Coach, Inc. (COH) Q2 2017 Earnings Conference Call January 31, 2017 8:30 AM ET
Christina Colone - Senior Director, Investor Relations
Victor Luis - CEO
Andre Cohen - President, North America and Global Marketing
Andrea Resnick - Interim CFO
Robert Drbul - Guggenheim Securities
Ike Boruchow - Wells Fargo Securities
David Schick - Consumer Edge Research
Erinn Murphy - Piper Jaffray
Oliver Chen - Cowen & Co.
Anna Andreeva - Oppenheimer
Michael Binetti - UBS Securities
Mark Altschwager - Robert W. Baird
Brian Tunick - Royal Bank of Canada
Good day, and welcome to this Coach conference call. Throughout the presentation, all participants will be in a listen only mode. Afterwards we will open the floor for your questions. [Operator Instructions] Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Christina Colone, Coach’s Senior Director, Investor Relations.
Good morning. Thank you for joining us. With me today to discuss our quarterly results are Victor Luis, Coach's Chief Executive Officer; and Andrea Shaw Resnick, Coach's Interim CFO. Andre Cohen, President of North America and Global Marketing, is also joining us.
Before we begin, we must point out that this conference call will involve certain forward-looking statements. This includes projections for our business in the current or future quarters or fiscal years. Actual results could differ in a material manner. Additional information about risks and another important factors that could cause results to differ from those in the forward-looking statements can be found in our latest Annual Report on Form 10-K and our other filings with the Securities and Exchange Commission.
Also, certain financial information will be presented on a non-GAAP basis. These non-GAAP measures exclude certain items related to our transformation plan, operational efficiency plan and Stuart Weitzman acquisition-related charges as well as the impact of foreign currency fluctuations, where noted. You may identify these non-GAAP measures by the terms, non-GAAP, constant currency. You may find the corresponding GAAP measure as well as the related reconciliation on our website, www.coach.com/investors, and then viewing the earnings release posted today.
Now, let me outline the speakers and topics for this conference call. Victor Luis will provide an overall summary of our second fiscal quarter 2017 results and will also discuss our progress on global initiatives. Andre Cohen will discuss our North America business in more detail. Andrea Resnick will follow with the financial and operational results for the quarter along with our outlook for FY 2017. After that, we will hold a question-and-answer session which will end shortly before 9:30. Victor will then conclude with some brief summary remarks.
I'd now like to introduce Victor Luis, Coach's CEO.
Good morning. Thank you, Christina. And welcome everyone. As noted in our press release, we are pleased with and proud of our performance this holiday season, particularly in light of the challenging and volatile global retail environment.
Our team delivered top line growth in each of our segments, highlighted by positive comparable store sales in North America with solid demand across channels and overall gross margin expansion. We continued to grow our business internationally with notable strength in Europe and mainland China which represents significant opportunities for our brands. Importantly we opened our first Coach House global flagship locations on Fifth Avenue in New York City and Regent Street in London which represent the fullest expression of our modern luxury vision to date and celebrate our heritage and seventy-five year history of craftsmanship.
And despite our deliberate pullback in the North America wholesale channel and unanticipated currency fluctuations, we delivered double digit earnings growth in the quarter. We were also thrilled with Stuart Weitzman’s results this quarter as we continued to implement our strategic priorities for the brand. We advanced our leadership position in fashion boots and booties during the winter selling season while driving global awareness and brand relevance through impactful marketing and the launch of key global flagships. This quarter strength which reflected strong growth in directly operated channels as well as the anticipated shift in wholesale shipments from the first quarter took brand sales growth to double digit for the first half and we continue to expect Stuart Weitzman sales to increase at a double digit pace this fiscal year.
More generally, we continued to execute the Coach brand transformation across the consumer touch points of product, stores and marketing. Our gifting assortment resonated with our customers globally across all price points and in all channels. We continue to transition more of the fleet into our modern luxury concept while enhancing our customer experience.
Finally, our holiday marketing was bold, innovative and fun, driving a dramatic increase in impressions globally. Also, during the holiday period we continued to elevate our brand through global celebrations of our seventy-fifth anniversary, including our first dual-gender runway show in early December here in New York City.
We also announced Coach’s partnership with the actress and singer Selena Gomez. Her work with Coach will be wide ranging and begin with her appearing in Coach’s fall 2017 fashion campaign. It will also include a special product collaboration for launch in the fall across our global network and with major wholesale partners.
Organizationally, we've announced two new leaders. First, Kevin Wills will join our team as chief financial officer in the coming weeks. Kevin is a proven leader who brings nearly thirty years of broad based and relevant retail and finance experience to Coach. His expertise and strong operational track record make him a valuable addition to the leadership team.
We're also delighted about the recruitment of Carlos Becil, coming in a newly created role of chief marketing officer for the Coach brand. Carlos is joining us from Equinox where he held the role of chief marketing officer for the last four years .In his new role, Carlos will partner with Stuart Vevers and our global marketing teams to continue to innovate and bring our brand messages to broader audiences around the globe.
