Investment Conclusion
Without question, we hate losing even more than we love winning. Though we a) have been into KATE big time since she was a strung-out $4 stock, b) still build up to a 35% EPS CAGR for the next 3-years, and c) d) and e) absolutely cringe at the prospect of backing away AFTER a 20% implosion, the fact is that the research has changed. And when the research changes, so do we. Specifically, the intermediate-term (TREND) call is uncertain enough that the name could just as easily see $12 as it could $20 (it’s $16 today). That kind of ‘push’ is not something we want to stay married to when management’s credibility is falling faster than it could lower its own expectations – or we could lower on our own. How things stand today, we’d opt to get back involved at either $12 or $20 (as odd as that sounds) after either the story is de-risked, we have the simple passage of time (6-9 months how we see it), or management steps up, puts its money where its mouth is and actually starts to own some stock in size.
To be clear, we would not short one squirt of this stock despite our diminished confidence in the team. The fact is that it remains a healthy, high-quality brand that is extremely likely to double earnings over just two years and is trading at just 12x ensuing EPS and 5.1x EBITDA. Furthermore, it has what we think is a defined $1bn near-term market opportunity with at least 100bps in margin upside per year – and still will be over 1,000 basis points below peers. To boot, sentiment around the name is simply atrocious, not reflected in current short interest which has come off some 400bps to 7.5% of the float with two-thirds of current sell-side ratings at a buy equivalent (which the chart below measures). But, the incremental interest on this name has completley dried up.
As a frame of reference on interest/sentiment -- For every 20 inquiries we get from investors on our RH Long call (where we still have very high confidence in the fundamentals and the team despite the stock telling/mocking us otherwise), 25 inquiries on our HBI short call, and 30 calls on our view of the dynamics behind NKE/FL/DKS/HIBB, we get maybe one or two from people being interested in going long KATE (and those are probably the two people reading this). If you want to go short that setup outright at $16…knock yourself out. But you’re probably going to lose. The only thing we hate more than losing ourselves is when our customers lose.
But building an Intermediate-term long case is quite tough – and that’s the duration on which most people involved in this perennial hedge fund stock will be focused. This print confirmed what we feared (and outlined in our note KATE | Thoughts Into The Print) headed into the quarter in that management took down guidance for the year by 11% due to some factors that come as no surprise, such as a) weakness at the high-end, b) volatility in the category overall, and c) re-basing ‘out-of-reach’ comp expectations to a beatable level (like competitors do) – with that last point as the most significant factor. But KATE also laid the biggest earnings egg under the current regime and put up a paltry 4% comp when all indications were that it could have, and should have, done better. Adolescent growth retailers should be comping better than 4% -- even in a moderate recession.
If you have the luxury of looking at 2018 numbers and staring through a few bucks downside from here, then it’s definitely time to dust off those KATE/FNP/LIZ files. They should result in a pretty penny 12-18 months out due to factors mentioned above. In all likelihood, we’ll be re-joining you on the table-pounding side of this call.
Here’s where we stand on each of the value creators on the sales and margin side after the print…
Sales: Perhaps there’s nothing more jarring to a long-term thesis than a sequential comp deceleration of 15 percentage points. Not that we’re not used to it from this company at this point, the only difference is that in past situations the company properly managed expectations, at least on the downside. Take a look at the 5.5 year history of KATE (first LIZ, then FNP) reported comps vs. consensus estimates, this is the first time the company missed expectations in nearly four years, and it wasn’t by a point or two, but a massive gap of 900bps. What gives? Management pointed to 4 key issues for the slowdown and attributed 700bps of the 900bps comp miss to the following factors: 1) an uptick in tourist dependent traffic issues in the outlet channel, 2) self-inflicted product transition headwinds, 3) others in the competitive set being more promotional, and 4) weaker consumer spending in Japan.
Call it what you want KATE, but if history has taught us anything with this company is that low-mid-teen comp guidance for the year was a low ball number, this isn’t a company who has ever done anything but obliterated comps. That means there was a serious change in the trend in the business in the two months between when the company reported 1Q numbers and the end of June. Given the confidence issues pervasive in this market when it comes to management – we think the top-line trend is troubling but the far greater concern is the management credibility issues associated with a miss of this magnitude for a company with an already suspect track record.
