Kate Spade & Co - Financial Operations Analysis - Research Paper Example

Kate Spade & Co: Financial Operations Analysis of Kate Spade & Co: Financial Operations Analysis Introduction: Kate Spade & Co. was established in Manhattan in 1976. It is a fashion company that offers a wide variety of man and woman apparel, accessories and fragrance items under the brand name of Kate Spade New York and Jake Spade Labels. In 2012, the company had three brands – Juicy Couture, Kate Spade, and Lucky Jeans brand. In October 2013, the company sold Juicy Couture Brand and in December sold the Lucky Brand Jeans and shifted its focus entirely to the sole brand Kate Spade. The company was renamed as a Fifth & Pacific Co. in 2012 but changed to Kate Spade & Co. in February 2014, to reflect the brand image of the company (Our Company - Kate Spade & Co., 2015) Weighted Average Cost of Capital: Weighted average cost of capital is the cost of capital of the firm. It is the rate that the company is expected to pay in order to finance its assets. It is calculated by multiplying each source of finance by their relevant weight and then adding up the product of all these sources (Weighted Average Cost of Capital, 2015). Formula of Weighted Average Cost of Capital (WACC): WACC = E / (E + D) * Cost of Equity + D / (E + D) * Cost of Debt * (1 - Tax Rate) 1. Weights: Market capitalization (E) = $4,366.5 Million. Average Short term debt = $38.07 average long term debt = $395.5 Book value of Debt (D) = $ 433.6 Total weight of equity = E / (E + D) = 4366.5 / (4366.5+ 433.6) = 0.9097 Total weight of debt = D / (E + D) = 433.6 / (4366.5 + 433.619) = 0.0903 2. Cost of Equity: Cost of Equity = Risk - Free Rate of Return + Beta of Asset * (Expected Return of the Market - Risk-Free Rate of Return) Current risk-free rate = 1.89% (10 Year Treasury Rate, 2015) Beta is the sensitivity of the expected excess asset returns to the expected excess market returns. Beta = 1.87. Expected Return of the Market - Risk-Free Rate of Return = 7.5%. (It is also called market premium.) Total Cost of Equity = 1.89% + 1.87 * 7.5% = 15.91% 3. Cost of Debt: Cost of debt = Interest expense / average debt Interest Expense for 31 December 2014 = $0 million Total Book Value of Debt (D) = $433.6 Million Cost of Debt = 0 / 433.619 = 0%. 4. Average Tax Rate: Two-year Average Tax Rate = 557.49%. Kate Spade & Co.s Weighted Average Cost of Capital (WACC) for could be calculated as: Formula of Weighted Average Cost of Capital (WACC): WACC = E / (E + D) * Cost of Equity + D / (E + D) * Cost of Debt * (1 - Tax Rate) = 0.9097 * 15.915% + 0.0903 * 0% * (1 - 557.49%) WACC = 14.48% Returns on investment of the company must be higher than the cost of capital. It increases the growth of the company and overall profitability. The Higher cost of capital results in loss of capital and decrease in growth over time. Return on investment of Kate Spade is 24.5% while its cost of capital is 14.48%. It means that the company is generating higher returns on capital than the cost required to generate that capital. It indicates that the future growth of the company is positive. International risks and their Impacts: • Declining economic conditions and instability in economic markets in Asia and Europe can significantly affect the consumers’ confidence and may lead to a decline in consumer purchases of fashion and related products. Global economic condition after the recession of 2008 have resulted in unemployment and declining consumer confidence which in turn have led to a decline in consumer spending, specifically of those goods which represents discretionary purchases including fashion related products. Significant declines in revenue were experienced by the company and it is likely that consumption patterns and habits of consumers have changed as a result of recession, and this may continue to affect the revenues of the company for a foreseeable future. If the global economy will not recover and continue to decline further, it will have a negative impact on long-term revenues, operating margin and earnings in international segments of the company. • Economic conditions have also forced the company to enter into a promotional environment, and both wholesale, and retail consumers are having pressure to increase discounts on sales. It had a negative impact on the company’s profitability. Additionally, international political situation and threats, terrorism and military conflicts in those countries where the company has its operations are resulting in a decline in consumer confidence and spending. There is a risk that these situations will have a material impact on the business, liquidity and financial condition of the company. • Changes in global climatic conditions may have an impact on the availability and prices of raw materials. Additionally, changes in the prices of marketing, labor and transportation may change as a result of legislation associated with climatic conditions. These factors may have a significant impact on the cost of sales of the company, and there is a risk that the company will not be able to pass these higher prices on to consumers. • Kate Spade has acquired and developed new product lines in international markets over time. Such acquisitions and developments include licensing arrangements and implementation of new business models. There are risks associated with such activities such as: • The company may fail to identify and explore business opportunities, new markets and growth in new markets where the company has the intention to initiate its operations such as India, Brazil, Russia and Asia. • New business models and new international markets have different methods of operations and different investment, marketing, and financial strategies from those incorporated in home operations. Buyers, both wholesalers, and consumers, may be different and have different buying behavior as compared to local buyers. • The company may fail to generate anticipated revenue, income and return on investment in new markets and for new product lines. Furthermore, the company may face unexpected events and uncertain liabilities. All these factors can have a material effect on the financial and operational activities of the business. It may be unable to deliver the level of performance, which