David Berman Essay

David Berman reviewed the macroeconomic returns on schedule turns as he inclined(p) for his regular appearance on CNBCs scream Box as a morning co- array. A leading expert on consumer related credit lines, Berman and his colleagues including portfolio manager Steve Kernkraut, a seas unmatchabled sell executive and analyst, were shop contributors to various TV shows. On April 4th 2005, Fortune magazine ran a story on Berman c eached King of the Retail Jungle, and on December 13th, 2004, Barrons ran a story called Smart Shopper where Bermans four stock picks as identified, appreciated 30% on average over the next quarter. Off bearing he was a fund manager as good as founder and president of Berman big(p) (which managed proprietary bullion) and founder of and general partner in New York-based Durban Capital, L.P. (which managed outside and proprietary heavy(p)). Glancing at his nones on macro efforts in retail stock turns, Berman wondered if he should talk approximately his impressions on the show.Berman held a bachelors distributor point in finance and masters equivalency in accountancy from the University of Cape Town in South Africa. He had also passed the South African chartered comptroller and the United States CPA examinations. Berman obtained his CPA qualification in California while an auditor for Arthur Andersen and Comp either where he examined the financial statements and ope dimensionns of a number of retail clients. He had been the auditor of Bijan, the notable mens upscale habit breed on Rodeo Drive and 5th Avenue. Prior to starting his own funds Berman worked as a portfolio manager and analyst primarily at two Wall thoroughfare firms. He evolved his investment style under the tutelage of Michael Steinhardt of Steinhardt Partners, which he joined shortly after graduating with distinction from Harvard Business School in 1991. From 1994 to 1997 Berman worked in consumer-related stocks at an separate large hedge fund. He subsequentl y launched Berman Capital in 1997 and Durban Capital in 2001.Professor Ananth Raman of Harvard Business School, Professor Vishal Gaur of the Stern School of Business at New York University, and Harvard Business School doctorial Candidate Saravanan Kesavan prepared this case. Certain details ache been disguised. HBS cases are developed solely as the basis for class discussion. Cases are not mean to facilitate as endorsements, sources of pristine data, or illustrations of effective or ineffective caution.Copy secure 2005 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, relieve Harvard Business School Publishing, Boston, MA 02163, or go to http//www.hbsp.harvard.edu. No part of this publication may be reproduced, fundd in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of Harvard Bus iness School.copy or posting is an infringement of copyright. Permissionshbsp.harvard.edu or 617-783-7860. 605-081David BermanBerman believed that his training as an accountant together with his MBA and practices he developed over the eld to refine accounting estimates enabled him to bank bill aspects of retail accounts that would be missed by most investors. The relationship mingled with gunstock and earnings and therefore share mo pelfary value, for typeface, while obvious to a retail merchant, was rarely recognized by analysts or investors. This relationship, Berman observed, is ASTOUNDINGLY powerful, but surprisingly fewer understand why. Most think its just a function of inventory risk. Its not. Its primarily a function of how the operating margins can be manipulated by management in the short term by playing round with inventories. For example, said Berman, if a retailers inventories are growing much faster than sales, then rough margins would be taller than they ordinarily should be, as the retailer has not taken the mark-downs that a solid disciplined retailer should take.Interestingly, Berman beamed, there is no law in GAAP that limits the number of twenty-four hour hitchs inventory to any norm, and as such, the practice of increase inventories beyond any norm goes unfettered. Berman continued managements sign-off on the inventories as being fairly valued, and the auditors pretty much rely on their word. Berman believed that from an investors perspective, its a game of musical chairs you dont want to be the go person standing. In other words, you dont want to be an investor when sales slow and when mark-downs of the bloated inventory finally need to be taken to move the goods.The relationship of inventories to sales was also an important one that Berman focused on. In a period of rising inventories on a square foot basis, Berman says it is quite obvious that same store sales should rise as the offering to the customer is that much gre ater. Simply put, the much offerings you put in a store, ceteris paribus, the bigger sales should be. It is at this time, Berman argued, that the stock price rises, as investors trust high valuations on retailers with higher sales, despite that this higher valuation is achieved primarily due to the higher inventories.An excellent example of the inventory to sales relationship was root word DepotIn 2001 and 2002 Home Depots new CEO, Bob Nardelli1, seemed to struggle in managing the transition from a cash in-flow GE-type philosophy to a retailer Home Depot-type philosophy. In his DeeBee Report2 dated June 10th 2003, Berman stated Bob Nardelli learned the power of inventory the hard way. In focusing on cash flow improvement, he dramatically lowered inventories and yes, addd cash balances only to see a huge decline in same store sales, and in its stock price the stock went from around $40 to $22. And so, under immense pressure, Nardelli reversed