Evaluating the true value of a piece of equity in a company, most typically a share of common stock, is a full-time profession for legions of workers in the financial sector and a frequent activity for countless amateur investors, as well. Many methods for such evaluations exist, and an examination of a company's financial records is an all-but-required element of any such attempt. Given the commonality of the practice, it is hardly surprising that formulas for financial analysis and profitability projections have been established, or that the myriad of competing formulas take on decidedly different forms in an effort to come the closest to accurate predictions of future performance based on an analysis of current figures. Though the general recommendations made by most of these financial-based valuations can be very similar, the specifics of their mechanism and their estimations of future profitability can differ significantly, as any detailed examination of a singular formula will demonstrate.
The following pages just such a detailed examination of one specific valuation formula, the Penman decomposition method (named for its progenitor Stephen Penman), to the retail fashion industry and several of its key players in both the United Kingdom and the United States. Burberry in the UK and The Gap, Inc. in the US will be the primary foci of this analysis, though a portfolio of other companies in the industry will also be included as context within which to assess the relative profitability of both focal firms. Through an application of this particular method of financial analysis and prediction to the assembled portfolio of industry players, it is possible to develop a clear assessment of Burberry's profitability in absolute terms as well as in relation to other companies in the industry and especially a primary US-based competitor, The Gap, Inc., while also forming a better real-world understanding of the process of valuation and profitability assessment. As the result of this analysis, directly practical recommendations as to the investment in Burberry and/or The Gap, Inc. can be made and trends in the industry as a whole can potentially be identified. This demonstrates not only the academic but also the directly practical power of the Penman decomposition method as a means of profitability assessment through financial record analysis, yielding projections for future potential based on current standings.
Prior to the presentation of the reformulated balance sheets necessary for the Penman distribution and the calculation of the relevant ratios, a brief overview and market assessment of the companies included in the portfolio will be given to provide a basic understanding of relation and position amongst the firms in the industry. Reasons for the selection of these firms as vehicles for developing an industry understanding and a means of comparison with Burberry and The Gap, Inc. will also be presented, followed by a detailed financial assessment of each of the firms included in the portfolio. This will enable the conducting of comparisons between firms, an assessment of the industry as a whole including quartile divisions and trends over time, and through the decomposition of financial documents and specifically the decomposition of return-on-equity measures as called for in the Penman decomposition method, the particular drivers of profitability in individual firms and potentially in the industry as a whole can also be identified. This will all contribute to more accurate assessments of Burberry's standing and potential profitability.
Key Players in the Retail Fashion Industry
Burberry
With over a century-and-a-half as a clothing manufacturer and retailer, Burberry remains a strong player in the retail fashion industry, and is especially well-known for its iconic trench coats and trench coat-inspired clothing lines (Burberry plc, 2012). Founded in 1856, Burberry coats and other outerwear ere popularized by many of the world's most famous explorers and aviators of the latter nineteenth and twentieth centuries, and the company now operates manufacturing facilities and retail locations throughout the world. The company has a current market capitalization of approximately six billion GBP, with revenue approaching two billion over the past twelve months and a profit margin of 14.18% (Yahoo Finance, 2012). In addition to its manufacturing and direct retail operations through its 230+ stores and 200 concession boutiques in other upscale department stores, Burberry operates wholesaling and licensing divisions with several of its brand names (Hoovers, 2012). Significant growth and product innovation has occurred within the company in the past decade, reaffirming its position in the fashion industry (Burberry plc, 2012; Hoovers, 2012).
The Gap, Inc.
The Gap, Inc. was founded in 1969, and has grown from a jeans-focused manufacturer and retailer to a specialty clothing retailer operating five major brands in over ninety countries when both physical stores (numbering over 3,000) and Internet-based sales are taken into account (The Gap, Inc., 2012). A market capitalization of 16.8 billion USD (approximately 10.6 GBP) and revenue of almost 15 billion USD (approx. 9.4 GBP) makes the company a very strong player in the US and international clothing retail business, and its five major brands (Gap, Old Navy, Banana Republic, Piperlime, and Athleta) are already or are quickly becoming household names in many regions of the world (The Gap, Inc, 2012; Hoovers, 2012a; Yahoo Finance, 2012a). Though there are some essential differences in the target market and overall operational strategy between Burberry and The Gap, Inc, the similarities of the company in their manufacturing, direct retailing, wholesaling and licensing operations make them ideal companies for comparison and could begin to point to differences in profitability between US-based and UK-based corporations operating internationally in the retail fashion industry (Hoovers, 2012; Hoovers, 2012a).
