Coach: More Than Just a Pretty Face?

The luxury-goods maker and retailer looks mighty sweet lately, though some analysts fear its stock, too, might be getting pricey

By Amey Stone

Coach, once known for stodgy brown leather pocketbooks, these days sports a striking lineup of pink-and-green totes and accessories in its bright, modern stores. The merchandise isn't the only thing to have metamorphosed in the past few years. From its pre-2000 days as a Sara Lee (SLE ) subsidiary, Coach (COH ) has lately turned into a growth investor's dream. Profits at the luxury retailer have soared on the back of stunning sales growth and remarkable operating margin expansion.

The growth shows little sign of abating. For the quarter ended in March, Coach's net income surged 83% from the same quarter a year ago, to $58.3 million, or 30 cents a share -- 3 cents better than Wall Street had been expecting. Operating margin in the quarter rose 8.3 percentage points, to 32.3%, and sales jumped 42%, to $313 million. Management credited surging store traffic, continued strength in Japan, and market-share gains.

CAUTIONARY POINTS.

  In an Apr. 20 conference call with analysts following Coach's release of fiscal third-quarter results, Chief Executive Lew Frankfort crowed, "We've never been more optimistic about our future." Frankfort engineered Coach's transformation in the past 10 years, partly by bringing in a hot new designer who added style and color to the product lineup and also by taking Coach public in a spin-off from Sara Lee (see BW, 3/29/04, "Coach's Driver Picks up the Pace").

Investors have almost nothing to complain about at Coach. The stock, which traded at $20 a year ago (factoring in an October, 2003, split), had rocketed to $41 just before the earnings announcement. By the market's close on Apr. 26, it was up to $44. Yet investors might be wondering whether Coach can continue to replicate such spectacular gains. Before rushing to buy, a few cautionary points might be worth consideration:

First, the stock isn't cheap. Research firm Morningstar puts its current price-earnings ratio at 49, vs. 33 for its industry and 28 for the benchmark Standard & Poor's 500-stock index. Analysts' median price target is $50, according to Thomson Financial, which doesn't leave that much more room to climb. "A lot of its success is already built into the stock, and you have to be careful of that," says Tom Taulli, an author and principal at Newport Beach (Calif.) investment firm Bridgewater Capital.

STORES OF KNOWLEDGE.

  Plus, the fickleness of fashion makes it notoriously difficult for top brands to retain their allure over time without an occasional hiccup. "Mistakes are easy to make in that type of business," warns Taulli. Coach's dependence on staying ahead of fashion trends is the main reason Morningstar gives the stock a tepid rating of two stars (out of a possible five), even though it gives Coach A-plus ratings for growth, profitability, and financial health. "Its prospects are bright, but its emphasis on trendy merchandise leaves us cautious," Morningstar analyst Heather Brilliant wrote in a February research note.

Looking into the second half of this year, some consumers who crave its pricey bags could soon be feeling the pinch if interest rates rise and the economy slows. Richard Hastings, an analyst with retail consulting firm Bernard Sands, worries that the future spending power of people who have been "faking their way into the investor class" could find that they don't have the borrowing power left to fund their expensive tastes. That could crimp growth at luxury retailers like Coach, he warns.

Michael Silverstein, head of the consumer and retail practice at Boston Consulting Group, says Coach gains protection from having its own stores. It gets immediate market feedback and can see right away what's selling and what isn't, giving it an opportunity to quickly adjust merchandise. "That's a powerful thing," Silverstein says.

OUTLET OUTGROWTH.

  As for the economic risks, Coach's merchandise is priced as "affordable luxury," he says. "Even if you don't have enough money to buy a new outfit, you can buy a new purse and get the same compliments," Silverstein says. "It's a good category for self-consumption." He also notes that Coach continued to grow when the economy was in recession, proving that its business model is well-insulated from economic slowdown.

Future growth seems all but assured as Coach adds stores, refreshes its merchandise (look for a new "resort" line in December), and builds its business in Japan. It also plans to add 100 retail stores in the U.S. over the next four to five years, bringing its base to 275 (it also has 77 factory stores and 100 stores in Japan). That's still far from a level that would spark worries about saturation.

Coach says sales in its 2004 fiscal year (ending in June) will reach $1.3 billion, 37% higher than fiscal 2003, and earnings will be at least $1.32 per share, up 67% from a year earlier. Before the recent conference call, analysts had been forecasting earnings of $1.25.

STUMBLE-WATCH.

  Merrill Lynch analyst Mark Friedman, in an Apr. 20 research note, applauded Coach for offering "fun product that is so appealing and so 'wow' that the high-end consumer can't resist." Coach has diversified its product mix, so it offers items at a broader range of price points (using materials like straw and cloth that are cheaper to buy than leather).

Yet the average ticket price keeps climbing, according to management. And Coach's success isn't completely dependent on fashion and flair. During the latest conference call, Chief Financial Officer Michael Divine also credited "hard work and blocking and tackling from our supply-chain group."

Coach has yet to stumble in its transformation to a high-fashion luxury brand. Still, a safer time to buy might be when it shows that it can't do everything right all the time. But with this butterfly of a retailer, you might just be a long time waiting for that to happen.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

Edited by Beth Belton