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KATE | Where Could We Be Wrong?

Takeaway: Fundamentals look good, and KATE will finally have much-needed valuation support in ‘16. But yes, we still worry ‘bout what they’ll say.

Let’s be real – there’s no company (not even RH) that worries us more headed into an earnings event – even when we think we have the fundamental story 100% nailed. That’s no different this time – a) we think we have the fundamentals nailed – and they look very good, and b) we’re worried about what management will say when they open their mouth tomorrow, and how the market will react.  But under $20 – heck, even under $30 – we’re very comfortable taking the risk.

 

We’ll go through our modeling assumptions, and more importantly, where we could be wrong tomorrow. But in the end, we think that timing finally looks good for KATE. Keep in mind the following…

 

  • Even though KATE has been executing extremely well on its plan, the fact is that earnings have been nearly entirely absent this entire economic cycle. How could a) the brand be relevant, or b) the company be great, if KATE can’t earn a single red cent in the greatest economic recovery in a generation? The stock has looked extremely expensive to the average investor who cared about nothing but current year earnings (which is pretty darn important, in fairness). 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 the company will report on Tuesday will be critical, in that the company should earn 15% more than it did in all of 2014. As the market starts to shift its attention to ’16 and ’17 it’ll see just under $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 20x an earnings rate that should grow 50%+ for 3-5 years. For the first time EVER, KATE will prove to have valuation support – and that support should prove to be considerable.
  • 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 its 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 $2.00-$2.50 EPS power in three years. The CAGR it takes to get there gets us to $40 on the low end (20x $2.00), and to $62 on the high end (25x $2.50). Either way, we’re talking around a 2-3-bagger from where the stock is today. This is one of the best risk rewards out there from where we sit.

 

KATE | Where Could We Be Wrong? - KATE Financials 2 29

 

Where Could We Be Wrong:

 

1) Category is dead: We never thought this was the case in the first place, but the market certainly did. Sentiment on the space has changed in a positive way evidenced by the performance of KORS and COH, up 41% and 18% YTD, respectively, vs. a flat XRT. KATE has underperformed its peers on the inflection because it has been radio silent for the better part of three months. According to COH, the NA premium handbags and accessories market was flat for the quarter ended in December. That’s off from HSD a year ago, and MSD intra-year. Yet, KATE has seen accelerating comps sequentially in every quarter this year. If we’re wrong – it’s that KATE, with about 4-5% market share of the global handbag market, doesn’t have the market share opportunity, which translates to growth inline with the category. That hasn’t been the case.

 

2) Growth drivers don’t grow: This is a mix of core and non-core.

    1. On the core side, the company is just 50% penetrated in the North American market. There is already a big batch of stores headed into the peak part of the maturation curve. That = a better margin profile and increased unit productivity. KATE only opened 15 doors in North America in 2015, but we expect the cadence to pick up in ’16 and beyond (management already said as much though it has not guided to door openings). The risk would be product saturation as the store profile is built out, but given KATE’s relatively low wholesale mix (30% vs. KORS 50%) we think there is plenty of opportunity.
    2. On the non-core side, the company has two handfuls of licenses in categories ranging from furniture, to watches, and Yoga wear that have/will launch in the latter part of 2015/16. Add on 4 new distribution agreements: Japan childrenswear, China JV, LatAm, and Europe (ex. UK and France). All of this is incremental to KATE, and comes with neither a large capital investment or balance sheet risk. If we’re wrong – it’s that new door growth comes at lower productivity as distribution fills out in NA, and customer acceptance in new regions/categories falls flat.

3) Margin drivers:  At $1.2bn in revenue KATE has a 9.1% operating margin, on a similar revenue base KORS was operating at a 19% EBIT margin and COH in the mid 30% range. For KATE to work from here we don’t need to assume a KORS or COH esque margin profile – just high teens. We get there through steady GM improvement as the company continues to promote quality of sale in both retail and wholesale. Taking accessory sourcing in house from Li & Fung. New doors coming into the peak part of the maturation curve. No Kate Spade Saturday/Jack Spade dilution. A partnered approach to unproven growth drivers (license/international), lowering upfront investment. If we’re wrong – it’s that KATE has a materially lower margin profile than the rest of its peer group. That’s true to some degree given its Retail (70%)/Wholesale(30%) mix, but we don’t think those are prohibitions on the climb to high-teens.

