Equity Analysis and Valuation

Transcription

1 Equity Analysis and Valuation Steven Mckinley Tyson Rusche Rachel Hooper Maxie Gallardo 1 P age

2 Table of Contents Executive Summary...8 Industry Analysis...10 Accounting Analysis...11 Financial Analysis...13 Valuation Analysis...17 Company Overview...17 Industry Overview...18 Five Forces Model...20 Rivalry Among Existing Firms...22 Industry growth...22 Concentration...24 Differentiation...25 Switching Costs...25 Scale Economies Learning Economies...28 Fixed to Variable Costs...29 Excess Capacity...30 Exit Barriers...31 Conclusion...32 Threat of New Entrants...32 Economies of Scale...33 First Mover Advantage...34 Distribution Access...35 Relationships...36 Legal Barriers...37 Conclusion...37 Threat of Substitute Products...38 Relative Price and Performance P age

3 Willingness to Switch...39 Conclusion...39 Bargaining Power of Customers...39 Switching Costs...40 Differentiation...41 Importance of Product for Costs and Qualities...42 Number of Customers...42 Volume per Customer...43 Conclusion...43 Bargaining Power of Suppliers...44 Switching Costs...45 Differentiation...46 Importance of Product for Costs and Quality...46 Number and Volume of Suppliers...47 Conclusion...48 Key Success Factors for the Industry...48 Cost Leadership...49 Economies of Scale...49 Efficient Processes...50 Simple Product Design...51 Low Cost Distribution...51 Low Research and Development...52 Differentiation...52 Superior Product Variety...52 Superior Customer Service...53 Closing Thoughts on Key Success Factors...53 Firm Competitive Advantage Analysis...54 Core Competencies Low Distribution Cost...54 Economies of Scale...57 Product Variety and Quality Page

4 Superior Customer Service...59 Conclusion...60 Key Accounting Policies...60 Type 1 Key Accounting Policies...61 Low Cost Distribution...61 Economies of Scale...62 Efficient Processes...63 Little Research and Development...63 Superior Customer Service...64 Superior Product Mix...64 Conclusion...66 Type Two Accounting Policies...66 Leasing Activities...67 Hedging and Foreign Currency Transactions...68 Goodwill...69 Defined Pension Plan...70 Research and Development...71 Conclusion...72 Accounting Flexibility...72 Goodwill...73 Leasing Activities...74 Defined Benefit Pension Plans...74 Conclusion...75 Accounting Strategy Evaluation...76 Operating Leases...77 Goodwill...77 Conclusion...78 Quality of Disclosure...78 Qualitative Analysis...79 Economies of Scale...79 Simple Product Design Page

5 Low Cost Distribution...81 Sales Mix...81 Customer Service...82 Conclusion...82 Quantitative Analysis...83 Sales Manipulation Diagnostic...83 Net Sales/Inventory...84 Net Sales/Accounts Receivable...85 Net Sales/Cash Sales...86 Sale Manipulation Diagnostics Conclusion...87 Expense Manipulation Diagnostics...88 Asset Turnover...88 CFFO/OI...90 CFFO/NOA...91 Total Accruals/Sales...93 Pension Expense/SG&A...96 Expense Manipulation Diagnostics Conclusion...98 Identify Potential Red Flags...99 Operating Leases...99 Conclusion Undoing Accounting Distortions Operating Leases Financial Statements Income Statement Balance Sheet Financial Analysis and Forecasted Financials Financial Analysis Liquidity Ratios Current Ratio Quick Asset Ratio Inventory Turnover Page

6 Days Supply of Inventory Working Capital Turnover Conclusion Profitability Analysis Gross Profit Margin Operating Profit Margin Net Profit Margin Asset Turnover Return on Assets Return on Equity Profitability Analysis Conclusion Capital Structure Ratios Debt to Equity Times Interest Earned Debt Service Margin Altman s Z-Score Conclusion Internal Growth Rate Sustainable Growth Rate Forecasted Financials As Stated Income Statement Restated Income Statement Balance Sheet Restated Balance Sheet Cash Flows Estimating Cost of Capital Cost of Debt Cost of Equity Size Adjusted Cost of Equity Alternative Cost of Equity (Backdoor) Weighted Average Cost of Capital Page

7 Method of Comparables P/E Trailing Forecasted P/E Price/Book Dividend/ Price Price Earnings Growth Ratio Price / EBITDA Enterprise Value / EBITDA Price / Free Cash Flows Conclusion Intrinsic Valuation Models Discounted Dividends Discounted Free Cash Flows Model Residual Income Model Abnormal Earnings Growth Model Long Run Residual Income Analyst Recommendation Appendix Work Cited P age

8 Executive Summary Analyst Recommendation: Sell (Overvalued) June 1, 2010 TSCO NYSE (07/01/10) $66.28 Financial Based Valuations 52 Week Range $39.68 $71.86 As Stated Restated Revenue 3.27 Billion Trailing P/E Market Capitalization 2.24 Billion Forward P/E Shares Outstanding Million Dividends to Price Institutional Ownership% 100% Price to Book Insiders Ownership% 1% P.E.G. Ratio Price to EBITDA As Stated Restated EV/EBITDA Book Value Per Share $ $ Price to FCF Return On Equity Return On Assets 18.92% 19.03% 10.73% 6.08% As Stated Restated Cost of Capital Discounted Dividends $ 7.30 N/A Estimated Adj. R² Beta Size Adj. K e Free Cash Flows $ $ Month Residual Income $ $ Year Long Run Residual Income $ $ Year Abnormal Earnings Growth $ $ Year Year Altman Z Scores As Stated Restated As Stated Backdoor K e N/A N/A Restated WACC BT 7.65% 7.74% WACC AT 4.82% 4.88% Cost of Debt BT 1.25% 5.60% Cost of Debt AT 0.79% 3.53% Published Beta 0.65 N/A Lower Bound Center Value Upper Bound K e 5.06% 9.08% 13.10% Size Adj. K e 6.56% 10.58% 13.10% WACC BT 4.36% 7.65% 10.94% Intrinsic Valuations 8 P age

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10 Industry Analysis Tractor Supply Company is a home improvement, farming and ranching retail store located nationwide. It focuses on selling items that appeal to the do-it-yourself market as well as the farming and ranching community. In the home improvement and hardware industry, Tractor Supply competes with Home Depot and Lowe s. Since the home improvement industry does not entail much differentiation, cost leadership strategies are critical to be profitable. Due to the housing bust in 2008, this industry has been hit hard throughout the current recession, but has recently begun to see profits rising within the last one to two years. In order to display the proper environment of this industry, we implemented the five forces model. This model helps determine the key success factors for a company within the industry. Listed below is a summary of the five forces model for the home improvement and hardware industry. Five Forces Model Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Buyers Bargaining Power of Suppliers High Moderate Low High Moderate In this industry, rivalry among existing firms is a high force in growing competition. Since differentiation is not a major factor in this industry, competing with existing industries is a large part of industry growth. Competition with other firms in the industry is based largely on cost leadership, making price a big factor in obtaining and retaining customers. Threat of new entrants does not pose as much competition as rivalry among existing firms. This is due largely to the fact that firms already existing in the industry 10 P age

11 are so well-established that new entry has little effect on their profits. New entrants also remain relatively small when it comes to profits and also tend to stay private, which allows much of the market share to go to existing public companies. Because items in the home improvement and hardware industry are commodities, threat of substitute products is almost non-existent. The industry does not focus on any specialty goods that could be replaced without a great deal of technical advancement. Because price has such a large impact on competition, bargaining power of buyers is relatively high. Companies in this industry offer the same products and services, so if a customer is unhappy with one company, they can easily switch to another. This makes buyer power a large factor in firm competition. On the other hand, bargaining power of suppliers is moderate to low. There is no shortage of suppliers for this industry, so companies have the upper hand in determining prices for supplies. However, because supplier relationship is still a relatively important factor within this industry, they still have some power over relations with companies. Observance of the five forces model allows a better understanding of the home improvement and hardware industry. Through this model we are able to determine that competition is based largely on price and cost leadership. This competitive advantage can be gained through key success factors such as low distribution costs, economies of scale and customer service. Effective implementation of these and other key success factors will allow for higher profitability in this exceedingly competitive industry. Accounting Analysis Evaluating Tractor Supply s accounting policies is necessary to determine the true financial standings of the company. Since requirements of GAAP are fairly flexible, analyzing a company s accounting policies can determine if financial information is being distorted by the company. For this, we must evaluate the level of disclosure of each company in the industry and determine how Tractor Supply compares. If a company has a low level of disclosure, or only includes that which is required by GAAP, it makes valuing the company harder for investors and raises a potential red flag. 11 P age

12 In order to perform Tractor Supply Company s accounting analysis, we must first analyze the firm s type one key accounting policies that coincide with their key success factors. Because the retail industry is mainly a price competitive market, most of these type one policies have to do with cost leadership strategies. However, there are some differentiation strategies involved in their type one policies as well, including customer service and product variety. We aggregated all of these policies and analyzed several account ratios in order to determine whether Tractor Supply Company provided an adequate level of disclosure. Overall, we found that Tractor Supply Company provided an impressive level of disclosure concerning their type one policies, much more than any of its competitors in fact. Type One Key Accounting Policies Low Cost Distribution Economies of Scale Efficient Processes Low Research and Development Superior Customer Service Superior Product Mix A firm s Type Two key accounting polices allow for considerable flexibility. Managers can use this flexibility to their advantage by distorting financials to mislead investors. Type Two accounting policies include leasing activities, Research and development, hedging and foreign currency transactions, goodwill, and pension plans. For Tractor Supply only the treatment of operating leases where a cause for concern for investors and could raise potential red flags. Tractor Supply aggressively uses operating leases which keeps these liabilities off the firm s balance sheet. Since the aggressive use of this type of leasing activity can potentially distort the firm s financials we have capitalized all of the operating leases which are illustrated in our restated financials. By capitalizing the operating leases a more accurate picture can be portrayed of the firm s financial statements. Below is a chart that illustrates Tractor 12 P age

13 Supply s aggressive use of operating activities as compared to other firms in their industry. Lease % by Type Tractor Supply Company Lowe's Home Depot Operating Leases 99.78% 91.30% 87.30% Capital Leases 0.22% 8.70% 12.70% Through our accounting analysis, we were able to determine that Tractor Supply Company has a fairly high level of disclosure when compared to the rest of the industry. Not only do they disclose ample information regarding most of their operations, their quality of disclosure also rates higher than Home Depot and Lowe s. Tractor Supply includes information such as previous year s financials as well as detailed discussions on key success factors. This information was limited in its competitors 10-k s. We were able to identify Tractor Supply s operating leases as a red flag in this valuation and thus capitalized them to create restated financials for the company. Financial Analysis The next step of valuing Tractor Supply is performing the financial analysis. First step is to measure Tractor Supply s liquidity, profitability, and capital structure. Through this analysis investors view the financial information for the firm and their competitors over the last five years in order to see underlying trends. The ratios allow investors to come to a conclusion on whether the firm is performing above, below or average with competitors in the industry. 13 P age

14 The liquidity ratios that were analyzed consisted of current ratio, quick asset ratio, inventory turnover, working capital turnover and days supply inventory. These ratios determine a firm s cash availability and how quickly a firm can convert their assets into cash to cover their short term debt obligations. Overall, relatively high liquidity ratios are preferred by firms. From our analysis we have come to the conclusion that Tractor Supply is on par compared to firms in the industry. Liquidity Ratio Tractor Supply s Performance Industry Trend Current Ratio Above Upward Quick Ratio Above Upward Inventory Turnover Below Downward Days Supply of Inventory Below Stable Working Capital Below Downward Overall Below Stable The next set of ratios that we analyzed was the profitability ratios. These ratios include seven common ratios: gross profit margin, net profit margin, operating profit margin and operating expense ratio, return on assets, return on equity and asset turnover. These ratios show how effective a firm is at turning revenues into profits. The results for Tractor Supply determined that the firm was underperforming competitors of just barely average with the industry. This is a cause for concern for investors because in most of the ratios the competition outperformed Tractor Supply, which implies that the competitors are more effective at implementing their cost leadership strategy. If Tractor Supply continues to underperform its competitors in controlling costs, then their bottom line will continue to suffer as well. 14 P age

15 Profitability Ratio Performance Trend Gross Profit Margin Underperforming Slightly declining Net Profit Margin Underperforming Stable Operating Profit Margin Underperforming Stable Operating Expense Ratio Underperforming Stable ROA Average Slightly declining ROE Average Declining Asset Turnover Outperforming Stable Overall Underperforming Stable The next step in our financial analysis consisted of analyzing the capital structure. Capital structure evaluates how a firm finances investment and operating activities. The ratios include debt to equity ratio, times interest earned, debt service margin and Altman s Z-score. Altman s Z-score was included in the evaluation of capital structure because banks and investors often use this ratio to determine whether a firm is a bankruptcy risk. Out of the three groups of ratios capital structure was the most favorable. Capital Structure Ratios Tractor Supply Industry Average Debt to Equity Below Downward Times Interest Earned Above Upward Debt Service Margin Above Downward Altman s Z-score Above Downward Overall Above Downward Once a financial ratio analysis has been completed we are able to take on the task of forecasting the financial statements for Tractor Supply. Through the use of the Five Forces Model, the state of the economy, and the recent 10-Qs provided Tractor Supply; we are able to attempt to accurately forecast the financial statements. We began by forecasting the sales growth rate, which is the most important factor in 15 P age

16 forecasting. We used ratios and ratio analysis, of past and present, to complete the rest of the forecasts for the income statement. This allowed us to arrive at the last line value of Net Income. For the balance sheet forecast we used the asset turnover ratio to forecast the assets, because this ratio connects the sales and total assets. To forecast the total liabilities and equity we must be able to tie them to the total assets. Since we are valuing Tractor Supply on their value, we are more concerned about the accuracy of the forecasted equity. Therefore we decided on a method which more accurately forecasts equity as a consequence may skew the liabilities. The statement of cash flows was the last of the financial statements to forecast, and because it is the most volatile it is the most difficult to forecast. This method involved calculating ratios for CFFI and CFFO and choosing the least volatile of them. We then use these ratios to forecast the statement of cash flows. This process of forecasting was performed for Tractor Supply on both an as stated and restated basis due to the use of operating leases. The final process that needed to be performed was to estimate a cost of capital for Tractor Supply. We achieved this by doing a regression analysis using a 95% confidence interval at different investment horizons. With our outputs we identified the 10 year treasury with a 24 month horizon as our best beta with the adjusted R 2 of 24.61%. This beta was applied to arrive at the cost of equity, the size adjusted value being 10.58%. We then calculated the cost of debt on both an as stated and restated basis. For Tractor Supply we came up with a weighted average cost of debt of 1.25%, this is due to a large amount of the firm s current liabilities lying in the short term at a lower interest rate. When restated, a large amount of long term, higher interest rate were added under the operating leases. This more reasonably stated the cost of debt at 5.6% before tax. After computing the cost of debt and cost of equity, we were able to arrive at a WACC BT of 7.65% stated and 7.74% restated on a non-size adjusted basis. 16 P age

17 Valuation Analysis After performing an industry analysis, analyzing account policies, and performing a financial analysis and forecast of Tractor Supply Company, we are now able to value the firm. We are taking a position of 10% analysts, and it is now possible to compare a number of intrinsic valuation models to the observed share price of $66.28 as of June 1, 2010 and determine whether the company is over, under, or fairly valued. There are two sections that the valuation analysis is comprised of, method of comparables and intrinsic valuation models. In order to perform both of these, we must first forecast key accounts for the foreseeable future. We then computed industry ratios in order to forecast a comparable share prices to the observed share price as a basis of comparison. While method of comparables can be a useful tool in valuation analysis, it does have its flaws. In order to more accurately determine the value of Tractor Supply Company, we must utilize intrinsic valuation models as well. Instead of basing comparable stock prices on industry competitors, the intrinsic valuation model uses the firm s own data and forecasts financial information in order to arrive at a share price to compare to the observed share price. These four intrinsic models include discounted dividends model, free cash flows model, abnormal earnings growth model (AEG), and the residual income model. All in all, these models do a better job of providing more relevant comparisons to base the company s value on, with the AEG and residual income having the most explanatory power of all. Our analysis reveals that Tractor Supply Company is consistently overvalued in both of these models on an as stated and restated basis. Therefore, we have arrived at the conclusion that Tractor Supply Company is overvalued. Company Overview Tractor Supply Company began in 1938 as a mail order tractor parts business by Charles E. Schmidt. By 1939, it became a retail store in Minot, North Dakota and since then has become the largest national retail chain for farming and ranching and has spread its business to homeowners and contractors as well. Tractor Supply currently 17 P age

18 consists of over 900 stores in 44 states across the nation. Their current headquarters is located in Brentwood, Tennessee. Tractor Supply Company operates retail stores under two names, Tractor Supply Company and Del s Farm Supply, and also operates a website at tractorsupply.com. Tractor Supply Company is aimed at meeting the needs of recreational farmers and ranchers. Tractor Supply stores are located in rural areas or on the outskirts of major cities and range in size from sq. ft. to sq. ft.(tractor Supply Company, 10-K). The company operates in six divisions: equine, pet and small animal products; hardware and seasonal products; truck, towing and tool products; work and recreational clothing and footwear; maintenance products for agriculture and rural use; and home décor(tractor Supply Company, 10-K). Below is the percent sales listed for each segment of Tractor Supply for the past three years. Product Category Livestock and Pet 33% 36% 39% Hardware and Seasonal 26% 24% 23% Truck Tool 20% 19% 18% Clothing and Footwear 10% 10% 10% Agriculture 7% 7% 6% Gift and Recreation 4% 4% 4% 100% 100% 100% Tractor Supply Company is the all around store for farming and agriculture offering items to improve vehicle functionality, towing equipment and other tools. Tractor Supply carries a variety of items for both rural and suburban communities. Industry Overview Tractor Supply Company and its subsidiary Del s Farm Supply are involved in the retail industry as a whole but compete in two more specific parts of the retail industry. The first of these we have competitors in, which are Home Depot and Lowes Home 18 P age

19 Improvement. This portion of the industry provides consumers with the everyday items that may be used in home upkeep and repair. These two competitors compete with Tractor Supply in home improvement materials, which include, but are not limited to, fencing material; lawn and garden; tools and hardware. According to the U.S. Census Bureau, even though home ownership is on a decline, the industry is still above their historical average and home owners don t want this asset to deteriorate (Lowes 10-K). This along with the current housing market beginning to perk up again in parts of the United States, such as Colorado and Virginia (Wall Street Journal), is proof that they have a customer base that will remain in the market. Majority of these customers are individuals who are in the market to do the repairs themselves in order to save money. This portion of the industry is very competitive with the market share. Tractor Supply has to compete with Home Depot and Lowes in the home improvement but they also deal in many agricultural aspects. In starting to deal in agriculture they have opened up a new form of industry in retail. In this part of the retail industry they deal in farm equipment repair parts, equine, pet care, and livestock accessories and supplies. In this portion of the industry the main goal is to provide customers with the supplies needed for the recreational farmers and ranchers. The main competitors in this portion of the retail industry consist of small local businesses. Tractor Supply Company is able to remain competitive with these competitors through providing assortments of products with. This portion of the industry controls a large portion of their business (Tractor Supply Co. 10-K). The improving economy is increasing the outlook on agriculture, which will persuade many farmers and ranchers to feed and continue operations as usual (Wall Street Journal). This means continued business with the livestock portion of Tractor Supply and the competitors. As far as the accessories for agriculture needs, they have many parts for mowing, haying, and harvesting grasses. As John Deere and Company has estimated an increase in machinery sales which will lead the need for an increase in replacement parts (Wall Street Journal). This portion of the industry has given them an advantage over Lowes and Home Depot because they offer products in a different segment. 19 P age

