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Over the years, Coach (COH) has established itself as a constant dividend payer to its investors.

Apart from paying constant dividends, the company is known for international expansions in emerging markets. According to McKinsey and Company, the emerging markets will grow by 50% over the next 12 years in the apparel industry. Coach is one of the prominent names in the apparel industry and its top priority is to boost its international sales.

Let's have a look at the company's dividend paying capacity, and its strategy to boost international sales.

Will International markets drive growth?

In the last fiscal year, Coach's international sales grew 9.9% year over year to $1.54 billion, driven by sales from new and acquired stores. Its store operations from international markets have grown almost 75% from 234 stores in fiscal year 2009 to 409 stores in fiscal year 2013. As part of its international expansion, the company opened 11 new locations in Japan and 30 stores collectively in China, Honk Kong, and Macau, in the last fiscal year, expecting higher revenue from the region.

It also acquired domestic retail businesses from its distributors in Malaysia and Korea in the same period. To harness the growing opportunity from international markets, the company has already developed relationships with selected distributors who sell Coach's product in 25 countries through department stores and freestanding retail locations. In the last fiscal year 's results, the company announced that it will continue to invest in distributor locations located in international markets. We believe that it will be able to increase international sales' contribution to the company's revenue, which stood at 30.31% in the last fiscal year.

Considering a scenario where Coach's overall revenue increases by 10.5%, based on the average growth of the last two fiscal years and riding on the acquisition it had performed in the emerging markets, then it can generate revenue of $5.61 billion by the end of the present fiscal. If the international market contributes the same 30.31% in overall sales, then the revenue is expected to reach $1.70 billion, witnessing a 10.4% rise from the previous year. So according to our analysis, international sales will lead to better results in the company's topline.

Should the company give away dividends?

Coach is known for paying constant dividends to its shareholders since 2009, and its dividend payout ratio has increased from 3.9% in the fiscal year ended June 2009, to 34.3% in the fiscal year ended June 2013. In the recent annual report, it has given an indication that it could discontinue the payment of dividends at any point in time. The reasons can be attributed to the $280 million capital expenditure it plans to make in the fiscal year ending in June 2014.

In the last fiscal year it paid dividends of $339.724 million, witnessing a 30.38% rise year over year, but its net income decreased 0.4% over the same period. Moreover, in the last fiscal year, the cash used in investing activities increased 119.91% to $570.5 million. All these activities led to negative retained earnings of $101.84 millions for the last fiscal year.

Despite the negative retained earnings, Coach announced a dividend of $0.3375 per share in the present quarter, a 12.5% increase year over year. Considering the increase in the annualized dividend by the same 12.5%, then it has to pay $382.18 million in dividends. Moreover, it repurchased shares worth $700 million in the last fiscal year, and the company still has to repurchase $1361.6 million by June 2015.

Considering a scenario where the company repurchases shares worth $700 million in the present fiscal year, pays dividends of $382.16 million, and makes a capital expenditure of $280 million, then all these activities call for a cash ouflow of $1.362 billion, not considering the operating cash inflows and outflows for the year. The present cash balance stands at $1.062 billion as per the latest fiscal results ended in June 2013. This figure is $300 million less than requirements with respect to its plans for share repurchases, dividend payments and capital expenditures.

Here is a look at the dividend paying capacity, profitability, and liquidity position of Coach and its peers which include Nike (NKE) and Wolverine Worldwide (WWW) in the previous fiscal.

Company

Profit margin in the last fiscal

Dividend Payout Ratio in the last fiscal

Free cash flow payout in the last fiscal

Nike

9.8%

30.1%

62.54%

Wolverine Worldwide

4.90%

30.7%

30.95%

Coach

20.37%

34.3%

115.00%

While going through the above chart it can be easily inferred that Coach has generated better profit margins by more than 10% compared to its peers. Moreover, it also distributed 34.3% of its profits in dividends in the last fiscal, the highest among its peers. But at the same time, it is giving more dividends than its free cash flow, which gives us an indication that paying dividends is affecting its cash reserves.

Coach's free cash flow has been increasing at an average rate of 33.86% over the last 2 years. Considering the same growth for the present fiscal, the free cash flow can reach to $393.39 million, just $10.2 million higher than our expected dividend payment for the fiscal year. So according to our analysis, dividend payments could hamper the liquidity position of the company and may further lead to continuous negative retained earnings, which it has witnessed over the last three fiscal years. Therefore, we believe the company can generate enough profits but not enough cash to facilitate dividends to its shareholders.

Conclusion

Coach has leveraged its revenue through international expansions and is generating increasing sales from the region. The rising international sales will play a major role to ensure overall revenue growth.

We also believe that the company's predicament about announcing dividends in the upcoming financial results will continue if it doesn't pay attention to its liquidity position. Although international sales will drive growth, it cannot give the company a cash rich status. We recommend to hold this stock since it requires a close analysis of its future cash flows.

Source: Coach: Should Income Investors Be Worried?

Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Madhu Dubey, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.