Tapestry, Inc.
Q4 2006 Earnings Call Transcript

Published: 1 Aug 2006

[Operator:]

Good day. Welcome to the Coach call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Vice President of Investor Relations at Coach, Ms. Andrea Shaw Resnick. You may begin.

[Andrea Shaw Resnick:]

Thank you, Brenda. Good morning and thank you for joining us. With me today to discuss our quarterly and annual results are Lew Frankfort, Coach's Chairman and CEO; and Mike Devine, Coach's CFO. Before we begin we must point out this conference call will involve certain forward-looking statements, including projections for our business in the current or future quarters or fiscal years. These statements are based upon a number of continuing assumptions. Future results may differ materially from our current expectations based upon risks and uncertainties, such as expected economic trends or our ability to anticipate consumer preferences or control costs. Please refer to our latest report on Form 10-K for a complete list of these risk factors. Also please note that historical growth trends may not be indicative of future growth. We presently expect to update our estimates each quarter only. However, failure to update this information should not be taken as Coach's acceptance of these estimates on a continuing basis. Coach may also choose to discontinue presenting future estimates at any time. Now let me outline the order of speakers and topics for this conference call. Lew Frankfort will begin with an overall summary of our fourth quarter and fiscal 2006 results, as well as our plans for the new fiscal year. Mike Devine will then follow with details on financial and operational highlights for the quarter and year as well as our outlook for the first quarter and full fiscal year 2007. Following Mike, we'll hold a Q&A session that will conclude by 9

[Lew Frankfort:]

Thanks, Andrea and welcome everyone. As we announce our fourth quarter results and the end of our fiscal year, we are very pleased with our performance and even more enthusiastic about the opportunities that lie ahead. We're confident that FY07 will be another excellent year for Coach with sales rising to at least $2.5 billion, or at least 19% ahead of last year. Historically, we have used the term accessible luxury to describe our marketplace position as a lane between the old world luxury brands and the more moderate segments. Today Coach is credited as the primary catalyst in changing the way in which American women perceive accessories. In fact, our average target consumer now buys four handbags a year, up from just two the beginning of this decade. This has resulted in more than a doubling in the size of the category during the last five years. While our business in North America has tripled in the same period, our U.S. market share has only grown from 16% to about 25%. Our strong fiscal 2006 performance speaks to our philosophy of operating Coach as a small business for large sales. FY06 was highlighted by a 23% increase in revenues and a 38% increase in net income. It was a year of many accomplishments, including

[Mike Devine:]

Thank you, Lew. Lew has just taken you through the highlights and strategies. Let me now take you through some of the important financial details of our fourth quarter and year end results. As mentioned, our quarterly revenues increased 23% with sales for both our direct and indirect channels matching this gain. For the full year, total revenues also rose 23% as did sales generated by our direct channel while our indirect revenues rose 24%. Excluding the negative impact of the weaker yen, total sales rose 25% for the quarter and 26% for the year. Net income for the quarter increased 31% to $118 million, or $0.31 per share as compared to $90 million or $0.23 per share in the year ago period. This was ahead of the analyst consensus estimate of $0.29 for the quarter. Net income rose to $494 million in FY06, up 38% from the $359 million earned in the prior year. Diluted earnings per share rose 38% to $1.27 versus $0.92 a year ago and ahead of analyst consensus estimates of $1.25. Our operating income rose 41% to $180 million in the fourth quarter versus $128 million in the same period last year. Operating margin in the quarter was 35% compared to 30.6% in the year ago quarter, a 440 basis point improvement. For the fiscal year, operating income rose to $765 million from the $573 million posted in the prior year, a 34% increase. Operating margin for the year rose to 36.2%, from 33.5% a year ago, up 270 basis points. In the fourth quarter, gross margin increased by 80 basis points on a year-over-year basis from 77.6% to 78.4%, bringing the full year to 77.6%, a 100 basis point increase. For the year, as in the quarter, gains from product mix and supply chain initiatives drove this improvement. As we expected, SG&A expenses as a percentage of net sales was substantially below prior year levels in the fourth quarter and represented 43.3% of sales versus 47% a year ago. For the full year, SG&A expenses as a percentage of net sales declined 180 basis points to 41.4% from 43.2% a year ago. All selling businesses saw their year-over-year spending rates decline as we also continued to leverage the top line volume throughout all of our centralized functions. Inventory levels at year end were $233 million, up about $49 million from $184 million last year and were about 27% above those prior year levels. Consistent with our top line constant currency sales growth, as our supply chain improvements and inventory management programs allowed us to support 29 net new U.S. stores, 16 net new locations in Japan, and substantially increased sales levels with only this moderate additional inventory investment. Cash and short-term investments stood at $538 million, as compared with $505 million a year ago. It should be noted that the 2006 fiscal year end cash balance reflects the repurchase of over $600 million of Coach common stock during the fiscal year. Accounts receivable balances rose $19 million or 29%, while days sales outstanding remained constant at only 33 days. Net cash from operating activities in the fourth quarter was $195 million, compared to $132 million last year during Q4. Free cash flow in the fourth quarter was an inflow of $161 million, versus $101 million in the same period last year, primarily driven by higher net income. Our CapEx spending, primarily for new stores and renovations, was $34 million, versus $31 million in the fourth quarter a year ago. For all of fiscal year 2006, net cash from operating activities was $597 million compared to $476 million a year ago. Free cash flow in fiscal year '06 was an inflow of $463 million, versus $381 million in fiscal year '05; while CapEx spending totaled $134 million, again primarily for new stores and expansions. Now I would like to provide you with some of our goals for fiscal 2007. Our current goals for the full fiscal year are

