Thursday, September 26, 2013

Coach: Aspiring to Be Your Aspiration

About a month or so ago, I heard a story about an adult woman buying a Coach (COH) Barbie doll for around $100. Actually she bought a couple, just for good measure. What struck me about this account was the fact that this woman didn't like Barbie dolls and had no plans of ever using them. She bought $100 molds of plastic for a single reason: the brand, Coach. Later she heard the dolls were sold out, and she was downright giddy about owning a pair of showcase items.

Now, whatever your view about Coach happens to be, it's hard to dispute the fact that there are many people out there who are willing to pay the premium. I don't get the excitement but it's not an aberration that it exists. In some manner, it's relatively similar to consumers paying up time and again for the Coca-Cola (KO) or Johnson & Johnson (JNJ) brand.

In this light, the most important item to consider moving forward would be the loyalty and moat provided by the Coach brand – perhaps even more so than the actual product itself. For instance, for all of the price inflation in raw materials or distribution challenges that might arise, these would likely pale in comparison to a large deflation of the brand.

Morningstar analyst Paul Swinand provides a nice summation:

"With such historically strong financial metrics, investors may worry how sustainable Coach's record is. Fashion-driven companies can often seem like high-return companies when products and styles are popular, and fade quickly when tastes and preferences change."

So the risk with investing in a company like Coach is relatively straight forward: They need to consistently innovate while simultaneously keeping loyal brand followers. With regard to innovation, the "cutting edge" of fashion is finicky at best. However, it remains that Coach has proven itself to be a well-followed brand that has been able to provide solid and consistent returns to shareholders, despite the choosy environment.

Yet that's not to say that th! e company isn't also provided with opportunities. For instance, the emergence into the men's category is seen as a true avenue for growth. Especially to this point is the expansion into the Asian markets where there is now projected to be more wealthy citizens than in North America. In tandem, this population appears to be even more receptive to the aspirational aspects behind the brand.

In addition, the underlying business of Coach held up remarkably well during the last recession. If anything could test the merits of an idea, it's churning out profits in the midst of one of the worse economic times.

Finally, Coach Executive VP and CFO Jane Niel had some encouraging words regarding shareholder returns during the last earnings call:

"We expect that dividend growth over time will be at least in line with net income growth and that share repurchases will be executed opportunistically."

Assuredly Coach doesn't stand on the same level as the tried and true "must have" consumer staples. Nevertheless, if you personally find that the brand is defensible, then Coach's current valuation might be of interest. An easy way to review Coach's past and potential future prospects is through the powerful fundamental analyzer software tool of F.A.S.T. Graphs™.

12 Years of Growth

Coach Inc. has grown earnings (orange line) at a compound rate of 27.5% since 2002, resulting in a $15+ billion dollar market cap. In addition, Coach's earnings have risen from $0.25 per share in 2002, to today's forecasted earnings per share of approximately $3.78 for 2013. Further, Coach initiated a dividend (pink line) in 2009 and has been able to increase this payout at a robust pace since then.

For a look at how the market has historically valued Coach, see the relationship between the price (black line) and earnings of the company as seen on the Earnings and Price Correlated F.A.S.T. Graph below.

12-Year Earnings and Price Correlated Graph

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Here we see that Coach's market price previously began to deviate from its justified earnings growth; starting to become undervalued in 2007 and only coming back close to fair value around in the last couple of years. Today, Coach appears undervalued in relation to both its historical earnings and relative valuation.

In tandem with the strong earnings growth, Coach shareholders have enjoyed a compound annual return of 23.4% which correlates closely with the 27.5% growth rate in earnings per share. Note that the slight underperformance is due to a declining P/E ratio. A hypothetical $10,000 investment in Coach on Dec. 31, 2001 would have grown to a total value of $118,480.98, without reinvesting dividends. Said differently, Coach shareholders have enjoyed total returns that were roughly seven times the value that would have been achieved by investing in the S&P 500 over the same time period. It's also interesting to note that an investor would have received approximately 3.3 times the amount of dividend income as the index as well; and this comes despite receiving dividends for only five years.

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But of course – as the saying goes – past performance does not guarantee future results. Thus while a strong operating history provides a fundamental platform for evaluating a company, it does not by itself indicate a buy or sell decision. Instead an investor must have an understanding of the past while simultaneously thinking the investment through to its logical, if not understated, conclusion.

In the opening paragraphs a variety of potential risks and opportunities were described. It follows that the probabilities of these outcomes should be the guide for one's investment focus. Yet it is still useful to determine whether or not your predictions seem reasonabl! e.

! Thirty leading analysts reporting to Standard & Poor's Capital IQ come to a consensus five-year annual estimated return grow rate for Coach of 12%. In addition, Coach is currently trading at a P/E of 14.5, which is inside the "value corridor" (defined by the orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Coach's valuation would be $94.94 at the end of 2018, which would be a 13.1% annualized rate of return including dividends. A graphical representation of this calculation can be seen in the Estimated Earnings and Return Calculator seen below.

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Now it's paramount to remember that this is simply a calculator. Specifically, the estimated total return is a default based on the consensus of the analysts following the stock. The consensus includes the long-term growth rate along with specific earnings estimates for the next two upcoming years. Further, the dividend payout ratio is presumed to stay the same and grow with earnings. Taken collectively, this graph provides a very strong baseline for how analysts are presently viewing this company. However, a F.A.S.T. Graphs' subscriber is also able to change these estimates to fit their own thesis or scenario analysis.

Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low risk treasury bonds. Comparing an investment in Coach to an equal investment in a 10-year Treasury bond, illustrates that Coach's expected earnings would be 4.6 times that of the 10-year T-bond interest. This comparison can be seen in the 10-year Earnings Yield Estimate table below.

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Finally, it's important to underscore the idea that all companies derive their underlyi! ng value ! from the cash flows (earnings) that they are capable of generating for their owners. Therefore, it should be the expectation of a prudent investor that – in the long-run – the likely future earnings of a company justify the price you pay. Fundamentally, this means appropriately addressing these two questions: "In what should I invest?" and "At what time?" In viewing the past history and future prospects of Coach we have learned that it appears to be a strong company with solid upcoming opportunities. However, as always, we recommend that the reader conduct his or her own thorough due diligence.

Disclosure: Long COH, JNJ, KO at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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