Tapestry, Inc. (TPR) aspires to be a global house of brands. However, poor execution to-date casts doubt on the viability of the strategy. Valuation is not low when compared to its peers. I would wait until a credible turn-around plan has been finalized and early results are evident before I commit my own capital to TPR.

Picture source: TPR presentation

TPR has around 276M shares outstanding, recently trading at around $25.5 per share. Net Debt at the end of September 2019 was around $810M, giving TPR an EV of around $7.8B. TPR pays an annual dividend of $1.35 per share. The shares yield around 5.3%.

From its base of Coach, TPR acquired Stuart Weitzman “SW” in May 2015, and Kate Spade “KS” in July 2017. These acquisitions were the beginning of the strategy of building the house of brands. The company also changed its name from Coach to Tapestry to reflect its aspiration. I used the word “aspiration” as management fumbled miserably in its execution. A new CEO came on board recently but has not had time to pull together a turn-around plan.

In this article, I will describe some underlying metrics that point to missing strategic initiatives and poor execution. I will also describe the strategy that I gleamed from the latest CC from the new CEO. I will explore TPR’s valuation vs peers and why I would not invest now.

Tapestry has not proven itself to be a platform to build a house of brands

TPR acquired SW in May 2015. Mr. Weitzman, the founder of SW, left SW in May 2017 (F4Q2017). Shortly after his departure, cracks showed in the business in F3Q2018. Management reported that SW’s “supply chain based in Spain was not prepared for the level of complexity and new development in this transitional period for the brand”. As a result, SW sustained an operating loss for F3Q2018. Since that time, SW was unable to make an operating profit except for F2Q2019 (see Figure 1). To correct the problem, TPR has to add “infrastructure and capacity to support the brand’s creative vision with quality on-time deliveries”. These investments continue to the present time.

Figure 1: Deepening operating loss in SW since the departure of Mr. Weitzman. Source: 10-Q and 10-K reports.

The above commentaries from TPR seemed to imply that TPR did not have a platform-based supply chain strategy and had to scramble to put one in place at SW when the supply chain failed to execute. While much of the decline in profitability in SW was blamed on the supply chain issue, it is likely that the brand lost its soul when the founder left the company. One value of a platform to a brand is to provide best practice business processes. In the case of SW, business processes such as succession planning, supply chain management, design processes, and design for manufacturing processes could have been deployed in SW to ease the transition of the retirement of Mr. Weitzman. It was likely that sharing of best practice was not part of the integration. In fact, one would wonder how much integration actually took place.

While SW is but a small sliver of the overall sales of TPR at 6.3% (Figure 2), the deepening loss at SW does point to the weakness in the execution of the multi-brand strategy. The weakness has really become painfully evident after TPR acquired KS.

Figure 2: TPR sales mix by brands. Source: F1Q2020 10-Q report.

KS is a bigger piece of TPR as shown in Figure 2. As such, poor results in KS have a much bigger effect on the overall results of TPR. TPR completed the acquisition of KS in July 2017 (F1Q2018). A key metrics for the retail trade is Comparable Store Sales “CSS”. KS’s CSS has consistent negative growth under TPR’s watch (Figure 3).

Figure 3: Comparable Store Sales growth for Coach and Kate Spade. Source: TPR earning releases.

A negative CSS results in negative leverage in KS’s expenses. This leads to a decline in the operating margin of the brand. This is shown in Figure 4.

Figure 4: KS’s operating margin declines. Source: 10-Q and 10-K reports.

TPR promised $50M of synergy in a presentation accompanying the announcement of the acquisition. Looking at the SG&A of both KS and TPR, it is difficult to determine if any synergy was realized. SG&A (as % of sales) for both KS and TPR corporate continues to increase. In fact, SG&A at TPR corporate is increasing rapidly recently as TPR invests in an ERP system, another necessity to support the house of brand strategy that was lacking. This is shown in Figures 5 and 6, respectively.

Figure 5: Kate Spade SG&A as % of Sales. Source: 10-Q and 10-K reports.

Figure 6: TPR corporate SG&A as % of Sales. Source: 10-Q and 10-K reports.

TPR brought Ms. Nicola Glass from Michael Kors in November 2017 to oversee the design at KS. Yet two years into Ms. Glass’s leadership, TPR reported that the KS brand was experiencing “product voids and merchandising challenges”. Management did not elaborate the root cause of these challenges, but it is clear that there are serious fundamental business process and oversight issues within KS and TPR.

Even at Coach, the largest brand by revenue in TPR, CSS is treading water at 1% to 2% in the last 4 quarters (Figure 3). At such low comps, Coach is losing leverage as well. With the decline in profitability at both KS and SW, and with the growth in corporate SG&A, the profitability of TPR has been on the decline. This is shown in Figure 7.

