Coach (COH): A great business which you should look into

I am not a fashionable guy and never follow luxury brands. But I know Coach is an affordable brand. So when Coach's stock is suffering, it arose my attention.

Summary:
Coach (COH) is a fashion-goods company with a long history. In the past decade, COH increased its EPS 31% per year thanks to its presence in Asia. Even with this high growth rate, COH employed little capital and continues to return excess capital to shareholders. Its management is respectful and leads to the success in Asia. The company has suffered from economic headwinds in 2012 and emerging threat from Michael Kors, another fashion-goods company which offers the same products as Coach. Economy is improving this year and Michael Kors is not a threat which Coach is unable to handle. At current price, Mr. Market is thinking moderate to low growth for Coach and ignoring its expansion in Asia. 6% earnings yield and increasing payout will offer good return to shareholders.

Investment Rationale:

I think many people are familiar with Coach so I won't take too much space to talk its history and business. In a nutshell, Coach is an well-established brand. It has a long history, founded in 1941, and clearly a leader in handbags and fine accessories. Handbag is its major product, accounting for 65% of its net sales. But right now, it is transforming itself into a lifestyle brand, not just a handbag brand, by broadening its product offering into outerwear, shoes, jewelry, watches, eye wear, and fragrance. 

Coach is aggressively expanding into international markets. Coach is famous in Asia. Its international business grew from 9% of net sales in FY 2000 to 31% in FY 2012, a CAGR of 32.7%. Even in Japan, a country of lost decade, Coach is able to grow 32.7%. Coach is expanding fast in China, where its store number increases to 96 in FY 2012 from 5 in FY 2005. All these meet its strategic initiative, aggressively growing international business. Coach carries out a multichannel strategy, including retail stores, factory stores, wholesalers and internet. 89% of its net sales is from retail and factory stores.

Due to its international expansion, annual revenue growth over the past 10 years is around 20.8%. CAGR in the past five years is 12.8%, slowing but still quite high number considering the period includes the Great Recession. Thanks to China, Coach was able to make a small gain in 2009. 

Usually, high-growth companies require lots of capital and sacrifice their margin to fuel their growth. Coach's operating margin indeed is declining, from an pre-crisis average of 36.7% to an post-crisis average of 31.3%. But Coach requires little incremental capital. Its employed capital only increases by 18% in the past five years while its earnings is up by 56.5%. Its CAPEX need is low so Coach can retain a lot of cash flow. What Coach has earned has become its free cash flow. And Coach distributed these huge cash flow to its shareholders. 

	Net Income	FCF	DVD	Repurchase	Total Payout
2002	85.8	51.9	0.0	9.8	9.8
2003	146.6	164.5	0.0	49.9	49.9
2004	261.7	381.0	0.0	55.0	55.0
2005	388.7	221.3	0.0	265.0	265.0
2006	494.3	462.9	0.0	600.3	600.3
2007	663.7	638.4	0.0	150.0	150.0
2008	783.1	748.7	0.0	1,336.6	1,336.6
2009	623.4	568.9	0.0	453.8	453.8
2010	734.9	908.6	94.3	1,150.0	1,244.3
2011	880.8	885.6	178.1	1,098.0	1,276.1
2012	1,038.9	984.2	260.3	700.0	960.3
Total	6,101.9	6,016.0	532.7	5,868.4	6,401.1

In addition, Coach can turn over its cash very quickly. Though Coach's turnover of inventory is long, it essentially receives cash much faster than it pays. Furthermore, its turnover of inventory is getting faster.  Thus, with high margin, returning cash to shareholders and efficient asset turnover, Coach has been enjoyed high return on capital employed. Its ROCE is average 41% in the past 10 years and ROE is also 40% as Coach has a negligible amount of debt. 

