When To Buy: Digging Into The Value Of Coach

Jul.24.14 | About: Coach, Inc. (COH)

Summary

Coach remains in the sweet spot of retail as mid level luxury is appealing to various demographics.

The company has retained its economic moat built by brand awareness.

Coach has diverse and relatively predictable earnings.

The stock offers a strong dividend with the potential for dividend growth.

The risks today are management, designer, and valuation.

When investing in a company it is important to layout a clear repeatable game plan. Our game plan focuses on quality at each step in the process and is as follows...

Management: Management teams drive business activity, and restrain or release shareholder value by the decisions they make.

Thematic View: Understanding the industry dynamics and what will lead to above market growth opportunities.

Economic Moat: Uncovering and quantifying an economic moat which makes it difficult for new entrants.

Stable & Above Market Earnings Growth: Predictability in earnings and cash flow generation is usually handed a premium valuation. If one can determine that future earnings will be more or less predictable, one can put more faith in valuation analysis.

Dividends: A company that has the ability to pay a dividend and increase dividends over time creates shareholder value.

Valuation: Given that we are valuation sensitive we harvest intrinsic values under various market conditions.

Patience: One of the hardest things to do in investing is staying patient. Investors as we do, need to trust the process and stay within the game plan. Once an entry point is determined, one must stick to this entry point.

MANAGEMENT:

Lew Frankfort - Executive Chairman

Lew Frankfort joined Coach, Inc. (NYSE:COH) in 1979 as Vice President of New Business Development; the company's sales were just $6 million. As of June 2013, under Mr. Frankfort's leadership, Coach's annual sales were over $5 billion. In 1995, Mr. Frankfort was named Chairman and CEO. Unfortunately, he has stepped away from the general lead and this year he became Executive Chairman.

Victor Luis - CEO

Mr. Luis was appointed Chief Executive Officer of Coach, Inc. in January 2014. Prior to his appointment, and beginning in February 2013, he held the role of President and Chief Commercial Officer of Coach, Inc., with oversight for all of the company's revenue-generating units, strategy and merchandising, also serving on Coach's Board of Directors. Most recently, he served as President, International Group, with responsibility for all of Coach's operations outside of North America. Today, Coach's strength is its international sales. When we meet with the management team the biggest question in our opinion is how Mr. Luis can translate his success internationally, back to the domestic US market.

Critical Departure of Reed Krakoff : Executive Creative Director

He was the lead designer of the brand since 1996. Krakoff has garnered the respect of his industry and peers and has received countless professional accolades to match. In 2007, Krakoff was elected vice president of the Council of Fashion Designers of America (CFDA), an institution that has been extremely supportive of his work. In 2001, the CFDA bestowed Krakoff with a distinct honor: Accessories Designer of the Year. In 2004, the CFDA once again awarded this distinction. He left to start his own brand.

Stuart Vevers - Executive Creative Director

He took over in June 2013. Served as creative director of LVMH Moët Hennessy Louis Vuitton's Loewe brand, he was hired to succeed Reed Krakoff. Designing in my opinion is the most vital part of Coach's operations, yet this remains a question mark. While Vevers was at Loewes , their top line went from $57.4 million euros in 2008, to $49.3 million euros in 2009, $58 millions euros in 2010, and back down to $57.2 million euros in 2011. This comes out to two negative years of year over year top line growth and a 4-year period of flat to negative growth. (financial data from Bloomberg Terminal)

INVESTMENT THEME:

Coach has various things working in their favor which should help boost sales and earnings over the long term.

The Good

1. Increased Global Luxury Demand: Global luxury goods sales reached $318 billion in 2013, and are forecast to expand 20% to $383 billion by 2018, according to Euromonitor. Clothing is the largest, accounting for 40%.

Source: Bloomberg data

2. Disposable Income Growth 10-Year 12.3% CAGR: The continued migration from rural areas to cities in China and rising disposable incomes will likely continue to drive luxury goods sales. China's urban population has more than doubled to 731 million in the past 20 years, boosting revenue for luxury goods retailers, many of which only have branded stores in tier-one and a few tier-two cities. The effect of migration slowing to 3% to 4% a year since 2004 has been more than offset by rising per-capita income.

