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RL: Great Story, But Early

Takeaway: RL is making all the right investments, and the TAIL story is a winner. But where the consensus numbers come out near-term is critical.

This note was originally published August 07, 2013 at 14:11 in Retail

RL: Great Story, But Early - rl111

We were negative on RL coming out of the print in May – not because we did not like what the company was doing – quite the opposite, actually. RL was investing in IT systems, stepping up its Retail and e-commerce investments on a global scale, and preparing to take in the Chaps license from Warnaco. But these initiatives cost money, and the outward capital flow unfortunately precedes turning on the revenue spigot by at least 9-12 months. Simply put, there’s almost no way that returns can turn up when this is happening, and valuation multiples don’t expand when returns are going down. Given that RL’s multiple was sitting near peak, it made sense to us to wait to get involved until the market to freaked out over sloppy results.

 

The financial results played out as we thought, but the reality is that if you asked us a couple of days ago if we’d see a sell-off this quarter, we’d have said ‘probably not’.  Don’t get us wrong, the quarter itself was poor, with 4% sales growth de-levering to an 11% decline in EBIT. Comps came in down -1%, and inventory growth outstripped sales growth by a factor of 2x. Again, not return-enhancing metrics – consistent with our concern last quarter. But that said, we think that expectations were set appropriately headed into this print. 2Q guidance of lsd growth and margins down 300-350bp vs last year seemed to be the big culprit, as they suggest EPS in the range of $2.25-$2.20 vs the consensus at $2.57.   The question, therefore, is likely whether that is the real number, or if it is a sandbag.

 

Our sense is that financial reality is somewhere in between guidance and current estimates. We’re coming out at $2.31 for 2Q, and where the consensus lands will be critical as it relates to our near-term take on the stock. We’ll watch that in the coming days, and will be back accordingly.

 

Long-term, we continue to like RL in that the actions that the company is taking today should propel RL’s top line over $10bn within 3-years, push EBIT margin into the 17-18% range, and take RNOA from 24% today to 35% as asset turns increase on top of a higher margin business. Those characteristics are tough to find. But the catch, once again, is that our estimates are hovering right on top of the Street’s for the next three years (based on last night’s consensus numbers – see table below). That’s rare for us and RL. We’re usually far above. That tells us that the Street finally has it right, or we’re missing something. Either way, we don’t have the conviction to jump in at current levels – at least not while it is still in the early half of its ‘investing year’.

 

Ralph Lauren Investment Summary

RL: Great Story, But Early - brian1

 

RL Profitability Roadmap: Solid Outlook Over Our TAIL (3-Year) Duration

RL: Great Story, But Early - rlroadmap

 

 

HERE'S OUR NOTE AFTER RL'S 4Q RESULTS 

 

5/23/13

RL: The Market Is Not Recognizing The Risk

 

Takeaway: Stocks don't go up when sales slow, costs increase, capex goes up materially and the stock is at 20x EPS. A textbook 'investing year.

 

Conclusion: We like what RL is doing, but the near-term financial implications will not be pretty and EBIT growth trajectory and RNOA will suffer. Even though this impact will likely be temporary, investors will need to wait until near the end of this calendar year until the risk profile improves. Until then, valuation matters.

 

DETAILS

We're surprised that RL was not down more on its 4Q print. Yes, the company overdelivered -- in typical RL fashion.  But there are enough factors that are changing negatively on the margin that we think will make  RL a good candidate for multiple compression in the sloppy quarters that lie ahead in the upcoming fiscal year.

 

We like this company as much as we ever have. It continually reinvests in its intellectual property to elevate the retail experience and gain share -- something that has worked for RL without fail.


Case in point…we kept a little scorecard of all the times that retailers and brands mentioned the words 'omni-channel' in press releases and earnings calls this earnings season. We stopped count at 100, and no, it did not take us long to get there. This has officially become the biggest cliché buzzword since 'supply chain' made it on to the scene 15 years ago. We swear that half of the execs talking about omni-channel don't even know what it means (if there even is a universally-understood definition). They're just following the cool kids.

 

Ralph is one of the cool kids.  It did not discuss 'omni-channel' once on its call or press release. Why? The reality is that it has been implementing a true omni-channel strategy for much of the past five-years…at a time when no one knew what it even was. Now RL is implementing retail and e-commerce models that others will be trying to implement in another five years. Simply put, we think that RL will continue to be a winner.  

