Contents

List of Tables, Figures and Charts. 2

Abstract 3

Introduction. 4

Background overview of Burberry plc (UK). 4

Background overview of Gap Inc. (US). 7

Literature Review.. 8

Theories on Profitability and Capital Structure. 8

Relation between Market-to-book ratio, profitability and leverage. 10

Overview of the Global Apparel Industry. 11

Methodology. 14

Data Analysis and Results. 15

Comparison between Gap and Burberry. 15

Comparison between Burberry and the UK Industry Averages. 19

Comparison between Gap and the US Industry Averages. 23

Conclusion and Recommendations. 31

Bibliography. 33

Appendix. 35

 

List of Tables, Figures and Charts

Table 1: Burberry Vs Gap ROE from 2002-2011…………………………………………..….14

Figure 1: Graph for Comparison of ROE for Burberry and Gap………………………………15

Figure 2: Graph for Comparison of ROA between Burberry and Gap……………………….…16

Figure 3: Comparison of SPREAD-Gap and Burberry ………………………………………………………19

Figure 4: ROE for Burberry vs. UK Industry ……………………………………………….….20

Figure 5: Burberry vs. UK Industry 2002-2011 ……………………………………………….21

Figure 6: ROE Gap vs. US Industry ……………………………………………………………24

Figure 7: ROA Gap vs. US Industry Averages …………………………………………………25

Figure 8: FLEV Gap vs. US Industry Averages……………………………………………….. 26

Figure 9: SPREAD for Gap vs. US Industry Averages ………………………………………..28

Table 2: Outstanding Common Shares against Shareholders’ Equity ………………………….35

 

Abstract

This paper presents a financial ratio analysis of Burberry Group plc and Gap Inc using the Penman’s financial ratio decomposition method. The idea is to analyse Burberry’s performance in the apparel industry as a UK-based company and compare it to its US-based competitor and also compare it against the overall UK apparel industry averages. Gap Inc is also analysed in terms of performance and then compared with the overall US apparel industry averages. The aim and objective of the paper is achieved by reformulating the balance sheets and income statements of the two companies so that it becomes easier to identify the components of the balance sheet and income statement that entail working and financing activities. The profitability owing to each activity is then worked out. The ratios that focus on leverage, operating and financing profitability and general shareholder profitability are used to assess the positions of Burberry Group plc in relation to its competitors and the entire apparel industry. Burberry is selected for its long history of operation in the clothing industry, having been established in 1856. Gap Inc is selected for the fact that it has witnessed rapid growth despite being young since its establishment in 1969. The apparel industry has seen a rapid growth over the last 4 years yielding interest in it. This has also attracted more firms into the industry. The literature review section reviews various theories and studies that have been researched on the topic and views of various authors regarding the relationship between market-to-book ratio, profitability and leverage of a firm on the capital structure decisions made by the firm are discussed to help in fitting the study into the context of existing work. The results indicate that Burberry has poor position both in the industry and against its US-affiliated competitor.

 

Introduction

The aim of this study is to compare two firms, one from the UK and another from the US. To achieve this, the study also focuses on the industries in which the two firms fall and compares the industry averages with the financial ratios worked for the firm. This objective is further achieved by focusing on two firms in the apparel industry- Burberry Group plc and Gap Inc. Burberry has been selected for its long history of operation in the clothing industry, having been established in 1856. Gap Inc is selected for the fact that it has witnessed rapid growth despite being young since its establishment in 1969. The apparel industry has seen a rapid growth over the last 4 years yielding interest in it. This has increased the level of competition and strategies firms put in place with respect to capital structure decisions can be revealed in various ways including analysis of their financial ratios and comparing the figures against the industry averages.

Under the literature review section, various theories and studies that have been researched on the topic and views of various authors regarding the relationship between market-to-book ratio, profitability and leverage of a firm on the capital structure decisions made by the firm are discussed to help in fitting the study into the context of existing work.

