Coach Widens the Playing Field

 Coach (COH) has developed a narrow Morningstar Economic Moat Rating through a brand that enables strong pricing, sourcing and distribution advantages, and capital efficiency. We believe these competitive advantages are sustainable over our explicit forecast period and will result in excess economic profits.

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 softgoods categories, as 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 offers some upside, currently constituting just over 10% of sales.

Additionally, Coach's international business is still underdeveloped and represents an opportunity if growth continues on its current trajectory. Many investors assume that Coach is too wed to the fortunes of the American consumer, but with long-run success in Japan as a guide, we think there is plenty of room for Coach to take share from European luxury goods makers in other markets. In Japan, Coach has had flat to low-single-digit growth rates for the past 10 years while other competitors generally have experienced declines. The company only just entered Europe in 2012 through department store partnerships and is now penetrating other wholesale accounts and opening retail stores. We believe there is room for a brand like Coach, offering unique styles and high-quality products at lower price points. In China, Coach lags other luxury brands with respect to sales, but also has greater growth potential. The company expanded its China business to more than $100 million in 2010 and projects that it will attain $530 million in sales in fiscal 2014. Coach should also see higher operating margins in China as it expands, thanks to lower operating costs and higher gross margins. Similar estimates can be made for Europe, where Coach has just a small number of boutiques and dedicated shops in department stores. We estimate that the company could attain $500 million in annual sales in Europe over our forecast period.

Powerful Brand Brings Economic Returns
While Coach might not have complete pricing power, given the price/value equation inherent at some level in consumers' decision to purchase its midtier luxury offerings, its ability to design, distribute, and source enables the firm to produce premium operating margins. Coach's gross margin 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 company has some pricing power in the range where it competes. Thus, in our opinion, Coach has a defensible economic moat. Brand history and the extensive directly operated and wholesale distribution network also contribute to the defensibility of the position, in our thinking. Our viewpoint is supported by returns on capital that have averaged more than 40% for the past five years, despite the recession. Operating margins have averaged above 30%, above the rate of many more prestigious luxury goods makers, which have operating margins in the 20%-30% range.

Expansion Can Be Risky
Remaining fashionable and extending the brand are constant risks for the firm, and as such, we assign Coach a high fair value uncertainty rating. If the company extends its brand beyond what consumers understand it to be, it could damage its core image. Coach has embarked on an ambitious plan to expand its product lines and become a full lifestyle brand, not unlike many older and more prestigious European luxury brands, but the strategy is not without risk. Footwear does leverage some competitive advantages in leather sourcing, but it is a different category than bags and accessories. We think men's accessories have lower risk, and we agree that the men's leather goods market is underserved, but we cannot be sure that the extension will not dilute the women's business.

While Coach has established a niche in the fashion world, and customers are very brand-loyal in the handbag and accessories category, the firm runs the risk that changes in tastes and preferences will eventually lead consumers to turn elsewhere.

Coach has been successful thus far extending the brand into new geographies, and a portion of our fair value estimate is based on that continued expansion. Today, sales growth prospects appear strong, but there is a risk that new entrants or other market forces could derail the international projects that today look promising for Coach.