3. Top Brand in the luxury sector which we believe provides a floor for the company; where the floor is we need to figure out through financial analysis. In 2013, Coach was globally the most-searched luxury handbag brand on the internet.

4. New Products Coming to Market (9/15) with Stuarts Designs: This has created some buzz, but this will need to wow the market to get back on track.

The Bad

5. Transformation will take a bit of time: The message from COH's senior leaders was consistent: the turnaround is going to take time and capital to reposition COH in this new competitive landscape. Product is the key. Focusing on moving away from the "high quality leather company", to a "fashion leader".

6. Poor Sales, Same Store Sales Relative to Industry Peers: Coach's 7% drop in sales is the lowest of its peers who have reported for the March quarter. On a constant currency basis, its 5% decline is also weakest, compared with growth at LVMH and Kering (both 6%), Burberry (12%) and Hermes (15%). Coach's U.S. same-store sales dropped 21% with weakness in North American women's bags and accessories offsetting gains in men's footwear and international. Creative director Stuart Vevers' collection is available in September.

PROCESS:

The Foundation

Source: Coach Sustainability Report

The Foundation: The company has a clear and repeatable process. Above is a table which summarizes their objectives per stakeholder group. Management focuses a tremendous amount of time and effort on quality. This can be clearly shown in their #1 focus, which is employee engagement. Coach has an internal webnet which allows for employees to communicate, providing feedback, updating business objectives, and hosting company meetings. This process and engagement trickles down to customers and even to suppliers and media.

Compensation

Source: Coach Sustainability Report

Maintaining a well educated and cohesive work force starts with education and compensation. Coach offers various levels of compensation for employees who engage in productive activities. An example of this is an employee who wants to refine their management skills by attending seminars can receive a reimbursement by the company. Coach also offers their own in-house coaching application and toolkits to ensure that each member of the team has the same focus and process. Compensation for each employee is robust and very competitive, with bonuses, salary, stock options, retirement plans, and financial protection plans all in place.

Supply Chain Controls

Source: Coach Sustainability Report

  1. The company focuses on high quality suppliers. Each step of the supplier process is analyzed. Everything from hours worked, wages, and conducting onsite audits.
  2. Working Hours: Coach will not knowingly use suppliers who fail to comply with the legal maximum working hours as specified by each country's standards and laws.
  3. Wages: Coach will not knowingly use suppliers who fail to pay their employees at the local minimum wage
  4. AUDITS AND PARTNERSHIPS: Currently, each factory receives at least one audit per year. To ensure their service providers and raw material suppliers are fulfilling their obligation, they conduct internal as well as external, independent third party audits. The auditors are experts in the local laws of the countries they operate in and speak the local languages.
  • A factory walk-through to evaluate the physical working conditions, as well as health and safety practices.
  • Confidential interviews with workers to provide freedom to speak on potential misconduct (forced labor, harassment, etc.)
  • A review of all relevant documentation (e.g. payroll, time records, employee age verification, licensures, certificates, waivers, etc.).

Distribution

Source: Coach Sustainability Report

  1. Distribution has become much more efficient, creating cost reductions and highlighting its focus on environment friendly activities.
  2. Old Distribution Route: Historically, for a Coach handbag to arrive at the flagship store in Hong Kong, it would be shipped via boat from the factory in southern China to the primary distribution center in Jacksonville, FL (NYSE:JAX). The bag would then be placed in another container and shipped via air back to their retail locations in Hong Kong. The total trip was a little over 18,000 miles, roughly three quarters of the way around the globe.
  3. Now: To support the growth in China and the region, in fiscal 2010 they established an Asia Distribution Center (NYSE:ADC) in Shanghai, owned and operated by a third-party, which allows them to streamline the logistics in this region, while reducing. Now that same handbag manufactured in southern China is transported roughly 1,500 miles to Coach's ADC and then shipped to their flagship store in Hong Kong. In fiscal 2013, 13% of Coach's worldwide units were shipped directly to their ADC.
  4. Sub-Hubs: Currently, Coach utilizes a network of distribution facilities and in-country hubs, all operated through third-parties in Japan, China, Hong Kong, Singapore, Taiwan, Malaysia, Korea, and the Netherlands. As Coach continues to expand its global footprint, they will continue to refine their distribution strategy to maximize shipping efficiency.
  5. LEADERSHIP IN ENERGY AND ENVIRONMENTAL DESIGN: Coach's Shipping and Storage Buildings were awarded LEED Silver certification by implementing 38 green design and construction features that positively impact the environment. Solar powered water heaters, waterless urinals, energy efficient lighting.

