3 Risks That Ralph Lauren Corp (RL) Investors Should Consider

Ralph Lauren Corp (NYSE:RL) is a global leader in design of premium lifestyle products such as apparel, accessories and fragrance collections.  While this is a type of company that is suitable for long-term oriented investors, it is essential to consider some essential risks that are not so clearly described in the typical bullish sell-side reports.

Ralph Lauren (RL)Ralph Lauren Corp (NYSE:RL) has generated strong results since the last five years due to its geographical and commercial diversification. In the last earnings report, the company delivered earnings that topped expectations. However, while I was reading Ralph Lauren’s form 10K, I found three risks that investors should evaluate.

Dependance on Mr. Lauren

As it was said before Mr. Ralph Lauren was the founder of Ralph Lauren Corp (NYSE:RL). Since its creation, this company has been managed by himself. There are two important situations that I would like to point out.

Firstly, the designs and all the important strategic decisions of the company are made by him. As he said “I try to design into a world that is constantly moving, and moving me”. How long can he get ahead of this changing world? Following what is recorded in Ralph Lauren’s form 10K, there are no signs of alternative staff that can help Mr. Ralph Lauren to be continually a step forward. In other words, Ralph Lauren has not succession plans. What could happen to the company if something happens to Mr. Lauren ?

In addition, the founder plays two important roles: being the Chairman and Chief Executive Officer and secondly, what for me is most important, being the majority stockholder of the company. Since March 2012, Lauren’s family owned 73% of the voting power of outstanding common stock of the company. These fact implies a big control over the company business by Mr. Ralph Lauren, any action that requires the approval of the stockholders can be controlled at a certain point by himself.

So, do you feel comfortable investing in a company so dependent on one key person? It might be a long or medium-term risk at this moment, even so it is a point that it has to be considered.

Profit Margins could be affected by higher commodity costs

This company depends on independent third parties that manufacture most of its products. We can find in Ralph Lauren Corp (NYSE:RL)’s form 10K that over 98% of the products were produced in Asia, Europe and South America in FY12. As it is well known, this industry is subject to significant pricing pressure. In my opinion is important to remark the secular uptrend of several commodities, such as cotton, which could impact Ralph Lauren margins. This chart shows clearly that cotton’s price has been increasing:

This is just one of many examples of how reflation is affecting the commodities market. This is a chain of consequences: commodities are more expensive, so prices of raw materials are higher, which means that Ralph Lauren profit margins get squeezed. Can Ralph Lauren set higher prices for their products? I would say it is not a viable alternative. Retailers and manufacturers were already wondering if they still had certain pricing power and now they have to face the rise of commodities prices.  The problem is that their products’ prices must be adjusted, however this is not an easy task. They need to understand which percentage of their products’ final price is affected by commodities prices and then, in a meticulous way, change customers’ prices so as not to affect too much their demand. Fortunately Ralph Lauren’s problem is a bit less complicated. The reason is that this company is a big retailer, so it can negotiate with its manufacturer’s and so get a bigger profit by reducing manufacturer’s margin.  Moreover, Ralph Lauren Corp (NYSE:RL) have different brands for different targets of the society. This is very important because it is probable that people who buy clothes in Champs will not suffer the increase in prices as will do people who buy in Purple Label.

However this negative shock was not enough to change the uptrend of RL profits. During the last year and in the following two, Ralph Lauren will be opening sixty stores in China, mainly in the principal avenues of the main cities. The idea is to diversify demand risks. Ralph Lauren has been investing in opening new stores in Asia as well as in online sales so as to cover the fewer sales that took place in Europe – which represents 22% of Ralph Lauren’s total sales.

It is important to remark that Standard & Poors expects that China could experience an economic correction in the short term, due to the country’s low investment productivity levels. This could affect Ralph Lauren Corp (NYSE:RL)’s expansion plans and diversification targets. While I do not think this is a short-term risk, is an issue to keep an eye on. If Chinese economy show clear signs of trouble, I think that Ralph Lauren’s investors should hedge their equity positions.
A close eye on valuation
It´s essential to consider valuation in every investment decision. Let´s compare how the market is valuing Ralph Lauren over its top peers:
Source: Google Finance
Ralph Lauren stock looks quite overvalued compared to Phillips-Van Heusen and Maidenform Brands, Inc. (NYSE:MFB). While Ralph Lauren has a much higer Return on Equity and Profit Margin than PVH Corp (NYSE:PVH) and Maidenform, the stock trades at P/S an P/BV multiples that are 2 times and 4 times the ones from PVH Corp (NYSE:PVH) and Maidenform Brands, Inc. (NYSE:MFB). Yes, I agree that Ralph Lauren has better profitability metrics, but that does not deserve such higher valuation ratios when compared to other companies. In addition Ralph Lauren´s exposure to Europe is high and could be a risk if macro conditions deteriorate.
When looking at these table, Hanesbrands Inc. (NYSE:HBI) looks attractive considering it trades at only 1 times sales with considerable future growth (Macy´s introduction in April and Wal-Mart shelf space gains are two good catalysts) combined with a high ROE, which is evidence of good management execution.
Foolish conclusion
Despite the different risks that the company has to face, this company doesn’t seem to have a bad performance. Prominent hedge fund managers Lee Ainslie (Maverick Capital) and John Griffin (Blue Ridge Capital) added to their Ralph Lauren position last quarter, which is a vote of confidence on Ralph Lauren’s medium term prospects.  While I think that Ralph Lauren Corp (NYSE:RL) is not immune to an economic correction or a material increase in commodity prices, I think that those risks do not represent a short term concern for long term, fundamental oriented investors.

The article 3 Risks That Ralph Lauren Investors Should Consider originally appeared on Fool.com and is written by Victor Selva.

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