I would like to take a moment to recognize and thank Andrea who has held the position of interim CFO over the last several months. She and our proven finance team ensured we continue to execute our strategies flawlessly. And I know you are all pleased to learn that Andrea will continue in her leadership role as global head of investor relations and corporate communications.
Now, as has been our practice since we implemented our transformation strategy more than two years ago, I'd like to share some of the actions we've taken to drive performance across the three Coach brand pillars of product, stores and marketing.
Starting with product, where Coach has emerged as a house of modern fashion design. In retail in the holiday quarter we successfully launched Heritage Gifts, a powerful year round dual gender gifting strategy grounded in glove tanned leather featuring pops of color and a balance of emotionally novel giftables.
Retail also continued to focus on elevation and fashion in Q2 with the expansion of Coach 1941 handbags and the launch of our first ever all-door pre- spring collection. Building upon product innovation, 1941 continues to be Coach's vehicle to deliver playful iconic Americana inspired themes.
In outlet, as we touched on during our last call, we kicked off the quarter with a very successful outlet only Pac-Man collaboration. Metallics, florals and patents and dressy silhouettes were also well received. In addition, the exclusive playful holiday prints anchored by our animated Coach bears collection drove consumer engagement via strong messaging to our outlet customers, including Windows, mailers, emails and in-store experience. Men’s continued to be a major focus for outlet and is on plan to be over 20% of the channel by the end of the fiscal year.
On stores, we're continuing to establish our modern luxury concept globally, renovating and opening 46 locations during the quarter, including four in our directly operated North America business, taking us to about 540 modern luxury locations globally across all channels. This is very much in line with our target to end the year with over 700 doors in the new format, representing the vast majority of our traffic. Consistent with the plan, these renovations have been driving significant inflections from previous trends and comps which exceed the balance of the fleet in the vast majority of stores around the world.
Of course, as we've said before, the in-store customer experience is a key component of our brand elevation strategy, which is based upon, first, differentiating the Coach experience through leather and craftsmanship; and secondly, developing personalized clientele and customer events.
I am delighted that our mystery shopper scores, our key metric that demonstrates how well we deliver our unique modern luxury experience, were up again in the second quarter at over 85% as compared to about 75% in last year's holiday quarter. In addition, it's great to see how clients are responding to our new leather services such as monogramming and leather conditioning, with new services such as unique MOG stamps being introduced throughout the year. Across the global fleet, there were 26 craftsmanship bars installed as of the end of the second quarter and we expect to add twelve more in the second half of the fiscal year.
We remain very excited about our global flagship focus. We view these stores as important retail and marketing investments for the Coach brand. These flagships include our Coach Houses on Fifth Avenue in New York City and Regent Street in London, both successfully opened during the second quarter in time for the important holiday season. Earlier this month we opened the Kuala Lumpur Pavilion flagship in Malaysia and will soon open our first flagship in Milan, Italy during February Fashion Week.
In North American department stores where we're repositioning the brand, we did four renovations last quarter and continued to see positive results from our shop manager program without performance versus the balance of doors in major accounts.
As noted, when we entered the fiscal year, one of our key strategic initiatives is elevating the Coach brand into North America wholesale channel. Through 1941, we've added some new locations in top tier specialty stores in North America and globally. We are now also in the process of rationalizing our North American department store distribution, taking our door count down by about 25% or by over 250 locations over the fiscal year, as well as reducing promotional events in the channel. In fall, we closed the first group of these locations, about 120, while the number of days on sale in department stores were reduced by about 40%. And we remain on track to close the balance of targeted doors this spring season.
On the marketing front, we held events across the globe celebrating the culmination of our anniversary year. Our global influencer driven campaign was our most significant one yet with over 2.6 billion global impressions, up 160% from last year's holiday season. Color was important in creating visual impact, highlighted by our Heritage Gifting program.
Large scale experiential marketing, including events in Europe and in Japan, such as our Covent Garden pop-up installation also drove engagement. Similarly, multiple brand moments around celebrity births, Coach House opening events and #Coach75 extended the life of our anniversary campaign. And to cap our anniversary year, as mentioned, we held our first dual-gender runway show in December in New York City generating excitement and brand buzz globally.
More generally, during the quarter we remained focus on creating desire for our brand highlighting our fashion positioning and our 75 year legacy of design innovation, craftsmanship and quality. Our goal is to enhance brand perception and make the category exciting for consumers with a singular message that cuts through: Coach’s unique modern luxury proposition focusing on leather craft and Stuart’s vision of Coach New York cool, familiar American culture interpreted [ph] with a twist from New York's original house of leather design. Of course, signing Selena Gomez as the new face of Coach will amplify the coach message given her very substantial global following, especially on social media.