Benetton Group
Italian-based clothing manufacturer and retailer Benetton Group was founded in 1965 by Luciano Benetton and his siblings, initially simply producing colorful knitted sweaters for sale in established stores in the Veneto region but quickly expanding its product line and moving into direct retail sales (Benetton Group, 2012). Facing lagging sales and internal issues that the Benetton family felt needed drastic changes in order to correct, the company was taken private earlier this year when the Benetton siblings bought all outstanding shares in the company and regained complete control of Benetton and its several still-popular (though waning) brands (Sanderson, 2012). As such, the company has no current market capitalization amount and is not required to publish its financial records in the same manner as public companies, however the group's franchise system of retail stores as well as the company-owned stores still generated over two billion Euros (approximately 1.8 billion GBP) in 2011 (Benetton Group, 2012). Though current financial information is not readily available, the most recently available figures show signs of a company in trouble yet with products and a brand that are still recognizable and in demand, and the former glory of the company is entirely salvageable according to many analysts (Hoovers, 2012b). As one of Europe and indeed the world's largest clothing manufacturers and retailers, no fashion/clothing retail industry analysis or comparison would be complete without the inclusion of the Benetton Group (Hoovers, 2012b).
H&M
Recognizable in Europe, the United States, and around the world as a purveyor of affordable everyday wear, fashion, and a range of accessories, and the newer H&M Home brand has brought the company into the interior design/home décor industry, as well (H&M, 2012). Founded in Sweden in 1949, the company now operates 2,600 H&M-branded stores in over forty countries, and the company's own team of designers is responsible for all H&M collections, leading to a tight cohesion between administration and design, yet the company does not actually manufacture its products but rather orders their designs though an international network of independent suppliers (H&M, 2012; Hoovers, 2012c). This strategy has served the company well during a period of rapid growth in terms of sales and geographic spread; H&M currently has a market capitalization of 406.3 billion Swedish krona (approximately 38.7 billion GBP), and in the first half of 2012 sales generated revenue of almost sixty billion krona (just over five-and-a-half billion GBP) (Hoovers, 2012c; H&M, 2012; MarketWatch, 2012). This company is in a slightly different position than many others in the industry, and appears to be on a trajectory towards its pinnacle rather than in years of potential decline as many of the other long-term players in the industry, but these differences actually make it an incredibly useful organization for use in comparisons and as H&M has a substantial industry presence its inclusion is more than warranted (Hoovers, 2012c).
Limited Brands
Though heavily focused on the United States with nearly 3,000 specialty stores operating under its various brands, Limited Brands has a sizable and growing international presence with almost 700 stores, some of which are company-owed while others are franchise operations (Limited Brands, 2012). Company brands such as Victoria's Secret and Pink operate in narrow segments of the retail fashion industry, while Bath & Body Works expands the company's industry scope to a variety of home, health, and beauty products, moving away from decades of exclusive focus on apparel that the company had held since its founding in 1963 (Hoovers, 2012d). While design takes place primarily in-house, manufacturing is achieved through independent suppliers, generating revenue of 10.24 billion USD (approximately 6.47 billion GBP) (Limited Brands, 2012; Yahoo Finance, 2012b). Despite the diversity of the company's two most prominent and profitable brands, Victoria's Secret and Bath & Body Works, Limited Brands has actually been undergoing a long process bringing greater focus to its operations, divesting itself of many companies and brands over the past decade-and-a-half, including Abercrombie & Fitch, Express, and more (Limited Brands, 2012). The company remains a major player in apparel, however, and has revenue in this area substantial enough to warrant closer inspection in terms of industry profitability (Hoovers, 2012d).
