Factors Justifying Our $141 Valuation of Ralph Lauren- Part 1

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Ralph Lauren

Premium lifestyle company Ralph Lauren (NYSE:RL) has been one of the worst performing stocks on the S&P 500 over the past year or so. The value of the stock has declined by close to 30% since the beginning of the year. The company announced results for the fourth quarter and full year of fiscal 2015 last month. (Fiscal years end with March.) It reported revenues of $1.88 billion in the quarter, a 1% increase over the same period in the year before. The retailer’s growth was driven by a modest increase in wholesale revenues, offset by a decline in revenue from the retail business and the licensing business on a dollar basis.

In this two part article, we are going to review the  factors supporting our$141 per share valuation of Ralph Lauren stock, commencing with a review of the company and recent initiatives. A second part on the valuation will follow.

Ralph Lauren is a global business and it has been facing large currency headwinds for some time. In constant currency terms, the company reported a 7% increase in the top line, with an 8% increase in revenue from operations in the U.S. and a 5% increase in revenue from Europe. ((Ralph Lauren Q4 FY15  Earnings Call Transcript, Seeking Alpha, May 2015)) These sales rates are solid if unspectacular, but the company’s gross profit margin fell by 80 basis points to 55.4% in the quarter. [1] The retailer attributed this to currency as well as sales mix effects. To emerge from this slump, the company has increased its investments in infrastructure, resulting in an 110 basis point increase in operating expenses, which rose to 45.3% of sales. [1] These developments taken together meant that the operating margin dropped by 190 basis points to come in at 10.1% of sales. [1] The flat top line growth combined with dipping margins has meant that earnings have been sluggish. Additionally, the company’s guidance for the future has been cautious, hinting that increased investments in the business and the strength of the U.S. dollar will continue to weigh down results in the upcoming year as well.

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See our complete analysis for Ralph Lauren

The Long Term View

Ralph Lauren has taken advantage of the value of its brand and grow its top line by 10% on average over the last decade. Surprisingly, in a business where inventory can become outdated and stale on the whims of fickle customers, the company had been able to maintain its gross margin at close to 60% for much of the period, which is quite a feat. However, gross margin began to tick downwards after cresting at 59.8% at the end of fiscal 2013. When margins begin to move downward in a structural fashion, it usually means that there are some demand problems with the business.

Customer-Product Mismatch

Ralph Lauren’s brand appeal was built on selling premium, high value apparel to a baby boomer demographic that was rapidly becoming more affluent and looking for new ways to spend the cash it was earning. However, that demographic, which formed the backbone of its prospective customer segment, is now aging. Consequently, the amount they spend on high-end clothes is also falling. The appeal of Ralph Lauren as a premium brand is now somewhat limited  to those who are newly affluent, and whose idea of high-value apparel is the same as that of the baby boomer demographic that has support the brand thus far. However, the idea of luxury for those already rich has shifted. Instead of Ralph Lauren, the merchants of choice for their dreams are now Kate Spade and Tory Burch. The plans to accelerate the development of the Polo brand might be an admission that Ralph Lauren’s management is becoming wise to these changing trends.

In management’s own words, the company’s Ralph Lauren brand, which forms the backbone of its department store business, serves a customer who is essentially in the over-35 age group. Its other popular brand, Denim & Supply, is defined under the millennial umbrella. These brands have helped Ralph Lauren solidify its bond with the older consumer. To remedy these problems, the company introduced a new Polo for women product line. Products made under this brand will be targeted to younger customers, with its main competitors being Burberry and Tory Burch. The Polo women’s business will replace the Blue Denim line so the sales made from the segment will not be entirely incremental. However, since the business will serve a wider range of needs than the Denim line, it will bring in higher revenues over time. [2]

The Polo women’s business is also consistent with Ralph Lauren’s stated aim of growing its women’s business to become an equal contributor to the overall revenues.  Currently, the split between revenues from the men’s and women’s mix is about 60/40. This is the reverse of the usual trend in the marketplace, and the opening of the women’s Polo line will allow the company to achieve greater share in the women’s luxury apparel market.

Earlier last year, Ralph Lauren opened a Polo flagship store on Fifth Avenue, New York. The store has done well, but the most interesting thing about the performance of that store is that nearly half of the sales from the store have been for the Women’s Polo business. As the management stated in the earnings call for the second quarter, this gives the company a new avenue for their retail strategy. The Polo for women brand differs from the Blue Label brand in several ways:  1) the average retail price for a product sold from the Polo brand is about 30 to 40 percent lower than under Blue Label, and 2) the product mix combines the preppy base of the company with a more rough-hewed street style. [3]  Instead of a product base built primarily around leather items, the Polo product mix is more cotton and torn jeans.  What this means is that in order for the Polo brand to replace the Blue Label brand successfully, Ralph Lauren needs to convince consumers to buy on average two more items per visit or attract enough new customers to be able to provide that same growth.

The consequences of this spending are that gross margins have ticked down and SG&A continues to creep up. As a percentage of revenue SG&A has risen in recent years to a high of 43%. Generally, a business would like to see some scale in SG&A as it expands but Ralph Lauren has been spending more and more money each year. It is generally a good thing to spend on top talent but an SG&A/revenue ratio in excess of 40% is generally too high for a business that is not financial services.

Changes to Drivers

The main changes to our forecasts and the factors driving our forecasts are explained below:

-Retail Revenue Per Square Foot: Revenue Per Square Foot(RPSF) is an important metric for retail companies that highlights their store productivity. It is an important indicator of the health of the business as a higher RPSF shows that the company is moving a higher number of products at competitive prices for each unit of store square footage added. However, Ralph Lauren’s RPSF has been trending downwards for two years. It has dropped by more than 20% over the last two years and while we expect it to start recovering because of the factors mentioned earlier in the article, it is unlikely that it will recover at a fast pace.

-Retail Segment EBITDA Margin: Given the decline in Retail Revenue Per Square Footage, increasing store count and investments in international expansion, the company’s operating margins have been dropping. The EBITDA margin for the retail segment has dropped from around 23% to close to 19% over the last two years. While we expect the company’s incremental investments in restructuring its business to start paying off, we expect the process to be gradual.

-Increase in Unallocated Expenses: As mentioned earlier in the article, the company is undertaking significant restructuring efforts in changing its brand image by targeting a different breed of customer. To this effect, it is having to redesign its products and stores, while also having to invest in its staff and marketing efforts. All these factors are contributing to an increase in general corporate expenses in the near term.

As a result of these factors, we believe that our current price estimate is a fair estimation of the cash flows that can be expected from the company going forward.

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Notes:
  1. Ref: 1 [] [] []
  2. Ralph Lauren’s Q3 2014 Earnings Call Transcript, Seeking Alpha, February 2014 []
  3. Ralph Lauren (RL) Q2 2015 Results – Earnings Call Transcript, Seeking Alpha, October 2014 []