Takeaway: COH might be batting only 0.0833, but momentum is building in an otherwise investable Retail tape.

Investment Conclusion: There’s a lot of bad things you can say about Coach’s quarter – its poor quality of earnings, lower than expected tax rate, 7th consecutive quarter of special charges, NA comps still not positive, and all indications that the brand is still in ‘Outlet Mall/Department Store purgatory’.  But for the first time in a while, you can add a few positive comments to the narrative as well. The biggest of which is that this is the first quarter in 12 where GAAP earnings actually grew for Coach (even on a full tax rate). That carried through to the balance sheet as well, with a 14 day improvement in the cash conversion cycle. Clearly not all is horrible at COH, which for years could do nothing right.  Look at the SIGMA below, which shows that COH has one of the best sales/inventory/margin trajectories in all of retail (that’s a pretty massive statement), which is very bullish heading into next quarter.  We put COH on our Long bench in March for many of these reasons. It’s 5 tickers removed from our top idea, and deservedly so.  But this is a management team that took control of the company when it was a complete disaster – yes, two-three years ago (when EPS growth turned squarely negative). These guys learned the hard way, and appear to be figuring it out.  If there’s one thing I learned about Retail in 20+ years, it’s that a 3-year stretch of value destruction does not end, only to start all over again. Quite the opposite -- in a sea of uninvestable names in retail, this is one where we think you can arguably take above consensus EPS growth to the bank.  It’s still sixth on our idea list – but with an upward bias.

COH | Objects in Motion Remain in Motion - 4 26 2016 COH sigma chart1

DETAILS OF THE QUARTER

 

Whack-A-Mole: This is the first quarter in 3 years that the Coach brand grew organically, with sales growth of 3% (4% C$) and earnings growth of 17%. Margins still haven’t found a floor, down another 70bps in the quarter, or maybe put a better way, down 14 percentage points in 3 years. North America comps were flat with the road-map in place towards positive comps in 4Q16. We give management a tremendous amount of credit for laying out the road map for the recovery and delivering on the promises. But, now that the mole has poked its head out of the sand – we’re at a critical inflection point in the COH story.

From here – the story is less centered on the quarterly cadence of comparable store sales, but sustained organic growth and a material inflection in the margin trends over the near term, and margin stabilization in the long term. Merch margins have been more or less stable throughout the entirety of the three year decline (down just 220bps on a $900mm revenue decline). The kicker must be SG&A leverage as the company returns to a more stable top-line outlook. But, gone are the days of double-digit/high-single digit comps as the company all but admitted it is no longer a market share taker, instead just not a market share ceder.

The SG&A leverage story makes us inherently uncomfortable, especially since its associated with an equally aggressive (in the case of COH) topline acceleration growth story in the low-to mid single digits. Sure there is some occupancy deleverage to recapture (about 300bps of the 13 percentage point decline from 2011-2015), but most of the charges COH recognized as part of its restructuring have been written off as one-time. Meaning there isn’t a lot of low hanging fruit to grab without a commensurate return to excellence on the top line. Management has talked about $150mm in annual run rate cost savings once we hit the conclusion on 2016. Though today’s new cost cutting/employee reorg plan speaks to that fact that COH has more wood to chop.

True House of Fashion Design: In fairness, this is a nit-picky observation, but we can’t totally get behind’s COH new ‘True House of Fashion Design’ mantra. The fact is that COH is a company with a new footwear asset (Stuart Weitzman), and an average handbag business highly weighted to the outlet channel. By itself, COH has never proven it can scale what at a time was a highly relevant product in one geographic region across the globe or categories. Management seems focused on acquiring new category exposure (a la Stuart Weitzman), that will produce the illusion of growth and diversify away from handbags. But, nearly anything COH could acquire, while accretive, will damage the profitability profile of the parent.

COH | Objects in Motion Remain in Motion - 4 26 2016 Algo chart2

COH | Objects in Motion Remain in Motion - 4 26 2016 earnings chart3