Coach Plus Kate Spade -- Bringing 2 Famous Brands Under One Roof

On this episode of Market Foolery, Chris Hill and Jason Moser discuss what they like about Coach's (TPR 0.30%) deal to buy Kate Spade (KATE) and why the markets were pleased with the quarterly reports of online furniture seller Wayfair (W -1.94%) and hotelier Marriott (MAR -0.13%). On the flip side, it appears investors were unhappy with what they heard from music streaming pioneer Pandora (P).

A full transcript follows the video.

This video was recorded on May 9, 2017.

Chris Hill: It's Tuesday, May 9th. Welcome to Market Foolery. I'm Chris Hill. Joining me in studio today, from Million Dollar Portfolio, Jason Moser. Happy Tuesday!

Jason Moser: Hey, hey!

Hill: Thanks for sliding out of your usual Monday slot.

Moser: It was my pleasure. You know I took the opportunity to --

Hill: Take a nap?

Moser: Well, I did, actually. I took a little bit of a cat nap. I did some work from home yesterday, I was able to finish up a report on Ellie Mae, which was great. Hey, while I was sitting there making dinner last night, I said, "Hey, Alexa, play Market Foolery." So I listened to you and Michael Douglass talk about the Berkshire Hathaway trip. It was a very good episode.

Hill: Yeah. Again, I said this on yesterday's episode, I think it's a sign of Michael's age --

Moser: Or lack thereof.

Hill: Yeah, or lack thereof, he looked great. If I had gone to Omaha for the weekend and gotten up before the sun, I would be totally dragging stuff. Earnings-palooza rolls on. We have a lot to talk about today. I actually want to start, before we get into the earnings, with, I would argue, the big business story from Monday, and that is Coach buying Kate Spade for $2.4 billion. I'm curious what you think of this deal. This is a week after Coach put up some pretty good numbers in terms of their latest earnings report. Shares of Kate Spade up on the buyout, and shares of Coach were up yesterday as well. I think it's because, among other things, enough investors looked at the deal that Coach was getting here and felt like they were getting value.

Moser: Yeah, I think that's a good point there. I think, generally speaking, my wife and I were talking about this last night, I say this as the owner of a Coach briefcase that I'm very fond of, I think this is the marrying of two fantastically mediocre businesses. And I don't mean that necessarily to say that this is a bad deal. I think what we've seen here over the course of the last five years really, is generally, what happens in retail. Particularly, we've been talking about Coach, and how it's affordable luxury and what not. At what point do you go from being luxury to affordable luxury to just totally mainstream? There was a point where you could see the writing on the wall with all the discounts they were listing, and the outlet stores and everything, and it became very clear that they stepped away from that affordable luxury, and they were making the strategic move to become more of a lifestyle brand. And I think that's fine. There's nothing wrong with doing that, because they really do need to figure out a way to increase volume. They're not just handbags anymore, it's handbags, they're getting into clothes and shoes and all sorts of other things. So, while I don't think either business on its own is a tremendous opportunity for investors going forward, I do think this probably makes more sense, some consolidation in this sector bringing together a healthy portfolio of different offerings.

And that's ultimately what Coach is doing. They'll still talk to that lifestyle brand, and try to bring more things out there for everybody to peruse. It's not just a handbag company. But, again, this is, to your point about value, I think this values Kate Spade at something like 16.5 times trailing earnings, which is really not that bad at all. Coach is the bigger company. Kate Spade, I think, has plenty of opportunity of grow, particularly globally. So, I think Coach took an opportunity to get in there and make a reasonable offer for a company that I'm sure they'll be able to extract some value from.

Hill: I think you mentioned the mediocre businesses, and I'm not going to dispute that. I will say, however, I think the brands are stronger than the businesses. I think that might be the potential promise for investors -- these are too pretty strong brands. Going back to the value point, Kate Spade, three years ago, that stock was around $40 a share. Now it's in the teens. So, the brands, I don't look at them as being damaged or even mediocre, I look at them as solid brands. If they can get the operation part right, then I think it can work out for them. And you mentioned the discount, that was a big part of the story last week with Coach. They started ratcheting back the discounting, and lo and behold, their margins started to look better.