[Andrea Shaw Resnick:]

Operator, let's open it up for questions. Please note that we will allow one question each per analyst and if necessary a clarifying follow-up. Thanks. Let's open it up.

[Operator:]

(Operator Instructions) Our first question comes from Bob Drbul - Lehman Brothers.

[Bob Drbul:]

Good morning. Have you seen anywhere within your business in either full price or the factory, any change in traffic trends throughout the quarter, up to where we are today? Based on the macro environment that's out there with gas prices, et cetera?

[Lew Frankfort:]

Good question. First on the full-priced side, interestingly we've seen an acceleration in same-store sales, same-store traffic during July. Traffic was running modestly ahead during the fourth quarter and it's running ahead -- somewhat higher traffic, that is. In terms of full-priced traffic, which has been running substantially ahead of last year during FY06, that trend continues through July on the factory side. So if anything, strengthening of same-store traffic on the full-priced side and same excellent traffic increases on the factory side.

[Bob Drbul:]

Okay. One clarifier for Mike. Can you give a little bit more color on the inventory levels, maybe by channel and where you are with that?

[Mike Devine:]

Sure. A few of the metrics I like to look at -- and we didn't include it in the prepared remarks -- inventory levels are especially clean coming out of Q4. Again, a metric that I like to look at is what percentage of sell-through in the factory channel was discontinued full-priced merchandise versus merchandise manufactured for factory? We actually hit a record high in Q4 on that metric of 81%. So I think that's the single most important thing that I look at to see how clean the inventories are. We are going in very well positioned, having built for our fall selling, some timing of receipts we got in earlier this year versus last. But the inventories are exceptionally clean right now.

[Bob Drbul:]

Great. Thank you.

[Operator:]

Our next question comes from Margaret Mager - Goldman Sachs.

[Margaret Mager:]

Hi, congrats on another great year.

[Lew Frankfort:]

Thank you, Margaret.

[Margaret Mager:]

I just wanted to ask about the outlook for next year, in particular your goal of achieving 10% same-store sales in both channels of distribution. Can you just talk about what gives you confidence that you can achieve that over the course of four quarters? And the fact that you've been doing very well for so long, but comparisons are not easy. Is there a price component? Traffic? What are you assuming to build into those comps in the next fiscal year? I have a question on your leveraging of your marketing expense. Can you just go over what's going on there, particularly as you talked about one of the keys that is building traffic is marketing. How do you balance the spend on marketing against that objective to build traffic? Thanks.

[Lew Frankfort:]

First, Margaret, Coach continues to be fortunate in that we're participating in a rapidly growing market. I commented that sales in premium accessories grew by at least 10% in the first half of calendar 2006. While we've been able to outpace the growth, we're nevertheless participating in a significant growth category. Second, we're benefiting from a very strong consumer franchise that's very loyal, that visits our stores very regularly. As I commented in the earlier question, where our traffic in same-store sales, same-store traffic continues to rise. More generally, on the product front, the three new lifestyle platforms are very significant. As we indicated, we have not introduced a new lifestyle platform in more than a year. This year we're introducing three. The first one, Signature Stripe, is off to a fantastic start. We're looking to see growth in comp store sales coming from all three key metrics. We're looking for traffic to continue to run ahead of last year. We're looking for conversion to come in at a higher rate, and we're also looking at an average ticket that is higher than last year, driven to some extent by UPTs, to some extent by limited edition product and so on. So we're very bullish.

