Holly Fashion

cASE 6 HOLLY FASHIONS sess I O A N A LYSI S Billion-dollal a pparel c ompanies s uch a s C alvin K lein a nd L iz C laiborne a re unusual i n t he g arment i ndustry, w hich c onsists p rimarily o f m uch s malier apparel m akers. O ne s uch f irm i s H olly F ashions ( HF), l ocated i n C herry F lill, freshly J eriey. H F w as s t impostureed 1 4 y spikes a go b y W illiam H amilton a nd J ohn W hite, who b etween t hem h ad o ver 2 5yearso f e xperiencew ith a m ajor g arment m anufacturer.A nd t he p artnership i nitially b lended v ery w ell. H amilton, r eserved and i ntrospective, i s e xtremely c reative w ith a r eal f lair f or m erchandising a nd trend s potting. M ainly a s a r esult o f h is g enius, t he H F l abel i s s ynonymous with q uality a nd tn f ashions. h ite, o Utgoing a nd f orceful, h as c ontri only ifed important m erchandising a nd m arketing i deas, b ut h as m ainly a ssumed t he duties o f t he f irms c hief o perating o fficer.Hamilton h as h ad l ittle i nterest i n t he f inancial a spectso f t he c ompany, m uch preferring t o w ork o n d esigning n ew f ashions a nd t he d evelopment o f m arketing s trategies. A f ew m onths a go, h owever, h e d ecided t put on h e h ad b etter become m ore i nvolved w ith t hd c ompanys f inancials. His m otivation i s t wofold. F irst, h e i s c onsidering t he s ale o f h is 5 0 p ercent interest i n H F. T hough h e m joys t he c reative s ide o f t he b usiness,h e i s t ired o f the c ash c runches t hat t he f irm h as e xperiencedi n r ecent y ears.P eriodically, t he retailers H F d eals w ith h ave e ncountered f inancial p loblems a nd h ave s tlung out t heir p ayments, w hich o f ex c a designd a m ad s cramble f or c ash a t H F A nd i f Hamilton d ecides t o s ell, h e k nows t hat h e i s l ikely t o b e i nvolved i n s ome stressful n egotiations s urrounding t he c ompanys v a1ue. T hough h e w ould h ire a c onsultant t o a id h im i n a ny,negotiations,h e d ecid es i t i s a g ood i dea t o e ducate h imself a bout H Fs f inancials.Another r eason t hat H amilton i s i nterested i n t he f irms f inancials i s s o h e can b etter j udge t he m anagerial c ompetence o f l Alhite. Ahen I IF w as s mall Hamilton t hought W hite d id a f ine j ob, b ut n ow h e w onders w hether / hite i s capable o f r unning a f irm a s l arge a s H F. A ctually, i f H amilton w ere c onvinced that W hite i s a c ompetent m anager, h e w ould n ot c onsider s elling o ut s ince h e 36 PARTI I F INANCIALA NALYSIS genuinely e ntoys b eing a n o wner o f a n a pparel f irm.B ut h e t hinks t he a pparel labor w ill f ace e ven t ougher t imes i n t he n ext f ew y ears, a nd w onders i f ltrhite i s t alented e nough t o s uccessfullym eet t hese c hallenges. BORROWING CONCEB. NS A4rites p ersonality i s s uch t hat h e m akes v irtually a ll m ajor o perating a nd financial d ecisions. A n i mportant e xample o f t his w as h is d ecision t hree y ears agone t o r etire a ll l ong-term d ebt/ a m ove t riggered b y W hites f ear t hat H Fs b usiness r isk w as i ncreasing.H e c ited t he d ifficulties o f s eemingly r ock-solid r etailers l ike B loomingdales a nd C ampeau t o s upport h is c laim. I M-Lite i s a lso concerned t hat f irms t he s ize o f H F h ave h ad d ifficulty m aintaining s table b ank relationships. D ue t o i ncreasingly s trict f ederal r egulations, s ome b anks h ave called i n l oans a t t he s lightest t echnicality, a nd m ost a re s crutinizing n ew b usiness l oans v ery c arefully. C onsequently W hite v iews b ank d ebt f inancing a s unreliable a nd t hinks t hat l oan o fficers a re c apable o f chewing u p m y t ime. Harnilton isnt sure what to make of these arguments, but he is concerned that this debt avoidance has significantly reduced FIFs financial flexibleness because it means that all