Background overview of Burberry plc (UK)

Burberry is a brand that was established 156 years ago when it was founded by Thomas Burberry. Over these many years of operation, Burberry has positioned itself in the apparel industry to become a major player in the luxury business not just in the UK but on the worldwide business arena. Nevertheless, the company has in the past concentrated its business in the UK, US and Japan. Japan accounts for more than 50% of the company’s brand sales while the US and Spain combined represent about 25% of the brand sales. An analysis that was carried out by the equity research firm, Credit Suisse in 2004 showed that the company’s focus of distribution on licensing especially in its Japanese market and wholesale approach in Spain results in low gearing for the company while creating a positive potential for increased consumer demand.

The company has two main investment options with the high-end apparel accounting for 60% of the company’s revenues and the accessories section accounting for 29% of the revenues.

In terms of creating shareholder value, the company has a longstanding record since the year 2000. It has achieved this through the acquisitions of brand licenses and distributors and the expansion of its distribution chains in its markets. GUS, which is the main shareholder, is fundamentally a seller for the company’s products. As at 29 August 2012, Burberry had a market capitalisation of 5.89 billion pounds with a volume of 698,953 shares being traded at the London Stock Exchange at an average share price of 1,362 GBP.  The industry average market capitalisation stood at about 884 billion pounds.

The company has more than 500 store locations worldwide and employing approximately 6700 employees. Prior to 1955, Burberry was an independent company, after which it was acquired by Great Universal Stores. While the company has had a long history of existence and operation, it was not until July 2002 that it was floated on the London Stocks Exchange as a publicly traded company. Burberry Group plc has an operating income of and its latest share price as of 26^th August 2007 closed at an average of 1,362 GBP (US $2,128).

The company faces great competition from the UK, US and globally. There are many companies competing in this industry on the global arena. The industry is less attractive to new entrants hence the greatest competition comes from the firms that are already operating. New entrants are not highly attracted to the industry because the value of the global apparel industry has only grown moderately in the past despite the fact that entry does not require large capital outlays. Major competitors in the apparel industry in the UK include Arcadia Group Limited, which is based in the UK, Giorgio Armani in Italy, Benetton Group in Italy among many others in the region. In the US, Burberry Group plc competes against companies such as Gap Inc.

Another aspect that can weaken the negotiating power of buyers is the likelihood of retailers fragmenting buyers more by differentiating themselves on the basis of the type or style of clothing they deal in. while style is viewed as an abstract concept that could be purely psychological, these fragments play a major role in winning consumer identity and loyalty (Yuen & Chan 2010). Customer loyalty as a driver for profitability of a firm has been explored extensively in previous studies. Customer loyalty and satisfaction are understood major drivers to a firm’s competitiveness, not just in the apparel industry, but in any industry (Yuen & Chan 2010). The conceptualisation of customer satisfaction varies from researcher to researcher. Cronin & Taylor (1992) argued in favour of the measures skewed towards transactions, with Anderson (1994) basing his arguments on the aspects of eventuality of the buying and consumption process. Regardless of the inclination of the researcher, customer satisfaction hinges on the extent to which goods and services meet the expectations of the buyer or consumer. Ultimately, the expectations of the consumer are drawn from the range of needs from the consumer, thereby establishing the link between consumer needs and satisfaction.

Background overview of Gap Inc. (US)

On the other hand, Gap Inc. is a US specialty apparel company established in 1969 and focuses on apparel, personal care products for all types of customers and is one of the major competitors in the global apparel business. It deals in casual apparel, accessories and individual care products for men, women and children under four main brands. The brands include piper lime, gap, old navy and banana republic. The company has an extensive online presence and it has also penetrated into the Chinese market even though it has plans to triple the number of stores in this market. Some of the websites that the company has its presence include wwws.babygap.com www.gap.com and www.piperlime.com, among others where it has its e-commerce stores. China being an emerging market for almost every industry, it creates an opportunity for many companies to show their international presence and garner an extra mark on the competitive edge.

