Description

Capri Holdings (CPRI)

Capri Holdings (“Capri”), the parent company of globally recognized luxury brands Michael Kors, Jimmy Choo, and Versace, represents a transformation story that is currently misunderstood by the market, with a significant sum-of-the-parts value-unlocking opportunity.  The Company’s transformation involves deemphasizing wholesale distribution in order to elevate the positioning of Michael Kors, which we believe will set up the brand for accelerating revenue growth and margin expansion, placing the Company on a path to achieve its long-term target of $8.0 billion in revenue at a 20% operating margin.  We believe the market, however, is mischaracterizing the acceleration of this plan as brand weakness.  We fundamentally disagree, as our channel checks indicate brand health remains strong and actually is improving.  As we evaluate the strength of the Company’s brands and global opportunities ahead, the Company’s current 5.3x EV/EBITDA multiple, representing a 29% discount to peers, and 13% free cash flow yield, are extremely compelling.  Simply aligning the EV/EBITDA multiple to peers implies $56.07 per share or 55% upside.  After the Company executes on its wholesale plan, we believe management could further unlock value by selling or spinning off Jimmy Choo and Versace, comprising 21% of our fiscal 2024 EBITDA, resulting in an additional $8.85 of upside for a total price target of $64.92 per share, or 80% upside from current levels.

Capri manufactures and distributes luxury accessories, footwear, and apparel in the Americas, EMEA, and Asia through direct to customer and wholesale channels.  Over the last several years, we have admired the Company’s ability to successfully elevate the positioning of its three brands by removing lower quality wholesale distribution and instead focus on direct-to-consumer sales through its expanding store fleet and e-commerce.  The Company successfully reduced wholesale from 33% of sales in fiscal 2020 (ending March) to 29% in fiscal 2022, primarily driven by Michael Kors as it represents 79% of the Company’s EBITDA.  The Company was on a path to reduce reliance further to 27% of sales in fiscal 2023.  However, when the Company reported fiscal Q3 2023 results in February, they were significantly below expectations, resulting in CPRI’s first earnings miss since 2020.  The culprit of the earnings miss was a much weaker than expected wholesale channel, and it led to a significant reduction in Q4 2023 and initial 2024 guidance significantly below the Street consensus.  Several market participants were questioning management credibility and the health of the Michael Kors brand. 

 In May 2023, Capri reiterated fiscal 2024 guidance while reporting better than expected Q4 2023 results.  The market, however, remained focused on the US wholesale channel and now had additional questions about the Company achieving the reiterated guidance due to the significant weighting to the second half of the year.   The shares have not moved materially since and are currently trading at 5.3x the Street consensus estimate that is below the Company’s reiterated guidance.  As it stands, the shares are sharply disconnected from similarly positioned peers Tapestry (TPR), Ralph Lauren (RL), and Canada Goose (GOOS) which currently trade at an average multiple of 7.5x next-twelve-months EBITDA, even though these peers serve a similar customer base, have similar geographic exposures and have some degree of exposure to US wholesale.

We believe that the shares possess significant upside as the Company executes the following catalysts: 1) demonstrates that the Michael Kors elevation strategy continues to be successful, in part by effectively deploying sales associates to improve wholesale sell through; 2) proves to the market that the fiscal 2024 guidance is achievable; 3) highlights the significant value of the ultra-luxury brands by more than doubling the accessories business at Versace and Jimmy Choo which carry accretive incremental margins; 4) utilizes free cash flow to repurchase 13% of the shares outstanding; and 5) executes a sale or spin-off of Jimmy Choo and Versace.  We believe the first four catalysts will cause a material re-rating in the shares to $56.07, representing 55% upside, with an additional $8.85 possible in the event of a sale or spin-off of Jimmy Choo and Versace.

Execution of the Michael Kors Elevation Strategy

We believe that CPRI is implementing a strategy at the Michael Kors segment which will accelerate growth, reinforce the brand, and ultimately help regain positive market perception and a multiple rerating.  We see the most recent pivots as part of an overall strategy to rebalance the Company’s channel mix by relying less on the wholesale channel while continuing to benefit from the strength of the Company’s direct-to-consumer channel.  There are two specific, short-term factors influencing Michael Kors, namely the over-inventoried nature of certain wholesale customers, and the fact that retailers are taking steps to reduce shrink by locking up high value items.  We believe that both these issues are temporary in nature and will be resolved over the next 12 months.

As the US emerged from the pandemic, retailers found incredibly strong consumer demand and a supply chain that had been put into disarray by COVID-19 related disruptions.  This affected the reliability of Asian manufacturing and dramatically lengthened the lead times needed to procure goods.  Because most expected demand strength to continue, many retailers ordered excess inventory, deducing that demand would remain strong and that supply chain disruptions could reemerge.  Unfortunately, as 2022 progressed, a perfect storm developed, when the supply chain lead times compressed which bloated inventory levels, and simultaneously, pockets of weakness in the US consumer landscape emerged.  Retailers were caught with significant amounts of inventory procured at very high prices and, as most companies plan 6 to 12 months in advance, looked to rapidly reduce forward wholesale orders.  We have seen this dynamic unfold at several companies we track.

