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Coach, Inc. (NYSE:COH)

Q4 2006 Earnings Conference Call

August 1, 2006 8:30 am ET

Executives

Lew Frankfort - Chairman, CEO

Mike Devine - CFO

Andrea Shaw Resnick - VP, IR

Analysts

Bob Drbul - Lehman Brothers

Margaret Mager - Goldman Sachs

Jeffrey Edelman – UBS

Paul Lejuez - Credit Suisse

Lorraine Maikis - Merrill Lynch

Christine Chen - Pacific Growth Equities

Anwan Hombula – HSBC

John Rouleau - Wachovia

David Glick - Buckingham Research Group

Jim Hurley - Telsey Advisory Group

Evran Coppleman - JP Morgan

Presentation

Operator

Good day. Welcome to the Coach call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Vice President of Investor Relations at Coach, Ms. Andrea Shaw Resnick. You may begin.

Andrea Shaw Resnick

Thank you, Brenda. Good morning and thank you for joining us. With me today to discuss our quarterly and annual results are Lew Frankfort, Coach's Chairman and CEO; and Mike Devine, Coach's CFO.

Before we begin we must point out this conference call will involve certain forward-looking statements, including projections for our business in the current or future quarters or fiscal years. These statements are based upon a number of continuing assumptions. Future results may differ materially from our current expectations based upon risks and uncertainties, such as expected economic trends or our ability to anticipate consumer preferences or control costs.

Please refer to our latest report on Form 10-K for a complete list of these risk factors. Also please note that historical growth trends may not be indicative of future growth. We presently expect to update our estimates each quarter only. However, failure to update this information should not be taken as Coach's acceptance of these estimates on a continuing basis. Coach may also choose to discontinue presenting future estimates at any time.

Now let me outline the order of speakers and topics for this conference call. Lew Frankfort will begin with an overall summary of our fourth quarter and fiscal 2006 results, as well as our plans for the new fiscal year. Mike Devine will then follow with details on financial and operational highlights for the quarter and year as well as our outlook for the first quarter and full fiscal year 2007. Following Mike, we'll hold a Q&A session that will conclude by 9:30 a.m.

I'd now like to introduce Lew Frankfort, Coach's Chairman and CEO.

Lew Frankfort

Thanks, Andrea and welcome everyone. As we announce our fourth quarter results and the end of our fiscal year, we are very pleased with our performance and even more enthusiastic about the opportunities that lie ahead. We're confident that FY07 will be another excellent year for Coach with sales rising to at least $2.5 billion, or at least 19% ahead of last year.

Historically, we have used the term accessible luxury to describe our marketplace position as a lane between the old world luxury brands and the more moderate segments. Today Coach is credited as the primary catalyst in changing the way in which American women perceive accessories. In fact, our average target consumer now buys four handbags a year, up from just two the beginning of this decade. This has resulted in more than a doubling in the size of the category during the last five years. While our business in North America has tripled in the same period, our U.S. market share has only grown from 16% to about 25%.

Our strong fiscal 2006 performance speaks to our philosophy of operating Coach as a small business for large sales. FY06 was highlighted by a 23% increase in revenues and a 38% increase in net income. It was a year of many accomplishments, including:

  1. The opening of 29 total net new stores in the U.S., 25 new retail stores and four net new factory stores.
  2. A 12% increase in full priced North American comparable store sales for the year, driven primarily by an increase in average transaction, as well as modest gains in traffic and conversion.
  3. Over 20% gains for U.S. department and specialty stores at POS.
  4. Another excellent year for Coach Japan where sales at retail rose 22% in constant currency to over $415 million despite flat category sales for accessories in Japan. In fact, Coach continued to leverage its number two position in the market reaching over 9% share this year up from 8% last year.
  5. Finally, the repurchase of over $600 million of Coach common stock during the fiscal year.

Most broadly, we once again effectively executed our growth plans and realized company-wide performance that outpaced our stated goals.

As you know, this morning we announced excellent results for the fourth fiscal quarter ended July 1, 2006 ahead of both our expectations and analyst's estimates. Our net income and EPS rose 31% and 33% respectively, from prior year levels as a 23% increase in sales, combined with a significant improvement in margins, continued to drive the bottom line.

Some highlights of our fourth fiscal quarter were:

  1. Net income rose 31% to $118 million, or $0.31 per fully diluted share, compared with $90 million, or $0.23 per share, in the fourth quarter of fiscal year 2005.
  2. Net sales totaled $514 million versus $419 million a year ago a gain of 23%.
  3. Direct to consumer sales, which as you know now includes Coach Japan, rose 23% to $419 million during the fourth quarter, from $341 million in the comparable period of the prior year.
  4. Lastly, U.S. same store sales for the quarter rose 18.5%, with retail stores up 10.9% and factory store sales up 29%.