The company has more than 3,260 store locations in North America, Japan, UK and Ireland. Out of all the stores, about 3,036 are operated by the company while the rest are franchised to third party operators. Given its strategy in store operation, having more stores being operated by the company has been cited as strength of the company and ability to command the market as the dependence on third parties in distribution and product sale is reduced. The strategy also helps in boosting the company’s autonomy in brands. Another strength of the company is its model of operating debt-free balance sheet and free cash flow. It is listed on the New York Stocks Exchange and its share price averaged 23 GBP (US $35.2) as at 27^th August 2012.

 

Literature Review

Theories on Profitability and Capital Structure

Previous literature has showed that the market-to-book ratio and profitability play a significant role as determinants of a company’s capital structure. Along this view are two theoretical viewpoints that attempt to explain the perspective taken by a firm when making such financial decisions.  Market-to-book ratio and a business’ profitability play important roles in the financial decision making. It is commonly expected for companies with higher market-to-book ratio exhibit lower leverage ratios. Lower leverage ratios indicate stronger financial standing of the company as there is reduced risk when a company has a lower leverage ratio (Hovakimian, Hovakimian, & Tehranian 2003). For that reason, firms that have higher market-to-book ratios are highly likely give out equity when opting for external financing. Moreover, companies with higher profitability have a higher likelihood of issuing debt. These empirical regularities are still a subject of much debate on the basis of the interpretations of the two factors. This debate arises because of the two schools of thought, which offer differing views on the issue of a company’s capital structure. One school of thought, the tradeoff theory, argues that firms opt for optimal capital structure by aiming to balance the tax factor and incentive benefits realised from debt financing as well as the expected costs associated with bankruptcy. On the same grounds, the theory further holds that firms that have higher market-to-book ratios have higher likelihood of greater growth opportunities (Gereffi & Memedovic 2003).

Whenever future investment opportunities arise, the firm would not wish to miss on the chances of good investments and therefore they are also determined to keep the leverage ratios lower to reduce those kinds of risks (Gereffi & Memedovic 2003). This approach makes them more likely to give out equity whenever investment opportunities come by and amend their target leverage ratios appropriately. Other scholars in the tradeoff theory of thought have also expressed views that firms that have higher profitability are typically under-levered because they tend to passively build up internal funds. This trend provides an explanation for the negative correlation between profitability ratio and the leverage ratio. Thus profitability fails to offer a proper explanation for the post-financing ratio since the passive function of the profitability has been corrected (Hovakimian, Hovakimian, & Tehranian (2003).

The costly external financing theory is the other school that that offers an explanation of the capital structure of a firm as the firm aims to strike a balance between the tax factor and financing opportunities. According to proponents of this theory, the theory has two arms. One arm is the pecking order theory and the other is the market timing theory. The first part of the theory (the pecking theory) is hinged on a fundamental assumption which holds that a firm’s external financing costs exceed the internal financing costs because of the asymmetric information. Relative costs thus have a defining role in determining the financing decisions of the firm. The market timing theory, on the other hand, assumes that market dynamics may affect the way firms select costs and this is likely to vary from firm to firm or even through time. These aspects are likely to arise from the fact that firms are likely to mis-price due to the dynamics of the market. This is likely to change the cost of equity financing. It implies that when this happens the pecking theory is rendered broken (Gereffi & Memedovic 2003). Even though the two arms of the costly external financing theory act in different ways, they have a common feature of placing emphasis on the significance of the external financing costs in determining the capital structure decisions.

The theory draws a lot from the firm’s market-to-book ratio and its profitability to develop the interpretation of the capital structure decisions made by the firm. Therefore, based on this theory, firms that exhibit higher market-to-book ratios have higher chances of issuing equity. This is as a result of the relationship between market-to-book ratio and cost of equity financing where a higher market-to-book ratio indicates a lower cost of external equity financing. This perspective of market-to-book ratio has become the chief foundation for a formal argument of the market timing theory (Baker and Wurgler 2002). Other scholars have argued that market valuation of equity is a major driving force of leverage ratios (e.g. Welch 2004). Firms fail to institute countermeasures that can help in offsetting the changes that occur to leverage ratios due to disparities in market valuations.

