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.
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.
- 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.
- 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.