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Coach Inc. (NYSE:COH)

F3Q07 Earnings Call

April 24, 2007 8:30 am ET

Executives

Lew Frankfort - Chairman and CEO

Mike Devine - CFO

Andrea Shaw Resnick - IR

Analysts

Bob Drbul- Lehman Brothers

Margaret Major - Goldman Sachs

Jeff Edelman - UBS

Kimberly Greenberger - Citigroup

Paul Lejuez - Credit Suisse

Julie - Merrill Lynch

Melissa Otto - WR Hambrecht

Jim Hurley - Telsey Advisory Group

Presentation

Operator

Good day and welcome to the Coach conference call. At this time for opening remarks and introductions I would like to turn the call over to the Vice President of Investor Relations at Coach, Ms. Andrea Shaw Resnick. You may begin.

Andrea Shaw Resnick

Good morning and thank you for joining us. With me today to discuss our quarterly results are Lew Frankfort, Coach's Chairman and CEO; and Mike Devine, Coach's CFO.

Before we begin, we must point out that this conference call will involve certain forward-looking statements, including projections to our business in current or future quarters or fiscal years. These statements are based upon a number of continuing assumptions. Future results may differ materially from our current expectations based upon risks and uncertainties such as expected economic trends or our ability to anticipate consumer preferences. Please refer to our latest annual report on Form 10 K for a complete list of these risk factors.

Also, please note that historical trends may not be indicative of future growth. We presently expect to update our estimates each quarter only. However, the failure to update this information should not be taken as Coach's acceptance of these estimates on a continuing basis. Coach may also choose to discontinue providing future estimates at any time.

Now, let me outline the speakers and topics for this conference call. Lew Frankfort will provide an overall summary of our third fiscal quarter 2007 results and will also discuss our strategies going forward. Mike Devine will then discuss details on financial and operational highlights for the quarter as well as our outlook for the fourth quarter and full year fiscal 2007 and our preliminary goals for fiscal 2008. Following that, we will hold a question-and-answer session that will end promptly at 9:30 a.m.

I would now like to introduce Lew Frankfort, Coach's Chairman and CEO.

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Lew Frankfort

Thanks Andrea, and welcome everyone. Once again, I am pleased to be speaking with you today about another terrific quarterly performance which reflects the strength of Coach brand, the power of our new product introductions, and the sustained rapid growth of the U.S. handbag and accessories category.

Clearly, the Coach proposition is very strong, generating increased levels of interest with both new and existing consumers, evidenced by both our double-digit comps at retail and the extremely high level of POS increases we are achieving in U.S. department stores this spring.

Before we get into the financial highlights of the quarter, I want to briefly touch on the closure of our small corporate accounts business through which Coach sold products to distributors for corporate gift-giving and incentive programs. As noted in the press release, we have decided to cease operations of this business in order to better control where our product is ultimately sold. Simply put, our goal is to curtail diversion of our product into non-image-enhancing environments such as the warehouse retailers and the discount chains.

Now, I would like to discuss the outstanding results of our continuing business. We just announced a sales increase of 30%, and a 50% increase in earnings per share for the quarter just completed on a continuing basis. It's worth noting that this was the 21st consecutive quarter that Coach achieved sales growth of at least 20%.

Some highlights of our third fiscal quarter were:

First, net income rose 45% to $147 million or $0.39 per share, compared with $102 million or $0.26 per share in the prior year;

Second, net sales totaled $625 million versus $480 million a year ago, a gain of 30%;

Third, direct to consumer sales rose 29% to $481 million from $374 million in the prior year;

Fourth, U.S. same-store sales for the quarter rose 20% with retail stores up 15.1% and factory stores up 26.6%. It's worth mentioning that in U.S. retail stores we have achieved a double-digit comp for 20 consecutive quarters.

Finally, sales in Japan rose 15% in constant currency, driven by distribution growth and low single-digit overall comps as we continue to grow our market share.

During the quarter, Coach opened seven North American retail stores including three in new markets for Coach: Tallahassee and Gainesville in Florida and Portland, Maine. At the end of the period, there were 244 full price and 90 factory stores in operation in North America. In Japan, five locations were opened, including one stand-alone retail store and four shop-in-shops, while three retail locations were expanded. At quarter end, there were 136 total locations in Japan.