20 As Tractor Supply Company is in a unique part of the retail industry they do not have any perfect matching competitor which leads to very unclear results. But given that Home Depot and Lowes compete in much of the same industry as Tractor Supply Company we are able to use them as competitors. The true competition does not lie in the huge publicly traded companies, but rather in the personal sector that consists of regional and local companies who are not required to release information to the public. We have done what we could given this imperfect information. Five Forces Model Michael Porter s Five Forces Model is used to determine impact of competition on the industry. This model uses both the external competition and the internal conflicts to give us an idea of the chances of profitability of an industry. These Five Forces include rivalry among existing firms, threat of new entrants, threat of substitute products, bargaining power of customer, and bargaining power of suppliers. Within the five forces there are two subcategories; one includes the competition and their effects, and the other is the potential bargaining power of the firm. Through the use of these five factors, a company is able to better determine what drives competition in its particular industry. The competition category consists of the three of the five factors. The first of these is the rivalry among existing firms. This is used to determine the amount of competition in an industry, either a high level or low level. If a firm is competing in an industry which has a high level of competition, it is common that they will take a cost competitive approach. In most cases, the approach for a firm in an industry with a low level of competition might focus more on innovation and brand image. The threat of new entrants is another factor. Determining the level of competition a firm is engaged in provides insight on the business strategy that would be most advantageous the firm. This factor looks at the possibility and difficulty of a new company entering the industry successfully. The easier it is to enter an industry, the more competition a company may potentially face. The third competition factor is the threat of substitute products and services. This takes a look at similar products that a customer considers a substitute 20 Page

21 and the likelihood that they will choose this product. These are the three factors that a company looks at in terms of competition. The potential bargaining power between the suppliers, buyers, and the firms within the industry make up the other two of the five forces. The bargaining power of the buyers is a very important factor to focus on. In a highly competitive industry, buyers will have most of the bargaining power as there are many alternative companies that can potentially provide the same product at a higher quality or lower price. In a less competitive environment, firm s can provide unique products or services, or may have exclusive rights enabling them to set prices. The last factor in the Five Forces model is the bargaining power of the suppliers. If a firm is able to dictate terms to its suppliers, or is able to switch to other vendors with relative ease and minimal costs, the bargaining power of these suppliers will be relatively low. This is very advantageous for a firm as they can dictate terms and prices, leading to lower costs and higher profits. Using the Five Forces model will give us the ability to do an evaluation of the industry will give the level of competition that exists. We will also be able to determine whether potential profits exist and are being captured. The table below is the analysis of the home improvement and agriculture related retail industry. Five Forces Model Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Buyers Bargaining Power of Suppliers High Moderate Low High Moderate 21 P age

22 Rivalry Among Existing Firms When analyzing a firm, it is important not only to understand the business itself, but also the competitors within the industry. One must have substantial knowledge of the firm s business environment as this information is pertinent in order to gain an understanding of how a company s competitors and its industry environment effects the firm s profitability. Some industries have a stagnant market growth which can result in a high level of price competition between competitors; while on the other hand, some industries experience a high market growth rate which decreases the need for competing firms to gain market share over each other. Thus, it is important to analyze the causes and effects of these rivalries by examining important issues such as industry growth rate, concentration, and differentiation and among other subjects. Industry growth As previously discussed, industry growth is a major factor that influences a firms competitive strategy. When in a stagnant industry, firms become highly competitive in acquiring market share, which can instigate price wars. When the industry is experience a boom in market availability, firms tend to concentrate more on profits than attaining a higher percentage of market share. In some cases, an industry can be oversaturated and experience a lack of demand to meet the supply the firm is producing, causing a drop in price competition. This is why it is important for a company to evaluate their position in the industry, and the state in which the industry is in. Industry Sales (Raw) Company Tractor Supply $ 2,370 $ 2,703 $ 3,008 $ 3,207 $ 3,268 Lowe's $ 43,243 $ 46,927 $ 48,283 $ 48,230 $ 47,220 Home Depot $ 16,485 $ 18,348 $ 17,053 $ 17,846 $ 15,902 (In thousands) 22 P age

23 Industry Revenue Growth Company Tractor Supply Company 14.60% 14.00% 11.20% 6.60% 1.90% - - Lowe's 18.60% 8.50% 2.89% - Home Depot 11.60% 11.40% 14.80% Industrial Average 14.93% 11.30% -0.24% 0.11% % % 2.10% % % (Tractor Supply, Lowe s, Home Depot 10-K) After studying and calculating 10-K data from the past five years, an obvious downward trend can be observed for all firms within the industry, which is most certainly an effect of the combination of the recent housing crisis and a recent surge in unemployment rates. In fact, the US home improvement market decreased by 11% in 2009 alone (Lowe s 10-K). Lowe s and Home Depot took the biggest hits because their business s are almost fully dedicated to home improvement, leading them to report a negative growth rate for about the past 3 years. On the other hand, Tractor Supply Company is only partially involved in home improvement, which is why the housing crisis had less effect on the firms overall revenue. Even so, Tractor Supply Company has sustained a noticeable drop in sales from the incident and their revenue growth rate has almost slowed to a halt. In fact, when you consider an average inflation rate of 3%, the firm has recorded a negative real revenue growth rate. This growth pattern illustrates a stagnant market in which price wars over market share are surely the driving factor behind these firm s business strategies. This is slightly more applicable when looking at Home Depot and Lowe s, as they are solely in the business of home improvement. While Tractor Supply Company does have a decent amount of home improvement products, the firm tends to carry products more tailored to the customers living the rural lifestyle (Tractor Supply 10-K). In addition, 23 P age

24 Tractor Supply Company has five other business segments that have the potential to mitigate these effects on the company s revenue. Although it is apparent that they re revenues have suffered, which can be attributed to a downed economy as a whole. Although Tractor Supply Company does have a good amount of homogenous products and similar products to those of Home Depot or Lowe s, they have a number of products that one would not find at a Home Depot or Lowe s. In any case, this stagnant market has prompted all firms within the industry to compete over market share. Concentration The number of firms determines the degree of concentration in an industry, the higher the number of firms, the lower the concentration level and the greater the level of price competition that results. On the other hand, an industry with a low concentration allows the market leader to dictate prices. Therefore, higher competition is found in companies with a low concentration (Palepu). Using the sales over the past five years tells us that Home Depot has been the leader in market share, followed by Lowes, and behind them is Tractor Supply. (Tractor Supply, Home Depot, Lows 10-K) Looking at the graph, the change in market share is noticeable with Lowes closing the gap on Home Depot, and with Tractor Supply slowly gaining more of the market as 24 P age

25 well. While Lowe s and Home Depot are the clear market share leaders, Tractor Supply Company is a kind of niche that focuses more on rural lifestyles as opposed to solely home improvement. This gives them the ability to stay competitive even with such a low market share. In general, there is a low concentration level in the home improvements industry which inevitably leads to price wars. Differentiation One of the most effective ways for a firm to avoid a price war in any industry is to focus on differentiation of its goods or services. As discussed previously, in the home improvements industry, firms like Home Depot and Lowe s have very low differentiation and focus more on cost cutting methods. While Tractor Supply Company does engage in these price wars in particular segments of its business, its main concentration is in the farm and ranch implements segment. However, even though Tractor Supply does not have any nation-wide or publicly traded competitors in its rural segments, It must still compete on prices with local and privately owned agricultural based businesses. This makes the switching costs relatively low because of the numerous amounts of small businesses that operate in the same geographical areas as Tractor Supply Company. In this situation, Tractor supply must compete on prices with large firms such as Home Depot and Lowe s, while also competing with more direct competitors owning local businesses. One factor that does give Tractor Supply Company an advantage over its competitors is the company s 13 private label brands scattered across all 6 of its business segments which can only be purchased at a Tractor Supply Company retail outlet. This allows them to build customer loyalty through quality products, giving them a little relief in the price wars game. All in all, while differentiation is one aspect of Tractor Supply Company, their main focus is to compete on prices with all businesses within the industry, be them large or small. Switching Costs Switching costs are the intangible expenditures customers incur when deciding to go from one firm s products or services to another s. This is an important factor for all 25 P age

26 firms in an industry to consider as it is a key indicator of how easily a customer can switch to a competing firm s products, and thus lose revenue. The extent to which an industry can avoid head-on competition depends on how much they can differentiate their products or services (palepu), and therefore, make it difficult for a customer to find the same value elsewhere. The more homogeneous a product or service is, the less the switching costs will be. In the case of Home Depot, Lowe s, and Tractor Supply Company, switching costs are quite low because of the amount of homogeneous product these firms sell, often using identical vendors and brands. However, Tractor Supply Company has 13 private label brands which can build brand loyalty, making switching costs higher for loyal customers. This gives a significant advantage to Tractor Supply Company over Lowe s and Home Depot which use mostly homogeneous or brand name products. However, the majority of Tractor Supply Company s business does deal with homogeneous or brand name merchandise, therefore switching costs for these items is very low. While Tractor Supply Company must offer sales and maintain low costs on all of its homogeneous products, having its private label brands gives it a slight advantage over the other firms. Overall, there is a great incentive to compete in a price war for all three firms in the industry. Scale Economies Economies of scale refers to a firm s ability to operate more efficiently according to the size and scale of their operations. In a manufacturing industry, this can be illustrated by a company s ability to mass produce products more efficiently, the larger the manufacturing operations become. In the retail industry, this refers to a firm s ability to manage their supply chain more efficiently, resulting in acquiring goods at a lower cost and increasing its logistical aptitude. The idea is that the longer a company exists in its industry and the bigger the scale of its operations, the more experience it gains at mastering the supply chain. In the retail industry, it is crucial to drive down costs to be competitive with the other firms. This gives larger companies and distinct advantage over independent stores and new entrants. A look at total assets for each 26 P age

27 firm in an industry will give the reader an idea of how each firm stacks up to the other in terms of size. Total Assets (in millions) TSCO $815 $1,008 $1,058 $1,231 $1,341 HD $44,482 $52,263 $44,324 $41,164 $40,877 LOW $24,682 $27,767 $30,869 $32,686 $33,005 (Tractor Supply, Lowe s, Home Depot 10-K) A quick glance at the table reveals the magnitude on which Home Depot and Lowe s operate when compared to Tractor Supply. This can be attributed to the fact that these two firms operate on a world wide scale, whereas Tractor Supply Company operates solely in the United States. One would think that because of the magnitude of the difference between the firms that Home Depot and Lowe s would become more efficient due to their sheer size, however, a look at sales to PP&E gives a better idea of how efficiently a firm is managing its resources and converting them into revenue. 27 P age

28 Sales to PP&E (Tractor Supply, Lowe s, Home Depot 10-K) The sales to PP&E ratio indicates how efficiently a firm utilizes its available assets and converts them into sales. A look at the graph clearly shows that Tractor Supply Company is using their available assets more efficiently than either Home Depot or Lowe s, converting their total assets into 8-9 times that amount of revenue. This can possibly be attributed to the fact that Home Depot and Lowes operate worldwide, whereas Tractor Supply Company operates solely in the US. This gives them an advantage because they can co-ordinate their logistics in a more efficient manner without having to deal with international issues that the other two firms are faced with. Clearly, scale economies give Tractor Supply Company a competitive advantage, having to utilize a smaller amount of assets to achieve the same amount of revenue. Learning Economies Learning Economies is an important issue to consider when analyzing rivalries between firms in an industry. If there is a steep learning curve, size becomes the main incentive for the firms, which will cause them to engage in a war over market share, especially if the market is stagnant. In the retail industry, there is much less technology 28 P age

29 or copyrighting involved, and more of a focus on cost control and efficient supply chain management. This can be seen by the lack of R&D expenditure in any of the firm s in this particular industry. Thus, leaning economies plays a very small role for Tractor Supply Company or any of its competitors. Fixed to Variable Costs An important factor to consider in any industry is the breakdown of a firm s cost structure. Fixed to Variable costs plays an important role when trying to determine whether an industry is pressured into a price war and must make a high volume of sales to support its fixed costs or if the firm is able to cut down on sales and inventory in a slow economic situation and avoid sustaining heavy losses. Through the use of the total cost formula, TC= FC + VC, one can find the slope of the variable costs, and determine whether there is a high ratio of fixed costs to variable costs. The general rule of thumb is that if the ratio is less than one, the firm has a relatively low ratio of fixed to variable costs. Fixed to Variable Cost Ratio Tractor Supply Company Home Depot Lowe's (Tractor Supply, Lowe s, Home Depot 10-K) Generally in any type retail industry, the firms are much less capital intensive, and more focused on efficient supply chain management, low costs, or differentiation. This leads to a lower amount of fixed costs, and a higher amount of variable costs. This can be advantageous as a low ratio allows a firm to support its fixed costs much easier in a down economy by lowering inventory and sales. As the chart shows, all firms in the industry consistently have a low fixed to variable cost ratio after ignoring negative numbers an outlying data. However, the outliers that Lowe s has shown can be seen in 29 P age

30 the fact that they have recently had to raise prices due to a high ratio of fixed to variable costs (WSJ). But overall, this illustrates the fact that these firms cost structures are mainly comprised of variable costs, which is to be expected in any retail industry. Excess Capacity Excess Capacity is what occurs when a firm or industry s supply is larger than the consumer demand. If this is the case, a firm will be forced to lower prices so that their excess inventory can flow quickly through stores and increase turnover. Too much inventory is a result of over production and overestimated consumer demand. When a firm does not plan out their inventory correctly, this causes inefficiencies in the warehouse or in production, costing the firm money. In a large industry, this is typically not a major problem in that a firm can cut prices and force the excess inventory out in a relatively short amount of time. However, it is always more efficient to accurately forecast demand and base supply off of this information. Firms strive to balance supply and demand; nevertheless errors in judgment are bound to occur. One of the major reasons excess capacity can occur for Tractor Supply Company is an unexpected changes in weather that can destroy crops and cause ranchers to cut down on livestock, thus lowering the demand significantly for farm and ranching supplies, especially during harvesting time. In this situation, Tractor Supply Company would have a huge amount of excess capacity with nowhere to put it, clogging up distribution centers and causing huge losses and over-packed inventory. Thus, excess capacity can have a significantly larger effect on Tractor Supply Company than either Home Depot or Lowe s. An effective way to measure excess capacity s effect on a firm is to look at how volatile same store sales for each firm from the past 5 years have been. Same-Store Sales Increase (Decrease) TSCO -1.10% 1.40% 3.40% 1.60% 5.70% HD -6.60% -8.70% -6.70% -2.80% 3.10% 30 P age

31 LOW -6.70% -7.20% -5.10% 0% 6.60% (Tractor Supply, Lowe s, Home Depot 10-K) Same-store sales for Home Depot and Lowe s have been decreasing steadily over the past 5 years, mainly due to the housing crisis that occurred recently among other issues. The effects of a slowing housing market, difficult comparisons to 2005 s hurricane recovery and rebuilding efforts, and significant deflation in lumber and plywood retail prices contributed to lower than expected sales (Lowe s 10-K). However, as the graph shows, same store sales have risen in recent years due to a slight turnaround of the housing crisis, and the fact that Americans are more willing to engage in discretionary spending (WSJ). Tractor Supply Company, on the other hand, has not experienced the same downward trend. Instead the same-store sales fluctuate year by year, which can partly be attributed to varying farming and ranching seasons which affect the firm s agricultural and rural side of the business. This can prove to be a challenge when planning out supply and forecasting demand as it is all but impossible to predict the weather for the upcoming year, demonstrating that excess capacity does have a strong effect on the industry, especially for Tractor Supply Company. Exit Barriers One must consider exit barriers when analyzing the degree of rivalry amongst competitors in an industry. Exit barriers are the costs of exiting the market and can be measured by how easily a firm can liquidate its assets and get a significant amount of their investment back. Often times, firms assets can be industry specific, making it hard to convert into other uses. Also, long term contractual agreements pose a major barrier to exiting the market. These include lease obligations and employee obligations among other items. In the retail industry, liquidating inventory would not be much of a concern as these items are commonly used, however most of the investment is lost. Also operating leases can be a major concern as well. In all three firms, over half of the operating leases have obligations that surpass 5 years. In addition, contractual obligations with 31 P age

32 suppliers and large asset write-offs make for an even more difficult exit from the industry. Although the retail industry is relatively non-capital intensive and has less industry specific assets, these obligations and write-offs result in moderately high exit barriers. Conclusion In any retail industry, cost cutting is the driving factor behind a company s business strategy. Stagnant industry growth rates, low concentration, and scale economies are all driving forces in the price wars that dominate the industry. To survive and stay competitive in this industry demands that firms must ensure efficient supply chain management, maintain good relationships with suppliers, and lower general costs. On the other hand, there are factors that drive rivalry amongst existing competitors down including differentiation, and learning economies. While Tractor Supply has relatively low amounts of each, it has a slight advantage over the larger firms in the industry such as Home Depot and Lowe s. Tractor Supply also has the advantage of competing in other segments of the retail industry including agricultural and rural areas, however, there are still local and privately held businesses to compete with which drive down costs. Fixed-to-variable costs are also another factor that may alleviate some of the pressure to engage in a price war. Keeping this ratio low allows them to cut down in bad economic times and still cover fixed costs. While Tractor Supply company does have some aspects of the business that prevent them from operating a solely price cutting strategy, the majority of their revenues come from products which must compete on price with other firms in the industry. In this case, rivalry with existing firms is quite high. Threat of New Entrants Firms in any industry must constantly be aware of new companies attempting to enter into the market. When a new firm enters the market, competition will increase, and if the firm is successful, cause profits to decrease for existing firms. Profitable markets that have high returns will attract new firms. Determining the threat of or barrier to new entrants relies on economies of scale, first mover advantage, 32 P age

33 relationships, and legal barriers. The more obstacles an approaching firm encounters to enter an industry, the less of a threat new entry into the market becomes. Economies of Scale Economies of scale refer to the cost advantages a company can gain due to expansion. If there are large economies of scale in an industry, it can cause new firms to require a high amount of fixed assets in order to compete. This can be detrimental to a new entrant in a cost leadership industry. In the home improvement and hardware industry, cost leadership is important in order to stay competitive. Companies are continually expanding and opening new stores to be more available and increase economies of scale. Existing companies in the home improvement industry are opening ten to over one hundred new stores yearly (Lowe s, Home Depot, Tractor Supply, 10-K s). Company New % New % New % New % New % Stores increase Stores increase Stores increase Stores increase Stores increase Tractor Supply 65 13% 82 14% 89 13% 91 12% 76 9% Lowe s % % % 115 7% 62 4% Home Depot % 125 6% 110 5% 62 3% % (Lowe s, Home Depot, Tractor Supply 10-K) The continuous expansion of companies in this industry persistently increases economies of scale, making new entry harder as time passes. However, smaller and privately owned companies have still managed to enter the industry and survive as long as they have to capital to facilitate a similar infrastructure. Despite some small companies succeeding, economies of scale have become a large barrier to new entrants in this industry. 33 Page

34 First Mover Advantage First mover advantage refers to the advantages in profit a company gains when entering an industry before competitors. As the industry expands with new entrants, the first mover becomes an industry leader because it is already established in the market. However, first mover advantage is not only profit based. Companies that become first movers are more likely to create relationships with suppliers and buyers causing new entry to be more difficult. In the home improvement and hardware industry, first mover advantage is limited as supplies and resources are not constantly changing or growing. Small or privately owned companies can and have entered into this market easily and been successful for their size in relation to their larger competitors. In the home improvement and hardware industry, first mover advantage is not critical in preventing new entrants. Because this is a retail industry and not specialty products, being the first mover has proved valueless. Small companies such as Ace Hardware and department stores like Sears have easily entered into this market and flourished despite not being the first to do so. However, Tractor Supply Company has been able to dominate the agricultural and ranching side of the market which competitors like Home Depot and Lowe s have yet to capitalize on. Tractor Supply not only offers home improvement and hardware items, but also clothing for farming and ranching, animal supplies for pet and equine, and other farming and ranching tools not available in their larger competitors. This has placed Tractor Supply Company at the forefront of this market among small time competitors that do not have the size or assets to compete. Companies such as Tractor Supply have gained large profits from the farming and ranching community, which kept them out of the negative after the housing bust (Tractor Supply, 10-K). For one of Tractor Supply Company s major home improvement and hardware competitors to enter this market would be extremely difficult as suppliers are limited and Tractor Supply has the majority. This part of the market is limited to one leading company and no major publicly traded competitors exist as of yet. 34 P age