course and focused intensely on i ncreasing inventories. Since Q2 of last year, inventories had been building until they were up 25% year over year. And yes, same store sales did improve, as did the stock price.Recognizing this as potentially a short-fix, Berman continued today the cynical would view this increase in sales with skepticism, noting that it wasnt of high quality as it was due, in part, to the massive inventory build. It is, however, pleasing to note that Home Depot simply got inventories back to normal, in that it now has turns similar to its competitors. The stock, following the same store sales and earnings increases, which in essence followed the inventories increase, rosiness from $22 at the start of 2003 to $36 by the end of 2003. When asked about this fix, Berman responded it will be more challenging for Nardelli to increase same store sales and margins going away forward because his increasing inventories and therefore same store sales is arguably a one-time benefit and is essentially what cau sed the fix. Berman concluded by1 Nardelli had worked at General Electric (GE) before taking over as CEO of the Home Depot.2 A periodic report where Berman discusses his thoughts on retail, focusing on inventories.Given his insights as articulated, Berman believed his fund could value firms more accurately through better valuation of inventory. This was pivotal to his investment strategy. You see, Berman elaborated, Wall Street basically ignores inventory. Its actually quite amazing to me This gives us one of our edges. Comparing recently gathered retailer numbers that examined total sales in the U.S. economy to total inventory, for almost 300 retailers, Berman remarked The total sales to total inventory numbers is also a crucial relationship over time, and it gives us a macro edge, if thats possible to believe. Indeed, at the end of Q2, 2003 I knew there would be serious inventory rebuilding in the economy going forward, as overall sales had enceinte at a faster rate than inventor ies. Indeed, in Q3, 2003 we saw a rapid and unexpected increase in GDP from 2.3% to 3.5% thanks in part to inventory rebuilding. This increase continued through Q1, 2004 when GDP growth reached 5%.Berman loved to discuss investment opportunities he had spotted by looking carefully at firm inventoryOne of the clearest examples was Saucony (Nasdaq SCNYA), a shoe partnership based near Boston, MA. Berman identified this company as a fuddled buy when he noticed in 2003 that even though sales were flattish, inventories had declined about 20% year over year. To Berman, this point well for future pull in margins. He started buying the stock at $14 in late 2003 due primarily to these lean inventories, despite that the stock was illiquid thus manifesting greater risk, and despite that management was remarkably coy about sharing nurture. A year later, the stock had doubled. During this time period, sales rose, as did inventories, and of course, the gross margin expanded significantly, a s expected.Earnings per share rose from $0.85 in 2002 to $1.29 in 2004. Bermans selling, which came shortly after management asked him to ring the Nasdaq bell with them, was once again based on a functionof his inventory analysis. This time it was the opposite scenario inventories were now growing at the same pace as sales, so the trend of sales to inventories had deteriorated and Berman was worried. To make matters worse, calls to management were not being returned. Sure enough, in March 2005, before Berman had gotten out of this illiquid position, Saucony announced it would miss earnings estimates and the stock cratered 20%.Yet another clear example was Bombay (NYSE BBA). In November 2003, Bombay Company, a fashionable home accessories, wall dcor, and furniture retailer, announced that sales were up 19% with inventories up 50% year over year. While the retailer beat earnings estimates, the company spoke of early November sales weakness, and the stock declined 20% that day to $1 0. Despite the decline, and noticing that inventories were up way too much, Berman felt the music had stopped. Going into Q4 it was clear they would energise to miss numbers again unless the consumer saved them, which would be a shocker, he said. Just over two weeks later they lowered earnings again and the stock crated another 20% to $8. Remarkably, just four weeks later, after Christmas, management lowered earnings yet again, and the stock declined yet another 20%. It was so sweet exclaimed Berman, to see the classic inventory / earnings relationship at work so quickly. In just one and a half months, the stock declined 50% primarily because of inventory mismanagement along with weaker sales.As Berman prepared to leave for the studio, Christina Zinn, a young apprentice he had just hired from Harvard Business School, walked in and presented him with a stack of papers containing the valuation of washstand B. River ( whoremaster B. River Clothiers, Inc. NASDAQ JONR). JONR is underva lued, Zinn remarked, and I think we should invest in this stock. Sales were up 24% in 2004 over the previous year, and gross margins, having risen for four straight years, seem to have peaked at 60% (one of the highest gross margins in all of US retail).2005, the companys price/earnings ratio is less than that of its primary competitor, workforces Wearhouse, which is at 17.5 times estimated earnings. This is particularly strange given that washbowl B. River has been growing faster than Mens Wearhouse during the last few years.Inventory productivity in the Retail SectorInventory dollar volume, the ratio of cost of goods sold to average inventory level, was commonly used to measure the performance of