Moser: Yeah, go figure. At some point or another. We see it with restaurants, we see it with retail, eventually you hit a year where your comparables become too easy to clear, and the business starts to look better just because the past really looked so bad. Coach, for a long time, was a brand that I think possessed more pricing power than it does today. I don't know that it really does possess a whole lot of pricing power today. But, I do agree with you. I think the brands themselves are still very strong, and can transcend lines. It doesn't have to be just a handbag company, it doesn't have to be just a shoe company or whatever. I think they throw lifestyle strategy around, they want to become a lifestyle brand, and you think, "OK, what does that mean?" I mean, I get it, you're going to go out there and see everything from keychains to handbags to shoes to hats to whatever, and that's going to be the best way for these businesses to monetize and grow on a meaningful level. And I think, just as we see with certain restaurants when they hit the ceiling of their growth opportunity, and I think a good example here would be something like maybe Buffalo Wild Wings. The idea was they were going to start bringing more different types of restaurants under their umbrella. That was the PizzaRev, that was Rusty Taco. I think Coach is looking at this very much the same way.

I think we'll see Coach continue to look at some strategic acquisitions. It's nice to see that they didn't feel like they needed to overpay. I think the folks over at Kate Spade realized they were caught in a really difficult situation, and the writing was kind of on the wall. They saw what Coach went through, and they knew, "This is where we're going to be going if we don't figure this out." And that's the problem, it's not too easy to figure out. At some point or another, you have to figure out a way to get merchandise into the consumer's' hands. Usually, the best way to do that is make it a price you can't pass up.

Hill: Let's get to some of the earnings today. We'll start with Wayfair, the online furniture retailer. Wayfair's first-quarter loss was smaller than expected, and Wall Street is apparently throwing them a parade, because the stock is up 22%. How good was this quarter?

Moser: Imagine if they were even more unprofitable! No, I kid.

Hill: [laughs] I mean, to cut Wayfair a little slack, their sales numbers looked good. Their revenue number, I think, is a big part of what's driving the stock today, because it wasn't just a smaller loss, it was like, "You guys are actually putting up bigger sales than we thought you were going to put up."

Moser: Yeah. Wayfair has been a fascinating company to cover. I've covered it since its IPO. We had it on the watch list in MDP for a time, removed it just because we felt like it was a bit smaller, a bit of a riskier play than what we were looking for in our portfolio. Someone asked me at some point in the past week or so on Twitter about Amazon starting to dip a toe into this line, moving into more home furnishing and home goods and things like that, and was that going to be the death blow for Wayfair? To me, that's that old, what's going to be the Wayfair killer? What's going to be the Netflix killer? Any time you start talking about that, I think you have to take a step back and realize, first and foremost, that ultimately validates the opportunity that Wayfair has been seeing and has built this business on, so there's something to that. To your point, they do continue to grow sales at a nice clip, so that means they're doing something right. I think part of that is the fact that it's a company very much built on being extremely customer-centric. I think when you have leaders who are building their businesses based on giving their customers what they want, whether it'd be value, quick delivery, whatever it is, those are generally very powerful businesses over time. 

Now, I think that with Wayfair, the metric that I always continue to pay the closest attention to is looking at the percentage of orders placed by repeat customers. Ultimately, what Wayfair is going to have to do to become profitable is, they're going to have to really ratchet back the spending on ad spend, marketing, and whatnot, those customer acquisition costs can be very expensive up front. So, they want to acquire customers and then keep those customers. That was a metric that really came through this quarter. It was 60.4% of orders placed by repeat customers this quarter, versus 55.4% a year ago. That is a trend that's going in the right direction. A trend that maybe isn't going in the right direction, operating expenses were higher this quarter than they were a year ago. So, the big question mark for Wayfair is, when they start pulling back on that spending, are they going to be able to maintain that growth? I think that's a fair question. I haven't necessarily come up with the answer yet. I think they're doing a lot of things right. 

The reaction today is a bit surprising, because the business is still unprofitable. So, I think it would probably behoove them to focus on trying to get profitable as quickly as possible. I feel like we're at this point in the market where the market is paying up for all sorts of growth, whether it's Tesla or Zillow or Wayfair -- it's not about profits, it's just about the promise. At some point, that worm is going to turn, so it's going to be in their best interest to try to at least get this business as profitable as they can as soon as they can so that they can at least tell that side of the story. I think it's a good business. Having just moved ourselves, I've seen one or two Wayfair boxes on our doorstep as well. But all in all, most of the metrics are all trending in the right direction. They're bringing in more active customers, they're hanging on to those customers, those customers tend to buy more over time, they become very valuable over lifetime. It remains to be seen exactly how important this move Amazon makes is. Time will only tell that one. But all in all, good quarter for Wayfair.

