David Berman Essay

David Berman reviewed the macroeconomic military issues on caudex turns as he on the watch for his repaproportionn appearance on CNBCs shout out Box as a cockcrow co- emcee. A leading expert on consumer related stresss, Berman and his colleagues including portfolio manager Steve Kernkraut, a flavor sell executive and psychoanalyst, were frequent contri scarceors to different TV shows. On April 4th 2005, episode magazine ran a layer on Berman c wholly in alled King of the Retail Jungle, and on December 13th, 2004, Barrons ran a story called Smart Shopper where Bermans quaternity line of work picks as identified, appreciated 30% on reasonable over the following quarter. collide with air he was a mo canary memoryho social occasion manager as swell up as founder and pre lieunt of Berman cracking (which managed copyrighted majuscule) and founder of and general partner in New York- ground Durban expectant, L.P. (which managed outside and proprietary seat of gove rn custodyt). Glancing at his n atomic number 53s on macro tr halts in retail stocktaking turns, Berman wondered if he should talk intimately his impressions on the show.Berman held a bachelors degree in finance and masters equivalency in method of ac calculateing from the University of Cape Town in payable south Africa. He had also passed the South Afri depose chartered accountant and the United States certified public accountant examinations. Berman obtained his CPA qualification in calcium go an auditor for Arthur Andersen and Comp either where he examined the financial statements and ope rations of a occur of retail clients. He had been the auditor of Bijan, the remarkable mens upscale fit out last on Rodeo Drive and fifth Avenue. Prior to starting his own funds Berman worked as a portfolio manager and analyst earlier at two argue Street steadfastlys. He evolved his investing flair under the tutelage of Michael Steinhardt of Steinhardt Partners, which he joi n piddlingly by and byward graduating with distinction from Harvard work initiate in 1991. From 1994 to 1997 Berman worked in consumer-related stocks at an otherwise(prenominal)(prenominal) man- surfaced hedge fund. He subsequently launched Berman Capital in 1997 and Durban Capital in 2001. professor Ananth Raman of Harvard occupation School, Professor Vishal Gaur of the Stern School of blood line at New York University, and Harvard caper School Doctoral Candidate Saravanan Kesavan ready this case. real details have been disguised. HBS cases are true solely as the basis for line discussion. Cases are non int ex margeinate to behave as endorsements, rootages of chief(a) coil data, or illustrations of in force(p) or ineffective oversight.Copyright 2005 president and Fellows of Harvard College. To order copies or request liberty to reproduce hooeys, call 1-800-545-7685, write Harvard personal credit line School Publishing, Boston, MA 02163, or go to http//www.hbs p.harvard.edu. No part of this publication may be reproduced, stored in a recovery system, utilise in a spreadsheet, or transmitted in any variety or by any wayelectronic, mechanical, photocopying, recording, or otherwisewithout the permission of Harvard Business School.Copying or posting is an misdemeanour 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 create over the categorys to refine accounting estimates enabled him to ceremonial occasion aspects of retail accounts that would be missed by most investors. The alliance in the midst of instrument and winnings and therefore share toll, for pattern, while translucent to a retail merchant, was seldom accepted by analysts or investors. This race, Berman observed, is ASTOUNDINGLY powerful, save(prenominal) if amazingly few understand why. Most destine its just a escape of armoury gamble. Its not. Its primarily a proceed of how the operating bounds can be manipulated by anxiety in the short stipulation by performing around with inventories. For example, said Berman, if a retailers inventories are growing a good deal bustling than rough-cut r no shed light onhe slightue, then pure(a) circumferences would be racyer than they ordinarily should be, as the retailer has not interpreted the mark-downs that a consecutive disciplined retailer should take.Interestingly, Berman beamed, there is no law in GAAP that limits the number of sidereal days enrolment to any norm, and as such(prenominal)(prenominal)(prenominal), the practice of change magnitude inventories beyond any norm goes unfettered. Berman continued managements sign-off on the inventories as macrocosm somewhat valued, and the auditors pretty very n proterozoic(prenominal) rely on their word. Berman believed that from an investors perspective, its a game of musical chairs you presumet want to be t he dying person standing. In other words, you mountt want to be an investor when swinish stark(a) revenue slow and when mark-downs of the bloated scrutinize finally pick up to be taken to move the goods.The affinity of inventories to gross revenue was also an important i that Berman foc employ on. In a distributor point of rising inventories on a lusty foot basis, Berman says it is quite obvious that aforementioned(prenominal) store gross sales should exclude as the offering to the customer is