THE HEDGEYE EDGE
We added COH to Investing Ideas as a long on 8/2/17. Despite the 35% YTD run – it’s just the beginning for shares of Coach. Handbags are not dead. It is a solid business with high (sustainable) returns and a very defendable per-capita unit consumption story and stable ASPs. It’s like the athletic category – but better. Handbag units per capita bottomed in 2009 and are holding stable in a modest uptrend of 1.3-1.4x.
Coach landed the deal of the century because of mis-aligned incentives at Kate Spade. Kate Spade’s management team was incentivized by the vesting of stock options to complete a takeover more than the price of the acquisition. Coach and Kate Spade were both attractive stand-alone investments before the merger, and the combination of the two at a low valuation is an even better investment.
Management’s projection of $50M in merger synergies is much lower than what we believe will be achieved. We think KATE can be operated at operating margins 200-400bps higher. Kate Spade had well above average sales productivity, but low profit margins. That represents a $700M EBIT opportunity. The chart below illustrates the strong correlation between sales productivity and profit margins in the industry with Kate Spade as the notable outlier.
After the first year we will likely see an acceleration in organic growth. The overlap between the two brands is low with Kate bringing a younger demographic with a distinct lifestyle compared to Coach.
Coach sees a significant opportunity to expand Kate Spade internationally where it has already built the infrastructure that it can leverage. Michael Kors, Coach’s largest competitor, is pulling back on promotions and inventory in 2017 which will lead to better industry margins. The combination of Coach and Kate Spade will deliver accelerating revenue and margin improvement on a lower operating asset base. That will drive asset returns higher and we believe the Street’s $2.67 EPS forecast for 2020 achievable two years earlier.
ONE-YEAR TRAILING CHART