[Mike Devine:]

In terms of leveraging our marketing expense, Margaret, for another year in FY06, we saw very small increases in absolute spending in our marketing and got leverage of about 20 basis points both for the quarter and the year. We really continue to execute our catalog, our website and our media spend consistent year-over-year and it's just becoming increasingly more and more efficient.

[Margaret Mager:]

Thank you.

[Lew Frankfort:]

You're welcome.

[Operator:]

Our next question comes from Jeffrey Edelman – UBS.

[Jeffrey Edelman:]

Thank you, good morning. Great job. Mike, could you discuss with us the profile of the new stores that you're opening? It looks like the average size is about 3,300 square feet. In terms of sales productivity and what kind of four-wall contribution you're realizing as you start to branch out into some smaller markets? Secondly, is there further to go in terms of sourcing efficiencies and mix to aid gross margins into the new year? Thank you.

[Lew Frankfort:]

Let me jump in just for clarification, when we talk about the store base growing by at least 100,000 feet, Jeff, that also included factory stores. It wasn't just the 30 full-priced stores, and it also included expansions. So on the full-priced side, we're still averaging somewhere between 2,300 and 2,500 square feet for a full-priced store. I think the factory side store is larger at 3,500 square feet. So the store size is not increasing. The model we have is working extremely well.

[Mike Devine:]

Jeff, as you well know our new stores are about as productive and profitable as I think any in retail, with our full-priced new store openings paying back on a cash basis in well less than two years, and our factories in under a full year. In fact, I just looked this morning in prep for the call and our sales per square foot across the full chain, full priced retail chain were up above $1,200 per square foot in FY06 for the first time ever and an even higher level than that, up above $2,000 per square foot in the factory channel for the new year. So as we continue to drive comps through the existing stores and add productive new stores to the base, we're seeing our average square footage continue to increase. So we're very pleased with our new store and their performance. If I can go back to your questions around profitability, we are confident and feel very good about our continued growth of our operating margins. As we just talked about, we saw a 440 basis point improvement this quarter alone in operating margins, with an assist from gross margin and we continue to leverage SG&A very nicely. So we are thrilled with our gross margin rates. They're extraordinary and most importantly sustainable, and we'll continue to drive operating income growth through that line and through SG&A leverage.

[Jeffrey Edelman:]

Great. Thank you.

[Lew Frankfort:]

You're welcome.

[Operator:]

Thank you. Our next question comes from Paul Lejuez - Credit Suisse.

[Paul Lejuez:]

Hi guys.

[Lew Frankfort:]

Hi Paul.

[Paul Lejuez:]

Seeing the gross margin, it seemed to come in above plan, maybe slightly. Just wondering how that happens, since factory, which dragged margin down; also the comps in the factory really came in, I would imagine, above plan. So I'm just wondering where the incremental margin came from? Is there perhaps an even greater opportunity to expand margin on the factory side than originally thought?

[Mike Devine:]

Sure, Paul, I think the primary driver is that each business unit within its own showed marked year-over-year improvement, including factory up more than 100 basis points against itself a year earlier. A couple other things work nicely in our favor, our hedge contracts were effective so the negative impact of currency in Japan came in better than our expectations and our supply chain continues to do an outstanding job as we realize some working cost benefits above our own expectations. So all those things taken together allowed us to beat our gross margin rate against our projections.

[Paul Lejuez:]

Can you tell us when your share repurchase window closed during the quarter and when it opens again, or no?

[Mike Devine:]

Closed on Friday June 15th and it will reopen this Thursday.

[Paul Lejuez:]

Thanks guys, good luck.

[Lew Frankfort:]

Thank you.

[Operator:]

Our next question comes from Lorraine Maikis - Merrill Lynch.

[Lorraine Maikis:]

Thank you. Good morning.

[Lew Frankfort:]

Good morning, Lorraine.

[Lorraine Maikis:]

Could you talk about your expectations for free cash flow in 2007 and walk us through your priorities on how to use it?

[Mike Devine:]

Sure. We expect another robust year for free cash flow. We're going to continue to drive higher net income, obviously, with the increase in our earnings per share. Our primary use for that cash will be to enable us to continue to drive the growth in the business through CapEx investments for new stores and expansions, and also technology gains where we can apply them to increase our efficiency and leverage our SG&A. As you know, we've also been aggressive buyers of our own stock at the appropriate levels as we just talked about. We did $600 million last fiscal year. So I would anticipate that that will be another primary use for our cash in FY07.

[Lorraine Maikis:]

Thanks, just a quick follow-up on Japan. You spoke about some rapid market share gains. Can you just talk about who you think you're taking the market share from?

