Coach's Questionable Call

You can learn a lot about a company by the content and tone of its press releases. With that in mind, let's take a spin through the first-quarter results that Coach (NYSE: COH  ) released Tuesday morning, because a few things immediately stood out to me.

First up, the company describes its earnings-per-share performance in pro forma terms instead of by generally accepted accounting principles, or GAAP. It's very rarely a positive when a company leads off with a description of its performance in anything other than GAAP terms. Since the only item in the reconciliation between GAAP net income and pro forma net income is stock option expense, it appears that Coach's reason for resorting to pro forma is that it doesn't like expensing stock options. Well, issuing stock options is a real, albeit non-cash, expense, and the Federal Accounting Standards Board requires Coach to account for this expense in its earnings reports. I don't have a lot of sympathy for Coach on this issue.

Honestly, I don't see why the company should spend time focusing on non-GAAP numbers, because Coach's 50% improvement in diluted earnings per share under GAAP is impressive and certainly nothing to scoff at. Yes, investors, including me, get riled when they see management and employees loading up on stock options, but Coach's share dilution runs only in the neighborhood of 3% per year. This means that, given a 50% increase in diluted earnings per share, stock option grants lowered Coach's earnings growth this quarter by only 6% (3%/50%). That's tolerable. However, at Coach's expected long-term growth rate of 20.3%, earnings growth dilution will amount to almost 15% at the current 3% rate of share dilution, which is too high for me. Every investor's tolerance is different, but anything above 10% is outside my tolerance level.

Yes, Coach reported an excellent quarter. Still, that doesn't mean investors should be running out to add Coach to their portfolios. Despite Coach's being a high-quality company, its P/E of 33 and 20% expected long-term earnings growth points to its being fully valued. Since I'm the curious sort, I did a back-of-the-envelope discounted cash flow analysis, and I arrived at a value of $30.50 per share, about $1.50 below its current market price. Furthermore, I would want at least a 20% margin of safety below $30.50 before jumping in, because of Coach's dependence on the somewhat fickle Japanese consumer, as well as on U.S. consumers continuing to pay up for luxury goods. In other words, I wouldn't buy Coach unless it fell to around $24.40.

If I had to own stock in a retailer that sells rather pricey goods, Kenneth Cole Productions (NYSE: KCP  ) and Abercrombie & Fitch (NYSE: ANF  ) are more attractively valued here. These two retailers aren't sellers of near-luxury goods like Coach is, but their valuations aren't near-luxury, either.

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NathanParmeleeowns shares in Kenneth Cole Productions but has no financial stake in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.


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