, long-term, not including men’s locations. In addition, our licensing partners operated 194 Michael Kors stores around the world, bringing our overall presence to 703 locations worldwide.”
The overall market for Coach’s luxury goods could decline due to the economy or changes in fashion trends. Because it has been several years since the last major recession (2008/2009), the risk of the overall economy falling may be higher. I believe this risk can be hedged to some degree by going long COH put options.
Some type of ‘Black Swan’ low-probability event could occur. For at-the-money call options, these events aren’t that important.
Fraud and/or aggressive accounting
Publicly-traded companies that perform secondary offerings are more likely to commit fraud and to “window dress” the business. Insiders have sold shares in four previous secondary offerings.
Nonetheless, I believe that the chance of accounting fraud is very low. The integrity of management is ok.
If there is some type of fraud occurring, there will be some type of fictitious asset on the balance sheet. I did not find signs of fictitious assets in KORS’ balance sheets.
Sometimes leases are valuable and sold for large sums of money. KORS is a buyer of such leases.
KORS capitalizes lease rights on its balance sheet. They are roughly a tenth of PP&E. I believe this is reasonable because FOSL also has lease rights in similar proportions.
Deprecation versus maintenance capex
As a shortcut for maintenance capex, I use capex from two years ago. (The more accurate way of doing things is to actually estimate growth and maintenance capex.)
For YE2014, D&A was $79.65M and GAAP profits were $661.49M. Capex for YE2012 was $88.19M. I do not believe that the disparity is material or unusual.
Free cash flow
Cash from operations minus cash from investing activities is significantly lower than GAAP profits. This is due to significant increases in receivables and inventory. I do not believe that either have been faked or manipulated.
The number of inventory turns has stayed fairly constant over the past few years. Inventory turns decreased dramatically from YE2011 to YE2012 (6.1 –> 3.61). Various SEC filings such as the F-1 explain:
In addition, as we continue to open more retail stores we expect our expenditures on inventory to increase at a greater rate than the increase in our sales as inventory related to retail sales typically experiences slower inventory turnover than that of wholesale.
Compared to COH, KORS has slightly more inventory turns and is roughly the same in terms of its cash conversion cycle.
While some companies have historically faked their cash balances, it is extremely rare for a non-Chinese company to do this. For the call options, events with very low probability do not affect the valuation of the options much at all.
Sales reserves for retail sales somehow went down year-over-year from $3.1M to $2.3M (source: 10-K). While this seems off, it is not material. Sales reserves for wholesale went up from $43.0M to $65.9M year-over-year so I see no cause for concern.
Computer equipment and software
The company capitalizes some of its software development costs.
Computer equipment and software as a percentage of PP&E has gone up. This could be reasonable as the company shifted its e-Commerce in-house.
YE2013: 29,429 / 366,156 = 8.03%
YE2014: 50,646 / 531,174 = 9.53%
Other checks for fraud
Do the margins make sense?
The existence of knockoff bags suggests that the margins on Kors product are legitimately very high.
Popularity on Google is skyrocketing. This suggests that their revenues are real.
Store count is consistent with the growth story.
The biggest issue is that Michael Kors is incorporated in the British Virgin Islands. If you want to do shady things like tax evasion, BVI is a good place to go. In practice, KORS does not seem to do much tax evasion given that its effective tax rate is a few percent higher than 35%.
EDIT (2/23/2015): Kors has minor tax benefits from its BVI incorporation. If its non-US earnings were to be repatriated, Kors would have to pay US tax on these earnings. Instead, it should pay BVI tax (essentially no tax) on its non-US earnings.
Nonetheless, the BVI incorporation is problematic for shareholders because it is very difficult for them to sue company insiders as explained by the various risk factors in the KORS 10-K.
Other things that management can do better:
- High insider pay. To be fair, insider pay has stayed roughly the same in the past few years.
- Staggered board.
- The company spent approximately “$1.4 million for the use of aircrafts owned by Sportswear Holdings Limited or its affiliates”, a related party (source: DEF 14A).
- I would have liked to see the use of corporate aircraft classified as a form of other compensation, especially if personal use was involved.
Many publicly-traded companies engage in practices along the lines of #1-#4, so KORS isn’t unusual in that regard.
