Welcome to the Coach conference call. At this time, for opening remarks and introductions, I would like to turn the call over to Senior Vice President of Investor Relations and Corporate Communications at Coach, Ms. Andrea Shaw Resnick. You may begin.
Andrea Shaw Resnick
Good morning and thank you for joining us. With me today to discuss our quarterly results are Lew Frankfort, Coach's Chairman and CEO, and Mike Devine, Coach's CFO. Mike Tucci, President of North American Retail, is also joining us.
Before we begin we must point out that this conference call will involve certain forward looking statements including projections for our business in the current and future quarters and fiscal year. 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 Annual 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.
Now let me outline the speakers and topics for this conference call. Lew Frankfort will provide an overall summary of our fiscal quarter 2010 results and will discuss our strategies going forward. Mike Tucci will review our key initiatives for the holiday season. Mike Devine will conclude with details on financial and operational highlights for the quarter. Following that we will hold a question and answer session that will end shortly before 9:00 a.m. Lew will then conclude with some brief summary comments.
Now I would like to introduce Lew Frankfort, Coach's Chairman, and CEO.
Thanks Andrea and welcome everyone. As noted in our press release we were pleased to generate quarter sales of slightly above prior year and encouraged by the sequential improvement of our comparable store sales in North America. We experienced strong consumer response to Poppy, supported at its launch by comprehensive new marketing programs. In addition our results reflected the positive impact of our new pricing strategy as we broadened the assortment of handbags in the $200-300 range.
Throughout the quarter customers responded well to our innovative, relevant products offered at price points that were particularly compelling. Beyond the top line we were also pleased with our high level profitability and substantial cash generation in Q1 as we continued to invest in our growth initiatives. Despite the economic backdrop and future uncertainties we remain confident in Coach’s durability and growth prospects over our planning horizon. Clearly the opportunities both in North America and abroad, notably in emerging markets are abundant.
While I will get into further detail about current conditions and the outlook for the category and our business shortly, I did want to take the time to review our quarter first. Some highlights from our first fiscal quarter were:
First, net sales totaled $761 million versus $753 million a year ago, an increase of 1%. Second, earnings per share totaled $0.44, even with prior year. Third, directed consumer sales rose 10% to $654 million from $592 million in the prior year. Fourth, North American same store sales for the quarter improved sequentially from the fourth quarter, declining 1% from prior year while total North American store sales rose 8% driven by distribution. Fifth, sales in Japan rose 11% in dollars and declined 3% on a constant currency basis as consumer spending remained very weak. Finally, we continued to generate very strong sales growth and significant double digit comps in China.
During the quarter we opened 10 North American retail stores including 8 in new markets for Coach. Pensacola, Florida; Midland and Tyler, Texas; Little Rock, Arkansas; Madison, Wisconsin; Charlottesville, Virginia and Kitchener and New Market, both in Ontario, Canada. In addition, we opened five factory stores. At the end of the period there were 340 full price and 116 factory stores in operation in North America.
Moving to Japan, two locations were added during the quarter. At quarter end there were 162 total locations in Japan with 20 stand-alone, full price stores including 8 flagships, 114 shop in shops, 23 factory stores and 5 distributor operated locations. Indirect sales which for context now represent about 15% of Coach’s sales on an annualized basis decreased 33% to $180 million from $160 million in the same period last year. This decrease was primarily due to reduced shipments into U.S. department stores where sales declined nearly 30% for the quarter, similar to the first half of the calendar year.
Discounting continued at a high level throughout the period while Coach was generally excluded from these promotions. It should be noted, however, that we did see an improving trend over the quarter and overall better full price sell through on lower and cleaner inventory levels. Naturally we will continue to tightly manage inventory into the channel given lower demand.
International retail sales rose in the period driven by both comparable location sales and distribution growth. We continued to experience better performance in locations catering to the domestic shopper where we saw significant sales gains than in those locations serving the international tourists where sales rose more modestly. The international domestic consumer represents a sizeable growth opportunity as Coach’s global awareness and presence increases.