35 Distribution Access The ability to distribute nationally at a low cost is an integral part of a successful business. For a cost leadership industry, distribution access could be a critical determent to new entrants into the market. Having access to wide spread distribution centers can minimize cost for shipping items to the retail stores as well as keep stores stocked to increase profits. A multitude of distribution centers can also reduce costs associated with receiving shipments from suppliers because a larger amount of inventory can be stored in one place as opposed to each store ordering inventory from a supplier as needed. Distribution access is a fundamental part of the home improvement industry. Centralized or even regional distribution centers with inventory systems are crucial to keeping stores well stocked and inventory costs down. Companies in the home improvement and hardware retail industry have multiple distribution centers to facilitate their stores nationwide. Listed below are the numbers of distribution centers for each company in this industry at the end of the fiscal year Company Number of Distribution Centers per year Tractor Supply Home Depot Lowe's (Tractor Supply, Home Depot, Lowe s 10-K) As stated in the 10-K, Home Depot is looking to remove all conventional distribution centers and convert to strictly regional centers. These distribution centers are critical to a successful business endeavor in this industry. The reduced cost of 35 P age

36 inventory and shipping makes a good distribution network necessary to succeed in the home improvement and hardware industry. Without adequate capital to build and facilitate distribution centers for inventory, any new entrant would surely fail in this market. Because of this harsh reality, distribution access is a major barrier to new entry into the market. Relationships Building positive relationships with suppliers can be an essential part of gaining market share in an industry. Relationships among buyers and suppliers can reduce costs and make entering the market more difficult. In a specialized market, having strong, positive relationships with suppliers is essential to staying profitable because merchandise is less accessible. In a large retail industry such as home improvement and hardware, merchandise is a commodity and is less scarce than a special retailer. For this reason two approaches were taken regarding supplier relationships. The first is a quality over price approach. Placing quality over price could lead to higher supplier costs, but also allows for better quality products. This approach was taken by Home Depot. Home Depot stated in their 10-K that they have strategic alliances and exclusive relationships with selected suppliers to ensure they have a better quality product. Although there are costs associated with this, such as supplier advantage and breaking relationships, the idea of better quality products has a large selling point amongst consumers. This approach can ultimately increase profits and drive down the threat of new entrants. The second approach, taken by Lowe s and Tractor Supply, is focused on low cost, which ultimately reduces costs for consumers. Lowe s stated in their 10-K that they purchase merchandise from over 7,000 vendors, with no single vendor accounting for more than 7% of total purchases. They also state that their focus is on reducing costs for customers and gross margin improvement for the company. Tractor Supply purchases products from a core group of approximately 850 vendors, with no one vendor representing more than 10% of [total] purchases during fiscal 2009 (Tractor Supply, 10-K). Both Tractor Supply and Lowe s acknowledge the ability to add or 36 P age

37 remove vendors at any time to reduce cost and neither hold any long-term contractual agreements with any vendors (Lowe s, Tractor Supply 10-K). This low cost relationship approach allows both companies to offer discounted prices to consumers which can increase profit and market share. However, the ability to locate and build relationships with vendors in this industry so easily creates a larger threat of new entrants into the market. The two different approaches to relationships in this market create a moderate threat of new entrants into the industry. Legal Barriers Legal barriers can act as a profit hedger and discourage potential new entrants into the market. Legal barriers are common in industries with specialized learning economies such as technology. Specialized learning economies introduce legal restrictions such as patents and copyrights that make competing in the market less advantageous. In the retail industry, learning economies are less specialized if not nonexistent. This causes less intellectual property amongst companies which lowers the amount of legal hurdles. Where legality is most apparent is with imported goods. In the home improvement and hardware industry, both Lowe s and Home Depot import merchandise from other countries. Outsourcing purchases requires companies to follow export laws from the foreign country as well as import laws from the U.S. This can not only be timely, but also costly, especially to a newly established company. However, importing merchandise is not required to be successful in this industry as seen with Tractor Supply Company, who purchases all merchandise within the U.S. With this in mind, legal barriers are not much of a nuisance to new entrants and thus the threat of new entry into the market is low. Conclusion After evaluating the economies of scale, first mover advantage, distribution access, relationships, and legal barriers, a level of threat of new entrants can be established. Overall, this industry has mixed outcomes that are spread fairly equally among the five sections. While the home improvement and hardware industry display a fairly high economy of scale and distribution access is extremely important to market 37 P age

38 profitability, there is no advantage for first mover unless it is into another market and legal barriers are not a major obstacle because importing is not required to succeed. Supplier relationship displays mixed results in its own because of several approaches that are available based on the overall market plan of a company. If a company wants to be a low cost competitor, they are not limited in suppliers causing entry into the market to be more accessible. However, if their market strategy involves quality of product, supplier relationships are necessary to guarantee a higher quality product, causing entry to be limited. Although high economy of scale and distribution access can be an expensive endeavor, if a company has enough capital, entering in the market is highly plausible. However, most newly created companies will not have enough backing to produce such a high amount of capital to facilitate the infrastructure required for the market. Thus, the overall threat of new entrants into the industry is moderate to high. Threat of Substitute Products In analyzing a firm s competition in an industry there are many dimensions. One of these dimensions is the use of substitute products and services. These substitutes may be provided in cheaper or more suitable fashion. This threat can drive a company to become a price competitor. An example of a substitute serves that the industry might see is a competitor using a trained technician to do the repair instead of just ending the transaction with the purchase of the product. To avoid a huge loss of consumers, Tractor Supply would have to respond with a competitive price for the product. In the agriculture retail there are very few substitutes for the equipment which is used. This is a positive factor for the industries competitors, who carry replacement parts needed to repair much of the equipment. This in return allows the industry s competitors to remain competitive by offering the standard parts. Therefore in a realistic aspect all that can really be substituted in the industry is the way business is conducted, or the services provided. 38 P age

39 Relative Price and Performance When looking into the threats of substitutes an important factor to keep in mind is the relative price and performance of what can be seen as a substitute. When similar product alternatives are given which perform the same function, determining the difference can become very difficult. The key determination factor that usually arises is a difference in the price or performance of the products. Given the nature of the industry in which Tractor Supply competes in all carry similar products and equipment, the prices are usually very competitive. A substitute taking the form of a service can become a possible deal maker, such as a small local equipment repair shop. This involves a specialized technician completing the repair with addition to the sale of the parts. Customers could see this as a valuable asset due to a lack of knowledge or time on their part. Willingness to Switch Having the substitute will not alone have an effect on Tractor Supply. Customers must be willing to switch to a repair service. Due to the fact that equipment frequently breaks down, the parts will be needed. The repair shop will be charging for labor along with the price of parts, but since majority of farmers know how to fix many of the problems that arise, they can save that money. This means that the willingness to switch and pay a premium is unlikely. Conclusion In the industries in which Tractor Supply competes there are very few threats of substitute products. Repair shops can be a form of a possible substitute but cause little to no threat due to the price difference. There is a very low threat of substitute products in their industry. Bargaining Power of Customers Bargaining power of customers is a key factor in determining how a firm needs to present itself to customers in order to be successful in their industry. It is important to understand the degree of power a customer has over a firm because the effects can be dramatic. If the customer has the upper hand in purchasing power then the firm 39 P age

40 needs to address the market with reasonable prices in order to edge out potential competition. Conversely, if the customer does not have buying power then the company may charge more for products. The home, farm, and ranch retail industry customer base consists of two parts; everyday individuals who would rather do it themselves, and business customers, which include contract services, and government customers. From the business perspective contract services include home builders, plumbers, electricians and heating and air conditioning companies. The government aspect includes buyers from federal state and local governments, military, and educational institutions. The main customers for Tractor Supply follow the two part base as well. The company serves individuals and business owners that consist of full and part-time farmers and ranchers, hobby farmers, rural homeowners and contractors. There are two important factors in determining the power of customers: price sensitivity and relative bargaining power. When exacting the amount of influence these two factors and ultimately the level of power customers have, it is important to look into many aspects of the industry. The level of demand, switching costs, product differentiation, importance of product quality, and availability are all important variables. Ultimately the bargaining power of customers can affect the overall wealth of a firm. Switching Costs Switching costs are important to customers. In effect, this is the cost they may endure for using a substitute product. The home, farm, and ranch retailers are usually located near or in large cities, which increases competition. As a result customers have the ability to shop for comparable products. This industry also carries similar namebrand products that could easily pose as a substitute to competitive products. Both of these factors drive switching costs down and allow customers to be price sensitive. For instance, Lowes and Home Depot are usually located within a few blocks of each other. The industry serves both individual consumers as well as business 40 P age

41 customers equally; one sector does not have more power over the other. Both firms strategically place their stores within a short distance of competitors. Firms do this in order to encourage customers to switch from one firm to another. Even though Tractor Supply s main competitors are Home Depot and Lowes, their strategy is a little different. The firm places their stores according to where there customers are, which is usually in rural areas. The firm places their stores outside of cities, thus making switching costs for customers a little higher considering they would have to drive into a city to purchase products from a competitor. Therefore, some customers face higher switching costs. Differentiation Differentiation among products is another key element. A customer considers how different one substitute is from another. In an industry where products are undifferentiated customers may use similar products interchangeably and gain bargaining power. However, if products are highly differentiated there are fewer substitutes that would be adequate replacements and customers lose bargaining power. In the home, farm, and ranch retailing industry many products offered are undifferentiated thereby making exchanges fairly easy. This increases the bargaining power of customers and allows them to engage in price sensitivity. The industry as a whole offers undifferentiated products to their customers, however stores have engaged in special contracts in order to gain a competitive edge over their competitors. For example, Home Depot offers Martha Stewart outdoor living and Tractor Supply offers private label products to their customers and due to binding contracts of suppliers this firm is the only firm that can carry the product. Therefore, customers may not obtain this product from any other company driving the bargaining power of customers down. However, all firms in the industry have a market cap of around 10% of products purchased from one supplier, which include the exclusive brand rights granted to one store. Therefore, the other 90% of the industries products consist of undifferentiated products which drive customer bargaining power up. 41 P age

42 Importance of Product for Costs and Qualities In an industry such as home, farm, and ranch retailing where products are highly undifferentiated, switching costs are low, and competition is fierce cost and quality of products play an important role. Many retailers in this industry carry the same namebrand products which increases the bargaining power of customers. Because customers have the upper hand many firms focus on quality, in-stock consistency, price, and customer service. Firms in this industry are known for catering to customers by offering various monetary incentives which include factory rebates, rewards programs, and weekly discounts on various items. The quality of products are virtually the same this industry therefore there is a heavy emphasis on superior customer service. Tractor Supply for example requires their employees to go through rigorous training in all areas of the company operations such as product knowledge, in-store vendor training, and frequent management skills training classes. Home Depot focuses on customer service by enforcing their employee modo of Make love to the customer (homedepot.com). Lowes also has a high emphasis on customer service offering expert advice to customers in order to help them make a decision on products and projects. Considering this industry is highly competitive with constant price incentives and undifferentiated products, customers are price sensitive and may choose a store for quality of customer service. Number of Customers Determining the level of power customers have in the market is important. However, customers are not only subject to the degree of price sensitivity but also the relative bargaining power. Relative bargaining power is an important concept for buyers to understand in order to fully comprehend the extent of their power over firms. There are several factors to be taken in to consideration: the number of customers in the market, volume of purchases per customer, number of customers relative to numbers of suppliers, and number of alternative products available. When customers have flooded the market, creating high demand, then bargaining power is lost. Conversely, customer demand is low, purchasing power is 42 P age

43 gained, and firms must adjust accordingly. Lowe s did a study to assess the number of customers in the market and demand of the industry as a whole according to their 10k. It was found that approximately $492 billion represented the US product demand in the industry in Troubling economic times were attributed to the market decrease of 11% for 2009 (Lowes 10k). Variables specifically affecting this industry include high unemployment which peaked at 12.5% (WSJ), slow growth in real disposable personal income, housing turnover well below peak levels, and a decline in home ownership. The factors above pertain to all firms operating in this industry, thus not one firm has a different explanation for the decrease in the number of customers. Volume per Customer While assessing the number of customers is an important factor in determining relative bargaining power, there is another key factor that must be considered: volume per customer. When estimating volume per customer the industry in which the firm operates must be taken in to consideration. In an undifferentiated industry with one large customer, there are numerous firms to choose from and said customer consumes a significant amount of a firm s product. This means the customer has a powerful influence over the firm. This is justified because undifferentiated products are consumed and the customer has alternative suppliers resulting in low switching costs. In a retail industry with companies like Home Depot, Lowe s, and Tractor Supply operating these companies provide products to a wide customer base. Since firms in this industry depend on the average consumer to generate their revenues, customers do not have relative bargaining power in this aspect. Customers may engage in switching from one company to another however, the loss in revenue the firm would endure would not be a substantial amount that could damage the firm. Therefore, with low bargaining power, a customer leaving a firm for the firm s competitor could not be beneficial to the customer. Conclusion In the home, farm, and ranch retail industry one can conclude that customers engage in price sensitivity. This is composed of low switching costs, relatively 43 P age

44 undifferentiated products, and importance of product. Cost and quality is almost uniform among firms. Companies in this sector have added another element in determining customers price sensitivity, which is the quality of customer service. Considering the factors above firms have implemented superior customer service practices by employing highly trained employees to assist and educate consumers on products. However, relative bargaining power of customers is slightly less powerful. The number of customers in the market is substantial and the products offered are necessities. This variable plays a role in the volume per customer as well. The industry relies on numerous customers who purchase in small quantities on a need basis. These key elements which comprise relative bargaining power leave customers with less control over individual business entities. In evaluating the elements that create the two key factors, price sensitivity and relative bargaining power, it is now feasible to estimate the bargaining power of customers in the home farm and ranch industry. Customers are price sensitive, but have moderate relative bargaining power over firms. The high degree of competition, low switching costs, undifferentiated products, uniform product costs and quality, and the importance of customer service in the industry have left customers with relatively high bargaining powers in the home, farm and ranch industry. Thus, competition among firms is high causing them to compete in cost leadership. Firms focus heavily on offering the lowest prices and the best service in order to outperform their competitors. Bargaining Power of Suppliers The industry s supplier base consists of thousands of domestic and international companies. The suppliers consists of small and large businesses that offer a variety of products from outdoor furniture, lumber, pet supplies, parts, lawn care and home décor. The bargaining power of suppliers determines the amount of control suppliers have over firms when negotiating price. The amount of control a supplier has depends on the industry in which they operate. An industry that has a surplus of suppliers 44 P age

45 cannot dictate prices because firms have many substitutes. If there are only a handful of suppliers, meaning a handful of substitutes for firms, suppliers have a significant influence on the price they can charge for their products. In the home, farm, and ranch retailing industry firms purchase finished goods from numerous domestic and international suppliers. In the fiscal year 2009 home depot stocked 40,000 different products during the year (Home Depot 10k). This illustrates a wide variety of suppliers which decreases their power in negotiating costs with firms. When suppliers are in surplus stores like Home Depot may form strategic alliances and relationships with specific suppliers (Home Depot and Lowe s 10k). In addition, companies that operate in this industry have a cap on the amount of total purchases they will enact from each supplier. Lowe s has a 7% cap (Lowe s 10k). Suppliers also compete by offering rebates and providing in-store training to employees on their products. In an industry competing on customer service this may put suppliers at an advantage. However, a global base of thousands of suppliers makes it difficult for suppliers to have bargaining power. Switching Costs Switching costs depend on the number of suppliers in the market and available substitutes. Firms in this industry purchase products from thousands of suppliers. For example, Lowe s and Home Depot have a supplier base of 7,000, and 12,000 companies respectively according to their 10k while, Tractor Supply has a smaller supplier base of 850 companies according to their 10k. Just because there are numerous suppliers in the market does not mean that companies have numerous substitutes. Companies like Home Depot and Lowe s have entered into exclusive carrying rights with certain suppliers. This benefits both supplier and firms, it gives the firm a competitive edge, but also gives the supplier bargaining power when negotiating price. Firms switching costs are relatively low if they do not have a contractual obligation with suppliers giving suppliers little bargaining power. Considering special contracts firms have with suppliers gives suppliers more price control. 45 P age

46 Differentiation Differentiation in products suppliers provide is another key element in determining bargaining power of supplier. When a supplier offers a specialized product it makes it difficult for firms to find a substitute, creating high switching costs. However, when products are undifferentiated and substitutes for the product are readily available switching costs are low. In the home, farm, and ranch industry there are numerous global suppliers with a fair amount of substitutes for general products. On the other hand, firms in the industry try to stand out by implementing private labels to give them a competitive edge according to Tractor Supply 10k. This creates product differentiation making it difficult for firms to find a substitute for a low switching cost. Suppliers of general products have little to no bargaining power because firms can easily switch without additional cost. Suppliers of private labels have gained power by providing firms with differentiated products. Therefore, suppliers that produce these lines have an advantage over those that do not. Depending upon which items suppliers provide determines the power they have over firms. Importance of Product for Costs and Quality The importance of product costs and quality depends on the industry in which the firm operates. In the cost competitive home, farm, and ranch retailing industry firms offer around 44,000 different products to consumers provided by global suppliers. While it may seem that firms have more power over suppliers in price negotiation, this is not entirely true. As previously mentioned, firms have contractual relationships with specific suppliers. Firms engage in such relations to gain a competitive advantage by offering products their competitors cannot obtain due to terms of the contract. In this situation firms cannot use alternative products leaving them with little bargaining power. The supplier also cannot sell this product to a firm s competitor. This also means firms want a top quality product that would be worth sacrificing potential alternative products, thus decreasing the power of suppliers as well. This creates a dependent relationship between both firms and suppliers. 46 P age

47 Alternatively, the majority of products sold in this industry are typically general products with plenty of substitutes, and the same quality. In order for buyers to gain market share they must purchase products from suppliers that can price competitively. This factor drives down costs for customers of firms which decreases suppliers bargaining powers. For example, Tractor Supply, Home Depot and Lowes all have a page on their website dedicated to supplier diversification. All companies welcome new suppliers and have strict requirements of chosen suppliers. All suppliers must be able to provide products within 72 hours of ordering, and must consistently have products in stock. All companies also emphasis on the fact that they want to promote diversification by ordering products from companies that are owned by women, veterans and minorities. Some suppliers may be at an advantage if they fall among one of the minority situations, however the firms in this industry appear to have the upper hand when bargaining with suppliers. Number and Volume of Suppliers As previously determined there are a large number of international and domestic suppliers, which decrease the bargaining power of customers depending on the products supplied. Firms have maintained relatively the same number of suppliers over time. The number of suppliers depends on the market cap of purchases from supplier that the company implies. Most firms in this industry do not allow suppliers to represent more than 10% of the market. The following is a chart that represents the number of suppliers for each of the following companies: Company Number of supplier Home Depot 12,000 Lowe s 7,000 Tractor Supply 850 (Tractor Supply, and Lowe s 10k home depot from supply chain brain) 47 Page

48 In addition, the number of suppliers this industry keeps total purchases from suppliers to a minimum. Tractor Supply has a cap of 10% and Lowes has a cap of 7% of total transactions from one supplier. However, the chart above illustrates numerous suppliers firms do not purchase from all their suppliers every year. This is simply the supplier base, for example Tractor Supply only used 250 of their supplier base in 2009 (Tractor Supply 10k). These factors decrease the amount of bargaining power suppliers have over firms. Conclusion Estimating the bargaining power of suppliers may be difficult depending on the relationships they have with individual firms. Due to the abundance of supplier base of firms providing general products, substitutes are readily available and have low switching costs which decrease the amount of power suppliers have. Conversely, exclusive products supplied to firms and their binding contractual relationship with suppliers leaves both the firm and supplier with bargaining power. When a buyer purchases top quality products in order to gain a competitive edge the suppliers gains leverage when negotiating price. In the home, farm, and ranch industry, firms have most of the power in price negotiations with suppliers. Key Success Factors for the Industry The driver of profitability in a firm is determined by what kind of strategy they choose to use. There are two basic forms of strategies that firms choose from; these are cost leadership and differentiation. This decision is made using the information that they gather from both their competition and from within their own firm. Cost leadership is the most common form used in the retail industry when the products being sold are commodities. Cost leadership is the firm s ability to offer similar products at lower costs than the competitors. This can be achieved through various techniques which include economies of scope, more efficient production, lower input costs, lower distribution costs, and low research and development or brand advertising. 48 P age

