We recommend a buy position on Coach (COH) due to its strong performance in the third quarter, which is expected to continue for the rest of the year, in addition to the fact that it is currently trading at cheaper valuations and has a respectable dividend yield of 2.1%. We also advise buying Ralph Lauren (RL) because we think that it is making the right moves for the long term, which have been discussed at length later on.
Industry Overview
After dismal performances in 2009 and 2010, this year the luxury market is up 19% as a whole, almost back to pre-recession levels. With the exception of two companies, all made pretty impressive gains. The three big reasons for this are: Asia's craving for luxury, a commitment to heritage, and the savvy use of digital media. Luxury brands had been wary of the digital realm for fear that it would hurt their exclusivity, but many successfully ventured into digital marketing this year. Chanel and Burberry both accomplished it in innovative ways while maintaining their status.
Coach
Company profile
Coach is a leading American manufacturer and retailer of leather goods, accessories and apparel for men and women. Coach occupies the affordable luxury segment, which provides high-end merchandise for both high and middle-income consumers. For example, prices for a Coach handbag can range from $298 to $6,000.
Coach is divided into three main revenue segments:
- Handbags (63% of net sales
- Accessories (28% of net sales)
- Other products (9% of net sales): These include footwear, business cases, jewelry, sun wear, travel bags, fragrance and watches.
As with any luxury or affordable luxury retailer, Coach heavily relies on an image of exclusivity to fuel sales. A luxury company can lose its "luxury" status if the brand becomes too easy to get or accessible. Coach thus takes a risk by having factory stores that sell discounted merchandise. None of Coach's competitors, such as Louis Vuitton and Gucci, has factory stores. However, Coach protects its luxury status by never selling the latest collection at these factory stores and by locating these stores at least 60 miles away from its full-price locations. There are no sales at the full-price stores. By having two different types of stores, Coach is able to serve two different sets of customers.
Drivers
The broad consumer shift to affordable luxury, improving economic conditions along with rapidly increasing demand for luxury goods in China and other emerging markets, are key factors driving Coach's growth.
Competition
Most of Coach's closest competitors are either privately owned or owned by larger European conglomerates. Hence, comparative data are unavailable. This includes Louis Vuitton and Fendi, both owned by LVMH Moet Hennessy L.V. (LVMUY.PK), and Gucci Group.
Coach's business model is distinguishable from the rest by the stress on "accessible luxury." This model thus reaches a larger demographic compared with many of Coach's higher-priced competitors, including Louis Vuitton, Gucci and Prada. These competitors tend to focus on a higher income, high-fashion demographic. Companies like Dooney & Burke and Cole Haan also emphasize "accessible luxury" and are Coach's most successful competitors; however, Coach's market share has continued to increase in their presence.
Coach is positioned well to take on competition from a recent upstart Michael Kors (KORS) too. For example, the fragmented fashion accessories segment is ripe for competition. Coach said the North American handbag and accessories market has been expanding at a rate of 10 percent. In 2011, Americans spent $8.5 billion on bags, according to Accessories magazine, an industry bible. We favor Coach because it takes a "portfolio" approach and brings products that cater to different price levels and fashion tastes while Michael Kors is busy moving down the fashion ladder to become increasingly accessible. Coach would be hard to catch as it has dominated the U.S. market for more than a decade and survived quite well through the recession. KORS may be prone to profit-eroding fashion "misses" according to Barbara Wyckoff, an analyst at Credit Agricole Securities USA in New York, who warns that Michael Kors' extraordinary growth is unsustainable.
Upcoming Catalysts
Economic slowdown in China may hit hard luxury retailers like Coach, which have significant exposure to the world's second-largest economy. China's economic expansion slowed during the third quarter of the year as government measures to control inflation hurt growth. Its economy grew at an annual rate of 8.1% in the first three months of the 2012, the slowest pace in almost three years.
Competition from Michael Kors Holdings Ltd., which went public earlier this year, and is aiming to more than double its North American stores to 400 and more than quadruple to 1,000-plus department-store boutiques. Michael Kors will operate in malls and street locations, sell accessories-heavy collections and focus on "accessible" luxury, like Coach.
Third-quarter results:
- Quarterly revenue rose 17%. Direct-to-consumer segment, which represents over 85% of business, including domestic retail businesses in Singapore and Taiwan, was up 18%, and indirect business rose 10%.