In fact, when opting for external financing, firms that have more positive equity market valuations have a higher probability of issuing equity, and this makes them further deviate away from their initial or target leverage ratios. This evidence is in agreement with the concept that companies are concerned more about external financing costs than their target leverage ratios.

This analysis focuses on two companies in the apparel industry. For the UK-based apparel company, Burberry plc is analysed while GAP Inc. is analysed for the US-based apparel company. It is important to have an overview of the global apparel industry to see how the two firms compare with the rest of the global apparel industry.

Relation between Market-to-book ratio, profitability and leverage

Penman et al (2006) observe that market-to-book ratio (which is also called book-to-price ratio- (B/P) has a positive correlation with subsequent profitability or stock returns. This relationship is now commonly referred to as the book-to-market (or sometimes also called HML) effect.  The market-to-book ratio stands as a feature that loads risk but it is not certain what direction the risk would be coming from since irregularities in the ratio could be as a result of either market mispricing of the firm’s stocks or due to actual pricing of the risk involved. When it results from the dynamics of market efficiency (when it underpins how efficient the market is) it is basically a rational attempt to price the risk (Penman 2004).  It could also be an interpretation of abnormal returns resulting from mispricing and in this case it underpins market inefficiency. Either way, it is important that information on the expected model of returns of the company is known to have full idea of what causes any change in the market-to-book ratio of the firm. Therefore, comparing the ratio with other financing ratios such as financial leverage (FLEV), return on equity (ROE) and the return on common equity (ROCE) is an important endeavour to gauge the position of the company in terms of profitability and leverage. This position is also supported by the study conducted by Zhang (2000).  Conservative accounting leverages ROCE equation and the leverage effect flows through the profitability accruable to shareholders. Hence, as the amount of anticipated ROCE grows, the market-to-book ratio also grows (Zhang 2000).

Overview of the Global Apparel Industry

The global apparel industry has been expanding considerably as a result of the trade policies that existed before 2005. In 2005, the World Trade Organization initiated an agreement on textiles and clothing (known as ATC), which removed a number of the quotas that previously helped in the regulation of the industry. This move caused a remarkable fluctuation in the balance of global apparel industry in terms of trade and production that made firms to restructure their strategies in bid to realign their production policies and sourcing systems in the midst of the new economic realities and the paradigm shift in the global politics (Karina, Stacey & Gereffi 2011). These changes have resulted in other significant factors that impact country competitiveness in the global apparel industry. These factors include costs of labour, production costs, and competencies among other minor factors.

Thus, emerging economies such as China and Bangladesh have provided opportunities as centres for lower-value assembly within the value chain of the apparel production because they offer low-cost alternatives in the production segment. In order for other smaller countries to maintain their competitiveness, they have to upgrade their workforce skills or else they fall out of the value chain. Nevertheless, Karina, Stacey & Gereffi (2011) observe that while the global apparel industry has become a trillion dollar industry, it has become an important economic stimulus for many economies especially for developing countries and low income economies account for about 75% of the world clothing exports. The industry is a prototypical model of buyer-driven industry with power asymmetries in the chain where the suppliers and the target buyers in the global apparel chain do not exhibit symmetrical power balance (Gereffi & Memedovic 2003).

Due to the power asymmetries between the buyers and producers, the global buyers are the ones who determine the type of products to be produced, where they are produced, who produces them and the costs of production. This constraint makes firms to outsource production or manufacturing by establishing a special network of global contract manufacturers especially in the developing countries since that is where costs of production are low and provide chances for competitiveness in the highly competitive global market. Most lead firms that create these manufacturing contracts are mostly headquartered in the developed nations such as US and those in Europe.

