Coach Is Still In A Lot Of Trouble

Sep. 5.14 | About: Coach, Inc. (COH)

Summary

Coach shares have been decimated following terrible operating results.

Continuing issues and delusional analyst estimates mean more downside is likely.

Shares should trade down into the $20s and could be a buy at that point.

Shareholders of Coach (NYSE:COH) have had a very rough couple of years. Since the spring of 2012, shares have plummeted from $75 to the $37 shares currently trade for, good for about a 50% decline. This decline has come on the back of horrible operating results for the luxury retailer, and investors have suffered for the company's execution issues. After being cut in half, are shares finally cheap? In this article, I'll take a look at Coach to see if shares are finally in value territory after being pummeled for so long.

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To do this, I'll use a DCF-type model you can read more about here. The model uses inputs including earnings estimates, which I've borrowed from Yahoo, dividends, which I've set to grow at 8% annually, and a discount rate, which I've set at a 7% risk premium to the 10-year Treasury rate.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior-Year earnings per share

$3.10

$1.89

$2.08

$2.20

$2.33

$2.46

x(1+Forecasted earnings growth)

-39.00%

10.10%

5.75%

5.75%

5.75%

5.75%

=Forecasted earnings per share

$1.89

$2.08

$2.20

$2.33

$2.46

$2.60

Equity Book Value Forecasts

Equity book value at beginning of year

$8.82

$9.36

$9.98

$10.61

$11.24

$11.87

Earnings per share

$1.89

$2.08

$2.20

$2.33

$2.46

$2.60

-Dividends per share

$1.35

$1.46

$1.57

$1.70

$1.84

$1.98

=Equity book value at EOY

$8.82

$9.36

$9.98

$10.61

$11.24

$11.87

$12.49

Abnormal earnings

Equity book value at beginning of year

$8.82

$9.36

$9.98

$10.61

$11.24

$11.87

x Equity cost of capital

9.40%

9.40%

9.40%

9.40%

9.40%

9.40%

9.40%

=Normal earnings

$0.83

$0.88

$0.94

$1.00

$1.06

$1.12

Forecasted EPS

$1.89

$2.08

$2.20

$2.33

$2.46

$2.60

-Normal earnings

$0.83

$0.88

$0.94

$1.00

$1.06

$1.12

=Abnormal earnings

$1.06

$1.20

$1.26

$1.33

$1.41

$1.49

Valuation

Future abnormal earnings

$1.06

$1.20

$1.26

$1.33

$1.41

$1.49

x discount factor(0.094)

0.914

0.836

0.764

0.698

0.638

0.583

=Abnormal earnings disc. to present

$0.97

$1.00

$0.96

$0.93

$0.90

$0.87

Abnormal earnings in year +6

$1.49

Assumed long-term growth rate

3.00%

Value of terminal year

$23.26

Estimated share price

Sum of discounted AE over horizon

$4.77

+PV of terminal-year AE

$13.57

=PV of all AE

$18.33

+Current equity book value

$8.82

=Estimated current share price

$27.15

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The model produced a fair value of about $27, or about $10 lower than shares trade for as I write this. The large discrepancy is certainly worth investigating, so we'll take a look at that in a bit.

But first, we need to understand what the model is telling us. The model is not computing a price target; it is showing us a fair value. The distinction is important, as a price target is some multiple of earnings projected out into the future; the fair value is a price at which shares are a buy today. The model is suggesting that the present value of Coach's discounted future earnings stream, adjusted for dividends, is around $27. That would imply Coach is still quite overvalued, and given the company's recent operational results, I'm inclined to agree wholeheartedly.

For example, Coach's results from the second quarter, third quarter and fourth quarter of this fiscal year all showed mid-single digit declines in revenue. While the fourth quarter saw a "beat" because expectations were through the floor, the fact remains that Coach has some very serious issues. The company's luxury brand name, I believe, is still very much intact with consumers. Everyone knows the Coach name, and knows that it stands for quality and luxury. However, that only goes so far as you still need people to actually come into the store and spend money, and Coach is struggling there.

For example, during the FQ4 report, Coach reported that comp sales in North America were down an eye-popping 17%! No business can weather that storm for long, but the good news is that next year, Coach will be comparing against this downright abysmal year, so it should look good by comparison. Inventory is also up, as Coach has had a problem getting customers in the door, and while the inventory situation isn't dire, I don't like seeing increasing inventory when a retailer can't even maintain, let alone grow, its top line. We'll need to keep an eye on inventory going forward, and in particular if revenues continue to decline.

Most alarming to me is that fact that Coach's margins were absolutely crushed in the fourth quarter. While still very elevated at more than 69%, Coach's gross margins fell 360 basis points in the fourth quarter, an enormous amount of gross margin dollars that flew out the door as customers didn't shop and Coach lost some pricing power. Gross margins are the most important metric for a retailer, as even a declining sales base can still be profitable, and while Coach still sports prodigious margins, having them fall at such a rapid rate is a red flag for me.

When you put all of Coach's operational issues together, including declining revenue, declining margins and increasing inventory, you've got a recipe for a stock you should sell. Analysts are forecasting Coach's revenue to increase more than 3% next year, and I can't see any justification for such an estimate. Further, earnings are expected to rise 10%, even though revenue and margins have been getting crushed for better than a year now. Where is this growth going to come from? Customers have voted with their feet in recent years and spent their money elsewhere. While Coach's brand is still very much intact, that isn't enough to forecast unrealistic growth, and I feel that is what analysts have done.

For argument's sake, let's assume the analysts are correct and Coach somehow magically finds 10% earnings growth next year; the stock is still too expensive. This company has a lot of issues it needs to solve before you can start slapping double-digit earnings growth targets on it, and given the most recent earnings report from about a month ago, those issues are just as deep as ever. I think Coach will fall into the $20s as more terrible earnings reports roll in, but at some point, the bleeding will stop and very weak comps will allow Coach to let it look like it knows what it's doing again. We are not there yet, so I would avoid Coach or, if so inclined, short it from $37; there is a lot of downside left in this story.

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.