anouchka
Thesis
Global apparel companies have been trading at large discounts to historic valuation recently. As the macro environment is deteriorating, it can be expected that the company’s revenues and profits will fall. However, once the confidence in the market and consumer spending returns, I believe the future for Ralph Lauren might be brighter than most.
In past years the appeal of Ralph Lauren Corporation (NYSE:RL) was damaged as previous management teams focused on sales volumes at the expense of the brand. This resulted in a broad retail footprint, which still includes many factory stores and a large wholesale footprint. The pandemic, the extended covid lockdowns in China and the war in Europe have shown how fragile the retail business can be. In addition, the changing clothing trends due to work from home and athleisure wear have resulted in companies such as Lululemon growing fast, whilst the more traditional names like Brooks Brothers and J. Crew have gone into bankruptcy.
In contrast, Ralph Lauren has been walking the tightrope somewhat successfully. The company has repositioned its retail footprint as it increased Direct to Consumer (DTC) sales, exited two thirds of its wholesale doors and cut off-price sales by 50%. The Asia segment has been turned around and the company is now looking to grow in North America. Going forward, the company plans to focus more on women apparel as it only accounts for a third of sales but women make 56% of the Ralph Lauren sales decisions.
Trading at a forward PE of 12x, if Ralph Lauren can stay the course, the longer-term prospects for this stock could be better than most.
Risks
Macro deterioration
The global macro conditions have recently deteriorated. The continued lockdowns in China, the war in Ukraine and global inflation reduced consumer confidence. The market is expecting a recession and the Ralph Lauren profits could be severely impacted. Nike’s recent results, which showed a 44% increase in inventory, could be indicating that apparel retailers will soon be taking large inventory mark-downs similar to those at Target and Walmart. No such news has come from Ralph Lauren yet. Instead, the shares rose on the morning of the company’s investor day when they reaffirmed the year-end profit targets. The global market is currently in flux and investors should not be surprised if the guidance is not met this year.
History of poor brand management
To fully understand the Ralph Lauren story, you need to go back a few years. The company had previously followed a so-called luxury pyramid structure that Calvin Klein and Michael Kors also employed. Luxury branding was at the pinnacle casting an aspirational halo over the more accessible lines. This led to a damaged brand. With Ralph Lauren as CEO and Roger Farah as COO, the company sold a large amount of product through factory stores, wholesalers, and off-price retailers such TJ Maxx.
Over the years the company created a number of brands that can still seem confusing to self-claimed aficionados, with one consultant saying:
I’m not sure which brand the Polo one is-whether it is the higher end or the lower end line … He has too many lines and I don’t know one from another.
One website called Sam Talks Style helps customers differentiate between the different Ralph Lauren brands. Amazingly, most of the logos, whether they are high end, lower-end or even licensed all say “Ralph Lauren’ under the name tag per the photos on the website.
The company also still has licensing agreements that allow other companies to design and manufacture products under the Lauren and Ralph brands per the latest 10K. These licensing products are normally sold at lower price points, hurting the brand, and should be canceled.
I believe this multitude of brand names confuse customers and should be reduced the same way Steve Jobs originally reduced the number of products at Apple when returned to the tech company. A 2017 study confirmed the view that the company had too much discounting and were sold in too many discount channels as shown below.
Retail footprint
The company’s factory stores were created to move large volumes of product. These stores currently still account for 65% of the company stores. This number is much too high. It is hard to think of any true luxury brand, where the majority of stores are based in outlets. At the most recent investor day the company said that they plan to pivot the factory stores into local Ralph Lauren stores by upgrading and elevating them. The Woodbury Commons outlet is the first example of this ‘local store approach.’
In addition to the factory stores, the company has more than 7,000 shop-within-shops in the US. The trend towards online shopping has resulted in some malls deteriorating faster than expected, hurting the brand. In Europe and Asia where markdowns were limited, and pricing discipline maintained, the brand upheld much better.
Changing fashion trends and maintain product quality
Fashion trends are constantly changing, and it is important for the preppy, country club brand to know when to evolve. Brooks Brothers, where Mr Ralph Lauren started off at, went into bankruptcy in 2021 as customers moved away from formal wear. Similarly, J. Crew lost touch with customers as it tried to go too high-end at the expense of quality and comfort. There are many, many other examples of companies failing to keep up with the latest fashion and Ralph Lauren must keep walking this tightrope. The company has said they are successful at reaching a younger consumer; however, this is hard to quantify.
