Tapestry - Earnings Call - Q4 2011

Transcript

Speaker 7

Good day, and welcome to the Tapestry Conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Senior Vice President of Investor Relations and Corporate Communications at Tapestry, Ms. Andrea Shaw Resnick. You may begin.

Thank you. Good morning, and thank you all for joining us. With me today to discuss our quarterly results are Lew Frankfort, Coach's Chairman, and Mike Devine, Coach's CFO. Before we begin, we must point out that this conference call will involve certain forward-looking statements, including projections for our business in the current or future quarters or fiscal year. These statements are based upon a number of continuing assumptions. Future results may differ materially from our current expectations based upon risks and uncertainties such as expected economic trends or our ability to anticipate consumer preferences. Please refer to our latest report, Annual Report on Form 10-K, for a complete list of these risk factors. Also, please note that historical growth trends may not be indicative of future growth.

Please note that the results for the fourth quarter and fiscal year ending July 2, 2011, included 13 and 52 weeks, respectively, while the same periods in fiscal 2010 included 14 and 53 weeks, respectively. All discussions of comparable store sales are calculated based on an equivalent number of weeks for each period: 13 weeks versus a comparable 13-week period for the fourth quarter and 52 weeks versus 52 weeks for the fiscal year. Now, let me outline the speakers and topics for this conference call. Lew Frankfort will provide an overall summary of our fourth fiscal quarter and annual 2011 results, and we'll also discuss our overarching strategy. Mike Devine will continue with details on financial and operational results of the quarter and year.

Following that, we will hold a question and answer session where we will be joined by Mike Tucci, President, North American Retail; Victor Lee, President, International Retail; and Jerry Stritzke, our President and Chief Operating Officer. This Q&A session will end shortly before 9:30 A.M. We will then conclude with some brief summary comments. I'd now like to introduce Lew Frankfort, Coach's Chairman and CEO.

Speaker 5

Thanks, Andrea, and welcome, everyone. As noted in our release this morning, we were very pleased with the fourth quarter results, including excellent sales and earnings growth. This quarter's performance demonstrated a continuation of the momentum we have been experiencing throughout FY11, as we continue to improve productivity while expanding our distribution in new and existing geographies. Our results reflect a growing recognition of the Coach brand globally and the success of our new initiatives. Before I review the highlights of the quarter, I wanted to mention our CFO transition. First, as you know, Mike Devine announced his retirement earlier this year, effective later this month. This will be his last earnings call with Coach, and we will miss Mike greatly. Mike has played a critical role in developing and executing the strategies that have driven our superior sales and earnings growth during his tenure with the company.

We wish him every success in the future. At the same time, we're pleased to welcome Jane Nielsen as our new CFO, who will be officially starting in early September. Moving on to some key highlights of our quarter and fiscal year. Our performance in FY11 was highlighted by increases of 18% in revenues, 20% in operating income, and 30% in earnings per share, all on a comparable 52-week basis. It was a year of many milestones, including, first, Coach surpassed $4 billion in sales, driven by gains in all of our business units. Second, we placed an increased emphasis on the globalization of our business, as we accelerated our international distribution growth, especially in Asia, while we continued to open new stores and gain market share in North America.

Third, we successfully refocused on a men's opportunity for Coach, as we began to open dedicated men's and dual-gender locations globally, doubling the business year over year. Fourth, we increased our quarterly dividend by 50% and authorized another $1.5 billion buyback in January, demonstrating our financial strength, cash flow generation, and our commitment to shareholder return. This annual performance was capped off by an excellent fourth quarter. Some key metrics were: first, net sales totaled $1.03 billion, an increase of 17% on a comparable 13-week to 13-week basis. Second, earnings per share totaled $0.68, up 22% from the $0.56 in the prior year on the same 13-week basis. Third, direct-to-consumer sales rose 18% on a comparable 13-week to 13-week basis. Fourth, North American same-store sales for the quarter rose 10% on a comparable basis from prior year, while total North American store sales rose 18%.

Fifth, sales in Japan rose 6% in dollars and declined 7% in constant currency, also on a comparable basis, modestly impacted by the ongoing effects of the earthquake and tsunami. Finally, we continue to generate very strong sales and comps in China. During the quarter, we opened three North American retail stores, including two in new markets for Coach: Fredericksburg, Virginia, and Albuquerque, New Mexico, as well as our first mall-based men's store in Copley Plaza in Boston. We also closed two locations. In addition, we opened nine factory stores, including six men's dedicated locations. At the end of FY2011, there were 345 full-priced and 143 factory stores in operation in North America. This was a net increase of three full-priced stores, including one men's retail store, as well as eight factory stores and 14 men's factory stores from the end of FY2010.

