Coach Still Flying First Class

By Stephen D. Simpson, CFA | May 02, 2011 AAA

Some things never change, including consumer behavior. Maybe the great housing boom/bust did force a few consumers to change their ways, but as the economy has rebounded, the demand for high-end consumer goods has gone along for the ride. As one of the more popular brands around, Coach (NYSE:COH) continues to deliver solid financial performance.

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On Target Performance
Even with the significant impact of the Japanese earthquake, Coach once again managed to modestly beat estimates. Revenue rose 14% this quarter, fueled by direct-to-consumer sales growth of 15%. North American comps were up about 10% (and ahead of expectations), while Japanese sales fell 9% in local currency. Such was the impact of currency moves, though, that Japanese sales were actually flat on a reported (dollars) basis.

Coach did not perform quite as well on the profitability side. Like so many companies, Coach is seeing pressure from currency, materials, shipping, and so forth. Gross margin declined about 140 basis points, while operating income (on a non-GAAP basis) rose 12%. Still, it is clearly worth noting that at over 29%, Coach produces exceptionally good margins (as well as very high returns on assets and capital).

Inventories did jump quite a bit from the prior levels. Inventory on a square footage basis looks to have climbed about 20% from last year and nearly 30% from the fourth quarter. That sounds bad, but the year-ago levels were depressed (Coach was fairly savvy about running down inventory when sales were weak), so it does not jump out as a problem. (For more, see Inventory Valuation for Investors: FIFO and LIFO.)

China and Men - Can They Deliver The Goods?
Coach is largely a one-brand company, which is relatively rare in publicly traded consumer goods companies. Even in luxury brands it is something of an exception. LVMH (Nasdaq:LVMUY), Richemont and PPR all feature a stable of brands. Of course, there are companies like Hermes (Nasdaq:HESAY.PK), Mulberry and Tiffany (NYSE:TIF) that have made a go of it with just a signature brand.

The question, though, is whether Coach can continue to find the levers for further growth. China is a big opportunity for Coach ... but it's also a big opportunity for LVMH, Mulberry, Hermes, and a small legion of knock-off artists. What about men? Is there enough business in wallets, shoes, belts, and so on, or can the company convince men to carry "totes"?

Ironically, new growth markets may not be the biggest risk for investors to consider. Diversification could be a bigger threat - Coach generates an exceptional amount of cash and it may be tempting to augment growth with an acquisition. Management has not shown that inclination so far, but investment bankers just love to come knocking on doors all full of ideas for companies' cash.

Time to Play the Higher End?
It's not necessarily obvious from the markets that the upper-end consumer spending thesis has played out. Retailers like Ross Stores (Nasdaq:ROST) and Jos. A Bank (Nasdaq:JOSB) have done pretty well lately (and they are more discount/bargain-oriented), while Nordstrom (NYSE:JWN) has been more of a laggard. Of course, it could simply be a question of where people are choosing to buy, as Coach and Tiffany have certainly outperformed Nordstrom. Even with that outperformance, though, the valuations are not exactly at nose bleed levels, suggesting that there could still be room for the sector. (For more see, How to Outperform the Market.)

The Bottom Line
Coach is an exasperating stock to value. Right now, it looks more or less fairly priced and therefore lacks that margin of safety that is so important to value investors. But it is also very hard to dismiss a company with a valued brand, very high ROICs, and excellent cash flow generation. Coach is clearly a high-quality company and it warrants a robust valuation, but investors may want to hope for a rare sale before loading up on the shares. (For more, see Value Investing + Relative Strength= Higher Returns.)

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