Learning a Timely Lesson From Coach

It's often the black swan -- the unknown and unknowable -- that catches us off guard as investors. Rigged accounting books, market disruptors from out of nowhere, or huge monsters rampaging over Seattle poke massive holes in our investment thesis -- and the whole thing falls apart. Sometimes, though -- and for me this was yesterday -- we miss the obvious. Coach (NYSE: COH  ) is taking a beating today after its pre-market call missed analyst expectations by $0.06.

Just yesterday, I wrote an article claiming that all would be well at Coach. In summary, I thought the hit or miss would come from Coach's ability to sell its new men's line and to perform overseas. The company did fine on those goals, but it failed to hit the most important one: women's handbags. That's the bulk of the company, and the one bit that I took for granted. In short, I missed the white swan. Here's a rundown of the earnings, and what investors should be on the lookout for in the coming months. Spoiler alert: It's not all that dire.

Earnings summary
Coach increased revenue by 4% in the second quarter, hitting $1.5 billion. That trickled down to become $353 million in income, which worked out to $1.23 per share. In the middle of the income statement, investors should be happy to find a slight uptick in operating margin to 35%. Gross margins stayed basically flat at 72%, which is a huge relief as it indicates that the company didn't have to delve too far into promotional territory over the holidays. It also means that Coach was able to hold on to its brand cachet, and that there is still a lot of room left to run with this brand.

The bad news came from the company's core business. North American comparable sales fell 2%, which analysts have blamed on consumers' concerns about the broader economy over the holidays. The company also lost revenue to Hurricane Sandy, but that couldn't account for the whole shortfall. On the conference call, management said that about 1% of the comparable store decline could be attributed to the storm, which highlights the biggest problem that Coach had over the quarter: a decline in foot traffic.

The problem
Coach didn't get customers through the door, which means that salespeople couldn't sell them its premium products. The company claimed that it could have fixed its comparable sales fall by entering a more promotional environment, but it chose not to. So in order to keep comparable sales up without more customers in the stores, the company needed to convert more of the opportunities that it was given by browsing customers. Instead, it failed to capitalize on the strength of its lower-end items.

Going into the holidays, Coach was upbeat about its phone and tablet cases, which sold at lower price points. Those items should have brought in browsers, who could then be sold middle-price merchandise. If the company could convert on those sales, then it should have been able to keep its comparable sales up. On the call it was revealed that Coach managed to succeed at the far ends of the sales spectrum, but fell short in the middle.

Sales of tech accessories were strong, as were sales of items over $400. It's the bit in the middle that was missing. That's a fault that lies with the product line, which needed to have more strength in the middle. The shortfall led not only to an overall decline in comparable sales, but to a fall in market share as well. By its own account, Coach holds about a third of the market for women's bags in the U.S., but this past quarter it lost out.

Who's competing with Coach
Coach most likely lost sales to companies like Michael Kors (NYSE: KORS  ) , or to discounters like TJX (NYSE: TJX  ) . Kors grew at a fantastic rate throughout all of 2012, and reported last quarter that comparable sales increased by 45% in North America. Since that brand hits higher cost points than most, customers probably also found their way to TJX discount brand T.J. Maxx. Over December, the company increased comparable sales by 6%, due to strong foot traffic. The same traffic that Coach was lacking.

While this is a real setback for Coach, it's probably not the end of the world. To me, it reinforces the lesson I learned: It's easy to overlook the things that seem to be going well. Hopefully, this will act as a wake-up call for Coach, as it has for me. If the company wants to hold on to its market share, it needs to have a plan in place for its core customers.

Investors still bullish about Coach's long-term performance can see today as a valuable lesson, and a chance to pick up some discounted shares. At midday, the stock was trading well below the apparel industry's average P/E at just 14 times earnings. It looks like Coach has entered a promotional environment after all.

Michael Kors is one of today's hottest high-end fashion brands, and that's translated into one of the bes-performing stocks in retail -- since its debut on the market in late 2011, the share price has more than doubled. But with all that growth, has the stock finally become too expensive, or is there still room left to run? The Motley Fool's new premium report on Michael Kors gives investors all the information they need to make the right decision. We cover the key must-watch areas, opportunities, and threats to the company that investors need to know. To claim your copy, simply click here now for instant access.


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