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Morningstar | Narrow-Moat Ralph Lauren Executes on Strategic Endeavors but May Crimp Gross Margin Pursuing Growth

Narrow-moat Ralph Lauren’s second-quarter results evidence that the firm continues to execute its brand revitalization strategy. Sales grew 1.6% (versus our full-year forecast of flat) driven by strong growth in China (up 13%) and digital sales (up 10%), while adjusted gross margin improved to 60.9% (up 100 basis points), stemming from its strategic endeavors to improve the brand’s image by reducing promotional activity while prioritizing e-commerce sales.

Due to recent results, management raised full-year sales expectations to flat to slightly up (versus slightly down prior) while maintaining profitability targets of increasing operating margins by 40 to 60 basis points. These align with our full-year expectations of flat sales growth and operating margins improving 50 basis points (11.1%). While shares sank at a high-single-digit rate, we advise investors to wait for a larger margin of safety as the stock still trades at a 20% premium to our $104 fair value estimate, which remains in place. Additionally, we do not plan to change our long-term forecasts calling for sales growth of 1%, gross margins of 62%, and operating margins of 12% on average over the next 10 years.

While the firm has expanded adjusted gross margin through brand accretive distribution (less off-price and more direct-to-consumer), we contend further increases will be harder to come by (we estimate gross margin peaking at 62%). In this vein, inventory levels grew 15% in the quarter greatly outpacing sales. While management cited some of this increase from using different shipping methods to reduce airfreight cost (approximately 5% of cost of goods sold), we believe the firm’s ambitions to return to top-line growth may lead to imprudent decisions (as seen in the past through large off-price retailer distribution). In an industry with low switching costs and a dependence on hitting fashion trends, we see high inventory growth in relation to sales growth as a risk to maintaining gross margin.

We are encouraged by the firm’s ability to continue to grow profitability (adjusted operating margins were up 50 basis points to 13.9%), while investing in brand advertising (up 30%), which we believe demonstrates a commitment to supporting the brand intangible asset behind its competitive edge.