Eight months ago, I wrote that Coach (COH +1.36%), shouldn't be paying a dividend. Coach has maintained its high dividend pay-out to appease investors, even as it's lost market share in North America to Michael Kors (KORS +2.08%) since that time. Many "in-flux" retailers, such as RadioShack (RSH +0.00%), have tried this strategy with disastrous results. To best serve investors, Coach should consider cutting its dividend soon.
Here's why Coach (still) shouldn't be paying a dividend.
Fashionable competition
Coach is facing an all out hand-bag blitz from Michael Kors. In Kors most recent quarter sales surged 56% and comparable sales rose 26.2%. Meanwhile, Coach's first quarter earnings dropped ($0.68 vs. $0.84) and revenue slid (7.4%) on a year-over-year basis. The reason was market share losses in North America; Coach's North American comparable sales have dropped over 20%, each of the last two quarters.
Coach's stock fell nearly 10% in the wake of its most recent quarter; the stock is now down 38% over the past year while Kors has risen 49%. Given the rough quarter, and the past year, I was surprised to see Coach maintain its current dividend last week.
Coach's plan sends mixed messages
Coach meets absolutely none of the characteristics of a typical high-yielding dividend stock. High yielding stocks are often in stable, no growth industries. Does that sound like apparel to you? High yielding stocks also typically have very few places left to invest their capital with high rates of return. But Coach's turnaround strategy is to renovate stores, beef up its product line, and to avoid discounting. Those strategies all offer a higher potential return than the 3.89% dividend yield, and they're all very expensive.
Coach is closing seventy under-performing stores, renovating flagship stores, and maintaining its dividend. This store closings feel like a mixed message, and it makes me wonder if Coach's dividend is impacting its budget for capital expenditures. One way to find out if Coach has the money to reinvest in itself is by measuring its operational cash flow, compared to its capital expenditures (or the CF to CAPEX ratio). The higher this number is, the better. As the chart below shows, Coach is still in-line with its peer but it's trending in the wrong direction, compared to Kors.
COH Cash Flow to CAPEX data by YCharts
Kors is planning on spending a whopping $400 million in CAPEX this year, meaning Coach may need to spend more to keep market share in the U.S. If the above trend continues at its current pace, that could be problematic.
Finally, let's remember that Coach's international sales, which grew 14% during the first quarter, are keeping the company relevant right now. It's not likely that all of Coach's expenditures can be funneled into reinvigorating U.S. growth. With new markets, and new opportunities, Coach may need to spend more than ever.
A scary precedent
There is precedent for retailers, in changing industries, holding on to a high yield. It's not good. Before I get into an example, it's important to remember where dividends come from--free cash flow. Over the past year Coach has paid out more cash in dividends than ever. At the same time, its free cash flow has dropped dramatically. Coach is paying out more, partly due to share repurchases, and bringing in less. Why?
COH Free Cash Flow (TTM) data by YCharts
As everyone on the planet knows, the past few years have not been good to RadioShack. What you may not remember is that the company started raising its dividend in 2012; when things got really bad. For years, the companies cash flow had declined and it made the poor decision to maintain its dividend. When things got worse, it compounded the error by hiking the dividend.
RSH Dividends Paid (TTM) data by YCharts
You may laugh at RadioShack's misfortune, but I remember plenty of "value" minded investors who supported the dividend. This strategy, to raise your dividend because things are going poorly may sound crazy but it's very common in stocks. I'm sure you can think of a few land-line phone stocks, big-box electronic stocks, our out-of-style apparel stocks that nearly lured you in on a dividend hike. They'll offer you a dividend to keep you around through the "slow growth phase," but remember, that's money taken away from the business. Like RadioShack these dividends tend to go higher, just before they're cut altogether.
The danger of the stock market
So why do companies keep a high dividend when things are at their worst? The short answer is that the stock market is a dangerous place. Due to the short-term focus of most investors, companies have to manage your expectations instead of managing their business. There's no way for us to tell if the excess reinvestment, in lieu of a dividend, would help stabilize North America for Coach. But, at a distance, I do think it's a better strategy.
Perhaps Coach's management team has done their homework and calculated that there is not a better place to invest the money. However, from the outside looking in, given the trends noted above, the dividend feels slightly risky right now.
