Tiffany Case

The case In July l993 . Tiffany& troupe concluded an agreement with its japanese distri furtheror, Mitsukoshi Ltd. that would fundament wholey change its business in lacquer. Under the impertinently agreement, Tiffanys wholly owned subsidiary, Tiffany& Company Japan Inc. (Tiffany-Japan), assumed focusing responsibilities in the operation of 29 Tiffany &Company boutiques previously ope come outd by Mitsukoshi in its descents and other locations in Japan.Tiffany looked earlier to the tonic arrangement, as it was now responsible for millions of long horses in inventory that it previously sold sweeping to Mitsukoshi, resulting in call forthd revenues in Japan derived from higher retail prices. It was in any case apparent, however, that fluctuations in the yen/dollar shift respect would now hit the dollar value of its Nipponese gross sales, which would be realized in yen. Since Nipponese sales were large and still growing, it seemed evident such fluctuations substanti al repair on Tiffanys approaching financial performance. Company BackgroundFounded in New York in 1837,Tiffany Company was an globally renowned-retailer, designer, manufacturer ,and distributor of luxury goods . The famous blue-box social club found its initial success in exquisite jewellery, nearly notably diamonds, but had since expanded its product line to include timepieces, china, crystal, silverware, and other luxury accessories. In the fiscal year ending January 31, l993 (FY1992), Tiffany earned $15. 7million on revenues of $486. 4million and had original assets of$419. 4 million. Recent financial statements are provided in Exhibits 1and 2.An historical summary of operations is provided in Exhibit 3. After more than a one C of independence, Tiffany was acquired by Avon Products, Inc. in 1979. For the next several age, Avon, a nationwide house-to-house cosmetics marketer, worked to expand Tiffanys product line to reach beyond its traditional large customer base to t he larger middle market. piece of music this diversification dodge resulted in enhanced sales for Tiffany from $84million in l979to $124million in l983, operating expenses as a percentage of sales grew inordinately from 34%to 43% in 1978and l983, respectively.Avon soon realized that Tiffanys traditional market niche was substantially unalike than its own and, in l984, decided to instal the company up for sale. The most attractive offer came from Tiffanys own bangment, who agree to buy concealment Tiffanys beauteousness and the Fifth Avenue pedigree building for a summate of $135. 5 million. In what ultimately took the form of a leveraged buyout (L B O), the terms of the divvy up distributed virtually all of the equity shares to three key investor groups. Management end up with 20% of total equity shares.Investcorp, the Bahrain-and London-based merchant bank that plump for management in the deal, received 49. 8%of total equity shares. The third base player, General Electri c Credit Corporation(GECC), ended up with 25. 7%of total equity shares. 1t was by an $85 million source arrangement with GECC that management was able to refinance a substantial portionof the purchase price. The aftermath of the LBO was pronounced by very tight free cash flow mate with substantive growth voltage on the horizon.After the company had once again become profitable and realizing that the companys growth prospects demanded more cash than could be generated internally, in 1987,management offered Tiffany business line to the public at or so $15 a share(adjusted for a subsequent stock split). In l989,Mitsukoshi purchased l. 5 million shares of Tiffanys common stock from GECC. As of January31, 1993, Mitsukoshi owned approximately 14% of Tiffany stock, the largest percentage of any unmarried institutional investor.Three other institutional investors collectively owned approximately 26% of the stock, followed by all Tiffany executive officers and considerors as a grou p at 4. 9%. In l993, Tiffany was organized into three distribution pass ons U. S. retail, direct marketing, and international retail. U. S. retail include retail sales in Tiffany-operated line of descents in the United States and sweeping sales to independent retailers in North America. The l6 put ins in this channel accounted for 50% of total sales in FY 1992 Direct marketing, representing the smallest channel of distribution, consisted of unified and catalog sales .In FY 1992, its sales represented 18% of Tiffanys total sales. International retail, which included retail sales through Tiffany-operated stores and boutiques, corporate sales, and wholesale sales to independent retailers and distributors, primarily in the Far easternmost and Europe, accounted for 32% of total sales in FY1992. Jewelry sales from all three channels accounted for 65% of 1993 sales, making jewelry the most significant product line. Exhibit 4 provides financial results of Tiffanys domestic and contrad ictory operations.The past several years for Tiffany were marked by a foreshorten of international expansion, beginning in1986 when it overt a flagship retail store in London. Additional flagship stores were then consecrateed in Munich and Zurich in 1987 and 1988, respectively. In 1990, the Zurich store was expanded. Stores were opened in Hong Kong at the Peninsula Hotel and at the LandmarkCenter in August 1988 and promenade 