Shares of Coach (COH) have struggled this year as Michael Kors Holdings (KORS) moved in on the company's luxury brand market and steals the spotlight. The company has an enduring brand and new initiatives that could help stabilize same-store sales. Investors should take advantage of the opportunity in valuation to add shares in a company with a consistent history of growth.
The 800-pound Kors in the room
Coach slid more than 7% in late October when the company reported a first-quarter profit that barely met estimates on a 6.8% drop in North American same-store sales. The company reported earnings of $0.77 per share on revenue of $1.2 billion, both flat on a year-over-year basis.
The drop in sales at stores open more than a year increased from a 1.7% drop in the prior quarter as competitors increased product offerings and distribution. Shares of Michael Kors Holdings jumped yesterday after the retailer reported an increase of 39% in revenue to $740 million and a 21% jump in same-store sales.
Kors now has a higher market cap of $16.1 billion, versus just $14.2 billion for Coach, but has less than half (43%) the sales over the last full year. Kors has been designing clothes for 30 years but really just rolled out his accessories line in 2004 which now accounts for 62% of sales. The IPO in 2011 helped fund an aggressive expansion strategy with plans to double the company's North American footprint.
Despite the recent loss of the fashion-spotlight, Coach is still a strong aspirational brand across the globe, international sales grew 10% in fiscal 2013 with sales in China up 40% to $430 million. The company dates back to 1941 as Gail Leather Products and has weathered competitor threats in the past. The fashion industry is fickle but constantly comes back to its legacy brands.
Coach books 69% of its sales in the North American market and plans on increasing retail square footage by 9% in 2014 with $280 million in capital spending. The company launched a new women's footwear line last spring and is planning to market its ready-to-wear line in the fall.
Coach is positioning in leather bags on stronger demand with the new appointment of executive creative director Stuart Vevers. Stuart was formerly a designer at Loewe and is well-known for his talent in leather accessories.
Even in a tough North American market, I think the expansion, along with some stabilization in same-store sales, could translate to $5.15 billion in sales over the next year. While this is growth of just 1.5% from 2013 sales, it is above the consensus estimate of $5.08 billion. A surprise in top-line growth and same-store strength could drive strong improvement in sentiment.
A history of consistent growth and cash returns
In its 2013 call, management guided for flat to slightly positive revenue growth in 2014 and an operating margin of about 28% which is down slightly from 30% in 2013. The company plans to buyback $700 million of stock in 2014 and should be able to increase the dividend as well. The company has increased free cash flow by an annualized 9% over the last three years while still maintaining a strong capital spending plan. Dividends, shown below on a diluted share basis, have increased dramatically from the first payment in 2009.
Shares are trading at 13.9 times trailing earnings, well below their five-year average of 16.5 times and below the industry average of 20.4 times earnings. Shares of Michael Kors Holdings are more than twice as expensive at 32.2 times earnings.
Coach has a strong balance sheet with $1.1 billion in cash and just $485 million in long-term debt. Cash flow from operations increased by 16% last year to $1.4 billion. While management has increased the dividend by an annualized rate of 44% since 2009, I think a 15% annual rate over the next few years is sustainable with growth slowing to 12% over the longer-term. This assumes the company continues to decrease share count through the buyback program. Discounting future cash flows, assuming a 7% cost of capital on a beta of 0.99, yields a present value of $54.59 for the shares.
The fair value is a 7% premium on the current price, not hugely attractive but I think greater upside exists in improving sentiment and multiple expansion. On a price multiple basis, I have a target price of $60.16 on 2014 earnings of $3.76 and 16 times trailing earnings.
Adding to Long-Term Growth and Dividends Portfolio
I am using the recent weakness to add COH to my Long-term Growth and Dividends Portfolio. I think the loss to Kors and other competitors is overblown and the company has an enduring brand with a strong history of returns. A refocus on leather and the new product lines could surprise the market with stronger North American same-store sales.
The addition follows EMC Corporation (EMC) on a growing market share of storage and big upside in its stake in VMware (VMW) and cloud services. I plan to add a position each week for a total of ten holdings and then update monthly. Returns are based on allocating $10,000 of the $100,000 model portfolio to each holding with cash invested in the market fund. While near-term losses are possible, I am positioning the portfolio to take advantage of short-term industry fear and significant future cash flow.