Here it goes…

On licensing

Ralph Lauren 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 the most successful had to do with regaining control over designing and selling different labels and product classifications. The most favorable cycle – by a country mile – was the one that just ended. And though some might argue otherwise, there’s no doubt in our mind that it did, in fact, end.

The strongest cycles were when the retailer 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 $100 million in sales on what should have been a billion dollar business. Or taking back a $400 million label like Lauren from Jones Apparel Group when Jones was generating a 28% margin and only paying Ralph Lauren 7%. There are over a dozen examples. But with Ralph Lauren taking back the Chaps label from PVH/Warnaco, there are officially no more meaningful licenses the retailer can pull back in house.

This matters because these license acquisitions are some of the most accretive deals we’ve seen in retail – and that’s not just because the acquisition costs for Ralph Lauren have usually been zero. While the retailer regained control of its content, we saw return on net operating assets go from 13% to 26% — making Ralph Lauren one of the highest return retailers in its segment of retail.

Question: Ralph Lauren 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 the retailer 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.

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On succession planning

There are only seven CEOs in the 500 companies listed in the Standard & Poor’s Index who are 74 or older. Ralph Lauren is one of them. Interestingly enough, this year with the pseudo retirement of longtime second-in-command Roger Farrah (who has been critical to the retailer’s growth trajectory), 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 chief financial officer Chris Peterson, who added chief accounting officer to his 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 Ralph Lauren.

We can’t imagine that the CEO 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 Nike (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.

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.

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On your pile of cash

Ralph Lauren today has 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,the company you should generate nearly $7 billion in cash from operations, and maintenance capex of maybe $1.75 billion. Tack on another $850 million in dividends, another $1 billion in stock repurchases to offset the dilutive impact of options. That’s about $3.6 billion, and leaves an extra $3.4 billion in cash – on top of the $500 million in net cash you already have.

Question: Will you 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 on cyclical margin risk (knowing full well that we’re already well over our theoretical 5-minute time limit.)

About 40% of your cash flow comes from U.S. department stores. While that is down materially from retail and international sales 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.

Question: If we see margins correct in your U.S. 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?

Brian McGough is Managing Director and Retail Sector Head at Hedgeye Risk Management. You can follow him on Twitter @HedgeyeRetail