Figure 7: Declining operating margin at TPR. Source: 10-Q and 10-K reports.

The poor execution results brought a new CEO, Mr. Jide Zeitlin, to TPR in September 2019. Mr. Zeitlin has been on the BOD of TPR for 13 years. Mr. Zeitlin led the F1Q2020 CC in November after being on the job for 2 months. While he has not completed his diagnostic work, some of his thoughts on how to improve the business is summarized in the next paragraph.

TPR needs to sharpen its focus on execution and on delivering results. TPR will focus on growing the existing brands and there will be no additional acquisition for the foreseeable future. The brands have to be more consumer focused. Investment will be measured against this consumer focus. Both corporate and the brands have to be more agile and more efficient and productive – a euphemism for a complex and high cost structure. Cost reduction is necessary as TPR needs to free up resources for investment in the brands and to build the platform and its digital capability. TPR needs to build more synergy between brands and to determine a model for its platform functions versus brand functions.

Mr. Zeitlin has not given a time-line to present a concrete execution plan. Most new CEOs take about 6 months to develop and articulate a turn-around plan. We should expect a public unveiling of this plan within another 3 months.

Valuation is not low compared to peers

TPR’s valuation is not low compared to its peers. I have chosen Capri Holdings (CPRI) and Ralph Lauren (RL) as TPR’s peers. This is shown in Table 1.

Table 1: TPR’s valuation compared to peers. Source: SA data base.

TPR’s shares do not appear to be undervalued compared to TPR’s peers, especially when compared to CPRI, which is executing a similar house of brands strategy. Perhaps investors are just very skeptical of this strategy and its execution. TPR’s dividend is attractive at 5.3%. However, given the risks in execution and some brands never prosper again once they lost their cache, I would wait until TPR shows evidence of execution in its results metrics before investing.

Execution risks abound

The first thing I would look for is a credible plan to bolster Coach’s business, a turn-around plan for KS and SW, and the articulation of the platform strategy to support a multi-brand strategy. While KS and SW are the brands that are suffering, TPR’s strategy and execution to bolster the Coach brand is of utmost importance. At more than 70% of TPR’s sales and most of its operating profits, Coach is more important to TPR than KS and SW combined in the near-term. Figure 3 shows that Coach’s CSS has declined YoY in FY2019 and into FY2020. If Coach’s CSS continue to decline, TPR share price will be significantly impacted. The results metrics that I would look for are solid and steady growth in Coach’s CSS, an inflection of KS’s CSS, as well as a steady gross margin for all the brands.

I would also look for a plan for efficiency improvement, and results that are actually reflected in a higher gross margin rate and a lower SG&A rate at both the brand level and the corporate level. I would also look for TPR’s plan to build a platform to support a multi-brand strategy. This platform strategy should result in synergy in the short term. I would look for actual results in capturing the synergy.

I have learned that turn-around is risky. Even if a turn-around works, it may take a long time and the share price may go even lower in the interim. In the case of KS, it may take a while to turn it around. While waiting for evidence of turn-around results may not allow me to buy at the bottom, I have learned that this approach gives me a better risk-adjusted return.

Another thing to watch is TPR’s capital plan. Dividend payment has been TPR’s preferred approach to return capital to share-holders. At around 5.3%, the dividend rate is quite attractive. However, one should continue to watch how well the dividend is covered by FCF. This is shown in Figure 8. While the dividend per share has not increased, the TTM FCF has declined. This resulted in a ratio of TTM Dividend vs TTM FCF to increase to the mid-70% level. If this ratio continues to increase, investors should grow more cautious.

Figure 8: TTM dividend to FCF ratio has increased recently. Source: 10-Q and 10-K reports.

In the last 2 quarters, TPR has used its cash to buy back its shares for the first time in a long time. This action reduced its cash and marketable securities position, thereby increased its net debt position. At the end of the latest quarter, TPR’s debt leverage has increased to 0.8 from as low as 0.1. While this level is not an issue, investors should watch for further deterioration should TPR continues to increase its net debt to buy shares.

Takeaway

TPR’s valuation is not low compared to its peers, especially compared to CPRI which is executing a similar house of brands strategy. Investors should be skeptical of TPR’s house of brands strategy and management’s execution. There are many risks in execution – growing Coach’s CSS, turning around KS’s CSS and profitability, turning around SW, and showing that a house of brands platform indeed adds value in synergy and leveraged capabilities. I would wait for new management’s turn-around plan and evidence of early execution success before considering investing in TPR.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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: All investments have many risks and can lose principal in the short and long term. The information provided is for information purposes only and can be wrong. By reading this you agree, understand and accept that you take upon yourself all responsibility for all of your investment decisions and to do your own work and hold the author harmless.

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2019-12-11