"In other words, the stock is priced as if Coach's growth is long in its past." - Chris Pavese, CIO of Broyhill Asset Management
A couple of months ago we read a research report from Broyhill Asset Management profiling Coach, Inc (COH). We found the analysis intriguing, and after doing some additional research on the brand and running our own discounted cash flow analysis we purchased shares in late March at an average cost of around $49.25.
When you think of Coach you probably picture their iconic handbags, but the company also designs, manufactures and sells a variety of accessories such as jewelry, shoes, fragrances and watches. The brand is well-established in the US with 30% market share, and Compete.com ranks the company #1 in online traffic amongst peers such as Gucci, Louis Vuitton and Chanel.
The company’s financial performance has been strong over the past ten years, with sales growth of over 20% and earnings growth of over 30% on a compound annual basis. The company generates strong free cash flow, and return on invested capital is significantly larger than industry average. From a valuation perspective the stock is priced attractively relative to its own history as shown by the chart below plotting price-to-earnings and price-to-sales ratios. Additionally, the dividend payout has been quadrupled over the past three-and-a-half years, yielding 2.4% at the time of our purchase. As Broyhill states in their report, “the stock is priced as if Coach’s growth is long in its past.”
But it’s Coach’s future growth potential that was perhaps the most important factor in our decision to buy the stock. In An Emerging Dichotomy published back in March, we made the following observation about emerging economic growth as compared to earnings growth for local emerging market and US companies.
While emerging economic growth has slowed it has still been quite strong, yet local companies have had a difficult time growing the bottom line over the past two and half years after the strong rebound from the financial crisis bottom. Meanwhile, US companies have done a better job expanding margins and consistently increasing earnings despite tepid revenues. In an ironic twist, the extension into emerging markets by US-based multinationals has been one of the factors driving strong earnings in S&P 500 companies to the detriment of smaller, local competitors.
Since that post we have reduced our direct exposure to emerging market indexes that are heavily weighted in financials and exporting industries. Meanwhile, one of the spaces we’ve grown interested in is US multinationals making a foray into the rapidly-growing emerging world, and in particular companies that may benefit from the ever-burgeoning consumer base.
Coach, already the second largest player in the Japanese market, is investing heavily into the growing Chinese consumer market. Last year China sales grew 64% and accounted for 6% of the company’s top line. Management anticipates opening 30 stores a year for the foreseeable future pushing China towards 20% of the company’s sales within the next several years. The uncertainty surrounding this international expansion, and all the new investment that comes along with it, has weighed on the stock over the past year depressing the valuation and creating what we perceive to be an appealing buying opportunity. Broyhill’s base case is that the stock’s valuation recovers back to its historical norms equating to a price target of around $76 over the next three years, while our own discounted cash flow analysis yielded an intrinsic value north of $80 per share.
The primary risks to the company’s future are the same as its opportunities. If its efforts to expand into new markets prove unfruitful the company will have invested years of time and resources with no shareholder value added. In this scenario the stock may continue to languish and its depressed valuation may become even cheaper. All things considered, we view this investment as having significantly more upside potential than downside risk, and the stock is a great way to gain exposure to an expanding emerging economy via a high quality US company with a stable and growing dividend.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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