Hill: Let's move on to Marriott. Their first quarter profits came in higher than expected. The stock is up around 6%, hitting a new high. They really crushed it this quarter. The stock is up 22%, but it's had such a great, steady run for so long here. You look at the fact that their occupancy rates are higher, and their room rates are higher. If you run a hotel, it doesn't get a whole lot better than that.

Moser: No it does not. Chris, I must say, I'm a little disappointed with this quarter. I was hoping maybe for a poorer performance and some tepid guidance, because we have this on our watch list in MDP and we have a very firm price that we're looking to add this to the portfolio at, and today's pop is not helping that cause.

Hill: It's not helping? [laughs] 

Moser: No, not at all. I really like this business. The uncertainty with Marriott for the past six months was the acquisition of Starwood. There was a little bit of a back-and-forth there with some competing bids and whatnot, but that deal went through, so now Marriott owns Starwood, and they've created the biggest hotel company in the world. And it's acting like it. RevPAR, which is revenue per available room, that's their version of comps, and that was up 3.1% for the quarter. Improving trends in Europe and Asia Pacific regions led them to vie for a bit more than optimistic revPAR for the remainder of the year. And when you get that, along with a management team that has made a commitment to return a lot of value to shareholders here over the coming three years, they're going to spend somewhere in the neighborhood of $7 billion in buying back shares, and another $1.5 billion in dividends over these next three years. That's ultimately how they juice that earnings growth, they bring that share count down and continue to pay out dividends.

It's a lovely business model. These guys don't own the buildings, they're not maintaining these buildings, they're just selling their services. They have this big portfolio of like, 30 different hotel brands. The folks that own the real estate say, "We want to work with Marriott because it's a known and respected brand, and it'll bring in a lot of traffic." Then they go in and run these hotels, and they do a darn good job of it. There's nothing to hate here. I was hoping for perhaps a little bit of a weaker outlook. We felt like it was fair, at least, to think it might happen, because of concerns as far as travel restrictions, the stronger dollar doesn't necessarily play into their favor, either. But it didn't work out that way. It'll remain on the watchlist. If you're an investor in Marriott today, I think you'll be feeling very good about owning these shares.

Hill: To go to something we talked about with Coach and Kate Spade, the Marriott brand is as solid a brand -- I'll just speak for myself, but I know if I'm traveling somewhere, if that's an option, I think, "OK, good, I'm fine." If I'm staying at a Marriott, I'm going to be taken care of. And it's not going to break my wallet.

Moser: And that's a very good point you make, and that's one of the bigger catalysts that they have going for them, is the loyalty program that Marriott has had has been very sound. They have a customer loyalty second to none. And really, Starwood is kind of the same nature, so the acquisition is really bringing two very powerful loyalty programs together. And I think that over time, that's going to be something that they exploit in a good way. Now, it's interesting to think --- the other day, I was reading a take on this sector in general, and how technology, and how review sites like TripAdvisor have changed that sentiment that you just expressed there. I think for a long time, people would say, "I'm going to go to Marriott because it's a known quantity, I know what I'm getting and I know it's going to be good," whereas now you can go to something like TripAdvisor and read all of these different reviews on all of these different hotels in the area. Hotels can be sort of a fragmented market, and suddenly now, it opens this world of opportunities up. I don't just have to go to Marriott, because I could find out what these other hotels are like, and I can really shop for the best deal. So it is a little bit of a different dynamic today than it was before, but Marriott fights that by having so many different brands under that umbrella that hit all of those different value points. And the acquisition of Starwood really only strengthened that.

Hill: You can email us. [email protected] is our email address. You can follow us on Twitter @MarketFoolery. We're Periscoping today's episode, if you're following us on Market Foolery, hopefully you're watching. And you can join our Facebook group, which is Motley Fool Podcasts. Thank you to Katie of Virginia who posted something for me in our Facebook group. She posted a picture of the newest limited edition Oreos flavor.

Moser: What is it?

Hill: Waffles and syrup. Again, if you're a Mondelez shareholder --

Moser: Is nothing off limits?

Hill: Apparently not. As Katie wrote, "The hits just keep on coming."

