It's in the Bag for Coach


By Amy Tsao On Feb. 24, luxury-goods retailer Coach (COH) issued earnings guidance that, at the time, defied logic. As war with Iraq loomed and fear grew that consumers would pull back, Coach raised its earnings-per-share forecast for the fiscal third quarter, which ended Mar. 29, to 29 cents a share, up 16% from consensus forecasts. On Apr. 22, the New York City-based outfit beat that improved number by 5 cents a share and raised targets for this fiscal year and next. The markets cheered, pushing Coach's share price to a 52-week high of $42.50, about 24 times fiscal 2004 earnings estimates.

The positive surprises aren't a first for Coach, having beaten consensus estimates 10 out of 11 quarters since going public in late 2000, according to earnings tracker First Call. The stock is up 220% in the same period, yet many investors bet that more gains are ahead. And despite the stock's run-up, its valuation has remained relatively stable. Next to other publicly traded luxury retailers, Coach's shares seem reasonably valued. Jeweler Tiffany (TIF) trades at $28 per share, or 20 times projected earnings for fiscal 2004, while Gucci trades at $95, or 35 times 2004 earnings.

A HANDLE ON GROWTH. The Coach brand's continuing popularity, the addition of new distribution channels, and higher margins all lend credence to Wall Street's bullishness. And bullish the analysts certainly are: Of 12 who cover it, 10 rate Coach a buy or strong buy.

Coach's impressive short-term results and its promise that the performance can be repeated are feeding investor optimism. In the latest quarter, net income rose 117%, to $31.9 million, on a 36% sales increase, to $220.4 million. "We can double our business in the next four to five years," says Chairman and CEO Lew Frankfort, who says he expects revenue growth to be at least 15% a year and earnings growth to be "materially higher" than that. And while Coach has an 18% share of the U.S. luxury-goods market, Frankfort says he can boost that to 30% in the next few years.

In a gloomy retail sector, Coach's robust performance is one of the few bright lights. "The strength of Coach speaks to the fact that there's a segment of the U.S. population that remains insulated from macroeconomic changes," says consumer analyst Eric Jemetz at New Amsterdam Partners. For the most part, consumers appear to be worried about the sluggish economy. "Chic shabby" Target (TGT) is turning in declines in monthly same-store sales, while Wal-Mart (WMT), the nation's largest retailer, is squeezing out single-digit sales gains.

"ASPIRATIONAL BRAND." However, Coach's popularity appears to go beyond catering to a crowd that doesn't stop spending when times are tough. Consumers seem to view Coach, whose buyers typically spend $200 on a handbag, as an affordable luxury, vs. more expensive items from Bulgari or Hermes. It's an "aspirational brand that has appeal to a larger audience," says Jemetz. (Neither he nor his firm owns Coach shares.) Yet sales at Tiffany and high-end department store Saks (SKS) have weakened in the past year.

Coach laid the foundation for its recent success years ago. Beginning in 1995, when Frankfort took the helm, names like Gucci, Louis Vuitton, and Kate Spade were gaining appeal, while Coach was seen as classic but staid. Frankfort brought in new designs, materials, and product lines to convince consumers that Coach is "stylish and feminine," he says. Besides its signature leather handbags, Coach expanded its lineup to include shoes, jackets, furniture, and pet collars. "You look now at Coach and see a much more updated product," says Buckingham Research analyst Lee Backus. (He doesn't own shares, and his firm has no investment-banking relationship with Coach.)

Others agree. "Coach is doing a great job of...bringing new consumers into the franchise through its new product offerings," says Goldman Sachs analyst Margaret Mager, who maintains her outperform rating. (Goldman has received investment banking fees from Coach in the past 12 months and may receive more in the next three months.)

WHOLE NEW BAG. A shift away from Coach's hallmark all-leather purses has helped boost margins. Many of its newer designs incorporate less expensive materials like straw or canvas. In the March quarter, gross margins rose from 68.8% to 72.5%, partly because of products made with combinations of materials. Margins have also been improving because Coach has been shifting manufacturing to low-wage countries. During the latest quarter, mixed-materials bags accounted for 70% of sales, up from 60% in the same quarter a year ago.

Coach also is expanding rapidly overseas. In Japan, the label is fast becoming a fashion must-have. "They're the new name on street," says Cary Nordan, equity analyst at BB&T Asset Management in Raleigh, N.C. (Nordan says BB&T owns the stock in its midcap fund, but he doesn't personally own Coach stock.)

Coach sells products in 92 locations in Japan and plans to add 30 more venues (at department-store counters or freestanding shops) in the next three years. Japanese buyers will contribute about 17% of sales this fiscal year, worth about $158 million. Backus figures that Japan could become a $300 million market. Frankfort has told Wall Street that Coach can double its market share in Japan, to about 6%, in the next several years.

"STAND BY AND WATCH." The spread of SARS in Asia may hurt overseas sales as the region's economies suffer from the fear surrounding the sometimes deadly disease. Frankfort says SARS is crimping sales in Singapore and Hong Kong, but he adds that those markets represent less than 1% of its total.

More important, some analysts are getting nervous about the lofty stock price. Standard & Poor's analyst Jason Asaeda raised his expectations for Coach, but he figures the valuation is too high for new investors to get in. And although the retailer has promised an additional 1% improvement in margins over the next 12 months, Nordan expects that such gains will be harder to achieve beyond that.

Frankfort knows that Coach's future depends on its ability to maintain an image as an accessible-luxury brand. But he's not worried in the least: "I say to skeptics: Stand by and watch. Our customer is telling us that she likes Coach more than ever, and she's buying at higher levels more often than ever before." If he's right, the stock should remain a top performer for the long term. Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column


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