Why Does A Deal Between Kate Spade And Coach Inc. Make Sense?

The shares of the affordable luxury retailer Kate Spade fell by as much as 8% once news surfaced that the company will spend a few more weeks negotiating a potential sale of the company, after it received an offer from Coach (NYSE:COH). Such a move would allow buyers to better assess Kate Spade’s first quarter results, out on May 4th, according to people familiar with the matter. When the news was trickling in late on Monday, April 3rd, the stock fell 1.85%, valuing the company at around $2.9 billion. If the company does manage to negotiate a deal, it could value the company lower than this level, with there even being a possibility of the deal not closing. While Michael Kors also seems to be interested in acquiring Kate Spade, it does not seem to be as actively involved as Coach. The latter has long been considered a suitable buyer for Kate Spade, given its focus on handbags and accessories. Furthermore, given Coach’s substantial presence in department stores and also internationally, Kate Spade would have the ability to grow in these segments. There are a number of other benefits both Coach and Kate Spade would receive if the deal goes through, some of which have been listed below.

1. Boost To Kate Spade’s Margins

The driving factor behind the sale of Kate Spade has been the pressure the company faced from activist shareholder, Caerus Investors, that had pushed the company to find an acquirer. The main reason for this has been to improve its profit margins, to a level which was comparable with industry peers. According to the letter sent by them to the Kate Spade Board of Directors, the EBITDA margins at the company are “400-1000 bps below peers.” Since the management has not been able to deliver on the margin targets set by them, the market has lost faith in the stock, resulting in the shares being traded at less than 8 times the consensus 2017 EBITDA, at the time of the letter, from over 35 times EBITDA in 2014. While the company has better growth prospects than many of its peers, Kate Spade trades at a discount to the peer set on EV/Sales. Being part of a bigger conglomerate would help the company to cut down on its costs, as a result of synergies between two luxury companies, and hence, give a boost to its margins.

2. Coach Inc.’s Experience With Integration

Coach acquired footwear brand Stuart Weitzman for $574 million in 2015, and its results in subsequent quarters have been boosted by stronger-than-expected sales from the footwear company. Coach has been able to effectively integrate the company, while carrying out the transformation of its brand. In the quarter ended December 2016, the net sales of the Stuart Weitzman brand increased over 25% due to the acquisition of its Canadian distributor in the fourth quarter of fiscal 2016, positive comparable store sales, and net store openings. Since Coach has experience with successful integration of another company, it could do the same with Kate Spade. Recently there have been complaints that Kate Spade has not kept up to date with changing trends and customer preferences. For this, also, Coach could prove to be beneficial. When Coach acquired Stuart Weitzman, it updated its product line, and hence, it could be expected to do the same with Kate Spade.

3. Kate Spade’s Success With Millennials

Kate Spade has had great success with the millennial customers, who have been the driving force behind the high growth rates the company has achieved. Millennials being their target market, Kate Spade has also adjusted its products to a more colorful and whimsical look, with subtle logos. Unlike Coach and Michael Kors, which have been known for their loud logos and were slow to adapt to this small logo trend, Kate Spade bags include a tiny stamp with its brand name. The former two companies are also now moving away from logos due to increasing preferences among millennials of clothing and accessories without labels or logos. Hence, an acquisition of Kate Spade would give Coach access to a younger clientele.

4. Improved DTC And Pricing Power With Department Stores

Coach in recent quarters has undertaken a number of steps to move away from the discounting, which has hurt its brand. During its fourth quarter and financial year 2016 (ended June), Coach announced its decision to pull the company’s handbags and leather goods out of 25% of department stores, or by over 250 locations; a move which is specifically designed to protect its luxury brand image. Furthermore, the company intends to reduce the markdown allowances to the channel, citing a highly promotional environment embraced by such stores. The heavy discounts offered in this channel makes it harder for consumers to spend more on a similar bag at the company’s own stores or its e-commerce websites. Kate Spade, which is still building out its wholesale network as it is a much smaller brand, is also taking a careful and cautious approach. Since outlet stores are usually located in tourist locations, they’ve been hit particularly hard, as a strong dollar has hit the tourist inflow into the US.

According to Kate Spade CEO Craig Leavitt, the company has made an attempt to shift towards the direct to consumer (DTC) channel, as e-commerce has been its fastest growing channel. This move towards a more focused DTC business is not easy. And hence, the merger of the two companies would help to fortify their online channels. Furthermore, the store closure program of Macy’s will put greater pressure on brands seeking to get prized department store space. For this as well, a combined company will benefit from its larger size, and will be able to leverage that to gain better pricing power with department stores.

Have more questions on Coach? See the links below:

• Could Coach Inc. Be A Takeover Target?
• Coach: A Lone Ranger In The Retail Space
• Coach And Michael Kors Still In The Hunt For Kate Spade

See our complete analysis for Coach