The China factor

Canadian resource stocks have faltered on news that economic growth in China appears to be slowing. Beijing confirmed this by reducing its target for GDP expansion this year by half a percentage point to 7.5 per cent. That’s the lowest it has been in eight years.

Of course, 7.5 per cent is astronomically high by our standards but the news hit like a bomb. Stock markets tumbled and the U.S. dollar shot higher as, once again, investors scrambled to its perceived safety. The TSX was hit especially hard as resource stocks dropped amid fears that Chinese demand for everything from potash to copper will weaken.

That may happen, but it’s not the whole Chinese story. In early January, the country’s commerce minister announced a new priority for the economy: boosting consumer spending. Massive government spending on infrastructure products will be reduced, hence the tremors running through the resource sector which supplies the raw materials. Instead, Beijing is implementing measures to encourage individuals to buy more goods and services, thereby pushing the country more towards the U.S. model where GDP is mainly driven by household spending.

One trend that is taking hold is an increasing appetite for American and European products and brands. We have seen this in the penetration of U.S. fast food outlets in China such as McDonalds (NYSE: MCD), Starbucks (NDQ: SBUX), and Yum Brands (NYSE: YUM).

But the Western commercial invasion goes well beyond hamburgers, coffee, and pizza. There is a growing demand for luxury items which are seen by many Chinese as representing status. Knock-offs can still be found in abundance in the markets but more affluent people are increasingly insisting on the genuine article and some companies are aggressively moving to capitalize on this.

One of them is New York-based Coach Inc. (NYSE: COH) which has become a world leader in fashion accessories such as purses, leather goods, watches, and jewellery. The company has 80 stores in China and Hong Kong, including nine opened in the last quarter alone, and continues to expand there. Chinese sales are growing at a double-digit rate and are expected to reach at least $300 million this year — and Coach is only getting started in that country.

At this stage, China is only a small part of the company’s total business. In its fiscal 2012 second quarter (to Dec. 31), Coach reported sales of $1.45 billion, a 15 per cent increase from $1.26 billion for the same period in the previous year. Net income totaled $347 million ($1.18 per share, fully diluted). That compared to $303 million ($1 per share) in the prior year’s second quarter, increases of 15 per cent and 18 per cent, respectively. Note that all figures are in U.S. dollars.

For the first six months of the 2012 fiscal year, net sales were $2.5 billion, up 15 per cent from the $2.18 billion in the first six months of fiscal 2011. Net income totaled $562 million, up 14 per cent from $492 million the previous year. Earnings per share (EPS) rose 17 per cent to $1.90 from $1.62.

The reason the percentage increase in EPS is higher is that Coach is actively buying back its stock. The company repurchased and retired nearly 4.8 million shares in the quarter at an average cost of $62.48, spending a total of $300 million. At the end of the period, approximately $600 million remained under the company’s current repurchase authorization.

Although Coach is expanding in both China and Japan (where it has 184 stores) the bulk of its business is still in North America and the results here continue to be encouraging. Comparable same-store sales in North America increased 8.8 per cent during the quarter and 15 per cent during the holiday season.

The balance sheet looks sound with more than $1 billion in cash on hand and long-term debt of only $23.2 million.

The big negative is the price. Coach stock has been very strong and at the March 26 closing price of $79.03 it was trading just below its all-time high of $79.24. The 12-month trailing p/e ratio was a hefty 24.6 and the stock is trading well above its 50-day and 200-day moving averages. Investors are showing a willingness to pay up for the growth potential.

The stock pays a small dividend of $0.90 annualized for a yield of 1.1 per cent. But the main attraction is the company’s rapid expansion and penetration into the Chinese market.

I like Coach shares a lot but conservative investors may prefer to wait and see if the stock pulls back to $75 or less. Ask a financial advisor if the stock is suitable for your portfolio.

Shanghai is the eighth largest city in the world. It is also the largest city in China, with over 20 million people. Photo © Cui Qunying

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