As a result of these efforts across customer touch points, we are seeing continued progress in consumer perception. Importantly in our U.S. brand tracking survey fielded in December, Coach’s repurchase intent with category drivers increased versus a year ago, while our brand affinities were strong with consumers overall. In addition, fewer consumers viewed the brand as promotional versus a year ago which we believe reflects our deliberate pullback in events over the last two years.
We are delighted with our progress and proud of all that our team has accomplished to drive Coach’s transformation. The Coach brand is very much on its way to evolving from a specialty leather and accessories brand to a true House of fashion design. We are excited to see our creative vision and direction gain traction and as has been our custom, we'll continue to update you on these initiatives as we move forward.
Turning now to a discussion of category trends. As we look ahead to the balance of FY’17, we believe the challenges that exist today affecting the category in specific and consumer spending in general will persist. This volatility was evidenced throughout FY’16 and the first half of FY’17 impacted by the U.S. election this fall and the significant strengthening of the dollar over the last few months.
Overall, with limited data points given the delayed year end reporting for several brands, we estimate that the North American premium men's and women's bag and accessories market was flat to up low single digits in the December quarter which we believe has continued to be impacted by negative trends seen in the U.S. department store space.
While Andrea will provide additional details on sales and distribution by geography, we wanted to touch on some current trends and strategies by market. So I'll turn it over to Andre for a discussion of North America.
Thanks, Victor. As you read in our release for the quarter, total North American Coach brand sales increased 2% on both a reported and constant currency basis, including the negative impact of our deliberate department store pullback.
Direct sales rose 5% in the quarter. Importantly, the second quarter marked the third consecutive quarter of positive comps in North America. Our brick and mortar comps rose approximately 4% in the quarter driven by ticket and conversion while traffic was down moderately. Overall, our aggregate comp was up approximately 3% with e-commerce impacting quarterly results. As you're aware we have a clear strategic direction to limit our promotional stance online given the negative impact on long term brand health.
Finally, our business to international tourists in our North America stores was essentially even during Q2 with declines in Chinese tourist traffic once again offset by other nationalities, notably Japanese and Korean visitors. Generally international tourists are less significant to the category and to luxury in general during the holiday season given the increased gifting purchases by domestic customers.
Now turning to our retail performance and the metrics we traditionally share on products. We continue to drive brand elevation with 1941 representing approximately one third of handbag sales in our top tier retail stores, consistent with plan. The penetration of the above $400 price brackets increased to nearly 50% of handbags sales, up from about 30% last year and generated another positive comp on a sales and unit basis. And as noted, we were also excited by the performance of our retail gifting assortment across categories. The iconic Dinky bag at $295 resonated with consumers, while novelty giftables increased over prior year and exceeded expectations.
Turning now to events marketing. In the second quarter we again held a Black Friday event, this time with a fixed percentage off offer but importantly excluding 1941, a significant part of our assortment as mentioned. This was followed by our semi-annual winter sale. In the third quarter we would again expect to hold a closed preferred customer event in March.
Looking ahead to spring, our goal is to continue to elevate and differentiate the brand by offering innovation and emotion through our product assortments, marketing and the in-store experience. We’ll also continue to position Coach as a year round gifting destination.
Specifically in retail, we will continue to reinforce our craftsmanship through the reinterpretation for Coach New York of our western rivets [ph] which was launched on the runway in Coach 1941. The cool kid static of 1941 takes on a more feminine flair with beautiful semi precious stones embellishing these highly wearable styles. In 1941, we will launch a new Rogue tote, at $695 which builds on the success of the now iconic Rogue bag with structured luggage handles, Bombay stitching details and a cool edgy all-day look.
We will also expand the Tea Rose platform with wild tea rose, its boldest expression yet with a mix of leather, resin and metal flowers. Finally, we relaunched our best selling Edie Shoulder Bag with a whole new look, plus a new larger size the Edie 42.
And for outlets as we transition into spring, we're excited to refresh the color palette and infuse retail inspired looks with bright colors, trend right color blocking and runway chic floral prints. In addition, we're launching two limited edition collections where we pay homage to our hometown of New York City and to our iconic designer Bonnie Cashin.
Men's will continue to grow by expanded lifestyle assortments to additional centers with increased marketing support. We look forward to our floral explosion in March when we introduce our new feminine petal bag, a drawstring silhouette designed to resemble a flower in bloom, and in the fourth quarter we're very excited about the launch of Disney for outlets which was our strongest ever collaboration in retail.
I’ll now turn it back to Victor for a discussion of international.
Thanks, Andre. Moving on to Coach brand’s International performance. As noted in our release, in the second quarter International Coach brand sales rose 3% on a reported basis and 1% on a constant currency basis.
By geography, Greater China sales were essentially even with prior year in dollars in the quarter. On a constant currency basis, sales rose 6% with positive comparable store sales overall. We continued to drive strong results on the mainland while Hong Kong and Macau experienced significant improvement in the quarter.
