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Stock Strategist

This Premium Label's on the Sale Rack

We see long-term value for Ralph Lauren despite management's reduced outlook.

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We believe  Ralph Lauren's (RL) portfolio of brands and long-run growth prospects are unchanged, and thus we are maintaining our narrow Morningstar Economic Moat Rating and $165 fair value estimate. The company gave lower-than-expected guidance during its fiscal 2014 fourth-quarter financial release, causing a decline in the shares, which we think are now 10% undervalued. Given Ralph Lauren's strong returns on capital and narrow moat due to its portfolio of iconic brands, we view the current risk/reward as positive on a relative as well as an absolute basis.

In the fourth quarter, revenue and margins outperformed expectations, with net revenue coming in at $1.867 billion, representing growth of 13.6%. High growth of 23.5% in the wholesale division, to $983 million, drove the outperformance. Management cited an improving Europe and better-than-expected sales in the United States (where Macy's is roughly 25% of wholesale) and said order pull-forward was a tailwind but not meaningful. Retail growth was just 5%, dragged down 2% by exchange rates and weak traffic because of weather in North America. Management's guidance had been for 10%-12% growth in total sales, and for growth from wholesale to be above retail. Although gross margins were down 305 basis points to 56.2%, the selling, general, and administrative expense ratio improved 325 basis points, leading to an operating margin of 12.2% compared with a 12.0% adjusted operating margin last year.

Initial guidance for fiscal 2015 suggests operating margins will decline another 75-125 basis points, and sales growth is projected to be just 6%-8%. The operating margin contraction is due to investments in retail stores, flagship brand locations, marketing for Polo for women and IT infrastructure. We view these investments positively for eventual operating margin expansion as well as the long-run growth of the brands.

Brand Image Is Entrenched and Undiluted
Over the past four decades, Ralph Lauren has constructed a considerable portfolio of brands centered on founder, chairman, and CEO Ralph Lauren. The brand has become entrenched among consumers, both domestically and abroad, which we view as an impressive feat, given the competitive marketplace and low customer switching costs in apparel. The company has developed a solid record of producing top-line growth and profits over the years through a combination of internal growth and acquisitions, which we believe can continue with international expansion. Ralph Lauren has delivered consistent returns on invested capital in the midteens or higher, well ahead of our cost of capital estimate, supporting a narrow moat.

Ralph Lauren historically has been able to distribute its products around the world without diluting its brand image or materially cannibalizing sales, which we view as uncommon in the consumer industry. Management has executed well in operating nearly 20 labels and has done a particularly good job of segmenting target customers and product price points to ensure apparel differentiation.

But Ralph Lauren is also targeting international markets for growth and has assumed direct distribution control from select licensees in the past few years. Revenue outside North America has increased faster than the company average over the past five years, and the company targets balanced revenue from Europe, the Americas, and Asia. An increased focus on building out its retail presence should help the firm further control its brands and boost gross margins. The firm has ample room for retail expansion over the next decade, in our view. It has also begun to build out its Web-based operations and runs several e-commerce sites. It is important to put the firm's focus on brand elevation into context; it closed more than two thirds of its Chinese retail outlets in 2012 after reacquiring the license and is strategically repositioning the brand to correspond with the luxury consumer.

Key Customer Relationships Offer Advantage
Ralph Lauren has a narrow economic moat, in our view, primarily because of its brand strength and key customer relationships. During the past 40 years, Ralph Lauren has evolved into one of the best-known aspirational brands, despite a highly competitive consumer marketplace. Ralph Lauren has developed key relationships with wholesale department store partners, ranging from the high-end Saks to exclusive products at Kohl's, which give it an advantage over smaller competitors with less established brands. In addition, Ralph Lauren's specialty retail push has expanded its brand cachet, more tightly controlling the brand image as it is introduced to emerging markets. Ralph Lauren charges premium prices for its products, allowing it to steadily increase gross margins from more than 50% to near 60% currently and to deliver midteens returns on invested capital.

Fashion Risk Could Limit Growth
Despite developing a portfolio of related subbrands, the company depends on the Polo and Ralph Lauren names. In addition, there is risk that the extension of the core brands has gone too far, and dilution could occur. While diversified across regions and demographics, the business carries some fashion risk and could limit the company's ability to grow, in our view. Macy's accounted for about 12% of total sales last fiscal year (25% of wholesale sales), which is a sizable dependence on one customer. Should the department store decide to drastically cut its orders, Ralph Lauren's top line would feel some pressure. Also, retailers may continue to manage inventories more tightly, which could take a toll on the apparel manufacturer's near-term sales. A portion of our international growth forecast depends on increased retail and wholesale penetration in China, a country that has produced strong growth historically, but with well-known structural imbalances in its economy that pose risks to companies that do business there. As such, we assign Ralph Lauren a medium fair value uncertainty rating. 

Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.