|Shares Out. (in M):||86||P/E||17.5||19|
|Market Cap (in $M):||11,900||P/FCF||17.5||19|
|Net Debt (in $M):||-800||EBIT||1,050||900|
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We don’t usually enter the consumer discretionary space, but we’ve always admired Ralph Lauren from afar. A friend of ours sells into the same customer base as RL, and just yesterday commented to us that “Ralph Lauren is the absolute master of brand management and is the best at brand segmentation that allows them to appeal to different customer bases while still maintaining their brand cache. Outside of the ultra luxury guys like LVMH, nobody does it better than Ralph Lauren.” And he’s been repeating this to us for years. High praise from a competitor. When the stock tanked in February on what was admittedly a sub-par earnings report, we thought it was interesting and put the project on our to-do list. We like it at this price.
The Business of Ralph Lauren
We usually start off with a business description, but you probably already know what Ralph Lauren does. They sell clothes and accessories under the various Polo brands through both the wholesale and retail channels around the world. There are obviously finer distinctions than that, but here are a couple of things to know, especially if you don’t routinely deal with consumer discretionary:
RL’s wholesale gross margins are lower than their retail gross margins, but that is more than offset by the increased SG&A costs in the retail business, and the capital intensity of the retail business. Wholesale EBIT margins are in the high 20’s and retail EBIT margins are in the high teens. To some extent, then, as RL grows its retail presence around the world, this will have the annually small but persistent effect of slightly decreasing the EBIT margins of the business, but that will be offset by the fact that international margins are generally higher.
RL has an absolute gem of a wholesale business in the US. The department stores, particularly Macy’s, love RL because it’s a marquee brand that can be given lots of shelf space and have great sell-throughs, leading to lower markdowns.
RL’s retail business outside the US is a great business that is growing nicely. The retail business in the US can be divided into the outlet stores and the non-outlet stores. The outlet stores have had a pretty bad couple of years, and it’s almost hard to see how it could get worse. They are cannibalized by RL’s internet sales (which have been growing rapidly), and by the general trend of outlet stores locating themselves closer to urban areas in recent years, which RL has been unwilling to participate in (we’d argue that this is probably the right move for the brand long term - brands that have succumbed to this trend could eventually see their cache erode. It’s one thing to sell off-price stuff 50 miles away from where you sell stuff full price, and another thing to do that 20 miles away). The non-outlet stores seem to be doing just fine, but RL doesn’t really make this easy to decipher outside the stray question on the earnings calls.
The Perfect Storm at Ralph Lauren
We view the Q3 earnings call that precipitated the disastrous stock price reaction as really the end-result of a couple of trends that have been going on inside RL’s financials for a while that were compounded in a major way by the collapse of various developed market currencies against the dollar over the past year. Some of these trends include the following:
RL spent 60-80bp of its 2015 (FY ends in March) revenue on re-structuring its entire online business, to make it more seamless on the back end, and allow it to work internationally. This spending is expected to continue into FY 2016 and 2017.
RL spent another 80-100bp of 2015 Revenue on accelerated store openings. This is in addition to what it normally had in the budget for this stuff pre-2015. It plans on spending this money over the next two years as well, and only start tapering it off in FY 2018 (which is CY 2017, mostly).
RL spent another 40-60bp in 2015 on advertising and marketing for various brand repositionings, brand introductions, increased brand awareness in China (where previous licensing partners didn’t do a great job with RL’s brands), and increased spending on marketing luxury products (i.e., at the super high-end). This incremental spending is also expected to last through 2016-2017.
So going into FY 2015 about a year ago, we knew we were going to have 200bp of margin pressure. Still, RL was pretty confident that with some operating leverage inherent in a growing consumer discretionary business, it could expect operating margins to be down 75-125bp over the course of the year. As you can see from the table below (thank you, UBS), that did not exactly play itself out as RL expected, and the primary reason for that is FX (while the 2015 numbers are listed as estimated, you can pretty much take them to the bank given that 3 quarters are already done, and guidance for Q4 was given halfway through the quarter).
FX volatility has had a particularly pernicious effect on RL’s bottom line because:
RL’s SG&A cost structure is pretty much all in USD, CHF, and HKD - look at what those currencies have done against EUR, JPY, CAD, and AUD (where a good amount of both retail and wholesale revenue come from at RL), and you can imagine that this is a pretty strong headwind.
