Description

Description:

KCP is a retailer that is growing EPS at 15%+ yet trading at what we believe to be 9.5x normalized earnings (net of cash).   The company has a pristine balance sheet with almost $5 per share in cash and no debt.  There are several issues that are temporarily depressing margins.  We believe these issues will be resolved over the next 12 months and the company will begin to show its true earnings power of $2+.  Historically, KCP has traded on average 17x earnings, with peak and trough multiples of 25x and 12x.   At a 17x – 20x multiple of normalized earnings, the stock is worth $34 - $40, or 40 – 65% more than where it is currently trading.     We believe that the downside on the stock is limited and that below $21, it represents an attractive takeout for a private equity firm. 

Kenneth Cole Productions (KCP) is a $500M+  retailer of footwear, apparel and accessories.  The company markets its products under the Kenneth Cole New York, Kenneth Cole Reaction, Unlisted, Bongo and Tribeca brand names.  KCP sells its merchandise through several channels including consumer direct, wholesale and licensing.   Kenneth Cole founded the company in 1982 and its headquarters are in New York City.   The company’s fashion strategy reflects a casual urban perspective and lifestyle.   Kenneth Cole New York is the company’s high-end brand and Kenneth Cole Reaction is the more mainstream brand. 

Wholesale Operations

The wholesale segment is the company’s largest division and represents approximately 55 - 60% of the company’s revenues.   The Company's products are distributed to more than 1,750 wholesale accounts for sale in approximately 6,000 store locations in the United States. KCP’s wholesales clients include Dillards, Federated and upscale specialty retailers, including Saks Fifth Avenue and Nordstrom.  Additionally, the company sells out-of-season branded products and overruns through the Company's outlet stores and to off-price retailers.  The Company also designs, develops and sources private label

footwear and handbags for selected retailers

Consumer Direct Operations

The consumer direct segment is the company’s second largest division and represents approximately 30 – 35% of the company’s revenues.  Consumer direct operations include Kenneth Cole New York (“KCNY”) retail stores (~50) and Kenneth Cole New York Outlet stores (~40).   Outlet stores enable the company to sell its excess wholesale and retail product.   Additionally, KCP sells its products through consumer catalogs and online at www.kennethcole.com and www.kennethcolereaction.com.  Fulfillment for the catalogs is performed by a third-party distribution center in New Jersey.

Licensing

Licensing represents approximately 10% of the company’s sales, and is its highest margin business.  KCP grants licensees to small and medium size manufacturers.  The company generally grants licenses for three to five year terms with renewal options, limits licensees to certain territorial rights, and retains the right to terminate the licenses if certain specified sales levels are not attained.

Why KCP is trading at depressed levels:

Kenneth Cole’s problems are exclusively contained to the company’s retail operations.  This division is losing money and has dragged the company’s operating margins down from 11.1% in 2003 and 2004 to an expected 6.8% in 2006.

KCP went through a failed brand repositioning strategy over the course of the past 18 months.  The company attempted to create a higher image for its Kenneth Cole New York (high end) and Kenneth Cole Reaction (one step below Kenneth Cole New York) brands and create sub brands below these two that did not conflict with each other.   In order to do this, the company began selling Kenneth Cole New York only at its retail stores (pulled product out of wholesale) and made Reaction its primary department store brand.    Management thought that this move would help to better align its brand positioning with retailer strategies, particularly as department stores have been going through a consolidation phase.   The strategy has worked well at wholesale (as the numbers have indicated) but failed at retail for a few reasons.  In order to separate KCNY as even more of a high end brand, the company dramatically increased the price of its shoes at retail.  Customers who were used to seeing prices starting at $150 for a pair of shoes now could not find anything for less than $220.   Furthermore, the company’s initial attempt to solve the problem was to start offering more Kenneth Cole Reaction product at KCNY stores.  The more mainstream Reaction product at high-end KCNY stores confused some of the company’s core customers.  Furthermore, the lower priced Reaction shoes began cannibalizing sales of higher end shoes.  

