Dividend Growth Newsletter portfolio holding Coach turned in a strong finish to calendar 2016, but we’re worried about rumored M&A activity. Let’s dig in.
By Kris Rosemann
We’ve been keeping a close eye on the speculative luxury goods ideas in the newsletter portfolios, and it hasn’t all been smooth sailing as Coach (COH) and Michael Kors (KORS) work to reposition their brands in the North American markets. Though we continue to see an opportunity for capital appreciation in shares of Coach (based on our fair value estimate of $41 per share), which is yielding ~3.7% at recent price levels, we’re growing concerned about the implications that M&A (if rumors come to fruition) will have on the long-term health of the dividend. Many, for example, are speculating Coach may purchase Kate Spade (KATE), while others have reported that Coach had been in talks with Burberry (BURBY). For now, however, Coach’s near-term free cash flow generating capacity and net cash position on the balance sheet are just good enough to keep it in the Dividend Growth Newsletter portfolio. The handbag maker’s Dividend Cushion ratio stands at 1.9, but a foolish debt-funded acquisition could alter the strength of the payout in a heartbeat. We’re not as comfortable with shares as we once were, prior to the Stuart Weitzman purchase, which absorbed a considerable amount of its net cash.
Nevertheless, Coach’s fiscal 2017 second quarter report, released January 31, suggests recent rebranding tactics may be bearing fruit. The company reported that net sales advanced 4% in the second quarter of fiscal 2017 from the year-ago period despite management’s estimate that reported sales were negatively impacted 1% from the strategic decision to reduce promotional events and close stores in the North American wholesale channel. The repositioning was not enough to keep the Coach brand from beating expectations for comparable sales in North America either, as it turned in 3% growth on a year-over-year basis compared to consensus estimates of 2.4% growth in the period. Coach delivered double-digit earnings per diluted share growth in the fiscal second quarter as well, as more than a one percentage point expansion in gross margin helped diluted earnings per share jump to $0.71 from $0.61 in the year-ago period. The reduction in North America Coach brand promotional activity helped support the bottom-line performance.
Though Coach will bring on board a new CFO in March (Kevin G. Willis), the executive team appears to be doing a lot of things right, as of late, in the midst of a very challenging retail environment. For example, a recent read into average spend per consumer on handbags suggests aspirational goods makers avoiding promotional activity is a sound strategy, as while the number of handbags purchased per consumer has been flat during the past three years, the average spend per consumer on handbags on a trailing twelve month basis has grown each year since 2014. Rival luxury brand firm LVMH (LVMHF), who is battling the ultra-aggressive discounting in retail by avoiding the listing of its products on Amazon’s (AMZN) online selling platform, also reported a strong finish to calendar 2016 January 26 as its revenue jumped 9% from the fourth quarter of 2015. Holding the line with price to maintain solid brand positioning looks like the best way to navigate the tumultuous environment.
Looking ahead, Coach reduced its fiscal 2017 revenue guidance in the quarterly release due to increased expectations for currency exchange headwinds. Management now expects revenue to grow at a low-single digit rate, compared to previous expectations for a low-to-mid-single digit increase. Coach still anticipates a double-digit growth rate in both net income and earnings per diluted share in the full fiscal year. We like the targets, and while the robust bottom-line expansion bodes well for the objectives of the income-oriented Dividend Growth Newsletter portfolio, we can’t rule out the possibility of potentially foolish M&A with Coach on the buying side of the negotiations table. Coach is doing a lot of things right operationally, but with shares now trading above average cost, even excluding dividends, the time may be ripe for us to rid the Dividend Growth Newsletter portfolio of this speculative position. The potential for further capital appreciation may not be worth the added risk of a dividend cut that may come with M&A activity, particularly in the context of the Dividend Growth Newsletter portfolio. Stay tuned.