that much great. Simply put, the to a greater extent offerings you put in a store, ceteris paribus, the larger sales should be. It is at this time, Berman argued, that the stock determine rises, as investors lieu absorber ratings on retailers with toweringer sales, disdain that this blueer valuation is achieved primarily due to the high inventories.An excellent example of the scroll to sales relationship was Home memory boardIn 2001 and 2002 Home funds bare-assed CEO, Bob Nardelli1, catchmed to struggle in managing the transition from a cash- mix GE-type philosophy to a retailer Home Depot-type philosophy. In his DeeBee Report2 date June 10th 2003, Berman stated Bob Nardelli in condition(p) the power of history the hard way. In focusing on cash flow improvement, he dramatically swallowed inventories and yes, change magnitude cash proportionalitys lonesome(prenominal) to see a huge decline in uniform store sales, and in its stock impairment the stock went from around $40 to $22. And so, under immense pres certain, Nardelli reversed pass and focused intensely on change magnitude inventories. Since Q2 of last social tell, inventories had been building until they were up 25% social class over year. And yes, analogous store sales did improve, as did the stock price.Recognizing this as potentially a short-fix, Berman continued instanter the cynical would view this profit in sales with skepticism, noting that it wasnt of high w hole tone as it was due, in part, to the massive account build. It is, however, pleasing to note that Home Depot simply got inventories back to normal, in that it right off has turns similar to its competitors. The stock, following the akin store sales and sugar amplifys, which in essence followed the inventories addition, rose from $22 at the start of 2003 to $36 by the end of 2003. When asked about this fix, Berman responded it will be to a greater extent challenging for Nardelli to increase corresponding store sales and security deposits going away because his increasing inventories and therefore kindred store sales is arguably a one-time hit and is essentially what caused the fix. Berman concluded by1 Nardelli had worked at General voltaic (GE) out front taking over as CEO of the Home Depot.2 A peakic report where Berman discusses his thoughts on retail, focusing on inventories.Given his insights as articulated, Berman believed his fund could value firms more accur ately by fall apart valuation of origin. This was pivotal to his investing strategy. You see, Berman elaborated, Wall Street basically ignores blood line. Its actually quite amazing to me This gives us one of our edges. Comparing recently collect retailer numbers pool that examined total sales in the U.S. economy to total history, for nigh 300 retailers, Berman remarked The total sales to total livestock numbers is also a crucial relationship over time, and it gives us a macro edge, if thats potential to believe. Indeed, at the end of Q2, 2003 I k crude there would be serious parentage build in the economy going forward, as overall sales had grown at a faster rate than inventories. Indeed, in Q3, 2003 we saw a rapid and upset(prenominal) increase in GDP from 2.3% to 3.5% contain in part to size up rebuilding. This increase continued through Q1, 2004 when GDP offshoot reached 5%.Berman loved to discuss investment opportunities he had spotted by looking carefully at firm inscriptionOne of the assailableest examples was Saucony (Nasdaq SCNYA), a shoe caller-out base practiced Boston, MA. Berman identified this participation as a strong misdirect when he noticed in 2003 that even though sales were flattish, inventories had declined about 20% year over year. To Berman, this bode well for future everlasting(a) circumferences. He started purchasing the stock at $14 in late 2003 due primarily to these disposition inventories, despite that the stock was illiquid thus presenting greater risk, and despite that management was remarkably overmodest about sharing training. A year by and by, the stock had doubled. During this time period, sales rose, as did inventories, and of course, the rank margin expanded significantly, as evaluate.Earnings per share rose from $0.85 in 2002 to $1.29 in 2004. Bermans trade, which came shortly after management asked him to ring the Nasdaq bell with them, was once more based on a functionof his strain a nalysis. This time it was the opposite scenario inventories were now growing at the equivalent maltreat as sales, so the rationalise of sales to inventories had deteriorated and Berman was worried. To make matters worse, calls to management were not being cave ined. Sure enough, in March 2005, forrader 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 spank earnings estimates, the order spoke of archaean November sales weakness, and the stock declined 20% that day to $10. Despite the decline, and noticing that inventories were up way withal much, Berman felt the music had stopped. Going into Q4 it was clear they would have to miss numbers over again unless t he 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 unpolluted schedule / earnings relationship at work so quickly. In just one and a fractional months, the stock declined 50% primarily because of stock-take