 

Additional Modeling Considerations  on the Print  

 

Sales Guidance – For the 4th quarter the current guidance implies a growth rate in the range of 4-22%. This, of course, is ridiculous. The company simply did not change annual guidance after the 3Q beat. And no, we don’t think it accurately reflects the company’s internal forecast accuracy. It just shows where guidance stands in the hierarchy for KATE. We’re slightly below the street on the revenue side at $437mm, 10% growth vs. the street at 11%, due to accounting on discontinued ops.

A few things to keep in mind…

1) KATE started to pull back on its Flash Sale promotions in 4Q14, eliminating a 75% off Flash Sale that occurred in mid-December 2013. We saw three flash sales in 2015 vs. just 2 in 2014 (but similar day count) which means the headwinds that have cost KATE ~$10mm in revenue over the past 3 quarters are now in the rearview.

2) There are 4 particular headwinds that would cost the company $30-$40mm in sales in 4Q. 1) Fx, 2) the licensing of the watch business to Fossil, 3) quality of sale efforts in the wholesale channel, and 4) new store openings pushed into FY16. Those headwinds are in consensus numbers. As we roll forward into 2016,  those headwinds turn into tailwinds and should provide additional upside.

 

Gross Margins – YTD, we’ve seen 75bps of gross margin leverage, but the 60.4% guide for the year assumes that gross margins are flat for the year implying that 4Q is down 150bps (which excludes the $8mm charge taken in 4Q14 from Jack/Saturday). That’s up against a -190bps GM (adjusted) number in the 4th quarter of last year which was caused by FX pressure in Japan, and outlet pull forwards; the exact same reasons cited this year.  Additional FX pressure can explain away maybe a fraction of the confusion over guidance, but we have a hard time getting to the company's numbers. The punchline here is that there’s no way KATE is going to simply ‘hit’ (and not beat) its fourth quarter GM guidance.

 

Same for SG&A/EBITDA Margin Guidance – The top end of the sales and EBITDA guidance assumes a 15.7% EBITDA margin rate for the year. That implies that the company will get just 50 bps of leverage in 4Q as it comps against $29mm in charges from Jack/Saturday. If we net out all of the charges associated with those two brands last FY, we get to an EBITDA margin rate of 15.9%. To date this year – the company has printed 300bps of margin leverage excluding all Jack/Saturday charges and 390bps of leverage reported. We would have to see a material weakening in the business to get to the implied profitability rate in 4Q. 


They Can't Stop the Bleeding

Takeaway: Global equity markets continue to crash alongside faith in central bankers' omnipotence.

They Can't Stop the Bleeding - Global economy cartoon 12.16.2014

 

Whether we're talking about the Fed, ECB, BOJ or PBOC, central planners the world over can't stop the bleeding in global equity markets. 

 

Case in point... more deflation in the Eurozone this morning. The key question for ECB head honcho Mario Draghi ahead of the March 10th meeting is can Draghi snap his fingers and magically change Europe's deflationary reality?

 

Nope. 

 

Here's some related analysis from Hedgeye CEO Keith McCullough from a note sent to subscribers this morning:

 

"European stocks had their slow-volume bounce last week (EuroStoxx600 +1.6% to -9.4% YTD), but resume their crash this morning with the DAX -1.6% (down 13% YTD and -24% from 2015 top) post a #Deflation print of -0.2% y/y for Eurozone CPI (versus 0.3% in January); Swiss 10yr falls to -0.45% as #NIRP (negative interest rate policy) continues to perpetuate #Deflation."

 

Take a look at Germany...

 

 

Here's Spain and Italy...

 

 

In other central planning news, the (up) Yen and (down) Japanese stocks story continues to defy the intent of the BOJ's negative interest rate policy.

 

It's just one more example of the crumbling credibility of central bankers. To be sure, when macro markets wake up to this reality, things are going to get downright nasty. McCullough has dubbed this evolving phenomenon the #BigBangTheory

 

Here's his take on the latest macro market developments out of Japan:

 

"The Yen is ramping (again) vs. USD this morning and that is not a good thing when it comes to the #BigBangTheory as it keeps Japanese stocks (Nikkei -1% overnight and -23.1% since last yr’s high) in crash mode w/ no “G20 help” this weekend."

