Two weeks ago, I whittled a list of large apparel companies down to seven companies based on low price-to-earnings and net debt-to-market capitalization ratios. From this list, I hope to find some companies that look like interesting prospects. To narrow down the list further, I'm going to look for several criteria: historical and projected earnings growth, operating and free cash flow generation, and accounts receivable and inventory management.

The companies in the target list are Liz Claiborne (NYSE: LIZ), Guess? (NYSE: GES), Nautica (Nasdaq: NAUT), Quiksilver (NYSE: ZQK), Oshkosh B'gosh (Nasdaq: GOSHA), Donna Karan (NYSE: DK), and Cutter & Buck (Nasdaq: CBUK).

Historical and Projected Earnings Growth
For historical earnings growth, I'm going to look at EPS gains over the past two years, annualized earnings growth over the past three years, and projected earnings growth this year. I've also listed First Call's compilation of long-term growth estimates.

       1998   1999   2000   3-Yr   Proj.
       EPS     EPS   Proj.   EPS    L-T
      Growth Growth Growth Growth Growth
GES    -29%   101%    28%     NC    23% 
NAUT     7%   -13%     9%     7%    13%
ZQK     24%    54%    21%    31%    20%
GOSHA   44%    27%    18%    43%     NE 
DK       NC     NC    65%     NC     NE
CBUK    44%    25%    11%    47%    21%  
Notes: NC=Not calculable; NE=No estimate

Looking at the numbers, Quiksilver, Osh Kosh B'Gosh, Cutter and Buck, and Liz Claiborne have had consistent earnings gains over the past three years. Liz Claiborne's earnings have been accelerating at a slow and steady pace. Quiksilver's growth is expected to moderate from its torrid growth over the past couple of years, but could still be a respectable 20%-30%. Osh Kosh B'Gosh and Cutter and Buck's growth is slowing down more significantly, with Osh Kosh projected to show higher growth numbers for the current year.

Guess and Nautica's earnings growth rates have hopped around over the past few years. Although they may have some nice attributes (and sporadic earnings are often found with apparel companies), I'm going to knock these two stocks off my investigation list.

Donna Karan's growth estimates are not calculable because earnings moved from a significant loss in 1997 to break-even results in 1998 and then profitability in 1999. While this shows similar volatility to the two companies knocked out above, three years of consistent improvement is good enough to keep me interested.

Operating and Free Cash Flow
Taking a look at how much cash a company is generating is very important. To compare these figures across companies, they are listed as a percent of net income.

       Op. Cash Flow       Free Cash Flow        
      % of Net Income     % of Net Income
      1997  1998  1999    1997  1998  1999
LIZ    79%   78%  153%     60%   26%  114%  
ZQK   -56%   -6%   17%   -137% -116%  -72%   
GOSHA 159%  144%  216%    130%  105%  194%
DK     NM    NM   276%     NM    NM   167% 
CBUK   30% -183%   NA     -18% -265%   NA
Notes: NM=Not meaningful; NA= Not Available. Donna Karan had a loss in 1998 and negative cash flow figures. In 1999, the company had break-even results and significant operating and free cash flow. Cutter & Buck has yet to file its 10-K for the year ending in April. Numbers are for fiscal years, but headline year is the one in which the greatest portion of each fiscal year falls.

These numbers are quite illuminating. While Cutter and Buck and Quiksilver looked attractive based on a price-to-earnings ratios and earnings growth rates, they look pathetic based on cash generation over the past couple of years. Cash generation is often reduced when companies fund rapid growth. Nonetheless, I don't have an inclination to be in apparel companies with such lackluster cash generation characteristics.

Osh Kosh shows excellent cash flow numbers for all three years. Liz Claiborne has solid numbers that are continuing to improve. The numbers for Donna Karan reinforce my previous supposition -- the company has been turning itself around over the past couple of years. The big question is figuring out how sustainable the turnaround will be.