During the quarter, as planned, we opened 12 retail stores bringing to 25 the number of new retail store openings in 2006. Last quarter's openings included our first stores at Omaha, Nebraska; Knoxville, Tennessee; and Fresno, California. We also opened three factory stores and closed one during the fourth quarter. Thus, at the end of the period, there were 218 full-priced stores and 86 factory stores in operation.

In addition, during the quarter we expanded one full-priced store, North Park Mall in Dallas, Texas bringing the total number of completed retail expansions to seven this year. We also expanded three factory stores in the quarter, bringing the full year total to five.

Indirect sales in the quarter rose 23% to $96 million, versus $78 million a year ago, driven primarily by substantial increases in international and U.S. wholesale shipments, while business to business contributed as well.

During the quarter in Japan, in addition to the Kobe flagship, we opened six other locations and closed one, while a wholesale location at the Nirita Airport was opened as well. This brought the total number of store openings to 16 net new locations, on target with our expansion plans. Thus, at the end of the fourth quarter we had a total of 122 locations in Japan with 20 full-priced stores, including eight flagships, 87 shop in shops, 11 factory stores, and four wholesale locations.

We were particularly pleased with the continued momentum of our North American full-priced business, both the gains posted by our own stores which continued to post double-digit comp gains and significant increases in U.S. department store POS sales; with comp sales running up over 20% last quarter and total sales up about 16%, after accounting for the closure of locations as a result of the Federated/May merger. Results continue to be driven by the monthly flow of fresh and relevant product which have positively impacted all key selling metrics.

For the factory channel, about two-thirds of our comp gains for both the quarter and the year came from a combination of conversion and ticket increases, which points to our strengthened merchandise offering; while the remaining third coming from increased traffic was in large part driven by new consumers to our database.

We were also pleased with the performance of Coach Japan this quarter where sales rose 12% in dollars and 20% in yen as our market share continued to grow rapidly. Our growth in Japan was fueled primarily by distribution, augmented by mid single-digit same location sales as we continue to focus on growing the overall market, primarily through our new and expanded locations.

Last quarter's performance was again especially noteworthy when you take into account the continued lackluster performance in Japan for imported luxury brands in general.

Finally, we were particularly pleased with the significant improvement in operating margins as efficiency initiatives and leveraged spending, in combination with our price cost initiatives and product mix improvements, continued to drive our bottom line results.

While Mike will get into more detail on our financials, I wanted to give you this recap and tell you how happy we are with Coach's fourth quarter and year end performance. I also wanted to touch on our product, the hallmark of the Coach brand, as it is the primary driver of our growth.

Throughout the spring season, well-received new product continued to drive our business, beginning in April with Optic Signature offering several key handbag silhouettes as well as accessories in footwear. In May the key item, shoulder tote, offered in multiple fabrications was a big win. In June, our Signature patchwork offering of perennial favorites was also very strong.

During 2007, we will be introducing three new major lifestyle platforms which we are especially excited about after a year spent successfully evolving established collections. As you know, Coach is known for innovation and we understand distinctive newness is key to driving our business.

The first new platform is our Signature Stripe collection. Introduced at the beginning of July, it was an immediate success and continues to exceed our expectations, currently representing about 14% of sales in retail stores in the U.S. and Japan. This tote-based assortment offered in our Signature pattern is casual, lightweight and functional. The totes are reversible, offering two bags in one and can be monogrammed allowing the consumer to personalize her purchase. An offering of accessories, footwear and wearables, completes this lifestyle collection and broadens our penetration of the casual weekend segment. Next quarter we will update this group with new color and style offerings.

We're particularly enthusiastic about the pending launch of the new Legacy collection in late September, our second new major lifestyle platform for 2007. Inspired by our archives, this collection will support our 65th anniversary and will be the center of our fall advertising campaign. The collection will also be featured in its entirety in our fall catalogue dedicated solely to Legacy.

A range of styles will be available in burnished, vintage leather, suede and classic Signature. Its classic modeled styling is enhanced by iconic hardware, such as turn locks, buckles or clip closures and colorful proprietary lining making this group distinctively Coach. A selection of wallets, cosmetic cases, wristlets, wearables, footwear watches and scarves will complement the collection. It's also worth mentioning that we recently piloted the Legacy collection both in the US and Japan with great success and broad consumer appeal.

Finally, the relaunch of Ergo coming this spring with soft styles and a sophisticated appeal will round out our new major initiatives for 2007. The original Ergo group, which was only handbags, represented 13% in its key selling period four years ago.

Of course, we will also continue to evolve our established collections as well, starting with the Soho collection in leather and Signature which we introduced in July. This year the collection is anchored with a key item satchel which was an immediate hit. The group also includes hobos and totes, perfect for business. The new introduction of vintage leather across all styles is being well received. A limited edition of bags with lacing and other embellishments completes this group. In July Soho ran north of 25% of U.S. retail store sales.

