Ralph Lauren Should have Trained Big Brown

Big Brown is like a poorly managed brand - under investing when it matters most. This is the antithesis of RL where returns just started a multi-year climb and the Street's numbers look low all-around.

Anyone watching Belmont on Saturday hoping for horse racing's first Triple Crown in 30 years walked away sorely disappointed. Hardly any sportscasters' post-mortem can point to a single factor as to why such an incredible horse could place dead last. Maybe it was the quarter crack in his left front hoof that cost three days of training, maybe it was the 9,000 RPM regimen over the preceding four weeks that caught up with him. The bottom line is the Brown lost big time - like so many companies are today.

Pardon my little missive, but there actually is an important overlapping investment theme. The best brands in Softlines invest in content on a very steady basis, and understand that when times get tough they need to double down on investment spend to gain share as opposed to printing too much margin. Metaphorically speaking, Big Brown 'printed too much margin' at the Preakness and the Derby by pushing the envelope and winning by a combined 10 lengths. By the time the Belmont came, there was no more gas. I think that Ralph Lauren is the antithesis of Big Brown.

RL is coming off a year where it invested in geographic infrastructure as well as in new product initiatives. It's about 3-4 quarters ahead of margin weakness experienced by other retailers. Why? Because RL played offense then, and others are playing defense now. RL took it on the chin with an SG&A hit when it saw the need to jump-start its global growth profile (Japan, handbags, dresses, Russia, leather goods, footwear, to name a few). Better than 80% of other brands tweaked SG&A down over the past 2 years, and now are subsequently paying the price in sales and gross margin. RL is at a point where its investments are paying off on the P&L, and as such growth in its cost structure is ebbing at the same time revenue starts to flow. I'll let you do the math as to what this means to operating profit growth. (Ok, I'll do it for you... 0% goes to 25%+ for 3+ years).

Returns are Accelerating. Over the past 6 years, RL has been right-sizing the ship. It has either been in asset acquisition mode (mostly licenses), or organic investment mode. Either way, there was a constant trade-off between operating asset turns and operating margins - the two key levers to driving returns in this business. Now RL is at a point where 95% of licenses are already repurchased, and the major infrastructure to facilitate the next 3-5 years of growth are already in place. This means that asset turns and margins both head up simultaneously, which has a magnifying impact on return on net operating assets. By my math, RL just hit an inflection point which will take it on a run of a 1,000bp boost in returns to somewhere around 27%-28%. The components are in the exhibit below.

Numbers look Very Doable. I simply cannot get the company's recent guidance for the upcoming quarter and year to synch. The Street is looking at a 3% top line growth rate, which represents a 600bp 2-year erosion in growth. I think that the Street is at least 400bp low, and in fact more often than not the sales rate should accelerate - not decelerate. The only factor that might prevent that is the fact that inventory ended the last quarter -2% with sales +20%. The books are very very clean. Any sales erosion (that is already in estimates) is likely to be offset by GM strength. Bottom line is that the Street is looking for a down quarter to the tune of 10%. I think we'll see +10-15%. I'm still of the view that RL will print $4.50 or better this year vs. the Street's $4.00. Similarly, the Street looks at least a buck low in '09 and '10. Tough to find names out there that look like this.

So we've got positive revision momentum, improving returns on a multi-year basis, an added $2bn+ in sales and $2+ in EPS over 2-3 years, and troughy valuations. Not bad at all...

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