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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Schlumberger Gives a Balanced Outlook

Leading Oil services company Schlumberger gave results recently which beat estimates but were a little bit underwhelming in the outlook. Before I go into more detail, I should point out my view on Oil services companies.

 I see them as correlated plays on the current price of oil. In my experience they have a higher correlation to spot oil prices than exploration and production companies do. This is because the marginal increase in demand for their services comes from the short to mid term price movement in Oil. With regards exploration companies, they are more determined by longer term considerations because-even with substantive reserves-they don't realise those reserves at current prices. For the integrated majors, oil prices can be damaging to some aspects of their downstream business as high prices could curtail demand and margins.


Schlumberger Results

The point of looking at Schlumberger is to discern some industry outlooks that could give clues as to which oil services stock you favour, in order to manifest a viewpoint of higher prices. I've made a few bullet points from the results and conference call

• Co focused on Smiths integration
• Pricing and margin pressure seen in the second half
• Strong activity in oil field services in N America
• Oil field services strong in North Sea,West Africa, Middle East and Asia
• Weakness in Mexico oil field services
• Technical successes scanning,reservoir production and drilling offerings
• Strongest 2011 growth in deep water seen coming from West/East Africa
• Demand recovery not as strong with natural gas
• Increased supply of unconventional gas in the US and liquefied natural gas (LNG) worldwide seen as limiting price growth

Short term, Schlumberger was not optimistic that a 'major return' to work would come in the Gulf of Mexico. The markets that contain a significant amount of uncertainty are Iraq, Russia, Mexico and Brazil. Although I suspect the risks are on the upside here.


Conclusion

I think gas services continues to look weak and the outlook wasn't great. Schlumberger mentioned possible margin pressure in the second half, but this will largely be determined by the price of oil. With regards Oil services stocks, it suggests focusing on oil at the expense of gas plays.

I would be a bit cautious with the stocks that rely on new activity, such as Transocean. Furthermore, according to Schlumberger, it will be late 2011 or 2012 before activity picks up in deep water Gulf of Mexico work. Again, I would stay clear of these plays.

Overall, a pretty balanced outlook for 2011.

Family Dollar and BJ's Wholesale Figures Don't Matter

Family Dollar and BJ's Wholesale Club  gave results today and disappointed the market with their sales guidance for 2011. On initial reading this does not seem to be reflective of a weak retail sales season.  However, it does seem to be representative of the problems of the lower income demographic that Family Dollar is focused on. Is this ultimately a problem for US retail spending?

I don’t think so!

US Income Inequality

The discounters (Family Dollar, Dollar General, BJ'sWholesale etc) always will have their profitability affected by marginal movements in income and expenditure of lower income demographics. However, the US has such an inequality of income in the States that a bifurcation of prospects tends to take place under certain conditions. I decided to look at some income distributions by quintile. These figures show the share of national income taken by different income groups.

 

	Low 20%	Next 20%	Mid 20%	Next 20%	Top 20%
% of  Income	3.4	8.9	15.3	23.9	48.5
% of Spending	8.2	12.6	17	23.5	38.6

source: Earnings View, Census of the Bureau

So the bottom 60% of the population does not spend as much as the top 20% Moreover, there are other factors that influence these numbers. For example, lower income groups spend much more of their income on gasoline and consumer staples such as foods. These prices have been rising recently and I would expect this to eat into their discretionary income.

 

and




The discounters had been doing well with customers 'trading down' into using their lower cost options but this trend seems to have slowed. The real problem with Family Dollar and BJ's latest sales figures is that higher staples (food, gasoline etc) eat into the discretionary income of lower income groups in the States. For example, here is a breakdown from the 2006 census of how much each 'quintile' spends on energy.

	Low 20%	Next 20%	Mid 20%	Next 20%	Top 20%
% Income	8	4.8	3.8	3.1	1.9
% Spending	4.1	4.2	4.3	4.0	3

source: Earnings View, Bureau Census

Moreover, this will rise with higher gasoline prices.


Product Mix Changing to Lower Margin Sales

The second issue is that these movements will affect the type of spending at the discounters. They can pass on the increased costs of food/gasoline but these are not high margin products. The result will be a drop in margins.  Indeed, at BJ Wholesale sales including gasoline rose 3.8% but excluding, they were only up 1.9% Discretionary spending on higher margin items appears to have slowed.

The third issue for the discounters is that unemployment remains high in the States and this will disproportionately affect lower income groups. Temporary staffing has been surging but permanent employment gains haven't yet kicked in. This makes employees nervous about opening up the purse strings.


Stocks to Buy?

I think these stocks may prove interesting as late cycle plays. Employment gains look like they are on the way and today's ADP report was particularly encouraging. Moreover any future drops in energy and food prices will benefit the discounters now that higher costs are being priced in by the market. The one blot on the horizon is the uncertain nature of the housing market. However, there will be plenty of time to monitor this in the next few months. These stocks are not a 'buy' just yet.

As for the wider retail market, I don't think these sales updates bear much relevance.

