By David Stockman, Budget Director under President Reagan and author of the bestseller, The Great Deformation: The Corruption of Capitalism in America. This article originally appeared on David Stockman’s Contra Corner.
For the last two decades Coach (COH) could do no wrong. Its aspirational handbags flew off the shelves at hefty prices, causing its sales to soar from $1.3 billion to $5.1 billion during the 10-years ending in fiscal 2013. Better still, its EPS soared by 6X, representing a 20% earnings growth rate over the same period. Greatest of all, its share price peaked at nearly $80 in 2012 after having opened the 21st century at $3 per share.
Needless to say, the believers and speculators who got on board for the 27X gain in twelve years were fabulously rewarded, as was its founder and largest stockholder, Lew Frankfort, who became a billionaire along the way. So the capitalist dream is still working in America, right?
Not exactly. Last night, Coach announced an earnings fiasco. Sales were down 21% from year ago levels, the 4th straight quarter of plunging top line results. Worse still, Coach announced that same store sales in its 544 North American stores and outlets, which account for 70% of sales, face even worse prospects in the period ahead. According to the Reuters account:
The clothes, shoes and handbags retailer said it expected North America same-store sales to fall in the “high teens” in percentage terms in the coming year.
Simply stated, a high teens same store sales decline at a luxury retail emporium is a death sentence. Accordingly, COH has now tossed its long standing business model out the window and is marching on the double in the opposite direction.
COH’s 27X share price gain since 2000 depended upon a pell-mell path of retail footage expansion by which it opened dozens of new stores every year for nearly two decades and thereby drove its sales steadily upward. But now it will close 70 of its NA stores or 13% of the total. And facing upwards of a 20% decline in same store sales in the coming year that is surely only the beginning of the shrinkage.
Not surprisingly, its shares took a 10% hit in the aftermarket, and that’s only the last hurrah for this once high flying canary. The stock has been weakening for two years owing to its recent faltering performance, and now stands at $35/share—down 56% from its peak and back to the price it first traded at in August 2005.
This can all be dismissed as the unfortunate life-cycle of a high flyer playing out its appointed rounds. And, indeed, the primary force knocking COH off its pedestal was two aggressive competitors in the same market for “aspirational” branded handbags, shoes and apparel goods—that is, Kate Spade and Michael Kors.
Self-evidently, the supply of aspirational buyers at Coach’s nosebleed price points was not nearly as great as the supply of competitive designs, products and merchandizing that its latter day competitors have flooded into the malls. Something had to give, but it wasn’t just old-fashioned capitalist survival of the fittest.
Instead, Coach blew it by playing the bubble finance game on the Wall Street casino—a destructive game which is part and parcel of the Fed’s misguided policy of financial repression and its wealth effects promotion of speculation in risk assets. In a word, Coach blatantly failed to reinvest in its business in order to preserve its ample head start against its current devastating competitors. Instead, it cycled nearly all of its cash flow into stock-buybacks, thereby levitating its share price by orders of magnitude more than its total earnings, sales and sustainable cash flow.
During the 10-years ending in fiscal 2013, Coach generated about $8.6 billion in operating cash flow—that is, revenue less cash operating expense and change in working capital. But it utilized $6.2 billion or nearly 75% of the net cash generated during its high flying days to buy back shares. By contrast, it applied only $1.5 billion to net investments in CapEx and some modest acquisitions.
That is only half the story. Throughout the last decade, COH reliably posted fat EBITDA margins of between 33-35% because that is how the high flyer momentum game is played. Open lots of stores, post fulsome cash flow margins, and wait for the sell-side analysts to sharpen their hockey sticks. Next, the momo traders get on board, the CEO appears on Cramer to talk up the home gamers, and it’s off to the races. At its peak in 2012, COH was trading at about 50X forward earnings.
Needless to say, the momo boys and girls never asked how COH could open 544 North American stores and many more abroad on virtually no CapEx. In fact, over the last decade the company’s revenues totaled nearly $32 billion, meaning that CapEx amounted to less than 5% of sales.
And realize, also, that this 5% of sales figure is essentially a low-side benchmark for maintenance CapEx in high-end retail where merchandising appeal must be continuously refreshed; it doesn’t even begin to reflect the capital utilization that would be required for the pell-mell opening of hundreds of new high-end stores.
The short answer, of course, is that COH didn’t need much CapEx to open stores because they were all financed through operating leases! But there are two giant problems with the rent-a-store approach to company building.
First, the cost of occupancy—which is extremely rich in the so-called in-line section of the mall were the likes of COH are positioned—becomes a fixed cash cost. So when traffic and sales turn down even modestly, there is no cushion. Instead, there is an immediate hit to margins; and if volumes at “weak stores” fall sharply—like 20%—operating cash flow can dry-up completely. Suddenly, a rent-a-store high flyer is in the store closure and lease write-off business—even if this destruction of capital is dismissed as “non-recurring” by the sell side analysts who never figure out that the gig is up.
But there is another more debilitating feature. It is rarely possible to run 35% EBITDA margins in a highly competitive luxury goods market without heavy and continuous reinvestment in design, product, marketing, in-store merchandising and staff support and training. Yet operating leases—because they are a fixed cash charge to the current P&L—inevitably squeeze out discretionary cash investments in the business operations mentioned above when a high flyer is under the gun to meet the rich EBITDA margins that get embedded in analyst hockey sticks. In other words, Coach’s high EBITDA margins were deceptive and unsustainable because they masked a big lump of cash leases.
Why is it so easy to build a 550 store retail emporium on operating leases? The answer is financial repression. Mall owners have enjoyed “cap rates” on their debt capital (most of their investment) which has been far below market clearing levels ever since the Fed launched into monetary central planning and interest rate pegging.
The mall REITs, in turn, collect a generous spread between their rents and their debt carry costs, but they also accord tenants like COH an unwarranted credit rating and therefore an implicit subsidy. The latter is based on the so-called national tenant credit status of fast expanding chains like COH and the demonstrated fact that the Fed will allow no stock market bubble to stay burst. So when push comes to shove, mall owners assume that even injured high flyers, like COH is currently, will be able to obtain enough cheap financing to pay the rent.
So we have a great deformation. High-flying retail rollouts like COH drastically over-invest in stores and square footage on the way up because occupancy costs have been made sub-economic by our clueless monetary politburo. At the same time, genuine entrepreneurs like Lew Frankfort in this case, and serial scam artists more frequently, are encouraged by the momo traders and sell side analysts to drastically under-invest in products, merchandising and service. There are few more strategic business errors than to underinvest in what’s inside when you are over-invested in fixed leases all around. Can you say Sears?
Coach may struggle on, but what happens when the current financial bubble ends up as the third stock market crash of this century? Well, what happens is that “demand” for “aspirational leathers” among the top 10% of households will plummet. Then the canaries will be fluttering up and down the mall aisles as Coach, Kate Spade and Michael Kors duke it out for the remnant of customers who will be left.
Needless, to say the momo traders have left the scene months, if not years, ago; and Lew Frankfort has cashed in his billions and retired. What will be left is empty malls, fired staff, closed stores and billions of operating leases written off as dead-weight destruction of capital. That’s how the Fed’s bubble finance works, and how it corrodes and corrupts the vital arteries of capitalism. Someone should take Janet Yellen to Sears… or even to Coach. By David Stockman. Check out his bestseller, The Great Deformation: The Corruption of Capitalism in America. This article originally appeared on David Stockman’s Contra Corner.