In Japan, sales rose 9% on a reported basis while constant currency sales decreased 2%, impacted by a decline in Chinese tourist spend as we lapped last year's dramatic increase. In Europe, our sales grew at a double digit pace in the quarter driven by new distribution and positive double digit comps. We've continued to experience very strong results in the UK benefiting from the currency weakness and increased traction with the local consumer. We were particularly pleased to open our Coach House location on Regent Street in London during the quarter where results to date have been strong and above expectations.
In Paris, our business for the quarter continued to be impacted by weak tourist traffic, though we did see relative improvement in December as we anniversaried the negative impact resulting from last year's tragic terrorist attacks.
In our other directly operated Asian markets outside of China and Japan, namely South Korea, Taiwan, Singapore and Malaysia, sales decreased low single digits in dollars and in constant currency. Our results were impacted by softness in Korea where macro-economic headwinds have pressured spending from domestic consumers. Excluding Korea, our business in our other directly operated Asian markets in aggregate rose mid-single digits in dollars and in constant currency.
Finally, I would point out that we're continuing to see disparate results in our international wholesale businesses which while small are important to growing brand awareness. For the quarter, our overall sales at POS increased slightly, driven by strong domestic performance offset in part by relatively weaker tourist location results. On a net sales basis, revenue also increased over prior year.
Now I'll turn it over to Andrea for details on our financial results and guidance for the balance of the year. Andrea?
Thanks, Victor. Victor and Andre have just taken you through the highlights and strategies. Let me now take you through some of the important financial details of our second fiscal quarter results as well as our outlook for FY’17. Please note the comments I'm about to make are based on non-GAAP results. Corresponding GAAP results as well as the related reconciliation can be found in the earnings release posted on our website today.
We are very pleased with our financial performance in the second quarter, particularly in light of the volatile backdrop. Our sales increased over prior year in each of our segments highlighted by positive comps in North America, continued growth internationally and strong performance of Stuart Weitzman. And on this higher level of sales, our gross margin expanded significantly over prior year.
We also made important investments in our brand and business as projected and delivered double digit growth in net income and earnings per share despite the strategically positioning of the Coach brand in the North American wholesale channel and headwinds associated with currency. Importantly our balance sheet remains extremely healthy with a clean inventory position and sufficient cash to support our strategic initiatives while returning capital to shareholders through our dividend.
Now turning to the details. Coach, Inc.'s net sales totaled $1.32 billion for the second fiscal quarter, an increase of 4% on a reported basis, including a positive impact of 40 basis points related to currency translation, a smaller benefit than originally anticipated given the significant strengthening of the U.S. dollar.
In addition, and as expected, the company’s strategic decision to elevate the Coach brand’s positioning in the North American wholesale channel through a reduction in promotional events and door closures negatively impacted sales growth by approximately 100 basis points in the quarter. Coach brand sales increased about 2%, including positive North America comp store sales and continued international growth as both Victor and Andre have discussed. Stuart Weitzman brand sales rose 26% as expected.
Consolidated gross profit totaled $906 million, an increase of 6% versus prior year while gross margin increased approximately 110 basis points to 68.8%. Coach brand gross profit increased 4% while gross margin increased 130 basis points over prior year to 69% even which included a benefit of approximately 30 basis points from currency.
By segment, total North America gross margin increased over prior year, including our directly operated business where we grew both gross profit dollars and gross margin rate over prior year. International segment gross margin increase over prior year both on a reported and constant currency basis. Stuart Weitzman brand gross profit rose 26% while gross margin rate was even with prior year.
As projected, total SG&A expenses increased 7% to $612 million and represented 46.3% of sales as compared to 45.1% in the year ago period, reflecting in part the impact of currency and investment in Stuart Weitzman, as well as higher marketing spend versus prior year.
Coach brand SG&A expenses increased 4% and represented 46.5% of sales compared to 45.4% in the year ago period. Stuart Weitzman brand SG&A expenses were $53 million compared to $38 million a year ago due to an increase in store occupancy costs associated with new openings, the timing of marketing expenses as well as the company's strategic investments in team and infrastructure.
Coach, Inc. operating income rose 3% to $294 million while operating margin was 22.3% essentially even with prior year’s 22.4%. Coach brand operating income increased 3% while operating margin increased 20 basis points over prior year to 22.5%. Stuart Weitzman brand operating income was $23 million or 19.8% of sales versus $22 million or 23.6% of sales in the prior year, reflecting key investments to support long term multi category growth as discussed.
Net interest expense was $5 million in the quarter as compared to $6 million in the year ago period. Total net income for the quarter increased 12% to $211 million with earnings per diluted share of $0.75, up 11% versus prior year.
Now moving to global distribution. In total we opened a net of eight Coach brand locations globally in the second quarter to end the period with 960 directly operated locations worldwide. In addition we opened five net Stuart Weitzman directly operated stores to the end the quarter with 82 locations. In FY’17 we continue to expect our Coach brand directly operated square footage to grow low single digits globally. This guidance assumes that Coach brand directly operated square footage in North America will decline slightly with net store closures in both our retail and outlet channels. Internationally we expect a mid single digit increase in square footage led by significant growth in Europe and a mid single digit increase in mainland China, partially offset by a low double digit square footage decline in Japan, as well as a modest unit decrease in Hong Kong and Macau. In our other directly operated businesses in Asia, we expect a little change in both unit and square footage.
