POLO RALPH LAUREN'A' : (rl)

INVESTMENT THESIS This week's Focus Stock of the Week Is Polo Ralph Lauren (RL: $81), which carries Standard&Poor's highest investment recommendation of 5-STARS, or Strong Buy. Polo Ralph Lauren and its family of brands spanning Polo, Lauren, Ralph Lauren Collection, Blue Label, Purple Label and more, is a leading global lifestyle brand company rooted in classic American styling with a strong fashion, quality and value sensibility. While luxury demand remains materially weaker than during the heyday of 2007, we are beginning to see signs of stabilization and modest improvement as the sharp deceleration of the final months of 2008 is lapped. To this point, RL projects a flat to low single digit same-store sales gain for its fiscal third quarter (ending December) and other strong retail brands are also projecting modest growth this holiday season. We agree with RL's COO Roger Farah who commented on the November 3 conference call with investors, "How we and others anniversary the sharp deceleration in sales trends that began in October last year will be critical in understanding how to plan for the new normal." We regard RL as highly able to navigate the current economic malaise based on our view of its superior brand positioning in virtually all channels and categories in which it participates. Standard&Poor's is not looking for a consumer-led recovery, but despite uncertain and volatile spending trends, and a potentially sluggish consumer pickup in 2010-2011, we see RL as ripe for market share gains as retailers and consumers alike are drawn to the quality we believe the Polo Ralph Lauren brand portfolio provides. In fact, in an environment where retailers are making reduced inventory investments, RL recently expanded distribution at Bergdorf Goodman and Saks, a testament, in our view, to brand strength and demand from increasingly selective consumers, as are recently introduced footwear collections from Lauren and Ralph Lauren Collection. We argue RL will be a beneficiary in the "new normal" where consumers are increasingly discriminating in their purchase decisions with a heightened quality/value focus. We see consumers deliberating and exercising thoughtfulness in their purchase patterns. Customers want brands they can trust for high-quality merchandise that have enduring value, in our opinion. For the near term, we believe conspicuous consumption is pass? and that these trends will penalize trendy fashion brands more than iconic heritage brands such as Polo Ralph Lauren. SUPERIOR INTERNATIONAL GROWTH PROSPECTS SEEN Geographic expansion, a more favorable merchandise mix and strong brand positioning provide RL with attractive long-term growth opportunities, in our view. We believe RL's assumption of direct control of its Southeast Asia (including China) business in January 2010 will provide substantial long-term growth opportunities with strong demographic underpinnings as RL seeks to grow this region to a third of sales, from an estimated $150 million at retail. The Asian Opportunity We expect a smooth transition when RL takes control, in January 2010, of its Asian business, which consists of eight Asian regions, including China, that generate a combined $150 million in sales at retail in Polo Ralph Lauren product. The business will include 500 store-level associates at 100 points of sale and about 250 corporate staff of locally based managers with responsibility for merchandising, IT, finance, HR, legal and other corporate functions. The scope of this investment speaks to the opportunity that exists in the growing Asian region, in our opinion. At present, China isn't even among RL's top-five Asian regions. According to consulting group McKinsey, the number of China's wealthy households hit 1.6 million in 2008 -- this in a population of 1.3 billion. McKinsey projects that number to grow to 4.4 million by 2015 at which point China would hold the fourth largest concentration of wealthy households, trailing only the U.S., Japan and the U.K. Luxury spending is expected to increase significantly with this growing demographic and many global luxury, apparel and sports brands are positioning themselves to ride this wave, including Coach (COH 36, Strong Buy) and Louis Vuitton. We note that Nike (NKE 64, Buy) has been in Asia for more than 20 years and generated $1.7 billion of sales in China in its most recent fiscal year ended May 2009. A THIRD A THIRD AND A THIRD In the long term, RL's goal is to derive a third of its consolidated sales in North America, a third in Europe and a third in Asia. The FY 09 (Mar.) sales mix was 72% U.S. and Canada; 20% Europe; and 8% Japan. Historically, the company has used international licensing partners to enter new markets and roll out new products and line extensions. Formidable sales and earnings drivers over the past five years have been consolidations of international operations, whereby RL bought back licenses, took brand control and consolidated back-of-the-house functions from a mosaic of operations (i.e., 12 European distribution centers to one). A similar effort has been under way in Japan for the past 18 months and is near completion, bringing together many disparate businesses and licenses into one unified organization. Despite softness in the Japanese luxury market, we expect this integration will result in a more cohesive brand and a product presentation better reflecting the company's sensibilities. (Japan revenues are included in the wholesale segment.) In China, we believe the exercise is simpler; RL is creating a greenfield organization with global operating standards and without the complexity consolidation entails: a key difference in the growth opportunities China presents versus the mature market of Japan. Polo Ralph Lauren's Global Brand Concepts We believe Polo Ralph Lauren is arguably the top American fashion house, with the concomitant creative design and marketing talent.