Accounts Receivable and Inventory Management
Accounts receivable and inventory management are imperative for successful apparel companies. If a company starts piling up inventory, sales have likely fallen below plan and an inventory write-down to clean out the excess might be forthcoming. Accounts receivable information gives insight into how well a company is collecting its bills. Another reason to watch receivables is that a bulging number can indicate the company is "stuffing the channel" (sending out lots of inventory at the end of the quarter to meet expectations) or retailers aren't paying because they plan on returning merchandise or requesting markdowns.

           Days             Days
         Inventory      Accounts Rec.
      1998 1999 2000   1998 1999 2000
LIZ    60   68   54     27   36   39 
GOSHA  62   55   40     21   20   14
DK     63   53   46     38   42   48
The numbers and trends in the above table reinforce what was gleaned from operating cash flow figures. Osh Kosh looks best on these metrics -- it has the lowest absolute numbers and has improved in each of the past two years. The other two companies have about equal absolute performance. Inventory is higher at Liz Claiborne, but receivables are higher at Donna Karan. Combining days inventory and receivables together, each company falls into the 93-94 day range. Trends are a little better at Donna Karan, though. Liz Claiborne's inventory and receivables cycles has increased from 87 days in 1998, but Donna Karan's have fallen from 101 days.

Numbers-Based Conclusion
Based simply on the numbers I've evaluated, Osh Kosh B'Gosh strikes me as the most attractive apparel company in the list. In addition to a low valuation, it has strong cash flow, low debt, and great working capital controls. Liz Claiborne looks like the most stable company, based on its consistent earnings growth, good cash flow, and decent cash flow. Donna Karan has turned the ship around from some challenges over the past couple of years. It could be attractive from a turnaround perspective, but investors will need to be confident that the recovery has legs.

Of course, you can't make investing decisions based solely on numbers -- particularly historical ones. While they show how a company has done in the past, they aren't necessarily indicative of the future. In addition, onetime events, unusual circumstances, or differing accounting principles can distort reported numbers. Since I did most of these calculations by hand using raw data from Bloomberg, the risk of miscalculation or data errors exists. I need to do some qualitative legwork before coming to a conclusion.

I did a little bit of research into the three finalists. Whew! I'm glad to have exerted that effort. You know all of those great numbers from Osh Kosh B'Gosh? Well, first-quarter results weren't so stellar. Sales were down 7% and earnings per share (EPS) were only up 3%. The EPS figure was propped up by a dramatic reduction in outstanding shares (due to stock repurchases) -- net income actually fell 28%. With these kinds of recent results, I won't be considering this company until business trends improve. (It also turns out that about 20% of last year's EPS gain was nonrecurring, related to a benefit triggered by Osh Kosh's falling inventories.)

Liz Claiborne and Donna Karan still interest me after further research. Donna Karan's emphasis on lucrative licensing deals (one of the licensees is Liz Claiborne) and reinforcing core operations seem to have enhanced its competitiveness. The biggest question in my mind is how the company will fare if consumer spending slows down. I'm not sure, but would speculate that Donna Karan stock will do fairly well over the long haul given its low valuation and improving prospects.

After looking everything over, Liz Claiborne is the apparel stock with the most appeal to me. Although its 10%-12% growth isn't spectacular, it seems most likely to have steady results. The company has several brands to serve a variety of markets, including its namesake brand, Dana Buchman, and Lucky. It also has alliances with Donna Karan and Kenneth Cole Productions in certain categories. Finally, the company has a growing division with brands serving moderate-prices stores such as Sears (First Issue), KohI's (Villager), Wal-Mart (Russ), and Target (Niki Taylor).

As any consumer-oriented company, Liz Claiborne could be affected by a slowdown in consumer spending. However, the company's breadth of brands and target markets should minimize the impact vis-a-vis competitors. It would also likely be the first to emerge from industry challenges. Given these positive qualitative attributes, a solid balance sheet, good cash flow generation, and a reasonable valuation, Liz Claiborne would be my first choice among apparel companies.