Finally, turning to Stuart Weitzman distribution. Year-to-date we've opened a total of seven net new locations and do not expect any additional openings for the balance of the fiscal year.
Moving on, net cash from operating activities in the second quarter was $366 million compared to $302 million the prior year. Our CapEx spending was $54 million in Q2 versus $106 million last year. Free cash flow in the quarter was an inflow of $312 million versus $196 million in the same period last year. As expected during the quarter we received approximately $125 million in net proceeds related to the sale of our previous headquarter buildings.
Inventory levels at quarter end were $465 million compared to an ending inventory of $438 million a year ago. At the end of the fiscal quarter, cash and short term investments stood at $1.8 billion as compared to $1.3 billion a year ago.
Our total borrowings outstanding were approximately $600 million at the end of the fiscal second quarter compared to approximately $900 million a year ago, reflecting the pay-down of our term loan in the first quarter as previously discussed.
Turning to our capital allocation policy, which has not changed. Our first priority is to continue to invest in our brands as we have a compelling opportunity to drive sustainable growth and value creation and we're putting our capital against this opportunity.
Our second priority, strategic acquisitions, is also about growth. While there is nothing imminent, we want to have the flexibility to act if and when it's in the best interest of Coach Inc. and our shareholders.
And, third, capital returns. We are committed to our dividend, expect our dividend to grow at least in line with prior year’s operational net income growth as our transformation gains further momentum.
As always, underpinning all of these priorities are our guardrails for allocating capital effectively, maintaining strategic flexibility, strong liquidity and access to the capital markets.
Now turning to our outlook for fiscal 2017 on a non-GAAP 52-week versus 52-week basis. We are maintaining our operational outlook for FY’17 while adjusting our revenue guidance based solely on current exchange rates. As you know our previous fiscal 2017 revenue guidance was for an increase of low to mid single digits, including an expected benefit from foreign currency of approximately 100 to 150 basis points. Given the significant strengthening of the U.S. dollar we are now projecting revenue to increase at a low single digit rate including an expected negative impact from foreign currency of 50 basis points for the full year, therefore representing a 150 to 200 basis point swing from previous guidance. This implies that currency will pressure top line results by over 100 basis points in the second half of the fiscal year based on current exchange rates.
This guidance continues to assume a positive low single digit comp for the Coach brand in North America for the year and in each quarter. We also continue to project double digit revenue growth for Stuart Weitzman for the year.
As an aside for you modelers out there, while we're projecting overall low single digit revenue growth in the second half of the year, we're forecasting topline variability by quarter. Specifically our nominal revenue is expected to decline in the third quarter based on: first, the negative currency impact of about 100 basis points; second, calendar shift in North America, including the later timing of Easter which falls into the fourth quarter this year versus the third quarter last year; third, our strategic North America wholesale initiatives with a continued reduction in promotions and the next tranche of door closures planned for 3Q; and finally, an expected shift in Coach international wholesale shipment timing from the third quarter into the fourth quarter based on our visibility into second half orders. Offsetting this, we're projecting strong topline growth in Q4 benefiting in part from those identified calendar and shipment timing shifts and despite an expected negative impact from currency of over 200 basis points.
Most importantly we are maintaining our operating margin forecast for Coach Inc., of between 18.5% and 19% for fiscal 2017. This guidance incorporates the negative impact of both Stuart Weitzman and the strategic decision to elevate the Coach brand’s positioning in the North American wholesale channel.
We continue to expect interest expense to be in the area of $25 million for the year. The full year of fiscal 2017 tax rate is now projected at about 26% with a significantly lower tax rate forecasted in 3Q versus 4Q consistent with our typical cadence based on the anticipated of expiration of statutes in the third quarter. And we expect our average weighted diluted shares outstanding for the year to be in the area of 283 million.
So taken together we're still projecting double digit growth in both net income and earnings per share for the fiscal year and we continue to expect CapEx for Coach Inc. to be in the area of $325 million.
In closing, we are very pleased with our performance in the quarter and the consistency of our execution against a volatile backdrop building on the successes we have achieved thus far in our transformation. Importantly we expect -- we continue to expect FY’17 to be the year when we return to growth across all financials, leveraging top line growth and supported by our operational efficiency initiatives which have allowed us to become a more nimble organization. Overall we remain confident in our ability to drive sustainable and profitable growth for Coach Inc. over the long term.
I’d now like to open it up to Q&A.
[Operator Instructions] Our first question comes from Bob Drbul with Guggenheim Securities.
Hi good morning. I just have two quick questions for you please. The first one, can you provide a little more color on the second quarter North American comp by channel? And then the second question is, can you provide a little more granularity exactly on the third quarter versus the fourth quarter and the big movements there?