- Gross margin rate expanded 100 basis points to 73.8% compared with 72.8% the prior year, driven by manufacturing cost benefits and new pricing strategies implemented in the quarter.
- Cash and short-term investments stood at $930 million compared with $886 million a year ago
- Capital expenditure was $41 million versus $42 million in the same quarter a year ago. Consistent with global growth initiatives, Capex for this year will be in the area of $200 million, driven by new store openings across all geographies and investments in technology necessary to enable expansion.
- Earnings per share rose 24% to $0.77 compared with $0.62 in the prior year versus $951 million a year ago, an increase of 17%.
- Very strong sales growth of nearly 60% and double-digit growth in China. There would be an expected $300 million in sales this year from China; and finally, sales in Japan rose 10% versus prior year in constant currency and rose 14% in dollars.
COH Valuation
The strong performance by Coach in the third quarter is expected to continue for the rest of the year. It is currently trading at forward P/E of 14x and has a respectable dividend yield of 2.1%. It is 27% off its 52-week highs. With prospects like these, we recommend buying Coach .
Ralph Lauren Corporation
Ralph Lauren sells mid-tier basics to high-end luxury labels. As of March 31, 2012, the company operated 379 retail stores, 474 concessions-based shop-within-shops, and 6 e-commerce Websites. It has operations in the Americas, Europe, and Asia. RL consists of Polo, Club Monaco and Chaps. RL operates in three segments including wholesale (49% of revs), retail (48%), and licensing (3%).
RL is focusing on expansion to Asia like other brands. Asia (China, Japan and South Korea etc.) accounts for 12 % of its revenue and is the fastest-growing market for luxury brands. Recently, RL was under pressure because of its efforts to take more control of its China operations. This requires closing stores operated with a partner and replacing them with Ralph Lauren shops in more desirable locations. The company is planning to open roughly 60 stores in China in the next three years, all in prominent spots. "We see Ralph Lauren gaining global market share via targeted investments in new products and retail/e-commerce expansion," S&P Capital IQ analyst Jason Asaeda said in a note.
RL has forecast a "mid-single digit" percentage increase in revenue for this fiscal year, which began April 1. That compares with a 20 percent rise last year. Despite some pressures for the current year, the company's fourth-quarter profit surpassed the analysts' forecasts easily.
Net income rose to $94.4 million, or 99 cents per share, from $73.2 million, or 74 cents per share, a year earlier. That was 15 cents higher than Wall Street's average estimate, according to Thomson Reuters. Revenue rose 13.7 percent to $1.62 billion. Sales at stores open at least a year gained 12 percent, with the biggest increase coming from the Club Monaco chain. Apart from investments in global e-commerce and the upgrade of its systems and infrastructure, RL needs to sustain growth.
Concerns about Europe
Like other brands that have exposure to Europe, Ralph Lauren expects wholesale numbers to decline in Europe, which is struggling with a debt and currency crisis. Geopolitical concerns are likely to control the consumer psyche for some time. Wholesale sales will edge down, while retail sales growth should be in the low double digits, Ralph Lauren said.
Other Upsides and Downsides for RL
The upside for the company is that it gets the bulk of its sales in the United States (70%) though sales will also dip from J.C. Penney Co.'s (JCP) plans to dump Ralph Lauren's "American Living" brand this year.
RL is also helped by the fact that it has an early-mover advantage in the e-commerce segment. The e-commerce segment represents roughly 10% of total retail sales today (more than at any competitor), and its continued double-digit growth combined with new website launches (i.e., Japan 2013) will improve earnings.
RL would also benefit from a multi-year channel transition from wholesale (20.5% EBIT today) to retail (16.3%), which it is currently undergoing with emphasis on Asia. This will improve brand equity over time but constrict margins due to increased investment in the coming years.
Meanwhile, Ralph Lauren also said it was doubling its quarterly dividend to 40 cents per share. The forward dividend yield for the company is 1.1%, which is a little low compared with its peers.
RL Valuation
It is trading at a forward P/E of 15x. It is trading at $140, which is roughly a 22% down from its 52-week high value. The debt-to-capital ratio is 7% only and the company has generated annual free cash flow of $930 million over the past two years.
We advise buying the Ralph Lauren because we think that it is making the right moves for the long term.
Investors can use the Consumer Discretionary ETF (XLY) to hedge against the long positions in RL and COH.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
