Article / 19 November 2012 at 11:42 GMT

Strong brand and basic business skills bag the prize for Coach

Matt Bolduc Matt Bolduc
Equity Analyst
Denmark

Executive summary

 

  • Fantastic management makes for a fantastic brand
  • Slowdown in the US will be overshadowed by Chinese growth
  • Superior financial management
  • No near-term catalyst but long-term looking good

 

Coach is one of those boring stocks and as a write it is difficult to make a cutting edge analysis on the stock. The stock has advanced steadily during the past years but has not been able to generate much excitement and investor conviction recently. 

Coach is not one of those undervalued plays that I usually look for. If we do an extremely quick and dirty cashflow calculation of its free cashflow, discounted at 8 percent with zero growth, we get a value of USD 12.5 bn, below the market's current value. But there is something to be said for a company that generates an return on equity (ROE) above 50 percent without any debt while maintaining strong sales growth in two main markets and being able to maintain the highest margins in the industry. Although it looks good historically, the past is sometimes a poor predictor of the future. So what makes the company so special? After all, few companies can grow this much and this quickly without some sort of competitive advantage.

Revenue and income growth

Competitive advantage and uniqueness are key to maintaining growth
While I scoured the internet for information on Coach, I realised that many research articles highlight all the possible information, valuation and performance measures which I have mentioned briefly above - all information that would be available to anyone. But for an investor who often looks for a company's intangibles, looking at ratios and past growth rates is quite unsatisfying. Some companies grow rapidly but quickly slow down due to a lack of competitive advantages.

One example of this is Chipotle Mexican Grill, the upscale fast food burrito maker. The company which has grown extremely quickly with revenue growth of 15-20 percent in the past five years is now down more than 40 percent after news got out that short selling master David Einhorn and his Greenlight Capital firm have been short selling the stock due to revamped competition from Taco Bell. The company also laid out disappointing guidance which further spooked investors. One theory is that what was once an upscale, unique and healthy Mexican fast food has now become just another somewhat generic burrito maker. Time will tell if this is the case, but when it comes down to it, CMG only makes burritos therefore making them unique.

So what makes Coach unique? Because when it comes down to it, Coach is just a luxury handbag maker. The brand is extremely strong and so is its reputation. But fashion companies are bound to similar fates as technology companies, which is that they often fall out of favour due to consumer whims or innovative designs by competitors.

Brand value is derived from strong management
Coach is one of biggest luxury handbag brands in the world. The company generates almost USD 5 bn of this USD 25-30 bn industry. In fact, Coach is the most frequently web-searched handbag company in the world, ahead of Louis Vitton (EPA:MC), Chanel and Gucci. Additionally, its retail operations are top notch, being fourth in the US in sales per square foot, behind Apple, Tiffany & Co, Lululemon which are all strong brands. And although the brand is very recognisable, especially in the US and Japan, I believe that the company is much more than just a brand. Because no matter what, the fashion industry is and will always be driven by fads and whims and will always face a high level of revenue risk. So again, we come back to the same question, what makes Coach special, and more importantly what will make the company grow at 10-15 percent for another 10 years?

Luxury brands

Customer data at hand is Coach's secret weapon
From the research that I have done, the reason for the company's continuing strong growth is actually pretty mundane. The company's continuing growth comes down to simple data crunching and market research. Coach's managers are equipped with daily sales reports which go hand in hand with a multitude of customer interview data, surveys, competitive studies and in-store product testing. Led by quick decision making and an agile organisation the company adapts extremely rapidly to changes in consumer tastes and new trends. Unlike most famous fashion brands, the company does not tell its customers what to wear, it instead tests and follows consumer trends to try to spot the next one, which is quite unusual in this industry.

This agility should not be discounted: many other firms simply wait for quarterly or even monthly sales numbers from their lines which have been designed a quarter or more before the release date. By contrast, Coach often uses its Japanese stores as its testing ground to see what will sell and will not sell. If a product unexpectedly and rapidly sells out, the company will quickly shift more resources to this product for its other markets. I like to see Coach in the same view as I see McDonald's, very agile and always willing to improve and refresh its menu (product line). Coach is fashion evolution driven by boring numbers and analysis, but boy does it pay off...

When you boil it down, the company has a strong brand because the company has a strong management; the two are inherently linked. But it also does not hurt that the company has been buoyed by the strong global luxury spending boom which has taken place over the past 10 years.

Not all sunshine and roses for Coach
Coach is facing a bit of headwind in the US with fast-growing Michael Kors (NYSE:KORS) biting at its heels, although the company said in its recent conference call with analysts that it has not seen any effect on its market share. Coach has seen strong same store sales growth of 5 percent in the US which is excellent considering the economic uncertainty and the lack of disposable income spending. In addition to strong same store sales, the company is planniny on opening 5 percent more stores in the US which will supplement existing sales.

Otherwise its fairly clear skies for the company; the company has fantastic growth potential in China with comparable double digit sales growth along with the opening of 30+ new stores in China alone, which could provide 30 percent+ plus growth rate to China alone. As it currently stands, China accounts for a bit less than 10 percent of the company's sales but this will quickly increase as the company steadily ramps up. Coach management also believes that China will become the company's biggest market relatively soon and will surpass the US, which currently accounts for 68 percent of the company's sales. 

But the risk remains that Coach's valuation could get crunched by a slowdown in sales - the main risk for the short term investor. At a P/E of 15, the risk is not huge, as the market has already factored a slowdown in growth. But even with a 'new normal' 10 percent EPS growth, which would be low for the company and especially given the company's recent foray into China, the stock could still warrant a P/E of 15. 

And one last thing...
To me this is the icing on the cake for any company with a reasonably priced stock: The company is very aggressive about buying back shares while maintaining a zero debt balance. The board has recently authorised another USD 1.5 bn buyback until 2015, which accounts for 10 percent of the company. Add to this the 2 percent or so yearly dividend yield, and over three years 16 percent of the company could be paid back to shareholders, making the stock 16 percent more valuable even if the company completely stops growing. 

Sure, buybacks are nothing sexy, but imagine where Apple stock would be if the company would have used its massive cash hoard to buy back shares a year ago, when the stock was trading in the 300 range? Apple could currently boost its EPS by 20 percent if it used USD 100 bn to buy back stock, which could arguably boost its stock price by 20 percent.

So the bottom line on Coach: good management, good undeveloped prospects, a strong brand and a lean balance sheet.... Not much more that you could realistically hope for. Unfortunately, I do not see a near-term catalyst for the stock, but for a long-term stockholder, this company should pay off handsomely.

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