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Did Michael Kors Just Hit Rock-Bottom?

Shares of luxury retailer Michael Kors a>strong>(NYSE:KORS) bucked the bearish market trend on Thursday, following the company's better-than-expected earnings report.

An hour before the closing bell, KORS was trading 11% higher, after reporting fiscal first-quarter sales of $986 million and earnings of 87 cents per share. Analysts were expecting earnings of 75 cents per share on revenue of $944 million.

The Decline of "Affordable Luxury" Abroad

Long-term KORS investors have gotten used to disappointment. After peaking at $101.04 in February of last year, the shares lost 62% of their value, hitting a low of $38.16 earlier this week.

Some of the decline may be due to the fickle nature of luxury consumers. In a world of fads and swiftly changing trends, it is tough for a company like Michael Kors to stay on the cutting edge of these fashion trends.

A few investors are worried that Kors has lost touch with its core affluent consumer base by pricing merchandise low enough to make items affordable for more middle-class shoppers. It's tough to keep an "exclusive" image if too many non-affluent customers are walking around with your branding.

Finally, the strong U.S. dollar has played a part in KORS' decline. A strong U.S. dollar makes Michael Kors merchandise more expensive in countries with relatively weak currencies. While non-US revenue only made up about 22% of the company's 2015 revenue, the strong dollar still plays a part in causing weak sales.

Weakness is Real, But Already Priced In

There is no question that business has been tough for Michael Kors. One only needs to look at the 9.5% decline in same-store sales to see that the company has a problem. KORS has been actively discounting its merchandise to try to help boost sales, and management guided investors to expect more of the same in the second fiscal quarter.

With that said, it appears that the stock has traded low enough to fully account for the weak fundamentals. Now it appears that KORS performance is turning out to be "less bad" than analysts and investors were expecting - causing the stock to rise.

For what it's worth, we believed there was a good chance that Michael Kors could rebound following the company's earnings announcement, simply because investors were so pessimistic that it would have been difficult for KORS to announce anything more bearish than what investors already believed.

Below is a quote from a trade alert we sent to our MTI Premium subscribers on Wednesday (before the KORS earnings announcement):

The strong dollar story is well documented and should be priced in to these stocks at this point. Investor sentiment for Michael Kors and other international luxury retailers has been weak.

Tomorrow, KORS will announce earnings before the market opens. Analysts have lowered their expectations ahead of the release. The stock has traded lower, currently sitting at $39.45 versus its price near $75 at the beginning of the year.

Because of the weak expectations, option premiums are very high. We can sell the September $37.50 puts which are nearly $2.00 out of the money for a price of $1.50. This gives us $300 in income. If shares of KORS are put to us and we are required to buy at $37.50, our income from the puts will go far in offsetting any further decline in the stock.

As it turned out, KORS earnings announcement was strong enough to prove to investors that the company can still turn a substantial profit, even with the challenges that it faces. That was enough to cause some investors to begin buying shares at a deep value and to cause short sellers to begin covering their position.

A Painful But Necessary Transition

Michael Kors is likely in the painful process of transitioning from a growth stock to a mature, cash flow-positive investment. As we discussed last week, growth stocks typically don't pay dividends. That's because they need to reinvest their profits in future growth opportunities.

But when a company becomes mature and has less of a need to reinvest its profits, investors can expect to start receiving dividend payments. Over the next few quarters, the management team at Michael Kors will have to determine whether they want to reinvest the company's profits into opening new stores and expanding their retail footprint - or if they want to start paying profits to investors.

Given the low level of growth and the still respected branding, we would encourage KORS to begin returning cash to shareholders in the form of dividends. This could actually help to drive the stock price higher as investors seek more yield and see that the company's management takes its responsibility to shareholders seriously.

For now, shares of KORS are trading near $43.75, while analysts expect the company to earn $4.25 per share in fiscal 2016. This means that even after Thursday's jump, investors are paying just over 10 times earnings to own this iconic brand.

While we were happy to take a quick profit on our KORS income trade, we'll be watching the stock carefully for another chance to make a bullish income trade.


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