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Factoring Return on Equity on Valuing Coach

May 2nd, 2016

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Image credit:Sorbis / Shutterstock.com

On the third Monday of each month, Ill comment on the performance of the premium portfolios and provide some additional analysis related to individual stocks. In this article, I will also present and explain my valuation model for Coach (Ticker: COH), the iconic American handbag company.

As an aside, please note that the premium portfolios have been updated. Please check your email for some of my thoughts on the update.

Premium Portfolio News

The performance of MoneyGeek's premium portfolios for the month of February 2016 were as follows:

Mar 2016

Last 12 Months

Since Apr 2013

Moderately Aggressive

+7.3%

+3.1%

+32.5%

Very Aggressive

+11.9%

-5.2%

+8.6%

Extremely Aggressive

+16.8%

-14.1%

-15.9%

Because the premium portfolios consist of U.S. and Canadian stocks, it makes sense to compare the results against the S&P 500 and the TSX Composite, which are the most widely used U.S. and Canadian stock market benchmarks, respectively. In March, a hypothetical portfolio of 50/50 Canadian and U.S. stocks would have returned +3.9%, so premium portfolios outperformed the market during the month.

The premium portfolios owed much of their good performances to oil stocks. During the month, BTE and MEG went up by 66% and 54% respectively, mostly thanks to rising oil prices. BTE had further good news to share, as that company came to an agreement with their lenders to relax their debt covenants further. The agreement substantially reduces the amount of debt thats subject to the covenants, which virtually eliminates the possibility of bankruptcy.

Oil stocks were not the only ones enjoying a good month. IBM share prices rose by 15.6% in March, although there wasnt any obvious reason why. IBM continued to use the vast amounts of cash it generates every month in order to buy companies that fit their growth strategy. Perhaps investors like those acquisitions.

Elsewhere, SWC had another good month, gaining 27% in March. SWCs rise didnt have anything to do with platinum and palladium prices, which didnt move much in March. Rather, investors have begun to feel much more optimistic about mining stocks in general, and SWC got the benefit of the optimism.

Not all premium portfolio stocks enjoyed a good month. BXE and TOT went down during the month by 15% and 9% respectively, mainly because natural gas prices, particularly in Alberta, continued to slide down due to oversupply. However, I dont expect natural gas prices to stay down for long.

Drilling activity has plunged to historically low levels both here in Canada and in the U.S. As a result, the U.S. Energy Information Administration (EIA) forecasts natural gas production to go down quite sharply in the coming months. On the other hand, demand for natural gas continues to go up because of increasing Liquefied Natural Gas (LNG), power generation and industrial uses. Its only a matter of time before natural gas prices start to respond the same way oil prices are responding now.

Other than the three stocks I mentioned above, all of the other premium portfolio stocks had returns in the +3% to +9% range. As of the time of this writing, the composition of my TFSA portfolio looks as follows.

BTE & BTE.TO: 33%

MEG: 26%

BXE: 14%

IBM: 16%

COH: 11%

Note that I didnt make any trades in my TFSA portfolio in the past month. The changes in the allocation from the previous month are purely due to stock price changes.

Ive been using the premium only articles to present my valuation model for each and every premium portfolio stock. Last month, I presented my model for IBM. This week, I will present my model for Coach, Inc.

Coachs Business Strength

As you probably know, Coach is a luxury retailer whose headquarters are based in New York. Theyre most famous for their handbags, though theyve made a concerted effort to branch out of that in recent years.

I was mainly attracted to Coach for two reasons. One, Coach has a stellar business record. Two, Coach stock appears cheap.

Let me first talk about Coachs business record. For me, two financial ratios in particular stand out.

The first is the net margin. This is the ratio of net income to revenue. In other words, its the number of cents we shareholders earn for each dollar of sales Coach makes. From the mid 2000s until 2013, Coach had an average net margin of 20%, which is about triple the stock market wide average of roughly 7%.

The second financial ratio that attracted me is return on equity. This measures the number of cents the company earned for each dollar that belongs to shareholders, called book value. From the mid 2000s until 2013, Coachs return on equity hovered between 40 and 50%, which is about four times the stock market average of 11%.

Now, the flaw in using either of these ratios is it assumes the companys net income is reliable. Because of accounting quirks, a companys reported net income often doesnt accurately reflect the amount of value the company created for its shareholders. However, in Coachs case, the companys net income does a pretty good job of reflecting this value.

Valuation Model

Given the high quality of the companys business, one would expect Coachs stock to be expensive. However, thats not the case. The link below shows Coachs valuation.

Valuation Model for Coach

As usual, Coachs value is divided into two parts - the companys liquidation value, and its earnings potential.

I estimate that Coachs liquidation value is about $879 million. In other words, if Coach were to sell all its assets today and distribute the proceeds to its shareholders, it would be able to distribute $879 million.

I also estimate that Coach will generate roughly $610 million in earnings in 2016. Note that as per usual, for the purposes of the model, I use a different definition of the word earnings from how its usually used. In my model, earnings refers to the change in liquidation value of Coach.

Next, Ive assumed that Coach will grow its earnings by 7% per year for many years. Then, using a discount rate of 10% per year, Ive arrived at the valuation of $71.74/share for the luxury retailer. For those of you who are not familiar with what a discount rate is, Ive explained the concept in previous articles such as this one.

In terms of valuing Coach, estimating the companys liquidation value and its earnings potential for next year are relatively straightforward. Furthermore, Coachs valuation wont change drastically even if Im off on those numbers by 10%.