inventory managers, canvas inventory productivity across retailers, and assess performance improvements over time.3 But wide variations in the annual inventory turnover of U.S. retailers year to year not only across, but also inside, firms make it difficult to assess inventory produc tivity in practice, as evidenced by the following example and questions. surrounded by 1987 and 2000 annual inventory turnover at Best Buy Stores, Inc. (Best Buy), a consumer electronics retailer, ranged from 2.85 to 8.53. Annual inventory turnover at three peer retailers during the same period exhibited similar variation at Circuit City Stores, Inc. from 3.97 to 5.60 at communicate Shack Corporation from 1.45 to 3.05 and at CompUSA, Inc. from 6.20 to 8.65. Given such variation how could inventory turnover be used to assess these retailers inventory productivity? Could these variations be correlated with better or worse performance? Could it be reasonably concluded from this example that Best Buy managed its inventory better than Radio Shack?Inventory turnover could be correlated with other performance measures. Strong correlations, as between inventory turnover and gross margin, might have implications for the assessment of retailers inventory turnover performance. (Figure 1 plot s the four consumer electronics retailers annual inventory turnover against their gross margins (the ratio of gross profit top of markdowns to net sales) for the period 1987-2000.)Relationships among Management MeasuresRelationships among inventory turns, gross margins, and capital eagerness were central to deriving suitable benchmarks for assessing corporate performance. (Figure 2 presents a simplified view of an income statement and balance sheet. Table 1 presents mathematical definitions for inventory turnover, gross margin, capital specialty, return on assets, sales growth, and other management measures based on Figure 2 .)Whereas return on assets, sales growth, return on equity, and financial leverage tended not to vary consistently from one retail segment to another, variation in the components of return on assets was observed between and within industry segments. (Table 2 lists retail segments4 and examples of firms.) Table 3 presents gross margins, inventory turns, GMROI5 , and asset turns for super markets, drugstores, convenience stores, apparel retailers, jewelry retailers, and toy stores.) Retailers with stable, predictable demand and long product lifecycles such as grocery, drug, and convenience stores tended to have better efficiency ratios (asset turns and inventory turns) than other retailers, retailers of short lifecycle products such as apparel, shoes, electronics, jewelry, andAn alternative measure of inventory productivity, days of inventory, could be substituted for inventory turnover for the present analysis.Classification of segments is based on S&Ps Compustat database.GMROI is defined as gross margin return on inventory investment.Variation in gross margins, inventory turns, and SG&A expenses within and between segmentsROE could be decomposed into gross margin and inventory turns, and further into the relationship between capital intensity and inventory turns (see below).Anticipating roughly similar ROE measures for different retailer s, all else remaining equal, a change in any of the component metrics on the right side of the equation would be expected to result in a compensating change in some other component metric. For example, for ROE among retailers to be eq weight a retailer with higher gross margins would need to experience a compensating change in some other component, such as inventory turns. gross(a) margin and inventory turnsGross margin and inventory turns were expected to be negatively correlated, that is, an increase in gross margin was expected to be accompany by a decrease in inventory turnover. A retailer that carried a unit of product longer before selling it (i.e., a retailer with slower inventory turns) would expect to earn substantially more on its inventory investment than a retailer that carried the inventory item for a shorter period. For example, Radio Shack, which turned its inventory less frequently than twice a year,was expected to realize higher gross margins on each sale than ret ailers such as CompUSA, which turned its inventory more than eight times per year. Retailers such as Radio Shack were said to be following the profit path (i.e., earning high profit with each sale), retailers such as CompUSA the turnover path (i.e., earning quickly after making an inventory investment small profits with each sale).Retailers within the same segment were expected to achieve equivalent inventory productivity. Inventory productivity could be estimated as the product of a firms gross margins and inventory turns, termed gross margin return on inventory investment or GMROI (pronounced JIMROY). If GMROI remained stable within a segment an inverse relationship between gross margin and inventory turns would be observed. (Figure 3 depicts the expected relationship.)A correlation between gross margin and inventory turns, although expected, did not, however, imply a causative relationship between the two variables. That is, a firm that increased its gross margin by better manag ing its inventory turns would not necessarily decline commensurately. The correlation between gross margin and inventory turns could instead resile mutual dependence on the characteristics of a retailers business.Capital intensity and inventory turnsInvestments in warehouses, information technology, and inventory andlogistics management systems involved capital investment, which, being accounted for as fixed assets, was measured by an increase in capital