Sure, I'll take the North America comp question and then Andrea will jump in with the guidance question. Bob, we're obviously very pleased with our performance in the second quarter in North America where we saw demand grow across all of our direct channels with an expansion in our gross margin. As you know in the first quarter we have a total comp of 2%. We saw that grow to 3% with our bricks and mortars comp being 4% for the holiday quarter, really benefiting from all of the actions that we have been taking over the last couple of years to drive our transformation across both channels. In retail, we're seeing our elevation take hold with the broader distribution of Coach 1941 and the continued rollout of our modern luxury concept. And I couldn't be prouder of the engagements of our teams with our consumers across both channels as well. And in outlets, we are seeing a level of innovation from our design teams at a level that we haven't seen in the past and that's really beginning to resonate. Of course that includes as we suggested during our prepared remarks some of those wonderful collaborations that we have seen.
In terms of our third versus fourth quarter guidance, I think the first thing I'd point out is we maintained our operational outlook for the year, including the expectation of a low single digit North America comps in both 3Q and 4Q. Obviously as we discussed we expect some variability between the quarters along with pressure from FX in the second half.
In the third quarter, as I enumerated our top line is being negatively affected by a number of timing items, including the shift of Easter into the fourth quarter as well as our international wholesale shipments which in turn are being driven by the change in our delivery to better match the fashion calendar. In addition, while not a comp impact our third quarter of last year ‘16 included the post-Christmas week. This year, due to the calendar shift that fell into 2Q and will not be included in 3Q. Of course in North America wholesale we're closing that next tranche of doors to get us over to 250 this quarter and in the fourth quarter where we started to pull back last year will begin to anniversary that impact of those strategic actions, so less of an impact on the year over year basis. Therefore projecting very strong topline growth in Q4 benefiting in part from these calendar and shipment timing shifts and despite a negative impact from currency which will -- if current rates hold, impact us by about 200 basis points, so a very strong fourth quarter.
Our next question comes from Ike Boruchow with Wells Fargo.
Good morning everyone. Congrats on a nice quarter. So just taking a step back focusing on the Coach brand’s profitability. So I imagine high 60s gross margins are probably not planned to move much higher from here over time. So I just kind of wanted to ask a big picture, where you see the Coach brand margin longer term and kind of how do we get there -- I don't think anyone expects 30% margins again. But how high is high today and I'm just asking because you deleveraged SG&A this quarter and I think you did in Q1 as well within the Coach segment. And I'm just wondering how you're planning out the investments needed to drive the top line of the Coach brand versus your goal of taking the operating margins higher over time?
Sure, sure. I think you're absolutely right there. In terms of gross margin, when you look back to 2014 when we originally gave our guidance we absolutely assumed that our gross margin would stay in 69% 70% ex-currency impact. And the real question is, at the time was the SG&A leverage and as we said as we try to positive comps, we’ll will begin to overall leverage that SG&A spend which we absolutely accept that. I think since 2014, the necessity to invest in our brand, higher overall occupancy costs etc for all brands, has probably brought down the upper end of that best in class profitability. But we're still focused on driving our profitability from these levels. We're very comfortable with it. We've shown the ability to lever as we would see the top line growth. So we do expect our operating margin to continue to move higher from here and we're very comfortable with that guidance.
Our next question comes from David Schick with Consumer Edge Research.
I’d like to put a couple different comments together into one question. So Victor, you talked about --
One question David.
Right -- house of fashion design -- it’s really one question I promise -- house of fashion design, you’ve done less distribution, you’re having great success at the higher price points. I guess what I am trying to say is your vision for Coach in 2020 and beyond, there is a lot of street focus constantly on the category, should we think less about the category and more about your core competencies of what you are doing across categories? How should we think about that, not margin but what Coach is now really great at and how that drives the long term future?
Yeah, well, obviously we're really great in our core category and that will remain a core competency going forward, David. We don't see ourselves becoming an apparel play, if you will. Obviously we've also talked about layering on other categories and we've made a very important acquisition in Stuart Weitzman, that has made us a very significant player both here in the U.S. and increasingly internationally in footwear. We're going to be leveraging that know-how of course for the Coach brand as well, especially as we take back our license later this calendar year and begin both the development design and production of shoes in house to have footwear become an increasingly important part of the Coach brand go forward.
As well, we do see outerwear as an area of growth for us. If you look at what we're doing with all of our runway shows and anything that you see within our stores you will see that outerwear plays a very important part of our apparel play, if you will, of what we're doing in terms of giving context to the Coach woman and the Coach man much more so than I would say a standard tops and bottoms T shirt and jeans type of business. We're not interested in getting into a basics business. So those three categories combined represent an $80 billion global opportunity and today at $4.5 billion, we obviously have a very small stake in that and so within both the Stuart Weitzman brand where you will see us add with our new creative director, handbag business and then within the Coach brand as we add footwear and outerwear you will see us take an increasingly large share of those three pieces of the pie.
