Wednesday, March 08, 2006

The Coach Story

In retail, there's really only one way to kill your competitors: tell a better story.

Just ask Coach (COH), the undisputed leader in accessible accessories. Its niche of aspiration-driven handbags and accessories has turned the company onto a cash cow and global brand with a business we believe is sustainable over the long term.

We are initiating coverage on Coach with a buy rating and a $42 price target. We arrive at our estimate by taking Coach's trailing 12 month EPS estimate of $1.20 and applying a 35x P/E multiple.

We believe Coach's growth strategy is sound and should mirror the "A game" execution pattern we've come to expect from the NY-based company. Coach's strategy has 2 legs: blow up even further in Japan (the Japanese consumer feels no qualms paying premium prices for top bags) and ramp up sales here in the US. In the US, Coach said it will increase store square footage. We think this'll give Coach more operating leverage and enable it to adjust pricing policies accordingly. Operating margins should remain in the upper 30 range and debt levels negligible.

We like how Coach is "pricing up" some of its merchandise, for better or for worse. Coach's decision to hike prices on some of its merchandise is striking, because the average selling price for most apparel has been in a secular downtrend, mostly due to imports, discounters, and heavy promotions. Such pricing pressure has crippled margins at many apparel companies. Coach's decision to go against the grain should be monitored closely. We assume Coach's new, higher priced products ($600 or more) will not cannibalize sales from Coach's core brand.

One note: last week, Coach and mall developer Simon Property (SPG) inked a deal we feel will add momentum to Coach's top line story. Simon's premiere malls and upscale lifestyle duplexes are compatible with the typical Coach shopper.

Simply put, the luxury segment and Coach's brand make an explosive mix. In the last 12 months, Coach garnered a 20% free cash flow yield (trailing 12 month FCF/sales). We believe the fireworks will continue throughout 2006. The most obvious risk to our thesis: Coach sells the one thing no analyst can predict -- fashion. As consumer confidence gyrates, so could Coach's stock price.

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