Factors Justifying Our $141 Valuation of Ralph Lauren — Part 2

In part 1 of this article we detailed the qualitative reasons for the reduction in our price estimate of luxury lifestyle company Ralph Lauren (NYSE:RL). RL has been one of the worst performing stocks on the S&P 500 since the beginning of the year, having declined by close to 30% since its January opening trade. The primary reason for the reduction in the stock price is as follows: the company grew its revenue at close to 10% over the 2004-2013 period, but its revenue growth rate has slowed over the past two years.  This has been due both to negative currency fluctuations and to the reduced spending habits of the aging demographic that the brand targets. At the same time, the company’s expenses have continued to rise and hence its earnings have been sluggish. In this article, we take a look at the rationales for our new forecasts.

See our complete analysis for Ralph Lauren

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. Moreover, even as the company’s revenue growth rate has slowed, it is still looking to expand its store presence in the calendar year 2015. In the first six months of the fiscal year 2015, the company managed to launch 20 new stores. It grew its international reach through the launch of the first Polo store in Singapore and a new flagship store in Hong Kong.  And it plans to launch a new store in London sometime next year.

So, compared to the 10% growth rate in retail revenue over the 2010-2014 period, we expect the company to only grow at 6% over the 2015-2019 period. ((Ralph Lauren 10-K, SEC)) At the same time, the square footage of its revenue stores should continue to grow, especially as it accommodates newer product categories in its stores. Consequently, revenue per square footage should expand at a much slower rate (2.5% vs 6%) compared to the 2010-2013 period.

–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. ^[1] While we expect the company’s incremental investments in restructuring its business to start paying off, we expect the process to be gradual.

Currently, it is trying to take control of its front-end services, which will be operated by a single partner for at least the next 2-3 years. This should allow the company to improve the shopping experience of customers as well as cut costs at the same time. The operational efficiency that this plan includes should help the company achieve a much higher profitability in the next few years. However, as an international business, Ralph Lauren generates a significant percentage of its revenues from outside North America. Given the strength of the U.S. dollar, the weakening Chinese economy and the sluggish European economy, it is likely to continue to face currency headwinds in the near future. As a result, these incremental decreases in operating costs are more than likely to be offset by the reduced top line growth, which should prevent the company from posting margins around the 22% mark of the 2010-2013 period. We expect the margins to gradually recover from 19% in 2014 to 21% by the end of our forecast period.

–Increase in Unallocated Expenses: As mentioned in part 1 of this 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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