NEW YORK — Merrill Lynch thinks the end of the Lauren and Ralph licenses at Jones Apparel Group is at hand, and it doesn’t believe the split will be good for either the licensor or licensee.
In a research note issued Friday, Merrill lowered its ratings for both Jones Apparel Group and Polo Ralph Lauren to "neutral" from "buy," saying that Jones would take a "two-year EPS hit" if the Lauren license were to be lost and that Polo already "has its hands full with the integration of its European operations, the rollout of Blue Label, consolidation of the Japan business and the expansion of its retail store base."
"We now believe that Jones will lose the Lauren license," analysts Virginia Genereux and Gina Gordon wrote.
The opinion followed not only various news accounts about friction between Jones and Polo and a possible Jones acquisition of Tommy Hilfiger Corp., but also an appearance by Roger Farah, Polo Ralph Lauren president and chief operating officer, at an ML Retailing Leaders Conference the week before last.
Although mum on negotiations between Polo and Jones regarding the Lauren name, the analysts said Polo "sees much more strategic rationale for operating that business vertically than in our prior discussions with them."
Although viewed as accretive to earnings by fiscal 2005, an integration of Lauren into Polo would also bring "substantial execution risk," the report pointed out, estimating that Polo currently receives between $36 million and $38 million in royalty revenue and "just over $20 million" in operating profit from Jones for Lauren. The ML figures assume a royalty of between 6.5 and 7 percent.
"Ralph’s wholesale business is currently running 10 percent to 11 percent operating margins, suggesting taking back the license would be accretive at $200 million in volume, versus current levels of $550 million," ML stated.
Of the three firms discussed, all of which are traded on the New York Stock Exchange, only Polo escaped a price reduction, rising 10 cents, or 0.5 percent, to close at $22.35 a share on Friday. Jones shares were down 81 cents, or 2.9 percent, to $27.18; while Tommy Hilfiger’s eased off 15 cents, or 2.1 percent, to $7.15 after Thursday’s 23.9 percent run-up on news of Jones’ interest in acquiring the firm.The report said the firm "would be surprised" by a Jones acquisition of Hilfiger based on the maturity of the business, now "on its fourth year of revenue declines and with operating margins arguably at their peak."
"Jones needs topline growth to grow earnings," the report said. "We should note that this is also the fourth year of EPS declines at Tommy, so we would not expect a buyer to pay much of a premium to comparable company multiples, which are now about nine to 10 times."
Although such an acquisition would lift 2004 EPS to the $3.30 range, without allowing for cost-reduction synergies, "the challenge with buying Tommy is that we think it is tough to grow EPS from there."
Also working against a Jones purchase of Hilfiger is the namesake designer’s lifetime employment contract, which guarantees him an annual cash bonus equal to 1.5 percent of U.S. revenues.
"Shareholders of an acquiring company may resist the assumption of such terms," the report said. "Alternatively, the departure of Mr. Hilfiger could have negative implications for the brand’s designs."
ML doesn’t believe that the Polo Jeans business in the U.S., a $400 million enterprise for Jones, is at risk. However, the loss of the Lauren line would basically leave Jones’ earnings per share "flattish" at about $3 "or slightly north" through the calendar year 2005. ML believes that termination of the license would take effect after the spring 2004 season.
The ML report doesn’t envision Jones taking this loss without a fight, calling the firm’s management "a group of excellent operators" who "will certainly move to replace the Lauren business."
In one scenario considered in the report, Jones secures the Calvin Klein women’s wear license from Phillips-Van Heusen, builds it to $75 million to $90 million in 2004 and then to $200 million in 2005. Assuming the rest of Jones’ business grows between 5 and 6 percent, EPS would rise to $3.05 to $3.10 in 2004, meaning accretion from CK of 5 to 10 cents a share, and to $3.15 to $3.20 in 2004.
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