is expected from its brand image and hence may destroy its goodwill. • International markets, where the company is initiating its business, have different laws and regulations. There is a risk that the company may fail to comply with those regulations, which may result in the company facing heavy penalties and legal costs. The non–compliance may also have an impact on the goodwill of the business internationally. • Costs of entering new markets may be miscalculated, or there may be unanticipated costs in launching the business. It may have a significant impact on the budgeted investments of the company, which the company may fail to meet. • There is a risk that the company may fail to attain the licenses in foreign markets to launch new products and product lines. • There is a risk that the company may fail to successfully develop new product lines in new international markets. • The fashion industry is largely dependent on the discretionary expenditures of consumers and is subject to changes in taste and fashion of consumers. Success of the company is also dependent upon the expansion of its operations in foreign markets and successfully developing product range that is according to the choice and culture of customers in those markets such as in India and Russia. Choice of consumers, due to different cultures and ethnicity, may not be similar to the home market and therefore the taste and fashion of consumers abroad cannot be predicted accurately and there is a risk that the company may fail to deliver the desired product range. • Hiring home managers in international markets may include a risk that they may not get along with the local working environment and market conditions. On the other hand, there is also a risk in hiring local managers that they may not be aware of the head office philosophy and may not be able to work according to company’s policies. • The company may face risk in possession of its trademarks in other countries. Other companies may enforce their right or claim to the trademarks or other proprietary rights of the company and it may require the company to make significant monetary payments to resolve those conflicts or, the company may, fail to resolve those conflicts altogether. • Foreign markets are subject to high competition, and some of the company’s competitor may be larger and may have better technological, financial, manufacturing, sales and marketing and distribution resources as compared to the Kate Spade. Such resources and easier access to debt financing of those competitors may enable them to respond more quickly to changes in demand and develop new products more quickly in response to changes in taste and fashion of consumers. Such competitors may also have better ability to survive in the recessionary and off-season periods. • There is the general availability of contractors and agents in the fashion industry due to which new entrants have easier access to the markets in which company operates. It may impact significantly on the competitive position of the company and overall business. Company may also be forced to reduce the prices and increase discounts and promotions, which may adversely impact the financial position of the company. • Kate Spade relies heavily on foreign manufactures for the production of their products. Delay or loss may be caused by foreign production facilities, which may be harmful to the reputation of the company. Kate Spade does not own any manufacturing facilities, and foreign suppliers manufacture its products. The company has manufacturing contracts with 230 suppliers in 17 countries out of which majority of suppliers are from Asia. In case of supplier’s delay in delivery or failure to manufacture the product on the timely basis or inability to meet the company’s quality standard could cause harm to the company’s operations. Company may be unable to deliver product on a timely basis to their customers who may then cancel orders or demand for reduction in prices. It could significantly harm the reputation of the company. Manufacturers could also fail to comply with the safety and quality standards regulations, which may result in the legal claims. • International sourcing operations of the company are characterized by the risk relating to imports and exports. There may be risks as give below: 1. US may impose quotas as a retaliatory measure for the goods that are imported by the company. 2. Embargoes, duties, and additional taxes may be imposed on the imports or exports, which may affect the company. 3. International trade agreements between US and other countries may expire, or new legislation may be activated which may result in quotas or other trade sanctions. It may have a significant impact on the cost of goods purchased from abroad. 4. Economic and political conditions of the countries from where the company imports their products, or terrorist acts in such countries, may result in the disturbance of trade with foreign suppliers. Management Response to Risk: The company provides the manufacturers with standards that they should comply with in manufacturing process. Manufacturers are also required by the company to comply with the laws and regulations prevalent in their operations. In addition, the company employs testing and monitors process on their behalf to address safety and content issues. The company makes advance commitments to ensure the availability of products and to reduce the risk of late deliveries and possible delay or loss in transportation. These advance commitments are made before receipt of any order from customers, and it keeps the company ready to deliver in a timely manner. It is the company policy to keep inventory well in advance to secure the position while minimizing the risk associated with excess inventories. In order to reduce the risk associated with foreign currency fluctuations, the company hedges the risk by using foreign currency collars, forward contracts and swap contracts (Cole & Obstfeld, 1991). Currency Risk and Management: Kate Spade import majority of its products from foreign suppliers and changes in the value of currencies in those countries may have an impact on the cost of products imported from such countries. Currency exchange rate can impact US Dollar value relative to foreign currency