Hermes
One of the oldest companies still operating in the retail fashion industry, Hermes of Paris, Inc. pre-dates even Burberry with its 1837 founding and has a wide variety of offerings from apparel to leather goods (including saddles and other tack), a plethora of accessories, and other consumer goods (Hermes, 2012; Hoovers, 2012e). A market capitalization of 23.3 billion Euros (approximately 18.5 billion GBP and an almost 21% profit margin on close to three billion Euros (approx. 2.38 billion GBP) makes the company a formidable player in all of its various sectors of operation, including in apparel, for which the company products and retails several specialty lines focused on specific demographics (Hermes, 2012; Yahoo Finance, 2012c). Like many other competitors in the apparel industry, Hermes is heavily diversified; unlike many competitors, it remains largely focused on upscale and luxury items, with Hermes customers often willing to pay pa premium for the brand and with the recent economic upheaval not appearing to have tarnished the company's image or earnings too significantly, or at all in the long-term (Hermes, 2012; Hovers, 2012e; Yahoo Finance, 2012c). The luxury aspect of Hermes' business focus makes it especially fitting as a comparison to Burberry.
TJX
On the other end of the clothing retail spectrum is The TJX Companies, which operates a variety of off-price retail stores in the United States, Canada, and Europe, offering seconds, overstocks, and other apparel and consumer goods at prices often significantly lower than those seen in mainstream department stores and specialty retail outlets (The TJX Companies, 2012; Hoovers, 2012f). With thousands of retail locations under the T.J. Maxx, Marshall's, T.K. Maxx, Home Goods, and other brands, The TKX Companies, Inc. is the largest discount clothing retailer in the United States and is one of the largest in the world, with a market capitalization of 34.4 billion USD (approximately 21.75 billion GBP) and twelve-month revenues of 24.25 billion USD (approx. 15.34 billion GBP) (Yahoo Finance, 2012d). Founded less than four decades ago and still relatively small and young on the international scene, this company also forms a contrast to many others in the portfolio in terms of its proven longevity and its scope of operations (The TJX Companies, 2012). Including this company in the portfolio will lead to a more comprehensive and ultimately more nuanced view of what drives profitability in the retail clothing industry.
Portfolio Overview
On the whole, the portfolio is comprised primarily of higher-end fashion retailers, approximately half of which are also manufacturers of the products they sell and most of which provide the design basis for their products. All companies included in the portfolio operate on an international basis, though the scale of spread and areas of concentration/higher sales vary considerably from company to company. Many of the companies included in the portfolio also operate in sectors other than clothing and fashion retail, insulating their profitability from changes in this particular market but also spreading these companies' interests and operations to a degree that could perhaps be detrimental to their growth and profitability. Examination of these issues through the analysis of these companies' financial records and specifically through an application of the Penman decomposition method.
Penman's Decomposition Method
Return-on-equity is a ratio often utilized to determine the profitability of a company to its shareholders, and is a useful measure as long as it is properly understood. According to some analysts and researchers, including Stephen Penman and Doron Nissim (2001), the traditional means of calculating return-on-equity and even of formulating balance sheets, income statements, and other financial records does not accurately reflect a firm's profitability as it combines financial and operating assets and liabilities in the firm's valuation (Wahlen et al, 2010). Separating these elements and otherwise decomposing and reconstituting the return-on-equity for each company can yield a more accurate and predictive assessment of current and future profitability, according to this view, and this must begin with a re-evaluation of financial documents. Once the various elements have been properly identified and controlled for in the financial documents, the formula for the Penman decomposition is relatively simple: return-on-equity is calculated as the sum of the return on operating assets and the financial leverage of the firm multiplied by the difference between the return on operating assets and the net borrowing costs to the firm by which its leverage was achieved (Nissim & Penman, 2001; Wahlen et al, 2010).
