Ralph Lauren's on the Sale Rack

After years of solid growth and margin expansion,

One of the biggest headwinds on revenue and operating margins is exchange rates, made worse by the location of the firm's European headquarters in Switzerland. Switzerland has various tax advantages, but the magnification of selling, general, and administrative costs that are measured in U.S. dollars versus Swiss francs is pressuring the ratio of expenses to sales and thus earnings in the short term. The dollar has appreciated more than 30% versus the euro through this last cycle, and the Swiss franc has had wide swings, appreciating more than 16% versus the dollar on a single day in January. In the first half of this fiscal year, the weighted average exchange rate impact on the firm has been over 500 basis points trimmed off the revenue line and 200-300 basis points trimmed off the operating margin.

We believe these types of issues should wash out in the long run. Historically, inflection points in currency revaluations often occur right around the start of a policy change, such as the Federal Reserve raising rates or the European Central Bank starting a quantitative easing program. The 2015 release of the euro peg by the Swiss National Bank appears to be falling into the same pattern, as the franc traded at its strongest levels in the days following the sudden policy action but has net weakened versus the dollar and euro since.

Europe Recovery Likely to Be Slower Than Expected Ralph Lauren has a significant percentage of business in Europe, its largest segment outside the United States. The segment, which includes Eastern Europe, Africa, and the Middle East, is predominantly Western Europe although an exact breakout is not disclosed. The worst from the financial crisis in the eurozone appears to be past, but if the U.S. recovery is a model for Europe, the pace of the general economic and consumer spending rebound will be slower and more tepid than many investors may expect. We believe this to be a positive over the long run because Ralph Lauren is well positioned to benefit from the loosening of consumer wallets in Europe.

Although Europe is a relatively mature market, it has also benefited more recently from inflows of luxury tourists looking to purchase goods at bargain prices due to the weak euro, a trend that could continue if the euro remains low. The company also cut some wholesale accounts due to credit issues during the crisis--accounts that were concentrated in Mediterranean countries such as Italy. Although we don't see that business coming back right away, the sales should be recovered eventually through other channels. As the region begins to recover macroeconomically, improvements in Ralph Lauren's business are being more than offset by the dollar/euro exchange rate, which has moved more than 30% in favor of the U.S. currency in the past 12-18 months. European luxury goods makers are enjoying the opposite effect as the weak euro makes vacation shopping attractive to global tourists, and firms producing in the eurozone also enjoy a cost basis denominated in the diminished local currency.

Even if investors understand the issues around exchange rates and Europe, we believe China and other international markets are being seen as risks rather than opportunities. In China and emerging markets such as South America, we believe the Polo and Ralph Lauren names are positioned as luxury labels because only the high-end brands of the portfolio are marketed. In addition, tourists from emerging markets make up a significant portion of sales in the firm's flagship stores. Yet Ralph Lauren derives relatively little of its business from abroad. Currently, about 63% of the business is U.S. domestic and 12% in total Asia, leaving 21% in Europe and 3% in Americas outside the U.S. While China and emerging markets have been a strong growth driver for the luxury industry since 2009, investors are currently worried about China's economy, focusing on the recent currency devaluation as a sign that the situation may be worse than understood.

Technology and Infrastructure Spending Affects Operating Margins Ralph Lauren is taking back its Internet business from the former GSIC, now a division of eBay. Outsourcing e-commerce once made sense for a number of brands, when the relative size of the online business was small and most brands didn't have the know-how or scale to execute e-commerce transactions and manage a website. Today, many brands are approaching 10% of total sales on the Internet and sometimes higher (we estimate Ralph Lauren's e-commerce business to be around 14% of retail sales and 7% of total revenue). Ralph Lauren pays a royalty to eBay for the hosting and fulfillment of its e-commerce business though a license that will expire in 2017. As the license expiration date approaches, the buildout of owned e-commerce capabilities, including inventory management and pooling, enabling returns from the Internet to be handled in stores, and warehouse enhancement and website buildouts, all must take place. We estimate that the current spending on additional e-commerce processes and infrastructure is roughly $25 million per year, representing about 30 basis points of operating margin. Most of the spending is up front, but some maintenance spending should be ongoing. Once the license expires in 2017, Ralph Lauren will no longer pay royalties to eBay. We estimate the current royalty payment to be 2%-3% of Internet sales or $10 million-$20 million per year, representing about 25 basis points of operating margin.

Ralph Lauren Targets Balanced Geographic Mix Longer Term The Ralph Lauren brand is positioned more as a luxury brand in China and emerging markets, although its history in China is shorter and less visible that most luxury peers. We believe Ralph Lauren's premium labels and the Polo brands are well situated in that its business can still be developed through store openings and further penetration of existing markets by increasing brand recognition. Its other brands should enjoy increased development and penetration from the natural increase in the middle class and overall consumption.