Indirect sales on a continuing basis increased 36% to $144 million from $106 million in the same period last year. POS sales at U.S. department stores sustained the second quarter’s torrid pace of over 30% and shipments into this channel were also very strong while we also realized significant gains in international wholesale shipments.

More generally, we estimate that the U.S. handbag and accessory category sales grew by 20% during the fall season, through December, as well as for the spring season through March. We were especially pleased with the continued performance of Coach North American retail stores which achieved another stellar quarter. Each metric of comp enjoyed healthy increases especially conversion and traffic, while average transaction size increased but at a lower rate than the second quarter.

Results in our full-priced businesses, both Coach retail stores and U.S. department stores, continue to be driven by the monthly flow of fresh and relevant product, especially new lifestyle collections such as Signature Stripe, Legacy and most recently, Ergo. It is worth mentioning that our U.S. factory store business also remains exceptional this quarter, reflecting the vitality of the Coach brand, the appeal of our product, our excellent value and the strength of premium factory incentives. Our sustained factory store sales growth reflects our ability to successfully offer two distinct store concepts, attracting two distinct consumer groups.

I also want to spend a minute on our Internet business, which achieved a 68% sales gain this quarter driven by significant increases in traffic and conversion. With over 13 million visits in Q3, Coach.com is a powerful marketing tool which drives traffic into our retail store. In addition, our online sales and conversion have benefited from site enhancements, a segmented email strategy and improved online merchandising. It's worth mentioning that our average Internet guest visited the site almost three times during the quarter, similar to the cadence of our monthly new product flow.

We were also very pleased with the performance of Coach Japan this quarter, where sales rose 15% in yen and 13% in dollars. Growth in Japan was fueled primarily by distribution through both new stores and expansions, augmented as expected by low single-digit comparable locations sales as our market share continued to expand against a weak category backdrop.

Finally, as always, we were pleased by the significant improvement in operating margins. While Mike Devine will get into more detail on our financials, I wanted to give you this recap of Coach's excellent third quarter performance and touch on some of the product highlights.

Across all businesses, handbag's and women's accessories continued to propel our business results as the look of our assortment continues to evolve to reflect changing consumer preferences. Earlier in the quarter, we saw excellent response to the Silhouette, a new shoulder bag group within Legacy, and an updated Hampton’s collection. In February, fresh interpretations of Signature Stripe sold very well, as did Soho. After Valentine's Day, the Hampton’s Weekend collection, including a new and distinctive patchwork design, was also successful.

We were particularly pleased with the performance of our new Coach fragrance, which launched in early March and represented over 3% of retail sales since its introduction. It's also worth mentioning that our over $400 handbag offering continued to perform quite strongly and comped at over 40%, representing 13% of handbags sales in the quarter.

Our business this April has continued to be robust, as we completed the introduction of Ergo, our third major new lifestyle platform for fiscal 2007, with considerable success. This month, we also successfully launched our Watercolor Stripe group, which complements Hampton's Weekend, our popular straw baskets and our best-selling Legacy silhouettes offered in a chic, neutral canvas. For Mother's Day, we're featuring a Legacy cotton Signature assortment building on the success of last year's small capsule group. Coming in June will be patchwork, a perennial favorite across a variety of best-selling Ergo styles and new styles as well as new styles and fabrications in Signature Stripe.

Looking forward to fiscal 2008, we are particularly excited by our two new lifestyle platforms which will be introduced into what is shaping up to be another year of rapid category growth. First, Bleeker will be arriving in October, and the second platform is Heritage Stripe, which will be fully launched in early spring. Of course, we will have the carryforward impact of the new lifestyle collections we launched during this year as we plan to update them with distinctive new styles.

Naturally, we are delighted with our performance and what this bodes for the seasons and years to come. Our opportunities notably in North America are virtually unlimited, given the strength and saliency of the Coach brand, our ability to bring innovative, relevant product to market at an accelerated pace, while gaining in new categories such as jewelry and fragrance as our FY07 results bear out.

Further, as I mentioned, we have seen no slowdown in the sustained and rapid category growth that we have experienced during the last several years. Last quarter, we discussed the key drivers of this category growth which remain intact as follows:

First, each year women are buying more handbags as they are increasingly using accessories to play a leading role in updating their wardrobes. As you know, this is a long-term trend which has developed over many years.

