As a luxury brand retailer, Coach Inc. (COH, Financial) enjoys strong pricing power, sourcing and distribution advantages, as well as capital efficiency, making it one of the top companies in the industry with a narrow economic moat. Its high quality handbags and accessories, sold at a more attractive price than its competitors, have garnered a large customer base with strong brand loyalty, resulting in a business with excess economic profits. Therefore, it should come as no surprise that investment gurus like John Griffin (Trades, Portfolio) and David Rolfe (Trades, Portfolio) recently acquired over 1 million shares in this company, hoping to gain long term rewards.
Of Capital Efficiency and International Expansion
The year 2014 is set to be a year of change for Coach, as former CEO Lew Frankfort was replaced by Baccarat’s ex-CEO Victor Luis, who is set on strengthening the company’s international business segment, as well as the expanding into the ready-to-wear and footwear market categories. However, while Luis has conveyed a new team of designers, including a new creative director, to efficiently penetrate the market, the firm’s luxury bags and leather accessories are likely to remain the core business. Nonetheless, Coach’s international business will provide strong growth opportunities, as 60% of sales currently come from the 550 North American retail stores. The company entered the European market in 2012 via department store partnerships, and management is expecting ongoing penetration (20 retail stores acquired in 2014) to result in $500 million in sales over the next five years.
The luxury retailers Japan business has also been a long-run success, maintaining single-digit growth rates for the past ten years, while competitors reported declines in the same market. Furthermore, Coach’s efficiency in designing, distributing, and sourcing its products have led to impeccable industry leading operating margins above 30% and gross margins of 72%, evidencing some pricing power in its competing category. Also, while China’s business is still lagging behind other luxury brands in sales, the firm sees significant growth potential in this segment, due to lower operating costs and higher gross margins. Thus, fiscal 2014’s projection of $530 million in sales for China seems accurate and should contribute to the firm’s excess returns on capital, which have averaged 40% over the past five years (currently at 42.9%).
Valuation and Future Outlook
I believe Coach’s efforts to develop the underpenetrated international market is a clever strategy, as revenue for same-store sales in North America is expected to decline by -4%. Moreover, the current operating margin of 31% is bound to drop to 27%, consequence of general and administrative spending, as well as control of selling. Nonetheless, the 10-year forecast period predicts these margins to stay above 27%, which seems plausible given the company’s historical values. Revenue growth also remains healthy, at a 15.8% growth rate, which should increase as the Chinese market segment blossoms.
Although Coach runs some risk of damaging its core image through its ambitious expansion plan to become a full lifestyle brand, I remain bullish that the affordable prices for luxury goods will retain most of the company’s customer base. On another note, investors should keep in mind that this firm’s sports a healthy 2.69% dividend yield, in addition to its 29.3% ROA and 15.7% EPS growth rate. When added to the 0-debt levels and the stocks trading price discount of 21% relative to the industry average of 18.4x, I think it’s clear that Coach is an absolute champion investment.
Disclosure: Patricio Kehoe hold no position in any stocks mentioned.
