Description

Ralph Lauren

Stock Price: $42.20

Market Value: $4500 mm

 

Summary:

Simply because a company is well respected does not ensure its success during these troubled times.  My thesis with regards to Ralph Lauren is simple: anyone selling discretionary merchandise throughout the world will not grow earnings next year; and as shocking as it may seem, the street still expects earnings to grow approximately 2% next year.   Given these inflated expectations, it is equally shocking to see the stock trade at close to a 50% premium to its closest comp.

 

Business:

 

Ralph Lauren sells clothes & accessories worldwide: they sell through other retailers (approximately 10,000 doors), they sell through their own stores (328 stores) and they sell online.  Ralph Lauren, at approximately $5bn in sales, is one of the largest apparel brand ever. Despite saturation of the brand, the company has managed to grow its own top line in the past five years through a couple of strategies: 1) new exclusive lines for dept stores, 2) buying out licensee agreements and 3) increasing its retail presence.  Sales are broken down as follows:

1)       2/3 men’s, 1/3 women’s (estimate, not disclosed in filings)

2)       60% wholesale, 40% retail

3)       75% US, 20% Europe, 5% Other (mainly Japan)

The company’s wholesale side is fully distributed worldwide through department stores and specialty stores.  Macy’s is the largest customer, with 24% of wholesale sales, and Dillard’s is number two at 12%.  The top 10 customers, who we can assume are US department stores, make up 69% of wholesale sale (close to 40% of overall RL sales).

 

The company operates 328 stores, approximately 2.5 mm sq ft of retail space.  The retail group has 85 full priced Ralph Lauren stores, 69 Club Monaco stores, 162 factory stores and 12 Rugby stores. 

 

Thesis:

Ralph Lauren’s reported results YTD have been very good, especially in comparison to their peers.  They have beaten or met their numbers every quarter they’ve reported, and have maintained their guidance for FY 2009 (company has a March year end so they only recently reported Q2 in Nov).  As a result, it seems that investors and analysts have been lulled in to a false sense of security with regards to the company’s future performance.  There are several factors that have been helping out performance this year which will not be repeated in the upcoming fiscal year:

1)       Launch of American Living occurred Feb 2008: Ralph Lauren put together an entirely new line (including women, men, children, home and accessories) that is being sold through all of JC Penney’s stores.  This contributed 2/3 of the top line growth for the wholesale segment YTD.

2)       Falling US dollar : with 25% of sales denominated in other currencies, this explains the rest of the wholesale growth YTD, and some of the retail performance.  I also estimate it is largely responsible for the gross margin improvement, though the company claims it’s 100-200 bps increase in gross margins is largely due to efficiency improvements.  I’m afraid that explanation simply doesn’t pass the “smell test”.

3)       Decreasing purchase price amortization: this has helped operating margin by at least 100 bps.  This has not been clearly explained by the company, but it seems that the purchase price amortization associated with the buyout of the Japanese licensors in 2007 has decreased significantly yoy, allowing operating margins to increase.

4)       Artificially low tax rate.  Tax rate is expected to be 35.5% this year vs its standard 38%

5)       Both Men’s and Luxury outperformed through August of CY 2008 ~ and RL is relatively over exposed to both segments vs its peers. 

Unfortunately for Ralph Lauren, most of these advantages disappear at the end of 2009 and 2010, leaving them exposed to the same level of destruction facing all others dealing in discretionary merchandise.  There are only two launches the company has scheduled for late FY ’09, early FY 2010:a luxury watch line and luxury female handbags.  Somehow, I doubt either of those will add as much in sales as American Living did.  The US dollar will unlikely be a tailwind in the upcoming year, and is more likely to be a headwind.  The consumer in Europe and Japan, while delayed in their realization of the world crisis, is now also retrenching in face of worldwide uncertainty. The company is heavily exposed to US department stores who are looking at negative comps in the mid-teens for the holiday season, are attempting to cut back spring orders and are planning on slashing fall orders.  36% of its wholesale sales comes from Macy’s and DDS, both of which have potential liquidity issues in the upcoming year and are likely to shut down stores.  While traditionally RL’s markdown exposure has been light, when department stores are selling their entire inventory 50% off, it seems unlikely that RL will escape this year.

 

In addition, luxury retailers such as Neiman Marcus are posting comps down well into the twenties, with no expectation for near term improvement.  Given Ralph Lauren’s relatively high rent/sq ft (I estimate it to be about $60/sq ft) and high expenses associated with it’s full line stores, any positive comps from the factory stores are unlikely to be enough to compensate for their full line issues. 

 

Numbers:

Stock Price	$43.40
Diluted Shares	104.854
Equity Value	$4,550.7
Cash	(417.6)
ST investments	(92.3)
Cap lease	73.2
LT Debt	439.2
	$4,553.2
FY ending March	$	x
FY '09 EBITDA	847.0	5.4x
FY '10 EBITDA	879.0	5.2x
FY 2009E EPS	$4.09	10.6x
FY 2010E EPS	$4.18	10.4x

 

Obviously current estimates are too high.  I’ve focused on 2010 numbers as I believe that guidance when it is released will be shocking to the street.   Given sales down 5%, and gross margin normalizing to FY 2005 levels, and a slight decrease in SG&A (which will be difficult as the company continues to open up new stores), current 2010 estimates are 30% to high, which means those purchasing the stock today are choosing to buy an apparel company for a multiple in line with the S&P…a questionable decision given overall cosumer weakness

 

Fiscal Year Ending March	FY06	FY07	FY08	FY09E	FY10E
Total Sales	$3,746	$4,295	$4,880	$4,910	$4,665
Cost of Goods Sold, Occupancy and Buying Costs	1,724	1,959	2,242	2,209	2,193
Gross Income	2,022	2,336	2,638	2,702	2,472
SG&A	1,477	1,664	1,933	2,030	2,000
Amortization of Intangibles	9	16	47	20
Operating Income	536	657	658	652	472
Depreciation and Amortization	127	145	201	210	210
EBITDA	663	802	860	862	683
Income Before Taxes	523	648	647	648	472
Tax Provision (Benefit)	203	244	224	230	180
Net Income (Pre-Extraordinary)	320	404	423	418	293
Diluted EPS (Pre-Extraordinary)	$2.98	$3.75	$4.02	$4.13	$2.89
Avg Diluted Shares Outstanding	107.2	107.6	105.2	101.2	101.2
Sales Growth yoy	13.3%	14.7%	13.6%	0.6%	(5.0%)
Gross Margin	54.0%	54.4%	54.1%	55.0%	53.0%
yoy change	301.9	40.6	(33.0)	96.0	(201.8)
Operating Margin	14.3%	15.3%	13.5%	13.3%	10.1%
yoy change	214.9	98.5	(180.8)	(21.0)	(315.3)
EBITDA Margin	17.7%	18.7%	17.6%	17.6%	14.6%
Tax Rate	38.8%	37.7%	34.6%	35.5%	38.0%

Note: historical numbers and FY ’09 estimates taken from Wall street model

Catalyst

Report Q3 ’09 results in February 2009. This should be when the company initiates FY 2010 guidance (traditionally they initiate guidance at this time). Also, given tentative commentary regarding their current guidance during the last conference call, it seems likely they will take down their FY 2009 numbers as well.