Description

I suspect the mere suggestion of Coach as a long idea will make a few members cringe.  But after its recent free-fall, I believe the shares now offer a compelling long-term investment opportunity regardless of whether we enter into a domestic or even worldwide recession.  The company is a high quality retailer with its growth story still intact yet the market has discounted the shares as if it were a second-rate retailer already in a deep recession.   The bullet investment thesis is predicated on the following:

1.       The company is led by arguably the best management team in retail with an excellent track record in both good and bad economic environments;

2.       Valuation is compelling as the company is trading at an earnings multiple that is less than 70% of its sustainable intermediate growth rate (which factors in a rather severe slowdown);

3.       Management has achieved returns on invested capital north of 38% for the last ten years along with the best margins in the luxury retail sector;

4.       The company has operating leverage at the SG&A line which management has acknowledged and is poised to exploit;

5.       The balance sheet is considerably overcapitalized and management intends to return capital through a $1 billion share repurchase which at current prices we believe provides exceptional value to shareholders;

6.       Growth prospects for the foreseeable future are robust as the company continues to grow its core U.S. and Japanese markets and expand into the largely untapped markets of Asia and the Middle East.  

Company Description.

Coach, Inc. (COH) is a leading designer and marketer of luxury lifestyle products. The Company’s primary product offerings include handbags, women's and men's accessories, footwear, outerwear, business cases, sunwear, watches, travel bags, jewelry and fragrance.  It operates through in two business segments: Direct-to-Consumer and Indirect.

The Direct-to-Consumer segment consists of full-priced retail stores and factory stores primarily in North America and Japan, the Internet and catalogs. This segment represented approximately 80% of Coach's total net sales with North American stores and Coach Japan contributing approximately 58% and 18% of total net sales, respectively.

The Indirect segment consists of wholesale to department stores and represents approximately 20% of total net sales.  Within this segment, the U.S. and international represent approximately 12% and 8% of total net sales, respectively.

The Company has a Great Business.

It is rare to discover a retailer with the economics that Coach enjoys.  To put this into perspective, imagine you had the opportunity to own a business where you could open a 2,500 square foot store and generate $1.7 million in year one sales, have a cash yield north of 44% and a payback period of just 1.3 years.  This is Coach’s full-price store average. Not good enough? Well how about opening a larger factory outlet store that generates $4.0 million in first year sales with a payback period of just 6 months and a 4-wall contribution north of 50%.  There are some great retail businesses out there and I believe this certainly one of them.

The Growth Story is Intact.

We believe Coach can sustain earnings growth in the high teens for the foreseeable future with support coming from multiple angles. 

First, the company is primarily a domestic and Japanese retailer and management intends to expand square footage in these core markets more than 15% annually.  Second, management expects same stores sales to be in the mid-single digits.  We believe this is very reasonable.  Using the last quarter as a point of reference, full-price retail comps were up 10.8% and factory comps were up 27.3%. So mid-single digit comps leads me to believe management is discounting a considerable slowdown.   Third, management expects productivity improvements to kick in during 2008 to the tune of 100 bps of margin which is essentially bringing SG&A to 38.5%. 

And lastly, the company has just recently begun to push into new markets, entering 11 new markets in 2007 and expecting to enter 11 more in 2008.  Frankly, the world outside the U.S. and Japan has barely been tapped. Throw in the recently announced $1 billion share repurchase and I think it’s very reasonable to believe that the company has multiple factors intact to support sustainable per share earnings growth of at least 18% for the next couple of years.      

How has management handled past recessionary periods?  Have a look at the 2000-2002 period (please note June fiscal year). 

FY00                       FY01                       FY02                       FY03

Revenue                $537                       $601                       $719                       $953
      Growth%          6.1%                       11.7%                     19.6%                     32.6%
EBITDA                   $78.2                      $123.7                   $158.8                   $276.2
     Growth %          89.3%                     58.2%                     28.4%                     73.9%

You can see the dip in EBITDA growth but growth nevertheless remained intact and returns on capital throughout the entire period exceeded well over 35%.  I don’t mean to make light of the affects a current recession would have on the company but management is acutely aware that a slowdown is in the cards yet they remain confident growth will remain intact and we believe they have planned for it accordingly.  I would call BS on a lesser management team, but these folks have a track record of doing what they say they will in good times and bad and I certainly wouldn’t want to bet against them.

Valuation.

So if you agree that Coach is at least a decent business and its growth story remains largely intact for the next couple of years, then what is it worth?  I have usually had good luck buying companies that are trading at earnings multiples below their intermediate term growth rates.  And even better luck when those companies happen to be of higher quality, generate ROICs north of 20% and are leaders in their markets.  Coach firmly falls into both camps.

At a recent price of $30.55 with 368.1 million shares outstanding, the company has a market capitalization of $11.24 billion.  Based on consensus estimates, the shares trade at just under 14.7 times FY08 earnings (fiscal year ends in June) and about 12.5 times FY09 earnings.  The company carries a net cash position of $1.2 billion or $3.35 a share.  Ex-cash multiples are 13.1 times FY08 and 11.1 times FY09.  This well below the lowest forward multiple since the company became publicly traded.

I believe it’s reasonable to assign an earnings multiple equal to one times a company’s intermediate term growth rate and still achieve a satisfactory return on investment.  If you can get comfortable that management will continue to extend its track record of doing what they say, I believe 18x the company’s consensus forward earnings equals a fair price of $44 which also happens to be about 44% upside.   In the mean time, the company should continue to generate large returns on invested capital while buying in shares at very attractive prices while we wait.

On a free cash flow basis, we also believe the company is attractively valued. Coach is a consistent FCF generator even when incorporating growth investments.  I think it’s also important to reiterate that given the ROIC management achieves on its growth investments, CAPEX is money very well spent.  

                                                FY05                       FY06                       FY07                       FY08E                     FY09E

Cash flow from Ops             $544.3                   $596.6                   $779.1                   $818.3                   $895.2
CAPEX (inc. growth)             ($94.6)                   ($133.9)                 ($140.9)                 ($200.0)                 ($220.0)
FCF                                          $449.7                   $462.7                   $638.2                   $618.3                   $675.2

Backing out the net cash position, the company has an enterprise value of approximately $10 billion or just over a 6% FCF yield.  I can’t find many companies that generate this type of yield AFTER growth CAPEX that support 18% plus growth in earnings per share. 

Conclusion.

Catalyst