By Brian Sozzi
The figures put forth by accessible luxury handbag and accessories maker Coach Inc. (COH) fell short of capturing the spirit of NY Jets head coach Rex Ryan (loud and overly positive), but rather channeled the spirits of former Indianapolis Colts coach Tony Dungy (confident, calm, and positive). Whisper numbers for earnings were slightly elevated going into the report, and though we were confident Coach would beat, we reasoned the drivers of the upside (gross margin predominantly) would be viewed as a letdown. Hence we suggested investors avoid accumulating shares pre-release.
The market’s reaction to the performance has been one of disappointment, resulting from (1) N.A. comps, though +3.2% and the first positive comp number in five quarters, were well short of most sell-side estimates, (2) no detailed guidance was issued despite apparent trend normalization in the business into January, and (3) inventories were scaled back by close to 30% y/y, which is not what one would expect in a business returning to supposed sustainable comp growth.
There were other aspects to the quarter that should ultimately garner more weight in the Coach investment debate. For starters, gross margin in the factory distribution channel rose amid a return to a rationale promotional cadence post the Christmas that never came in 2008 and renewed management attention on made for factory products. Considering inventory levels are very lean at both full-price retail stores and wholesale POS, Coach management intends to penetrate the factory channel with products that carry better economics than years past. This is an important consideration when modeling for potential earnings as the factory channel has been a gross margin anchor, increasing as percentage of net sales for a long as we have covered the company. Now, factory appears to be a dual positive proportion for Coach (sales and margin growth) into FY11.
Second is the continued discipline by which Coach is viewing new square footage, most notably in N.A. and Japan. Coach will maintain mid to high single digit percentage square footage growth in these two countries for FY10, but the kicker will be China where new square footage is scheduled to ramp by 50% in FY10. Importantly, the fundamental dynamics of Coach China were implied by management as changing “meaningfully” in FY11 from a profit drain to a profit generator. We assign a high probability on this occurring given the robust economic growth and buying trends of the consumer base that favor Coach. Big picture in terms of the top line is that assuming a mid-single digit percentage comp increase for the next six quarter and an increased rate of growth at Coach China, among other factors, we seem it appropriate to raise our sales estimates up.
Finally, there was interesting conversation on product pricing, particularly on the re-engineered goods that Coach brought to market in July 2009. Our interpretation was that there are price opportunities on the Poppy collection that will play out later in FY10. Mostly, the opportunity is for higher prices on a collection that launched to considerable consumer fanfare.
In conclusion, we have made modest adjustments to our FY10 and FY11 modeling (note these estimates are included in the Thomson Reuters consensus). FY10 EPS shifts to $2.07 (consensus: $2.07) from $2.10, accounting for tougher operating expense comparisons as bonus accruals and investment spending increases and counteracts success on the gross margin line. We are now at $2.37 P/S for FY11 (consensus: $2.28) from $2.35, adjusting for a stronger gross margin and net sales base. Primary considerations include increased operating expenses as a percentage of net sales y/y and a gross margin above our prior reasoning.
Currently, Coach shares trade on a P/E multiple of 14.7x our upwardly revised FY11 estimate, a multiple we believe is inappropriate for a company having noticeable growth levers at its disposal. The multiple is among the lowest in our specialty retail sector coverage. Once again, we deem this an attractive valuation given Coach’s strong comparative balance sheet ($1.1 billion in cash, minimal debt), growing business in the key Chinese retail market, and U.S. comp trends that though below historical norms, should generally outperform the sector average. We are valuing Coach on a 18.9x multiple to our FY11 P/S estimate, yielding a price target of $45.00.
Disclosure: We do not own the stock.