Coach Inc Now One Step Closer to Building Its American Fashion Empire

In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by senior Fool.com contributor Asit Sharma as the duo covers two major company tie-ups from the past week. First, in the fashion world, Coach (TPR -2.16%) announced the acquisition of Kate Spade (KATE). Meanwhile, Comcast (CMCSA -0.52%) and Charter (CHTR 0.46%) launch a partnership as they prepare to dip their toes in the wireless industry. Tune in to learn more.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, May 9th. Today's show will be focused on company tie-ups and partnerships that have been making headlines in the past few weeks. Joining me via Skype to talk corporate matrimony is senior Fool.com contributor, Asit Sharma. Welcome back, Asit! Great to have you with us!

Asit Sharma: Awesome, it's great to be back, Vince!

Shen: Our first story is quite timely with the handbag and accessories maker Coach announcing yesterday morning that it would be acquiring industry rival Kate Spade in a multi-billion dollar deal. Asit, a really quick take before we dive into some of the specifics that I'll share with our listeners. What's your overall first impression of the deal?

Sharma: Overall, I think it's probably a smart deal. I do like the fact that Coach, we're seeing their portfolio extend out and broaden. They're picking up another very nice brand, which has some potential. The buzz about this deal is that Coach is going to acquire millennial shoppers through Kate Spade. But I want to put out something controversial from the start and get your opinion. To me, this is Coach's idea of millennial shoppers. I think to a certain age group, millennial shoppers are looking at brands that are even younger and more hip than Kate Spade. However, the data that I've seen says about 60% of their customers are so-called millennials. So I do like the very top level implication of this deal, I think it will be beneficial for both companies.

Shen: Yeah. Getting into some of the deal basics here before we dive into specifics about what management is thinking, what Coach and their team is trying to achieve through this kind of deal. This is an all-cash transaction. Coach currently has a net cash position of about $1.3 billion. With the offering price, they're giving Kate Spade shareholders $18.50 per share. That's just a 9% premium off the Friday closing price -- this deal was announced first thing Monday morning. But that is after the stock enjoyed a pretty bullish run in the past few months, because the Wall Street Journal reported in late December that Kate Spade was seeking out a buyer due to pressure from activist investors. So if you look at Kate Spade's stock trading prior to this report, this $18.50 per share offer price actually represents about a 27.5% premium.

The deal is expected to close in the third quarter of 2017. Something that gets mentioned in a lot of these press releases announcing an M&A deal -- they see run rate cost synergies of $50 million within three years of deal close. After the deal closes, Coach's portfolio, as you mentioned, Asit, will now have its namesake brand, they'll have Stuart Weitzman, the shoe company they acquired in 2015, and now this Kate Spade added to its portfolio.

I would like to get into setting the stage for Coach, in terms of what they've seen in the past few years, because this is definitely a company that has struggled quite a bit in the 2013 to 2015 period. Management has been very focused on making certain tweaks to turn the business around, thinking about optimizing their store footprint after growing it very quickly and then running into some weakness in retail, and seeing this bloated network hurting them, revitalizing their brand after lots of discounting and promotion took away some of that aspirational nature of it. But overall, I think what it comes down to is that Coach can take some of the lessons it's learned from its previous run and the issues it had from its subsequent recovery, and hopefully apply that to Kate Spade a little bit, and take the Kate Spade business to the next level. What do you think, Asit?

Sharma: I agree, Vince. If you were to look at Coach's revenue for the past five years, they've certainly had a U-shaped curve. They peaked right in the middle of 2013, as you were talking about. That revenue has fallen about 12% since that period, and it's picked up since about midway through 2015. And that reflects their learning curves, as you mentioned. One of the things that Coach is going to be very keen on with Kate Spade is to understand what channels should we sell in? They're pulling back in department stores. You and I have covered this many times -- the retail industry is in deep flux. If you are in brick and mortar, you really need to be rethinking your strategy. And Coach has done that.

