This article was originally published for RealMoney on January 30, 2008.
Despite the rally over the last couple of days, Jim Cramer says retail is not the right play here. We are probably early in the consumer slowdown, so expecting an immediate snap back seems wishful thinking.
On the other hand, there do seem to be some compelling valuations out there. The trick is in deciding where to call the bottom, or in finding stocks where expectations have sunk so low that they may already be discounting the worst case scenario.
With that in mind, I decided to look in the bargain sale rack for retailers that have seen their estimates slashed, but that offer good valuations in terms of earnings and cash flow. One that quickly caught my eye is Coach (COH).
Despite a solid track record of beating estimates in recent quarters, analysts have been aggressively trimming estimates over the last month. The company has far too much North American exposure for most people’s comfort, though a flagship store opening later this year in Hong Kong should accelerate penetration to the Chinese market, which the company expects can quickly become its third major region.
Consensus expectations for the year ending in June have fallen from $2.07 to $2.04, while the June 2009 expectations have fallen from $2.46 to $2.35. As a result, Coach’s Zacks rank (a measure of momentum in earnings revisions) fell two notches to 5 last week. This is the lowest possible score, signifying that Coach’s earnings momentum is among the worst 5% of all companies tracked.
Sometimes, though, being among the worst means things can only get better. The company reiterated its prior guidance of $2.06 for this year, and investors have rewarded it with a 25% rally this week. Nonetheless, the shares are still down 45% from the 52-week high.
Last year Coach discontinued promotional corporate sales, and that announcement marked the high point for the stock. In hindsight, investors were right to sell. But I still think the move was a sign of strength.
For the six months ended December 29, 2007, net sales were $1.7 billion, up 24% from the $1.3 billion reported in the first six months of fiscal 2007. When higher margin sales to consumers are growing more than 20% annually, why should the company discount its products and dilute its brand? The answer is that it shouldn’t - and management made a tough decision to reduce earnings in the short term to protect the brand.
As to valuation, the rally hasn’t taken Coach even close to overvalued territory. At 16.3x trailing earnings and 12.2x FY09 estimates, the P/E multiple easily seems justified for a company expected to average 18% annual growth over the next five years.
Coach has $900 million in cash and virtually no debt, so even the toughest recession should be survivable. With an enterprise value of just under $10 billion and $679 million in free cash flow (cash from operations less capital expenditures) over the last 12 months, its free cash flow yield of 6.8% offers a 400 basis-point premium over the current 5-year Treasury. That would almost justify buying the shares even if no growth were expected.
The company has also been putting its cash flow to good use. During the second fiscal quarter, it repurchased and retired 20,480,927 shares of its common stock (more than 5% of the total shares outstanding) at an average cost of $34.51, spending a total of $707 million. At the end of the period, $661 million was available under the company’s current repurchase authorization, which was put into place in early November.
With the shares now more of a bargain than they were then, I’d expect that authorization to be used up quickly. And when I look under the covers, I come away thinking management knows what they are doing by buying back the shares now.
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