Capri Holdings: A Risky Way To Capture Significant Upside As The FTC Looms (NYSE:CPRI)

Some of the best investment opportunities, about during mergers and acquisitions activities. When one firm agrees to buy out another, there is often a spread of some sort between the price at which shares are trading and the price at which the acquirer has agreed to purchase them in the near future.

This spread exists for two reasons. First, there is a time value of money piece of the pie. In short, the market is accounting for the fact that, while you have your money in the firm, you could have it in something like a risk-free asset. That necessitates a discount, with the size varying based on interest rates and how long it’s expected until the deal goes through. Second, you have a risk component associated with the deal falling through. When you see a large spread in price, that is certainly because the market believes that the chance of the deal falling through is higher than you might normally expect.

One company that is supposed to be bought out in an all-cash transaction that happens to be sporting a massive spread is Capri Holdings Limited (NYSE:CPRI), the luxury fashion group that owns Michael Kors, Versace, and Jimmy Choo. As of this writing, shares of the company are trading at $38.93. That implies a 46.4% upside should it ultimately be acquired, as planned, by rival Tapestry, Inc. (TPR) in exchange for $57 per share. It’s also only marginally higher than the roughly $35 that shares were trading at immediately before the purchase was announced in August of last year.

At this time, this means that the market is forecasting a near 100% chance of the deal falling through. This creates an interesting opportunity whereby investors might be able to get significant short-term upside. And in some cases where I have seen this kind of spread in the past, I have viewed the picture in a very positive light. This is because I viewed the situation as a favorable risk-to-reward scenario.

But that only makes sense when either you think the deal will go through or you believe that shares are attractively priced, or at least no worse than fairly valued if the transaction is not completed. And while the market might be underestimating the chance of the deal going through, there is definitely risk here from a fundamental perspective that gives me pause.

An interesting picture right now

To be perfectly honest with you, I wish I could tell you that I knew whether, beyond any doubt, regulators would approve or shoot down the merger between Capri Holdings and Tapestry. But the fact of the matter is that nobody knows for sure what will transpire. What I do know, and what the market seems to be reflecting, is that there is some risk of the deal falling through. Back in early November of last year, the FTC sent requests to both companies seeking additional information. But this wasn’t its first request for information. It was actually its second. This does happen occasionally, but it’s not terribly common.

Not much has transpired since then. We do know that, recently, Henry Liu, Director of the FTC Bureau of Competition, made some comments at the 2024 American Bar Association Antitrust Spring meeting about the FTC needing to focus more on “head-to-head competition” when evaluating deals. But he did not say anything about this particular transaction.

In its February 8th second quarter earnings call for the 2024 fiscal year, the management team at Tapestry assured investors that they are proceeding forward with the deal as planned, with the most recent statement from that end confirming that they are on track to complete the merger by the end of this year. In addition, they highlighted how, in November, they issued $6.1 billion in debt to use on this purchase. They notified investors that they received approval from the Chinese Regulatory Authority for the deal, and they just received approval from their European counterpart. Furthermore, they also detailed that they expect to capture over $200 million of synergies within three years of the deal closing, and they said that they still expect to close the transaction this calendar year.

This doesn’t mean there won’t be any challenges of it. The most recent news that came out is that the FTC is “leaning” toward filing a lawsuit to block the deal. That would certainly reduce the chance of it going through, but it would ultimately come down to what the courts believe is appropriate at that point. The FTC does not win every case. Last year, for instance, they ended up being defeated in court when trying to prevent the merger between video game publisher Activision Blizzard and Microsoft Corporation (MSFT).

If I had a gun held to my head and was forced to guess which direction this transaction would go, I would say that it would likely be approved and completed. But if it doesn’t work out, there could be some additional downside for shareholders of Capri Holdings.

I say this because fundamental performance as of late has been rather depressing. In the chart above, you can see financial results for the third quarter of the 2024 fiscal year compared to the same time in 2023. And in the chart below, you can see results for the first nine months of the 2024 fiscal year compared to the first nine months of last year.

Revenue has taken a hit. But even more problematic has been a decline in profits. In the first nine months of this year, for instance, the company generated profits of only $243 million. That’s 63% lower than the $650 million reported one year earlier. Operating cash flow, adjusted operating cash flow, and even EBITDA have all taken a beating during this window of time.