What Kate Spade provides it is a portfolio beyond us, beyond that namesake brand which, frankly, five years ago, Coach thought it would bank on forever. It's no longer, as you mentioned, this really aspirational brand. But it still has an extremely respected space in the luxury segment. And we can see Coach potentially becoming a player in the broader luxury segment. Kate Spade could be a good experiment, could add on, very conceivably, some other high-end brands and a more aggregated approach to revenue.

So condensing all that down, Coach is thinking in terms of channels, where will we be selling, and it's also thinking in terms of brands beyond us, beyond Coach. And that's again, another reason why shareholders should be pleased. The premium on this deal, as you mentioned, is not that huge, so it's an efficient spend for Coach. And I think for Kate Spade, they get a very deep-pocketed parent that can help with some of the issues that this brand has been experiencing. I'll bring it back to you, if you want to talk about what we've seen with Kate Spade.

Shen: Something I wanted to speak to to provide some context is the scale of these businesses. Last 12 months, Coach, over $4 billion in revenue. Kate Spade, about $1.5 billion. If you look at their store networks and their footprint, Coach, between its actual retail stores, as branded, you'll see them in malls and shopping centers, they have their outlets, and they also have -- this is something you mentioned that they've started cutting back on -- their shop-in-shops in department stores, where they have their dedicated space, all Coach products, in major department stores. They're cutting back on that. But still, between those three different categories, over 900 stores, whereas Kate Spade is just over 250. I'm looking at some financials for Coach in the past few years. You mentioned how, around 2014, 2015, the revenues declined after putting up several years of double-digit growth. But something that's really telling, too, is on the bottom line, you really see their operating margin start to get squeezed as they are moving into certain channels that, yes, are potentially helping them to grow that top line, but they take a hit with discounting and promotions, having to lower that price to move product. The operating margin in 2013, for example, over 20%. In the most recent last 12 months, about half that, at 11%. I think they're trying to prevent Kate Spade, with this acquisition, from experiencing the same thing. 

And management spoke to this, actually, specifically when talking about some of their main priorities once they add Kate Spade to their portfolio is getting the company out of these flash sales and certain wholesale channels, especially in urban areas where you have a lot of customers who can access Kate Spade goods cheaper. That hurts not only their profitability, but also it hurts to associate the brand with that lower price point. Otherwise, if you look at the networks for these stores, and the customers for the stores, I know you mentioned you were a little skeptical, Asit, about the idea of the millennial access that Kate Spade offers. Coach's internal research team said about 60% of Kate Spade customers are in that millennial category. But otherwise their overlap doesn't seem too bad, about 35% of Coach stores overlap with Kate Spade locations at the moment. Coach claims from its research that only 10% of their actual customers overlap, presenting an opportunity there for them to branch out and bring people into the fold. 

I think, if you're looking at this longer term as a Coach investor, and the benefits that Coach can bring to the Kate Spade brand into their network, it's really in terms of distribution and broadening and expanding the markets that Kate Spade operates in. During the conference call, when they announced the deal, management talks about the fact that brand awareness in North America, for Kate Spade, at 30%, for Coach at 70%. Whereas, in Japan, which is the main Asian market where Kate Spade operates, it's 11% for Kate Spade and 50% brand awareness for Coach. In China, where Kate Spade is only about 1%, pretty much untapped, Coach has 23% awareness. So just to give you an idea of how Coach can help Kate Spade expand its distribution significantly.

I like the fact that, overall, Coach is thinking longer-term. After previously sacrificing their brand for near-term growth and results, they're willing to endure some near-term financial pain for more sustainable growth. With Kate Spade, they've noted that pulling out of flash sales, pulling out of these wholesale channels, will hurt near-term growth and revenue, but longer-term, it makes it much more sustainable. The way I think about it, too, a company that it reminds me of is Urban Outfitters. This is a company that has several distinct brands that are intended to appeal to younger shoppers, then you keep them loyal and moving them into the other brands within the company portfolio throughout their lives, as their tastes change, as they mature. This is, I guess, Coach's way of potentially doing that, getting the millennials through Kate Spade, and then even though they say their core customer demographic for Coach is people in their 20s to 40s, I think generally it appeals to an older shopper, bringing them in after they reached that point from Kate Spade. Any final thoughts, Asit, on this deal, in terms of management's approach before we wrap up here?

