Kate Spade's Wild Ride
Board: Value Hounds
The wild ride of Kate Spade in Q2Stores Jun-14
Kate Spade had a wild ride last week. Q2 2014 results were released and the market fell in love and sent the stock up 10% only to be followed by a fast and precipitous drop of 30% when the conference call was done. It went from $39 up to almost $43 only to hit $28 all within the space of 6 hours. Try to tell me the market isn’t totally nuts.
Maybe the market hasn’t spent enough time with Kate?
Kate’s not a clear-cut clean story with a well-trodden path to the top of aspirational luxury retail, but it does have some features of interest. It’s taking on the likes of Michael Kors and Coach and scoring some knockouts that bode well for its future. It’s not luxury like Richemont or Louis Vitton or Hermes. It’s aspirational luxury and can readily be compared to Kors and Coach.
The reorganization of the business into Kore KATE is progressing beautifully but the numbers are ugly. The long string of nearly useless acquisitions has been slowly jettisoned with Juicy Couture being the last to leave in February, but an overhang of low margins, no earnings and high debt remain. All of the changes have made Kore KATE hard to track on comparable year over year basis and the market doesn’t seem to grasp the scope and difficulty of the massive transition. There will be setbacks, but some key numbers continue to do well.
Transforming a hideous past into a handsome future
KATE has been aggressively downsizing to get to a monobrand that has substance and a star-power brand name. Kate Spade will be the only retail brand standing at the end with Adelington as a minor licensing business. As Fifth & Pacific the company struggled for years under the black cloud of has-beens and irrelevant poorly performing trade names like Liz Claiborne, Lucky Jeans, MEXX, DKNY and Juicy Couture. Revenue and earnings growth are a faint sweet memory from the last decade -- about when the Liz Claiborne style hopelessly jumped the shark. Kate Spade has been their one and only star and the company is astute enough to realize it’s the only brand they want associated with the business. By the second quarter of 2014, the company was Kate Spade that included Specialty, International, outlet, Saturday and Jack Spade. There is also the Adelington Group that does wholesale of Lizwear and Liz Claiborne New York (not doing well and revenue declines have become SOP).
These are some of the acquisitions they had to liquidate:
•DKNY Jeans & Activewear (1997)
•Segrets Inc (1999) — Paid $54 million for an 84.5% in the company best known for Sigrid Olsen.
•Lucky Jeans (1999) — Paid around $135 million for an 85% stake.
•Mexx (2001) — It cost around $264 million to acquire the European brand.
•Juicy Couture (2003) — For around $50 million.
•Kate Spade (2006) —And Jack Spade for $124 million.
What did Kate lose with just the divestiture of Lucky and Juicy? Only 2/3s of their revenue. One misguided journalist from Barron’s noted KATE had never recovered from the 2008 recession seemingly unaware that most of the revenue evaporated when business segments were sold off. In fact Kore Kate is growing fast and has recovered.
Reporting results are now the Kate Spade segment:
•Kate Spade North America (U.S. and Canadian)
•Kate Spade International (Japan, Southeast Asia, Europe and South America)
Kate Spade brands are New York, Kate Spade Saturday and Jack Spade.
The Adelington Design Group continues as its own segment.
For reporting, Kate management likes to use EBITDA as a measure of the company’s progress towards profitability and it’s this guidance that sank them in the second quarter as it was cut back. I don’t put much stock in EBITDA since it excludes some important costs that are often ignored by corporate America as a way to make earnings look better.
While the expenses are sometimes non-cash they are the way GAAP earnings are calculated and Corporate America needs to get over things like options expense and just keep them in there. We investors are grown up enough to decide what to keep and what to ignore. We don’t need to be spoon-fed EBITDA and told it’s good for us. It’s the downward guidance on EBITDA expansion progress over the next two years that sent KATE down almost 30% along with a slight drop in gross margins.
You can argue that options expense and D&A are non-cash but they are not extraordinary one-time charges and if we are going to compare earnings across companies, it’s best to keep these GAAP expenses in rather than start making exceptions. If restructuring, acquisitions and impairments are one-time events, it’s reasonable to at least look at the results without those. EBITDA has some use as a measure of progress intra-company.
The adjusted EBITDA for Kate in Q2 was $32 million and a $21 million increase compared to the second quarter of 2013. While that indicates improvement what’s more important is the company’s return to positive operating income. Operating margin was 3.7%. While that looks unimpressive compared to KORS operating margin of 30%, you have to consider that KATE has been operating in the red since 2009 when they had all their moving parts. To achieve positive operating income in a short time after restructuring is encouraging in light of their years of failure.
FWIW Coach operating margins have dropped to 8.8% in Q4 down from 26% one year ago – a not encouraging trend.
What took shares down was a downward revision to 2014 EBITDA of 50%. It was projected to increase by 1% and revised to 0.5. They also retracted the 2016 EBITDA margin guidance of 25% and pushed it out further—maybe 2017 or beyond? The current EBITDA margin is 12% and 25% is a doubling, fairly ambitious, and can be used to track Kate’s progress.
A couple of analysts felt the angst over gross margin decline (2.4%) was a bit hysterical since most of it was due to the liquidation of 2013 inventory at Saturday as KATE sorts out relevant product for the nascent business.
From the CC:
However the largest impact on gross margin rate for the quarter was the result of off price sales margin primarily driven by the Kate Spade Saturday brand due to excess inventory and raw material disposal from prior seasons that were the result of a launch business that lacked scale.
Kate has room to grow into scale
First, it's a small store base:
Lack of scale is an important concept here and the downsizing of Fifth and Pacific (Kate predecessor) has left the entire remaining company with the same lack of scale partially accounting for margins that underperform peers.
