Don't Ride Coach Just Yet

By Kristin Graham | October 22, 2009 AAA

A rapidly shrinking luxury market has been devastating to upscale retailers and consumer goods product companies. Years of hasty growth was fueled by middle-class shoppers binging on credit cards and tapping home equity to peer over the barrier that separated them from the wealthy.

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Hitting The Brakes
The credit-bubble collapse has brought Coach's (NYSE: COH) double-digit growth to a screeching halt. In its first quarter, sales dropped 1% to $761 million and net income fell 3.5%. Expansion and the launching of a new product line helped improve North American store sales by 8%. However, indirect sales plunged 33% as department stores like Macy's (NYSE: M), Nordstrom (NYSE: JWN) and Saks (NYSE: SKS) tightened inventory levels after having to heavily discount and send leftovers to bargain outlets like TJ Maxx (NYSE: TJX).

In an attempt to rejuvenate anemic sales, Coach is tailoring its business model around the "new normal" notion that economists and investors have referred to recently. After all, it's a natural instinct for management to rush out and adapt to the changing consumer landscape. Handbag selections ranging from $200 to $300 were broadened, and overall pricing strategies have been re-established.

Poppy Won't Pop Growth
The new Poppy collection, a budget-friendly concept consisting of products with price points ranging from $198 to $598, is targeted to frugal fashion enthusiasts. Management views it as an outlet to regain some of the lost "wanna be upper class" shoppers it lost throughout the recession. In my opinion, however, this comes across as a desperate attempt to buoy near-term sales and could have a long-lasting damaging effect on the brand.

Like CEO Lew Frankfort, you may disagree, as Coach's Q1 reports suggest the brand was well-received. And I'm not necessarily doubting that initial sales will be strong. Young girls will likely gush over the new products that fall into their spending budgets.

The problem stems from the fact that the Coach brand stands for expensive sophistication - not value-oriented and chic. Skimming Poppy's offerings, the products appear tacky, and the edgy look clashes with traditional Coach merchandise. In the end, this may drive away some of Coach's older, more loyal and deeper pocketed customers who purchase Coach for its classy image. The new line introduces the possibility of brand confusion among consumers.

China: Always The Answer To Growth
Despite criticizing Coach's domestic business strategy, I do think the company has an exciting growth story overseas - specifically in China. While the numbers have yet to be confirmed, management estimates that imported bags and accessories in China grew 40% in the Q1.

The good news is that sales in China still represent a very small portion of Coach's overall revenue. Given that management can properly penetrate the Chinese consumer market, there is vast potential in the region. Currently, brand awareness clocks in at just 8% in China. That's compared to 72% in the U.S. and 63% in Japan.

Bottom Line
Despite being critical of Coach in this analysis, I do like the company. I certainly question its adaptation strategy to the recession and whether it will impact the company's brand image. However, Coach produces a superior product, and flashing a product endorsed with the Coach name remains a symbol of status - an attractive quality that generates favorable long-term prospects.

Based on ratio analysis, I don't necessarily think Coach is attractively priced at 16 times forward earnings, particularly given a risky near-term outlook. My recommendation is for owners to hold on to shares, but for those shopping around for shares to wait for a better deal. (For more, see Analyzing Retail Stocks.)

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