[Lew Frankfort:]

It's a good question, Lorraine. We prefer not to mention specific competitors. There are some brands that are growing and there are some brands that are slowing. On average the market is flat and we're up 20%. We prefer not to be more specific than that.

[Lorraine Maikis:]

Okay. Thank you.

[Operator:]

Our next question comes from Christine Chen - Pacific Growth Equities.

[Christine Chen:]

Thank you. Congratulations on another great quarter.

[Lew Frankfort:]

Thank you, Christine.

[Christine Chen:]

I think in the past you had given metrics on how much average ticket or average transaction was up, and then the percentage of limited edition versus the year before. I was just wondering if I can get those numbers.

[Lew Frankfort:]

What we have done is provide directional numbers, and as I said earlier, our average ticket was up, driven by a combination of factors. In part driven by an increase in UPTs; in part by limited edition product rises; and lastly, by higher prices due to more sophisticated make.

[Mike Devine:]

What we had talked about is ticket was high single-digits and then we got up to 10.9 also being helped by conversion, modest improvements in conversion and traffic. But the biggest driver again in Q4 was our AUR, and that was driven in part by an increase year-over-year in limited edition, where we grew to about 4% of our full-priced sales, up from 3%. But also very importantly our middle tier of product offering, our novelty product offering, was up significantly by I think more than 20 points of penetration year-over-year. That also helped us to drive the high single-digit increase in AUR.

[Christine Chen:]

Great. Thank you so much.

[Operator:]

Thank you. Our next question comes from Anwan Hombula - HSBC.

[Anwan Hombula:]

Yes, good morning and congratulations. I had a question regarding the P&L, the SG&A leverage, which was strong during the year and even stronger during Q4. Is there a way of splitting it out between the out-performance of factory versus full-priced retail and also the contribution of Japan? I know you made a lot of efforts there following the integration of CGI. How much is linked to that and how much can we expect in this current year?

[Mike Devine:]

Sure, the primary drivers of the SG&A leverage in Q4 were firstly Coach Japan for the quarter had tremendous SG&A leverage driven by top line sales growth, but also the fact that we did not anniversary a significant marketing effort in last year's Q4, where we spent about $5 million on a Play for Peace concert that again did not get anniversaried. Secondly, you're right on point, the tremendous leverage that the factory channel is providing with its 29% comp, and plus 30% overall growth also drove significant SG&A leverage as well as all of our centralized activities, our distribution functions, the marketing that Margaret asked about earlier. So we really had it all come together for us nicely in Q4.

[Anwan Hombula:]

Can you just remind us of the guidance on the gross margin on the SG&A level for this year?

[Mike Devine:]

Our guidance for FY07 is to continue to expand operating margin, up somewhere in the neighborhood of about 50 basis points year-over-year, sustaining our extraordinary gross margin rates and gaining leverage through our SG&A.

[Anwan Hombula:]

Thank you.

[Lew Frankfort:]

You're welcome.

[Operator:]

Our next question comes from John Rouleau - Wachovia.

[John Rouleau:]

Wondering with the launch of three new platforms this year, will you actually be increasing the number of platforms that you're delivering year-over-year? Will you begin to scale something else back? What's happening on the SKU side in terms of the new platforms?

[Lew Frankfort:]

Excellent question. Actually, we do expect to see some modest increase in SKU count, but since we have fixed real estate, we try to make everything work extremely productively. So part of our notion, for example, this fall with the Legacy launch is to actually reduce the amount of space that we devote to men's products, especially in a select number of our flagship stores, so that we can create Legacy shops. Second, we're going to take a sharper look at the number of styles and SKUs we offer in the established platforms, in order to narrow them to make shelf space for the new collections. What we will probably do in FY08, assuming success of these established platforms, is look for ways to integrate perhaps two of the platforms into one. That is an existing one, for example, Hampton’s Weekend and Signature Stripe might very well be integrated in the following fiscal year, taking the best of both.

[John Rouleau:]

Just as a follow-up for clarification, does that mean the number of deliveries will actually, on the handbag side, increase in FY07 or will we get shorter intervals between deliveries?

[Lew Frankfort:]

Deliveries will remain constant. Basically we do 12 major floor sets a year and that will continue. We also do 12 deliveries, as you know.

[John Rouleau:]

Great. Thanks. Keep up the great work.

[Lew Frankfort:]

Thank you.

[Operator:]

Our next question comes from David Glick - Buckingham Research Group.

[David Glick:]

Good morning and another congratulations. Any change during the quarter in terms of the customer cross-shopping between the full-priced stores in the U.S. and the factory channel? Is that still hovering around 20%? Is there any delta there?