In addition to the problems at the company’s KCNY retail stores, the outlet strategy has resulted in a significant drag on margins as well.   Historically, the outlook stores have been used as a dumping ground for the KCNY stores.   KCNY stores have not been responsible for discounting at all, so buyers would buy as much product as they wanted without worrying about how much the KCNY stores would sell.  At the end of each season, product was dumped on outlets.  These outlets were often stuck with this merchandise until the season rolled around the following year.  As a result, inventory moved very slowly through the stores and this lead to even bigger markdowns at the outlets.   Exacerbating KCP’s problems at the outlet stores was the fact that as of the beginning of this year, KCP had no made for outlet product which would have offset some of this fashion / markdown risk.   Most other retailers use their outlets to sell excess inventory AND design product that is specifically tailored to be sold in outlet stores.  In fact, made for outlet represents the majority of what is sold at most other retailers’ outlets.     

The combined problems at retail (outlet and full price) have resulted in severely depressed operating margins relative to the company’s historical margins as well as margins of its competitors.   

Competitors’ operating margins:

Sketchers’ (SKX)                                high single digits

Steve Madden (SHOO)                       15%

Jones Apparel (shoe division)    low double digits

Phillips-Van Heusen (PVH)                  12.5%

VF Corporation (VFC)                        12.5%

Kenneth Cole’s historical operating margins:

2002    10.4%

2003    11.1

2004    11.2

2005    8.9

2006e  6.7

Key Catalysts

Although it may take time, KCP’s problems are fixable.  The company is in the right place in terms of fashion and has been gaining shelf space at wholesale – both of these trends bode extremely well for the company’s future.    As mentioned previously, KCP’s issues are contained in its retail division.  We believe that the company is in the early stages of a turnaround that will result in operating margins that return to their 11%+ historical level in 2008 and beyond.   

The company is undergoing several initiatives that should drive operating margins back to its historical 11% level.   First, the company is lowering its prices in its KCNY stores while removing some of its Reaction product in those stores.   This should remove some of the confusion amongst its core customer base and stop the cannibalization of the company’s higher end products.   Second, the company is making its KCNY buyers responsible for discounting some of its excess product at the KCNY stores instead of using the outlets as a dumping ground.  This should make the buying process significantly more efficient than it has been as it forces accountability for the buyers.  Third, the company has begun to develop product that is made specifically for outlet.  Made for outlet merchandise represented 0% of sales at the beginning of this year.  Management anticipates that it will represent 50% by mid 2007 and over the longer term, is expected to generate 70% of outlet sales.  Consequently, the outlet stores will eventually become a profit center instead of detracting from the company’s bottom line.   

As KCP is in the first inning of its revamped strategy, we have begun to see a slight improvement in comps at the KCNY stores.   Comp store sales were down 13.5% in Q1 2006, down 13.2% in Q2 and down 10.2% in Q3.   Management has guided to a “down high single digit comp” in Q4.   I expect these comps to turn positive in 2007 and reach a 5% level in 2008. 

In 2004, the retail division had an operating margin of 6.5%.   In 2206, I estimate that retail’s operating margin will fall to (10%) while wholesale margins will be approximately 11%.  If the company is successful at returning to 2004 levels through its initiatives, it will improve overall profitability of the company by 500 basis points which equates to roughly $0.75 - $0.80 in earnings (50 basis points in operating margin improvement = roughly $0.08 in earnings). 

Recently, KCP has overhauled its senior management team to help deal with its problems.  The company has hired a new COO, EVP Wholesale, SVP International and SVP Reaction.   Joel Newman, COO was hired in February and came from Tommy Hilfiger where our checks indicated he was a very strong manager.  Richard Ollicker, EVP Wholesale came from Steve Madden where he was the President.  Henrik Madsen joined as SVP International.  Formerly, he was head of the European division of Jones Apparel.   Doug Jakubowski joined as SVP Reaction last year and came from Perry Ellis where he served as President of the menswear division.  Together with Kenneth Cole, who founded the company and drives much of the strategy today, we believe the senior management team has deep domain expertise and will be very effective at orchestrating a successful turnaround at KCP. 

Valuation:

KCP is currently trading at 18x  2007e (consensus).  2007 consensus is a bit distorted by increased spend to bring one of its licenses in house (costing approximately $0.20).  We believe that the company will earn $2+ / share in ’08 through a combination of its retail initiatives and conservative growth assumptions.  Our $2 earnings number assumes and operating margin of 10%.  At a 17x – 20x multiple, this represents a $34 - $40 stock price in 12 to 18 months, or 40 – 65% upside from current levels.

• Operating margins returning to historical levels
• Company fixing its problems in the retail division
• Potential private equity buyout

Catalyst