Coach: A Business And Industry I Hate, But A Valuation I Love

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 |  About: Coach, Inc. (COH), Includes: KORS
by: Brian Grosso

Summary

Coach possesses some decent business qualities, but I have a very strong distaste for softlines retail and the company's recent management turnover and sales troubles in the U.S. compound that.

Fantastic ROIC of 39.9%.

Really, really cheap at 10x NOPLAT and 12x FCF. Never have I seen a comparable ROIC business selling so close to single digit after-tax multiples.

Wealth creation opportunities through financial leverage. A 2x EBITDA net debt position is not unreasonable and would mean $3.6B in additional funds for share repurchases or a buyout.

Just cannot bring myself to invest in a business I qualitatively dislike so much. Serious opportunity for investors less negative on retail and Coach's business.

Business

Coach (NYSE:COH) was founded in 1941 and designs and sells (but does not manufacture internally) handbags and accessories under the Coach brand.

I like that the company outsources manufacturing to independent manufacturers because that is a capital-intensive business and obsessing over branding and design is probably necessary in an ultra-competitive global fashion & retail landscape.

I also like that the company has a strong brand as this is the textbook example of a potential source of competitive advantages. That said, the company's description of the Coach brand befuddles me:

The Coach brand represents a blend of classic American style with a distinctive New York spirit.

My immediate reaction to this was something to the effect of, "Wow, how do they sell these bags overseas then? Don't other countries hate America and its status symbols?" Joking aside, with the company losing market share in the U.S., international success is critical and so a less American image might be necessary to do well over the next 5-10 years. I may be totally off here though as I am far from a fashion expert and am not really in touch with culture outside the U.S. at all.

I like that the company is a market leader with the leading handbag brand in North America and the leading imported handbag and accessories brand in Japan.

It is also nice to see many signs of a diverse revenue stream with:

Source: COH 2013 10-K

  • A move toward a gender-neutral brand
  • A shift outside of North America with 31% of FY13 sales coming from outside NA
  • Licensing revenue in sunwear, watches, fragrances, and footwear
  • Retail operations in addition to wholesale sales

All that being said, I don't like the Coach business or its industry. I was burned big-time investing in an apparel retailer (Body Central Corp.(NASDAQ:OTCPK:BODY)), which died a surprisingly-fast death primarily as a result of rapidly changing consumer tastes. Fashion trends and consumer preferences probably change a bit slower in handbags and accessories than in apparel, but this isn't all that redeeming for me. I'd pit both categories last on my hypothetical ordered list of retail categories by desirability and I don't even like retail to begin with. It is my least favorite industry because:

  • It faces major headwinds from e-commerce (I think this is a rare situation where the media is actually understating the long-term implications of a broad trend).
  • There is little room for real, sustainable differentiation (more than just saying such and such a company has a brand so it's differentiated; a business that is actually meaningfully shielded from competition and adverse economic forces).
  • It is highly competitive, especially softlines where there are not so many niche opportunities as hardlines, a la PetSmart (NASDAQ:PETM).
  • There is direct exposure to dangerously volatile consumer preferences. I am not at all intending to be sexist, but the collective mind of female consumers, in particular when it comes to fashion trends, is a powerful, dangerous, and highly unpredictable force.

There is no way around the fact that Coach is basically at the mercy of all of this and that is highly disturbing from a long investment standpoint.

Add to that that the company is experiencing turnover in its President & Executive Creative Director position and losing market share big-time in the U.S. and I am very concerned and I think justly so.

A mentor and buy-side analyst wisely said something to the effect of the following to me recently:

To invest in a business I hate, it'd have to be so ridiculously and unreasonably cheap as to tie my hands.

He gave the example of HP (NYSE:HPQ) 18 or so months ago at 5x FCF. I wholeheartedly agree with this approach and am now approaching Coach with a high degree of skepticism.

ROIC

ROIC is the best quantitative measure of business quality, in my opinion, and so I always like to take the time to have a calculation I am confident in. Here, I calculated the number using:

EBIT(1-t) / (Total Assets - Goodwill - Current Liabilities + ST Debt)

I calculated 39.9% for LTM. That's absolutely excellent. 8-10% is probably average. Normally this tends to align with the conclusions I draw in the Business section, but not at all in this case which is why I'm pulling my hair out trying to come to a definitive conclusion on the stock as I go through this.

Valuation

Over the last 10 years, COH has grown:

  • EBIT 12% annually
  • Rev 13.3% annually
  • Eps 17.3% annually

Even with the sales troubles recently (U.S. sales down almost 20% in Q3 and company is losing market share to Michael Kors (NYSE:KORS) and others), I still think COH is capable of growing EBIT mid-single digits to low teens over the next 5-10 years and per share growth should continue to be amplified by share repurchases. Considering all that and the company's fantastic 40% ROIC and 4% dividend yield, I'd think the stock cheap at 18x or so. The company currently trades at:

  • P/NOPLAT 10.16x
  • P/FCF 11.7x
  • EV/EBITDA 6x
  • P/E 10.3x

I think shares are extremely cheap. It is an extreme rarity in my experience for such a high ROIC business to trade near single digit after-tax multiples.

A Random, But Critical Point

Coach has a very strong balance sheet with a net cash position of $565M. This seems nonsensical for such a high ROIC business. Despite the recent operational troubles, I don't see a 2x EBITDA net debt position as out of the question and if the company did that, it could raise $3.6B. With that and the company's current cash, the company could repurchase 47% of outstanding shares at this price or a buyer could fund 47% of an LBO with Other People's Money "OPM." There has also been a lot of private equity activity in softlines retail recently and this could be a major ST catalyst. I see a lot of opportunity in this and it makes the quantitative story even more tempting.

Conclusion

Coach stock is really, really cheap for that of an ultra-high ROIC business and there is a lot of wealth creation opportunity in the company's unlevered balance sheet, but I just cannot bring myself to invest in a company I qualitatively dislike so much. For investors less disenchanted with softlines retail and Coach's business, this could be a once-in-a-year long opportunity, but it's an avoid for me.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.