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Tommy’s Tough Reality: Hilfiger Struggles With Federal Probe

Tommy Hilfiger has maintained his cool persona, but the company that bears his name is under much pressure from a grand jury investigation.

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NEW YORK — Surrounded by assistants, cameramen and hordes of hopeful designers at a casting call for his new reality TV show, Tommy Hilfiger was in his element — the master of ceremonies offering opinions on style and serving up well-crafted sound bites.

“Fashion and pop culture are now one,” the designer said, latching onto a phenomenon that he helped propel with advertising campaigns featuring David Bowie, Lenny Kravitz and Beyoncé Knowles. Dressed in ripped jeans, an untucked striped shirt and a dark blazer, Hilfiger was preparing for “The Cut,” in which 16 aspiring designers will compete for the chance to create their own collections under the Tommy Hilfiger label. The program is to debut next year on CBS.

Hilfiger, 53, honorary chairman and principal designer of the company that generated $1.88 billion in revenue for the year ended March 31 — his salary was $18.3 million — appeared to be at the top of his game.

But just days earlier, Tommy Hilfiger Corp. announced that it was under criminal investigation by the U.S. Attorney’s Office in Manhattan regarding its commission policies. The inquiry might ultimately endanger the brand and result in additional tax liability of as much as $160 million, Wall Street analysts and industry executives said.

Subpoenas, some seeking documents as far back as 1990, were issued to the company, as well as former and current executives. Hilfiger has delayed releasing its earnings for the quarter, and its market capitalization has plummeted more than 30 percent, or $365 million, since the announcement. The company’s stock has fallen to $9.19 from $13.17 in New York Stock Exchange trading. About 10 shareholder lawsuits have been filed against the corporation.

“It’s not some minor violation,’’ said management consultant Emanuel Weintraub. “This is a very serious matter, which goes to the integrity of the company and impacts Wall Street’s opinion….This will pass. Tommy will not close down, but it has to slow them down.”

Slowing down would be a move in the wrong direction for Hilfiger, which is trying to rev up its business under the direction of David Dyer, who was named president and chief executive officer after being lured from Lands’ End in August 2003.

“It was a company that had a few fabulous years, more than a few, and just couldn’t find its way again,” said a portfolio manager at an investment firm that owned Hilfiger stock who spoke on condition of anonymity. “I was waiting for more evidence that the turnaround was happening [when the investigation came to light].”

While the outcome of the inquiry is open to question, it could hardly have happened at a worse time, as Hilfiger is seeking to diversify through acquisitions after sales declines in its core line as well as some misfires in the introduction of H Hilfiger, the new better brand that features Bowie and Iman in its advertising.

Asked about the charges at the casting call last month, Hilfiger said, “I’m not going to comment on that today.”

In a statement last week, the company said the investigation “is focused on the appropriateness of the commission rate paid by the company’s subsidiaries to Tommy Hilfiger (Eastern Hemisphere) Ltd. as well as other related tax matters, although there can be no assurance that the scope of the investigation will not be expanded.”

The corporation said it is providing requested documents to law enforcement authorities. It is not known which current or former employees were subpoenaed. While Hilfiger and Joel Horowitz, current chairman, were both at the company at the time, the investigation’s scope also covers the time frame when Silas Chou and Lawrence Stroll were co-chairman of the company and held significant stakes. The pair left their executive roles in 2002 after selling their shares to spend more time on their other fashion investments, including Asprey and Garrard.

Hilfiger has hired former U.S. Attorney for Manhattan Mary Jo White as lead counsel. White pursued high-profile organized crime and corporate liability cases during her term from 1993 to 2002, including the prosecution of mob kingpin John Gotti, and now heads a team of eight former assistant U.S. Attorneys as a partner at Debevoise & Plimpton here.

Hilfiger’s board launched an internal inquiry through a new special committee of independent directors, including Clinton Silver, Mario Baeza and Jerri DeVard. Auditor PricewaterhouseCoopers cannot complete its review of the firm’s second-quarter financial results until it sees the special committee’s review.

Hilfiger has released pretax profits, which fell 14.4 percent to $69.3 million, for the second quarter. Net revenues slid 2.2 percent to $536.1 million. Wholesale revenues dropped 7.1 percent to $387.4 million, while European revenues shot up 28.3 percent to $195.6 million. Sales in owned stores increased 12.8 percent to $129.8 million and licensing revenue picked up 19.3 percent to $18.9 million.

The company lowered its outlook for the year ending March 31, 2005, citing poor sales and higher-than-expected markdown expenses, and will hold off on filing its quarterly statement with the Securities and Exchange Commission. In a statement, Hilfiger said it does not expect the delay to cause any of its debt to become due early. It also retained FTI Consulating Inc. to review the buying office commission rates.

The commissions cover services such as product development, sourcing and quality control. Commissions between subsidiaries are not uncommon in the increasingly global fashion industry. The standard for such fees is about 5 to 8 percent of the cost of the unit sold by the factory. One former Hilfiger executive, who worked on the divisional level and asked not to be identified, said the commissions employed by the company were in line with these industry standards.

“They’re very close to the vest and they’re very buttoned-up in terms of all the legal stuff,” the former executive said. “I’m in touch. It completely took people by surprise.”

There is some room for interpretation in the laws governing such commissions, said Dominique Vincenti, vice president of the Global Practice Center of the Institute of Internal Auditors, an advocate of the internal audit profession, based in Altamonte Springs, Fla.

