FY 2013 has not been a fruitful year for Coach (NYSE:COH). As a matter of fact, even company management called FY 2013 a transition year. The question is where this transition leads to. In my opinion, the transition is in the wrong direction due to management's reluctance to accept even worse short-term results.
It is not a surprise that competition is heating up in the accessible luxury women handbag sector. While many analysts and commentators emphasize the impact of competitors such as Michael Kors (NYSE:KORS), Kate Spade (FNP), and Tory Burch, I emphasize that Coach itself is losing its soul. As management mentioned, competition is not a new thing to the company. Coach has stood out from numerous competitors in the past. However, this time, Coach is the one creating the problem for it to compete.
Factory Stores Caused the Brand Problem
The problem all stems from factory stores. It is OK to have small amount of your store base as factory stores to sell aged inventories at a higher margin. But over-reliance on factory stores is a problem. A while ago, in order to gain consumers who would otherwise not buy a regular-price Coach bag, Coach came up with a solution to promote its factory store bags. It has opened more factory stores than regular stores in North America for years and frequently gave coupons to the factory store channel. The result was that Coach grew at double digits in North America.
Management pushed the stock price higher and higher and also sold quite a lot of stock during the uptrend. (See the insider transaction report, where you will find Coach executives sold quite a lot of stock during 2011 and early 2012.) Eventually, although the overall comps in FY 2011 were at 10.6% in North America, based on my observations the double-digit comps came from factory stores rather than full price stores. (Note: Coach never breaks out direct sales numbers between the full price channel and the factory store channel.)
When the North America comps declined to 6.6% in FY 2012, in order to bail out the stock price, management rolled out an even more aggressive strategy -- an online factory store site. Traditionally, factory stores are located far from cities so that only cost-conscious customers will go there. Now, with the online factory store, every customer can conveniently purchase discounted Coach bags. To make things even worse, there are still numerous regular brand bags discounted by at least 50% in the online factory store. We have to ask ourselves: Who will even bother to go to a regular Coach store to buy full price handbags?
The side effect is the brand dilution. When outlet or factory store products are limited, brand equity will see minimal impact from the off price channel. Coach's situation is completely the opposite. According to Cowen's Faye Landes, more than 60% of Coach's North America sales come from the factory store channel. Also, that is not uncommon now that there are more factory store Coach bags than full price Coach bags on the street. A premium brand handbag is supposed to be carried by more premium customers. When the handbags are mostly carried by customers without a proper brand image, many consumers pursuing premium brands will stay away. That is exactly what happened to Coach. Many people have been buying Michael Kors or Kate Spade in the last couple of years not because they like MK or KS that much, but because they want to have other brand alternatives. They do not want to be associated with the images of many factory Coach customers.
In my opinion, Coach is completely aware of this brand dilution issue. That's why Coach has had a recent management change. What has been troublesome is that the new management is still avoiding correcting the issue. Coach hired a new SVP to ramp up its full price store brand image, but is it a brand only associated with the image of its stores? Absolutely not. Also, Coach has started this year to frequently offer 25% off coupons to its full price products. Many people may notice that Coach's gross margin actually ends up higher with these coupons. Coach, in fact, is raising the full price. It just tried to use the promotion to lure people. It worked perhaps for one quarter. Then, people started to catch on to the trick. Frequent coupons are a route to disaster for a premium brand. What's worse is that according to the latest earnings conference call, Coach mentioned it will open around 20 stores (mostly factory stores) in FY 2014 while closing 15-20 full price stores.
In addition, in order to save declining sales, Coach planned other categories such as men's, shoes, and apparels. These are not necessary bad initiatives, especially men's and shoes. However, these initiatives cannot fix Coach's brand issue. Coach also aggressively opens stores in Asia to compensate for the declining North America sales. Some investors are especially encouraged by Coach's international sales. Remember, fashion is a global thing now, although a time gap still exists. In China, for example, Coach still capitalizes on the time gap by selling many handbags to less fashion-conscious customers. The more fashion-sensitive crowd, however, already avoids Coach at their best.
In its latest earning report, Coach still claims it enjoyed double-digit comps in China. In my opinion, the high comps number was mostly helped by new stores or distribution expansion. Coach is expanding its stores at a double-digit pace. New stores -- mostly in tier three cities, which connect much more slowly to the North America trend -- enjoy high double-digit comps, which offset the weakness of stores in tier one cities. It is just a matter of time before Coach sees the same comps decline in America in China.
In my opinion, it is extremely erroneous to value a big company with declining competitive advantage using P/E ratios (trailing or forward). Yes, Coach is still extremely profitable with return on equity of around 40% and net profit margin of above 20% in the last 12 months. It is maybe the most profitable company in the handbag industry with more than a $1 billion market cap. But the past is the past. One cannot value a company with a rear-view mirror. Given the competitive landscape in the premium/luxury goods industry, Coach's extremely high profitability is never sustainable in the long term.
If Coach keeps the current strategy, we will see continued underperforming sale trends in North America, and soon a deceleration of sales trend in Asia. Eventually, there are only that many costs Coach can cut to smooth the earnings. Double-digit earnings declines will not be a surprise. Many investors made the mistake when they bought Apple (NASDAQ:AAPL) around $650 to claim Apple should deserve a trailing P/E of at least 15. Therefore, it is unwise to simply say Coach is solid buy just because it has a trailing P/E of only 13.5.
The solution to Coach's problem can be both very simple and very difficult. The simple solution is that Coach needs to close the online factory store and gradually close more factory stores. Also, Coach needs to lower the regular full price slightly to lure more people to buy its bags in the full price stores. The difficult solution is that the short-term sales and earnings numbers will be a disaster. But the brand image will be saved and eventually so will be the stock price.
Until Coach fixes its brand problem (over-reliance on factory stores), staying away from Coach is the best idea. However, I do not recommend shorting this stock either because the downside potential -- helped by a strong balance sheet and current international expansion -- is not big enough to justify the risk of a correct strategy realignment.
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.