Thursday, July 3, 2014

The Loser Now Will Be Later to Win -- First in a Series: Coach

(We'll be looking at laggard stocks in a bull market.  Here's our first)

We had a classy girlfriend some time ago who owned a Coach leather bag.  We wonder who’s kissing her now. Probably her grandchildren, which has been part of Coach’s recent woes, a reputation as a yesteryear luxury brand.  Be that as it may, we thought of bygone romance when looking at a list of the worst performing stocks in the S&P 500 in the first half of 2014.  While the Street is almost universally bearish, we think Coach’s turnaround strategy, overseas growth, plump dividend, profitability metrics and reasonable valuation merit a buy recommendation.

Let’s look at the bear case first. Coach, whose shares declined 38% in the first half of 2014, recently cratered after it announced it was closing 70 stores, or about 13% of its retail outlets, and would incur charges of up to $300 million over the coming quarters. CFO Jane Hamilton Nielsen told investors that as a result of the closings and a reduction in promotions revenue would decline in the low double digits

Coach was responding to plummeting same-store sales in North America, which more than offset strong gains in Chin.  In effect, Coach was admitting that its “accessible” luxury strategy was a bust.  And though not stated, the move was largely in response to the market share gains of competitors Michael Kors (KORS) and Kate Spade & Co. (KATE).  Though women’s handbags and accessories have slumped, Coach is experiencing double-digit same-store sales in Asia and a stronger men’s business. 

Some analysts have compared Coach’s about-face to the failed end-of-promotions strategy of J.C. Penney, but Coach remains a highly profitable company with the means to reposition itself, in our view.  Key to the rejuvenation of the brand will be the work of Stuart Vevers, the English designer charged with retooling the Coach look.  We’re no fashion experts, but reviews were glowing at last winter’s New York fashion week.

Key to our outlook for Coach is its reasonable valuation compared with its profitability metrics.  The shares trade at about 16.5 times next year’s earnings estimates, about even with that of the S&P 500.  But Coach boasts a 38.6% return on equity, more than double the industry average of 18.8%.

And while waiting for brand restoration to show results, investors are rewarded with a dividend yield of nearly 4%.  The dividend payout ratio of 40% is high, but with minuscule debt and positive cash flow it should be safe for now.

Our recommendation is not without risks, chief among them a collapse in consumer spending, not a negligible possibility.  And, of course, Coach could fail to recapture its cachet as America’s top luxury brand.  But we think the stock is a bargain at current levels and that a year from now it will command a price-earnings multiple equal to that of KORS.  That gives us a target price of $54, some 58% above current levels.


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