Why Coach Earnings Will Surprise To The Upside Next Quarter

| About: Coach, Inc. (COH)

Coach (NYSE:COH) reported its December quarter earnings last week and the market reacted with a 15% price drop, making Coach the worst performer on a day which saw the S&P 500 index moving steadily higher. Even though at Coach net sales and earnings grew 4% year on year, the market expected more, and focused on the US where same store sales fell 2% year on year.

This extreme market reaction to earnings misses, which we saw also with Apple (NASDAQ:AAPL) last week seems to be the result of the current high valuations of the market, where growth estimates must be met to justify the high PE multiples.

Coach is now trading at a ttm PE of around 14, no bargain by anyone's standards, but under the the market and sector average. I believe that the market reaction is overdone and Coach is a buy at this level, as growth in earnings will pick up, starting next quarter.

Coach is a retailer in the high end consumer products sector which is critically dependent on holiday season sales, so the December quarter performance, with the holiday season sales is the most important performance quarter, right?

Not so fast! Coach has been transforming the business from a US based brand into a global luxury goods brand, with a strong focus on Asia. This has been a major shift in the footprint including a rapid growth of stores in China, which now total 100 on the mainland, plus others in Hong Kong, and other regional markets with a high Chinese ethnic consumer base.

The other key international market for Coach is Japan, where economic conditions have been challenging, and the rising Japanese Yen (up around 10% yoy) saw currency impacts equivalent to 1% of global sales for the quarter. The recent strength of the Yen has been attributed to the recent Japanese QE programme, but this is not likely to be sustainable.

Coach now generates 1/3 of its sales outside US, with heavy weightings towards China and Japan. Here are CEO Lew Frankfort's comments from the earnings call.

"Moving on international sales, which today represent nearly one-third of Coach total sales rose 12% in the second quarter. As mentioned the China sales rose about 40% from the prior year. This sales growth was fueled by distribution and double-digit same-store sales growth.

Clearly, the Chinese consumer has embraced Coach, as evidenced by these results, as well as the increasing contribution of the Chinese stores to have a global sales and the extremely high repurchase intent among existing consumers."

A simple fact that stateside investors might miss is that Christmas isn't such a big deal in China and Japan. The big holiday season and gift giving period is around lunar New Year, which falls in the 1st quarter of the calendar year. At this time of year, sales of luxury branded goods hit their peak, especially in China, where gift giving is part of the business culture as well as giving gifts and money to relatives, plus its bonus paying time. The new customer base of Coach has a different seasonal spending pattern, and the impact of this with the rapid footprint expansion should lead to a strong Jan-Mar quarter sales pattern in the future.

As a frequent traveler around the region, I have witnessed the increasing footprint of Coach, which has stores in most of the major regional airports, and key high end retail outlets. As the Chinese travel peak is in January and February, coinciding with lunar New Year these outlets are particularly well placed to capitalize on the seasonal uptick in sales. Consumer sentiment in China and the rest of Asia is increasingly bullish, and this should translate into increased overall luxury goods sales.

The Bottom Line

COH is positioning extremely well to develop an international footprint, and this comes at a cost - CapEx in the last quarter was up to $61m from $31m in the 2nd quarter the prior year, and this is planned to total $250m this year, as the international store expansion continues.

The international sales growth to justify this expense is clearly in evidence, but the seasonal sales pattern in Asia will push a significant amount of this impact into the 3rd quarter earnings. In addition the men's product line will appeal to the Asian consumer, and I expect to see this product range get better traction in Asia than the U.S.

COH is in a growth phase, incurring significant expense to expand distribution, and still managing to produce a 4% increase in earnings, and consistent operating margins.

The current price level does not fully reflect the future earnings growth potential.

Disclosure: I am long COH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is not an investment advisor, and is not making a recommendation. Readers should undertake their own research, and not rely on the contents of this article.