I was reading the news one morning last week and noticed that Coach reported earnings that disappointed and the stock was off 8%. I’ve never really looked at Coach and don’t know much about the company, but I glanced at some of the numbers and was impressed by how strong the business appears to be.
Although I prefer investing in stocks that are cheap and obviously undervalued, I’m always looking at great businesses to study them and learn more about them, as occasionally they are offered up as bargains by Mr. Market. I have a database of great companies I track on a spreadsheet watchlist I created from paging through Value Line. These are companies that have certain quantitative characteristics of great companies–things like high margins, consistent free cash flow generation, high returns on capital, etc…
I thought I’d write an intro post on what I look for when trying to identify quality. This is not going to be comprehensive, just a summary of the basic numbers. Reading through Value Line day after day, I have gotten efficient at quickly identifying a few common data points that are relevant across most businesses.
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Once you practice this type of analysis, it can be done in 1-2 minutes per business. It’s a procedural memory thing… I know what to look for to quickly get a basic handle on what I’m dealing with. I find ideas through reading Value Line, the paper, blogs, 13-f’s, etc… and then use Morningstar or GuruFocus to look up some quick data points to tell me if I should dig deeper. It’s not complicated. No Bloombergs needed, no fancy spreadsheets allowed…
So whenever I read something that prompts me to take a quick look at a stock, a minute or two is all the time I need to initially spend on it to tell me if I should read the filings and annual reports and begin to dig deeper.
Coach-Possibly a Very Good Business
At this point, I don’t know if Coach (the stock) is a good value, but I do think Coach (the business) appears to be a great business. The vast majority of the time, these businesses collect dust on my watchlists as most great businesses are priced accordingly.
Investing is all about returns on capital invested, and those returns can come from buying undervalued assets or quality businesses. Often times, the former gets priced more cheaply relative to intrinsic worth than the latter, and so we go where the largest discounts are to fair value. But if you want to study businesses, study the great ones, as ideally—as business owners—those are the ones we’d like to own. The best ones can create a significant amount of value for shareholders over a long period of time.
I’m steadily building my database of businesses, and that knowledge accrues over time—as Buffett says, it’s like compound interest.
Just to reiterate, I haven’t done any research on Coach other than glancing at the numbers very briefly. This post is not a recommendation, or even a suggestion that the stock is a good value (although it might be).
I just thought it would be beneficial to post some brief numbers to show a snapshot of what I like to look for in a good business. Coach certainly appears to be a good business based on the numbers. It’s an asset light business that produces high returns, high margins, consistent free cash flow, and it’s growing.
I plan to read the filings and I just emailed the IR department and requested a hard copy of the recent annual report (why is it that reading hard copies of annual reports are so much more enjoyable than reading them off the screen?). I might follow up with some more details at some point.
For now, let’s glance at the numbers to see what a good business looks like. These are just basic summary numbers I pulled from Morningstar and Guru Focus.
First, take a look at some overall summary numbers over the past 10 years:
The company is growing at consistently high rates. Sales, earnings, cash from ops, free cash flow, and net worth are all growing substantially. The business has very high margins, Sales per share growth has averaged about 20% per year over the past 10 years:
They have achieved high revenue growth, but they’ve also generated consistent cash flow growth. Better yet, their reinvestment needs (total capex) is quite low for such a growing enterprise. So the business throws off a lot of cash, and that cash stream is growing. One of my favorite parts of this business is their high margins: Look how efficient they are at turning sales into free cash flow. They turn every $1 of sales into about 23 cents of FCF (10 year data from 2003 to 2013):
Here is a look at their other margins, which just based on the numbers would indicate the possibility of an economic moat with around 70% gross margins and 30% pretax margins:
A business like Coach uses a relatively small amount of tangible assets in the operations of their business, so normal price ratios to book values don’t tell much about value. However, I do like to look at the progression of a firm’s net worth over time because this is often a great way to look at shareholder value creation over the long term. Coach’s net worth has been growing at a rate of about 14% per year over the past decade:
One of my favorite ways to quickly look for signs of quality is to look at the returns on equity or total capital that a firm produces. As I page through Value Line, this is one of the first lines I look at. Return on capital is a simple measure to determine how much money the company is producing for its owners on the capital that they’ve invested (ROC generally includes both equity and debt capital, so I prefer ROC to ROE because it adjusts for leverage to give you a true picture of how good the business is).
In this case, ROE is basically the same as ROC because Coach is very lowly levered. As you can see, Coach produces incredibly high returns on their assets and equity:
Return on equity (ROE) has three possible drivers:
- Profitability (net profit margins),
- Efficiency (asset turnover, or sales/assets), and
- Financial leverage (assets/equity)
In Coach’s case, their incredibly high returns are due to their high margins. They are able to mark up their merchandise significantly over their costs of that merchandise (COGS). And we know margins are driving the returns because the asset turnover is modest and Coach has an extremely healthy balance sheet very basically no debt and over $1 billion in net cash.
Finally, a quick look at their common-sized balance sheet (numbers are listed in % of assets, which makes it easy to compare line items):
As you can gather from taking a quick look, the business uses very little fixed assets (it’s “asset-light”) to produce their earnings. Total liabilities are only 31% of total assets, and there is basically no long term debt.
The company is very liquid and has healthy financial leverage ratios. The Current Ratio measures current assets to current liabilities (the ability the company has to meet its current obligations). Quick ratio is a more liquid and conservative measure that uses only cash and receivables (excludes inventory) and compares that sum to current liabilities. These data points are more useful to evaluate businesses that may have questionable strength. In Coach’s case, the business is clearly not at any immediate risk of a liquidity problem or long term leverage problem.
So collectively, these data points show the signs of a quality business.
Obviously, as investors, we need to figure out if the shares are undervalued. Ultimately, we’d like to arrive at a valuation of the business and establish a margin of safety between that valuation and the share price. One quick comment I’ll make is that while I haven’t done any detailed work, I like situations like this because the business looks interesting and a quick look at common value metrics show that the valuation isn’t overly exuberant at these prices.
Here’s a look at the 10 year progression of the Enterprise Value to Earnings before Interest and Taxes (EV/EBIT is Greenblatt’s preferred earnings multiple because it accounts for leverage and adjusts for varying tax rates, which the P/E ratio does not).
In this case, this valuation metric looks to be fair for a high quality business, thus the reason I thought I’d summarize the numbers and mention that Coach might be worth looking at further.
To Sum It Up:
Coach is a great business that produces high returns on capital and has very high margins. The business has produced positive free cash flow in each of the last 10 years, and that cash flow has grown steadily and significantly.
I don’t know if Coach will continue to grow, and I’m uncertain of its durability, but looking at the last 10 years’ worth of data shows the portrait of a great business. As Buffett said, investors don’t profit from historical growth, so further evaluation is needed to determine the likelihood of the business being able to continue producing these impressive returns.
I thought a basic intro post into some things I like to look for in quality businesses would be of interest to some readers.
Best of luck in your search for value…