We believe the trio of CPRI brands resonates with each of their respective target markets and provides both product and geographic diversity across the portfolio. This diversification will lower CPRI’s business risk over the longer-term once they successfully integrate the acquisitions. Additionally, each brand’s category expertise provides significant opportunity for product extensions to drive growth. While FY20 is an investment year, the market share and operating leverage opportunities should be evident in FY21 and beyond. We believe in the strength of the luxury segment and CPRI’s brand portfolio and believe shares are undervalued for a multi-year horizon investor.
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This custom model provides a template for calculating the impact of a 25% tariff on goods from China imported into the U.S. including average unit cost increase, margin hit in basis points, earnings reduction and average unit retail necessary to offset tariff impact.
Use our Tariff QuikCalc Model (click here) to quickly calculate the impact to a retailer's cost, margins, earnings, and, most importantly, to determine the percent increase in prices needed to offset the tariff. We have done this work for our coverage universe, but this is only a small sample of the retailers, vendors, and manufacturers impacted. Therefore, we developed a "quick and dirty" model to give you a general sense of the impact. For the average specialty retailer, we estimate an average unit cost increase of 4.2%, which if entirely unmitigated through price increases results in an average earnings reduction of 35%. The average unit price increase necessary to offset the higher tariff is 2.1%.
The April reading was the fourth consecutive month at 1 or the worst score possible. In April, 50% of retailers posted a short position >15% (up from 47.8% in March). We note the percentage of retailers with a short position over 15% continues to increase month-over-month. We rank Sector Sentiment on a scale of “1” being the most negative sentiment to “10” being the most positive sentiment. The basis for the ranking is based on the number of retailers in the sector with >15% short positions.
During 4Q18, inventory risk continued to increase as sector inventory grew at a faster rate than sales. Given a macro backdrop that is no longer fueled by tax stimulus, we believe this is harbinger of margin pressure in FY19. Note that this is a snapshot entering 1Q19, so any top-line weakness in 1Q will result in even greater inventory excess. We expect this inventory risk to build progressively throughout FY19 as retailers try to “comp the comp” but lack pricing power and must simply drive unit volume to deliver positive comps. Simply put, sector wide business and performance risk has materially increased.
The January reading plummeted, falling two rankings from December’s reading of 3/10, suggesting investors started re-shorting stocks during the January rally after being sidelined at year end. In January 45.7% of retailers posted a short position >15% (up from 39.1% in December). Since we last published this report on 12/17/18, the XRT is up 1% vs. the S&P 500 +4%. We rank Sector Sentiment on a scale of “1” being the most negative sentiment to “10” being the most positive sentiment. The basis for the ranking is based on the number of retailers in the sector with >15% short positions.
Although many companies posted sales upside for the holiday season, we think the upside is the result of deeper promotions (despite clean inventory) in order to coax consumers to shop. CPRI and TPR reported quarterly earnings last week that echoed this sentiment. Both companies cited a promotional environment, among other issues, that resulted in misses on the top-line and on gross margin vs consensus. We expect general misses to gross margin and sales given the trend of deeper promotions over the last four quarters from a peak score of 43 or “Flat” in 1Q18 to 33 or “Deeper” in 4Q18.
Future looks bright. While the FY3Q19 results were weak in the areas expected – sales and gross margin – management gave a path to high teen margins that resonated with investors. Over a three-year horizon, CPRI expects improvement in the operating margin to approach the high-teen range, with Jimmy Choo and Versace driving the majority of operating margin improvement and Michael Kors stabilizing.
Our checks for FY3Q19 suggest CPRI could potentially report a sales, gross margin and/or EPS miss. We noted aggressive promotions to drive conversion beginning mid-November and continuing through current-day checks in January. These checks are consistent with broader checks suggesting weak sales and deeper promos. The product miss from last quarter was expected to carry forth into the current quarter. Also, CPRI completed the acquisition of Versace in the quarter, and we expect to get an update on the progress and initiatives to drive this business in CY19. As with TPR (TPR – Outperform), CPRI investors are concerned with China, Europe, and department store exposure. Each of these is a more material risk factor for CPRI than for TPR. For the Kors brand, the Americas region is about ~60% of sales, Europe is low 20%, and Asia/Other is mid-teen percent of sales, while wholesale is about 30% of sales. Though smaller footprints than the Kors business, about 50% of Versace sales are from Asia, while about 50% of Jimmy Choo sales are reliant on Europe. We believe the stock is currently priced for FY20 EPS in the $5.00 range (Cons $5.08). CPRI will report FY3Q19 on 2/6/19 before market; 800-263-0877 (4719600).
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