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Summary

  • Future earnings at COH may be depressed, but not enough to justify the current price slide.
  • Balance sheet is strong to very strong with no long-term debt and a great current ratio.
  • FCF is sufficient for future CAPEX to stem the declining sales while still leaving room for dividend growth.
  • COH has room for capital appreciation through earnings beats and/or multiple expansion as worries subside.

Elevator Pitch

Due to competition and lackluster recent results, Coach (NYSE:COH) has fallen almost 40%. While some drop is warranted, the stock has fallen too far and now presents solid value.

Company Description

Coach, Inc. (Coach) is a marketer of accessories and gifts for women and men. The Company offers a range of modern, fashionable handbags and accessories. Its product offerings include women's and men's bags, accessories, footwear, wearables, jewelry, travel bags, sunwear, watches and fragrance. The Company operates in two segments: North America, which includes sales to North American consumers through Company-operated stores, including the Internet, and sales to wholesale customers and distributors and International, which includes sales to consumers through Company-operated stores in Japan and mainland China, including the Internet, Hong Kong, Macau, Singapore, Taiwan, Malaysia and Korea and sales to wholesale customers and distributors in 25 countries.

Thesis & Catalyst For Coach, Inc.

All financial information is gleaned from Scottrade Company profile of COH as of 7/21/14.

Income Statement Analysis

Coach has experienced consistent income growth over the past 3 full calendar years, with only a slight drop in revenue over the trailing twelve months when compared to 2013 (but still above 2012 levels). Gross margins remain consistent at 62-63%, but net income and EBITDA margins have started to compress slightly in the trailing twelve months, dropping from highs of 21.8% and 34.4% to current levels of 19% and 31.1%, respectively. These margin compressions can be attributed to increased competition from Michael Kors (NYSE:KORS), Kate Spade (NYSE:KATE), et al., but do not concern me as the levels are relatively stable over recent history and fashion trends are cyclical. News is already starting to come out that Kors may have expanded too fast. Coach management has implemented change strategies to bring sales margins up by funneling more sales through their landmark stores and diverting some traffic from outlet retail locations. They have announced plans to close 70 stores, but also are looking to open landmark stores in key markets. These two moves can help stabilize the Coach brand as a premium product. While Coach has stated that it expects to see low double-digit declines in revenue for the coming fiscal year, I believe this to be somewhat pessimistic.

Balance Sheet Analysis

There is no debating the fact that the income statement will take a hit in the following twelve months. Management has admitted as much. So the question for a value investor should be "Does Coach have the balance sheet to weather the storm and make the necessary changes?" Coach has a very strong balance sheet. They have ample cash and short-term investments. In fact, at the end of fiscal 2013, they had enough Cash and ST investments to cover all liabilities. They carry minimal amounts of receivables compared to total sales, although receivables have been ticking up slightly. Given the cash position, this does not bother me. Inventory is rising with sales levels. The company carries minimal levels of intangibles. On the liabilities side, the company has no long-term debt and short-term debt, as mentioned before, is amply covered by current assets. The fact that the company carries no long-term debt has allowed it to grow the equity in the company at a much faster rate than rise in short-term liabilities. The company's balance sheet shall continue to get stronger, despite the revenue decline. This should provide management with the flexibility to aggressively make any necessary adjustments to return to sales growth.

It also provides for the opportunity to issue bonds and perform a stock buyback, much as Apple did last year. Although I would not advocate this as a prudent use of the balance sheet strength, I do believe it is an option, if share prices fall below $30 and management can buy back shares at a deep discount.

Cash Flow Analysis

With a strong income statement and very strong balance sheet, cash flow analysis is the last piece of the puzzle for me. My preferred method of calculating and reviewing Free Cash Flow is Cash from Operations minus CAPEX minus dividends. Using that formula, Coach has produced over $700 million of FCF each of the last three years. Cash from Ops has ranged from 24.8% of sales to 27.8% of sales, with the percentage increasing each of the last three years. CAPEX has topped out at 17% of Cash from Ops and Dividends have increased to 24% of Cash from Ops, both in the most recent fiscal year. To forecast FCF, I will assume the 15% decrease in revenues and use the lowest of the last three years' ratios. That would result in revenue of $4.3 billion and Cash from Ops of $1,071 million. Given the closing and opening of new stores, CAPEX will likely rise. Coach has not announced a timetable for the closings and openings so I am assuming a jump in CAPEX to 30% of 2013 Cash from Ops, which would be $424 million. This would leave approximately $647 million for dividends. In Fiscal 2013, Coach paid $340 million in dividends and has declared dividends projected to be $370 million for 2014. Given the assumptions, Coach should produce enough cash to cover dividends and further strengthen the balance sheet.

The above calculation of free cash flow also demonstrates that Coach has some room to raise dividends to help stem the decline of the stock, if they deem necessary. As a shareholder conscious of the balance sheet strength required for a company in an industry subject to the whims of fashionistas, I would be comfortable with Coach raising the dividend to as high as $0.40 per quarter. This would result in a projected dividend total of $439 million and would be covered adequately by FCF.

Valuation

Even with the decline in revenue of 15%, COGS remaining at the current elevated levels, SG&A expenses remaining flat at their current absolute level, my EPS forecast would still be $2.98. Given the history of Coach and the value of the brand, I would feel comfortable with a multiple of 12. This would give a forward price target of $35.76. Today's (7/21/14) closing price was $34.32. Assuming that management can stop the bleeding, which I believe they can with the additional marketing and focus on maintaining a premium brand, the stock is slightly undervalued at this point in time. Given the almost 4% dividend that Coach pays. I believe that the Income Statement would justify a Buy rating on COH.

I think Coach currently trades at the bottom of its range for the next 12 months. Management has already laid out a pretty bleak picture for the upcoming year. The company has options to deploy its cash to generate stockholder value. It has a strong brand that adds value. The company currently trades at multiples well below other "hot" stars in the industry despite the track record that Coach has earned.

Given all of these factors, I think Coach could surprise to the upside with improvement in any number of areas. China may offer increased opportunity. The ECB is considering quantitative easing, which helped spark a revitalization in the US. Coach is reigning in the Outlet stores that dampen their premium brand.

I have a price target of $40.95 on Coach for the next twelve months, but believe it could easily climb much higher with some multiple expansion and a surprise earnings beat, after how low management has set the bar.

Competitive Landscape

Michael Kors is the new big player on the scene. Coach is suffering some market share attack from Kors and Kate Spade. I've spoken with a number of women, younger and older, wealthy and of limited means, and all still hold Coach bags in high regard. This is anecdotal, so I place minimal emphasis on this, but for a fashion company these questions need to be asked. When I look to analyze a company such as Game Stop or Electronic Arts, I talk to gamers. When I started my research on Coach, I spoke with women who have Coach bags, those who still want Coach bags, and some who don't have Coach bags. The overwhelming majority of these women still held Coach relevant. So while I do believe Kors and Spade have come into the market for a fight, I don't feel that Coach is dead. In a war of attrition, I'll lean towards the only one who has survived as a market leader for over 50 years. I will admit that consumers are fickle beings and Coach could start sliding down a slope as competitors gain steam, but their history indicates that the consumers will stick with Coach.

Source: The Long Case For Coach, Inc.