intensity. Firms that made such capital investments often enjoyed higher inventory turns. Hence, inventory turns could be positively correlated with capital intensity.That an increase in inventory turnover and coincident decrease in gross margin was not necessarily indicative of improved inventory management capability suggested limits to the use of inventory turnover in performance analysis. If, however, two firms had similar inventory turnover and gross margin values but different capital intensities the firm with the lower capi tal intensity might possibly have better inventory management capability. It was thus desirable to incorporate changes in gross margin and capital intensity into evaluations of inventory productivity.Zinns Analysis of John B. RiverBerman fidgeted in his chair. He enjoyed opportunities to evangelize to and educate television audiences, but found the wait in the studio tedious. Until called to hold aside on various aspects of managerial performance and investment strategy he would, he decided, wade through the report Zinn had prepared for him.Company BackgroundOn November 8, 2004 John B. River Clothiers, Inc., a leading U.S. retailer of mens tailored and casual clothing and accessories, opened its 250th store. The retailer employed, in addition to the physical store format, two other channels catalogs, and the Internet. Production of John B. Rivers designs according to its specifications was contracted to third party vendors and suppliers.John B. Rivers product suite, intended to co me a male career professional from head to toe, was identified with high quality and value. Its upscale, classic product offerings included tuxedos, blazers, shirts, ties, vests,pants, and sports wear. Excepting branded shoes from other vendors, all products were marketed under the John B. River brand.Trends in workplace clothing were an important determinant of John B. River sales growth. Thus, the early 1990s trend towards acceptability of informal clothing in the workplace was cause for concern to a retailer that emphasized mens formal suits. But in the early 2000s the pendulum seemed to spend back, with increasing numbers of employees preferring to dress more formally for the workplace.The material in this section is from John B. River Clothiers, Incs 2004 10-K StatementRetail stores were John B. Rivers primary sales channel. Eighty percent of store space was dedicated to selling activities, the remaining 20% allocated to stockroom and tailoring and other support activities. Ta iloring was a differentiating service highly valued by the retailers clientele. John B. River catered to high-end customers and so located its retail stores in areas with appropriate demographics. Its seven outlet stores provided a channel for liquidating excess merchandise.John B. Rivers catalog and Internet channels accounted for approximately 11% of net sales in fiscal 2003 and 12% of net sales in fiscal 2002. Approximately eight million catalogs were distributed over these two years. Catalog sales were supported by a toll-free number that provided access to sales associates.The primary competitors of John B. River were Mens Wearhouse Inc. (Ticker MW) and Brooks Brothers (privately held). Apart from competing with thesespecialty retailers, John B. River competed with large department stores such as Macys and Filenes, which enjoyed substantially greater financial and marketing resources.Supply ChainJohn B. Rivers merchandise buying and planning staff used sophisticated information systems to convey product designs and specifications to suppliers and third party contract manufacturers and manage the production process worldwide. Approximately 24% of product purchases in fiscal 2003 were sourced from U.S. suppliers. Mexico accounted for 15% and none of the other countries from which products were sourced accounted for more than 10% of purchases. An agent was employed to source products from countries located in or near Asia.All inventory was received at a centralized distribution center (CDC), from which it was redistributed to warehouses or directly to stores. Store inventory was tracked using point-of-sale information and stock was replenished as necessary. John B. River expected to spend between $3 and $4 million in fiscal 2004 to increase the capacity of its CDC to accommodate 500 stores nationwide.Growth Strategy and RisksJohn B. River had developed a five-pronged strategy for achieving growth. First, it think to further enhance product quality by elevat ing standards for design and manufacture. Second, it planned to expand catalog and internet operations. Third, it intended to introduce new products. Fourth, it was moving towards eliminating middlemen from the sourcing of products Fifth, it was committed to providing consistently high service levels by maintaining high inventory levels.Anticipating that growth relied on opening new stores, John B. River planned to expand to 500 stores. Approximately 60 stores were opened in fiscal 2004, increasing store count to 273, and about 75 to 100 stores were planned from2005-08. Upfront costs associated with opening a new store included approximately $225,000 for leasehold improvements, fixtures, point-of-sale equipment, and so forth and an inventory investment of approximately $350,000, with higher inventory levels during peak periods.John B. Rivers growth strategy was sensitive to consumer spending. John B. River relied on its emphasis on classic styles to retain a time out in mens suits, a strategy that rendered it less vulnerable to changes in fashions but dependent on continued demand for classic styles.Zinns Analysis of John B. Rivers Financial StatementsInventoryJohn B. River used the