Coach 3Q13 Earnings Preview; don’t throw it in the bag 4/16/2014

Coach Inc. (COH) - $49.25

Why Read?

Coach has been called many things: growth stock, value stock, value trap, turnaround; the list goes on. Sales have grown +57% over the last 4 fiscal years, while Net Income has grown +67% and EPS +90%. The stock also trades at around 12x FY12 FCF and with nearly $800m in cash on the balance sheet Coach has plenty of room to maneuver. At the same time Coach has faced severe competition from the likes of Michael Kors and Kate Spade to name a few. Estimates have continued to fall, as well as gross margins, as Coach has had to rely on growing the outlet channel to drive sales. Beginning in FY08, Coach started to expand heavily into Asia hoping to tap into virgin markets, but we believe the results there are not as rosy as investors hope. *Nota Bene: for the purpose of my models I have pushed Coach’s FY back a year. I.e. Coach FY14 = Consumer Fox FY13

_________________________________________________________________________________________________________  § Margins melting: Coach has always boasted impressive gross margins; consistent with the high

priced segment they operate in. Gross margins have fallen from 78% in FY05 to 74% in FY12. Over the same period the number of outlet stores has risen from 85 to 193 in North America. We expect gross margins will continue to decline, forecasting a 70.2% gross margin in FY13E. Operating margins have declined from 35% in FY05 31% in FY12. Not the SG&A leverage one would hope with sales up 149% over the same period.

§ China fundamentals breaking down: China has been Coach’s saving grace, a bright future to sell to investors. It is a vast market with high luxury spending where Coach hopes to rekindle growth and grow brand cache. We expect all is not as well in China as management would like investors to believe. Disclosure changes, opaque metrics, and growing average store sizes to offset square footage productivity. We like none of it.

§ Relying on Men’s for growth: Women’s handbag sales only increased +1% in FY12, down from +11% in FY11, while total men’s sales increased +47% in FY12 and +83% in FY11. We expect that Women’s handbag sales could turn negative in FY13.

§ Internet traffic trends: Web visitors decreased -2.6% to 74m in FY12 after a +11.8% increase in FY11. We believe declining Internet traffic is an indicator of decreasing brand cache and equity. We are not impressed.

§ Estimates: We expect 3Q13E revenue of $1.15bn vs. consensus of $1.13bn. For 3Q13E we expect Coach to earn $0.61 vs. consensus of $0.62. For FY13E we expect $4.9bn in sales vs. a consensus of $4.89bn. For FY13E we expect Coach to earn $3.09 vs. a consensus of $3.14.

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Margins melting:

As Coach has kept its North American full-price retail store segment essentially flat since 2008, they have continued to expand their North American Outlet segment. Gross profit margins have certainly suffered from this strategy shift, although sales have grown.

In 2Q13, Coach began to break out its gross margin by segment.

Segment Gross Profit Margins 2Q12 2Q13

North America Gross Profit Margin 67.28% 63.84%

International Gross Profit Margin 79.73% 77.94%

Other Gross Profit Margin 88.21% 82.25%

North American gross profit margins decreased (343), International gross profit margins decreased (179), and Other gross profit margins decreased (596) in 2Q13.

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Store  Openings  vs.  Gross  Margin  

North  America  Full  Price   North  America  Outlet   Gross  Margin  

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Gross Margin Breakouts Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 North America

             

Promotional Activity negative negative -180 Average Unit Cost -130 Channel Mix positive negative Inventory negative negative positive International FX -180 Total Gross Margin Bps Change (2) 3 35 2 (95) (296)

Gross margin declines were primarily due to the North America segment. Nearly the entire gross margin decline in the International segment was due to negative FX impacts. Promotional activity remains a drag on the North America segment. We do not expect this to reverse anytime soon as traffic has still declined over the last year. Despite sales having increased +149% since FY05 Coach has experienced declining operating margins. We do not expect this trend to reverse. A strengthening in the Yen could held relieve some of the FX headwinds but otherwise we expect heavy investment in distribution, advertising and increased headcount as they continue to rollout new stores. The new Hudson Yards building will also most likely not help in any SG&A leverage as “new” often means “new” expenses. All of the building plans and layouts are in the back of the most recent 10-K for those of you who are interested. Looks spiffy.