	Receivable days	Inventory days	Payable days	Cash conversion cycle
2002	13.1	209.5	34.8	187.8
2003	12.7	208.2	38.9	182.0
2004	12.6	193.6	45.2	161.0
2005	12.9	184.5	58.5	138.9
2006	12.9	187.2	64.8	135.3
2007	13.4	188.3	67.9	133.8
2008	12.3	172.7	66.2	118.8
2009	12.2	156.2	55.3	113.1
2010	11.0	148.5	44.9	114.6
2011	11.1	141.9	40.5	112.4
2012	12.2	145.2	43.0	114.4

All these indicate that Coach has a moat and is a typical company favored by Warren Buffett, requiring little capital to grow its business. Its moat comes from its branding power, which attracts loyal customers. 

In addition to strong business, Coach has a stable and competitive management team. Its CEO, Lew Frankfort, is a veteran. He joined Coach in 1979 and was named Chairman and CEO in 1995. So Coach's international success is pretty much directed by Lew Frankfort. He was recognized as one of the 30 most respected CEO globally by Barron's from 2005-2008, and 2012.  Reed Krakoff is Coach's executive creative officer, an important position in a fashion company. He has served as the role since 1996 and worked for several design houses.

However, the stability of management may face challenge next year as Lew Frankfort will step down as CEO. He will remain the post of executive chairman. Fortunately, a seven-year veteran in Coach, Victor Luis, will become the next CEO. I believe that the company's strategy will not change dramatically under Luis as he is credited for international expansion for the past seven years. He led the success plan in Asian markets.  Nonetheless, the transition of CEO is still a risk to be taken into account.

With competitive business, strong brand and credible and stable leadership, Coach is definitely a great company. But the stock price has been declining since 1Q 2012, which may offer a good price for a great company. However, I still have to see what has happened in Coach and whether the problems are structural or temporary.

Its top-line growth reached peak in Q1 CY2012, and since then dropped from double digits to single digit in Q4 CY2012 at only 3.8%. 3.8% is the worst number since the Great Recession. The downtrend is primarily due to its declining comp. store sales growth in North America. In the latest quarter, Coach recorded a negative SSS growth of -2.2%. The sliding sales led to the anemic earnings growth, 4.2% and 5.4% in previous two quarters, respectively.

In the latest earnings call, the company blamed the disappointment for the macro headwind caused by fiscal cliff and Hurricane Sandy, and intensified competition in women's handbag. Is the company's reasoning justified?

Historically, fashionable companies can somehow defy economic headwind as they have brand power. Consumers interested in luxury goods are also more affluent. Comparing Coach's peer performance can tell us whether Coach is especially weak last year.  The selected peers are based on COH's proxy statement.

Comparable store sales YoY%

Apparently, COH's peers had been through some slowdown in the fourth quarter. A few companies recorded positive same store sales, like GPS, LTD. AEO and ANF saw sharp slowdown. But for high-end luxury brands, like TIF and GES, SSS was negative.  

However, we have seen an upstart, Michael Kors. And there's no secret that Michael Kors is seen as the biggest threat to Coach. Both companies offer nearly the same products. Prices are also alike. And right now, Michael Kors is gaining Coach's market. Women are talking about Michael Kors is selling the hottest handbags and Coach is losing its design edge.

Michael Kors is definitely the threat to Coach. But is it the threat that Coach can not deal with? I don't think so. Even if in North America, Coach is losing its customers to Michael Kors. I think this is normal for a emerging player in the market. And don't forget that Coach has also been hot before. With branding power, Coach has some customer base. Furthermore, Coach has a much higher brand awareness and footage in Asia. Coach is an established brand in Asia while Michael Kors is still in the early stage. Coach is still growing in emerging markets, where people's purchasing power is expected to grow further.

When I start to study COH, it traded at around 13x TTM EPS and 11.5x Fwd EPS. On 4/10, COH jumped 2.57% to 51.21, a fairly-valued price. This price is not depressed price. But you pay a fair price for a company with established brand, competitive management, friendly-to-shareholders policy, and expanding emerging-market business. This is not a bad deal and lower price will make me more excited to buy.

Disclosure: I am holding the long position of COH and will buy more if the price goes lower.