Just last week we introduced our updated classic Chelsea collection offered in crinkled leather, new buck and Optic Signature. The key item satchel is new to the collection and is doing quite well. A range of classic hobos is also being offered. The attitude of the bags, including their contrasting handles and proprietary turn-lock detail, all lent to Chelsea's overall appeal.

In September, we will evolve our Hampton’s collection. This group is feminine refined and classic. Our new group of hobos in multiple sizes and the book tote will complement our classic carry-alls. The collection will be available in soft pebbled leather, Signature patterns and an introduction of embossed Signature on leather. The pallet is neutral-based and sophisticated. Functional accessories, footwear and scarves will complete this lifestyle collection.

Our business will be supported by updates to the foundation we're building in this quarter, in addition to fresh groups of duffels, gallery totes and our popular patchwork. Duffels will feature vintage styling and additional functionality like adjustable straps in all sizes as asked by our consumers, offered at compelling price points.

Gallery totes will be in multiple fabrications, including rich patent leather and embossed Signature suede with beading. We're also looking forward to offering a large selection of holiday gifts under $100, such as the important $98 key item wallet, as well as wristlets, scarves, cosmetic cases and the new zodiac charms. An adorable selection of pet accessories such as collars, leashes and coats will be available as well.

Clearly, the vitality of the brand is driven by the strength of our product and our fall and holiday assortment is powerful, underscoring our optimism about the seasons ahead. Our formula for success has remained constant, despite a changing environment. We have five unvarying elements that separate us from the competition: our distinctive brand, our leadership position, our loyal consumer base, our multi-channel international distribution, and our focus on innovation and the consumer.

The engine that drives these elements is our strong and seasoned management team, fueled by innovative, exciting products and supported by an adaptive dynamic global sourcing and supply chain.

Our brand has never been stronger, nor has our proposition ever been more vibrant. We are well positioned to continue to capitalize on the many opportunities available to us and have the vision, strategy and tactics in place to realize our long-term growth plans.

Our overall arching goal is to continue to expand our market share in handbags and small leather goods, by delivering accessible luxury accessories to a broad, loyal and consumer base. To this end, we're focused on two primary growth drivers. First, increasing our own retail distribution internationally, with an emphasis in North America and Japan. Second, driving productivity; giving consumers more reasons to visit our stores and purchase while she's there.

In terms of distribution, our primary focus is the continued acceleration of growth in North American retail, given the doubling of the premium accessory category to $5 billion in recent years and its continued more than 10% growth during the first part of 2006.

We plan to add about 100 new U.S. retail stores over the next three years, bringing the retail store base to just over 300; while we now believe that North America, including Canada, could comfortably support at least 400 stores. During FY07 we intend to open at least 30 new retail stores, 20 in the first half alone, which will include seven new full-priced stores for Coach.

We're also pleased to tell you that our first opening of the new fiscal year at the Mohican Sun Casino in Connecticut has been an instant success and is on plan to generate $7 million in sales in its first year. In addition, we expect to add about five new factory stores in FY07 and have already closed one store for a net of four new stores. We expect new stores to add at least 100,000 square feet, over 12%, to our U.S. total retail square footage in FY07.

In keeping with our strategy to expand our most productive locations, we will also be expanding at least eight retail stores in FY07, mostly in the second half of the year. This includes some of our most productive locations such as Roosevelt Field here on Long Island and both Chestnut Hill and South Shore in the Boston area. In addition, we're also planning on expanding at least four factory outlets. Taken together, expansions in both channels are expected to add about 13,000 square feet or about 1.5% to our base.

Outside the U.S. we're continuing to aggressively expand market share with the Japanese consumer from about 9% this past year to a goal of 15% during the next few years, primarily through new stores and expansions. Overall, we expect that we could eventually have a total of at least 180 Coach locations in Japan across the same multi-channel distribution model that we have established in the U.S. In FY07 we expect to open between 15 and 20 net new locations in Japan, a net increase of at least 25,000 square feet or at least 13% to the store base.

Similar to the U.S., we also plan to expand about 20 of our most productive retail and factory locations in FY07, adding about 10,000 square feet or about 5% to our retail base.

Overall in FY07, we expect CJI sales to grow about 20% in constant currency from FY06 as we continue to gain share rapidly. Our gains will primarily come from distribution growth as we accelerate our new store opening plans, taking advantage of the many real estate opportunities in this market. Also, we're continuing to target mid single-digit comps for the year.

As noted in the third quarter call, the opportunities outside of our core markets of North America and Japan are plentiful. Notably in east Asia, especially in greater China, we are intensifying our efforts to build awareness by creating a presence that will position us for meaningful sales in the future as we recognize that Mainland China will become an important market for luxury brands during the next several years.

