Coach (NYSE:COH) Investment Case
We believe Coach (NYSE: COH) represents a significant investment opportunity for long-term investors.
Coach is a manufacturer, distributor, and retailer of handbags and accessories, and is expanding to broader product categories. Its products offer the quality of higher luxury brands but at more attractive price points. Although about 60% of sales come from its 543 North American retail stores, Coach also sells its products through department stores, international shops, e-commerce, its catalog, and Coach stores in Japan and China. Coach recently started establishing European distribution, with 20 stores acquired in fiscal 2014.
We base our recommendations on several key measurements. These include a sustainable competitive advantage, narrow economic moat, compelling valuation based, financial strength, and management focus on long-term shareholder value generation.
Investment Thesis
We believe the stories of Coach’s demise are greatly exaggerated. Despite several years of slower growth and a perceived stumble against competitor Michael Kors (NYSE: KORS), Coach’s investment thesis relies on several core measures.
1. Sustainable Competitive Advantage
Through the course of its 75 year history, Coach has maintained leadership in the luxury leather goods and accessories business with high returns and steady growth. Having survived the 2008 Great Recession with this story mostly intact, the company is now refocusing its brand strategy, distribution systems, and core markets. Even during this period of consolidation, the company is forecasting relatively stable 69%-70% gross margins. While the US market continues to pressure results, Coach’s competitive advantage allows the company to pull other market levers. An example of this is the company grew its China business from just over $100 million in 2010 to a projected $540 million in sales in fiscal 2014.
2. Economic Moat
We believe Coach’s economic moat remains intact. The company’s brand strength, direct operating model (US based Coach stores) and revised wholesale distribution network (China and Europe in 2015 forward) create a clear economic moat. While taking a hit in the past several years, returns on capital have remained high averaging nearly 40% for the past five years (2010: 45.1%, 2011: 55.5%, 2012: 56.9%, 2013: 46.7%, 2014 est: 37.3%). Operating margins remain some of the best in the retail industry (2010: 31.9%, 2011: 31.4%, 2012: 31.7%, 2013: 30.0%, 2014 est: 27.4%). Management expects the decreases in 2014-2015 to mark a low point as the company invests heavily in SG&A and rise to historical levels in 2016.
3. Financial Strength
The company retains a fortress like balance sheet giving it the ability to invest in new markets or product development as necessary. Cash and equivalents have increased from $700M in 2010 to $1.14B in 2014. The company carries no long term debt. The company’s 5 year average ROE is 49.2% and its 5 year average cash flow as a percent of revenue is 21.8%. The company pays out an annual dividend at the rate of 3.9% that represents a payout ratio of only 27.7%.
4. Management
Coach’s management team is exemplary in two important ways. First, the personnel from Lew Frankfort as Executive Chairman and Victor Luis as CEO have deep industry experience in the luxury retail marketplace. What we like the most is Luis’ successful experience in growing the international presence of LVMH brands previous to Coach. While the loss of Reed Krakoff was tough, we believe the new design team led by Stuart Vevers is will provide great leadership and abilities moving forward. Vever’s experience at Mulberry is exactly the type of skill sets we feel Coach needs in taking its products to the next level.
Equally important to their skill sets, we are very impressed to see management is aligned with shareholders. In 2013 for instance Frankfort was purchasing Coach stock in the open market even with the knowledge he was leaving the CEO position.
A majority of Coach's board is independent, and officers and directors own nearly 5% of the shares outstanding. The CEO and Chairman’s positions are separated which we believe is essential for good stewardship.
Finally, management has shown great capital stewardship by making the decision to return capital in the form of dividends starting in 2009 and buying back stock when it was trading significantly below fair value.
Valuation
Utilizing a discounted cash flow model we estimate the company is worth roughly $51 per share. The current price of $34.72 (06/22/2014) represents a roughly 32% discount to fair value. We derive the estimated value of $51 per share with the following assumptions:
| Cost of Capital: | 10.9% | |
| Projected Annual Growth Rates (Free Cash Flow): | 2014 – 2015 | -2.7% |
| 2016 – 2022 | 7.5% | |
| Projected Annual Growth Rates (Revenue): | 2014 – 2015 | -8.2% |
| 2016 - 2022 | 9.8% |
We have modeled a relatively difficult period for 2014 and 2015 slightly in excess of Coach’s guidance. We project an average decline in revenue of (8.2%) for those years with margins dropping below 20% and CapEx of roughly $470M. From 2016 forward we expect margins to return closer to their historical average of 30% along with a measurable decrease in SG&A from its high in 2015.
Risks
Moving forward Coach faces very real risks from three strategic initiatives. First is its effort to move beyond accessories and into a full lifestyle brand such as LVMH. Second is expanding its geographic footprint into Europe while restructuring and reducing its store base in the US. Last, this year will be the first full launch of Vever’s designs.
The first risk is that Coach’s design team – headed by Vever – gets the latest fashion trends wrong. We believe his team’s deep industry experience in the luxury market mitigates this significantly. However, if not well received an additional risk is damaging the market place’s perception of Coach as an iconic – and therefore necessary – purchase. The second risk is misreading the demand for Coach’s product in the growing Asian markets and its new distribution plans in Europe. Recent historic sales numbers in Asia alleviate these concerns but Europe remains to be seen. Third, the restructuring and tightening up of store locations in the US creates an atmosphere of defeat by main competitors such as Michael Kors and Coach loses its hipness. Last, management makes a series of poor choices in capital allocation thereby losing its financial strength and watering down the brand through acquisitions or new product development.
Conclusion
Coach is a well-managed company focused on creating shareholder value over the long term through wise allocation of capital and strategic vision. Management continues to create significant shareholder value through high levels of corporate profitability, return on invested capital, and sustained market share and revenue growth. The company has created a strategic plan to reignite growth over the next 10 years utilizing these strengths.
Utilizing a discounted cash flow model, we believe the stock price represents a 32% discount to fair value as of June 23rd, 2014. All of these factors point to Coach as a strong investment opportunity for value investors over the long term.