49 Companies who are able to perform this successfully will be able to earn higher profits and begin to focus on tight cost control. The use of tight cost control reduces many of the unnecessary costs such as high overhead and manufacturing costs. This leads to higher profits and greater control over the company. Differentiation is another strategy which is used by firms to maximize profit capabilities. The firms that use this strategy strive to become a provider of a unique product or service to customers at a price premium that they will pay. This can be achieve by using techniques such as offering superior product variety or quality, having superior customer service, flexible delivery, and investing in brand image or research and development (Palepu). A firm who chooses to operate in differentiation will rely heavily on creativity and innovation from within. A firm chooses the strategy in which they wish to operate. Successful firms operate using one of the strategies, but should never completely ignore the other strategy. Tractor Supply mainly operates using cost leadership, but must be aware that there are ways in which they may be able to differentiate from their competitors. Cost Leadership As a price taker and commodity product provider, Tractor Supply and its competitors in the industry are more likely to be involved in the cost leadership form of business. This industry deals similar products to customers and would be very difficult to differentiate themselves. By becoming more efficient and lowering costs, they are able to offer products at lower prices for consumers and potentially increase their profitability. Economies of Scale Using economies of scale in the retail industry is done by lowering variable costs. This is a large factor in this industry and has the ability to increase profitability of the firms. Due to the fact that the retail industry is not in charge of producing their products, they must be able to effectively manage their supply chain. This involves managing the inventory and distribution of the products. Buying items in bulk is a factor that helps in the retail industry. Doing this allows the firms to obtain products at 49 P age

50 discounted prices and maintain a running inventory. The best way to manage the inventory costs is to keep low amounts of inventory in stores and have good relationships with the suppliers. These relationships can lead to quicker responses from the suppliers, meaning quicker delivery. Distribution of products can be done successfully by placing distribution centers in convenient locations, with the location of stores in mind. This can greatly decrease the amount of time it takes for products to be received and decreases the costs of the delivery of these products at the same time. This is a necessary factor in remaining competitive in the retail industry and implementing a cost leadership strategy. Efficient Processes To be competitive in the retail industry, firm must analyze every one of its business processes and maximize its efficiency to stay on par with its competitors. Everything from distribution to purchasing and stocking must be executed with as little costs as possible associated with it. This efficient management of the firm s processes will cut costs and lead to increased profitability. One way a firm can cut costs is to efficiently manage its purchasing methods. It is essential to effectively manage inventory to maintain low costs and confusion. In the case of Tractor Supply Company, using an Electronic Data Interchange (EDI) makes purchasing more efficient (Tractor Supply Company 10-K). With this system, Tractor Supply Company can more easily communicate with its vendors which use the same system, making communications between mass amounts of vendors much easier to organize. Distribution and store layout are also key areas in which it is advantageous to improve efficiency. Through the use of RDC, Lowe s and Home Depot are able to more effectively manage their international distribution processes, cutting costs and creating a more organized system. Efficient store layout will allow a firm to more capably restock inventory and provide customers with an easier way to browse a store s merchandise. All of these factors cut costs and improve customer satisfaction, which translates directly into improved profit margins. 50 P age

51 Simple Product Design Simple product design is essential to maintaining cost leadership. In manufacturing, this means producing goods at a basic level to avoid any unnecessary costs that can be incurred. In the retail industry, this usually applies to efficient store layouts. Setting up stores that maximize capacity saves valuable square footage that can lower overall store by store costs. In addition, it important that the layout of a store is set up such that a customer can easily find what he or she is searching for. This enables the customer to get in and out of the store quickly, creating space for more customers to shop. In addition, this creates customer satisfaction, as it can be irritating to the consumer when they cannot find what they are looking for in a quick and easy fashion. Simple store design is also essential in efficiently restocking merchandise, saving time and money paid to employees. For any firm in the retail industry, these factors are essential for maintaining low costs store to store. Low Cost Distribution Minimizing distribution costs can be a huge factor when competing in a cost leadership environment. Transportation, fuel costs, and third-party logistics coordination are all factors that make up the distribution overhead. The more a company grows, the larger the costs associated with distribution become. In the case of Lowe s and Home Depot, distribution costs are huge as they operate internationally, and must be carefully analyzed in order to prevent wasteful distribution processes. The efficient management of a firm s supply chain is a big factor when attempting to lower input costs. Even with Tractor Supply Company which operates solely in the US, distribution must be as efficient as possible. One method that Home Depot and Lowe s employ is called Rapid Deployment Center (RDC). With this logistics system, these firms are able to compile an aggregation of store product needs to a single purchase order, and then rapidly allocate and deploy inventory to individual stores upon arrival at the center (Home Depot, Lowe s 10-K). This process allows for improved transportation, simplified order processing, and reduced lead time which can quickly add up to a lot of money saved each year. On the other hand, Tractor Supply Company employs a third-party logistics provider in order to 51 P age

52 manage the drivers contracted to them(tractor Supply Company 10-K). This greatly improves distribution efficiency by allowing third-party experts to be completely dedicated to the system. All three of these company s rely on efficient and low cost distribution to keep input costs down, and therefore offer more competitive prices. This is essential in any retail industry as rivalry amongst competitors is high, and low prices are the key. Low Research and Development Industries that practice differentiation create new unique products that customers are willing to buy. This is evidence that they have a research and development division, and therefore costs. The retail industry is able to maintain low research and development costs. This is because they have continuing products which cannot be differentiated in substantial ways. So instead of using the differentiation strategy, retail stores are able to cut these costs out. They have no reason to fund something that will not be able to supply a return to the firm. Firms in this retail industry offer products at competitive prices, and monitor the prices of competing stores and adjust their own accordingly (Tractor Supply 10-K). Price competition will close the profit margins, and will decrease available money to reinvest. This causes the retail industry to avoid the research and development all together. Differentiation While the home, farm, and ranch retailing industry is mainly cost leadership, firms engage in differentiation strategies in order to gain a competitive edge. There are two types of differentiation firms implement in order to compete; product variety and superior customer service. Firms in the industry believe these factors aid their success in engaging in a high price competitive market. Superior Product Variety Overall, the product lines offered in the industry are relatively the same; however firms have implemented private labels and exclusive carrying rights to make their store a destination store for customers. Firms such as Lowe s offer exclusive brand names in several categories in order to further differentiate their products 52 P age

53 variety, while giving their customers great quality and value (Lowe s 10k). Home Depot has recently partnered with Martha Stewart Living Omnimedia, to offer an exclusive Martha Stewart Living brand of home improvement products (Home Depot 10k). While Tractor Supply offers private label products that give their customers superior value for a competitive price. In conclusion, the industry as a whole believes that product variety is a key element to their business strategy. Superior Customer Service In addition to product variety, firms compete on superior customer service. The industry serves typical consumers who have home farm and ranch needs. Therefore the industry views their customer base as life-long customers. Firms in the industry have found customer service to be a valuable key element to their success. Due to the fact that firms in this industry mainly offer similar products, they have focused on customer service in order to stand out amongst customers. Stores such as Tractor Supply believe friendly responsive and seasoned advice helps to promote strong customer loyalty and repeat shopping (Tractor Supply 10k). In addition, their employees are required to endure rigorous training in the overall company operations, frequent management and skills training, and product information. Even suppliers have recognized the importance of superior customer service in the industry and provide in store training on products. Home Depot and Lowe s have also added a different element to their customer service by providing free installation on items. Above all, the industry considers customer service as an important element in gaining market share. Whether it is friendly employees, knowledge of products or free labor, the industry has created unique superior customer service that would make their store a destination store. Closing Thoughts on Key Success Factors In the home improvement retail industry the strategy of cost leadership is taken. Firms use this strategy in order to become cost competitive. Being able to effectively implement cost leadership will lead to being able to engage in tight cost controls and determine prices in the industry. Being able to successfully achieve this will lead to 53 P age

54 higher profit margins for the individual firms. Companies who are able to break into the rare diversification of products can obtain large shares of the market from competitors. By being able to have economies of scale, simple product design, efficient markets, low distribution costs, and low research and development costs enables the retail industry to focus mainly on cutting costs and using cost leadership. This firm also has differentiation with the quality and variety of the products, as well as having a superior customer service. Firm Competitive Advantage Analysis Through the industry evaluation, two competitive factors exist in which firms compete on, cost leadership and product differentiation. Tractor Supply may be a smaller home, farm, and ranch retailer, but they still compete on the same level with larger firms in the industry. Tractor Supply has implemented these factors and as a result core competencies have become evident. Tractor supply continually focuses on improving economies of scale, distribution costs, product variety and superior customer service in order to gain market share, and ultimately increase the firms overall value. Core Competencies Core competency refers to a firm s ability to create a business in which it provides consumer benefit, limits imitation of company structure with competitors and can be transitioned over a multitude of products. In the home improvement and hardware industry, perfecting core competencies can lead to a large increase in a company s competitive advantage. This industry competes largely on cost leadership and differentiation. Tractor Supply Company has been able to implement and perfect four key competencies that set them apart from their industry competitors. These factors are: low distribution cost, large economies of scale, superior product variety and better-quality customer service. Low Distribution Cost Distribution access is essential to strengthening market share in the home improvement and hardware industry. Although all three companies have large, 54 P age

55 nationwide distribution, Tractor Supply has been able to limit cost due to strategically placed distribution centers, superior logistics, and lack of international affairs. Company Number of Distribution Centers per year Tractor Supply Home Depot Lowe's Table 1 (Lowe s, Home Depot, Tractor Supply 10-K) Company New % New % New % New % New % Stores increase Stores increase Stores increase Stores increase Stores increase Tractor Supply 65 13% 82 14% 89 13% 91 12% 76 9% Lowe s % % % 115 7% 62 4% Home Depot % 125 6% 110 5% 62 3% % Table 2 (Lowe s, Home Depot, Tractor Supply 10-K) Table 1 lists the number of distribution centers for each company in the home improvement and hardware industry for the past five years. As shown by the tables, Tractor Supply has been able to maintain six regional distribution centers despite consistently increasing the number of stores within the country. Their strategic placement of distribution centers has allowed them to refrain from adding additional centers as the business increases. As stated in their 10-K, Tractor Supply will not need 55 P age

56 to add a distribution center or expand on their existing ones until the company reaches over 950 stores. The company has been able to identify areas of key success to their industry and concentrate their distribution centers to be accessible by multiple key areas. Tractor Supply has also placed high importance on the logistics of their distribution network. How efficiently the network functions is a key component of low cost distribution. As seen in Table 1, Home Depot has had sporadic changes in distribution centers throughout the past five years. This is based solely on their transition to a higher technology and more efficient distribution system. Because they were not able to efficiently manage their distribution network from them beginning, changing it now has been a large endeavor for them. Tractor Supply has had no such problems. They manage their transportation activity in-house through the use of a web-based transportation management system (Tractor Supply 10-K). Not only does this lessen costs of third party management, but web-based management is the most efficient way to handle distribution as moved inventory is recorded immediately. Webbased management also requires less capital as once it is implemented, any employee can run it and only one programmer is necessary for up-keep. Tractor Supply is the only company in this industry using web-based management for their distribution network. Tractor Supply is also the only large firm in the industry that is not international. They previously had several stores in Canada which they sold in 1987 to become a national based company. Limiting networking to strictly national has allowed Tractor Supply to minimize the amount of distribution centers keeping costs relatively low. Not included in Table 1 are the import centers for both Lowe s and Home Depot which currently have one and eighteen respectively. Lowe s import center is a third-party center in Canada which allocates higher costs. The eighteen import centers owned by Home Depot are also managed by them increasing labor costs as well as overhead. Lowe s also operates three more facilities in support of their international business. Removing international business within the company has allowed Tractor Supply to have significantly lower distribution costs as it eliminates importing costs and liabilities. 56 P age

57 Tractor Supply s ability to strategically place distribution centers, obtain superior logistics and limit cost from international affairs has allowed them to lead the industry in low cost distribution. Economies of Scale As stated in the five forces analysis, creating large economies of scale in the home improvement and hardware industry is necessary for substantial profits and market share. This is not only achieved by increasing the size of the company with store growth but also how efficiently a firm manages its resources and converts them into revenue. The table below shows the percent growth in stores within the past five years. % Increase in the Number Stores Company % increase % increase % increase % increase % increase Tractor Supply 13% 14% 13% 12% 9% Lowe s 14% 12% 11% 7% 4% Home Depot 10% 6% 5% 3% 0.6% (Lowe s, Home Depot, Tractor Supply 10-K) A simple glance at the table shows that despite the fail of the U.S. housing market in 2008, Tractor Supply maintained a fairly consistent growth while Home Depot s and Lowe s growth dropped significantly as the economy continued to plummet throughout This consistent growth has allowed Tractor Supply to not only create a larger economy of scale, but also maintain it more efficiently than its major competitors. Not only have they maintained a steady growth in stores, but they have also converted resources into revenue more efficiently than their competitors. Below is a graph depicting the sales to property, plant and equipment ratio of Tractor Supply and its core competitors. 57 P age

58 Sales to PP&E (Lowe s, Home Depot, Tractor Supply 10-K) As shown in the graph, Tractor Supply has more efficiently transferred resources into revenue over the past several years than that of its competitors. Tractor Supply has been able to convert their total assets into 8-9 times that amount of revenue. Although this can partially be contributed to the fact that both of its competitors are international, this much of a difference also indicates Tractor Supplies efficiency in sales to property, plant and equipment. Because of their efficiency in this aspect of the business, they have not only created a large economy of scale, but also have succeeded in managing it more effectively than its major competitors in the market. Product Variety and Quality In the home, farm and ranch retail industry, there are thousands of different products with equally different qualities. Tractor Supply offers a full line, in-stock product supply with an average of 15,000 to 19,000 unique products per store (tractor supply 10k). In addition, Tractor Supply guarantees product variety by implementing a 10% purchasing cap on vendors. This firm has also been providing customers with private label brands which also contribute to the variety of products offered to customers. Since the firm is in a price competitive industry, they believe consistent quality of their products is important as well. Tractor supply has a dedicated buyers team that consistently researches vendor line reviews, engages in assortment planning, 58 P age

59 and testing of new products and programs (Tractor Supply 10k). Tractor Supply has a supplier base of 850 vendors which provide them an assortment of variety and quality products. Tractor Supply s wide variety of quality products and their dedicated buying team have allowed their smaller firm to effectively compete amongst large competitors. Superior Customer Service In a high cost competitive industry it is essential for firms to focus on consistently improving in-store qualities. Tractor Supply has continually achieved this by offering superior customer service. In order to constantly improve their customer service the company has implemented a rigorous training program that deals with every aspect of the company inside and out. The program consists of a full management training program which covers all aspects of operations, product knowledge modules produced in conjunction with key vendors, frequent management skills training classes, semi-annual store manager meetings with vendor product presentations, vendor sponsored in-store training programs and ongoing product information updates from their management head quarters (Tractor Supply 10k). In addition, Tractor Supply seeks to hire employees with farming and ranching background particularly in general maintenance. Tractor Supply not only focuses on customer service needs concerning products but also competes in other aspects as well. The company operates an online website that allows customers to order products and have them shipped to the store or their residence. This allows the firm to reach customers that do not have a store in their area. Also, the firm offers gift cards and private label credit cards for individuals and business customers. Although Tractor Supply is relatively smaller than its competitors, the company has implemented superior customer service that is on par with larger competitors. The company s customer service offers highly knowledgeable employees that can aid customers with products. This alone makes the firm a destination store for customers and ensures customer loyalty. In addition, the company runs an online website and offers private label credit cards to customers. Overall, the company provides superior 59 P age

60 customer service that allows them to compete in the industry and has given them a competitive advantage in the market. Conclusion Competition in the home improvement and hardware industry is strong. Without creating and implementing key core competencies, a company like Tractor Supply would have a difficult time competing with companies like Lowe s and Home Depot. Tractor Supply s core competencies of low distribution costs, economies of scale, superior product variety and quality customer service have allowed them to not only compete with such large companies, but also continue to grow and succeed. Their ability to recognize and employ technological advancements as well as strategically manage their distribution and resources has allowed them to thrive in an industry where competition continues to strengthen. Tractor Supply is a company that has displayed that the ability to recognize and perfect core competencies is an invaluable competitive advantage in their industry. Key Accounting Policies When analyzing any firm, it is crucial to examine the accounting policies that the company employees. Although all firms must adhere to Generally Accepted Accounting Principles (GAAP), there are a significant amount of areas where managers have flexibility with the constraints of GAAP. Management has the flexibility to choose which types of accounting estimates and strategies to employee. Often times they choose the strategy that most benefits the firm. In addition, managers can choose to be either conservative or aggressive in their accounting estimates. While this is perfectly legal and acceptable, being aggressive as opposed to conservative and vice-versa can greatly distort the figures on the balance sheet. Accounting policies are split into two segments, Type 1 and Type 2 Key Accounting Policies. Type 1 accounting policies are those that the analyst should identify and evaluate to measure the firms critical factors and risks (palepu). In other words, these policies are directly tied into key success factors for the firm and industry. 60 P age

61 In the retail industry, this has to do mainly with inventory management and distribution. Type 2 accounting policies are those accounting methods that can lead to possible distortions, regardless of what industry a firm is in. Usually, these accounting estimates have many areas that allow a good deal of management discretion, often leading to distortive figures. Operating leases and pension liabilities are good examples of type 2 policies in the retail industry. Type 1 Key Accounting Policies Type 1 key accounting policies directly tie into a firm or industries key success factors. In the retail industry, these success factors are almost always related to cost leadership. In this section, we must analyze the disclosure of the various factors of cost leadership such as low cost distribution, inventory management, and economies of scale. Careful examination of each company s financial data will give us a clear idea how Tractor Supply Company discloses its accounting information pertaining to these value added activities. Low Cost Distribution Low cost distribution is vital in the retail industry as maintaining low variable costs is a key success factor for any firm. As a firm grows, so does its distribution networks, and therefore its distribution costs. The larger this distribution network becomes, the more important it is to properly coordinate and reduce costs associated with it. Tractor Supply Company has 6 distribution centers located around the United States, and in 2009, ran approximately 67% of its merchandise through this network (TSCO 10-K). The efficient management of a firm s distribution network is crucial to all firms in the retail industry, in which cost cutting is essential to stay competitive. Home Depot alone has 48 distribution centers placed in strategic areas in order to minimize transportation costs (Home Depot 10-K). To efficiently manage its distribution network, Tractor Supply Company runs its inbound and outbound transportation activities through the use of a web-based transportation management system. In addition, it uses two third-party logistics coordinators who are responsible for managing drives and tractors, delivering merchandise from the vendors directly to their stores. Minimizing 61 P age

62 empty miles, and careful monitoring of transportation routes and delivery schedules help to minimize costs associated with distribution (TSCO 10-K). Going through Tractor Supply Company s 10-K gives the reader a very clear view of how their distribution network is run, supplying an acceptable amount of information on the subject. Economies of Scale Another key success factor in the retail industry is the utilization of economies of scale. The biggest factor regarding economies of scale is the firm s sheer size. While Tractor Supply Company has a little over 1.3 billion dollars worth of assets as of 2010 (TSCO 10-K); this is only about 3% of the assets owned by the larger firms in the industry. As of 2010, Lowes and Home Depot have total assets of 33 and 40 billion dollars respectfully (Lowe s and Home Depot 10-K). A look at the sales to PP&E ratio will give the reader an idea of how efficiently each firm is using its assets to generate revenue. Sales to PP&E Although Tractor Supply Company has a much smaller amount of assets, it is still able to use economies of scale to its advantage, having a sales to PP&E ratio between 8 and 9 depending on the year, approximately triple that of Home Depot or Lowe s. While this surely has to do with the complications of international distribution among other 62 Page

