Fundamental Analysis of Coach, Inc.

¶ … Economy (Market) Analysis

Industry Analysis

Company Analysis

Brief History of the Company

Analysis of Financial Statements (Ratio analysis)

Liquidity Ratios: Current ratio

Operating Efficiency: Asset Turnover

Operating Profitability Ratios: Net profit margin, Return on Equity, and Du Pont

Risk Analysis: Business Risk and Financial Risk, Variability, and Debt/Equity

Application of CAPM and Analysis

10F.Estimating the Value of the Company and Analysis

EPS

10• P/E

11• Sustainable Growth Rate

11• PEG

12• Investment Decisions

13G.Additional Measures of Relative Value and Analysis

13• P/BV

14• P/CF

14H.Measures of Value Added and Analysis

14• EVA

15• MVA

15I.Comments and Conclusion

References:

1.Economy (Market) Analysis

Consumer spending proved very resilient against the challenge of gradually rising energy prices, as indicators of sales in the retail sector show. However, the difficulties caused by hurricanes Katrina, Rita and other tropical storms, as well as tensions in oil-rich areas might lead to record-high energy prices.

However, the retail sector in the Southeast was not very affected, especially in regard to its tangible assets: stores and means of transportation. The hurricane season is almost over, and the retailers hope to see an improvement in sales figures, especially because of the pressures all of them were subjected to this summer. After the fears caused by hurricane Katrina, the federal government took no chances and evacuated the population in affected areas, thereby making retailers with an important presence in the Southeast, such as Wal-Mart's (WMT), Dollar General (DG), Fred's (FRED), Family Dollar (FDO), and Dillard's (DDS). Fortunately, these problems are gradually solved.

2.Industry Analysis

The impact of the hurricane on oil and natural gas production and distribution will probably affect the retail sector some months from now on. Filling-up gas tanks and heating consumers' homes will definitely impact on the amounts available for spending in other sectors, and all retailers will definitely feel the pressure. In addition, transportation costs for all retail companies are subject to serious concerns.

High-end retailers such as (Coach COH), the object of this analysis, Neiman Marcus (NMG.A), Nordstrom (JWN) and Best Buy (BBY) are facing a serious test. High-energy prices related problems have plagued the industry during the previous few years, but the aforementioned companies have managed to get through the difficult periods without substantial difficulties, so no important slowdown should be expected. If, however, the stock price should happen to fall in some cases, that would probably be an opportunity to take advantage of, since prices will surely go up after a while.

The impact of high energy prices will have an impact on the results recorded by retailers throughout the year, and especially during the winter holydays, which are paramount for the industry. However, the impact will not probably be that significant, especially in the case of high-end retailers such as Coach, and all negative consequences should be on the short-term. Obviously, any short-term estimation of the price of COH shares is risky, since Coach might be under the influence of other factors. However, on the long-term, short-term phenomena such as the surge in energy costs will not influence substantially the value of the shares, which possess attractive growth potential.

Coach is an actor on the jewelry and accessories market, which has recorded increasing revenues during the last half of decade. Coach is one of the biggest players in the industry and has evolved alongside the market. Its earnings experienced rapid growth over the last few years, and that reflects in the value of the earnings per share indicator, which is now at record highs.

3.Company Analysis

A.Abstract

Coach is well-known for its high-quality, trendy designs, and managed to find a niche on the fiercely disputed market of moderate labels and designer brands. Coach gradually developed its brand and it currently faces little competition in the accessible luxury segment. This position represents a definite advantage for Coach, which will enable it to compete on the long-term with its present or future peers. Thanks to a financing structure based mainly on equity and to a low debt cost, the returns on invested capital exceed its cost of capital. Coach is currently expanding, takes advantage of all types of opportunities, both operational and financial, and has a strong position on the market because of its capacity to bring innovative products to consumers.

Coach is specialized in providing high-quality everyday accessories in variety of styles and materials. Among its products one could find wallets, handbags, footwear, watches and other accessories. More than half of its sales come from its U.S. retail stores network, which includes more than 200 stores. Sales strategies are also put in practice through department stores, international shops, the Internet, and a special company catalog.

The financial analysis of the Company indicates that the company has growth potential, although the price of shares is currently quite high. However, what is considered expensive in the present might be regarded as an opportunity in the future. Consequently, moderate buys of Coach shares are recommended at the time.

B.Methodology

This paper contains a top-down analysis of Coach Inc. past and future evolution. The study employs the usual methods of financial analysis, such as financial ratios, in order to determine whether Coach stock is desirable at this time or not. Mathematical models such as CAPM have also been employed in order to assess the possible evolution on the market, based on previous results.

