This could pump the brakes on Coach's recovery

Shoppers walk past a Coach outlet store.
Luke Sharrett | Bloomberg | Getty Images

A dramatic slowdown in Kate Spade's comparable-sales growth threw a wet towel over Wall Street's budding optimism surrounding one of its biggest competitors.

Shares of Coach were bouncing between positive and negative territory Wednesday, after Kate Spade said its same-store sales grew just 4 percent during its fiscal second quarter. That was a marked drop-off from the previous three-month period, when the brand logged a 19 percent lift in that metric. It also fell shy of analysts' forecasts for a 12 percent gain, according to Retail Metrics.

Kate's results reignited fears about the already tepid handbag space, where excess inventories and heavy promotions have caused sales to decelerate. But with the fashion brand blaming much of its shortfall on outlet stores, its miss could have broader implications for Coach.

Kate Spade's outlet locations account for roughly 38 percent of its 173 North America stores. For Coach, these shops made up about 44 percent of its 462 domestic stores as of last year. Analysts had already expressed doubts about Coach's so-called "factory" business prior to Kate Spade's report.

Though the brand has been showing signs of improvement, Citi analyst Paul Lejuez said a true recovery means boosting its performance in outlet centers. Coach has been remodeling these shops and filling them with better products, but it remains challenged by fewer international tourists and deep discounting. The company generates roughly 40 percent of its sales from its outlet locations, according to Citi.

"While the factory store remodels look good, we continue to believe that Coach will not be able to reduce promotions meaningfully in the channel and at the same time drive sales," Lejuez said.

Indeed, Kate Spade's management said the brand was forced to take unplanned promotions in the outlet space due to heavy competition. Those discounts contributed to a contraction in its gross margin rate during the quarter.

With Coach long regarded as the weakest of the three reasonably priced luxury brands, Wall Street has recently been warming up to it. The label's North America division is expected to show its first quarterly comparable-sales gain in three years when it reports fiscal fourth-quarter earnings next week.

Though Coach is challenged in the outlet space, its minimal exposure to the challenged department store space is a positive for the brand. Whereas roughly 40 percent of Michael Kors' revenues come from these accounts, wholesale only accounts for about 5 percent of Coach's sales, according to analyst estimates.

The company's shares are up roughly 37 percent over the past year, near $42.