It's our intention to open at least ten locations in major cities on the Mainland during the next two to three years, while also continuing to expand our retail store base in Hong Kong, where we recently and successfully opened a major retail store in Canton Road our 13th Hong Kong location. While it's early days, this store is tracking to do at least $5 million in its first 12 months.

To this point, we have already secured four locations in Mainland China for FY07 openings including stores in important cities of Schengen and Xian as well as additional locations in Shanghai and Beijing.

The other important sales driver will be to continue the productivity of our existing locations. First the and most generally we're continuing to build market share in the rapidly growing North American women's accessories market by leveraging our unique position as an accessible luxury lifestyle brand. As part of this strategy, we're emphasizing new usage occasions such as Weekend, exemplified by our recent introduction of Signature Stripe and offering limited edition products to heighten our cache, especially with our top tier customers.

To this point we believe all three components of comp growth are still available to us:

  1. Transaction increases through a tiered merchandise offering including higher, limited edition penetration along with driving units per transaction with a broader assortment of add-on items in new categories such as jewelry and fragrance which we plan to introduce during calendar 2007.
  2. Conversion. We just returned from our annual U.S. store manager's conference; the focus of which was our new Coaching initiative. This evolved method of reinforced selling and service behaviors, including engaging multiple customers simultaneously, is expected to drive conversion and customer loyalty. In addition to being well known for great product, we are striving to be well known for great service. The next step in the Coach service initiative has been enthusiastically embraced by our retail field team and we are optimistic about the results it will bring.
  3. Driving traffic. Compelling presentations, excellent service, laser-focused marketing techniques, sophisticated advertising campaigns, a dynamic website, and clientele will all continue to bring our consumer into our stores.

These strategies and actions are designed to enable us to achieve superior financial results through our planning horizon. I will now turn it over to Mike Devine, our CFO, for further financials.

Mike Devine

Thank you, Lew. Lew has just taken you through the highlights and strategies. Let me now take you through some of the important financial details of our fourth quarter and year end results. As mentioned, our quarterly revenues increased 23% with sales for both our direct and indirect channels matching this gain.

For the full year, total revenues also rose 23% as did sales generated by our direct channel while our indirect revenues rose 24%. Excluding the negative impact of the weaker yen, total sales rose 25% for the quarter and 26% for the year.

Net income for the quarter increased 31% to $118 million, or $0.31 per share as compared to $90 million or $0.23 per share in the year ago period. This was ahead of the analyst consensus estimate of $0.29 for the quarter. Net income rose to $494 million in FY06, up 38% from the $359 million earned in the prior year.

Diluted earnings per share rose 38% to $1.27 versus $0.92 a year ago and ahead of analyst consensus estimates of $1.25.

Our operating income rose 41% to $180 million in the fourth quarter versus $128 million in the same period last year. Operating margin in the quarter was 35% compared to 30.6% in the year ago quarter, a 440 basis point improvement.

For the fiscal year, operating income rose to $765 million from the $573 million posted in the prior year, a 34% increase. Operating margin for the year rose to 36.2%, from 33.5% a year ago, up 270 basis points.

In the fourth quarter, gross margin increased by 80 basis points on a year-over-year basis from 77.6% to 78.4%, bringing the full year to 77.6%, a 100 basis point increase. For the year, as in the quarter, gains from product mix and supply chain initiatives drove this improvement.

As we expected, SG&A expenses as a percentage of net sales was substantially below prior year levels in the fourth quarter and represented 43.3% of sales versus 47% a year ago. For the full year, SG&A expenses as a percentage of net sales declined 180 basis points to 41.4% from 43.2% a year ago. All selling businesses saw their year-over-year spending rates decline as we also continued to leverage the top line volume throughout all of our centralized functions.

Inventory levels at year end were $233 million, up about $49 million from $184 million last year and were about 27% above those prior year levels. Consistent with our top line constant currency sales growth, as our supply chain improvements and inventory management programs allowed us to support 29 net new U.S. stores, 16 net new locations in Japan, and substantially increased sales levels with only this moderate additional inventory investment.

Cash and short-term investments stood at $538 million, as compared with $505 million a year ago. It should be noted that the 2006 fiscal year end cash balance reflects the repurchase of over $600 million of Coach common stock during the fiscal year.

Accounts receivable balances rose $19 million or 29%, while days sales outstanding remained constant at only 33 days.

Net cash from operating activities in the fourth quarter was $195 million, compared to $132 million last year during Q4. Free cash flow in the fourth quarter was an inflow of $161 million, versus $101 million in the same period last year, primarily driven by higher net income. Our CapEx spending, primarily for new stores and renovations, was $34 million, versus $31 million in the fourth quarter a year ago.

For all of fiscal year 2006, net cash from operating activities was $597 million compared to $476 million a year ago. Free cash flow in fiscal year '06 was an inflow of $463 million, versus $381 million in fiscal year '05; while CapEx spending totaled $134 million, again primarily for new stores and expansions.