All global industries rely on international standards, so does the apparel value chain. For this reason, factories have to measure their performance regularly to ensure achievement of the standard quality, time-to-time tracking of price and timely delivery of the products. All these present challenges facing the companies in the apparel industry and any company that fails on any of the small issues is likely to be overcome by the challenges and fall out of the competition.

The global apparel industry is also characterised by market segmentations where the market segment that takes the largest share of the global apparel retail market is the women’swear segment. This segment accounts for over 50% of the industry’s global total value. Other segments include the menswear, which represents 32.5% of the industry (as per the 2010 figures) and children’s clothing. This segmentation is based on the target consumer. With respect to segmentation by region, America and Europe have an equal representation of the industry’s global value with each accounting for 37.3% of the value. Asia-Pacific represents about 23%.

 

Methodology

This section provides the methodological approach taken to achieve the objectives of the study and answer the research questions. Profitability analysis using the traditional activity-based approach has traditionally presented a number of problems, one of the main ones being the contamination, where the method fails to distinguish between the financing factor and the operating factor. The traditional approach also mixes up the two factors, even though this problem is resolved when the drivers are decomposed into ROA, SPREAD and financial leverage. Since the value drivers still fail to distinguish between the two main factors, a more efficient financial ratio decomposition method is needed to deal with the problem.

The logic behind the Penman is that analysis of a company’s profit should be based on the incorporating the financing factor and the operating factor as two separate factors in the analysis.  Several ratios are calculated to help in the step-by-step arrival at the conclusive results. Some of the basic financial analyses carried out include calculation of the sales to net operating assets ratio, the operating income to net operating assets ratio, and the return on equity ratio. Return on assets is also worked out alongside other ratios.

The first step in the analysis is the reformulation of the income statement and the balance sheet. The process of reformulating the balance sheets and income statements is done so that it becomes easier to identify the components of the balance sheet and income statement that entail working and financing activities. The profitability owing to each activity is then worked out. The ratios that focus on leverage, operating and financing profitability and general shareholder profitability are used to assess the positions of Burberry Group plc in relation to its competitors and the entire apparel industry.This enables easier computation of the ratios under the Penman’s financial ratio decomposition method. The analysis uses data from 2002 to 2012. SPSS and Excel are used as the main tools of analysis for the data.

Data Analysis and Results

Comparison between Gap and Burberry

In the analysis and comparison of the ROE for Burberry Group plc and Gap Inc. the graph below shows the relationship of the two firms in terms of the comparison since 2002 to 2011. As the graph indicates, the ROE for Burberry has been less turbulent than that of Gap, which shot up sharply between 2002 and 2004 jumping from -0.52% in 2002 to 13.34% in 2003 and then further to 23.32% in 2004. Generally though, looking at the figures, it is evident that Gap Inc exhibits higher ROE ratio than Burberry. This shows that Gap is better at and capable of generating cash from its internal operations than Burberry. Profitability metrics thus, based on the results of the ROE shows that Gap Inc is better placed than Burberry. Another important observation from the results is that Gap’s ROE is more turbulent while Burberry has an almost streamline ROE over the 10-year period of comparison. Gap Inc has a median ROE of 22.33% while median ROE for Burberry is 0.24%. Thus for both companies, the mean and median for ROE are positive in all cases. However, even though the median ROE for Burberry is positive it is small at 0.24%.

