Stock Analysis: Coach (COH)

Company Description:

Coach, Inc. (Coach), incorporated in June 2000, is a designer and marketer of handbags and accessories. The Company offers luxury lifestyle accessories to the customers and provides consumers with fresh and relevant products. Coach's handbags and accessories use a range of quality fabrics and materials. Coach's primary product offerings include handbags, women's and men's accessories, footwear, outerwear, business cases, sunwear, watches, travel bags, jewelry and fragrance. It operates in two business segments: Direct-to-Consumer and Indirect.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 6/30/07):

General Development of Business

Founded in 1941, Coach was acquired by Sara Lee Corporation in 1985. In June 2000, Coach was incorporated in the state of Maryland. In October 2000, Coach was listed on the New York Stock Exchange and sold approximately 68 million shares of common stock, split adjusted, representing 19.5% of the outstanding shares. In April 2001, Sara Lee completed a distribution of its remaining ownership in Coach via an exchange offer, which allowed Sara Lee stockholders to tender Sara Lee common stock for Coach common stock.

In June 2001, Coach Japan, Inc. was formed to expand our presence in the Japanese market and to exercise greater control over our brand in that country. Coach Japan was initially formed as a joint venture with Sumitomo Corporation. On July 1, 2005, we purchased Sumitomo’s 50% interest in Coach Japan, resulting in Coach Japan becoming a 100% owned subsidiary of Coach, Inc.

In March 2007, the Company exited its corporate accounts business in order to better control the location and image of the brand where Coach product is sold. Through the corporate accounts business, Coach sold products primarily to distributors for gift-giving and incentive programs.

Narrative Description of Business

Coach is one of the most recognized fine accessories brands in the U.S. and in targeted international markets. We offer premium lifestyle accessories to a loyal and rapidly growing customer base and provide consumers with fresh, relevant and innovative products that are extremely well made, at an attractive price.

In response to our customer’s demands for both fashion and function, Coach offers updated styles and multiple product categories which address an increasing portion of our customer’s accessory wardrobe. Coach has created a sophisticated, modern and inviting environment to showcase our product assortment and reinforce a consistent brand position wherever the consumer may shop.

Finally, we utilize a flexible, cost-effective global sourcing model, in which independent manufacturers supply our products, allowing us to bring our broad range of products to market rapidly and efficiently.

Coach offers a number of key differentiating elements that set it apart from the competition, including:

A Distinctive Brand — Coach offers distinctive, easily recognizable, accessible luxury products that are relevant, extremely well made and provide excellent value.

A Market Leadership Position With Growing Share — Coach is America’s leading premium handbag and accessories brand and each year, as our market share increases, our leadership position strengthens.

Coach’s Loyal And Involved Consumer — Coach consumers have a specific emotional connection with the brand. Part of the Company’s everyday mission is to cultivate consumer relationships by strengthening this emotional connection.

Multi-Channel International Distribution — This allows Coach to maintain a critical balance as results do not depend solely on the performance of a single channel or geographic area. The Direct-to-Consumer channel provides us with immediate, controlled access to consumers through Coach-owned stores in North America and Japan, the Internet and the Coach catalog. The Indirect channel provides us with access to consumers via U.S. and international wholesale locations.

Coach Is Innovative And Consumer-Centric — Coach listens to its consumer through rigorous consumer research and strong consumer orientation. Coach works to anticipate the consumer’s changing needs by keeping the product assortment fresh and relevant.

We believe that these differentiating elements have enabled the Company to offer a unique proposition to the marketplace. We hold the number one position within the U.S. premium handbag and accessories market and the number two position within the Japanese imported luxury handbag and accessories market.

Products

Coach’s product offerings include handbags, women’s and men’s accessories, footwear, outerwear, business cases, sunwear, watches, travel bags, jewelry and fragrance.

Design and Merchandising

Coach’s New York-based design team, led by its Executive Creative Director, is responsible for conceptualizing and directing the design of all Coach products. Designers have access to Coach’s extensive archives of product designs created over the past 65 years, which are a valuable resource for new product concepts. Coach designers are also supported by a strong merchandising team that analyzes sales, market trends and consumer preferences to identify business opportunities that help guide each season’s design process.

