2023-09-19 10:53:23 ET
Summary
- Tapestry, formerly known as Coach, announced the acquisition of Capri Holdings, formerly known as Michael Kors, in a transformative deal.
- Tapestry's organic improvements have not resulted in a higher share price, as operating improvements on a per share basis were offset by valuation multiple compression.
- The acquisition creates a $12 billion global luxury empire, but investors have reacted negatively given a huge assumed debt load, causing a decline in Tapestry's market value.
Tapestry ( TPR ) hit the newswires over the summer as it announced a transformative deal. The company, once better known as Coach, announced the acquisition of Capri ( CPRI ) , the company once better known as Michael Kors.
It has been a very long time since I last looked at Coach, in fact, it was 2017 when I looked at Coach after it announced a $2.4 billion deal for Kate Spade. What followed were years of relative stagnation, albeit that sales and margins improved in a modest fashion, while a significant chunk of stock was bought back over time as well.
This organic improvements were accompanied by a flattish share price, marking huge valuation compression as the gradual improvement story has been derailed following a mega deal with Capri, set to create a lot of uncertainty and debt concerns for the upcoming period.
A Quick Recap
Coach ended up acquiring Kate Spade in 2017, a significant transaction which followed the purchase of Stuart Weitzman two years before. The strategic direction of Tapestry to grow a collection of brands, like its European counterparts have done so successfully, made sense (at least on paper). The deal added some $1.4 billion in sales, creating a substantial addition to its own business, which generated some $4.5 billion in sales at the time.
With 283 million shares trading at $45 per share, the company commanded a $12.7 billion equity valuation at the time, or $1.1 billion if we factor in the net debt position post the deal. This looked like a reasonable valuation for a business which saw pro forma sales near $6 billion on which the company targeted company-wide operating margins of 15%, which might result in pro forma net earnings of around $600 million, equal to about $2 per share.
With an earnings multiple in the low-twenties and net debt standing at 1 times EBITDA, valuations looked like quite some good news has been priced in, certainly as shares had seen some momentum in the months before. This followed quite volatile price action in the years before as shares peaked at $80 in 2012, after which shares fell to the $30 mark in 2015.
The renewed M&A in the mid 2010s made investors a bit upbeat, but given the track record and high valuations, I was cautious to get involved in the mid-forties back in 2017.
Gradual Improvements
As it turned out, shares rose to the $50 mark in 2018 before selling off to the $30 mark pre-pandemic. Even as shares have risen to the $50 mark in 2021, they fell back to the $30 mark in 2022, and rose to the forties this spring, and now are back to $30 again.
To see where we stand, we got to mid-August, when Tapestry posted its fiscal year 2023 results. Full year sales were flattish at $6.66 billion, up some ten percent from the pro forma revenue base in 2017. Promising is that operating profits of $1.17 billion (which came in flat as well year-over-year) worked down to operating margins of 17% and change, better than anticipated in 2017.
With net earnings reported at $936 million and continued buybacks executed upon, reported earnings came in at $3.88 per share. The 235 million shares outstanding valued equity at $9.4 billion, as this number excludes a net debt load of just over $900 million.
The company guided for 2023 revenues to grow to $6.9 billion with earnings seen at $4.10-$4.15 per share, as this earnings number is based on the expectation of no share buybacks following the Capri deal. It was quite clear that the business traded at non-demanding multiples at around 10 times earnings, as shares are dead flat since 2017 on a net basis, with earnings per share multiples having halved.
On top of the organic achievements which have not resulted in a higher share price, it was Tapestry which announced a next transformative move.
Going After Capri
A week ahead of the release of the 2023 results, Tapestry announced the purchase of Capri Holdings in a deal valued at $57 per share, granting the business an $8.5 billion enterprise valuation which was equal to about 80% of Tapestry's own valuation (pre-deal).
The deal creates a huge portfolio of luxury brands as Tapestry's Coach, Kate Spade and Stuart Weitzman brands will be combined with Capri's Versace, Jimmy Choo and Michael Kors brand. The deal creates a pro forma $12 billion global luxury empire to create more diversified operations, brands and geographical coverage. This comes as Tapestry's $6.7 billion revenue base is complemented by the $5.5 billion revenue base of Capri.
While the deal multiples look largely fair, investors barked at the 59% premium offered, as the combination targets $200 million in synergies, the market has not taken the deal well. Shares fell from the low-forties to the $35 mark upon the deal announcement, falling further to the $30 mark in the weeks which followed. With shares down over $10 per share since the deal announcement, the company has lost some $2.5 billion in value.
This comes as the company will finance the $8.5 billion deal in debt, with own net debt reported around $900 million, for a $9.4 billion pro forma net debt load. With Tapestry posting EBITDA near $1.4 billion, Capri posting EBITDA near a billion and synergies seen at around $200 million, leverage is seen near 4 times excluding synergies, or over 3.5 times if we factor in synergies.
In that light, given the substantial net debt load, I wonder if investors are actually pleased with a 17% increase in the annual dividend to a run rate of $1.40 per share, depleting the company from over $300 million in annual cash flows.
With shares down to $30, the market value of the firm has fallen to $7 billion, as the market is clearly worried about the leverage taken on here.
And Now?
A 7-8 times pro forma earnings multiple looks too compelling, assuming the Capri deal has no impact on earnings per share in the fiscal year of 2024. The big elephant in the room is execution of the deal, which is always a big if in luxury land, but certainly given the huge debt load incurred in such an uncertain period of time. With that, I mean with that is uncertainty in the end markets in which both businesses operate, and the uncertainty on interest rate and debt markets.
Right now shares are cheap for a reason and while the deal might very well play out in the end, there are plentiful of risks as well. This makes that I am withholding from now on the back of too much leverage, too many question marks, concerns on the strategic rationale, concerns on the success of M&A in luxury and concerns about the mediocre track record of the business.
Management could have pursued another route or deal structure, involving a stock component in the price and less of a premium being offered, as the debt load simply feels far too high to feel comfortably.
While I do not feel too happy to commit equity here yet, despite the sell-off, a long-dated upside call strategy might be an interesting strategy in anticipation of a rebound, as improvements in the prospects for the merged business will translate quickly into the share price of Tapestry.
For further details see:
Tapestry: Anything But A Luxury To Investors