Now I would like to provide you with some of our goals for fiscal 2007. Our current goals for the full fiscal year are:

Net sales growth of at least 19% to at least $2.5 billion, with at least 10% comparable store sales gains in both the U.S. retail and factory channels.

A total sales increase in Japan of about 20% in constant currency, which would translate to sales of about $500 million, assuming a flat exchange rate, driven primarily by distribution growth through new store openings and expansions augmented by mid single-digit same location sales growth.

An operating margin of nearly 37% which will result in operating income dollar growth of over 20% above FY06 levels.

Interest income of about $35 million, about flat to FY06, will add to pre-tax income. While net income will be somewhat offset by a higher tax rate rising to about 38.5%, due to the fact that incremental taxable income is being taxed at higher rates.

Including these factors, we expect to generate EPS growth of at least 22% which will produce earnings per share of at least $1.55 compared with the analyst consensus estimate of $1.53.

For FY07 we expect CapEx to rise to about $150 million, primarily for new stores and expansions both here and in Japan. As Lew noted, we'll be opening at least 35 new U.S. retail and factory stores and continuing our North American expansion programs. In Japan, we'll be opening about 15 to 20 net new locations.

For the first fiscal quarter of FY07, we are targeting net sales of about $535 million, representing a year-over-year increase of at least 19%, with U.S. comparable store sales gains of at least 10% in the retail channel and mid-teens in the factory channel. Operating income up at least 21% year-over-year, and earnings per share of at least $0.30, an increase of about 25%.

While these are our current goals, our actual results may vary from these targets based upon a number of factors, including those discussed under The Business of Coach, Inc. and risk factors in our annual report on Form 10-K. Coach also does not assume any obligation to update these targets as the year progresses.

In summary, we're confident that our growth strategies will enable us to continue to gain share in the large and growing global market for client accessories and gifts. Thank you, everyone for your attention and now Lew, Andrea and I would be happy to take some questions.

Andrea Shaw Resnick

Operator, let's open it up for questions. Please note that we will allow one question each per analyst and if necessary a clarifying follow-up. Thanks. Let's open it up.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Bob Drbul - Lehman Brothers.

Bob Drbul - Lehman Brothers

Good morning. Have you seen anywhere within your business in either full price or the factory, any change in traffic trends throughout the quarter, up to where we are today? Based on the macro environment that's out there with gas prices, et cetera?

Lew Frankfort

Good question. First on the full-priced side, interestingly we've seen an acceleration in same-store sales, same-store traffic during July. Traffic was running modestly ahead during the fourth quarter and it's running ahead -- somewhat higher traffic, that is.

In terms of full-priced traffic, which has been running substantially ahead of last year during FY06, that trend continues through July on the factory side. So if anything, strengthening of same-store traffic on the full-priced side and same excellent traffic increases on the factory side.

Bob Drbul - Lehman Brothers

Okay. One clarifier for Mike. Can you give a little bit more color on the inventory levels, maybe by channel and where you are with that?

Mike Devine

Sure. A few of the metrics I like to look at -- and we didn't include it in the prepared remarks -- inventory levels are especially clean coming out of Q4. Again, a metric that I like to look at is what percentage of sell-through in the factory channel was discontinued full-priced merchandise versus merchandise manufactured for factory? We actually hit a record high in Q4 on that metric of 81%. So I think that's the single most important thing that I look at to see how clean the inventories are.

We are going in very well positioned, having built for our fall selling, some timing of receipts we got in earlier this year versus last. But the inventories are exceptionally clean right now.

Bob Drbul - Lehman Brothers

Great. Thank you.

Operator

Our next question comes from Margaret Mager - Goldman Sachs.

Margaret Mager - Goldman Sachs

Hi, congrats on another great year.

Lew Frankfort

Thank you, Margaret.

Margaret Mager - Goldman Sachs

I just wanted to ask about the outlook for next year, in particular your goal of achieving 10% same-store sales in both channels of distribution. Can you just talk about what gives you confidence that you can achieve that over the course of four quarters?

And the fact that you've been doing very well for so long, but comparisons are not easy. Is there a price component? Traffic? What are you assuming to build into those comps in the next fiscal year?

I have a question on your leveraging of your marketing expense. Can you just go over what's going on there, particularly as you talked about one of the keys that is building traffic is marketing. How do you balance the spend on marketing against that objective to build traffic? Thanks.

Lew Frankfort

First, Margaret, Coach continues to be fortunate in that we're participating in a rapidly growing market. I commented that sales in premium accessories grew by at least 10% in the first half of calendar 2006. While we've been able to outpace the growth, we're nevertheless participating in a significant growth category.

Second, we're benefiting from a very strong consumer franchise that's very loyal, that visits our stores very regularly. As I commented in the earlier question, where our traffic in same-store sales, same-store traffic continues to rise.

