Why the Coach and Kate Spade Deal Is a Win for Both Companies

As Coach (NYSE: COH) rollsKate Spade (NYSE: KATE) into its budding portfolio of fashion companies, investors will watch closely to see if Coach can leverage its reach and experience to take both brands to the next level. In this segment fromIndustry Focus: Consumer Goods, the castdives deep into the rationale for the $2.4 billion deal.

A full transcript follows the video.

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This video was recorded on May 9, 2017.

Vincent Shen: Overall, I think what it comes down to is that Coach can take some of the lessons it's learned from its previous run and the issues it had from its subsequent recovery, and hopefully apply that to Kate Spade a little bit, and take the Kate Spade business to the next level. What do you think, Asit?

Asit Sharma: I agree, Vince. If you were to look at Coach's revenue for the past five years, they've certainly had a U-shaped curve. They peaked right in the middle of 2013, as you were talking about. That revenue has fallen about 12% since that period, and it's picked up since about midway through 2015. And that reflects their learning curves, as you mentioned. One of the things that Coach is going to be very keen on with Kate Spade is to understand what channels should we sell in? They're pulling back in department stores. You and I have covered this many times -- the retail industry is in deep flux. If you are in brick and mortar, you really need to be rethinking your strategy. And Coach has done that.

What Kate Spade provides it is a portfolio beyond us, beyond that namesake brand which, frankly, five years ago, Coach thought it would bank on forever. It's no longer, as you mentioned, this really aspirational brand. But it still has an extremely respected space in the luxury segment. And we can see Coach potentially becoming a player in the broader luxury segment. Kate Spade could be a good experiment, could add on, very conceivably, some other high-end brands and a more aggregated approach to revenue.

So condensing all that down, Coach is thinking in terms of channels, where will we be selling, and it's also thinking in terms of brands beyond us, beyond Coach. And that's again, another reason why shareholders should be pleased. The premium on this deal, as you mentioned, is not that huge, so it's an efficient spend for Coach. And I think for Kate Spade, they get a very deep-pocketed parent that can help with some of the issues that this brand has been experiencing. I'll bring it back to you, if you want to talk about what we've seen with Kate Spade.

Shen: Something I wanted to speak to to provide some context is the scale of these businesses. Last 12 months, Coach, over $4 billion in revenue. Kate Spade, about $1.5 billion. If you look at their store networks and their footprint, Coach, between its actual retail stores, as branded, you'll see them in malls and shopping centers, they have their outlets, and they also have -- this is something you mentioned that they've started cutting back on -- their shop-in-shops in department stores, where they have their dedicated space, all Coach products, in major department stores. They're cutting back on that. But still, between those three different categories, over 900 stores, whereas Kate Spade is just over 250. I'm looking at some financials for Coach in the past few years. You mentioned how, around 2014, 2015, the revenues declined after putting up several years of double-digit growth. But something that's really telling, too, is on the bottom line, you really see their operating margin start to get squeezed as they are moving into certain channels that, yes, are potentially helping them to grow that top line, but they take a hit with discounting and promotions, having to lower that price to move product. The operating margin in 2013, for example, over 20%. In the most recent last 12 months, about half that, at 11%. I think they're trying to prevent Kate Spade, with this acquisition, from experiencing the same thing.

And management spoke to this, actually, specifically when talking about some of their main priorities once they add Kate Spade to their portfolio is getting the company out of these flash sales and certain wholesale channels, especially in urban areas where you have a lot of customers who can access Kate Spade goods cheaper. That hurts not only their profitability, but also it hurts to associate the brand with that lower price point. Otherwise, if you look at the networks for these stores, and the customers for the stores, I know you mentioned you were a little skeptical, Asit, about the idea of the millennial access that Kate Spade offers. Coach's internal research team said about 60% of Kate Spade customers are in that millennial category. But otherwise their overlap doesn't seem too bad, about 35% of Coach stores overlap with Kate Spade locations at the moment. Coach claims from its research that only 10% of their actual customers overlap, presenting an opportunity there for them to branch out and bring people into the fold.

I think, if you're looking at this longer term as a Coach investor, and the benefits that Coach can bring to the Kate Spade brand into their network, it's really in terms of distribution and broadening and expanding the markets that Kate Spade operates in. During the conference call, when they announced the deal, management talks about the fact that brand awareness in North America, for Kate Spade, at 30%, for Coach at 70%. Whereas, in Japan, which is the main Asian market where Kate Spade operates, it's 11% for Kate Spade and 50% brand awareness for Coach. In China, where Kate Spade is only about 1%, pretty much untapped, Coach has 23% awareness. So just to give you an idea of how Coach can help Kate Spade expand its distribution significantly.

I like the fact that, overall, Coach is thinking longer-term. After previously sacrificing their brand for near-term growth and results, they're willing to endure some near-term financial pain for more sustainable growth. With Kate Spade, they've noted that pulling out of flash sales, pulling out of these wholesale channels, will hurt near-term growth and revenue, but longer-term, it makes it much more sustainable. The way I think about it, too, a company that it reminds me of is Urban Outfitters. This is a company that has several distinct brands that are intended to appeal to younger shoppers, then you keep them loyal and moving them into the other brands within the company portfolio throughout their lives, as their tastes change, as they mature. This is, I guess, Coach's way of potentially doing that, getting the millennials through Kate Spade, and then even though they say their core customer demographic for Coach is people in their 20s to 40s, I think generally it appeals to an older shopper, bringing them in after they reached that point from Kate Spade.

Asit Sharma has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Coach. The Motley Fool has a disclosure policy.