Decision to Grant Money in Debt to PVH Corporation - Case Study Example

James Watson, Investment Executive inserts his/her Researcher August 13, Decision to grant ?20m in debtto PVH Corp. PVH is responsible for the designing, production and sourcing of apparel for men, women and children. These products are then marketed on a wholesale basis through intermediaries (retailers) such as department stores as well as directly to the customers through the company’s retail outlets. The types of apparel offered include formal shirts, sports and neckwear along with shoes. The company mainly operates in Asia, Europe and North America with its headquarters in New York. Research and analysis has shown that PVH currently has high level of debt and interest payments which is reflected in its high debt-to-equity ratio (showing that the company is highly geared). Furthermore, the company has a relatively small, concentrated customer base, intense competition which could lead to volatility in earnings and an underfunded pension plan. Therefore, it is increasingly important for PVH to secure its market position and reduce its dependence on debt rather than increasing it. Discussion Liquidity It is important to analyze the financial liquidity of PVH in order to ascertain its ability to take on more debt. The current ratio of a company reflects its ability to take on short term debts or debts within a period of 12 months (Baker & Powell, 2005). Usually a current ratio of PVH’s current ratio is 2.39 (NASDAQ, 2013) which reflects that for every $2.39 of current assets, the company has $1 of current liabilities. Normally, companies having a current ratio over 1 are considered to have strong liquidity position or ability to pay off short term debts (Weil et al., 2012). This is visible in the case of PVH. Although the short term liquidity of PVH seems to be high (as indicated in the research), its long term liquidity remains very weak. Furthermore, the high current ratio may not be a good indication as a review of PVH’s Balance Sheet shows that majority of its current assets (almost a third of the dollar value) are tied up in inventory which indicates a major problem. This is because inventory may take time to convert to cash and may, therefore, negatively affect the company’s ability to pay off its short term liabilities (Ross et al., 2012). Therefore, the high liquidity indicated by the high current ratio may, in effect, be insignificant because of too much inventory being held. Furthermore, PVH’s cash flow statement indicates a positive operating cash flow of 453m which, in itself (Yahoo! Finance, 2013), indicates a high level of cash availability and liquidity. However, the relevant figure in this case is not operating cash flow but levered free cash flow as the latter takes interest on debt into account. In short, levered free cash flow indicates a cash position of a firm after it pays off the interest on its debt (Penman, 2009) . This is a negative value (-45m) for PVH (Yahoo! Finance, 2013) which indicates high interest payments and suggests that the cash generated may not be sufficient to ensure continuity of the business in future. Debt position PVH’s financial position indicates an already high level of long term debt as a percentage of its total liabilities (roughly 58%). Furthermore, it is important to understand the financial leverage of PVH in order to further determine its ability take on the additional ?20 million. This is explained by the total debt to equity ratio which describes the relative proportion of debt and equity that the firm uses for financing its assets (Heitger et al., 2008). A higher ratio typically suggests an aggressive growth strategy with the effect of increased earnings, albeit often with high interest charges. Normally, a debt-to-equity ratio over 20% is not considered a healthy sign (NASDAQ, 2013). The total debt to equity ratio of PVH is very high (108.65) which suggests that the company is highly geared (NASDAQ, 2013). This already high debt indicates the high interest charges that could lead to PVH’s bankruptcy in future if not compensated through higher earnings. Revenues and customer base Although the financial position of PVH is extremely important in determining its ability to take on additional debt, its branding and competitive position is just as important to analyze. PVH corp. has several successful brands under its umbrella such as Calvin Klein, Tommy Hilfiger, Van Heusen, ARROW, IZOD and Bass with other licensed brands including Michael Kors, DKNY, Nautica and others (MarketLine, 2012). The company can, therefore, leverage its brand equity to take on the additional debt of ?20 million despite its currently weak long term liquidity position. Furthermore, the financial performance of the company as indicated by its net income and growth rates has been very strong. The revenues have almost doubled by 57% from 2010 to 2012. Net profit has also demonstrated a 40% increase in the same period (MarketLine, 2012). This strong financial performance of PVH has enhanced the investor confidence. The strong shareholder support could, therefore, act as a major facilitator in the process of getting the additional debt of ?20 million as this money is estimated to be used for expanding the company’s operations (opening new stores). Paradoxically, the revenues and profitability of PVH are highly risky because of a highly concentrated customer base. 5 customers contribute to almost a fifth of the company’s revenues (DATAMONITOR, 2011). There is also a lack of long term contracts with these customers with high volatility in orders which could stop anytime. Given this high level of uncertainty, the profitability of the company could weaken, reducing its ability to bear the burden of interest charges (in addition to the already high interest charges) accompanying the new debt. Underfunded pension plan On the other hand, the underfunded pension plans of PVH strongly go against the decision to obtain additional debt. These pensions are being provided for certain employees that are unionized. As of last year, the company’s pension fund liability stood at $399.3 million which was $130.8 million higher than the fair value of its assets (MarketLine, 2012). This underfunded state of the pension fund obligation of PVH means that it shall be required to make contributions in future to maintain the required levels of funding (MarketLine, 2012). This shall further constrain the financial liquidity of the firm by reducing the amount available for the working capital as well as capital expenditure. Competitive pressure The company also faces serious threats from its external environment including that of competitors and counterfeit products. Since PVH deals with various price points and a diverse range of customers, it faces threat from both small and big rivals. From Giorgio Armani, Gucci, Prada, Burberry and Lacoste to Perry Elis and Ralph Lauren, the company faces intense competition since it is part of the apparel industry which has changing fashions and variety of methods for retailing (DATAMONITOR, 2011). Failing to cope with competition could negatively impact the corporation’s profitability and, therefore, its ability to pay off debts in future. Furthermore, PVH faces strong competition from counterfeit products specially for its Calvin Klein and Tommy Hilfiger brands as these are priced relatively high (PVH Corp., 2011). Furthermore, the global economic downturn has made low-cost products attractive to suit the small budgets of most customers. Not only can these low-quality counterfeits directly reduce PVH’s sale of high-priced products (and reduce its market share) by making the lower-priced alternatives attractive but also indirectly negatively affect its brand image (PVH Corp., 2011) Rising cost of production (expenses) In recent years, the cost of production in U.S has risen due to soaring labor costs primarily owing to rising healthcare and increase in salaries and wages. The government’s policy to increase the minimum labor wages along with increased overtime has led to high costs of labor for PVH. With approximately 25,700 workers and major operations in the U.S (Plunkett Research, 2013), these high labor costs could shrink the profit margins of the company. On the other hand, the total executive compensation for PVH has been declining since 2010 and stood at $29.77 million in 2012 as opposed to $49.62 million in 2010 (Morningstar, Inc., 2012). At the same time, however, the company’s stock price has shown as a steady increase and stock options offered to PVH’s directors have substantially increased. The overall compensation of CEOs at PVH has increased by an astounding 46% which is only slightly higher than the stock return (57%) (Morningstar, Inc., 2012). Although base salaries remain unchanged, the high level of stock options could actually have a positive impact on the corporation’s taxable income. Profits could increase as high stock option deductions lower the taxable income. This saving could be used to finance the high level of interest charges after the new debt. Limitation Nevertheless, a major weakness of existing literature on PVH is that it does not point to the prospective earnings from the two new stores that would be built in London with the help of the additional ?20 million. The payback period of this investment needs to be calculated to determine when exactly the cost of this new debt would be recovered. Information regarding the cash flow generated from the two new stores is, therefore, required for the decision to be made. In lieu of the above, it is recommended that the investment bank does not grant new debt in ?20 million to PVH considering that it is highly geared and has an already high interest expense. The debt to equity ratio of 108 indicates that majority of the company’s operations are being financed by debt which suggests that a condition of bankruptcy can arise if the company is unable to pay off its debts. Furthermore, considering that there is high variability in earnings, the risk of defaulting can increase especially if sales fall due to influx of cheap, low-quality counterfeits as well as direct competitors. Also, the corporation is relying on a concentrated customer base which could reduce regularity in earnings. Most importantly, the company has an underfunded pension plan which shall require large contribution by PVH in future and reduce the funds available for paying off its debt obligations. Adding to this is the negative levered free cash flow is already an alarming sign as the company already has high level of interest expense. References Baker, H.K. & Powell, G., 2005. Understanding Financial Management: A Practical Guide. Oxford: Blackwell Publishing. DATAMONITOR, 2011. Company Profile: PVH Corp. London: DATAMONITOR DATAMONITOR. Heitger, D.L., Mowen, M.M. & Hansen, D.R., 2008. Fundamental Cornerstones of Managerial Accounting. Mason: Thomson: Southwestern. MarketLine, 2012. Company Profile: PVH Corp. London: MarketLine MarketLine. Morningstar, Inc., 2012. PVH Corp. [Online] Available at: HYPERLINK "http://insiders.morningstar.com/trading/executive-compensation.action?t=PVH" http://insiders.morningstar.com/trading/executive-compensation.action?t=PVH [Accessed 12 August 2013]. NASDAQ, 2013. David Dreman Guru Analysis for PVH Corp. [Online] Available at: HYPERLINK "http://www.nasdaq.com/symbol/pvh/guru-analysis/dreman" http://www.nasdaq.com/symbol/pvh/guru-analysis/dreman [Accessed 11 August 2013]. Penman, S.H., 2009. Financial Statement Analysis & Security Valuation. 4th ed. New York: Mc Graw-Hill. Plunkett Research, 2013. PVH CORP: COMPANY PROFILE. [Online] Available at: HYPERLINK "http://www.plunkettresearchonline.com/ResearchCenter/Opencompany.aspx?Industry=4&comid=5458" http://www.plunkettresearchonline.com/ResearchCenter/Opencompany.aspx?Industry=4&comid=5458 [Accessed 12 August 2013]. PVH Corp., 2011. Annual Report 2011. Annual Report. New York: PVH Corp. PVH Corp. Ross, S.A., Westerfield, R. & Jordan, B.D., 2012. Fundamentals of Corporate Finance. 10th ed. New York: McGraw-Hill. Weil, R.L., Schipper, K. & Francis, J., 2012. Financial Accounting: An Introduction to Concepts, Methods and Uses. 14th ed. Mason: Cengage Learning. Yahoo! Finance, 2013. PVH Corp. (PVH) -NYSE. [Online] Available at: HYPERLINK "http://uk.finance.yahoo.com/q/ks?s=PVH" http://uk.finance.yahoo.com/q/ks?s=PVH [Accessed 11 August 2013]. Read More