THE HEDGEYE EDGE
We added Tapestry (TPR) to Investing Ideas as a long on 5/16. Tapestry shares have pulled back nearly 20% since reporting earnings at the end of April. We view the pullback as a buying opportunity.
Handbags are not dead. It is a solid business with high (sustainable) returns and a very defendable per-capita unit consumption story and stable ASPs. It’s like the athletic category – but better. Handbag units per capita bottomed in 2009 and are holding stable in a modest uptrend of 1.3-1.4x.
Tapestry landed the deal of the century because of mis-aligned incentives at Kate Spade. Kate Spade’s management team was incentivized by the vesting of stock options to complete a takeover more than the price of the acquisition. Coach and Kate Spade were both attractive stand-alone investments before the merger, and the combination of the two at a low valuation is an even better investment.
Management’s original projection of $50M in merger synergies less than a year ago is now $100 to $115M. We think KATE can be operated at operating margins 200-400bps higher. Kate Spade had well above average sales productivity, but low profit margins. That represents a $700M EBIT opportunity. The chart below illustrates the strong correlation between sales productivity and profit margins in the industry with Kate Spade as the notable outlier.
After the first year we will likely see an acceleration in organic growth. The overlap between the two brands is low with Kate bringing a younger demographic with a distinct lifestyle compared to Coach.
The Street is also missing the licensing opportunity at the two brands. There are no fewer than 25 licenses that can be repurchased, taken in house, and/or renegotiated. Tapestry has brought back four licenses in the past three quarters. The licenses are the drivers of future revenue and profit growth that come with lower execution risk as the businesses are already operating with Tapestry oversight.
Management sees a significant opportunity to expand Kate Spade internationally where it has already built the infrastructure that it can leverage. Michael Kors, Coach’s largest competitor, is still pulling back on promotions and inventory in 2018 which will lead to better industry margins. The combination of Coach and Kate Spade will deliver accelerating revenue and margin improvement on a lower operating asset base.
That will drive asset returns higher and we believe the Street’s $3.14 EPS forecast for 2020 will be achievable a year earlier. This was a growth stock that just turned into a value stock that will likely accelerate growth again in the second half. We think this stock is a double over the course of 12-18 months.