|Shares Out. (in M):||280||P/E||17||16|
|Market Cap (in $M):||10,395||P/FCF||21||16|
|Net Debt (in $M):||-1,244||EBIT||839||943|
|Borrow Cost:||General Collateral|
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We are recommending a short of Coach (COH), as we see this as an opportunity to take advantage of short-term thinking investors putting an excessively high valuation on a tainted brand. Coach (COH) is trading at 8.5X peak (2013) earnings (after making a small adjustment for the addition of Stuart Weitzman), a level that we believe the company is highly unlikely to ever achieve again. This limiting factor creates a quasi-free call option for short sellers, which allows an investor to bet against a brand that is clearly declining, but whose short-term performance can be less predictable.
No company has ever fully recovered from overexposure:
Overexposure varies case to case and is tough to define pre-hindsight. It is possible that certain brands needn’t 500 stores to be overexposed and were done at 50. However, in certain extreme cases we believe that overexposure is similar to how the Supreme Court once described porn--we may not be able to define it, but we know it when we see it. We believe that Coach (COH) is a brand that has clearly been overexposed. COH reached a height of roughly 40% of the North American premium handbag market in 2013. This is an amazing and eye popping number, given the number of competitors and the lack of barriers to entry in the industry. COH got there by going down market from a high-end luxury brand to mass market affordable luxury brand. This down-market sell strategy is another sign of overexposure, and while it likely quickened COH’s rise, it also should lead to a quicker and potentially deeper fall.
Thinking about retail--and by retail we are referring to specialty apparel retail brands--we began to ponder if fallen retailers can be truly turned around. Brands can be categorized into two types, those that restrict supply and those that do not. The ones that restrict supply, usually found in luxury goods, can be incredibly durable. The ones with unrestricted supply seem to have a very short half-life. The typical pattern that we see in unrestricted retail is that a brand does well for a while targeting a certain audience. Take for example Dress Barn. For years it targeted predominantly baby boomer women and expanded to fully exploit that opportunity. When its target customer ages, the unrestricted retailer responds by chasing its customer while simultaneously trying to acquire a new generation of customers. This tends not to work with acquiring the new generation, as people do not want to shop at a place with older customers. Simply put, women don’t want to shop where their mothers shop. Overtime the economics of this unrestricted brand deteriorates, though there can be short-term upturns along the gradual decline if the brand hits a trend right. The alternative for unrestricted brands is to fully follow its aging target customer and ignore the trailing aging generation. But as customers age, their taste change. Eventually they do not associate the brands they shopped with their new tastes. In addition, they are likely spending less. Brands will choose this seemingly odd strategy because it’s the least bad alternative. No unrestricted supply apparel business once it starts truly declining seems to turn around.
We set about to look for counter examples to this thesis. We defined a turn-around as a return to peak performance. So we began to search for examples of this, which would seem to run counter to our thesis. Let’s start out with a quote from Warren Buffett. In 2005 Buffett when asked about Sears, he responded in part by saying “Can you think of an example of a retailer that was successfully turned around?” So it appears that Mr. Buffett, has never witnessed this phenomenon. We couldn’t think of an example either.
We next spoke with four industry experts and analysts with a combined approximate 100 years of experience. These experts have not witnessed a turn-around as we defined it. They were able to recall several examples of stabilization after a fall. For examples, Tommy Hilfiger and Lacoste both have viable businesses. They are just the same size as they were at their peaks.
All of the examples so far have been narratives. Looking for something more concrete we stumbled across the Brand Z top 100 most valuable global brands. This is a publication has been valuing brands since 2006. We looked across retail, apparel and luxury categories since 2006 and could not find a brand that had fallen off the list and later got back on. We did see examples such as Gap, Abercrombie, and Espirit that had fallen and not returned. Our look at Brand Z scores did also further illuminate how stable luxury brands are (see exhibit 1 below) and how important limiting supply is to that. The list has largely been the same since 2008, and all of the companies that make the list every year limit supply in some way. Louis Vuitton and Hermes (#1 & 2 since 2008) are notoriously effective at this. Vuitton destroys any unsold product, and there is a multi-year wait for many Hermes products.
Lastly we kept digging up company histories for possible counter-examples. We did find a couple of retailers (Express & Guess) and there are likely more who have had extended periods of ups and downs, but we could not find any who fit our definition of overexposed who did this.
So judging by history, we would expect Coach to never return to its 2013 peak net income. Other factors will also weigh on Coach’s future performance. New forms of shopping are emerging such as Stitch, which sends a trunk full of clothes and accessories to woman on a subscription basis. The expert we spoke with believes that this form could one day be 20% of the market. This form uses their own brands in this trunk, not COH products. This form will appeal to fairly well-off but less fashion obsessed woman, basically a woman who cares how she looks, can afford to dress well, but doesn’t make it her first priority. This description fits the typical COH customer. Additionally, the used and borrowed bag market is growing. Every bag that is resold undercuts demand for a new bag. (We also note that these services usually do not sell Coach products, another reason to say COH is no longer a luxury brand.) We believe these new shopping forms are two factors that could severely downsize the women’s branded handbag market.
