Conclusion: We’re adding Kate Spade (KATE) to our Best Ideas list as a long. We’ve actually been very positive on KATE since the stock was struggling to break the $5 barrier when the Street thought that (the former) Liz Claiborne was going bankrupt. However, with sentiment turning overwhelmingly bullish, the stock recently flirting with $40 on a non-existent earnings base, and virtually no contention around the story, it was tough to remain as vocal. But all of that has changed dramatically on August 12 when the company printed an outstanding quarter, but botched its messaging around long-term margin targets. Since then, the stock simply can’t seem to catch a bid, and is down 33%. The amount of controversy around this name today (down $1.8bn in equity value) absolutely dwarfs the diminimous change we’ve seen to the economic reality of its growth trajectory and cash flow. The reality is that the core value drivers are in place, and are very much in-tact. We think that the company will earn $1.40 in 2016, which is 40% above the consensus. The company reports earnings around Nov 6, and we’re comfortable getting ahead of that event. We’ll be hosting a call in the coming weeks to outline our thesis in full detail.
Stock Roadmap. This is a company that should grow earnings at a 60% CAGR over 5-years. The stock might look expensive at 40x next year’s earnings. But keep in mind the following. 1) The consensus is wrong. We’re 15% above consensus next year, and are probably conservative. It’s trading at less than 30x the real number. 2) Earnings should ramp by between $0.50 and $0.80 per year off a base of only $0.28 – for every single year through 2018. That’s a CAGR of 60%. What kind of multiple does that growth deserve? Even if you want to argue that it deserves a higher risk premium to account for fashion risk, we think that at least a 40x multiple is extremely fair. If our model is right, that equates to a stock of $38, $65 and $87, and $120 in years’ 1 through 4 of our model (50x in year 1 giving way to 40x as it matures).
Still Huge Runway. And while we talk about ‘maturity’, let’s keep in mind that Kate might have been around for a while, but it is still in its early adolescence from a global branding perspective. Kate Spade only did $743mm in sales last year. That compares to $4.8bn for Coach, and $3.6 for KORS. KATE does not exactly want to aspire to be Coach. But the reality is that KATE can double in size and still be only 50% as big as KORS. It’s even smaller than Tory Burch, which is likely to go public over the next 12-18 months. Our point is that fashion risk in this space matters most at two points; 1) when a brand is tiny and is trying to gain consumer acceptance. Kate has already done that. 2) When the brand becomes ubiquitous, margins are stretched, and the company needs to find non-core areas to grow. Kate is nowhere close to that point.
That last statement deserves some context. Kate Spade is nowhere near the point where it needs to grow outside the core. But the reality is that it is with its Kate Spade Saturday brand. Quite frankly, we couldn’t care less about Kate Space Saturday. It only has 10 stores today, and generates about $20mm. That’s only about 1.8% of sales. It simply does not matter as it relates to the growth runway in Kate Spade New York. But the reality is that the company is investing in the concept, which is likely to pressure margins (this is what largely drove the stock down after the print). So even though it’s irrelevant to our thesis, the fact that the company is backing it financially means that – to an extent – we need to care about it.
Margin Targets. Here’s the statement from the COO that sucked the oxygen out of the room on the conference call.
“With respect to our 2016 targets, which we outlined at our Investor Day last year, we expect to achieve an adjusted EBITDA margin of 25% for the former Kate Spade segment. Given the longer-than-expected Kate Spade Saturday ramp-up coupled with our revised 2014 margin rate outlook and because of our limited visibility into 2016, we feel that it is responsible to re-evaluate the timeframe of achieving this goal, which we will perform as part of our annual business planning process later this year. We will assess whether any short-term adjustment to the timeframe is warranted, and we'll update you in November during our third quarter earnings call. To be clear, if a short-term adjustment is even necessary, we expect the most likely adjustment would be a shift to 2017. This is all the commentary we will have on this topic today, and we will not address this further during the Q&A.”
This wss one of the worst commentaries on a company’s outlook that we’ve ever heard. This is a company that had just crushed the quarter with the stock up 12% pre-market. Here’s a couple of thoughts on the margin target.
1) Yes, margin targets will very likely get pushed out by a year. But we don’t care. What the company should have said is “We’re probably going to hit our 2016 revenue target two years early because of how well we’re executing on our plan. Growing the footprint of our brand(s) is our top priority, and if we have to give up 2-3 margin points in order to achieve our goal, then we’re perfectly happy to do that.” That’s good offense. They played bad defense. But we think they since got the message.
2) Consider the following math: Previous target from the company was $1.2bn in revenue at a 25% EBITDA margin. That’s $300mm. If we take down margins by 300bp and apply to where the top line is likely to come in ($1.9bn), we get to $418mm. That’s 40% higher EBITDA than previous guidance suggests. That would have been valuable information to include on that last conference call.
3) There are many people that will differ with us (the market certainly does) but we simply don’t care a whole heck of a lot about margins right now. The margin will come. For now we want pure unmitigated growth. If this was Coach, Kors or any other mature company, then margins would matter a lot more to us. But for a company that can triple its revenue base in 4-5 years, we’re a lot more inclined to focus on the top line, and will usually (within reason) support the costs that might go along with achieving those goals.