Coach Betting on China

During financial year 2010, Coach Inc. (COH) returned to double digit EPS growth rate by reporting an EPS of $2.33 compared to prior year EPS of $1.91.  The company increased its total square footage by 8% in North America, 5% in Japan and 50% in China.  For financial year 2011, the company plans to increase its total square footage by approximately 10% including an addition 60% retail space in mainland China. 

China continues to be the strongest growth opportunity for Coach where it currently holds a 5% market share in a $2.5 Billion luxury handbag and accessory market (as reported by Coach in its most recent conference call).  As part of its China strategy, Coach is concentrating on the ever expanding Chinese middle class by opening shops in second and third tier cities.  As the “first imported luxury accessories brand” in several of these cities, the company reported that these stores were performing particularly well.

Sales from China contributed $100 Million to the global revenues of approximately $3.6 Billion.  Given the expectation that the Chinese market would contribute 20% of the total global luxury handbags and accessories market (existing 10%) in the next few years, I estimate that Coach would potentially record $1 Billion in revenues from China in the next 10 years. This would represent a 15% share of the Chinese market.

Coach also reported a major foray in the $4 Billion Men’s premium bag and small leather goods sector.  The company hopes that sales from this sector would contribute 10% of the total company sales, up from the existing 4%. 

Company Financials and Valuation

Coach continues to enjoy strong financials with approximately $700 Million in cash and short term investments, minimal long term debt and healthy free cash flows.  During the last financial, the company generated $910 Million in free cash flow and authorized a billion dollar stock buyback.  Additionally, the company pays an annual dividend of $0.60/share. 

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Company Fundamentals/Earnings

Market Cap = $12.4 Billion

Sales (TTM) = $3.6 Billion

Income (TTM) = $735

Net Profit Margin = 17.7%

LT Debt to Equity ratio = 0.02

Return on Equity = 46%

Current Ratio = 2.46

TTM EPS = $2.33

My 2011 EPS Estimate = $2.66

Average Analyst 2011 EPS Estimate = $2.66

Average Analyst 2012 EPS Estimate = $2.95

Current P/E = 17.83

Current P/E (Peers) = 16.56

Current P/E (S&P 500) = 18.55

Discounted Cash Flow Valuation

DCF valuation of Coach was performed by employing a two-stage model with a high growth period of 5 years.  The major inputs and the valuation results are presented below.

High Growth Period:

-          Bottom-Up Beta for high growth period – 1.1

-          Risk Free Rate – 2.76% (10-Year Treasury Bond)

-          Risk Premium – 6.5% (5.1% US risk premium and 1.4% emerging market risk premium to account for the revenues from Chinese and Japanese markets)

-          High Growth Rate – 14%

-          Cost of Equity during High Growth Period = 10%

The projected free cash flow to equity during the high growth period are as follows:

Year 1 – 1.98

Year 2 – 2.05

Year 3 – 2.13

Year 4 – 2.20

Year 5 – 2.29

Present Value of free cash flow to equity in High Growth Period – $10.64

Stable Growth Period:

-          Bottom-Up Beta for stable growth period – 1.0

-          Risk Free Rate – 4%

-          Risk Premium – 5.5%

-          High Growth Rate – 4%

-          Cost of Equity during High Growth Period = 9.5%

Present Value of Terminal Price = $44.43

Summary:

Present Value of FCFE in High Growth Period = $11

Present Value of Terminal Price = $44

Cash = $2

Fair Value of Stock = $57

Relative Valuation

The estimated fair value using various relative valuation methods is presented below.  It should be noted that the data from the last four financial years was taken in calculating the averages shown below.

P/E

Existing P/E – 17.83

Historical P/E – 17.93

Fair Value - $42

P/S

Existing P/S – 3.43

Historical P/S – 4.05

Fair Value - $49

P/FCF

Existing P/FCF – 15.14

Historical P/E – 17.97

Fair Value - $49

(P/E) / (P/E – Peers)

Existing (P/E) / (P/E – Peers) – 1.08

Historical (P/E) / (P/E – Peers) – 1.03

Fair Value - $40

(P/E) / (P/E – S&P 500)

Existing (P/E) / (P/E – S&P 500) – 0.96

Historical (P/E) / (P/E – S&P 500) – 0.89

Fair Value - $38

PEG

Existing PEG – 1.27

Historical PEG – 1.05

Fair Value – $34

Average Fair Value based on Relative Valuation - $42

Fair Value

By blending my DCF and relative valuation based fair values, I estimate a fair value of $50 a share.  I currently have a 12-month price target of $48 derived by applying a multiple of 18 to my 2011 EPS estimate. 

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision)

Disclosure: Long COH