Just over three years ago, the firm took back its China business from a distribution partner, where the brand was positioned rather narrowly as an American sportswear label and where a number of points of sale were more in line with general apparel and sportswear businesses than a luxury brand. The company closed nearly 100 points of sale and cut the relationship with a wholesale business partner that was outside the desired luxury positioning, starting nearly from scratch to develop flagship stores around the higher-end labels in major cities.

However, even before the company shrank its China operations, it was underpenetrated in Asia Pacific in general compared with other luxury goods firms, with the region (including Japan and other countries) representing about 12% of total revenue at the time of the transition. Fiscal 2015 Asia revenue is still roughly 12% of the total business. By comparison, Tiffany's Japanese business alone represents more than 13% of total revenue. With a portfolio of both luxury and more affordable labels, Ralph Lauren's store distribution network is quite small, with fewer than100 stores in China and 128 in all of Asia including Japan. Prada has more than 180 stores in Asia excluding Japan; Coach, which has also been late to develop its China business, has over 170 stores there; and Adidas (including franchises) has more than 5,000.

Greater China revenue is not disclosed in filings but has been cited by management as being at around $200 million in 2015 or less than 3% of global revenue. Some hard-luxury companies have nearly 40% of sales in China and global retail networks at times exceeding 50% of revenue.

As with other American affordable luxury brands but to an even greater extent, Ralph Lauren has been slow to penetrate China, with that strategy now appearing to have benefits as the retail landscape continues to evolve rapidly, saving the firm from costly store relocations or closings. Now, having positioned the brand more narrowly around only the higher-end labels, cut points of distribution, and raised average prices, the luxury positioning appears to be working and should pave the way for future growth, in our view. Although the company makes no prediction and management has no timetable, the firm has set a broad goal to have the global business balanced roughly one third in each respective macro region (Americas, Europe, Asia). Put in perspective, the firm currently generates roughly $7.6 billion in revenue and would have to add revenue of $0.9 billion in Europe and $4.0 billion in Asia while holding the Americas region constant (our forecast assumes growth in the Americas).

We believe these growth targets are reasonable as the market is growing and Ralph Lauren probably has only a minimal market share with $200 million in sales in the largest economy outside the U.S. Admittedly, the Chinese apparel, luxury, and accessories markets are hard to define, hard to size, and more difficult to observe. Already, statistical economic figures such as GDP or retail sales given by China's National Bureau of Statistics raise questions about accuracy. But we can probably agree that growth is positive and above the rate of the developed world.

Women's Products a Large Opportunity With Low Risk Ralph Lauren has historically been mainly a men's brand, having started in men's ties, shirts, and suits, including the popularization of the men's Polo collared knit shirt in the 1970s. Women's products were introduced subsequently, and the current mix of men's and women's is estimated to be roughly 60/40. Overall, at least in the broader North American consumer soft-goods market, we estimate the split in apparel, footwear, and accessories is greater than 60% women's. Department stores, for example, run much higher percentages of products targeted at women. Accessory-heavy luxury goods companies such as Coach are often even higher.

There are several brand evolutions and introductions that should favor the women's business at Ralph Lauren--not that the men's business will shrink, but that the segments are naturally positioned with a greater percentage of women's products. We are extrapolating the current momentum of the company's women's products into the future, but we also believe that additional human talent, design, retail space, and management attention will be drivers and that the historical focus on men's is the main reason for the firm's difference from the market.

Also, we believe the accessories business is underpenetrated compared with peers and with the total market, and it would not be unreasonable for accessories' percentage of total revenue to reach the mid- to high teens. The double-digit growth rate would eventually slow, but it's currently adding a bit more than 1 percentage point to total annual top-line growth. Some of the current growth can be continued relatively easily by expanding the doors that carry accessories or just placing the merchandise more prominently and in greater inventory volume in retail stores. Some stores in Asia, for example, already have accessories over 20% of the total sales mix. In the North American luxury and affordable luxury markets, the accessories category has been growing faster than apparel, thus Ralph Lauren has expanded market share but has not fully participated in one of the industry growth drivers of the post-recession period.

We believe that for Ralph Lauren, accessories will also be a contributor to international growth. If the firm can reach or exceed midteens penetration for the category as a percentage of total sales, we believe it could add another $500 million-$1 billion to the top line. Just as in the women's lines, the attention level and mix of products and new introductions suggest there are price points and areas of the market that have not been addressed. Accessories is a fragmented category, which can work for a large new participant. But the diversity of the products and market naturally lends itself to some fragmentation, in our view. We believe that Ralph Lauren's owned retail and strong wholesale business, where it is one of the most important vendors to some department stores in both volume and image, will allow it to take additional share.

