RL: Opacity Gone

 

RL remains one of our favorites. Numbers are still too low. But let’s acknowledge some risks that loom on the horizon.

 

 

RL pulled another RL. EPS of $1.78 came in well above $1.66 consensus expectations and our own $1.70E. Solid revenue growth and tighter cost control offset continued margin pressure and a higher tax rate that impacted EPS by ~$0.07. There are plenty of puts and takes on the quarter, the biggest of which are…

 

     1)      Pro: RL’s increasing control over its own distribution through owned retail in Asia, and just about the best track record for trading dot.com vs. retail stores out of any brand we know of – even powerhouses like Nike.

     2)      Con: FY13 will be the first year in 5+ that we’ll be looking at a real organic growth rate for RL.  Yes, we’ll see expansion of retail stores, dot.com and meaningful expansion in Asia. But these are all existing businesses.  Previously, acquired (and consolidated) licenses goosed the top and bottom line. With the opacity of the model largely we’ll get a better sense as to the real organic numbers.  That’s not bad, because we still get to near 20% organic EPS growth. But with tourist growth slowing in its largest markets, we’ve got to keep our eye on the ball.

 

All in, we remain well above the Street next quarter at $1.20 vs. $0.95 (pre call) and over $10 in EPS 2-years out (F14). With a favorable setup in Q4 due to timing shifts last year and strength at retail and internationally (Asia in particular), RL continues to be one of our favorite names in retail.

 

Here are a few things worth considering in the quarter:

     1)      Gross margin pressure remains persistent. We cant ignore this one, especially with the sales/inventory spread running negative for six quarters running.

     2)      Inventories were up +28%, and RL blamed 12% of this growth from non-comp items (South Korea, Home, new stores and e-com). The shift of South Korea and home from licensing has been a strong incremental sales driver (5% of total sales this quarter) so we’ll front them that. If we assume inventory levels stay at the current 2yr run rate, against an easier comp next quarter the sales/inventory spread should turn positive for the first time in the last six quarters. While that gives us a bit more comfort on Gross Margins, the numbers don’t lie, and they remain high.

     3)      Management noted that tourist traffic is off meaningfully in its two top markets – US and Europe. In addition, Fx was a non-event in the quarter, but will start to become a headwind in Q4 after providing a 2% tailwind YTD.

     4)      In the upcoming year, they lap Korea, meaning that this is the first year in a very long 9 years that will show the real organic growth rate of the company. Korea has accounted for ~3% of incremental growth in F12 and Home another 1-2%. We have sales up 13% next year after +23% this year driven by +7% from existing stores, +2% e-com, and 4-5% in wholesale driven more by product expansion than new door growth.

 

Bigger picture, keep in mind that this is the year where Roger Farah’s contract comes up for renewal. His RL stock alone is worth over $7.5mm, and we can’t think of a retailer that wouldn’t love to get their hooks in him given his credibility built at RL. It’d be shocking to us for him to ‘pull a Ron Johnson’ and go elsewhere. But if we were to craft a doomsday scenario for RL, this would definitely be part of it.

 

As for revenues in Q3, similar to last quarter strong retail performance accounted for 11% of RL’s consolidated 16.5% top-line growth. Existing comps contributed +10.5%, Korea (+2%), and e-commerce (+1.5%) while wholesale contributed +4% offsetting the modest decline in licensing due to the loss of Korea. With revenues coming in largely in-line with our expectations and wholesale a bit stronger on the margin, we have taken our revenue estimates up 2pts to +22% in Q4 offset by the shift in SG&A expenses of ~$16mm into Q4 and slightly higher tax rate accounting for $0.11 and $0.04 in EPS respectively and a net reduction of $0.13 to our Q4 number.

 

In looking out over the next few years, the increasing shift towards retail will create a natural tailwind (see table below) at the same time the company is increasingly focusing on product expansion (handbags, footwear) that will drive increased productivity. In fact, the first question Roger was asked in the Q&A was about RL’s partnership with JCP. In short, the response was something to the effect of the company has so many exciting opportunities that they are looking to focus their energy elsewhere. We agree and remain bullish on the immediate-term TRADE and longer-term TAIL here.

