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Free Cash Profiles: The Apparel Industry

With their whopping working capital and inventory needs, clothing companies depend heavily on their ability to borrow.
David M. Katz, CFO.com | US
December 2, 2011

As they do each year, analysts are zeroing in on sales figures for Black Friday and Cyber Monday to construct earnings forecasts for the clothing industry. Yet while sales growth is a prime indicator of health in the rag trade, the state of the credit markets may be equally important in gauging the industry's health.

That's because apparel is inherently an industry that needs financing in order to grow. Burdened with the costs of stocking up on inventory for high-buying seasons, clothiers must borrow to support sales even in the best of times.

Thus, CFO's Free Cash Profile (FCP) snapshot of 42 public firms in the apparel business registers an extremely unfavorable median of -12.68% for the 12 months ending with the third quarter of 2011 (see chart, below). Based on data provided by Cash Flow Analytics LLC, the FCP measures the ability of a company or an industry to spawn free cash flow as it grows. (To learn how FCPs are calculated, see "How the Free Cash Profile Works," also below.)

Clothiers' bleak FCP is partly a reflection of the seasonality of the business, according to Charles Mulford, a Georgia Tech accounting professor who developed the metric. "The second and third calendar quarters are ones where firms are likely building seasonal inventories.  Cash tied up in inventory is cash that can't be reported as available for shareholders, pushing down free cash generation and the free cash profile," he says. 

Things will inevitably get better in the fourth quarter, as clothing sales bloom and working capital needs are drained. Still, the growth of clothing companies can be expected to have chewed up more cash in 2011 than it generated.

Thus, at the end of the fourth quarter of 2010, when firms are at their most liquid, the apparel industry's FCP still fell slightly short of break-even (-.78%). "What does a negative free cash profile imply?" Mulford asks. "It implies that as you grow, [the companies] will consume cash. They need to attract incremental capital to support growth."

There is, however, a small sweet spot within the industry: four companies with yearly revenues of between $300 and $800 million. Those four firms — Iconix Brand Group, Bebe Stores, True Religion Apparel, and Kenneth Cole Productions — recorded a median FCP of 6.10%.

In contrast, the 21 clothiers with revenues of more than $800 million scored a median FCP -10.61%, while the 17 firms with revenues of less than $300 million recorded a median profile of -20.62%.

Normally — perhaps resulting from the advantages of scale — bigger companies register better profiles. Why is that not the case in the clothing business?

Mulford thinks that the reason is that the middle-market companies have the rare ability to get their landlords to wait for payments or their customers to pre-pay for their purchases. In the industry as a whole, companies rarely claim such advantages.

In recent 10-Ks, for instance, Bebe and True Religion reported deferred rent or lease provisions as a portion of revenue of 7.73% and 3.3%, respectively. For its part, Iconix recorded 8.75% of its sales as deferred revenue (which might include deferred rent and lease payments, as well as customer prepayments). Even Kenneth Cole, which recorded just .24%, exceeded the industry median of 0%.




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