Total square footage grew 7% for the year. Moving to Japan, two locations were added: a shop and shop and a men's factory store. Separately, all but two of the stores that were closed due to the earthquake and tsunami had reopened by year-end, and over the last month, the remaining two have reopened. At year-end, there were 176 total locations in Japan, with 20 standalone full-priced stores, including eight flagships, 119 shop and shops, 30 factory stores, and seven duty-free locations. In total, a net of nine locations were added in Japan during FY2011, and three were expanding, yielding total square footage growth of about 4%. In China, we added 11 new locations, nine on the mainland and two in Hong Kong. At the end of the quarter, there were 66 Coach locations in China, including 53 locations on the mainland and 22 cities.

Additionally, there were 11 locations in Hong Kong and two in Macau. In aggregate, there was an increase of 25 net new locations for the fiscal year, for a square footage increase of 62%. Indirect sales, which represent about 13% of Coach's sales on an annualized basis, increased 12% on a comparable 13-to-13-week basis, or 4% as reported, to $113 million. This increase was driven by both international wholesale shipments and shipments into U.S. department stores. At POS, international sales rose significantly, driven by both distribution and comps, while U.S. department store sales rose high single digits. We estimate that the addressable U.S. women's handbag and accessory category rose 5% to 10% during our fiscal fourth quarter. Over the same period, Coach's bag and accessory sales rose about 14% across all channels in North America, including in our own stores.

For the fiscal year ended June, we estimate that the addressable category rose about 10% to approximately $9.3 billion, while Coach's North American bag and accessory sales rose 14% across all channels and 17% in our own stores over the same period. Separately, it's worth noting our customers' outlook for the economy has been stable over the last few quarters, with a third of those surveyed still believing that the U.S. economy is improving. Our intention to purchase Coach remains high, with over two-thirds of consumers surveyed noting they probably or definitely would purchase a Coach product in the next 12 months. Our total revenues in North America were up 17% in the quarter on a comparable 13-week to 13-week basis, with our directly operated stores up 18% as distribution growth augmented the comp performance.

Fueling these overall comp results were strong gains in both the full-priced and factory channels, driven by significant increases in conversion from prior year, while ticket and traffic were essentially the same. We were particularly pleased with the improvement in the conversion rates, since it is the driver that we have the most control over through product and service. We also have been delighted by the very strong sales trends we're experiencing in our North American Coach.com business, our largest store, which, of course, is also extremely profitable. While we have long viewed this channel primarily as a marketing vehicle, sales growth accelerated at a significant double-digit pace during the fourth quarter. We expect that internet sales will grow rapidly in the years ahead, while also, importantly, driving consumers into the stores.

While the fall season is just underway, we are pleased with our current trends and consumers' continued response to our product and positioning. As noted for the quarter, we posted a 7% decrease in local currency in Japan and a 6% gain in dollars, excluding the extra week from last year's results. Five of the seven stores that remained closed at the end of March due to earthquake and tsunami damage reopened during the fourth quarter, and the remaining two just reopened this month, as mentioned. Generally, business in Japan is trending where it was prior to the events on March 11, as business improved over the period. Naturally, I want to call out China, which is our single largest geographic growth opportunity. During the fourth quarter, as for all previous quarters this year, we achieved significant double-digit comp growth.

As I referenced earlier, we are opening stores primarily on the mainland, where increasing numbers of consumers are participating in the category. Moving on to product. During the fourth quarter, we maintained a high level of product innovation and distinctive newness. In April, we introduced the collection of Natalie novelty straw totes, along with new colors in a dream sea print and Poppy. In May, we launched Audrey, a modern tote story featuring perforated leather, op-art, and print concepts. Additionally, our lead collection for Mother's Day was Madison, offered in fresh colors and patterns. For June, we introduced new leather and pattern colors in Kristen, as well as a strong new op-art print. Our Kristen hobo continues to be the key item within the collection.

This season's product was very well received, and both handbags and women's accessories achieved strong comps in the quarter, with handbag penetration in our North American retail stores remaining at 55%. In addition, in July, we launched the new Chelsea collection and evolved Poppy with updated styles, patterns, and prints. The Chelsea collection features a modern, faceted turn lock inspired by our heritage and offered in timeless silhouettes. Poppy had an updated look with new leather and logo fabrics and new push lock closures. In August, we're offering new fall fabrications, colors, and patterns in Madison, and a new shoulder bag in Chelsea. On the factory side, our strong results were fueled by a powerful combination of new product introductions with key styles offered at great prices. Additionally, our inventory investment strategy enabled us to capture sales upside throughout the quarter.

