Tapestry, Inc.
Q3 2007 Earnings Call Transcript

Published: 24 Apr 2007

[Operator:]

Good day and welcome to the Coach conference call. At this time for opening remarks and introductions I would like to turn the call over to the Vice President of Investor Relations at Coach, Ms. Andrea Shaw Resnick. You may begin.

[Andrea Shaw Resnick:]

Good morning and thank you for joining us. With me today to discuss our quarterly results are Lew Frankfort, Coach's Chairman and CEO; and Mike Devine, Coach's CFO. Before we begin, we must point out that this conference call will involve certain forward-looking statements, including projections to our business in 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. Please refer to our latest annual report on Form 10 K for a complete list of these risk factors. Also, please note that historical trends may not be indicative of future growth. We presently expect to update our estimates each quarter only. However, the 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 providing future estimates at any time. Now, let me outline the speakers and topics for this conference call. Lew Frankfort will provide an overall summary of our third fiscal quarter 2007 results and will also discuss our strategies going forward. Mike Devine will then discuss details on financial and operational highlights for the quarter as well as our outlook for the fourth quarter and full year fiscal 2007 and our preliminary goals for fiscal 2008. Following that, we will hold a question-and-answer session that will end promptly at 9

[Lew Frankfort:]

Thanks Andrea, and welcome everyone. Once again, I am pleased to be speaking with you today about another terrific quarterly performance which reflects the strength of Coach brand, the power of our new product introductions, and the sustained rapid growth of the U.S. handbag and accessories category. Clearly, the Coach proposition is very strong, generating increased levels of interest with both new and existing consumers, evidenced by both our double-digit comps at retail and the extremely high level of POS increases we are achieving in U.S. department stores this spring. Before we get into the financial highlights of the quarter, I want to briefly touch on the closure of our small corporate accounts business through which Coach sold products to distributors for corporate gift-giving and incentive programs. As noted in the press release, we have decided to cease operations of this business in order to better control where our product is ultimately sold. Simply put, our goal is to curtail diversion of our product into non-image-enhancing environments such as the warehouse retailers and the discount chains. Now, I would like to discuss the outstanding results of our continuing business. We just announced a sales increase of 30%, and a 50% increase in earnings per share for the quarter just completed on a continuing basis. It's worth noting that this was the 21st consecutive quarter that Coach achieved sales growth of at least 20%. Some highlights of our third fiscal quarter were

[Mike Devine:]