ECONOMIC MOAT:

Market Share

Market share is declining in the US to 13.95%, but is stable and slightly improving in Asia ex-Japan region. Japan is 9.61%, Asia Pacific is 2.43%.

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Brand Awareness

Even though sales have been coming down, the brand remains one of the strongest. Luxury brands can have an intangible economic moat around them. Coach has consistently been a top brand in the luxury sector which we believe provides a floor for the company; where the floor is we need to figure out through financial analysis. In 2013, Coach was globally the most-searched luxury handbag brand on the internet.

QUALITY & DIVIDEND:

Source:Bloomberg Terminal Data

Debt to EBITDA & Current Ratio: Both indicators are in strong position. The current ratio stands at 2.27 and the company virtually has 0 debt.

Source:Bloomberg Terminal Data

Dividend Yield / Payout Ratio: The current dividend yield is 3.8%, which is the highest it has been since the start of its issuance of dividends. The payout ratio is moving higher also, and is expected to increase given the expected drop in net income. Cash as a percent of the balance sheet is falling.

Click to enlarge Above is a chart highlighting the quality checks put in place.

Source:Bloomberg Terminal Data

EARNINGS STABILITY

Earnings are shifting from US centric to international. The top two charts shown below highlight the shift from 90% US in 2000, to 58% today. US growth in sales continues to fall; however, international sales growth has been rather stable. The bottom two charts show the flat and slightly falling margin since 2009. Additionally, earnings is falling given the lack of revenue and falling margins.

Click to enlarge

Source:Bloomberg Terminal Data

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Source:Bloomberg Terminal Data

VALUATION:

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Source:Bloomberg Terminal Data

Absolute Valuation: Valuation is a critical part of any of our investment decisions. Coach is trading at its biggest discount since 2008 on an absolute basis.

Click to enlarge

Source:Bloomberg Terminal Data

Relative Valuation: The stock is trading at a discount to its luxury peers.

RISKS

Company Risk: While the company maintains a strong brand, brands can be destroyed through failed execution. The biggest risk to Coach today is Stuart Vevers. Taking over for Reed Krakoff is no easy task. Reed developed much of everything you know of Coach today, from the Cs on purses, to the Cs on leather shoes. Stuart will need to create a brand refresh, one that works for all ages, and maintains that middle-market look and feel.

Industry Risk: The market continues to see increased competition. The likes of KORS have eaten into Coach's product lines and therefore sales. The increased competition has forced Coach to close 70 underperforming full price stores, and 9 factory stores. Should Coach not execute properly on their designs and sale strategies, Coach could see increased top and bottom line pressures.

Conclusion

After analysis of the company covering various core facets of business development, we continue to believe in Coach as a business. The company maintains a strong brand and maintained reasonable margin stability, even though sales have been falling. The company has been actively attacking international markets with great success; however, we need to see greater success here in the US. The critical component of Coach's core business is the success of Stuart Vevers (lead designer). He has had some success but this success may or may not translate to Coach. His first line of products comes out in September. To be conservative, we do not expect much success right away, therefore, we continue to model in negative growth for the next 18-24 months, creating a re-rating in valuation. We do expect earnings to accelerate and turn positive between months 17-20 based on brand strength and factoring in accelerated international sales. Given the inputs in our models our fair value takes us to $43.16, with a margin of safety purchase price of $31.5. Our most bearish model suggests a downside price of $28.35, and our most bullish price of $66.80. Couple this valuation with a strong and potentially growing dividend. Until $31.5 we will remain patient even though we may miss an opportunity.

Fair Value Graph

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Disclaimer:

This is the pure opinion of Sean Emory and TheMarketMeter.com. Please read the disclosure on the TheMarketMeter.com for further information. The information within is derived from Bloomberg data, Coach Investor Presentation, Coach 10-K, and data derived by TheMarketMeter.com

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.