We estimate that the addressable, U.S. handbag and accessory category declined 5-10% last quarter, an improvement over the 10-15% decline experienced in the first half of the calendar year. At the same time, Coach’s bag sales declined 1% across all channels in North America over the most recent quarter. It is worth noting we have seen a significant improvement in our customer’s outlook for the economy and intention to purchase over the next year.
Our total revenues in North America were essentially even with prior year in the quarter, with our directly operated stores up 8% as distribution growth offset the slightly negative comp performance. As noted, Q1 same store sales were down 1% showing sequential improvement from last quarter. Fueling this trend was better traffic and transaction size comparisons from 4Q. Average transaction size in full price was only slightly lower compared to prior year as increased handbag penetration offset lower average unit retail in handbags.
In factory, where we continued to leverage the flexibility inherent in our business model to drive sales through pricing, we saw increases in traffic and tickets while conversion levels were maintained. It is important to note that our factory store growth continues to be driven by increased spending of factory channel, loyal Coach shoppers. We have seen no increase in cross channel behaviors.
As noted, in Japan we posted an 11% increase in dollars on a 3% decline in constant currency, a sequential improvement from fourth quarter levels. Our market share further expanded against a very weak category backdrop. Coach now holds a 14% Yen share of the Japanese imported accessories market. Our growth in share in the very tough Japanese market reflects the strength and relevance of our accessible luxury positioning with the Japanese consumer who is becoming more discerning and value oriented.
Once again, I want to call out China, which is only a very small portion of our total sales to date but is growing rapidly and represents a significant opportunity for Coach. We estimate that the market for imported bags and accessories in China grew by 40% over the last year. During the first quarter we continued to achieve significant double digit comp growth as the Coach brand is taking hold with increasing numbers of consumers, both domestically and mainland China and with many of the Chinese who are traveling to Hong Kong. Our blend of New York fashion and accessible price points is resonating with Chinese shoppers. Coach’s potential in the China market is reflected in our very low, unaided brand awareness at 8% compared to 72% in the U.S. and 63% in Japan among targeted consumers.
Similar to our approach in the U.S. and Japan we are building a multi-channel distribution model in China including stand alone stores, shop in shops, department store and factory store locations as the factory outlet market begins to develop. During the last quarter we added five new stores on the mainland, bringing our total Coach China store count to 33 including Hong Kong and Macao.
We are also pleased to announce our first flagship location on the mainland scheduled to open next spring in Shanghai. The 7,000 square foot store will reflect Coach’s latest flagship designs. While Mike Devine will get into more details on our financials and of course I will discuss our outlook in some detail, I did want to give you this recap. Mike Tucci as you know has joined us today to discuss our product performance for Q1 and our holiday sales initiatives. Mike?
Thanks Lew and good morning. During the first quarter as always we maintained a high level of product innovation and distinctive newness. Clearly the big news in July was Poppy. While Poppy is youthful in attitude, it proved to have broad customer appeal. Presented in a variety of silhouettes and vibrant colors and prints, Poppy offers great value with an average handbag price of about $240. The launch was supported by a comprehensive marketing campaign, utilizing several elements in digital media, including stand alone, flash Poppy websites, email campaigns, Facebook, fashion blogs and targeted online banner to get the word out.
The compelling Poppy assortment combined with marketing and press around it drove more traffic into our stores, resulting in a significant improvement in trends from the past few quarters. Poppy will continue to be a key collection throughout FY10, regularly updated with new colors, prints, fabrications and silhouettes.
It is also important to note that Poppy was not the only story in Q1. Maggie, a key item concept, was also introduced in July, providing a more sophisticated counterpoint to Poppy. Maggie has evolved and will continue to be important throughout the holiday season as the anchor to our Madison collection. In addition, the product launches that followed over the quarter such as [Trifecta], Garnet and Brook were also well received and further supported our overall handbag rebalancing strategy.
Earlier this month we started flowing in our holiday assortment including a pre-launch of the Madison collection and the introduction of new Poppy styles and fabrics. The initial reception has been excellent. You will continue to see a high level of newness over the next few months with updates to Brook and Garnet and a new tote group, Alex, for December. We are also excited about our gifting program highlighted by two new women’s accessories groups, Waverly and Gramercy, which will work across all of our handbag offerings and colorful, fun, Poppy items offered at great price points under $100.