denominated prices at which company conducts its business. Changes in the foreign exchange rate may have a significant impact on international sales, a/c receivables and inventory held abroad. Hedging is the management strategy used to reduce the risk of fluctuations in the price of commodities, currency or other assets (Hedging, 2015). Kate Spade addresses the risk of currency fluctuations by hedging the currency. The company uses foreign currency collars, forward contracts and swap contracts to hedge the variability in cash flows particularly those, which are associated with inventory purchases from Japan. In December 2013, the company had entered into forward contracts, which were to mature by December 2014 to sell 2.1 billion yen $21.1 million. The company to manage currency risk connected to intercompany loans uses foreign currency forward contracts. In December 2013, the company had forward contracts to sell 4 billion yen for $38.4 million, which were to mature on March 2014. The company had a transaction gain of $1 million in 2012 and $38.4 million in 2013 related to those derivative instruments. These gains are reflected in the other net income. The company sold 81.25% interest of Global Mexx business on 31st October 2011. The Purchase consideration of this sale was designated as the hedge in euro – denominated functional currency subsidiaries. These hedges were de designated by the company. In order to reduce risks associated with Tender Offer, the company entered into forward contracts to sell $182 million for €128 million, which was settled in 2011. The company also entered into forward contracts of non–hedging derivative instruments to sell $415.7 million. These instruments were to expire in July 2011. The company made a gain of $2.5 million from these instruments, which are shown in the net income for the year ended December 31, 2011. On December 2013, the company had forward contracts of $59.5 million in which the company had unrealized gains of $0.9 million. Net foreign currency transaction losses of the company are as follows: Year ended December 31st 2013 Year ended December 31st 2012 Foreign Currency transaction losses $9328 $1532 Sources of funds: Year ended December 28th 2013 Year ended December 29th 2012 6% convertible notes - 18287 10.5% senior secured notes 382209 383662 Revolving credit facility 2997 Capital lease obligations 8995 4345 Short term borrowings (3407) (22632) Long term debts $390794 $383662 Stakeholder’s deficit $32482 $126930 Total liabilities and stakeholders deficit $977511 $902523 (Annual Report: Kate Spade & Co., 2013; Annual Report: Kate Spade & Co., 2012) Evaluation of sources of funds: 10.5% secured notes: The Company used $219.9 million received from the issuance of 10.5% senior secured notes to obtain a tender offer for repurchasing of 128.5 million euro of company’s outstanding euro notes. The company to fund general business purposes uses remaining proceeds of secured notes. Net proceeds from the additional notes, obtained from offering on June 2012, were used to repay borrowings under amended facility and to fund the redemption of €52.9 million principle of Euro notes on July 2012. The company received net proceeds of $125 million from the sale of Juicy couture IP. These proceeds could be used by the company for any purpose they deem fit and are not subject to any condition by Senior notes indenture. The company intends to use these proceeds for the payment of various transition and transaction cost and for other general business purposes, which also include debt reduction. Amended Facility: In November 2013, the company amended the amended facility to sale the Juicy Couture IP. On February 2014, the company amended the amended facility to sell the LUCKY BRAND of the business. The amended facility allows the company to borrow the amount, which is lesser of $350 million and a borrowing base, which is computed monthly. The amended facility included the sub-facility of $55 million, multicurrency sub-facility of $100 million and the option to expand the facility further by $100 million. The amended facility also includes the availability of $200 million to issue the letter of credit. However, the company is restricted by the Amended Facility to take loans, issue dividends or enter into merger, consolidation or liquidation arrangements. The company is also restricted to make investments or sell assets subject to certain exceptions. The company forecasts that borrowing facility availability under the amended facility will be sufficient to fund liquidity requirements for next 12 months at least. Convertible notes: The company issued convertible notes on June 2009, which bore interest at the rate of 65 per annum. These notes were matured on June 2014. Net proceeds from the issuance of notes were used to repay $86.6 million of borrowings that were outstanding under the amended facility. In 2012, note holders entered into an agreement with the company to convert convertible notes into shares of the company. Till December 2013, all the convertible notes were converted into the common stock and there are now no further outstanding convertible notes. The capital structure of the company depends heavily on external borrowing, and it is therefore considered to be highly leveraged and as a consequence the company is bearing the high-interest cost. Furthermore, restrictions are also imposed by the Amended facilities borrowings according to which the company may not enter into any merger or acquisition arrangement and cannot give cash dividends to its shareholders. References 10 Year Treasury Rate. (2015, April 08). Retrieved from http://ycharts.com/indicators/10_year_treasury_rate Annual Report: Kate Spade & Co. (2012). Manhattan: Kate Spade & Co. (2013). Annual Report: Kate Spade & Co. (2013). Manhattan: Kate Spade & Co. Cole, H. L., & Obstfeld, M. (1991). Commodity trade and international. Journal of Monetary Economics , 3-24. Hedging. (2015). Retrieved from http://www.businessdictionary.com/definition/hedging.html Our Company – Kate Spade & Co. (2015). Retrieved from http://www.katespadeandcompany.com: http://www.katespadeandcompany.com/web/guest/ourcompany Weighted Average Cost of Capital. (2015). Retrieved from http://www.investopedia.com/terms/w/wacc.asp Read More