Revenue is sometimes expressed in percentage points (100%), in order to facilitate the comparison with similar companies. Consequently, other indicators, such as the Net margin or the Return on Assets are also expressed in percentage points.

C.Brief History of the Company

According to the data provided by the company itself in the 10-K form, Coach was founded in 1941 and has grown from a family-run workshop in a Manhattan loft to a leading American designer and marketer of high-quality, modern American classic accessories. Coach developed its initial expertise in the small-scale production of classic, high-quality leather goods constructed from "glove-tanned" leather with close attention to detail.

Coach sells its products worldwide through its own retail stores, select department stores, its online store and its catalogs. Coach has built upon its brand awareness in the United States by expanding into international markets, particularly in Japan and East Asia, diversifying its product offerings beyond leather handbags, further developing its multi-channel distribution strategy and licensing products with the Coach brand name.

D.Analysis of Financial Statements (Ratio analysis)

• Liquidity Ratios: Current ratio

The Current ratio is a liquidity ratio used to measure a company's ability to pay short-term obligations; and is calculated by dividing current assets by current liabilities. In addition, the ratio also gives a hint about the efficiency of the company's operating cycle.

The ratio indicates the company's ability to pay back short-term liabilities with their short-term assets. A high current ratio means that the company is very able to pay its obligations. A ratio under 1 indicates that the company is not able to pay off short-term obligations, which raises the concern for bankruptcy. Although it is not a sure that bankruptcy procedures will be initiated, a low current ratio it is not a sign of financial health.

A company's operating cycle (the ability to turn products into cash) is also scrutinized by the current ratio. Collection problems or long inventory turnover can trigger liquidity problems.

Coach exhibits impressive liquidity ratios, especially considering the steady increase during the past few years: the current ratio is currently at around 2,67, with a peak in 2004 at 3,88. The company has a very effective liquidity management program, as it succeeded to increase for the last few years the value of both the current ratio and the quick ratio by almost one point per year, which indicates that short-term debt are covered a few times over by short-term assets.

• Operating Efficiency: Asset Turnover

The asset turnover for the previous years has slowly decreased from 2,06 (in 2002) to 1,44 (in 2005). The somewhat constant values recorded by the Asset Turnover indicator during the last few years show that the company's management decided that the value of assets was to small when compared to the turnover, making further expansion difficult, or that some of the assets were already depreciated and their time-span had been exceeded. A analysis of other indicators, such as the Return on Assets, which records constant growths for some years, shows that the number of assets employed by the Coach is not excessively large when compared to the level of revenue. Consequently, Coach's management has probably found an optimal level for the Asset Turnover indicator at approximately 1.4-1.5

• Operating Profitability Ratios: Net profit margin, Return on Equity, and Du Pont

The Net profit margin recorded significant growths during the previous years and it has now reached 22.72%, which is more than double the value of 2001, for instance. What is really impressive is that the company has managed to maintain a very high level of the Return on Equity indicator: more than 42.5% percent during a 5-year period and a very high degree of stability is definitely important for any investor. Although ROE has constant values, analysis of other financial ratios revealed that Coach's management gradually decreased the financial leverage (which is now at around 1.31) and increased at the same time the Return on Assets Indicator. The company's assets are more efficiently used, while debt has steadily decreased, as indicated by the Debt/Equity indicator, currently at around 0.02.

The DuPont model involves three components, which are all used in the calculation of return on equity: the net profit margin, asset turnover, and the financial leverage (or equity multiplier). The examination of each input individually indicates the sources of a company's return on equity and facilitates the comparison with its competitors. In Coach's case, the DuPont model would look as follows:

ROE = Net Profit Margin x Asset Turnover x Financial Leverage

ROE = 11.93

x

2.06

x

1.72

= 42.18%

(in 2002)

ROE = 22.72

x

1.44

x

1.31

= 42.85%

(in 2005)

Although the value of ROE in the two years I chose for the purpose of this analysis are remarkably similar, one could notice a sharp increase of the Net Profit Margin (it has doubled in three years time), while the Asset Turnover and the Financial Leverage have registered significant decreases. As mentioned before in this paper, Coach's management has probably found an alternate way to employ the company's assets (by resorting to new, not yet depreciated assets, for instance), which might explain the lower value of the Asset Turnover Ratio. As for the Financial Leverage, Coach's financial structure has changed to a more equity-based one, which is good news for shareholders, considering recent favorable forecasts.

