Is the Kate Spade Stock Bubble About to Explode?

NEW YORK (TheStreet) -- Wall Street has fallen in love with preppy handbag and accessory maker Kate Spade (KATE).

However, based on the financial performance of the company, the great Kate Spade stock bubble may be about to explode.

The company is estimated to announce its second-quarter earnings on Aug. 8. In just one telling sign of excessive optimism, Kate Spade has missed Wall Street's earnings expectations for four consecutive quarters. For the first quarter, the company actually delivered its first sales beat vs. consensus forecasts in three quarters, yet still fell shy of Wall Street's profit estimates.

Yet hopeful investors have pushed shares of Kate Spade up 17.27% year to date, outpacing the 3.7% rise in the Bloomberg Branded Apparel Index. Fueled by bullish commentary from chief executive officer Craig Leavitt, those investors are expecting the company to become the next Polo Ralph Lauren (RL) -- a global lifestyle brand powerhouse.

Wall Street has specifically warmed to Kate Spade because it sees a future for the company in these areas:

  1. An ability to maintain a mostly non-promotional, full-price market for its products that range from bright-colored housewares to quirky ballet flats.
  2. The continued rollout of product extensions. In November, for example, Kate Spade will unveil its first swimwear collection consisting of 70 pieces.
  3. A dramatic increase in global square footage via the opening of new specialty stores, concessions and likely flagship stores in international tourist destinations. Kate Spade currently operates 118 specialty stores, 51 outlet stores, and 43 concessions.
  4. Further penetration of lucrative online sales. Digital sales already comprise approximately 20% of Kate Spade's business.

All told, Leavitt has gone on the record stating Kate Spade is destined to reach the $2 billion sales mark by year end 2016, which would represent a 169% surge from 2013.

While Wall Street chooses to remain infatuated with Kate Spade's future growth potential, there is one not-so-slight problem being overlooked. Kate Spade has done close to nothing in terms of profitability in over six quarters to justify its exorbitant market valuation.

According to Bloomberg data, Kate Spade's same-store sales have increased well north of 20% in the past eight quarters, clocking in at a 22% gain in the first quarter of 2014. The lack of consistent profits on very strong same-store sales figures, even when factoring in the company's investments for infrastructure and product line extensions, is a major red flag.

By the Numbers

Profit margins: Per Bloomberg, Kate Spade's earnings before interest, taxes, depreciation, and amortization (EBITDA) margin has been negative in three of the last six quarters. On the aforementioned 22% first-quarter same-store sales increase, Kate Spade's gross margin fell 210 basis points year over year and the EBITDA margin was an unsexy negative 7.32%. The company blamed the pressured gross margin on the "absence of licensing sales and increased promotional activity at Juicy Couture and the impact of a change in sales mix due to timing at Kate Spade." On Nov. 6, 2013, Juicy Couture was sold to ABG for a total purchase price of $195 million, and was licensed back to Kate Spade until Dec. 31, 2014 to support the wind down of operations.

Kate Spade's forward price-to-earnings multiple of 56.41 carries a stiff premium vs. the rest of its peer group. That makes little sense when comparing the performance of the company to a rival in Michael Kors (KORS). The stock has a P/E of 16.15. In its first fiscal quarter of 2015, Michael Kors reported a 24.2% increase in same-store sales and registered a 62.19% gross profit margin, the latter being far superior to what Kate Spade has recognized in prior quarters.

Industry environment: Key to Wall Street's optimistic view on Kate Spade is that its sophisticated, preppy merchandise sidesteps the discounting on the floors of major department stores Macy's (M) and Nordstrom (JWN). Macy's and Nordstrom rely on Kate Spade for 5.15% and 4.77% of their revenue, respectively, based on Bloomberg supplier data.

It will be a tall order for Kate Spade to avoid unplanned discounting in light of the floor positioning of the company's department store shops next to Michael Kors and Coach (COH), as seen here in this self-produced Vine video. As soon as one handbag maker moves to offer a promotion on in-season merchandise, the other will tend to follow suit. For Kate Spade, that could lead to surprising disappointment on the robust profit margins Wall Street expects from the company.

Michael Kors acknowledging that it used increased markdowns to drive sales in its first fiscal quarter is an indication that Kate Spade may have been lured into unplanned promotional measures.

Watch More: Norwegian Cruise Line CEO Outlines Earnings Beat Strategy

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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