Tapestry: Deal Risk Despite An Attractive Valuation (NYSE:TPR)

Investment Thesis

Tapestry, Inc (NYSE:TPR) is a luxury apparel company beginning the second part of its business strategy called “Futurespeed”. With a previously successful strategy prior through its “Acceleration Program”, the company saw higher average spend per customer, better retention rates, and won new customers. As the company looks towards it future, it announced a deal earlier this year to buy Capri Holdings Limited (CPRI) in a huge transaction that poses deal risk for investors today. In this article, I’ll discuss what I like about Tapestry’s growth plans and valuation, but also the potential downsides to investing in shares today amidst the risk present.

Company Overview

While you may not have heard of Tapestry before, you’ll likely have heard of its brands. Most notably, this includes brands like Coach, Kate Spade, and Stuart Weitzman. Under these brands, the company offers accessible luxury accessories for women including bags, footwear, and more.

Tapestry started off as just Coach and was founded in 1941. More recently in the last decade, it acquired Stuart Weitzman (a women’s footwear brand) in 2015 and acquired Kate Spade in 2018. Today the company has over 900 Coach stores, 400 Kate Spade stores, and 100 Stuart Weitzman stores. By channel, about 59% of products are sold in stores, 29% are sold online, and 12% are sold through wholesale distribution or other third parties.

Business Strategy

In FY2020, Tapestry embarked on a business strategy it dubbed its “Acceleration Program“. In the three years of its multi-year strategy, the company had made good progress on its goal of better serving the needs of its customers through its three brands. Thus far, Tapestry had focused on its customer by emphasizing premium branding which has led to higher average spend per customer, better retention rates, and winning new customers. Year over year, the company had been seeing double-digit growth in new customer gains as it focused in on brand-building activities.

In Q1 of FY2023, Tapestry launched the next phase of its program, called “Futurespeed“, after the successful results of the Acceleration Program between FY2020 and FY2022. Part of the new business strategy revolves around establishing its brands’ competitive advantages and focusing more on driving a more digital, data-driven, and consumer-centric company. Going forward, it aims to leverage its online capabilities to capture new customers in new markets. As it did for its previous program, Tapestry announced three targets it wants to hit by FY2025. This includes a target of $8 billion in gross sales (implying a CAGR of 7%), an operating margin of 19%, and a cumulative cash return of $3 billion to shareholders. In addition to this, it aims to balance a dividend payout ratio of 35% to 40% with cumulative share repurchases of $2.1 billion over the three year period.

To me, these are ambitious goals given the scope of the transformation and the fact that the transition is going to require significant investment throughout its three brands. Through the acquisitions of Kate Spade and Stuart Weitzman, Tapestry still needs to prove out how these fit into the strategy. In addition, the Coach brand is significantly more profitable than Kate Spade and Stuart Weitzman, exhibiting pricing power as more of a true luxury product, and so the smaller two brands are detracting from the company’s overall profitability ratios.

Earlier this year, Tapestry announced that it was merging with Capri Holdings in an $8.5 billion deal. Shares fell immediately upon the announcement but have since recovered back to where they were (also likely as a result of the rest of the market increasing as well). Following a discussion on recent results and financials, I’ll discuss how the deal fits into the strategy, my thoughts, and how I see this impacting the financials of Tapestry.

Financials

When looking at Tapestry’s latest earnings, this was a record quarter for both revenue and earnings. Revenue came in at over $1.5 billion, up 2%, and earnings was up 18% compared to last year. Much of the reason we are seeing disproportionately better growth in earnings compared to revenues is that the company has expanded gross margins by 250 basis points, experiencing lower freight costs and better operating performance.

The company saw 3% sales growth for Coach, but saw challenges for its other two brands, Kate Spade and Stuart Weitzman. It’s also starting to see nice growth in the Asian market with China sales up 9% and overall international sales up 7%. This strong growth has now led to sales exceeding the peak levels they were at just two years ago. Both Coach and Kate Spade are brands that resonate with Chinese consumers so I expect this growth to continue.

While North America and Europe were mostly flat on the revenue front, the company acquired over 1.2 million customers in North America alone, of which half were Gen Z and millennials. This shows that Tapestry’s strategy of targeting younger generations is working. It also underscores the effectiveness of the company’s targeted marketing and product strategies aimed at capturing the attention and loyalty of younger generations.