This equation makes explicit that there can only be a return on equity when the cost of borrowing is lower than the return on operating assets, as anything else would lead to a negative multiplier in the equation and thus yield a negative result for the return on equity. In addition, the return on equity is made up of real return on operational assets and the degree to which the company was able to profit from financial leverage, making explicit the combined elements of profit generation for stakeholders without obscuring or conflating these elements (Wahlen et al, 2010). The traditional mode of calculating return-on-equity incorporates both operational and financial aspects of a company's financial records, as well, but it does not separate these elements out or provide a clear explanation of their mechanism and interaction in creating value for a company and its shareholders. The Penman decomposition is based on the premise that these aspects of a company and their interactions are central to the profitability of the firm, and that accurately identifying these elements is necessary in carrying out true due diligence before undertaking an investment (Wahlen, 2010; Melumad & Nissim, 2009). Applying this method to the companies described above will lead to a fair and accurate assessment of their current profitability and potentially their future profitability based on current account standings, thus offering an understanding of how Burberry stacks up against the industry and against specific competitors such as The Gap, Inc. in terms of profit potential for shareholders.
Financial Analyses
Burberry
Armed with this understanding of the Penman decomposition method of analyzing and predicting profitability and given the basic background information that exists for each company in the portfolio, real and meaningful analysis of Burberry and its competitors can be presented. Calculating the return on capital employed by Burberry over the past decade using the Penman decomposition method to define and delineate the terms of the equation-understanding the true amount of capital employed for operational and financial leveraging purposes and calculating returns based on the above-described formula-shows the company to be far less profitable than a simple assessment of the price-to-earnings ratio or the traditional return-on-equity measures suggest, with the highest rate of return seen in 2008 at 1.19%, followed closely by the 1.17% return-on-capital-employed that the firm achieved in 2009, however in the decade spanning 2002 to 2011, the company averaged a return-on-capital-employed of only 0.19%, and actually showed a negative return for three years, from 2004 through 2006. The return-on-assets calculated for these three years using the Penman decomposition method was also slightly negative, with a low point of a negative 2.85% return-on-assets in 2005 and an average return-on-assets for the decade running 2002 through 2011 of just 0.13%. This initial assessment demonstrates a lack of strong profitability for equity shareholders in Burberry over the past decade, though without a wider analysis of competitors/the industry as a whole and a closer inspection of Burberry's accounts this assessment is not entirely valid.
Turning to look at Burberry's financial leverage serves to brighten the outlook for the company and its equity shareholders, to some degree, with the company appearing to be have significantly consolidated income from financing activities and thus the profitability of equity ownership as growth in the value of equity has been generally outstripped by growth in net financial assets; on average over the decade of observation, Burberry's financial leverage ration when calculated as net financial assets (or liabilities) over equity has been a negative 17.21%. The only years of observation during which Burberry showed a positive financial leverage ratio, indicating a net amount of financial liability, were 2008 and 2009, and even then the company's financial leverage ratio did not reach six percent. Meanwhile, Burberry's financial leverage reached its lowest point in 2011, the last year for which compete data is available, at negative 42.19%. Shareholder equity, represented as a liability (i.e. a negative number) in this calculation, has tended to increase over the period of observation, which would ordinarily lead to smaller financial leverage ratio all else being equal, however the growth in net financial assets over this period has been far more substantial (a 2648% increase in net financial assets from 2002 to 2011), and thus even the growth in shareholder equity during this period (474% from 2002 to 2011) did not dilute profitability but rather shows greater consolidation of value overall. Net operating assets have also grown overall during the period, though they have fallen off in recent years following a peak in 2009, and this again suggests a potential return to stronger profitability, though return on assets and return on equity both remain quite low as measured and calculated through the Penman distribution.
At the same time, the company's operating assets and its operating income have both declined substantially from their peaks earlier in the decade of observation, and though financing costs have also fallen during the period this drop has not been precipitous and net income has fallen as a result. Financial assets have also fallen off considerably over this period, almost certainly marking some divestment of certain assets and not merely their degradation or depreciation, however Burberry's financial liabilities shave decreased even further and this is not a direct cause of the low return-on-equity and return-on-capital-employed that the company currently posts according to the Penman decomposition. A comparison of operating income to sales shows a company that is at once struggling yet finding effective ways to deal with hard times-sales in 2011 are a third of what they were in 2002, yet operating income has only been reduced by half over the same period. On the whole, when considered solely on its own merits and without consideration of industry contexts or larger economic issues and trends, Burberry appears to be revamping its business in a manner that will make the company leaner and increase overall profitability, however it has not reached a point of true success in this endeavor and is still struggling with reduced sales and operational income which will of course limit its future potential.