Accessories also tend to have higher gross margins and less seasonal markdown risk. Many accessories-heavy European luxury goods companies have gross margins in the mid-60s or even over 70%. We calculate a near doubling of the size of the domestic accessories business to around $750 million, implying a 10%-11% compound annual growth rate for five years and an 8%-9% compound annual growth rate for 10 years. At this rate, the accessories business could exceed $1 billion by the end of our forecast period. We model the domestic women's business growing only midsingle digits, despite comments by management that it would grow at a rate above the firm's average. At this rate of growth, the segment would move from just under $2 billion today to $3 billion in 2025. This figure seems achievable as it would still not reach parity with the domestic men's business. In our analysis, we assume roughly 50%-60% of the accessories growth allocated to women's lines.

Global Brand Restructuring Should Improve Cost Structure While some may be skeptical that reductions in head count and stock-keeping units can both save money and increase sales, our experience with department stores, specialty retailers, and other major wholesale brands lends credence to Ralph Lauren's strategic undertaking. The company itself has said that already in the women's business, sales are increasing in the categories where SKUs have been reduced.

Ralph Lauren's new strategy will organize the firm around global brands, with each brand operating its own design, merchandise development, sourcing, and marketing. The firm estimates the global brand restructuring will yield $100 million a year in annual savings, with most of the spending being taken in fiscal 2016 and benefits starting gradually in fiscal 2017. The announced spending is roughly $100 million, with $80 million in cash and $20 million in noncash charges. The majority of the initial savings is from a head count reduction, which in the short run can be very attainable. In the long run, care has to be taken that head count doesn't slowly drift back to prior levels, despite the new operating structure. As the reduction is about 5% of the global workforce, or 750 jobs, we estimate that would equal modestly under $100,000 per worker, which sounds like a reasonable figure for a fully loaded white-collar design or marketing professional.

We believe our model to be sufficiently conservative as it still contemplates operating margins being below historical levels of 15%-16% through 2018 but equaling the historical average in the long run. We model a 2018 operating margin 250 basis points above this fiscal year's projection of 12%. Other influences on operating margin include sourcing costs, which have risen in past years but should moderate over time with the strong dollar and lower commodity costs. Gross margins are off their peak of over 59% in 2013, but they are still above the long-run average and have grown over time with scale and pricing. We believe some additional leverage is available over time, but we do not forecast any years above the prior peak level.

Despite Headwinds and Concerns, Execution Risk Low Many investors have assumed that Ralph Lauren's exposure to Macy's, at 12% of the total business and 26% of the wholesale segment, is a potential problem, Macy's has recently experienced declines in same-store sales and closed stores in the past two years, and U.S. department stores in general are at best stagnant or will potentially continue a long-run decline. But overall, Macy's has held steady as a percentage of the total wholesale business and declined only slightly as a percentage of Ralph Lauren's total sales, suggesting business is still solid.

Although the reorganization and the infrastructure spending are going to take time and have coincided with a growth slowdown and foreign exchange headwinds, we believe execution risk is relatively low. In our view, Ralph Lauren has not suffered a major mistake such as overemphasizing the outlet channel. Despite having more brands, the firm has expanded its off-price channel more slowly than Coach or Michael Kors, for example. The brand has been extended horizontally through subbrands, but the luxury-price segments are still commanding premiums. Importantly, the core Polo and Ralph Lauren brands' positioning has not changed, and there is no major fashion image turnaround to undertake. The firm still is planning on opening roughly 50 owned retail stores per year, and its retail portfolio is skewed toward prime locations in major cities, thus minimizing exposure to retail traffic changes.

Its Internet business is still relatively small and growing, but the take-back from eBay will happen over a number of years and should be accretive to brand positioning and to sales in the long run, not to mention eventual leverage on profitability. Even the SAP implementation, which is never without risk, is now past the hurdle of the core domestic changeover, making subsequent regional implementations lower risk. The firm is not in the midst of any other major acquisition integration, and beyond the global brand reorganization and the increases in technology spending, it is pursuing its traditional strategy and positioning for the brands.

We mention this long list of things Ralph Lauren does not have to do because many of its peers are facing similar organizational, strategic, and operational challenges. Coach, for example, has a new design team and a new management team, is closing stores while refurbishing others, has moved headquarters to an owned real estate development project in Manhattan, and has completed a modest yet not insignificant acquisition. Ralph Lauren is already a lifestyle brand well known around the globe, it just has to accelerate growth in some high-potential markets such as China and reap the benefits of its infrastructure spending. We believe the probability of success and the low stock price make the risk/reward equation favorable.