Conclusion: After being bearish on the name for nearly three-years, we’re taking Coach off our Retail Short List. To be clear, the fundamental story is absolutely broken, and the financial model is not far behind. Our numbers 2-3 years out are 20%+ below consensus, and we truly don’t think that this company will earn $2.00 again until close to 2020. But as broken as this model may be, the stock, unfortunately, is not. We think that the absolute best-case downside on a short at these levels is about $5, which is hardly enough on a $36 stock. And the truth is that we’d need to see the company face-plant on its recently-announced Brand repositioning, and there are no expectations for any meaningful results for another 1-2 years. Until then, the company probably has a hall pass to be sub-par, and the stock will probably be rewarded if the company hits a quarter even if by accident.
We’ve been struggling with valuation support on Coach given that we expect Gross Margins to cough up another 300bp, and EBIT margins should stay stagnant in the mid-high teens for years to come. But the flip side is that the dividend currently sits at 3.72%, which is reasonably attractive. The key here, unlike other higher yielding retailers is that the dividend is safe – even on our beared-up numbers. In fact, we’d need to see about a 700bp hit to Gross Margins in order to threaten the dividend. That would equate to a 13% EBIT margin. As much as we think that Coach has been relegated to an Outlet brand, it’s extraordinarily unlikely that it will ever see a 13% margin level again. At a 13% margin, we’re looking at about $1.33 in EPS. If we generously give it a 15x multiple, it suggests $20, or a 6.8% yield. That’s probably not going to happen.
In fact, Coach is on the short list (no pun intended) of names we think could, should, and probably will be acquired over the next 1-2 years. The brand just lost the team that took COH from $500mm to $4bn (Krakoff, Stritzke, Tucci, Frankfort) and has as much instability in the executive ranks as it does with its brand. A strategic or financial buyer could shield the management team from the near-term expectations associated with the capital markets, and focus strictly on revitalizing the brand – like it did the last time it grew stale and Sara Lee spun out Coach in 2000.
LBO: Makes more sense that one might think. The cash flow here is extremely compelling. The public market is getting a 3.72% yield, but a private buyer could take that up to the teens and not miss a beat. The transaction at $36 is on the rich side (a $30 stock with a 20% premium), gets us a 17.2% IRR with 6.9x debt/EBITDA. The leverage is on the high end of deals done to-date. But not out of the realm of what we’d consider doable. Again, this is based on zero margin recovery, and assumes a 10x exit multiple (equal to entry). Let us know if you’d like our LBO model.
Strategic Buyers: We think that the three most likely are Fast Retailing (Japan), Kering (the former PPR/Gucci -- France), and LVMH (France). These companies could all digest COH in a heartbeat – from a leverage and dilution standpoint – at a price as high as $45. Fast could actually do the deal as high as $60 and it would be accretive. Same goes for Richemont and Inditex, though Coach would be further outside their respective cores.
COH Acquisition Accretion
Source: Hedgeye and Factset
Leverage Pre and Post COH Acquisition
Source: Hedgeye and Factset