The number of billionaires in the world and their combined net worth, as compiled by Forbes, has doubled since 2009 when these figures fell for the first time in five years. Ever since that fall, the list has been growing with more and more Asians joining the ranks of the world's richest people. This growth in the wealth of the rich has boosted luxury spending in the world which provided a growth opportunity to the providers of luxury goods and services.
Better times are expected to come and the number of the rich people in the world will continue to grow. This situation provides a great growth opportunity to the manufacturers of luxury goods. One such company that has grown significantly over the last few years is Coach (NYSE:COH). The company is involved in the design and marketing of premium bags, accessories and other wearable items through its retail and whole sale operations around the world. Over the years, the company has experienced double digit growth in its revenues and earnings through the rapid expansion of its operations in the domestic and international market. It is the company's increasing global presence and consistent high demand from consumers that has driven my attention towards this company. In this article, I will examine the major sources of growth achieved by the company and assess whether this growth will be replicated in the future.
Source: Coach Financial Statements
Despite the recession that prevailed in the US economy, Coach was able to continuously increase its net sales. Although the growth slowed in fiscal year 2009, the CAGR achieved over the last 5 years has been approximately 12 percent. The growth has been achieved through the acquisition of retail operations internationally and also through the expansion of the company's retail network domestically.
Source: Coach Financial Statements
The above graph shows Coach's domestic retail network expansion. It can be seen clearly that the company has focused on expanding its factory outlet network in North America rather than expanding its retail stores. The factory outlets generally stock discontinued items or products to be sold at significant discount to their retail prices. Given the difficult economic circumstances in North America, this expansion strategy has really paid off as evident from the company's on average 8.2 percent per annum growth in net sales in North America over the last three years.
In terms of distribution channels, the company has seen phenomenal growth in its direct sales, while its indirect sales through wholesale or licensing operations have been growing at a comparatively slower pace. During the period 2009 to 2012, the company's direct net sales grew at a CAGR of 15.8 percent and contributed approximately 89 percent of the total net sales in FY2012 as compared to 84 percent in FY2009. Conversely, indirect net sales only grew at a CAGR of 1.8 percent over the same period.
The difference in growth between these two channels is due to two reasons. One is the continuous retail network expansion and opening of new company operated stores each year. Another factor that contributes to both the growth in direct channel as well as indirect channel is the acquisition of retail operations of its distributors in the international markets. For instance, the company acquired Hong Kong, Macau and Mainland China operations in the fiscal year 2009, Singapore and Taiwan operations in the fiscal year 2012 and Malaysia and Korea operations in the fiscal year 2013. These acquisitions have contributed to the high growth in its direct channel and also to the growth in its international segment that has grown at an average annual rate of 16 percent over the last three years.
Source: Coach Financial Statements
The company's cost structure has remained somewhat stable over the last five years. Cost of goods sold has ranged in between 27 to 28 percent of net sales while selling, general and administrative expense has ranged in between 41 to 43 percent of net sales over the 5 year period. This means that the company was able to translate its high revenue growth in its bottom line. Over the last 5 years, Coach's earning per share has increased at a CAGR of more than 17 percent. This is approximately 5 percent more than the revenue growth achieved by the company. This excess increase in earnings per share is due to the share repurchase program adopted by the company and on average, it has repurchased more than $760 million worth of shares each year over the last 5 years.
SEGMENTS AND MERCHANDISE
Although the company is still heavily dependent on the North American market, it was able to diversify its revenue generation sources in the last few years. North America contributed 68.5 percent of the total net sales of the company in fiscal year 2013 as compared to 71.5 percent in fiscal year 2011. United States is still the largest single market for the company as the country's net sales were equivalent to 65.7 percent of the total net sales of the company last year. Despite the high geographic concentration, this ratio has declined by 3.9 percent since fiscal 2011.
Japan is the second largest market for the company with 15 percent of the total net sales coming from the country. Even Japan's contribution to the total net sales has fallen by 3.2 percent since 2011.
The greater diversification of revenue base has been achieved primarily through the acquisition of international operations, as mentioned above. The international operations acquired by the company, especially the Chinese operations, have been growing substantially over the last few years. For instance, the collective network of the company operated stores in China, Singapore, Taiwan, Malaysia and Korea has grown at a CAGR of 28.9 percent over the last 5 years. This growth in retail network has led to a growth of more than 41 percent in the revenues generated from sales in international markets (excluding Japan).
The high growth achieved in these markets has been the result of the growth in purchasing power of the population as measured by GDP per Capita, purchasing power parity, and the personal disposable income level. In the future, I believe that these markets will continue to show high growth which will result in further diversification of the company's revenue generation sources.
Source: Coach Financial Statements
Even in terms of merchandise the company has been able to improve its diversification with the largest gains achieved in its Men's category. This broader product portfolio will help the company to sustain growth in the future as now it will be able to target a wider audience. However, I believe the company is still heavily dependent on women's handbags which may hamper its growth in the future. Although this particular aspect of merchandising may be a problem for the company on one hand, it also shows that the company has ample room to expand its other segments in order to diversify its revenue generation sources and spur growth in the future.
The luxury goods market is expected to grow faster than the global GDP growth in the next 2 to three years, crossing the $250 billion mark by 2015. According to Bain & Company, the largest growth is expected to be seen in the South East Asian markets while other Asian markets such as China and Japan are expected to witness a growth of 5 to 7 percent each year through 2015. These expectations present an attractive growth opportunity for Coach as it has expanded its operations in key Asian markets such as China, Japan, Malaysia and Singapore where this growth will occur.
Another favorable aspect of these forecasts is the higher growth expectations for leather and accessories market which is the core business of Coach. Along with the high growth expectations for Asian markets, I also expect the company to see major growth in the US market as well. The increasing wealth of the affluent society in the country will continue to spur demand for the company's premium products and new arrivals. Additionally, the expansion of its factory outlet, where discontinued products or discounted products are sold, will enable the company to target a much wider audience in the country.
All in all, the future prospects for the luxury goods market, especially for Coach, are highly promising.
Due to the company's strong history of share repurchase and dividend payments, I have decided to value the company on the basis of modified payout dividend discount model. Given the high growth potential for this company in the coming years, I expect the earnings of Coach to grow by 12 percent over the next few years with a large chunk coming from the Asian markets. However, I expect the company to reduce its modified payout over the years as a high payout is not sustainable in the long run. I have applied a terminal growth rate of 3 percent. Based on these assumptions, I have projected the dividend payout of the company, as shown in the figure above.
I have taken the following assumptions in order to calculate the value of the company: a market risk premium of 5.7 percent which is based on the consensus estimate, a risk free rate of 2.72 percent which is the current yield on long term treasury securities and a beta of 1.29, taken from Morningstar. Using the CAPM method I have calculated the required return of 10.07 percent. Based on the required return and the expected payouts above, I have calculated the company's target price to be equal to $68.69 which provides an upside potential of approximately 25.54 percent.
In order to calculate the potential in the investment I have done a sensitivity analysis on the calculated valuation of the company by taking different growth rates and required return assumptions. Based on the sensitivity analysis the company's shares offer a maximum upside potential of 72.41 percent and a maximum downside of -17.08 percent.
Thus based on my analysis and the valuation done I will give a buy recommendation for the company. This is because of the high upside potential and a relatively lower downside derived from the sensitivity analysis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.