Second, the trend is broadening across geographies and demographics which is evidenced by the continuing traffic gains we realizing in Coach stores. These gains are in part coming from new consumers, many of whom are trading up to Coach as well as the strong sales we are experiencing in secondary markets such as Fresno, California which was open last year and Evansville, Indiana which opened earlier this year. We're also seeing increased interest from the moderate customer. This is clearly illustrated by the category strength in department stores, where the average handbag price continues to rise dramatically.

Third, we continue to see more square footage devoted to the category in department stores, given its relative outperformance, creating a virtuous cycle.

Fourth, new players are entering the accessories category, which is a good thing as it drives interest, while disproportionately benefiting the market leaders. Our latest analysis estimates that at least one-third or more of new consumers are actually trading up to Coach; once again, pointing to a larger market opportunity beyond the traditional premium buyer that we have always considered our target consumer.

Finally, we would point to the sales levels we are achieving in the stores we have opened in the first half of fiscal 2007. Excluding Mohegan Sun, which is running at over an $11 million clip, compared with our plan of $7 million which would unduly influence the average, the other 18 stores opened during our first half, generating annual volumes of $2.1 million, more than 20% higher than our pro forma. Further, this level of strength is consistent whether at the Mall of Georgia in Beaufort, our fifth store in the Greater Atlanta market, or at CLO Vista in El Paso, Texas, a new market.

Two weeks ago, I was traveling with Mike Tucci on the West Coast when we visited about 15 stores in the Southern California market and saw new Coach stores in malls such as the Galleria at Tyler in Riverside and the shops at Dos Logos in Corona, outside of the Los Angeles market. Both are excellent examples of Coach stores that are performing very well and represent a great opportunity. These stores are part of multi-store portfolio packages with key mall developers which provide us with an exceptional economics. They also illustrate our success with new stores, which opened outside of a major metropolitan area.

Thus, with the accessories market rapidly expanding and the Coach brand so vibrant, the potential for Coach in its current concept is clearly greater than we ever thought possible.

As most of you know, we have been implementing five key strategies that focus on sustaining growth within our global framework. Clearly our first priority and still our largest opportunity is North America. First, most generally, we are building market share in the rapidly growing North American women's accessories market by leveraging our leadership position as a top of mind and preferred brand for self purchase and gifts. As part of this strategy, we have been emphasizing new usage occasions such as weekend, through such collections as Signature Stripe, introduced this fiscal year in the first quarter; and more sophisticated product such as Legacy, introduced last fall to heighten our cache, especially with our higher end customers.

We are confident that our new collections in the pipeline for FY08, notably Bleeker and Heritage Stripe, will further enhance our appeal. The Bleeker Collection will offer the consumer a lightweight and fresh interpretation of bags and accessories inspired by our bestselling icons. It will be priced midway between our core collections and Legacy. The Heritage Stripe collection features our signature padded uncoated cotton canvas, a first for Coach. This is a fabric which has long been appreciated by consumers for being chic, durable, sporty and timeless.

Our second strategy is the continued rapid growth in North American retail. We plan to add about 40 retail stores in North America in each of the next several years. We will grow our North American retail store base with a continued focus on adding stores within existing markets, opening new markets in the U.S. and by accelerating our store openings in Canada, where we have only have four locations today.

Given the larger addressable market for Coach, we now believe that North America in total can easily support about 500 retail stores, including up to 20 in Canada. This roadmap for expansion is based upon a buildup of individual malls and locations that have already met our demographic requirements and economic hurdles.

Our FY07 retail openings include seven completely new full-priced markets for Coach, five of which we mentioned already opened during the first nine months of the fiscal year and two coming in the fourth quarter. Also in keeping with our strategy to expand our most productive locations, we will also be expanding seven retail stores this year, all in the fourth quarter. In aggregate, these 40 new stores will add over 100,000 square feet to our retail store base during FY07 while expansions will add 6,000 additional square feet.

We are also planning on opening three more factories stores in the fourth quarter of this year and expanding three more outlets as well, given the success we have experienced through our previous outlet store expansions. Thus in total, factory store development in FY07 will add about 40,000 net square feet to our store base. Therefore, in total, the square footage of our North American Coach stores will, in aggregate, grow about 17% in FY07.

For FY08, we expect to open 40 new North American retail stores which will include 11 completely new markets such as Wichita, Kansas and Baton Rouge, Louisiana, to name just two and more than five new factory locations as well. In addition, we will be expanding at least 10 retail stores and several factory stores. Taken together, we would expect total square footage to grow at a similar rate in FY08 as we are realizing this year.