 

 

Meanwhile, over in China... the PBOC cut the banking system's reserve requirement ratio again by 0.5 percentage points as the economy continues to slow. China's stock market is down 48% since June. Here's what growth slowing looks like in China Shanghai Composite Casino:

 

 

While permabulls pray for more cowbell, we're bullish on growth slowing proxies like Long Bonds (TLT) and Utilities (XLU). 

 

Our message: Fade Central-Planning storytelling...


RTA Live: February 29, 2016

 

 


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MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND

Takeaway: Risk is now more positive than negative in the short-term, but the intermediate and longer-term durations still skew negatively.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM11 2

 

Key Takeaway:

Risk has been in modest retreat for the last two weeks alongside an emergent stabilization in oil in the low $30s and the less bad than feared +1.0% GDP print on Friday. We wouldn't take too much comfort from that as risk in Asia continues to creep higher. The Chinese Interbank Rate, a gauge of systematic stress in the Chinese banking system, notched up by 11 bps week over week to 2.05%, its highest level since April 2015. Additionally, the median CDS spread in Asia widened by 5 bps last week, bringing the M/M change to 11 bps. 

 

 

Current Ideas:

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM19

 

Financial Risk Monitor Summary

• Short-term(WoW): Positive / 4 of 13 improved / 3 out of 13 worsened / 6 of 13 unchanged
• Intermediate-term(WoW): Negative / 4 of 13 improved / 7 out of 13 worsened / 2 of 13 unchanged
• Long-term(WoW): Negative / 1 of 13 improved / 6 out of 13 worsened / 6 of 13 unchanged

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM15

 

1. U.S. Financial CDS – Swaps tightened almost across the board for US Financials as 4Q15 GDP came in better than expected. The median contract tightened by -9 bps to 100 last week.

Tightened the most WoW: JPM, C, HIG
Widened the most WoW: MMC, CB, XL
Widened the least/ tightened the most WoW: JPM, TRV, LNC
Widened the most MoM: AIG, MMC, PRU

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM1

 

2. European Financial CDS – Swaps were mixed across European banks last week with essentially no W/W change in the median. 

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM2

 

3. Asian Financial CDS  Swaps on Asian banks were flat to wider last week, led by the increase at State Bank of India which widened by +13 bps to 195.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM17 2

 

4. Sovereign CDS – Sovereign swaps were mixed last week. On the positive side, Portuguese sovereign swaps tightened the most, by -20 bps to 326. On the negative, Irish swaps widened by +7 bps to 66.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM18

 

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM3

 

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM4


5. Emerging Market Sovereign CDS – Emerging market swaps mostly tightened last week. Brazilian CDS tightened the most, by 19 bps to 455, as the country's central bank reported that Brazil's budget deficit narrowed in January, although the improvement came from one-time revenue sources.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM16

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM20

6. High Yield (YTM) Monitor – High Yield rates fell 28 bps last week, ending the week at 8.56% versus 8.84% the prior week.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM5

7. Leveraged Loan Index Monitor  – The Leveraged Loan Index rose 7.0 points last week, ending at 1789.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM6

8. TED Spread Monitor – The TED spread was unchanged last week at 32 bps.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM7

9. CRB Commodity Price Index – The CRB index fell -0.5%, ending the week at 162 versus 163 the prior week. As compared with the prior month, commodity prices have decreased -3.0%. We generally regard changes in commodity prices on the margin as having meaningful consumption implications.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM8

10. Euribor-OIS Spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread widened by 1 bps to 15 bps.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM9

11. Chinese Interbank Rate (Shifon Index) – The Shifon Index rose 11 basis points last week, ending the week at 2.05% versus last week’s print of 1.94%. The Shifon Index measures banks’ overnight lending rates to one another, a gauge of systemic stress in the Chinese banking system.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM10

12. Chinese Steel – Steel prices in China rose 2.6% last week, or 54 yuan/ton, to 2125 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity and, by extension, the health of the Chinese economy.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM12

13. 2-10 Spread – Last week the 2-10 spread tightened to 97 bps, -7 bps tighter than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM13

14. CDOR-OIS Spread – The CDOR-OIS spread is the Canadian equivalent of the Euribor-OIS spread. It is the difference between the Canadian interbank lending rate and overnight indexed swaps, and it measures bank counterparty risk in Canada. The CDOR-OIS spread tightened by 1 bps to 39 bps.

