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Years ago, I created a wish list of stocks that I'd love to own. In order to make it onto this list, I established rigorous requirements for entry:

-Upward trend in sales, operating income, net income, EPS, and book value for the past 10 years
-High return on book value/shareholder's equity
-Consistent high margins (gross, operating, and net income)
-Decreasing number of outstanding shares
-Less than 5 times annual net earnings in long-term debt
-Sustainable dividend payout ratio (less than 60%)

Not surprisingly, the majority of companies that made it onto my list were brand names that I recognized--companies that were leaders in their respective industries, and that possess a durable competitive advantage. Their stocks are generally expensive, historically trend perpetually higher, and rarely present a decent buying opportunity. Recently, one such company on my list has finally faced a temporary challenge that has caused its stock to be priced below its intrinsic value: Coach, Inc. (NYSE:COH).

Company Description

Coach is an American luxury design company that offers a multitude of products, including women's handbags, small leather goods, men's and women's bags, footwear, sunwear, fragrances, and other accessories. Coach owns and operates full-priced retail and outlet store locations internationally, and utilizes distributors to help expand their brand presence around the globe. Coach also runs e-commerce websites in over 24 countries.

Buying Opportunity For Coach, Inc.

Shares of Coach have lagged the broader market over the past year. The primary reasons for this include 1) increased competition in the women's handbag market, 2) a slight decrease in sales in Coach's North American business (which consists of 68% of net sales), 3) Coach's transformation into a global lifestyle brand, and 4) a major change in Coach's executive/creative management.

However, Coach has a number of strengths that offset these risks: 1) a strong brand, 2) growth opportunities in their men's business, international expansion, and their strategy of growing into a global lifestyle brand, 3) solid financial strength, and 4) low business valuation compared with the company's average P/E ratio for the past 10 years, and compared to the average current P/E ratio of other luxury goods companies. The problems plaguing Coach today are temporary in nature, and have caused its shares to be priced at an attractive valuation for a potentially lucrative long-term investment.

Competition (And Other Threats)

Michael Kors (NYSE:KORS) is considered to be Coach's biggest threat, and is also one of the primary reason for Coach's lagging stock price. While Coach's North American sales have declined 1% with a same-store sales decrease of 6.8% during the past quarter, Kors' parallel sales in the same market increased 31% with a same-store sales increase of 21%. This wouldn't be such a big deal if Kors was just some company making a few million dollars in annual sales. On the contrary, Kors reported net sales of $2.18 Billion on March of 2013 compared with Coach's reported net sales of $5.08 Billion on June of 2013. At just less than half of Coach's net sales, growth of total revenue in the ~30% arena is very threatening to Coach's leading market position.

In addition to the numbers listed above, another reason why Coach's stock is struggling is due to management's plan to transform the business from an international accessories business into a global lifestyle brand anchored in accessories. Major changes in a company's business should be a cause for concern. In this case, it appears as though Coach, the market leader in women's leather handbags, is following Kors' strategy in becoming a global lifestyle brand. Does this mean that Coach is running out of ideas on how to steer their company into the future? While Coach is starting to follow in Michael Kors' footsteps rather than carving out a unique path for other competitors to take note of, I'll explain how this strategy actually makes good sense in the "Strengths and Opportunities" section below.

The other threat to Coach's business is the drastic change in their executive management team. Generally, one change to a company's executive management is no cause for concern. However, almost half of Coach's management is changing. North American Group President Mike Tucci and Chief Operating Officer Jerry Stritzke left the company in August of 2013. Chief Executive Officer Lew Frankfort is retiring in January of 2014, to be replaced by current President and Chief Commercial Officer Victor Luis. And Executive Creative Director Reed Krakoff has decided to leave Coach to lead his own brand independently. Coach's new Chief Creative Director will be Stuart Vevers, who has a long history of fashion innovation and success at such companies as Calvin Klein, Bottega Veneta, Givenchy, Louis Vuitton, Mulberry, and Loewe. All in all, while there are many changes occurring in Coach's executive management team, the new successors are all very well-equipped to lead Coach into their next phase of growth as a global lifestyle brand--and Vevers might just be the breath of fresh design innovation that Coach needs to help turn around their struggling North American women's handbag business.

