Here’s the Three Key strategic Questions we’d ask Ralph Lauren in conjunction with its 4Q14 print on Friday morning. Note that we have been addressing these ‘Three Key Questions’ as if we had 5 minutes with the CEO to address only 3 issues that are central to the debate. But the reality is that the chance of anyone getting access to Ralph Lauren himself after the call is just about zero. But let’s keep it real and address these to the CEO. As long as he has the title, he deserves the questions. Here goes…
- Lower-Return Mega-Cycle?
The Context. This question revolves around one major theme. This is a company that has successfully navigated through decade-long mega-cycles over the past 40 years, and it’s starting a new one right now. Some cycles have been choppy, some were perfectly executed. But all had to do with changing control over content – either from a channel, geographic, or category perspective (or all at once, like we saw in the latest cycle). The strongest cycles were when RL was taking back control of its content (as opposed to licensing it out). For example, taking back a handbag license when the licensee only generated $100mm in sales on what should have been a billion dollar business. Or taking back a $400mm label like Lauren from Jones Apparel Group when JNY was generating a 28% margin and only paying RL 7%. There are over a dozen examples. But with RL taking back the Chaps label from PVH/Warnaco, there are officially no more meaningful licenses RL can pull back in house. This matters because these license acquisitions are some of the most accretive deals we’ve ever seen in retail – and that’s not just because the acquisition costs for RL have usually been zero. While RL re-took control of its content, we saw RNOA go from 13% to 26% -- making RL one of the highest return retailers in its segment of retail.
The Question: So the question here is this…RL is starting off a new cycle where it has to invest significant capital to grow. The opportunities are there, we think. But there’s a real capital cost that needs to be put against these ideas. Is it mathematically possible for these new initiatives to be higher return than the slam-dunk growth opportunities that RL has had over the past 10-years? If not, how should we think about the trajectory of financial returns? If returns go down, the multiple probably is not going up.
- Succession Planning.
The Context: There are only seven CEOs in the S&P who are 74 or older. Ralph Lauren is one of them. Interestingly enough, this year with the pseudo retirement of Roger Farrah (who has been critical to RL’s growth trajectory), Mr. Lauren is taking a greater role in the organization as opposed to the diminishing role one might expect from a 74-year old CEO. We’re ok with that for one reason -- and that’s the enhanced responsibilities given to Chris Peterson, who added CAO to his CFO role this year. We think that Peterson is every bit the rock star that Farrah was. But what we don’t know is what the company will look like in a Ralph-less state. We understand why the company is unlikely to openly discuss succession. Few companies do. But we don’t necessarily need to know its plan – we just need to know that it has one. That’s where we’re unsure about RL. We can’t imagine that Mr. Lauren starts off every Board meeting saying “let’s talk about who’s going to take my job.” Also, unlike other iconic majority holders in a dual-class structure company – like Phil Knight at NKE (who exited gradually and gracefully) – Ralph remains critical to product design and the strategic direction of the Brand. So on one hand, we absolutely want him to remain in his current role. But on the other, we need to gain some confidence that the company will not miss a beat in the event that we wake up one day and Ralph Lauren is no longer a part of the company he built.
The Question: So the question for Ralph is whether he has given the Board a mandate to go external for the next CEO, or if it will come from within? If the latter, will Ralph hand the keys over to David Lauren (EVP Marketing) as his legacy? The question for Peterson, Nemerov, Farrah and the rest of the ‘Office of the Chairman’ is whether or not they have confidence that a succession plan actually exists? This seems like a bogus question, but it’s one we need to be crystal clear on for a company with $13bn in equity value and has one holder who accounts for over 60% of the voting power.
The Context: You’ve never had this much cash before, which happens to come at a time when there are fewer acquisition opportunities than at any time in the past 20 years. Specifically, over the next 5-years, you should generate nearly $7bn in cash from operations, and maintenance capex of maybe $1.75 billion. Tack on another $850mm in dividends, another $1bn in stock repurchases to offset the dilutive impact of options. That’s about $3.6bn, and leaves an extra $3.4bn in cash – on top of the $500mm in net cash you already have.
The Question: The simple question is whether or not you will push for the Board (i.e. Ralph) to meaningfully step up stock repo activity. You’ll get paid more for that than for building a war chest of cash. But the real question is how many high-return capital projects can you invest in to deploy that capital in a way that will accelerate top line growth and/or margin improvement.
Bonus Question (knowing full well that we're already well over our theoretical 5-minute time limit.)
Cyclical Margin Risk
The Context: About 40% of your cash flow comes from US department stores. While that is down materially from when Retail and Int’l were both in their infancy, it’s still a big pill to swallow. Your real estate and positioning within department stores is probably the most defendable of any major brand. But one fact remains – the department store group as a whole just completed year 5 of a margin expansion cycle and is now sitting at peak margins. There has never been a margin expansion cycle that’s lasted longer than…you guessed it…5-years.
The Question: If we see margins correct in your US wholesale channel, do you think that the macro factors causing the decline would also hit your retail business? Do you think you can sustain margin even in the event of a broader industry margin correction? What levers do you have to pull to help you deliver?