More generally, on the product front, the three new lifestyle platforms are very significant. As we indicated, we have not introduced a new lifestyle platform in more than a year. This year we're introducing three. The first one, Signature Stripe, is off to a fantastic start.

We're looking to see growth in comp store sales coming from all three key metrics. We're looking for traffic to continue to run ahead of last year. We're looking for conversion to come in at a higher rate, and we're also looking at an average ticket that is higher than last year, driven to some extent by UPTs, to some extent by limited edition product and so on. So we're very bullish.

Mike Devine

In terms of leveraging our marketing expense, Margaret, for another year in FY06, we saw very small increases in absolute spending in our marketing and got leverage of about 20 basis points both for the quarter and the year. We really continue to execute our catalog, our website and our media spend consistent year-over-year and it's just becoming increasingly more and more efficient.

Margaret Mager - Goldman Sachs

Thank you.

Lew Frankfort

You're welcome.

Operator

Our next question comes from Jeffrey Edelman – UBS.

Jeffrey Edelman – UBS

Thank you, good morning. Great job. Mike, could you discuss with us the profile of the new stores that you're opening? It looks like the average size is about 3,300 square feet. In terms of sales productivity and what kind of four-wall contribution you're realizing as you start to branch out into some smaller markets?

Secondly, is there further to go in terms of sourcing efficiencies and mix to aid gross margins into the new year? Thank you.

Lew Frankfort

Let me jump in just for clarification, when we talk about the store base growing by at least 100,000 feet, Jeff, that also included factory stores. It wasn't just the 30 full-priced stores, and it also included expansions. So on the full-priced side, we're still averaging somewhere between 2,300 and 2,500 square feet for a full-priced store. I think the factory side store is larger at 3,500 square feet. So the store size is not increasing. The model we have is working extremely well.

Mike Devine

Jeff, as you well know our new stores are about as productive and profitable as I think any in retail, with our full-priced new store openings paying back on a cash basis in well less than two years, and our factories in under a full year.

In fact, I just looked this morning in prep for the call and our sales per square foot across the full chain, full priced retail chain were up above $1,200 per square foot in FY06 for the first time ever and an even higher level than that, up above $2,000 per square foot in the factory channel for the new year.

So as we continue to drive comps through the existing stores and add productive new stores to the base, we're seeing our average square footage continue to increase. So we're very pleased with our new store and their performance.

If I can go back to your questions around profitability, we are confident and feel very good about our continued growth of our operating margins. As we just talked about, we saw a 440 basis point improvement this quarter alone in operating margins, with an assist from gross margin and we continue to leverage SG&A very nicely. So we are thrilled with our gross margin rates. They're extraordinary and most importantly sustainable, and we'll continue to drive operating income growth through that line and through SG&A leverage.

Jeffrey Edelman – UBS

Great. Thank you.

Lew Frankfort

You're welcome.

Operator

Thank you. Our next question comes from Paul Lejuez - Credit Suisse.

Paul Lejuez - Credit Suisse

Hi guys.

Lew Frankfort

Hi Paul.

Paul Lejuez - Credit Suisse

Seeing the gross margin, it seemed to come in above plan, maybe slightly. Just wondering how that happens, since factory, which dragged margin down; also the comps in the factory really came in, I would imagine, above plan. So I'm just wondering where the incremental margin came from? Is there perhaps an even greater opportunity to expand margin on the factory side than originally thought?

Mike Devine

Sure, Paul, I think the primary driver is that each business unit within its own showed marked year-over-year improvement, including factory up more than 100 basis points against itself a year earlier. A couple other things work nicely in our favor, our hedge contracts were effective so the negative impact of currency in Japan came in better than our expectations and our supply chain continues to do an outstanding job as we realize some working cost benefits above our own expectations. So all those things taken together allowed us to beat our gross margin rate against our projections.

Paul Lejuez - Credit Suisse

Can you tell us when your share repurchase window closed during the quarter and when it opens again, or no?

Mike Devine

Closed on Friday June 15th and it will reopen this Thursday.

Paul Lejuez - Credit Suisse

Thanks guys, good luck.

Lew Frankfort

Thank you.

Operator

Our next question comes from Lorraine Maikis - Merrill Lynch.

Lorraine Maikis - Merrill Lynch

Thank you. Good morning.

Lew Frankfort

Good morning, Lorraine.

Lorraine Maikis - Merrill Lynch

Could you talk about your expectations for free cash flow in 2007 and walk us through your priorities on how to use it?

Mike Devine

Sure. We expect another robust year for free cash flow. We're going to continue to drive higher net income, obviously, with the increase in our earnings per share. Our primary use for that cash will be to enable us to continue to drive the growth in the business through CapEx investments for new stores and expansions, and also technology gains where we can apply them to increase our efficiency and leverage our SG&A.

