A Luxury Bag at a Bargain

 Coach (COH) has developed a narrow economic moat through a brand that enables pricing, sourcing, and distribution advantages, and capital efficiency. Despite the company's recent struggles, it is still creating economic profits, and at a level greater than most retailers. The firm's first-quarter 2015 earnings report shows financial results in line with guidance and suggests that plans for transformation are well underway and tracking to management's road map. As such, we see no reason to change our $45 fair value estimate or our moat rating, though we continue to believe the execution of the plans will take time and involve risk.

Although the first products designed by Stuart Vevers, Coach's creative director, just hit full-priced stores in September, management said it was pleased with the performance and added that items priced over $400, all-leather products, and novel styles performed best. The overall tone of the comments was mixed, though, as the company said that given the large reduction in promotions the success of new products was too little to move the needle on the overall results. Management also said that it was too early to tell, alluding to positive signs and positive comps over $400, but saying visibility was difficult with the shift in promotions. Since our focus is on the long term and the value of the brand, although perhaps the market was looking for more positive commentary, we believe the price and design elevation are positives and fashion changes often can be slow to catch on with the public.

In the quarter, total sales declined 10% to $1.04 billion, and North American same-store sales declined 24%. Both were in line with guidance for double-digit revenue declines and mid-20% North American same-store sales declines. Earnings per share declined to $0.43 from $0.77 in last year's first quarter. Adjusting for $37 million in one-time charges, which we expect to be mostly noncash, earnings were $0.53 per share and modestly above the mean of analysts' expectations. Gross margins declined 300 basis points to 68.9%, and selling, general, and administrative expenses deleveraged 770 basis points to 51.6%. The gross margin performance was 100 basis points better than we had modeled, with the SG&A in line.

Although some investors may be concerned that international growth was just 4%, or 6% excluding currency headwinds, reaching $381 million, we believe that although not precise, prior guidance was clear that distribution network openings would slow until the brand transformation was complete. China grew at just 10%, as the company has slow distribution growth. The firm does not disclose international comparable-store sales but said that they were positive and that it still expects 20 openings and 10 closings in China. Overall, international growth is now just over a third of the total business, and management still sees contributions of $600 million in China and $100 million in Europe in fiscal 2015 (no change from earlier guidance).

International Growth Potential Is a Positive
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 in other softgoods categories, as consumers of bags and leather 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 also offers some upside; it currently constitutes around 14% of sales.

Coach's international business is still underdeveloped and represents an opportunity if growth there can continue for the long run. Although fiscal 2013 and 2014 struggles highlight Coach's market concentration in North America, using long-run success in Japan as a guide, we think there is plenty of room for Coach to take market share in other geographies. In Japan, Coach has had flat to low-single-digit growth for the past 10 years while competitors generally have experienced declines. The company entered Europe in 2012 through department store partnerships and is now penetrating further wholesale accounts and opening retail stores. We believe there is room for a brand such as Coach offering uniquely American styles and high-quality products at lower price points. In China, Coach lags other luxury brands with respect to sales, but has greater growth potential. The company increased its China business to more than $100 million in 2010 and approximately $550 million in fiscal 2014. Coach should also see higher operating margins in China as it expands because of lower operating costs and higher gross margins. In Europe, where Coach has just a small number of boutiques and is developing dedicated shops in department stores, the company should leverage selling, general, and administrative expenses over time and now projects $100 million in revenue in fiscal 2015.

Our Fair Value Estimate Is $45 per Share
Our fair value estimate of $45 per share incorporates fiscal first-quarter results and management's reiteration of full-year guidance for low-double-digit revenue declines and high-teens operating margins. Our fair value estimate implies 18 times forward fiscal June 2015 year-ending earnings per share. On an enterprise value/EBITDA basis, our valuation implies 9 times fiscal June 2015 estimates, and on a cash flow yield basis, our fair value estimate suggests approximately 3.7% cash flow yield for fiscal 2015, at the low end of a five-year historical range of 4%-6%. Fiscal 2015 metrics include $55 million in one-time charges for store closings and restructuring. Our estimate for earnings per share in fiscal 2015 has not changed from $1.69 GAAP, and our adjusted earnings per share estimate is up by one penny to $1.82.

