Coach Follows The Playbook - 1st Down

| About: Coach, Inc. (COH)

On January 23rd, Coach (NYSE:COH) reported its 2nd quarter fiscal quarter earnings, with a modest 4% net sales increase suppressed by a 2% US same store reduction in sales. The reaction from a nervous market was marked - Coach shares dropped 15% to $50 in a single day. In my article, "Why Coach earnings will surprise to the upside next quarter" I suggested that the market reaction was over-stated. As a result of the changing seasonal sales profile, the January - March quarter will be progressively more significant to Coach. On April 23rd, the 3rd quarter earnings beat expectations, with a 7% increase in sales, and a 10% increase in earnings per share.

The share price bounced back, to close on the 24th at $56.3. In this article I will consider some of the factors at play, and look forward to the next quarter.

The business profile.

Coach, Inc. engages in the design, marketing, and distribution of handbags, accessories, wearables, footwear, jewelry, sunwear, travel bags, watches, and fragrances for women and men in the United States and internationally.

Coach has traditionally been a US based firm, with international expansion established via a strong Japanese presence, currently totaling 191 stores. While Japan has been a solid contributor, economic stagnation there has restrained growth. More recently, Coach has embarked on a more aggressive expansion progam. Coach has been transforming the business from a US based brand into a global luxury good 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.

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

"Moving on to China, during the quarter we opened one new location on the mainland, bringing the total number to 118 locations, including 100 on the mainland in 41 cities. Following our Asian distributor acquisitions over the last 21 months, we now directly operate 93 locations in Asia comprised of 49 in Korea, including one location we opened in the quarter, 27 in Taiwan, 10 in Malaysia, and 7 in Singapore."

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 strong 1st calendar quarter sales in the future. This is mainly the result of the lunar new year holiday. During the holiday period, ethnic Chinese from around the world travel to visit family, spending on gifts even more enthusiastically than Americans at Christmas.

As important as family gift giving, in the Asian business culture, generous gifts are exchanged between business associates at this time of year. In China in particular, this extends into government employees, as many businesses in China are state owned. The new Chinese leadership under Xi JinPing has implemented an austerity drive, seeking to curtail the excessive spending by the government elite. The impact on this is uncertain for Coach, as it is possible that the more affordable price point of Coach products compared to European luxury brand rivals, or indeed the lower cost of handbags to gold watches will benefit sales in this environment. What is certain is that Coach China sales grew by 40% in the quarter, demonstrating the earnings power of the heavy investment that Coach has made in distribution. The investment here continues, but slowing with 7 new locations planned for the coming quarter.


As a major contributor to sales, the Japanese market has some risk for Coach earnings. Under the new easing policy, the Japanese Yen has seen significant devaluation vs the USD, which introduces some currency risk for Coach. Conversely, stimulus in Japan should be good for sales. There is a response to this more optimistic outlook, with continued investment in Japan, via 7 new stores to come on line in the next quarter, mostly dedicated mens' stores. On the analysts call Jane Nielsen CFO explained that Coach hedge the currency risk.

"We actively hedge, overall, for transactions, so that we minimize the impact to cost of goods sold by hedging in a layered fashion every quarter so that we are protected about three quarters out to a substantial degree. We'll continue that practice. Really, our objective is to smooth the impact of the yen on our costs over time."

In effect, I expect the net impact from Japan to be positive.

What about the US?

Despite this international expansion, Coach still has 2/3 of its sales in US. Here too the news is promising. North American sales grew 7%, with a 1% net sales increase on a same store basis. Here Coach is also changing, with an effort to expand from a womens' handbag brand into a 'lifestyle brand'. In essence, this means a product expansion into footwear and clothing, and a demographic expansion into mens' products. Easter this year fell into the first calendar quarter, so Easter related sales would have provided some tailwind to US sales. I am more cautious about the US outlook for Coach in the light of competition from brands such as (NYSE:KORS).

Outlook for the next quarter.

Coach has started to see the growth materialize from its extensive investments in China. Management however remains cautious on outlook, with concerns around currency risk and the US economy. As a result, despite the strong quarter, Coach has maintained its full year earnings guidance. Taking this into account, and the seasonal shift of Easter sales into the March quarter this year, I do not anticipate outperformance in the next quarter earnings.

Longer term outlook.

I remain bullish on Coach as well positioned for future Asian growth, and a strong play on China. If Coach continues to build brand loyalty in China, this should create strong momentum for sales in all regions outside the US. This is because the store footprint is well positioned for the Chinese tourist market, both around Asia and in their European operations. Coach is currently valued at around 13.5 x forward earnings. The dividend yield is now close to 2.5%. As a stock with high growth potential, this represents reasonable value at current pricing, while any future dips could create a more compelling opportunity.

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 a private investor, not an investment advisor. The analysis presented is for readers interest, and should not be taken as advice. Readers should take professional advice before making any investments.