1/23/2008

Coach Gets Bagged
By Brian Sozzi

Quarterly Snapshot

Today, Coach Inc. (ticker symbol: COH) announced its 2Q`08 financial results.  The company recorded net sales of $978.0 million (consensus $965.2 million) and diluted earnings per share of $0.69 (consensus $0.68).  These figures were modestly ahead of management’s expectations of $970.0 million in net sales and $0.68 in diluted earnings per share outlined on the 1Q`08 earnings conference call.  Contributing factors to the upside versus consensus estimate earnings per share result were aggressive share repurchase activity and execution on variable expense control.  We modeled for net sales of $980.0 million assuming a low-single digit percentage comparable store sales (comp) increase that failed to occur.  The diluted earnings per share result was in line with our forecast.

If one would like to use the earnings report put forth by Coach as a proxy for upcoming holiday quarter financial releases from retailers, than disappointment should be expected.  The company is known for handily eclipsing its internal operating targets seemingly every quarter as consumers snatch up the latest handbag and accessory styles.  However, the fact that this trend halted for 2Q`08 (began in 1Q`08) speaks volumes to the current state of the retail environment, as consumers reduce mall visits and allocate less of their incomes to discretionary purchases.

The rather lukewarm 2Q`08 report and FY`08 guidance from Coach is reflective of (1) surprising 1.1% comp decrease at North American retail stores, (2) steeper than expected gross margin contraction brought about by promotional activity and currency fluctuations, (3) general caution by management on consumer spending patterns for the spring selling season, (4) further weakening in customer traffic and a new worry of lower amounts spent per transaction, and (5) prolonged shift in gross margin composition.  Adding further fodder to the bear argument on Coach shares is a differing approach to how management runs the business, specifically on the basis of product pricing.

Investment Thesis
The new year has started off on a downbeat note for global equity investors as U.S. recessionary fears run rampant.  In many respects, the panic selling (or capitulation) that continues to envelope major indices is not without justified reasons.  The calamity in the sub-prime mortgage market that began in August, once thought to be an isolated event, has spread throughout the economy in the form of huge write-downs at major financial institutions, possible default at bond insurers, and a reluctance to lend to consumers and small businesses.  Toss in a soft employment reading of 18,000 net new jobs created for December, a spike in the unemployment rate to 5.0%, and economic indicators (manufacturing, retail sales, building permits) across the board flashing warning signals of sluggish if not negative GDP growth in the world’s largest economy, and it’s apparent why consumer spending has moderated. 

As a result of these macro developments, in all likelihood, debt laden consumers will continue to spend thrifty into 2H`08.  As the Federal Reserve’s cumulative 175 basis reduction in the overnight lending rate (since the start of the easing cycle in August) and the proposed fiscal stimulus policy permeate the economy later in 2008, there is a possibility consumers could become more open to discretionary purchases ahead of Christmas.

It goes without question that Coach is a market leader in the luxury handbag and accessories retail sector.  The company is aggressive in terms of product newness (flowed in monthly) and has been ahead of the curve in the expansion of its lifestyle handbag collection to new usage occasions (wristlets, jewelry, footwear).  Moreover, Coach is perhaps one of the best run retailers among our coverage universe of softline good companies, as it tightly controls operating expenses and inventory.

However, we are growing increasingly concerned about the direction of Coach’s business at this juncture as it attempts to attract new customers and retain its loyal base of patrons.  The implementation of pricing strategies for the holidays and openness to continue them going forward raise a red flag as it pertains to future gross and operating margins.  Also contributing to margin uncertainty is the expansion of lower-priced handbag categories, not to mention increasing penetration of factory store sales to full price retail sales.  Given our points of worry, we recommend investors use the market’s positive response to the earnings report to reduce exposure to the stock.  In order for us to become more constructive on the stock, we would like to observe (1) strengthening retail sales or consumer confidence, (2) the ability to hold the line on prices during the spring selling season, (3) moderation in mall traffic declines or (4) stabilization in Coach’s downward trending gross margin rate.

Written by Brian Sozzi, a Research Analyst for Wall Street Strategies (www.wstreet.com) specializing in the apparel/hardline goods sectors of the retail industry.