PPRUF - Capri Holdings: The Discount Is Not Justified

Summary

• Capri operates in a large and growing personal luxury market that is relatively resilient to adverse macro headwinds.
• The company may become a beneficiary of industry consolidation.
• Strategic brand development plans include both expanding its physical footprint and increasing same-store sales.
• We expect the company's margins to improve in the long term as Versace shows a steady improvement in operating leverage as revenue grows.
• Capri has a healthy balance sheet and a solid cash flow that allows it to actively buy back.

Investment Thesis

Capri Holdings ( CPRI ) operates in a large and growing personal luxury market that is relatively resilient to adverse macro headwinds. In addition, there is a consolidation in the market, one of the beneficiaries of which may be Capri.

The firm has significant opportunities for both extensive and intensive growth. The company retains space to open new retail stores. Capri is relatively under-represented in Asia but is actively working to develop the region, helped by easing Covid restrictions in China.

The company aims to strengthen Versace's position in the luxury leather and premium women's footwear markets and plans to increase the share of accessories in the sales structure. We expect the company's margins to improve in the long term as Versace shows a steady improvement in operating leverage as revenue grows.

With a healthy balance sheet and solid cash flow, Capri is actively repurchasing shares. The size of the current buyback program exceeds 12% of the company's market capitalization. We rate shares as a Buy .

Company Profile

The company was founded in 1981 and until 2018 was known as Michael Kors Holdings Limited. In 2017, the firm bought Jimmy Choo PLC , a luxury footwear and accessories brand, for $1.35 billion. In December 2018, the company acquired Versace , the famed haute couture brand, for $2.12 billion. Today, Capri Holdings is one of the ten largest players in the luxury industry in the world. The company specializes in designing, producing, and selling clothing, footwear, and accessories under Versace, Jimmy Choo, and Michael Kors brands. The breakdown of revenue by brand is shown below:

Most of Capri's revenue comes from the Americas - $3.21 billion or 56.8% of total sales. EMEA accounts for $1.49 billion or 26.3%, while Asia accounts for $955 million or 16.9%.

Luxury Market Opportunities

On the same day that the IMF warned of a slowdown in the economy and a potential recession, the French luxury industry mastodon LVMH Moet Hennessy ( LVMHF , LVMUY ) released financial results that far exceeded analysts' expectations and earlier forecasts of the firm's management. A week later, the maker of the iconic Birkin bag Hermès ( HESAY , HESAF ) also showed impressive financial results . In November, Capri and Ralph Lauren ( RL ) consistently beat Streets' consensus.

Asked by analysts about the "divorce" between macroeconomic conditions and the sustainability of the luxury industry, LVMH's Chief Financial Officer Jean-Jacques Guiony replied that "Luxury is not a proxy for the general economy" and emphasized that consumer behavior of buyers in the luxury industry is not consistent with the economy. In other words, while poor shoppers are cutting spending, wealthy consumers are still spending money, allowing luxury companies to raise prices without hurting demand.

The long-term outlook for the luxury industry is also positive. According to Bain & Co. , the personal luxury market is valued at about €353 billion ($381.9 billion) in 2022, up 21% from a year earlier. The market is expected to grow at a compound annual growth rate in the range of 5.46-6.40% until 2030 and reach €560 billion ($605.4 billion) in the middle of the forecast range.

The luxury consumer base will increase from 400 million in 2022 to 500 million by 2030. Generation Z and Alpha spending are expected to grow at about three times the rate of other generations and reach a third of the market by 2030. So early fears that the luxury industry will not resonate with the younger generation amid the popularity of sharing economy seem groundless.

Consolidation is observed in the personal luxury market. The market share of the seven largest brands has grown from 17% in 2000 to 33% in 2021. The number of independent fashion houses is steadily declining, being taken over by large conglomerates. However, the industry is still fragmented. We are likely to see a large number of mergers and acquisitions in the future.

During industry consolidation, Capri can expand its brand portfolio as the firm's management has significant experience in M&A and strategic initiatives to develop acquired companies. In addition, Capri itself can become a target, since it is several times smaller than the market leaders - Kering, Richemont, Hermès, and LVMH.

Easing Restrictions in China

Throughout 2022, China has had one of the toughest anti-Covid regimes in the world, known as the zero-Covid policy. And while luxury companies have performed strongly this year, restrictions in the Middle Kingdom have negatively affected their sales. China is the second largest market in the personal luxury industry, accounting for approximately 21% of global purchases . While Europe and the US are still the largest markets, China is expected to take the lead by 2030 with a 25-27% share.

After the November protests in China, there was a sudden lifting of many restrictions . Negative Covid tests are no longer required to enter public transport, restaurants, and other public places. In addition, since January 8, the authorities have fully opened the borders and lifted quarantine measures for arrivals.

In the most recent quarter, Capri sales in Asia were down 2% on a reported basis (in constant currency revenue increased by 12%). In China, sales were down in the high teens and decreased by a low double-digit in constant currency. In addition, the latest cut in revenue guidance does not take into account the recent easing of restrictions. Further easing of restrictions could be a driver for growth and provide the company with better results.

Capri is actively expanding its presence in Asia. Versace presented the fall collection in Bangkok, Chinese stars Gao Yuanyuan and Wang FeiFei joined Michael Kors ambassadors, and Jimmy Choo began collaborating with Japanese actress and model Ayami Nakajo. In the long term, China and other Asian markets provide significant growth space for the company, as the region currently accounts for only 16.9% of total revenue.

Company Strategic Plans

In July 2022, on the last investor day , Capri unveiled strategic plans for the development of brands. Michael Kors is expected to remain a core brand, but its share will drop to 62.5% of total revenue, while Versace and Jimmy Choo will reach 25% and 12.5%, respectively.