Our next question comes from Erinn Murphy with Piper Jaffray.
Good morning. You guys as you’ve elevated the brand, can you talk a little bit more about what you're finding about the consumer who have been purchasing that 1941 collection? And then I think you said that you'd be introducing this spring a Rogue at $695, I think it's a little bit of a sharper price point than you've seen in the balance about Rogue collection, but who do you view as the incremental consumer there? Thanks.
Sure. So we’re really seeing two groups of consumers responding to 1941. The first one, as we expected, is new consumers who hadn't really connected with the brand in the past and who find that they’re sort of more fashion forward, a bit understated aesthetic 1941 really works for them. But what was more surprising for is is that we’re finding a lot of lapse consumers returning to the brand because -- consumers who lapsed in our sort of logo heyday who were coming back because of the leather -- on the leather static of 1941. So that was, I’d say, a positive surprise for us.
In terms of price points, really 1941 stretches from $295 for a Dinky back which has been one of our top sellers especially across the holidays all the way up to $1500 for a Rogue bag in exotics. So we don't see it as being purely a high high price point collection, it doesn't drive the above $400 comp clearly but it's not just that, it spreads across a wide range.
Our next question comes from Oliver Chen with Cowen & Co.
Hi congratulates on really solid results. Victor, we had a question regarding the long term path and strategic acquisitions. What are your thoughts about Coach in the future in terms of being a multi brand modern luxury house? You've done a great job but sort of I am just curious about your general thoughts around that framework, and on the gross margin line which is very impressive, what should we model or think about going forward in terms of the Coach brand gross margin it was really impressive this quarter? Just curious about some more details of the drivers. Thank you.
Sure. Andrea will answer the gross margin question in a minute. In terms of how we think of Coach and go forward, I believe that before the Stuart Weitzman acquisition we've been clear that we see Coach Inc. being larger than just the Coach brand. Obviously we've made our very first and significant acquisition with Stuart Weitzman, we're really pleased with the results there. The team has done an amazing job, we’re continuing to drive that business and obviously we have continued to invest both in managements and into design talents and I'm very excited about the opportunity for Stuart Weitzman and I would say before thinking about the larger vision beyond those two brands that our team is very focused on executing in our core business and organic business and doing a terrific job and driving both the transformation of the Coach brand as well as in driving the Stuart Weitzman brand which we see moving beyond footwear into handbags and accessories player as well in the years ahead.
So as we think about acquisitions beyond Stuart Weitzman, Oliver, we've been very very consistent for years now in terms of our capital allocation strategy. Obviously we've been very excited about thinking of the three categories as I touched upon earlier that we believe are the closest to us and the most branded in the fashion space, handbags and accessories, footwear and outerwear especially and that would be obviously part of our consideration set, we're not interested in turnaround plays, we're very interested in brands that are great brands and that growth potential where we can leverage both our skill set, our structure, our systems, our infrastructure, supply chain and know how that we have in helping great brands develop global.
In terms the Coach brand gross margin in the second quarter which was up 130 basis points including about 30 basis points from currency. We once again had a benefit from channel mix in there. Probably the most significant was the ongoing lower product costs which were somewhat offset but not completely offset by our ability to pass that along to lower prices to our customers, the product cost a big positive impact forward. As we move forward through the balance of the year we would expect in the second half for our gross margin for the Coach brand continue to be expanding on a year over year basis most notably in the third quarter. Again we would expect channel mix to actually be in a slightly really bigger benefit in the third quarter, ongoing benefit from product costs as well as the end of the day continued source margin expansion for the close poach brands in the second have notably in third quarter.
Our next question comes from Anna Andreeva with Oppenheimer.
Great thanks so much. And congrats guys on that navigating the environment really well. A question was on remodels and the outlet channel, specifically I think you had mentioned that the recent ROI was better than when they initially. Can you maybe provide some color on that? How many stores have been remodeled currently and how should we think about the opportunity down the road and then secondly just quickly the flash sale impact moderated this past quarter. How do we think about that headwind going forward?
Sure. Good morning. So we mentioned I think last call we've been doing research both through our consumer insights group and field teams to try and understand how consumers react to this new remodel. There are few actions we took based on those findings, a few months ago that is starting to pay off where we are seeing improved results, so larger rooms, not so much segmentation within the stores, more tables to make the products more accessible. We've got a new findings we are now acting on, particularly that’s a signage in the stores, more visible Windows that are being implemented as we speak. And we've seen strong performance actually, these outlets are more luxury remodels. Overall we’ve remodeled so far 69.
In terms of the flash sales -- our EOS impact as we call it internally are e-outlet store which is as you call the flash sales model, the impact in the second quarter was really a slight bump versus previous performance of around Black Friday, gifting in general. Overall as we have stated in the past we are not actively recruiting new consumers into the database, we’re only mailing those who shop within our outlet channel. And so I would again expect the database to continue to shrink and its performance to consume shrink as well.
Our next question comes from Michael Binetti with UBS Securities.
