8/2/2011
By Brian Sozzi, Research Analyst

For the second consecutive quarterly earnings release, the market looks prepared to sell the news on Coach (COH).  At first glance, Coach had a solid quarter of top and bottom line growth in a North America retail environment best characterized as volatile.  Keep in mind that Coach is not a traditional luxury goods play, distributing lower priced/quality (Poppy) handbags and accessories to department stores in North America and having a factory distribution channel (anyone ever visit the Gucci outlet?).  So it's plausible that with the renewed weakness in consumer spending evidenced in 1Q, Coach's goods would not necessarily be a top of mind purchase for a head of household of a middle income family, which is dealing with higher food, gas, and back to school bills.  Although Coach's China story remained nicely intact in the quarter (double-digit percentage comp growth), we think there was consumer related stress on the North American business...one just had to engage in a game of puzzle building to find it.

Understanding the Early Move in the Stock (down)

* Coach's North America comp of 10.1% was fine compared to other specialty retail chains in the mall, but directionally the trend continues to soften on a sequential basis.  Usually when comp trends begin to moderate for a retailer, its stock tends to fall out of the good graces of Wall Street as it means less leverage on expenses.  Coach is in full international expansion mode and is contending with elevated input costs, so signs of less leverage equates to concerns on achieving future consensus earnings estimates.

* Gross margin missed consensus, chiming in at 71.8% versus 71.95%.  However, the shortfall can be swept aside as immaterial.  What cannot be disregarded is the amount of year on year degradation totaling 154 bps, which essentially wiped out a reasonable performance on gross margins for FY11 (finished the year down 30 bps, strongly influenced by 4Q).  We believe Coach was heavy on inventory moving into the quarter (+26% year on year) and was a bit more promotional at department stores as a result, while at the same time factory sales continued to penetrate gross profit dollars (lower gross margin; trade down consumer continues?).  Note that gross margin matched consensus in 3Q11.

The stock is priced for perfection, and unfortunately a level of excellence was not inherent in the report if we put the pieces to the puzzle together correctly.  Numbers were good, but good in this trading environment and with a stock priced for earnings sizzle will likely be sold by the market.  We will be paying careful attention to the comp composition (transaction value versus traffic) and the cause of the gross margin drop.  But, at the moment, we feel the market's initial response is appropriate.

July 29, 2011 Pre-Earnings Note

"We would not be buyers into the release given the high probability for a sell the news type reaction by the market.  Coach shares have been on a tear since the 3Q11 earnings report in April, and we think a blowout quarter will be required to induce a positive stock reaction.  Coach likely performed well in 4Q11, but that is short of blowout."

Brian Sozzi
Wall Street Strategies

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