By Brian Nelson, CFA
Why would we include Coach (COH) in the portfolio of the Dividend Growth Newsletter portfolio? This was a question we were asked quite frequently when shares had dipped into the mid-$20s, but we don’t hear it too much now with the company’s shares breaking north of $40 each. The company was added to the Dividend Growth Newsletter portfolio at $37.55 per share in September 2014, but the handbag maker has been paying a rather hefty yield since then, adding up to a respectable total return for the unique exposure within the context of a dividend growth strategy.
The position in Coach had given us heartburn in the past, “Coach…Ouch! (April 2015),” and we weren’t exactly pleased with the company’s use of the net cash on the balance sheet in the Stuart Weitzman deal, “Coach Back on Track (October 2015),” which we pegged as a distinct negative for income holders in light of the use of cash, which otherwise could have gone to growing the dividend. We’re glad that we were patient. The company’s fiscal 2016 third-quarter results, released April 26, revealed a company that is getting back on track. Net sales advanced 13% over the prior-year period on a constant-currency basis, while non-GAAP earnings per share leapt 23%, to $0.44. Management also reiterated that it expects to return to positive North American comparable store sales in the fiscal fourth quarter, a material inflection point. We like a lot of what we saw in the press release, particularly the double-digit expansion in mainland China and Europe.
The Dividend Growth Newsletter portfolio is rather conservative in the sense that it is filled with companies with strong business models that generate robust traditional free cash flow generation with robust balance sheets. Coach adds unique diversity to the portfolio, and while it comes with a number of unique risks–including its ties to fashion risk, volatile tourist spending flows, and macroeconomic and promotional dynamics–we’re going to let the company’s turnaround continue to play out. The Stuart Weitzman purchase is working out as planned, according to management, and we like CEO Victor Luis’ focus on efficiency initiatives, even if it means job cuts. The company achieving its previously-stated goal of a 20% operating margin for the Coach brand by fiscal year 2017 will continue to build confidence in the turnaround and position the company nicely for ongoing earnings expansion.
Veterans in this business know that successful turnarounds are few and far between, but we’ve been watching one in Coach for some time now. The company reiterated its fiscal 2016 constant currency revenue growth and margin guidance, with Coach brand revenues expected to advance at a low-single-digit pace, excluding currency and Coach brand operating margin targeted in the mid-to-high teens; we’ll be watching margins closely in light of promotional competition and troubles across several “desperate” mall-oriented retailers, “Debt, Debt and More Debt (April 2016).” Net cash at Coach stood at ~$400 million at the end of the March quarter, offering continued financial flexibility. We’re viewing the improving performance at Coach as a strong read-through for Best Ideas Newsletter portfolio Michael Kors (KORS), even if it may not materialize in the near term.