Wednesday, December 12, 2012

Questions For Coach

It looks like competition in mid market fashion and apparel is heating up both in North America and in China. Subsequently the leading players are having to adjust their strategies. In a sense there is nothing new here; the fashion industry is always subject to changing trends and fortunes. In this article I want to take a look at how Coach (NYSE: COH) has adjusted to competition from the likes of Michael Kors (NYSE: KORS).

How is Coach Shaping Up?

Coach is attractive for many reasons; for example, unlike other mid market retailers like VF Corp or PVH (NYSE: PVH) it does not have significant European operations. The latter saw European sales at Calvin Klein decline by 10% recently, and I suspect the plans to bring some European operations in-house will be harder then they think it is.  On the contrary, Coach’s plans focus almost purely on Asia and North America.

I previously looked at the stock in an article linked here after Coach had reported lackluster results. At the time it became apparent that Kors had made meaningful inroads into Coach’s core territory of ‘affordable luxury’ in the US, and the challenge was to respond. Similarly, China has been looking weaker for retailers like Tiffany and Burberry, so questions were naturally being asked about its future growth prospects there.

I’ve summarized the key challenges for Coach in the following points.

  • Continuing growth in China?
  • Coach had cited increased promotional activity by its competitors as helping reduce footfall at Coach; how is Coach going to respond?
  • What about its e-commerce plans?
  • How about its plans to expand men’s products and Legacy brand sales?

On the whole I think Coach did pretty well in the quarter, but there are still question marks over how it generated this performance. Net sales were up 11%, with North America recording an 8% increase driven by an 11% increase in direct sales. Meanwhile international sales were up 15%, with a huge 40% jump in sales from China.

In order to look at how Coach generated this performance I’m going to run down the answers to these questions in turn.

First, China sales rose 40% with a combination of good same store sales growth and contributions from new stores. Moreover, expansion plans remain undiminished and Coach plans to open another 30 stores in China this year in order to grow sales footage by 35%. The surprising thing about China is that all the new stores will be dual-gender, which is a sign of confidence in the men’s offering; but it is also somewhat of a step into the unknown.

Moreover, the announcement of an e-commerce distribution channel for China is somewhat surprising for a company trying to establish an aspirational brand in a new territory. Might it not cannibalize sales or devalue the brand? Analysts always compare what Coach is doing with e-commerce with Nordstrom (NYSE: JWN), but the difference here is that the latter is not cannibalizing its own brand by doing this. In other words it can sell different brands/products across different channels.

Second, same store sales growth was up 5.5% in North America, but it was largely due to factory store comparables that benefited from increased promotions. Indeed, Coach claimed that overall promotional activity was actually down, but there was an increase in in-store promotions.  As for the full priced stores, their sales growth was quoted as being similar to ‘prior quarter trends,’ while its internet business was cited as driving overall comps. In other words, the key to the resumption of growth in North America was the promotional activity (couponing) in the factory stores and the increase in e-commerce related revenues. Moreover, men’s sales were also cited as a key driver of growth in Q1.

By way of comparison, sales trends at department stores were flat, with shipments actually declining. It’s hard not to conclude that the likes of Kors and Ralph Lauren (NYSE: RL) are not stealing customer interest and purchasing dollars from Coach within the department store.  I suspect the increased competition will force Coach into rethinking its approach to department store sales.

Third, with regard to e-commerce activities, North America is doing fine and the launch in China is evidence that Coach is trying to use e-commerce to drive sales via new distribution channels.

Lastly, in the tone of Coach’s post earnings presentations it is clear that it expects near term growth to be driven by its Legacy brand and its men’s products. Indeed, both were cited as key drivers of current growth, and the intent to open dual gender stores in China is a sure sign of this. I would suggest that this is a tacit acceptance of the fact its core market of women’s handbags and apparel is under threat.

The Bottom Line

In conclusion, this was a good quarter for Coach, but there are still questions here. It seems that its core market is under threat and much will depend on how it expands sales within its men’s products and emerging markets. Margin expansion opportunities will come from reducing costs but shifting to production to areas like Vietnam; however, if I am right about the need to increase promotions in the future, margins could be pressured the other way.

On the other hand, the stock is not expensive on a cash flow or EV/Ebitda basis and its management’s track record deserves some respect. The stock is very interesting down here, but I think it is worth monitoring the questions I’ve raised here.  If you feel like all of my questions have been answered, you may want to buy in.