Our product assortment was also supported by our in-store and direct marketing campaigns. Naturally, I also want to touch on men's, a global initiative. As many of you know, we decided about 18 months ago that we would create a strong capability to leverage our reputation in the marketplace for quality leather men's products. Over this period, we've built a team and the infrastructure to become a market leader in the men's category, and we've begun to expand our global footprint in men's. In the U.S., we've opened three full-priced dedicated men's stores: Bleecker Street in New York, Copley Plaza in Boston, and most recently, Garden State in New Jersey. In addition, we've created about 40 dedicated men's concept shops and select full-priced flagships. We also opened a total of 14 North American men's dedicated factory stores, as mentioned.

Our results have exceeded our expectations and underscore the opportunity for Coach men's in the U.S. Outside of the U.S., where the male customer tends to be more style conscious, we've also opened a number of men's dedicated stores, notably in Japan, where we have seven men's stores today. Our future store growth in Japan will primarily be dedicated men's locations. More generally, in Asia, including China, we are seeing excellent early results from dual-gender stores. Our first-year results have been excellent, as our men's sales doubled to over $200 million in FY2011. This performance underscores our confidence in men's as a significant growth driver for Coach, and we now believe it could contribute 25% or more of the company's growth over the next several years. As we enter FY2012, beyond the men's initiatives, our overarching strategies remain largely unchanged.

We will continue to focus on expansion opportunities, both in North America and increasingly in international markets. In addition, as always, we're focused on improving performance in existing stores by increasing Coach's share of our consumers' accessories wardrobe, while continuing to attract new customers into the franchise. Moving on to distribution growth, we expect that our square footage globally and across all channels will increase about 12% in FY2012 compared to 9% last year. Starting in North America, we will open about 40 new stores in FY2012, with more than half being dedicated men's locations. In total, we expect to open about 15 net new full-priced locations, about half will be men's, and 25 factory outlets, including 15 men's stores. In total, we expect North American square footage growth of about 7% this year, in line with last year and driven by men's.

As we've discussed many times, outside of North America, China is clearly our largest geographic opportunity, given the size of the market and the rate of growth. The Chinese consumer has embraced Coach, as evidenced by the significant double-digit comps we're consistently generating and the extremely high repurchase intent among existing customers. Our sales in China totaled over $185 million, up from $108 million last year, as the market grew rapidly and we increased our share to 6% on the mainland. In addition, our unaided brand awareness among PRC consumers jumped to 16%, about double last year's level. This year, we will accelerate new store openings with about 30 locations planned for the mainland. The vast majority will be dual-gender stores, given the size of the men's opportunity in China.

Overall, we're now projecting sales of between $280 and $300 million for FY12, up from our previous guidance of $250 million. We also intend to open a few locations in Hong Kong in FY12, along with one or two in Singapore, where we just acquired the operations of our distributor last month, as planned. In FY12, we will make significant investments towards increasing awareness in China, as we leverage our 70th anniversary campaign to build on our positioning as a New York fashion brand, grounded in heritage and history. This integrated campaign will have several key elements, including an international brand ambassador, Gwyneth Paltrow, who has proven relevancy in China and other international markets. In Japan, the overall consumer market remains very challenging, and the category continues to contract. Our focus continues to be on gaining market share, and we have done this quite well in our core women's business.

As discussed, we're now also focusing on men's, where we have seen early success. During FY12, we expect to open about 15 net new locations in Japan, nearly all of them dedicated men's stores. In total, we expect the net square footage growth in Japan will increase by about 10% this year, compared to about 3% last year. Finally, beyond our directly owned international businesses in Japan, China, and now Singapore, we do have significant and growing distributor-run businesses in other Asian countries. We're also pleased to announce distribution agreements to open the first Coach stores in Brazil, which are expected to open next spring, and in Vietnam, with the first openings expected late this calendar year. During FY12, we expect to open between 35 to 40 net new international hotel locations, bringing our total number to nearly 250.

Touching on Europe, last year we opened a total of 14 locations, including seven in Printemps in France and through our joint venture with Hackett, six shops and shops in El Corte Inglés, five in Spain, and one in Lisbon, along with one retail store in the UK. We've been pleased with our initial performance and the early reaction of domestic shoppers and international tourists to the Coach proposition. For FY12, we expect three additional openings in Printemps, including two men's shops, as well as a number of new locations in Spain, the UK, and Ireland through our joint venture. Naturally, we're very excited about our new Bond Street flagship, which is on target for a September opening and will be supported by our new ad campaign featuring Gwyneth Paltrow.

