Thursday, January 27, 2011

Coach is a Luxury Retail Play Exposed to Fast Growing Emerging Markets

What the Chinese Middle Class Want

High end hand bags and accessory company Coach gave good earnings and demonstrated  that the high end of the retail market is where you should be looking to buy stocks in the sector. The dichotomy between the high and bottom end of retail has been previously discussed here

In summary, I think Coach is the sort of stock that would suit a lot of portfolios. Coach has a well regarded management team and the company has a number of profit drivers. In addition, many of these revenue streams are on fire at the moment. Coach generates a lot of cash and is a good stock to be looked at for inclusion in a Growth At Reasonable Price (GARP) structured portfolio.

Before I discuss the results, I want to describe the profit drivers.

Coach Profit Drivers

They are numerous and this is why Coach's stock has had such a great year

  • Emerging middle class in China making aspiring to the Coach brand
  • Recovery in discretionary spending at the high end of Western markets
  • Shift of production to lower cost manufacturing centers
  • Increasing online sales and opening men's stores
  • Consumers 'traded down' during the recession and bought Coach instead of premium luxury brands like Louis Vuitton or Gucci

All of which, have contributed to Coach's top and bottom line. Coach is an established and very well regarded brand in Japan and, this has translated well over to China. There is potential for expansion in China as they only have 52 retail stores there, as opposed to 171 in Japan and a combined (retail & factory) of 478 in the US.

On a less positive note, they are exposed to rising raw material costs and they appear to have held back margins. Furthermore, any fashion business is exposed to the constant challenge to innovate and keep the brand popular.

Coach Q2 Earnings

A brief look at the earnings

  • Gross Margins were flat at 72.4%
  • Inventories rose 36%
  • EPS diluted of $1 vs. 97c estimates
  • Revenues increase 19% for the quarter
  • Free cash flow of $382m for the quarter

Coach don't give EPS or revenue guidance but here are a few points from the conference call

  • CapEx for 2011 forecast at $150m
  • Gross Margins for 2011 forecast at 72-73%
  • Operating Margin for 2011 seen flat at 31.5%
  • High single digit same stores growth forecast for the rest of the year in North America

The market was disappointed with the flat gross margins in the quarter plus the outlook for margins in future. In this quarter margins were held back by a larger proportion of sales taking place lower margin factory stores. This could be a structural issue, but it appears unlikely. It could also be the phenomenon (which has been observed at Burberry in London) of a pick up in purchasing by Far Eastern purchasers who want to buy Coach products in 'bulk' at factory stores.

Higher Raw Material Costs

In addition, higher raw material costs are holding back margins and, this issue looks set to continue. Coach will have to rely upon top line sales growth, unless they can raise prices. The co could find this relatively difficult because they are known to be at the lower end of the luxury spectrum. The good news is that Coach is generating good top line sales growth at the moment.

Inventories were high in order to support a combination of the strong growth in sales in North America, new store openings and the Asian distribution center.

Coach Evaluation

Coach is exposed to good growth trends. Flat margins are a concern but, they are generating good top line growth. Trailing free cash flow is at $879m which puts them on a FCF/EV of 5.84% with a current stock price of $54 this looks good value, for a company set to grow earnings in the low teens. The main concern would be a dramatic fall off in demand in Asia, if China falls into a real estate slump. This is a possible outcome for 2011, but not one to worry about unduly for now.

Analysts have this on EPS of $2.89 and $3.29 to Jul 2011 and 2012 respectively. I think this is cheap. Nevertheless, I run a hedged portfolio and already hold Nordstrom in the retail space (less exposure to China) so I won't be picking up Coach just yet. However, I do think it deserves a good look and will put it on monitor. Should China appear to be successful at smoothing inflation/real estate markets than Coach will probably be bought if it is at this kind of evaluation.

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