After announcing a 30.4% increase in comparable sales, Kate Spade (NYSE:KATE) shot up in early morning trading on Tuesday this week. But by noon, the stock had fallen close to 20%, erasing the stock's 2014 gains. What sort of problem lurked below the surface that caused the decline? Promotions. Kate said that its Kate Spade Saturday brand, which had been a highflier, took a hit on overstocked merchandise, and helped push gross margins down 3 percentage points from 2013's second quarter.
That sent investors running for the hills, as it became clear that Kate Spade wasn't going to be spared the fate that pulled Michael Kors (NYSE:CPRI) down the previous week. The short explanation is that handbag competition is getting too hot to sustain full-priced sales. The longer story encompasses Americans' wages, home improvements, optimism about a new brand, and rabid ducks. OK, not rabid ducks, but the other three, for sure.
The fall of the handbag
Until spring this year, it seemed like handbag retailers could do no wrong. Kors set the standard for what kind of crazy sales and strong margins a brand could put up, and after shedding Lucky Brand and Juicy Couture, Kate Spade seemed set to repeat Kors' success. Kate's brand was so hot that the company moved ahead with its lower-priced Kate Spade Saturday brand at full steam, which ended up being an overextension.
In this quarter, Kate Spade had to throw out material from its previous Saturday seasons that never made it into product, an issue that the company blamed on "a launch business that lacked scale." The Saturday brand is doing well, but management revised its estimates for investment and growth this year, as the company is expecting things to take longer to really get off the ground.
That covers the optimism problem that Kate Spade was experiencing, but there's still a root problem: Why did Kate have to cut back to sell, and why are customers still expecting more for less?
Macroeconomic issues, microeconomic woes
The problem reared its head last year in full force. Americans aren't making more money in a way that allows them to feel comfortable buying nonessential products the way they used to. Wages have been slow to grow in America, with high unemployment and low productivity keeping the bargaining power in the hands of employers.
According to the newest Labor Department figures, that may be slowly changing, but for now, consumers are still working with very little in the way of raises. That means that families are having to make more decisions. Either a person can buy that new handbag at full price, or she can buy a handbag from a competing brand on sale and get shoes for her kid.
In addition to being on the lookout for discounts, Americans are also spending on home improvements in a way that cuts into nonessential purchases. Existing-home sales have been on the rise, driving consumer spending on renovations and upgrades. While new-home sales can help push up spending on home goods, existing-home sales push up demand for other categories as well, and those expenditures leave consumers with less in their pocket for things like purses and designer watches.
The promotional environment creeps in
It's clear that the macroeconomic setup leads to a promotional environment, where Kors and Kate Spade have to keep pushing prices down in order to bring in new customers. In Kate's defense, the company is really only seeing pressure at the Saturday brand, while its main brand has had much less promotional pressure.
The risk of being left out when promotions do hit the market is huge. While it might seem prudent to simply let the promotions pass, sweeping up the competition, that would lead to a huge decline in Kate Spade's brand visibility, as more customers switched over to competitors. The company said that it is "not going to sit on the sidelines while there is a meaningful promotional activity among retailers and competitors."
Michael Kors is under the same pressure as Kate Spade. In its second-quarter release, the company said that it expects its fiscal 2015 gross margin to fall approximately 50 basis points compared to its 2014 margin. The company was adamant that it was not going to engage in heavily promotional activity, but it may be the case that the market simply drags it into a promotional world, whether it wants to go or not.
Tension between the two brands is going to continue to fuel these sorts of margin declines and promotional moves as long as Americans are forced into tight spots.
Can Kate Spade turn it around?
The long view for Kate Spade isn't nearly as bad as it may seem right now. The company took its biggest margin hit this quarter, and the second part of the year should be much clearer sailing. Its Saturday brand is still growing, its main brand hasn't taken nearly the same margin hit, and consumers might be on the rebound.
According to the latest data from the Labor Department, productivity is increasing, giving employees more bargaining power when it comes to wages. That should lead to a natural increase in wages and more money in consumers' purses and less promotion in the retail environment. That doesn't mean that things are going to suddenly bounce for Kate Spade, but it should mean good news in the long run.
Andrew Marder has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple and Michael Kors Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.