Coach speaks the language of luxury but it is increasingly running a volume business.
F. Scott Fitzgerald wrote in The Crack-Up (1936) that "the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function."
Whether the same applies to corporate strategy can be the subject of doubt. But it is clear that Coach's "one brand, two distribution channels" approach has not delivered the growth and earnings expected by shareholders. Coach (COH) is trying to elevate its brand in one channel, full price stores, while at the same time unwittingly depreciating the same brand through another channel, factory stores. An outside observer can be forgiven for viewing these efforts as "two opposed ideas in the mind".
The most successful companies tend to have a clear unambiguous mission and message. But Coach appears to be, on many levels, a company that is mired in ambiguity, or even confusion, which explains why its stock has drifted aimlessly for over a year while peers Michael Kors (KORS) and Kate Spade (FNP) have scaled new highs.
Here are a few questions about Coach, with ambiguous answers:
- Is Coach a luxury goods company?
Yes. Its handbags come with a quality and price tag (several hundred to over a thousand dollars) that put them in the category of luxury for most consumers. It has "full price stores" in prime locations such as New York's Fifth Avenue. Coach offers accessible luxury at a price point where the European luxury players cannot compete effectively.
No. Coach's pricing is far below that of European über luxury names like Hermès, Bulgari or Louis Vuitton. Coach derives two-thirds of its North American sales from lower-priced sales at factory outlets. That is nearly half of total sales, a percentage that is too high for a true luxury company.
In addition, Coach runs too many discounted sales for a luxury company. Between Thanksgiving Week and the end of the year, I counted no fewer than a dozen discounted sales on Coach's Twitter account. (Side note: It is not clear why Coach advertises some of its discount sales as "Semi-Annual". This practice encourages some customers to just wait a few months for better prices).
Coach Stock: Another Semi-Annual Sale
- Will Coach be a growing company again?
Yes. The company is seeing rapid growth in its men's line and in international sales, most notably in China. International comps will improve in 2014 as the yen's near-30% decline phases out gradually. An acceleration in the US recovery will help North American sales rise again.
No. North America sales are in decline due to structural, not cyclical, reasons, in particular the aging of Coach's customer demographic.
- Does Coach have a strong management team?
Yes. Coach is highly profitable, generates strong cash flow and has no debt. Management has taken decisive steps to develop new revenue streams. For example, the men's line now accounts for over 10% of total sales. And sales in China are booming.
No. Coach was too slow to develop a foreign presence. In North America, an overreliance on factory outlets has damaged the brand. And the effort to transform Coach into a broader lifestyle brand raises its risk profile since it is no longer just "sticking to its knitting".
- Is Coach still a hot brand?
Yes. Coach's new creative director, Stuart Vevers, will reinvigorate the brand with new products that will be introduced this week at Fashion Week in New York.
No. Michael Kors, Tory Burch, Kate Spade are the new hot brands. Coach is associated with an older demographic and is past its prime. It will be difficult to rejuvenate the brand.
- Is Coach a good investment?
Yes. It has a low valuation and strong cash generation. Growth will return in 2014. The disconnect between valuation and profitability will correct itself through a rise in valuation.
No. North America will remain a problem for a long time and margins will continue to erode. The disconnect between valuation and profitability will correct itself through a decline in profitability.
Scale vs. Exclusivity
Adding to the confusion are some statements by Coach executives in recent weeks. Here are two examples:
Francine Della Badia, President of North American Retail, at a Morgan Stanley Conference (full transcript here): [my emphasis]
"We're very proud of our factory business and our factory consumer, and if you think about economics alone, there is more scale available to us to participate in a handbag category that's under $300 than at our full-price average unit retail of $300. So I love our factory business, I'm very proud of our factory business."
If I am interpreting this message correctly, Ms. Della Badia is saying that Coach can make more money selling a large number of sub-$300 handbags at factory outlets, than a smaller number of higher priced handbags at full price stores. This is disconcerting talk from a luxury goods company.
But it fits a now familiar pattern: Coach likes to speak the language of luxury but it is largely pursuing a mass-market volume strategy. Coach continues to open new stores at factory outlets.
The second statement is from Coach's recent earnings call in which Kimberley Greenberger of Morgan Stanley asked whether the outlet business damages the brand. Although we all know the straight answer to this question, the circuitous response offered by new CEO Victor Luis was revealing (full transcript here): [my emphasis]
GREENBERGER: "Victor, you mentioned the endeavor to restore brand equity, and I'm just wondering, how do you think about that effort over time with the ongoing increase in square footage in factory? It would seem in some ways that those two things worked against one another, given that typically expansion in factory is not really brand enhancing. It certainly increases distribution opportunity, but having more discount product out in the marketplace would not really seem to be congruent with the effort to restore brand equity. So I'm just wondering if you can help us with how you think about those two opposing forces."
LUIS: "It's obviously a question we get often, and what I would share is that we believe the brand, first and foremost, must be led through the full price channel. And what you see, again, in Lower Fifth, what you see in South Coast Plaza, in terms of a direction for the future of our fleet and the equity that we want to drive through that fuller lifestyle experience, where consumers are engaging with the brand differently, without a doubt will be both a business driver but just as important, if not more so, the halo for the entire multichannel strategy that we have."
"Outlets, in terms of their importance globally, are unquestionably the fastest growing certainly bricks and mortar channel in the luxury space. That is not only true for U.S. based multichannel brands. It is increasingly true for European and traditional luxury brands who are driving further relevance for the channel globally, whether it be here in the U.S., where it's quite a mature channel, but of course increasingly in Europe, and now, more than ever, increasing in China and the rest of Asia as well. And so as that channel grows, we want to make sure that we participate in it, and take our fair share there."
LUIS: "The key is not just to see it as a promotional channel, but to see it as a channel which is of relevance to a certain consumer, who does not shop in other channels, and where we have the leadership position and see continued growth moving forward."
What Mr. Luis is saying, again if I am interpreting this correctly, is that the full-price store is an important driver of the company and "just as important, if not more so," it is a place to valorize the brand and the factory outlet business. If this means that the luxury higher end business is an important place to advertise the factory outlets, then we are in tail-wags-the-dog mode with full-price stores seen as essential to boost factory sales, instead of factory stores seen as an unfortunate but needed outlet to clear some excess inventory.
Both Ms. Della Badia's and Mr. Luis' statements indicate that the factory store is one of the company's core businesses, if not the main core business. But this business poses a threat to brand equity, to growth and to profit margins.
Coach's strategy dilutes its "exclusivity." In a recent study on the global luxury industry and survey of 10,000 core luxury consumers, the Boston Consulting Group (BCG) and Altagamma indicated that 25% of luxury brands are at risk of losing their exclusivity. Antonio Achille, partner and managing director at BCG, said this: [my emphasis]
"Exclusivity is a core attribute that a brand and a product must have for core luxury consumers. Brands need to recognize that there are several ways to lose exclusivity, some of which can be only partially controlled, such as fake copies, but others are in control of the brand, for instance, discounting too often, too intense use of licenses or poor distribution. Once exclusivity is lost, the equation to rebuild it is very complex, takes time and there is no guaranteed success."
In my last article on Coach, I speculated that it may be the target of a takeover. Since then, the stock has made a round trip from the high 40s to the high 50s and back. This is yet another iteration in a tug of war between some investors who have given up and others who keep waiting for Coach to perform.
Fitzgerald's next sentence in The Crack-Up was: "One should, for example, be able to see that things are hopeless and yet be determined to make them otherwise."
Will Coach shareholders make things otherwise?
P.S. Michael Kors reported another stellar quarter this morning.
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.