The development strategy can be summarized as follows:

• Versace . Management expects the brand to reach $2 billion in revenue with 300 retail locations. By comparison, in FY 2022, Versace's sales were $1.08 billion with 209 stores. Sales per location should increase by 28.8%, from $5.2 million to $6.7 million.
• Jimmy Choo . It is planned that in the future the brand's revenue will reach $1 billion, and the number of stores will be 300 units. Today Jimmy Choo earns $618 million with 209 locations. Thus, sales per location should increase from $5.2 million to $6.7 million.
• Michael Kors . The management pursues a targeted policy of brand premiumization. The company reduced supply by closing wholesale stores, which dropped from 3,889 in 2016 to 2,742 in FY 2022. As a result, total brand sales over the same period fell from $4.71 billion to $3.95 billion. Michael Kors is expected to reach $5 billion in revenue through retail expansion and e-commerce development.

Management's plans are achievable. First, Capri retains significant room to open new retail stores. The company ended FY 2022 with 1,271 stores, while LVMH Moët Hennessy has over 5.5 thousand retail locations worldwide. Secondly, as noted above, Capri is relatively under-represented in Asia. This region accounts for only 16.9% of total sales. By comparison, Tapestry makes 33% of its revenue in Asia and LVMH 41%.

Capri can achieve revenue growth per store through the development of e-commerce. Versace's e-commerce revenue is expected to rise from $140 million to $500 million. Online sales of Jimmy Choo will grow from $88 million to $250 million. And online sales of Michael Kors will reach $1.4 billion versus $700 million in FY 2022. Thus, according to expectations, the share of e-commerce in total revenue will increase to 25%, which is also not an exorbitant goal. According to Bain , the share of online sales in the luxury goods market will be 28-30% by 2025.

Financial Performance and Capital Allocation

According to the Q2 FY 2023 results , the company's revenue increased by 8.6% year-over-year and reached $1.41 billion. Versace made $308 million (+9.2% YoY), Jimmy Choo $142 million (+3.6% YoY), and Michael Kors $962 million (+9.2% YoY). FY 2023 sales are expected to reach $5.70 billion, implying less than 1% growth (+7% on a constant currency basis).

The new outlook was well below the consensus of $5.83 billion. The main contributor is an expected $100 million drop in Michael Kors' wholesale sales. This nuance allows us to remain optimistic about Capri's growth prospects, as the expected reduction is in line with the brand's premiumization strategy. CEO John Idol notes that DTC sales remain strong , including in the Michael Kors segment:

"We're actually quite pleased in our own channels. And as it relates to our direct-to-consumer / e-commerce part of the business, that's actually trending extremely strong. You could see by the level of database increase that we had at Michael Kors, which was 17% . And that's on a very, very large database already. We're definitely attracting consumers. We're engaging with consumers, and we're seeing very strong results." - CEO John Idol

Capri has several growth points in each of the brands. The company aims to strengthen Versace's position in the luxury leather and premium women's footwear markets. In addition, Capri plans to increase Versace's men's and women's accessories penetration to 50% of the brand's revenue over time, which is currently 20%. The share of accessories in Jimmy Choo's revenue is planned to increase from 20% to 30% over the next years and up to 50% in the long term.

The management raised its forecast for profitability. Gross margin is expected to increase by 50 basis points to around 66.7% by the end of the year. The operating margin is projected at 18.3%, up 2.3 percentage points from a year earlier.

We expect the company's margins to improve in the long term as Versace shows a steady improvement in operating leverage as revenue grows. If in 2019 the operating margin of the brand was -8%, then according to the results of the last reporting period, the TTM indicator reached 17.1%. Versace has significant room to grow, with revenue about 3.2x less than Michael Kors.

Capri's net debt is $1.4 billion. TTM operating cash flow, adjusted for changes in net working capital, is $1.0 billion. A healthy balance sheet and solid cash flow allow the company to actively buy back shares. Capri repurchased $350 million worth of shares in the second quarter and another $100 million in October. In addition, the Board of Directors approved a new buyback program for $1 billion, which equals 12.3% of the company's current capitalization.

Comparable Valuation

Tapestry ( TPR ) and Ralph Lauren are the closest peers for a comparable valuation since these companies target the same price segment as Michael Kors and Jimmy Choo. However, Capri's portfolio includes Versace, a more premium brand. Thus, we have added to our sample the larger players in the luxury industry such as Burberry ( BURBY ), Richemont ( CFRHF ), and Kering ( PPRUF ).

Source: Seeking Alpha

Capri trades at a discount to peers. It is noteworthy that the company demonstrates better financial performance than some competitors. For comparison, the net margins of Ralph Lauren and Tapestry are 8.1% and 12.3% respectively.

Given the active buybacks and the expected increase in Versace's share of the overall sales structure, the current multiples seem unreasonably low. In our opinion, Capri should trade at the RL's level. At a P/E of 15x, the stock upside potential is about 35%. The catalyst could be the implementation of a new buyback program or an increase in sales in China amid the easing of Covid restrictions.

Conclusion

Capri operates in the vast personal luxury market, which is also relatively resilient to macro headwinds and is growing at a fast pace. In addition, the company may become a beneficiary of industry consolidation. Capri's management has set strategic brand development plans that include both expanding its physical footprint and increasing same-store sales. An easing of restrictions in China could lead to faster sales growth, and an increase in Versace's share of total revenue is likely to improve the company's operating leverage. Capri has a healthy balance sheet and a solid cash flow that allows it to actively buy back shares. The company trades at a discount to peers. We are bullish on CPRI.

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