INVESTMENT SUMMARY AND CONCLUSION
In January of last year, we issued a note stating that ‘KATE Put Up the Best Comp in Retail’. Roughly a year later, we’re saying the same exact thing. Sure, a 14% number this year might not seem eye-popping, but a) it went up against an incredibly difficult 28% in 4Q14, and b) virtually every company in the space has sharply decelerated since last year. KATE is leading, again. This is a rarity for us to say, but the quarter, and the conference call were both bulletproof, at least based on the standards KATE has set in the past.
We’re not making any meaningful changes to our model, as our thesis is unchanged, and the story is progressing as expected. We like the fact that the company is starting to talk about (gasp!) E-P-S as a financial metric. That’s been our contention for the past six months, that an actual earnings base after seven years of losses would give investors a more tangible valuation metric, as opposed to the ‘adjusted EBITDA’ numbers that no one really trusts anyway.
The current 25x p/e on current year numbers might seem like a stretch. But the earnings growth rate for the next three years is 40-50%. Using a multiple with a 50% discount to growth in 2017, we get to a $40 stock. We don’t want to get greedy with a high-beta high-multiple stock in this tape where its style factors are so clearly out of favor. But when all is said and done, we think the company will continue to execute, and valuation will prove supportive for this stock to work.
1) Topline: The way we are doing the math on 2015 (adding back Fx and quality of sale initiatives) we get to 21% revenue growth in NA and 6% Intl (14 percentage point headwind from Fx). Despite the noise associated with a lot of shifting pieces on the top line due to international agreements, etc. – KATE reported 18% revenue growth vs. reported growth of 7%. Putting that into the context of the segment is dead talk, commentary out of COH which has reported decelerating category growth in NA premium handbag & accessories market from HSD a year ago to flat in the quarter ended in December, and a pullback in the promotional posture a 13% comp is downright impressive. In fact it’s the best number in retail we saw printed in 2015.
But, let’s be clear about one point…2015 was a bridge year for KATE. With promotional cadence planned flat in ’16 in the NA market (at both wholesale and retail after a significant pullback), new international agreements ramping up after a year of reorganization, and 14 new licensed product categories launched in late 2015/early 2016, we expect to see sustained comp growth. KATE’s guidance was markedly bullish on the comp line at low-mid teens, and keep in mind that KATE has blown these numbers out of the water in past year. In 2014 and 2015 the company initially guided to 10%-13% and HSD comp growth, but printed 24% and 13% in each year, respectively. We expect that trend to continue.
2) Margins: The growth algorithm for KSNY this year looked like this: 8% reported adjusted revenue growth leveraging into 38% adjusted EBITDA growth. As good as that looks on both an absolute basis (profitability rate up 350bps) and relative to expectations (reported 16.7% EBITDA margin vs. guide of 15.7%), if we adjust the 2014 number for the Kate Saturday/Jack Spade liquidation we get to a reported EBITDA margin of 15.9% (see chart below). That means we saw just 80bps of leverage in the core business on 18% revenue growth.
Keep in mind that the target for 2015 was 15.7% meaning that to hit the target for 2016 of 18-20% we would need to see 230-430bps of leverage in 2016. Updated guidance now implies only 190-300bps of leverage in 2016, when it appears that the majority of the outperformance in 2015 relative to the targets guided to was due to outperformance on the sales line. Or put another way, KATE didn’t push out costs to hit this year’s numbers. Plus, we should start to see the benefit of in-house sourcing (30-50bps this year) continued growth of higher margin international distribution agreements, a growing (higher margin) licensing category which was just 2% of sales in 2015, and general corporate leverage on a higher sales base. We won’t get greedy in 2016 on the EBITDA side, as KATE continues to invest in order to fuel the top line. But, maybe the bigger takeaway is that the company targets of 18.6%-20% are just stopping points on the way to the mid-20s.