Segments

Coach operates in two reportable segments, Direct-to-Consumer and Indirect, which represent channels of distribution that offer similar products, service and marketing strategies.

The Direct-to-Consumer segment consists of channels that provide us with immediate, controlled access to consumers: retail stores and factory stores in North America and Japan, the Internet and Coach catalogs. This segment represented approximately 80% of Coach’s total net sales in fiscal 2007, with North American stores and Coach Japan contributing approximately 58% and 18% of total net sales, respectively.

Coach began as a U.S. wholesaler to department stores and this segment remains important to our overall consumer reach. Today, we work closely with our partners, both domestic and international, to ensure a clear and consistent product presentation. The Indirect segment represented approximately 20% of total net sales in fiscal 2007, with U.S. Wholesale and International Wholesale representing approximately 12% and 5% of total net sales, respectively.

Marketing

Coach’s marketing strategy is to deliver a consistent message each time the consumer comes in contact with the Coach brand, through our communications and visual merchandising. The Coach image is created internally and executed by the creative marketing, visual merchandising and public relations teams. Coach also has a sophisticated consumer and market research capability, which helps us assess consumer attitudes and trends and gauge the likelihood of a product’s success in the marketplace prior to its introduction.

In conjunction with promoting a consistent global image, Coach uses its extensive customer database and consumer knowledge to target specific products and communications to specific consumers to efficiently stimulate sales across all distribution channels.

Manufacturing

All of our products are manufactured by independent manufacturers. However, we maintain control of the supply chain from design through manufacture. We are able to do this by qualifying all raw material suppliers and by maintaining sourcing offices in Hong Kong, China and South Korea that work closely with our independent manufacturers. Coach also operates a European sourcing and product development organization based in Florence, Italy that works closely with the New York design team. This broad-based, multi-country manufacturing strategy is designed to optimize the mix of cost, lead times and construction capabilities. No one vendor provides more than 13% of Coach’s total units.

Seasonality

Because Coach products are frequently given as gifts, Coach has historically realized, and expects to continue to realize, higher sales and operating income in the second quarter of its fiscal year, which includes the holiday months of November and December. In addition, fluctuations in sales and operating income in any fiscal quarter are affected by the timing of seasonal wholesale shipments and other events affecting retail sales. However, over the past several years, we have achieved higher levels of growth in the non holiday quarters, which has reduced these seasonal fluctuations. We expect that these trends will continue.

Competition

The premium handbag and accessories industry is highly competitive. The Company mainly competes with European luxury brands as well as private label retailers, including some of Coach’s wholesale customers. Over the last several years the category has grown rapidly, encouraging the entry of new competitors as well as increasing the competition from existing competitors. However, the Company believes that as a market leader we benefit from this increased competition as it drives consumer interest in this brand loyal category.

The Company believes that there are several factors that differentiate us from our competitors, including but not limited to: distinct newness, innovation and quality of our products, ability to meet consumer’s changing preferences and our superior customer service.

Employees

As of June 30, 2007, Coach employed approximately 10,100 people, including both full and part time employees. Of these employees, approximately 3,100 and 4,900 were full time and part time employees, respectively, in the retail field in North America and Japan. Approximately 50 of Coach’s employees are covered by collective bargaining agreements. Coach believes that its relations with its employees are good, and it has never encountered a strike or work stoppage.

Risk Factors

• The growth of our business depends on the successful execution of our growth strategies.
  

• Significant competition in our industry could adversely affect our business.
  

• We face risks associated with operating in international markets.
  

• A downturn in the economy could affect consumer purchases of luxury items and adversely affect our business.
  

• Our business is subject to the risks inherent in global sourcing activities.
  

• Our business is subject to increased costs due to excess inventories if we misjudge the demand for our products.
  

• Our operating results are subject to seasonal and quarterly fluctuations, which could adversely affect the market price of Coach common stock.
  

• Provisions in Coach’s charter and bylaws, Maryland law or its “poison pill” may delay or prevent an acquisition of Coach by a third party.
  