 

Here’s a sense as to how sales mix versus estimated Gross Margin by segment is impacting consolidated results.

 

RL: Opacity Gone - RL mix shift

 

RL: Opacity Gone - RL SIGMA

 

RL: Opacity Gone - RL expectations vs reality

 

 

Casey Flavin

Director

 

Here are our notes from the call:

 

Revs: +16.6% (better than low-teen expectations)

  • Contribution from South Korea and home textiles collectively added incremental +5% to sales
  • Fx neglibible

 

Wholesale:

  • Double digit rev growth in US and Europe
  • Continued momentum in men's and children's apparel globally
  • Expansion of newer merch categories: handbags and footwear, Lauren products in Eur
  • Strength in dept store channel globally offset softness in select specialty store mkts
  • EBIT impacted by COGS inflation and impact of new categories D&S and Home

 

Retail:

  • Double-digit comps in all major geographic regions = 12% comp in Q3
  • .com +31%; RL stores +7%; Factory +9%; Club Monaco +17%;
  • Unseasonable weather impacted US and Eur in Oct and Nov
  • Consumers shopped later in season - impact of highly promotional season
  • Traffic most challenging in US and Eur RL stores - experienced 'a stark deceleration' in tourist sales vs 1H
  • Asia growth remains strong
  • Club Monaco trend right has the momentum - conversion and units/trans up
  • Top .com categories: Men's, children's and Denim & Supply among top performers categories in Q3
  • Opened 7 stores; closed 3 stores = 378 at qtr end
  • Strong operating profitability on tough comp yy driven by strong comp and int'l market profitability

 

Licensing:

  • Revs down -1% (SK and Home)
  • EBIT up due to lower net costs re S. Korea and home transitions

 

GM: -150bps due to

  • Peak cost inflation for fall/holiday season
  • Mitigated by selective price increases, greater retail mix, and e-commerce

 

SG&A: + 15.5%

  • Shift in timing from certain corporate expenses in the quarter to Q4
  • Increase due to incremental rent (retail growth), depreciation, and labor
  • Also incremental cost associated with transition of South Korean lic and home textiles ops

 

BS:

  • Inventory +28%
    • o 12% from non-comp items (home, South Korea, new stores, int'l e-com)
    • o 9% merchandise to support comp products, geographies , and distribution
    • o 7% COGS inflation and FX impacts
  • CapEx $68mm - new stores, S-in-S installs, and infrastructure investments
  • Repo'd $395mm in stock YTD - have $577mm remaining under SRA
  • $1.3Bn in cash; $1Bn net cash

 

 

Outlook:

 

Q4:

  • Revs: ~20%
    • Mid teen rev growth at wholesale
    • Mid 20%s rev growth at retail
    • Reduction in HK and China doors and anniversary of S Korea
    • FX expected to have a net negative impact on consolidated revs
  • OM: equal to or slightly below prior yr (was -50bps) - originally -100-150bps at the beginning of the year
    • Assumed cont. inflation pressure
    • Large wholesale shipment qtr for Spring
    • Clearance at retail
    • Incremental expense incurred with closing stores in China
  • Tax 34% (This adds an incremental $0.02 to earnings vs. the 35% we're modeling)

 

 

F13:

  • Sales will anniversary S Korea and Home
  • Fewer Chinese doors
  • Drivers will continue to be geographic expansion, new stores, and expanded accessories

 

General:

  • continued focus on our key growth initiatives, which include expanding our international presence, extending our direct to customer reach, and new merchandising innovations have resulted in a more profitable mix of business compared to the prior year.
  • International revs up 40% YTD
  • More than mid-teen expansion in US
  • Expanding Lauren apparel and launch of handbags and footwear in Club Monaco have been well received
  • Keeping investment behind e-commerce launches
  • Despite meaningful headwinds in Eur 'poised' for substantial growth

 

  • Double-digit comp growth in Japan
    • Better than expected sales on more profitable platform
  • Implementing similar disciplines in Korea
    • Still top destination for Chinese shoppers
  • Closing 95 points of distribution in China by end of F12 = 60% of network they had in place at beginning of the year
    • Bold move but critical
    • Taking accelerated action to build strongest foundation possible in most important global lux market
    • Will take a deliberate approach to building out store base to find most attractive locations
    • In aggregate, int'l ops gained 400bps of share in overall rev mix YTD