For fiscal 2015 (year ended June), we project a revenue decline of 13.1% (unchanged), with mid-20s negative same-store sales growth implied in North America. Gross margins are now forecast to be below 68%, less than company guidance for around 70%. Although cost pressure worries have diminished, increased SG&A around the design changes should cause operating margins to dip below 18%, in line with the company's expectations of high teens operating margin but more negative than our prior assumptions. We model roughly 100 basis points of additional gross margin decline, year over year, in fiscal 2015, as we remain concerned that some inventory clearing may still have to occur in the outlets and that fresh product from the new designer may face some reluctant consumer acceptance. In fiscal 2015, we model capital spending of $450 million.

Over our 10-year explicit forecast period, we model operating margins first averaging 23.7% for the first five years going from under 18% in fiscal 2015 to over 27% in year five, and remaining between 26% and 27% after that. This is somewhat more conservative than the company's plans to return to 30% operating margins by fiscal 2019. Top-line growth to reach our cash flow-based valuation averages just over 4%, or just over 6% excluding the previously mentioned 13% decline forecast for fiscal 2015. Although we have increased our capital spending assumptions for fiscal 2015 through 2017, we model spending eventually returning to 4%-5% of sales.

Brand and Premium Pricing Lead to a Narrow Moat
While Coach might not have complete pricing power because of the price/value equation inherent at some level in consumers' decision to purchase its midtier luxury offerings, the company's ability to design, distribute, and source has historically enabled it to produce high operating margins. Coach's gross margins (currently in the high 60s despite recent headwinds), 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 firm has some pricing power in the range where it competes. Despite the short-term adverse fashion cycle, we believe the Coach brand to be valuable and believe the company will again be able to return to high operating margins, which should drive returns on capital back into the high 20s and even 30s. Thus, in our opinion, Coach's brand and premium pricing warrant a narrow economic moat. Brand history and the extensive, directly operated, and wholesale distribution network also contribute to the defensibility of the position, in our thinking, and although currently in a reinvestment phase, the revamping and refurbishment of the network only serve to reinforce the brand image and solidify the economic moat. Our viewpoint is supported by returns on capital that have averaged over 40% before fiscal 2013. Operating margins have averaged above 30% in the past, and despite short-term declines in fiscal 2014 and 2015, they can eventually reach the high 20s again, in our view.

Since we believe a good part of the moat stems from its brand equity, we forecast that Coach will not damage its long-run brand position at the core and can re-establish itself as more fashionable for younger customers. Weakness in North American sales comes from tough comparisons in lower price points and logo bags and lower traffic to malls and outlets, while the high-end leather goods and new leather lines at flagship stores are still selling well, suggesting that the prestige of the brand is not diminished if the product fashion is compelling.

Management's Exemplary Performance Returns Cash to Shareholders
Lew Frankfort was replaced by Victor Luis at the beginning of 2014. Luis, who was head of international operations, has been assembling a new team of designers and management, including Stuart Vevers. Luis' experience includes terms as CEO of Baccarat, running North America, and with other  LVMH (MC) brands earlier in his career. We believe his international experience will be important to the growth of the firm.

A majority of Coach's board is independent, and officers and directors own nearly 5% of the shares outstanding. Frankfort is currently chairman but will retire after the November annual meeting. Jide Zeitlin, currently the lead outside director, will be appointed the next chairman of the board. Thus the chairman and CEO roles will remain split, a structure we view favorably. We believe management does a good job of providing transparency around the business. Overall, corporate governance is sound and aligned with shareholders, in our opinion, and we rate Coach's stewardship of shareholder capital as exemplary given its long record of above-average returns and recent actions to return cash to shareholders. We note that in 2013, Frankfort bought Coach shares on the open market, despite having announced his diminishing role.