Beyond the opportunities in the Coach brand, as you know, we launched Reed Krakoff last September in a few boutiques in the U.S. and Japan, as well as through prestigious international specialty retailers. We are pleased that the product is appealing to the targeted pinnacle luxury consumer. As we mentioned on the 3Q call, Valerie Hermann joined Reed Krakoff as President and CEO this April from YSL and has been a valuable addition to the leadership team. What I have just reviewed are our strategies to drive our business at a double-digit pace, given the continuing strength of the Coach business and our increasing global expansion. We have significant runway ahead of us, both in North America, which remains a growing market, and worldwide, while our refocus on men's provides an additional opportunity for growth.

At this time, I will turn it over to Mike Devine, our CFO, for further detail on our financials. Mike? Thank you, Lew. Lew has just taken you through the highlights and trends, let me now take you through some of the important financial details of our fourth quarter results. As mentioned, on a comparable non-GAAP basis, our quarterly revenues rose 17%, with direct-to-consumer, which represents about 87% of our business, up 18%, and our indirect segment up 12%. Similarly, operating income rose over 20%. Net income for the quarter increased 18% and totaled $202 million, with earnings per diluted share of $0.68, up 22%. On a reported basis, sales rose 9%, net income rose 4%, and earnings per share gained 7%.

For the fiscal year, sales rose 18% on a comparable non-GAAP basis, totaling $4.16 billion, while earnings per share were $2.92, up 30%, and net income was $881 million, up 24%. On a reported basis for the full year, sales rose 15%, net income gained 20%, and earnings per share increased 26% from fiscal 2010. For the quarter, operating income totaled $312 million, up 20% from the prior year on a comparable non-GAAP basis, and 5% above the $297 million reported in the year-ago period. Operating margin was 30.3%, 80 basis points better than the 29.5% generated in the prior year on a comparable basis and versus 31.2% on a reported basis.

During the quarter, gross profit rose 6% to $740 million, from $697 million reported a year ago, while gross margin rate was 71.8% versus 73.3%, reflecting the impact of higher sourcing costs, partially offset by channel mix and modestly lower levels of promotional activity in our North American factory bid. SG&A expenses, as a percentage of net sales, totaled 41.5%, compared to the 42.1% reported in the year-ago quarter. We were pleased that we were able to gain 60 basis points of leverage on a reported basis in the quarter, as our primary direct businesses here in North America and in Japan provided leverage to the corporate P&L, more than offsetting the impact of our investment spending. We believe we're striking the right balance between driving future growth opportunities and operating efficiencies.

For the full year, operating income totaled $1.3 billion and 32% of sales, up 20% from the prior year on a comparable basis and 14% above the $1.15 billion reported in the year-ago period. On a comparable basis, operating margin expanded 50 basis points and was above our stated objective and last year's actual margin of 31.5%. On a reported basis, operating margin was 31.4% versus 31.9%. During the year, gross profit rose 15%, $3.02 billion, from $2.63 billion a year ago. Gross margin was 72.7% versus 73.0% a year ago. SG&A expenses, as a percentage of net sales, totaled 41.3%, compared to the 41.1% reported in fiscal 2010. As a reminder, there were a number of items that affected comparability for the fourth quarter and the full year. First, the 53rd week in FY10 contributed about $70 million to sales, $24 million to net income, or $0.08 to earnings.

In addition, as noted in our press release, we recorded certain one-time items during the third quarter of 2011, which resulted in a substantially lower tax rate of 26.5% in that quarter. These included a favorable settlement of a multi-year tax return examination, which decreased Tapestry Inc.'s provision for taxes by $16 million. In addition, the company made a $21 million contribution to the Coach Foundation and also contributed 400 million yen, or just under $5 million, to the Japanese Red Cross. Together, these contributions totaled nearly $26 million pre-tax, impacting GAAP SG&A expenses by that amount and precisely offsetting the benefit of the tax settlement to both net income and EPS. Moving to the balance sheet, inventory levels at quarter end were $422 million, up about 16% from FY10 year-end, consistent with our expectations and sales growth.

This inventory level allows us to support 25 net new North American stores, eight net new locations at Coach Japan, and 25 additional Coach China stores from the year-ago period, as well as the Asia distribution center, the Reed Craker brand, and our men's initiatives. Further, our current inventories support the strong underlying business trends and will allow us to maximize sales this summer and fall. Cash and short-term investments stood at $702 million, essentially even with $696 million a year ago, after $1.1 billion of share repurchase in the interim 12 months. During the fourth fiscal quarter alone, we repurchased and retired about 6.3 million shares of our common stock at an average cost of $60.08, spending a total of $381 million. At the end of the year, approximately $962 million remained under our present repurchase authorization.