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Operating  Margin  -­‐  Trailing  4  Qtrs  

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China fundamentals breaking down: In FY12, China revenue per store turned negative, declining -0.7%. This number is only an estimate, based upon the $430 approximated China revenue and a 40% growth rate from the year prior. In the latest 10-K for FY12, Coach began to lump Taiwan, Singapore, Korea, Malaysia square footage into their total China square footage. In addition they have yet to quantitatively break out China comparable store sales, preferring to approximate with “double digit”, which is certainly not a small approximation. With a China comparable store base of over 100 stores we believe it is time to start quantifying comparable store sales. Total China sales have decelerated from +64% in FY11 to +40% in FY12 and +25% in 2Q13. At the same time, the average square footage of China stores has only increased. We believe that sales per square foot results have been disappointing and Coach has gamed disclosures to create opaque metrics for investors. At the same time, International wholesale doors have decreased -13% since FY10, in an attempt to prevent cannibalization from company owned international stores. We believe this sales shift within the International segment will continue to add to gross margin pressure. Relying on men’s for growth: Women’s handbag sales were barely positive in FY12, increasing only +1.3% and down from +10.9% in FY11. These results are less than inspiring for a retailer that primarily sells Women’s handbags, which still make up 63% of Coach’s total sales. In FY11, Men’s handbag sales increased +53% while Men’s accessories increased +129%. With total Men’s sales increasing +47% in FY12, we believe Men’s accessories have continued to drive total Men’s growth and Men’s handbag sales have materially decelerated. This trend, as Men’s becomes a greater percentage of total sales (just 11% in FY12) will lead to increasing margin pressure and declines in ASP.

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Revenue Per Store 2010 2011 2012 North America $6,255 $6,563 $6,482 Growth

 4.9% -1.2%

China $3,560 $3,859 $3,832 Growth     8.4% -0.7%

Avg. Square Feet 2010 2011 2012 North America 3,249 3,344 3,556 Growth

 2.9% 6.3%

China 1,933 2,101 ?

Growth     8.7%    

Category Sales 2011 2012 Women's Handbags 11% 1%

Women's Accessories 10% 2%

Men's 83% 47%

Other 15% 22%

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Internet traffic trends:

Web Visitors 2009 2010 2011 2012 Web Visitors (millions) 59,000 68,000 76,000 74,000 Growth 15.3% 11.8% -2.6%

After two years of strong growth, total number of web visitors has turned negative, declining -2.6% in FY12. We believe some of this decline is due to limiting the access to flash sale sites, but remain disheartened, as we would like to see that effect offset by high growth in international web traffic. We also expect the higher gating of internet flash sales has led to decreased to lower internet sale conversion by decreasing the immediate call to action. Going forward, Internet should become a greater portion of Coach’s sales and FY12 web traffic results do not create much confidence. Promotions both in store and online will continue to drive sales but at the detriment of gross margins.

Wrap-up: We believe at these levels Coach is not worth shorting but also not worth investing in either. It’s a solid pass in our books. With a P/E ratio of just 16x our FY13E and FY14E earnings estimates of $3.09 and $3.03, respectively, compared to other luxury retailers, Coach is a bargain. Unfortunately we believe that Coach’s star will continue to fade and already the cracks have begun to show. Estimates have continued to fall. On April 14th, 2012, Analysts were expecting $4.77 for FY13, at the beginning of FY13 they were forecasting $4.12 and now they are only expecting $3.14. We expect analysts’ false hopes will continue to be crushed.

We are disappointed in Coach’s disclosures in their International segment although we do applaud them for beginning to break out their segment gross margin profitability. We would like them to begin to give a quantified comparable store sales number for China and are wary of them beginning to lump all of the Asian stores ex-Japan into one bucket. We would be happy to short COH on any solid pop but see no reason to be short into the print. We expect shares of Coach to wallow for some time.

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