To tap this creative energy, in January 2007 RL created Global Brand Concepts to develop lifestyle brands for specialty and department stores, partnering in the design, operations, marketing, merchandising and advertising functions with retailers seeking to differentiate themselves with unique new brands. In February 2008, it launched its first exclusive brand, American Living, exclusively created for JCPenney (JCP 31, Buy), spanning more than 40 product categories -- from women's outerwear to draperie and babies to tabletop. It was a successful launch, in our view, despite unprecedented global economic challenges. In 2009, American Living is experiencing better sell-throughs following adjustments to product and inventory levels. We note American Living is exclusive to JCPenney in the U.S., and thus we believe this brand could provide additional international growth opportunities for RL in the longer term. COMPANY PROFILE Since its modest beginnings in men's ties in 1967, Polo Ralph Lauren has grown into one of America's leading lifestyle brands encompassing multiple permutations targeted at specific demographics, usage occasions and price points, with merchandise available at approximately 6,100 retail locations throughout the world. Licensor relationships extend the brand to fragrances, eyewear, leather goods, jewelry, and extensive home merchandise offerings. All told, we believe the Polo Ralph Lauren brand generates about $12 billion in sales at retail worldwide. We think lifestyle branding got its start with Ralph Lauren, and the company has successfully parlayed its moneyed American ambience into categories spanning men's haberdashery to bespoke suits, women's collection to table top and fragrance to house paint. The company operates in three segments: Wholesale (FY 09 sales of $2,887 million; profit margin 21.3%, before unallocated corporate expense, asset impairment and restructuring charges); Retail ($1,937 million; 8.3%); and Licensing ($195 million; 53.1%). RL's brands include Polo by Ralph Lauren, Ralph Lauren Purple Label, Ralph Lauren Collection, Black Label, Blue Label, Lauren by Ralph Lauren, RRL, RLX, Ralph Lauren Childrenswear, Rugby, Club Monaco, Chaps (solely available at Kohl's (KSS 56, Buy)) and American Living (exclusive to JCPenney). RL sells its apparel and home furnishings products mainly to upscale department stores, specialty stores, and golf and pro shops. We think critical to department store distribution, which represents RL's largest wholesale customer group, are the approximately 10,000 Ralph Lauren shops-within-shops dedicated to the company's products. We believe the 87 Ralph Lauren stores (at September 30, 2009), in addition to being strong profit centers, are marketing showcases exemplifying the Ralph Lauren luxury lifestyle, and RL is increasing the proportion of exclusive or limited-distribution product in its stores as part of its overall brand positioning. The company's retail store fleet also included 11 Rugby stores, 62 Club Monaco stores, and 168 Polo factory stores. International licensing partners operated 94 Ralph Lauren stores and 61 Club Monaco stores. The company earns royalties from product and international licensing partners that manufacture and sell at wholesale specified products under one or more of its trademarks. Payments range from 5% to 8% of sales, and licensing partners must allocate 2% to 4% of sales to advertising. RL has successfully bought back many of its licensed businesses -- first domestically and then internationally -- in the past five years as it takes worldwide control of its brand franchise. At the same time, licensing partners such as a newly formed joint venture with Financiere Richemont SA to design, manufacture and sell luxury watches and fine jewelry, enable RL to enter new product categories.