1989, respectively. Taipei saw the opening of a store in1990, as did slap-up of Singapore (at the Raffles Hotel), Frankfurt, and Toronto in 199l. Also in l991, the London store was expanded.In l992, Tiffany opened five new boutiques in Japan, and two new boutiques were opened by an independent retailer in Korea. Early 1993 saw actd international growth, with the opening of two more boutiques in Japan, a sustain store in Singapores NgeeAnnCity, two boutiques by independent retailers in Saipan and the Philippines, and the expansion of the Peninsula Hotel sto re in Hong Kong. Exhibit 5 shows the growth in the exit of Tiffany stores and boutiques more or less the world from 31 to 79, implying a 250% increase from 1987 to 1993.These 79 retail locations included l6stores in the United States,56 stores in the Far East,6stores in Europe, and l store in Canada, all of which ranged in size from700 to 13,OOO gross square feet, with a total of approximately 127,OOO gross square feet devoted to retail purposes. Tiffanys oecumenic majuscule expenditures were $22. 8 million in FY l992. compared with $41. 4 million in FY 1991. These expenditures were primarily for the opening of new stores and boutiques and the expansion of existing stores.Management anticipated capital expenditures to drop further to $18. O million in FY l993 before rebounding to approximately $25. O million in FY 1994. Management in addition anticipate to open four or five new stores per year in the foreseeable future. To support future expansion plans, and fluctuations in se asonal working capital needs, management planned to rely upon internally generated funds and a $ speed of light million noncollateralized revolving credit facility easy at interest order based upon Eurodollar rates, a prime rate, certificate of deposit rates, or currency market rates.As in the past, cash dividends were expected to be maintained at a relatively moderate level, which would permit the company to retain a majority of its earnings. Impetus for Change in the Japanese Operations While Tiffany found new market potential across the globe, nowhere was permit as promising as in Japan, where Tiffanys sales accounted for only(prenominal) 1% of the $20 billion Japanese jewelry market. The thriving Japanese economy of the late l980s and very early 1990s stimulated a booming demands for certain types of expensive and glamorous Western goods.Among these were Tiffany products, principally those of the fine jewelry line marketed toward older women. However, as the Japanese econom y at last slowed and Japanese consumers became more cautious in their spending, the demand for Tiffanys luxury items also slumped. In response to soft consumer demand in Japan, Mitsukoshi cut back on Tiffany inventory levels. Mitsukoshis wholesale purchases from Tiffany-Japan declined from 23%of Tiffanys total sales in FY 199l to 15%in FY1992. Declining wholesale shipments were also accompanied by a small decline in gross margin from 49. %in FY1991 t0 48. 7%in FY 1992. Despite lackluster consumer demand in the get-go half of FY 1993, however, Tiffany continued to believe that Japanese sales had attractive long-run growth potential. It was for this reason that Tiffany sought greater control over its future in Japan and ultimately decided to restructure its Japanese operations. From 1972 through July1993, Mitsukoshi acted as the principal retailer of Tiffany products in Japan, purchasing selected goods from Tiffany-Japan on a wholesale priming.Mitsukoshi sold the products on a ret ail basis to the Japanese consumer, realizing bread in the form of relatively higher retail prices. Since the wholesale transactions were denominated entirely in dollars, fluctuations in the yen/dollar exchange rate did not represent a source of volatility for Tiffanys expected cash flows. Instead, Mitsukoshi bore the gamble of any exchange rate fluctuations that took surface between the time it purchased the inventory from Tiffany and when it finally made cash settlement.Typically, Tiffany trade in sold by Mitsukoshi was priced at a substantial premium (l00% in some cases) over the domestic U. S. retail price for such merchandise. The new agreement between the two companies, however, fundamentally changed both companies financial situations. In repurchasing the merchandise previously sold by Tiffany to Mitsukoshi, Tiffany-Japan assumed new responsibleness for establishing yen retail prices, holding inventory in Japan for sale, managing and financing local advertising and pub licity programs, and controlling local Japanese management.Mitsukoshi on the other hand, would no longer be an independent retailer of Tiffany products but would still receive fees equaling 27% of moolah retail sales in compensation for providing boutique facilities, sales staff, collection of receivables, and security for store inventory. With greater control over retail sales in its Japanese operations, Tiffany looked forward to long-run improvement in its performance in Japan condescension continuing weak local economic conditions. However, increased sales and profits were not the only changes that Tiffany could anticipate as a result of the new agreement.Tiffany now faced the risk of foreign currency fluctuations previously borne by Mitsukoshi. Past history warned Tiffany that the yen/dollar exchange rate could be quite volatile on a year-to-year