Net cash from operating activities in the fourth quarter was $221 million, compared to $182 million last year during Q4. Free cash flow in the fourth quarter was an inflow of $164 million versus $152 million in the same period last year. Our CapEx spending was $57 million versus $29 million in the same quarter a year ago. For the full fiscal year 2011, net cash from operating activities was $1 billion, compared to $991 million a year ago. Free cash flow in fiscal year 2011 was an inflow of $886 million versus $910 million in fiscal year 2010. CapEx spending totaled $148 million for the year, compared to $81 million in the prior year.

It's important to note that based on our current plans for FY12, we expect the CapEx for next year will be up in the area of $200 million, up to the area of $200 million, driven by the timing shifts of certain projects, primarily for the opening of new stores across all geographies and investments in technology necessary to enable our global expansion. While we are not giving specific guidance for FY12, we see the year unfolding very similarly to FY11, with strong revenue trends, robust core businesses delivering leverage, while we continue to invest in the future. First, and most generally, we do expect to achieve double-digit sales with earnings per share growth ahead of the top line. Our sales will be driven in part by at least mid-single-digit comp store sales in North America.

Second, as we've said before, our gross margin is likely to improve sequentially in the first half of the year versus the second half of FY11, though we'll still contract on a year-over-year basis. The second half is expected to be slightly easier as we anniversary increase sourcing costs, while channel mix and our sourcing initiatives contribute to profitability. On balance, we expect gross margin to remain high and in the 72 to 73% range for FY12. Third, on SG&A, we expect our core businesses to continue to deliver leverage, while we will also continue to invest in global growth for the future. Fourth, we are committed to delivering an operating margin similar to what we've generated over the past two years. Fifth, our tax rate is likely to be in the area of 33% for the year as we further refine our international tax strategies.

In summary, our fourth quarter and FY11 results demonstrated our ability to manage our business nimbly while investing prudently in longer-term opportunities. We're accelerating our distribution plans to leverage the emerging market opportunity with a particular focus on China, while also exploring new geographies, capitalizing on the increasing popularity and recognition of the Coach brand with discerning consumers globally. We are also optimizing the brand's potential in men's, leveraging our long heritage in this category. With a business model that generates significant cash flow and with virtually no debt, we are in a position to take advantage of profitable growth opportunities globally while continuing to return capital to shareholders. As Lew Frankfort mentioned, this will be my last earnings call, so before I open it to questions, I just wanted to say that this has been the most remarkable and rewarding 10 years of my professional career.

I'm quite proud of what Coach has accomplished over this time. In addition to all the many people at Coach I need to thank, at this time I'd especially like to thank all of my many, many good buy-side and sell-side friends out there. Your support has been tremendous. I'd also like to welcome Jane, who I know is listening as she takes the best CFO job in global branded retail, and close by saying that I plan to be a long-time shareholder as Tapestry's prospects have never been brighter, and I look forward to watching its continued success as I pursue more work and spend more time with my family. Thank you. I would now like to open it up to questions and answers. Thank you, Mike.

Speaker 7

Thank you. At this time, if you would like to ask a question, please press star one on your touch-tone phone. To withdraw your request, you may press star two. Once again, to ask a question, please press star one. Our first question comes from Bob Durbell with Barclays Capital.

Speaker 3

Hi, good morning. Mike, congratulations, and best of luck, and Lew and everybody, congratulations on the quarter. I guess the first question that I have is, on the comp results for this quarter, what really drove the upside to your plans? Do you think those drivers should remain intact for potential for upside in your plans for the next fiscal year?

Speaker 5

Mike Devine will take that.

Speaker 2

Sure. Thanks, Bob. We had, we're very pleased with the quarter. We're very pleased with the year. The drivers behind it, conversions, significant. More importantly, behind conversion, improved handbag productivity, through pricing, where we had average unit retail increases, as well as unit comps. That was a significant driver, and I think it speaks to the longer-term rebalancing of the assortment and driving a focus on balance in our assortment and handbags. Additionally, we're starting to see men's become a comp driver, contributing to overall productivity in our stores, particularly in the significant high-profile stores where we have men's, in a more definitive and larger format within those stores. As you well know, we tend to be conservative planners.

