By Leo Sek, Clime Asset Management
Oroton Group Limited (ASX: ORL) is a retailer of luxury fashion brands in Australia and New Zealand. Apart from the Oroton brand it has the Australian distribution rights for Polo Ralph Lauren.
ORL underwent a significant restructure in 2006 when the newly appointed CEO Sally Macdonald divested the underperforming Aldo, Marcs and Morrissey brands. From that point ORL focused on “high margin” and “up market” products.
ORL’s main focus is the design and retailing a wide range of Oroton products including bags and small leather accessories, jewellery, ties, umbrellas, knitwear, lingerie, men’s underwear and shoes. Products are sold through 38 own retail stores, 2 David Jones concession stores and 6 factory outlets. Products are also sold online.
ORL has been the Polo Ralph Lauren license owner for the Australia and New Zealand territory for over 20 years. Merchandise is sold through 8 own retail stores (1 of which is in New Zealand); 9 Myer concession stores; 5 David Jones concession stores and 5 factory outlets.
Although management does not disclose operating segment results, broker estimates are that the Oroton business contributes more than 60% of group EBIT. Oroton is a premium brand that delivers high margins. The Polo brand is also a premium range but royalties reduce the profit margin.
Management has restructured the distribution for Polo Ralph Lauren. It has replaced direct to retail wholesale arrangements with department store concessions. This should give ORL greater control over retail pricing and should improve gross margin. The tradeoff is that ORL carries more stock on its balance sheet which requires higher working capital funding.
Rent paid for department store concessions are generally higher than owner stores due to higher foot traffic. The offsetting benefits are lower fixed capital requirements and higher turnover.
As a retailer of luxury goods, one would think that ORL’s sales are highly leveraged to consumer sentiment and thus the macroeconomic outlook. This was evident for Polo with negative 1% sales growth in FY09 and negative 6% sales growth in the first half FY10. However, in contrast the resilience of Oroton was evident with 17% sales growth in FY09 and 18.5% sales growth in first half FY10. ORL’s targeted marketing campaigns to high income women appear to have cushioned the impact of the global financial crisis.
ORL needs to stay at the forefront of fashion trends. Therefore it relies on the in- house design team to stgelop new products that will maintain and grow sales.
Thus, Oroton and Polo could be described as premium brands with different trading characteristics. Oroton is the primary earnings and cash contributor, being more resilient to economic downturns and has carved out a unique presence in the Australian market. In contrast, the apparel market in which Polo operates is highly competitive with players earning tight margins. For example one key competitor is Country Road and they earn a net profit after tax margin of around 4%.
Whilst it is arguable that ROE could be improved and working capital requirements reduced by discontinuing or divesting the Polo license, this would leave ORL as a single brand business. This would place significant business risk on profit should something adverse happen with the Oroton business or brand. It would also affect the business economies of scale for ORL as there are scale benefits in running two brands.
It is estimated by market analysts that Oroton could hit market saturation point at 50 to 60 stores and Polo Ralph Lauren at 30 to 35 stores in the Australian market. There are currently 46 Oroton and 27 Polo stores, with 2 stores planned for the second half of FY10.
To deliver future profit growth, ORL can expand its geographic presence; purchase other luxury fashion brands; introduce new product ranges or refurbish stores. Management has chosen the last two options for now, launching in house lingerie, men’s underwear and embarking on a store refurbishment program. They are cautious about expanding offshore and acquiring domestic brands given past experience.
Myer and David Jones are important sources of sales, particularly for Polo. Any change in trade terms e.g. rent expense, could negatively impact ORL sales and profit.
As the majority of products are manufactured in Asian factories, a stronger Australian dollar should work in the company’s favour.
ORL has fully outsourced its warehousing and distribution functions. This has delivered cost benefits by reducing headcount and lowering warehousing costs. However, there is supplier risk with such an arrangement.
We see a history of sustained profit and return on equity (“ROE”) growth from FY07 to forecast FY10, characteristic of a strong performing business. This coincides with the change in CEO in 2006.
Operating cash flow exceeded profit after tax from FY05 to first half FY10, indicating a high level of cash flow generation. This has allowed ORL to pay out 70% – 80% of profit after tax as fully franked dividends. This has provided shareholders with a robust income stream.
The growth in profit from 2007, prior to the economic downturn, through to 2009/10 is impressive. More impressive is that this was achieved with there being no new capital raised apart. Capital increased from retained earning of approximately $8 million. Over this period earnings growth was approximately $7 million which shows a high capital retained to profit conversion ratio. Simply stated, ORL is a highly profitable business.
Capital management looks sensible with a dividend policy that allows the business to retain sufficient cash to fund organic growth.
Gearing is low, with net debt to equity of 18%. Also, interest cover is high at 64 times, meaning ORL should have little trouble servicing its debt.
For the reasons above, as well as the resilience shown during the global financial crisis, we have adopted a Required Return of 14.5%.
The market currently requires 105% profitability (“APF”) to justify the current price. We have adopted a higher profitability level of 112% which we regard as achievable given the Oroton business demonstrated strong like for like sales growth. However, the maintenance of this level of profitability will be a challenge for management in coming years.
We believe the stock is in value at current market levels but investors should note that the current share price and the StockVal valuation represent a high multiple of equity. Thus, should the APF or profitability dip for any reason in the future then the valuation could fall dramatically.
Clime Asset Management and StockVal are part of Clime Investment Management (ASX:CIW).
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