Thank you, Lew. Lew was just taking you through the highlights and strategies. Let me now take you through some of the important financial details of our third quarter results. Before we get into the details, I thought it might be worthwhile to touch on our exit from the corporate accounts business and its impact on both historical financials and our original expectations for FY07 so that you can adjust your models accordingly. Simply put, the business has represented about 3.5% of sales over the last few years and a somewhat larger percentage of our earnings on an incremental basis as we allocate no corporate design or other centralized function expenses to this business. For example, in FY06 the business generated $76 million in sales, and $0.08 in earnings per share. These figures are clearly laid out in the supplemental table included in our press release from earlier today. Had we continued to operate the business at first half '07 levels, we would have expected to generate about $90 million in sales and over $0.10 in earnings for the full year. We posted $0.06 of EPS in the first half, which is also in our supplemental table. Therefore, we were anticipating about $0.04 in the second half of the fiscal year, equally divided between the third and fourth quarters. As noted, we decided to exit the business early in the third quarter, generating sales of $8 million and EPS of under $0.01 for this stub period. It's worth noting that while we have shut this business down, we will see a run out over the next few months, albeit at a very modest level, as we do plan to fulfill a small amount of outstanding orders. As results from this business are now considered discontinued operations, all discussion of our results here and in the future will be on a continuing operations basis only. Let's get back to the results from our continuing operations. As mentioned, our quarterly revenues increased 30% with direct to consumer which represents over three-quarters of our business, up 29% and indirect of 36%. Both our POS sales and U.S. department stores and shipments to these customers increased significantly during the quarter. We also saw continued double-digit POS sales growth in international sales, led again by domestic doors as well as a rebound in shipments. Net income for the quarter increased 45% to $147 million compared to $102 million, while earnings per share rose 50% to $0.39 per share versus $0.26 per share in the year-ago period. Including discontinued operations, albeit for only the partial quarter, total earnings per share were $0.40. This was ahead of the analysts' unadjusted consensus estimate of $0.38 for the quarter. Our operating income rose 48% to $227 million in the third quarter versus $154 million in the same period last year. Operating margin in the quarter was 36.2% compared to 32% in the year-ago quarter, a 420 basis points improvement. In the third quarter, gross profit rose 29% to $486 million, up from $376 million a year ago, while our gross margin rate continued to be exceptionally high, at 77.8% as compared to 78.4%. SG&A expenses as a percentage of net sales were well below prior-year levels in the quarter and represented 41.5% of sales versus 46.4%. Naturally, the leverage we achieved on our U.S. stores was significant, given the level of comp reported for both channels. We also saw excellent leverage on what we refer to as our semi-fixed corporate functions. Inventory levels at quarter end were $250 million, about 19% above prior year levels and well below our sales increase. Further, this inventory increase allows us to support 44 net new U.S. stores, 20 net new locations in Japan and the substantially increased sales levels. Accounts receivable balances rose $14 million or 13%. Again, well below our sales growth of 30%. Cash and short-term investments stood at $936 million as compared with $838 million a year ago. Net cash from operating activities in the third quarter was $97 million compared to $98 million last year during Q3, as timing of interim cash tax payments in this year's Q3 offset our significant cash increase from net income. Free cash flow in the third quarter was an inflow of $72 million versus $49 million in the same period last year, mainly due to higher net income. CapEx spending primarily for new stores and renovations was $25 million versus last year's $49 million. Now I would like to provide you with some of our updated goals for fiscal 2007. For the fourth quarter, we are targeting net sales of $640 million, representing a year-on-year increase of 28% from last year's $501.6 million on a continuing basis, with U.S. comparable store sales gains of at least 10% in the retail channel and mid-teens in the factory channel and a low single-digit total comp gain at Coach Japan. Operating income, up about 36%, reflecting more than a 200 basis point improvement in fourth quarter operating margin year over year. EPS of about $0.40, an increase of 36%. We will compare this guidance to an adjusted analyst consensus of $0.38 for continuing operations, given the $0.02 contribution we originally expected from corporate accounts in the fourth quarter which would then go to the published consensus of $0.40. Therefore, our current goals for the full fiscal year are net sales growth of 28% to at least $2.6 billion; and we are targeting an operating margin increase of 300 basis points to nearly 38%, driven by further SG&A leverage; operating income dollar growth of about 37% above FY06, with interest income of about $40 million, adding to pretax income, while net income will be somewhat offset by a higher tax rate at about 38.5% for the year, due to the fact that incremental taxable income is being taxed at higher rates. Including these factors, we expect to generate EPS growth of 40% on a continuing basis which will produce earnings per share of $1.67. Again, we would compare our guidance to an adjusted analyst consensus of $1.62, given the $0.10 contribution we originally expected from corporate accounts for the year, which would then foot to the published consensus of $1.72. For FY07, we continue to expect CapEx to be about $160 million, primarily for new stores and expansions both here and in Japan. As Lew noted, we will be opening 47 net new U.S. retail and factory stores and continuing our North American expansion program. In Japan, we will be opening 19 net new locations. Our preliminary goals for the full fiscal year 2008 on a continuing operations basis are net sales growth of about 20% to at least $3.1 billion, with at least 10% comparable store sales gains in both the U.S. retail and factory channels and low single-digit comp location sales gains in Japan. With our continued focus on profitability, pretax income dollar growth of nearly 25% above FY07 levels. Again, two factors will somewhat moderate that growth on the EPS line in 2008

[Operator:]

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

[Bob Drbul:]

Lew, the question that I have with the results today and the decision to exit the corporate accounts business is, why would you do that today? Why now? What led you to that decision at this point in time? It is a very profitable business.