In addition, our holiday products will be supported by a significant investment in marketing building on the successful elements from our Poppy launch this summer. We will execute a targeted strategy beginning in mid-November to highlight a powerful gifting message for the holiday shopping season. Our primary focus will be to leverage Coach.com, digital meetings and compelling prints and in-store marketing to drive traffic.
While great products supported by creative marketing has and will continue to be key in driving productivity, the consumer is also responding to our new pricing strategy. Starting with Poppy in July we rebalanced our assortment within our current range by increasing the proportion of handbags to prices below $300 from about 30% of the assortment in FY09 to 50% this year. As we have said before, this rebalancing gives the consumer more choices at prices she is willing to pay or is able to afford. As you know, we are designing into this price point, engineering collections that can provide this excellent value and still generate excellent margins.
Now that this rebalancing is in place, we have begun to achieve the goals we set out for our North American full price business. These include higher handbag penetrations, now running at about 57% of sales versus 52% a year ago or a 10% increase. As planned, this improvement in merchandise mix favoring handbags has resulted in essentially flat overall average unit retails in our stores. Additionally, we saw an improvement in traffic trends from the very weak levels of the first half of the calendar year.
The execution of our strategies resulted in a sequential improvement in retail store performance from Q4 levels. As we move through FY10 our primary focus will continue to be on restoring productivity to our existing full price store base. At the same time, our results in the factor channel remain robust. Here we are focused on maintaining very high levels of productivity through the introduction of innovative, factory exclusive products combined with in-store and direct marketing initiatives targeted at our best factory consumers.
It is also important to note that we managed our North American store business in aggregate. As such, we will continue to fine tune our marketing and promotional levels to maximize the long-term returns of both channels while maintaining the integrity of our full price proposition in retail stores.
Moving to our stores, as Lew mentioned we opened 10 new retail stores in Q1 and on average they are generating annualized volumes of about $1.6 million. All of the new stores are very profitable and operate at high levels of productivity. As discussed, our FY10 emphasis is on new markets for Coach.
I also want to mention we are beginning to explore broader men’s opportunities for the brand both in North America and globally. We will be opening our first men’s stand alone store this spring adjacent to our Bleecker Street store here in New York. We view this concept as a laboratory where we can pilot emerging men’s collections and evolve our merchandising [practice]. Ultimately we will use these learning’s to help refine our global, long-term men’s growth strategy.
With that I will turn it back to Lew for a discussion of our overarching strategies and opportunities for growth. Lew?
Thanks Mike. Setting the course for the new normal does not change our long-term strategy although we have sharpened our focus on distribution putting more emphasis on international growth, especially China. At the same time, we are continuing to build market share here in North America and grow our store base although at a slower pace due to the environment.
As you know, in FY10 we are opening 20 North American retail stores rather than the 40 we have opened in each of the last two years. In addition, we are focusing on those store segments where we have seen the best relative performance, notably Canada, with six openings planned for this year in new U.S. markets. A total of 14 of this year’s stores are targeted for the New York American market for Coach including the eight new markets opened in Q1. In total we expect North American square footage growth of about 9%, down from 13% last year.
In China we expect to open about 15 new locations for this year compared with four net new locations opened last year. To support future growth as mentioned in our press release, we will also open our first Asia Distribution Center in Shanghai before the end of the fiscal year, allowing us to better manage the logistics in this region. With the investments we are making in stores, marketing, organization and infrastructure, we are positioning ourselves to replicate our success in Japan.
Moving on to Japan, this year we expect to open about 10 new locations including a few Poppy shops. In addition we will be opening our first new exclusive men’s locations next spring. In total, we expect square footage in Japan will increase by 5% this year compared to 8% last year. This year we plan to open more than 30 new locations in what we call our international wholesale business. In Asian markets such as Korea, Taiwan and Singapore Coach is among the top five brands with significant potential for further strong growth.
We have also made considerable headway in the Middle East and expect continued robust performance. Finally, as we grow our brand awareness across new markets, global travelers will increasingly represent a growth opportunity for Coach. At about $4 billion in global sales for fashion and accessories, we believe we can double our share of the global travel retail market from about 4% today to around 8% during our next 4-5 years.