We have not talked yet about the current trends going against the handbag market. For years into the mid-2000s the handbag market rode incredible growth as woman made a shift from status spending on shoes to bags. That shift has finally stalled, and apparel spending in general seems to be flattening. A premium handbag is a status symbol. So if women aren’t buying bags for that status, what are they doing? A different accessory? Enter social media, where displaying experiences are status symbols. On Social media one simply can post a photo of a fancy restaurant or a trip to a hip destination and have it seen by an audience. With a bag it’s just whoever sees you that day, but with social media it’s all your friends and more. One could argue the move to getting status from events and social media is far more effective. I am uncertain about this going forward, but it certainly has a logic to it and could be the icing on the cake in our short thesis.
Does the recent Rise in Same Store Sales Counter our Short Thesis?:
Coach has had a few decent quarters recently with a return to low single digit comps. So does this mean that COH is out of the woods and there is a return to growth for the brand? We looked for previous cases of overexposure and decided that Gap in the early 2000s and Abercrombie & Fitch a decade ago are classic examples of overexposure and two (unlike some others) that we could get good data on. Both of these companies are now nowhere near their peaks, but they had some rebounds along the slide down--so the answer is yes!!
Gap’s North American namesake business peaked in 2001 (see Exhibit 2 below), with SSS down 42% since 2000. Along the way, there were three years when same store sales actually rose. So what did those three years of positive comps? There seem to be three contributing factors, easy comparisons, store closures and though we can’t quantify it, being on trend.
Abercrombie suffered a similar cumulative drop in their same store sales from their peak in 2007 (see exhibit 3 below), falling 41%. Yet Abercrombie had two consecutive years of rising comps during this stretch. Once again the primary driver appears to have been easy comparisons and a decline in store counts. We would note that Abercrombie was still expanding internationally during this time, which blunted the percentage change in stores, but if we look at store closures we see just how much the company was cutting back.
Looking at these two examples can put some context around COH’s recent bounce (see exhibit 4 below). COH’s recovery in North America was aided by very weak comparison’s a raft of store closures in 2015 & 2016, as well as a decrease of 25% in wholesale doors. On top of that, the company might also be benefitting from a new designer (Stuart Vevers) and the “1941” line which has drawn good reviews—in other words, it’s been on trend. All of these are likely short lived. If the company can accelerate comps in consecutive years or continue to rise with stable or increasing store counts, then we would have to revisit our thesis.
So what caused Abercrombie’s fall to be so much quicker than the Gap’s? There are a host of reason’s including a decline in the category, a much faster changing demographic, and being very off trend. But what we think is the biggest reason is that Abercrombie started discounting during the crisis, which likely further tarnished the brand. COH’s move to “affordable luxury” might similarly quicken the company’s fall.
We see other factors that also point to a more imminent fall for Coach. While COH gives out very little financial details, it is believed that the company gets 70% of its sales and likely an even higher amount of its profits from outlets. Outlets can be a nice add-on to a successful brand, but too many clearly tarnish the brand. Outlets can add value in the short-term, even when a brand is struggling. However, the more outlets added, the more the brand losses its premium. As you add outlets you undercut the core stores overtime, and the outlet customers see the erosion of those premium sales and they no longer see their purchases as a bargain value and get turned off the brand themselves. Outlets are seen as a small side business and a way to extend the life of a brand. Donna Karen is a good example of this as it continued to add outlets as recently as last year. This is why increasing % of outlet sales are a good omen for a future fall.
So why have we focused so much on the North American market when COH is expanding internationally? Well we believe in Europe that customers have long established brands that are made in Europe with better craftsmanship. It is difficult to see a bag mass manufactured in Asia having much success as a luxury product in Europe. In Asia, where luxury companies thrive and appear to have a less sophisticated customer, they tend to take their cue from the other markets and will likely just lag the domestic trends.
Reason for Anomaly:
So why does this opportunity exist? Why would COH trade for 17X 2017 earnings when earnings are so likely capped? I believe the answer is short-termism dominates the market, and I believe it is especially prevalent here. In my work on this, when I asked what the bulls were saying, nobody disagreed with my core thesis nor saw some great brand, rather it was a difference in time frame. Bulls see weak comparisons, a brand that appears to be on trend as a way to beat comps and a recipe for a stock price increase. The investors that would normally bet against something like this are turned off by fashion as they see it as something that is less predictable and where they do not have an advantage. Long-term investors are in general turned off by fashion because the business track record of fashion retail has not produced many sustained winners. So by applying a more nuanced long-term view, we may be using some time arbitrage in the space.
We of course have the usual risks that the company outperforms our expectations and any financial engineering, like we would have for any other stock, but I would rather focus on potential flaws to our logic. We could be applying a narrative bias in our analysis. While other sustained luxury brands have not discounted like COH, they have offered lower priced items, which may cheapen the brand. For example, Louis Vuitton sells wallets that, while expensive, are a fraction of the price of a bag. Some brands also create a cheaper related brand, like Armani with Armani Exchange and like the many labels of Ralph Lauren. We would also note that Ralph Lauren uses a lot of outlets, though Lauren’s retail strategy is different as they mostly wholesale and own very little non-outlet stores. We would also note that that Ralph Lauren is currently struggling. We do see these strategies as very different, though one could at least argue the other size.
While we see very little risk of COH stock going to the moon, there is the possibility of continued slow growth, combined with buybacks that lead to a slow march up for shares.
Earnings misses, same store sales declines.
While a large acquisition would dilute our short thesis long-term, we believe it would be a catalyst short-term. COH seems to be actively on the hunt for large acquisitions, with rumors that Burberry rejected multiple offers from COH. There are almost no synergies for COH with another large brand since both would likely retain autonomy. The issues, we discuss above, are well known in the fashion world and thus a large premium would be needed to get a deal done.
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