first-in-first out method to value inventory. During price increases FIFO valuation generated higher net income than LIFO valuation. John B. Rivers inventory had been growing rapidly over the past four years. Zinn was surprised by the inventory growth, especially that inventory had grown faster than sales. Although inventory grew by 54% in 2003, corresponding sales growth was only 23%. In 2004 however, sales grew 24% while inventory grew by only 4%. Inventory at the end of 2004 however continued to be high at 303 days. Further the days payables increased from 54 days in 1998 to 82 days in 2004. Payables as a percentage of inventory however had declined from roughly 33% in 1998 to roughly 27% in 2004. But Zinn was not sure these concerns had much impact on her valuation of the comp any.Financial ratios flow rate ratio and quick ratio had been hovering around 2 and 0.2, respectively.10,11 The large difference between these two ratios reflected the fact that most of John B. Rivers current assets were inventory. Obsolescence costs would consequently be fairly high and could place the retailer in financial distress.The other financial ratios were indicative of a healthy company. ROE had increased from 15% to 27% since fiscal 2000. This increase had been by and large fueled by an increasing profit margin (0.7% to 5.5% over the same period).John B. River had enjoyed rapid growth in sales over the last few years. Annual Sales growth had increased from 9% in 1998 to 24% in 2004, fueled by sales growth in existing stores (approximately 8% per year) as well as the opening of new stores and increased sales from the retailers catalog and internet channels. John B. River enjoyed a healthy increase in gross margins from 51% to 60% over the same period. Tables 4 and 5 provid e key operational metrics for John B. River and Mens Wearhouse.Prospective AnalysisZinn had taken the Business Analysis and Valuation (BAV) class at HBS and discovered the BAV tool.12 She had used this tool to create a simpler prototype (used in the present analysis) to capture key aspects of valuation. Table 6 provides some key historical operational metrics for John B. River that Zinn used for her prospective analysis.Current ratio, defined as the ratio of current assets to current liabilities, was an indicator of a companys ability to meet short-term debt obligations the higher the ratio the more liquid the company.Quick ratio (or acid-test ratio), defined as the ratio of (cash + accounts receivable) to current liabilities, measured a companys liquidity.The BAV tool was an Excel-based model developed by Harvard Business School faculty for valuing companies.Key assumptions made by Zinn in performing the prospective analysis of John B. River included the following.1) Time horizon Zinn chose a five year time horizon from 2005 to 2009 based on expected sales growth (derived from management projections). Beyond 2009 Zinn assumed the company to have reached a steady state defined by terminal values.2) Sales growth Zinn assumed that managements projections for new stores were reasonable and that the new stores would be equivalent in size and productivity with the retailers existing stores. Using growth assumptions about stores and same store sales, Zinn computed sales growth for fiscal years 2005-2008 to be 18% (based on 15% square footage growth and 3% same store sale growth), and 10% for 2009. Sales after 2010 in Zinns analysis were expected to grow at the 4% industry standard for retail apparel stores13.3) Gross margin Gross margin had been steadily increasing Zinn expected it to hover around 60% for the next five years and then assumed gross margin to reach its terminal value to reflect increased competition.4) Other assumptions about the income statement Zin n assumed that SG&A to sales and other operating expenses to sales would continue at the 2004 levels for the near term (till 2008).5) Assumptions about the balance sheet Zinn assumed that current assets to sales, current liabilities to sales, and long term assets to sales would continue at their 2004 levels, that is, the company would maintain a similar capital structure and remain as productive with its long term assets as in 2003. Zinn obtained terminal values from industry norms for Mens and boys clothing stores14. The market risk premium was assumed to be 5%, risk free rate 4.3%, marginal tax rate 42%, and cost of debt 4.5%. Based on these assumptions, the value of a JONR share was estimated to be $43.58. Given the current (April 11th, 2005) closing price of $34.37 (see Figure 4 for historical stock prices of JONR), Zinn rated the stock a strong buy.Youre On the Air in Five MinutesBerman knew he had to return to thinking about the bigger questions that would be posed by the host of the TV show. Yet he could not take his mind off of Zinns analysis. Berman smiled, knowing that his apprentices results were diametrically opposed to his own intuition. He recollected his conversation with the CEO and CFO of John B. River during one of the quarterly earnings calls when he was trying to learn about the retailer. When questioned about the steep increase in inventory, the CEO had mentioned that John B. River was planning to grow inventory in certain basic items like white shirts, khaki pants etc. as well as increase product variety to enhance service levels to its customers. Berman was not sure about this strategy of John B. River and wondered if the companys gross margins were temporarily inflated based on increased inventories over the years. On the other hand, inventory management had improved of late. As reported on the 4th April 2005, Q4, 2004 sales had increased 24% while inventories were up only 4% year over year.