Thus, with all geographies and channels we plan to grow our square footage by 9% this year, modestly below the 11% growth last year primarily due to opening fewer new stores in North America.
In summary, naturally we are feeling very good about the early success of our FY10 initiatives noting the sequential improvement in our key store productivity metrics in North America and increased handbag penetration which bodes well for Coach. Our [inaudible] results have shown the continuation of the strengthening trends that we saw in Q1 with the consumer responding well to innovation such as our updates to Madison and Poppy at a wide range of price points.
In addition, as Mike Tucci, we are well positioned for the holiday season with a broad range of great products at particularly compelling prices. At this time, I will turn it over to Mike Devine, our CFO, for further details on our financials. Mike?
Thank you Lew. Good morning everyone. Lew has just taken you through the highlights and strategies. Let me now take you through some of the financial details of our first quarter results. As mentioned, our quarterly revenues increased about 1% with direct consumer, which represents about 85% of our business, up 10% and indirect down 33% primarily due to lower shipments to U.S. department stores.
Net income during the quarter totaled $141 million with earnings per diluted share of $0.44. This compares to net income of $146 million and earnings per diluted share also of $0.44 in the prior year’s first quarter. Our operating income totaled $223 million below the $233 million last year while operating margin was 29.3% versus 31% even.
We are pleased with these results and our continued high levels of profitability. During the quarter gross profit totaled $550 million versus $558 million a year ago. Our gross margin rate was 72.3% versus 74.2% a year ago. The year-over-year change in rate was a function of promotional activity in factory stores and channel mix with the [store opening] benefits offsetting the impact of sharper pricing.
We are particularly pleased with our expense ratio in Q1 as SG&A expenses as a percentage of net sales totaled 42.9% compared to 43.1% reported in the year-ago quarter a 20 basis point improvement. As a result of the profitability initiatives put into place over the last few quarters we believe our expense spending strikes the right balance between driving for future growth opportunities and operating our core businesses efficiently.
Inventory levels at quarter end were $338 million, 16% below the $402 million reported at the end of last year’s Q1 and essentially even on a two-year basis. This inventory level allows us to support 35 net new North America stores, four net new locations at Coach Japan from the year-ago period as well as our 33 Coach China stores.
Cash and short-term investments stood at $995 million as compared with $410 million a year ago. During the first quarter we did not repurchase any shares. Thus, $710 million still remains available under the current repurchase authorization.
Net cash from operating activities in the first quarter were $241 million compared to $76 million last year during Q1. Free cash flow in the first quarter was an inflow of $221 million versus $10 million in the same period last year. Our CapEx spending of $20 million versus $58 million in the same quarter a year ago. It is important to note that based on our current plans for FY10 we expect CapEx will be in the area of about $110 million.
As I have already said, we are very happy to report first quarter earnings per share equal with prior year on essentially even sales showing sequential improvement compared to recent quarters. In spite of the continued difficult economic backdrop, our goal for the balance of FY10 is to achieve continued, gradual quarterly improvement versus our FY09 earnings per share results. Coming out of Q1 we believe we are well positioned to achieve this goal.
I believe it would be helpful for you modelers out there to keep a few things in mind when looking at the balance of the year. First, our gross margin is likely to stay in the 72% area over the next few quarters versus our previously stated range of 70-72%. Second, while we were able to leverage our expense base in Q1, we would note that similar improvements will become more challenging to achieve as we ramp investments for the RK brand in China and anniversary saving initiatives over the balance of the year. Finally, our tax rate is likely to remain in the area of 37% for the year as we noted on our July call.
Before we open it up for Q&A I wanted to reiterate Lew’s earlier comments. Our first quarter results demonstrate Coach’s strength, our resiliency and the flexibility and balance our diversified operating model provides in challenging times such as these. Thank you all for joining us all on our conference call today. Now Lew, Mike Tucci, Andrea and I will be happy to take questions. As Andrea mentioned this will be followed by a brief comment by Lew.
(Operator Instructions) The first question comes from the line of Bob Drbul - Barclays Capital.
