Tuesday, August 14, 2007

Too Early to Jump Back on Ralph Lauren's Horse

Shares of Polo Ralph Lauren (RL-$81.71) climbed 4.3% today on news that the premium clothing and home furnishings maker had set a $250 million stock buyback.

The 10Q Detective is puzzled as to why investors reacted so positively to this news, for repurchased shares at Ralph Lauren—though accounted for as treasury stock at cost and held in treasury—go through a revolving door, back out to Named Executive Officers.

For example, during the three-months ended June 30, 2007, 1.7 million shares of Class A common stock were repurchased at a cost of $170 million under an existing $250 million program; however, 6.01 million stock options and 836,000 performance-based (and non-vested) Restricted Stock Units were outstanding and due to Named Executive Officers.

Pursuant to his existing executive employment agreements, founder and CEO Ralph Lauren is entitled to annual grants of options to purchase 150,000 shares of the Company’s Class A Common Stock and annual issuances of 100,000 restricted stock.

Last week, shares in Polo Ralph Lauren stumbled 16.5% as the Company
missed analyst expectations for the first-quarter for fiscal 2008 ended on June 30, 2007, and more importantly for the Street, cut its yearly guidance.

Ironically, less than one-month prior, the Board lauded Messer. Lauren for the Company’s 2007 financial performance by rewarding him with restricted stock, options, and a cash incentive bonus of $5.5 million, $2.7 million, and $16.5 million (representing his maximum bonus opportunity), respectively.

Contrary to prior guidance of a Fiscal 2008 effective tax rate of 38 percent, management is now estimating a FY 2008 effective tax rate to be approximately 39 percent, due to the impact of the company's adoption of FIN 48 (which clarifies the accounting for uncertainty in income tax positions). The higher tax rate will shave approximately 6 cents in share-net. As a result, the Company now expects FY 2008 diluted earning per share to be in the range of $3.64 to $3.74 compared to prior expectation of $3.70 to $3.80, incorporating the effect of the tax rate change.

In our view, a change in tax rates is not what rattled the Street. In terms of earnings’ cadence for fiscal 2008, a slower payoff from new business initiatives, such as
``American Living'' (where Polo will be offering an exclusive lifestyle brand for JC Penny) and the Polo Ralph Lauren Watch and Jewelry Company, is what unnerved analysts.

In addition, management had formerly intimated that accessories, denim, and retail would show progress in providing incremental growth opportunities. However, in the recent quarter, operating income in retail and licensing fell 1.7% and 17.0%, respectively.

CFO Tracey T. Travis said the Company does not expect to see “the first signs of revenue related to some of those investments beginning [until] the fourth quarter and continuing into fiscal 2009. This will result in suppressed earnings in the first three quarters of the year with full earnings growth disproportionately weighted to the fourth quarter.”

Description of Businesses

Polo Ralph Lauren’s business is affected by seasonal trends, with higher levels of wholesale sales in the second and fourth quarters and higher retail sales in the second and third quarters. These trends result primarily from the timing of seasonal wholesale shipments and key vacation travel, back-to-school and holiday periods in the Retail segment.

The wholesale segment, which represented 54% of Fiscal 2007 net revenues, consists of products sold principally to leading upscale and certain mid-tier department stores, specialty stores and golf and pro shops.

The retail business (representing 41% of Fiscal 2007 net revenues) consists of retail-channel sales directly to consumers through 147 full-price and 145 factory retail stores and through a retail Internet site located at
http://www.ralphlauren.com/ (formerly known as Polo.com). In Fiscal 2007, the website averaged 2.3 million unique visitors a month and had 1.1 million customers.

Approximately 22% of licensing revenue is derived from two product licensing partners: Impact 21, a former sub-licensee for Japan, and WestPoint Home, Inc, which accounted for 14 percent and 8 percent, respectively, of licensing revenue in Fiscal 2007.

WestPoint Home, Inc. offers a basic stock replenishment program that includes bath and bedding products and accounted for approximately 77% of the net sales of Ralph Lauren Home products in Fiscal 2007. Given the existing housing slump, on the recent earnings call management did not even bother to talk up organic growth prospects in this segment.

