Description

Investment Thesis

• RL is a decent investment at $156.25 where one can earn ~40% to ~100% over 2-3 years in a base-upside scenario with good downside protection in a low case scenario.
• The embedded profitability of Ralph Lauren, particularly within its direct-to-consumer retail/online business, is much greater than it currently reports. This is in part due to making long-term investments in technology through a new SAP system as well as undergoing a restructuring (including many store closures/relocations) of the Asia-Pacific retail business that began in FY2012, which in the short-term depresses operating margins.
  • Management was clear that FY2015 (ending 3/31/15) would be another “investment” year. Looking out into FY2016 and beyond, its margin potential should begin to come through and likely hit its potential in FY2018.
  • In addition to its “investment” expenses, RL appears to have a very bloated SG&A cost structure within its retail business. Some of this will be right-sized due to the SAP implementation whereas other costs might not be.
    • Whether or not its full margin potential will ever be realized over a realistic timeframe is up for debate. Ralph Lauren controls the company with super voting shares and owns ~31% of RL’s equity. While management has enough economic incentives to run an efficient operation to maximize profitability, there might be other factors (such as cultural) in play that keep it from reigning in SG&A expenses.
    • RL’s brands in emerging markets are underpenetrated, particularly in China, where the business had been historically run by a poor performing licensee. This is a major revenue/profit opportunity that it will look to realize going forward after having executed closed a majority of the inherited store base.
    • Ralph Lauren’s strong brands enable further expansion into existing, but underpenetrated categories:
      • RL’s gender mix of business is ~2/3 male, ~1/3 female whereas the industry mix is ~60% female, 40% male. Merchandise sold to females tends to be higher margin. This is a long-term opportunity on which RL is acutely focused.
      • RL has just 8% of its sales in high margin accessories. RL has had good success with the 2013 debut of its high-end Ricky handbag collection. In Feb. 2014, RL hired Valerie Hermann as President of its luxury collections, a newly created post. She was head of operations at Yves Saint Laurent until 2011 and most recently served as President & CEO of Reed Krakoff.
      • RL is also very underpenetrated in the denim business. It launched the brand, Denim & Supply, a few years ago. Its product is sold through 400 doors (primarily Macys), up from 300 doors a year ago.
      • While on the surface RL does not appear to be cheap on a P/E basis at ~16x NTM EPS, one must consider that it has ~6% of its market cap in net cash, which reduces the valuation to ~15x NTM EPS. RL does not require much capital to grow. It returns ~100% of free cash flow to shareholders via share repurchases and dividends. RL should be able to grow its EPS at a 10%+ rate for many years to come. It currently sports a 1.1% dividend yield.

BUSINESS OVERVIEW/DESCRIPTION

Ralph Lauren’s brands are among the most globally recognized. Its branded products are featured across apparel, accessories and fragrances as well as children’s and home furnishings. RL employs a disciplined product segmentation strategy across several brands for various price points and distribution.

• Ralph Lauren is one of the largest apparel brands in the world second only to Nike in terms of apparel related sales.
• RL has continued to gain market share of a growing U.S. apparel industry over time. In 1999 it had 0.64% share of the U.S. apparel market, 0.73% in 2005 and now has 1%. Said another way, while the industry has grown at a 15 year CAGR of 4.2%, RL has grown at a 7.3% annual rate.
• RL reports its business results in three operating segments: Wholesale (45% of revenue), Retail (52%) and Licensing (3%).
• Also, it geographically breaks out its revenue into three regions: The Americas (66%), Europe (21%) and Asia (13%).   

Wholesale (LTM $3.3B revenue—46% of revenue, 49% of EBITA)

