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Can Coach Keep Up?

Having lived in Japan the past few years, I couldn't possibly have missed the growing cachet of Coach (NYSE: COH  ) products. The increasing number of handbags bearing the company's signature "C" logo that I passed on the streets of Tokyo regularly caught my eye. But I never gave the company's stock much attention, because I felt its shares fully reflected its growth potential. Now, with the company's 10-K filing showing up on Friday and its trailing P/E closer to 30 than to 45, I'm willing to take a deeper look.

All of my Japanese Coach sightings weren't an accident. Coach still derives the bulk of its sales from the U.S., but like Tiffany (NYSE: TIF  ) , Coach knows that Japanese women have a voracious appetite for luxury goods. In its 10-K, the company disclosed that it will reinvest all of its profits in Japan into future growth. It seems pretty clear that Coach bought out joint-venture partner Sumitomo to keep that growth to itself.

Coach's sales growth has been stunning, but the company has been able to power profit growth even further with an outsourced manufacturing model that capitalizes on the lower cost of making handbags and other goods in Asia. Kenneth Cole (NYSE: KCP  ) uses a similar model in shoes, as do a number of retailers in apparel. Some may view a luxury brand manufacturing goods outside the U.S. or Europe as a negative. But it's quality control over products, not country of origin, that draws in customers and allows the company to flourish. Judging by Coach's sales growth and margin expansion the last four years, customers seem to enjoy the product regardless of where it was assembled.

Across the board, Coach has near-sparkling financials. The option grants to management are slightly higher than I'd prefer, given the ample cash compensation already being paid, but they aren't out of line, with dilution in the neighborhood of 3%. However, the company's stock-buyback program isn't doing shareholders any true favors, since the option dilution exceeds the shares repurchased.

After spending some quality time with the company's annual filing, I still come back to Coach's valuation. While I love its free cash flow generation and growth potential, I'm not willing to pay up for that growth. The company's continued success in Japan is hardly a sure thing. As much as Japanese consumers enjoy luxury goods, like all consumers, they can be fickle; growth could slow in short order as consumers move on to the next brand.

A slightly lower price, along with a cash dividend to share some of its robust free cash flow with shareholders, would cause me to take another look at Coach. For now, I'll sit on the sidelines and continue to watch the company's bags pass me by.

We've shouldered further Coach-related Foolishness:

NathanParmelee owns shares in Kenneth Cole but has no financial interest in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.

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