Coach's Turnaround Strategy Could Muddy Kate Spade Benefits -- Update

Coach Inc.'s purchase of Kate Spade & Co. comes as Coach itself battles to eke out a turnaround amid a sour retail environment. And it is unclear if the so-called synergies are enough to solve the problems each retailer faces.

Coach said Monday it would pay Kate Spade shareholders $18.50 per share in cash, for a total transaction value of $2.4 billion. The company has shut more than 125 full-price stores since 2014, reducing its U.S. footprint by roughly one third, and cut back on heavy discounting as part of a transformation project.

Sales at Coach have climbed in recent quarters, recovering from the lows hit in 2015, but remain off the levels notched in 2013. Sales at Kate Spade have slipped, and the company has shed apparel lines to focus on handbags. The company began exploring the possibility of a sale late last year, according to a Wall Street Journal report.

"This is a big bet in a category that has faced recent pressures," said Paul Lejuez, analyst at Citibank, in a note to clients.

U.S. retail sales have declined in February and March, after posting anemic growth for the bulk of 2016. U.S. companies have also been hurt by a run up in the value of the dollar.

The combination of both businesses is expected to generate around $50 million in savings by 2020, said Coach Finance Chief Kevin Wills during a Monday conference call. But plans to pull back from selling Kate Spade bags via online flash sales and at off-price retailers would effectively cancel out the upfront benefits of the deal.

This raises questions about how much value the Kate Spade purchase will bring to Coach shareholders, said Citi's Mr. Lejuez.

"You really need to believe that there's more than $50 million of annual synergies once these companies are combined," Mr. Lejuez said. "If there's really nothing else, it is hard to get excited about the deal."

But other analysts said Coach's strategy of cutting back its store footprint and reducing reliance on steep discounts could grow value at Kate Spade over the long run.

"You can discount less if there's fewer products out there," said Simeon Siegel, a retail analyst with Nomura Instinet. "Coach has done a strong job of it with their own brand over the last couple of years," he said.

Coach is also betting there is potential for the Kate Spade brand in international markets.

"Kate Spade, under current management, can't take it to the next level. That's where Coach can come in and add value," said Dylan Carden, analyst at William Blair & Co. "It is a leap of faith, but to some extent they've done it with the Coach brand," he added.

Coach expects to eliminate duplicative sales, general and administrative expenses once the two companies become a single public entity, a Coach spokeswoman said in an email.

"The opportunities to generate long term sustainable growth -- after the initial pullback -- are significant, including tapping the international potential, notably in Asia and Europe, as well as distribution opportunities here in North America," she said.

Coach is well positioned to fund the deal, with plenty of cash and little debt. About half the transaction cost, or $1.2 billion, will come from cash on hand. The rest will be funded through $1 billion in senior unsecured notes and two bank term loans.

About 54% of Coach's $1.3 billion in cash on hand as of Dec. 31 is labeled as "permanently reinvested" overseas. Repatriating that money to fund the Kate Spade deal could saddle Coach with a hefty tax bill. However, President Donald Trump's proposed tax plan would cut the tax rate for overseas earnings.

Regardless, refilling Coach's coffers could take some time. The company's quarterly net income has oscillated between highs of $200 million and lows of $12 million over the past 10 quarters. Meanwhile, Kate Spade's quarterly net income slumped to $1.4 million in the most recent quarter, from $85.5 million in the final three months of 2016.

Still, Coach is likely getting a good deal on its purchase. Caerus Investors, the investment fund that called for Kate Spade to be sold in November, had expected a much higher value for the retailer's stock. Back in November, Caerus Investors said Kate Spade lost value due to mismanagement of the brand and a deal could get a 50% premium on the stock, or about $25 a share. Similarly, Wells Fargo analysts had predicted that Kate Spade investors could get $23 per share if the company was acquired.

Coach is paying $18.50, a 28% premium to the stock's closing price as of Dec. 27, the last trading day before The Wall Street Journal reported that Kate was exploring a sale. Shares rose 8.3% Monday to close at $18.38.

--David Benoit contributed to this article.

Write to Tatyana Shumsky at tatyana.shumsky@wsj.com

(END) Dow Jones Newswires

May 08, 2017 19:14 ET (23:14 GMT)