Ralph Lauren’s Drivers And Risks To $190 Valuation

Lifestyle company Ralph Lauren (NYSE:RL) achieved revenue of more than $6.9 billion and a net margin of 10.4% in 2012. Store closures associated with its Asia-Pacific restructuring plan, the discontinuation of its American Living brand and macro-economic weakness in Europe affected its sales growth in 2012, which dipped to 4% in the year. This compared to revenue growth of 20% and 14% in 2011 and 2010 respectively.

We feel the sales growth decline in 2012 is a temporary trend and Ralph Lauren holds long term potential as the company leverages its strategic initiatives. Expanding into Asian markets and growing its direct-to-consumer and accessories businesses, we believe are the key drivers that will fuel Ralph Lauren’s growth in the future. Improved profitability and improving signs in Europe, are other factors that favorably impact Ralph Lauren. Our price estimate for Ralph Lauren stands at $187, which represents a premium of 6% to the market price.

The key risks for Ralph Lauren include concentration of its wholesale sales among few customers and continued economic uncertainty in Europe.
See our complete analysis for Ralph Lauren

Drivers for Ralph Lauren

Continued Growth in Americas Market

Ralph Lauren has posted continuous revenue growth from the Americas region, which accounts for over 65% of its revenues. It has been able to maintain its strong brand identity in the region over the last several years despite weak macro conditions. The expansion of its e-commerce business and increased sales through factory stores have also contributed to revenue growth in the region.

Improving Profitability

Ralph Lauren’s gross margin improved by 220 basis points annually in Q3 2013 to reach 59.3%, due to lower input costs, a favorable product mix and disciplined expense management. Its operating margin increased by 150 basis points over prior year to 16.5%. According to the company’s guidance, the operating margin in Q4 2013 is expected to increase by 125-150 basis points over prior year. ((Ralph Lauren Management Discusses Q3 2013 Results – Earnings Call Transcript, Seeking Alpha, February 6, 2013))

Both the wholesale and retail segment recorded higher operating margin in Q3. While its wholesale operating margin increased by 470 basis points to 19.7%, the retail segment operating margin grew by 60 basis points to 19.8% (excluding Rugby-related charges).

Improving Conditions In Europe

Sales in Europe, which account for around 20% of Ralph Lauren’s sales, have recorded some weakness in recent years due to weak macroeconomic conditions in the region. However, the company showed improving trends in the region in Q3. It achieved 8% y-o-y constant currency growth in Europe led by growth in retail sales. The wholesale business in the region continues to be plagued by weak economic conditions in Southern Europe.

Expansion into Asia

Expansion into Asia is a major growth strategy for Ralph Lauren as the luxury market is growing rapidly in the region. China is the centerpiece of its strategy in Asia. As part of its Asia restructuring plan, Ralph Lauren closed down a significant part of its distributor network in China, to replace it with its own network of stores. With this move, Ralph Lauren targets direct control over its business in China to enhance its premium brand image in the country.

We expect these efforts to not only enhance Ralph Lauren’s sales in Asia but also in other developed markets where Chinese customers account for a significant percentage of sales. The company’s management projects Chinese customers to account for 30% and 15% of luxury sales in Europe and US respectively. ((Ralph Lauren Management Discusses Q3 2013 Results – Earnings Call Transcript, Seeking Alpha, February 6, 2013))

Enhancing Direct-to-Consumer Business

Ralph Lauren is focused on expanding its direct-to-consumer business by opening more company-owned stores, e-commerce sites, and converting its former licensing operations into company-owned business. It has added 36 new factory stores during the last three fiscal years. In Q3 2013, Ralph Lauren started providing online sales in Italy, Greece, Spain and Portugal. It also plans to open e-commerce sites in Korea and China soon.

The share of the direct-to-consumer channel of overall revenues has increased from 46% in 2009 to 52% in 2012. We forecast Ralph Lauren’s future growth to be driven by growth in the retail channel, which will also have a positive impact on its bottom line.

New Product Categories

Ralph Lauren also plans to grow its emerging product categories such as Denim & Supply and accessories (which includes handbags and small leather goods) by enhancing their distribution globally and increasing the presence of these categories in retail stores and e-commerce channel.

Key Risks for Ralph Lauren

Dependence on few wholesale customers

In fiscal 2012, Ralph Lauren’s three largest wholesale customers represented around 40% of its wholesale revenues and around 20% of its total revenues. Macy’s is the largest customer for Ralph Lauren, which accounted for approximately 20% of its total wholesale revenue in fiscal 2012. Since Ralph Lauren typically does not form long-term contracts with its customers, any loss of sales to these customers can directly impact the company’s top line.

Continued Economic Uncertainty in Europe

While Ralph Lauren has witnessed some improving signs in Europe in the most recent quarter, its wholesale business in the region continues to be affected by weak macro-economic conditions in Italy, Spain, and Southern Europe.

Increased E-Commerce Business Can Cannibalize Brick and Mortar Sales

As Ralph Lauren continues to enhance its e-commerce business, its brick and mortar sales could be negatively affected due to cannibalization. This could weigh on the profitability and sales growth of the retail stores and necessitate the need to close stores or alter the mix of its sales channels.

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