KATE | Critical Inflection Point

Takeaway: We think that 3Q is fine, and that after 7 yrs, EPS will inflect and begin to lend valuation support. One of the best risk/rewards in retail

Though few sane people would argue this by looking at how the stock trades, we think that the quarter looks solid for KATE, and the long-term investment thesis is fully on track. We think timing here is absolutely critical, and that timing finally favors the long side. Keep in mind that this company has been a serial restructurer, having traded under three different tickers in five years, and the only constant during that time period has been a lot of red at the bottom of the P&L. Even though KATE has been executing extremely well on its plan, the fact is that the stock has looked extremely expensive to the average investor who cared about nothing but current year earnings. This is why the stock got annihilated when the category (Kors) hit a wall. It simply had no valuation support. That’s why we think that the quarter we’re currently in (4Q), will be critical, in that the company should earn 30% more than it did in all of 2014. In fact, we’re a few short months away from people focusing on $1.00+ in earnings power for next year – a level it hasn’t seen since 2007. People will be looking at a name trading at 18x an earnings rate that should grow 50%+ for 3-5 years.

 

So why has the stock been acting like death?  For starters, it’s perfectly fair to be worried about what management will say on the call. Even though we think the trends look good, the fact is that KATE’s track record with communication is not good. We think it’s getting better, but wounds take time to heal.  In addition, it’s extremely tough to dispute that tax-loss selling was an issue here. Last week was fund year-end, and KATE was down 44% YTD through Friday. The double whammy of tax-loss selling and the “what will they say on the call next week” served as a vicious cocktail for the stock, we think. There was virtually no fundamental news out – even out of COH last Tues – that should have rocked this name like it did.

 

Watch what KATE does, not what it says. Ultimately, ‘what it does’ will create the value we know is about to be unlocked. Do we need better disclosure? Yes. Enough financial information to build a basic retail/multi channel model (like RL, KORS, COH, and pretty much every other real company that sells product in this space)? Yes. Management to put it’s money where its mouth is and buy stock when real believers in the story are sweating it out on the down days? Yes. A CFO who is on the conference calls (like every other company in the S&P)? Yes, please. But these are factors that can all be fixed – quite easily, actually. The thing that KATE has down pat is execution on the Brand growth and profitability strategy. We’ll take that.

 

Ultimately, we think we’ve got between $2.50-$3.00 in EPS power in three years. The CAGR it takes to get there gets us to $62 on the low end (25x $2.50) to $90 on the high end (30x $3.00). Either way, we’re talking around a 3-4-bagger from where the stock is today. This is one of the best risk rewards out there from where we sit.

 

Here’s a Few Considerations Regarding the Quarter

The ‘Space’ – COH indicated on its call last week that the premium North American women’s and men’s handbag category grew at a LSD rate in the most recently completed quarter (no change from 3 months ago). That’s not a big surprise to us considering that two of the biggest competitors in the space, COH and KORS with market share in excess of 40% have comped negative in North America at a HSD to LDD clip. But, if we do some quick math on that and assume that a) COH and KORS market share = 40%, b) the category is growing at 3%, and c) the absolute dollar growth rate for COH and KORS is ~ -5%. Then that means that the rest of the space is growing in the high single digit range. For a company like KATE, with only 5% share of the US handbag market and significant market share available to capture as the company builds out its US distribution network, that’s not as ‘toxic’ an environment as commentary would otherwise suggest.

 

Flash Sales/Promotions – this might be the first quarter in recent memory that there has not been excessive chatter about the space being overly promotional. That’s particularly the case with KATE, as the company continues to step off the Flash Sale accelerator in the DTC channel while working with wholesale partners to remove the brand from promotional events (in other words, when you see online promos at retailers like Lord & Taylor, it includes Coach, Kors, but not Kate). At DTC in NA specifically, KATE ran 4 sales in 3Q15 compared with 5 in 3Q14. 75% off Flash Sales were pared down from 3 to 1 in the quarter the company will report on Thursday. In 2Q (reported 90 days ago) the pull back in Flash Sales cost the company $6mm in revenue or three percentage points of growth on the adjusted consolidated revenue line, and 400-500bps on the comp line (reported comp of 10% vs. mid-teens adjusted for change in Flash Sale strategy). Due to timing KATE had 3 days of its mid-year Friends and Family sale pushed into the 3rd quarter vs. only one day last year, and the company added an additional 25% of Sale Items event in early September. The bottom line is that on an underlying basis, KATE is absolutely, positively less promotional than a year ago, as well as on a sequential basis.

 

E-commerce trends – sequentially e-comm growth ended the quarter right in line with where the company ended the 2nd quarter with the index traffic rank up 7% YY based on our analysis. Traffic rank is a 90-day moving average that takes into account both unique visitation and page visits per user and ranks each URL relative to the internet in aggregate. Since late August, when KATE bottomed it has outperformed the rest of the space (COH, KORS, & Tory Burch) by a wide margin (see chart 2). Comparisons at the e-comm level ease up in the 3rd quarter as KATE comps against a 23% growth rate vs. a 26% growth rate in 2Q (assuming a 20% e-comm weight). That’s not as marked as the sequential step down in Brick and Mortar compares where the company reported a 32% comp in 2Q14 and a 13% in 3Q14, but on the margin compares in this channel ease up in the 3rd quarter as KATE continues to pull back on its Flash Sale posture. The bottom line is that recent trends, which will presumably be implicit in the company’s guidance, are directionally encouraging.

 

KATE | Critical Inflection Point - KATE ecomm 1

KATE | Critical Inflection Point - KATE ecomm 2

 

GM guidance – KATE is guiding to a 60.4% gross margin rate for the year, which is flat to LY after adjusting for the $8mm inventory right down hit the company took in the 4th quarter from Jack/Saturday. YTD the company has leveraged Gross Margin by 190bps (65bps if we adjust for the $6m hit in 2Q14 from the Kate Spade Saturday inventory liquidation) and current guidance would imply that gross margins need to be down in excess of 125bps in 2H. The company has a tough compare in the 3rd quarter, but we have a hard time reconciling the delta between the 1H and 2H performance. Especially when you consider that the factors cited as headwinds (Fx, increased outlet penetration) should be annualized by 4Q15 when the company comps the Juicy outlet pull forward and Fx pressure from 4Q14. On the positive side, KATE will see the benefit of the JV conversion, the elimination of Jack Spade and Kate Spade Saturday retail doors, and increased licensing penetration. We don’t have KATE getting back the full 210bps of GM it lost in FY14, but given that there is 130bps from inventory right downs alone, and the current trends we’ve seen in the business it only makes sense that the company gets the majority of it back.

 

KATE | Critical Inflection Point - KATE earnings 2


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