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.
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.
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Key Takeaway: While easy to lose track of trends across domestic macroeconomic data during earnings season, one thing’s for sure and two things are for certain: U.S. economic growth continues to slow and the economic expansion itself is now well past-peak. The risk to “risk asset” prices embedded in 2016E nominal GDP and earnings growth forecasts remains great.
It’s earnings season and we know you’re busy, but that doesn’t mean macro catalysts cease to exist. That being said, it’s neat when the top-down and bottom-up signals are implying the same conclusion: the domestic economy is mired in industrial and earnings recessions.
A quick update on the latter recession:
- Though Q3 earnings season to-date, 387 of 500 S&P 500 companies have reported.
- Sales growth decelerated to -5.3% YoY from -3.4% YoY in Q2.
- EPS growth decelerated to -4.3% YoY from -1.9% YoY in Q2.
A quick update on the former recession:
- We received three key data points regarding the broad health of the domestic manufacturing and production economy over the past three trading days: OCT Markit Manufacturing PMI, OCT ISM Manufacturing PMI and OCT Factory Orders. No, we do not consider the ISM Milwaukee PMI, MNI Chicago PMI or ISM New York PMI as indicative of the health of the broader economy. Each represents little more than opportunities to cherry pick data to form-fit an existing narrative and we do not believe in cherry picking data.
- The former key data point (Markit Manufacturing PMI) registered a sequential acceleration in OCT and is now accelerating ever-so-slightly on a trending basis.
- The latter two key data points (ISM Manufacturing PMI and Factory Orders) registered sequential decelerations in OCT and SEP, respectively, and both continue to decelerate on a trending basis.
Aside from the fact that Real GDP growth slowed on queue against steepening base effects in Q3, the [other] critical risk to broader economic growth remains the likelihood that the aforementioned recessions spillover into an eventual consumer-led downturn. That would be in line with how a typical business cycle works:
- Inflation peaks, then slows;
- CapEx and Manufacturing growth peaks, then slows;
- Employment and Wage growth peaks, then slows; and finally
- Consumption and Services growth peaks, then slows.
Given that those catalysts have all played out in order since the start of 2014, we retain confidence in reiterating our view that domestic economic growth is likely to slow into a full-blown recession by mid-2016. For those of you who remain skeptical of this view, we encourage you to review the following presentations – each refreshed as of today:
- U.S. GIP Model Summary (45 slides): http://docs3.hedgeye.com/macroria/Hedgeye_U.S._GIP_Model_Summary.pdf
- U.S. Economic Cycle Indicators (10 slides): http://docs3.hedgeye.com/macroria/Hedgeye_U.S._Economic_Cycle_Indicators.pdf
- Global Demographic Analysis (17 slides): http://docs3.hedgeye.com/macroria/Hedgeye_Global_Demographic_Analysis.pdf
Going back to the most recently reported data, a quick update on the fourth business cycle catalyst highlighted above:
- In the past three trading days we received three key data points regarding the broad health of the domestic consumption economy: SEP Real PCE, OCT University of Michigan Consumer Sentiment and OCT Passenger Vehicle Sales.
- The former key data point (Real PCE) recorded a modest sequential acceleration in SEP to its trend line (i.e. 3MMA), but the aforementioned trend has now decidedly stagnated.
- Consumer Sentiment recorded a decent sequential acceleration in OCT, but is still decelerating on a trending basis; meanwhile, Passenger Vehicle Sales growth continued its trend of acceleration with a sequential uptick in OCT.
The key takeaway here is that broad consumption growth remains overwhelmingly positive from an absolute perspective (e.g. the current 3MMA of Real PCE growth is in the 91st percentile of all readings on a trailing 10Y basis). Given that Real PCE represents over two-thirds of U.S. GDP, the real risk to the economy is that the consumer slows alongside the trend in employment growth. Friday’s OCT Jobs Report will be telling in that regard.
