Don't Buy This Company, Buy Their Key Brand Instead

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I'm constantly reminded of advice that Peter Lynch gave in his two books, “One Up On Wall Street” and “Beating The Street.” One line that I'll never forget was his comment that many times in researching a company, he would find that a competitor, or a customer might be a better investment. I've found this to be true in practice, and in doing some research on Fossil (NASDAQ: FOSL), I found myself looking at one of their key brands as potentially a better investment.

I've owned Fossil in the past with mixed results, and while I think the company will do well in the future, Michael Kors (NYSE: KORS) seems like the better opportunity. I became aware of Michael Kors over the last year or so in keeping up with Fossil and reading their earnings reports. While originally the company seemed somewhat overvalued relative to their expected growth rate, that no longer appears to be the case. One thing that Michael Kors, Fossil, and their competitors Ralph Lauren (NYSE: RL), and PVH Corp (NYSE: PVH) have going for them is that they market to a higher-end clientele.

In today's seemingly sluggish economy, retailers who sell to customers at higher prices, seem to be more insulated from the ups and downs of mid-line retailers. The idea is to establish multiple key brands and then expand those brands to other areas. In Fossil's case the Fossil name is a key brand, but they also own Skagen, and they license Michael Kors, and others. Ralph Lauren of course is known for Polo and the Ralph Lauren name, and PVH Corp owns Calvin Klein, Tommy Hilfiger and more. What sets each of these companies apart from a mid-line retailer like The Gap is, their ability to command higher margins from premium pricing. The perceived higher quality allows this pricing structure, and for those who can afford these names, on a regular basis, a slow economy may have little to no effect on their day to day lives.

If you look at Fossil's last quarter, you can see that the company did fairly well considering the malaise in the general economy. Overall revenue increased 6.4%, and the company reported diluted EPS increased 17.4%. What I noticed was a consistent theme, if Fossil showed strength in a particular division, it was unusually due to strong sales of the Michael Kors line. For instance, watch sales in North America were up 9.9% and much of this was due to Michael Kors. Jewelry sales in North America increased by over 14% and the company again attributed this to the introduction of the Michael Kors line. Growth in watch sales in Asia-Pacific was better than 24% and again, Michael Kors was a key contributor.

There are two key takeaways that investors learn from Fossil's earnings. First, Michael Kors is a popular brand that extends beyond watches and into jewelry. Second, if Fossil lost the license for Michael Kors, the company's results would look very different. This goes to something else that Peter Lynch once said. He suggested avoiding companies that are too reliant on one customer. He said if the loss of one customer would be catastrophic to a business, he wanted to avoid that risk. If you look at some of the numbers, they just reinforce the point that Michael Kors could be the best investment of the group.

Though each of the companies we've named have strong margins due to their pricing, Michael Kors beats their competition soundly. If you look at the operating margin for each company, it's really no contest. Fossil and PVH Corp both license Michael Kors lines and reported operating margins of 16.53% and 14.26%, respectively. Ralph Lauren owns many of their brands so their margins are slightly higher at 18.71%. Michael Kors has the benefit of making money from the license of its brands, which makes the company money without the expense of production. This competitive advantage leads to a category best operating margin of 32.11%. When it comes to Michael Kors valuation, I would argue again the company is in a class of its own.

Fossil, whom I originally set out to research sells for about 16.4 times projected earnings and is expected to grow by 17.75% in the next few years. Ralph Lauren and PVH Corp both sell for forward P/E ratios in the teens and are expected to grow between 12.5% and 13.5%. In stark contrast, Michael Kors sells for a higher P/E of over 25, but analysts expect nearly 30% growth in the next five years. The company has also beaten analyst estimates each of the last four quarters by an average of 63%. Though the company carries a higher P/E ratio, the much faster growth rate more than offsets this higher relative price.

Though I still like Fossil, investors should consider Michael Kors first. The company's lineup of watches, jewelry, and other goods are popular, and the company's licensing of their brand to other manufacturers leads to higher margins. With higher margins and faster growth, investors should skip buying Fossil and buy their key brand Michael Kors.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Fossil. The Motley Fool owns shares of Fossil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus