Tapestry, Inc.
Q4 2007 Earnings Call Transcript

Published: 31 Jul 2007

[Operator:]

Good day, and welcome to the Coach conference 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 for Coach, Ms. Andrea Shaw Resnick.

[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 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. Please refer to our latest annual report on Form 10-K for a complete list of these risk factors. A 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, 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 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 2007 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 year fiscal 2008. Following Mike, we will hold a question-and-answer session that will conclude by 9

[Lew Frankfort:]

Thanks, Andrea and good morning, everyone. As we announce our fourth quarter results and the end of our fiscal year, we are very pleased with our excellent performance and are equally enthusiastic about our prospects. We're confident that FY08 will be another great year for Coach with sales planned to rise to about $3.16 billion, 21% ahead of last year. We are seeing a continuation of about 20% growth in the premium handbag and accessory category in North America, and heightened interest in the category globally, as it takes hold in emerging markets for luxury goods, such as greater China. Given the strength of the Coach brands and the resonance of the Coach proposition internationally, we are in position to capitalize on these opportunities both at home and abroad in the years ahead. Our performance in FY07 was highlighted by a 28% increase in revenues, a 37% increase in net income, and a 41% increase in EPS. It was a year of many accomplishments, including

[Mike Devine:]

Thank you, Lew and good morning, everyone. 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 Lew mentioned, our quarterly revenues increased 30%, with sales of our direct businesses up 29% and the indirect business up 34%. For the year, total revenues rose 28% with sales generated by our direct channel rising 30% while our indirect revenues were up 20%. Net income for the quarter increased 41% to $159 million, and EPS rose 43% to $0.42 per share, as compared to $113 million or $0.29 per share in the year ago period. Net income rose to $637 million in FY07, up 37% from the $464 million earned in the prior year. Diluted earnings per share rose 41% to $1.69 versus $1.19 a year ago. Our operating income rose 43% to $245 million in the fourth quarter versus $172 million in the same period last year. Operating margin in the quarter was 37.6% compared to 34.3% in the year ago quarter, a 330 basis point improvement. For the fiscal year, operating income rose to $993 million, a 39% increase, and operating margin for the year rose to 38% from 35.1% a year ago, up 290 basis points. In the fourth quarter, gross profit rose 29% to $509 million from $394 million a year ago. Gross margin continued at its exceptionally high levels, finishing at 78.1% versus 78.5% in the prior year. During the year, gross profit rose 28% to $2.02 billion as compared to $1.58 billion a year ago, while gross margin was 77.4% versus 77.7% last year. As expected, SG&A expenses as a percentage of net sales were substantially below prior year levels in the fourth quarter, and represented 40.5% of sales versus 44.1% a year ago; a 360 basis point decline. For the full year, SG&A expenses as a percentage of net sales declined 320 basis points, 39.4% from 42.6% last year. All selling businesses saw their year-over-year spending rates decline and we also continued to leverage top line volume across all of our centralized functions. At year end, cash and short-term investments stood at about $1.2 billion as compared with $538 million a year ago. Inventory levels were $291 million, up about 25% above prior year levels, below our 30% sales growth as our supply chain improvements and inventory management programs allowed us to support 48 net new U.S. stores, 20 net new locations in Japan and substantially increased sales levels with moderate additional inventory investment. Accounts receivable balances rose $23 million or about 28%. Net cash from operating activities in the fourth quarter was $257 million compared to $195 million last year during Q4. Free cash flow in the fourth quarter was an inflow of $214 million versus $161 million in the same period last year, mainly due to higher net income. Our CapEx spending, primarily for new stores and renovations, was $43 million versus $34 million in the same quarter a year ago. For all of fiscal year 2007, net cash from operating activities was $779 million compared to $597 million last year. Free cash flow in fiscal year '07 was an inflow of $638 million versus $463 million in fiscal year '06, while CapEx spending totaled $141 million, again primarily for new stores and expansions, as well as investments in corporate infrastructure. Now I'd like to provide you with some of our updated goals for fiscal 2008. We are looking for net sales growth of about 21% to at least $3.16 billion, driven by distribution growth and productivity gains. We expect to open at least 46 new stores in North America, 15 to 20 new locations in Japan, and about 30 new international locations, while we continue to expand select, highly productive locations globally. We expect to achieve at least 10% comparable store sales gains in both the North American 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 about 26% above FY '07 levels. Two factors will somewhat moderate that growth on the EPS line in 2008. First, the higher share count, brought about by option exercises. Secondly, a higher tax rate, rising to about 39% due to the fact that incremental taxable income is being taxed at our maximum rates. This taken together would produce net income growth of about 25%, and earnings per share of at least $2.06, up over 22% from the $1.69 we just reported for FY07. Moving to the first fiscal quarter of 2008, we are targeting net sales of about $655 million, representing a year-on-year increase of over 23%. For the quarter, we expect to open about 18 stores in North America, five in Japan, and five international wholesale locations with several expansions across these geographies, all augmented by U.S. comparable store gains of at least 10% in the retail channel and mid-teens in the factory channel with low single-digit comp location increases for Japan. We're looking for operating income to be up at least 25% year over year and earnings per share of at least $0.39 , an increase of more than 25%. For FY08, we expect CapEx to rise to about $200 million, primarily for new stores and expansions both here and in Japan as discussed. In addition, we will be expanding our distribution center in Jacksonville by about 50% or 280,000 square feet to support Coach's projected sales growth over the next five years. While we upgraded the technology at this facility a year ago, we've now decided that a physical expansion is necessary to accommodate the faster than expected growth of our business. This will require CapEx of about $12 million to $15 million in FY08. While these are our current goals, our actual results may vary from these targets based upon a number of factors, including those discussed under the business of Coach Inc. and risk factors in our annual report on Form 10-K. Coach also does not assume any obligation to update these targets as the year progresses. In summary, we're confident that our growth strategies will enable us to continue to gain share in the large and growing global market for fine accessories and gifts. Thank you everyone for your attention. Now Lew, Andrea and I will be happy to take some questions.

[Operator:]

Our first question comes from Bob Drbul - Lehman Brothers.

[Bob Drbul:]

Lew, the question that I have regarding Japan, when you look at the high single-digit comp in Japan, do you think that marks a significant improvement or change in the environment? How about maybe just Coach's success in Japan? Do you think this is an inflection point?

[Lew Frankfort:]

Good question, Bob. We actually believe that it has a lot to do with the strength of the collections we introduced last spring. Ergo was a phenomenal success. It actually generated 30% of sales during its launch month, much higher than we thought. As a result, we benefited particularly and we're taking those learnings forward as we introduce new Ergo groups, both in September and next June. Overall, we believe that the improvement is really within the range of variability. So, we're still forecasting 10% to 15% overall growth.

[Operator:]

Our next question comes from Margaret Mager - Goldman Sachs.

[Margaret Mager:]

Congratulations on 22 excellent quarters. Could you just talk about why the factory outlet channel is performing at double the pace of the full price channel? I know you said conversion and traffic were up double digit in factory outlet, but could you give us more color as to why that is occurring? Is it marketing that you're doing?

[Lew Frankfort:]

I'm with you.

[Margaret Mager:]

That's one question. On CapEx, even if we take out the distribution expansion, it's still up 31% year over year. Why is that? If you could elaborate. Lastly, going forward, your points of leverage in your business model, what can we expect or how should we think about how you'll create further leverage and push your operating margins up even further above already truly excellent levels?

[Andrea Shaw Resnick:]

Thanks for keeping it to one question, Margaret.

[Margaret Mager:]

If you want to answer one that's fine.

[Lew Frankfort:]

Mike, why don't you take the CapEx and the margin expansion questions first?

[Mike Devine:]

Margaret, you may recall that we guided to FY07 CapEx spending earlier in the year, I think on the last call, to about $160 million and we came in at about $140 million. That's purely timing of projects and settling up of invoices, if you will. So the way I think about it, if you look across the two years and you move the $20 million of timing out of '07 and into '08 and layer on the spend at Jacksonville, you're roughly, from our '07 guidance of $160 million, you get in the neighborhood of the $200 million. So it really does not represent any significant change in strategy from our thinking for '07. We feel it's relatively consistent, it's more about timing other than the Jacksonville issue. So in talking about operating margins, obviously we saw another great quarter of SG&A leverage where, overall, we drove total increase in our operating rate improvement by 330 driven by SG&A leverage of 360, another great year where we got the operating margin up to 38%, 290 basis points above where it was for the full year. All of this happened, we think consistent with our guidance for the year on flattish gross margin rate, down slightly from last year, largely driven by channel mix and incredible SG&A leverage. As we said many times, we believe that there is much leverage behind that for '08 and beyond. If we can continue to grow our top line in the neighborhood of 20%, you'll see us create great leverage in our centralized functions whether it's the Jacksonville distribution center or advertising or design and finance teams, everything that we have here in New York. If we can continue to comp at 5% to 7% in the North American retail business, that business will continue to deliver leverage, as well. We're now seeing leverage coming out of Coach Japan. So, much leverage to come and we're optimistic that we'll continue to see operating margins grow into the future.

[Lew Frankfort:]

With regard to our factory store outlet performance, there's a lot I can say about the channel. I'll just provide some headlines in relationship to Coach. First for Coach, our factory store channels is equivalent to our diffusion brands. We never go on sale in our full price and our accessories concept. If someone wants to buy Coach on sale, they need to go to a factory store outlet. In fact, about 80% of sales in North America we estimate are purchased on discount. In Coach, we have an extremely loyal factory store customer who wants the Coach brand, but only wants to buy it at a discount. We do no external marketing whatsoever. It's entirely a pull strategy, which means that consumers are just are coming in increasing numbers because they're satisfied with what they realize. What we have done, as you know, is improve the merchandise offering, and I do think that's attracting consumers, as well. So despite the higher gasoline price and concerns that some people have about consumer confidence, we're not seeing it at all in our factory store business or in our other channels.

[Margaret Mager:]

Is there any risk you're pulling traffic away from full price into factory outlet?

[Lew Frankfort:]

We measure it consistently, and the answer is no.

[Operator:]

Your next question comes from Jeff Edelman - UBS.

[Jeff Edelman:]

Lew, a very insightful discussion earlier. My question relates to price points in the U.S. stores. Given the 17% increase in the handbags over $400, are we seeing a shift in mix as you're pulling more customers up into the lower end price points? Just a follow-up on that

[Lew Frankfort:]

Just a clarification, Jeff. Handbags over $400 actually increased 75% to 17% of handbag sales in our own stores and in department stores it increased from 2% to 9% during the same period. So what we're finding is that consumers are attracted to the bags that have greater make. At the same time having a very broad and diversified consumer base, we are mindful of maintaining sharp price points. We have also seen an increase in sales of our smallest across the body bags, as well. So we're finding that there's growth on both ends and we do have a good assortment in the middle, as well. Our overall handbag price during the fourth quarter in Coach stores actually only increased about 4% to about $280 from slightly under $270. The average handbag price actually only went up about 4%.

[Jeff Edelman:]

And the new product mix as it relates to the first half of the year?

[Lew Frankfort:]

I believe the average handbag price to be up in mid to high single-digits. However, it will be offset somewhat by increased penetration of lower-priced categories such as jewelry and fragrance, which will be growing rapidly.

[Mike Devine:]

Just to build off of what Lew said, we're looking for jewelry and fragrance to be about 4.5% of sales in '08 versus less than a 1.5% in '07. That's going to pull down average ticket.

[Operator:]

Your next question comes from Kimberly Greenberger - Citigroup.

[Kimberly Greenberger:]

I just had a quick question to follow-up on Bob's question. You had indicated that Ergo was 30% of sales in its launch month.

[Lew Frankfort:]

In Japan.

[Kimberly Greenberger:]

That was in Japan?

[Lew Frankfort:]

Only Japan. That was a significant driver to the incredible 23% increase in the total quarter sales.

[Kimberly Greenberger:]

Terrific. Thanks for that clarification. Mike, could you just comment on the merchandise margin or gross margin trend within each channel? That would be helpful. Lew, if you could just give us a quick comment on your outlook for the next two quarters in your indirect sales. I know you've seen 34% and 36% growth in the last couple of quarters. It looks like in the first and second quarter you're up again 10% to 11% increases last year. Would you expect this trend rate to change? If you could just comment there, that would be great, thanks.

[Lew Frankfort:]

I think I'm going to answer the second question first. I think what you're actually referring to when you say 10% to 11% is actually our shipments, not our POS sales. The way we really look at our business is our POS sales. Let me answer it from a POS sales perspective. Our business out of the box in July in North American department stores has continued extremely strong both in our accessories world as well as footwear. We have every reason to believe we will continue in the indirect businesses in North America to experience very strong POS increases year-on-year. At the same time, our international wholesale business, especially our locations focused on the domestic consumer, is doing extremely well. Year-on-year, we expect to see extremely strong results. Last year in the first half, I know we did some inventory balancing and our shipments did not keep pace intentionally with our POS sales. I think we're in the better inventory position. So it's likely that we will see our shipments more closely reflect our POS sales in the first half.

[Mike Devine:]

Kimberly, let me talk to gross margin a little bit. I can't do it though, without first starting and saying that we believe the most important operative metric, of course, is to look at consolidated operating margins and we're thrilled with the expansion we had in the quarter and the year. But moving back to gross margin rate, for the quarter we continue to have excellent trends in our business unit, gross margins while on consolidated we were off; channel mix, the fact the factory grew more quickly than the business as a whole and CJI, our highest gross margin channel grew more slowly, hurt us almost 60 basis points. So, if you adjust out for channel mix, we actually saw organic gross margin rate improvement. If I could just elevate the story to look at the full year, for that time period, our gross margin year over year was down about 28 basis points. If you look there, channel mix and also the currency, the FX impact, those two things were a drag of 82 basis points. So our organic margin actually was up more than 50 basis points year over year, adjusting for those two factors with virtually every channel up year over year dramatically. In fact, ironically, the biggest improvement came from our factory store year-over-year gross margin rate improvement. We're very happy with the underlying trends in our gross margin rate and particularly seeing that it's being driven, the improvement year-over-year and factory, is also very helpful.

[Operator:]

Your next question comes from Liz Dunn - Thomas Weisel.

[Liz Dunn:]

Let me add my congratulations. My question relates to your mounting cash balance. Can you weigh in on what your plans are? To what point you are comfortable buying back stock? Is there any potential that you would consider an acquisition of another luxury brand with complementary categories? What are you just going to do with all this cash?

[Mike Devine:]

Let me first start, maybe hold the question about the acquisition for Lew at the end, but let me lead off by saying that first and foremost, our primary use of our cash is to reinvest in our core business. This is driven largely by investment in new stores and expansions globally. We're also looking at infrastructure improvements. Lew mentioned some in the prepared remarks, technology to further lower our SG&A rate, both in the in-store environments and in our centralized functions. I mentioned we're also going to invest and increase the size of Jacksonville to handle the continued accelerated growth of the business. As you mentioned, historically we've used our cash as part of a share buyback program. In fact, last year in about a three-and-a-half month period, we spent more than $650 million on buyback. I think as most of you know, we have an authorization out there today that will allow us to go to the market and make a purchase of $500 million. The board has always supported us when appropriate to take that number higher. We've not publicly said at what point we'll get into the market, but we've been opportunistic buyers and we would look to continue to execute that strategy. As I also look out further for other uses of the cash, I could see at some point in the not too distant future using that cash to buy out one of our international wholesale distributors, in effect looking to replicate the CJI model that we have used so effectively to drive shareholder value. Then at the end of the day, we are in a position where we're building cash and we're comfortable building that cash balance. As Keith Monda, our Chief Operating Officer likes to talk about, to have powder dry money so we can further extend the growth of the story beyond our LRP period. Lew, do you want to talk to the acquisition?

[Lew Frankfort:]

Sure. First, we're not terribly enthusiastic about an acquisition in the foreseeable future, primarily because our opportunities as a mono brand continue to be boundless. We do have an articulated road map to double our business to $5 billion over the next four or five years and we feel very confident that we can do that staying focused on the opportunities with Coach. So we're not looking at anything at the moment. We'd be very cautious in this arena.

[Liz Dunn:]

Any chance of any dividend?

[Lew Frankfort:]

There's always a chance of a dividend. We talk about it probably every three months. We come up on balance saying, not for now.

[Operator:]

Your next question comes from Randy Konik - Bear Stearns.

[Analyst for Randy Konik:]

Just a quick question regarding your product mix. With the upcoming Heritage Stripe line planned for '08, how should we think about your mix of leather versus mixed material handbags? Specifically, with this line being coated canvas, could we expect to see a cyclical return to more non-leather bags in the next year or two? Thank you.

[Lew Frankfort:]

The short answer is that we're actually expecting, on the contrary, to see an increase in the role that leather plays within our handbag assortment in FY08 driven in large part by Ergo as well as Bleeker. Looking in its entirety, we think there'll be a modest increase in the role that leather plays compared to prior year.

[Operator:]

Your next question comes from Christine Chen – Needham.

[Christine Chen:]

Thank you. Congrats on another amazing quarter. I wanted to talk a little bit about international. You had mentioned that international wholesale was up. I was wondering if that was consistent across the different geographies or in one area versus the other? I also wanted to ask about the jewelry and the beauty business if you have any product introductions coming in, what we might see there?

[Lew Frankfort:]

As Mike Devine indicated, we do expect jewelry and fragrance to account for --

[Mike Devine:]

About 4.5 points of penetration in our full price channel.

[Lew Frankfort:]

So less than 1%?

[Mike Devine:]

Just under 1.5%.

[Lew Frankfort:]

1.5% this year. So we do expect these new flanker categories to be important on the margins.

[Christine Chen:]

For international across the geographies, is the performance pretty consistent or are certain areas performing better than others?

[Lew Frankfort:]

Excellent question. First, what we're finding is that the locations that are focused on domestic consumers, major markets like Korea, Greater China or Taiwan are performing remarkably well as our brand takes hold with local consumers. We're experiencing great growth also in the Middle East and other Southeast Asian countries. Markets that are focused on the Japanese tourists have been suffering. Japanese tourist levels of travel did not increase in '07 compared to last year, and actually the Japanese consumers are spending less on gifting when she travels than she did prior year. So we are seeing a much greater increase in domestic locations. Our focus, of course, is in developing the indigenous populations in these developing countries.

[Andrea Shaw Resnick:]

At this point it's 9