Also telling is the fact that growth in the 77.7% of the U.S. economy that falls within the Services Sector has negatively inflected and is now driving broader measures of economic momentum lower as of OCT:
Source: Bloomberg L.P.
Source: Bloomberg L.P.
One key risk to our bearish call on the economic cycle is that credit remains a-plentiful and keeps consumption growth elevated as it traverses a series of difficult growth compares through 2Q16. If, however, the Fed’s 4Q15 Senior Loan Officer Survey results are telling, credit too is now moving past-peak with respect to this economic expansion:
- Hedgeye Financials Team: 4Q15 SENIOR LOAN OFFICER SURVEY | SIGNS OF A SLOWDOWN (11/3)
- Moody’s: “U.S. Corporate Defaults to Hit a 4-Year High…” (11/2)
- FT: “M&A Volumes Weaken in October Despite Megadeals” (11/1)
Sticking with the theme of threes, the critical risk to domestic “risk asset” prices are threefold as well:
- Bad news becomes bad news again (as implied by the now-positive 1M correlation between the S&P 500 and the Implied Yield on the Fed Funds Futures Contract 1Y Out) – just as it had been during the previous two economic downturns;
- Equity sentiment is likely now pervasively bullish, insomuch as it had been pervasively bearish at the AUG/SEP lows (we currently have data though 10/27; on Friday we will receive data through today's close); and
- At this new “all-time high” (for all intents and purposes), market breadth continues to confirm the now-obvious degradation of recent micro trends, as well as the dour nature of our macro outlook.
Source: Bloomberg L.P.
Source: Bloomberg L.P.
Current Hedgeye Extreme Sentiment Monitor:
End-of-September ESM Refresh:
All told, while easy to lose track of trends across domestic macroeconomic data during earnings season, one thing’s for sure and two things are for certain: U.S. economic growth continues to slow and the economic expansion itself is now well past-peak. The risk to “risk asset” prices embedded in 2016E nominal GDP and earnings growth forecasts remains great:
Furthermore, another round of Deflation’s Dominoes remains a critical risk to manage over the NTM: “Are You Prepared for a Deepening of the Global Earnings and Industrial Recessions?” (10/22)
When will asset markets start to broadly discount investor consensus being wrong on the domestic economic cycle again? We don’t know. The best thing we can do in the interim is continue to remain grounded in the data.
Enjoy your respective evenings,
Below is an excerpt from today's Early Look by Hedgeye CEO Keith McCullough:
...[A]s a friendly reminder to those of you who didn’t know, I got fired for being “too bearish” on November 2nd, 2007. By the end of that month, the almighty SP500 was down over 6%, on the way to an almost 60% peak-to-trough crash.
...On that score, as of last night’s close, 360 of 500 companies in the SP500 have reported the following:
- Revenues down -5.1%
- Earnings down -4.2%
Our Financials team led by Josh Steiner and Jonathan Casteleyn nailed the Short Call on Encore Capital Group (ECPG). Shares are down 12.5% amid speculation that the debt financing company will face increasing FTC scrutiny. They added ECPG to their Best Ideas Short list on 11/19/2014. Since then shares are down 19%.
In their ECPG Black Book, they cite “regulatory risk,” among others factors, as catalysts that could send the stock lower. See the slide from their Black Book below.
In September, the Consumer Financial Protection Bureau forced Encore to pay up to $42 million in consumer refunds, a $10 million penalty and stop collection on over $125 million worth of debts. In a press release the CFPB noted that Encore:
“… bought debts that were potentially inaccurate, lacking documentation, or unenforceable. Without verifying the debt, the companies collected payments by pressuring consumers with false statements and churning out lawsuits using robo-signed court documents.”
As today’s selloff clearly illustrates, investors think the regulatory woes are only going get worse before they get any better. In a press release, the FTC said it would be announcing “a major law enforcement initiative involving the debt collection industry.”
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.
LONG SIGNALS 80.46%
SHORT SIGNALS 78.35%