Low-quality products specifically designed for outlet stores
It’s sneaky and deceptive. The article “The truth about those outlet store designer ‘bargains’” illustrates this practice with pictures.
Issues that seem fine
The boss who married his intern
Apparently Michael Kors met his future spouse/partner in 1990 when Lance Lepere was an intern at Kors’ company. Lepere is currently paid slightly over $1M/year. Kors and Idol are usually paid around $13-14M/year each. The Kors/Lepere relationship does not seem like nepotism to me because it seems that the relationship was initially professional.
The company buys goods from a related party
From the 10-K:
We routinely purchase knitwear from a manufacturer affiliated with Silas K. F. Chou, one of our directors, and members of his family. Purchases by the Company from this manufacturer totaled approximately $8.1 million in Fiscal 2014.
The total amount is immaterial compared to Kors’ cost of goods sold ($1,294M). If Mr. Chou was trying to be a charlatan, the related party numbers would be much higher.
The luxury business is very tough
From what I can tell, the business lost money before John Idol came on board. Knowledge@Wharton has an interesting profile piece on John Idol. One of the interesting tidbits from the article is this comment:
“[Michael Kors] was a $20 million business in 2004,” Idol said. “It was losing money and probably would have gone out of business had we not bought it.”
The F-1 filing notes:
The Company has U.S. state and non-U.S. net operating loss carryforwards of approximately $2.9 million and $27.6 million, respectively, that will begin to expire in 2026 and 2016, respectively.
I did not figure out how the company managed to lose so much money.
Capital allocation at KORS does not seem very good. The company sits on excessive levels of cash. It should return some of it to shareholders via dividends, share repurchases, a tender offer, etc.
I believe Michael Kors and John Idol sold shares in all of the secondary offerings and the IPO with the exception of the latest secondary offering (Sept 5 2014).
KORS’ private equity backer Sportswear Holdings has sold off its entire stake via secondary offerings. They have a lot of experience in the field and may know what they’re doing.
The bottom line
The fashion/brand risk really bothers me (largely because I don’t fully understand it). Clearly KORS has been devaluing its brand by designing low-quality product specifically for outlet stores. This seems like something that could end badly. At the same time, Coach did well with similar strategies under its old CEO Lew Frankfort. Devaluing its brand made a lot of money for a very long period of time. In any case, the risk may not matter as going long KORS and short COH should theoretically hedge out this risk.
EDIT (2/23/2015): Practically all of KORS’ competitors in the middle market space seem to engage in made-for-outlet strategies: Coach, Kate Spade, Marc Jacobs, Prada, Calvin Klein, Tory Burch, Mulberry, Burberry, Mulberry, Gucci, and Ralph Lauren. Higher-end brands like LV, Hermes, Feragamo, and Chanel do not seem to do this.
Operationally, I think that KORS is clearly better managed than COH. Coach’s CEO found ways to fix what isn’t broken (e.g. get rid of all the top execs) and cause North American same store sales to drop by over a fifth. Coach is doing dopey things such as spending $750M+ on a New York office building. Objectively, KORS has incredible same store sales growth while COH’s figures are trending worse. KORS has better returns on invested capital (86% versus 34%). Valuation-wise, KORS has a lower P/E ratio despite higher growth (Coach is shrinking).
- Both trades (long KORS short COH) combined are largely a bet on the operating skill difference between the COH and KORS management teams. By the numbers, I think that KORS management is clearly better.
- As well, it is a bet on KORS achieving a higher P/E multiple than COH given that KORS is the better company. See #1.
- Less importantly, KORS has more room to grow because it is far from saturating its markets based on store count.
- If putting on the trade via options, you have to worry about whether you are underestimating or overestimating future volatility. Because the implied volatility on these options is somewhat low, it is unlikely that you are overpaying for volatility / overestimating future volatility.
*Disclosure: Long KORS call options and long COH put options.
The Coming Crash Of Michael Kors… Take It To The Bank – This provocative article explains how Michael Kors is destroying its brand.
Reddit.com r/Female Fashion Discussion discussion about the aforementioned article.
The secret about TJ Maxx designer discounts – TJ Maxx and its ilk sell items that aren’t closeout inventory. Not only that, some items were specifically designed for discount outlet stores.
The truth about those outlet store designer ‘bargains’ – Good article with pictures showing outlet product versus full-price product