Baron Funds: Tiffany and Ralph Lauren Should Outperform

In its last quarterly shareholder letter (.pdf, 6/30/07), analyst Matt Weiss of Baron Asset Fund [BARAX] commented on portfolio holdings in the luxury retail sector:

During the quarter, shares of Polo Ralph Lauren (RL) performed well, as its quarterly earnings surpassed expectations and continued to demonstrate the company’s evolution from a luxury apparel licensor into a global lifestyle brand. Sales across business lines were strong, with the wholesale segment up 10% and retail same store sales up 6%, with notable strength in Europe, Chaps, and Kids. Net income rose 17%. However, we believe it was the announcement earlier this year of several initiatives that has propelled the shares of late and has positioned the company, in our view, for sustainable double-digit growth.

In January, building off the success of its Chaps line at Kohl’s, the company announced the launch of Global Brand Concepts, a new sales channel, in which it will develop exclusive lifestyle brands for moderate and better department stores. Named “American Living,” the first partnership is with J.C. Penney, and the collection will include a full range of Polo products for debut in 600 J.C. Penney stores set for next spring. In March, the company agreed to buy the remaining 50% of Polo.com it did not own from NBC and ValueVision Media. The company’s online business, though small, has been quite profitable and has grown at a 30% rate. E-commerce for Polo is now limited to only U.S. customers, but we expect this will be expanded globally now that the company owns the platform outright. In April, the company acquired its largest licensee in Japan for $360 million in an effort to gain control of the brand and expand its presence in this key market. We believe that Japan holds large potential, representing just 10% of Polo’s global sales, through mostly a wholesale menswear offering. We believe a broadened assortment of women’s and childrenswear, combined with profitable retail stores, will boost sales and earnings in that region.

Tiffany’s (TIF) posted another gem of a quarter, with sales advancing 15% and earnings 20%. The company saw its strongest gains in its flagship New York store, now responsible for 10% of sales, as well as from Asia excluding Japan and Europe, where same store sales each rose over 20%. We believe that momentum in Tiffany’s business is occurring for the following important reasons: 1) the company has been opening smaller stores that generate greater sales productivity at lower cost, 2) new and emerging luxury markets such as China and Korea hold important potential, 3) the company should begin to reap the margin benefit from years of heavy investment in real estate, manufacturing, and distribution, 4) a new hedging program aimed at containing precious metal cost inflation has been reducing LIFO charges and increasing gross profit, and 5) with the dollar at a record low versus the Euro, Tiffany’s U.S. stores have experienced record tourist traffic and also enjoyed the earnings benefit from translation of foreign sales back to U.S. dollars. Shares have pushed to fresh highs this year as these stronger sales results and the wind- down of the major investment cycle has accelerated profit growth. In addition, we think the recent purchase of a large stake by a perceived “activist” investor and the likely exit of an unprofitable, non-core business have attracted new institutional holders who anticipate continued sparkling results.