Ralph Lauren (RL) reported first-quarter earnings a few weeks ago. Weak results were expected, as the company’s first-quarter felt the full-blown effects of the pandemic.

That said, we believe performance should trend higher from here. Many companies we have been following point to April as being the trough of the pandemic. Since then, many businesses have opened their doors and are seeing sequential month-to-month improvements and even some are seeing positive comps in June.

RL is on a similar path albeit at a weaker pace. The company still sees pressure weighing on its second-quarter results driven by lower foot traffic at its stores and wholesale partners. The company exited 200 wholesale doors during the quarter, some of which were by design but others due to a department store going bankrupt.

Although near term pressures are going to keep a lid on its stock price, we are still bullish in RL. The company’s effort to increase its digital penetration and the decision to exit weak wholesale doors should bode well for future results. With a direct-to-consumer approach, the company is regaining control of its brand image, thus positioning its products to higher end-markets.

Currently, analysts are expecting EPS of $5.83 at the end of fiscal 2022. With shares trading at $68, that puts RL’s forward earnings multiple at 11x. If we apply an average market multiple of 16x to expected EPS, we get a fair value estimate for RL of $93 per share, for a potential upside of 37%.

The full quarter impact from COVID-19

RL reported first-quarter sales of $487M, down 65.9% compared to its prior-year period, and missing the consensus estimate by $105M. The company also missed EPS expectations by $0.11 by reporting EPS on a non-GAAP basis of minus $1.82.

The company experienced a full quarter impact from the pandemic during their Q1, with widespread store closures across all of their 3 operating regions. Brick-and-mortar comps were down 70% in their North American and European regions, while Asia comps were down 33%. Weakness in N.A. and Europe was caused by longer store closures on average, compared to Asia, which saw an earlier recovery in Korea and Mainland China, offset by Japan, its biggest market in Asia. Today, nearly all of their stores are back online in all three regions, however, the company exited the quarter with negative comps at their brick-and-mortar stores:

As stores reopened, we experienced significant traffic and comp declines initially, but strong growth in conversion rates and average basket size. In the weeks that followed, we saw sequential improvement in brick-and-mortar traffic and comps, although both metrics were still negative as we exited the quarter. – Q1 call

While the company was heavily impacted by store closures in their brick-and-mortar network and wholesale partners, RL’s path to recovery has been led by online sales growth. Targeted digital marketing and acceleration in the roll-out of online capabilities, such as “buy online ship from store” led to a 68% online growth in Asia and 44% growth in Europe. The company also stated that N.A. returned to positive online comps during the quarter.

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The increase in online sales also led to a higher AUR as the company takes more control of the promotional environment. AUR grew 25% in its first quarter, led by double-digit increases in N.A. and Europe, surpassing management expectations.

This resulted in a strong gross margin performance for the quarter, which came in at 71.8% on an adjusted basis, compared to 64.5% in the prior-year period. The increase in adjusted gross margin was the result of a better mix from online sales with lower contributions from off-price retailers and factory stores. Although the company expects gross margins to moderate beyond Q1, management still sees strong margin performance due to improved pricing and promotional activities.

RL is continuing with its strategy to reduce wholesale exposure

The company’s North America wholesale segment saw its revenues decline by 93% during its first-quarter period. On a sell-in basis, the company stopped shipping Spring/summer inventories to approximately all of their wholesale accounts in March, as the pandemic was erupting, in order to realign inventories to current demand thus preventing excess inventory build-up and heavy promotional discounts. The company began shipping very limited quantities of replenishment products in June and is closely working with its wholesale partners on ways to approach the Fall/Holiday period:

We are, as I said, encouraged by the week-on-week improvements that we saw in Q1, although our trends were still negative as we exited the quarter. And we do expect that indoor and mall environment could remain challenged through the coming quarter. But as we move into Fall/Holiday, we’re very clear that we’re going to continue to prioritize inventory management, which could be a headwind to sell-out if demand picks up, but is really important for our long-term strategy. – Q1 call

During the quarter, the company also decided to exit approximately 200 lower-performance wholesale doors, representing about 5% of their sales to the channel. Management’s decision to exit low-performance stores is based on two simple questions:

So our guiding principle in terms of wholesale presence is really the combination of: Will the brand show up in a way that is consistent with the image we want to build? And is the location financially attractive? – Q1 call

We believe these actions are going to be beneficial to the company in the long term as decreased exposure to department stores and off-price retailers avoid the heavy discounting of inventories, actions their wholesale partners have taken to reignite dwindling store traffic and increased competition. There are three main areas in which a reduced wholesale exposure can help RL moving forward as the company continues to position its brand as a premium brand: 1) Higher AUR due to a less promotional environment; 2) Better profitability as a result of better price controls; and 3) Connecting with their customers, which increases their brand equity.

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The Bottom Line

We like the decision by the company to focus more on its direct-to-consumer channel and less on wholesale partners. It gives them more control over the image they want to create on their customers’ minds. Also, direct interaction with their customers gives them firsthand data that they can use to their advantage, like for example, anticipating new trends and changes in consumer taste.

Although April might have been the trough of the pandemic, there are still uncertainties regarding customer behavior. The company still sees low foot traffic and with capacity constraints due to social distancing guidelines, it could be a while before brick-and-mortar sales start to normalize.

That said, analysts are expecting a recovery in RL’s EPS for their financial year 2022, with forecasted EPS of $5.83. At a recent price of $68, the company is trading at a forward multiple of 11x. Applying an earnings multiple of 16x, we get a fair value estimate of $93 per share for RL.

The company ended its first quarter with $2.7B in cash on its balance sheet and $1.9B in total debt. Their strong liquidity position should be more than enough to weather the storm.

To conclude, we see RL as a solid company with a strong brand. Efforts to realign its brand image and increase its direct-to-consumer penetration should pay dividends in the long run.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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