Investors are more optimistic about Coach (COH +3.42%) after the company exceeded analysts' expectations for fourth-quarter revenue and earnings. In the past, I've written that there are good reasons Coach's stock could start to rise, making the stock a good candidate to add to a diversified portfolio. The better performance last quarter is just further evidence that things are starting to look up for the luxury retailer. However, Coach is still a work in progress that isn't guaranteed to keep improving. Let's look at the three biggest factors that could derail Coach's recovery.
Brand transformation could flop
One of the strongest selling points of Coach's turnaround story is its transformation from a designer handbag retailer to "a modern luxury lifestyle brand across all key consumer touch points." While Coach's sales of women's handbags are in flux, the company is expanding into other categories to extend its brand power. Women's handbags accounted for 55% of sales in fiscal 2014, down from 65% in fiscal 2006, and that percentage could come down significantly in the years ahead as Coach revs up its product diversification.
As part of the brand transformation, Coach hired renowned designer Stuart Vevers to replace Reed Krakoff as creative director. A few months after taking over, Vevers showcased Coach's fall 2014 collection in a February New York Fashion Week presentation. The presentation failed to generate enough buzz to drive traffic to stores, however, as U.S. comparable-store sales accelerated their decline to 21% in the third quarter. Granted, the new collection only hit stores in fiscal 2015, which began in July, but the lack of consumer interest despite the Fashion Week buzz is a troubling sign.
Moreover, Coach's expansion into other product categories risks diluting its handbag brand. If people no longer think "handbag" when they think of Coach, its high-margin handbag business could fade. This could end up hurting its earning power in the long run.
Aspirational customer base
When you think of Coach's core customer, you probably think of affluent women. Indeed, spending hundreds or thousands of dollars on a handbag seems to only make economic sense for high-net-worth individuals. However, there is substantial evidence that the high status that comes along with designer handbags increasingly attracts aspirational customers whose discretionary spending may shrink during recessions.
For instance, 38% of Coach's stores and 55% of its square footage in North America is devoted to outlet stores. Moreover, Coach's U.S. outlet square footage has grown by more than 15% per year over the past three years, while its retail square footage has decreased. Outlet stores target price-conscious customers, which is not the kind of customer a price-inelastic retailer attracts.
Also, Coach sells a number of totes and other bags in the $200 to $400 price range -- well within reach of many middle-class Americans.
Taken together, the growing importance of outlet stores and the proliferation of lower-priced bags and accessories indicate that Coach's customers are largely aspirational. This could be part of the reason its gross margin has fallen from 77% in 2005 to 69% in 2014. A continuation of this trend could lead to a lower stock price.
Competition on the rise
Coach is no longer the clear leader in women's handbags. Michael Kors (KORS +5.25%), Kate Spade (KATE +0.00%), and Tory Burch are invading the space at similar price points. In fact, the four companies compete across many product categories, including clothing, watches, shoes, and accessories. The primary differentiator between these companies' products is the brand -- and brands come and go in the fashion world.
Michael Kors is already threatening to overtake Coach in total revenue; in its most recent quarter, Michael Kors was 80% the size of Coach as measured by revenue. In addition, Michael Kors is growing by double digits, while Coach is struggling to remain in place. This situation indicates that Coach's current offering is losing market share. The company may never recover if up-and-coming brands remain in vogue while the ubiquitous Coach wears on consumers.
Foolish takeaway
Coach is starting to pull out of its death spiral, but it isn't out of trouble yet. The company must successfully transform its brand while fending off competition for its increasingly price-conscious customer. If it can do so, investors are set to make a lot of money. But if the death spin resumes, investors will lose big time.