63 factors, it shows that Tractor Supply Company is efficiently using its size to cut down on costs. Through careful reading of the Tractor Supply Company s 10-K, all of the pertinent information regarding new store openings, distribution centers, and total assets are readily available, providing an acceptable level of disclosure regarding economies of scale. Efficient Processes Efficient processes further allow a firm to cut variable costs through various processes such as purchasing and distribution. As previously discussed, efficient distribution management is critical in cutting costs and staying competitive. In addition, an efficiently managed purchasing process will allow a firm to create good relationships with its suppliers, and cut costs all around. A breakdown of the purchasing process can be studied through analysis of Tractor Supply Company s 10-K. Tractor Supply Company purchases its merchandise through a core group of around 850 vendors, 250 of whom make up approximately 90% of their purchases (TSCO 10-K). In addition, Tractor Supply Company has not experienced any difficulty finding alternative vendors if prices are too high or the relationship is strained. The firm also avoids long term vendor contracts to avoid any legal disputes if it decides to switch to a lower cost or higher quality vendor (TSCO 10-K). In addition, Tractor Supply Company transmits 97% of its purchase orders through an electronic data interchange (EDI) system, and is expanding this number (TSCO 10-K). All of this information is easily found on Tractor Supply Company s income statements, giving the reader a clear idea of how each of these processes is run. Little Research and Development In the retail industry, research and development is almost non-existent, especially with firm s that sell a good deal of commodities and/or homogeneous products. Tractor Supply has no research and development costs at all, as the manufacturing and vending companies do the research on their own products, and the retail firm is simply an intermediary between manufacturers of products and the consumers. The objective of a retail store is to acquire these products for a low cost 63 P age

64 and sell them to the customer for as high a price as they are willing to pay, maximizing its profit margin for each product its sells. A competitive cost-cutting industry such as retail must drive prices as low as possible to under-cut the competition that the profit margins are so small that there is no money to invest into research and development even if they wanted to. Thus, research development plays no role for Tractor Supply company or any of its competitors. Superior Customer Service In the retail industry, some stores focus solely on price-cutting such as discount stores, while others also compete on customer satisfaction. The best way to make sure a customer comes back to your store is to give that customer good prices and a great overall experience. Thus, it is important to make sure employees provide superior customer service, so that your store stands out over the competition. In the case of Tractor Supply Company, employees with a vast knowledge on the agricultural and rural aspects of the business are key to ensuring customer satisfaction. Tractor Supply Company s 10-K clearly states the expectations of its employees, citing that knowledgeable, friendly, and responsive customer service is vital to promote strong customer loyalty and guarantee repeat shoppers. They also cite that the firm engages in vendor sponsored in-store training programs, and are continuously updated with new product information from their management headquarters (Tractor Supply 10-K). Having this large section of their 10-K entirely dedicated to their customer service policies illustrates how important customer service is to the firm in order to gain an edge over its competitors. Superior Product Mix Having a superior product mix is a great way for a firm to distinguish itself from its competitors. In the retail industry, having competitive prices is crucial to survive. However, having unique products is also essential in order for a firm to gain an edge on the competing firms in the industry. Firms like Home Depot and Lowe s mostly sell homogenous or similar products, making product price their main objective. For a much smaller firm such as Tractor Supply Company, having a product mix which consumers 64 P age

65 can only find at its stores is crucial to its survival. In addition to selling many products that can also be found at a Lowe s or Home Depot, Tractor Supply Company also sells many agricultural and rural products that are unique to the firm. Product Category Livestock and Pet 33% 36% 39% Hardware and Seasonal 26% 24% 23% Truck Tool 20% 19% 18% Clothing and Footwear 10% 10% 10% Agriculture 7% 7% 6% Gift and Recreation 4% 4% 4% 100% 100% 100% (Tractor Supply Company 10-K) Hardware and tool products make up a significant amount of the firms product mix. Most of these items can be found at a Home Depot or Lowe s at similar prices. In order to differentiate itself from these firms, Tractor Supply Company also sells a good deal of seasonal and rural products. In this area of its business, Tractor Supply Company does not directly compete with the other major firms in the industry. Instead, the firm must compete with local and independently owned businesses that cater to these specific needs as well. Tractor Supply Company has a distinct advantage over the smaller firms in this area because of its sheer size and scale economies, leading to lower overall prices in most cases. Taking advantage of this superior product mix gives Tractor Supply Company a distinction from Lowe s and Home Depot, allowing them to generate revenues in unique areas not offered by its major competitors. Tractor Supply Company s 10-K gives a great deal of information regarding its superior product mix, allowing the reader to gain a clearer understanding of this area of the firm s business. 65 P age

66 Conclusion Overall, the level of disclosure pertaining to Tractor Supply Company s key success factors is quite impressive. Extensive paragraphs can be found in each area including a section on distribution, purchasing, customer service and merchandising. In addition, Tractor Supply Company discloses a vast amount of financial information, including numbers from up to 5 years in the past. This gives the reader an excellent idea of the progress the firm has made over time. This is much more than either Lowe s or Home Depot Disclose, making information much more readily available to the reader. Tractor Supply Company goes far beyond the required level of disclosure proscribed by gap and gives the reader a much better idea of what the company s goals and policies are, in addition to specific financial information. Type Two Accounting Policies Type Two accounting policies are crucial for valuing a firm, because when misstated it distorts the investor s view of the firm. Type Two accounting policies are important because items can be flexible or restrictive in reporting the economic consequence of business activities. Understanding the key accounting policies in this section is imperative, regardless of the industry in which the firm operates. It is important to analyze leasing activities, hedging and foreign currency transactions, goodwill, defined pension plans, and research and development. Leasing activities are when a company builds a store but doesn t want the value to be on their balance sheet, so they sell them, but then rent them for a long period of time. Consequently engaging in leasing activities causes the companies liabilities to be understated and distorts the overall value of the firm. Foreign currency transactions arise usually from operating stores abroad, which requires the company to deal with exchange rates. Goodwill usually arises when firms merge with other companies. Goodwill appears on the balance sheet of the purchasing firm and is determined by the amount of the purchase price which exceeds the property plant and equipment. Companies sometimes offer pension plans to their employees which promise them a certain lifestyle after retirement. Below is an analysis of the key accounting policies which are crucial in determining if the firm has any misleading information that can potentially distort value. 66 P age

67 Leasing Activities Companies engage in leasing activities for many reasons; tax benefits for firms, and offers flexibility in adjusting for size and technology. There are two classification of leases firms engage in; operating leases and capital leases. In an operating lease the lessor (owner) transfers only the right to use the property to the lessee (firm). When the lease expires the lessee must return the property to the owner. Since the lessee doesn t have the risk of ownership, the lease expense is considered an operating expense and is recorded in the income statement, therefore having no effect on the balance sheet. Capital leases are more risky for the lessee, but with risk come benefits. At the signing of capital leases the payments are recognized as both an asset and a liability on the balance sheet. The firm then is allowed to claim depreciation each year and deduct interest expenses associated with the lease payment. In conclusion, capital leases recognize the expense sooner than operating leases, thus operating leases allow for less disclosure of the consequences in a firm s economic business activities. In addition, firms also engage in purchase obligations, which mean the company has promised to pay a specified amount for a benefit they will receive in the future. This benefit could be merchandise, or construction for new stores. Companies generally recognize this obligation with leasing activities, due to the fact they are off balance sheet activities. However, many firms in retail industry prefer to use operating leases over capital leases. Many firms prefer this method because it allows them to keep their leases off balance sheets which could alter the value of the firm, if they were included. Below is a table that represents Tractor Supply s future operating and capital lease payment for the next five years. Payments Due by Period Less than 1 year 1-3 years 4-5 years More than 5 years Total contractual obligation Operating $ 161,214 $ 311,229 $ 280,260 $ 732,276 $ 1,484, P age

68 Leases Capital Leases $526 $352 $292 $2,072 $3,242 Purchase Obligations $2, $2,683 Total $164,423 $311,581 $280,552 $734,348 $1,490,904 As the chart illustrates, Tractor Supply mainly uses operating leases and has a fairly small amount of purchase obligations. Since purchase obligations are small there is no need to make restatements. On the other hand, many firms engage in operating leases due to the fact that it keeps these liabilities off their balance sheets. Considering firms highly utilize leasing activities, we will now convert them into a debt equivalent in order to restate the balance sheet and gain a more comprehensive evaluation of the firm. This is important because leases can alter the investor s view of the firm, by not including leases in the firm s balance sheet. Hedging and Foreign Currency Transactions Hedging of foreign currency is a strategy companies use to compensate for monetary loses due to volatility in exchange rates, which adds risk to the revenue generated by the firm. The most popular way companies deal with the added risk of foreign currency is through the use of forward contracts. Forward contracts are contracts that lock in a fixed exchange rate, for future receipts and payments. The rate is usually the market determined forward exchange rate (buzzel.com). This allows companies to manage the risk by having stability for future payments in foreign currency. Forward Contracts limit the amount of losses a company could endure from the exchange rate. However, while it offers protection for a company, it also hinders their ability to earn extra profits. Foreign Currency transaction adds to the fog that makes evaluating a firm difficult. The main reason firms deal with foreign currency is because they operate outside of the United States. Another reason is firms purchase products from suppliers outside the United States. Engaging in such activities causes distortion in the firm s 68 P age

69 statements due to volatility in exchange rates of foreign currency. In 2007 Tractor Supply sold their stores in British Columbia, which in turn forced the company to deal with foreign currency. Tractor Supply disclosed that the assets and liabilities from the sale of the store were translated into US dollars at year-end exchange rates, while revenues and expenses were translated at average rates for the period. The books show that a total of 22 million dollars accounted for foreign currency in However, the company did not report foreign currency transactions for the fiscal years of 2008 or 2009, so no restatement is necessary. Goodwill Goodwill is an intangible item that usually arises from the merging of companies. Goodwill is calculated by the amount of the purchase price which exceeds the tangible net assets of the company acquired. Goodwill in the home, farm, and ranch retailing industry, is not a very common issue that firms face. If a company s goodwill is larger than their tangible net assets, then the firm could be overvalued and impairs the firms overall worth. Impairments occur when the carrying value exceeds the market value of the acquired firm. Tractor Supply s goodwill arose from the acquisition of a small firm called Del s. Tractor Supply has a relatively small amount of goodwill on their balance sheet from the acquisition approximately 10,258,000 compared to their tangible net assets 370,245,000. Since their goodwill is less than 20% of their property plant and equipment, this shows that the firm s value isn t significantly distorted by goodwill, and no restatement is necessary. However, the company annually tests for impairments of goodwill by using a two step impairment process. The first step is used to identify the potential for impairment. The company compares the fair value of Del s with the carrying value of its net assets, which includes goodwill. If the fair value is less than the carrying value of Del s then, goodwill could be distorted, and the second step is preformed. The purpose of the second step is to measure the amount of impairment loss to be recorded. In performing the second step the company would compare the implied fair value of goodwill with the current carrying amount of goodwill, and an impairment charge would 69 P age

70 be recorded as a charge to the companies operating expenses. At the fourth quarter of the fiscal year 2009, the company preformed this test and found that the fair value exceeded the carrying value of Del s by $100,000. Therefore, the company did not find the value to be distorted and the second step was not necessary (Tractor Supply 10k). Defined Pension Plan Pension plans are for the employees of the firm once they have retired. There are two types of pension plans defined-benefit plan, and defined-contribution plan. Regardless of which type of plan a firm uses it is important to analyze and assess the value of the plan because this can potentially fog the investor s view of the firm s value. A defined-benefit plan is when retired employee receives a specified amount based on the employee s salary history and years of service. This plan is the riskiest for the company and their investors for several reasons. The defined benefit plan places the investment risk associated with market fluctuation and the investment decision making upon the employer instead of the employee. The money for the plan is pooled into one large account for all recipients. Therefore, the plan s payouts are dependent on the fund portfolio and if the fund does not perform as expected, then it could be costly for the firm and investors. If the firm cannot meet the required payments then the firm may dip into shareholder s earning or even borrow money to meet their contractual obligations. Not only does it add risk to the firm and investors, but it can significantly distort the value of a firm. Since firms have the responsibility of investing the money, they must also account for these activities on the balance sheet. In doing so the company must make future forecasts of expenses the firm will incur. The firm s projection of these expenses is calculated using a discount rate, which is chosen by the firm. If the companies chosen discount rate do not accurately meet the required amounts of the plan, the company must dip into the earning of shareholders in order to make the payments. Too high of a discount rate can understate the companies liabilities and overstate net income. Likewise, with too low of a discount rate the companies liabilities will be overstated and consequently understate net income. 70 P age

71 On the other hand, a defined-contribution plan is a retirement account, in which the employee and/or employer elects to contribute a specified amount of the employee s salary each month or year into an individual account, such as a 401k. This type of pension fund alleviates the company from many risks as those associated with a DB plan. One main reason is the company can better project forecasting of future expenses associated with the plan, due to the fact contributions are made on a yearly basis. This short term forecasting allows for a more accurate discount rate. This allows for less distortion of liabilities on the company s balance sheet. Also, the investment risk of market fluctuations and decision making fall upon the employee and not the employer. Tractor Supply offers their employees a defined contribution plan also known as the Tractor Supply Company 401k Retirement Savings Plan. An employee becomes eligible for the plan once they have completed the requirements which are 21 years of age, completed 12 months employment and perform a 1,000 hours of service in a year. The company matches 100% of the employees elected contribution up to 3% of the employee s eligible compensation. In addition the company matches 50% of the employees elected contribution from 3% to 6% of the employee s eligible compensation. All contributions are immediately 100% vested (Tractor Supply 10k). Company contributions to the plan during the fiscal 2009, 2008, and 2007 were approximately $3.2 million, $2.8 million, and $2.6 million, respectively. This type of pension plan does not pose as a risk for the firm because, all contributions are made immediately and do not require the company to forecast future payments. Research and Development Research and development is another important key accounting policy that can potentially distort the investor s view on assessing the value of a firm. Many industries consider this activity to be a part of their key success factors, because some industries compete on innovation and the quality of their products. Therefore, Research and Development become crucial in gaining a competitive edge. Companies view Research and Development as an asset, because of the chance of future benefits. However, 71 P age

72 since the future benefits cannot be determined they must classify this activity as an expense. In the retail industry, it is uncommon to see companies invest money into Research and Development, because firms in the industry are cost competitive. Conclusion As illustrated above, Type Two accounting policies are crucial to the accounting analysis. It is imperative to review items like leasing activities, foreign currency, goodwill, pension plans, and research and development, in order to determine if there are distorted items on the balance sheet. If it is determined that the company s balance sheet is significantly distorted, then it should be recognized as a potential red flag and the balance sheet must be adjusted in order for the investor to gain a better view of the firm s value. Next, we must analyze the accounting flexibility firms are allowed under General Accepted Accounting Policies, otherwise known as GAAP. Accounting Flexibility Under GAAP managers are allowed different levels of flexibility in their application of accounting methods. Flexibility granted to firms has created two different accounting methods implemented by managers. First, conservative accounting is used by managers to justify the expensing of research and development, advertising, and the fast write down of intangible assets. However, conservative accounting does not necessarily mean good accounting. In the use of this method managers have the opportunity to engage in income smoothing, which is intentionally overstating current period expenses during good times. Managers use income smoothing to help ease the cost for future bad times. This causes assets to be understated and delays analysts from assessing poor performance. Second, aggressive accounting on the other hand is when managers put off write offs such as; maintain low liabilities and high assets. This results in the opposite effect of conservative in which aggressive overstates assets. However, both approaches have the same consequence, in that they delay analysts from spotting problematic performance. In the next section we will explore the affects of both methods on goodwill, research and development, pension benefits, and leasing 72 P age

73 activities. We will also apply these techniques to discover what type of accounting methods Tractor Supply uses and why. Goodwill Goodwill is an intangible item that arises when a company acquires another company. Goodwill is determined by the fair value which exceeds the net tangible assets of the company being acquired and is reported on the balance sheet. It is important to analyze how managers use flexibility when accounting for goodwill. First it is important to understand the rules for accounting of goodwill. The old way of impairing goodwill was to amortize the amount over a life of 40 years. In other words goodwill had a definite life and would be depreciated yearly over the 40 year lifespan. However, the accounting for goodwill changed and no longer has a definite lifespan. Instead, the asset has an indefinite life and is tested for impairments yearly. Goodwill is impaired, if fair value is less than the carrying value. Therefore the firm must impair goodwill to the adjusted fair value and write the impairment as an expense. However, managers can manipulate the test to create or hide impairment. Impairment tests are difficult to measure, because goodwill is an intangible asset, therefore the managers can manipulate the test. Managers implementing conservative accounting may impair goodwill when the firm is strong or weak in performance. Managers may impair goodwill by overstating asset impairments and overstating expenses managers can show lower future expenses boosting earnings in years of average performance or when the firm is in financial trouble. Managers using aggressive accounting methods prefer to delay goodwill write downs. If managers delay write downs then this boosts reported profits because assets are overstated. For example, Tractor Supply for example has a relatively small amount of goodwill approximately $10,258,000. In reviewing the past five years of the companies 10k, there have been no asset write-downs or impairments found. Thus, implies that the firm engages in aggressive accounting, in order to maintain overstated assets. Overall regardless of which type of method is used, when accounting for goodwill there is great potential for flexibility. 73 P age

74 Leasing Activities The two types of leases operating and capital have become one of the main ways managers manipulate financial data. Operating leases are more beneficial to management than capital leases because operating leases are not accounted for on the balance sheet. However, regulators have taken notice to the high usage and came up with the following regulations, a lease must be classified as a capital lease if it meets any of the following criteria established by the Financial Accounting Standards Board: 1. If the lease life exceeds 75% of the life of the asset 2. If there is a transfer of ownership to the lessee at the end of the lease term 3. If there is an option to purchase the asset at a bargain price at the end of the lease term 4. If the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset While this limits manager s flexibility in accounting methods it does not terminate it. Managers implementing conservative accounting methods can understate assets, by being able to circumvent the criteria. Managers implementing aggressive accounting methods benefit most from operating leases. Aggressive accounting allows for the most flexibility in this area in that firms like to keep liabilities low. Since operating leases are off balance sheet activities aggressive accounting has found a giant loop hole. This allows for liabilities to stay low and assets to remain high. When analyzing Tractor Supply it was disclosed that 94% of their leases where operating leases. Considering the heavy influence on operating lease, it is determined that this firm engages in aggressive accounting methods. As described above operating leases may have significant flexibility. Defined Benefit Pension Plans Pension plans are designed by the firm to help assist employees once they have retired. There are two types of pension plans; defined contribution plan and defined benefit plan. The defined contribution plan is less risky for a firm and investors. The defined contribution plan is an individual account formed and maintained by the employee. As the name implies to employee and employer contribute a portion to the 74 P age

75 plan monthly or yearly. However, a defined benefit plan is the responsibility of the firm to form and maintain. The employer promises an employee a certain monetary amount once the employee has retired. The employer creates and invests one portfolio for all employees who are expected to benefit from the plan. This requires that the firm use a discount rate to account for the future expenses. However, if the firm does not use an accurate discount rate it can harm the firm and investors. When assessing the liability of a pension plan the firm must find the present value of the future payments using the discount rate. However, the discount rate does not account for future changes in the market, which exposes the firm to great risks. If the discount rate is too high, then the funds will not fulfill the obligations. In this case a firm will have to decrease earnings of shareholder, or even borrow money. Therefore, a manager s chosen discount rate is a very important decision, because it could affect the firm s future value. Managers are allowed flexibility when choosing a discount rate. This could be problematic for firms whose managers abuse the flexibility granted. A manager could choose a low discount rate in order to understate liabilities, resulting in a higher net income. The firm would then appear more attractive to investors but only in the short run. The long run affects would ultimately outweigh the short term, causing the firm s value to be severely distorted and ultimately decreasing the earnings of shareholders. Therefore it is important for investors that managers disclose the discount rate used in assessing the value of a defined benefit plan. Conclusion Assessing the amount of flexibility managers have when implementing accounting methods is crucial for analysts. As described above depending on conservative or aggressive managers the use of flexibility can vary. However, it is important to understand the different uses in which managers apply their strategies because both have potential to impair the balance sheet. Tractor Supply has a very small amount of goodwill, which hasn t been written down or impaired over the past five years. In addition, the company offers a defined 75 P age