• Approximately ¾ of its wholesale business is in North America while ¼ is in Europe.
• RL uses Shop-in-shops within department and specialty stores to enhance the brand recognition and differentiate its positioning. They range from 700 – 7,400 square feet. Typically, the build-out cost is shared with the wholesale customer. At the end of FY2013, there were ~20k shop-in-shops through ~11k doors for RL branded products at wholesale partners.
• Within North America, its top 3 customers accounted for 45% of these sales—Macy’s being the largest at 25% with its merchandise sold through ~2/3 of its doors.
• Here is how the # of doors (ex. shop-in-shops) RL’s brands have been distributed to has changed over the past 6 years. The # of doors in the Americas has purposefully declined as RL has increased its distribution through its direct-to-consumer channel through its own stores and websites. During the recession, it closed a lot of footwear only doors as it was in the process of re-launching its footwear business.
• Additionally, Chaps branded products are sold in the U.S. through ~1,200. RL took back the license from PVH in April, 2013.
• Wholesale revenue has grown at a fairly steady clip with the exception of FY2013, which declined YoY due to the ~$150M impact from the discontinuance of the majority of the product categories sold under the American Living brand after the fall 2012 selling season.
• EBITA margins for the wholesale business are fairly steady in the 17%-19% range. LTM EBITA margins are a bit depressed due to its SAP implementation, unfavorable foreign currency dynamics, continued weakness in Europe and the negative mix impact from taking in-house a lower margin ~$200M U.S. Chaps menswear business. RL agreed to pay PVH a transition services agreement for one year, which is a one-time expense that incrementally depresses margins as well. Once it’s fully integrated, margins for the Chaps menswear business will improve closer to the wholesale average and in-line with the Chaps women’s and children’s business.
  • One should expect over the next 1-3 years for wholesale margins to remain somewhat depressed due to continued IT investments as it moves from completing its implementation in North America to focusing on installing SAP for the European and then Asia-Pacific business. Per management, “Regarding IT infrastructure, we will begin the next phase of SAP implementation, which is focused on our European operations. We'll be starting this phase as we are simultaneously completing the successful implementation of our North America wholesale and global supply chain operations. Over time, we believe SAP should enable appreciable productivity improvements and procurement savings.”
  • Upon concluding the implementation of SAP (and removal of duplicative IT systems) for the entire wholesale business as well as fully integrating Chaps into the mix, the wholesale EBITA margin should expand 100 – 200 bps (see model).
  • The North American wholesale business has been a steady performer over the past 6 years with a 4.0% CAGR.
    • While sales from FY2008 through FY2011 were relatively flat as RL reduced the number of doors its brands were distributed through, productivity per door increased by 45% over the past 7 years.
    • RL’s European wholesale business remains an opportunity for improvement given how depressed the business has been since FY2009 in large part due to the tough macroeconomic conditions.
      • The number of wholesale doors RL is distributed through has more than doubled since FY2008 while sales are up less than 20%.
      • Management recently stated:

“Our European wholesale operations reached an important inflection point in shipment trends for 2014 spring/summer season, following several quarters of strategic reductions and wholesale shipments to Southern Europe, we are now returning to growth. Before the financial crisis, Europe was a substantial driver of the company's sales and profit growth. We are pleased the region's economic climate has stabilized to a point where we feel more confident about returning to our pre-recession trajectory. At 20% of our consolidated revenues, Europe remains a significant area of opportunity for the company in wholesale and retail channels throughout the region.”

• The European wholesale business carries higher than average wholesale margins because the customer base is made up of a more fragmented, specialty store component that does not have the same buying power as the U.S. department store base. If RL can just get back to FY2012 European wholesale sales levels at a ~20% contribution margin, this would provide a nice boost to profits (see model).

Retail (LTM $3.8B revenue—52% of revenue, 40% of EBITA):

