Kate Spade: Don't Bail Just Yet

| About: Kate Spade (KATE)

Summary

KATE missed lofty Wall Street estimates, but it is still growing.

Inventory mismanagement came back to bite, but KATE can right the ship.

Shorts had a good day but KATE can spoil the party with continued growth.

Kate Spade (NYSE:KATE) took a dive after its earnings miss, falling 18% and closing out near its 52-week low. For Q2 2016, KATE missed consensus estimates for EPS by $0.03, reporting EPS of $0.11 for the quarter. Revenue was better as KATE beat estimates by $1.14 million with a top line of $319.69 million, a 17.2% increase year-over-year. So the company is still growing the top line, but is this recent drop a good time to buy KATE? Let's dive a little deeper into KATE and put it in the ring versus Michael Kors (NYSE:KORS) and Coach (NYSE:COH) to get better perspective.

Now that KATE has taken a beating, its valuation will look better all else equal but that doesn't mean the updated valuation is better than KORS' or COH's. The bottom falling out of a stock price doesn't automatically make that stock a buy. Let's look at some summary trading statistics for the three fashion houses:

Trailing P/E

Forward P/E

P/S

KATE

24.8

15.5

1.7

KORS

11.0

10.0

1.9

COH

29.7

18.8

2.7

Click to enlarge

Source: finviz.com

KATE is the cheapest with respect to sales, but KORS comes out on top when considering earnings. KORS looks especially cheap with trailing and forward P/E multiples of 11 and 10, respectively. The S&P 500 has a trailing P/E of 20 and a forward P/E of 19 in comparison. Taking a closer look at KORS - in its latest quarter, KORS beat on earnings and revenue. EPS came in at $0.98, beating estimates by a penny, and revenue beat estimates by $50 million - growing 11% year-over-year to $1.2 billion. So KORS has some momentum while KATE seems to be hitting a wall. Like KORS, COH beat Wall Street estimates in its latest quarter with EPS of $0.44 and revenue of $1.03 billion, beats of $0.03 and $10 million, respectively.

Industry Wide Pains vs. Self-Inflicted Wounds

KATE's recent fall was partly attributed to a tough tourism environment, which should hurt all luxury retailers and apparel makers. KATE's results were also hurt by poor management of its inventory, however, such as not meeting the strong demand for its Cameron Street handbags. This is especially bad in the fashion industry because demand can be fleeting. You have to capitalize on transitory demand and milk it for what it's worth. There's no guarantee that what's popular now will be popular a year from now. So this is unfortunate for KATE and its investors. Now KATE is struggling with whether to maintain that exclusivity or embrace the discount outlet route much like COH and increasingly like KORS - which some would argue has hurt the brands.

KATE, COH, and KORS walk a thin line between affordable luxury and expensive commodity. The consumer seems to be more price conscious at the moment, but trying to be all things at all times could hurt your brand in the long-term. KATE could increase sales with lower margins by embracing the discount and outlet route more fully, but I think it would diminish the exclusivity of the brand and make room for the next Kate Spade to come along and take the place that it once held. KATE has to decide where it wants to be. It may have to suffer some short-term pain in order to reap the benefits when consumers become less price conscious and luxury spending increases.

Fortunately for KATE, its CEO Craig Leavitt has stated that the company won't go bottom fishing and try to increase sales at the expense of margins and brand strength. As he puts it, KATE is going to put emphasis on catering to the full-priced customer and not the bargain-hunting customer. The full-priced customers value the brand and anything devaluing the brand could turn a KATE full-priced customer into another fashion retailer's full-priced customer.

In the vein of capturing the full-priced customers, I like KATE's strategy to further learn about its markets and not treat its line of products in only a myopic macroeconomic approach. Instead, KATE has taken a microeconomic approach to its stores which it refers to as 'microassorting;' this microassorting method helps to discern the specific demand each store or market has for KATE's assortment of handbags, shoes, and accessories. In turn, KATE can extract the greatest value from its customers and offer a more personalized product as opposed to white-washing its sales strategy. Leavitt stated that microassorting improved KATE's ready-to-wear category by double-digits, so I expect even better results for KATE as microassorting becomes more ubiquitous in the company.

Keep on Shorting or Reverse?

I like KATE's approach to its operations like microassorting, save the recent inventory hiccups, and I think its valuation has taken a good enough hit to make it a more compelling investment. I don't think it's a screaming buy per say, but I believe when a company's fundamentals are still fairly strong and its stock price declines that risk has decreased and not increased. Investors looking for value view risk more as a function of price than of volatility or beta. A slowdown in tourism will affect KATE as it will COH and KORS and it was evident in this quarter's same-store sales growing 4% instead of what analysts were expecting - 13.2%. That's a significant mismatch, but sales are still growing - not declining - and that's important.

Morningstar showed that KATE had a high short percentage at 10.3% versus 5.2% for COH, but KORS had an even higher short interest at 13.2%. Shorts had a nice gain with the recent drop, but investors should keep an eye on whether these shorts unwind or if they persist. Now that the momentum has turned against KATE, the short interest could grow and lead to an opportunity for investors that if KATE outperforms expectations in the next quarter, a short squeeze could materialize. The recent sell off has eliminated many short-term holders of KATE, so I don't think another quarter that falls short of expectations will manifest a 18% drop in one day.

KATE's lackluster results have cast a shadow on the whole industry, but the price drop has eliminated risk, not increased it. KATE's forward P/E of 15.5 is reasonable, especially compared to the market's P/E of 19 in a slow growth economy with GDP growth of 1 to 2 %. KATE grew revenue by 4% in the last quarter as previously mentioned and has increased revenue 11% in the first six months of 2016 compared to first six months in 2015. Growth like that is hard to find. KATE can right the ship and current and prospective investors can take advantage of this recent fall in share price. Keep an eye on the shorts and continuing shareholders could recover paper losses quickly with one good quarter.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KATE over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.