Since its dividend policy was instituted in 2009, Coach (COH) has shown a consistent focus on growing cash payments to shareholders. Over the past 5 years, the dividend has grown at a compound annual growth rate of nearly 70%.
While the rapid pace of dividend growth has leveled out, the company was still able to grow payments by 9% last year to its current $1.35 a share. This equates to a respectable 4.3% yield, roughly double that of the S&P 500.
While earnings currently completely cover dividend payments, investors should note that the company’s payout ratio has increased nearly every year to its current level of 48%. While this isn’t necessarily concerning if earnings continue to grow, the recent dip in EPS puts pressure on future dividend raises.
Can investors trust Coach’s 4.3% yield?
Coach Faces Historically Long-Term Struggles
This year, analysts expect EPS to drop to $1.91 off lower revenues and profitability. This would put the dividend payout ratio at 71% of earnings. Over the past 5 years, EPS has shrunk by an average of -2.4% a year, with the average analyst forecasting -6.5% annual EPS growth over the next 5 years.
As we’ll see, Coach’s struggles aren’t new.
While Coach showed an ability to capitalize on growing emerging markets such as China, increasing revenues by 18.6% annually over the previous decade, profitability has failed to keep pace. Profit last quarter of $465.9 million was roughly the same as it was nearly a decade ago in 2006.
A big part of stagnating profitability has been pressures on selling prices. Over the past decade, gross margins have fallen from an average of 78% to about 70%. Last quarter, gross margins dipped dramatically to 63%. Despite a global brand name, Coach has not been immune to pricing pressures.
Coach has also shown a dramatic inability to control costs. SG&A as a percentage of gross profit has grown from roughly 55% a decade ago to over 75% today. With lower selling prices and rising costs, it’s little wonder that Coach has struggled to increase profits over the long-term.
Valuation
Despite Coach’s inability to sustain selling prices and control costs, it still trades in-line with peers such as Michael Kors (KORS) on an EV/Revenue basis. This is despite Michael Kors having higher profit margins and an expected EPS growth rate of nearly 9% over the next 5 years.
The premium is most likely due to investors chasing Coach’s higher yield (Michael Kors currently does not pay a dividend). If the dividend is cut, expect many income investors to bail out.
Coach has shown an ability to generate roughly 100% free cash flow from net income. With net income down to $466 million, expect to see free cash flow levels trend towards this level. This means that net income would have to drop another 20% for the dividend to become unsustainable. Over the past 4 quarters alone, net income is down nearly 44%, with a 20% drop in the past 3 months alone.
While investors can have their own opinion on the company’s long-term viability, this puts the current dividend payment in extreme doubt. As mentioned before, should the dividend be cut, the premium being placed on COH shares in comparison to peers could disappear.
For now, an investment in Coach should be a bet on a turnaround, not an income play.