Strengths and Opportunities

Coach has a very strong and recognizable brand. The very word "coach" itself conjures up images of luxury handbags due to the pervasiveness of the company's global and cultural reach. Fashion can be a very fickle industry, yet Coach has been in business as a luxury goods company for 72 years. Over the years, Coach has survived through changes in management, recessions, and competitive threats. Perhaps most interesting of all, the Coach brand has evolved through numerous phases of growth throughout its history; and we are all witnessing yet another new phase of growth that is about to be underway in the form of a new CEO, Executive Creative Director, and as a global lifestyle brand.

Just at a time when Coach's North American women's handbag business is struggling, Coach is going through a lot of changes, most of which can be viewed as opportunities. To start with, having a new creative director at the helm responsible for sprinkling new magic into the company's products should be enough fuel to spark new demand and life into their North American market. International sales are growing at a double digit pace--China's sales numbers alone grew 35% during this past quarter. Coach's men's bags and accessories business grew 25% this past quarter, and management expects annual sales to reach $700 Million in 2014 and is projecting sales of $1 Billion within three years. In addition to the above-mentioned results and future expectations, Coach is beginning to place more emphasis on its line of accessories as part of its revamped strategy toward becoming a global lifestyle brand, including footwear, sunwear, clothing, fragrance. They are also planning on expanding further into under-penetrated international markets, most notably in Asia and Europe. All these factors will help Coach's North American business to stabilize and continue to grow again, and to help grow total sales.

While changes to any company's business introduces an air of uncertainty toward the future, and investors do not like uncertainty and change, one should always consult where a company has been as a helpful indication of where it might go. Obviously, while past results cannot be relied on to predict future performance, analyzing management's performance in the past can be a helpful exercise to see what might be in store for a company moving forward into the future. The great news is that Coach's fundamental financials are some of the strongest that I've seen of any company that I've analyzed.

Financial Strength

One of the first things I do when investigating a company is to dig into their financials. I simply go down the checklist of criteria that I've established for potential companies to enter my "Dream List of Acquisitions." I will now analyze Coach using these same criteria.

Upward Trend in Earnings
YearSalesOp IncomeNet IncomeEPSBVS
2013$5.08 Bil$1.52 Bil$1.03 Bil3.618.55
2012$4.76 Bil$1.51 Bil$1.04 Bil3.536.99
2011$4.16 Bil$1.30 Bil$880.80 Mil2.925.49
2010$3.61 Bil$1.15 Bil$734.94 Mil2.334.93
2009$3.23 Bil$977.08 Mil$623.37 Mil1.915.33
2008$3.18 Bil$1.19 Bil$783.06 Mil2.174.37
2007$2.61 Bil$1.03 Bil$663.67 Mil1.695.12
2006$2.11 Bil$797.23 Mil$494.28 Mil1.273.09
2005$1.71 Bil$637.57 Mil$388.65 Mil1.002.80
2004$1.32 Bil$447.66 Mil$261.75 Mil0.682.08

The numbers in all 5 categories increased steadily for the past 10 years. Even during the Great Recession in 2009, while sales were up, the decline in Operating Income, Net Income, and EPS were minimal, which speaks volumes about the strength of the Coach brand.

Consistent High Return on Book Value/Equity (>12%)
YearEPSBVSROE
20133.618.5542%
20123.536.9951%
20112.925.4953%
20102.334.9347%
20091.915.3336%
20082.174.3750%
20071.695.1233%
20061.273.0941%
20051.002.8036%
20040.682.0833%

The average company in the S&P 500 has a return on equity of about 12%. For the past 10 years, Coach has averaged a 42.2% return on equity, which is way above average.

Decreasing Shares Outstanding
YearNet IncomeEPSShares Outstanding
2013$1.03 Bil3.61281.90 Mil
2012$1.04 Bil3.53285.12 Mil
2011$880.80 Mil2.92288.51 Mil
2010$734.94 Mil2.33296.87 Mil
2009$623.37 Mil1.91318.01 Mil
2008$783.06 Mil2.17336.73 Mil
2007$663.67 Mil1.69373.09 Mil
2006$494.28 Mil1.27365.86 Mil
2005$388.65 Mil1.00377.12 Mil
2004$261.75 Mil0.68376.37 Mil

In addition to dividends, another great way for a company to return cash to shareholders is through share buybacks. The great thing about share buybacks is that investors own a larger piece of the company, and there are no tax consequences. Buybacks are also evidence that a company possesses great financial strength. Starting from 2007, Coach's outstanding shares went from 373.09 million to 281.90 million, a 25% decrease in 7 years.

