Is Coach a Falling Knife?

Source: Coach

Coach (NYSE: COH  ) , a leading distributor of luxury handbags and accessories, has seen its share price fall by more than 30% in the past 52 weeks. Currently trading at 6.5 times its trailing-twelve-month EV/EBITDA and 12.0 times its trailing-twelve-month P/E, Coach looks like a bargain for value investors. However, investors risk catching a falling knife with Coach, as recent events cast doubts over Coach's brand strength and strategy.

It's also possible to compare Coach with Hershey (NYSE: HSY  ) and Vera Bradley (NASDAQ: VRA  ) to gain a better understanding of its competitive advantages (or lack of them).

Brand power
Almost every consumer company will say it has strong brands, if asked. The difference between strong and weak brands lies in market share stability and pricing power. Coach has recently disappointed on both counts.

According to Euromonitor research, Coach's share of the domestic handbag market has declined from 19% in 2011 to 17.5% in 2012. In the third quarter of fiscal 2014, Coach experienced a 21% decline in comparable-store sales, which represented the fourth consecutive quarter of negative same-store sales growth. This is a strong indication that Coach has lost further market share since 2012. It suggests that Coach's branding power isn't as strong as perceived, as competitors were able to 'steal' its loyal customers.

With respect to pricing power, the indicators are negative as well, with Coach's gross margin on a gradual decline. Coach's five-year average 2009-2013 gross margin of 72.7% falls significantly below its 2004-2008 margin of 76.4%. Furthermore, Coach announced this month that it will offer discounts on its handbags at its full-price U.S. stores. This represents a departure from its prior policy and will likely dilute its brand in the minds of consumers.

It's worth comparing Coach with Hershey, which sells another woman's favorite -- chocolate. Hershey's brand power is far superior to that of Coach, as its track record shows.

In terms of customer retention, Hershey has increased its top line in every single year of the past decade, and boasts a decent 10-year revenue compound annual growth rate of 5.5%. Its loyal customers have continued to consume chocolate, even in the depths of the 2008-2009 global financial crisis.

Hershey also has a majority share (44.5% in 2013) of the U.S. chocolate market, with 1.5 times and seven times the market shares of the second-largest and third-largest players, respectively. Its revenue resilience and superiority in market share offer the strongest evidence of Hershey's ability to keep customers coming back.

Hershey also boasts significant pricing power. It has expanded its gross margin by 1,290 basis points to 45.9% since 2007, while raising product prices in 2002, 2008, and 2011. Moreover, private label's 3.2% share of the domestic confectionery market suggests that pricing hasn't played a significant part in consumers' purchasing decisions for chocolate.

Using Hershey as an example, the analysis suggests that there are other consumer companies with better brands in the market, apart from Coach.

Source: Coach

Brand extension
In the face of falling handbag sales, Coach has attempted to broaden its appeal by diversifying its product portfolio. Footwear, men's accessories, women's apparel, sunglasses, and watches are among some of Coach's new additions. While Coach can derive limited cost synergies in some of these categories due to its sourcing capabilities in leather, it has limited revenue synergies.

As Coach is traditionally known for its handbag and accessories brand, diversifying beyond its core products might confuse and even alienate its loyal supporters. More importantly, most of these products such as footwear and women's apparel carry significantly higher fashion risk, compared with accessories which are largely complementary in nature.

Coach could take some advice from its handbag & accessories peer Vera Bradley. Vera Bradley delivered a disappointing set of results for fiscal 2014 with flat revenue growth and a 14.6% drop in earnings. Vera Bradley's brand extension efforts contributed to this. In recent years, Vera Bradley has extended its brand to products such as office stationery, infant wear, and glasses. As a result, its brand became diluted and its positioning as a luxury handbag & accessories company suffered.

In response, Vera Bradley has embarked on a SKU rationalization exercise in the second quarter of fiscal 2014. The initial results have been impressive, with the summer SKU count down by 30% this year. Looking ahead, Vera Bradley is targeting a 35% reduction in SKUs for 2015. In my opinion, Coach is committing some of the mistakes that Vera Bradley made earlier, by stretching its brand too thinly.

Foolish final thoughts
There are very few companies with sustainable competitive advantages in retail, particularly in luxury fashion where consumer preferences are constantly evolving. Coach doesn't seem to be the exception. Coach's brand hasn't deterred competitors successfully in recent times and the brand looks likely to be diluted in the future with brand extension efforts. Notwithstanding its low valuation, I will advise investors to avoid Coach.  

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