The 4Q print changes nothing related to our long-term call re: $9 in EPS power. But RL’s response to inflation and reinvestment in new product – while positive strategically -- hits our intermediate-term (TREND) model and view. Short-term (TRADE), we wouldn’t touch this name. There’ll be a chance to buy this great business at a far better price.
This is a name where we fundamentally believe in where the company is headed strategically. But with industry fundamentals starting to crack, RL’s valuation simply defying gravity – already representing the $8-$9 in earnings power we think it has over the course of 2-3 years -- and the inevitability of RL’s perennial ‘guide down and smoke’ philosophy finally catching up with it, we’re actually surprised it was not down far more on the day. This is a great brand and a great business. But at $114.70, we don’t think it will be a great stock. We’ll look forward to buying this one back lower.
Changes to our Thesis
We think it’s best to tear this beast apart by duration, and then see how today’s event altered this one way or another.
Long-Term (TAIL): This quarter changed not a thing. Now that RL has complete control of its geographic and product licenses, it can consistently take up product mix to higher end apparel and accessories, take this brand from $15bn at retail up to $20bn. Ultimately we’ll be looking at upwards of $9 in EPS power and 25% RNOA within 3-years. In fact, it’s quarters like this where RL is not afraid to take it on the chin with margins in order to sustain profitable top line growth in the outer years that separate it from the pack.
Intermediate-Term (TREND): Definitely some moving parts here. The company may have only missed the consensus by $0.04, but it missed our estimate by $0.20. Every line of the model was spot on, except for wholesale margins. Part of this was more delivering from the holiday shift than we anticipated (part of which should make itself whole in the current quarter). In addition, we were definitely not anticipating RL’s response to inflation. Specifically, it only took up prices on high end product, and left prices on lower/mid product unchanged – hence absorbing the margin squeeze. On one hand we could argue that this is good for retail partners as RL is being rational and is not strong-arming the chain. But on the flip side, it will compress the perceived value gap between its’ product and that of the competition. Good for Ralph, bad for competition. Questionable for the industry.
It also invested in a new high-end denim label for both men and women as well as a its bedding and bath business. Lesser companies would pull back on investing in this kind of environment. Not RL. That said, we still need to take down our EPS estimates for this year – though it does not jeopardize our $9 3-year number.
Immediate-Term (TRADE): We wouldn’t touch RL here on a TRADE duration. We’re quite surprised it did not trade off more meaningfully on this miss. This company never misses. Check out the chart below. It shows a few things…a) for a given quarter, where the Street’s estimate were before management guided, b) where estimates shook out after they guided, and c) what RL ultimately printed. That’s OK if you’re like VFC where you do it by a few pennies at a clip. This is the ultimate ‘guide down and beat’ company. But RL does it by 20-30%. The good news is that it’s almost always to the upside. But that has become the norm. The bad news is that the sentiment has gotten to a point where RL needed to beat by a certain amount to avoid going down. With the stock having outperformed retail (RTH) by 12% and the S&P by 15%, respectively, for the year-to date, we’ve been concerned that this would catch up with them. Given the weakness we expect to see in the broader retail space throughout the remainder of this year, we can’t imagine that anyone will give retailers’ multiples – even RL’s – the benefit of the doubt.
DETAILS ON THE QUATRER
- Sales: 1.4 billion +7%
- Wholesale segment: +2%
- Strong growth in U.S. wholesale shipments
- Continued growth in foreign department stores
- Offset by a planned decline in Japanese wholesale shipments
- Softness in some European specialty stores
- Wholesale operating income: 136 million
- The operating profit margin declined 670 basis points
- The decline in margin rate is primarily attributable to the cost of goods inflation, lower Japanese wholesale shipments and continued investment in new merchandise categories.
- Comparable store sales increased +7%
- (excluding sales at the Asian stores and concessions shops that we assumed in the fourth quarter of fiscal 2010. *These sales will be included in comps getting in the first quarter of fiscal 2012)
- Retail segment operating income: +40%
- Operating margin improved 80 basis points
- Licensing: -6%
- Higher fragrance licensing revenues were more than offset by a decline in international licensing revenues related to the South Korea transition. Consolidated inventory was at 39% at the at the end of the fourth
- Total Comparable Store Sales
- Consolidated Comps up +7% reflecting:
- 8% increase at factory stores
- 10% growth at Club Monaco
- RalphLauren.com sales increased 21%
- The 3% decline in Ralph Lauren comps during the first quarter is due to HSD reduction in Japanese operations. Excluding Japan, Ralph Lauren comps were flat
- Gross Margin 56.8%
- Some of the inflationary cost of goods pressure we experienced in the fourth quarter was offset by a higher level of full price selling at most of the retail concepts and this seasonal variation in overall channel mix.
- Operating Expenses: $693 million +12%
- Operating expense margin rose 240 basis points to 48.6% in the fourth quarter reflecting incremental expenses associated with the recently transitioned South Korean operations,
- Operating Income:117 million -32%
- Primarily do the calendar shifts affecting the comparability of the period.
- Effective tax rate in was 34.4%
- Was approximately 250 basis points higher
- Net income: +$73 million
- Impact from Japanese earthquake was $0.02 on 4Q earnings.
- Balance Sheet
- Inventory: +39% reflecting;
- Inventory this time last year was very low. So the comparable period was understated and this period inventory overstated.
- The transition of the Southeast Asia and greater China region and South Korean inventory was incremental this year versus last year.