Consistent High Margins
YearGross MarginOperating Income MarginNet Income Margin
201372.9%29.9%20.3%
201272.8%31.7%21.8%
201172.7%31.3%21.2%
201072.9%31.9%20.3%
200971.9%30.2%19.3%
200875.7%37.4%24.6%
200777.4%39.5%25.4%
200677.7%37.7%23.4%
200576.7%37.3%22.7%
200474.9%33.9%19.7%

Companies that earn a gross margin greater than 40%, and earn a net income margin greater than 20% display the financial strength of a company that possesses a durable competitive advantage. For the past 10 years, Coach has averaged a 74.6% gross profit margin, and has averaged a 21.9% net income margin. More importantly, the consistency of these high margins is incredible.

Long-Term Debt < 5X Annual Net Income
YearNet IncomeLong-Term Debt
2013$1.03 Bil$485,000
2012$1.04 Bil$985,000
2011$880.80 Mil$23.36 Mil
2010$734.94 Mil$24.16 Mil
2009$623.37 Mil$25.07 Mil
2008$783.06 Mil$2.58 Mil
2007$663.67 Mil$2.87 Mil
2006$494.28 Mil$3.10 Mil
2005$388.65 Mil$3.27 Mil
2004$261.75 Mil$3.42 Mil

Coach has carried practically no debt during the past 10 years, which means that the cash generated from organic operations is sufficient for continuing the business (and, in Coach's case, also sufficient for returning cash to shareholders through an increasing dividend and share buybacks).

Sustainable Dividend Payout Ratio < 60%
YearEPSDividendPayout Ratio
20133.611.2434%
20123.530.9828%
20112.920.6823%
20102.330.3816%
20091.910.084%
20082.17--
20071.69--
20061.27--
20051.00--
20040.68--

Coach started paying a dividend to shareholders beginning in 2009, and has rapidly increased the payout over the past 5 years. With the financial strength displayed by Coach, and with a 34% dividend payout ratio, it appears that the dividend rate is very safe and has the potential to continue increasing at a quicker rate than earnings for the next few years before stabilizing to be more in line with the growth rate of earnings.

Altogether, it is very evident that Coach more than likely possesses a durable competitive advantage based on their fundamental financial performance over the past 10 years. Having a longer-term perspective on the company's performance, or seeing how the executive management team has guided the company over a 10-year period, should give investors solace that fiscal 2013's weaker-than-average performance for Coach truly is, as management has mentioned numerous times, an "investment year" for the company, and that future performance starting with 2014 and 2015 should begin to show improvements as the company transitions into its next phase of growth as a global lifestyle brand.

Attractive Valuation

There are a few methods that I use for measuring the quality of a company's current valuation: 1) company's average P/E ratio for the past 10 years, 2) comparison of P/E ratios between competitors within the same industry, and 3) taking into consideration the relatively risk-free 10-year treasury bond yield against a conservative projection of the company's growth prospects into the future (based on past performance).

Company's Average P/E Ratio For The Past 10 Years
YearP/E Ratio
201316
201217
201122
201016
200914
200813
200728
200623
200534
200433

The numbers listed in the above chart are rounded to the nearest whole number, and are approximate. Based on this information, the average P/E ratio for Coach's stock has been about 21.6 over the past 10 years. The highs and lows indicate that the stock's value has fluctuated widely. However, it wasn't until during the Great Recession when the stock took a big hit and started trading in the low to mid teens--plus, the challenges of the company during the past year or two are indicative of the most recent low P/E ratios.

