Coach (COH) has been somewhat of a black mark on the “hit rate,” or percentage of ideas outperforming the broad market return, in the Dividend Growth Newsletter portfolio, and while we continue to encourage readers to evaluate the weightings we ascribe to positions in the newsletter portfolios for insight on our level of conviction, that Coach resides in there at all means it had been one of our top ideas, added September 19, 2014 at $37.55. Coach currently yields ~4.5%.
When we first added Coach to the Dividend Growth Newsletter portfolio, we were aware of the fashion risks and the troubling signs in its North American women’s handbag business. What we liked most about the company, however, was its fantastic balance sheet health, which offered a degree of optionality. At the conclusion of fiscal 2014, ended June 28, the company recorded ~$867 billion in cash and short-term investments against current debt of ~$141 million and no long-term debt, resulting in a net cash position of ~$726 million. The balance sheet has changed quite a bit since then, mostly as a result of the Stuart Weitzman brand purchase. At the end of the September quarter, net cash stood at ~$386, not terrible, but not as robust as it once was either.
That said, we simply cannot be disappointed with a company that has generated cash flow from operations of ~$937 million, ~$985 million, and ~$1.414 billion in the fiscal years ending 2015, 2014, and 2013, respectively, versus capital spending of ~$199 million, ~220 million, and $241 million for those corresponding years. During the past three years, cumulative free cash flow generation has totaled $2.68 billion versus cumulative cash dividend payments of $1.09 billion, revealing significant coverage on the basis of free cash flow generation alone. Perhaps we shouldn’t be so disappointed in the weakened balance sheet in the context of such strong free cash flow generation, but the Stuart Weitzman addition was a distinct negative for income-oriented investors, in our view.
The cash outflow on the balance sheet wasn’t something we weren’t completely expecting, but the Stuart Weitzman brand isn’t performing poorly. Net sales of the brand totaled $87.5 million during the quarter, or ~8.5% of Coach’s total revenue stream, and the division’s non-GAAP gross margin (57.8%) and non-GAAP operating margin (17.2%) was solid. The performance helped Coach to top-line growth of 3% on a constant-currency basis during the quarter, and non-GAAP earnings per share of $0.41, matching consensus quarterly expectations implying material progress in its “transformational journey.” During the quarter, Coach experienced double-digit constant-currency sales gains in Europe and mainline China, and we were pleased to see expectations for “a return to top line growth in fiscal 2016 and positive North American comps by the end of the year.”
Coach’s weighting in the Dividend Growth Newsletter portfolio is ~1.5%, and we’re in no hurry to remove it. On the basis of its Dividend Cushion ratio of 2, the company’s dividend is solid, and its annual yield is among the highest for corporates with such a lofty “cushion.” We think fiscal 2016 will be a promising one for Coach, and we maintain our view that the firm could be a takeout candidate by a larger peer in coming periods. In late calendar 2014, LVMH Moet Hennessy (LVMHF) had taken a liking to recent fundamental developments, and stabilization of results may be enough to bring suitors back to the table. Kering and Richemont (CFRUY) may be interested acquirers as well. In the meantime, we’ll keep collecting the dividend payments and wait for price-to-fair-value convergence. We value shares in the high-$30s, with upside potential to the mid-$40s on the basis of the high end of the fair value range.