Bankruptcy
The retail industry has been a hotbed for bankruptcies. Companies have failed as they didn’t adjust for changing consumer taste or were over-leveraged. Significant future lease expenses enable retailers to earn high returns on equity, however they also represent a large future commitment that needs to be accounted for. Ralph Lauren’s lease commitments are down to $1.7 billion from a peak of $2.4 billion in 2014 as the company reduced its retail footprint. The company had debt of $1.2 billion, cash and equivalents of $1.8 billion and additional lease commitments of $1.7bn at quarter-end. Overall, the company is in a good financial position but falling profits can quickly turn a relatively benign balance sheet looking like an insurmountable mountain to climb.
Family controlled business
The company’s healthy balance sheet is in part due to it being founder led. Mr. Lauren controls 85% of the business through his ownership of the B shares and has managed the company’s capital conservatively. The dual class share structure does however mean that shareholders have little control over the decisions that the Lauren family makes, a real downside when investing in the equity. Mr Lauren’s son, David has a prominent role at the company and could very likely be CEO one day.
Outlook
Despite the company’s history and the ever-looming risks, the business prospects over the longer-term remain good.
Reducing mass-market volumes
The new management team under Patrice Louvet have in recent years started to turn the company around and removed apparel from mass-market sales channels whilst increasing prices. The company exited two thirds of the US wholesale doors and cut off-price sales by 50%. The company sold its Club Monaco business to a private equity firm called Regent L.P. and licensed the Chaps business to the OVED Group. These moves resulted in the US business’ revenues declining from $5 billion in 2015 to $3 billion in 2022. The falling sales isn’t all bad news. This smaller retail footprint should hopefully elevate the brand and allow the company to increase prices going forward.
Increasing full-price stores
Given the smaller footprint, the company now plans to open more than 250 full priced stores over the next 3 years. This comprises 200 stores and concessions in Asia Pacific, up to 50 full-priced stores in Europe, and up to 20 new full-price stores in North America. These openings will be focused on 30 large and high-income cities globally, such as Beijing, Shanghai, Milan and Munich.
Increasing Prices
The company has been doing an excellent job of increasing prices and Average Unit Revenue (ARU) is up 64% over the last 4 years. At the investor day, the company said that they had increased the price of the Polo shirts, which are well overdue, without seeing an impact on demand. At $110, I do think there is still significant pricing power left in the polo shirts. The cheapest Burberry polo shirt I could find on their website was $480.
The prices increase at the factory stores seems to be making progress too. I was recently surprised to find a regular men’s polo selling for $110 at the Riverhead, NY factory store, compared to $110 charged at the downtown Brooklyn Macy’s and $110 on the Saks Fifth Avenue website. The company’s DTC business is also doing well having grown to 26% of total sales with margins in line with wholesale, which has historically had the highest margins.
Asia
The biggest success story for Ralph Lauren over the last few years has been the turnaround of the Asia business. This region which includes Japan (the biggest sales contributor in the region), South Korea and China was unprofitable in 2015, yet generated $229mm of operating revenue in 2022.
Going forward, a large growth area for the company is expected to be China which accounts for only 5% of the company sales or roughly $300mm. Clearly there is a significant opportunity for growth in this region. The company had failed to enter the Chinese market successfully on two previous occasions. The company originally entered China by licensing the brand and allowing 3rd parties to manufacture and sell the apparel. After this did not work, the company entered the market by selling high-end luxury items. This turned out to be unprofitable due a lack of volume. This time around the company is entering China leading with the Polo brand, which I believe will be much more successful.
Women Segment
At the investor day, the company outlined ambitious plans to grow more in the women segment. The Ralph Lauren women’s business is less than a third of sales, despite 56% of the shoppers being female. Since fiscal 2018, the company has grown the women business 38% and I expect the company to build on this momentum going forward.
Valuation
The company said at the recent investor day meeting that it expects 2025 sales to increase by mid to high single digits and operating margins of 15% plus. I estimate this would result in 2025 operating income above $1 billion and EPS of $11.00, which would mean 11% growth a year from the $8.07 that the company made in 2022. This EPS growth rate would increase even more if you factor in the $2 billion of annual buybacks and dividends (more than 30% of the current market cap) that the company plans to return to investors over the next 3 years.
Unfortunately, given the current macro environment it is hard for me to believe that Ralph Lauren will hit these numbers, and I’m laying the blame at the macro level not the company’s. It is hard to know what will happen over the next few years. However, over the long term I believe the company can grow at 4%. If I apply a discount rate of 10%, I get a valuation of $128, or roughly 41% above the current price. This would appear to be enough margin of safety for the conservative long-term minded investor.
Investing in upper-market apparel brands can be risky. However, if you have a management team that executes well, looks after the brand and a valuation that makes sense, then long-term investments in a name like Ralph Lauren could deliver decent results.
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