As you know, we've also been aggressive buyers of our own stock at the appropriate levels as we just talked about. We did $600 million last fiscal year. So I would anticipate that that will be another primary use for our cash in FY07.

Lorraine Maikis - Merrill Lynch

Thanks, just a quick follow-up on Japan. You spoke about some rapid market share gains. Can you just talk about who you think you're taking the market share from?

Lew Frankfort

It's a good question, Lorraine. We prefer not to mention specific competitors. There are some brands that are growing and there are some brands that are slowing. On average the market is flat and we're up 20%. We prefer not to be more specific than that.

Lorraine Maikis - Merrill Lynch

Okay. Thank you.

Operator

Our next question comes from Christine Chen - Pacific Growth Equities.

Christine Chen - Pacific Growth Equities

Thank you. Congratulations on another great quarter.

Lew Frankfort

Thank you, Christine.

Christine Chen - Pacific Growth Equities

I think in the past you had given metrics on how much average ticket or average transaction was up, and then the percentage of limited edition versus the year before. I was just wondering if I can get those numbers.

Lew Frankfort

What we have done is provide directional numbers, and as I said earlier, our average ticket was up, driven by a combination of factors. In part driven by an increase in UPTs; in part by limited edition product rises; and lastly, by higher prices due to more sophisticated make.

Mike Devine

What we had talked about is ticket was high single-digits and then we got up to 10.9 also being helped by conversion, modest improvements in conversion and traffic. But the biggest driver again in Q4 was our AUR, and that was driven in part by an increase year-over-year in limited edition, where we grew to about 4% of our full-priced sales, up from 3%. But also very importantly our middle tier of product offering, our novelty product offering, was up significantly by I think more than 20 points of penetration year-over-year. That also helped us to drive the high single-digit increase in AUR.

Christine Chen - Pacific Growth Equities

Great. Thank you so much.

Operator

Thank you. Our next question comes from Anwan Hombula - HSBC.

Anwan Hombula – HSBC

Yes, good morning and congratulations. I had a question regarding the P&L, the SG&A leverage, which was strong during the year and even stronger during Q4. Is there a way of splitting it out between the out-performance of factory versus full-priced retail and also the contribution of Japan? I know you made a lot of efforts there following the integration of CGI. How much is linked to that and how much can we expect in this current year?

Mike Devine

Sure, the primary drivers of the SG&A leverage in Q4 were firstly Coach Japan for the quarter had tremendous SG&A leverage driven by top line sales growth, but also the fact that we did not anniversary a significant marketing effort in last year's Q4, where we spent about $5 million on a Play for Peace concert that again did not get anniversaried.

Secondly, you're right on point, the tremendous leverage that the factory channel is providing with its 29% comp, and plus 30% overall growth also drove significant SG&A leverage as well as all of our centralized activities, our distribution functions, the marketing that Margaret asked about earlier. So we really had it all come together for us nicely in Q4.

Anwan Hombula – HSBC

Can you just remind us of the guidance on the gross margin on the SG&A level for this year?

Mike Devine

Our guidance for FY07 is to continue to expand operating margin, up somewhere in the neighborhood of about 50 basis points year-over-year, sustaining our extraordinary gross margin rates and gaining leverage through our SG&A.

Anwan Hombula – HSBC

Thank you.

Lew Frankfort

You're welcome.

Operator

Our next question comes from John Rouleau - Wachovia.

John Rouleau – Wachovia

Wondering with the launch of three new platforms this year, will you actually be increasing the number of platforms that you're delivering year-over-year? Will you begin to scale something else back? What's happening on the SKU side in terms of the new platforms?

Lew Frankfort

Excellent question. Actually, we do expect to see some modest increase in SKU count, but since we have fixed real estate, we try to make everything work extremely productively. So part of our notion, for example, this fall with the Legacy launch is to actually reduce the amount of space that we devote to men's products, especially in a select number of our flagship stores, so that we can create Legacy shops.

Second, we're going to take a sharper look at the number of styles and SKUs we offer in the established platforms, in order to narrow them to make shelf space for the new collections. What we will probably do in FY08, assuming success of these established platforms, is look for ways to integrate perhaps two of the platforms into one. That is an existing one, for example, Hampton’s Weekend and Signature Stripe might very well be integrated in the following fiscal year, taking the best of both.

John Rouleau – Wachovia

Just as a follow-up for clarification, does that mean the number of deliveries will actually, on the handbag side, increase in FY07 or will we get shorter intervals between deliveries?

Lew Frankfort

Deliveries will remain constant. Basically we do 12 major floor sets a year and that will continue. We also do 12 deliveries, as you know.

John Rouleau – Wachovia

Great. Thanks. Keep up the great work.

Lew Frankfort

Thank you.

Operator

Our next question comes from David Glick - Buckingham Research Group.

