Description

Tommy Hilfiger (Ticker: TOM)
May 24, 2005

Disclosure Statement:
This is not a recommendation to buy or sell the stock. We own shares of the company, and we may buy more shares or sell shares at any time.

Investment Overview
Tommy Hilfiger (TOM) is publicly traded apparel company with a tarnished image. With LTM revenues of $1.8 billion, Tommy Hilfiger is one of the largest lifestyle brands in the industry, on par with the core Jones and Liz brands. At $11, the company is trading at 3.6x trailing EBITDA and 11x forward earnings, or 9x forward earnings if you back out the $2.19/share in net cash on the balance sheet. In comparison, Jones Apparel (JNY), Liz Claiborne (LIZ) and Polo Ralph Lauren (RL) are trading at an average of 8x trailing EBITDA and 14x forward earnings. The valuation discount is partially explained by an ongoing US Attorney’s Office tax investigation which could result in a fine of up to several hundred million dollars. However, even incorporating a worst case $300 mm fine (which is much higher than it is likely to be – my estimate is around $200 million), the company would still be trading at 4.9x TTM EBITDA (forward earnings already incorporate a higher tax rate). The remaining discount is explained by the “show-me” attitude the Street has towards the company. Of the ten analysts who currently cover TOM, only one has a buy rating. Six analysts have a hold rating and there are three sells. After years of corporate governance issues and declining revenues, the Street is now waiting for a full turnaround before offering their support. As a result, they have ignored the early signs of a turnaround, which include: 1) revenues are expected to stabilize in the upcoming year, 2) over 50% of the top management has been replaced breathing new life into the firm, 3) door rationalization has been completed which should help reduce the amount of TOM merchandise on the clearance racks, and 4) the announcement of a new strategy to move away from a 60% fashion forward mix to a 20% fashion forward mix. The backdrop for the turnaround is in place, and the results are bound to show improvement over the next year to two years. At worst, the stock is worth $13 as a slowly declining annuity; at best, the stock could close to double as the company successfully turns around its operations and begins to show growth in late 2005 and the first half of 2006.

Company Description/History
Tommy is best known for its sportswear brand which peaked in popularity during the late nineties. By riding a strong fashion trend, TOM grew its revenues from $227 mm in 1994 to almost $2 billion in 2000. During this time, Tommy Hilfiger (Designer and Chairman) and Joel Horowitz (CEO) made a fortune through a variety of related party agreements and extremely generous compensation. Since 2000, the brand has steadily declined in the US, with anemic sales performance and steadily declining margins. The saving grace of the company has been the spectacular growth of its European operations. The brand remains strong and growing in Europe. In an effort to turnaround the company, TOM hired David Dyer to replace Joel Horowitz in late 2003. Dyer is best known as the CEO responsible for fixing Land’s End and selling the company to Sears for 13.8x LTM EBITDA. His arrival at TOM was lauded by the Street, with investors immediately assuming TOM would finally be put up for sale. However, like any CEO, Dyer proclaimed he was there to fix the company, not to sell it. (After all, fixing a company up before you sell it usually gets you a better price.)

Dyer’s first major act was to reduce TOM’s distribution by taking down the number of department store doors where the brand could be found. In reducing distribution, Dyer sacrificed near term performance in the interest of the long run health of the brand and the company. FY ’05 (year ending 3/31/05) revenue growth is expected to be negative high single digits, driven by US wholesale revenues expected to be down in the mid-teens. The Street’s desire for immediate results was left unsatisfied, driving the stock down from a peak of $18 in 2004 to $13. While the investors who purchased the stock at $18 may be no fan of Dyer’s, few who remember their marketing 101 can argue that putting your product where it doesn’t sell enhances brand value. The presence of the brand at low-performing doors, such as Dillard’s, had perhaps been inspired by employment agreements such as Tommy Hilfiger’s (he earns a % of company revenue each year) rather than by good business sense. The rationalization of distribution was needed to reduce the amount of Tommy Hilfiger product on clearance racks at department stores and at off-price retailers such as TJ Maxx and Ross Stores.