The manufacturing cost base is in Asian currencies, which, see the previous bullet point, except that this one hurts on the gross margin line and not on the SG&A line.
The result is that every 100bp of FX headwind in sales ends up translating into 40bp of headwind on the operating margin line, and RL expects 2016 as a whole to have 550bp of FX headwind for FY 2016 sales, which translates into something like 220bp of EBIT margin headwind, on top of the 175bp decline in margins we saw on the EBIT line in FY 2015.
Where Does that Leave Us?
The trouble, and opportunity, with Wall Street is that most participants have a hard time seeing past the next twelve months, and an almost impossible time seeing past the next 24 months. Fortunately for the group of investors who are (hopefully) reading this, looking 3 years down the line is part of the strategy, if you can make a reasonably informed estimate of what the x-factors will be at that point. So here’s our view:
We believe that revenue at RL can grow MSD for a very long time to come. Based on our discussions with competing vendors, even the US wholesale business (the ones the sell-side deems no-growth and mature) can probably grow share slowly for years to come, leading to LSD revenue growth. International should be easier from a revenue standpoint given that, as RL likes to say, â of its sales are in the US and â of the market is abroad. Overall, a 5% run-rate of revenue growth in constant currency seems reasonable to us.
Operating margins: There are a bunch of puts and takes here so we list them as follows:
Of the 200bp in margin pressure that we saw in 2015, and will continue seeing in 2016, and some in 2017, we think that at least half will be over by FY 2018. So +100bp.
$100M in cost savings that RL has committed to in a restructuring on the Q3 call. That’s about 1.3% in operating margins, but let’s be conservative. +100bp. (funny note here - Morgan Stanley’s 2/5 note only counts this for 10bp, because their price target is based only on the next fiscal year, so they basically just ignore this cost-cutting effort).
RL discussed on the previous call that it will be starting the process of price increases internationally, where it’s gotten hit on FX, in combination with cost negotiation with its Asian suppliers, where it’s gotten inversely hit on FX. We’d tack on 50bp to gross margin from here.
The general trend of faster international growth and faster retail growth will also add to the gross margin over the next 3 years. We call this +50bp.
Tack on these 300bp (which will probably be more, but say 300) onto the 220bp of margin contraction that we’ll see in FY 2016 (which is also, in our view, RL management giving investors the “expect the worst” treatment) and you will probably see FY 2018 estimates (which will firm up <2 years from now by the way) price in operating margins in the 14% range. And if you see any reversal in the recent action of USD/EUR, USD/JPY, etc. then you will get expansion on top of that.
How much is that worth?
RL has a stellar reputation among investors and has historically garnered a really nice multiple. Its management team is not promotional, they buy back lots of shares, they have a conservative capital structure, and they don’t do stupid deals or throw money at low-ROIC memory holes. The PE multiple has thus always been rich - in fact, the only time it’s gone below 17x for more than a few weeks was in the middle of the financial crisis.
You can look at this in a few ways. At $135/share, with about $10 of cash on the balance sheet, RL trades at about 13.5x normalized FY 2016 (CY 2015) earnings. Which, for a company with the above characteristics that will, with share buybacks and the dividend, grow HSD or even low-double-digits for a long time, is a very good deal. Certainly in this market, and certainly when the downside here is hedge-able with all the other consumer discretionary crap that is trading at all time highs. Or, you can say, in February of 2017 (2 years from now), we’ll be looking at forward EPS of close to $11 a share on RL (we’re including share buybacks here), which at its historical PE of 18x, will be worth just about $200/share, for a 50% return on this (including dividends) in < 2 years.
More importantly, the downside risk here is - we think - mostly baked in. From a sentiment standpoint, consensus is already basing their multiple on trough margins of a year in which revenue growth will be nil due to FX. And RL has many levers to pull in order to get fundamentals, at least from a margin standpoint, higher. Even place a lower than historical multiple on numbers that are less dire than what we already know the next 12 months will be, and you end up with a price right around where we are right now. So we are fairly comfortable that real capital impairment is an extremely low-likelihood event here.
The risk of course, is a true global recession that decimates consumer discretionary spending, which will make flat revenue comps seem like a dream rather than a bad year. But in that case, bets are off across the board. The bottom line, in our view, is that there is nothing fundamentally broken about Ralph Lauren’s business, though that’s what the stock price is currently pricing in.
Getting closer to 2018...
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