[Lew Frankfort:]

Sure. For us, it became a brand integrity issue. We conclusively learned that many of our corporate accounts were diverting goods to unauthorized channels. You have heard and we have talked about our product turning up in such places as Costco. The only way to control where our product is sold was to exit this business. It's the right thing for the franchise and we decided to do that.

[Operator:]

Your next question comes from Margaret Major - Goldman Sachs.

[Margaret Major:]

Hi Lew and everyone and congratulations on another tremendous quarter. I have a couple questions. First of all, when you look at next year's openings, the uptick in your ultimate target of 500 stores, could you just talk about existing market opportunity versus new market opportunity in the context of the total potential? With the same-store sales for this quarter, where you said traffic and conversion are quite strong but average transaction value was down a little bit versus last quarter.

[Lew Frankfort:]

I am sorry, Margaret. It was down slightly compared to second quarter. It was still high, but the increase was lower.

[Margaret Major:]

Thank you for that clarification. In the context of your outlet for fiscal '08, same-store sales and full price targeted at 10%. Can you talk about how you think of anniversarying the launch of Legacy in September/October and the acceleration of your business that resulted from that launch? How does that factor into your 10% comp guidance? Would you think that once you start anniversarying that it may be below 10%? How do you think about it over the course of the year? Thank you.

[Lew Frankfort:]

Your first question has to do with new and existing markets. We estimate that about 75% to 80% of new stores will be open in what we would call existing markets, with the remaining 20% to 25% in entirely new markets. However, what we have learned, Margaret, is what we often refer to as an existing market when we open a new store, it's a new market because most of the consumers who are shopping within that area are either new to Coach or primarily only shop in that area. A perfect illustration in the Tristate area is Jersey City. We consider Jersey City an existing market, yet when we opened a store and spoke to our consumers, most of them did not shop previously in any other Coach stores. In terms of our overall comps, which we are extremely pleased with, I'd like to just go back over them. They were primarily driven by increases in conversion and traffic and a modest increase in average ticket, lower than the mid single-digit increase that we experienced in Q2 versus the prior year. That was in part due to the introduction of new items, lower-priced items in February such as fragrance, which has a lower AUR, and we found ourselves selling a great amount of fragrance units. The other thing, when we look at our comp is in Q3, we did have a considerable amount of returns from sales in Q2 that were actually recorded in Q3. You cannot look at any changes from Q2 to Q3. Our comps were extremely strong. Relative to next year, we are projecting comps of at least 10% and this is the highest guidance we have ever gave at this time in our history for a new year. If you go back to last April or any prior year, we were never as bullish as we are now. That is driven by a confluence of factors

[Margaret Major:]

Can you specifically address how price factors into the comp guidance for fiscal '08 pricing? I know it is mixed, not just raising prices, but could you just address that?

[Lew Frankfort:]

The short answer is that we are looking at our comps to be primarily driven by conversion first, traffic second and average ticket third. We see average ticket in many ways as a bonus, as a dividend. Our job is to convert more people that visit and our challenge, of course, is to have higher traffic year on year. Our conversion and traffic were up very substantially in Q3, continuing the trend that we have experienced since last July. We see no reason to expect that to decline.

[Margaret Major:]

Congrats to you and everybody at Coach.

[Lew Frankfort:]

Thank you.

[Operator:]

Our next question comes from Jeff Edelman - UBS.

[Jeff Edelman:]

Thank you, good morning and nice job. As we think about the new product flow which has clearly had a positive impact, would you discuss the disposition and then phase out of the older lines? Has this moved into the factory outlets and has this been an extra catalyst behind those sales?