Bob Drbul - Barclays Capital
I guess I was wondering if you can go into a little bit more about your sales expectations for the second quarter for full year fiscal 2010. How are you thinking about it looking at planning the business? Are you looking at it on a 2-year basis? I guess sort of tying it together with that, do you think the inventory levels will impede continued sales gains given that they are down 16%?
Good questions. First, consistent with what Mike Devine said earlier in reference to our gradual improvement in earnings per share over the prior year for the rest of FY10 we also anticipate modeled increases in sales as we move forward in FY10 from quarter-to-quarter. We are planning conservatively. We have the ability to as you well know to chase inventory and we don’t think it is going to impede sales at all. We have actually a more focused product assortment this year than we did last year; I think our SKU offering is actually down about 15% so inventory is very healthy.
Let me just build on that or provide another fact. Because of the great sourcing work that our supply chain team has done our average unit cost is actually down about 8% over where it was a year ago so as a result on a unit basis which we think obviously is more important than raw dollars our inventories are down only 8% and above where they were two years ago at the same time. We feel like we are in very good position with our inventories.
The next question comes from the line of Kimberly Greenberger – Citigroup.
Kimberly Greenberger – Citigroup
I had a couple of really brief questions if you will indulge me. Gross margin, Mike I was hoping you could give us a relative magnitude on the gross margin impact of the mix shift versus promos. I am wondering if you can also talk at all about any sort of monthly progress in your North American comps throughout the quarter. Would you care to comment on October month to date? Share repurchases, any intention to re-enter the market on share repurchases?
I will take the gross margin question first. For the quarter where we were down year-over-year by about 190 basis points which by the way was a significant closing of the gap. In Q4 I think we were about 550 basis points below the year earlier quarter so we are pleased with where gross margin is landing north of the 72% range we had given. Of that 190 basis points the vast majority of it is increased factory promotions. We had not started our deepest discounting during Q1 of last year. We really took it to its greatest levels during the December quarter and then perpetuated it through the balance of the year and we have carried it into FY10 so we still are seeing negative compares in this quarter from factory discounting. The good news is that we anticipate anniversarying that for Q2 through Q4 for the balance of the year and therefore actually delivering some of the sourcing costs upside as gross margin rate improvement in the factory channel. Our full price we would expect sharp pricing again to be offset by sourcing and that is why we are feeling good about guiding to a 72% range for year-ago which of course represents year-over-year improvement for the back three quarters of the year.
As to the October results, as we mentioned we have seen a continuation of the strengthening trends that we experienced in Q1 with the consumer responding well to our innovation such as the relaunch of Madison and Poppy.
I will take the question in terms of share repurchase. You know the markets obviously were very volatile during our September quarter. You have seen that we have been big buyers of our stock over the last three years. We spent $2.7 billion in 2007 through 2009 retiring more than 65 million shares. We still have $710 million available to us. So that is still a lever we have available to us as a method of returning cash to our shareholders.
The next question comes from the line of Analyst for Loraine Hutchinson – Bank of America/Merrill Lynch.
Analyst for Loraine Hutchinson – Bank of America/Merrill Lynch
Could you just provide some color on your SG&A plans for this year? I know improvement in the future will get tougher but do you expect to get leverage? Also how should we think about variable expense impacting operating margins as comps get better?
As I said in the prepared remarks and you picked up on, the compares for the balance of the year will get more challenging. We really thought very differently about our spending in Q1 last year before the holiday sales did not materialize. As we all know, we had challenging top line back three quarters of the year and we took a dramatically different approach to spending Q2 through Q4 of last year so anniversarying those activities will be again more challenging. As an example we took a number of compensation actions, most notably we stopped accruing bonuses in Q2 through the balance of the year and then as we all know we actually had a headcount reduction in Q3. None of those activities were we required to anniversary in Q1.
That being said, I am feeling very good about the underlying good news the first quarter represents. Our two primary direct businesses both here in North America and Japan both provided leverage not only to their own P&L but to the corporate P&L as well as we were able to manage our variable expenses in both of those important markets very nimbly, applying labor at just the right levels to maximize conversion and also now as sales move up our percentage of rent in many of our locations will not kick in until we get to higher sales levels. So we are feeling very good. I would project those two large businesses will continue to be able to provide leverage through the balance of the year at low negative comp as we reported in Q1. So we are feeling very good about where we are in SG&A in the main.