Burberry and the UK
In order to determine Burberry's profitability not in absolute but in relative or contextual terms, an examination of how its figures compare to the UK retail clothing and fashion industry as a whole must be conducted. By providing just such an examination, this section will help to illuminate what of Burberry's perceived problems and potential successes are truly indicative of the company's own internal struggles and product or marketing issues, and which are more accurately attributed to overall trends in the context within which Burberry operates. How Burberry performs in comparison to the industry as a whole is of key importance to investment strategy as it could indicate future potentials quite strongly, with a stronger-than-average position increasing the likelihood of profitability and ongoing value for equity ownership while a worse-than-average and/or declining position would indicate a lower likelihood of profitability and should dissuade equity investments.
Unfortunately for Burberry and its current investors, the latter scenario seems to be the case given a basic comparison with the UK industry means on a variety of ratios. The average return-on-equity in the UK retail clothing and fashion industry is more than six times that of Burberry-1.19% compared to the 0.19% of the company of interest. Performance this far below the industry mean, while certainly not conclusive in and of itself, strongly suggests that Burberry is experiencing its own problems independent of whatever industry issues might exist. Tracking the return-on-equity figures for both Burberry and the UK industry on average, in fact, shows that Burberry has actually remained largely independent of industry trends, and though the industry's return-on-equity has been on a downward trend since 2004 it began to climb back up in 2011 while Burberry's own figures continued to drop. The company was better for investors than the average UK retail clothing and fashion company from 2008 to 2010, however in all other years observed Burberry underperformed the industry in terms of return-on-equity, and often significantly so.
Turning to measures of return-on-assets, the story grows even more bleak for Burberry. The UK industry average return-on-assets during the decade running from 2002 to 2011 was 1.16%, almost nine times Burberry's 0.13% return-on-assets over the same period. Again, Burberry so significantly underperformed the industry average during much of this period that even the better relative performance over the course of the last four years, from 2008 to 2011, is not enough to truly dent the degree to which the company is behind in delivering returns. Both Burberry and the UK industry as a whole declined in returns-on-assets during the first four years of observation, from 2002 to 2005, with Burberry starting much lower and declining much further, and though Burberry began a turnaround two years before the industry did it still took three years for the company to surpass the industry due to its previous losses, and the gap by which Burberry leads the industry in return-on-assets has shrunk every year and is now a negligible 0.08%. The fact that these measures both fairly consistently show an underperformance by Burberry when compared to the UK average, and that both also show the company in its second period of decline in a single decade, seem to demonstrate that the improvements that are (or seem to be) being made when it comes to the company's assets and liabilities are not being effectively translated to returns and profitability for equity shareholders or even for the company itself in terms of generating profits from its assets.
The initial analysis made of Burberry's financials suggested a company that is going through-and has been going through-difficult times both due to internal issues and due to an inability to effectively maintain and generate sales, but that it might be able to recover from this downward trend through the continuation of certain actions the company has recently been taking. This analysis of Burberry in the light of the UK retail clothing and fashion industry on average, however, is far less optimistic, showing a company that has struggled significantly when compared to the industry as a whole, and one that remains in decline and essentially underperforming even though it has greater control over its books and its operations (that is, its operational assets and liabilities as well as its financial assets and liabilities). Based on both the individual or absolute analysis of Burberry and the contextual or industry-based analysis of the company, the decomposition of its books and the calculation of its return-on-equity and return-on-assets according to the Penman decomposition and the analysis of the UK retail clothing and fashion industry via the same methods points to a company still too imperiled and uncertain to warrant a strong recommendation for investing in an equity stake in the company. A return to stronger profitability and a performance at least matching that of the UK industry on average would need to be demonstrated before any such recommendation could be made. Analyzing the company and the industry using the Penman decomposition method enabled the greater scrutiny and detail that allowed for this determination to be made, showing the power and the efficacy of this particular mechanism of valuation.