Hey guys, good morning, great quarter. I think your answer is, I was hoping over from another call. But I just want to get a little bit more -- a little more detail on the margin outlook. I mean I think you guys have done a really nice job of helping us think about the longer term outlook as I look through your Power Point from 2014 here. So a lot of that thinking was obviously at a time when the category is growing a lot faster. So I guess we know that prior peaks for your business aren't the best North star for models on the operating margin opportunity but we've talked about the opportunity for the brand to return to mid twenty's over time. And Andrea, I think you just said it was chime in that, the best in class number that you gave at the Analyst Day changed a little bit. Given what you know about the category and your growth rates today, is mid-20s still an appropriate rate to think about over the next few years? And if so, what do you think are the biggest sources of leverage is at the top line trajectory we see today?
Michael, I think I gave that answer to Ike I but I don't mind this is happening later year. I think the biggest point of leverage is obviously the returns to positive growth and positive comp. And so you've already seen that come through in our results, we backed to continue to come through in our results. Our target has always assumed continued sales growth for Coach, stable gross margins and leverage in expenses. While we're going to continue to invest in our business and those items really haven't changed. And that's what we're going to maintain going forward and you've seen that leverages come through already. So I think the path -- the trajectory remains positive and as I already mentioned to Ike.
I'll call Ike for the rest. Thanks.
Or check the transcript.
Our next question comes from Mark Altschwager with Robert W. Baird.
Good morning and thanks for taking the question. I was hoping you could provide a bit more detail on your current growth outlook for China. It's encouraging to hear the pressure has eased in Hong Kong, Macau. So I guess what inning are you in with right sizing your footprint in that region and do you have a view on when it can return to growth? And then looking at the mainland just any current thoughts on where the store fleet stands today and how you're thinking about balancing brick and mortar versus digital growth longer term, just, what is the growth algorithm we should think about for mainland China medium to longer term? Thank you.
Yes, there may be some confusion because you mentioned return to growth, we've been growing very strongly in China since we took that business back in 2008, I believe it was, and have grown it from what was approximately a $30 million business to over $600 million today. Team has done an amazing job in driving our distribution there. Today we're at approximately across Greater China which would include Hong Kong, Macau and mainland China, 191 doors, we have 172 doors in China, still very much opportunity for growth in second and third tier cities. As you may know, China has approximately 200 or more cities with a population of a million or more and given more accessible price points we believe we're going to be seeing continued opportunity for us to develop distribution beyond what the traditional luxury brands have and have tremendous opportunity of course to continue to grow within same stores there as the middle class continues to evolve in that markets and as we continue to see of course the population urbanizing. So the long term story within mainland China is very very exciting indeed.
In terms of Hong Kong and Macau we've seen a much better performance over the last quarter. And that is very a significant for us, it's a very important market of course especially for PRC tourists and it's been 18 to 24 months since we saw the first protests from Occupy Central and I think all of us in retail and luxury retail especially are very happy to see that market’s stabilized and hopefully in the future become a source of growth.
Our final question comes from Brian Tunick with Royal Bank of Canada.
Pretty tough environment. I guess wanted to hear more about the factory channel perspective, did you guys feel like the holiday overall was more promotional in the factory channel when you looked at your competition? Can you maybe talk about from a product perspective what percentage today is Stuart design and the halo, you've talked about in the full priced stores? And as we think about the comp improvement at the factory channel, how much it come from AUR versus conversion over the next couple of quarters? Thanks very much.
Good morning. The factory channel was very promotional this Q2, we saw our competition go deeper than they've ever gone. So the environment itself was deeply promotional. We were driven really by innovation as Victor mentioned earlier, a couple of really impactful new launches. The PacMan was one of them and then we had our Bears collection around Christmas that were highly highly successful. So I think we navigated the promotional environment, focusing more on innovation really than just deep discounting. Most of the product today in factories is designed by Stuart. We have a small share of retail leads that end up in factory but it's primarily new designs and I think we talked about a year ago about the factory outlet. There was -- aimed to a fast tracking innovation, we're seeing the results of that over the last few months and very pleased with this. Traffic continues to be challenging in general in the channel. So we are counting on both conversion and higher ADTs, average tickets to drive growth and productivity.
End of Q&A
Thank you. That concludes our Q&A. I'll now turn it back over to Victor Luis for some closing remarks.
Thank you, Christina. As is our custom I just want to close by, first and foremost congratulating all of our teams across the world both in the Coach and the Stuart Weitzman brands for all of their hard work and dedication. Against what is a continuing volatile and unpredictable global market, I couldn't be prouder of all of them, their commitment to driving innovation, the strong engagement that they have with consumers across the globe. And it's truly their hard work that is reflected in our results. And I thank their commitments and their can-do spirits and thanks to them that we remain very optimistic about the long term opportunities for our brands. Thank you.
Ladies and gentlemen thank you for joining this Coach conference call. Please disconnect your lines and have a wonderful day.
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