Surging cotton prices over the past year have put pressure on gross margins. Google the following words, "rising cotton prices hurting gross margins", and stories appear about Nike (NYSE:NKE), Carter's (NYSE:CRI) and Wal-Mart (NYSE:WMT). That's just the first page. Companies have taken all kinds of different approaches to coping with higher input costs. Some have increased prices while others have sought alternative materials. Now it appears that rising cotton prices has led to a surge in production, which will ultimately lead to a drop in cotton prices. One company that appears to be fine either way is Ralph Lauren (NYSE:RL) the maker of Polo, one of the best investments in the apparel business.
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Ralph Lauren's situation is a thing of beauty. Its debt-to-capital ratio is a mere 7.5%; Its net debt is a surplus of slightly less than $1 billion, and its free cash flow for the trailing 12 months is 7.7% of revenues. The company is in a great position to generate cash and, despite cotton prices rising, operating margins are higher than they've ever been. Not many apparel companies can make this claim. Ralph Lauren has achieved double-digit returns from both metrics in nine out of the last 10 years. In this regard, it's unsurpassed.
Ralph Lauren's three-pronged attack has it building and extending the brand internationally, with a focus on specialty retail. Asia is the main beachhead of its international expansion. With the acquisition of its South Korean licensee in January, it now has most of Asia under its direct control, with 44 stores and 503 concession shops. In its third quarter conference call, President Roger Farah suggested that it has all kinds of opportunities in the region beyond traditional menswear including accessories, handbags, watches and jewelry. Current Asian operations are very modest in scope, representing just 9.2% of overall revenues. In five years, its Asian revenues should rival those in Europe.
Both its retail store network and its e-commerce businesses are doing fabulously. Same-store sales in the third quarter grew 15%, while RalphLauren.com experienced a 33% increase in revenues. The website continues to gain traction. In 2010, it averaged 3.5 million unique visitors each month, generating 390,000 new customers to go along with 1.7 million existing customers. Yet, its online sales represent no more than 5% of its overall revenues. Williams-Sonoma's (NYSE:WSM) are over 40%, so you can see the tremendous potential here. As for its retail stores, operating margins have never been higher. In Q3, they were 280 basis points higher at 18.6%, a record for the third quarter. Other retailers might be having a problem with cotton prices, but not Ralph.
The Bottom Line
Some pundits worry about Ralph Lauren after Ralph is gone, much like those who worry about Berkshire Hathaway after Warren Buffett goes to the big stock market in the sky. Ralph Lauren is 70. That's young these days, so shareholders likely won't have to worry for a few years. Whenever this happens, you can be sure it'll be even stronger than it is today. It's much ado about nothing. If you like apparel, this has to be in your portfolio. (For related reading, also take a look at Analyzing Retail Stocks.)
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