• Sales mix is 64% Americas/22% Europe/14% Asia
• 400+ free-standing locations made up the following concepts:
  • Ralph Lauren (100+ stores)
  • Factory (200+)
  • Club Monaco (60)
  • 500+ concessions (mostly in Asia)
  • Over the past 5 years, RL has grown its store base by 24% and plans to continue this growth at a mid-high single digit rate by:
    • Opportunistically opening very large Ralph Lauren flagship stores in affluent urban locations such as in NYC and London. These stores often serve more for marketing than as a direct profit center given the high rents and in-store labor. These stores can be in all of the European capital cities.
    • Opening Polo stores in secondary European cities like Manchester. Currently, there are no Polo stores in Europe. Overall, there is a greater retail opportunity in Europe v. the U.S going forward.
    • RL has a ~20% ROIC target for new stores, distribution expansion and technology initiatives to support the retail/ecommerce business.
    • RL’s retail EBITA margins are significantly below where they should be given the high productivity of its direct-to-consumer business doing close to $1,000 per sq. ft. in sales. RL’s EBITA margins are the lowest among the comp base due to having the highest SG&A as a % of sales despite having the highest gross margin and sales productivity.
    • RL does not have the highest advertising or stock-based compensation as a % of sales in the retail apparel industry. However, these are the only two expenses within SG&A that are broken out by every company. Thus RL’s high SG&A expense as a % of sales must relate to something else—the most likely culprits being its large investment into its Asia business it has yet to leverage, duplicative IT systems, SAP implementation expenses, variable-based pay (8% sales commissions at the 115+ Ralph Lauren stores), high in-store labor that can include health benefits and 401-Ks for its sales associates and possibly some bloated corporate overhead.
    • Some might argue that RL’s high rent expense as a % of sales is a factor in its bloated SG&A. But the majority of rent expense is captured in cost of goods sold. While RL does have higher rent expense as a % of retail sales it also has a higher average unit retail price, which is why its high merchandise margin allows for its gross margin to be among the best in the retail apparel industry.
      • RL’s retail op. margins expanded from 6.6% in FY2010 to 12.7% in FY2013 while rent expense as a % of retail sales only increased by 6 bps over that time period. This indicates that RL has the ability to drive margin expansion within its retail business provided its sales productivity remains healthy.
      • Another sanity check is to look at the break-down of its three businesses based on its financial filings. RL discloses sales and operating margins for each of its three businesses pre-unallocated corporate overhead.
        • We know it is likely that RL’s retail gross margin is higher than its wholesale gross margin. Within its retail business, in exchange for being able to capture more of the economics of the merchandise margin it has to take on store rent, occupancy and depreciation expense. Additionally, even when factoring in the higher SG&A costs (from commissions, in-store labor, distribution, etc.), the direct-to-consumer business is typically a higher margin business than wholesale—especially in RL’s case given the extremely high sales per square foot productivity. Below are some notable quotes taken from the annual reports of other wholesale/retail apparel comps. Granted there are business and mix differences from these companies compared to RL’s business, but directionally this helps support the case that RL’s retail business should have operating margins at least as high as its wholesale business.
          • Nike (NKE): “Gross margin increased 30 basis points, largely driven by price increases and the favorable impact of our higher margin Direct to Consumer business…”
          • Under Armor (UA): “Historically, we have recognized a majority of our net revenues and a significant portion of our income from operations in the last two quarters of the year, driven primarily by increased sales volume of our products during the fall selling season, including our higher priced cold weather products, along with a larger proportion of higher margin direct to consumer sales.”
          • VF Corp (VFC): “Operating margin improved 150 basis points in 2013 over 2012 due to a continuing shift in the business mix toward higher margin direct-to-consumer businesses…”
          • Another good comparable business is Hugo Boss. As one can see below, as a greater % of its sales mix has been made up of its own retail sales over the past 5 years (from 27% in 2008 to 49% in 2012), its adjusted EBITDA margin has increased 650 bps while its EBITA margin improved 530 bps. This was largely due to a greater mix of higher gross margin retail business increasing gross margin by 910 bps, which was partially offset by retail business that carries higher SG&A as % of sales, which detracted 380 bps from its EBITA margin.
          • The general rule of thumb is that for a similar mix of merchandise sold, retail gross margin tends to be ~1,000 bps higher than wholesale gross margin. But given RL has relatively high rent expense as a % of retail sales, I assume the spread is less.
          • Thus between eliminating “investment” expenses (implementation and maintaining duplicative IT systems throughout implementation) of SAP and its Asia-Pacific retail business that is not yet at optimal scale to leverage fixed costs, there is at least 150 bps of margin expansion to come by FY2018 if not sooner.
          • Additionally, there is another 360 bps – 630 bps of margin expansion opportunity from better managing normal, recurring SG&A expenses over time, in large part driven by the SAP system integration.
          • Lastly, upon having SAP installed and working properly throughout all of its markets and distribution channels, there should be a gross margin lift from:
            • Fewer markdowns given better matching of supply and demand of merchandise by market
            • Better aggregation of purchase orders to result in greater centralized purchasing and ordering

Licensing (LTM $170M revenue—2% of revenue, 11% of EBITA)

• The Ralph Lauren brand is very strong. This enables the company to participate in merchandise outside of its core apparel and accessories categories.
• This segment includes royalties on sales of eyewear, fragrance, home products and certain apparel products.
• Each licensing partner pays RL royalties based on a % of sales. The typical licensing agreement lasts 1-5 years.
• In FY2013, 44% of licensing revenue was earned from its top 4 partners—Luxottica at 12%, Peerless at 10%, Warnaco Group at 9% and L’Oreal at 9%. Here is a list of its key license partners that remain:
• International license partners operate 62 Ralph Lauren stores, 32 Ralph Lauren concession shops and 64 Club Monaco stores and shops. Club Monaco could very well take in-house its Asia licensed business in the future.
• RL has taken various licensed businesses in-house over the years in order to gain better control over its brands. It took back Lauren in 2004, children’s wear in 2005, Polo Jeans and footwear in 2006 and accessories in 2008. More recently it bought in the Asia-Pacific (excluding Japan and South Korea) licensed operations on 12/31/09, South Korea on 1/1/11, Lauren by Ralph Lauren bedding and bath operations in May 2011, Chaps menswear wholesale in April 2013, the Australia/New Zealand business in Q2’14 (9/30/13 ending) and the tailored clothing business from Peerless where it will be under RL’s control in fall 2014.This can explain the revenue decline from FY2010 through the LTM.

Opportunities

1)      Benefits from SAP Implementation: RL has lots of duplicative IT systems that stem from its various acquisitions made over the past 15 years. Its wholesale and retail businesses are essentially operated as six separate entities with separate IT systems that don’t communicate with one another nor leverage their combined scale for sourcing, purchasing and/or distribution. Per my conversation with the company I was told, “Our IT systems look like a bowl of spaghetti that will ultimately look like a bowl of ravioli upon completion of installing SAP throughout our global operations.”

There is a long way to go as RL is only mid-way through completion of the North American operation for wholesale and retail. Next year it will begin implementing European wholesale and retail. In 2016 it plans to begin implementation within Asia-Pacific. Since SAP won’t be fully implemented until 2017, the full benefits won’t likely come through until FY2018. What SAP will do for RL is:

• Better match supply and demand for its merchandise. This will improve sales productivity, reduce markdowns and thus lead to higher gross profit dollars. It will achieve this by standardizing global systems and processes. Today it is difficult to get robust information at an item level in a timely manner. For example, the same item made, but sold in different channels and/or regions have different item definitions given they are being tracked through different IT systems. As a result, management cannot easily determine in real time how well an item is selling by channel, which impacts future order levels. Ultimately it will have an end to end insight into its supply chain. It will know exactly where any product is and where it is going at any point in time.
• Reduce SKU count, which will reduce cost of goods sold and thus improve gross margin. There are a lot of items made with less than 500 of them produced globally—and these are not super luxury goods like an Hermes handbag selling for $10k+. Currently, there is only 20% overlap in product assortment by channel and region. This is because each region (currently run as a very separate entity) orders a majority of its own merchandise at different times. RL will have greater centralized merchandising run out of NYC. There will be more focused oversight over how regional teams place their orders. The goal is to get to 80% product commonality by region and distribution channel, which will lower design and production costs. This will allow RL to fully leverage purchasing when it goes to source the product.
• Eliminate duplicative IT systems and labor expense from SG&A.
• Get better return on advertising dollars. Because each channel and region is run very independently with separate merchandising teams (i.e. only 20% merchandise overlap), each market is largely selling different items. As a result, there are over 1,000 ad campaigns produced for each season adding up to over 5k per year. The goal is to have many less ad campaigns, but ones that are far more impactful.

