Sunday, September 16, 2012

Coach Losing Out to Michael Kors?

Coach $COH recently delivered results below market estimates and the stock took the equivalent of a violent hand-bagging from a demented harridan. The problem appeared to be limited to North America, where sales rose a paltry amount amidst strong competition and a declining market share. In comparison, international operations did fine. So is this a temporary setback or is there a more fundamental issue?

Coach Occupies an Enviable Niche

I’ve long been interested in this company for a few reasons. I’m fascinated by how it has managed to establish itself as a leading brand in Asia. I’m also struck by the marked cultural difference between US and European fashion brands. In general, US brands don’t seem to be able to exist while being focused on price, whereas European retailers are focused more on quality retention. In the US, if the price is right, the consumer will judge the quality. In Europe, if the quality is right, the consumer will judge the price. In terms of the luxury market, Coach is something of an anomaly and as a consequence has carved out a very profitable niche.

Its handbags are not of the quality of a Louis Vuitton or Richemont brand. Nor is it close to one of the leading Italian brands, or Burberry or even a small independent like Mulberry. However, to be fair, it isn’t trying to be. It operates in the middle ground, which analysts like to describe as "affordable luxury." The beauty of occupying this space is that you can drive margins higher by shifting production into China or Vietnam, etc. Any corresponding loss of quality or cache is fine as long as you compete on price. It is not the same thing for the leading European brands. Alas, only one who dates high maintenance women would really know so much about how these things work.

Speaking as one who dates high maintenance women, I can assure you that Louis Vuitton bags are bought strictly for their quality first and then price second. Coach bags are bought and used as everyday bags. All of which leaves Coach in an enviable position. It can expand margins via cost cutting (without driving customers away) and it can pursue its international expansion into the fast growing Asian market.

And Others Have Noticed

Unfortunately, it appears that others are gunning for this niche, and Coach’s problem is that it can’t really defend its market share on price (already relatively cheap) and innovation, and new product launches will likely trim its margins. In particular US mid-market brands like Michael Kors $KORS and Ralph Lauren $RL appear to be eating away at Coach’s market share. Kors is expanding its handbag sales and both these companies are of a similar standing to Coach in terms of consumer awareness and cache.

In the recent conference call, management cited increased promotional activity by competitors and a decline in traffic at its factory stores, which they believed was primarily responsible for the slowdown in North American sales growth.

Frankly, I think this is an issue and it might not go away unless Coach matches promotional activity. As I have tried to argue above, competing on quality doesn’t tend to trump pricing with the US consumer. That said, Coach has recently introduced the Legacy brand, about which the company seems very excited. However, it appears to be a more leather oriented suite of products. Of course, the margins on leather bags tend to be significantly lower than those of canvas (note how Louis Vuitton innovates with the canvas bags to drive sales) so I would expect some margin compression with the Legacy brand.

It’s not surprising that Coach’s CEO expanding the Legacy brand into non-handbag products such as jewelry, watches and scarves. These items traditionally have huge profit margins, but Coach needs to be very careful it doesn’t denigrate its brand.  With more than two thirds of sales originating from US stores, these challenges are significant.

Putting North America Aside

Otherwise, the earnings report was pretty good. China sales were up a whopping 60% and total company sales increased 13%. Coach is a very strong brand in Japan and sales were up 16% in constant currency. As is usual with luxury companies these days, Asia is the focus and Coach is committed to opening 30 stores a year in China. It also announced it would be buying the domestic retail business in South Korea from its current distributor. Indeed, the forthcoming fiscal year was described as being an ‘investment year.’ Much of which will be focused on Asia, but Coach is also expanding its men’s products sales and investing in e-commerce initiatives.

The e-commerce initiatives are not going to be on the scale of what a company like Nordstrom $JWN is doing, but then again Nordstrom does not have the issue of possibly competing against its own products within distribution channels. In plain English, this means Nordstrom will likely have more control over differentiating what is discounted online, whilst Coach needs to protect its brand overall.

On a more positive note Coach is highly unlikely to suffer the kind of faddish sentiment that seems to be affecting Abercrombie & Fitch $ANF at the moment. Sure you can dream up a marketing gimmick and pump perfume and loud music and customers in order to create a ‘retail experience’ and then sell them a product whose quality can easily be matched elsewhere.  This will work for a while, but as Abercrombie is finding out, you need to change the act if you want to keep bums on seats. No such issues for Coach.

Where to Next for Coach?

The stock is certainly not expensive and its management has a history of delivering. The initiatives all make sense and Coach remains a well regarded brand in some very fast growing international markets. The question is, under the heat of competition, just how strong is its brand in the US?

Moreover, is the age of the US consumer deleveraging and trading down going to erode margins? I suspect we have seen a sign of this in the latest report and cautious investors might want to wait a while before seeing how successfully Coach is reacting to the new competition trying to take its profitable niche away.

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