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There is a serious tendency toward capitalism by the well-to-do peasants. -- Mao

Designer IPO's
by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (June 12, 1997) /FOOLWIRE/ -- To expand upon what Tom said, Polo Ralph Lauren is a mature brand name and has run a stable business over the years. While DONNA KARAN (NYSE: DK) has not been run to generate cash, Ralph Lauren generated gross cash flow of $134 million and free cash flow of $99.3 million in the year ended March 31, 1997. Other money managers have compared the offering to TOMMY HILFIGER (NYSE: TOM), a hot designer of the last few years, saying Polo was looking too rich in comparison. Through nine months, Hilfiger is running better margins and is generating a good deal of gross cash, but it's not generating the free cash flow that Polo is. We'll also look at fiscal 1996 multiples for Donna Karan.

Annualized free cash flow (FCF) at Hilfiger was $54.9 million and gross cash flow (GCF) was $105.4 million. Multiples on the two measures of cash flow are as follows:

                     GCF          FCF
Donna Karan          6.84         11.9
Polo Ralph Lauren   23.0          31.2
Tommy Hilfiger      15.8          30.3

*Hilfiger numbers annualized off nine-month financials. DK = FY1996

Based on the stronger measure by which one should value a company, the amount of cash that can be pulled out of the business given neutrality in working capital and financing, Polo and Tommy Hilfiger are similarly valued. However, Polo grew revenues 15.7% last year while Hilfiger came close to tripling that rate, having grown the topline just under 40%, through nine months of 1996. In its most recent quarter, revenue growth slowed slightly, to about 35%. Why, then, should Polo attract the same valuation when Hilfiger is growing much faster?

Number one, besides the lesser capital expenditure needs of Polo, Hilfiger's asset management needs are much different than Polo's. Year over year, Polo's inventory investment was neutral, meaning that its net inventory did not change, even though sales grew 15%. A company that can support greater sales on the same amount of inventory is doing something right. However, to support its rapid growth, Hilfiger had to increase inventories by 52%. That's cash that could otherwise be going to marketing, other brand-enhancing measures, or shareholders' benefit. The divergence between the two is not all that encouraging, even given that one should understand that growing businesses need to support sales growth with greater inventories. If you don't have the items on the shelf, you're not going to make that sale. One wants to see tight control of working capital as the quarters go by, though, especially in apparel.

Secondly, mature, proven companies attract greater valuations because they have shown ability to generate earnings and cash flow year after year. Every wonder why price/earnings multiples on Russian equities are so low? A main reason is that investors aren't totally confident that those companies will be able to generate those earnings repeatedly. Same thing with Hilfiger -- not everyone is confident that fickle young consumers will be wearing Hilfiger next year. Polo has proven itself to be an evergreen type of company, able to generate growth over a long period of time.

Finally, Polo is able to spend much, much more on its marketing, even though it might choose to slack off in that area, having built a good deal of brand equity. In recent years, the company's sales, general, and administrative (SG&A) expenses have fallen between 33% and 35% of sales, possibly a touch more than the usual consumer branded business prototype of 25%. Hilfiger has been devoting about 27% to 28% of revenues to SG&A expenses, about what you'd like to see. That investment has been paying off, too, in the company's growth rate. Nevertheless, Polo has a big advantage when it can steer, say, half of its SG&A budget, amounting to $187 million, into marketing and advertising versus Hilfiger's financial resources. With less of a corporate infrastructure, say Hilfiger can spend 60% of its SG&A on marketing and advertising. That amounts to $113, or 40% less than Polo. Not only is the spending smaller in absolute dollars, but Polo is spending to build upon already-strong brand equity while Hilfiger is still trying to create brand awareness. Polo's advertising and marketing dollars are worth more, then.

In all, Polo is going to attract the large-cap sort of valuations that other proven consumer entities such as PROCTER & GAMBLE (NYSE: PG) or even something like KELLOGG CO. (NYSE: K) garner. That's because there's less risk in the proven brands and the proven financial performers. Considering the greater safety, investors are willing to pay up for companies like Polo. At the same multiple to free cash flow, Hilfiger might offer more growth, but it also represents a higher risk. A company like Donna Karan, that has proven lately only how good at losing money it is, and at how erratic their earnings are, just isn't going to attract the multiples of these companies until it can get things under control. At that point, the loosely efficient market will do its thing.

(To The Process of Going Public)

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