(FORTUNE Magazine) – At the Coach flagship store on Madison Avenue, a chic 30-ish woman wearing designer Seven jeans and pointy shoes swings her little Louis Vuitton bag off her shoulder. She picks up a Coach bag, priced at $268, from a display table--a sleek, feather-light model in rich brown called the Ergo. "I can't believe it," she says to a friend, admiring the bag's curves in front of a full-length mirror. "What a great color. What great leather. This is Coach?"

You'd better believe it. Just a decade ago Coach was a sleepy division of Sara Lee known for making briefcases and handbags as indestructible as tanks--and about as stylish. But the company has gotten a full-body makeover that extends to its balance sheet. While most luxury-goods makers are floundering, Coach has been posting some truly astonishing numbers. Since Coach went public in October 2000, its stock is up 155%; Tiffany and Gucci fell 36% and 4%, respectively, over the same period (see chart). For the 2002 fiscal year ended June 29, Coach's revenues grew 20%, to $719 million, while net income rose 34%. Its gross profit margins exceed 67%, vs. 54% five years ago. And Coach stores "have incredibly high [annual] sales per square foot, roughly $865, compared with a traditional retailer like the Gap, which has $200 to $300," says UBS Warburg apparel and footwear analyst Jeff Edelman. "No retail chain like this in the U.S. has this kind of sales."

How is Coach doing it? To understand that, you need to know how far the company has come. Coach was founded by leather artisan Miles Cahn in 1941 in a SoHo loft in New York City. The family-run company grew slowly, building a reputation for heavy, unlined leather bags in classic styles. Coach refurbished worn or damaged bags free, even if customers had owned them for years. Priced about 50% lower than high-end designer bags, they were sold in department stores such as Bloomingdale's and Saks Fifth Avenue, in Coach's own stores, and in Coach catalogs.

By 1985 the Cahn family was ready to retire from the retail business--they now own a goat-cheese farm in upstate New York--so they sold Coach to Sara Lee. But by the mid-1990s "business casual" had transformed women's fashion, and Coach's offerings looked as out of date as wide lapels. Consumers flocked to trend-conscious competitors such as Gucci, Prada, and newcomer Kate Spade. In the second half of 1995, Coach's same-store sales growth in Japan--a leading indicator of worldwide trends--plummeted from 40% to 5% "as if overnight," says CEO Lew Frankfort, a no-nonsense 23-year Coach veteran who runs the company to this day. "We were about to hit a wall."

Frankfort knew he had to give Coach a drastic makeover without losing its hard-won reputation for quality. His first step was to hire Tommy Hilfiger designer Reed Krakoff as creative director in late 1996. "Coach was an American icon, but something was missing," says Krakoff, perched on a white Coach leather sofa in his all-white office. He is surrounded by inspiration for the company's latest collections: glossy art books on the likes of Alexander Calder and Le Corbusier, a collage of Giacometti and Color Field prints, and original 1960s and '70s Coach designs. "I had to take these ideas and make them fun--young in spirit."

Under Krakoff's direction, the company began using fabric, nylon, and lighter-weight leathers to make edgier styles--and more of them. In the old days Coach introduced a new collection twice a year; now it does so every month. The design effort is paying off: The readers of shopping magazine Lucky recently named Coach as the most "splurgeworthy luxury brand." A recent Women's Wear Daily survey found that upper-income American women rank Coach products ahead of such megabrands as Ralph Lauren, Donna Karan, Hermes, Prada, and Fendi.

Unlike those other labels, whose styles are typically dictated by a single designer's sense of what's cool, Coach's styles are dictated by what customers think is cool. The company spends about $2 million a year on consumer surveys alone. A year before rolling out a product, Coach talks to hundreds of customers, asking about everything from comfort and strap length to style. Additionally, it asks them to rank new designs against existing items. Six months before a collection's launch, Coach tests the new products in a cross-section of stores around the country. "The tremendous amount of testing they do differentiates them from a lot of other fashion companies," says Robert Ohmes, a retail analyst at Morgan Stanley.

And it's not just bags and briefcases anymore. Over the past few years Coach has radically expanded its product line to include gloves, shoes, jewelry, watches, men's and women's apparel, outerwear, luggage, furniture (there's a co-branded Steelcase office chair), even cars (you can buy a Lexus RX 300 with a Coach leather interior). The company has transformed its dark, woody stores into white, high-ceilinged aeries that better showcase the merchandise. Coach's 74 factory stores, also being made over, are high-revenue opportunities for testing and marketing rather than way stations for liquidating bad products. These stores sell Coach at a discount of 15% to 50% and bring in an unusually high $1,075 per square foot.

Customers can't see one big change Coach made that has significantly boosted its bottom line: outsourcing. This year Coach closed its last manufacturing facility; all production is now done in 40 outside plants in 15 countries, which lowers costs and allows the company to get designs to market faster. As a result, gross margins have risen 24% over the past five years. As for debt, Coach has virtually none.

Some things haven't changed. Customers can still have their bags refurbished free. And prices are still reasonable. With bags averaging $200 apiece, Coach dominates the "accessible luxury" sweet spot: Its products appeal both to customers who have to stretch to afford them and to those who think nothing of shelling out $700 for Yves Saint Laurent's hot Mombasa bag. "Coach has not just gained market share from those trading up and trading down," says Morgan Stanley's Ohmes. "It may be stimulating incremental business [by inducing people to buy more products]. It changed the way its particular market worked."

Perhaps what most distinguishes Coach from competitors is its close management. Coach's top executives chart sales for every store and every type of merchandise every day; during the holiday period, they may get three updates daily. Such rigorous tracking let execs drastically ramp up production of the Ergo bag in just a few days when they saw that it was blowing out of stores in Japan, where Coach introduces its most fashion-forward designs. Each month, rather than each quarter, Coach's CEO, COO, and CFO conduct a review of each business unit and revise annual estimates accordingly. "Their execution and business planning is in the league of a Wal-Mart or a Target," says Lehman Brothers analyst Bob Drbul.

Now that Coach has updated its styles and spiffed up its margins, its current challenge is expansion. In the U.S., Coach plans to add 100 stores to its existing 140 over the next few years; the company believes its own stores have more potential for growth than its 1,400 department and specialty-store locations. Though Coach has generally avoided Europe's unprofitable accessories battleground, it will grow from two to 25 locations in Britain. It is focused most intently on Japanese shoppers, who account for 45% of the world's luxury spending. They constituted 20% of Coach's $720 million in 2002 annual sales, and executives expect their massive Ginza flagship store, which opened in May, to generate the highest sales volume of any Coach store in the world. Because Coach has just 2% to 3% of the luxury handbag and accessories market in Japan, there's plenty of room to grow. Analysts believe its share could more than double over the next three to five years.

Coach is also looking to tap undeveloped revenue streams. Gifts make up 40% of all Coach purchases, so the company is expanding a series of prewrapped products targeted at rushed holiday shoppers. And with men providing less than 15% of its sales, Coach is coming out with a new line this spring of casual, lightweight men's bags to fill what Krakoff calls a "huge gap in the market."

The key question is whether Coach can maintain its sizzling growth as the company gets bigger and bigger, especially if the economy continues to languish. "At some point, they're going to come up against their successes," says Lehman's Drbul. Frankfort says he isn't worried, pointing to Coach's "balance between logic and magic." Keeping that balance over the long term would be a neat trick indeed.

FEEDBACK jboorstin@fortunemail.com