protects will have to be equity financed. In fact, over the past five years t here h ave b een n o d ividen ds b ecausea ll e arnings h ave b een r einvested. And two years ago each of the partners had to founder $15,000of capital in order to m eet t he c ompanys c ashn eeds. A nother i nfusion o f c apital m ay b e n ecessary sincet he f irms p resentc ashp osition i s l ow b y h istorical s tandards. ( imbibe xhibit 2 . E More j mportantly, h owever, H amilton f eels t hat t he c ompany i s n ot b enefiting f rom t he l everage e ffect o f d ebt f inancing, a nd t hat t his h urts t he p rofitabiiity o f t he f lrm t o t he t wo o whers. WORKING CAPITAL CONCERNS Hamilton s uspectst hat F Fsi nventory i s excessive a nd t hat capital i s u nnecessarily t ied u p i n i nventory. n/hites p osition i s t hat a l arge i nventory i s n ecessary t o p rovide s peedy d elivery t o c ustomers. H e a rgues t hat our c ustomers expect q uick s ervice a nd a l arge i nventory h elps u s t o p rovide i t. Hamilton is skeptical of this argument and wonders if there isnt a mole efficient w ay o f p roviding q uicker s ewice. H e k nows t hat a c onsultant r ecommended t hat H I very s eriously c onsiderb uilding a s tate-of-the-artd istribution center. T he p roposed f acility w ould a liow F F t o r educe i nventory a ld a lso handle big orders from retailers such as Kmart and Wal-Mart. VVhite rejected the suggestion a rguing t hat t he e sttnated $ S-million t o $ 8-mi11ion ost i s e xcessive. c Hamiiton a lso q uestions / hites c redit s tandards a nd c ollection p rocedures.Hamilton t hinks t hat / hite h as b een q uite g enerous i n g ranting p ayment extensions t o c ustomers, a nd a t o ne p oint n early 4 0 p ercent o f t he c ompanys receivablesw ere m ore t han 9 0davs o verdue. F urther. / hite w ould c ontinue t o . C ASE6 H OLLYF ASHIONS 37 accept and ship orders to these qetailers eyen when it was clear that their skill t o p ay w as m arginal. l hites p osition i s t hat. he d oesnt w ant t o l ose s ales and that the rough multiplication these reta ilers face are only temporary. Hamilton also wonders about the wisdom of departure up job discounts. HF is frequently offered terms ol 1. 1. 0, net 30. That is, the ships company receives a l-percent discount if a bill is paid in ten days and in any event full payment is anticipate within 30 days. ffiite rarely takes these discounts because he wants t o h old o nto o ur c ash a s l ong a s p ossible. H e a lso n otes t hat the d iscount isnt especially generous emd 99 percent of the bill must still be paid. FINAL THOUGHTS disrespect ill of Hamiltons concems, however, the retationship between the two partners has been relatively smooth over the years. And Hamilton admits that he may be unduly critical of yhites management decisions. After al1,he concedes, the m an s eems t o h ave r easonsf or w hat h e d oes, a rd w e h ave b een i n the black either year since we started, which is an impressive record, really, for a f um i n o ur b usiness. Further, Hamilton has discuss ed with two condultants the possibility of selling his half(a) of the firm. Since FIF is not in public traded, the market value of the companys s tock m ust b e e stimated. T hesec onsultants b elieve t hat H F i s w orth between $55 and $55 per share, figures that seem instead good to Hamilton. QUESTIONS 1 Calculate the firms 1995proportions listed in Exhibit 3. . P art o f H amiltons e valuationw ill c onsisto f c omparingt he f irms r atios t o . the perseverance numbers shown in Exhibit 3. (a) Discuss the limitations of such a comparative financial analysis. (b) In view of these limitations, why are such industry comparisons so frequentlym ade? 3, Hamilton thinks thai the profitability of the firm to the owners hasbeenhurt by Whites reluctanceto use ftuch inteiest-bearing debt. Is this a reasonable determine? E xplain. 