Oroton shines

PORTFOLIO POINT: The retail and brand management group continues to perform strongly while the retail sector struggles.

The challenges facing Australian retailers have been widely publicised. The strong Australian dollar, higher interest rates and an explosion in online retailing are all frequently trotted out as reasons for the sector’s underperformance.

For years when conditions were favourable for retailers, investors would look to established big-ticket department stores such as Harvey Norman (HVN), David Jones (DJS), Myer (MYR) and JB Hi-Fi (JBH). But as the perfect storm of conditions has descended on Australia, so too have the share prices of these household names with high levels of fixed costs.

Despite these challenges, the business model of the listed “brand managers” continued to thrive and should offer retail investors with an alternative to traditional retailers and the pitfalls they face.

Three well-known Australian “brand managers” include Pacific Brands Limited (PBG), Premier Investments Limited (PMV) and OrotonGroup Limited (ORL).

While it is hard to justify Pacific Brands and Premier Investments as a possible investment due to their high levels of intangibles, mediocre levels of profitability and uncertainty regarding their strategic response to the changing retail landscape, Oroton is showing qualities that should help it wade through the challenges currently being faced by the sector.

As with any new trends, there will be winners and losers. Flexible, adaptable, forward-thinking managers will seize the opportunity and grow value for shareholders, while those with a “hold the fort” mentality may well be left behind. With a well-articulated strategy encompassing brand management and enhancement, effective product positioning, measured Asian expansion, strict financial controls and an impressive online platform, Oroton is my preferred retail exposure.

Oroton was founded in 1938 and listed on the ASX in 1987. In 2006 the company underwent a significant restructure led by incoming CEO Sally Macdonald, who divested a handful of underperforming brands to concentrate on just two: Oroton and Polo Ralph Lauren.

Oroton sells a wide range of products: Oroton leathergoods and accessories for men and women are pitched as affordable luxury; while Polo Ralph Lauren is famous for its high-end casual wear. Oroton has held the exclusive licence for Polo Ralph Lauren for nearly 20 years in Australia and New Zealand and holds the longest-standing licensee agreement with its US parent.

Over time, the overall focus of the company has shifted more towards the Oroton brand, which, by the end of 2011, is forecast to account for 59 of the company’s 92 stores. The store rollout program is continuing successfully, with 16 new stores planned for 2010-11, increasing its footprint by 22%.

In the period between 2006 and 2010, management significantly reduced the head office administration staff count from about 150 to 50. This move was typical of the group’s focus on costs, and coupled with the more recent outsourcing of logistics, has greatly improved profitability at a time when competitors were doing the opposite.

A significant portion of the Oroton business model focuses on long-term brand development and elevation. Management refer to themselves as not only retailers, but also brand managers. There is clearly much perceived value in the brand names Oroton and Polo Ralph Lauren; customers buy an Oroton handbag, not simply a handbag.

The business process for the Oroton brand involves in house product design followed by predominantly Asian manufacture. This scenario means Oroton benefits from a stronger dollar. The product is then sold through its Australasian network.

Significant improvements in Oroton’s sales/NPAT margin were realised from 2006 to 2008, with margins incrementally increasing since that time. This demonstrates management have become increasingly effective in prudently cutting costs and maximising profits for shareholders.

Oroton achieved like-for-like sales growth of 17% for 2008-09 and 10% for 2009-10. Although not publicly disclosed, it is estimated that the Oroton brand accounted for about $100 million of the $146 million of group revenue for 2009-10. Oroton’s strong growth since 2006 has shifted the revenue split between Oroton and Polo Ralph Lauren significantly and is now the clear growth and profit driver of the company.

Outlook and risks

Strong recent sales and financial performance would suggest Oroton is a business that is well equipped to tackle the emerging challenges for the retail landscape. Their “affordable luxury” mantra primarily targets the middle to upper class; many of whom would not drastically feel the effects of the aforementioned interest rate hikes.

Oroton management continue to invest in what they term “retail innovation”. This is a strategy that has paid off with the continued growth of their online platform. Launched in 2006, Oroton.com has evolved to become a very effective driver of sales for the company. It grew by more than 50% in 2009-10 to become a top-five store (by sales), and was recently noted by management to be tracking as their number one store so far this financial year.

Macdonald recently commented that the online strategy was critically important and “continues to pull in new customers to the brand and converts them at a higher price point. In fact, we have evidence to prove that our online channel doesn’t cannibalise our physical stores.”

Asian expansion

As mentioned earlier, Oroton plans to roll out a further 16 stores in 2010-11 with a new focus being in Asia. Oroton’s first international store was opened in Hong Kong in September 2010 and four more are planned for Singapore and Malaysia.

Management appear to have a measured approach to the potentially lucrative Asian expansion. They still feel there is about 25% growth left to fill out the company’s Australian footprint, but it is the Asian expansion success that will be critical to their long-term organic growth plans.

As with all businesses, success is often linked to the quality of the team that drives the business. Oroton is currently well served by an excellent management team, but a couple of key person risks seem to exist in the highly regarded head designer, Ana-Maria Escobar, and the clearly talented CEO Sally Macdonald.

The obvious risk to the business exists if either or both were to be poached by competitors at a time in the future.

From analysing the company financials and meeting with management in person, it would appear that the company is managed prudently. Macdonald stresses the importance of “strict hurdles” when appraising the business and new opportunities.

Management ownership is quite high with directors owning a total of 43% of Oroton. This provides a high level of vested interest for directors to continue to act in the best interest of long-term investors.

Fundamentals

Oroton’s financial position is sound, with the key fundamentals all in good order. The balance sheet is strong; assets are comprised of very little intangible assets and the net debt to equity ratio of 32.5% suggests the gearing is quite manageable. Profit has grown considerably year on year, and operating cash flow has well exceeded reported profits over the past five year review period.

Capital management over the past five years has been impressive. Oroton management have raised minimal new capital, paid an increasing level of fully franked dividends and have focused on substantially improving profitability (NROE) from a negative number in 2006, to in excess of 100% in 2010. Oroton’s organic growth is currently self-funding; over the past three years shareholders have not been required to stump up any new capital, despite testing economic times.

With an eye to Friday’s close of $8.78, I currently value ORL accordingly:

The following valuations are based on analysts’ forecasts and are subject to change.

The graph shows the strong growth in value over the past 5 years. Price has consistently lagged value but ultimately appears to following over time. The current market price is at a good discount to both the 2011 estimate and 2012 estimated values.

The graph shows earnings and dividends per share steadily increasing over time, with the turnaround in Oroton’s fortunes especially apparent in 2006–07. All dividends are fully franked and, on current prices, represent a good comparative level of grossed up yield.

The financial performance, brand strength and high owner-manager quality would certainly currently place Oroton among Australia’s best quality niche retailers. With all potential investments, it is wise for investors to take a step back and assess not only the merits of the investment itself, but further consider the industry and macro-economic conditions in which it is operating.

Such a view may make some investments unattractive at a given time, while in other circumstances this may give one the clarity to make a quality long-term decision in the face of shorter-term headwinds. We suggest that sector wide weakness in the retail sector may provide the astute long-term investor opportunities to cherry-pick the better quality forward-thinking retailers, such as Oroton, when their prices are appearing at substantial discounts to value.

Adrian Ezquerro is an analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (ASX:CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.