[Lew Frankfort:]

Let me go to the question at the end. The answer is no. Only about 20% of our sales in factory stores come from discontinued product. Most of our sales are either product made exclusively for factory or products that we have made from discontinued products of several years ago. So, the short answer is what is going on in factory is unique to factory. You know, Jeff, that the consumer is older, she's more functionally oriented, she likes leather and she likes to make a greater investment. The bags tend to be more straightforward than they are in full price.

[Jeff Edelman:]

I believe you are making some selective price adjustments on Legacy as we look at fall holiday '07. Are we seeing that occur in any other product lines?

[Lew Frankfort:]

Without making adjustments in existing styles, what we do each year when we introduce new styles is we obviously look at what the costs are, the make, the amount of materials, the amount of time it takes to make a product and we develop a first course and out of that we determine a fair price. The Legacy products that we are introducing next fall, some of them do have additional make and are more complex with additional ornamentation and detailing; certain products are increasing in cost.

[Operator:]

Your next question comes from Kimberly Greenberger - Citigroup.

[Kimberly Greenberger:]

Mike, I was wondering if you could comment on your SG&A, if you could just give us any sort of rough breakdown on the contribution to the decline in SG&A rate of 490 basis points. Any detail there would be helpful. On the gross margin line, if you could talk about mix versus any other pressures that you might have seen during the quarter, as slight as it was, that would be helpful as well. Thanks.

[Mike Devine:]

Let me just start off by saying we couldn't be more thrilled with our improvement in operating margin, up 420 basis points over Q3 last year. As you point out, it's largely being driven by improved SG&A leverage. The good news is we're getting it from a number of sources. As we mentioned in the prepared remarks, the comps that we are driving through our North American retail business is delivering improved SG&A leverage. We are also seeing it in our indirect sales groups, particularly in U.S. wholesale where we're seeing shipments up dramatically with very modest increases in sales support necessary to drive that business. We also saw for the second quarter in a row, a very modest amount of SG&A leverage to Coach’s total P&L coming out of Coach Japan. The lion's share, the majority of the SG&A improvement, is coming through our corporate functions; our centralized activities, that as we grow the top line at 30% rates, SG&A leverage is pouring into the operating income line. We're very excited about that. If I could then now switch to your question on gross margin rate, again we are very pleased actually with our gross margin rate. In many ways we feel it is healthier this quarter than it even was last quarter, albeit down from last year. We are seeing organic gross margin improvement, we're seeing good things going on within each channel and it's really channel mix which is I think is what you were referring to, that's driving the negative year-over-year performance. When you see our factory channel growing as quickly as it is, that’s going to have a negative channel mix impact. We also see Coach Japan, which is our highest gross margin channel, while we are thrilled with the 15% constant currency growth, it is not at the overall 30% growth. That is also having a negative impact. The indirect business that is pouring so much SG&A leverage in also grew more quickly than the company as a whole and also had a negative impact. So, great organic gross margin rate trends but the underlying channel mix issue that you referred to is causing a negative year-over-year compare. We don't believe that is a concern, we focus on operating margin. We do expect to see the negative channel mix impact us again in Q4 because the trends in our business are going to continue

[Kimberly Greenberger:]

Great Mike, that was very helpful. On the SG&A rate declines that we are seeing, as you look out into fiscal '08, how would you expect the composition of the improvement in SG&A to change? Or do you expect it to come from areas that you saw in the third quarter? Thanks.

[Mike Devine:]

Kimberly, I think we are going to see the same trends continue

[Operator:]

Your next question comes from Paul Lejuez - Credit Suisse.

[Paul Lejuez:]

Just of little bit more on the gross margin line. Can you talk a little bit about input prices, labor that you are seeing over in the factories in China, leather costs? I was just wondering if there has been any change to the percent of your shoppers that cross over between retail and factory?