STRONG BALANCE SHEET RL ended the first half of FY 10 with net cash of $662.6 million, or about $6.69 per share. Long-term debt consists of $307.5 million in Euro debt at 4.5% due October 2014 and represents about 10% of total capitalization. Cash from operations for the first six months of FY 10 was $320 million, down from $388 million in the similar period in FY 09. The dividend was doubled to $0.40 annually on November 4, concurrent with a $225 million expansion of the share repurchase program to $431 million. Capital expenditures are projected at $220 million in FY 10 ($53 million was spent year to date), which compares to $185 million in FY 09 and $217 million in FY 08; we expect depreciation and amortization expense of about $190 million in FY 10. We believe international expansion is a lucrative growth opportunity for the company, and RL is courting European, Asian and Japanese luxury customers in their own locales. In FY 10, approximately 50% of its $220 million capital budget will be allocated to high-growth international markets, with the remainder supporting strategically located flagship stores, wholesale shop-in-shop installations and infrastructure investments. FINANCIAL AND OPERATING OUTLOOK We look for FY 10 sales of $4.9 billion, down 3% from FY 09. We are encouraged by quarterly comp improvement: -16% in March, -11% in June and -6% in September. Comparisons should ease in the second half of FY 10, and we look for flat retail sales at $1.9 billion, including a 10% e-commerce gain. We project flat to about +3% comps for the December quarter as RL laps the very weak 2008 holiday retail environment and a year-earlier -13.5% comp. We estimate a 4% decline in RL's wholesale business in tandem with reduced inventory at retail offset by growth in Asia. We project a 5% sales gain in FY 11. We see about 30 basis points of EBIT margin contraction in FY 10, to 13.5%, but we forecast 70 basis points of expansion in FY 11. Supply chain and sourcing initiatives should mitigate margin pressure in FY 10 and beyond, by our analysis.

VALUATION The shares recently traded at 17X our FY 11 estimate, a discount to peers. We believe RL deserves a P/E multiple in line with peers due to its attractive growth opportunities and superior balance sheet and operating metrics. Applying a P/E multiple of about 20X, in line with RL's peers, to our FY 11 EPS estimate of $4.80, we arrive at our 12-month target price of $95. Our discounted cash flow model, which assumes a 9.2% weighted average cost of capital, 2% terminal growth rate and modest growth assumptions in the 2010-2019 timeframe, also results in an intrinsic value of $95. CORPORATE GOVERNANCE Our overall assessment of RL's corporate governance is favorable. Some governance experts regard the combined chairman and CEO position as a negative. However, we believe Ralph Lauren has done an exceptional job navigating a domestic and global marketplace that has become increasingly complex since he started the firm in 1967. Moreover, with what we view as a strong executive team and an independent board that is like-minded regarding operating risk and brand stewardship, we expect continued disciplined growth over the long term. The company has Class A and Class B shares. Mr. Lauren and family hold all Class B shares, which are convertible at any time into Class A shares on a one-for-one basis. Class A shares trade on the NYSE. In total, Mr. Lauren and/or entities he controls hold about 86% of the voting power of the outstanding common shares. We note that shareholders do not have cumulative voting rights in director elections; however, even if they did, it would be muted given Mr. Lauren's controlling interest. Independent outsiders make up more than two-thirds of the board of directors. The full board is elected annually and governance guidelines are publicly disclosed at www.poloralphlauren.com INVESTMENT RISKS Risks to our recommendation and target price include integration risk from recent licensee acquisitions; execution risk in Asia; a sharp decline in consumer discretionary spending, consumer sentiment or income levels; and/or a significant increase in unemployment. We are basing our projections on unemployment peaking in mid-2010 at about 10.6% and we do not see a V-shaped recovery in employment. In addition to the aforementioned controlling interest of Mr. Lauren and family is the "key person" risk associated with the founder, who remains a driving force behind the Polo Ralph Lauren lifestyle image and strong brand equity. We believe the design staff is steeped in Mr. Lauren's design sensibility and that president and COO Roger Farah is a capable leader. We note that Mr. Farah has been the key executive in communication with the investment community for the last seven years. Nonetheless, we think a loss of Mr. Lauren's services could have a deleterious effect on RL shares. CONCLUSION Despite the obvious challenges and risks in the prevailing global macroeconomic environment, we regard RL as materially undervalued. Amid these unprecedented times, RL achieved a 1% increment in September-quarter operating results, captured market share and saw increases in retail orders. We expect the company to continue to deliver sales, earnings and cash flow growth and shareholder value while investing in the future. In our view, RL shares are compellingly priced and offer significant potential for capital appreciation./Marie Driscoll

16-Nov-2009 10:00:06 (14806921)   Copyright 2009 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.