While it's early in the quarter in Q1, the trends and tempo of the business that we saw coming out of Q4, we really see that continuing in the early stages of July. We like what we see happening with the response to product, largely driven by Chelsea, very strong response to what I would call a more refined look within Poppy and continued reaction to newness in our factory channel, where we continue to refine our flow strategies there. I think the other important channel to mention is that our digital opportunity continues to be a growth driver for us, not only from a sales and revenue standpoint, but in terms of visitation and browse. We know that a large reason for consumers coming to our sites is to pre-shop our stores. We see that as a continued opportunity as we enter into Q1.

Speaker 3

Great. Just one follow-up question is, I think Lew, you mentioned strong gains on a comp basis in both full price and factory. Was there a variance between the two this quarter?

Speaker 5

It was roughly the same.

Speaker 3

Great. Thanks very much.

Speaker 7

Thank you. Our next question comes from Omar Saad with ISI Group.

Speaker 1

Good morning. Thanks for taking my call. I'd like to add my congratulations to Mike as well. Best of luck. A quick question on your international wholesale business. It sounds like there's a little bit of acceleration in the store growth plans for this year, especially in light of a couple more of those businesses now being in-house. Could you put that in context? What's going on there, especially with the announcement today on Brazil and Vietnam? Thank you.

Speaker 5

I mentioned earlier that our growing awareness globally has created substantial opportunities for us. First, in existing markets, we're finding that we're gaining on higher awareness and increased traction, which gives us confidence that we can continue to open new locations. We're also benefiting in many markets from the global tourist, who is contributing substantially to our sales in many locations. Due to the new distribution agreements and increased traction, we're in a position to open many more locations than we have had, than we have opened in the past.

Speaker 1

How will the sourcing work in Brazil, where I know there's sometimes some tariff issues for imports? Is your partner there going to source locally?

Speaker 5

We're going to be, consistent with the way we run our business, we're going to do all sorting. We're going to deal with the tariffs as we need to. The assortment will be a global assortment.

Speaker 1

Okay, great. Thanks. One quick question is on men's. Could you remind us what it was historically at its peak in terms of a % of total Coach sales? Do you think it could get back there someday?

Speaker 5

I'm sorry.

Speaker 2

Men's is a peak.

Speaker 7

20 to 25% of our sales, as recently as the late 1990s, Omar.

Speaker 1

Thank you.

Speaker 5

It's conceivable that we could. Right now we're looking to grow our business from about 4% to over 10% during our planning horizon.

Speaker 1

Thanks a lot. Good luck.

Speaker 5

Thank you.

Speaker 7

Thank you. As a reminder, please limit yourself to one question. Our next question is from Kimberly Greenberger, Morgan Stanley.

Speaker 4

Great. Thank you. I want to send my best to Mike. I hope you really enjoy retirement.

Speaker 5

Thank you, Kimberly.

Speaker 4

I wondered if you could talk about your pricing and your mixed strategies in North America. Are you planning to increase price in order to offset rising cost of goods sold? Mike, could you help me a little bit on your gross margin outlook? Can I read your comments to mean that you're expecting flat gross margin in 2012, or do you think there's a possibility you could see some recovery in the year, obviously with the improvement in the second half of the fiscal year?

Speaker 5

Why don't I take the latter half of that first, and then perhaps Mike or Lew can jump in on the first part of the question. You know, Kimberly, yes, what we're asking people to model is essentially a flat gross margin rate at this point in the year. It's still very early days of the year, but we're actually feeling guardedly optimistic about gross margin. We do believe that the quarter just reported is likely the low point, and we feel that we can continue to deliver margin rates similar to 2010 and 2011 for FY2012, with some gradual upside improvement in the out years. That's in spite of continued sourcing pressures, the most worrisome of which is wage inflation in China. As we've talked about, we're at the beginning of a very aggressive program to move 50% of our units produced out of China.

While it's early days, we're ahead of schedule on this one, and we'll continue to battle it as we're now actually hearing some rumblings of wage inflation elsewhere. In terms of materials, our design merchandising sourcing teams have done just a remarkable job in designing into cost and counter-sourcing. Of course, our cost of materials are not as dramatically impacted as some of the apparel brands you might be following. We do feel like as we move into the second half of the year, we'll be anniversarying the worst of those, the material cost inflation. Really, all the other dynamics of the business will be helpful to gross margin as we move forward, most notably channel mix, as our full-priced businesses in our mature markets continue to trend positive, and notably China grows far more quickly than total Coach.

Also, the conversion of these distributor businesses, namely Singapore thus far with Malaysia on the horizon, will also be helpful to gross margin rate. I think ultimately, long-term, as men's shares increase, we can also drive gross margin rate longer term as our relatively new men's team gets their legs under them. Frankly, we believe that our male consumers are not as bargain-obsessed as their wives and girlfriends. The last thing I think that can be helpful to gross margin rate is as the overall economy generally improves, I think we'll continue to see full price trending nicely and perhaps over time, have a little bit of pricing power in the factory channel as well. We're looking for, to model a relatively flat FY2012.

