In my February Coach
, I said that the company was vulnerable to the outlet channel shoppers in the US, and that the gross margin was much higher than that of the competition and was unlikely to hold, which were huge reasons to stay away from the stock.
Those are two intertwined concepts now. I have just read -- and was somewhat surprised to learn -- that Coach’s outlet sales last year had reached 73% of its total North American units, up from about 43% in 2006. That might not be a huge problem, except when you have a 28% value share of US handbags. Management can say that these are different shoppers going to different stores, but these shoppers are not segregated from one another in their daily lives. So the cache of the brand will tend to disappear as the Coach shop or department store buyer sees many more women of all income levels wearing Coach handbags.
While I still roll my eyes when rag trade people and sell-side analysts talk about “lifestyle brands,” to the extent that there is any ability to build a “lifestyle brand” out of the base of women’s handbags, I have to be very skeptical of the base that will be used to build it, given the situation outlined above. The unexpected management turnover of the COO and president of the North American group operations, on top of a formerly announced creative director change to come, makes recreating Coach as a “lifestyle brand” seem very unlikely to happen within anybody’s investment horizon -- and it will very likely be expensive in terms of advertising and promotion. And, if it happens, it is also likely to be at a gross margin significantly less than the 73% the Coach has now.
So the quarterly results showed that Coach continues to lose share in North American handbags, with comps down 1.7%. At the same time that the economy looks to be growing at only a 1% GDP in the second quarter without much momentum, Coach is still growing square footage in the outlet channel at a faster rate than it's growing real estate for its full price stores (double digits vs. flat). Yet the outlet shopper is more vulnerable to the slowing economy. And management currently predicts low single-digit North American comps store sales in FY ’14.
China and the Far East are still doing well enough with double-digit comps, allowing operating income to be flat with last year, and diluted EPS is up $.03 to $.89. Plus Coach could buy back some significant amount of shares, if it so chose.
I see a company that is likely still over-earning. A low gross margin percentage in the low 60s, the same level as its more upscale competitors, is probably coming in the next two to three years, with the potential for something even lower, if the brand cache is heavily lost in the US. A mix of lower gross margin, increased overhead expenses from too much square footage in the US, or sharply lower sales growth (or outright declines) are all possible depending on management’s strategy from here.
I do feel that the brand may be extremely compromised at this point, both by an unprecedented (in my experience) 73% of units going out of outlet stores in the US with more to come, and by the huge management turnover, which I believe comes in one way or another from the expectations about the brand’s situation now and the ease of building it back in the US. Feeding that into revenue growth, I believe that the men’s and the clothing initiatives will not gain much traction. And apparently, the shoes are not doing well, though Coach has managed to pull off some decent results in men’s accessories.
Longer term, while China and the Far East may continue to grow, I have to believe that it is grossly optimistic to think that Coach can sustain either a 28% value share in US handbags in the face of more competition from Michael Kors
(NYSE:KORS) et al. and a likely compromised brand cache, or a 72% gross margin when luxury brands with better names than Coach average in the low 60s. I would also think it likely that Coach’s future gross margin could be in the 50s easily. Of course there is a sales vs. gross margin trade-off here for management to ponder.
So, looking at long-term earnings growth, I would use, maybe optimistically, a mid-single-digit sales growth rate and some ongoing gross margin decline to result in, let’s say, a 2% five-year EPS growth rate before stock buybacks. A 2% growth rate based on a $4.11 FY15 sell-side consensus estimate (still being revised as I write this) and a 4.2% risk-free rate (long Treasury bond plus 50 bps) results in a $41 price. If buybacks could add 3% per year, a $46 price might be justified.
No positions in stocks mentioned.
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