Obviously, some of that pain can be chalked up to the decline in revenue. There are multiple pain points here. The company’s gross profit margin, for instance, worsened slightly, and its depreciation and amortization costs grew. But the most painful thing from a profitability perspective has been a surge in selling, general, and administrative costs from 46.3% of revenue to 53.3%. That decline, according to management, was mostly because of higher store costs, increased marketing investments, and the deleveraging of operating expenses caused by lower revenue.

While it might be tempting to view this as a short-term blip on the radar, investors would be wise to understand that the past has not been particularly pleasant for Capri Holdings. For years now, the company’s financials have been worsening year-over-year. Up through 2023, the business had done well with its Versace line. Revenue went from $843 million in 2020 to just under $1.11 billion in 2023. Profits for that line ultimately peaked at $185 million in 2022 before pulling back to $152 million last year.

But back in 2020, that line actually lost $8 million. In the first nine months of 2024, however, the brand reported revenue of $766 million. That’s down 7.9% from the $832 million generated one year earlier.

But Versace was the star of the show, in the sense that it has been the best performer lately. Also, a growth story has been the Jimmy Choo line, with revenue climbing from $468 million in 2021 to $633 million in 2023. This increase followed a two-year decline in revenue for the brand.

However, profits from it have never really been that robust. The best year on record dating back to at least 2018 showed profits of only $38 million. And while revenue dipped by only $1 million from $482 million in the third quarter of 2023 to $481 million at the same time of the 2024 fiscal year, profits plunged from $45 million to $11 million. Higher store costs, as well as marketing investments that seem not to be paying off for now, can be blamed for this weakness.

But the real problem child has been Michael Kors. Ever since hitting $4.51 billion in 2019, the brand has been on the decline. By 2023, it had plunged to $3.88 billion. And in the first nine months of 2024, it came in at $2.70 billion compared to the $2.97 billion generated one year earlier. Profits have also taken a hit, dropping to $518 million in the first nine months of 2024 compared to the $721 million reported for the same period of 2023.

You would think that, given the pain that these units are going through, the entire luxury fashion market is suffering. But that doesn’t appear to be the case. According to one reputable source, the global market is expected to climb by between 3% and 5% this year. That is worse than the 5% to 7% rise previously anticipated. But growth is growth all the same.

There is a silver lining here. And that is the fact that historically speaking, Tapestry has established a pretty good track record of helping brands recover. Notably, we have the Coach brand that it owns. After seeing revenue plunge from $4.27 billion in 2019 to $3.53 billion in 2020, with profits declining from $1.15 billion to $589.4 million, the company was able to return the brand to full health and then some. By 2023, revenue had hit $4.96 billion, with profits almost tripling to $1.53 billion. And as illustrated by the chart above, results for the first two quarters of the 2024 fiscal year show continued improvement relative to the same time in 2023.

Between management rhetoric and its ability to turn things around when it comes to a struggling brand, I would argue that Tapestry would very much like this transaction to still be completed. But if something happens to make it not be completed, I could see some additional downside. In addition to concerns that fundamental performance will continue to weaken without a new owner, there’s the fact that current performance indicates that shares are rather pricey, especially relative to similar firms.

In the chart above, you can see how shares are priced using data from 2023 and estimates for 2024. And in the table below, you can see how they stack up against five other fashion brands. When it comes to both the price to earnings approach and the EV to EBITDA approach, our prospect ended up being the most expensive of the group. And when it involves the price to operating cash flow approach, three of the five firms ended up being cheaper than it.

Click to enlarge

Takeaway

At this point, I view Capri Holdings as a very binary prospect. If the transaction between it and Tapestry gets approved as currently structured, investors can capture tremendous upside in a short window of time. On the other hand, the market has concerns about the likelihood of the deal going through. In some cases, investors can take solace in knowing that the downside is limited. But that’s not exactly the case here. It wouldn’t be shocking to see the stock drop 20% or 30% should things fall through.

Because of this uncertainty, investors who are more cautious should definitely stay away from the picture. But for those who don’t mind taking some risk, I would say that Capri Holdings Limited stock makes for an interesting, but likely nerve-wracking, “buy” candidate.