and even month-10-month, basis. Exhibit 6 illustrates the significant strengthening of the yen against the dollar during the l O yea rs ending in 1993. While a continuation of this strengthening would enhance the dollar value of Tiffanys yen denominated cash inflows, there was the distinct gap that the yen might eventually become overvalued and crash suddenly, just as the U.S dollar in 1985. Indeed,there was some evidence that the yen was overvalue against the dollar in 1993 (see Exhibit 7) Hedging to Manage Foreign Exchange chance The possibility of sharp, unexpected movements in the yen/dollar exchange rate had prompted Tiffanys management to study the desirability of engaging in a program to manage exchange rate risk. To reduce exchange rate risk on its yen cash flows, Tiffany had two basic alternatives available to it. One was to enter into forward agreements to sell yen for dollars at a pre larnd price in the future.The other was to purchase yen put options. The terms at which Tiffany could purchase forward contracts and put options, along with other financial market data, are shown in Exhibit 8. Before co mmitting Tiffany to a hedging program, management wanted to be sure it understood what the potential risks and rewards were for each of these so-called derivative instruments. Perhaps more importantly, it was essential to determine whether or not a risk management program was permit for Tiffany, what it objectives should be, and how much, if any, exposure should be covered. pic This included a $ 75 million secured revolving credit facility a $10 million, 16% subordinated note due in 1992 and common stock warrants to purchase approximately 25% of the companys equity on a fully diluted basis. Prior to Mitsukoshis purchase of Tiffanys common stock from GECC, Tiffany and Mitsukoshi entered into an agreement by which Mitsukoshi concord not purchase in excess of 19. 9% of Tiffanys issued and peachy common shares. This agreement would expire on September 31, 1994.Due to the significant number of Tiffany boutiques already operating in Japan, future openings there were expected to choke only at very modest rate, if at all, in the near-term future. Tiffanys business was seasonal in nature, with the fourth quarter typically representing a proportionally greater percentage of annual sales, income from operations, and net income. In FY 1992, net sales totaled & 107,238,000, $120,830,000, $105,897,000, and $152,431,000 for the first, second, third, and fourth quarters, respectively. Management expected this pattern to continue in the future.Tiffany management believed that a retail price reduction in Japan of 20% to 25% would likely result in a substantial increase in unit volume of jewelry sales. The redemption of inventory by Tiffany necessitated the reversal of $115 million in sales and related gross profit previously accepted on merchandise sold to Mitsukoshi. Accordingly, Tiffany recorded a gross profit previously recognized $57. 5 million reserve to provide for product returns. , which reduced the second fiscal quarters (ended July 31, 1993) net income by approx imately $32. 7 million, or $2. 7 per share. Of the $115 million of sales being reversed, only $52. 5 million of inventory held in Mitsukoshi boutiques was positively repurchased during the month of July 1993 (Mitsukoshi agreed to accept a deferred payment on $25 million of this repurchased boutique inventory, which was to be repaid in yen on a quarterly basis with interest of 6% per annum over the next 4 1/2 years). Approximately $62. 5 million of Tiffany & Company inventory maintained in Mitsukoshi warehouses would be repurchased throughout the period ending February 28, 1998.Payment for this warehouse inventory was to be made in yen 40 days following actual receipt of the inventory. Fees were reduced to 5% on certain high-value jewelry items repurchased from Mitsukoshi. Tiffany Japan would also pay Mitsukoshi incentive fees equal to 5% of the amount by which boutique sales increase year-to-year. Calculated on a per boutique basis. In Tokyo, Tiffany boutiques could be established only in Mitsukoshis stores, and Tiffany-brand jewelry could be sold only in such boutiques (though Tiffany-Japan reserved the correct to open a single flagship store inTokyo). =============================================================================== The suggested questions In what way(s) is Tiffany exposed to exchange-rate risk subsequent to its new distribution agreement with Mitsukoshi? How serious are these risks? Should Tiffany actively manage its yen-dollar exchange-rate risk? Why or why not? If Tiffany were to manage exchange-rate risk activity, what should be the objectives of such a program? Specifically, what exposures should be actively managed? How much of these exposures should be covered, and for how long? As instruments for risk management, what are the header differences of foreign-exchange options and forward or futures contracts? What are the advantages and disadvantages of each? Which, if either, of these types of instruments would be most leave for T iffany to use if it chose to manage exchange-rate risk? How should Tiffany organize itself to manage its exchange-rate risk? Who should be responsible for executing its hedges? Who should have oversight responsibility for this activity? What controls should be put in place?