David Glick - Buckingham Research Group

Good morning and another congratulations. Any change during the quarter in terms of the customer cross-shopping between the full-priced stores in the U.S. and the factory channel? Is that still hovering around 20%? Is there any delta there?

Lew Frankfort

The short answer is no, we've done a lot of deep probes using a lot of different methods to look at what the crossover is, and is the rate changing? The bottom line is that it's not changing. What we're finding, as I mentioned earlier, is that two-thirds of the increase in comps is actually coming from increased conversion of the people who were visiting the stores, as well as higher ticket; with the remaining one-third coming from people who are new to our database. A good portion of those consumers are new to the Coach franchise making their entry in the factory sector -- which doesn't surprise us -- since 85% of goods sold in America are sold on sale. It's not unusual since we don't go on sale in full-priced. Some of the aspirational or value-oriented consumers would seek us out in factory.

David Glick - Buckingham Research Group

Great. Thank you very much.

Lew Frankfort

You're welcome.

Operator

Our next question comes from Jim Hurley - Telsey Advisory Group.

Jim Hurley - Telsey Advisory Group

Good morning and congratulations on a great quarter and year. The first question is about the SG&A leverage and in particular, how much would you say you're getting from new in-store systems, like the client track and smart scheduling?

Mike Devine

It's a great question, Jim, and I would have to say we don't disaggregate it to that level. But we are absolutely seeing a pick up in our store staff spending far less time on their administrative functions dealing back with corporate, dealing with maintenance of the store, et cetera. So we haven't broken it down. But it's clearly a significant player in what's going on in the stores. We're able to do more with less. I'm sorry, I don't have a hard number for you.

Jim Hurley - Telsey Advisory Group

That's fine. Is that only in place in the full priced retail stores?

Mike Devine

No, it's in factory as well.

Jim Hurley - Telsey Advisory Group

The second question was on UPT trends and how they compared to your expectations, especially for Mother's Day?

Lew Frankfort

Our UPTs as we commented some time ago was up for Mother's Day and was up for the quarter, and we've been running at a higher level of UPTs for the last six or nine months, and that trend we expect to continue during FY07. Certainly with the launch of jewelry and fragrance in the second half of FY07, that's going to augment UPTs.

In addition, these three lifestyle collections have incredibly powerful components of accessories, wallets, wristlets, scarves, wearables, footwear and the like. When we look at Signature Stripe running at about 15% of our sales in our full-priced stores, about 5% of that alone is accessories. Our intention with these other two collections, as I mentioned, is to have a full range of lifestyle accessories.

Operator

Our final question comes from Evran Coppleman - JP Morgan.

Evran Coppleman - JP Morgan

First question, we're looking at the difference between the 23% growth in sales in the direct to consumer business and the 18.5% comp growth, and the 5% delta versus your double-digit square footage growth. We're wondering why you're not getting more contribution from the double-digit square footage growth?

Secondly, you've had such strong growth in the category of accessories over the last number of years, when will the cycle slow? What are the drivers of the growth in if category, if you can comment on that. Thank you.

Lew Frankfort

Let me do the second part first. It's an interesting question, and we ask consumers all the time what they're thinking about relative to accessories. The reality is that we don't see this as a cycle -- that is, the increase in the role of accessories. This is the first time that accessories has really grown at a rate much faster than overall apparel spend.

Women really see accessories as a much more important component of their wardrobing, and they're using accessories to update their wardrobe in the same way they use to purchase apparel. They tell us that and they behave that way. What consumers tell us they're looking for is innovation, relevance and value.

For example, even during the holiday period, when we ask consumers what they were considering besides Coach, whether they made a purchase of Coach or not, very few people talked about other accessories, and no one talked about apparel. Candidly they talked about buying iPods and the new Nano or DVDs, days at the spa and so on. All these products have in common innovation and relevance.

The other thing I'd like to say is in our FY07 projections and beyond, we're only anticipating 3% to 5% category growth. So we're not expecting the category to continue to grow robust in our conservative planning, but the reality is that it's up over 10% in the first half of this calendar year, and we expect to see double-digit growth continuing.

Andrea Shaw Resnick

In terms of the difference in spread between comp gains and DTC sales, I'm sure you realize that there are several contributors to this spread between comps and DTC sales, including the timing and contribution of new store openings as you suggested, there are seasonal factors. There's the performance of non-brick and mortar channels like the Internet, and, of course, you've got to remember that CJI is now included in BTC so you've got all sorts of other items including currency fluctuations and, of course, CJI's comps that come into it.

Evran Coppleman - JP Morgan

Thank you.

Andrea Shaw Resnick

That will conclude our conference call. As always, Mike and I will be available for call back throughout the day today. I look forward to speaking with you and have a great rest of the summer.

Lew Frankfort

Thank you, everybody.

Operator

That does conclude today's conference call. Thank you for joining.

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Source: Coach Q4 2006 Earnings Conference Call Transcript (COH)
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