As the year plays out, the wild card will be the promotional levels probably in factory, but there is gradual improvement and upside into the out years.

Speaker 2

Sure. Okay. On retail pricing, the answer is we absolutely see opportunity for pricing, and it's not absolute price increases. It's driven by mix and offer. A couple of things that are happening in the market that are favorable to us. One is we're in a strong leather cycle, which affords us the ability to get higher retails, and that will drive average unit retails up in our handbag category. It had an impact on Q4, where you see average handbags over $400 contributing 17% to our overall handbag sales versus 11% in the prior year. That's a big deal. The refinement of the Poppy strategy allows us to work the mix inside of Poppy for some potential retail upside.

One other significant opportunity is what we're calling small bags and cross-body, which offers us a pricing opportunity and also protects our opening price points, both within Poppy as well as in the overall mix. That's a very important element. While we dialed back to a target of $300 and landed in the $280 range a couple of years back, we're now working our way back and trying to capture that $20 of upside in average unit retail in handbags. I think over time, we see that as a real opportunity. On the factory side, it's a similar story, with a strong leather trend and also being very creative there on our pricing strategy to create differentiation in our retail strategy between leather offer and signature offer, which the customer accepts on the factory side and allows us to gain average unit retail increases in our handbag category.

That was also helpful and a driver, and we see that continuing.

Speaker 5

A driver of gross margin rate as well, particularly in factory.

Speaker 2

Thank you, Mike.

Speaker 5

I'd like to just add one clarification. Mike Devine, when we talk about 50% of our units coming from outside of China, what we're really referring to is incremental production requirements. We plan to maintain the same level of jobs in China that we have today, but all of our future requirements we're planning to come from outside of China.

Speaker 4

Great. Thank you.

Speaker 7

Thank you. Our next question comes from Brian Tunick with J.P. Morgan Chase.

Speaker 6

Thanks. Mike, congrats as well, and wish you well, Mike. My question is on the SG&A side. Maybe talk about the investment spending this past year on RK in Europe and the continuation of the design build-out. How much of a drag was that this past year, and how should we think about that going forward in FY 2012? Can this business get back to that 38% SG&A as a percentage of sales, especially as you get to that $5 billion in revenue target over the next couple of years? Quickly, on the Hong Kong listing, is there any update on timing of what we should be looking for and your thoughts on that?

Speaker 5

I'll take the simpler one, the Hong Kong listing, first, although actually it's not simple. It's proving to be complex, and we're currently going back and forth with the exchange, answering some questions based on the documents we submitted, required to get listed. I think we're looking, probably for a listing sometime in the early fall. Going back to SG&A, we were very pleased, actually, the fourth quarter in the way we just delivered. As we talked about, we delivered, on an as-reported basis, 60 basis points of leverage to the SG&A line, and we did that in spite of losing some of our healthiest revenue from Japan as a result of the earthquake. Again, that's on the 14 versus 13-week compare. We're continuing to see great leverage being delivered by our mature businesses here in North America and in Japan, while we continue to investment spend.

We've talked about that investment spending in, as it was directed for RK, the infrastructure build in China, and in other parts of Asia to allow us to capitalize on the opportunity there as being an investment in the neighborhood of about $0.08 this most recent year. I think we can look to see that investment continue to improve into 2012 and into the out years. Valerie Herman has come in and is really doing, I think, a number of the right things around RK. We're likely to pick up a couple of pennies of investment spend there. What will happen is that in the first half of the fiscal year, we will pick up the Singapore direct expenses, and while relatively modest to total Tapestry Inc., that will be a drag to the SG&A rate.

It will take Victor Luis and his team a little bit of time to bring that business to its full profit potential. We will get there, but get there quickly. It takes a while for us to install our retail processes, adjust the assortment. Remember, when we transition a business from the distributor to a direct business, we're buying that inventory back at wholesale prices. The first six months of selling is also at somewhat reduced gross margin rates. Going forward into FY12, the balance of all these investments and the leverage we expect to get from our mature businesses looks like we're going to have a pretty flat SG&A rate for the year while we grow the business a very strong double-digit top line.

Speaker 7

Thank you. Our next question comes from Lorraine Corrine Maikis Hutchinson, Bank of America.

Speaker 4

Thank you. Good morning. I just wanted to follow up on the men's business. How are you thinking about the total store base for both factory and full price domestically, and then in Asia?

