Coach Offers High-End Outlook

The company's second-quarter earnings top Wall Street's estimates, with strength in Japan.
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Updated from 9:13 a.m. EST

Stellar results from

Coach

(COH)

in its holiday quarter show that the luxury handbag retailer continues to be one of specialty retail's biggest winners.

The company says its fiscal second-quarter earnings jumped 37% to $174.2 million, or 45 cents a share, from $126.9 million, or 32 cents a share, a year earlier. Before option expenses, Coach earned 47 cents a share in the December quarter, up from 34 cents a share in the year-earlier period. Analysts were expecting earnings of 44 cents a share on that basis, according to Thomson First Call.

For fiscal 2006, the company maintained its guidance for sales of about $2.1 billion, an increase of 23% from the prior year. But Coach boosted its earnings outlook, forecasting a profit, before option costs, of at least $1.33 a share. Including about 10 cents of option costs, Coach says it should earn at least $1.23 a share.

Wall Street is calling for earnings of $1.20 a share and revenue of $2.1 billion. The company's prior guidance, given in October, called for full-year earnings of $1.28 a share, before options, and net earnings of at least $1.18.

"Our profitability improvement highlights our ability to achieve further gross margin expansion and to leverage our expenses as our sales base increases," Coach's chairman and chief executive, Lew Frankfort, said on a conference call with analysts.

The retailer's second-quarter net sales jumped 22% to $650.3 million from $531.8 million a year earlier, on a same-store sales gain of 19.9%. Gross margin expanded to 77.6% from 75.8%, which the company attributed to sourcing-cost benefits and product-mix shifts.

"As far as fundamentals go, they're really hitting on all cylinders," says Pacific Growth Equities analyst Christine Chen. "All aspects of their business are strong. The stores look great, the merchandise looks great, and they're gaining market share in the U.S. as well as in Japan, where there is an even bigger opportunity for them." Chen doesn't own shares of Coach, and her firm has no banking relationship with the company.

Coach shares recently were up $2.21, or 6.9%, to $34.28. Chen says the large pop was partly a response to the retailer's solid results in Japan, where it has pinned a portion of its future growth plans. Japan is known for its thriving luxury market, where women shoppers have a particular affinity for handbags, and the Japanese economy has shown signs of resurging from its funk. Still, a recent drop in the Japanese stock market put investors on edge, and the market remains a wild card for many retail investors on Wall Street.

Coach says its same-store sales in Japan rose in the high single-digits, beating expectations for a mid-single-digit gain. Total sales in the nation rose 20% on a constant-currency basis, but only 7% in dollar terms, due to weakness in the yen. Coach recently opened two new stores there, and it has expanded its existing locations.

Coach's direct-to-consumer sales, which now include operations in Japan, increased 21% to $504 million from $416 million a year ago.

Shares of Coach have gained steadily since 2000, when the company went public. Its branding method has changed the way women buy handbags, and its "affordable luxury" products and pricing mix has successfully enlarged the market. Shares of Coach are now trading close to 24 times earnings estimates through 2006.

"That's certainly not cheap, but it's not out of line with the company's growth rate," says Chen, who has a buy rating on the shares. "The biggest threat to the stock's valuation is obviously that they have a fashion miss and allow competitors to grab back share. But this company has an incredible eye on what's going on in the market as far as trends, and there's a lot of brand loyalty when it comes to handbags."

Morningstar analyst Kim Picciola says there are some concerns that the Coach brand could lose some cachet as its products become more mainstream and its profit margins continue to benefit from sourcing cheaper materials.

"At some point, the brand could lose its luster, but there are no signs of that happening yet," Picciola says.

Another threat to Coach's valuation comes from the headwinds that could face U.S. consumers in 2006 as interest rates and oil prices continue to rise and the housing market shows signs of weakening.

"Coach looks somewhat insulated from the problems facing consumers because it is still a luxury good and consumer spending at the high-end is thriving," Chen says.