INVESTMENT CONCLUSION
This quarter was ‘about in-line’, meaning that revenue, EBITDA, EBIT, EPS and Guidance were all at or slightly better than expected. ‘In line’ might not seem like a big deal, but make no mistake… For KATE, ‘in-line’ is a huge deal. First off, let’s keep one thing in mind. KATE just put up a 19% comp, and 50% growth in e-comm, by our math. That’s the biggest comp in all of retail. You can say the same about KATE in 3 of the past 4 quarters. #respect. When it beat comp expectations in the past, however, it would usually manage to miss revenue (like it did all last year). Not this quarter. This time it beat. Only by 2%. But it still beat.
More importantly, this is a company that has lost money every year since 2007. Despite having strong sales momentum over the past three years, it had no EPS, and only a convoluted non-GAAP Adjusted EBITDA number that was impossible to model. When the ‘handbag space’ melted down – KATE’s brand was fine, but its stock was annihilated because it had zero earnings/cash flow and valuation support. Well, that ends now. True, we only saw $0.05 in EPS this quarter (up from $0.03 last year), but that will accelerate meaningfully both sequentially and y/y. When all is said and done, we’re at $0.85 this year and a 3-year CAGR of 54% through 2018. Even if we’re wrong and KATE ‘only’ earns the consensus, we’re still looking at a 44% CAGR. We can count on one hand the number of companies that will put up that kind growth in US Retail.
Is 29x current year EPS rich? No, it’s not. Within 12-18 months, people are likely to be eyeing $2+ in EPS power – and that’s with the company investing at a continued high rate in the brand to facilitate such profitability. Importantly, our margin forecast in 2018 is 19% -- well below the 32% peak achieved by competition such as KORS and COH. Those companies underinvested and over-earned. That won’t be the case with KATE. In the end, we think that $2.00 in EPS power at a scant 0.5x PEG multiple (or 25 p/e) suggests a $50 stock by the end of 2017. Basically, that’s a double from where we are today in a very underowned stock.
DETAILS OF THE QUARTER
When Boring Is Good – Over the past 3 years and change (13 quarters) KATE has been consistently inconsistent in its quarterly numbers. Here’s a quick recap: comps beat consensus expectations 100% of the time, this quarter was no different with comps coming in at 19% vs. the Street at 12.5%. Despite the consistent comp outperformance sales have missed consensus expectations in 8 of 13 quarters, including every quarter in 2014. This quarter KATE actually beat, as the noise which clouded most of the models due to discontinued operations (Jack Saturday) and the conversion of Intl businesses to JV/distributorship agreements is now completely in the rear-view. The flow through to EPS has historically been just as noisy, with the company missing earnings expectations in 7 out of 13 quarters, but this quarter the print was right in line. While we can poke holes in the flow through to EBITDA margins from a 19% comp, the fact is that KATE is now a model-able company actually earning money on a GAAP basis, which we think quiets a lot of the concerns which plagued the name for the better part of 2015.
“Mid-Tier Distribution” – This is an evil word in retail nowadays, and may give bears a negative to latch onto from this print. And to be fair, management could have done a better job clarifying just how dep down the value curve the brand was going in order to open distribution. But, we give them credit for sticking to the distro game plan. Over the past few quarters it’s clear that the store growth would be calculated in North America. We’d much rather see the company open the tightly guarded wholesale distribution pipeline on a case by case basis to hit 2nd or 3rd tier markets rather than opening hard physical assets in markets that may not support the ROI KATE has become accustomed to. That distribution strategy makes even more sense now that KATE has cleaned up its promotional posture within wholesale accounts. Overall we view this as a positive.
Noise, Over and Done With – Now that we’ve passed this 1Q print the noise on the P&L is over and done with. The last remaining remnant of the 2015 restructuring was the SE Asia/China JV which cost the company $6mm in sales this quarter. From here on out we are looking at an apples-to-apples comparison within the operating segments. We still have issues with adjusted EBITDA numbers and lack of clarity on the size of segments by channel (retail, wholesale, and licensing), but KATE is lightyears ahead of where it was at this time last year. That’s bullish for anyone incrementally new to the name trying to wrap their hands around this business model.
Key points on line items:
- Unit/Sq. Ft. Growth: Total owned units were up 11% YY in the quarter, with the total store count up 24% inclusive of partnered unit growth. That’s primarily a function of metered growth in NA and a shift in the international store growth in newly minted JV/distribution JV territories. We think it’s important to point out the extremely big e-comm growth rate despite the slower store opening cadence in NA, which speaks to KATE’s ability to reach beyond its store footprint to attract new customers on the e-comm side.
- Top Line: Comps 19% on C$ basis, though Fx was neutral. That translated to 15% reported growth (or 20%+ excluding the $10mm watch inventory sale in 1Q15 and $6mm in sales from China/SE Asia). The non-comparable Asia and watch anniversaries explain away the delta between comp growth and reported top-line. On the e-comm side, the channel added eleven percentage points to the reported comp. At just over 20% of sales that means the e-comm channel was up 40%-50%. We expect more of the same as the company laps two more quarters of negative Flash Sale growth.
- Gross Margin: No flow through from a 19% comp as 80bps of merch margin improvement were offset by 100bps of headwind from Fx and a promotional outlet channel. If we had to pick a bone with this print it would be on the GM line and corresponding inventory level, but management set the bar from improved GM flow through for the balance of the year which translates to accelerated earnings growth. We’ll stomach near term choppiness for the longer term picture as licensing categories pick-up steam and Li&Fung benefits are recognized.
