Kate Spade: Buy The Dip

| About: Kate Spade (KATE)
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KATE comps slowed dramatically due to weaker tourism and heavier promotional activity by other retailers.

We think the worst is over on both of these fronts in terms of their impact on DTC comps.

The stock offers good value here at 23-26x guided Fy16 earnings.

Shares of Kate Spade (NYSE:KATE) are off more than 19% today, 8/3, following disappointing ER which saw comp sales abruptly slowdown. After a string of quarters with mid-to-high teens DTC comps, KATE saw DTC comps fall to a mere 4% in Q2, adversely affected mainly by a slowdown in tourism and heavy promotional activity at outlets. We think a 20% haircut in market cap is excessive as a result of these two issues, and think the valuation is now fairly attractive considering the company's long-term growth potential. We are buying this dip.

KATE Price Chart

KATE Price data by YCharts

It really looks like the quarter was maligned by two major factors. The first, a slowdown in tourism, is to be expected and a near-term headwind that should fix itself with time. Management seemed to blame the tourism headwinds on continuing adverse currency conditions, but the USD was actually slightly weaker in Q2 than it was in Q1. We think the bigger factor at play here was a string of global terrorist attacks and shootings recently which, naturally, has kept people from traveling. While it is impossible to predict the future of such tragic events, we do think that 15.1% North American growth and 6.6% International growth even in light of these headwinds is quite impressive. We can't imagine that these tourism headwinds will accelerate, and believe the worst should be over for KATE in terms of weak tourism.

^DXY Chart

^DXY data by YCharts

The second, heavier than expected promotional activity at outlets, is something that will likely persist and continue to adversely affect gross margins. Outlet centers are in direct competition with Amazon (NASDAQ:AMZN) and other nonstore retailers for the value-oriented consumer, so the price wars will likely continue. As KATE adjusts to more deeply discount at its outlets, though, comps should not be adversely affected by this going forward.

The long-term positive here is that KATE is a mainly full-priced retailer that sells a preeminent brand name. KATE has powerful brand staying power, and this is defensible against off-price retail encroachment (consumers have proven that they will continue to doll out a premium for KATE products). This is likely a result of the brand's popularity. According to Piper Jaffray, KATE is the second most popular handbag name among American teens and is only growing in popularity.

Beyond this popularity, KATE has lots of growth potential. Management sees KATE as a $4 billion retail business in the future. That is more than 3x last year's sales, and we think it's doable. The company only has 426 locations to Michael Kors' (NYSE:KORS) 668 and Coach's (COH) over 1,000, so there remains lots of room for unit expansion. This lessens the pressure on consistently strong DTC comps to get to that $4 billion mark. Nonetheless, DTC comps have been strongly positive, ex this quarter, and the guide is still for high single-digit to low double-digit DTC comps for the full year. Even mid to high single-digit comps over the next several quarters coupled with the company's unit growth implies significant sales and earnings growth potential.

This brings us to a discussion of the stock's valuation. The stock currently trades around 23-26x this year's guided earnings which are projected to grow 26-40%. Even on the low-end of the guide, the forward PEG is right at 1. Over the next 5 years, analysts think the company can grow earnings at just under a 30% clip, and we think that is doable given the growth we outlined above. The 5-year forward PEG, then, is under 1.

We don't think the stock offers tremendous value here, but we do think it offers good value. We like the company's strong brand name, and view that as defensible against brick-and-mortar's otherwise secular decline. The growth story is still strong, and the near-term tourism headwind and longer-running outlet price war concern are not enough to warrant a 20% haircut in market cap. We are buying the dip here and hope to sell higher in a near-term window.

Disclosure: I am/we are long KATE.

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.