Sharma: Sure. I wanted to reiterate what you're saying, Vince, and slap a metaphor on it. This is like the older uncle who comes and grabs the wayward nephew and says, "Come on, kid, you're doing a few things wrong, let me help you out." You look at Coach's penetration into Asia and its brand recognition, you're absolutely right that they can help Kate Spade grow. Also, being that avuncular figure to tell Kate Spade that, "The way you're approaching your margin is detrimental to the long-term growth of your brand, and our combined profits." The last thing that shareholders should be pretty excited about, if you were to look at Kate Spade, go back a few years, it was trading in the hundreds [for valuation multiple], and dwindled down, the valuation of Kate Spade, what we call EV/EBITDA, that's a fancy term for the relationship between earnings on the market value, including the debt. Kate Spade, that valuation was in the hundreds, and it's dwindled all the way down to just below 11. Coach has its own valuation at around 13.

Whenever you acquire a company whose enterprise value to EBITDA is lower than yours, that's good for shareholders. So there's long-term value that Coach will probably take advantage of by buying a company which gets less economic benefit out of every dollar than it does. Just as you say, Vince, it's going to improve Kate Spade's financials, it's going to improve the distribution, move it to new markets. I think that's going to be a great thing, long-term, for shareholders. I'm still skeptical, though, about who exactly this millennial shopper is.

Shen: Final points that I'll make, this deal is expected to close in the third quarter of this year. Management has said the deal should be accretive by the end of fiscal 2018 for Coach. Big picture, and something I thought was interesting on the Coach management side, the CEO, he was the one who instituted a new creative director to take the company's image and its offerings to a more classic style that people would respect, and would have that aspirational luxury value. But, something he's also spoken to is, with the Stuart Weitzman deal, and now adding Kate Spade, is this idea of creating an American fashion conglomerate similar to a lot of the major players that we see in Europe, basically hoping that the increased scale and the diversification of their product in their brand portfolio will allow them to expand and grow well into the future. This is, I would say, their first big step into potentially achieving that goal. But it will definitely be one that is interesting to watch. 

Our second company tie up now, Asit, we have two beloved American institutions, Comcast and Charter. Who doesn't absolutely love their cable company?

Recently, Comcast unveiled a first look at Xfinity mobile, basically its foray into a wireless service offering. This was announced in early April. The core of this offering, Comcast wants to piggyback on the Verizon network while also allowing its mobile customers to access its Wi-Fi hotspots across the country. It actually has 16 million of them, pretty impressive. Basically, this gives subscribers connectivity at an affordable price, according to them. If you're somewhere without a hotspot, you are on the Verizon network. Otherwise you just connect to the wifi. They tout certain figures like the fact that 70% or 80% of wireless traffic is over wifi networks, not LTE networks. I guess the icing on the cake of this recent announcement for Xfinity mobile, Comcast and Charter are now announcing this week that they would be partnering up for some of their wireless efforts, the idea being, they invest together in some of the infrastructure, the operational aspects, to tackle what is a very competitive space. What are some of your initial thoughts on Xfinity mobile or the partnership, and the idea that these companies are trying to dive into this space?

Sharma: I think it's interesting how vague the wording of the agreement was. We got back that they were going to explore these operational efficiencies but nothing really specific. Some back office billing, improvements in the mutual Wi-Fi networks. One of the interesting things of the agreement is that they're restricted, Charter and Comcast, to only supporting so-called material transactions in the wireless industry. What that means, to me, it means there could be a joint venture down the road. I think this potentially opens up the door for a team up to maybe buy a wireless network, perhaps Sprint or T-Mobile are the two companies that would come to mind. I think it's a case of, as you said, two very beloved brands -- we say that somewhat facetiously, but, two very large companies that are looking for ways to continue to grow their revenue. Last year, Comcast did about $80.5 billion in revenue. Charter did $29 billion. Once you reach that size and scale, especially in the cable industry, which itself is fraught with potentially slower growth, there's almost no alternative but to try to monetize the way that each of these companies has into Wi-Fi. I think for Comcast, if they can better monetize those hotspots, that's one tangible, obvious thing they can get out of this deal. But, again, I'm intrigued by the possibility that there's something bigger in the works, perhaps, for next year in the 2018 timeframe. What are your thoughts, Vince?

