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Inquiry Takes Toll on Hilfiger Shares

Shares of Tommy Hilfiger Corp. plunged in NYSE trading after the disclosure that a subsidiary is the target of a federal criminal investigation.

NEW YORK — Shares of Tommy Hilfiger Corp. plunged 21.8 percent in New York Stock Exchange trading on Monday after the disclosure Friday that a subsidiary, Tommy Hilfiger U.S.A. Inc., is the target of a federal criminal investigation.

Several Wall Street analysts downgraded the stock, saying that unknown details surrounding the inquiry by the U.S. Attorney’s office in Manhattan and uncertainty regarding its outcome will likely cloud the firm’s future. Shares fell by as much as 26 percent, to $9.75, before closing at $10.30, down $2.87 from Friday’s close. It was a new 52-week low.

Tommy Hilfiger U.S.A. said in a statement on Friday that it had received a grand jury subpoena for documents relating to the commission rate it paid to a non-U.S. subsidiary. Investigators are seeking documents dating to 1990, and the company is cooperating, the statement said. In addition, some current and several former employees also received subpoenas. Officials at Tommy Hilfiger on Monday declined further comment.

Tommy Hilfiger U.S.A. said that the commission rate was paid for services that included product development, sourcing, production scheduling and quality control functions, but didn’t elaborate.

Industry professionals, who spoke on condition of anonymity, told WWD that the typical arrangement in the industry is a rate of 5 to 8 percent of the cost of the unit sold by the factory, also known as FOB or “freight on board.” They said that intercompany transfers are typically part of a transfer pricing agreement between the sister firms.

Generally, a higher commission rate would lower profits for the firm making the payment, which has the consequence of reducing taxes owed. The receiving firm would see higher profits on its income statement and end up paying more tax, but the tax rate for operators in Asia also tends to be lower than here in the U.S.

Tommy Hilfiger Corp., based in Hong Kong, is seeking to restore sales and profits. Over the last three quarters, Hilfiger earnings have seesawed from profit to loss, while top-line results have been inconsistent. For the most recent quarter, ended June 30, the company reported a net loss of $7.6 million, compared with last year’s earnings of $17 million. Sales fell 10.5 percent to $328.6 million from $367.2 million.

This story first appeared in the September 28, 2004 issue of WWD.  Subscribe Today.

Some analysts speculated that the inquiry centers on taxation issues.

“We believe these buying agency commissions, which are an effective royalty on Tommy’s wholesale businesses in the U.S. and Europe, effectively shifted profits to lower tax jurisdictions,” wrote Virginia Genereux, a Merrill Lynch analyst, in a research note on Monday. Her “neutral” rating on the stock was unchanged.

Dennis Rosenberg of Credit Suisse First Boston estimated in his research note that the potential tax liability relating to the investigation is “less than $100 million before interest and penalties.” He downgraded the stock to “neutral” from “outperform.”

Prudential Equity Group analyst Lizabeth Dunn on Sunday downgraded the stock to “underweight” from “overweight.”

“While we think [Hilfiger] is in turnaround mode, we think the investigation will completely overshadow the turn until it is resolved,” she wrote in her report. “We think the stock could trade down sharply on the open, and further over the coming weeks. Our price target of $8 [lowered from $18] is about 40 percent below Friday’s close.”

Dunn also noted financial implications for the company: “We believe the investigators are looking into whether [Hilfiger] has been shifting around income to avoid paying taxes. It is difficult to know the magnitude of the potential liability, but our best estimate is more than $100 million. That magnitude of settlement would not create a liquidity issue [in our view], but it would evaporate most of [Hilfiger’s] net cash position.”

She added that the investigation comes at an unfortunate time for the apparel firm, which Dunn noted has made “significant” progress in corporate governance over the last two years.

According to her report, Tommy Hilfiger Corp.’s tax rate has been falling for 11 years, although it rose over the last two years. The tax rate in fiscal 2004 was 22 percent, and the analyst, in lowering her earnings estimates for fiscal years 2005 and 2006, had priced in a jump in the tax rate to 35 percent. At that level, the earnings per share estimate for 2005 is $1.04, down from $1.30. The EPS for 2006 is now at $1.10 from her previous estimate of $1.47.

Dunn wrote that she had a lot of questions: “How long will the investigation take, who from the current management team is involved, how bad could this get — and will the company’s history of self-dealing management come to light?”

She also wrote about her concern that the investigation could stir up other issues. Dunn noted the increase in commissions over time, such as when Tommy “bought its Canada, women’s wear and jeanswear businesses from senior executives and directors” of the firm in place at that time. She also criticized the payout to designer Tommy Hilfiger, who gets 1.5 percent of sales paid in cash and earned $68 million over the last three years. She was critical of the payout to former chief executive officer Joel Horowitz, who was paid 5 percent of operating income during his tenure as ceo. Horowitz, who remains chairman, in the last three years got “$32 million — all while the company was seriously underperforming the industry.”

And, while Dunn raised the possibility that, “[if] this turns out to be fraud, we think the U.S. Attorney may prosecute individuals,” her concern centered on the ramifications for the company’s balance sheet.

“The company’s credit facility requires a minimum net asset value of $1.2 billion. As of the [first quarter], the company had $1.22 billion in shareholders’ equity, or net asset value. If the company has to pay a large settlement, net asset value will decline by the charge. Therefore, the credit facility would be in violation of the covenant,” Dunn wrote.

The analyst speculated that, while solvency would not be an issue, a violation of the covenant might cause Tommy to restructure the facility, necessitating more onerous terms.

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