"International sales decreased slightly…"
That's a sentence you do not want to see when you are looking at a company which is viewed by many as a significant player in the booming global luxury goods sector. And yet, there it is, in Coach's (COH) first quarter report released a few days ago. To be fair, the slight decrease in sales was due to rare and large currency fluctuations. The dollar rose by 27% against the yen in the last year, an extreme move not often seen with major currencies. On a constant currency basis, international sales rose 9% in the quarter, which is reasonable but not a barn burner. A bright spot was China where sales boomed 35%. So there was some good news behind the headline.
Despite the recent Q1 disappointment, Coach's net income and free cash flow margins remain strong. Its main problem is not profitability but the fact that North America contributes 67% of total revenues and has essentially gone ex-growth.
If you put Coach in the bucket of luxury goods companies (which are mostly European), it is clear that Coach is badly underperforming. Sector peers LVMH (OTCPK:LVMHF), Burberry (OTCPK:BBRYF), Richemont (CFR.VX) and others have zoomed ahead with sales, profits and stock prices not far from their all time highs. The main reasons for their greater success have been their more aggressive expansion into Asia and stronger brand management.
But if you put Coach in a more general bucket of consumer and apparel companies, then it is doing better than some and worse than others. The issue, however, is that the company's future will be largely determined by which bucket it puts itself in. As a luxury goods company, it can maintain some pricing power and it will preserve or raise its margins and market value. It could also merge with or be acquired by one of the Europeans. But as a general consumer company, its brand will get tarnished. Its margins will continue to erode and so will its valuation.
Coach's problems can therefore be summed as follows:
- An insufficient geographic footprint outside the U.S.
- A large North American presence which has stalled.
- A brand that is in danger of falling out of the "luxury" sector.
The store opening program can be accelerated overseas if there is sufficient confidence that the luxury boom will continue. Coach has a strong balance sheet and is generating positive free cash flow. In theory, therefore, it has important untapped reserves which it can deploy to open stores at an accelerated rate.
North America will be more difficult to fix, given intense competition from the likes of Michael Kors (KORS) and Kate Spade (FNP). Here, design appeal and brand management are key to an eventual recovery. Coach faces the risk of what the French call "Cardinisation", the fate met by the Pierre Cardin brand when it became so ubiquitous that it lost its luxury stamp.
In this sense, the fact that 60% of Coach's North American sales occur in factory outlets is positively troubling. Sales at these outlets come at better margins because of lower costs and higher volumes but they damage the brand and could reclassify it outside of the luxury sector. And that could be the beginning of a death spiral for pricing.
A quicker fix would be to sell the company to another luxury goods firm. An acquirer who already has a large presence in Asia and Europe could quickly boost Coach's overseas revenues and lower its costs. Conversely, Coach's large US presence could be of benefit to an acquirer looking to grow its own American sales. One problem is that a buyer may initially look to strengthen the brand by closing some factory outlets. This could reduce North American volumes in the near term, a consideration which may depress any proposed takeover premium.
So is this a good price to buy the stock?
Yes, because international sales growth will soon return and for the possibility of a takeover.
No, because branding issues and North America are unlikely to be resolved in the next quarter.
All in, it is a buy for speculative portfolios. More conservative investors should look to buy at a lower price if the company takes steps to avoid further erosion of its margins and to move its brand upscale.
Note: Last year, I wrote more generally about prospects for the luxury goods sector.
Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Coach stock or any other security. The reader is responsible for any loss he may incur in such trading.