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.
