Coach: The Risk That No One Has Mentioned

By Ronald Thomas, CFA  FEB 04, 2013 4:15 PM

It's possible that Coach's competition will make it a sort of perpetual underachiever.

 


Coach's (NYSE:COH) stock has taken a beating after its last quarterly result. Investors have just woken up to competition in the US. With this recognition has come increased promotional activity. Muted consumer demand has also been recognized as somewhat of a problem. That should not have been any surprise because of the huge amount of sales in the outlet channel.

Coach's management is emphasizing category and product extensions outside of women’s handbags, and said that it would not cut prices. So analysts have cut their EPS numbers and price targets and gone on to the next company to report. A few have turned more bullish on Coach at the lower price. Now that more competition has finally caught up to Coach, it is missing the most important and scariest thing for the stock: probable gross margin contraction.

Let’s go back to basics. Coach’s gross margin is 73%. Averaging the gross margin of Louis Vuitton (EPA:MC), Burberry (LON:BRBY), Richemont (VTX:CFR), and Hugo Boss (ETR:BOS3), I get 64%. Actually, I cannot find any sell-side analysis from a couple years ago that had others, such as Gucci (PINK:GUCG), that pulled down the average of these much more upscale, stronger brand names to an average nearer the high 50s, as I remember. No matter. Remember that Michael Kors (NYSE:KORS), which has a 57% gross margin, is the chief share taker from Coach now.
There is absolutely no reason that a near- luxury brand, such as Coach, should have a higher gross margin than full-fledged luxury brands over the longer term. And there is probably good reason for Coach’s gross margin to trend toward that of Kors. Beyond that, there is the matter of Coach’s huge proportion of factory outlet sales. For the longer term, that is not a strength for brand cache, which is the most important factor supporting huge gross margin percentages for all of these businesses. Averaging the 64% gross margin of these four full-fledged luxury brands and Kors’ 57%, I get a 61% target for Coach.

So if I adjust 2013 EPS estimates for Coach for a 61% gross margin, I can go from $3.75 to $2.70. I am not saying that Coach is going to encounter this sort of profit pressure in the short term, i.e., the stock may not be the proverbial “falling knife” from here. But it seems likely that competition will make it a sort of perpetual underachiever.

Plugging that $2.70 into my earnings discount model, Coach would have to be growing EPS from that $2.70 level at a 15% compound annual growth rate to justify its present price. That would be especially tough considering that Chinese distribution will almost certainly be growing relatively fast for Kors, Kate Spade, Dooney & Bourke, and Cole Haan off of their present small or nonexistent bases.
No positions in stocks mentioned.

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