76 contribution plan which allows for less flexibility. However, the company has a significant amount of operating leases, which allows the firm the most flexibility. Considering the following factors, this firm uses aggressive accounting methods. As illustrated, managers are granted a significant amount of flexibility when implementing accounting methods. Regardless if it is conservative or aggressive both can potentially cause significant impairments on the balance sheet. It is important for investors to realize where managers can use accounting to their advantage, because this can significantly alter their view on the firm. Accounting Strategy Evaluation A firm s accounting strategy must be considered when performing a valuation of a firm. GAAP does have some guidelines that must be followed pertaining to disclosure. However, managers have a significant amount of flexibility in deciding what to divulge on their financial statements. Firms can choose to either be very transparent on these statements, providing high levels of disclosure and financial data, or they can choose to reveal the bare minimum. This makes their financial statements much more difficult to evaluate, giving the reader a small amount of insight into the company s actual financial health. Generally, there are two types of accounting strategies a firm can choose to follow, aggressive accounting or conservative accounting. When a firm participates in aggressive accounting, managers try to hold onto assets for a longer time or eliminate liabilities prematurely in an attempt to inflate balance sheet accounts. This can be done by delaying asset write-offs, using unrealistic discount rates for liabilities, and manipulating restructuring charges. On the other hand, managers can be more conservative with their accounting estimates. This concept can be justified by expensing R&D instead of capitalizing the costs. This concept is also illustrated when managers rapidly write-down assets. Neither conservative nor aggressive is the right method to choose. However, it is important for the analyst to understand which method the firm employs in dealing with certain issues, as this gives the reader a clearer picture of the firms actual financial status. 76 Page

77 Operating Leases All companies have a significant amount of flexibility within GAAP regarding disclosure, making it important to analyze whether the firm s manager are using conservative or aggressive accounting. Investigating this will help the reader get a more transparent idea of the firm s real economic situation. Operating leases are important to analyze as they are a liability that a company can keep off of its balance sheet. It is important to consider whether a firm is aggressively using operating leases as opposed to capital leases in this regard as this can significantly distort a firm s actual liabilities. The following chart breaks down the percentage of operating leases to capital leases for the firm s competing with Tractor Supply Company. Lease % by Type Tractor Supply Company Lowe's Home Depot Operating Leases 99.78% 91.30% 87.30% Capital Leases 0.22% 8.70% 12.70% This chart illustrates just how many firms in the industry utilize operating leases to keep liabilities off of their balance sheet. This aggressive accounting can distort the realistic picture of just how much a firm has in lease obligations. Tractor Supply company uses operating leases for almost all of its stores and warehouses, while Lowe s and Home Depot are not far behind. This is to be expected in the retail industry as using capital leases can diminish net income, making a firm look unhealthy compared to its competitors. Therefore, almost all retail firms are aggressive in their accounting of capital leases, Tractor Supply being no different. Goodwill Goodwill is another area in which firm s have flexibility in their accounting estimates. Goodwill used to be straight line depreciated over a 40 year life. Recent changes in GAAP state that goodwill has an indefinite life and must be analyzed every fiscal year to determine whether the purchase price exceeds tangible net assets. This 77 P age

78 change gives managers a choice of whether to impair goodwill, or leave it the same. Conservative managers will write down goodwill when they feel that the intangible asset has lost value. Aggressive managers will delay goodwill impairment for as long as possible in order to inflate assets on the balance sheet. Leaving this decision to management discretion provides opportunities for abuse of goodwill. The analyst must decide whether the goodwill balance is fair, or should be further impaired or reverse impairment. Tractor Supply Company has $10,258,000 of goodwill on their balance sheet compared to tangible net assets of $370,245,000, which quite a small amount. This goodwill was a result of the acquisition of Del s Feed and Farm Supply in Since then, Tractor Supply Company has tested for impairment and found that fair value for Del s exceeds its carrying value by $100,000 dollars. Therefore, the firm found no reason to impair goodwill. This can be interpreted as an aggressive accounting strategy regarding the lack of goodwill impairment; however, if the tests of value for Del s Feed and Farm Supply were run properly, there would in fact be no need for impairment. Conclusion Through analysis of industry wide and firm specific accounting strategies, it has been determined that Tractor Supply Company has a relatively aggressive accounting policy. The treatment of leases, almost all being operating, is a very aggressive accounting approach. Keeping all of your lease obligations off of the balance sheet can distort a firm s actual worth. In addition, the lack of goodwill impairment can be viewed as aggressive, and must be considered when valuing the firm. The retail industry altogether is quite aggressive with its accounting strategies, and Tractor Supply Company is no different. Quality of Disclosure Quality of disclosure refers to the ability of a firm to properly and informatively disclose information on their financial reports and type one key accounting policies. Depending on the quality of disclosure, it can be fairly easy to determine a company s 78 P age

79 value or extremely difficult. Valuation can be difficult because manager s determine how much a company discloses on its financial statements after the minimum required by GAAP. If a company discloses less information, it can lead to an inaccurate valuation of the company as they try to hide short comings. However, more disclosure is not always better. Companies often disclose more than necessary as an attempt to cover up their weaknesses through unnecessary information. Because of this, quality of disclosure is not limited to the financial statements. For this valuation, we will analyze qualitative and quantitative analysis of the company s 10-K. Qualitative Analysis Qualitative analysis refers to evaluating the quality of information. In this case, it is specifically geared towards the information disclosed in a company s SEC filings such as the 10-K. Analyzing a company s disclosure of information in detail can explain a lot about the firm s business operations. A company s willingness to disclose financial information, good or bad, on the company can have both a positive and negative effect. For example, a company that displays too little information could raise red flags as to what their true financial status is. On the contrary, a company that discloses too much information could be attempting to cover up financial downfalls with unnecessary extra information. Both cases can be a warning sign for potential book misrepresentations. When analyzing a company s financial statements for such red flags, it is important to look at their key success factors. In most cases, this is reflected in a firm s core competencies. A company s core competencies are considered the skills they maintain in order to substantially compete in their industry. In the case of Tractor Supply, the key success factors to consider when analyzing the 10-K include: large economies of scale, simple product design, low distribution costs, product variety or sales mix, and customer service. Economies of Scale To be a leader in the home improvement and hardware industry, a company must establish high economies of scale. Economies of scale can be defined as reducing marginal cost by increasing assets and production. As indicated by GAAP, economies of 79 P age

80 scale must be properly disclosed in a company s financial statements. Most companies disclose information on economies of scale when discussing property, plant and equipment, or total assets. Economy of scale for Tractor Supply, much like its competitors, is discussed in more detail under their growth strategy. Tractor Supply states in their 10-K that their current growth strategy includes to expand geographic market presence through opening new retail stores. Tractor Supply states over the past five years they have maintained a 13% growth rate annually. Their growth strategy also determines their continued growth plan stating [we] have plans to open 70 to 80 stores in fiscal Discussing not only previous growth but also plans for the future shows larger disclosure of economies of scale in Tractor Supply s financial statements. This same amount of disclosure is evident in both Lowe s and Home Depot as well. All companies in this industry are fairly open with the information involved in economies of scale and growth strategy. Simple Product Design In terms of the retail industry, product design can be defined by store layout and other techniques that lower cost. Because of product design s effects on a company s financials, it is necessary to disclose this information. In terms of product design, Tractor Supply discusses in detail its store environment and product placement strategies. Stores utilize several layouts, designed to provide an open environment, optimal product placement and visual display locations (Tractor Supply 10-K). The design of their stores is an important part of a company s ability to make sales. The company is also able to utilize these layouts in order to easily change and modify the store for seasonal products and promotions. Although the company fully discloses the reason for their store design, the ability to determine its effect on financial growth is unable to determine. Tractor Supply Company goes into more detail regarding its store design than its competitors showing a greater willingness to discuss their reasoning for their design. 80 P age

81 Low Cost Distribution Distribution is an important part of a company s abilities to lower costs. In the home improvement and hardware industry, Tractor Supply has used distribution as a key success factor to differentiate from its competitors. As stated in their 10-K, Tractor Supply uses many factors to lower distribution cost including, strategically placed distribution centers and a web-based transportation management system. Both factors are able to differentiate Tractor Supply from its competitors and lower costs. Tractor Supply also discusses its growth strategy for its distribution centers, stating that their current centers will be able to distribute for up to 950 stores before expansion is necessary. Although actual financial benefit from their distribution strategies is not determined, when compared to its competitors, it is apparent that their distribution strategy is a key factor in their success. This conclusion was easily determined as all companies within the industry are willing to disclose information regarding distribution. Lowe s and Home Depot also discussed in great detail their distribution center locations as well as their strategy for distribution. This made determining distribution as a key success factor for Tractor Supply fairly straightforward. Sales Mix Another key success factor for Tractor Supply Company is its product variety or sales mix. Tractor Supply s ability to increase product variety has allowed them to become a strong competitor in the home improvement and hardware industry. As stated in their 10-K, Tractor Supply offers an average of 15,500 to 19,000 unique products per store that are not included in their competitor s stores. Tractor Supply also discusses in detail their trademark and private label items offered at each store. Home Depot discussed much less in regards to their sales operations than the other companies in this industry. Tractor Supply and Lowe s disclosed similar amounts regarding sales mix in the company. Tractor Supply also includes the percent sales for each product category for the past three years, showing where their strongest product line exists, which are products that are not available at its competitor s stores. This was not seen with its competitors. Tractor Supply discusses in large detail its sales mix in its 10-K. 81 P age

82 Customer Service The most information Tractor Supply discusses in its 10-K is regarding its customer service. This is true with its competitors as well. One of Tractor Supply s most important key success factors is their ability to deliver quality customer service in their stores. Tractor Supply includes not only their goals for customer service, but also the full steps of their training program. Their willingness to disclose so much regarding their customer service shows the importance they place on customer service as a key success factor. Tractor Supply also discusses their online shopping benefits at TractorSupply.com in order to better provide for their customers. Tractor Supply also states in its 10-K that they promote customer service by having store team members who provide friendly, responsive and seasoned advice. This shows that not only are they focused on providing a friendly environment, but also on their employees knowledge of the services and products they offer, creating both a pleasant and unique store experience that they hope will increase customer loyalty. The amount of information Tractor Supply includes regarding customer service is substantial compared to its competitors. Lowe s and Home Depot discuss this information in detail, but they lack the thoroughness that Tractor Supply has in its discussion. Conclusion After reviewing Tractor Supply s 10-K in full, it is fair to determine that they have a high level of disclosure, especially in regards to their competitors. Although Tractor Supply does not disclose all information and several key success factors are unable to show the companies economic gain, both the quality and presentation of the information in their 10-K exceeds that of their competitors. Tractor Supply makes their 10-K easy to read with multiple charts that display several years of information regarding their financials and their key success factors. This was difficult to locate in Home Depot s 10-K as previous information was not discussed and charts were limited. Lowe s had a similar presentation as Tractor Supply, but their 10-K included less previous information than Tractor Supply s. Overall, Tractor Supply s disclosure regarding its key success factors and other financial information is much higher than that of its competitors allowing valuation to be more credible. 82 P age

83 Quantitative Analysis Performing a quantitative analysis is an important step an analyst must take in order to get a more transparent picture of a firm s financial health. Key areas in sales and expense accounts are particularly subject to management discretion, often leading to manipulated figures. By conducting a ratio analysis of each of these potentially distorted areas, an analyst can identify potential red flags, and therefore reasonably conclude whether or not management has misreported numbers. The two key areas that are evaluated deal with sales and expense accounts. An analyst can identify potential red flags by comparing key accounts such as inventory, net sales, and accounts receivable to industrial average s and the firms past history. Running these sales manipulation diagnostics will help the analyst identify potentially distorted accounts that may have been intentionally manipulated in order to under or overstated net income. Running core expense manipulation diagnostics is also a valuable tool as it can help identify accounts that have been manipulated in order to under or over state net income as well. After any red flags have been identified, it is the analyst s job to restate these manipulated accounts in order for the reader to get a more transparent view of the firm s financial position. Sales Manipulation Diagnostic There are always incentives for managers of a firm to distort sales figures and key income accounts in order to make the firm look financially healthier. By doing this, managers are able to improve their own image, guaranteeing job security and possible promotions. In addition, many managers have stock options, tying their firm s performance directly to their income. By inflating sales figures, net income can be overstated, increasing the value of the firm s stocks. By using raw form ratios, an analyst is able to asses past and industrial data in order to identify any sales accounts that have been potentially manipulated. If one firm is significantly different than the others in the industry, an analyst will be able to conclude whether this is an outlier or if there was intentional account manipulation involved. On the other hand, the magnitude of change is not important for change form ratios, instead potential red flags are raised when a sign change is involved. If the sign 83 P age

84 is positive from year to year, then one can assume that the accounts used in the ratio are increasing or decreasing together as is normal. However, if the sign becomes negative then the accounts are fluctuating in an abnormal pattern, and a potential red flag is raised. If there are three or more potential red flags raised in the sales manipulation diagnostic, then there are huge concerns that intentionally distorted figures are present in the firm s financial statement. Net Sales/Inventory Identifying unusual patterns in the net sales/inventory ratio over the past 5 years is a good way for the analyst to identify potential red flags for a particular company. Taking past data, and comparing it to other firms in the industry will clearly reveal whether there is a significant outlier that should be further analyzed. Inventory turnover should be relatively steady year to year. The logic being that as a firm increases its sales, it must also increase inventory to replace sold products. If this is not the case, there could be possible distortions in a one of the accounts in an attempt to overstate net income. Net Sales/Inventory (Raw) (Tractor Supply, Home Depot, Lowe s 10-K) The chart shows that Lowe s and Home Depot have higher inventory turnover than Tractor Supply Company, hovering between 6 and 7. Tractor Supply Company has a 84 P age

85 lower inventory turnover than the other firm s but still maintains a relatively steady ratio, staying between 4 and 5. The other firm s are more efficiently turning over inventory, but this can be attributed to the fact that these companies aren t perfect competitors to compare to Tractor Supply. The fact that Tractor Supply s raw form ratio has stayed relatively steady shows that there is no obvious reason to raise a red flag on these accounts. Net Sales/Inventory (Change) (Tractor Supply, Home Depot, Lowe s 10-K) One must also analyze the change form ratio for net sales/inventory in addition to analyzing the raw change ratio for the accounts. In this form, the magnitude of change is not important. Instead, sign change is the important factor to consider. A quick glance at the graph reveals that Tractor Supply Company is all over the charts with its changes in inventory turnover. This means that for certain years, an increase in sales revenue is associated with a decrease in inventory, which is abnormal. This raises some concern about Tractor Supply s accounting methods. Net Sales/Accounts Receivable Net sales/accounts receivable is another useful tool to help analyze possible account manipulation. This ratio demonstrates how much cash was collected on receivables and compares the figure to net sales. A steady ratio reveals that the 85 P age

86 company s cash collection has not significantly changed and raises less concern for account distortion. However, there are no accounts receivables in the case of Tractor Supply Company or Lowe s. This is relatively normal for many firms in the retail industry. These firms offer no financing options to customers and make all of their sales on a cash basis. On the other hand, Home Depot does finance some sales; therefore they do have an accounts receivable account. However, there is no reason for an analyst of Tractor Supply Company to look into Home Depot s net sales/accounts receivables as they have no such account to compare to it. Therefore, this ratio does not apply to Tractor Supply Company. Net Sales/Cash Sales Net sales/cash sales is a ratio which analyzes cash flow from sales to the firm s net sales. In the retail industry in particular, this ratio should either hover around one or be exactly on. This is because most firms in the retail industry don t off credit to its customers and make all of their in store sales on a cash basis. If the ratio is lower than one, there is cause for concern as the firm is collecting more cash than they can account for in sales. If the ratio is higher than one, this means that the firm is recognizing sales that cannot be backed up by cash. If the firm has a number significantly lower of higher than one, there may be potentially distorted accounts. 86 P age

87 Net Sales/Cash Sales (Raw) (Tractor Supply, Home Depot, Lowe s 10-K) The graph illustrates the fact that Lowe s (except for a minute amount of receivables in 2006) and Tractor Supply Company conduct all of their sales on a cash basis. Home Depot is the only firm that deals with accounts receivables. Although Home Depot does fluctuate over one, this is very minimal, going only as high as As far as Tractor Supply Company, there is no cause for concern in this area. Therefore, this is no reason to look examine a change form graph. Sale Manipulation Diagnostics Conclusion In most areas, Tractor Supply Company is on par with the rest of the industry. Although two out of three of these ratios were not relevant to Tractor Supply Company, one ratio did turn out to be revealing. When analyzing the change form graph pertaining to net sales/inventory, a cause for concern was observed. In this instance, over the course of a couple years, an increase in sales revenue is associated with a decrease in inventory. This could imply that Tractor Supply Company is inflating its revenues, and may be a continuing occurrence as we analyze core expense diagnostic ratios. 87 P age

88 Expense Manipulation Diagnostics Expense manipulation diagnostics studies financial ratios pertaining to the expenses of a company. When comparing to the industry as a whole, this can display potential expense misrepresentation to either over- or understate earnings. Understating expenses is a key way that fraudulent managers can increase net income on the income statement. If a company has a ratio that is an outlier within the industry, this can determine if they are misrepresenting expenses on their financial statements. In this section we will analyze five key ratios to determine the validity of Tractor Supply s expenses with respect to its competitors. Asset Turnover The asset turnover ratio is defined as sales divided by total assets. The asset turnover ratio measures the efficiency at which a company uses its assets to generate revenue. It also determines if a company is properly depreciating assets over time. Volatile asset turnover ratios could mean revenues and assets are not being properly stated on the financial statements, usually because of expense manipulation or improper depreciation practices. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO P age

89 LOW HD In the home improvement and hardware industry, Tractor Supply and Lowe s portray similar trends that depict appropriate asset turnover in the raw form whereas Home Depot has a large increase in Tractor Supply displays a consistent asset turnover with its competitors and does not display any outliers that would lead to the assumption that information is being misrepresented. Because Tractor Supply remained relatively similar to the norm of the industry in the raw form and did not show volatile changes, it is safe to assume that expense manipulation was not the case when using assets to generate revenue. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD As depicted in the change form of the ratio, or sales divided by the change in assets, Tractor Supply faces a large increase in the ratio in This can be credited to the relatively small increase in total assets due to the housing market bust and higher 89 Page

90 increased revenues that resulted from their differentiated markets. This determines why Tractor Supply was able to see an increase in asset turnover while its competitors decreased slightly. CFFO/OI The ratio of cash flows from operations to a firm s operating income creates a link between the income statement and the statement of cash flows. This ratio shows the cash flow from operations in relation to the firm s operating income. Therefore, cash flows from operations and operating income should draw a parallel. Cash flows and operating income are positively related, so if one increases, the other should as well. Observance of this ratio can help to identify expense manipulation in the firm. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD As seen in the raw interpretation if this ratio, Tractor Supply experiences a significant increase again in This can also be attributed to the increase in revenues despite an almost stagnant asset year. The increase in revenues cause cash flow to increase 90 P age

91 while operating income actually decreased due to less asset gaining activity from the company. Although this is a significant outlier in both Tractor Supply and the industry trend, it shows the positivity Tractor Supply gains from its differentiated markets. This determines Tractor Supply as a differentiated company, rather than a red flag for expense manipulation. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD The cash flows from operations compared to the change in operating income is a better indicator of the course of the industry as it portrays the decrease in cash flows that each company faced due to the housing bust in This ratio depicts that Tractor Supply actually more closely followed the industry trend and that any short comings were experienced by the industry as a whole, giving no reason to believe that such volatile changes are an effect of improper accounting activities. CFFO/NOA The ratio of cash flows from operations with respect to net operating assets explains the relationship operating assets has on cash flows from operations. A higher 91 P age

92 ratio exhibits more efficiency in creating cash flows with operating assets. Net operating assets are determined by plant, property, and equipment less depreciation. This aspect makes the ratio easily manipulated by depreciating assets faster or by incorrect amounts. If the ratio does not remain fairly constant over a number of years, this could determine a red flag. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD At first glance, Tractor Supply s performance with this ratio could be a red flag determinate. As seen by Tractor Supply s variation from the industry norm in the raw form of the ratio, this ratio peaked despite the decrease the companies saw in assets during the economic crisis that began in This can be attributed to the variety of products they sell that does not limit them to the home improvement industry like its competitors. Tractor Supply continued to receive cash from sales based on their ranching products which allowed for more cash flows from their operating activities. 92 P age

