Why Are Tapestry’s Profits Likely To Witness A Decline In FY 2020?

Tapestry (NYSE: TPR) has achieved steady revenue growth in the last couple of years driven by rising comparable-store sales (comps) as well as e-commerce sales for its largest brand, Coach.  Moreover, the company’s acquisition of Kate Spade has provided a boost to the company’s revenues. However, the apparel company’s expenses have followed a similar trend over this period – resulting in profits remaining broadly level. Although the company’s revenues are likely to fall by 1.2% in FY 2020 (ending June), expenses are likely to fall at a slower pace (-0.6%). This should result in Tapestry’s earnings margin (i.e., revenues less all expenses, expressed as a percentage of revenues) contracting by 60 basis points from 10.7% in 2019 to an expected 10.1% in 2020 – resulting in a slight reduction in Tapestry’s profits for the year. Notably, the spread of the coronavirus is likely to adversely impact the company’s FY 2020 results. Tapestry expects its second-half results to be negatively impacted by approximately $200-$250 million in sales and $0.35-$0.45 in earnings per diluted share.

Trefis breaks down the company’s major expense components in its interactive dashboard, ‘How Does Tapestry Spend Its Money?‘ parts of which are summarized below. Notably, operating expenses (which include selling, general and administrative expenses (SG&A), and other management costs) are expected to be $3.2 billion in FY 2020 – making up 60% of Tapestry’s $5.35 billion in total expenses for the year. Tapestry’s operating costs are nearly 1.6x of the company’s manufacturing costs or the cost of sales (COGS).

• Tapestry’s total expenses have increased by 34% since 2016, going up from $4 billion to $5.4 billion in 2019. Operating expenses have been the single biggest contributor to this increase, as they swelled from $2.4 billion in 2016 to more than $3.2 billion in 2019. Moreover, the acquisition of Kate Spade has also contributed to higher expenses.
• The company’s total expenses are expected to decline by 0.6% in 2020, likely driven by a $44 million decrease in the operating expenses.
• However, the company’s total expenses as % revenue are likely to nudge ahead from 89.3% in 2019 to 89.9% in 2020.

Cost Of Sales

• The cost of sales includes the expenses incurred to acquire and produce an inventory for sale, including product costs, freight-in, and other related costs. COGS is one of the most significant expense drivers, accounting for more than one-third of the company’s total expenses in 2019.
• COGS have increased by 37% over the last few years – rising from $1.44 billion in 2016 to $1.97 billion in 2019 primarily as a result of strong revenue growth, resulting from the Kate Spade acquisition.
• One-time acquisition charges related to the acquisition weighed on the company’s gross profit in 2018, with the company’s gross margin declining to 65.5%. However, this metric recovered to 67.3% in FY 2019.
• We expect COGS to remain flat at $1.97 billion in FY 2020, which represents a gross margin figure of 66.9%.

Operating Expenses

• Tapestry’s operating expenses have increased by 35% since 2016, going up from $2.4 billion to $3.2 billion in 2019, led by an increase across all operating channels, as well as the acquisition of Kate Spade. Higher marketing expenses related to Kate Spade has been an important contributor to this increase.
• Additionally, operating expenses as % of revenues are also on the rise – increasing from 53.4% in 2016 to nearly 53.8% in 2019.
• We expect total operating expenses to decrease by 1.3% to just shy of $3.2 billion in 2020, representing 53.7% of Tapestry’s Total Revenues of $5.95 billion.

Non-Operating Expense (Income)

• Tapestry’s non-operating expenses have increased from $27 million in 2016 to $48 million in 2019 mainly due to higher interest expense.

Additional details about how Tapestry’s Non-Operating Expense has trended over the years are available in our interactive dashboard.

Income Taxes

• Tapestry’s income tax expense has steadily decreased over the last few years, falling from $166 million in 2016 to around $123 million in 2019. The tax rate figure was unusually high in 2018, mainly due to additional provisional income tax expense incurred due to the enactment of the US Tax reform.
• The effective tax rate is expected to be around 17.5% in FY 2020.

Per Trefis estimates, Tapestry’s EPS is likely to fall from $2.21 in 2019 to $2.17 in FY 2020. Taken together with a P/E of 13.4x, this works to a fair value of $29 for Tapestry’s stock, which is higher than the current market price.

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