Current P/E Ratios of Relevant Companies
CompanyCurrent P/E Ratio
Coach Inc.16
Michael Kors Holding Ltd.33
Ralph Lauren Corp. (NYSE:RL)22
Tiffany & Co. (NYSE:TIF)26
L Brands Inc. (LTD)23
Fossil Group Inc. (NASDAQ:FOSL)20
Nike Inc. (NYSE:NKE)27

The average current P/E ratio of all the companies listed in the above table (excluding Coach) is 25.1. Michael Kors, Coach's primary competitor, is trading at a P/E ratio of 33, roughly double that of Coach's valuation. While Kors' lofty valuation is more justified due to the company's rapid growth during the past few years, even the more mature companies with growth closer to "average" are valued above a P/E ratio of 20. Taking this factor alone into consideration, Coach has a potential "catch-up effect" of approximately 25% (4+16=20, and 4/16=25%) if its stock were to gravitate closer to its industry peer average.

Company's Future Prospects Vs. 10-Year Treasuries

Interest rates are still being held back due to the Fed's QE program. Currently, the 10-Year Treasury Notes are yielding about 2.75%. In this environment, most stocks of reputable companies with healthy earnings and balance sheets would be preferable for investment over the relatively risk-free treasuries. However, I would begin feeling nervous if a stock's P/E ratio was nearing the upper thirties, since a company's earnings at that level are worth roughly the same as treasuries. For example, an investment into a company whose current annual earnings are valued at a P/E ratio of 40 would be worth 2.5% (1/40=2.5%). Coach's current dividend yield alone is 2.5%, which is almost equivalent to the 10-year treasury yield.

If an investor owned 100% of Coach, their before-tax return would be close to 30%--fiscal 2013 pretax earnings of $1.524 Billion divided into gross sales of $5.075 Billion is equal to 29.9%.

A potential investor of Coach today, with shares trading at a P/E ratio of about 16, would start off their investment earning about a 9.6% pretax return (6.25% after-tax return considering 35% taxes).

Since Coach evidently has a durable competitive advantage, one could argue that the company will continue to increase their earnings well into the future for many years to come. Their EPS growth rate over the past 5 years has slowed considerably, yet still clocks in at about 10.5% per year. Let's see what Coach's EPS could look like 10 years into the future using this growth rate.

Future EPS At 10.5% Average Annual Growth
YearFuture EPS
20239.80
20228.87
20218.02
20207.26
20196.57
20185.95
20175.38
20164.87
20154.41
20143.99
20133.61

Let's say that an investor purchased shares of Coach today with EPS of $3.61, at a P/E ratio of 16 (around $55.00/share), and held onto their shares until the year 2023. Let's assume that Coach's earnings were in fact $9.80/share during 2023. If Coach's P/E ratio was still 16 in 2023, then its share price would end up being $156.80/share, and the investor would have earned a 10.5% average annual return on their investment, which isn't bad at all. But let's say that we were in the middle of a roaring bull market: Coach's business was performing wonderfully, and the market was pricing its shares at a modest P/E ratio of 23 (which is slightly above its average P/E ratio during the past 10 years, and slightly below where its peers are valued today). With EPS of $9.80, and a P/E ratio of 23, COH shares would be trading at $225.00/share. In this instance, an investor would have earned an average annual return of closer to 15%, which is definitely above average compared with the long-term performance of the S&P 500 index.

The best part of the above visualization into the future is that, so long as Coach truly does posses a durable competitive advantage, and they continue to increase their EPS at an average annual return of approximately 10.5% per year, then the above scenario could potentially play out. Granted, if the economy was in a recession 10 years from now, Coach's P/E ratio could be in the single digits. But in the end, a company's earnings power truly is the single most important factor when considering executing an investment.

Conclusion

After analyzing their financials over the past 10-year period, it is evident that Coach possesses a durable competitive advantage. This assumption should give investors comfort knowing that the current pessimism in the market price of Coach's shares due to the increase in competition, executive leadership change, and struggling North American women's handbag sales is temporary in nature. As soon as the transition into a global lifestyle brand materializes, fresher and innovative product designs from Stuart Vevers begin hitting shelves, and North American sales stabilize, (and after this happens, the media should begin to focus on the more positive attributes of Coach's business again, such as their international expansion, and their growing men's business,) there could be a correction in the market valuation of Coach's shares to the upside of approximately 25%. And for the patient long-term investor, at Coach's current valuation, there is the potential for market-beating returns to the tune of around 15% per annum over the next 10 years.

Sources:

Source: Why Coach Is A Good Long-Term Investment