MK is no LV: It’s Not Coach Either

Is this any way to manage a Jet Set brand? Maybe, if you’re looking for a quick exit.

Listening to Michael Kors CFO Joe Parsons speak at ICR on January 16, 2013 on the Kors Jet Set aesthetic—spanning wings, wheels and water—I was reminded of the brand Louis Vuitton, also rooted in luxury travel.

I make the comparison to Louis Vuitton for several reasons, beginning with its origins as a provider of luggage in the 1850s. In October 2010, I visited Paris (not just because I love to travel… and I especially love Paris) to see the installation of a Coach shop-in-shop at the Printemps flagship on Boulevard Haussmann, and do a store tour of Ralph Lauren’s new Left Bank flagship on Boulevard Saint-Germain. While I was there, I visited the Musée Carnavalet (the museum of the history of Paris). I never quite understood the fascination and demand for Louis Vuitton until I walked through the museum’s exhibit, Voyage en Capitale, Louis Vuitton & Paris.

On exhibit were the tailor-made trunks for nobility, celebrity and the wealthy. The exhibit told the brand story rooted in travel, a phenomenon that excites the imagination with the romance of new places and people, and different cultures and experiences. What holds more allure than travel? At the show, I discovered the basis of the brand’s aspirational DNA, which combines best-of-class quality and aesthetic with fashion’s excitement and superior execution at every touch point.

Is Michael Kors brand association with Jet Set travel designed to be the LV of the 21st Century?

Past performance is not indicative of future results, or is it?

Well, Kors may capitalize on travel’s allure, though I would argue that flying for all but the very wealthy is similar to herding cattle—and not at all glamorous even for the luxury traveler. The Michael Kors brand has enjoyed phenomenal sales growth in the past four years as evidenced by a 49% CAGR, with sales growth accelerating in 1HF13 to a 73% clip. Income grew even faster at 124% four-year CAGR and 135% in the most recent six-month, year-over-year period, reflecting a 1000+ basis point increase in gross margin. This is principally due to a growing proportion of higher-margined handbags, accessories and small leather goods (SLGs). There are strong double-digit same-store-sales gains, ranging between 36% and 45% in the most recent six quarters which also helped to increase the bottom line. North American store count almost tripled since 2009 to 214 (from 74).

This heady growth is reminiscent of another pacesetter—Tommy Hilfiger in the 1990s, led by the same Silas Chou and Lawrence Strulovitch who are on the board of Michael Kors. Tommy Hilfiger grew from $107 million in 1992 to $1.7 billion in 2001, before dropping to $836 million in 2008. At Tommy, sales grew by expanding wholesale, entering new categories, and growing off-price. The brand also propelled the growth of a new lifestyle category, Urban. But when that demographic moved on to newer (and more authentic) urban brands, Tommy lost the Hip Hop shopper as well as the mainstream mall mom. Sales and earnings shortfalls followed, and the shares plummeted 39% in 2000 when the company announced 2001 profits would drop by 30% to 40%.

I worry that the celebrity Michael Kors enjoys due to his past participation in Project Runway could be just as fleeting as the Hip Hop related success of Tommy Hilfiger.

What’s the brand management strategy?

One truism for good brand management visible at companies as varied as Coach, J. Crew, Louis Vuitton, Ralph Lauren and Zara, is getting the supply/demand equation right. Controlled supply creates demand. Look at the success of J. Crew’s limited edition collection, which frequently sells out quickly; or Zara’s fast fashion and Coach’s full price product, both with shallow inventories. Limited supply nurtures brand equity, grows demand, and supports full price. Compare that to what Michael Kors is doing in its full-price locations, wholesale accounts, and the off-price channel. This holiday season, Michael Michael Kors handbags and SLGs were discounted 50%+ at Macy’s, Century 21 and Nordstrom Off the Rack in New York where many international shoppers get their first access to the brand. In fact, the Kors flagship on Fifth Avenue was already offering pre-holiday discounts. This is very disturbing for me. I worry that management is so focused on optimizing current demand that they are diluting the long-term value of the brand. When will the momentum end?

It’s always hard to be ahead of trend, be a latter-day Cassandra (who foretold the fall of Troy), and prophesize doom. Doom maybe overstatement, but trading at 31X EPS estimates for the next 12 months versus 19X for a peer group of 12 apparel and accessory brands and retailers; 15X for Coach shares; 19X for Ralph Lauren; and 18X for LVMH, I see little upside. While sales and earnings are likely to achieve better than industry growth for 24 months, multiple contractions are likely. Looking at CapIQ revenue and EBITDA (earnings before interest, taxes, depreciation and amortization) estimates through 2017, the incremental revenue in 2014 is $600 million for both, and thereafter, Michael Kors is projected to add about $100 million more to revenues annually than Coach, arriving at $4.4 billion revenues in 2017 to Coach’s projected $7.5 billion. Moreover, on an EBITDA basis, Coach’s EBITDA margin of 35.4% in 2012 compares with Michael Kors 23.8%; by 2017 analysts project Coach’s EBITDA margin to expand moderately to 36.4% a full 780 basis points wider than the 28.6% projected for Michael Kors. Recently Coach reported weaker than expected North American sales and EPS, prices, and Capital IQ of CapIQ estimates, plus shares were off about $10 or 16%. Nonetheless, why exactly does Michael Kors stock trade at more than 100% premium (31X versus 15X) to Coach shares based on forward p/e multiples?

I’m not sure investors are fully cognizant of the creative machinery and superb execution at Coach that is not easily to replicate. Coach designs for its full-price locations and flows new collections monthly, employing a broad and shallow inventory discipline (read little inventory risk). Full-price sales trends, along with regular communications with its consumer base, reveal best-selling silhouettes and colors, which Coach then produces for its factory stores, deriving economies of scale with its deep inventory commitments. Fewer than 20% of Coach clients cross-shop full-price and outlet channels. The factory product is derivative of the flagship merchandise, arriving in the outlet channel six to 12 months after the original product sold at flagship. Coach operates these two distinct channels targeting two different shopper profiles with different merchandise. Not so at Michael Kors, where products follow a more traditional seasonal pattern. Kors doesn’t offer the same level of excitement and newness that Coach does with its strategic flow of new merchandise monthly.

I recently heard Chanel’s Global CEO Maureen Chiquet who entertained questions for almost 90 minutes at the Global Luxury Retail Forum. In sum, luxury brands are about exclusivity; they are in the desire business; and it is strategic not to be everywhere. ‘Nuf said!

Note: Forward p/e’s are based on closing prices on January 15, 2013. Full disclosure: I have a small position in Coach and a healthy inventory of Coach bags and accessories.