 

But this is one of those years where the negatives to the story are likely to outweigh the positives. Specifically…

  1. FX will be a meaningful headwind in FY14 -- especially given RL's significant exposure to Japan.  Check out the Yen's move over the past six weeks. Not good.  FX is a $75mm hit to EBIT for the year.
  2. RL's Global SAP implementation, Korean e-commerce rollout, acceleration of retail rollout -- including NY flagship. There's another $75mm hit to EBIT this year.
  3. Capex is going from $276mm last year to up to $450mm in FY14 -- that's one of the biggest capex increases we're seeing out of anyone in retail.

 

In fairness to RL, it has proven to be an exceptional steward of capital in the past, and we have no reason to think that will change this year.  But the reality is that the $150mm in extra costs puts RL in a hole for 13% EBIT growth. This would be ok if we could justify solid double-digit top line growth as an offset -- but the reality is that we cannot (even if partially due to FX). So we've got slowing sales, eroding margins, and a step-up in capex. Any way we cut it, we can't justify the combination of these factors leading to any form of multiple expansion.  


Boom. Asian Contagion

(Editor's note: What follows below is a complimentary excerpt from Hedgeye CEO Keith McCullough's "Morning Newsletter." We send these market notes out every weekday morning before 9am ET, along with our immediate-term risk ranges on select asset classes. To learn more about this excellent Hedgeye research product and how you can become a subscriber, please click here.)

 

Boom. Asian Contagion - guy56

MACRO GRIND

Since #RatesRising and #DebtDeflation have been the two Q313 themes most of our clients want to talk about, that’s what I have focused my time ranting about. That, however, doesn’t mean that our 3rd major Macro Theme for Q3 doesn’t exist. In fact, today is as glaring an example as any in which #AsianContagion should be jumping off your screens.

 

Reviewing the risks of #AsianContagion:

  1. Some overvalued Asian currencies are breaking down from an intermediate-term TREND perspective
  2. Some Asian debt markets are getting increasingly nervous about the negative deficit impact of a weakening currency
  3. When both a country’s currency and debt deflate, you get local inflation and local #RatesRising – that’s bad

From a process perspective, our Senior Asia analyst, Darius Dale, called out the following equity divergences 24 hours ago:

  • Indonesia -5.6% DoD vs. a regional median delta of -0.2%
  • Thailand -3.3% DoD vs. a regional median delta of -0.2%
  • India -9.1% MoM vs. a regional median delta of -1.2%

Then, on Indonesia in particular, he called out yesterday’s key economic data point:

  • 2Q Current Account Balance - current account deficit widened to a record on both a nominal basis and as a % of GDP

And finally, we get this morning’s Bloomberg headlines (under Economy):

 

A)     “Rupiah Forwards Plunge To Lowest Since 2009 As Bond Risk Surges”

B)      “Rupee Drops To Record on Fed Tapering Concern”

 

These macro headlines (i.e. old news) come after Indian, Indonesian, and Thai markets move. The proactive risk management Macro Trick is to know they are moving (and why) before consensus realizes it. This macro theme is 1.5 months old.

 

Indonesian stocks are -11% in the last 3 days and India’s stock market continues to be one of the worst in the world for 2013 YTD – all for Hedgeye playbook reasoning (this kind of stuff confuses Keynesians who think weak FX is a good thing!).

 

Again, to review in the most simplest of complexity’s terms:

  1. Currency Burns, then local  
  2. Inflation Accelerates and Growth Slows; and finally          
  3. Deficit worries (and credit risk) rise; and bonds fall (#DebtDeflation)

If you want to be really worried about something other than the US Bond market crashing, we’d suggest Asia (ex-Japan). That’s not a new Hedgeye Jedi Macro mind trick as of this morning either. That’s what was already trending.

 


DKS: Still Bearish; ROIC Going Lower

Takeaway: DKS’ 2Q print validated our bear case that it is trading greater investments from lower cash margin, and ultimately, a lower multiple.

DKS’ 2Q print validated our bear case that the company is putting up a greater proportion of incremental capital on both the P&L and the balance sheet for disproportionately less cash flow in return.  Our view is that this trend (which also applies to Macy’s and Gap) will mitigate any kind of valuation support, as multiples have no business being near their tops when returns are rolling over like we see today.

