Hedgeye macro analyst Matt Hedrick explains why we remain bearish on European equities (via EZU) and the Euro (via FXE) and tells us that today’s weak economic data from Europe remains consistent with our bearish take on the region.
Takeaway: Botched communication ≠ a broken story. This story is fundamentally on track. Could be dicey for a qtr. But the roadmap to $70 is there.
Conclusion: This story is not broken -- far from it. This selloff is a perfect storm that could have easily been avoided by the company. Say what you want about uncharacteristically sloppy investor communication. It’s justified. With a 75x multiple, they have zero room for error. But the growth story here is intact as it relates to a) retail expansion, b) same store sales growth, c) category expansion, d) geographic diversification, and e) channel growth. Are there questions about how much capital Kate Spade Saturday needs to grow? Yes, and that’s perfectly normal. But if Saturday went away entirely our model would not miss a beat. The story is still 100% on track. People don’t seem to want to buy ahead of an ‘official’ rebasing of long-term guidance w Saturday-related costs. So it may be dicey for a quarter. We’ll pick our spots to add. But longer term, if you believe in our numbers, it’s not tough to get to a $70 stock.
Whenever a stock collapses like KATE just did – giving away $1.7bn in market cap (or 32%) in the course of about 90 minutes – it’s usually a punch in the jaw to let the market know that something has radically changed with the fundamental story. In KATE’s case, however, that’s simply not the case. The way we see it, this stock action was overwhelmingly driven by some very poorly chosen words by management on the conference call. The stock started to give up some early gains as CEO Leavitt spoke about the quarter being promotional, but absolutely collapsed after 52 minutes of prepped remarks when COO Carrera said something that sounded like…
[We gave you long term targets at the analyst meeting last year. Based on investment in Kate Spade Saturday, we may or may not push those targets out by a year. We’ll let you know in the fall.]
Ok, let’s put this into perspective. There are few companies that can make a statement like this – a very JV error -- and not get dinged materially. Mind you, as good as Leavitt and Carrera are operationally, both have little experience speaking to/through capital markets. But a 32% hit to market cap is more than a ding. It’s a high-speed collision. Take those comments, and now combine with a high-expectation stock that trades at 75x current-year earnings and is comping 30% -- then it gets a lot more dicey. The icing on the cake is that not only has Coach blown up, but the mighty KORS, which has served as a halo for KATE, has also started breaking down. Note good in combination with weaker gross margins due to clearance and investment in Kate Spade Saturday (a brand that is immaterial to the story today). On top of all that, KATE just restated its financials into a format with better forward disclosure, but did not give 2H13 restated numbers -- making it extremely difficult for the Street to build financial models in line with new reporting structure over the next two quarters.
Combining all these factors, it makes sense to us that the stock got hit on this conference call. Note that we did not say ‘get hit on the print’, because that was otherwise solid. This was almost all about perception instead of financial factors. The company comped 30%, grew revenue at 49%, expanded margins by 658bps, and earned money for the first time in a 2Q since 2008. Something else to keep in mind… while the 30% comp was easy to get excited about (until management lost control of the call), the the fact of the matter is that upside to the SSS comp is finite. It won’t end next quarter, or next year. But it will ultimately moderate as KATE hits its steady-state store productivity rate, which we model at $2,000 in 2018. But keep in mind that KATE only reported $266mm in revenue this quarter. That compares to KORS at $919mm and COH at $1,136. There’s a lot of growth here that is not comp-related.
- Store growth should go from 245 stores today to 600 in year 5. For what it’s worth 560 of those stores are Kate Spade NY, while the remainder is Kate Spade Saturday and Jack Spade.
- International: The fact that US revenue was up 55% and International was up 54% is no mistake. The growth by geography is extremely balanced. As it relates to Int’l store growth, we saw recent openings in Macau, Hong Kong, Mexico, Middle East/Abu Dabi, and Malaysia.
- Wholesale vs. Retail: We like how KATE is expanding its wholesale doors. It’s not simply opening up the whole product line, like so many other brands do. But rather it is opening specific product categories at different wholesale accounts. This helps prevent channel conflict, and gives retailers content they believe to be exclusive.
When all is said and done, we’re not changing our earnings estimates. We think that KATE ramps from $0.30 in EPS this year to $1.58 in just two years. It’s next to impossible to find a ramp like that. Key modeling assumptions…
- Store count goes from 245 to 600, as previously noted – with little help from Kate Spade Saturday.
