This Luxury Retailer Offers Good Upside Potential

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

The shares of luxury retailer Coach (NYSE: COH) have seen a lot of ups and downs this year. Coach’s share price dropped a whopping 19% in just a single day after the company announced its 4Q12 results in July as the investors were concerned that modest same store sales growth (North American SSS rose 1.7% vs. consensus estimates of 6.4%) was a sign that the company is losing its market share to Michael Kors Holdings (NYSE: KORS). However, the company has recovered well in the recent quarter and posted strong SSS growth (5.5% vs. Consensus estimates of 2%) in North America, and as a result the shares are moving up.

Going back to 4Q12 results, I think the competitive threat posed by Michael Kors was overblown as factory stores were principally responsible for the lower than expected SSS growth and Michael Kors presents competition in full-line stores rather than factory stores. The factory channel improved once the company began its typical couponing and I believe the acceleration in the U.S. same store sales should alleviate fears that Coach is losing momentum. While same store sales benefited from price promotions in the factory channel, it is encouraging to see that Coach earns full margin in this channel even at 30% off the outlet price given its scale and buying power. Factory channel products are all new versions of previous best sellers; building in a clear predictability factor.

In addition, the Company was able to drive double-digit SSS growth in China, which demonstrated strength against a challenging macroeconomic backdrop. Mulberry’s profit warning further suggests that Coach’s strength is indeed due to strong products and execution – not just broad industry strength. Here are some key reasons that makes me bullish on this stock.

Multiple Growth Opportunities

I believe that tactical investments in initiatives like Legacy, Men's and China should help drive sustainable growth. After acquiring its retail operations in China from its former distributor in 2009, Coach has been rapidly increasing its distribution network in the region. In FY12, the company posted a tremendous 64% revenue growth in China. Despite tougher comparisons, Coach has sustained momentum in China in 1Q13, generating net sales growth of nearly 40% on a double-digit SSS increase. Coach should have solid growth going forward as it tweaks its e-commerce strategies and layers on China e-commerce in 2Q. Moreover, the company continues to occupy a sweet spot below designer that is increasingly relevant as 250 million people enter the middle class in China over the next few years.

Moreover, the men’s category remains a high-margin business and a key differentiator for Coach. The company indicated a strong demand for its expanded product line for men and I think male business will act as a strong growth driver in the future as the men’s luxury market is expanding rapidly and Coach still has a low market share.

Share Repurchase Should Support Stock

Coach continues to reward its shareholders with substantial share repurchases. In 1Q13, the company repurchased 3.1 million shares at $56.59 each, or $175 million total. $85 million remains under the current repurchase agreement. Moreover, the Board of Directors have authorized the repurchase of up to $1.5 billion of outstanding stock by June 30, 2015 which could add 1% to 3% to EPS growth over the next six to eight quarters depending on the actual completion date.

Room for Multiple Expansion

Despite an expected growth rate of over 14% over the next five years, Coach is trading at a forward P/E of 12.94. Thus, I feel the company is undervalued on a PEG basis. Let’s analyze the valuation multiple and some other key metrics of Coach with respect to other luxury retailers including Tiffany (NYSE: TIF) and Saks (NYSE: SKS).

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Tiffany</p> </td> <td> <p>Saks</p> </td> <td> <p>Coach</p> </td> </tr> <tr> <td> <p>Forward P/E</p> </td> <td> <p>15.34</p> </td> <td> <p>17.50</p> </td> <td> <p>12.94</p> </td> </tr> <tr> <td> <p>PEG Ratio</p> </td> <td> <p>1.49</p> </td> <td> <p>1.37</p> </td> <td> <p>1.05</p> </td> </tr> <tr> <td> <p>Operating Margin (ttm)</p> </td> <td> <p>18.55%</p> </td> <td> <p>5.04%</p> </td> <td> <p>31.22%</p> </td> </tr> <tr> <td> <p>Return on Invested Capital</p> </td> <td> <p>13.9%</p> </td> <td> <p>4.9%</p> </td> <td> <p>52.1%</p> </td> </tr> <tr> <td> <p>Dividend Yield</p> </td> <td> <p>2.0%</p> </td> <td> <p>NA</p> </td> <td> <p>2.10%</p> </td> </tr> </tbody> </table>

When compared to Tiffany and Saks, Coach has significantly better operating margins as well as ROIC (return on invested capital). Thus, Coach is efficiently using its capital, and its competitive positioning allows it to generate solid returns from that capital. In addition, Coach also provides a marginally better dividend yield as compared to Tiffany, while Saks does not provide any dividend at all. However, Coach’s superior execution and good growth prospects are not reflected in the stock price as the company has the lowest forward P/E as well PEG ratio among these companies. Thus, I see ample room for multiple expansion in Coach’s stock.

To conclude, I believe the stock has a solid upside and presents a good buying opportunity at the current levels. Coach is not the North American growth story it once was, the company has strong international growth prospects as it continues to invest in its international expansion. Moreover, Coach remains the most efficient user of its own capital as measured by returns and the company is rolling new fixtures to select wholesale doors and full price stores. I see a limited downside risk as the recently authorized share repurchase program will continue to provide some support to the stock.

sandeep2gupta has no positions in the stocks mentioned above. The Motley Fool owns shares of Coach and Tiffany & Co. Motley Fool newsletter services recommend 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.If you have questions about this post or the Fool’s blog network, click here for information.

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