We believe investors were caught off guard when Capri reported this dynamic as well, because the prevailing marketplace assumption was that the luxury market typically remains more resilient in times of consumer weakness.  We still consider that to be true as evidenced by the strength of the companies direct-to-consumer channel.  We do, however, believe a significant under-the-radar factor contributing to the weakness in the wholesale channel, specific to Capri, was that several large wholesale customers were reacting to large increases in shrink.  Because of the relative value and ease of resale of Capri’s products, several important wholesale accounts locked up their products, which dramatically hampered the customer experience and impacted sell through.  Capri has responded by once again adding sales associates in select locations (a practice the Company had in place before the pandemic), which should have the dual effect of elevating the experience for customers and removing the need for retailers to lock up products.  This low cost and simple change should positively influence the Company’s trajectory in the wholesale channel.

We believe market participants are extrapolating these two external factors to wrongfully question the health of the Michael Kors brand.  Michael Kors wholesale points of distribution have been reduced by 20% since the end of calendar 2018, which has resulted in improved positioning and significant increases in average unit retail (AUR).  Said another way, Michael Kors has actively avoided wholesale revenue to gain more control over the brand’s experience, setting up for accelerated revenue growth and margin expansion towards its $5.0 billion long-term revenue target for the brand.  We applaud Capri taking more control over the relationship with customers.  At the time of the 2022 investor day, Capri had a customer database of 61 million at Michael Kors, which has grown at over a 20% CAGR since 2018.  This should lead to an acceleration in direct-to-customer revenue as more data and insights are collected.  We believe that if the Company resolves the inventory and shrink issues, its shares should re-rate materially to peer EV/EBITDA multiples of 7.5x which implies a fair value of $56.07 per share, or 55% upside.

Dissecting the Company’s Fiscal 2024 Guidance

We see a strong rationale for the Company’s 2024 guidance trajectory and expect that achieving improved results throughout the year will demonstrate management credibility and a higher multiple, more in-line with comparable peers.  When the Company provided initial 2024 guidance in conjunction with Q3 2023 earnings in February 2023, management did not provide quantitative quarterly commentary.  The Company simply provided sales and operating margins by brand, coupled with tax rate and earnings per share of $6.40.  When the Company reiterated guidance in May, they provided a breakdown of Q1 2024, first half and second half 2024.  Based on this, investors could imply Q1 2024 EPS of $0.70, Q2 2024 of $1.80 and 2H 2024 of $3.90.  With what appears to be an improvement in earnings over the course of the year, investors have questioned the achievability of this guide.  We, however, disagree with this premise and note that several disclosures lend credibility to the guidance provided in conjunction with the Company’s Q4 2023 earnings report. 

After a deep dive with management, we have concluded the following: 1) Earnings will be pressured in Q1 2024 due to specific brand building investments at Versace that were not capitalized.  We estimate this is a $0.15-$0.20 headwind in the quarter that does not repeat for the rest of the year.  2) The Company likely has inventory capitalized on its balance sheet procured at higher costs which will provide an additional drag that eases as the year progresses.  Real time data suggests freight prices have eased further, which is supportive of margins improving over the course of the year.  3) Based on the Company’s share count provided with the guidance reiteration, we also infer that the Company’s outlook does not include any share repurchases, which should provide additional support to earnings per share.  As discussed below, we estimate that the Company will generate $600 million of free cash flow, enabling it to repurchase 13% of the shares outstanding at current levels.  We estimate this would add $0.30 to earnings per share if executed at an average price of $40.00 in fiscal 2024.

Further, we remain comfortable the Company’s outlook contemplated the current weaker wholesale demand levels to continue, implying a negative mid-teens sales outlook for the wholesale channel in fiscal 2024 after being down over 20% in the second half of fiscal 2023.  We are optimistic that the Company’s initiatives, such as selectively adding sales associates, can positively influence the trend driving upside to initial guidance.

While acknowledging the macroeconomic outlook is uncertain, we believe there are sufficient initiatives underway to allow Capri to achieve or outpace the current street consensus for 2024 of $6.08, which would imply a 5.9x P/E multiple.  We are optimistic that as management executes, the shares should appreciate to $56.07, based on peer EV/EBITDA multiples resulting in 55% upside.