Third, outside the U.S. we are continuing to increase market share with the Japanese consumer, driving growth in Japan primarily by opening new retail locations and by expanding existing ones. During this fiscal year we expect to open a total of 19 net new locations in Japan and similar to the U.S. we will expand about ten of our most productive retail and factory locations. Taken together, they will add about 35,000 square feet, or 18% to our store base in FY07.

For FY08, we plan to open about ten to 15 net new retail locations and a few factory outlets as this channel becomes more important to Japanese consumers. We will also continue to expand key locations. Overall, we expect to increase our square footage in Japan at about the same rate in FY08 as we are growing it this year. Despite the continued weakness in the Japanese luxury accessories market, we are continuing to target constant currency sales growth of 10% to 15% for both the balance of this year and for FY08, driven primarily by distribution growth and low single-digit comps.

Our fourth strategy is to raise brand awareness in emerging markets to build a foundation for substantial sales in the future; specifically Greater China, Korea and other emerging geographies were the category is rapidly growing and Coach is taking hold, are increasing in importance. During the third quarter, six net new Coach locations opened internationally, primarily focused on Asia and the Middle East. For FY07 we expect to open a total of about 30 net new international locations, including seven net new locations in Mainland China.

During FY08, we now expect to open through distributors about 30 net new locations focused on Greater China, Southeast Asia and the Middle East. It remains our intention to open at least ten more locations in major cities in Mainland China during the next two years, bringing our total to at least 20 locations.

Lastly, of course, we continue to have an overall focus on improving the rate of profitability so that our bottom line results continue to outpace top line performance.

Coach continues to evolve as the house of American accessories for the 21st century, providing an integrated environment in which the broad and diverse fashion attitudes and functional requirements of our loyal consumers are not only met, but also inspired. At the same time, we continue to focus on strengthening the emotional bond between Coach and our consumer through great product fulfillment, store visits and compelling clientele programs.

I will now turn it over to Mike Devine, our CFO, for further detail on our financials.

Mike Devine

Thank you, Lew. Lew was just taking you through the highlights and strategies. Let me now take you through some of the important financial details of our third quarter results. Before we get into the details, I thought it might be worthwhile to touch on our exit from the corporate accounts business and its impact on both historical financials and our original expectations for FY07 so that you can adjust your models accordingly.

Simply put, the business has represented about 3.5% of sales over the last few years and a somewhat larger percentage of our earnings on an incremental basis as we allocate no corporate design or other centralized function expenses to this business. For example, in FY06 the business generated $76 million in sales, and $0.08 in earnings per share. These figures are clearly laid out in the supplemental table included in our press release from earlier today.

Had we continued to operate the business at first half '07 levels, we would have expected to generate about $90 million in sales and over $0.10 in earnings for the full year. We posted $0.06 of EPS in the first half, which is also in our supplemental table. Therefore, we were anticipating about $0.04 in the second half of the fiscal year, equally divided between the third and fourth quarters.

As noted, we decided to exit the business early in the third quarter, generating sales of $8 million and EPS of under $0.01 for this stub period. It's worth noting that while we have shut this business down, we will see a run out over the next few months, albeit at a very modest level, as we do plan to fulfill a small amount of outstanding orders. As results from this business are now considered discontinued operations, all discussion of our results here and in the future will be on a continuing operations basis only.

Let's get back to the results from our continuing operations. As mentioned, our quarterly revenues increased 30% with direct to consumer which represents over three-quarters of our business, up 29% and indirect of 36%. Both our POS sales and U.S. department stores and shipments to these customers increased significantly during the quarter. We also saw continued double-digit POS sales growth in international sales, led again by domestic doors as well as a rebound in shipments.

Net income for the quarter increased 45% to $147 million compared to $102 million, while earnings per share rose 50% to $0.39 per share versus $0.26 per share in the year-ago period. Including discontinued operations, albeit for only the partial quarter, total earnings per share were $0.40. This was ahead of the analysts' unadjusted consensus estimate of $0.38 for the quarter.

Our operating income rose 48% to $227 million in the third quarter versus $154 million in the same period last year. Operating margin in the quarter was 36.2% compared to 32% in the year-ago quarter, a 420 basis points improvement. In the third quarter, gross profit rose 29% to $486 million, up from $376 million a year ago, while our gross margin rate continued to be exceptionally high, at 77.8% as compared to 78.4%.

