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COH: Was, Is, And Will Be A Value Trap

Takeaway: 4Q validated our concerns about COH. Until mgmt takes down expectations (when mgmt fully churns in Jan), it will remain a value trap.

Conclusion: The 4Q print validated our concern that revenue growth cannot coexist with a 30%+ margin at COH. We think that the revolving door in the C-Suite synchs with our view, but that the company won’t let more realistic margin expectations seep into the consensus view until Frankfort has fully transitioned in Jan. We wish the company would just take down expectations – as our sense is that it is cheapish (15x) on a beared-up margin level. But until that happens, we face downward earnings risk to earnings of up to 25%. Maybe not a great short, but definitely still a value trap.

 

DETAILS

We have not been a fan of Coach by any stretch for much of this year, and the 4Q print hardly warms us up to the name. If there is anything that gets us more excited about COH it is the fact that the stock is 10% less expensive now than it was at yesterday’s close. But unfortunately, valuation is not a catalyst, and there's still downside to street estimates.

 

Fundamentally, the release confirmed what we’ve been concerned about – that revenue growth and a 30%+ EBIT margin cannot coexist peacefully at Coach. It’s abundantly clear that the company continues to lose share in its core business (women’s handbags in the US) as brands like Michael Kors, Kate Spade and Tory Burch muscle in on Coach’s territory. International continues to be a bright spot for growth, but markets like China have a long way to go before they can make up for share loss in the US.

 

Men’s and Footwear are great…but make no mistake, these are more expensive businesses – both in terms of R&D and marketing, but also as it relates to the working capital requirements of the business. Think about it… a handbag SKU might come in 3 colors. But a footwear SKU comes in 3 colors, and then each of those in a spectrum of 18+ different sizes. We’re not saying that footwear is a bad business, but simply that the level of capital required to grow is greater than COH is accustomed.

 

All of this leads us to the biggest component of the release, which is that Mike Tucci (President North America) and Jerry Stritzke (President and COO) both resigned and will be leaving in August. (For what it's worth, we've always thought that Tucci was money in the bank. He's a big loss. Stritzki is too.). So within a 12-month time period, we’ll see the exit of these two gents, plus Reed Krakoff and CEO Lew Frankfort (who becomes Executive Chairman in January).

 

Our sense is that the Executive Management team (who has better information than we do) sees where the company is headed – into a period of increased investment spending needed to build out the organization to maintain Coach’s standing as a World Class brand. This would result in a lower realized margin level – presumably something in the mid-20s at best.

 

The biggest problem we have with the stock is that company still has not embedded this lower guidance into expectations. While we don't don't condone it, we see where they’re coming from. Would Frankfort, Tucci, Stritzke and Krakoff want margins to be taken down in their final days at the helm after such a long run of success? No way…

 

We think that COH will continue to tread water as a value trap until the new team is fully in control, after which we’re likely to see the top line capitulate (unlikely), or (more likely) expectations for margins come down. If we look at a $6bn top line in 2 years at a 25% EBIT margin, we’re looking at $3.50 in EPS power.  The good news is that the stock is not very expensive on that number at 15x. The bad news is that the consensus is sitting at $4.66. We’re not in a rush to get ahead of what could be as much of a 25% downgrade in EPS expectations over 12 months.  


EAT – EARNING PREVIEW

We believe EAT will report disappointing 4Q13 results.


Over the past month, the S&P has risen 5.3% while the Bloomberg Full Service Restaurant Index has declined 2%.  During this time, EAT has only declined 1% and sits 6.9% below its all-time high of $41.93.  At 7.8x EV/EBITDA, EAT is currently trading below its peer group average of 8.7x.  That being said, we believe the whole group, including EAT, could see multiples revised lower in the coming months.

 

We continue to believe EAT is one of the best managed companies in the restaurant space, but it is not immune to the industry’s softening secular trends.  After seven straight quarters of positive traffic growth (3Q11 to 1Q13), Chili’s is looking at its third consecutive quarter of a decline in traffic growth.  We believe that the slowdown in traffic trends at Chili’s can be attributed to the confluence of a secular decline in industry trends and aggressive discounting from DRI.

 

EAT – EARNING PREVIEW - Chilis Tra

 

 

Sales Trends


In 3Q13, EAT reported 20% EPS growth on a 0.6% decline in revenue growth.  In 4Q13, street estimates are looking for EPS growth of 23% ($0.74) on revenue growth of 1.2%.  Given the reported decline in industry sales trends in June, we believe it will be very difficult for EAT to realize the 180bps sequential acceleration in revenue growth that consensus is looking for in 4Q13.

 

HEDGEYE – Same-store sales trends at Chili’s are a critical variable in the financial performance of the company.  We foresee sales trends at lunch slowing under the pressure of increased discounting from DRI.  The company has only beaten revenue estimates in 4 of the last 8 quarters.

 

EAT – EARNING PREVIEW - EAT SSSSS

 

 

Operating Margin Trends


We expect cost of sales to decline 60-70bps year-over-year, driven mainly by favorable mix in part to the 3Q13 introduction of its pizza and flatbread category coupled with some benefit from menu pricing.  Since 2Q11, EAT has made significant progress in bringing down labor costs through the implementation of its “Kitchen-of-the-Future” initiatives.  However, we suspect that some of this continued benefit from labor deleverage will be partially offset by weak same-store sales trends.

 

Between other operating expenses and G&A, we don’t believe EAT has enough leverage in the P&L to produce the 150bps year-over-year improvement in operating margin that the street is expecting.

