Coach vs Starbucks: At least one of these is very mispriced

What do Starbucks (NASDAQ:SBUX) and Coach (NYSE:COH) have in common? At first glance, not much. Apart from the fact that both companies have really strong brands and very loyal customers, they operate in two completely different sectors. One sells handbags and the other sells coffee. 

Why do I find these companies interesting?
Starbucks and Coach are very interesting right now because they are prime examples of how valuations can quickly escape investors' scrutiny. One of these companies - Coach - has had higher historical growth in almost every financial respect. But on a price per free cashflow valuation, Starbucks is miles ahead even though both companies' growth driver, discretionary income, is very similar. While historical performance is often a poor predictor of future performance, companies that keep growing and keep earning strongly, typically have a competitive advantage that simply makes them better companies.

If we look at growth measures we can see that both companies have done very well. On the revenue side in the past 10 years, Coach has grown by 21 percent while Starbucks has grown 15 percent on a cumulative average basis. For net income, Coach expanded by 28 percent while Starbucks grew at 20 percent. In terms of EPS, Coach advanced by 31 percent and Starbucks went 21 percent ahead. All are excellent growth rates (shown in Chart 1 below).

Due to the law of large numbers, neither company can be expected to continue to grow at these rates. But it's not hard to imagine that these companies will be able to continue to grow at rates that are much higher than economic growth given that they most likely have distinct competitive advantages.

But the disconnect between these two companies is that one of them is valued much more than other on both a P/E and P/FCF ratio. Both companies produce about one billion dollars of free cash flow per year but Starbucks is 230% more expensive than Coach!

Sure we can assume that Starbucks has better prospects. Or maybe we can assume that at least one of these companies is actually quite mispriced, especially since the cheaper company, Coach, is actually the one with the highest historical growth, better financial performance and the most stable earnings growth.

Given the large discrepancy in valuations, the market obviously believes that Starbucks has a much brighter future than Coach and expects it to grow far faster.

If we take a helicopter view of the two companies perhaps we can get a general idea of their differing prospects, bearing in mind their abilities to grow.

At present, 86 percent of Coach's revenue derives from two mature markets - the US and Japan. The growth from these markets is around 10 percent which is still rather good. Meanwhile, the US accounts for 76 percent of Starbuck revenue. From a geographical perspective both companies have 'conquered' their home markets. Both companies are expanding rapidly in China which will drive the bulk of their  growth in the near and long term.

Is Starbucks expected to outpace Coach by such a large margin as to warrant a 175 percent premium? Perhaps, but my common sense tells me that this premium might be a bit much, given the similarity in their historical growth patterns, their expansion into similar growth markets and management capabilities.

Cashflow matters much more than earnings
Investors often zone in on the P/E, but earnings are not really the best way to dictate a company's value. Cash generation is actually the ultimate way to calculate the value of a company. The interesting thing between both companies is that Starbucks actually earns much more net income at around USD 1.4 billion vs Coach's USD 1 billion. But from a free cashflows perspective, which is truly what matters in investing, Coach's business is more cash generative than Starbucks per dollar of earning. In fact, in the past 10 years Coach has managed to earn two percent more cashflow per dollar of earning compared to Starbucks. Two percent might not sound like much, but for sustained for a decade or more, the compounding effects will make sure that this small two percent will become increasingly larger. 

But let's get back to the main point of miss-valuation. If we value Starbucks relative to Coach on a free cashflow perspective, Starbucks is actually trading at a 230 percent premium not the measly P/E premium of 175 percent! I would guess that most readers would now most likely question the valuation of one or both companies. Something clearly doesn't add up completely.

So again - is Starbucks worth more than twice or three times as much as Coach? For all the reasons cited above, I definitely do not believe this to be the case. The most likely answer is that Starbucks is a bit too pricey while Coach is undervalued. So how do you trade this?

You can use Beta (Covariance of daily returns of Coach and daily returns of Starbucks/Variance of daily returns of Coach) to determine what type of hedge ratio you can expect long Coach and short Starbucks. Correlation doesn't work as well as it shows the direction of relationship but it doesn't account for the magnitude of the relationship, unlike the Beta coefficient which does.

Unfortunately the 2-year Beta (Chart 4) for Starbucks relative to Coach has been somewhat unstable, and practically unusable. The 1-year Beta has been even less stable but this little analysis still highlights how easily stocks can get mispriced. 

Moral of the story: If Starbucks is properly priced, than it's extremely likely that Coach is very underpriced so buy it. And if Coach is properly priced, stay out of Starbucks, or better yet short it.