Shares of Coach Inc. (COH) have declined 32.4% from their 52-week high of $79.70 achieved in March. At $53.86 per share, the stock is trading fairly close to the 52-week low of $48.24 and offers a 2.2% dividend yield. COH's tempting valuations and solid dividend growth prospects have convinced me to be a buyer at this level, given that a further downside appears to be very limited. In this article, I will elaborate on the analysis that supports my bullish view.
COH's valuations are compelling based on the company's strong financial performance relative to its peers. Comparing COH's financials to those of some fashion accessory retailers (see comparable analysis table below), COH's growth prospects appear to be the company's primary weakness. Analysts on average predict the company's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 10.8%, 11.1%, and 11.5%, respectively, over the current and next fiscal years. Those growth estimates are somewhat lower than the peer averages of 13.8%, 13.1%, and 15.3%, respectively. However, COH's EBITDA margin is forecasted to expand by 0.2%, slightly higher than the peer average of 0.1%. On the profit side, COH has a leading margin performance as all of the firm's profitability margins are the highest in the group and its capital return metrics are also substantially above the par. In terms of leverage and liquidity, COH carries almost no debt, and both the firm's current and quick ratios are fairly in line with the peer averages, reflecting a healthy corporate balance.
If looking at the other comp set consisting of some primary luxury retailers (see comparable analysis table below), one would make a similar conclusion on COH's relative financial performance. The growth potential remains a primary concern for COH, but the gap to the peer-average growth level is smaller. COH's profitability and capital return performance again dominates the peer group.
To summarize the financial comparisons, COH's mediocre growth rates appear to be the primary drag in the stock's valuations. However, given that the company's growth estimates are not overly lower than the peer averages, and the firm is considerably more profitable than most of the peers, the stock should deserve a valuation that is fairly in line with the peer-average level. Nevertheless, the COH's current valuations at 7.9x forward EV/EBITDA, 13.5x forward P/E, and 0.93x PEG represent average valuation discounts of 7.5% and 25.7% to the peer-average trading multiples for the fashion accessory and luxury retailing groups, respectively, suggesting an undervaluation (see tables above).
COH's forward P/E multiple has underperformed the trading multiple of the S&P 500 Index over the past 12 months. COH's P/E multiple premium has compressed from almost 40% in a year ago to just 2% at present (see chart below). I believe the stock should command a solid premium valuation over the market level given that 1) COH's estimated long-term earnings growth rate of 14.5% is significantly higher than the average estimate of 7.9% for the S&P 500 companies; 2) COH's robust profitability margins are also substantially higher than the market averages; and 3) the company has a trailing free cash flow margin at 20% and a sustainable dividend yield of 2.2%.
COH's 2.2% dividend yield is safely backed by the company's robust free cash flow and commitment for high dividend growth. COH's annual dividend per share has grown substantially over the past few years with a 2-year CAGR of 61.2%, and the annual dividend payment historically only represented a small portion of the annual free cash flow, meaning that there is an ample capacity to sustain a double-digit dividend growth down the road (see charts below).
According to a historical dividend yield chart shown below, there appears to be a pattern that subsequent to a dividend hike, the dividend yield initially rose but then dropped. Given the current low-interest market environment, this repetitive pattern may partially be owing to a strong demand from income-oriented investors. As such, the yield's upside is somewhat limited by that buying force. Assuming a reasonable dividend yield range between 2.0% and 2.5%, and supposing that COH would raise the annualized dividend per share by just 15% from the current level at $1.20 to $1.38 in April 2013 (COH usually raises dividend in April), this conservative scenario would imply a stock value range between $55.20 and $69.00, indicating that COH's downside is safely protected by the dividend growth.
According to Thomson One data, sell-side analysts have an average target price of $68.20 for COH, representing a 27% upside. Applying a 15.0x forward P/E multiple to the analysts' estimated FY2014 EPS of $4.44, one can arrive at a target stock price of $66.60. It is noted that the rationale for the 15.0x P/E multiple is based on COH's estimated long-term earnings growth rate of 14.5% and 1-year forward P/E average of 16.7x.
In conclusion, given the significant upside potential and solid downside protection, I believe COH currently offers an ample margin of safety and a tempting risk/reward profile. Therefore, I strongly recommend buying the shares now.
The comparable analysis tables are created by the author, all other charts are sourced from Capital IQ, and all financial data is sourced from Capital IQ and Thomson One.
Disclosure: I am long COH.