• Risk Analysis: Business Risk and Financial Risk, Variability, and Debt/Equity

Business risk refers to the variability in operating income caused by certain inherent factors of the business, debt financing aside. The business risk is under the influence of changes in prices, sales volume, competition levels and variability of inputs. With regard to the business risk currently faced by Coach Inc., one should consider the impact of hurricanes Rita and Katrina on oil and natural-gas production and distribution.

The retail sector will probably suffer the consequences by the end of the year. As a result, consumers are likely to pay more on gas for automobiles and for heating, and pay less for discretionary spending, which is likely to affect retailers, especially high-end ones. Although the segment proved quite resilient in the battle against economic difficulties during the previous years, disregarding the effect of higher energy costs is not recommendable. Coach Inc., as well as other high-end retailers might experience some losses, which translates into a drop (more or less acute) of the stock price.

The financial risk refers to the additional variability in return caused by the debt contained in the financial structure. Financial risk is measured by using such ratios as Debt/Asset ratio or the Debt/Equity ratio. The financial gearing is the extent to which the capital structure of a company is financed by debt. Obviously, high ratios make the company more vulnerable to the pressure of debtors or to unfavorable conditions on the market.

In Coach's case, aside from the high-energy costs, which will probably plague many industries, there is no apparent need for concern. Its capital structure is financed mainly by equity, the Debt/Asset ratio only reaching 23.30%. What is indeed remarkable is that the Debt/Asset ratio was almost double 5 years ago. The company's management succeeded at slowly decreasing Coach's financial risk, with an average decrease of the Debt/Asset ratio of 5 percentage points per year.

With regard to the Debt/Equity ratio, it has recorded incredibly low values. The current figure is 0.02, while the record was set last year -- only 0.01. The values have been generally low during previous years. 2002 was not such a great year, with a Debt/Equity ratio of 0.15, 7 and 1/2 times higher than the current one.

Overall, one could conclude that the business risk in Coach's case is quite low, especially considering the stable results recorded during the previous years, while the financial risk is truly insignificant.

E.Application of CAPM and Analysis

The CAPM formula is as follows:

Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium). The Expected Market Risk Premium may be calculated by deducting the Riskless Return (or Risk Free Rate) from the Expected Market Return).

Beta measures a stock's volatility in relation to the market. The market is defined as having a beta of 1.0, while individual stocks are ranked in accordance to how much they deviate from the market. Stocks with deviations higher than that of the market have a beta above 1. The MSN Moneycentral evaluation of the beta in Coach's case, available on the Internet, is 1.3, which indicates that Coach had evolutions that exceeded by 30% those of the market (either price increases or decreases). High-beta stocks, like Coach are, in theory, riskier than others or the market portfolio, but provide a potential for higher returns.

However, beta has plenty of shortcomings. The most important one is that it is actually a statistical measure of past evolutions of a certain stock in relation to the market. It does not incorporate new information and is based solely on the assumption that the volatility of the stock (which it measures) will remain more or less the same in the future. Past price movement are relatively poor predictors of future evolutions, so the use of the CAPM model is not very safe.

The Riskless Return or the Risk Free Rate is the rate at which an investment is placed with a minimal possible risk. The value often used is the interest rate of the Treasury Bills, since these financial instruments are (at least in theory) riskless. The current value is 3.75%.

The Expected Market Return is probably the most difficult to predict, since it involves complex analysis of the evolution of an entire economy. The S& P. 500 index is a relevant indicator thereof, since it is representative for all industries. The 2005 estimation for the aforementioned index varies depending on the analyst. For the purpose of this paper, I have used the value provided by MSN Moneycentral, available on the Internet, of 7.55%. (More optimistic evaluations have been made, but recent energy-related events should prompt a more cautious analysis) Please note that this estimation may vary, as the impact of current events on the market increases in significance.

Riskless Return = 3.75

Beta = 1.3

Expected Market Return = 7.55

Expected Market Risk Premium = Expected Market Return - Riskless Return

Expected Market Risk Premium = 7.55 -- 3.75

Expected Market Risk Premium = 3.8

Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium).

Expected Security Return = 3.75 + 1.3 * 3.8

Expected Security Return = 8.69

The Expected Security Return value of 8.69% means that an investment of 100 monetary units in COH stocks will have a return of 8.69% (under the aforementioned conditions), more than a percentage point above the market average.

F.Estimating the Value of the Company and Analysis

• EPS

The Earnings per Share indicator is important to any investor, since it indicates the profit obtained per each share. In broad sense, the difference between revenues and costs, i.e. The total earnings available for common stock is divided by the number of shares. (Dividing it by the book value per share is calculating the return on equity). COH stock exhibits very good figures: 47.10%, up to this date, with a record of 72.2% last year. The three-year average amounts to 62.10%, which is impressive, especially considering the stability of the values.