As is often the case with other companies, the real difficulty of valuing Coach comes down to estimating its earnings growth. If you change the 7% growth assumption by even just 1%, the value of Coach changes rather dramatically. Therefore, the question is whether Im being too optimistic about Coachs growth prospects. To answer this question, let me first start with Coachs recent history.

Coachs Turnaround

Since earning about a billion dollars in 2013, Coachs net income fell off a cliff, falling to $450 million in 2015. Heres what happened:

By the 2000s, Coach had established itself as a popular luxury brand. But when the company tried to grow further, it faced a familiar problem in the luxury industry. Being a luxury company meant that they had to price their goods highly, so that the vast majority of people couldnt afford them easily. At the same time, the company had to reach more customers if they were to grow.

Since the company couldnt find many more affluent customers to sell to, they had to lower their prices in order to attract more customers. However, doing so would cheapen their brand so it would cease to be luxury.

Coach attempted to solve this problem by using factory outlets. The company placed these outlets outside of the high end retail districts where normal Coach retail stores are found, and packed the outlets with older Coach products, selling them at huge discounts. By only selling older handbags, the company hoped to avoid cheapening their brand.

For the first few years, this strategy appeared to be working. Coach sales went through the roof from mid 2000s until the early 2010s, mostly driven by increased sales from outlet stores. Unfortunately, the outlet strategy couldnt prevent their brand from cheapening.

In luxury, ubiquitous popularity is considered the kiss of death. As Coach handbags became ever more popular, they lost their status as luxury items, and sales began to dip. To make matters worse, lower prices on handbags sold meant that Coach had to cut costs in order to maintain the same profit margins. Cutting costs led to the deterioration in the quality of its handbags.

Recognizing this problem, Coachs management set out to change direction. The company hired a new creative director, eliminated most of its sales events, and significantly increased the price of its new products. In addition, the company invested heavily into crafting new products, renovated its stores, and put money into marketing.

While these changes are arguably good for the company in the long run, they predictably had terrible results in the short run as they were the reverse of the outlet strategy. Instead of making their products affordable to more customers, they made them affordable to fewer. Instead of cutting costs, they increased them.

In light of these changes, whats incredible is not that Coachs margins shrunk - its that Coachs net margin still remained close to 10%, still above the stock market wide average. This speaks to the brands resilience. Fashion may be fickle, but fashion brands endure.

After two years of declining earnings, analysts - as well as Coachs management - expect earnings to start rising again, as the pain and effort that the company put in is finally starting to pay off. Now the question is, for how long and how quickly will the company grow?

Relation Between Return on Equity and Growth

In theory, a companys earnings growth rate is equal to its long term return on equity. Let me show you using an example.

Lets say that shareholders contributed $100 million to start company XYZ, so the book value of XYZ starts at $100 million. If XYZ achieves a return on equity of 7% in its first year, that means XYZ earned $7 million (i.e. 100 x 0.07). After the first year then, the book value rises to $107 million. If XYZ achieves a return on equity of 7% in its second year, that means XYZ earned $7.49 million (i.e. 107 x 1.07). The growth of XYZs earnings from $7 million in first year to $7.49 million in its second year is 7%.

Although this works in theory, it doesnt work in reality for two reasons.

One, dividends mess up the calculation because they reduce the companys book value. For example, if XYZ paid $7 million in dividends after its first year, the book value would have gone back down to $100 million, and achieving the 7% return on equity would have earned XYZ $7 million in its second year. In other words, XYZs earnings would not have grown.

Two, the return on equity fluctuates from year to year. For example, if the return on equity goes down to 5% for XYZ in its second year, earnings would have gone down to $5.35 million. In this instance, XYZs earnings would have gone down, despite registering a positive return on equity.

Despite these two limitations, return on equity is still a great yardstick to use in order to estimate a companys growth.

The upside of the company paying us dividends is that we can use those dividends to buy more stocks. We should figure this potential gain in our calculations.

Also, the fluctuations in the companys return on equity smooths out over the long term, so we can use long term returns on equity to estimate the companys growth rate. For example, if we believe XYZs return on equity will fluctuate between 5 and 7% per year, we can assume a long term return on equity of 6%, and doing so will roughly track the companys earnings growth over the long run.

With this in mind, lets tackle the issue of trying to estimate Coachs long term earnings growth. Earlier in this article, I mentioned that Coachs return on equity was incredibly high, hovering between 40 and 50% for a decade until 2013. Even during the difficult years of 2014 and 2015, Coachs return on equity never dipped below 20%. Even when you account for dividends, its hard to make the case that Coachs earnings growth will register less than 10%.

There are also business reasons to think that Coachs growth will continue. Coach is positioning itself as a lifestyle company, which means that theyre aiming to sell clothes and other accessories, and not just handbags. Theyre sticking to selling to affluent customers - theyre just trying to sell more stuff to them. Such a strategy should avoid the cheapening of their brand.

Furthermore, Coachs international growth has always remained strong, and theres a lot of room to grow, especially in Europe. The company is also trying to grow its mens business. There are signs that all of these efforts are starting to bear fruit, and it will be a long time before they run out of room to grow.

In the spreadsheet valuation model, I assumed that Coachs earnings would grow by 7% per year. Although this is a higher growth rate than most other companies Ive modelled so far, I hope you can appreciate why I assumed such a number. If Coach does deliver 7% or higher growth, the stocks price will appreciate much higher in the coming years.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.