[Lew Frankfort:]

Let me just take the second part first. Zero, Paul. There is absolutely none. In fact, we're opening full price stores in what was previously factory store markets and enjoying great results in our full price business without losing anyone from the factory store channel. It is a distinct consumer.

[Mike Devine:]

Back to gross margin, yes Paul, there are some inflationary pressures on some of the elements of our cost of goods sold. The good news is though that with the hard work of the sourcing team to this point we have been able to largely offset them. The pricing power that we have been able to enjoy has been able to offset them and that is why we are enjoying the strong organic gross margin improvements that I talked about earlier.

[Paul Lejuez:]

The share guidance you gave as part of your EPS, you said that it would be higher. Are you including any share repurchase activity in your estimates?

[Mike Devine:]

No, we are not estimating any additional share buybacks at this time.

[Operator:]

Your next question comes from Lorraine Makis - Merrill Lynch.

[Julie:]

You have been growing your market share pretty steadily in Japan. Have you changed your strategy there at all recently, other than expanding your distribution?

[Lew Frankfort:]

We have become more sophisticated as we have gotten to know the market better. And as a result, we are focused more on clientele programs and are able to drive more purposeful business into our stores. We are actually developing some of the same Coach service components that we have so successfully introduced in the United States into Japan.

[Julie:]

Can you talk a little bit about the profitability over there? I know you mentioned that SG&A came down for the second quarter in a row. Do you expect that to continue?

[Mike Devine:]

We are really calling for flat a SG&A year for '08 coming out of Coach Japan. We are conservative planners so we will see as we actualize where it really comes in, but I wouldn't model it as being a significant contributor to SG&A leverage going forward when I spoke earlier, the way we think about our centralized functions. The store profitability in Coach Japan is the highest of any of our stores globally, because of the price premium we enjoy and other luxury brands enjoy in Japan, so driving top line growth and continuing to take market share ultimately, of course, will drive earnings per share and that is our strategy.

[Operator:]

Your next question comes from Melissa Otto - WR Hambrecht.

[Melissa Otto:]

Congratulations on a great quarter. Just a follow-up question on Japan. Are there opportunities to improve the productivity of the stores and could you articulate some specifics that might actually get that comp to be a little bit better than low single-digits?

[Lew Frankfort:]

Let me first say Melissa, we are pleased with the low single-digit comps. We're opening a lot of additional locations in Japan, which is obviously a much smaller market geographically than the United States. We are finding there is some trade off and our entire strategy is to build market share. You need to appreciate that our growth is occurring in an environment that is extremely lackluster. Having said all that, we are constantly focused on improving the experience consumers have when they visit our stores. I mentioned a moment ago that we are adopting many of the practices we have successfully introduced in the United States to create special moments for customers so that we can engage with them more effectively so that they will visit us more frequently. It's a never-ending pursuit of improving service and that will continue.

[Melissa Otto:]

I just had a quick follow-up on China. You had mentioned that in China you are hoping to get to a target of 20 stores. Any color on the pirating going on there, the copies around the Coach bags and how that might be impacting your business or not really impacting your business?

[Lew Frankfort:]

First, we are pleased that over recent years we have found a growing respect in China for intellectual trademark rights. They have been working cooperatively with us to reduce and eliminate counterfeiting wherever it can be detected. It has not been a material problem for us whatsoever.

[Melissa Otto:]

That is great to hear. Thank you so much and congratulations.

[Operator:]

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

[Jim Hurley:]

I would like to add my congratulations as well. The question I have is on the tiered merchandising strategy that worked so well in the full price retail stores. Just wondering where you are with employing that strategy both in the factory outlet and also in Japan? The other question relates to fragrance and whether or not fragrance is a destination purchase in the store or if it was more an add-on purchase with other items?

[Lew Frankfort:]

With regard to tiered merchandise, in Japan we have actually a very similar structure to the one that we have in the United States where we do have three primary levels of stores

[Andrea Shaw Resnick:]

Thank you, everyone it is now 9