93 (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD The cash flows from operations with respect to the change in operating assets better indicates Tractor Supply s actual performance within the industry. Tractor Supply experienced a large increase in cash flows from operations as the housing bubble grew, but as seen in 2008 and 2009, Tractor Supply s CFFO/NOA ratio begins to decrease reaching values closer to its competitors. This large increase in 2007, can be attributed to more people buying home improvement items from Tractor Supply than in previous years. Total Accruals/Sales Total accruals can be measured in two ways, as operating cash flows less net income, or operating income less operating cash flows. This ratio displays the relationship between sales and cash flows. In essence, this ratio determines if the company s total accruals are supported by its sales. If there is an unexplained decrease in this ratio, it determines an understatement in expenses. If there is an unexplained increase, then expenses are being overstated, creating a big bath for the company. 93 P age

94 (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD (Tractor Supply, Home Depot, Lowe s 10-K) TSCO P age

95 LOW HD As seen in both measurements of the raw form of this ratio, the values of all companies are sporadic from year to year. Focusing on the first form of the ratio, there is a more apparent trend within the industry, however it is nearly impossible to determine if any of the companies are manipulating expenses as there is no real industry trend to compare to. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD P age

96 (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD As displayed by total accruals with respect to the change in sales, the industry displays a similar in trend until 2008, where Lowe s displays a large increase in In the industry, none of the companies experience a sign change over the last five years, which determines proper disclosure. This shows that Tractor Supply s total accruals with respect to sales ratio is not a means of manipulation as the raw form of the ratio could portray. Pension Expense/SG&A The ratio of pension expense to selling, general, and administrative expenses is used as a means of analyzing the percent of selling, general, and administrative expenses that is contributed by pensions. Ordinarily, firms would like to keep this ratio relatively low. This is because the smaller this ratio is, the less the company is spending on pensions for retired workers. Firms prefer to minimize this expense as the money they spend on pensions does not contribute any profitable activity for the firm. 96 P age

97 (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD Although this ratio places Tractor Supply fairly low under its competitors, it is apparent that not only has Tractor Supply managed to keep pensions fairly constant, they have also been able to payout much less than their competitors. This is most likely attributed to the significantly smaller amount of employees they have compared to their competitors. 97 P age

98 (Tractor Supply, Home Depot, Lowe s 10-K) TSCO LOW HD Pension expense with respect to changes in selling, general and administrative expense in each year furthers the continuity of Tractor Supply s pension plan, whereas Home Depot s large drop is exposed in 2006 when viewing changes in selling, general and administrative expenses. It is safe to confirm that Tractor Supply s pension expense with relation to selling, general and administrative expenses is of no concern to financial valuation. Expense Manipulation Diagnostics Conclusion When reviewing the ratios necessary in performing an expense manipulation diagnostic, it is fair to trust that Tractor Supply Company was honest in producing its financial statements. Discrepancies within the ratios with respect to Tractor Supply were dissolved by either viewing the ratio in raw and change form or by taking into account the drop in economic prosperity for the entire industry beginning in When taking into account both of these factors, there appears to be now red flags in the financial reporting of Tractor Supply with respect to its competitors. 98 P age

99 Identify Potential Red Flags Red flags are signs that a company has potentially misreported financial data or disclosure through accounting distortions. These red flags can be identified through a qualitative analysis and quantitative analysis of sales and expense ratios. It is imperative that an analyst identify these potential distortions and attempt to identify why they exist. Red flags can pop up through unexplained changes in accounting, unusual inventory decreases in relation to net sales, and large asset write-offs among other issues. Once an analyst has identified these areas of potentially distorted accounting figures and has attempted to undo these distortions, the reader will have a much clearer idea of the firm s actual financial status. In the case of Tractor Supply, operating leases is the main area of concern and has been identified as being a potential red flag. Operating Leases Operating leases are a large issue in the retail industry, as most if not all companies have a huge chunk of their leases classified as operating as opposed to capital. This can cause distortions in accounting estimates as operating leases are a way to take advantage of off balance sheet financing. This treatment of operating leases raises a red flag as it results in a firm s liabilities being understated, leading to an overstatement of retained earnings. Tractor Supply Company Lowe's Home Depot Operating Leases 99.78% 91.30% 87.30% Capital Leases 0.22% 8.70% 12.70% Although Tractor Supply Company has a massive chunk of their leases classified as operating, it is important to note that this is the norm for every firm in the industry. By taking advantage of operating leases, Tractor Supply Company effectively leaves almost 1.5 billion dollars off of the books, an enormous amount when one considers that their total on-the-books assets is only 1.2 billion dollars. It is crucial to determine what the 99 Page

100 effects of this off-balance sheet financing has on the company; therefore, we must undo this distortion in order to get a more transparent view of the firm. Conclusion After analyzing Tractor Supply s use of operating leases, it has been determined that this is not a significant red flag due to the fact that it is an industry norm. Even though it utilizes off-balance sheet financing to keep the liabilities off the books, analysts are very aware that almost all retail firm s engage in this accounting strategy. Through the use of Tractor Supply s 10-K, the analyst is able to redo financial statements and undo this distortion, giving the reader a much more transparent view of the firm. Undoing Accounting Distortions After identifying potential the potential red flags the next job to be done is restate the reported numbers to undo the distortions. In order to this the person doing the analysis should restate the financial statements. The task of undoing the distortions is almost impossible to complete perfectly. The restated statements will show current and prospective investors a clearer view of the firm than what is provided to them otherwise. When looking at a firm such as Tractor Supply Company, we found that the only distortion that was significant involved the operating leases. So in order to more clearly state the financial statements we capitalized these operating leases. Operating Leases When a firm shows that a large amount of operating leases which do not appear in the financial statements the best way to recognize them is to capitalize them. The restatement of the financial statements therefore requires us to capitalize these assets. To do this we must find the present value of the future operating lease payments. Given information on the capital leases, this becomes a quick easy job. To do this the present value of the capital lease payments must be found using a plug and play form of guessing. The overall goal is to find a present value capital lease payment that equals the actual payment given in the firm s 10-K. In doing this process we found the rates to be 8.25%, 8.48%, 8.31%, 7.9%, and 8% in 2005, 2006, 2007, 2008, and 100 P age

101 2009, respectively. Using these rates and the given operating lease payments values, we found the present value of the operating leases and then created an amortization table to dispense the payments through the life of the asset. While creating the table, we used straight line depreciation and the beginning balance of the present value of the expense to find the annual depreciation of the asset. Shown below are the tables which summarize the amortization of these operating leases. In Thousands 2005 Rate 8.25% Year OL Payment pv factor pv payment Year Beg. Balance Interest Payment Ending Balance , , ,004 40,508 83, , , , ,254 36,981 78, , , , ,545 33,540 74, , , , ,200 30,129 69, , , , ,858 26,883 65, , , , ,547 23,723 55, , , , ,567 21,084 55, , , , ,948 18,228 55, , , , ,473 15,137 55, , , , ,907 11,790 55,703 98, , , ,994 8,167 55,703 51, , , ,458 4,245 55, , , Rate 8.68% Year OL Payment pv factor pv payment Year Beg. Balance Interest Payment Ending Balance Change in Loan , , ,751 53, , ,948 50, , , ,948 48,603 99, ,587 51, , , ,587 44,145 94, ,666 49, , , ,666 39,812 89, ,467 49, , , ,467 35,542 84, ,476 48, , , ,476 31,289 70, ,910 39, , , ,910 27,855 70, ,909 43, , , ,909 24,122 70, ,175 46, , , ,175 20,066 70, ,385 50, , , ,385 15,657 70, ,187 55, , , ,187 10,866 70,856 65,197 59, , , ,197 5,659 70, , , , P age

102 2007 Rate 8.31% Year OL Payment pv factor pv payment Year Beg. Balance Interest Payment Ending Balance Change in Loan , , ,346 64, , ,109 62, , , ,109 59, , ,711 63, , , ,711 53, , ,345 63, , , ,345 48, , ,602 63, , , ,602 43, , ,325 62, , , ,325 38,004 88, ,556 50, , , ,556 33,785 88, ,568 54, , , ,568 29,215 88, ,010 59, , , ,010 24,266 88, ,503 64, , , ,503 18,905 88, ,635 69, , , ,635 13,100 88,773 81,962 75, , , ,962 6,811 88, ,962 1,205, , Rate 7.90% Year OL Payment pv factor pv payment Year Beg. Balance Interest Payment Ending Balance Change in Loan , , ,398 70, , ,788 74, , , ,788 64, , ,678 76, , , ,678 58, , ,839 76, , , ,839 52, , ,815 76, , , ,815 46, , ,045 75, , , ,045 40,531 98, ,370 57, , , ,370 35,974 98, ,140 62, , , ,140 31,058 98, ,993 67, , , ,993 25,753 98, ,541 72, , , ,541 20,030 98, ,366 78, , , ,366 13,854 98,205 91,015 84, , , ,015 7,190 98, ,015 1,359, , Rate 8.00% Year OL Payment pv factor pv payment Year Beg. Balance Interest Payment Ending Balance Change in Loan , , ,782 78, , ,630 83, , , ,630 71, , ,778 87, , , ,778 64, , ,194 87, , , ,194 57, , ,178 88, , , ,178 50, , ,644 84, , , ,644 43, , ,604 61, , , ,604 38, , ,681 65, , , ,681 33, , ,485 71, , , ,485 27, , ,593 76, , , ,593 21, , ,549 83, , , ,549 14, ,611 96,862 89, , , ,862 7, , ,862 1,484, ,782 Financial Statements In determining the impact of the distorted quantities on financial statements, it is necessary to compare the original statements to the restated statements which we found. The original financial statements can be found using the past five year s data from the firm s 10-Ks. In order to have restated statements it is necessary to create a trial balance for the same years. The trial balance shows the adjustments made to 102 P age

103 accounts contained in the income statement and balance sheet. The trial balance for Tractor Supply Company for the years 2005 through 2009 is provided below. Trial Balance- Balance Sheet 2005 As Stated Adjustments Adjusted DR CR DR CR DR CR Assets Total Current Assets 531, ,413 Capitalized Operating Leases, net 491, ,004 Land 17,319 17,319 Buildings and improvements 223, ,585 Furniture, fixtures and equipment 115, ,784 Computer software and hardware 32,311 32,311 Construction in progress 9,842 9,842 Accumulated depreciation and amortization 140, ,366 Goodwill 12,436 12,436 Deferred income taxes 7,530 7,530 Other assets 4,941 4,941 Liabilities and Shareholder's Equity Current Liabilities: Total As Stated Current Liabilities 290, ,681 Non-Current Liabilities: Straight line rent liability 18,502 18,502 Other long-term liabilities 17,175 17,175 Capital lease Liability 491, ,004 Revolving credit loan 8,212 8,212 Capital lease obligations, less current maturities 2,527 2,527 Preferred Stock, 40,000 shares authorized; 1.00 par value; no shares issued Common Stock, 100,000,000 shares authorized,.008 par value; 39,433,449 and 38,302,373 shares issued and outstanding in 2005 and 2004, respectively Additional paid-in capital 99,047 99,047 Treasury stock, at cost, 3,216,187 shares Other comprehensive loss Retained earnings 378, ,347 Balance Sheet Check Figure 955, ,172 1,446,176 1,446,176 Income Statement Net Sales 2,067,979 2,067,979 Cost of Sales 1,428,428 1,428,428 Warehouse, delivery, SG&A 469, ,087 Capitalized Operating Expenses Depreciation of Capitalized Leases Depreciation and amortization 34,020 34,020 Capitalized Leases Interest Expense Interest expense 1,632 1,632 Provisions for Income Taxes 49,143 49,143 First TB Pass 2,937,482 3,023,151 3,428,486 3,514,155 Change in NI Income Summary 85,669 85,669 Trial Balance 3,023,151 3,023, , ,004 3,514,155 3,514, P age

104 Trial Balance- Balance Sheet 2006 As Stated Adjustments Adjusted DR CR DR CR DR CR Assets Total Current Assets 669, ,611 Capitalized Operating Leases, net 610,751 40, ,834 Land 19,495 19,495 Buildings and improvements 248, ,063 Furniture, fixtures and equipment 146, ,128 Computer software and hardware 46,853 46,853 Construction in progress 15,404 15,404 Accumulated depreciation and amortization 174, ,339 Goodwill 10,288 10,288 Deferred income taxes 10,779 10,779 Other assets 5,976 5,976 Liabilities and Shareholder's Equity Current Liabilities: Total As Stated Current Liabilities 353, ,507 Non-Current Liabilities: Straight line rent liability 24,399 24,399 Other long-term liabilities 18,640 18,640 Capital lease Liability 42, , ,000 Revolving credit loan 0 Capital lease obligations, less current maturities 2,808 2,808 Preferred Stock, 40,000 shares authorized; 1.00 par value; no shares issued Common Stock, 100,000,000 shares authorized,.008 par value; 39,433,449 and 38,302,373 shares issued and outstanding in 2005 and 2004, respectively Additional paid-in capital 129, ,249 Treasury stock, at cost, 3,216,187 shares 0 Other comprehensive loss Retained earnings 469,355 1, ,188 Balance Sheet Check Figure 1,172,619 1,172, , ,501 1,742,453 1,742,452 Income Statement Net Sales 2,369,612 2,369,612 Cost of Sales 1,623,466 1,623,466 Warehouse, delivery, SG&A 555, ,834 Capitalized Operating Expenses 83,258 83,258 Depreciation of Capitalized Leases 40,917 40,917 Depreciation and amortization 42,292 42,292 Capitalized Leases Interest Expense 40,508 40,508 Interest expense 2,688 2,688 Provisions for Income Taxes 54,324 54,324 First TB Pass 3,451,223 3,542, , ,759 4,102,481 4,195,322 Change in NI Income Summary 91,008 1,833 92,841 Trial Balance 3,542,231 3,542, , ,759 4,195,322 4,195, P age

105 Trial Balance- Balance Sheet 2007 As Stated Adjustments Adjusted DR CR DR CR DR CR Assets Total Current Assets 691, ,924 Capitalized Operating Leases, net 772,346 50, ,451 Land 23,151 23,151 Buildings and improvements 279, ,313 Furniture, fixtures and equipment 175, ,941 Computer software and hardware 61,732 61,732 Construction in progress 10,006 10,006 Accumulated depreciation and amortization 217, ,215 Goodwill 10,258 10,258 Deferred income taxes 16,692 16,692 Other assets 6,169 6,169 Liabilities and Shareholder's Equity Current Liabilities: Total As Stated Current Liabilities 379, ,856 Non-Current Liabilities: Straight line rent liability 30,886 30,886 Other long-term liabilities 24,541 24,541 Capital lease Liability 50, , ,544 Revolving credit loan 55,000 55,000 Capital lease obligations, less current maturities 2,351 2,351 Preferred Stock, 40,000 shares authorized; 1.00 par value; no shares issued Common Stock, 100,000,000 shares authorized,.008 par value; 39,433,449 and 38,302,373 shares issued and outstanding in 2005 and 2004, respectively Additional paid-in capital 151, ,317 Treasury stock, at cost, 3,216,187 shares 150, ,049 Other comprehensive loss Retained earnings 563, ,650 Balance Sheet Check Figure 1,425,235 1,425, , ,242 2,146,686 2,146,686 Income Statement Net Sales 2,703,212 2,703,212 Cost of Sales 1,850,504 1,850,504 Warehouse, delivery, SG&A 641, ,603 Capitalized Operating Expenses 103, ,816 Depreciation of Capitalized Leases 50,896 50,896 Depreciation and amortization 51,064 51,064 Capitalized Leases Interest Expense 53,013 53,013 Interest expense 5,037 5,037 Provisions for Income Taxes 58,763 58,763 First TB Pass 4,032,206 4,128, , ,058 4,857,566 4,953,714 Change in NI Income Summary 96, ,148 Trial Balance 4,128,447 4,128, ,151 4,953,714 4,953, P age

106 Trial Balance- Balance Sheet 2008 As Stated Adjustments Adjusted DR CR DR CR DR CR Assets Total Current Assets 684, ,002 Capitalized Operating Leases, net 892,398 64, ,036 Land 25,410 25,410 Buildings and improvements 325, ,081 Furniture, fixtures and equipment 198, ,881 Computer software and hardware 74,589 74,589 Construction in progress 12,615 12,615 Accumulated depreciation and amortization 274, ,543 Goodwill 10,258 10,258 Deferred income taxes 13,727 13,727 Other assets 5,977 5,977 Liabilities and Shareholder's Equity Current Liabilities: Total As Stated Current Liabilities 400, ,843 Non-Current Liabilities: Straight line rent liability 38,016 38,016 Other long-term liabilities 25,211 25,211 Capital lease Liability 62, , ,161 Revolving credit loan 0 Capital lease obligations, less current maturities 1,797 1,797 Preferred Stock, 40,000 shares authorized; 1.00 par value; no shares issued Common Stock, 100,000,000 shares authorized,.008 par value; 39,433,449 and 38,302,373 shares issued and outstanding in 2005 and 2004, respectively Additional paid-in capital 168, ,045 Treasury stock, at cost, 3,216,187 shares 203, ,915 Other comprehensive loss Retained earnings 645,673 2, ,548 Balance Sheet Check Figure 1,554,455 1,554, , ,760 2,382,491 2,382,491 Income Statement Net Sales 3,007,949 3,007,949 Cost of Sales 2,095,688 2,095,688 Warehouse, delivery, SG&A 715, ,961 Capitalized Operating Expenses 126, ,419 Depreciation of Capitalized Leases 64,362 64,362 Depreciation and amortization 60,731 60,731 Capitalized Leases Interest Expense 64,182 64,182 Interest expense 2,133 2,133 Provisions for Income Taxes 51,506 51,506 First TB Pass 4,480,474 4,562,404 1,085,304 1,083,179 5,437,054 5,516,859 Change in NI Income Summary 81,930 2,125 79,805 Trial Balance 4,562,404 4,562,404 1,085,304 5,516,859 5,516, P age

107 Trial Balance- Balance Sheet 2009 As Stated Adjustments Adjusted DR CR DR CR DR CR Assets Total Current Assets 834, ,329 Capitalized Operating Leases, net 975,782 74, ,415 Land 27,646 27,646 Buildings and improvements 350, ,505 Furniture, fixtures and equipment 226, ,967 Computer software and hardware 88,700 88,700 Construction in progress 11,562 11,562 Accumulated depreciation and amortization 335, ,135 Goodwill 10,258 10,258 Deferred income taxes 11,091 11,091 Other assets 4,922 4,922 Liabilities and Shareholder's Equity Current Liabilities: Total As Stated Current Liabilities 418, ,580 Non-Current Liabilities: Straight line rent liability 45,515 45,515 Other long-term liabilities 32,140 32,140 Capital lease Liability 74, , ,172 Revolving credit loan Capital lease obligations, less current maturities 1,407 1,407 Preferred Stock, 40,000 shares authorized; 1.00 par value; no shares issued Common Stock, 100,000,000 shares authorized,.008 par value; 39,433,449 and 38,302,373 shares issued and outstanding in 2005 and 2004, respectively Additional paid-in capital 190, ,938 Treasury stock, at cost, 3,216,187 shares 219, ,204 Other comprehensive loss Retained earnings 761, ,382 Balance Sheet Check Figure 1,785,184 1,785,184 1,050,391 1,050,391 2,686,599 2,686,599 Income Statement Net Sales 3,206,937 3,206,937 Cost of Sales 2,171,980 2,171,980 Warehouse, delivery, SG&A 784, ,066 Capitalized Operating Expenses 145, ,109 Depreciation of Capitalized Leases 74,366 74,366 Depreciation and amortization 66,258 66,258 Capitalized Leases Interest Expense 70,499 70,499 Interest expense 1,644 1,644 Provisions for Income Taxes 67,523 67,523 First TB Pass 4,876,655 4,992,121 1,195,257 1,195,500 5,922,936 6,038,645 Change in NI Income Summary 115, ,709 Trial Balance 4,992,121 4,992,121 1,195,500 6,038,645 6,038, P age

