The past year has not been kind to shareholders of Capri Holdings Ltd. (CPRI), as the shares are down ~53% over the past twelve months. A reader suggested I look in on the name, and the price drop certainly has me intrigued, so I thought I’d wade in with an opinion. I’ll look at the financial history here and the stock itself. I’ll also look at what insiders are doing, and I’ll spend some time looking at the recent controversy about the Chinese government’s reaction to an apparently highly offensive t-shirt. As I often do, I’ll also offer what I think is a good options trade as either a surrogate for or supplement to a straight stock position. For those who can stand neither the suspense nor my writing, I’ll jump to the point. I think Capri Holdings is a “buy” at the moment. I’ll go through my reasoning below.
A quick review of the financial history here suggests that, financially at least, this is a business that has hit the occasional speed bump. While revenue has grown at a CAGR of 3.6% and gross profit is up at a CAGR of about 3.7%, net income is actually lower now than it was in 2015. An investor in this business needs to be comfortable with the business cycle and the volatility inherent in the fashion demand.
That said, I would suggest that management is very shareholder-friendly in that they have returned about $3.1 billion to shareholders over the past 5 ¼ years in the form of stock buybacks. This buyback activity has done much to remove some of the volatility in earnings per share. A shareholder-friendly management is critically important, in my view, because the alternative virtually guarantees shareholder loss.
I must also comment on the capital structure, as the company’s debt level has climbed dramatically with the Versace purchase. I’m actually not that concerned the capital structure for a few reasons. First, the company has made paying down debt on a fairly aggressive schedule a priority, per the following slide from its most recent investor relations deck.
In addition, given that fully 81% of long-term debt is the term loan, and that term loan is tied to LIBOR, I don’t think the interest payments are excessive or will endanger earnings very much in the future. Note that in order to maintain this rate, the company must maintain a leverage ratio no greater than 3.75-to-1 over a four-quarter period (where the ratio is calculated by total debt + six times rent to EBITDAR). I consider this to be generous terms, and I think there’s little risk that the company won’t maintain this ratio.
Thus, in terms of the financial history here, I’d suggest that while the company remains quite profitable, investors should expect some volatility in that profitability over time. Welcome to common stock investing.
(Source: Company filings)
As I’ve said repeatedly, a great company can be a terrible investment if the investor overpays for it. The reason for that is simple enough. If the shares are priced for perfection on the back of waves of euphoric optimism, anything less than perfect execution will surprise investors negatively and will cause the shares to drop. Netflix (NFLX) investors, for instance, know something about this phenomenon. For that reason, I need to spend some time talking about the stock itself as a thing distinct from the underlying business. I specifically want to see whether the shares are optimistically or pessimistically priced. While being pessimistically priced is no guarantee of great returns, if the shares have too much optimism embedded in their price, that virtually guarantees loss, in my view.
I try to determine the market’s level of optimism or despondency using a host of measures, two of which I write about on this forum. The first is a simple price-to-free cash flow calculation. Per the graphic below, I think it reasonable to suggest that Capri Holdings is the definition of pessimistically priced relative to its history. Investors are currently paying only ~$11 for $1 of future cash flow, which is both objectively and relatively inexpensive.
In addition, I employ the methodology described by Professor Stephen Penman in his excellent book Accounting for Value to work out what the market must be assuming about long-term growth. The exact methodology is beyond the scope of this article, but in a nutshell, Penman walks investors through a method where they can use a standard finance formula (and the wonderment of high school algebra) to isolate the “g” (growth) variable to answer what the market is assuming about future growth. Applying this methodology to Capri Holdings at the moment suggests that the market is assuming zero growth from this company in perpetuity. I consider this to be a ludicrously pessimistic forecast, and that fills me with some confidence in my bullishness at these levels.
Appeal To Authority
Another idea that I’ve been accused of “going on about” relates to the fact that not all investors are created equal. Some investors are simply better at this for a host of reasons relating to their emotional makeup or their training. Also, some people are better investors in a given name because they are insiders. As people who live and breathe their business, they know more about it than any Wall Street analyst ever will. In my view, the rest of us would do well to pay attention to whether these well-placed individuals agree or disagree with our theses.
