Keith shorted COH in the Virtual Portfolio today on the short-side for a TRADE. While COH looks cheaper today 25% lower than when it reported 3-months ago, valuation is not a catalyst. We want to be clear that we hardly think this is a fat-tailed call after the precipitous drop. It is one of those names where the levels are sending a clear signal to sell at the same time fundamentals are more challenging on the margin. This might be a short-lived TRADE, but a good one nonetheless.
Here are a few things to keep in mind re the intermediate-term fundamentals:
- The company is accelerating the rollout of men’s line to 100 stores in NA by the end of the F12 (this current quarter) from 42 at the end of FQ3 and will account for ~8% of total sales by year end ($400mm+).
At the same time, China is closing in on $300mm in sales and store growth continues at a heated pace on a relatively low base of 85. The focus here is increasingly on Tier 2 and Tier 3 cities to capitalize on the growing middle-class shopper that tend to shop at home versus overseas. Combined, these two initiatives will account for nearly half of COH’s top-line growth this year and then again roughly next year. As such, slowing demand in China increases the likelihood of more meaningful top-line deceleration.
- NA comps came in slightly better than expected in Q3 (6.7% vs. 6.2%E), but decelerated on both a 1yr and 2yr basis sequentially despite easier yy compares and strength in both e-commerce and men’s suggesting a more meaningful deceleration in the core women’s business.
- Sales at U.S. department stores slowed and actually declined perhaps reflecting a heightened competitive environment. To keep this in perspective, COH’s exposure to the wholesale channel is well below its competitors at ~13%, but it suggests that perhaps department stores have more options (i.e. brands) available to choose from and so do consumers. We’re less concerned about the impact on Indirect sales than the pressure on COH’s retail store base from more aggressive brands like KORS, Kate Spade, and Tory Burch. This is will require COH to step up spending to defend its share in a way that it isn’t accustomed to marking an important shift in the domestic competitive landscape.
- In addition, management dialed back its expectations for square footage growth in Japan (~18% of total sales) down 5% to +10% for F12 shaving roughly 1pt of top-line growth over the next 12-months. We think these factors combined will result in a deceleration in top-line growth over the next two years down from 15%+ last year and we expect again this year to 12.5% and 11% in F13 and F14 respectively.
- The sales/inventory spread eroded 3pts sequentially to -5% with inventory growth up +21% in Q3. We’re willing to chalk some of this growth to new store inventory and buying in APac businesses and related inventories, but this is gross margin bearish if sales decelerate faster than expected.
- This is particularly notable in light of gross margins rebounding up +100bps to 73.8% in Q3 after dipping below 72% in Q4/Q1. The elimination of in-store couponing as well as increasing international mix should be an intermediate-term tailwind though we expect the mix contribution to be more modest than originally expected with Asia slowing on the margin.