SG&A expenses as a percentage of net sales were well below prior-year levels in the quarter and represented 41.5% of sales versus 46.4%. Naturally, the leverage we achieved on our U.S. stores was significant, given the level of comp reported for both channels. We also saw excellent leverage on what we refer to as our semi-fixed corporate functions.

Inventory levels at quarter end were $250 million, about 19% above prior year levels and well below our sales increase. Further, this inventory increase allows us to support 44 net new U.S. stores, 20 net new locations in Japan and the substantially increased sales levels. Accounts receivable balances rose $14 million or 13%. Again, well below our sales growth of 30%.

Cash and short-term investments stood at $936 million as compared with $838 million a year ago. Net cash from operating activities in the third quarter was $97 million compared to $98 million last year during Q3, as timing of interim cash tax payments in this year's Q3 offset our significant cash increase from net income. Free cash flow in the third quarter was an inflow of $72 million versus $49 million in the same period last year, mainly due to higher net income. CapEx spending primarily for new stores and renovations was $25 million versus last year's $49 million.

Now I would like to provide you with some of our updated goals for fiscal 2007. For the fourth quarter, we are targeting net sales of $640 million, representing a year-on-year increase of 28% from last year's $501.6 million on a continuing basis, with U.S. comparable store sales gains of at least 10% in the retail channel and mid-teens in the factory channel and a low single-digit total comp gain at Coach Japan.

Operating income, up about 36%, reflecting more than a 200 basis point improvement in fourth quarter operating margin year over year. EPS of about $0.40, an increase of 36%. We will compare this guidance to an adjusted analyst consensus of $0.38 for continuing operations, given the $0.02 contribution we originally expected from corporate accounts in the fourth quarter which would then go to the published consensus of $0.40.

Therefore, our current goals for the full fiscal year are net sales growth of 28% to at least $2.6 billion; and we are targeting an operating margin increase of 300 basis points to nearly 38%, driven by further SG&A leverage; operating income dollar growth of about 37% above FY06, with interest income of about $40 million, adding to pretax income, while net income will be somewhat offset by a higher tax rate at about 38.5% for the year, due to the fact that incremental taxable income is being taxed at higher rates.

Including these factors, we expect to generate EPS growth of 40% on a continuing basis which will produce earnings per share of $1.67. Again, we would compare our guidance to an adjusted analyst consensus of $1.62, given the $0.10 contribution we originally expected from corporate accounts for the year, which would then foot to the published consensus of $1.72.

For FY07, we continue to expect CapEx to be about $160 million, primarily for new stores and expansions both here and in Japan. As Lew noted, we will be opening 47 net new U.S. retail and factory stores and continuing our North American expansion program. In Japan, we will be opening 19 net new locations.

Our preliminary goals for the full fiscal year 2008 on a continuing operations basis are net sales growth of about 20% to at least $3.1 billion, with at least 10% comparable store sales gains in both the U.S. retail and factory channels and low single-digit comp location sales gains in Japan. With our continued focus on profitability, pretax income dollar growth of nearly 25% above FY07 levels.

Again, two factors will somewhat moderate that growth on the EPS line in 2008: a higher share count brought about by option exercises; and secondly, a higher tax rate rising to about 39% due to the fact that incremental taxable income will be taxed at higher rates. Taken together, this will produce net income growth of nearly 24% and earnings per share of at least $2.02, up at least 21% from the $1.67 targeted for FY07.

Once again, we would compare our FY08 guidance to an adjusted consensus estimate of $1.98. We estimate an $0.11 contribution from corporate accounts was embedded in next year's analyst estimates to yield the current published consensus of $2.09.

While these are our current goals, our actual results may vary from these targets based upon a number of factors including those discussed under the business of Coach Inc. and risk factors in our annual report on Form 10 K. Coach does not assume any obligation to update these targets as the year progresses. In summary, we are confident that our growth strategies will enable us to continue to gain share in the large and growing global market for fine accessories and gifts.

Thank you, everyone for your attention. Lew, Andrea and I will be happy to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bob Drbul - Lehman Brothers.

Bob Drbul - Lehman Brothers

Lew, the question that I have with the results today and the decision to exit the corporate accounts business is, why would you do that today? Why now? What led you to that decision at this point in time? It is a very profitable business.

