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Don’t Chase Ralph Lauren’s Post-Earnings Rally

Leo Sun, The Motley Fool

Shares of Ralph Lauren (NYSE: RL) recently surged to a three-year high after the apparel retailer's fourth quarter numbers topped Wall Street's expectations. Its revenue declined 2% annually to $1.53 billion, but beat estimates by $50 million. On a constant currency basis, its revenues fell 7%. Its adjusted earnings rose by a penny to $0.90, topping estimates by seven cents.

Ralph Lauren expects flat to slightly negative revenue growth on a constant currency basis for the current quarter, and a low-single-digit sales decline for the full year. Those numbers seemed anemic at best, so I was surprised to see Ralph Lauren's stock jump after the report.

A group of Ralph Lauren models wearing Polo shirts.

Image source: Ralph Lauren.

Granted, expectations for Ralph Lauren have been low over the past few years due to sluggish mall traffic, competition from fast fashion retailers, and the resignation of its turnaround CEO amid a conflict with its namesake founder. However, I still think Ralph Lauren's post-earnings pop was mostly unjustified.

Why the bulls got excited

Ralph Lauren's 2% sales decline marked its smallest annual drop in two years. Its comparable store sales also showed improvement in two of its three main markets: North America and Asia.

 

Q1 2018

Q2 2018

Q3 2018

Q4 2018

North America

(8%)

(9%)

(10%)

0%

Europe

(8%)

(6%)

(8%)

(6%)

Asia

2%

3%

3%

4%

Comparable store sales growth, constant currency basis. Source: Quarterly reports.

Ralph Lauren attributed its recovery in North America to a 6% jump in brick-and-mortar comps, which was offset by an 18% decline at its main website. That shift was intentional, and part of its ongoing efforts to reduce online promotions. The bankruptcy of department store chain Bon-Ton also weighed down its North American wholesale growth.

The company attributed its growth in Asia to robust sales in both the retail and wholesale channels, with 6% sales growth in Japan on a constant currency basis, 34% growth in mainland China, and 22% growth across the Greater China region.

Simply put, Ralph Lauren is protecting the brand appeal of its products in North America by throttling its sales in off-price channels, relying more heavily on Asian markets, and shortening its turnaround of new products to compete against fast fashion rivals. This resembles Guess' (NYSE: GES) turnaround strategy, which relied on higher sales in Europe and Asia to offset its soft North American sales.

Ralph Lauren's gross margins are also holding steady. Its adjusted gross margin rose 440 basis points annually to 59.8%, but its adjusted operating margin dipped 110 basis points to 5.6% due to higher marketing costs.

Why the bears still smell blood

CEO Patrick Louvet, who took the top job last year, has made progress getting Ralph Lauren back on track. But the company still hasn't resolved some of its biggest problems.

The first major problem is Europe, where total revenues rose 13% on a reported basis but fell 1% on a constant currency basis. Those numbers, coupled with its negative comps growth, indicate that its digital wholesale business is cannibalizing its retail stores. The region's operating margins also declined on a constant currency basis.

A model wearing a Ralph Lauren dress.

Image source: Ralph Lauren.

During the conference call, CFO Jane Nielsen claimed that the company would implement "a number of changes in our product assortments and promotion structures to improve the traffic and conversion trends in our European stores." But if those efforts don't pan out, the region's negative growth could offset its gains in Asia.

Ralph Lauren's turnaround times are improving, but they remain well behind many of its industry peers. 90% of its products now have a nine-month lead time, up from 50% in the prior-year quarter. For comparison, Inditex's Zara, the market leader in fast fashion, has a turnaround time of about two weeks. Urban Outfitters (NASDAQ: URBN) recently claimed that nearly 50% of its products had a lead time of 12 weeks or less.

Wall Street expects Ralph Lauren's revenue to stay roughly flat this year as its earnings rise 4%. Those are dismal growth numbers for a stock that trades at 22 times this year's earnings.

For comparison, Guess -- which trades at 26 times this year's earnings -- is expected to post 8% sales growth and 39% earnings growth. Analysts expect Urban Outfitters' revenue to rise 6% as its earnings jump 45%, yet its stock trades at just 19 times this year's earnings.

The bottom line

Ralph Lauren looks healthier under Louvet's leadership, but the company still needs to improve its North American business, revive its European business, fend off the competition in Asia, and shorten its turnaround times. It could certainly accomplish those things over the long term, but the stock seems too pricey relative to its growth potential -- so investors should stick with other apparel plays instead.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.