Sundry Photography
In September, I concluded that shares of Tapestry (NYSE:TPR) were anything but a luxury to its investors. Tapestry, perhaps still better known as Coach to many investors, announced a big deal for Capri (NYSE:CPRI), perhaps still better known as Michael Kors, over this summer.
Given the massive premium offered, and the fact that the deal was paid for in cash (thus debt) I was quite cautious given the execution and leverage concerns. These concerns have not been alleviated after Capri is showing some revenue and earnings declines, making me still very cautious to get involved.
Some Perspective
Coach had tried to create a US luxury powerhouse in the 2010s as Coach acquired Stuart Weitzman and Kate Spade in the period 2015-2017, trying to grow a collection of luxury brands under a single roof, like its European counterparts have successfully done.
Hard to belief but Coach was a $45 stock in 2017 when the company acquired Kate Spade, as the 283 million shares of the business were awarded a $12.7 billion equity valuation at the time, or close to $14 billion enterprise valuation. This deal created a $6 billion powerhouse in terms of sales, set to post operating margins in the mid-teens, translating into earnings power of around $2 per share.
Trading at a premium valuation at the time I saw no need to get involved with the shares. Forwarding to 2023, Tapestry had grown sales to $6.7 billion, a modest 10% increase from 2017 which shows some stagnation as sales growth has not kept track of inflation. Operating profits of $1.17 billion worked down to margins of 17%, a decent result given the stagnation on the topline. The combination of modest sales growth, modest margin expansion, and huge buybacks meant that earnings had risen to nearly $4 per share, essentially having doubled over a 6-year window.
Moreover, the company guided for 2023 revenues to grow to $6.9 billion, with earnings seen between $4.10 and $4.15 per share. This means that a demanding multiple in the 20s has fallen to about 10 times earnings, as investors have in essence seen huge valuation multiple compression over time. Essentially shares were trading flat in the forties in June this summer (compared to 2017) when earnings per share have doubled.
The Thesis Changes
In August, Tapestry announce a huge and transformative deal for Capri, as a $57 per share offer for its peer valued the business at $8.5 billion, a deal tag equivalent to 80% of Tapestry´s own valuation ahead of the announcement.
The deal was set to essentially double the global luxury empire to $12 billion in sales, combined out of multiple luxury brands. Investors were not too pleased despite a 59% premium offered for Capri´s shares, even as Tapestry guided for $200 million synergies, as shares fell to the lower thirties following the announcement of the deal, shedding some $2.5 billion in value.
The disappointing reaction could be explained by the fact that the deal will entirely be paid for in debt, as a net debt load of $900 million will turn into a $9.4 billion net debt load. This results in about a 4 times multiple based on Tapestry´s $1.4 billion EBITDA number, while Capri contributes about a billion in EBITDA, as synergies have the potential to push this leverage ratio down a bit, perhaps down to less than 4 times EBITDA.
In the light of the excessive debt (certainly in this rate environment) I wondered if it was a smart move to announce a 17% increase in the annual dividend to a run rate of $1.40 per share, depleting the business from $300 million in much-needed annual cash flows (although share buybacks were halted at the same time)
Trading at 7–8 times earnings at $30 per share, the multiple looked compelling, as the big elephant in the room was execution of the deal which is a big if in any environment, certainly given the mixed track record of Tapestry in this. Moreover, the added debt is a huge concern as well. I believed that another deal structure (less of a premium, or some stock thrown in as well) might have been more suitable, as the potential is evident if the deal goes well, yet I have been reserved.
What Now?
Since September shares have gradually been slipping to the higher twenties as the first quarter results do not instill much confidence. First quarter sales came in flat at $1.51 billion, albeit up 2% in constant currency terms. Operating earnings of $253 million were flat as well, with earnings up 5 cents so $0.84 per share solely on the back of a reduced share count.
Net debt was pretty stable around a billion dollars, even as inventory levels dropped a bit, as the company actually obtained shareholder approval from Capri´s investors late in October, although that the FTC sent a second request early in November. With regard to the organic outlook for 2024, Tapestry did not alter its guidance.
Early in November, Capri posted its (second) quarter results as well. Revenues were down over 8% to $1.29 billion as earnings were under severe pressure, with operating profits down about 60% to $100 million, both not very encouraging signs.
A Final Word
While the antitrust review might put some doubt on the deal, quite frankly I think that a deal being blocked actually will be a positive at these levels, as a massive buyback at these levels is much more accretive than a deal for Capri, in my belief (even if it involves a big break-up fee).
The reality is that given the size of both businesses, and the fact that we are talking of luxury businesses, antitrust likely is not a major issue in my view. Amidst all of this, with deal chances being really high, I am quite cautious. While Capri has seen a decent first quarter, the quarterly results of Capri have been rather disappointing, all while pro forma net debt seems to come in a tick higher than I expected.
Amidst all this I am actually quite cautious, as I do not like the capital allocation moves of the business as well, with the company suspending buybacks while shares trade at low levels, while the dividend was hiked for no good reasons. While the company targets gross leverage at 2.5 times two years after closing, there is some time to pass before this happens, and some real operational risks to overcome in the meantime.
Amidst all this, I am still taking a wait-and-see approach, although I continue to keep a close eye on the shares and deal here.