ROE

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

GAP

-0.52%

13.34%

23.32%

23.27%

22.10%

13.90%

17.63%

25.73%

22.57%

27.01%

Burberry

0.35%

0.30%

-0.54%

-1.09%

-0.58%

0.18%

1.19%

1.17%

0.78%

0.16%

Table 1: Burberry Vs Gap ROE from 2002-2011

Figure 1: Comparison of ROE for Burberry and Gap

For financing leverage in the analysis, levered profitability after decomposition (ROCE) has a mean of 18.83% for the US affiliated firm Gap Inc while that of Burberry Group stands at 0.19%. For the two companies, when a correlation analysis is done between the ROE and ROA, they both have a strong positive correlation that is almost close to unity. Therefore, the correlation between ROE and ROA for Gap is 0.9607 while that for Burberry is 0.9555. This relationship is expected for a business whose assets generate profitable sales. However, when ROA is analysed individually for the two firms, it is evident that Gap has a higher mean of 32.08% while Burberry has 0.13%. The graph below also shows that ROA for Gap has witnessed a steady growth for the years under review. The graph also shows a streamline movement of the Burberry over the ten-year period under review. It is like one it would be construed as to imply Burberry avoids high-risk-high-return capital decisions.

Figure 2: Comparison of ROA

The mean of the two constituents of the financing leverage effect, FLEV and SPREAD, for Burberry Group are both negative at -17.21% and -1.23% respectively.  However, for Gap Inc, one component, FLEV, is negative at a mean of -28.28% while SPREAD is positive at a mean of 29.62%.  When the two components were analysed for correlation for the two companies, the results indicate that they both have negative correlation. The Pearson correlation coefficient between FLEV and SPREAD for Gap Inc is -.83979 while that for Burberry is -0.1448. These results indicate that the correlation between Gap’s FLEV and its SPREAD is stronger than that for Burberry despite both being negative.  There is thus a big and noticeable disparity in the two companies.

The relationship between negative FLEV and a company’s profitability has been documented by Penman and Nissim (2003). The negative FLEV indicates that the financial assets exceed the financial liabilities and this is a favourable situation for the company to aim for. The FLEV measure does not include the operating liabilities of a business but includes the financial assets.

Financial leverage lifts the return on capital employed (ROCE) over the return on net operating assets (RNOA), with the effect of leverage being determined by the magnitude amount of FLEV and the spread between the return on net operating assets RNOA and the borrowing rate. A company that has a positive spread is in a favourable position than the one that has negative spread (Penman and Nissim 2003).

Some authors have related this negative correlation between the two components arising from a positive correlation between FLEV and the net borrowing rate of a firm.  It implies that a firm that has higher leverage has a higher risk and therefore the lenders charge higher interest rates to compensate for the increased risk. But the primary reason for the negative correlation between Gap’s FLEV and its SPREAD is the negative correlation between the firm’s FLEV and its ROA (standing at -0.858) since profitable business organisations firms tend to have low net financial obligations. The correlation between Burberry’s FLEV and its ROA is positive at 0.566. In comparing the SPREAD for the two firms, the mean SPREAD for Gap Inc was found be positive while that for Burberry is negative (at 29.62% and -1.23% respectively). The chart below provides a good graphical overview of these results.

Figure 3: Comparison of SPREAD-Gap and Burberry

From the individual figures for the two companies over the 10-year period, it can be deduced that Gap Inc has maintained a relatively positive SPREAD and growing over the years than its competitor in the UK, Burberry. However, throughout the analysis, from what has been mentioned earlier up to now, it is evident that the period between 2003 and 2006 had particular effect on the two firms. This is evident from the way the two graphs move (though not with the same magnitude) in a similar manner with respect to direction.

Comparison between Burberry and the UK Industry Averages

For the analysis and comparison of Burberry Group plc and the UK apparel industry averages, all the ratios analysed for Burberry Group plc and Gap Inc. are carried out. Graphs are also generated to provide a better picture of the comparisons since 2002 to 2011. The results show that Burberry has a higher (stronger) correlation between its ROA and ROE than the industry average. However, both correlations are positive. Burberry has a correlation of 0.955 while the industry average is 0.648. With respect to the actual ROE, Burberry has a ROE of 0.19% against an industry average of 1.19%. It can thus be deduced that Burberry has a performance that falls below the industry average hence its position in the industry is worse than an average firm in the UK apparel industry.

Figure 4: ROE for Burberry vs. UK Indus.............