East 72 2Q18 Letter: Short Macquarie and Ralph Lauren

Smart Money

We are short Macquarie

  • If it’s not apparent from what’s happening at Australia’s four large banks as they shed fund management type businesses at varying prices, banks are no different to other companies
  • They have high growth, attractive ROE components, low growth regulated components, but have the capability to rack up one off asset sales
  • Folks with long memories will realize that when Macquarie Group peaked out in 2007, the then earnings base of $1.9bn pre-tax was comprised of $1.15bn of asset sale profits
  • Such was the love of the “Millionaires Factory” that the market at the May 2007 peak of $97 (unadjusted) was valuing a conservative post tax estimate of recurrent earnings of ~$2.40 a share at a 38x P/E
    • It doesn’t need a financial crisis to adjust that
  • In the past two full years, MQG has racked up pre-tax gains of $878 million in the year of March 2018 from asset sales and fair value gains after impairments. That’s about a quarter of pretax profit last year and over a third the prior year. Forward estimates for MQG simply assume a continuation of this type of contribution
  • Of equal note is the stellar profitability of leasing – over $900 million pre tax each year. The largest contributor by far to leasing is aircraft leasing, where Macquarie are a third tier player, and the profits of the biggest player, excluding asset sales, are valued at ~8.5x pre tax in an equity value of about $8bn
  • From an equity market cap of $42bn, by the time we remove these parts, we believe the “jewel in the crown” Macquarie Asset Management business – which made $1.45bn in 2017 excluding one offs but including performance fees – is valued at over $33.5bn by the market
    • Remember performance fees across the group were $595 million in FY2018, up from $264 million in FY2017
    • On our analysis, the market is valuing the sexiest bit of Macquarie at 29x P/E where one-third of last year’s profit was performance fees
  • So the standard spiel on Macquarie is that it’s in a sweet spot for its core business, infrastructure build is booming around the world and it’s smart, connected player which benefits from a lower A$. And that it’s only trading on a P/E of 15.5x forecast earnings for the year to March 2019, which include all sorts of very low multiple streams
  • When you pull away the one-offs, and properly assess the low valued but profitable components, where Macquarie has no competitive advantage, then you are paying mightily for the bit where it maybe does
  • Analysis of the company verges on eulogistic, and the shares have returned nearly 46% including dividends in the last year
    • Six months ago, we were long; we are now short

Eighty year olds try a millennials turnaround

  • 14 members, 3 of whom are over 80 years old, and another 5 are over 70. Nothing wrong with that, in the right business. But what if the business is selling clothing/fashion/design and the market they need to target are millennials?
    • Oh and your major strategy involves taking your brand out of your discount stores and moving it into the full price equivalent? But in your largest market discount stores are 80% of the network
  • Welcome to the $10.3bn market value turnaround, which at one point just over a month ago was up 112% in a year, so investors are “expectant”. Welcome to Ralph Lauren
    • We are short
  • In the past 3 years, RL has racked up $1.15bn of restructuring charges, made the accounts so opaque you can barely calculate a realistic gross margin and whilst carrying a net $1.4bn of cash/marketable securities, also have a bunch of accrued liabilities which offset prepayments by over $750 million
    • Let’s assume enterprise value is around $8.9bn
  • RL’s sales have fallen 19% over the past 3 years to ~$6.2bn, and operating income is down 37%, to around $650 million prior to restructuring charges in the year to March 2018
  • In early June, after a positive response to the FY18 results, RL held an investor day to enunciate the turnaround strategy
    • Despite 160 very stylish slides, it looked more aspirational than detail
  • RL’s high society country club dream looks dated against immense transformation in consumer behavior, with fleeting fashion trends, heavy consumer segmentation and reliance on social media marketing
  • RL has managed to devalue its core products through off price channels and discounting, but is now trying to replicate similar successful strategies at Michael Kors and Tapestry
    • However, RL is trying to do so from a position of having proportionally far more factory stores than these peers, and where they expect wholesale to fall from 33% to 24% of total sales in five years – wholesale margins are believe to be more than twice retail
  • RL aims to increase net sales by $1bn over five years, driven extensively by new distribution and digital – areas where to date the company has not delivered
  • RL is attempting to wind down existing profitable channels, and in their own words “recruit several million new customers annually” and reset their offering in the newly growing – but highly competitive – denim market
  • RL already has massive channel conflict with multiple price levels for similar product, suggesting sales contraction may be far greater than expected
  • Based on current share price levels, it appears to us that the recovery is already well and truly baked in, and we have limited confidence it can be executed

East 72 Quarterly Report to 30 June 2018

Image Source: The TTABlog