But that’s a more backward looking review of the topline, going forward we still see KATE essentially doubling its reported revenue base to north of $2bn over the next 4 years, but have less confidence in the company’s ability to meaningfully exceed those levels given the choppiness we’ve seen reported by the company over the past 18 months as it reacts to waning consumer demand in the category and a constantly changing business model. Here’s where we stand on each of the value creators…
1) Store Build and Maturity: This isn’t necessarily new, but the company has taken a considerable step back in its store growth plans. For a company with just over 100 full price doors in NA and 65 outlets (compared to KORS at 390), 9% sq. ft. growth in the US, and just an incremental 5 new fully owned doors (23 YY) doesn’t exactly scream compelling growth story. We give the team at KATE some credit for using different vehicles to expand the footprint, mainly e-comm which has a track record in the branded space 2nd to none and some opportunistic ‘better’ wholesale expansion, but for this model to work we need to see the top line pumped by well executed real estate expansion. We think the opportunities are there, but given management’s reluctance to step on the accelerator, maybe the question should be why is the pace so slow?
2) Market Share Opportunity: KATE ended 2015 with ~5% share of the global handbag space, compared to KORS and COH who collectively account for 40%+ of the market. That simple discrepancy in KATE’s relative share compared to its most closely associated (and we should note only publically traded) competitors explains why the company has been able to defy gravity at the same time that its competitors and the wholesale partners who sell them have been bleeding. We still think there is plenty of share out there to be gobbled up, but we just saw the first resistance to KATE’s product assortment evidenced by the soft June novelty commentary. And, a) the outlook for category growth may have bottomed but doesn’t appear to be accelerating from LSD, plus b) the spending patterns of the upper quintile (right in KATE’s consumer wheelhouse) which represent 40% of consumer expenditures here in the US just put up two consecutive quarters of negative YY growth for the first time since 2010.
The punchline there being our lower confidence in KATE’s ability to demonstrably outperform the rest of the market in a soft category and weakening macro environment doesn’t bode well for accelerating top-line trends.
3) Quality of Sale: We’ve been flat out bullish on KATE’s decision to buck the trend in the retail space and promote quality of sale for its brand both in the wholesale and fully owned distribution channels. But, there is a big difference between protecting the brands accessible luxury image and playing offense. Clearly the company wasn’t quick enough on the trigger in 2Q to balance the delicate relationship between the two. We get that merch margin expansion in the full-price channel is important, but when it comes at the expense of sales dollars for a growth company still trying to establish its presence in the handbag market the public-markets are less forgiving. Now that the company is turning back on the promotional juice, it might re-excite the consumer, but we think on a deeper level it speaks to the need for a strong promotional posture for a brand like KATE who is only in month 7 of new normal when it comes to promotional cadence after a yearlong pull back effort. Ultimately what it comes down to is that KATE needed to promote to ensure category/retail leading performance in its early days, then it didn’t, and now it does again.
4) International: Sales in the international segment were up 20% on top of a 25% decline in 2Q last year. There is plenty of noise due to the decision to partner in SE Asia and Brazil that makes the compares tricky here, but the one metric we really care about, average sales per sq. ft. in company owned retail (mainly in Japan and W. Europe) was down 12% in constant currency for the first 6 months of the quarter. We like the partnered low capital/low risk strategy especially at a time when international demand looks dodgy, but it’s hard to get more bulled up in light of the slide in owned retail.
Margins: In regular circumstances, 140bps of margin leverage (90bps of adjusted EBITDA) on a 4% comp would be more than enough to get us excited about a retail print, but this is KATE and the bar is set much much higher. The obvious hiccup in the latest print was on the gross margin line, which underperformed expectations for the second consecutive quarter. The 200bps of deleverage flat out stinks when you consider the company most likely got a 75bps lift (in line with 1Q commentary) in full-price product margins, meaning that the off-price (~20% of the business), which we think accounted for the largest chunk of the GM drag, cost the company around $8mm in gross profit. The wholesale bit we understand is due to timing, but there was also an offset on the EBIT line as wholesale comes at a lower SG&A rate.
Over the long term, we’d argue that the company doesn’t need KORS or COH esque margins which topped out at 32% for this stock to work, but we also think the climb towards 20% and ultimately $2.00 in earnings power will be more measured than our original thesis called for on a slightly lower top line trajectory. If this quarter taught us anything on KATE, it is that the P&L is highly levered to a slowdown in demand. The ironic thing is that the company moved away from its Flash Sale events to promote quality of sale, but those same events were accretive to margins. With those tempered, the company had no online vehicle to stimulate demand and promote margin traction into a softening outlet environment.
Corporate leverage has another 18 months or so to run, the Li & Fung transition will be good for about 60bps plus in year 1, next year will be all about easy compares, and the shifting dynamics in international and sales mix (between retail/wholesale/licensing) KATE has plenty of runway to grow the margin profile organically. The building blocks are certainly there, but given the volatility in the face of easy compares execution of the plan and recognition of the upside has us much more concerned.