- The remaining quarter of the increase is attributable to cost of goods inflation and foreign-currency dynamics.
- CapEx:~$255 million reflecting;
- Support of retail stores
- Wholesale shop development worldwide
- Continued infrastructure investment.
- Repurchased approximately 6 million shares of stock for an aggregate of 578 notary during the year including two million shares for $247 million during the fourth quarter.
- board authorized an additional $500 million for share repurchase
- Cash position: 1 billion
- Next 3 years company intends to invest over $1 billion in total capital to continue advancing strategic objectives.
- $500 million in capital we intend to invest over the next 3 years for
- Concession shops
- Continued development of global e-commerce
- *Nearly 70% of this capital will be allocated to international markets.
- Company believes it will generate over $3.5 billion of EBITDA over the next 3 years
- The company finished assuming control of distribution in South Korea during the fourth quarter
- Completed the last phase of multi-year mission to bring Asian operations in-house
- China and South Korea concessions shops performed better than anticipated during the quarter. Japan sales were down approximately 30% in the weeks following the earthquake and tsunami compared to the relatively flat performance in the quarter to date period prior to the disaster.
- Easter Shift
- There was an extra 53rd week that in results last year in the fourth quarter and a later Easter week this year that shifted that holiday sales growth into the first quarter of fiscal 2012 versus the fourth quarter that we are reporting now.
- There was also the timing of the high volumes sales week post-Christmas that fell within the third quarter of fiscal 2011 compared to the fourth quarter of fiscal 2010.
- On a normalized calendar basis, the shifts negatively affected sales growth in the quarter by approximately 10 full percentage points.
- Cost pressures
- Company made pricing adjustment by brand and region to help mitigate inflationary pressures.
- Pricing change does not completely offset higher costs.
- "In general, we've determined not to not to pass on the full impact of our higher cost of goods and the magnitude of inflation is such that we do expect our gross profit margin and our operating margin to be down in 2012."
- "We believe the customer, the consumer will accept some higher prices due to the strength of our brand and the consistent quality of our merchandise but after a decade of apparel deflation the actual customer reaction remains unknown until the merchandise is available for sale in stores."
- First Quarter
- Sales: Increase in the mid 20% range
- Wholesale expected to grow at low 20%
- Retail expected to grow faster.
- Comparable store sales are projected to increase by LDD
- Operating Margin: flat
- Fiscal Year 2012
- Sales: Increase in the mid teens range
- Retail expected to grow faster than wholesale
- Operating Margin: down 150bps
- Tax rate is estimated at 33%
- CapEx: expected to be 325million
SG&A Growth Spending:
- Excludes any restructuring charges related to repositioning in China
- Expect to leverage operating expenses
- Continue to invest in infrastructure and advertising – expect these to continue
SG&A Flex Dependent on Sales:
- Retail is growing faster than wholesale
- Strategy in growing Asia is primarily driven by growing the retail base vs. wholesale distribution
- Key for the company has been that they have invested on high return opportunities over the last several years, which is what is driving sales today
Input Cost Flow Through:
- If you look at run-rate for Q3, adj Q4, and Q1 outlook, top-line trend is strong
- Did not take many price increases in the spring, but have for fall
- Those increases dependent on price of product and merchandise categories
- Range from LSD to mid-twenty percent increases
- Some of bigger cost inflation was realized in lower end of product quality pyramid
- Believe cost increases will begin to moderate in Spring of 2012
- Not going to alter cut or quality of product
Pricing by Categories:
- A bit more cautious in lower end categories where consumers are more sensitive to price inflation
- Not determined by gender
Club Monaco/Rugby – Int’l Expansion:
- Club Monaco growing in success
- Have had many retailers in Europe looking to carry the line
- The European partners feel that they can carry it in proper distribution channels as well as at stand alone locations – test this February in Browns of London extremely successful
- Believe CM represents a substantial opportunity in Europe – will be opening first store in Europe in London later this year
- Rugby expansion also targeted in Europe
- Denim will be reintroduced in 250 stores in US and Canada in both Men’s and women’s
- the Denim & Supply business in Europe will replace the existing Polo Jeans Co. business closed 4yrs ago
- Historical target of 1/3 of business from domestic/Eur/China increasingly challenged given the strength of domestic business
- Japan and South Korean business are heavily dominated by department store shop-in-shops
- In Japan, have seen a very positive response as the company has ‘elevated’ both women’s and kid’s product categories – more logoed pieces
- In Korea, added a very strong team that came on with acquisition
- Have been replenishing new inventory over last 5-months
- Customer has responded well to new fashion
- Much of demand driven by Chinese coming to Korea for shopping weekends given the currency arb
- China/Dixon acquisition required RL to build the region from scratch
- Also more stand alone retail
Expanding Home Category:
- Began shipping in May
- Focus on Bed and Bath
- Have been working hard on this over the last 2-years ramping more recently
- Have recently added lighting and rugs
- All changes team has made have been received very well
- SG&A outlook suggests significant ramp due to Korea build out
- Also to support new initiatives like home
- Expanding e-commerce distribution (Europe and exploring Asia)
- Additional international growth opportunities
- Dilutive in Q4, accretive in F12
Japanese Business/Travel & Tourism:
- Japanese business hardest hit 2-months following tsunami disaster, travel and tourism still down dramatically
- Chinese having difficulty obtaining visas to travel to US so going to Europe instead
- Starting to see improvement in ‘mood’ of Japanese shopper
- Headline issue is the Chinese tourist shifting from US to Europe where RL doesn’t capture as much business