Luxury lifestyle company Polo Ralph Lauren (NYSE:RL) posted net revenue growth of 4% annually to $1.65 billion in Q1 fiscal 2014. Excluding the impact from adverse currency movement and discontinued operations, net revenue rose by around 6%. In line with our expectations, RL's profits came under pressure during the quarter. Gross margin fell by around 150 basis points annually to 60.7% on account of the integration of Chap's sportswear business and adverse currency impact. Operating expenses as a percentage of revenue rose by 10 basis points annually due to higher costs associated with the company's growth strategies and transition of newly assumed businesses, which were partially offset by better expense management. This resulted in a 7% year-over-year decline in net income to $181 million in Q1 fiscal 2014.
The company gave a modest outlook for the second quarter of fiscal 2014 as its top-line growth and profits will be impacted by the integration of newly assumed businesses and the timing of investments in strategic growth initiatives. Moreover, it reported weak comparable stores sales growth in the first quarter. These results and forecasts did not go down well with the company's investors and led to a more than 8% drop in its stock price.
We believe Ralph Lauren's sales growth and profits will accelerate in the second half of the fiscal year. The company is making accelerated investments in its growth strategies including the expansion in its retail footprint, e-commerce channel, and new product categories (such as Denim & Supply and accessories) and making changes to its management information systems. While these investments will impact profits in the short run, it will boost sales growth in the long run.
Sales Growth in the Wholesale Channel Outpaced Overall Revenue Growth
Ralph Lauren's wholesale sales grew by around 6% annually in Q1, surpassing the company's overall revenue growth. The recent integration of Chap's men's sportswear business and the continued growth in the North American market boosted revenue growth at this channel. The management forecasts wholesale sales in the second quarter to be in line with the prior year as SAP implementation will delay certain wholesale shipments from the second quarter to the third quarter.
The retail segment sales grew by around 3% driven by new store openings and high growth in the e-commerce channel. Excluding the negative impact from discontinued operations and adverse currency, retail sales rose by 6% annually.
However, consolidated comparable store sales fell by 1% in dollar terms and rose by 1% in constant currency terms during the quarter. The Easter timing shift negatively affected comparable stores growth by approximately 2%. Comparable-stores sales growth declined compared to 4% constant currency growth recorded in the previous quarter, and we believe the slow growth in this metric is worrying. Moreover, comparable stores sales growth fell owing to lower traffic levels at retail stores. Given the accelerated investments Ralph Lauren is making in growing its retail store channel, continued weakness in this metric could impact the company's revenue growth and profits in the future.
Progress Seen Against Strategic Initiatives
In fiscal 2014, Ralph Lauren will increase its investments in areas such as retail store expansion, e-commerce capabilities, and management information systems, and this will impact operating profit by around $75 million during the year. Progress for each of these strategic initiatives was reported in the first quarter. RL undertook a successful pilot implementation to move some of its brands from legacy systems to SAP during the quarter. The company will continue to roll out these management system changes to other brands and product categories during the year. We believe the company could reap productivity and procurement savings in the future post successful implementation of this change.
Ralph Lauren continues to make investments to grow its direct-to-consumer business. It opened two new flagship stores in China, its key growth market during the first quarter. Additionally, it opened a new Polo store in East Hampton in its strategy to open dedicated Polo stores around the world. It also added two new Denim & Supply stores in Q1. Ralph Lauren is making several investments to enhance its e-commerce business and plans to launch e-commerce operations in South Korea later this year.
The company is also making headway in growing its new merchandise categories such as handbags, footwear, eye wear, watches and fragrance. Handbags, small leather goods, and footwear comprised for around 8% of RL's revenues in fiscal 2013, and we believe this proportion will rise in the future.
Outlook for Q2 Fiscal 2014
- Net revenue to grow by a low single digit percentage. This includes a 200 basis point net negative impact from adverse currency and discontinued operations.
- Operating margin to be around 300-350 basis points lower than the previous year on account of investments in growth strategies, integration of new businesses and adverse currency impact.
- Tax rate is forecast at 31.5%.
We are in the process of updating our price estimate for Ralph Lauren's stock.
Disclosure: No positions.