For instance, she said the law stipulates that a commission needs to be commensurate with the cost of the service. But that means that an appropriate commission may range from enough to cover the expense of hiring an agent to the costs of setting up an office to perform the function.

Beyond the range offered by varying interpretations, there is potential to manipulate the system for financial gain. Inflating commissions and leaving more money overseas could lower a firm’s U.S. tax burden, legal experts said.

“If you’re serious about it and you’re really doing it on a big scale, that can definitely distort significantly your financial results,” Vincenti said. “It can represent some fair amount of money.”

Hilfiger Corp., which is based operationally in Hong Kong, but has established itself as a “tax resident” of Barbados, has made no secret that its tax strategy is a key part of its business plan.

“The company’s effective tax rate has been and is expected to continue to be a major factor in the determination of the company’s profitability and cash flow,” said the firm in its annual report, filed with the SEC in June.

Last year, Hilfiger’s tax rate was 22.1 percent, while U.S.-based competitors such as Polo Ralph Lauren Corp., Jones Apparel Group and Liz Claiborne Inc. all hovered at about 36 to 37 percent.

“You have to be somewhere in the neighborhood of 35 percent-plus,” said an executive at another apparel manufacturer, who asked not to be identified. “It’s a challenge to have a tax rate as low as they did.”

Hilfiger’s stock has historically traded at a discount to shares of other vendors because of its low tax rate, Prudential Financial analyst Lizabeth Dunn wrote in a Sept. 26 research note.

Assuming a 35 percent tax rate over the last 11 years, Dunn said Hilfiger might find itself with $160 million worth of additional tax liability, in addition to the possibility of fines and interest.

“In a worst-case scenario, if the investigation does escalate and this becomes a headline story, we think this could damage the Tommy Hilfiger brand,” Dunn said.

Dyer said during a conference call last week with analysts and investors that “the investigation is a distraction and has taken time, but I am really trying to focus this organization on running and managing the business.’’

After a hot run in the Nineties, the firm’s signature brand has had a few tough years and is undergoing a repositioning that has cut into sales. Hilfiger’s strategic direction before the investigation included cutting back the core brand in the U.S. to bring supply and demand into balance, and making an acquisition to expand the firm’s business beyond the Hilfiger brand umbrella.

The inquiry and the possibility of a charge for back taxes might disrupt any possible acquisitions and distract management as it tries to turn around the firm’s business, said financial analysts, investors and consultants. Weintraub, for one, noted that the mergers and acquisitions process often moves slowly and might not be disrupted by the investigation.

Cutting a deal and diversifying the firm’s business into another brand has been on Hilfiger’s wish list for some time. “We are continuing to look at acquisitions,” said Dyer on the call.

In May, Hilfiger confirmed that it had had discussions with hip-hop lifestyle firm Marc Ecko Enterprises, but nothing came to fruition.

“We’ve talked to them, but we’ve talked to a lot of people,” said the designer at the time.

One of the benefits of buying another brand would be to complement the mature core business. For the six months ended Sept. 30, the firm’s revenues slid 5.5 percent to $864.7 million. Part of that is because of steps Hilfiger has taken to streamline its department store distribution, pulling back at Dillard’s, for instance, and the repositioning of its young men’s business.

The better-priced H Hilfiger collection, which was sold exclusively to some 100 Federated Department Store units in women’s this past spring, faltered somewhat out of the gate, with sell-through at regular price below expectations. Distribution for women’s will be cut by about 15 stores for spring, though some of that will be made up with new specialty store accounts.

Despite its rocky start, one buyer said stores are willing to give the H line a chance. However, stores’ patience might be slipping some with the core Tommy Hilfiger brand.

“Business has been tough,” the buyer said. “It’s not just a season, it’s not two seasons. It’s literally going on years.”

The buyer described the line as “mainstream better,” noting that “they trick it up a little, but not much.”

Given Hilfiger’s relatively special situation, its foreign base and its low tax rate, analysts and fashion executives aren’t overly concerned that the investigation will spread to other companies.

“The issue is fairly unique to Tommy, in that, if it’s a matter of concern that they evaded some U.S. income taxes, nobody else has that opportunity because they’re U.S. domicile incorporated companies,” said David Griffith, equity analyst at Manhattan-based Tradition Asiel Securities.

Anita Britt, executive vice president of finance at Jones Apparel, said, “On the apparel side, we historically used an agent, and then we started up our own office a couple of years ago and migrated more of our better brands through our own office. So we had sort of a model of what was the market rate for an agent and then, when we set up our own office we sort of mirrored that relationship.”

Even if the other large apparel vendors aren’t as open to such an investigation as Hilfiger, cracking down on such a high-profile company would send a message to other firms in the industry that might be lax in their tax policies.

Andrew Jassin, managing director of fashion consultancy Jassin-O’Rourke Group expects other large firms to come under similar scrutiny.

“It’s going to open a lot of different cans of worms, which, unfortunately, at the end of the day, may not change anything,” he said.

At A Glance: Tommy Hilfiger Corp.

  • Founded in 1984.

  • Stock price Friday: $9.19.
  • Market capitalization: $843.4 million.
  • 52-week low/high: $8.47/$18.25.
  • Based in Hong Kong, tax resident of Barbados.
  • Fiscal 2004 sales: $1.88 billion.
  • Fiscal 2004 profits: $132.2 million.
  • Famous faces in advertising: David Bowie, Lenny Kravitz and Beyoncé Knowles.
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