CONCLUSION: We did not like RL's quarter one bit. Almost every line of the P&L failed to impress us, and the erosion in the cash cycle further impeded RL's ability to convert GAAP profit to cash. Though CFO Peterson crushed it on the call, Roger Farah was definitely missed. We took our numbers down to be about in-line with RL's guidance. This is the first time in nearly a decade that we don't have confidence that RL will meaningfully beat expectations. We need a sit-down with management to reignite our confidence in the story.
This quarter did nothing to ease our growing concerns about RL. We were upbeat into the print, but despite the beat, we did not like the quarter one bit. Specifically…
- RL technically beat the quarter -- with EPS of $2.23 versus the consensus at $2.20. But by our math, it had a $0.09 tax benefit relative to expectations. We call that a miss.
- Sales were up only 2.8%, but the company somehow managed to translate that to EBIT down 15%. Yes, there was a business model change with its Chaps business moving from Licensing to Wholesale -- and FX hurt as well. But even excluding those items operating cash flow was down.
- Inventories were up 15%, or nearly 6x the rate of sales growth. That amounts to seven more days inventory on hand than a year ago. That would maybe be palatable, but last year's DIH was up a whopping 17 days. In other words they had an easy comp and couldn't comp it.
- On the plus side, Receivables were down 4%, which is great. Unfortunately, the DSO decline was entirely offset by weaker payables. In the end, the cash conversion cycle (DSO +DIH less DPO) came crashing in at 137 days -- up 7.7 days vs last year. This marks the worst 2Q cash cycle in 13 years.
- One thing we still don't get is how net PP&E came in at $1.28bn -- a 36% sequential increase, or $336 million. That's the size of RL's entire capex budget this year. And in fact, it spent $148mm this quarter. Perhaps there's a simple answer that we're just unaware of, but it's rare to see PP&E go up 2x the rate of capex. (Chaps closed in 1Q, not 2Q -- so that shouldn't explain it).
- Comps at retail stores were down 1%. Bulls will point to the fact they'd have been up 1% excluding FX. But is +1% really anything to be bullish about?
- Roger Farah was not on the call. I guess that was inevitable given that he's operating in a diminished role versus the past 10+ years. But for anyone wondering about his level of involvement in the day to day operations of the company, his absence from the call sent a pretty clear signal. It's possible that he chose to abstain in order to give more limelight to Jackie Nemorov, as Roger's presence on the call might have undermined her role to the employee base. But still, it clearly tells the Street that he's handing over the reins.
- As for Jackie Nemorov, we'd give her a C+ for how she came across on the call and the confidence that we think she instilled in the investment community. Seriously, did we have to hear about why it's a good idea for us to buy our wives a Ricky bag? Or that the company hosted a fashion show for dogs this quarter? The answer there is a big No from our perspective. She should have used her Presidential debut as a venue to highlight her precision on the numbers and focus on a smaller number of key big ideas. The sad thing is that we think that Nemorov is extremely competent, and is a very good leader internally. But it did not come across on the call.
- At risk of playing favorites, we think that Chris Peterson was absolutely fantastic on the call. He gets an A+. He was crisp, clear, confident, and answered every question in a way that both gave good insight into the company, but also furthered RL's agenda. It's amazing to thing that he has only been the CFO of a publicly-traded company for a year. Truth be told, if Peterson was not at RL, we'd be extremely negative on it right now. His presence numbs the blow of Farah stepping back to a huge extent.
- Its SIGMA trajectory is horrendous. Last quarter was bad enough when margins turned down by 260bp, but at least inventories were somewhat manageable (-5% relative to sales). But in 2Q14 we saw a 330bp erosion in margins on top of a -12% erosion in the inv/sales ratio. As a point of reference, it's been 14 quarters since RL's sales/inventory spread has been positive.
- The biggest plus is that we're likely to see a 25% acceleration in growth over the next two quarters. Chaps coming online to RL's wholesale division is a big help, and it looks like Europe is finally in a good enough place to start taking more inventory. In addition, Peterson made it clear on the call that the first two months of the quarter were weak, but September was significantly stronger. That's a trend that is impossible to ignore.
RL SIGMA IS ONE OF THE WORST IN RETAIL THUS FAR THIS EARNINGS SEASON
HERE'S OUR NOTE FROM EARLIER THIS WEEK
RL: ST and LT Calls Are Very Different
CONCLUSION: We have a bifurcated view on RL right now. We like it from both a TRADE and TREND perspective, as expectations are too low headed into Wednesday's print, as RL guided to a msd decline in EPS, but in reality they’re going to post EPS growth of at least 1,000bps higher. Furthermore, the company will begin to show a meaningful acceleration in EPS growth over the next two quarters (near 30%) that should put it in the top decile of earnings growers in retail.
But from a TAIL vantage point, we're far less constructive. As much as we like how the company is executing on its long-term initiatives (international expansion, dot.com, and real estate), we're concerned about the recent changes in the C-suite. In the end, our degree of confidence in how the company will be executing three-years out is partially diminished.
So why are we concerned about management? Roger Farah shifting 50% of his time away from the company simply does not sit well with us. The fact is that Roger has been incredibly effective over the past decade. Ralph might be the CEO, but Roger has basically executed on everything that is outside of the creative side of the organization. Yes, it's a positive that the company still has him given that it was a risk that he'd leave entirely. But we just don't buy the concept of a part-time COO. The way we see it, you're ether in or you're out. It's like being half pregnant.
On the flip side, the promotion of Chris Peterson is a big positive. He's one of the top 5 retail CFOs we've met -- which says a lot. At P&G he was heavily responsible for parts of the organization outside that of a traditional CFO (and his division of P&G was 5x the size of RL).
Similarly, Jackie Nemerov, who was also promoted and reports directly to Ralph Lauren, is far more capable than many on Wall Street likely give her credit for. There's no one at the company (perhaps with the exception of Ralph himself) who has earned more respect and loyalty by her direct and indirect reports. In the end, as incredibly effective as Roger has been over the years, the reality is that some of that was likely Nemerov adding to the size of his halo.
Lastly, we need to consider Ralph Lauren himself. He's one of the more successful CEOs in retail, and has created one of the best brands in apparel. But we can't ignore the fact that he just turned 74. There's not a whole lot of CEO's in the S&P that are over 70. In fact, there are only 14 CEOs in America who are older than 74. Not that there is a set formula for when a person needs to stop working, but it’s worth noting that the average retirement age for CEOs is between 60-65.
We're not questioning Mr. Lauren's competence. How could we? But he's such a powerful force inside the company, and the likelihood of him being the boss in another five years -- at least in his current capacity -- is not too great. We don't have a problem with this at all. But where we're more concerned is that we're not sure the Board has any clear succession plans for Mr. Lauren. That's probably because the Chairman of the Board is also the CEO -- and he has no plans to go anywhere anytime soon.
In the end, there are two things that are certain; 1) The company is executing and has increasing momentum in its business, but 2) The company is undergoing the most significant period of transition in the executive offices that RL has seen since before 2000.