2)      Grow International Business, Particularly in Asia-Pacific:

• Sales in Asia are primarily driven by the retail business. Over the short-term, management expects revenue growth to be negatively affected by reduced distribution in greater in China as the company repositions its brand within this region and closes 65 stores. Going forward, RL has guided to adding 60 stores in Asia (mainly China) over the next 3 years, which will bring the Ralph Lauren store base to ~100.
  • RL’s current distribution by # of doors in Asia is fairly small and thus has a lot of room to grow.
• In part due to this relatively small distribution of its brand throughout Asia-Pacific, this region makes up just 13% of its global revenue compared to other apparel/luxury brands. Approximately 70% of this revenue is generated in Japan and South Korea leaving a real opportunity to grow in China.
• RL has the ability to take share in a growing affordable luxury market whose underpinning is supported by an emerging upper middle class.
• While China is the biggest emerging market opportunity, other markets such as Russia and Brazil present growth potential as well. For example, Polo Ralph Lauren ironically has good brand equity as a leather goods company, but not so much when it comes to apparel despite its strong heritage there.
  • Similarly in Brazil, Polo Ralph Lauren has a strong brand name in fragrances, but much less so in apparel.
• Considering less than two years ago, RL’s Asia revenue used to be 13% larger than where it is currently all while the luxury market has continued to grow at a healthy pace, there should be some impressive growth to come in light of the 60 stores RL is putting up over the next 3 years. Consider that the average full price Ralph Lauren store does ~$4.9M in sales. With an additional 60 stores plus some same store sales growth from the existing base, that’s a ~$300M revenue opportunity that can be realized over the next 2-3 years. This doesn’t factor in potential growth from other emerging markets such as Russia or Brazil as well as a rebound in Europe.
• When factoring in the potential rebound from Europe’s sluggish economy, international revenue including Asia and Europe could easily grow at a 10%+ CAGR over the next 3 years. Over time management expects RL to earn an increasing portion of its revenue and profits from overseas.

3)      Grow Women’s Business, Particularly within High Margin Accessories:

• At just 8% of total revenue, the accessories category within handbags, footwear, jewelry/watches, etc. provides a compelling growth opportunity over the next number of years. RL has made real progress in this category since taking its business in-house in 2008 when it bought in its licensee. It launched the Ricky/Soft Ricky line in 2013, which has performed well.
  • Accessories carry much higher average unit retail prices and therefore much higher gross and contribution margins on merchandise sold when the business is at scale. However, currently RL’s accessories are at a sub-optimal level of scale and thus have lower than average contribution margins. As this business ramps up over time, there will be a sales and margin benefit.
  • RL’s sales mix is ~2/3 men and ~1/3 women whereas the apparel industry average is ~60% women and ~40% men. To this point, RL is launching Polo women in 2014. While it’s difficult to gauge what the long-term opportunity is in terms of sales and profits, it should help add another leg of growth to revenue, particularly in the U.S. where the brand is so strong.
    • Per management: “About Polo women, we are actually doing a brand launch, both in retail and wholesale simultaneously…We will begin to ship Polo women [this fall] in about 150 U.S. doors and then significant number of doors in Europe and in Asia, all simultaneous with this very unique launch. We previewed with many, many, many customers from all over the world, actually late December into early January, met with some very positive response to the line. We also intend to put an important marketing and advertising and PR strategy around that launch, around the world, doing something more similar to what we did when we launched our Soft Ricky. And so we will have a unified message around the world, around the Polo brand in general, and both Polo men's and women's.”

4)      Grow Denim Business:

• RL has a relatively small denim business despite having been in the category for decades. RL had historically licensed out the business, but took the Polo Jeans business in-house in 2006. After that it effectively shut the business down as there was product being inappropriately sold by its former licensee. RL now has a more deliberate good, better, best strategy (RRL at the high-end, Black Label with broader distribution and Denim & Supply primarily in Macy’s) as the market has various price points that need to be met.
• This improves its ability to take share within the growing U.S. denim market that stood at ~$15 billion in 2011 and is expected to grow at a ~4% CAGR according to Euromonitor.
  • The number of doors Denim & Supply is being distributed through is increasing from 300 in 2013 to 400 in 2014. Also, in 2013 Denim & Supply opened its first freestanding stores in New York and Boston as well as 12 stores in Europe to improve brand awareness. It is also sold online and through a concession presence in Asia. D&S is a full lifestyle brand selling tops, bottoms and accessories. RL is putting marketing muscle behind it because it believes it has the potential to be distributed through more doors than Polo and/or Ralph Lauren given the more affordable price points.   