Lew Frankfort

Sure. For us, it became a brand integrity issue. We conclusively learned that many of our corporate accounts were diverting goods to unauthorized channels. You have heard and we have talked about our product turning up in such places as Costco. The only way to control where our product is sold was to exit this business. It's the right thing for the franchise and we decided to do that.

Operator

Your next question comes from Margaret Major - Goldman Sachs.

Margaret Major - Goldman Sachs

Hi Lew and everyone and congratulations on another tremendous quarter. I have a couple questions. First of all, when you look at next year's openings, the uptick in your ultimate target of 500 stores, could you just talk about existing market opportunity versus new market opportunity in the context of the total potential? With the same-store sales for this quarter, where you said traffic and conversion are quite strong but average transaction value was down a little bit versus last quarter.

Lew Frankfort

I am sorry, Margaret. It was down slightly compared to second quarter. It was still high, but the increase was lower.

Margaret Major - Goldman Sachs

Thank you for that clarification. In the context of your outlet for fiscal '08, same-store sales and full price targeted at 10%. Can you talk about how you think of anniversarying the launch of Legacy in September/October and the acceleration of your business that resulted from that launch? How does that factor into your 10% comp guidance? Would you think that once you start anniversarying that it may be below 10%? How do you think about it over the course of the year? Thank you.

Lew Frankfort

Your first question has to do with new and existing markets. We estimate that about 75% to 80% of new stores will be open in what we would call existing markets, with the remaining 20% to 25% in entirely new markets. However, what we have learned, Margaret, is what we often refer to as an existing market when we open a new store, it's a new market because most of the consumers who are shopping within that area are either new to Coach or primarily only shop in that area.

A perfect illustration in the Tristate area is Jersey City. We consider Jersey City an existing market, yet when we opened a store and spoke to our consumers, most of them did not shop previously in any other Coach stores.

In terms of our overall comps, which we are extremely pleased with, I'd like to just go back over them. They were primarily driven by increases in conversion and traffic and a modest increase in average ticket, lower than the mid single-digit increase that we experienced in Q2 versus the prior year. That was in part due to the introduction of new items, lower-priced items in February such as fragrance, which has a lower AUR, and we found ourselves selling a great amount of fragrance units.

The other thing, when we look at our comp is in Q3, we did have a considerable amount of returns from sales in Q2 that were actually recorded in Q3. You cannot look at any changes from Q2 to Q3. Our comps were extremely strong. Relative to next year, we are projecting comps of at least 10% and this is the highest guidance we have ever gave at this time in our history for a new year. If you go back to last April or any prior year, we were never as bullish as we are now.

That is driven by a confluence of factors: the strength of the Coach brand; our new collections that we are introducing in '08; of course the expansion of jewelry, as well as the carryforward of the existing collections; and overall the vibrancy of the brand and the continued expectation of category growth. So, you can look forward to only good things from us.

Margaret Major - Goldman Sachs

Can you specifically address how price factors into the comp guidance for fiscal '08 pricing? I know it is mixed, not just raising prices, but could you just address that?

Lew Frankfort

The short answer is that we are looking at our comps to be primarily driven by conversion first, traffic second and average ticket third. We see average ticket in many ways as a bonus, as a dividend. Our job is to convert more people that visit and our challenge, of course, is to have higher traffic year on year. Our conversion and traffic were up very substantially in Q3, continuing the trend that we have experienced since last July. We see no reason to expect that to decline.

Margaret Major - Goldman Sachs

Congrats to you and everybody at Coach.

Lew Frankfort

Thank you.

Operator

Our next question comes from Jeff Edelman - UBS.

Jeff Edelman - UBS

Thank you, good morning and nice job. As we think about the new product flow which has clearly had a positive impact, would you discuss the disposition and then phase out of the older lines? Has this moved into the factory outlets and has this been an extra catalyst behind those sales?

Lew Frankfort

Let me go to the question at the end. The answer is no. Only about 20% of our sales in factory stores come from discontinued product. Most of our sales are either product made exclusively for factory or products that we have made from discontinued products of several years ago. So, the short answer is what is going on in factory is unique to factory. You know, Jeff, that the consumer is older, she's more functionally oriented, she likes leather and she likes to make a greater investment. The bags tend to be more straightforward than they are in full price.

Jeff Edelman - UBS

I believe you are making some selective price adjustments on Legacy as we look at fall holiday '07. Are we seeing that occur in any other product lines?

