Coach and Michael Kors: The Widening Gap Indicates the Clear Investment Winner

On Coach’s earnings call, it finally admitted what we all knew: Michael Kors is stealing market share. But will Coach’s planned turnaround lead to a Fossil-like performance?

Jan 23, 2014 at 9:51AM

If you read Coach's (NYSE:COH) quarterly report or listened to the conference call, then there's not much to create excitement. The company is clearly, and admittedly, losing share to Michael Kors Holdings (NYSE:KORS), but a planned turnaround effort has some investors optimistic. Hence, is Coach a good investment, a Fossil (NASDAQ:FOSL) in the making, or should it be avoided?

The Coach/Kors fundamental disconnect is growing
The one single strength of retail amid pricing competition and e-commerce growth has been the luxury space. Coach once owned this space in the handbag/accessory arena but has fundamentally fallen off a cliff.

In the company's fiscal second quarter, it reported revenue of $1.4 billion, which represents a 5.3% year-over-year decline. Given the aggressive pricing within the industry, a 5.3% decline isn't all that surprising. However, what's mind-boggling is the company's 13.6% drop in North American comparable-store sales, which has historically been its best market. This decline represents a cliff-dive, and the fact that no real sales guidance was provided is reason to be pessimistic looking forward.

In the meantime, Michael Kors continues to thrive! Last year, the company saw comparable sales growth of 41%, and for 2014, Wedbush retail analyst Corinna Freedman expects comps growth in the neighborhood of 20%-plus. Compared to Coach's double-digit decline, the distance between these two competitors is growing fast.

Is Coach now a buy?
At some point even a fundamentally declining business reaches a point where its valuation suggests it may be a buy. Investors are often willing to buy such stocks if they believe a turnaround is possible, or if the valuation disconnect between it and its peers  is so large that stock value is evident.

The problem is that given the declines we're seeing, Coach hasn't reached this point yet.

Coach trades at 12.7 times forward earnings and 3.0 times sales. At first glance you might think that Coach is presenting value. However, Michael Kors trades at 23 times future earnings with a price-to-sales ratio of 6. Essentially, Michael Kors is twice as expensive as Coach according to both of the key valuation metrics used by retail investors.

Yet isn't Kors worthy of that premium? Doesn't the fact that Kors is growing by more than 20% and Coach is declining by double digits weigh in the favor of Kors? Sure, Kors is more expensive, but it's well deserved.

Until Coach shows a recovering or even a stabilizing business, it's really hard to value its stock, as we don't know how far this ship can sink. With that said, Kors keeps growing, Coach keeps losing, and most investors would agree that a growing retailer is worth far more than one that's not.

Are Coach's problems temporary or macro-related?
Coach "longs" point to new product launches as a reason to be optimistic. In the past, we've seen new product innovations and launches drive specialty and luxury retailers higher, such as with Fossil.

Fossil saw its stock fall from $130 to $70 back in 2012 when a softening macro environment affected growth and created margin pressure. The problem for Coach is that this "horrible" quarter for Fossil still included growth of nearly 10%, and as of its last quarter, the company saw growth of 18% year over year.

Hence, Fossil recovered, and looking ahead to this year, is expected to grow 10%. Furthermore, at 16 times forward earnings, Fossil isn't too much more expensive than Coach, a company that's clearly not operating on the same level.

Moreover, as we've seen in this luxury or trend-setting retail space, once a brand begins to lose momentum or fall out of favor with consumers, it is very hard for it to recover. As of today, Coach doesn't seem to have a plan to compete, and that definitely weakens the investment outlook.

Final thoughts: Questions without answers
Looking at Coach, there just seem to be too many questions.

The company gets 50% of its sales from an outlet-store channel that is declining faster than brick-and-mortar retail as a whole. Therefore, how does it effectively change this dynamic?

The company's creative head, Reed Krakoff, who was a lead designer throughout Coach's growth years, is no longer with the company. After 16 years Krakoff left to pursue his own brand. Now, Stuart Vevers, who previously held positions at Loewe and Mulberry, is the new executive creative director. While Vevers has had success in the past, handbags are different from coats, and there are many questions as to whether he will make too many changes to the trademark Coach brand, causing further problems. Anytime a new creative director replaces a legendary one, questions arise, and Vevers must prove his place at Coach.

Last, and most important, how long can Coach operate at this pace without having to cut costs? A business can't lose 13.6% of its comp sales and continue to pay a 2.8% annual dividend, expand internationally, develop new products, and advertise aggressively. Hence, what gets cut, and how does the market respond?

The bottom line: The future is uncertain for Coach, and as of now, this is a business with a double-digit loss in North American comp sales, its most important market. Thus, Coach is definitely a risky investment, even after a 7% post-earnings loss.

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Fool contributor Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Coach, Fossil, and Michael Kors Holdings. The Motley Fool owns shares of Coach. 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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