• P/E

The Price/Earnings ratio is currently at 32.39. The figure is quite high, considering the fact that several analysts estimate a forward P/E ratio of 22-24 (Yahoo! Finance, Morningstar). The S& P. 500 P/E ratio is almost half that value, which makes Coach shares quite expensive for the moment. However, since revenues have grown very rapidly during the previous years, a similar phenomenon is possible for the following year as well.

• Sustainable Growth Rate

The majority of stocks in the jewelry/accessories industry have experienced a period of fast growing revenue and earnings over the last few years. Coach had excellent results in relation to growth, as its revenues have grown quite rapidly over the past three years. Other companies in the industry have recorded similar results during the last three years and Coach is no exception to the rule. COH stock doesn't pay a dividend, a thing quite common for the companies in its industry. One objective would be to opt to buy back stock rather than pay dividends, since it might be more tax efficient for shareholders.

As for the Sustainable Growth Rate, it measures how much a firm can grow without borrowing additional money. Exceeding this rate automatically conducts to the need to borrow funds from another source to facilitate further growth. The formula is: SGR = ROE x (1 -- dividend payout ratio). As previously mentioned, Coach does not distribute dividends (it has not done that for several years), so it uses its entire profit for growth. Consequently, the Sustainable Growth Ratio is equal to the ROE, i.e. 42.85% in 2005.

• PEG

The Price/Earnings to Growth (PEG) provides a more long-term perspective than the P/E ratio. The PEG ratio is calculated by dividing a company's P/E ratio by its projected long-term growth rate.

PEG = P/E ratio / long-term growth rate

PEG = 32.39 / 42.85 = 0.7675

It is difficult to predict the future evolution of the PEG ratio. If the P/E ratio decreases and the Sustainable Growth Rate remains more or less unchanged (similar ROE and a zero dividend payout ratio are the prerequisites), the PEG ratio should decrease. However, some analysts (e.g. Yahoo! Finance) predict a PEG ratio of 1.11 in 5 years time.

• Investment Decisions

1.Comparing the estimated value to the current market price

The current market price is around $32 per share, due to the fact that Coach has opened new stores and that the industry Coach is a part of grows at a rate of about 20% a year, because of several factors (reduced costs and larger sales bases, for instance). The company has invested a lot, in terms of both time and money, in its international operations. Consequently, international sales are expected to contribute significantly. However, the majority of profits will still be made up of U.S. based operations (stores, web or catalog-based orders).

The price has increased over the last few months, and chances are that the growth will continue for a short while. Therefore, estimating that the real value of the stock is at around $35-$37 is not exaggerated. Obviously, Coach has to continue to expand on both levels: in the U.S. And aboard. The management seems committed to that objective, but failing to accomplish the expansion plans might affect the estimated value of the shares and trigger a decline in stock prices.

2.Comparing the expected rate of return to the required rate

Coach stock had a return of about 10.8% over the last year and chances are that the rate of return in the future stays more or less constant. The required rate of return, calculated earlier based on the CAPM theory amounted to only 8.69%, which makes the stock attractive by reference to its past evolution. However, the value of 8.69% calculated for the rate of return was based on the premise that the market (the S& P. 500 index) will grow by only 7.55% this year. More optimistic estimates (a growth of the S& P. 500 index by 10.5%, caeteris paribus) point out that COH stock might have a required rate of return of: 12.525

Expected Market Risk Premium = Expected Market Return - Riskless Return = 10.5 -- 3.75 = 6.75

Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium) = 3.75 + 1.3 * 6.75 = 12.525

Under these conditions, COH stock might be considered too risky, due to the fact that its volatility (the beta coefficient) is rather high. Consequently, the difference between the expected rate of return and the required rate depends largely on the general evolution of the U.S. economy, which is difficult to predict.

G.Additional Measures of Relative Value and Analysis

• P/BV

The Price / Book Value ratio is a method for finding low price stocks neglected by the market. If a company has a book value less than 1, the conclusion is that either the market evaluates the asset value as overstated, or the company has very poor return on its assets.

P/BV provides valuable information for investors looking for growth at a reasonable price. Significant differences between P/B and ROE, which is a key growth indicator, are sometimes interpreted as bad signals. Combinations of low ROE and high P/BV ratios indicate overvalued growth stocks. Therefore, a growing ROE should be accompanied by a P/BV ratio doing the same.