Coach's Top-Line Growth Is Really Clutch

Narrow-moat

First-quarter revenue grew 1% year over year, with strength in most key markets and distribution channels. Although Coach sales at North American department stores declined approximately 30% on both a point-of-sale and net sales basis, we think this is solely reflective of the company’s decision to rationalize department store distribution and reduce promotional events in the channel, a decision we view as key to elevating the brand. In the first quarter, Coach closed about 120 of its planned 250 (about 25% of door count) location closures for the year.

Despite this headwind, demand in other channels indicated brand strength. Total Coach North American brick-and-mortar comparable-store sales rose approximately 4%, while aggregate North American comparable-store sales increased approximately 2%, including the negative impact of e-commerce, driven by a further decline in the company’s e-outlet flash sale business. International Coach brand sales rose 7% (3% on a constant-currency basis) on double-digit growth in Mainland China and Europe, offset by softness in Hong Kong and Macau, and weak Chinese tourist spending in Japan. Stuart Weitzman sales totaled $88 million, versus $87 million reported in the year-ago period, affected by wholesale shipment timing.

Coach has developed a narrow economic moat through a brand that commands high gross margins, sourcing and distribution advantages, and capital efficiency. Despite the company's recent struggles, it is still creating economic profits, and at a level greater than many lifestyle brands, or even some 100-plus-year-old European brands.

Attention to capital efficiency and consumers' strong brand loyalty have been key drivers of Coach's economic returns. We judge brand to be more important in bags and leather accessories than other soft goods categories such as apparel, since consumers tend to be more brand loyal. Despite Coach's long-run plans to increase penetration in footwear and ready-to-wear, we believe accessories will remain the core of the business. The men's business also offers some upside; it recently constituted around 17% of sales. At one time, men's constituted over 30% of the business but fell as low as 5% in the past decade.

Coach's international business is still underdeveloped and represents a long-run growth opportunity. Using success in Japan as a guide, we think there is plenty of room for Coach to take market share in other geographies. The company entered Europe in 2012 through department store partnerships and is now penetrating further wholesale accounts and opening retail stores. We believe there is room for a brand such as Coach offering uniquely American styles and high-quality products at lower price points. In this region, where Coach has just a small number of boutiques and is developing dedicated shops in department stores, the company should leverage selling, general, and administrative expenses over time, with sales of about $135 million in fiscal 2016 despite the strong U.S. dollar. In China, Coach lags other luxury brands with respect to sales, but has greater growth potential. The company has seen rapid growth in its China business (to an expected $600 million in fiscal 2016, up from about $100 million in 2010), and should also see higher operating margins as sales in the country expand, because of lower operating costs and higher gross margins.

While Coach might not have complete pricing power because of the price/value equation inherent at some level in consumers' decision to purchase its mid-tier luxury offerings, the company's ability to design, distribute, and source has historically enabled it to produce high operating margins. Coach's gross margins (close to 70%) and gross margin return on investment (taking inventory value and turns into account) are among the best in our coverage list, lending evidence that the firm has some pricing power in the range where it competes. Despite the short-term adverse fashion cycle, and in addition to the mistake of overpromoting online, we believe the Coach brand to be valuable and believe the company will again be able to return to high operating margins, which should drive returns on invested capital back into the high teens. Average prices continue to rise, reaching over $300 for the first time since 2009 and supporting our view that the brand has deep roots that give the firm an economic moat. Brand history and the extensive, directly operated, and wholesale distribution network also contribute to the defensibility of the position, in our thinking, and although currently in a reinvestment phase, the revamping and refurbishment of the network only serve to reinforce the brand image and solidify the economic moat. Our viewpoint is supported by returns on capital that averaged over 40% before fiscal 2013. Operating margins have averaged above 30% in the past, and despite short-term declines, we believe they can again reach the low-20% range during our 10-year forecast period.