In fall 2004, the stock crashed down from $13 to $9 over the course of a month due to a US Attorney’s Office investigation. The exact language is as follows: “Tommy Hilfiger U.S.A., Inc. ("THUSA"), a wholly-owned subsidiary of Tommy Hilfiger Corporation (NYSE: TOM), announced that it received yesterday a grand jury subpoena issued by the U.S. Attorney's Office for the Southern District of New York seeking documents generally relating to THUSA's domestic and/or international buying office commissions since 1990.” Unfortunately for Tommy shareholders prior to September 2004, this particular US Attorney’s Office has as its claim to fame taking on people such as Martha Stewart, Frank Quattrone, and Bernie Ebbers. The long potential liability period also frightened many investors. Despite the subpoena for documents going back to 1990, the most relevant time period is really from FY2001 onwards, since during the nineties, the company was reporting a tax rate in the mid-thirties, in line with its peers. It is only in the past four to five years that TOM has consistently reported a tax rate of 20% or below. If TOM’s tax rate had been 36% since 2001, an extra $140 mm in taxes should have been paid. According to an international tax attorney at a Big 4 firm with whom I discussed discuss potential fines and penalties, they will most likely owe the back taxes plus interest plus a 20% penalty (attorney wasn't clear if the penalty would apply to the interest as well as the back tax amount, but that isn't too material). There are actually 3 possible levels of penalty 20%, 40% and 50%. 50% is for completely egregious all out fraud where proper audit consultation was not employed and it is almost never implemented. 20% is what usually is imposed when a company can prove they acted in good faith and hired reputable auditors and attorneys who blessed their tax strategy. 40% is for cases in-between. Since TOM employed PWC, a very reputable auditor (if such a thing exists anymore), I think they are going to end up at the 20% level. Since I thought the likely back tax amount to be $140-150 million, layering on interest and a 20% penalty gets you to around a $200-220 million fine (depending on assumptions about interest rates). Worthy of note, TOM had $543 mm of cash on its balance sheet as of 12/31/04 ($200 million cash net of debt), so the company can easily afford to pay any tax bill and fine that come its way, and still have plenty of liquidity for operations and perhaps even some tuck-in acquisitions. Even if I was 100% off in my assessment that the fine will be roughly $200 million (which I don’t think I will be), TOM would only have to lever to 1x EBITDA if the fine came in at $400 million – which is an acceptable while not desirable level of leverage.

Despite the tax headache, Dyer has continued to quietly put in place a turnaround strategy for the company. During the last conference call (on 2/2/05), a clear strategy and direction for the company emerged. As opposed to chasing sales in unprofitable areas, Dyer has refocused the company on the concept of selling product profitably. The company is foregoing low return marketing initiatives, such as attending the MAGIC trade show, where fewer of their customers are in attendance each year. Dyer spoke at a February 11, 2005 investor meeting about shifting the merchandise strategy. Going forward, TOM will target 25% replenishment/EDI order business (basic jeans, t-shirts, etc.), 50-60% “fashion predictable” product, and 15-20% fashion forward product. Even the fashion forward items will avoid the riskier trends as the goal is to increase the amount of product selling at or close to full price. This is a change from last year when 60% of TOM’s business was fashion forward, a merchandising strategy which has led to significant markdowns.

Several initiatives over the past couple of months have gone by with little notice from the Street due to the tax overhang. First, over 50% of the senior and mid-level management has been hired since Dyer started. Second, the company acquired the trademarks associated with the Karl Lagerfeld brand. Mr. Lagerfeld is best known as the designer at European luxury brands Chanel and Fendi. TOM plans to develop a line with Mr. Lagerfeld that will reach a broader audience in the US than that of Chanel and Fendi, which are prohibitively expensive for the general population. Third, TOM announced a restructuring of its US operations to right-size them to the current sales base. As a result of this restructuring, 200 people have been fired and an estimated $40 mm in savings will be obtained. Results from this restructuring should be visible in FY2006 (which runs 4/1/05 to 3/31/06). This $40 million in savings will be partially offset by the loss of approximately $60 million of sales and $24 million in gross income associated with the young men’s jeans division, which is being closed. The combined impact of the restructuring and the closure of young men’s jeans should be a little over 12 cents per share in increased earnings (assuming a 30% tax rate), which would be worth $1.35 in stock price at the current forward P/E of 11x. The stock nevertheless barely moved on the restructuring news.

If for some reason the management at TOM fails turn to the company around, investors still have a good chance of making money in this investment through a sale of the company. Valuations of deals in the apparel space have generally been 8-9x EBITDA. 8x EBITDA yields a sale price of $17.50 assuming 100% of net cash goes to back taxes and government fines, and a price of approximately $16.50 if back taxes and government fines come in higher at $300 million. A strategic acquirer could easily pay this price and have it be highly accretive because there would be significant savings in SG&A. It is worth noting that Jones Apparel (JNY) was rumored to be considering a purchase of TOM in 2003. While the recent acquisition binge at JNY makes them a less likely buyer of TOM in the immediate future, there are other potential buyers within the apparel space such as Liz Claiborne (LIZ) and VF Corp (VFC).