- Comps slow as the company reaches $2,000 per square foot, which we expect will happen in 5-years time.
- EBIT margins top out at 21% at KSNY, and 18% on a consolidated basis (includes 5% in D&A).
- Interest expense goes away entirely in 3-years as internally generated cash flow outstrips capex needs to build stores.
Valuation vs Peers
A quick point on valuation. When we look at earnings today, it’s flat-out expensive. But that’s always been the case. Here are five high-growth (actually 4 high growth + Coach) names where we look at where the stocks are trading on today’s earnings, versus 2018 (if you want to look at 2016, as some people will, the chart looks extremely similar). KATE is expensive today, but right in line with KORS on out-year numbers. The only company that looks meaningfully better is RH.
Takeaway: We are removing Legg Mason (LM) from our high-conviction stock idea list.
Jonathan Casteleyn, co-head of Financials, explains the decision below.
We are removing shares of Legg Mason (LM) from our Investing Ideas list. The combination of a change in quantitative signal as well as the lack of forward fundamental catalysts are the reason for this change. Legg Mason stock has moved from Bullish to Bearish Trend duration during the course of this week and in combination with the company having made an acquisition announcement of Martin Currie two weeks ago, the potential to roll in new assets accretively via deal making has now been discounted in the stock.
Since adding LM to our Investing Ideas newsletter on the week of March 25th, shares have appreciated by 3.0% versus the Asset Management Group return of -1.0%. Thus the combination of this excess return and also the stock starting to change quantitative signals as well as now a lack of fundamental catalysts, lead us to remove the stock from our Investing Ideas newsletter.
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Euro Pacific Capital CEO Peter Schiff discusses how ridiculous the U.S. government's inflation numbers are with Hedgeye CEO Keith McCullough on HedgeyeTV's "Real Conversations." Other topics include gold, interest rates, and reckless Fed policy.
Investment Recommendations: short Eurozone equities (EZU) and EUR/USD (FXE)
Germany’s Expectations of Economic Growth (as surveyed by ZEW) tanked in today’s release of August data – the 6 month forward looking indicator fell -68% M/M! Similarly, Eurozone Expectations fell -51% M/M. The data further confirms our investment recommendations to be short Eurozone equities (EZU) and EUR/USD (FXE).
- Germany - ZEW Survey Expectations 8.6 AUG (17.0 est.) vs. 27.1 prior
- Germany - ZEW Current Situation 44.3 AUG (54.0 est.) vs. 61.8 prior
- Eurozone - ZEW Survey Expectations 23.7 AUG vs. 48.1 prior
The weakness in the survey mirrors declines/misses in more recent German high frequency data:
- German Factory Orders dropped -3.2% in July M/M (vs expectations of +0.9%) and fell -2.4% Y/Y (vs exp. +1.1%) and +7.7% in June
- German IFO Business Confidence Expectations fell to 103.4 in July versus 104.8 in June
- German Industrial Production rose +0.3% in June M/M (vs exp. +1.2%)
From a quantitative perspective, both the DAX and EUR/USD remain broken across our intermediate term TREND and long term TAIL lines.
We believe our investment recommendations are grounded in a few key points:
- Draghi will be on hold to issue outright QE – in the Fall Draghi may begin issuing QE-lite (ABS buying) to follow on his June announcement of the TLTROs (a new lending program intended to reach the “real” economy). We don’t expect these programs in and of themselves to reverse what’s been slowing economic data and expect the inflation rate will be the big tell – if CPI doesn’t bounce off its current 0.4% Y/Y level, we think market expectations of QE will be put into motion.
- EUR/USD weakness – a more dovish ECB and beginning signs of a quantitative breakout in the US Dollar may continue to drive the cross lower.
- Geopolitical risks clear and present – regionally we expect tensions with Russia over Ukraine and threats of contagion flair-ups (like the financial issues at Banco Espirito Santo) to persist. Further we expect risk premium to remain elevated as conflicts, like the war between Israel and Palestine and US involvement in Iraq, to play into downside risks in equities, globally.
For a more nuanced view of EU regional data and policy dynamics see our note titled Draghi Dangles QE Carrot; On Hold for Now
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