The Real Reason Why Coach Has Been Struggling

COH: Coach logo
COH
Coach

In 2012, the shares of luxury retailer Coach (NYSE:COH) peaked at nearly $80. In the intervening period, the stock has declined by more than 50%, reflecting the company’s poor financial performance. Last quarter, Coach’s revenues declined by 18% with comparable store sales down by 21%, representing the fourth consecutive quarter of decline in its same store sales. Worse, the company, expecting poor prospects ahead, guided for a decline in same store sales in “high-teens”. Many analyses have been put forward to explain Coach’s poor performance during this period, ranging from its fading brand value in the face of competition from Kate Spade and Michael Kors to an incoherent brand strategy which involved propping up the brand through its retail stores and depreciating it through the factory channel. However, a closer look at the company’s financials gives us a glimpse of the truth behind the decline.

Read our complete analysis for Coach, Inc

Lack of Reinvestment

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From 2008 to 2013, Coach increased its annual revenues from $3.2 billion to $5.1 billion backed by 40% expansion in its store count and a 15% aggregate increase in same store sales. Additionally, the company managed to maintain an average EBITDA margin of close to 40% for that period. These seem like indicators of a highly profitable business, so how did these problems arise then? To answer that, we need to take a closer look at what the management was doing with its cash profits. Compared to $6.1 billion in cash profits generated during that period, Coach’s capital expenditures were only $893 million, implying a reinvestment rate of about 14%. For every 1 dollar in cash profits made by the company, only 14 cents were reinvested into the business; the rest was used for buying back stock, thereby inflating the stock price at high multiples of its earnings, sales and cash flow.

Capital expenditure as a percentage of revenue for the period was about 4%. Now a 4% reinvestment of revenue generated from sales seems like a really low ratio required to maintain a high-end business where significant expenditures must be made to even keep up the appeal of its stores with high square footage, let alone a ratio high enough to finance a rapid increase in store count. Of course, Coach did not need much capital expenditure to finance its store openings as they were all financed through operating leases, and this is where the problems become clearer.

Fixed Cash Costs

A premium brand like Coach usually places its stores in the in-line section of a mall where the costs of occupancy become fixed cash costs. The problem with running your business with high fixed costs is that when sales go down there is no room for maneuvering. The only way a company can scale back its losses in case of such an event is through store closures. This is exactly what Coach did when it announced last month that it was closing as many as 70 North American stores, which amount to 13% of its North America store count and 7% of its global store count [1]

This strategy created another problem: it is highly difficult to run a business with nearly 40% EBITDA margins in a highly competitive luxury market without significant and continuous reinvestment in product design, marketing strategies and merchandizing. But operating leases, which are fixed cash charges for the ongoing business, reduce the amount available for reinvestment in the business, especially when such high margins contribute to the appeal of your stock price. The high margins boasted by Coach were deceptive as they were hiding the significant fixed costs the business was incurring to maintain them.

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Notes:
  1. Coach to close 70 stores in North America as sales fall, Reuters, June 2014 []