Geographic Area Information

As of June 30, 2007, Coach operated 254 retail stores and 93 factory stores in the United States, five retail stores in Canada and 137 department store shop-in-shops, retail stores and factory stores in Japan. Coach also operates distribution, product development and quality control locations in the United States, Italy, Hong Kong, China and South Korea.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Overview

In order to sustain growth within our global framework, we continue to focus on two key growth strategies: increased global distribution, with an emphasis on our direct retail distribution in North America and Japan, and improved productivity. To that end we are focused on four key initiatives:

• Build market share in the rapidly growing North American women’s accessories market by leveraging our leadership position as a preferred brand for both self purchase and gifts. As part of this initiative, we continue to emphasize new usage occasions, such as weekend casual and evening. We also continue to introduce more sophisticated products to heighten our cachet, especially with our higher-end customers. Lastly, we continue to enhance the level of customer service in our stores by focusing on additional opportunities to deliver excellent customer service.
  

• Rapidly grow our North American retail store base by adding stores within existing markets, opening in new markets in the U.S. and by accelerating store openings in Canada. We plan to add about 40 retail stores in North America in each of the next several years and believe that North America can support about 500 retail stores in total, including up to 20 in Canada. In addition, we will continue to expand select, highly productive retail and factory locations.
  

• Expand market share with the Japanese consumer, driving growth in Japan primarily by opening new retail locations and expanding existing ones. We plan to add about 15 – 20 new locations in fiscal 2008 and believe that Japan can support about 180 locations in total. We will also continue to expand key locations.
  

• Raise brand awareness in emerging markets to build the foundation for substantial sales in the future. Specifically, Greater China, Korea and other emerging geographies are increasing in importance as the handbag and accessories category grows in these areas. In fiscal 2008, we intend to open approximately 30 net new locations, through distributors, in Greater China, Southeast Asia and the Middle East. This includes at least five more locations in major cities in mainland China, bringing the total number of locations in mainland China to at least 16.

In addition to the strategies outlined above, we continue to focus on improving our rate of profitability and delivering superior returns on investments. By leveraging expenses, our operating margin expansion will continue to outpace our sales growth, which will drive increased cash flows from operating activities.

Fiscal 2007 Highlights

During fiscal 2007, an increase in sales, combined with an improvement in margins, continued to drive net income and earnings per share growth. The highlights of fiscal 2007 were:

• Net income from continuing operations increased 37.2% to $636.5 million.
  

• Earnings per diluted share from continuing operations increased 41.3% to $1.69 per diluted share.
  

• Net sales increased 28.4% to $2.6 billion.
  

• Direct-to-consumer sales rose 30.5% to $2.1 billion.
  

• Comparable store sales in North America rose 22.3%, with retail stores up 16.4% and factory stores up 30.0%.
  

• Coach Japan sales, when translated into U.S. dollars, rose 15.9% driven by expanded distribution and mid-single-digit comparable store sales. These increases in sales reflect a 2.9% decrease due to currency translation.
  

• In North America, Coach opened 41 new retail stores and seven net new factory stores, bringing the total number of retail and factory stores to 259 and 93, respectively, at the end of fiscal 2007. We also expanded six retail stores and seven factory stores in North America.
  

• Coach Japan opened 19 net new locations, bringing the total number of locations at the end of fiscal 2007 to 137. In addition, we expanded nine locations.
  

• In mainland China, together with our distributors, Coach opened eight net stores.
  

• In March 2007, the Company exited its corporate accounts business in order to better control the location and image of the brand where Coach product is sold. Through the corporate accounts business, Coach sold products primarily to distributors for gift-giving and incentive programs.
  

Common Stock Repurchase Program

On October 20, 2006, the Coach Board of Directors approved an additional common stock repurchase program to acquire up to $500 million of Coach’s outstanding common stock. This authorization expires in June 2008.

During fiscal 2007 and fiscal 2006, the Company repurchased and retired 5.0 million and 19.1 million shares of common stock at an average cost of $29.99 and $31.50 per share, respectively. As of June 30, 2007, $500 million remained available for future repurchases under the existing program.