Speaker 2

Right, Kay? We're a little further along on the factory side only because it's more demonstrated there. We do have 15 stores open. We opened a handful of stores this past several weeks, so we're adding to that. The factory opportunity from a store count standpoint is significant, and while we're not committing to a long-range number, we will be nimble and aggressive in terms of taking opportunities in the marketplace to gain space on the factory side. On the full price side, we're really pleased with what we see happening in the couple of stores that we have open outside of Bleecker Street. We've committed to a handful of stores this year that we're working on, including a format where we have men's and women's side by side with a pass-through that will open in the spring in Pentagon Center Mall outside of D.C. That's when we talk dual-gender.

That's the format that we want to get into the marketplace. It's a format that we're seeing a lot of success with internationally, and we think that opportunity may play itself out in North America as well. I think it's important to note on the full price side that men's is a more premium proposition for it, and we're going to target the absolute best real estate within the full price arena. As we get more experience, we'll be better informed, and we'll approach the men's full price opportunity accordingly.

Speaker 5

Victor, would you touch on Asia for us, please?

Speaker 6

Sure. First, from the size of opportunity perspective, I think it's important to understand the scale of the opportunity that stands in front of us. We're looking at a premium handbag and accessories market in Asia of about $12 billion today, of which approximately 25% is men's. That would be the approximate penetration in Japan. In PRC and mainland China, we see the penetration of men's closer to 50%. A truly tremendous opportunity for us. From a distribution perspective, of course, you're all aware that we have a more mature distribution in Japan. As Lew mentioned in the speaker's note today, we have already seven locations in Japan, three full price locations and four factory locations. We're planning to open 15 doors in FY2012, the vast majority of which will be men's freestanding locations.

Increasingly, we're also experimenting with bringing men's into current women's doors where it makes sense from a distribution perspective. This is slightly more difficult in Japan, given that most of our locations are in department stores where often we're on the women's handbag floor. In China, the opportunity is truly boundless, as we like to say. We have today 53 locations in the mainland, combined with 13 in Hong Kong and Macau, as you know. Of those 53 locations in the mainland, already 23 of those are those dual-gender locations that Mike referred to earlier. Of the 30 locations that we plan to open in FY2012, approximately 27 of those will also be dual-gender locations. It is very much at the center of our strategy. We have the opportunity to go boldly there, given that, of course, we are building distribution from scratch.

Across other Asian markets, we are looking at full strategies as we are in Japan and here in the U.S., where we have the opportunity to start with new doors, and it works. We're going in with a dual-gender location, and we're not, we're going in with the men's standalone locations.

Speaker 7

Thank you. Good luck to you, Mike.

Speaker 5

Thank you.

Speaker 7

Thank you. As a reminder, please limit yourself to one question. Our next question comes from Dana Telsey, Telsey Advisory Group.

Speaker 0

Good morning, everyone, and congratulations. Mike, best of luck. I wanted to ask a couple of things. How much production are you planning to shift out of China in this upcoming year? If you think about the outlook business and the returns, what was the penetration of the made-for product this quarter versus last year, and how do you see those margins? Thank you.

Speaker 5

For the first question, in terms of over 85% of our production will be coming out of China this year. If I understood your question correctly, and Mike, in terms of made-for factory.

Speaker 2

About 85%.

Speaker 5

80% fits in with where we've been.

Speaker 2

To close out on that, yes, Dana, that does carry a slightly higher margin than the full price transfers into the channel.

Speaker 0

there any thoughts on any remodels for the full line stores for this year with CapEx dollars?

Speaker 2

There are a couple of things happening. One is we're actually in the process of taking a look at the entire fleet on the full price side, and in particular looking at potential locations where we either have lease opportunity or space opportunity to better position men's and renovate the store at the same time. An example I would give you, a couple of examples locally. One would be, we're about to reopen our store at 342 Madison, where we were able to reformat the space and add a men's point of view and shop in that space. We did a very significant project at 595 Madison. We have at least allocated slightly more capital to the idea of renovation and remodels within North America, particularly around taking advantage of the men's opportunity.

Speaker 7

Thank you all for joining us on our conference call today. That will be our last question. I'd like to turn it back now to Lew for a few closing words. Lew?

Speaker 5

I think our results and our comments speak for themselves. We're off to a great start in fiscal 2012. We believe we have the strategies in place to continue to grow at double digits, with the bottom line growing faster than the top line. As I've said many times before, stay tuned. Thank you, and have a good day.

Speaker 7

Thank you. This has concluded the Tapestry Earnings Conference. We thank you for your participation. You may now disconnect your line.