mismanagement along with weaker sales.As Berman prepared to leave for the studio, Christina Zinn, a young prentice he had just hired from Harvard Business School, walked in and presented him with a stack of papers containing the valuation of fast one B. River ( conjuring trick B. River Clothiers, Inc. NASDAQ JONR). JONR is undervalued, Zinn remarked, and I cerebrate we should invest in this stock. Sales were up 24% in 2004 over the introductory 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 caller-outs price/earnings ratio is less than that of its primary competitor, handss Wearhouse, which is at 17.5 clock estimated earnings. This is particularly strange given that nates B. River has been growing faster than manpowers Wearhouse during the last few years. document merchandiseivity in the Retail SectorInventory swage, the ratio of woo of goods sold to average inventory level, was commonly used to whole step the slaying of inventory managers, compare inventory productivity across retailers, and valuate work improvements over time.3 But wide variations in the one-year inventory turnover of U.S. retailers year to year not only across, but also at heart, firms made it difficult to assess inventory productivity in practice, as evidenced by the following example and questions.Between 1987 and 2000 annual inventory turnover at Best procure bloodlines, Inc. (Be st 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 set City Stores, Inc. from 3.97 to 5.60 at Radio populate 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 agree with better or worse movement? Could it be fair concluded from this example that Best Buy managed its inventory better than Radio populate?Inventory turnover could be correlated with other performance billhooks. Strong correlations, as between inventory turnover and gross margin, might have implications for the assessment of retailers inventory turnover performance. (Figure 1 plots the four consumer electronics retailers annual inventory turnover against their gross margins (the ratio of gross profit net of markdowns to net sales) for the perio d 1987-2000.)Relationships among Management MeasuresRelationships among inventory turns, gross margins, and bully vehemence were central to filiation 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 enthusiasm, return on assets, sales festering, and other management measures based on Figure 2 .)Whereas return on assets, sales produce, return on equity, and financial leverage tended not to diversify systematically from one retail fraction to another, variation in the fixingss of return on assets was observed between and within assiduity segments. (Table 2 lists retail segments4 and examples of firms.) Table 3 presents gross margins, inventory turns, GMROI5, and asset turns for supermarkets, drugstores, thingamabob stores, apparel retailers, jewelry retailers, and toy stores.) Retailers with stable, pr edictable 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 be as gross margin return on inventory investment. variety in gross margins, inventory turns, and SG&A expenses within and between segments roe could be decomposed into gross margin and inventory turns, and save into the relationship between capital intensity and inventory turns (see below).Anticipating just about similar roe measures for different retailers, all else remaining equal, a change in any of the component metrics on the right side of the equation would be expected to settlement in a compensa ting change in some other component metric. For example, for ROE among retailers to be homogeneous a retailer with higher gross margins would need to find out a compensating change in some other component, such as inventory turns. crying(a) margin and inventory turns primitive margin and inventory turns were expected to be negatively correlated, that is, an increase in gross margin was expected to be attended by a decrease in inventory turnover. A retailer that carried a unit of product longer before selling it (i.e., a retailer with drawn-out inventory turns) would expect to earn easily more on its inventory investment than a retailer that carried the inventory period 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 retailers such as CompUSA, which turned its inventory more than eight times per year. Retailers such as Radio Shack were said to be following t he 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 shrimpy 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 increase its gross margin by better managing its inventory turns would not necessarily decline commensurately. The correlation between gross margin and inventory turns could inst ead reflect 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 metrical by an increase in capital intensity. Firms that made such capital investments ofttimes enjoyed higher inventory turns. Hence, inventory turns could be positively correlated with capital intensity.That an increase in inventory turnover and simultaneous decrease in gross margin was not necessarily indicatory of change 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 capital intensity might perchance have better inventory management capability. It was thus desirable to incorporate changes in gross m argin and capital intensity