Capital Allocation

• Cash flow has been mainly used to buy in licensees, grow its store base, repurchase shares and pay dividends.
  • Return on Acquisitions/New Stores: RL targets a ~20% after-tax ROIC on acquisitions of licensees as well as new stores over a 3-5 year horizon. RL has consistently hit these targets over the past 15 years (with ROCE averaging ~20%), having spent $1.3 billion on acquiring licensees, $0.2 billion on Club Monaco and $1.0 billion on growth capex for new stores and technology initiatives.
  • Capex:
    • Next 3 years: From FY2015-FY2017 it expects to spend at an elevated level of $400-$500M per year compared to depreciation of ~$225M. It is spending incremental capital on SAP, a multi-platform upgrade for its ecommerce sites and ramping up retail sq. ft. growth to 6%-8% per year compared to 3%-4% in FY2012-FY2013. FY2014 capex of ~$400M is elevated compared to previous years due to SAP and doubling its North American ecommerce distribution capacity.
    • Post SAP Implementation: With sq. ft. growth likely coming down to mid-single digits in FY2018 and beyond, annual capex should be in the $250-$275M range, which approximates depreciation plus some growth capital spending for ecommerce and new stores.
• Share repurchases: Over the past 7 years, RL has averaged repurchasing a net $360M per year on share repurchases. Currently, it has a $730M share repurchase authorization. The company says it intends to typically spend $400-$600M per year on share repurchases going forward.
• Dividends: RL has a ~15% pay-out ratio, which it doesn’t intend to change. As a result, one can expect the dividend to increase in-line with EPS growth of 10%+ per annum. Currently, RL has a 1.1% yield.

Financials

• Accounting games: none. Over the past 15 years, earnings have approximated operating cash flow minus depreciation and stock-based compensation. Capex has exceeded depreciation due to investments to grow the business. Here are the cumulative buckets of reconciling earnings to cash flow from FY1998 to present:
  • Net income: $5.9 billion
  • D&A: $2.3 billion
  • Stock based comp, net: $0.4 billion
  • Asset write-down/restructuring costs: $0.3 billion
  • Bad debt expense/other: $0.1 billion
  • Working capital growth: ($0.3 billion)
    • Cash flow from operations: $8.7 billion
      • Capex: ($3.0 billion)
      • Acquisitions: ($1.5 billion)

• Balance Sheet Opportunities:
  • Improving Accounts Payable/Inventory: As of the last quarter, it stood at a very low 18.5%. This compares to VFC, Hugo Boss and NKE in the mid-high 40s. GPS is in the mid-high 60s. This issue likely has something to do with its various segments and regions running as six different entities. Upon the SAP integration being complete this opportunity should be fully realized. Assuming it was to move this up by ~30% to the high-40s would result in $335M in cash or ~$4 per share equal to ~2% of the market cap.
  • RL is underleveraged given it has net cash of over $12 per share equal to almost 10% of the market cap. Also, it has just $8M outstanding letters of credit for which it is contingently liable. While it has operating leases for its retail stores, since the average remaining lease terms is ~5 years and its operating margins are robust and likely growing over time, RL could easily take on debt to use for greater share repurchases. That being said, Mr. Lauren is conservative and thus is unlikely to do this.
  • Tax Rate Opportunity: Currently, RL has a 29% tax rate with ~68% of its business coming from North America. As higher margin revenue from Asia and Europe makes up an increasingly larger % of RL’s business over time, its tax rate should come down to the ~25% range over the next 3-5 years. From FY2009 to FY2014, the tax rate dropped ~3% as the North American business as a % of the total declined from ~72% to ~68%.
  • Share Repurchase Opportunity: At $400-$600M per year in share repurchases over the next 2 years would reduce shares outstanding by ~7%.

Low/Base/High Scenarios (based on CY2017E)

Low: ~$11 op. EPS x 12 (P/E) = ~$134 + ~$12/share net cash + ~$3 dividends = ~$150 total value (-4% over 2 years)

Base: ~$13.50 op. EPS x 15 (P/E) = ~$203 + ~$13/share net cash + ~$3.50 dividends = ~$220 (+40% over 2 years)

High: ~$17 op. EPS x 18 (P/E) = ~$300 + $14/share net cash + ~$4 dividends = ~$318 (+100% over 2 years)

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author and/or his/her employer may or may not have a position in any security discussed in this report. Further, the author and/or employer may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be correct as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information.

Catalyst