 

  • DD comps and strong mo at wholesale suggest taking share
  • Clear that e-com becoming increasingly more important channel for customers - RL remains committed to spending here
  • Launched in several European countries (France and Germany earlier this year)
  • Club Monaco will launch e-com this spring in US and Canada
    • o Also creating style guides and developing a magazine to showcase collections
  • In Q3, mobile phones and tablets accounted for 20% of traffic to RL.com and nearly 10% of sales = ~$0.03 in EPS

 

  • Direct operations in Asia and adding additional key product categories will fuel profitable growth for next 5-10yrs

 

  • Men's and Children's apparel particularly strong
  • Women's also solid
    • o Blue label strong especially Int'lly
  • Club Monaco resonating with women - looking to grow the platform over the next few years
  • Handbag and footwear
    • o This spring among most 'well received' ever
  • Expanding international Lauren and Polo leather goods
    • o Due to profits and productivity seeing in existing markets
  • Denim and Supply launch in Q2
    • o Rolled out hundreds of shop-in-shops globally
    • o Balanced sales mix between men's and women's - younger customer
    • o See opportunity to open more freestanding stores given success thus far

 

Cost inflation:

  • Beyond just cotton; also cashmere, wool, silk, leather, and exotic skins
  • Made strategic price adjustments in the fall - not full offset = maintains value to customers
  • Expect to see margin relief with Fall shipments
  • Believe they've gained meaningful market share gains as a result

 

 

Q&A:

 

Partnership with JCP:

  • At end of 5yr commitment for American Living and have decided to move away from business after Spring/Summer shipments
  • I think the mid tier channel had a more challenging third quarter
  • Have met with RJ and team several times
  • "we have a lot on our plates that is very exciting and challenging and we want to make sure our efforts and energies are aligned with the opportunities"
  • Have left the door open for further dialog
  • Will be spending time controlling brand best way they know how - i.e. owned retail
  • De minimus impact on P&L
  • Domestic wholesale efforts focused on existing customers - Chaps at KSS where they are #1 brand

 

China Store Network - Flagships:

  • 95 door closures more than 60 started year with
  • Following new store openings in HK and Shanghai and strong demand for lux goods, decided to get more aggressive about closing B and C locations
  • Negotiating in Beijing, Shanghai, and HK for flagships
  • Also looking to build flagships in Japan and Paris as well as China

 

Cost Inflation/ Regional Profitability:

  • Maintained quality, didn't sacrifice RM trim or fit
  • Picked up mkt share
  • Expect margins to rise in '12
  • Mix helping - DTC + Int'l markets higher margin
  • Also product category expansion in accessories and other higher margin

 

SG&A Exp Shift to Q4:

  • In corporate, advertising, and some e-commerce investment, some headcount that had initially planned in Q3
  • Also restructuring and impairment charges in Q4 re China door closures (taken out of adj EPS)
  • Magnitude $15-$18mm range

 

European landscape:

  • Sense of uncertainty among local customers if /how euro crisis will be resolved
  • Wholesale bookings at this point mostly men's
    • Early reads are up, getting market share with most retailers operating cautiously (inventory and capital)
    • Investing in brands they feel most strongly about
  • Second piece is that small specialty stores getting squeezed
    • RL will be looking to build up monobrand RL-owned stores as a result
    • England, France and Germany
    • Will also leverage e-com launches

 

Growing Concepts Denim & Supply and Club Monaco:

  • ~200 doors at Macy's; 100+ int'l
  • Club Monaco sold through owned retail domestically and soon to be .com in Asia
  • Have licensed partners in Asia that are growing footprint
  • Strong in Europe through S-in-S and dept stores looking into free standing stores

 

New Int'l Head - Succession Planning?:

  • Just joined
  • His background is in running luxury businesses
  • LVMH watches
  • International customers
  • Every one of those high priorities for RL
  • Also have John Hawkes in Europe (joined in Fall) and Mark Daily in Asia (joined this time last year)

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