Coach: Why I Sold Covered Calls At $35 To $38

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Management has been doing a workmanlike job on the turnaround, as reflected in Fiscal 2Q 2016 earnings.

However, margins have not recovered to previous levels, and may not do so.

Current share prices may reflect excessive optimism on the future trajectory of margins.

Coach (NYSE:COH) shares responded positively to earnings for the company's second quarter (fiscal year ends in June), and are now trading in the $37 area. The second quarter is seasonally the strongest, and results have an outsize effect on yearly profits. Management continues the critical task of restoring the brand's iconic luster, previously dimmed by excessive promotional and outlet sales. Importantly, they are having success on that front.

From the conference call (transcript):

And as we increased our positive brand impressions, we continued to reduce the number of eOS events from prior year, and are now at our planned sustainable cadence of about two events a month or six to seven a quarter.

As a result of these efforts, we have seen continued progress with consumers in our quarterly North America brand-tracking survey, fielded in December. Importantly, our overall brand affinities remain strong with consumers. And this quarter, we were particularly pleased to see notable improvement among category drivers in the high quality and unique attributes compared to six months ago, which we believe is a direct reflection of the investments we have put into the make of our product.

At this point, the turnaround is developing favorably, and may be declared a success.

Margins, Earnings and Valuation

My original (hypo)thesis for Coach's recovery relied on the assumption that revenue could grow from a stabilized base at about the 2011 level, with margins returning to historical levels. Revenue is slightly above the projected level, and using quarterly ratios, a generic projection shows 2016 growing 3.2% over 2015.

Looking forward, management guides operating margins in the mid to high teens, 17.5% from my point of view. However, GAAP earnings will be less, about 5.5% based on recent history. With that in mind, I use 12% margin, and project normalized GAAP EPS at $1.87. Looking for growth of 5% (currency neutral), I apply a PE of 15.4, arriving at a fair value of $29.

On a more optimistic basis, if management is able to work GAAP net income as a percentage of revenue up consistent with their long term view, which I interpret as 17.5%, a share price of $42 comes into view. Probably the best bet is somewhere in the middle, about $35 per share.

Stuart Weitzman

The acquired business is developing favorably, as mentioned on the call:

We are also excited about Stuart Weitzman's results during the quarter, which exceeded expectations. Boots, in particular, sold well, notably in domestic retail stores and in spite of the unseasonably warm weather. Stuart Weitzman's strong outperformance against the category clearly reflected the brand's strong development of fashionable trend-right product as well as its growing relevance with increasing numbers of consumers globally. We are also excited to see Stuart Weitzman continue to gain traction internationally, notably in Asia where the brand is still nascent but has significant long-term potential.

Covered Calls as a Strategy

Coach has a definite seasonal pattern to its share price, based on speculation around the seasonality of earnings. I expect the shares to give back some of their recent gains and then head upwards as 2Q 2017 approaches.

As the price hit $35, I sold May 2016 calls at 35, 37 and 38. The market maker wouldn't buy at the bid for the 36 strike, so I sold more at 37. The thinking is, I will be paid to stick around, and wouldn't mind having the shares called away.

Reservations and Caveats

At this point, the future is very much dependent on margins. As the Christmas season progressed, Coach noted strong promotional and discount activity form the competition, and responded with more of the same. I conjecture that Michael Kors (NYSE:KORS) has over-expanded and will have some inventory to liquidate, pressuring the market for aspirational luxury handbags. Here's what management said on the topic:

I think in terms of how we dealt with the higher level of competitive promotional activity, we tried to be as nimble as possible. We played with couponing. We shifted within variable pricing in stores, handouts, multiples, et cetera. So we tried to be as nimble as we could. We were a little less blunt than we were in the past with sort of a one-off 50%-off coupon. We varied a lot our toolkit I'd say in promotions.

Competition which relies heavily on promotions reduces the strength of the brand. There's fine line to tread here, and it may affect margins long term.

On the 4Q 2015 conference call (transcript), CEO Victor Luis addressed the issue of long term margins:

Ultimately, our objective is to drive operating income dollar growth and restore Coach to a place of best-in-class profitability, which, reflecting the changing market dynamics, will now likely be in the mid to high 20%s given the required SG&A investments in marketing, customer experience and stores in a more competitive marketplace.

I believe he's talking about operating margins here, and adjusted downward by 10% to get at the GAAP bottom line. I see realism here: to remain competitive SG&A will have to be higher than it was in the past. That's how I arrived at 17.5% potential net income and the optimistic possibility of $42 per share.

Also, Coach sells in China, where the economy is not growing as rapidly as many expected.

Locking in a Loss

I've been in this trade for over two years, and if the calls I sold are exercised it will lock in a loss. The point is, unrealized losses are sunk costs, and should be disregarded in the decision making process.

I think share prices are somewhat ahead of current performance, and are pricing in positive developments that have yet to occur. Under the circumstances, the income from covered calls is attractive.

Disclosure: I am/we are long COH.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I sold covered calls over my position.