Jimmy Choo and Versace Have a Long Growth Runway

We believe the Company has provided a credible path to achieve the long-term target of $8.0 billion in revenue, up from the $5.7 billion expected in 2024.  While management has not set a specific timeframe for this goal, we are excited by the opportunities for product innovation and extensions.  For example, we believe the Company could grow accessories five-fold at Versace to drive $1.0 billion in revenue and nearly three-fold at Jimmy Choo to $300 million, leveraging the strengths and trends in the Michael Kors business.  Further, we are excited about extensions in footwear, men’s and casual to drive growth.  The growth at Jimmy Choo and Versace, combined with the successful elevation strategy should allow the Company to achieve its long-term targets of $8.0 billion in revenue at a 20% operating margin.  Based on peer multiples of 7.5x, this would imply a value of $108.71, or over 200% upside.  While management has not provided a date for these targets, we believe this is illustrative of the long-term growth that is achievable once the wholesale strategy is complete.  This long runway provides opportunity for CPRI to appreciate well above our near-term price target.

The Durability of CPRI’s Strong Free Cash Flow Supports Large Capital Returns

As CPRI executes on its transformation, we believe it will use its strong free cash flow to further enhance shareholder value.  We estimate Capri’s free cash flow in fiscal 2024 will be $600 million (representing a 13% free cash flow yield) with a modest 1.5x net leverage at the end of March 2023.  Thus, we believe management will prioritize returning cash to shareholders through share repurchases.  If management were to deploy all free cash flow to buybacks, which we believe is likely, this would result in upward pressure on EPS estimates and reduce the float by 13%.  Worth noting, we do not forecast any cash generation events that are one-time in nature, suggesting that $600 million of annual repurchases is a reasonable ongoing assumption.

We are pleased to see members of management publicly express confidence in the strategy through significant insider buying.  In March 2023, CPRI’s Chairman and CEO, Tom Idol, purchased 240,000 shares at prices ranging from $40.80 to $42.00 for $10 million, and the Company’s CFO, John Edwards, purchased 4,900 shares at a price of $41.07.

Evaluating the Sum-of-the-Parts Opportunity

If the valuation disconnect does not improve, we believe the Company is on a path towards highlighting the underappreciated value embedded in its ultra-luxury brands Jimmy Choo and Versace which combined represent 21% of EBITDA.  We see the potential for a sale or spin-off of these brands which will add an additional $8.85 of value per share to our base case target, based on our sum-of-the-parts analysis, representing 80% upside from current levels. 

Today, the shares are trading at a sharp discount to similarly positioned luxury peers, which trade at an EV/EBITDA multiple of 7.5x.  However, we believe simply applying this peer multiple ignores the ultra-high-end luxury positioning of Jimmy Choo and Versace, which we estimate will represent 21% of the Company’s EBITDA in fiscal 2024.  If we apply a true ultra high-end luxury multiple like LVMH (MC FP), Moncler (MONC IM), and Kering (KER FP), which trade at an average EV/EBITDA multiple of 12.0x, to Versace and Jimmy Choo, and the peer multiple of 7.5x to the Michael Kors 79% of EBITDA, it implies a fair value of $64.92 per share, or 80% upside from current levels. 

Moreover, the Company acquired Jimmy Choo for $1.2 billion in 2017 and Versace for $2.2 billion in 2018 for 16.5x and 22.0x trailing EBITDA, respectively, which at a total price of $3.4 billion represents 56% of the entire enterprise value of Capri.  Other luxury transactions have recently occurred in the mid-teens to low 20s multiples of EBITDA, suggesting our fair value estimate may be conservative if the Company were to run a formal sale process. 

Valuation and Conclusion

In summary, CPRI represents a significant opportunity to invest in a high-quality luxury business that is undergoing short-term, wholesale related sales reductions, and trades at a meaningful discount to peers.  We believe the market is extrapolating this reduction and pricing the Company’s shares as if the reduction in wholesale orders is representative of brand health, permanently impairing the Company’s long-term earnings power.  When this debate is resolved, we see prospects for a meaningful re-rating to $56.07 per share or 55% upside.  Further we see upside to $64.92 per share or higher, if the Company executes a sale or spin-off of Jimmy Choo and Versace.  We believe the Michael Kors strategy and its execution and innovation at Versace and Jimmy Choo should lead to a significant growth runway to $8.0 billion of revenue over time, resulting in a price target of $108.71 using a 7.5x EV/EBITDA peer group average multiple.

If this value is not realized, we believe that Capri would represent a compelling takeout candidate.  We have witnessed several transactions of similar size over the last few years and note the recent acquisitions of Creed, Zegna, and Etro showcase the interest of large public players and private equity in the luxury goods sector.

As always, we will continue to monitor CPRI, the retail landscape, and the health of the US consumer and will add to, or subtract from, the position as conditions warrant.

Catalyst

1) demonstrates that the Michael Kors elevation strategy continues to be successful, in part by effectively deploying sales associates to improve wholesale sell through; 2) proves to the market that the fiscal 2024 guidance is achievable; 3) highlights the significant value of the ultra-luxury brands by more than doubling the accessories business at Versace and Jimmy Choo which carry accretive incremental margins; 4) utilizes free cash flow to repurchase 13% of the shares outstanding; and 5) executes a sale or spin-off of Jimmy Choo and Versace.