Coach Is Following the Wrong Path for Growth

Coach's recent results remain lackluster. This is not merely happenstance; its market share has fallen, taken by luxury retail's latest star, Michael Kors . However, Coach is playing a dangerous game of follow the leader instead of paving its own path. This is an area of retail that requires constantly providing innovate products. Therefore, the game can only lead to trouble.

The top is falling down
The company's sales continued its downward trajectory. Its third quarter sales fell 5% on a constant currency basis, to $1.1 billion. North America was the usual culprit, with an 18% decline in sales to $648 million while comparable store sales fell by more than 21%. Although the region has been faltering, it represents the majority of Coach's business; this quarter, it accounted for 58.9% of sales.

Management blamed the sales decline on lower traffic, which it attributed in part to poor weather and the timing of the Easter holiday. Many people throughout the country had trouble getting around with the bitter cold and all the snow that was on the ground. If this had been an off quarter, it might be understandable. Unfortunately, this has been occurring for some time.

The prior quarter, the key second quarter that includes the holiday season, North American sales declined by 9% and comparable sales fell 13.6%. Once again, management blamed lower traffic even though the weather was not horrible for the entire period. The same categories, women's handbags and accessories, also showed weakness. At least the company provides consistent reasons for its poor quarterly performances.

Coach's International segment remains a bright spot, with a 20% increase in sales on a constant currency basis to $440.6 million. Still, the majority of its sales, and 85% of this quarter's operating income, are derived from North America. Clearly, the company will need to fix the segment's problems.

Net income fell 20.1% to $190.7 million. Diluted earnings per share declined by 19% to $0.68, helped by share buybacks. However, this will likely be little consolation to shareholders.

Kors running over Coach
Meanwhile, Michael Kors' results have continued to be stellar, and the company recently capped off a fantastic year. Michael Kors' revenue for its fourth quarter leaped by 53.6% to $917.5 million, and net income advanced by an eye-popping 59.2% to $161 million. Earnings were $0.78 a diluted share, 56% higher than a year ago.

The company was firing on all cylinders, with each of its segments (Retail, Wholesale, and Licensing) experiencing 50% or greater growth in its respective top line. In North America, an area plaguing Coach, Kors saw revenue rise by 43% to $739.4 million.

In response to Kors, Coach is moving toward a greater emphasis on lifestyle, including clothes, accessories, jewelry, bags, and shoes. In other words, it is trying to be more like Michael Kors. This seems like a time-consuming and expensive road to develop and market new product lines, only to end up with products that are not much different from its competitors. Moreover, Michael Kors attracts a more upscale clientele than Coach. This means that playing copycat could be even more harmful since its customers may not be used to the higher prices.

Returning cash may not be friendly
Coach has been spending money on repurchasing shares and dividends. At a time when it is facing stiff competition and its sales are floundering, a better use of cash might be investing in stores, spending on innovation, and differentiating merchandise.

The company spent $524.9 million to buy back shares for the first nine months of this year, compared to $400 million in the year ago period. This reduced the fully diluted share count by 1% to 278.5 million.

Granted, the company kept the quarterly dividend rate at $0.3375. In past years, common holders could count on receiving an annual raise. However, it still shelled out $283.7 million.

This comes at a time when it is generating less cash flow. Coach produced free cash flow of $511.7 million for the first nine months of the year, down 41.8% year-over-year due to much lower operating cash flow. Thanks to returning over $800 million in cash to shareholders via dividends and repurchases, the company burned cash.

Final thoughts
Michael Kors has been on a roll. Unfortunately, the shares reflect this fact, trading at a trailing P/E of 33. This means high growth expectations are priced into the stock, and any missteps are likely to result in a falling share price.

Meanwhile, Coach's shares have taken a beating, losing over 29% of its value over the past year. It might be tempting to jump in, especially since the trailing P/E is only 13. However, it is more prudent to take a pass. The company has stumbled, and its plan to right itself does not seem the right way forward.

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Lawrence Rothman has no position in any stocks mentioned. The Motley Fool recommends Coach and Michael Kors Holdings. The Motley Fool owns shares of Coach and Michael Kors Holdings. 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.

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