Coach (COH) shares significantly declined during the quarter and have been a relative detractor since we first began purchasing shares in July 2012. With clearer hindsight, where did we go wrong on our initial timing? Our view then was that the Company's lackluster North American sales slump was largely due to a pause in creative new product. Thus, our initial investment in these shares came far too early in the Company's efforts to reinvigorate their iconic brand.
Of course, the journey in our ownership in Coach, thus far, has been long...and wrong. When we initiated Coach, we recognized that there was increasing competitive encroachment in the North American handbag and accessories market. However, we underestimated the aggressive expansion of Coach’s competitors, as well as the pernicious effects of brand underinvestment during the previous business cycle. The core risk of Coach has been centered on its North American business, which has been losing share over the past, roughly 3 years. Competitors Michael Kors, Kate Spade and Tory Burch have all successfully copied key aspects of the high return on capital Coach playbook, and now the original progenitor of "accessible luxury" now finds itself at the crossroads of not only redefining and rebuilding its own brand, but fighting off it's well entrenched progeny. We still think Coach has a sustainable competitive advantage, and we do not think that the competitive inroads of Coach's peer group are sustainable over the next 3 to 5 years.
In our view, the Company’s competitors have expanded too quickly and will soon reach a point of saturation. For instance, Michael Kors reported roughly $400 million in sales for its fiscal 2009; the Company recently guided to just above $4 billion in sales for the period ending June 2015 - a roughly ten-fold increase in just six years. For more perspective, consider the growth of the Company’s well-known peers: Burberry - an iconic affordable luxury brand that is over 100 years old - eclipsed $400 million in sales 2001. According to IBES estimates, the Company will surpass $4 billion in March 2017. In other words, it has taken Burberry, roughly 16 years to go from $400 million to $4 billion in sales. But that's actually about normal: Ralph Lauren took at least 15 years. Coach: 16 years. Hermes: 22 years, and Tiffany's: 25 years. All told, we think the exclusivity of the Kors value proposition is at risk, and therefore not sustainable.
We attended Coach's Investor Day last month in New York. Over the course of the Company's four-hour presentation we found ourselves nodding our head in agreement as the Company addressed mistakes and shortcomings in their current brand and marketing strategy. We agree too that the Company's comprehensive remedies are welcome news for frustrated shareholders. However, as we sat throughout the detailed presentations from all of the Company's top executives it became quite clear that the "fix” at Coach will be very expensive, inducing a sharp decline in the Company's earnings power over the next 12-18 months - and the projected brand and earnings renewal won't be quick. In fact, the fix will take a few years to fully complete in order for the Company to reclaim their once vaunted industry leading profitability.
While the effects of these competitive pressures and unforced-errors are being felt by shareholders today, we still think Coach’s steady-state earnings power over the next three to fives years will be significantly higher compared to what the business will earn over the next 12-18 months. Further, the Company’s international segment continues to grow at a robust pace, as their revenues represent still small share of each of their geographical addressable markets. We believe the success of the Company’s growth efforts in China and Europe, combined with flat market share in the more mature Japanese market, and a robust balance sheet, is enough to justify a substantial portion of the current market capitalization.
Several months ago, Coach embarked on an aggressive plan to reinvest in the brand and buttress its competitive positioning in North America. We think this is very necessary after years of underinvestment. This reinvestment plan has included the hiring of a new head of creative, and repositioning the brand by curtailing dilutive impressions, particularly by closing underperforming stores and online "flash-sales" as well as elevating flagship full-price stores to dictate Coach's value proposition of modern luxury. While these investments have hurt sales growth over the past 6 months and will continue to do so for the next 12 months, we think it will lead to a healthier brand impression and a much higher, sustainable level of earnings power in 3 to 5 years.
In our opinion, the Company's competitive positioning remains relatively unassailed in its international markets - especially in faster growing markets, such as Greater China. As the North American business remains challenged, we expect international will come to represent 40% or more of revenues.
We look at future earnings power, particularly over the next 3 to 5 years. While we underestimated the rate of competitive incursion and its effects on Coach's business in the near-term, we still think Coach has the ability to post earnings that are two to three times higher than trough earnings estimates, over the next 3 to 5 years. The Company's total addressable market is expanding at a robust mid to high-single digit rate and should be close to $50 billion in 5 years. We expect that the negative leverage from the Company's aggressive reinvestment will subside over the next 12 to 18 months, and double-digit earnings growth will resume.
Despite the planned sales declines and a dramatic increase in overhead (as a percent of revenues), Coach is still immensely profitable. This speaks to the Company's financial strength and competitive positioning. Currently, we estimate the market is assigning a $2.5 billion value to the Company's North American business - we expect sales in North America to bottom around a similar level, leading to a price to sales multiple of just 1X. We believe that a 1X price/sales is much too low for a Company that has a profitability profile and growth opportunities similar to Coach. That said, our valuation assumptions for North America are predicated on the continued success of Coach's international franchise. In addition, the Company remains dedicated to paying its current dividend, which is nearing a 4% yield. If Coach runs into difficulties overseas, there is a good chance we will move on, as the international business is the financial engine that will drive the near-term transformation in North America and support the Company's fortress balance sheet. Last, and as always, if we find a meaningfully more attractive risk-reward opportunity, we will sell Coach.
Philosophically, we expect stocks to track in-line with earnings growth, over a multi- year time horizon. We continue to think that the Company's aggressive reinvestment in the brand will yield earnings that are at least twice as high as today, particularly over the next 3 to 5 years. All told, we believe that the market has amply discounted the North American business at current prices and that the shares offer an excellent risk-reward profile at current valuations, so we added to positions.
From David Rolfe (Trades, Portfolio)’s Wedgewood Partners Second Quarter 2014 Client Letter.
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