The investment idea came to my attention as it survived one of my favorite screens based on the work of Graham and Dodd in the Intelligent Investor, which looks for cheap valuation, a healthy dividend, and a strong balance sheet:
• Earnings Yield > 2.0x AAA Corporate Yield
NTM P/E = 13.6 E/P = 7.4% (2.2x the 10 Year AAA Corporate Yield of 3.4%)
• Dividend Yield > 2/3 AAA Yield
Dividend Yield = 2.5% (74% of AAA)
• Total Debt < Tangible Book Value
Total Debt of just $1.0mm vs TBV of $1.6B
Furthermore, they have a very healthy net cash position exceeding $1B
Being a screen survivor alone is not sufficient. I then need to understand the business model, contemplate the competitive dynamics of the industry, and then try to couch the upside potential versus the downside risk.
Business Model / Industry Dynamics
The company operates in the luxury retail industry, which is certainly subject to numerous macro and micro risks (elaborated on later), but it is striking that they have consistently generated best-in-class fundamentals:
• Gross Margin consistently above 70%
• Operating Margin consistently above 30%
• ROIC of 40-50%
• 5 Year EPS CAGR of 11%, with the only hiccup in the last 10 years occurring during the global recession
These are the type of high quality fundamentals that Buffett would love. But not only are their historic fundamentals impressive, they also have ample opportunities for growth from square footage expansion, inchoate penetration in China, and focus on new segments (Men's) and categories (shoes). Further supporting the bottom line are transformation initiatives aimed at streamlining the organization and leveraging global and technological capabilities, as well as a renewed commitment to return excess cash to shareholders.
Such fundamentals would not seem to warrant a discount to the market multiple. The stock currently trades at a 5% discount to the S&P 500 vs a 5 year average premium of 15%. The discrepancy comes from concerns about emerging competitive threats, particularly Michael Kors (KORS), as well as Kate Spade and Tory Burch. I do not dismiss those threats, but feel like the current valuation largely discounts a worst case scenario, especially considering that competitors are acting rationally, evidenced by stabilized gross margins (COH GM% has increased in each of the last three quarters). So I do expect share loss to persist, but so long as the pricing environment remains benign, I believe that COH's historic fundamental track record is sustainable.
Upside Case- assuming top line growth slows, but margins are stable coupled with more aggressive share repurchases, I think EPS can grow at an 8% CAGR in the near term, yielding $4.33 in FY15 (fiscal year ends in June). I believe this is within reason as it represents a slowdown from their historic growth rates. An 8% growth rate for 5 years, which then slows further to 2% in perpetuity, discounted back at 10%, warrants a multiple of 15.8x.
Again, this is within reason as it suggests a 9% premium to the current market multiple vs a historic premium of 15%. So a scenario that assumes a slowdown from historic growth rates and a reduced relative multiple yields a $68.41 stock price for FY15. Discounted back a year gets me to $62.19.
Downside Case- my downside puts heavier weight on the company's risk factors, namely:
• Macro- global economy impact on consumer spending; raw material prices; tax policy and the repercussions on the luxury sector
• High managerial turnover recently
• Company's turnaround does not progress as planned
• Mix shift toward footwear and apparel causes gross margin pressure
• Fashion mis-steps / poor inventory management
I am a buyer at $51.73, which offers 2:1 upside to my price target of $62.19 (+20%) relative to my downside price of $46.50 (-10%).