DETTA INLÄGG ÄR ETT UTDRAG UR KVARTALSBREVET JAG SKICKADE TILL PANDIUMS ANDELSÄGARE 10 NOVEMBER 2016.
We invested in Ralph Lauren (RL) during the quarter. The investment case is simple:
1. It is a good business with a competitive advantage
RL is one of the strongest apparel brands in the world which has led to high returns on capital employed and earnings growth. Since the IPO in 1997 they have grown earnings per share from $1.2 to $7.9 in 2015, an annual growth rate of 11%.
As a value investor I am not interested in businesses that operate in industries that change fast or are subject to fashion risk. But, I do not think RL is one of those businesses. The company has been around for 49 years. The brand has been strong throughout the decades. A large share of the profits come from styles and products that are not fashion. The best example is the Polo shirt that has been sold by RL since 1972. Also, it seems that brand longevity among these kind of brands is fairly high. The big luxury brands, Louis Vuitton, Gucci, Chanel, Hèrmes have been around for 50-180 years. RL is not as luxurious as those specific companies (although there are sub-brands that aspire to) but I think it tells something about the stability of these kind of brands.
2. RL is currently not earning as much as it should be able to
The last couple of years RL’s profit margins have been declining for a couple of reasons:
- The current retail market is tough with lower foot traffic and more promotions which has pushed gross margins down.
- RL has not managed its recent growth well and lost focus of profitability. They have opened too many underperforming stores and have too many weaker sub-brands.
- Their execution has been poor. Inventory levels has gone up faster than sales and that has forced them to more promotions to shift the excess. They have also let general costs rise too fast.
Overall the factors above have affected the brand strength and profitability. Based on peer group analysis and historic performance RL should be able to earn about 40% more compared to today.
3. It is trading at a low price compared to historic norms
If RL can achieve profit margins in line what they have done historically the stock is trading at 10 times earnings. For a stock that historically has demanded a premium multiple of 19.5x that seems cheap.
4. Management has a viable plan for earnings recovery
The new CEO, Stefan Larsson, has outlined a plan to turn things around.
- They are going to focus on the three big brands that are strong and produce high returns on capital. By focusing their efforts and advertising dollars on fewer brands they will hopefully be able to strengthen the brand again.
- They are going to cut costs by reducing the number of management layers, close unprofitable stores and other general cost reductions.
- They are cutting the lead time from 15 to 9 months which will enable better inventory planning, reducing the share of discounted sales and thereby improving gross margins.
The good thing about the plan is that it is already half done. The headcount reductions were done during the year and half of the planned stores closures are completed. They still have some general cost cutting to do but my peer group analysis indicate that the target is achievable and possibly even too low.
Going forward I think the company has a lot of growth potential. They have only a fifth of the marketshare in Europe and Asia compared to the US. There is potential to increase sale of womenswear and accessories. Besides that, the global market is expected to grow 4-5% annually the coming years.
5. There is downside protection
First, the brand provides protection. I have trouble imagining a brand that has been built patiently for almost 50 years suddenly becoming obsolete. Second, we are paying a low price. If you look at what we are paying compared to sales it has only been this low in the two previous US recessions.
There are a couple of reasons the stock is cheap. As with most of my cases, it is one that needs a couple of years to work out. Most investors are not willing to wait that long. Second, near-term, it will become a bit worse before it becomes better. Third, the retail industry itself is very unpopular now due to the recent poor performance. But, none of these factors matter for the long-term investor.