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Standard & Poor's


01/26/15 10:00:06 AM



This week's Focus Stock of the Week is Kate Spade & Co. (KATE: $28.70), which carries S&P Capital IQ's highest investment recommendations of 5-STARS, or Strong Buy. This company -formerly known as Fifth & Pacific Companies, Inc. (until February 2014) and, prior to that, Liz Claiborne, Inc. (until May 2012) - designs and markets premium-priced fashion accessories and related products for women and men under its family of namesake brands, comprising Kate Spade New York, Kate Spade Saturday and Jack Spade. Pursuant to its mono-brand focus, KATE recently divested certain non-core brands and acquired some its namesake businesses from international partners (further detailed below).

During the 2014 second quarter, the company realigned its businesses into three reportable segments, namely, Kate Spade North America, comprising about 77% of third quarter revenues (latest available); Kate Spade International (principally in Japan, Southeast Asia, Europe and South America), comprising about 20%; and Adelington Design Group (consisting of exclusive supply and/or licensing agreements with the Liz Claiborne and Monet brands), comprising 3%.

KATE's products are sold through wholly owned specialty retail and outlet stores, select specialty retail and upscale department stores in the U.S., company operations in Brazil, Japan and the U.K., a joint venture in China, a network of distributors in Asia and the Middle East, and the brand's e-commerce website. Key strategic initiatives include the opening of branded retail stores, increasing the proportion of apparel sales, accelerating Jack Spade's growth, increasing international sales in Asia, and growing e-commerce sales. By the end of the 2014 third quarter, the company operated 98 specialty retail stores and 57 outlet stores in North America, while the international unit operated 43 and 11, respectively, as well as 50 concessions.

The company divested its Juicy Couture and Lucky Brand businesses in November 2013 and February 2014, respectively, generating more than $370 million in combined liquidity. Earlier, in 2011, it sold the Liz Claiborne and Monet brands to J.C. Penney for about $268 million. It also sold the Dana Buchman trademarks to Kohl's Corp, and the Kensie, Kensie Girl and Mac & Jac trademarks to Bluestar Alliance LLC - in most cases retaining exclusive supplier and/or licensing agreements. Conversely, during 2013 and early 2014, the company reacquired the existing Kate Spade businesses in Southeast Asia for $32 million and, earlier in 2012, acquired the 51% interest in Kate Spade Japan from its former joint venture partner for $41 million.

With the fourth quarter and full year 2014 earnings release expected in late February, we project a 13% decline in net sales for 2014, mainly due to some of the previously highlighted asset divestitures. This outlook also reflects a planned opening of about 80 owned and partnered retail stores globally, translating to more than 30% in retail square footage growth. However, with ongoing retail expansion and conversions, we see net sales to rebounding nearly 28% in 2015, with continued strong gains in the Kate Spade North America and Kate Spade International segments - the latter also benefiting from a continued strong growth of the licensing business - versus a notable decrease in the Adelington Design Group. Consistent with guidance, we see a rapidly growing e-commerce business driving high-teens to low-twenties percentage growth in direct-to-consumer sales, with strong demand for handbags and small leather goods, as well as tech accessories and an expanded offering of watches.

Consistent with full year guidance for margin expansion in excess of 150 basis points, we project 2014 adjusted EBITDA margins of 12.5%, thanks in part to reduced promotional activity. This also accounts for the incremental costs of stores expansion (including conversions of select Juicy Couture locations), as well as brand marketing for the relatively nascent Kate Spade Saturday brand, and certain transition costs for the divested Lucky Brand. Even so, with the benefit of global supply chain initiatives, we believe KATE is on track to achieve a seemingly ambitious target range of 18% to 20% in adjusted EBITDA margins by 2016. With lower interest expense after a reduction in net debt on the proceeds from recent asset divestitures, we forecast 2015 EPS of $0.67, a significant improvement from projected EPS of $0.27 in 2014.

We believe the shares offer attractive upside at recent levels. Our 12-month target price is $36, which implies a price-to-sales ratio of 3.3X based on our 2015 estimates. This notably represents a significant premium to the comparable average forward multiple of 1.5X for a peer group of accessories, apparel and luxury goods providers. We believe KATE's premium multiple is partly warranted by potentially significant opportunities to reap the benefits of increased brand equity through sustainable market share gains in North America and international markets.

Finally, we highlight some potential risks to our recommendation and target price. First, we think the company could be vulnerable to fashion and inventory, including a lackluster response to its newer product assortments. Lastly, we think KATE's strategic and financial goals could be significantly derailed by a major deterioration in global macroeconomic conditions - including consumer confidence, employment and spending - both in the U.S. and certain international markets of Europe, Asia and South America where the company is presently pursuing expansion opportunities.

S&P Capital IQ's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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