Oil Stocks Exposed to Kurdistan

I thought it would be useful to look at some of the Western oil companies that are focused on Kurdistan. I think these could be good oil stocks to buy. They are interesting for a number of reasons, most of which are predicated on a successful resolution of disagreements between the central Government and the Kurdistan Regional Government (KRG)

1. They tend to be characterised by being smaller companies who moved in on the market when the central Government said they wouldn’t allow any of the companies with KRG licences to take on development projects in the rest of the country.  This means that these companies are potential takeover targets once the political issues are resolved.
2. There is likely to be significant upside potential due to de-risking once/if this process takes place.
3. Iraq is oil rich and Kurdistan is under explored. The early movers have advantages.

 Oil Companies Involved in Kurdistan

The four companies identified are DNO (Norwegian), Gulf Keystone Petroleum, Heritage Oil and Sterling Energy. I have added a link below to some Goldman Sachs research whereby you can source forecasts and outlook or these stocks.

Before going any further, it should be understood that this idea is a speculative one, based on a successful resolution of the problem between the KRG and central Government. The standoff centres on licences issued by the KRG with these oil companies. The licences are based on Product Share Contracts (PSC) which central Government has consistently said it would not ratify. Naturally, as they are not ratified, export licences have not been issued. Furthermore, the PSCs may be torn up or be made subject to significant revisions in the political horse trading process with the central Government.

Kurdistan Production Share Contracts

Essentially, the PSCs are seen by some as being on more favourable terms to the Oil companies than would be the case under typical Iraqi service agreements. Furthermore, the KRG are effectively getting a subsidy from the rest of Iraq in order to pay the contractors exploration and developmental costs, because these costs are paid centrally from revenues emanating from total Iraqi production. Currently, Kurdistan’s oil production is proportionally lower than the rest of Iraq per head.

My hunch is that these licences will be ratified but there could be pressure to renegotiate contracts downwards for the contractors. With a new Government formed and the necessity of Baghdad to garner Oil revenues, I consider it unlikely that they will seek instability by not ratifying. Furthermore, Kurdistan remains a pet project of US foreign policy, even though the politically powerful Oil majors are not there yet. The pressure to get their oil industry developed will be significant. However, quantifying this viewpoint is not easy, although I note that Goldman Sachs ascribe a 50% political risking to the NPV calculations. I suspect the outcome could be more benign than the risks implied by Goldman Sachs.

Iraq/Kurdistan Oil Contract Dispute

The reason I suspect that they will be benign is that, the PSC agreements appear to be generous, but not overly so. According to Peter Wells when comparing Iraq’s Technical Service Contracts (TSC) with Kurdistan’s PSC agreements

“The contrast with the KRG is considerable. The KRG’s PSCs have been awarded by opaque, secret negotiations to companies with, in the main, very limited major international field operating experience. The profit sharing terms of the KRG PSC are simplistic by the standards of modern PSCs and yield lower revenues and value to the state than PSCs in

comparable countries.”

Furthermore, if we look at figures 4 & 5 you will see that his modelling produces 97% of state take under the PSC but around 99% under the TSC. This isn’t a huge percentage difference to the State, but it is to the contractors share. In other words, assuming $60 a barrel of oil, he might get $5bn instead of $8bn under this model.

However, in his response to this paper, Muhammed Mazeel al-Aboudi articulates the KRG position on Iraq’s TSC agreements

“The contracts are, therefore, not in the best interest of Iraq – even with the important budget needs. These will be long-term contracts and need to be properly offered, reviewed, and approved in accordance with the Constitution and an oil and gas law that is in accord with the Constitution.

In the Kurdistan Region, by contrast, IOCs will, on average, receive a “gross undiscounted profit” figure of just $1.58 (at NPV of 10%) for each barrel of oil discovered and produced from any large field discoveries – almost 40% less than $2.20/B in the case of Ministry of Oil proposed contracts. “

So, by way of contrast, the KRG argue that the Iraq TSC agreements are too generous! I’ve included a link to the KRG’s views below.

Stocks to Buy and Benefit from Oil in Kurdistan

I think the important point is that the KRG thinks –or at least they say-that their contracts are not unfavourable relative to Iraq TSC. With the political wind moving behind the KRG it could mean that they get what they have already signed up for.

Of the four companies noted, Sterling Energy appears to be an also ran. They have had disappointing results in Kurdistan and the potential uplift is minimal. Gulf Keystone Petroleum appears to have the largest upside potential from a successful resolution. Heritage Oil is very interesting but contains the added risk of a tax dispute with the Ugandan Government over the sale of some of its assets. Since the idea here is to gain exposure to Kurdistan specifically, this might preclude an aggressive position with Heritage Oil. DNO is very interesting. Although the evaluation discount does not appear to be large, they have assets in production and would give good upside potential given successful political resolution.

Source:

Al-Aboudi, Muhammed Mazeel ‘Iraq’s TSC And PSC Agreements – A Good Deal For Iraq?’ http://mepep.com/postedarticles/oped/v53n03-5OD01.htm

Goldman Sachs Research http://www.oilbarrel.com/fileadmin/content/pdfs/Brokers_Notes_Oct_10/50%20E%20and%20Ps%20to%20change%20your%20portfolio.pdf

Kurdistan Regional Government Website

http://www.krg.org/articles/detail.asp?smap=02010100&lngnr=12&anr=30161&rnr=223

Wells, Peter ‘Iraq’s Technical Service Contracts-A Good Deal for Iraq?’ http://www.iraqoilforum.com/wp-content/uploads/2009/12/Iraqs-Technical-Service-Contracts.pdf