With that in mind, I would point out that both John Idol and Thomas Edwards have, over the past few months, bought ~$30,278,000 and $400,000 worth of Capri Holdings stock respectively. In my view, when people who know this business best put their own capital on the line, that is a very powerfully bullish signal. I think the rest of us should take note of it.
The China “Debacle”
Versace recently had to apologize for printing an “offensive” garment, and because of that, some investors worried that the company was “undone” by this Chinese “blunder.” I think that’s overstating it just a bit.
In order to be completely honest in my analysis, I’ll state my biases upfront. After my time living in Asia, I can say that anything that offends the Communist Party of China (the same folks who brought you the Tiananmen massacre, forced organ harvesting, and reeducation camps) is an objective good, in my view. I also have to wonder at the brittle, fragile and delicate sensibilities of a regime that is offended by a t-shirt. I can just picture Winnie the Pooh lookalike Xi Jinping clutching his pearls as he collapses onto his fainting couch at the very sight of the offending piece of cotton. I could write all day about the comic potential of totalitarians everywhere, but I must now turn to putting the recent problem in China in context for this business and try to answer how important all of this is to Capri Holdings.
In my view, not very important at all, actually. While the China World Beijing Flagship store is Versace’s largest store in Asia, that doesn’t actually mean very much. In regard to Hong Kong, on the most recent conference call, John Idol stated the following in answer to a question about the protests there (emphasis added):
And then lastly is, obviously, Hong Kong is an issue. And it appears to be getting worse, not better. So I can’t tell you what the implications of that will or won’t be, because we just don’t know, but – we have a very strong and significant business there with all of our brands and it does concern us. Again in the total scheme of things, it won’t be material to the overall group, but it definitely impacts in that region itself.
This suggests to me that Hong Kong may impact the region, but not the overall business.
Looking more broadly at the entirety of the Asian market suggests that China may not be that significant.
(Source: Capri Investor Presentation, June 4, 2019)
“Asia” is obviously made up of a number of geographies in addition to China (Japan, Malaysia, Singapore, etc.). Per the slide above, all of these geographies combined represent about 19% of sales. Given that Japan, an obvious component of this 19% figure, is the world’s second-largest luxury goods consumer, the Chinese impact seems even less relevant. I would suggest that, all in, China currently represents ~7% of global sales for Capri Holdings. Hong Kong (a completely separate, distinct, somewhat sovereign) area may represent an additional 2% of global sales, and it may be the case that citizens of Hong Kong actually desire this so-called offensive garment. Thus, in my view, China is significant, but not critical to the company, and certainly is far less important than its Asian neighbor Japan.
An Options Trade
Those who may want to own this company over the long term but are worried about further share depreciation have a choice – they can wait for shares to drop. Personally, I find this option insufferable. The alternative is to sell some put options on the company at a strike price that is even more attractive. In my view, this trade creates a “win-win” of sorts. If the shares rally from these levels, the investor simply pockets the premium. If the shares drop further, the investor will be obliged to buy, but at a net price that they find reasonable.
In terms of the specifics, my preferred puts on Capri Holdings at the moment are the May 2020 puts with a strike of $27.5. At the moment, these are bid-asked at $2.35-2.50. If the investor simply takes the bid on these, and that bid is subsequently exercised, they will be doing so at a net price about 23% below the current, already discounted, level.
In my view, there are too many positives here to ignore. The business remains profitable, though somewhat volatile, and management treats shareholders well, in my view. The stock is trading at a deep discount to the overall market and to its own history. Additionally, the market seems to be forecasting a long-term growth rate of zero for this business, which I consider to be ridiculous. I think the feelings of the Chinese Communist Party are less relevant than some investors suggest, given that that market remains relatively unimportant. Finally, and perhaps most importantly, the people who know this business best have just made significant purchases. Being on the same side of the table as them makes me quite comfortable in my long thesis. And for those still not convinced, I think the put options mentioned here are decent proxies for outright share ownership. I think price and value can remain unmoored for some time, but will inevitably meet at some future date. I think investors would do well buying at this price before it rises to match value.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CPRI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I’ll also be selling the put options mentioned in this article.