Lew Frankfort

Without making adjustments in existing styles, what we do each year when we introduce new styles is we obviously look at what the costs are, the make, the amount of materials, the amount of time it takes to make a product and we develop a first course and out of that we determine a fair price. The Legacy products that we are introducing next fall, some of them do have additional make and are more complex with additional ornamentation and detailing; certain products are increasing in cost.

Operator

Your next question comes from Kimberly Greenberger - Citigroup.

Kimberly Greenberger - Citigroup

Mike, I was wondering if you could comment on your SG&A, if you could just give us any sort of rough breakdown on the contribution to the decline in SG&A rate of 490 basis points. Any detail there would be helpful.

On the gross margin line, if you could talk about mix versus any other pressures that you might have seen during the quarter, as slight as it was, that would be helpful as well. Thanks.

Mike Devine

Let me just start off by saying we couldn't be more thrilled with our improvement in operating margin, up 420 basis points over Q3 last year. As you point out, it's largely being driven by improved SG&A leverage. The good news is we're getting it from a number of sources. As we mentioned in the prepared remarks, the comps that we are driving through our North American retail business is delivering improved SG&A leverage. We are also seeing it in our indirect sales groups, particularly in U.S. wholesale where we're seeing shipments up dramatically with very modest increases in sales support necessary to drive that business.

We also saw for the second quarter in a row, a very modest amount of SG&A leverage to Coach’s total P&L coming out of Coach Japan. The lion's share, the majority of the SG&A improvement, is coming through our corporate functions; our centralized activities, that as we grow the top line at 30% rates, SG&A leverage is pouring into the operating income line. We're very excited about that.

If I could then now switch to your question on gross margin rate, again we are very pleased actually with our gross margin rate. In many ways we feel it is healthier this quarter than it even was last quarter, albeit down from last year. We are seeing organic gross margin improvement, we're seeing good things going on within each channel and it's really channel mix which is I think is what you were referring to, that's driving the negative year-over-year performance. When you see our factory channel growing as quickly as it is, that’s going to have a negative channel mix impact. We also see Coach Japan, which is our highest gross margin channel, while we are thrilled with the 15% constant currency growth, it is not at the overall 30% growth. That is also having a negative impact. The indirect business that is pouring so much SG&A leverage in also grew more quickly than the company as a whole and also had a negative impact.

So, great organic gross margin rate trends but the underlying channel mix issue that you referred to is causing a negative year-over-year compare. We don't believe that is a concern, we focus on operating margin. We do expect to see the negative channel mix impact us again in Q4 because the trends in our business are going to continue: very strong factory growth, more modest growth at Coach Japan and we're seeing incredibly strong trends continue into 4Q in the U.S. wholesale channel.

We will expect, as I talked about in the prepared remarks, to once again see operating income grow significantly over prior year.

Kimberly Greenberger - Citigroup

Great Mike, that was very helpful. On the SG&A rate declines that we are seeing, as you look out into fiscal '08, how would you expect the composition of the improvement in SG&A to change? Or do you expect it to come from areas that you saw in the third quarter? Thanks.

Mike Devine

Kimberly, I think we are going to see the same trends continue: leveraging with strong comp growth, that is a business with a lot of variable expense, adding new stores, et cetera. At the comp rates we projected, we expect to be able to hold steady on an SG&A rate there and then have the top line growth leverage our centralize our functions. So, I think we will see trends continue.

Operator

Your next question comes from Paul Lejuez - Credit Suisse.

Paul Lejuez - Credit Suisse

Just of little bit more on the gross margin line. Can you talk a little bit about input prices, labor that you are seeing over in the factories in China, leather costs? I was just wondering if there has been any change to the percent of your shoppers that cross over between retail and factory?

Lew Frankfort

Let me just take the second part first. Zero, Paul. There is absolutely none. In fact, we're opening full price stores in what was previously factory store markets and enjoying great results in our full price business without losing anyone from the factory store channel. It is a distinct consumer.

Mike Devine

Back to gross margin, yes Paul, there are some inflationary pressures on some of the elements of our cost of goods sold. The good news is though that with the hard work of the sourcing team to this point we have been able to largely offset them. The pricing power that we have been able to enjoy has been able to offset them and that is why we are enjoying the strong organic gross margin improvements that I talked about earlier.