The next question comes from the line of Jennifer Black – Jennifer Black and Assoc.
Jennifer Black – Jennifer Black and Assoc.
I wonder what your response to your CRM event was. Do you see definitive changes in consumer behavior or do you think it is a better product or both? I also wonder with today’s consumer being more discrete how does that affect your brand? For example with the OP art versus one of your solid, beautiful, patent bags. Does it vary by age as far as how discrete she is?
In regard to our CRM initiatives, a good portion of them have been focused in recent months on our factory channel which as you know we are able to use promotional leverage to help pull people into our factory stores. They have worked very well because the factory consumer wants to buy a brand, Coach, however at an excellent value. What we have found with regard to our product, our product has been extremely important both in factory and especially in full price. Our consumers have embraced our new offerings. I think it is a function of great products at especially compelling prices. So a cautious consumer feels really wonderful when they actually pick up the bags and see for instance in the case of Poppy a price point for a full size bag at $198.
Now with regard to our consumer preferences whether it is for OP art or patent leather what we have found is a high level of interest in novelty. Consumers are looking for cheery products. They are looking for bright products to help complement their wardrobe. We have seen a real increase in our sell through of novelty and we are well positioned for the holiday season in that arena.
The next question comes from the line of Neely Tamminga – Piper Jaffray.
Neely Tamminga – Piper Jaffray
Just one clarification and then just a general question on directional expectation for retail average ticket. If we have kind of gone through the tougher compares and obviously the comps have eased considerably, just remind us what the composition of that comp was last year and how you would expect either AUR or average ticket to compare in the Q2 period. Then one clarification, SG&A are you looking for like a low single digit on the year increase in dollars? That would be really helpful for the modelers.
I will speak to the handbag average retail unit performance and to give you a basis or a foundation our average unit retail on handbags for Q1 was $290 this year, down about 14% from the prior year and right where we targeted it from a performance standpoint. Our expectations as we move into Q2 will be to hold average unit retail in handbags at roughly those levels and to continue to focus on increasing the number of handbag units sold at an average store rate which we did achieve in Q1. To take our productivity improvement through increased penetration of handbags, all of those drivers and metrics are the foundation of our plan for Q2 and beyond. We see that playing out with the assortment that we have put into the stores thus far.
In terms of your question about SG&A I am going to answer it in another way. What I would say is that we are planning SG&A spending that will be a couple of points above where our top line growth would come. So in spite of the leverage we achieved in Q1 with the modest de-leverage in the back three quarters of the year and for the year in total.
The next question comes from the line of Christine Chen - Needham & Company.
Christine Chen - Needham & Company
I just wanted to ask about China. I know you gave the numbers of stores you are opening this year but ultimately how many stores or how many locations rather do you think that market could support? Does the shopper shop differently than the Japanese customer? Can you quantify the contribution in this quarter to sales?
We are just at the tip of the iceberg. The opportunity is extremely large. There are over 125 cities in China with a population more than one million people. I visited just a few weeks ago with my colleagues a number of cities in China, secondary cities, as they are modern, the infrastructure is extremely strong and the emerging professional middle class is embracing imported accessories. Needless to say that Coach is high on her list. It is early days and it is too early to say how large the market can be. We do believe that we have an opportunity for the market to be larger than Japan is today within the next 5-6 years. We are not planning that way but we are ready for the opportunity. You can expect we will see ramping up in the years ahead the number of stores that we are opening from the 15 this year.
Christine Chen - Needham & Company
And does that customer buy a specific type of product more than others? Logo versus non-logo?
Very good question. We actually see her as primarily a fashion driven consumer. She likes the same styles and the same shape in the main as consumers both in Japan and in the United States. We are finding very little differentiation in what she is purchasing from us. The only thing I will add is she is [departing] with a bag so she makes her first imported purchase she wants it to be something that can be seen by others and to contain her essentials. We are finding our accessory penetration lower to date but that we expect is because it is a developing market.
The next question comes from the line of Liz Dunn – Thomas Weisel.