[Lew Frankfort:]

The short answer is no, we've done a lot of deep probes using a lot of different methods to look at what the crossover is, and is the rate changing? The bottom line is that it's not changing. What we're finding, as I mentioned earlier, is that two-thirds of the increase in comps is actually coming from increased conversion of the people who were visiting the stores, as well as higher ticket; with the remaining one-third coming from people who are new to our database. A good portion of those consumers are new to the Coach franchise making their entry in the factory sector -- which doesn't surprise us -- since 85% of goods sold in America are sold on sale. It's not unusual since we don't go on sale in full-priced. Some of the aspirational or value-oriented consumers would seek us out in factory.

[David Glick:]

Great. Thank you very much.

[Lew Frankfort:]

You're welcome.

[Operator:]

Our next question comes from Jim Hurley - Telsey Advisory Group.

[Jim Hurley:]

Good morning and congratulations on a great quarter and year. The first question is about the SG&A leverage and in particular, how much would you say you're getting from new in-store systems, like the client track and smart scheduling?

[Mike Devine:]

It's a great question, Jim, and I would have to say we don't disaggregate it to that level. But we are absolutely seeing a pick up in our store staff spending far less time on their administrative functions dealing back with corporate, dealing with maintenance of the store, et cetera. So we haven't broken it down. But it's clearly a significant player in what's going on in the stores. We're able to do more with less. I'm sorry, I don't have a hard number for you.

[Jim Hurley:]

That's fine. Is that only in place in the full priced retail stores?

[Mike Devine:]

No, it's in factory as well.

[Jim Hurley:]

The second question was on UPT trends and how they compared to your expectations, especially for Mother's Day?

[Lew Frankfort:]

Our UPTs as we commented some time ago was up for Mother's Day and was up for the quarter, and we've been running at a higher level of UPTs for the last six or nine months, and that trend we expect to continue during FY07. Certainly with the launch of jewelry and fragrance in the second half of FY07, that's going to augment UPTs. In addition, these three lifestyle collections have incredibly powerful components of accessories, wallets, wristlets, scarves, wearables, footwear and the like. When we look at Signature Stripe running at about 15% of our sales in our full-priced stores, about 5% of that alone is accessories. Our intention with these other two collections, as I mentioned, is to have a full range of lifestyle accessories.

[Operator:]

Our final question comes from Evran Coppleman - JP Morgan.

[Evran Coppleman:]

First question, we're looking at the difference between the 23% growth in sales in the direct to consumer business and the 18.5% comp growth, and the 5% delta versus your double-digit square footage growth. We're wondering why you're not getting more contribution from the double-digit square footage growth? Secondly, you've had such strong growth in the category of accessories over the last number of years, when will the cycle slow? What are the drivers of the growth in if category, if you can comment on that. Thank you.

[Lew Frankfort:]

Let me do the second part first. It's an interesting question, and we ask consumers all the time what they're thinking about relative to accessories. The reality is that we don't see this as a cycle -- that is, the increase in the role of accessories. This is the first time that accessories has really grown at a rate much faster than overall apparel spend. Women really see accessories as a much more important component of their wardrobing, and they're using accessories to update their wardrobe in the same way they use to purchase apparel. They tell us that and they behave that way. What consumers tell us they're looking for is innovation, relevance and value. For example, even during the holiday period, when we ask consumers what they were considering besides Coach, whether they made a purchase of Coach or not, very few people talked about other accessories, and no one talked about apparel. Candidly they talked about buying iPods and the new Nano or DVDs, days at the spa and so on. All these products have in common innovation and relevance. The other thing I'd like to say is in our FY07 projections and beyond, we're only anticipating 3% to 5% category growth. So we're not expecting the category to continue to grow robust in our conservative planning, but the reality is that it's up over 10% in the first half of this calendar year, and we expect to see double-digit growth continuing.

[Andrea Shaw Resnick:]

In terms of the difference in spread between comp gains and DTC sales, I'm sure you realize that there are several contributors to this spread between comps and DTC sales, including the timing and contribution of new store openings as you suggested, there are seasonal factors. There's the performance of non-brick and mortar channels like the Internet, and, of course, you've got to remember that CJI is now included in BTC so you've got all sorts of other items including currency fluctuations and, of course, CJI's comps that come into it.

[Evran Coppleman:]

Thank you.

[Andrea Shaw Resnick:]

That will conclude our conference call. As always, Mike and I will be available for call back throughout the day today. I look forward to speaking with you and have a great rest of the summer.

[Lew Frankfort:]

Thank you, everybody.

[Operator:]

That does conclude today's conference call. Thank you for joining.