 

HEDGEYE – Unfortunately, DRI’s aggressive discounting is making life difficult for every player in the casual dining space and particularly for EAT.  We don’t expect EAT’s management to respond to the increased promotional environment and this could hurt traffic trends on the margin.

 

EAT – EARNING PREVIEW - EAT OPM

 

 

Sentiment

 

Illustrated in the chart below, 52.4% of analysts rate EAT a Buy, 42.9% rate EAT a Hold, and 4.8 rate EAT a Sell.  The sell-side is slowly beginning to come around to our bearish view as a few analysts have downgraded the stock from Buy to Hold in July.  Short interest in the stock is currently 11.12% of the float.

 

HEDGEYE – We believe that EAT’s 4Q13 results will confirm our bearish thesis on the company and the rest of the casual dining industry.

 

EAT – EARNING PREVIEW - EAT ANR

 

 

Valuation


At 7.8x EV/EBITDA EAT is trading at a slight discount to its Casual Dining peer group trading at 8.7x EV/EBITDA.  Facing slowing traffic trends and significant pressure from DRI’s aggressive discounting, we believe EAT is appropriately valued slightly below its peer group. 

 

HEDGEYE – We believe the whole group is likely to see multiples revised lower in the current quarter.

 

EAT – EARNING PREVIEW - EAT PE

 

EAT – EARNING PREVIEW - EAT EV EBITDA

 

 

The company is hosting its earnings call on Friday morning at 10:00am EST.  We’ll post on anything incremental after the call.  

 

 

 

Howard Penney

Managing Director

 


Morning Reads on Our Radar Screen

Takeaway: A look at some stories on Hedgeye's radar screen.

Morning Reads on Our Radar Screen  - Screen Shot 2013 07 30 at 9.27.01 AM

 

 

DARYL JONES: MACRO

As the Second U.S. Housing Bubble Inflates: Rapidly Escalating Prices (via Seeking Alpha)

 

Former ECB Chief Economist Warns "ECB Will Soon Have to Support France with Bond Purchases" (via Mish's Global Economic Trend Analysis)

 

 

 

HOWARD PENNEY: RESTAURANTS

Chipotle Eating Higher Avocado Cost Shows Fed Disinflation Worry (via Bloomberg)

 

 

 

BRIAN McGOUGH: RETAIL

Back-to-School Retailers Shift to Dorm-Room Market (via BusinessWeek)

 

 

 

JONATHAN CASTELEYN: FINANCIALS

Deutsche Bank Profit Unexpectedly Falls on Legal Costs (via Bloomberg)

 


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[VIDEO] #DebtDeflation: Q3 Macro Theme #2

 

Right now, total global debt outstanding is three times total equity.  This has created a massive Supply/Demand mismatch, as the supply of debt dwarfs the availability of equities. Nearly every major investment class is broken on Hedgeye’s macro screen including Gold, 10-year Treasurys, Emerging Markets and high-yield bonds.

 

The trends have reversed, and you should expect the outflows to be just as poorly planned as the inflows were.  Indeed, the real risk is that there is a rush for the exits, leading already-crumbling asset classes to implode.

 

Hedgeye CEO Keith McCullough digs deep into this critical #DebtDeflation Q3 Macro Theme and how investors should position themselves.


Bad is Good

Client Talking Points

JAPAN

Japanese Industrial Production for June came in at -4.8% y/y vs expectations for -2.6%. Given the complete Japanese co-opting of western style Keynesian policy, the accelerating slowdown is viewed as a market positive as it ensures continued easing and ongoing Yen debasement – exporters benefit and things priced in (less valuable) Yens go up.   The Yen, despite recent strength, failed at our 97.61 resistance line which, of course, is positive for the dollar, on the margin.   The $USD remains Bullish in our quantitative risk management model with immediate downside/upside at $81.46/82.39. 

10 YR

With the SPX off a whopping 37bps yesterday on vapid volume, the 10YR barely took notice – advancing 4bps to 2.60% and is holding that level this morning.  With a record over-allocation to fixed income funds and near historic lows in investible cash, we continue to think money flows from bonds to equities as investors and asset allocators adjust portfolio’s to reflect the realities of #RatesRising.        

Asset Allocation

CASH 37% US EQUITIES 24%
INTL EQUITIES 14% COMMODITIES 0%
FIXED INCOME 0% INTL CURRENCIES 25%

Top Long Ideas

Company Ticker Sector Duration
WWW

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.

MPEL

Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016. 

HCA

Health Care sector head Tom Tobin has identified a number of tailwinds in the near and longer term that act as tailwinds to the hospital industry, and HCA in particular. This includes: Utilization, Maternity Trends as well as Pent-Up Demand and Acuity. The demographic shift towards more health care – driven by a gradually improving economy, improving employment trends, and accelerating new household formation and births – is a meaningful Macro factor and likely to lead to improving revenue and volume trends moving forward.  Near-term market mayhem should not hamper this  trend, even if it means slightly higher borrowing costs for hospitals down the road. 

Three for the Road

TWEET OF THE DAY

#Water is the next great asset class, the next great uncorrelated investment - @JamesGRickards

QUOTE OF THE DAY

"..We can ease policy further if needed.  The recent decline in the exchange rate seems to make sense from a macroeconomic perspective. It would not be a major surprise if a further decline occurred over time.” Glenn Stevens, RBA Governor

STAT OF THE DAY

Japan Industrial Production -4.8% YoY vs -2.6% estimate.  Nikkei Up on more Japan QE.   



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