Coach (NYSE:COH) is a seller of accessories for women and men. Coach is most prominent for its handbags and according to Luxurysociety.com, Coach was the number 1 searched handbag brand in the world in 2012. Coach mainly sells through 2 channels: Direct to customer, where they sell goods through full priced shops and factory stores, and indirect where they sell through retailers. By selling products through both full priced shops and factory stores, Coach has positioned itself to target customers through a wide net of price points. This article aims to discuss if Coach is a good long-term investment.
Good long-term profitability
The profitability of a company in the luxury goods industry is often very strongly tied to their brand. The stronger or the more popular a brand is, the higher the demand for its goods. Consequently, it bestows great pricing power on the company.
A strong brand is often determined by 4 primary factors: Quality, Design, Service and personality of the brand.
Of the 4 primary factors, I believe that design and brand personality (more on that later) play the most important roles in determining a purchase. To understand why design is important, one must be willing to embrace the fact that true brand loyalty does not exist. I define true loyalty as purchasing a product from a brand without even bothering to look around at others. This, I believe almost never happens. More often than not, consumers will window shop around several reputable brands (they usually are all located near one another), before purchasing a design they like the best.
I believe that designs are mostly based on serendipity. However even so, experience plays a part as well by increasing the probability of "meeting" serendipity through the understanding of the wants and needs of their target groups. In this sense, Coach has done a great job. They have been constantly on the move surveying customers after customers on current preferences. This, in my view, increases the probability of "home run designs" dropping into the minds of the in-house designers at Coach.
If you believe that design is a matter of probability, then being a large and prominent brand like Coach certainly yields the company many benefits on the design front.
First, as Coach increases the size of its creative team to cater to the various demands of designs around the world, they are in fact increasing the probability of hitting designs which will be loved by many.
Secondly, being large and reputable tempts many aspiring or seasoned designers with a diverse range of consumer insights to come under Coach's wings. These people like to associate themselves with these large brands to boost their portfolio of which they can leverage to start their own brands in the future or to negotiate for higher pay as they move from one brand to another. Henceforth, being able to select the people with the best insights amongst the throngs of people who applied to be a designer at Coach, Coach is effectively increasing the probability of having good designs under its portfolio.
So, to borrow a concept from Mr. Warren Buffett, being large serves as an economic moat to Coach. With more well accepted designs, there will be lesser consumers who churn to other brands while at the same time more new consumers will be attracted. With higher demand comes higher pricing power and hence large margins. The best thing of all is that this economic moat expands as the company gets larger. To see the effect of this economics in play, Coach is able to release new designs consistently and frequently as well as have an average of 70% of Coach's revenue coming from designs released that year.
On the operational front, being a large brand like Coach often gives them the power to pressure suppliers into giving them larger discounts so as to lower costs; especially when Coach's preferred mode of manufacturing is through 3rd party manufacturers instead of building their own manufacturing capacities.
Running neck and neck with design in terms of importance is brand personality. No matter how impressive the design of a product may be, a consumer would not like to be associated with a brand that has a personality they are not comfortable with. If you are a lover of classical music, can you imagine yourself carrying brands linked to heavy metal?
However, and no matter how impactful the marketing maybe, brand personality can only be formed or communicated through its designs. Therefore, both ranks top when creating a strong brand.
This brings me to the largest issue currently facing the company - its lack of a strong brand personality. However, investors can take comfort in the fact that the company's management is breaking through by focusing on remaking its brand into a lifestyle brand. Although the author believes that the makeover isn't really complete as yet, it is moving in the correct direction. This can be seen from the increased revenue and profit for the past few quarter's earnings result versus a year ago.
Quality of the product is the next important factor on the hierarchy after design and brand personality. The design and brand personality of the product can win a purchase from a consumer, but it is the quality of the product that secures a long-term buyer. In this sense, Coach is well known for selecting the best 10% of leathers to use for their hand bags. This, backed with constant quality checks on the manufacturers certainly ensures customers the quality the company promised of their handbags. In fact, the quality of Coach's handbags has often received much positive feedbacks from customers.
One issue many will bring up at this point is the selling of Coach's products through their factory stores at a huge discount to their retail price. Won't that dilute the brand? I believe that to a certain extent it does. However, the damage isn't great. The products sold at the factory stores are usually designs which was left over from the previous season. Furthermore, the factory stores are rather inconveniently located and the service standards there are greatly lowered. In other words, a purchaser at the full priced stores can be assured that the additional premium they are paying for goes into better service received and having the most "up to date" designs. Also, I do think factory stores are an ingenious idea to milk from leftover products (with a decent margin of course) whose other destiny is to be destroyed, like what most other competitors are doing.
Further, pushing the pricing power of the company is its foray into the ultra-luxury segment through its Reed Krakoff brand. This segment targets the ultra-wealthy who have shown particularly interesting economics. In this segment, the more expensive the product is, the more demand there is for the product. This segment is all about exclusivity. A (very) high price point brings about such feelings for the product and therefore creates more demand.
However, one trend that could be adverse to Coach's profitability would be the rising costs of manufacturing in developing countries like China and most parts of Asia. However, as Coach contracts with 3rd party manufacturers, it provides them with the flexibility to shift their production to regions with lower costs of manufacturing.
Good long-term business volume
The potential volume of business for Coach has greatly increased over the years due to the increasing wealth around the world. According to Forbes, there were 1426 Billionaires in 2012, up from 1125 in 2007. And according to Capgemini, there were 11 million Millionaires in 2011, up from 10.1 million back in 2007. In addition, China and many parts of Asia are witnessing a rapid expansion of their middle income class. This, together with improving global outlook has restored consumer confidence and resulted in increased spending on luxury goods.
Another booster to the Coach's business volume is the interest men now show in fashion and personal grooming. Coach has released a series of product lines for Men and has thus been garnering rather good responses.
On top of that, Coach has created a digital strategy to harvest on the growth of online shopping that has certainly made shopping (and purchasing) a lot easier. Many consumers now prefer to shop wherever and whenever they want instead of making their way down to the mall of which they might leave disappointed if they do not find anything of interest.
Due to the increased competition in this industry, now made even worse with the rise of Asian designers and brands, many investors are worried about the effects it will have on the top and bottom lines of the companies operating in this industry. To illustrate why this worry is trivial, one can see the Luxury goods industry as a parallel to a mall filled with various types of restaurants. Each has their own specialties and ambiance and hence attracting particular groups of people. Many a times, in the short term, the restaurant will see some customer head to their competitors for some meals. In the long term, however, customers who really like the restaurant will keep coming back to it. (The prerequisites are good designs, strong brand personality and quality as explained above of which Coach has 2 but lacking in 1.) Henceforth, competition in the industry, although damaging, won't rock the boat of a strong brand much.
To conclude, based on the economics of the company, as well as the long-term trends pushing the company, I believe that Coach would be a great long-term hold.
I have valued the company to be at approximately $77 per share versus its current market price of $57.76 (at 24th May 2013). I believe the current undervaluation could be linked to the fact that many investors are uncertain of the results of their brand makeover. However, I believe the improving operational performance is a good sign that things have gotten better and will continue to be. Henceforth, it would be a great time to buy into Coach now.
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.