A Loser, a Winner, and a Hidden Gem in Affordable Luxury

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When many investors think of the fashion industry, they tend to think of handbags. After all, companies like Louis Vuitton, Burberry, Prada, and Gucci built empires on the endless desire for pricey purses and accessories. Over the past several decades, however, a new class of affordable luxury handbags, which cost hundreds of dollars rather than thousands, has emerged.

Although this market was once dominated by Coach (NYSE: COH), which was founded in 1941, younger brands like Michael Kors (NYSE: KORS) and Fifth & Pacific’s (NYSE: FNP) Kate Spade have emerged as major contenders in an increasingly crowded market. Which of these three fashionable companies is best positioned to capitalize on rising consumer sentiment, which hit a six-year high in July?

The loser: Coach

Shares of Coach, the largest name in affordable luxury handbags and accessories, plunged on July 30, after the company reported a drop in profit, weak same-store sales, and the departure of two key executives -- Mike Tucci, the President of the North American segment, and Jerry Stritzke, the company’s President and Chief Operating Officer.

For its fourth quarter, Coach earned an adjusted $0.89 per share, up 3.5% from the $0.86 per share it reported in the prior year quarter. Sales rose 5.8% year-on-year to $1.22 billion. Coach’s profit was in line with analyst estimates, but revenue came up short of the consensus estimate of $1.24 billion.

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Coach reported solid sales growth across the globe, with a 5.6% increase in North America and a 6.6% gain in international markets. However, North American same-store sales declined 1.7% while direct-to-consumer sales rose 5%, indicating that more purchases were made online rather than at brick-and-mortar locations.

China was the standout performer in the international markets, reporting a year-on-year sales increase of 35%. Although Japan reported a 4% sales increase on a constant currency basis, sales actually declined 15% on a dollar basis, due to the dramatic weakening of the yen during the quarter.

In recent years, Coach has attempted to expand its fashion collection to include more accessories, clothing, shoes, and men’s bags. Coach also plans to emphasize its outlet stores over its full-price locations in an effort to improve sales volume. However, Coach’s executives don’t believe that the addition of all these products and a renewed focus on lower-end consumers will directly boost same-store sales, which are still forecast to rise at a “low to mid-single” digit rate for the rest of the year.

In other words, Coach’s numbers tell the same old story for the company -- its numbers are still rising, but stale single-digit growth just isn’t appealing when compared to Wall Street’s favorite new kid on the block, Michael Kors.

The winner: Michael Kors

Michael Kors, which went public in December 2011, has become a favorite of shoppers and investors alike. Last quarter, the company reported earnings and revenue growth of 131.8% and 57.1%, respectively, a trend that Wall Street expects to continue when it reports first quarter earnings on August 6.

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Under the guidance of designer Michael Kors, who rose to international fame as a judge on Project Runway, and CEO John Idol, Kors has established itself as the trendy affordable luxury brand that makes Coach look stodgy and dated by comparison. Same-store sales climbed 35% year-on-year in North America and surged 63% in Europe -- growth rates that Coach can only dream of. Kors is also quickly establishing footholds across Asia and penetrating key markets such as China and Japan.

Kors is looking to diversify its product line into men’s sportswear, shoes, and leather goods, strategies that have been closely followed by Coach. For the full year, Kors expects same-store sales to rise 15% to 20% -- outpacing not only Coach, but most of its comparable industry peers.

Kors is a solid growth stock, but with great earnings come ever higher expectations. The stock is trading at 34 times trailing earnings, compared to a P/E of 14.3 for Coach and 22.7 for Ralph Lauren. This means that any sign of weakness in Kors’ first quarter earnings could cause the stock -- which is already up 62% over the past twelve months -- to nosedive.

The hidden gem: Kate Spade

No article about affordable luxury would be complete without mentioning Kate Spade. Kate Spade, which produces handbags, accessories, clothing and footwear, is rising just as fast as Michael Kors. Kate Spade is the largest of Fifth & Pacific’s primary fashion brands, which also include Lucky Brand and Juicy Couture.

Last quarter, sales of Kate Spade’s products rose 63.1% year-on-year to $141 million. Same-store sales surged 22%. However, Kate Spade’s robust growth was offset by slumping sales at Juicy Couture, which reported a 10.7% decline to $98 million. Lucky Brand, its contemporary clothing brand, helped offset Juicy Couture’s decline with a 16.5% increase in sales to $117 million.

Faced with mounting evidence that Juicy Couture, which rose to prominence on the popularity of its trendy velour track suits, is falling out of fashion, the company hired a new CEO last year to help turn around its lagging performance. Last quarter’s results definitely didn’t show the improvement that Fifth & Pacific was looking for, and the company is now reportedly looking to sell or spin off Juicy Couture.

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If Fifth & Pacific is successful at spinning off Juicy Couture, I believe that this stock could really take off. For now, however, the company is still unprofitable, and there is a major disparity between its surging stock price and its lackluster revenue growth.

The Foolish bottom line

As Heidi Klum states every week on Project Runway, “In fashion, one day you’re in, and the next day you’re out.” In my opinion, Coach, once the best growth stock in affordable fashion, is definitely out, and its smaller rivals, Michael Kors and Kate Spade, are in.

Coach is playing with fire by relying heavily on outlet sales to carry its top line growth for the rest of the year. That move could irreversibly cheapen its brand and drive more prospective customers to Kors and Kate Spade instead.

Kors is a clear winner in this sector, but investors should be wary of overly optimistic growth forecasts, which could sink the stock. Lastly, Kate Spade is a rapidly growing brand that is enjoying as much success as Michael Kors, but it must first break free of Juicy Couture and Fifth & Pacific’s other weaker brands to truly thrive.

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Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Coach. The Motley Fool owns shares of Coach. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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