First revenue shipments for most of the lifestyle brands being developed for specialty and department stores will not be seen until Spring 2008—missing two critical selling periods: back-to-school and holiday periods.

Operating Results

The Company reported a share-net increase of 8 cents, or 10.8%, to 82 cents, driven primarily by a 12.2% gain in sales (to $1.07 billion). This revenue growth was partially offset by a decline in gross profit percentage of 40 basis points to 55.3%, primarily due to the effect of purchase accounting associated with recent acquisitions (Japanese business transactions and a small leather goods acquisition), and an increase in SG&A expenses, primarily related to recent expansions and the overall growth in the business.

Analysts had forecasted a profit of 85 cents per share on sales of $1.1 billion.

Of note, interest income of $8.2 million contributed about 5 cents (after-tax) to net income.

Financial Condition and Liquidity

The Company’s cash flow remained robust. Net cash provided by operating activities increased $48.2 million (year-over-year) to $280.8 million during the three months ended June 30, 2007. This net increase in operating cash flow was driven primarily by a net decrease in working capital needs, principally due to a decrease in accounts receivable days sales outstanding as a result of improved cash collections in the Company’s Wholesale segment.

Current assets of 2.17 times current liabilities, however, is slightly misleading, for less $604.7 million and $99.2 million in inventories and prepaid expenses, respectively, working capital drops to $209.6 million.

Nonetheless, the quick acid ratio of 1.26 means the Company still has enough in liquid assets to cover an unexpected drawdown of liabilities.

Albeit the Company generated free cash flow of $236.1 million in the last quarter, the just-announced $250 million stock buyback might not be the best use of funds.

Goodwill and other Intangible Assets (consisting principally of re-acquired licensed trademarks and customer relationships/lists) of $922.5 million and $373.9 million, respectively, account for 32.4% of total assets.

The 10Q Detective noted, too, that ‘charges against revenue to increase reserves’ (including estimated end-of-season markdown allowances, costs associated with potential returns of products, and operational charge-backs) increased $26.5 million to $94.3 million year-over-year. This increase was likely the result of retail customers being aggressive about clearing inventories in general through the spring/ summer season(s).

Investment Thesis

Current expectations call for a high single-digit revenue growth in the 2Q:08 to be followed by a mid-teen rise in revenue by the 4Q:08 leading to share-net of $3.64 to $3.74 for fiscal 2008.

In our view, although Polo Ralph Lauren is trading at a slight discount to other players in the space—a current P/E multiple of 22 times fiscal 2008 EPS and a TTM multiple of 24.97 times, respectively—we believe the stock price fairly values the expected earnings growth.

Successful execution of brand building (new merchandising lines), proving that acquisitions will be accretive to earnings, and a strengthening of its global competitive position are necessary catalysts for expansion of Polo Ralph Lauren’s earning’s multiple.

Margin expansion will be difficult to achieve in quarters two and three, for planned investment costs will continue to weigh on the Company for the duration of 2007.

In addition, delays in bringing in-house recent key acquisitions, including its leather goods, media (through which the Company operates its e-commerce initiatives), and Japanese businesses (that were formerly conducted under licensed arrangements) could adversely impact margins, too, leading to higher than anticipated integration costs (currently estimated at 27 cents per share).

Investment Risks and Considerations

The success of Polo Ralph Lauren’s business depends on its ability to respond to constantly changing fashion trends and consumer demands. At present, a big chunk of the Company’s sales comes from the men’s channel. Management is looking to jumpstart growth in the women’s room as the new American brand label unveils a new dress division through JC Penney.

In the wholesale business, the Company has two key department-store customers that generate significant sales volumes. For Fiscal 2007, Federated Department Stores and Dillard Department Stores represented approximately 29 percent and 14 percent of all wholesale revenues.

Approximately 80% of net sales are earned in the U.S. and Canadian markets. Ergo, Polo Ralph Lauren is gambling on accelerated operating profit growth at a time when most economists are expecting a material slowing in discretionary consumer spending.

Editor David J. Phillips does not hold a financial position in Polo Ralph Lauren. The 10Q Detective has a Full Disclosure Policy.

1 comment:

Anonymous said...

In the current climate, which does not exactly seem friendly for such a luxury/consumer discretionary brand, I would expect a negative earnings surprise to be more likely than a positive one.