With interest rates at lows, the equity markets at all-time highs, and executive teams looking for strategic and opportunistic growth opportunities, the table is set for some wheeling and dealing, in our view. We think Coach (COH), the aspirational maker of handbag and accessories, is on the radar of a number of suitors, the most likely being LVMH Moet Hennessy (LVMHF), according to Prime Retailer:
LVMH groups representatives have recently shown interest in Coach, sources say. Recent shows and fashion line has appealed to the design team of LVMH, one of the persons admits. It could be the turnaround that attracts LVMH – turning its attention from classical high end luxury accessories label to full RTW apparel lineup.
There are five reasons why we think Coach may be attractive to a potential acquirer:
1) The company’s shares are dirt cheap. Shares of Coach have been punished recently as a result of poor performance from its North American women’s handbag business. However, we value the company at nearly $50 per share, materially higher than its $35 per share price tag. During fiscal 2013, the company earned more than $3.60 per share on a diluted basis, putting its valuation at roughly 10 times achievable earnings should it turn around its North American business, and this valuation excludes its robust net cash position on the balance sheet. Coach’s attractive price tag sets the table for an opportunistic play from a potential suitor, in our view.
2) Coach’s balance sheet is extremely healthy. Unlike situations where a struggling firm may need a white knight to ensure survival, a suitor would not be bailing out Coach in any way. To the contrary, Coach is quite healthy. The firm had more than $860 million in cash and just $140 million in current and long-term debt on the balance sheet as of mid-2014. In this light, we think its robust financial profile makes a deal much easier to consummate, as a suitor would not have a difficult time lining up debt financing. From a financial standpoint, Coach is an investment-grade credit, which was recently reiterated by Moody’s in the company’s recent unsecured shelf registration.
3) Coach’s free cash flow generation is solid. The company’s cash-flow generating profile is quite robust, and we think this is a key attribute to getting any deal done. Coach generated over $765 million in traditional free cash flow (cash from operations less capital expenditures) during fiscal 2014, and its free cash flow generation in fiscal 2013 and fiscal 2012 was even better. Under any combination, a potential suitor would not have to absorb its own pre-merger free cash flow to support Coach’s operations. In fact, Coach’s excess cash flow could be used to help support the strategy of the potential acquirer’s portfolio. This would be a win for any suitor.
4) It is common for luxury companies to hold a large portfolio of brands. Richemont (CFRUY), for example, has a luxury-goods portfolio that includes such prestigious names as Cartier, Van Cleef & Arpels, Piaget, Vacheron Constantin, and Montblanc, among others. LVMH Moet Hennessy has over 60 prestigious brands spanning segments such as wines & spirits, fashion & leather goods, perfumes & cosmetics, watches & jewelry, and selective retailing. Brand diversification is important to reduce the fashion risk that is typically inherent to a luxury-good maker’s operations.
In 2011, LVMH bought Italian peer Bulgari and paid a 60% premium for the company, so it’s not uncommon to see luxury goods maker’s pay up for strong brands either, and Coach is certainly one of those. Though either a Richemont-Coach or LVMH-Coach combination may result in more of an extension of the combined entity’s existing business lines, a deal may make particular sense for Coach, which remains heavily reliant on a struggling North American women’s handbag and small leather goods operation. As increased diversification (lower volatility) would reduce the discount rate applied to a future expected free cash flow stream, Coach, under any acquisition scenario, would be worth considerably more to an acquirer than on a standalone basis.
5) The synergies and growth opportunities would be material. Either a Richemont-Coach or LVMH-Coach combination may spark greater interest in the combined entity’s handbag and leather goods operations, helping Coach to stabilize and then potentially grow its North American women’s business. In any combination, cost-sharing and margin enhancement potential would be material. For one, bringing Coach’s operations in-house would reduce a well-armed competitor, inevitably improving the competitive profile of the luxury goods space. In particular, LVMH’s global retail network would be a huge asset to Coach’s line of products, as the latter seeks to diversify geographically. The recent designs at Coach have caught the eye of LVMH, and this has likely spark deal talks, even if they may not have been reported as such. It is very likely Coach has had talks with many a suitor already, with Kering perhaps close to the top of the list as well.
Wrapping Things Up
Coach is certainly a risky entity that is heavily exposed to fashion trends, which are difficult for any experienced expert to predict. However, the company does pay a safe and healthy 4% dividend yield that we think offers some support to the stock in the mid-$30s. We view the prospect of a suitor scooping up shares of Coach at a substantial premium as merely icing on the cake. Our fair value estimates of Coach, Richemont and LVMH Moet Hennessy are unchanged. We don’t expect to alter our relatively small weighting in Coach in the Dividend Growth portfolio at the moment.
Luxury Goods – Ultra & Aspirational: BID, CFRUY, COH, CTHR, FOSL, KORS, LUX, LVMHF, RL, TIF