4. The case mentions that hite rarely takes trade discounts, which are typically 1 /10, n et 3 0.D oest his s eeml ike a w ise f inancialm ove? E xplain. 5. C alculatet he c ompanysm arket-to-book dV/BV) r atio. ( Therea re 5 ,000 O shares f c ommons tock. ) o 6. Hamiltons property is that White has not competently managed the firm. Defend this position using your foregoing an. swers nd other information in a the c ase. 38 PARTII FINANCIAL ANALYSIS 7. Vyhites position is that he has effectively managed the firm. Defend this position using your previous answers and other information in the case. 8. Play the place of an arbitratoi.Is it possible based on an examination of the firms r atios a nd o ther i nformation i n t he c aset o a ssessW hites m anagerial competmce? Defend your position. 9. ( a) A re t he r atios y ou c alculited b ased o n m arket o r b ook v alues? E xplain. (b) W ould y ou p refer r atios b ased o n m arket c ir b ook v alues? E xplain. screening 1 Holly F ashionsI ncome S tatements1 993-1996 ( 000s) 1993 Sales Costo f g oods Grossmargin Adrrinistrative Dq)reciation EBIT lnterest EBT Taxes Net income 1994 1995 1996 $985. 0 748. 6 236. 4 169. 4 10. 8 56. 1 7. O 49. 1 19. 7 $1,040. 0 n4. $1,236. 0 $1,305. 0 978. 8 202. 8 1 14 51. 0 4t. 0 18. 0 $27. 0 a7a, 307. 8 236,I 13. 6 58. 1 53. 1 21. 7 _-$3L9 249. 3 14 4 62. 6 58. 5 23. 5 ___$99 EXHIBIT 2 BalanceS heetso t he H olly F ashionsC ompany f 993-1996 ( 000s) 1993 ASSETS Cash $40. 4 Receivables r53. 2 Inventory 117. 0 5. 9 Other cwrent Current assets u. 8 Grossf ixed Accumulaied disparagement (12. 0) 32. 8 Net fixed Totala ssets $349. 3 1994 1995 1996 $s1. 9 158. 9 121. 1 6. 2 338. 0 58. 9 (23. 4) __35t $38. 6 t75. 1 $10. 6 224. 8 19L. 9 7. 8 435. 1 96. 4 (s1. 4) 45. 0 $480. 1 193. 4 7. 4 414. 5 78. 1. _al continued) C ASE6 H OLLYF ASHIONS 39 EXHIBIT 2 (Contirwed) t993 LIABLITIES & NET WORTH Accounts payable Debt due Accruals Current liabilities Long-term debt reciprocal s tock Retained e arnings Total L &NW $53. 8 10. 0 1 9. 7 , 8 3. 5 60. 0 150_0 1994 1995 r996 $v. f $85. 2 10. 0 24. 7 120. 9 40. 0 180. 0 114. 6 $u. 2 10. 0 26. L 120. 3 30. 0 180. 0 149. 8 $48q. 1 10. 0 26. 0 90. 7 50. 0 150. 0 82. 8 $349. 3 $455t EXHIBIT 3 Financial R atios ot t hb H olly F ashionsC ompany 1 993-1996 Ind*r11 (Presen r993 r994 1995. 3. 7 3. 4 2. 6 L7 1. 8 1. 3 1. 6 .8 r996 1993-19961. Liquidity RatiosCurlent Quick Leverage atios R Deb(%) 41.. 1 37. 7 35. 3 8. 0 8. 5 11. 6 6. 4 6. 4 4. 8 FixedA sset Turnover 30. 0 29. 3 30. 1 TotalA sset Turnovet 2. 8 2. 8 2. 7 Timesinterest eamed Activity Ratios lnventory Tulnover (CGS) 47 57 71 3. 9 1. 3 8. 1 6. 0 40 25 72 3. 5 2. 8 2. 0 (continued) P ARTI I F INANCIALA NALYSIS DGIIBIT 3 (Conrinued) Ifld r) 1993 1994 1995 AverageCollection Period old age Pulchases Outstanding** (Present) 1996 1993-1996+ 50 68 18 31 25 32 earnabilityR atios M Gross argin ( %) 24. 0 25. 5 24. 9 Net Profit Margin (%) 3. 0 2. 6 2. 6 Return on virtue (%) 14. 3 11. 6 0. 8 8. 4 7. 2 7. 0 5. 8 6. 0 6. L Retum on Total ( Assets %) Operating Margin*** (%) 26 3. 1 1. 2 27. 3 19. 5 7. 8 11. 8 8. 7 9. 9 7. 2 3. 1 iThe thre numbers for each ratio arc comPuted in the following wsy. Ratios for all firms in dre indushy are arrange in what is considerd a strontest-to-weakest order The middle number rePlsenis the median ratioj that is, half the firms in the industry had mtios better than the median ratio and half had ratios that wer worse The top nunlber represents the uPPer qua4ile figure meaning 25 Pelcent of the firms had ratios befter tlran this.The disappoint number represents the lowest quaftile, that is, 25 Percent of the firms had ratios worse than this. *This shows the average lentth of clock time that trade debt is ouhtandint. AIso caled the averate Paymeni Period. Calculated is A /P ( CGS/360). 1**Calculateda s ( EBIT + D ep)/Sales.