Liz Dunn – Thomas Weisel
My question is related to gross margin stabilization. You are now saying gross margin should remain in the range of 72% versus your prior guidance that was a little bit weaker than that. Can you just talk through how you have been able to impact slipping into some of these lower price points and should we just think about gross margin at that stable 72% rate for the foreseeable future or is there opportunity to go higher over the longer term?
We feel good about the 72% range for the foreseeable future. There are obviously many variables and we don’t have a crystal ball to predict with perfect clarity. The big levers are going to be the required level of promotional activity in our factory channel and then channel mix. We feel very good that we know what we are going to deliver the product at in terms of the cost and the sourcing initiative has really been very powerful for us. We know they are strong enough to offset the sharper prices for the Poppy collections and others as we rebalance our assortment. In the factory channel really what is going to make the determination as to how much upside there will be will be the level of promotion required to continue to drive traffic and deliver the productivity and enormous operating margins that channel delivers when we deliver top line dollars.
Now we have very good vision through FY10 on our cost base. We are also benefiting from the macro economic backdrop in this regard that our raw materials and input costs are at lower levels than we have achieved over time. As the economy turns there will be some inflationary pressures in FY11 so that will cause us to need to continue to be sharp in our products, planning, design and production and sourcing to look to offset those which we feel we have a capability to do.
The next question comes from the line of Dana Telsey - Telsey Advisory Group.
Dana Telsey - Telsey Advisory Group
Can you talk a little bit about on the factory store side as you transition from full price merchandise in factory to direct and made for factory, how is that going? How are those price points being adjusted? Are lower raw materials, how important are lower raw material prices to the growth in margins you are seeing at 72%?
On the factory side it is important to note that in Q1 and actually as we look forward through the balance of this year we restored our mix in factory back to a more traditional level of made for factory product in a range of around 75%. It has been lower than that in the back half of last year based on the amount of clearance activity that we had in the channel. That bodes well for us as we have more pricing flexibility there. We have more promotional flexibility and frankly our margin returns there on made for factory products have been excellent which allows us to mix the business differently.
We really have seen no movement in average unit retail in factory from our historical levels and we have no plans to really change the model on the factory side. We think the balance between full price at about $300 in factory and probably half that is the right balance. It is the right relationship. If you travel into our factory stores today you will notice that from a look and feel standpoint while it is clearly a Coach store there is no aesthetic overlap between the two businesses. We have clean platforms in full price which are really driven by Madison and Poppy on both ends of the fashion spectrum and then we have a real foundational business on the factory side with Hansons and Soho as the anchors to that business.
Over time we have been able to realize some cost savings. I think Mike has outlined what we have been focused on there in terms of raw material benefits, hardware benefits, make and trim opportunities on the factory side all with the intention to maintain very strong margins in the factory business and also allow us to be aggressive there because it is our promotional channel in the business model.
The next question comes from the line of Erwan Rambourg – HSBC.
Erwan Rambourg - HSBC
I just wanted to come back to Japan because you have had a sequential improvement in Yen terms from last quarter to this quarter and most of your European competitors are actually noticing a stabilization of trends if not a worsening of trends. Should we consider this as a Poppy related boost or is there something else you are doing differently? Related to that, I just wanted to come back to your comment on China and saying that eventually in 5-6 years time China could be as big as Japan. Should we consider that your long-term target? I think you stated $250 million by 2013 could be interpretive at this stage.
Well first to your second question, $250 million is extremely conservative. We are not yet prepared to provide numbers. We are just starting our time and our resources in China to really understand how large this could be. We are running well ahead of where we thought we would be and are finding great reception with Chinese consumers, particularly with repeat purchasing which is key to developing a sustained brand.
With regard to Japan it is Poppy actually created an inflection point in Japan. We had an integrated, comprehensive launch in late June throughout Japan. We even created a few free standing, temporary locations for Poppy in prime locations such as [inaudible] and Poppy has been enormously important to us.
In addition, we actually benefited from a year-over-year improvement in our men’s business which has become a much more important focus for us in Japan. That contributed to the gains as well. More generally, we do believe that the very challenging economy in Japan is forcing consumers to make very tough choices in terms of where they will spend their accessory dollars. Fortunately they are spending a disproportionate amount or a growing amount on Coach.
The next question comes from the line of Laura Champine – Cowen.
