Coach (COH), a leading American marketer of luxury handbags and other fashion accessories, posted lackluster results in Q1 fiscal 2014, which led to 8% drop in its stock price. The fashion retailer’s sales increased by 2% on a constant currency basis, but a weaker yen dragged its sales down by 1% to $1.15 billion. The company reported disappointing results in the North American region, where it continues to struggle in the women’s handbags and accessories market, owing to rising competition from fashion newcomers such as Michael Kors (NYSE:KORS), Kate Spade and Tory Burch.
Coach’s gross margin dropped by 100 basis points during the quarter and operating margin also slipped to 27.9% as compared to 28.6% in Q1 last year. We expect the profitability to continue to decline in annual terms during the coming quarters. However, the international (ex. Japan) and men’s businesses saw strong growth during the quarter and we expect them to be long-term growth drivers for the company.
Weak Performance In North America, Guidance Continues To Be Negative
Coach’s sales in North America dropped by 1% in Q1 fiscal 2014, with 1% and 6.8% fall in direct sales and comparable store sales respectively. We are discouraged by this significant decline in comparable stores sales as it indicates that Coach is losing market share to newer fashion players such as Michael Kors. The decrease in sales was also attributed to weak in-store traffic trends during the quarter.
The future guidance is also less promising as the company’s management projected the North American comparable stores sales growth to decline in the high single-digits for the rest of the fiscal year.  North America, contributes for around two-third of Coach’s sales and we believe intense competition in the women’s handbags and accessories market in the region will be closely tracked by the market in the coming months as it will play a vital role in the company’s share price movement. We believe Coach will continue to struggle in the North American market in the near-future due to increased competition.
Coach’s Transformation Strategy Being Undertaken To Boost Sales
Coach is undertaking a transformation of its brand to move from an accessories brand to a lifestyle brand. The company has introduced an innovative capsule collection of lifestyle categories such as bags, outwear and footwear in this holiday quarter as part of this move. It has also enhanced its marketing activities to spread this new brand image among customers. We believe the results of this strategy will take some time to yield significant results as a full reflection of this new brand image may take a few years to complete.
International Business Represents Long-Term Growth Driver
Coach’s international sales fell by 1% in dollar terms due to the weaker yen. However, it rose by 9% in constant currency basis. China continues to be a sweet spot for the company as sales rose by over 35% in the region driven by increased distribution and double digit comparable stores sales growth. The company has major expansion plans in China as it expects to grow its square footage by around 25% in the region during the fiscal year. It also forecasts sales to grow by more than 20% in China during the entire fiscal year. (Coach’s CEO Discusses F1Q 2014 Results – Earnings Call Transcript, Seeking Alpha, October 22, 2013)
Coach’s sales in the other Asian markets of Korea, Taiwan, Malaysia and Singapore also continued to grow at a strong rate. The fashion retailer has completed the acquisition of its European joint venture, and plans to open 50 wholesale and 10 retail stores across the region during the fiscal year. (Coach’s CEO Discusses F1Q 2014 Results – Earnings Call Transcript, Seeking Alpha, October 22, 2013)
Japanese sales fell by 2% on a constant currency basis, however, in dollar terms in decreased by 22%. We believe that a weaker yen will continue to pose a headwind to the company’s sales in the region in the coming quarters.
Coach also aims to grow its distributor-run business in Latin America, other Asia-Pacific countries (Australia, Thailand and Indonesia) and in the Middle East. Due to these measures, we think the proportion of international sales in Coach’s overall sales will increase in the future.
Men’s Business Also Holds Upside
Facing pressure in the women’s handbags and accessories market, Coach is focusing on the growing men’s business to increase its sales. Sales in the global men’s bags and accessories business rose by 25% in the first quarter and the company further estimates sales in this business to grow by over 20% during the fiscal year. 
We are in the process of revising our $59.50 price estimate for Coach’s stock.
- Coach’s CEO Discusses F1Q 2014 Results – Earnings Call Transcript, Seeking Alpha, October 22, 2013
Disclosure: No positions