Burberry vs. The Gap, Inc.
Analysis of Burberry against the UK retail clothing and fashion industry as a whole is one way of creating a contextual or relative valuation for the firm, but it is by no means the only manner in which the current standing of the company can or should be compared to other environmental figures to determine how the company is faring overall. Though the company is based in the United Kingdom it does business on an international scale, and though it is going to be directly impacted by changes in UK legislative and economic environments it is also necessary to compare Burberry's financials to those of some of its foreign competitors that operate in a similar industry and on a similarly international basis. The Gap, Inc. was selected as the competitor for primary comparison with Burberry due to the similarity of many of the products it provides and the price point of many of its offerings, despite the fact that demographic profiles of its customers are different as described in the above sections on the companies' backgrounds. In addition, as Burberry is striving to gain a stronger share of younger demographics-an age group that The Gap, Inc. has a somewhat stronger presence with-a comparison between these two firms in terms of competitiveness and future profitability makes a great deal of sense and serves a readily observable purpose of setting targets for Burberry (and measuring the distance it has to go).
If there was any hope that Burberry's outlook would be impacted in a positive direction by comparison with a foreign competitor such as The Gap, Inc., that hope is quickly dashed by a cursory examination of the return-on-equity of the two companies. In the first year of observation, 2002, Burberry actually outperformed The Gap, Inc., which had a negative return on equity of 0.52% compared to Burberry's 0.35%. The US company underwent a major turnaround in the following year, however, jumping to a 13.34% return-on-equity in 2003 compared to Burberry's 0.30%. Overall during the decade of observation, The Gap, Inc. had an average return-on-equity of 18.83%, and though there has been not insignificant volatility in the company's return-on-equity over this period it did never again dropped below 2003's level. Burberry, meanwhile, had an average return-on-equity over the same period of just 0.19%, and while The Gap, Inc. is experiencing a slight upswing and has long been a consistently strong performer according to this measure, Burberry has been consistently tepid and has been experiencing a slight downward trend for the past three years, making the US competitor a far more attractive investment opportunity for equity shareholders based on this measure of returns alone.
The returns-on-assets of the two companies increases still further the lack of confidence in Burberry's potential future profitability, with The Gap, Inc. outperforming even the return-on-equity that it demonstrated during the period. When it comes to this measure, The Gap, Inc. actually started out stronger than Burberry in 2002, with a 1.51% ratio compared to the UK company's 0.64%, and The Gap, Inc.'s performance simply got stronger and the gap between it and Burberry all the wider as the decade progressed. The period of observation ended with The Gap, Inc. at a return-on-assets ratio of 51.13% and Burberry at 0.49%; the US-based company had an average return-on-assets ratio of 32.08% for the decade, while the UK-based Burberry had only a 0.13% return-on-assets average over the same ten years. Again, despite some volatility in The Gap, Inc.'s return-on-assets during this period, substantial increases were seen overall for the company and it is experiencing a current increasing trend, while Burberry has had a minimal or even negative return-on-assets and is currently experiencing a downward trend. This comparison yet again demonstrates that Burberry's future profitability is far from assured, and that this lack of confidence in the company is not simply the result of industry-specific or larger economic trends and influences, but rather is a problem (or more likely a series of problems) specific to Burberry itself, as both the UK industry as a whole and major foreign-based competitor The Gap, Inc. are both performing significantly better than Burberry. The Gap, Inc. is not even the top performing US-based firm in the retail clothing and fashion industry, but in fact the past decade appears to have been very good to the US players in the industry as a whole, and The Gap, Inc. actually underperforms in terms of return-on-equity and return-on-assets when compared to the US mean. While US business are doing better than UK businesses generally, then, Burberry is still underperforming by any comparison, and is doing far worse than a below-average US competitor.