Laura Champine – Cowen
My questions are a follow-on to the gross margin guidance maintained around that 72% level. Does that imply your mix of full price and factory is likely to stay stable where it is or should we see full price [grow] as a percentage of the mix in the December quarter?
That is a very good question and the answer to your question is yes. We do assume that we will carry through the balance of the fiscal year a full price factory mix about in line with what we just achieved in Q1. As Lew just talked about, the full price business strengthening in Japan. Mike Tucci talked about it strengthening here in North America. Channel mix was not nearly the detractor of Q1 FY10 as it has been in recent quarters as we have seen an inflection point in that business as getting healthier. Channel mix will not be a detriment going forward that it has been in prior quarters.
The next question comes from the line of Janet Kloppenburg – JJK Research.
Janet Kloppenburg – JJK Research
I was wondering on the average cost outlook, I thought you say it may actually track higher in 2011 but I am wondering what the prospect is for lower cost as we move through the rest of the year and if you could give us an update on your plans for marketing this holiday season in terms of dollar spending versus last year. I just was not clear if you had been accruing for bonuses. If you had accrued for bonuses here in this quarter and going forward versus what you had done last year. Mr. Tucci, I was wondering if you could talk a little bit bout Poppy and the customer base there. Is it all a youthful base or are you seeing some crossover and what opportunity that might represent.
I will take the questions on average cost and the bonuses. We are in very good shape and have contracts with most of our raw material suppliers and our factories through the balance of fiscal year introduction. So we feel like we have great vision to what our costs will be and so we would anticipate delivering similar year-over-year average unit cost favorability. Now we began to capture some of those improvements during the back half of the year so the 8% will gradually decline but we won’t see average unit cost increasing. We look forward to delivering that in the 72% guidance that I have talked about and given.
FY11, we haven’t by long shot given up on holding our average unit cost content. I will just point out there is likely to be some inflationary pressures we are going to look to offset them. Secondly, in terms of the bonuses, we did accrue bonuses both this year and last year in Q1. So there was not a challenging compare there if you will in this most recent quarter. That changes on a year-ago basis. Our plans are at this moment in time to deliver bonuses in FY10 so therefore to accrue for them year ago this year as a compare again it is a situation in 2009 where that was not the case so it challenges the leverage.
I will take care of the Poppy and the marketing piece. On the Poppy side, my feel on Poppy is that it actually is selling very broadly across our consumer base. We see that through all channels. We do believe it has driven some energy into the stores with the fashion consumer but it is selling broadly.
On the marketing side, very important for holiday to understand we are actually spending about the same amount in marketing. However, we have reshaped our marketing expense dramatically away from traditional print emphasis and away from packaging to fun concepts and programs similar to what we did for the Poppy launch. So it is [DWT] to support our gifting programs. Significant investment in online advertising including some association with fashion blogs, our continued relationship with other social networking sites that are out there, a very targeted approach to in-store marketing both in mall and in our windows and in-store which we got feedback very quickly with the launch of Poppy it was highly effective in bringing people into the store and getting a strong message out there.
All of this will break into market mid-quarter. It is really a different type of quarter in Q2 where everything is shaped to the end leading to December 26th obviously and so we are going to target our marketing this quarter, November 15th and drive the marketing spend November 15th right through the Christmas selling period and I think you will see a very dominant, very mixed in terms of platforms with a high level of energy in our stores from a marketing standpoint.
Andrea Shaw Resnick
With that we will conclude our Q&A session and pass it on to Lew for some closing remarks. Lew?
Obviously as you can hear from our prepared remarks and our questions we feel that we did have an inflection point with the arrival of Poppy and the rebalancing of our assortment to a much more compelling price point. We feel very good about our position in the holiday season ahead and more broadly we feel that the expectations where we are taking to adjust to a consumer who is spending less than she did for the long-term, that is for the foreseeable future, we do not expect the consumer to spend as much as she did in discretionary areas. So our adaptations we think are positioning us well and we are looking forward to restored growth and we think that is available to us. Thank you very much.
Andrea Shaw Resnick
That will conclude our call. Thanks everyone. Have a great day.
This does conclude the Coach earnings conference. We thank you for your participation.
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