Moving over to the balance sheet, Tapestry had $622 million of cash on the balance sheet at quarter end, with $2.93 billion of long-term debt. This put its Net Debt to EBITDA ratio at 1.3x and its Debt to Equity ratio at 134%. For an apparel company, I’d say this is a manageable debt load, with total debt making up 29% of the company’s enterprise value.

Capri Holdings Deal

While debt may look manageable on the surface, we need to consider how this will change post-acquisition. The Capri deal is a huge one for Tapestry, giving Tapestry access to other well-known brands like Versace, Michael Kors, and Jimmy Choo, which have room for revenue and margin growth if they can be successfully integrated following the merger.

However, in my view, the acquisition brings a set of risks that need consideration. Firstly, given Tapestry’s track record, the previous acquisitions of Kate Spade and Stuart Weitzman didn’t work out as expected, so if history is any indication, we shouldn’t be too optimistic. Kate Spade and Stuart Weitzman didn’t have the same pricing power Coach does, and while it did diversify the company and expand their market, the two acquired companies’ margins haven’t improved meaningfully post-acquisitions. As evidence, Coach’s margins were 73.5% for FY2023 versus 63.4% for Kate Spade. Coach as a brand has more cache, a higher price point (with much less wholesale distribution for its bags), and is historically more established, founded in 1941 versus 1993 for Kate Spade.

Secondly, the acquisition is likely to be dilutive as Capri trades at a higher P/E ratio than Tapestry. With management expecting the deal to close sometime in 2024, this deal will likely reduce the new company’s margins too. For example, margins for Michael Kors aren’t nearly as good as they are for Coach, despite the Michael Kors brand being comparable to Coach. Tapestry has a ROIC ratio of 40.1% while Capri has a ROIC ratio of just 16.1%, so it seems that Tapestry is buying a worse business (S&P Capital IQ). That said, if Tapestry thinks it can integrate Capri and run it more efficiently, then there may be potential upside here.

At present, Coach current accounts for roughly three-quarters of Tapestry’s sales and over 90% of its operating income. Post-acquisition, Coach will likely contribute less than half of sales and a much smaller portion of operating income. As the company has reduced wholesale distribution to keep its brand image and position itself as a luxury product, I believe Tapestry could do the same with existing brands and boost margins for the company. How much would be lost or gained in profitability from cutting wholesale distribution and charging higher prices would be unknown however.

Valuation

Based on the 15 equity research analysts with one year target prices on Tapestry, the average price target is $41.14, with a high estimate of $60.00 and a low estimate of $30.00. From the average, this implies about 9.4% upside, not including the current dividend yield of 3.7%.

When looking at the Price to Earnings ratio over the last decade, Tapestry’s multiple has fluctuated dramatically, but we seem to be at the low end of the historical range and 9.5x seems like a reasonable price to pay for a low-growth retailer.

When stacking the company up to its comparable, Tapestry seems to be trading below its competitors on both a P/E and EV/EBITDA basis. Given comparable growth rates, I’d say shares are slightly undervalued next to the peer group. The potential undervaluation is likely due to the deal risk the market may be seeing here, as discussed previously. If we don’t see a deal, I think there’s a reasonable chance shares climb on the back of less perceived risk.

Conclusion

Tapestry is anchored by its Coach brand but hasn’t really figured out how to make its Kate Spade and Stuart Weitzman acquisitions turn out for shareholders. While the company’s business strategies “Acceleration Program” and subsequent “Futurespeed” program have highlighted its commitment to winning new customers and improving retention rates, I’m not confident in its acquisition strategy.

In the example of Kate Spade, Tapestry believed it could take Kate Spade’s revenues to $2 billion in a few years post-acquisition but it wasn’t able to (revenues for Kate Spade are still just $1.4 billion 5 years later) and it also struggled on the profitability front. Note that Tapestry paid $2.4 billion for Kate Spade and today Kate Spade only generates $115 million of operating income. Not the best results to say the least.

So when considering the impending merger with Capri, I don’t feel confident enough to buy the stock today and I don’t think the deal will prove to be successful for Tapestry. If I could only own Tapestry for the Coach business, I would, seeing that Tapestry as a whole generates significantly better returns on invested capital (ROIC) and is a more profitable company.

While I view Tapestry’s valuation as attractive when compared to its competitors and its historical valuation range, I don’t believe this is enough to compensate for the deal risk here. Hence, I will wait on the sidelines for now to see if the deal goes through. If it doesn’t I would be inclined to up my rating from a hold to a buy.