Paul Lejuez - Credit Suisse

The share guidance you gave as part of your EPS, you said that it would be higher. Are you including any share repurchase activity in your estimates?

Mike Devine

No, we are not estimating any additional share buybacks at this time.

Operator

Your next question comes from Lorraine Makis - Merrill Lynch.

Julie - Merrill Lynch

You have been growing your market share pretty steadily in Japan. Have you changed your strategy there at all recently, other than expanding your distribution?

Lew Frankfort

We have become more sophisticated as we have gotten to know the market better. And as a result, we are focused more on clientele programs and are able to drive more purposeful business into our stores. We are actually developing some of the same Coach service components that we have so successfully introduced in the United States into Japan.

Julie - Merrill Lynch

Can you talk a little bit about the profitability over there? I know you mentioned that SG&A came down for the second quarter in a row. Do you expect that to continue?

Mike Devine

We are really calling for flat a SG&A year for '08 coming out of Coach Japan. We are conservative planners so we will see as we actualize where it really comes in, but I wouldn't model it as being a significant contributor to SG&A leverage going forward when I spoke earlier, the way we think about our centralized functions. The store profitability in Coach Japan is the highest of any of our stores globally, because of the price premium we enjoy and other luxury brands enjoy in Japan, so driving top line growth and continuing to take market share ultimately, of course, will drive earnings per share and that is our strategy.

Operator

Your next question comes from Melissa Otto - WR Hambrecht.

Melissa Otto - WR Hambrecht

Congratulations on a great quarter. Just a follow-up question on Japan. Are there opportunities to improve the productivity of the stores and could you articulate some specifics that might actually get that comp to be a little bit better than low single-digits?

Lew Frankfort

Let me first say Melissa, we are pleased with the low single-digit comps. We're opening a lot of additional locations in Japan, which is obviously a much smaller market geographically than the United States. We are finding there is some trade off and our entire strategy is to build market share. You need to appreciate that our growth is occurring in an environment that is extremely lackluster.

Having said all that, we are constantly focused on improving the experience consumers have when they visit our stores. I mentioned a moment ago that we are adopting many of the practices we have successfully introduced in the United States to create special moments for customers so that we can engage with them more effectively so that they will visit us more frequently. It's a never-ending pursuit of improving service and that will continue.

Melissa Otto - WR Hambrecht

I just had a quick follow-up on China. You had mentioned that in China you are hoping to get to a target of 20 stores. Any color on the pirating going on there, the copies around the Coach bags and how that might be impacting your business or not really impacting your business?

Lew Frankfort

First, we are pleased that over recent years we have found a growing respect in China for intellectual trademark rights. They have been working cooperatively with us to reduce and eliminate counterfeiting wherever it can be detected. It has not been a material problem for us whatsoever.

Melissa Otto - WR Hambrecht

That is great to hear. Thank you so much and congratulations.

Operator

Your next question comes from Jim Hurley - Telsey Advisory Group.

Jim Hurley - Telsey Advisory Group

I would like to add my congratulations as well. The question I have is on the tiered merchandising strategy that worked so well in the full price retail stores. Just wondering where you are with employing that strategy both in the factory outlet and also in Japan? The other question relates to fragrance and whether or not fragrance is a destination purchase in the store or if it was more an add-on purchase with other items?

Lew Frankfort

With regard to tiered merchandise, in Japan we have actually a very similar structure to the one that we have in the United States where we do have three primary levels of stores: core fashion and flagship. What we have found in Japan is what we are experiencing in the United States, increasingly our stores are graduating up from one level to the next as our brand appeal broadens in all areas.

In factory, we do not have a tiered merchandising approach per se, but we actually do analysis of demographics and selling by types of store and we have modified our assortments and the levels of merchandise to reflect the different consumers so that in the most high end factory stores you will see a somewhat more dominant preference of the more sophisticated part of the factory assortment.

With regard to fragrance, as you know, we did a fairly extensive marketing campaign where we launched fragrance and that spurred a great deal of interest. What we're finding is that about 75% or 80% of consumers who are buying fragrance are existing Coach users, which is not a surprise, its expected and that’s what we were hoping. We are finding that a good number of consumers are coming in just to sample our fragrance. With Mother's Day and coming we expect fragrance to be very strong item.

Andrea Shaw Resnick

Thank you, everyone it is now 9:33. The market is open and we are going to conclude our call. As always we will be available all day today for your questions. Thanks and have a great one.

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