Moser: Waffles and syrup, I don't know how to feel about that.

Hill: It has to be the easiest gig in the world if you work in the Oreos division for Mondelez, because it's just like, "What ideas do you have for flavor? We'll try anything. Ham and potatoes? Great, Jason, we're going to have some people work on that, we'll throw that out there."

Moser: [laughs] Ham and potatoes, an interesting combo.

Hill: Someone will buy it. Pandora's first quarter loss was smaller than expected, but unlike Wayfair, revenue fell short of expectations, and the stock down about 8% this morning. We were talking before we started taping with our producer Dan Boyd. This is kind of like Coach and Kate Spade, the brand is stronger than the business. I feel like that's a little bit what's going on with Pandora. I like Pandora. Dan was talking about, "I listen to Pandora a lot." So do I. I use it a lot. The business part, they're struggling with, and I'm wondering if they are starting to put themselves in a position for sale.

Moser: As a listener of Pandora, do you pay for subscription?

Hill: No, I do the ad-supported model.

Moser: OK. Deezy, do you pay for a subscription? No, OK.

Hill: He's shaking his head no.

Moser: OK. There's the problem right there. I think that is it in a nutshell for them. And I'm sure there probably is a suitor out there who could make Pandora bit more of an attractive business. I think this is a testament to, No. 1, I think they dragged their heels a little bit. I just don't think they really thought the competition in this space would ramp up so quickly. Also, the economics of this business, of this market, are really difficult. There aren't many musicians out there today who are going to sit there and tell you how profitable being a musician is, who are like, "You have to be a musician because when you put out a record or a song, it's a never ending spigot of money that keeps on flowing." It doesn't work that way anymore. Really, if you want to be a successful musician, you have to figure out a way to tour for a living. And I think that's one of the concerns, that you have musicians wanting more, and you have businesses that can only pay so much, because they can only bring in so many subscribers, or that ad-based model is only going to let them spend so much on the content. When you look at Pandora -- I agree with you that the brand is still somewhat strong. I think it's something that's recognizable. 

But when you look at the financials of this business, ever since these guys went public, they've never been profitable, they've never been cash flow positive. And there's a reason for that. One time, it was a neat offering because of the advent of streaming music. But then you had Amazon, you had Apple, you had Spotify. And really, I'm looking at Apple and Amazon here as two of the big competitors out there, and the reason why they're so formidable is that they are not just in the business of streaming music. The streaming music is essentially complementary to everything else that they offer. And I think that makes Pandora's business really difficult to sustain on any meaningful level. Now, to that end, sure, I bet you there's probably a bigger player out there that could buy Pandora, figure out a way to make it a bit of a better offering as we see internet music continue to take the direction it's taking. I've heard before of rumors out there that perhaps Sirius XM would be interested in acquiring Pandora for some reason. So who knows? But I think when you look at the economics of the business, and you look at the history that Pandora has, it only gets tougher for them. And if over the past five years, they've not been able to make it work, I can't fathom a solution that helps them make it work going forward, other than an acquisition. I mean, I wouldn't buy shares based on that thesis. So, I think they're really stuck between a rock and a hard place.

Hill: I'm wondering who's making the case for Sirius XM buying Pandora.

Moser: I don't know. 

Hill: Sirius XM seems like they're covered, both in terms of music and business model. Unless the price is so amazing ... Sirius XM is, what, a $22 billion company, something like that? It's roughly 10 times the size of Pandora.

Moser: Yeah, somewhere in the neighborhood of 30 to 32 million subscribers. Now, I think a lot of those subscribers came on for Howard Stern. I could certainly relate to that. But I do think that, Stern's contract, I think he has 3.5 more years on his current contract. Once that ends, I think the going wisdom is he's going to hang it up and do something else with his life. But they'll continue to have access to his content for an additional seven years beyond that. Perhaps they would see something in owning that Pandora brand. Again, as we've seen in retail, some consolidation in the sector makes it a little easier. Perhaps consolidation there. At this point, I'm sure they could buy Pandora for a song. No pun intended.

Hill: [laughs] We're going to wrap up now. I've said this the other people, I expect that from Simon Erickson, I don't expect that from you.

Moser: Well, I said no pun intended. It's kind of like Ricky Bobby, "I said with all due respect!"

Hill: Jason Moser, thanks for being here!

Moser: Thank you.

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening, we'll see you tomorrow!