MONDAY MORNING RISK MONITOR | ASIA RISK RISING IN THE BACKGROUND - RM14


Joshua Steiner, CFA



Jonathan Casteleyn, CFA, CMT


The Macro Show Replay | February 29, 2016

 


Yen, Europe and UST 10YR

Client Talking Points

YEN

The Yen is ramping (again) vs. USD this morning and that is not a good thing when it comes to the #BigBangTheory as it keeps Japanese stocks (Nikkei -1% overnight and -23.1% since last year’s high) in crash mode with no “G20 help” this weekend.

EUROPE

European stocks had their slow-volume bounce last week (EuroStoxx600 +1.6% to -9.4% year-to-date), but resume their crash this morning with the DAX -1.6% (down 13% year-to-date and -24% from 2015 top) post a #Deflation print of -0.2% year-over-year for Eurozone CPI. The Swiss 10YR falls to -0.45% as #NIRP continues to perpetuate #Deflation.

UST 10YR

The UST 10YR didn’t really budge during last week’s U.S. stock market levitation – more importantly, with the 10YR = 1.74% this morning, the Yield Spread has compressed to another new low of 96 basis points wide (10s/2s) and that keeps the Financials (XLF) as our favorite S&P Sector Short vs. Utes (XLU) long.

 

*Tune into The Macro Show with Hedgeye CEO Keith McCullough live in the studio at 9:00AM ET - CLICK HERE

Asset Allocation

CASH 65% US EQUITIES 0%
INTL EQUITIES 0% COMMODITIES 4%
FIXED INCOME 25% INTL CURRENCIES 6%

Top Long Ideas

Company Ticker Sector Duration
XLU

Our preferred growth slowing vehicle remains Utilities (XLU) in equites. Hitting on Friday’s revised GDP report (Q/Q SAAR Q4 GDP revised to +1.0% from +0.7%), a deep-dive into the number doesn’t support an incrementally stronger economy:

  • Consumption was revised down marginally but net exports were up with the negative revision to imports outweighing the negative revision to exports. That’s good for the number but lower global trade activity is not a good sign for global growth;
  • Much of the actual change in the revision was due to inventories, which contributed +0.31pts to the headline number
GIS

General Mills (GIS) hit an all-time high last week when it reached $60.18 on Thursday. Although this would not be a great entry point, it is also not a reason to get out if you have a long-term view. Nothing has changed in our fundamental story and we have no reason to lose faith in our thinking to date.

 

Over the course of the past few years, GIS has made strategic acquisitions within the natural & organic / wellness space (we call it the string of pearls approach). Although they are not largely meaningful to top or bottom-line right now, they are changing the way the company thinks about its broader portfolio.

 

We continue to believe GIS is one of the best positioned consumer packaged foods companies due to its strong brands and best-in-class people and organization.

TLT

Our preferred growth slowing vehicle remains (Long-Term Treasuries) TLT in fixed income. A flattening in the yield spread (10YR Treasury Yield – 2YR Treasury Yield) continued last week into double digit basis point territory (currently at 96 basis points). Year-to-date the yield spread has declined 44 basis points while the 10YR Treasury Yield has dropped 47 basis points. As a reminder the yield curve flattens as the economy slows with policy and/or liquidity management driving the short-end higher and defensive positioning and/or discounting of lower future growth/inflation driving the long end lower. 

Three for the Road

TWEET OF THE DAY

NEW VIDEO | McCullough: How To Think About Volume https://app.hedgeye.com/insights/49431-mccullough-how-to-think-about-volume… cc @KeithMcCullough $IWM $SPY $DJIA

@Hedgeye

QUOTE OF THE DAY

I attribute my success to this: I never gave or took any excuse.

Florence Nightingale

STAT OF THE DAY

There are 7% fewer babies born on leap year day as there are people born on any other day.


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