Are Investors Ignoring Coach’s Growth Story in China?

Coach (NYSE: COH  ) reported very disappointing third-quarter results on April 29. The once ultra-popular and now somewhat "passe" fashion retailer earned $0.68 per share to beat the consensus estimate by $0.07. Its revenue of $1.1 billion, however, fell short of the consensus estimate by $30 million.

More alarming is the fact that the company's comparable-store sales fell 21% in North America, while total sales in the region dipped 18% from the year-ago quarter to $648 million.

Where sales aren't declining
Coach's international sales rose 14% year-over-year to $441 million, with sales in China rising over 25% as comparable-store sales in the country rose at a double-digit rate.

In the recent quarter, Coach added five net stores in China (including PRC, Hong Kong, and Macau) to bring its total footprint in the region to 142 stores, of which 128 are located in Mainland China.

Coach plans to open 30 net locations in China (for roughly 25% square footage growth) throughout the coming year and the company projects that this will boost its total sales in China to $540 million.

During Coach's third-quarter conference call, none of the analysts directed questions toward Coach's growth initiatives in China. Instead, analysts questioned the company's declining traffic in North America, weather issues, and competitive environment, among other things.

For those who are not aware, despite recent concerns over China's economic growth, projections still call for China to become the world's biggest luxury-goods market by 2020, according to a report by Fortune Character Institute reported by Chinadaily.com.

Reports that call for China to become the world's largest luxury market by 2020 are far from new. A 2012 report by McKinsey explained that China had become a leading luxury market by 2010 and could become a dominant force by 2020.

According to the report:

Affluent consumers will remain an elite minority, making up only 6 percent of the population in 2020. (In the United States in 2010, more than half of the population earned at least $34,000.) But that 6 percent will translate into about 21 million affluent households, with 60 million consumers.

McKinsey further estimated that more than 75% of China's urban population will earn between 60,000 yuan and 229,000 yuan, or roughly $9,800 to $37,000, each year by 2022.

China's evolving economy is developing into a middle-class market and this bodes well for Coach as it sells $400 handbags in the country. As such, Coach does not intend to compete directly with European brands that sell handbags for ten times the price, which attract only the wealthiest segment of shoppers.

In fact, Coach is "outflanking" European giants like Louis Vuitton, according to Bloomberg.

According to comments made by Andrea Shaw Resnick, Coach's senior vice president, during a Morgan Stanley conference presentation in late 2013, Coach is benefiting in China because consumers do not have a preconceived notion of Coach as purely a handbag brand, a factor that could be negatively impacting North America.  

The executive said:

I would also point to the success of our lifestyle dual gender presentation in places like China where there wasn't necessarily a preconceived notion of Coach as a pure handbag brand where illustratively just last quarter one-third of our sales in mainland Chinese stores came from men's and other lifestyle categories. 

Stacking up the competition
Michael Kors (NYSE: KORS  ) blew past analysts' estimates when it reported its third-quarter earnings on Feb. 4. The company saw its sales rise 57% year-over-year to $1.0 billion, easily beating the consensus estimate by $140 million.

One of the reasons for Michael Kors' growth is that the company communicates with its customers effectively to convey the glamour, luxury, and wide assortment of its brand offerings.

Looking at the companies' respective websites, Michael Kors considers itself a "global luxury lifestyle brand," while Coach simply describes itself as a "design house of modern luxury accessories."

Based on the companies' respective quarterly results, consumers prefer a luxury lifestyle brand over a designer that simply sells accessories. 

However, Coach is in the very early stages of transforming its brand into more of a lifestyle brand.  The company recently hired a new creative director, British fashion expert Stuart Vevers, who came from Lowew (owned by LVMH Moet Henessy Vuitton) and previously had a stint at Mulberry.

Unfortunately, according to Citi analyst Oliver Chen, it could take multiple years for Coach to convince consumers that (like Kors) it is a "lifestyle brand."  The analyst further added that "a traffic restoration is tough to expect for any retailer." 

Kors knows that it holds the upper hand in North America and guided for its comparable-store sales to rise by 15% to 20% in the fourth quarter.

Foolish take
Michael Kors is firing on all cylinders and eating Coach's lunch in North America, which is partly why shares of Coach are trading near 52-week lows.

It is possible that many investors are focusing on Coach's declining North American sales while not fully understanding that the company is well positioned for growth in what will soon be the world's largest luxury market.

Investors that can stomach short-term weakness and volatility while focusing on Coach's long-term global expansion opportunity may find Coach to be a suitable investment idea. Coach is planning a 25% square footage expansion in China and positioning itself to win the long-term battle in China while taking initiatives today to improve its North American business.

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