In my February
, I said that the company was vulnerable to the outlet channel
shoppers in the US, and that the gross margin was much higher than
that of the competition and was unlikely to hold, which were huge
reasons to stay away from the stock.
Those are two intertwined concepts now. I have just read -- and was
somewhat surprised to learn -- that Coach's outlet sales last year
had reached 73% of its total North American units, up from about
43% in 2006. That might not be a huge problem, except when you have
a 28% value share of US handbags. Management can say that these are
different shoppers going to different stores, but these shoppers
are not segregated from one another in their daily lives. So the
cache of the brand will tend to disappear as the Coach shop or
department store buyer sees many more women of all income levels
wearing Coach handbags.
While I still roll my eyes when rag trade people and sell-side
analysts talk about "lifestyle brands," to the extent that there is
any ability to build a "lifestyle brand" out of the base of women's
handbags, I have to be very skeptical of the base that will be used
to build it, given the situation outlined above. The unexpected
management turnover of the COO and president of the North American
group operations, on top of a formerly announced creative director
change to come, makes recreating Coach as a "lifestyle brand" seem
very unlikely to happen within anybody's investment horizon -- and
it will very likely be expensive in terms of advertising and
promotion. And, if it happens, it is also likely to be at a gross
margin significantly less than the 73% the Coach has now.
So the quarterly results showed that Coach continues to lose share
in North American handbags, with comps down 1.7%. At the same time
that the economy looks to be growing at only a 1% GDP in the second
quarter without much momentum, Coach is still growing square
footage in the outlet channel at a faster rate than it's growing
real estate for its full price stores (double digits vs. flat). Yet
the outlet shopper is more vulnerable to the slowing economy. And
management currently predicts low single-digit North American comps
store sales in FY '14.
China and the Far East are still doing well enough with
double-digit comps, allowing operating income to be flat with last
year, and diluted EPS is up $.03 to $.89. Plus Coach could buy back
some significant amount of shares, if it so chose.
I see a company that is likely still over-earning. A low gross
margin percentage in the low 60s, the same level as its more
upscale competitors, is probably coming in the next two to three
years, with the potential for something even lower, if the brand
cache is heavily lost in the US. A mix of lower gross margin,
increased overhead expenses from too much square footage in the US,
or sharply lower sales growth (or outright declines) are all
possible depending on management's strategy from here.
I do feel that the brand may be extremely compromised at this
point, both by an unprecedented (in my experience) 73% of units
going out of outlet stores in the US with more to come, and by the
huge management turnover, which I believe comes in one way or
another from the expectations about the brand's situation now and
the ease of building it back in the US. Feeding that into revenue
growth, I believe that the men's and the clothing initiatives will
not gain much traction. And apparently, the shoes are not doing
well, though Coach has managed to pull off some decent results in
Longer term, while China and the Far East may continue to grow, I
have to believe that it is grossly optimistic to think that Coach
can sustain either a 28% value share in US handbags in the face of
more competition from
) et al. and a likely compromised brand cache, or a 72% gross
margin when luxury brands with better names than Coach average in
the low 60s. I would also think it likely that Coach's future gross
margin could be in the 50s easily. Of course there is a sales vs.
gross margin trade-off here for management to ponder.
So, looking at long-term earnings growth, I would use, maybe
optimistically, a mid-single-digit sales growth rate and some
ongoing gross margin decline to result in, let's say, a 2%
five-year EPS growth rate before stock buybacks. A 2% growth rate
based on a $4.11 FY15 sell-side consensus estimate (still being
revised as I write this) and a 4.2% risk-free rate (long Treasury
bond plus 50 bps) results in a $41 price. If buybacks could add 3%
per year, a $46 price might be justified.