Changing consumer preferences suggest that fashion risk is almost unavoidable in the apparel industry. Astute investors would rather focus on apparel companies with low risk, rather that ones that promise exciting growth prospects. Perry Ellis (NASDAQ:PERY), a leading distributor of apparel products to wholesale customers, fits the bill by offering shareholders low risk via its growing licensing business and excellent sourcing capabilities.
As of February 2013, Perry Ellis was the licensor in more than 140 license agreements across its entire product range, with 40 companies licensed to sell its flagship Perry Ellis brand of dress pants, belts, and wallets, and 17 licensing agreements for its Original Penguin-branded apparel.
Unlike its other men's sportswear and women's sportswear segments, Perry Ellis' licensing business is capital-light, avoiding the need for significant investment in distribution channels and additional marketing spending. This is reflected in the historical EBITDA margins for Perry Ellis' licensing business of between 60% and 80%, which are significantly higher compared to the Perry Ellis Group's overall 5%-8% EBITDA margin.
As a result, Perry Ellis has been actively growing its licensing business. For the nine months ended November 2013, it grew revenue and operating income from its licensing segment by 8.6% and 37.6%, respectively, compared to the year-ago period. The strong growth came from additional licensing agreements.
The licensing business is currently the largest profit contributor for Perry Ellis at $22.7 million for the past nine months, followed by its Men's Sportswear and Swim segment with operating income of $6.6 million. This helped to offset losses for Perry Ellis' Women's Sportswear and Direct-to-Consumer business. Looking ahead, Perry Ellis has plans to grow its licensing business further.
In May 2013, Perry Ellis granted rights for its Original Penguin men's underwear and loungewear to Delta Galil in the U.S. and Canada. Subsequent to that, it entered into a licensing agreement with Bioworld Merchandising for the rights of its Ben Hogan brand of men's and women's hats and sports bags in October 2013.
As Perry Ellis expands its licensing business, it is worth looking at a pure licensor to understand the potential margin expansion opportunities and the low-risk characteristics of such a business model. Iconix Brand (NASDAQ:ICON), ranked as the second-largest licensing company globally by License magazine, owns a myriad of brands from the luxury Badgley Mischka to lifestyle fashion brand Mossimo.
It boasts consistent operating and net profit margins in excess of 60% and 30%, respectively. This is reflective of the high profit potential associated with a 100% licensing model, given the absence of operational and inventory risks, along with limited working capital and capital expenditures needs. While a traditional retail company needs to be responsible for sourcing, manufacturing, warehousing, distribution and retail, a licensing company like Iconix Brand only has to be concerned with marketing the brand and expenditures associated with advertising and public relations. Also, while Iconix Brand has remained profitable and free-cash-flow positive in each of the past 10 years, Perry Ellis has recently suffered operating losses in its women's sportswear and direct-to-consumer segments.
While consumer demand is inherently unpredictable, sourcing costs and supply chain efficiency are very much within the control of the companies themselves. Perry Ellis has a low-risk sourcing strategy in place. First, Perry Ellis is well diversified geographically. As opposed to other apparel companies, it isn't completely reliant on China, which accounted for 39% of its sourcing purchases in fiscal 2013. Vietnam and the Middle East contributed the other 40% of its sourcing, helping to reduce concentration risks with China. Other Asian countries (apart from Vietnam and China) and the U.S. made up the remaining 21%.
Second, Perry Ellis has more than 300 employees located in major supply hubs including Vietnam, Taiwan, Bangladesh, and Indonesia to ensure that its suppliers adhere to high-quality manufacturing standards.
Last but not least, Perry Ellis' relationships with some of its global suppliers extend back more than four decades.
On the other hand, lululemon athletica (NASDAQ:LULU)had to recall its black Luon yoga pants in March 2013 because of an unacceptably high level of sheerness. In response, Lululemon said it would diversify its supplier base by adding two additional suppliers for its key fabrics.
Prior to the product recall, Lululemon's five largest suppliers accounted for approximately 60% of its 2012 purchases.This illustrates the importance of strengthening one's sourcing capabilities and reducing supplier concentration, something that Perry Ellis has done very well, looking at its gross margin stability historically. From fiscal 2007 to 2013, Perry Ellis delivered gross margins within a narrow range of 32%-35%.
Foolish final thoughts
It is always very tempting to invest in an apparel company based on potential upside, but that would hardly be the wisest thing to do. Instead, investors are best advised to pick a company such as Perry Ellis, which has minimized its downside risks by expanding its licensing business and strengthening its sourcing capabilities.
Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Iconix Brand Group and Lululemon Athletica. The Motley Fool owns shares of Perry Ellis. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.