 

Like many retailers quarter-to-date, sales trends were soft, and the company did not have a firm grasp as to why. It comped down for the second quarter in a row, and though gross margins held steady, inventories were up 12.4% on 6.6% sales growth. That’s not a good setup by any stretch for gross margins heading into the back half.

 

If there’s any bullish angle, it’s that earnings expectations might finally be down to more doable levels. But the reality is that this stock is still trading at over 18x current year earnings, which is downright expensive.  Based on our model, it will never have over a 9% operating margin again (see our assumptions below). We’d need to see consensus estimates come down by about 25% in the outer years for us to back off of our bearish stance on DKS. That’s unlikely to happen.

 

Avoid the temptation to support it here. Let it cook.

 

DKS: Still Bearish; ROIC Going Lower - 8 20 2013 12 14 32 PM

 


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Morning Reads on Our Radar Screen

Takeaway: A quick look at some stories on Hedgeye's radar screen.

Keith McCullough – CEO

Rupiah Forwards Plunge to Lowest Since 2009 as Bond Risk Surges (via Bloomberg)

Asia stocks hit by fears about emerging markets (via MarketWatch)

Fukushima Plant Has 300-Ton Water Leak (via New York Times)

 

Morning Reads on Our Radar Screen - duut

 

Brian McGough – Retail

J.C. Penney Posts Slower Sales Decline on Ullman Plan (via Bloomberg)

Retailer Dick's Sporting Goods misses estimates, shares fall (via Reuters)

 

Jonathan CasteleynFinancials

Capital Flows Back to U.S. as Markets Slump Across Asia (via Bloomberg)

1997 Asian financial crisis (JC note: If someone blows up in China this is your analog. via Wikipedia)

 

Kevin Kaiser – Energy

E&P Investors Fear the Oil Party Hangover (via Wall Street Journal)

BHP delays $14 billion Canada potash push as profit drops (via Reuters)

Go Your Own Way – Offloading Heavy Canadian Crude On The Gulf Coast (via RBN Energy)


GALAXY 2Q 2013 CONFERENCE CALL NOTES

Galaxy beat our 2Q EBITDA estimate and we were high on the Street.  High mass hold and controlled corporate costs were the driving factors. 

 

 

"We are very pleased to report improving financial results across the business and that Phase 2 of Galaxy Macau remains on schedule. The Group also expanded its existing Cotai landbank with the strategic purchase of the Grand Waldo Complex.  We also strengthened our balance sheet by prepaying a significant portion of our bank borrowings. I am particularly delighted that the half year culminated in the Group being included as a constituent of the Hang Seng Index. Looking into the future, Macau's prospects for the remainder of 2013 and beyond continue to be bright. We believe that our development pipeline for Phases 2, 3 and 4 plus the Grand Waldo Complex on Cotai position us well for continued growth." 

 

- Dr. Lui Che-woo, Chairman of GEG 

 

CONF CALL 

  • Galaxy Macau:  opened new premium mass Pavilion club, will open new VIP room in late Q3
  • Starworld:  all-time record in mass; opened new premium mass room, made some shifting in VIP rooms 

 

Q & A

  • Sands Cotai Central competition:  all operators have benefited from SCC opening, including Galaxy Macau
  • Galaxy Macau revenue growth:  visitation has grown especially in mass segment
  • Galaxy Macau Phase 2 capex:  YTD over a billion dollars; have spent $2.8 BN of $19.6BN budget; significant ramp-up in capital outflow at the end of this year and 2014.
  • Henquin Island:  Galaxy looking at it
  • 2Q Hold adjusted EBITDA:  refused to give it given 'no standardized definition'; wants analysts to focus on the volume growth
  • GM Phase 3/4:  combined capex HK$60-80BN -start the project out with the arena and construction could start at end of year/ early 2014.
  • Net cash $5 billion before Waldo acquisition
  • Took Waldo tables and employed them at other properties
  • Table mix:  1/3 VIP, 2/3 MASS; 3Q 2013 will have a little more VIP tables
  • GM Phase 2 table count:  working closely with govt 
  • GM Phase 3/4: some gaming
  • Starworld:  VIP RC - tables yielding better, redesigned new VIP room, more rewards, 16 VIP operators down from 17; Q3TD is very positive
  • Non-gaming revenue decline:  accounting adjustment - reclassification of travel-related revenue; Starworld disruption at L16
  • No fees with prepayment of loan


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