Why Coach Is Still A Nice Accessory For Your Portfolio

Nov.13.13 | About: Coach, Inc. (COH)

What's in a name? Quite a bit if you're Coach, Inc. (NYSE:COH). With the exception of a relatively small dip in its 2009 fiscal year - which ran right through the heart of the financial crisis and Great Recession - the luxury goods retailer has increased earnings per share in every year of the past decade, a decade in which the American consumer supposedly suffered a fatal blow.

That impressive run is due in part to a strong brand name. Yes, there have been concerns that its relatively large number of factory stores is diluting that brand name, but overall the Coach name remains a strong one that many associate with class, status and success. U.S. consumers - who frankly were never as tapped out as some pundits might have had you believe - have been willing to spend for items that embody those qualities, even when the economy has been sluggish and the headlines have been fear-filled. And overseas, sales growth has been strong. That has given Coach what Warren Buffett might call a "durable competitive advantage" over many of its peers, as evidenced by its sparkling 38% average return on equity over the past decade and its 20% profit margins, which are tops in the retail apparel industry. (Morningstar analyst Paul Swinand also notes that "the company's ability to design, distribute and source enable it to produce premium operating margins.") All of that's part of why my Guru Strategies (computer models based on the approaches of Buffett and several of history's other great investors) triggered a Trade Alert on the $14-billion-market-cap firm on Oct. 23. My back-testing has shown that historically, stocks possessing similar fundamental characteristics as Coach have on average returned more than 19% over a six-month period, beating the S&P 500 benchmark 70% of the time.

Love From The Gurus, But Not The Street

My Buffett-based model has long been a fan of Coach, thanks in part to its stellar ROE and persistent earnings growth. In fact, my Buffett-inspired 10-stock portfolio picked up the stock in September of 2009, and it hasn't let go. And it's paid off - Coach shares jumped sevenfold from the March 2009 market bottom to mid-March of last year, and my Buffett-based portfolio captured a good chunk of those gains. Since then, however, the stock has struggled. The latest catalyst was the firm's announcement that it expects to deliver flat to low single digit sales growth in its 2014 fiscal year, which caused shares to fall more than 10% over a two-day period in October. Some weakness in North America, in part due to increased competition, is a driving factor behind the guidance change. Investors also may be nervous that Coach is in the process of changing up its business model, shifting from a handbag/accessory specialist to more of a "lifestyle brand," a la Louis Vuitton.

But it looks like the declines are an overreaction. That's what my Joel Greenblatt- and Benjamin Graham-based approaches, which actually triggered this particular Trade Alert, are telling me. Both of these models look for companies with strong balance sheets that are trading at attractive prices, and that's just what they see in Coach.

Graham, known as the "Father of Value Investing," was Buffett's teacher and mentor at Columbia University. Having lived through his own family's financial troubles when he was a young boy, and then through the Great Depression, which hit shortly after he opened his own investment business, he was extremely conservative. The model I base on his "Defensive Investor" approach looks for companies whose long-term debt was no greater than the value of their net current assets. Essentially, this indicated that if you were to buy the whole company and liquidate its assets, you would have at least enough to pay off a firm's long-term debt, a very good sign. Graham also wanted a firm's current ratio - that is, the ratio of its current assets to its current liabilities - to be at least 2.0, a sign of strong liquidity. With less than $1 million in long-term debt and more than $1.1 billion in net current assets, Coach easily passes the first test. And its 2.65 current ratio passes the second test.

In terms of valuation, Graham looked at the price/earnings ratio from two different perspectives, one using trailing 12 month earnings and the other using three-year average earnings, in case the past year's earnings were anomalous. Neither of those should be higher than 15. Coach's 14.4 TTM P/E ratio makes the grade, but its 15.5 PE using three-year average earnings narrowly misses. Still, the stock seems to be trading at a reasonable value.

The Greenblatt-based model differs from the Graham-based approach in its specifics, but it uses many of the same concepts. Instead of using the P/E ratio, it looks at earnings yield. Typically this is the inverse of the P/E ratio, but Greenblatt used a much more sophisticated approach. Instead of earnings he looked at earnings before interest and taxes to get a clearer idea of how strong the firm's operating business is. And instead of share price, he looked at enterprise value, which includes not only the price of the company's shares, but the amount of debt it uses to generate earnings. On this basis, Coach's earnings yield is 11.3%, indicating very good value.

Of course sometimes a firm is cheap for good reason - it's a dog. Because of that Greenblatt also looked at return on capital, but again he did so in a slightly different way than most. The model I base on his writings divides a firm's earnings before interest and taxes by tangible capital employed (net working capital plus net fixed assets). Coach's ROC on that basis is 63.2% - very impressive.

All in all, Coach is dealing with some issues that should cause a bit of concern. But with shares down about 30% over the past year and a half or so, investors are downright frightened, and it appears that they are significantly overreacting. Given the firm's long history of success, exceptional balance sheet and reasonably priced shares, Coach should be in good position to handle those challenges going forward.

Disclosure: I am long COH. 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.