It is also conceivable that a private equity firm would consider taking a run at TOM. Because this is not a capital intensive business, and D&A and CapEx have been close to a wash over time, the free cash flows in the business could potentially support a more levered company. Private equity funds remain awash with cash, and they are showing a particular interest in the retail sector specifically, as well as the whole consumer segment more generally. I used to think it was unlikely that a private equity player would want to get involved with a company like TOM because of the concentrated brand risk as well as the risk the US wholesale business is in permanent secular decline. The business also might be perceived to have too much fashion risk. With so much cash floating around in private equity funds, it seems that the willingness to look at more volatile consumer businesses may be increasing, as evidenced by the participation of a major private equity firm in the LBO of Brookstone stores (BKST). In that deal, JW Childs, along with a strategic investor, took private what could be argued is an extremely fad-dependent and hit-driven retailer for a valuation of well over 7x EBITDA. Maybe this was just one possibly dumb deal, or maybe this deal, in conjunction with the bidding wars over TOY (which had some great real estate but was clearly in massive secular decline) and NMG/A (which was clearly a great company but at a very full price with little opportunity for cost-cutting), shows that private equity may be willing to take on more risk on the consumer front than in the past.

Current Valuation

Share Price: $11.00
Shares: 91.3 mm
Market Cap: $1,004 mm
Net Cash: $200 mm
Enterprise Value: $804 mm

TTM EBITDA: $226 mm EV/TTM EBITDA = 3.6x
2005E EBITDA: $200 mm EV/2005 EBITDA = 4.0x
2006E EBITDA: $211 mm EV/2006 EBITDA = 3.8x

2005E EPS: $0.93 P/E – 2005 = 11.8x
2006E EPS $1.00 P/E – 2006 = 11.0x

Fair Valuation

At a 14 P/E (in-line with the peer apparel vendors), the stock should trade $14 (+27%).

If TOM got back to a more normal operating margin of 10%, it would earn about $1.35 at its current sales level. A 10% operating margin compares to an estimated 7.4% TOM operating margin in FY2005, and is well below the 11% reported by LIZ and 14% reported by JNY and RL in calendar year 2004. At 14x $1.35, TOM would trade just under $19 (+73%). Earnings could grow to more than $1.35 either through accretive acquisitions or a return of the core Tommy brand to growth (although that growth would most likely be confined to the single digits).

If TOM were to be bought, an acquirer could easily pay 8x EBITDA and have the acquisition be accretive without even taking the operational synergies into effect, which would be sure to be plentiful. At 8x EBITDA and assuming all the net cash goes to the government, TOM would trade just over $17.50 (+59%).

Catalyst

Catalysts
1) Resolution on tax issue. These issues historically take between 6 and 9 months to resolve. As the issue was announced in September ’04, there could be a resolution announced in mid calendar year 2005.
2) Stable to slightly growing year over year results in the upcoming year (FY2006) which would signal the beginnings of a successful turnaround.
3) An accretive acquisition or a sale of the business. Because of the huge operating synergies realized in apparel industry mergers and acquisitions, and given the underlevered state of its balance sheet, almost any acquisition that TOM considered would be accretive to earnings. TOM itself would be an accretive acquisition for several companies (including LIZ, JNY, and VFC). TOM is one of the few properties out there large enough to “move the needle” for these potential acquirers, who have relied on acquisitions to fuel all their growth over the past decade. Private equity players could also consider an LBO of the company.
4) “The Cut” – a reality series starring Tommy Hilfiger that appears to be a cross between The Apprentice and Project Runway – generates some renewed interest in the brand among US Consumers. I don’t hold out a lot of hope on this being a major catalyst – but you never know (it worked for Trump and they are hoping it will work for Martha). Premieres Thursday, June 8 and 8 PM on CBS. http://www.cbs.com/primetime/the_cut/

Risks
1) Tax settlement could be larger than anticipated, limiting TOM’s ability to make acquisitions.
2) European side of the business could slow as the European consumer continues to be a weak spot for the global footwear and apparel companies, most notably the athletic footwear companies.
3) Retail consolidation, particularly at department stores, leads to pricing pressure for their vendors, including TOM
4) Disappointing FY06 guidance when the company reports 4th quarter earnings on June 15, 2005