Saturday is also a lower margin business intended to cover younger shoppers with less to spend. Kate Specialty lost only 0.8% in what was called a massive promotional environment. As the store base grows, we should see SG&A move to an even lower percentage of revenue. Interest expense will also be spread over a larger store base and higher operating income. I would also look for more efficient inventory control and less need to correct mistakes caused by too few stores trying to sell too much stock aka the Saturday Massacre.
Back to Q2
Overall it was a good quarter with increases in both North American and international Kore Kate. Revenue was $266 million growing 49% year-over-year. North American revenue was up 55% and International Kate was up 54%. The traffic in domestic stores increased 26% on comps of 30%. TTM sales per square foot were $1,477.
Kate does lack scale at present with only 96 specialty stores domestically and 39 international stores. The goal is for international to eventually be 2/3 of the business and for domestic stores to number around 250. There is a lot of growth ahead of them and as they grow and scale up. Margins will improve. Kate will open 16 stores in 2014.
The company does have outlet stores: 51 in the US and 11 internationally. There was an unplanned shift in outlet openings in Q2. It was the result of the need to convert empty Juicy real estate into stores. Some of the locations became Kore Kate but nine were converted to outlets.
The most impressive Kate numbers are the comps. While we have seen Coach comps decline by double-digits and Kors slow to 24%, KATE posted 30% in Q2. Granted that will moderate in the back half, but high teens is still respectable.
[See Post for Tables]
Gross margins year-over –year decreased but June 2013 had Juicy and Lucky revenue and the comparisons aren’t valid. In fact, the second quarter of 2014 is unlike any previous quarter as KATE with KATE finally flying solo with Lucky Jeans divested in February. There is no doubt Q2 was promotional but it’s hard to decide just how bad the contraction was without a purely Kate gross margin to look at in June 2013. More importantly, even with the divestiture of so much of the business over the past two years, operating margins turned positive without scale and without help from Lucky Jeans, and Juicy Couture over the past six months.
From the CC:
It's important to note that all the new stores exceeding our expectations. And I want to underscore that this does not represent a shift in our strategy relating to our retail expansion plans which emphasize our focus on full price specialty stores.
We took advantage of a one-time opportunity of the Juicy divestiture and speed our ratio of outlet to specialty store openings for the year. In fact we now expect that we will reduce our previously stated long-term goal of 125 outlet stores to 100 or less in North America.
Many analysts feel this is where Coach went astray cheapening the brand and siphoning off sales from full retail as it opened evermore outlets and closed retail. It’s a positive that management recognizes outlets are not the best way to grow revenue in the luxury segment. Coach has conceded it’s their best alternative and will be closing retail stores and stepping up outlet openings in 2014 and 2015. Kore Kate is taking a different tack.
Guidance and relative value
And to that point we now expect our direct to consumer comp results for 2014 to be in the range of 15% to 17% versus our previously guided range of 12% to 15%.
Put all that together for the full year and you have first an increase in our estimate of full year adjusted EBITDA from a range of 115 million to 125 million to a new range of $120 million to $130 million. Second, a further improvement in our estimated comparable sales increased from a range of 12% to 15% to a range of 15% to 17% including the benefit of the additional week.
Regarding promotional sales:
Okay. And is something you’re expecting to continue through the remainder of the year?
Yes. At this point unfortunately that is -- I think we have to move forward on the basis of that expectation and we’ve said -- many times you’ve heard me say that we -- we’re not going to be in the front of the path, but we’re not going to be last either and risk losing market share. So we’re going to respond, react and respond to what’s happening competitively and try and stay towards middle, back middle of the pack and that’s what we’ve done and we'll continue to do but we can’t just sit on the side lines and risk the potential bleeding market share.
If discounting continues through Christmas, guidance may need to be revised down.
There is a fair amount of bad news:
•Failure to stay on schedule for EBITDA margin expansion predictions
•Promotional wars with Kors et al
•Lack of scale to absorb inventory efficiently mainly at Kate Saturday
•Lower gross margins
•Kate Saturday taking more time to get up to speed
•Negative earnings last two quarters and positive earnings in the December Q were only possible through sales of assets
•No positive cash flow from operations in 2014
But there are things that Kate is doing that make them an interesting investment target. The recent correction to $29 was a good opportunity but fleeting. We may get more if the back half of 2014 sees no improvements and if comps drop further than the mid-to-high teens anticipated. The current $31 is a shade expensive compared to peers, but the growth potential looks better than either Kors or Coach if growth and comps stay in the neighborhood they are now living in.
Kate’s not a great value compared to Kors and Coach. Part of that is due to the torching of 2/3 of the business in the past year. Over the years, the acquisitions have added revenue but also delivered a string of negative earnings -—in 2006 Liz earned $2.50 and that was the last positive year. Over the past two years, realizing acquisitions were not the road to riches, Kate has cut away the dying retail segments that were dragging them down and is placing all bets on the Kate Spade brand alone in retail. They still hold wholesaler Adelington.
The transition has been painful, consuming cash and generating no-to-low margins. On this basis, Kate looks like just about the worst idea in retail right now and to add insult, it’s trading at a premium. There is a lot of expectation of superlative growth built into the current price of $31. Any disappointing slowing comps or revenue growth will send the price down -—the Q2 euphoria at $42 that evaporated a few hours later to $29 is the perfect illustration of the dangers of Kate.
But it’s hard to ignore Kore Kate revenue growth and comps that rival Michael Kors (KATE also has rights to Far East growth unlike Kors). Will Kate eventually grow into higher EPS, margins, and cash flow? Q2’s substantial growth, comps, increasing sales/SF and small store base with room to spread would argue that this is a story still in its infancy with strong vitals that will support growth.