Financial Highlights:

Revenue Growth (1-yr): 23.7%
Revenue Growth 6-yr average): 27.4%

Net Income Growth (1-yr): 28.9%
Net Income Growth (6-yr average): 48.5%

Earnings-Per-Share Growth (1-yr): 33.1%
Earnings-Per-Share (6-yr average): 45.0%

Free Cash Flow Growth (1-yr): 37.8%
Free Cash Flow Growth (6-yr average): 52.4%

Net Profit Margin (current): 24.4%
Net Profit Margin (7-yr average): 18.7%

Return On Equity (current): 41.1%
Return On Equity (7-yr average): 43.9%

Debt Ratio (current): 0.22
Current Ratio (current): 4.26

Financial analysis:

• Debt ratio of 0.22 is certainly pretty low, but what is even more impressive is that the company had consistently paid down debt and went down to 0.22 today from 0.42 in 2001. I understand other investors’ concern that company might not be “efficiently using the leverage” that is available to it, but personally I prefer lower debt ratios as that leaves a lot more room for growth. If the company will decide to fund growth with debt in the future, that will be just fine for me knowing that I got in before then and will therefore be in a more advantageous position than investors who will get in at a later time when debt ratio will be higher.
  

• ROA has been very consistent throughout the past six years. Currently it stands at 29.6% and 6-yr average is 30.3%.
  

• ROE has been just as consistent and results are just as impressive. Currently it’s at 41.1% and 6-yr average is 43.9%.
  

• All margins (gross margin, operating margin, and net profit margin) have been significantly improving over the past seven years, as a matter fact operating and net profits margins have more than double during that period (!). Profit margin is currently at 24.4% and company posted an 18.7% 7-yr average.
  

• Revenue growth has been consistent and grew 23.7% in the 2007 fiscal year while 6-yr average is 27.4%.
  

• Net income growth has been even more impressive, although more spiky (as in “volatile”) than revenue growth. Net income grew 28.9% in the last fiscal period and posted a 48.5% 6-yr average.
  

• Free Cash Flow margin has improved from 14.9% in 2001 to a solid 24.4% margin in 2007. FCF growth is one metric that seems to have been least consistent in the past six years: it decreased by 29% in 2002 and then kept going up by 154%, 131%, 3%, and 38% in 2003, 2004, 2005, 2006, and 2007, respectively. All that craziness averaged an amazing 52.4% average annual free cash flow growth for the past six years. I don’t like the inconsistency, but the overall positive numbers definitely make me a little bit giddy right now.
  

• Coach’s Current Ratio is rather impressive at 4.26. This shows that the company is currently holding a lot of cash on hand, enough to pay for the current expenses four times over. This may suggest that company is holding the extra cash for a possible acquisition opportunity.
  

Discounted Cash Flow (DCF) Analysis:

I used discounted cash flow analysis to arrive at the intrinsic value of the company. I estimated that free cash flow would grow at an average rate of 15% per year for the next 5 years, 10% per year for the following 5 years, and at 3% (trailing GDP growth) perpetually after that. Company’s free cash flow grew at an average rate of 52% during the past nine years, which makes my conservative estimate rather plausible.

I used a discount rate of 10.5% because Coach is a mature company with an established market leader position although its dominance is offset somewhat by the risk of the fast-moving fashion market.

Using the assumptions listed above, my intrinsic value of the stock came out to $47.99. My intrinsic value of Coach is somewhat higher than what Morningstar has as a “fair value” for this company. I believe our difference in opinion lies in the fact that Morningstar underestimates this company’s growth potential.

Pros:

• Growth in the past six years has been absolutely phenomenal and the company is highly profitable.

• Luxury consumer market isn’t as susceptible to the economic slowdown effects as other consumer markets are.

• This is only the second time in seven years when Coach is being severely underpriced, mostly because of short-term concerns.

• Coach has been successful in international markets and keeps expanding, particularly in Germany and Japan.

Cons:

• A significant portion of company’s consumers are at the bottom range of the luxury market and can be more price sensitive during turmoil in the market.

• Company’s has reduced its sales forecast for the 2008 fiscal year due to slower store traffic in the first quarter of this fiscal year.

• Coach depends on getting the fashion trends right and any mistake could stifle growth.

Final Decision:

Coach has shown incredible profitability and growth rates in the past and I believe it has a significant potential for future growth. Currently, Coach’s stock trades at $33 vs. $48 that I have for intrinsic value of the company. Given my safety margin of 30-50%, it is within my buying price range $24-$33. Coach is certainly among my final picks for the portfolio.