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Why Coach Will Remain Lost

By Lawrence Rothman – Feb 7, 2014 at 12:31PM

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Coach is trying to emulate Michael Kors, but faces an uphill battle

Coach's (TPR 1.40%) earnings continue to disappoint investors. However, the luxury retailer has bigger problems than what is reflected in another quarterly sales decline. It is playing follow the leader as Michael Kors (CPRI 2.72%) has been stealing market share. However, like a chess player that follows the other player's moves, this will lead to trouble.

Until Coach returns to its familiar path, it may be advisable to look elsewhere.

Results continue to falter
Total sales fell nearly 6%, to $1.42 billion in its key second quarter. The period includes the holiday season, and typically represents about 30% of the year's top line. However, the sales decline does not tell the whole story since it includes new store openings.

North America, responsible for nearly 70% of sales, continued to be an area of weakness. While total sales dropped by 9%, to $983 million, comparable store sales were down 13.6% as there was lower traffic. In other words, fewer people visited the stores. Obviously, if people do not go to the store, they will not spend money there. If you are thinking people turned to the Internet, online sales did not help boost comps, management said on its earnings conference call.

Management blamed weakness in women's handbags and accessories. Unfortunately, these categories account for over 80% of sales.

The International segment did manage sales growth of 2%, to $425 million. China was an area of strength, with a 25% increase and a double-digit comp increase. However, it is too small and growth is not fast enough to offset weakness in North America.

The sales decline led to weaker margins. Gross margins and operating margins fell 300 basis points and 430 basis points from a year ago, to 69.2% and 30.7%, respectively.

Net income plummeted 15.7%, to $297.4 million. Shareholders will find little consolation that diluted earnings per share fell by 13.8%, to $1.06, thanks to share buybacks.

Playing follow the leader
Meanwhile, Michael Kors has been on a roll. In its second fiscal quarter, which ended late-September, revenue jumped nearly 39%, to $740.3 million and net income did even better, rising 49%, to $145.8 million.

Comparable store sales rose 23%, continuing a string of 30 consecutive quarters of growth. In North America, it was up 21%. Management credited its accessories and watch offerings.

In response, Coach is trying to focus on lifestyle, including clothes, accessories, jewelry, bags, and shoes. This sounds very much like Michael Kors. It would seem expensive to develop and market new product lines that are not much different from its competitors, rather than focus on its knitting or differentiating its products. This is especially true since Michael Kors attracts a more upscale clientele than Coach. Following the leader could take the company down a wrong and expensive path. Granted, it is a limited survey, but on a recent trip to Marshall's, one could not help notice how many Coach shoes were sold at a discount retailer.

Returning cash may not be so great
In the midst of the battle for market share, Coach is spending money on buying back shares and increasing dividends. Typically viewed upon favorably, the company's long-term interests will be served better if it used its cash for product development and marketing its wares.

Coach spent $350 million on share repurchases during the first half of its fiscal year, reducing its second quarter diluted share count by nearly 5 million from a year ago, to 281.5 million.

The company has been raising dividends annually. Since 2009, it has gone from $0.30 a share to $1.35. Normally, this would be a good thing, indicating the company's confidence in the future. However, the last couple of years, Michael Kors has really put a dent in Coach's business.

Final thoughts
Michael Kors is doing well. However, Coach was the darling of Wall Street not too long ago. Fortunes can change quickly in retail, and it is a race to stay ahead of the competition and on top of the latest consumer trends. Trading at a P/E of 33, Michael Kors' stock is not cheap, and it will have to keep performing at high levels.

Coach is trading at a much more modest 14 times earnings. However, it has a lot of work to do to reverse sales. Following Michael Kors does not seem the way to do so.

Investors should look elsewhere for profitable opportunities in the retail sector.

Lawrence Rothman has no position in any stocks mentioned. The Motley Fool recommends Coach and Michael Kors Holdings. The Motley Fool owns shares of Coach. 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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