Polo Ralph Lauren (NYSE: RL ) has been on a superb stretch with quarter after quarter of solid operating performance. If you have a winning horse, why jump off of it? That's the question I was left pondering after analyzing the iconic retailer's latest results and quarterly earnings conference call.
In this edition of Fool on Call, we will take a closer look at the company's third quarter, first focusing in on what's been working exceedingly well. Then we will turn our attention to its just-announced major partnership initiative with J.C. Penney (NYSE: JCP ) -- a venture that I believe the shareholders are better served without.
It's a winning horse
Over the last four years you will be hard-pressed to find another major label that has performed as well as Polo Ralph Lauren, save for my favorite iconic brand, Guess? (NYSE: GES ) . In many ways the new life that both apparel retailers are breathing has happened because of similar genetic make-ups in their respective turnaround plans: recapturing control of brand identity, designing desirable trend-right merchandise, building retail stores, developing e-commerce presence, and expanding internationally.
The winning strategy continues to work. In the third quarter, net revenues, excluding the impact of an acquisition, increased 10% compared to the same period a year ago. As a side note, the acquisition I am referring to is its purchase of Polo Jeans from Jones Apparel (NYSE: JNY ) for the amount of $260 million in cash. This follows on the heels of its acquisition of Ralph Lauren Footwear for $112 million from Reebok. Both purchases were important for the company in order to continue implementing one of its core turnaround strategies: recapturing control of its brands.
Getting back to its third-quarter sales, if we take a closer look at the numbers we start to find what's really growing the company, and also, what's holding it back. Its wholesale division sells Polo merchandise through a store-in-store approach for major department stores like Federated (NYSE: FD ) and Nordstrom (NYSE: JWN ) . Excluding the impact of Polo Jeans, it grew by just 5%. Meanwhile, retail stores, which include Ralph Lauren, Club Monaco, and Rugby, achieved double-digit growth of 13%. Coming in with the fastest growth is Polo.com, which increased revenues by 17%.
Retail operating margins (which includes both retail stores and Polo.com) for the third quarter trended upward, now at 17.6%, up from 13.3% this time last year. This compares favorably to wholesale operating margins, which were 17.1% in the period, but trending down from the 18.1% that it achieved last year. Here's the point: while profitability between retail and wholesale are roughly the same, by far the fastest sales growth is coming from the former, suggesting to me that Polo has a huge opportunity before it by just focusing on, and expanding upon, retail.
Consider that of the 13% increase in retail store revenue, 7.4% growth came from those units that have been open for more than a year. The healthy comps increase indicates that customers are attracted to its retail concepts. And with only 73 Ralph Lauren units, 65 Club Monaco units, and 11 Rugby stores in operation to date, there is enormous opportunity for growth here.
Polo's management seems to get it. During the Q&A portion of the call, management heaped more praise on its Club Monaco concept, adding, "There is a very aggressive opportunity to roll that business out internationally." With Ralph Lauren they already know there is a tremendous international opportunity, as the company has seen in London, Milan, and now Tokyo. The response to the new Tokyo store has been so strong that management is looking at other markets in Japan for expansion.
And while Rugby's international opportunities were not mentioned, having personally visited a location in Chapel Hill, N.C., I think the concept is tailor-made for the world market given that much of its merchandise has that rugby- and soccer-influenced prep look. Both sports, of course, garner greater attention in markets outside the U.S.
In addition to retail store opportunities, in the prepared remarks it was pointed out that a new call center will be completed and fully operational by April 2008, allowing Polo.com to increase its order capacity. Overall, the evidence seems to suggest that management is going to stick with its winning horse, and ride with what got them here: strong retail growth through store and online expansion.
It's a long-shot horse?
I was about convinced to declare Polo Ralph Lauren a winner for the next five to 10 years out, but then COO Roger Farah gave his prepared remarks, and the evidence began to point another direction.
First he mentioned that opening new retail stores and expanding internationally would be important pieces of its long-term growth strategy. I'm thinking to myself, "Yep, sounds good." Then he added that one major merchandise push that consumers will begin to see in coming quarters is an expansion of the dress category. Again, I'm saying to myself, "Hey, I like dresses. They look nice. And Ralph Lauren supermodel Valentina Zelyaeva looks absolutely stunning in this RL dress featured at a recent show. By the way, I wonder whether she's married?"
From Valentina, to beautiful dresses, to retail development, to international expansion, I could see myself a winner with Ralph Lauren. But suddenly my hopes were dashed when Farah went on to describe a new partnership with J.C. Penney that will feature an entirely new brand called American Living. That's right, folks, the company that brought you such great names as Polo, Ralph Lauren, Club Monaco, Rugby, Purple Label, Black Label, and Blue Label is about to greatly expand its wholesale presence through a new brand called American Living, a name that sounds more like a TV show for the Travel Channel than an icon that will shape the apparel industry for the next generation.
One analyst in the call seemed particularly enamored by the partnership, almost asking rhetorically, "Is there any reason why this can't be a business that's over $1 billion a couple years out?" My hunch: probably not. Does that make it a good deal for long-term-minded shareholders? My hunch again: probably not.
This was not addressed in the call, but based on the description of the American Living brand and that it will be sold exclusively in J.C. Penney -- a department concept that does not offer anywhere near the premium merchandise of, say, a Nordstrom -- I get the overall sense that this new brand will be a few notches down from the premium-level we've come to expect from Polo Ralph Lauren. What this also means is that the average selling price for the new merchandise will be lower, and as one would expect, margins will be lower. This in turns means that as wholesale begins to take up a greater percentage of net revenues, net margins will be negatively impacted.
Not only that, we know from Farah's remarks that the company will be incurring significant expenses in fiscal 2008 as it prepares the American Living line for distribution in calendar year 2008. This allocation could've been spent on investing in more retail store openings, a plan that offers faster growth rates and further, does not dilute the highly profitable Polo Ralph Lauren brand.
A Foolish forecast
American Living will hit store shelves in early 2008 and by the end of that year it should be fully distributed. That means overall sales for Polo Ralph Lauren in 2008 will likely be significantly higher than in 2007, reflecting the early penetration of American Living in J.C. Penney. And by 2009 it should be even greater because it will by then have a full year of full distribution.
By the end of 2009 at the latest, I suspect growth rates will begin to significantly taper off, reflecting the slower pace of wholesale that will by then be a greater percentage of net sales. And as I alluded to previously, margins will also begin to be challenged in 2008 and beyond, for very much the same reason.
In a nutshell, Polo Ralph Lauren's winning horse is in expanding retail. But the winnings from that horse get diluted when too many other less-than-Preakness-quality thoroughbreds are mixed in. In this Fool's opinion, long-term-minded shareholders that look at an investment for three, five, and 10 years out, would've been better served if Polo Ralph Lauren stuck with its winning horse.