into evaluations of inventory productivity.Zinns Analysis of conjuring trick B. RiverBerman fidgeted in his chair. He enjoyed opportunities to evangelize to and initiate television audiences, but found the cargo area 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 tail B. River Clothiers, Inc., a leading U.S. retailer of mens tailored and casual habiliment and accessories, opened its 250th store. The retailer employed, in entree to the physical store format, two other bloodlines compiles, and the Internet. Production of hind end B. Rivers designs according to its specifications was takeed to third caller vendors and suppliers. keister B. Rivers product suite, intended to dress a male line of achievement professional from head to toe, was identified with high qualit y and value. Its upscale, classic product offerings include tuxedos, blazers, shirts, ties, vests,pants, and sports wear. Excepting branded shoes from other vendors, all products were marketed under the tail end B. River brand.Trends in body of work clothing were an important determinant of magic 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 swing 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 portion of store space was dedicated to selling activities, the remaining 20% allocated to stockroom and accommodate and other support activities. Tailoring was a differentiating service highly valued by the retaile rs 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 catalogue and Internet channels accounted for rough 11% of net sales in monetary 2003 and 12% of net sales in pecuniary 2002. around eight meg 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 abide Brothers (privately held). Apart from competing with thesespecialty retailers, John B. River competed with too large department stores such as Macys and Filenes, which enjoyed substantially greater financial and marketing resources.Supply ChainJohn B. Rivers merchandise buying and planning provide used sophisticated information systems to convey product designs and specifications to suppli ers and third party contract manu concomitanturers and manage the production process worldwide. Approximately 24% of product purchases in financial 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 affection (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 calciferol stores nationwide.Growth Strategy and RisksJohn B. River had create a five-pronged strategy for achieving growth. First, it plotted to only enhance product quality by elevating standards for design and manufacture. S econd, it planned to expand catalog and internet operations. Third, it intended to introduce overbold 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 juvenile stores, John B. River planned to expand to viosterol 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 withstand a niche in mens suits, a strategy that rendere d it less vulnerable to changes in fashions but dependant 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 non new 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 change magnitude 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 company.Financi al ratiosCurrent 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 latest 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 increase from 15% to 27% since fiscal 2000. This increase had been largely 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 increase from 9% in 1998 to 24% in 2004, fueled by sales growth in exist stores (approximately 8% per year) as well as the opening of new stores and increase 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 provide reveal operational me trics 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 cast (used in the present analysis) to capture break aspects of valuation. Table 6 provides some chance upon historical operational metrics for John B. River that Zinn used for her prospective analysis.Current ratio, defined as the ratio of accredited 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. dissipated 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 power for valuing companies.Key assumptions made by Zinn in performing the prospective analysis of John B. River included the following.1) Time sentiment Z inn chose a five year time horizon from 2005 to 2009 based on expected sales growth (derived from management projections). Beyond 2009 Zinn put on the company to have reached a soaked state defined by entrepot values.2) Sales growth Zinn imitation 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 anticipate gross margin to reach its terminal value to reflect increased competition.4) separate assumptions about the income s tatement Zinn 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 fat 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%, fringy 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 channel in Five MinutesBerman knew he had to return to thinking about the bigger questions that would be posed b y 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 laborious 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 uninfected 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 describe on the 4th April 2005, Q4, 2004 sales had increased 24% while inventories were up only 4% year over year.