Thursday, March 21, 2013

More Bad News For Coach

Sometimes companies can be a made the victims of their own success. This looks to be the case with Coach (NYSE: COH) at the moment. Having established itself as the leading US player within its affordable luxury niche, the company finds itself beset with encroaching competition from the likes of Michael Kors (NYSE: KORS) even while the mid-market consumer remains constrained. The market has wasted no time in pricing all of this in, so is now the time to buy the stock?

Coach’s Prospects in Bullet Points

As ever, it is worth pointing out that we are looking at the price of the company more than the company itself. With that said I don’t think just buying value is a correct strategy. We buy value because we think it gives us upside skew if the underlying earnings improve. So what about Coach’s earnings prospects?

For a primer on the previous trends within Coach there is an article linked here. For now I’m going to run through the issues with bullet points:

  • Coach claims 30% market share within its marketplace and this position leaves it vulnerable to competitors aiming for its customers. Its margins are notably higher than Kors, which implies future susceptibility to pricing competition and margin erosion.
  • A weak mid-market North American consumer is seeing footfall declines at Coach. Interestingly Coach argues this was across the board and that it didn’t promote its way to growth. However, I note that the previous quarter’s growth was largely due to factory store comparisons that benefited from promotional activity.
  • Sales in China grew 40% in the quarter, and international sales were up 12%. International prospects remain strong but they only represent around 27% of current sales. North America remains the key, and the region's comparable same store sales declined 2.2% in the quarter.
  • Coach is focusing on non-core categories in order to drive growth in the future--in particular footwear, men’s accessories (a category growing at 25%) and apparel. The plan is to leverage its core brand in order to sell more lifestyle products.
  • Competitors stepped up pricing competition within the critical December period, as Christmas turned out to be weaker than many had expected and Coach admitted to losing market share in its core handbag category.

What Does All of This Mean?

Putting these points together creates a mixed picture for Coach. It is achieving strong growth in categories like men’s accessories, online sales and its international operations, but this is needed to offset an increasingly competitive core North American handbags market.

Moreover, its affordable luxury niche doesn’t offer the competitive moat of high quality in the way that, say, Louis Vuitton does. Similarly competitors like KORS or Ralph Lauren (NYSE: RL) are capturing market share within handbags and accessories. Moreover, RL has vastly more experience with men’s retailing and less of a brand reputation to protect. In other words, it can afford to be aggressive on pricing.

The expansion of its footwear activities is nothing new in the marketplace. Indeed, J.C. Penney (NYSE: JCP) is making the category a key part of its turnaround success. In a sense the troubles at JCP and other department stores are reflective of the weakness in the mid-market, and the response of many of these companies is to jump on the footwear and accessories bandwagon.The difficulties at JCP also imply that there is more significant market disruption to come as the department stores adjust strategies and sales channels in order to fight for share within a weakening market.

In summary, I think that Coach is looking to expand in categories in which it is not an established leader, while facing increasing competition and potential margin erosion in its core market. On the other hand, a glass half full assessment of the same facts would argue that Coach is leveraging the power of its existing brand in order to generate profits within higher growth categories.

Where Next for Coach?

My hunch is that investors follow the trends in the retail market, and KORS has the hot hand right now. Moreover, the weaker traffic reported at Coach’s stores also means weaker traffic for its growth categories. Coach finds itself in a tricky situation. Does it increase promotions in order to drive traffic but possibly lower the brands perceived value, or does it hold pricing and try to drive growth through other categories?. At the moment it seems to be arguing for the latter. This could prove a risky strategy if the mid-market consumer doesn't come back.

We may well see strong growth from areas like footwear and men’s accessories, but the core, handbags and women’s accessories, remains the key to its future growth. My hunch is that the challenges in its core market could go on longer than many people think and the company will need a stronger overall retail market in order to start growing its core North American market again. The key metric to follow is traffic, and until that comes back I will keep Coach on the monitor list.