Shen: That's a really interesting idea, I had not even considered that. There have been rumors in the past of deals within this space, not only on the cable company side with Comcast and Charter, but potential deals in terms of bringing in Sprint or T-Mobile, Verizon also looking at bringing in Charter, potentially, so these cross-sector deals, it's definitely an interesting idea. If you take this partnership announcement at face value, the idea that, not only with the infrastructure, but if Charter has its own Wi-Fi hotspots, and a customer who's part of this mobile offering has access to it, it expands the reach, expands the quality of the service. But something to keep in mind is, right now, the Big 4 wireless companies have already shown year after year that competition is really intense. For either of these companies, despite their size, scale, resources, to get into the wireless space will be no easy feat. 

I think it's important to note that this wireless offering that Comcast is going to be giving to its subscribers, it's very much tied to its current customers. It's actually a requirement, if you want to sign up with Xfinity mobileyou have to at least be an internet customer with Comcast at the moment. So targeting its current customer base. Also, thinking about it on the Verizon side, they are not going to want a really big, new competitor to enter the space. Already pretty intense, they've already seen their subscriber numbers hurt by the various promotions and the really smart marketing from the smaller players like T-Mobile and Sprint. This is an interesting way for Comcast to get into the space, and it reminds me of a service that my brother used to use, I think it was called Republic Wireless, similar idea where you would only access the actual LTE wireless service when you absolutely had no access to Wi-Fi networks. It was driven mostly by wifi connectivity. But the Xfinity mobile service, though announced, is not expected to launch for at least a few more weeks. When that happens, we'll have more details there. Any final thoughts from you, Asit?

Sharma: Just that this is very similar to the previous transaction we talked about, between Kate Spade and Coach in that we're seeing this across industries that to broaden out revenue, there's consolidation that's going to occur. And it doesn't matter whether you're in handbags or wireless. The spectrum of services that you can provide is increasingly broad. So companies which -- again, Coach is similar both to Comcast and Charter in that all three are mature companies with slowing growth curves. We're going to see much more of this in the coming years, and this industry in particular, between broadband, wireless, between content. There's going to be no end to the mergers and types we'll see.

So my final thought is, this is a precursor to some type of joint venture. Really quickly, that phrase, material transactions. I came up through the ranks as an auditor, and where material usually needs context is related to your annual revenue. So for a transaction to be material between these two companies, as I said, $29 billion on one side and over $80 billion on the other, that implies to me that there's some type of acquisition of a new company that is going to form out of this exploration on the wireless side, within maybe the next year or two. So, keep your eyes open, keep them peeled, and let's see what happens.

Shen: Thank you, Asit. A theme that just came to me for both these stores we talked about today, with Coach and Kate Spade, Comcast and Charter, it's company seeing the writing on the wall, seeing that on one hand, for Coach and Kate Spade, in their space, in the middle level of the luxury apparel and retail market, that's seen a lot of weakness recently, people either going up to the more premium level or going down to brands like H&M or fast casual offerings, needing to consolidate there in order to diversify their business a little bit and put up a stronger moat. And here, you have two companies in the older cable space maybe seeing the writing on the wall with wireless, and firing their first volley into the space, trying to get a foot in the door before it's too late. But thanks again, Asit, for joining us.

Sharma: Absolutely. It was a pleasure, Vince. Thanks a lot!

Shen: Thank you Fools for listening. You can reach out to us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus, or send any questions to [email protected]. Don't forget to check out podcasts.fool.com to hear our other shows. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!