108 After we finished our analysis on Tractor Supply s operating leases, we were able to undo the distortions through the adjustments as shown in the trial balance. This allows us to provide a clearer view of the firm s financial data. Using the trial balance allows us to restate the financial statements. Income Statement Income statements measure the over a period of time, and show the profits and losses for the fiscal year. Comparing the original income statement and the restated income statement we are able to see any changes in net income due to the capitalization of operating leases. The operating leases do not have a substantial impact on the net income of the firm. Given first is the original income statement given on Tractor Supply s 10-K. This is followed by the restated income statement with the effects caused by capitalizing operating leases. As Stated Income Statement NET SALES 2,067,979 2,369,612 $2,703,212 $3,007,949 $3,206,937 Cost of merchandise sold 1,428,428 1,618,249 1,850,504 2,095,688 2,171,980 GROSS MARGIN 639, , , ,261 1,034,957 Selling, general and administrative expenses 469, , , , ,066 Depreciation and amortization 34,020 42,292 51,064 60,731 66,258 OPERATING INCOME 136, , , , ,633 Interest expense, net 1,632 2,688 5,037 2,133 1,644 INCOME BEFORE INCOME TAXES 134, , , , ,989 Income tax expense 49,143 54,324 58,763 51,506 67,523 NET INCOME 85,669 91,008 $96,241 $81,930 $115, P age

109 Restated Income Statement NET SALES 2,067,979 2,369,612 $2,703,212 $3,007,949 $3,206,937 Cost of merchandise sold 1,428,428 1,618,249 1,850,504 2,095,688 2,171,980 GROSS MARGIN 639, , , ,261 1,034,957 Selling, general and administrative expenses 469, , , , ,066 Capitalized Operating Expenses 0 (83,258) (103,816) (126,419) (145,109) Depreciation and amortization 34,020 42,292 51,064 60,731 66,258 Depreciation of Capitalized Leases 0 40,917 50,896 64,362 74,366 OPERATING INCOME 136, , , , ,376 Interest expense, net (minus Capital interest) 1,632 2,688 5,037 2,133 1,644 Capitalized Leases Interest Expense 0 40,508 53,013 64,182 70,499 INCOME BEFORE INCOME TAXES 134, , , , ,232 Income tax expense 49,143 54,324 58,763 51,506 67,523 NET INCOME 85,669 92,841 96,148 79, ,709 After comparing the income statements, the impact of capitalizing the operating leases on the net income, and other income statement accounts, of the firm is very minuscule. The undoing of the distortion makes the income statement more clearly regarding how the capitalized operating leases affect business. Balance Sheet Balance sheets are ongoing documents which state the current position of a firm. This document consists of assets, liabilities, and equity. Shown below are the original and restated balance sheets for Tractor Supply Company. First is the original, which is given in Tractor Supply s 10-K. The second is the restatement of the first with the effects of capitalizing the operating leases. Since capitalizing operating leases deals with the liability and asset accounts, the balance sheet is the best of the financial documents to view the impact of capitalizing these leases. The effects can be seen below. 109 P age

110 As Stated Balance Sheet ASSETS Current assets: Cash and cash equivalents 21,203 $26,393 $13,700 $36,989 $172,851 Inventories 460, , , , ,249 Prepaid expenses and other current assets 38,380 37,007 41,959 41,902 42,320 Deferred income taxes 11,079 11, ,676 17,909 Total current assets 531, , , , ,329 Property and Equipment: Land 17,319 19,495 23,151 25,410 27,646 Buildings and improvements 223, , , , ,505 Furniture, fixtures and equipment 115, , , , ,967 Computer software and hardware 32,311 46,853 61,732 74,589 88,700 Construction in progress 9,842 15,404 10,006 12,615 11, , , , , ,380 Accumulated depreciation and amortization (140,366) (174,339) (217,215) (274,543) (335,135) Property and equipment, net 258, , , , ,245 Goodwill 12,436 10,288 10,258 10,258 10,258 Deferred income taxes 7,530 10,779 16,692 13,727 11,091 Other assets 4,941 5,976 6,169 5,977 4,922 Total assets 814,795 $998,258 $1,057,971 $1,075,997 $1,230,845 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable 185,397 $229,171 $258,346 $286,828 $273,208 Other accrued expenses 102, , , , ,375 Current portion of capital lease obligations 1,049 1, Income taxes currently payable 1,421 11,550 5,062 7,605 Total current liabilities 290, , , , ,580 Revolving credit loan 8,212 55,000 Capital lease obligations, less current maturities 2,527 2,808 2,351 1,797 1,407 Deferred income taxes Straight line rent liability 18,502 24,399 30,886 38,016 45,515 Other long-term liabilities 17,175 18,640 24,541 25,211 32,140 Total liabilities 337, , , , ,642 Stockholders' equity: Preferred Stock, 40,000 shares authorized; 1.00 par value; no shares issued Common Stock, 100,000,000 shares authorized,.008 par value; 39,433,449 and 38,302,373 shares issued and outstanding in 2005 and 2004, respectively Additional paid-in capital 99, , , , ,938 Other comprehensive loss (11) (22) (150,049) (203,915) (219,204) Retained earnings 378, , , , ,139 Total stockholders' equity 477, , , , ,203 Total liabilities and stockholders' equity 814,795 $998,258 $1,057,971 $1,075,997 $1,230, P age

111 Restated Balance Sheet ASSETS Current assets: Cash and cash equivalents $ 21,203 $ 26,393 $ 13,700 $ 36,989 $ 172,851 Inventories 460, , , , ,249 Prepaid expenses and other current assets 38,380 37,007 41,959 41,902 42,320 Deferred income taxes 11,079 11, ,676 17,909 Total current assets 531, , , , ,329 Property and Equipment: Land 17,319 19,495 23,151 25,410 27,646 Buildings and improvements 223, , , , ,505 Furniture, fixtures and equipment 115, , , , ,967 Computer software and hardware 32,311 46,853 61,732 74,589 88,700 Construction in progress 9,842 15,404 10,006 12,615 11,562 Capitalized Operating Leases, net 491, , , , , ,845 1,045,776 1,271,594 1,464,612 1,606,795 Accumulated depreciation and amortization (140,366) (174,339) (217,215) (274,543) (335,135) Property and equipment, net 749, ,437 1,054,379 1,190,069 1,271,660 Goodwill 12,436 10,288 10,258 10,258 10,258 Deferred income taxes 7,530 10,779 16,692 13,727 11,091 Other assets 4,941 5,976 6,169 5,977 4,922 Total assets 1,305,799 1,568,091 1,779,422 1,904,033 2,132,260 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 185,397 $ 229,171 $ 258,346 $ 286,828 $ 273,208 Other accrued expenses 102, , , , ,375 Current portion of capital lease obligations 1,049 1, Income taxes currently payable 1,421 11,550 5,062 7,605 Total current liabilities 290, , , , ,580 Revolving credit loan 8,212 55,000 Capital lease obligations, less current maturities 2,527 2,808 2,351 1,797 1,407 Deferred income taxes Straight line rent liability 18,502 24,399 30,886 38,016 45,515 Other long-term liabilities 17,175 18,640 24,541 25,211 32,140 Capital lease Liability 491, , , , ,172 Total liabilities 828, ,354 1,214,178 1,296,028 1,398,814 Stockholders' equity: Preferred Stock, 40,000 shares authorized; 1.00 par value; no shares issued Common Stock, 100,000,000 shares authorized,.008 par value; 39,433,449 and38,302,373 shares issued and outstanding in 2005 and 2004, respectively Additional paid-in capital 99, , , , ,938 Other comprehensive loss (11) (22) (150,049) (203,915) (219,204) Retained earnings 378, , , , ,382 Total stockholders' equity 477, , , , ,446 Total liabilities and stockholders' equity 1,305,799 1,568,091 1,779,422 1,904,033 2,132, P age

112 Financial Analysis and Forecasted Financials In order to determine the value of a firm, we must perform a prospective analysis of the company being analyzed. This includes performing ratio analysis and forecasting financial statements. Ratio analysis is performed in order to get a clearer picture of how the firm s different financial accounts coincide and work together, giving the reader a better idea of how the firm is performing. This also aids in forecasting financial statements as many of these ratios are used to calculate future account balances. Through the utilization of these ratios, common sized financial statements, and observable trends, we are able to forecast future performance with reasonable assurance. Financial Analysis A financial analysis of a firm s financial statements allows the reader to get a much clearer picture of the firm s financial status. Aggregate line totals don t tell the whole story, and they are hard to make sense out of. Utilizing financial ratios tells a better story of how the firm is performing. In addition, these ratios can be compared to industry competitors in order to benchmark the firm and analyze how it is performing relative to the competition. These ratios fall under the category of liquidity, profitability or capital structure. Through the utilization of these ratios, the analyst is able to more clearly represent how Tractor Supply Company is performing relative to the competition. Liquidity Ratios Liquidity Ratios are calculations made from the balance sheet that help assess a firm s financial health. These ratios determine a firm s cash availability and how quickly a firm can convert their assets into cash to cover their short term debt obligations. This is important because, when a firm is interested in obtaining a short term line of credit, creditors use these ratios to determine the amount of risk a firm posses. Therefore, a firm s main goal is to focus on achieving high liquidity ratios in order to show creditors that the firm can meet their current obligations. However, too high liquidity ratios could imply that a firm isn t investing enough money back into the company which is 112 P age

113 necessary to grow and expand. The ratios used to determine a firm s liquidity are current ratio, quick asset ratio, inventory turnover, working capital turnover and days supply inventory. Current Ratio The current ratio gives analysts an idea of the firm s ability to payback it s shortterm liabilities, debts and payables, using the short-term assets, cash inventory and receivables. The ratio is calculated by current assets divided by current liabilities. The higher the ratio suggests that firm is more capable of paying off its debt obligations. A ratio less than one indicate that a firm would not be able to meet their debt obligations at that current point in time. The ratio may also give investors an idea of the firm s efficiency concerning the operating cycle or its ability to sell inventory. Due to the fact business operations differ it is important to compare firms within the same industry to better evaluate the level of an individual firm. Below is a chart and graph that compares Tractor Supply s current ratio with other firms in the industry, Lowe s and Home Depot. As you can see Tractor Supply has a current ratio of 1.99, which is the highest point for the firm in the past five years. However, when comparing Tractor Supply with Lowe s and Home Depot suggest that Tractor Supply is well above par with other firms in the industry. Tractor Supply s high current ratio is due to the firm s growth strategy. The firm opened 76 store in 2009, which is a 9% increase and 91 new stores in 2008, with a 12% increase. The company has an aggressive growth strategy that has led to a compounded annual growth rate of 13% over the last five years. The high increase in sales growth is the main factor attributing to the high current ratio. However, the industry as a whole took a hit with the recent recession, causing ratios to fall in 2007 and On the other hand, Tractor Supply still managed to achieve a ratio well above par compared to other firms. Therefore it is safe to say that Tractor Supply will have no problem meeting their current debt obligations. 113 P age

114 (Tractor Supply, Home Depot, Lowe s 10-K) Current Ratio Tractor Supply Home Depot Lowes Industry Average Quick Asset Ratio The quick asset ratio, also known as the acid test, determines whether a firm has enough short-term assets to cover current liabilities without selling inventory. The ratio is calculated by quick assets (cash, accounts receivables, and short-term investments) divided by current liabilities. If a current ratio is less than one then the firm could be in trouble and investors should be cautious. The quick asset ratio excludes inventory in order to focus on the stability of cash and receivables. However, the ratio also indirectly assesses how dependent a firm is on inventory, by comparing it to another liquidity ratio, working capital ratio. If the quick ratio is significantly lower than the working capital ratio, then current assets are highly dependent on inventory, which is 114 P age

115 common in the retail industry. But before you can asses a firm you must compare it with the industry. Below the chart and graph assess the industry s current ratios over the last five years and as stated above if the ratio is below 1 it could mean financial trouble. However, since the industry as a whole has experienced a ratio below one then it is important to look at the attributing factors, before analyzing a specific firm. First, when comparing the ratio to the current asset ratio above, one could determine that the industry is dependent on inventory. However, this may be the case but, you must compare this ratio with working capital which will be discussed later in this section. One of the main factors causing such a low ratio is the recession. The retail industry as a whole was hit hard, but this retail industry mainly serves homeowners. So not only did the recession cause consumers to not spend, but the housing bust caused millions of people to lose their homes, hitting the home needs retail industry even harder. Since the housing bust in 2006 the industry average has declined to the lowest point in 2007 at.08, cut in half when compared to 2006 at.16. However, in 2009 the industry has started to grow with a ratio of.26. Now, that the attributing factors have been explored to explain the industry as a whole performing below par, investor s can asses individual firms. In 2005 thru 2007 Tractor Supply s ratio remained half of the quick asset ratios of competitors. However, in 2009 the ratio went from.09 in 2008 to a staggering.41, which has outperformed Lowe s and Home Depot. The sharp incline is due to the firm experiencing tremendous growth and recovery from the recession. Considering, the industry average is below one it is difficult to assess financial health with the quick ratio. However, Tractor Supply has outperformed other firms in the industry by more than half, leading an investor to conclude that the firm is improving their financial stability. 115 P age

116 (Tractor Supply, Home Depot, Lowe s 10-K) Quick Asset Ratio Tractor Supply Home Depot Lowes Industry Average Inventory Turnover Inventory turnover is a ratio that determines how many times a company s inventory is sold and replaced over a period. It is calculated by cost of goods sold divided by inventory. A low ratio implies poor sales and too much inventory, while a high ratio indicates high sales or inefficient buying. High inventory levels are troublesome for companies because it is an investment that isn t making a return and could potentially lose value if prices decline. It is important to compare the industry to gain a better analysis of how one firm is performing. Tractor Supply s inventory turnover has been well below the industry average for five years. However, Tractor Supply is a considerably smaller firm than Lowe s and 116 P age

117 Home Depot, which causes Tractor Supply to have a lower cost of goods sold and inventory, which attributes to the lower ratio. Since the firm is much smaller it is difficult to compare to the industry average. However, the firm has shown significant improvement over the past three years from a 2.72 in 2006 to a 3.61 in While Tractor Supply has been steadily increasing inventory turnover since 2006 the industry average fell from 2008 to Tractor Supply has been steadily increasing their inventory turnover ratio, while the industry average decreased in the past year, leads to the conclusion that tractor supply has been efficiently managing their inventory. Inventory Turnover Tractor Supply Home Depot Lowes Industry Average (Tractor Supply, Home Depot, Lowe s 10-K) 117 P age

118 Days Supply of Inventory Days supply of inventory allows investors to assess how long it takes a company, in days, to turn inventory into sales. It is calculated by taking the number of days in a year 365, by the inventory turnover ratio. The lower the days supply of sales the better, because this indicates the company is efficiently generating sales. Since inventory turnover and days supply sales directly related the two graphs are opposite. Days Supply of Inventory Tractor Supply Home Depot Lowes Industry Average As the chart and graph illustrate Tractor Supply is well above in industry average which is not a good sign. However, considering Days supply of inventory s strong correlation to inventory turnover, these same factors apply to how quickly Tractor Supply turns inventory into sales. Since Tractor Supply is a considerably smaller firm causing the inventory turnover ratio to be low and therefore causing a high days supply of inventory. However, the firm is increasing efficiency in turning inventory and is almost on par with the industry average, which is a good sign for investors. Home depot is considerably larger and has been the most efficient at turning inventory with 84.9 days in Lowe s has remained in the middle for five years and again for 2009 with while Tractor Supply has the highest with for The improvements illustrated by Tractor Supply are due to the firm s significant growth over the past five years of 13%. If the firm continues to grow and increase inventory turnover allowing for smaller days supply then this will help the firm s financial health. 118 P age

119 (Tractor Supply, Home Depot, Lowe s 10-K) Working Capital Turnover Working capital is a ratio that compares the decrease in working capital, which is used to fund operations and purchase inventory, to the sales generated in a given period. It is calculated by sales divided by working capital (current assets minus current liabilities). Working capital is used to purchase inventory and fund operations, which in turn become sales for the company. The ratio is used to assess the relationship between the money used in working capital and the money generated from sales. The higher the ratio the better because this implies the firm is receiving more cash from sales than the firm uses to fund the sales. Tractor Supply has well outperformed the industry average at a peak in 2008 with However, the firm experienced a significant decrease in 2009 to This indicates that the firm is not efficiently using their money to meet short term obligations to generate sales. Regardless of the drop in 2009 the firm still is well above the industry average indicating that the firm efficiently utilizes working capital to generate sales. 119 P age

120 (Tractor Supply, Home Depot, Lowe s 10-K) Working Capital Turnover Tractor Supply Home Depot Lowes Industry Average Conclusion After determining the liquidity ratios, it is now possible to analyze Tractor Supply s position in the home needs industry. Tractor Supply s current ratio is well above par demonstrating that the firm can meet short term debt obligations. However, the quick ratio for the industry is below one, making it difficult to determine a firm s financial health. Taking this into consideration Tractor Supply has significantly increased the quick ratio in 2009 resulting well above the industry average and this is a promising sign for investors. The inventory ratios for the firm are below the industry average, but this is due to the size of the firm. The firm is significantly smaller than its 120 P age

121 competitors in the industry, causing the ratios to indicate the firm is not financially healthy. As the firm has grown significantly in the past five years, Tractor Supply has demonstrated an upward climb that is more on par with the larger firms in the industry. Therefore, investors can see that as Tractor Supply grows, their ratios are growing in the correct direction. Overall, Tractor Supply s liquidity is difficult to classify due to the noise in the turnover ratios, however in 2009 the company has demonstrated to be about average with firms in the industry. Below is a chart that compares Tractor Supply s performance with the Industry. Liquidity Ratio Tractor Supply s Performance Industry Trend Current Ratio Outperforming Upward Quick Ratio Outperforming Upward Inventory Turnover Underperforming Downward Days Supply of Inventory Underperforming Stable Working Capital Underperforming Downward Overall Underperforming Stable Profitability Analysis When valuing a company, it is essential to look at its profitability. This can be done by evaluating the profitability ratios of the company. Profitability ratios explain how efficient a company is at turning net sales into net income. Although previous profits can be easily accessed for any public firm, this cannot portray profit forecasts for the company. For this, profitability ratios are essential. These ratios create a benchmark to forecast profits for a company and determine their overall value, which can become extremely important when investing. For this valuation, we will use seven common ratios: gross profit margin, net profit margin, operating profit margin and operating expense ratio, return on assets, return on equity and asset turnover. 121 P age

122 Gross Profit Margin Gross profit margin measures gross profit as a percentage of sales. Since gross profit is determined by sales less cost of goods sold, a higher gross profit margin indicates better management of cost of goods sold. If a company can effectively manage the cost of inventory, it can increase gross profit making the company more profitable. In the home improvement and hardware industry, effectively managing inventory costs is essential to a profitable company. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO HD LOW Industry 30.93% 31.71% 31.54% 30.33% 32.27% 33.42% 33.52% 32.79% 33.61% 33.65% 33.73% 34.23% 34.52% 34.64% 34.21% 32.69% 33.15% 32.95% 32.86% 33.38% When assessing the home improvement and hardware industry, Tractor Supply performs well below the industry average over the past five years. The industry average for gross profit margin is around 33% of sales. Both Home Depot and Lowe s fair at or above the industry average while Tractor Supply has performed as low as 3% below the average as seen in both 2005 and If Tractor Supply cannot better manage their cost of goods sold, they will continue to be out performed by their competitors. 122 P age

123 Operating Profit Margin When valuing a company, it is important to also consider the operating profit margin. This ratio portrays operating income as a percentage of net sales. A higher operating profit margin indicates a company s ability to manage selling, general and administrative expenses. Because of this, it is necessary to also look at the operating expense ratio, which shows the percentage of sales that go to selling, general and administrative expenses. If a company can effectively lower these expenses, the operating expense ratio will decrease as the operating profit margin increases. In an efficient company, the operating profit margin and operating expense ratio should be negatively related. When analyzing operating profitability, we will look at both the as stated and restated operating profit margin. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO TSCO(restated) HD LOW Industry 6.60% 6.25% 5.92% 4.51% 5.76% 8.79% 8.03% 7.88% 6.57% 7.96% 10.84% 11.49% 10.65% 9.36% 6.11% 10.52% 11.11% 11.29% 9.74% 7.27% 9.19% 9.22% 8.93% 7.55% 6.78% 123 P age

124 When viewing the as stated operating profit ratio, Tractor Supply is far below the industry norm, while its competitors follow above the trend line. As seen with the restated ratio, Tractor Supply Company follows the industry trend more closely and even passes it in It is also imperative to notice that Tractor Supply is beginning to slope upward while its competitors and the industry as a whole are still on a downward sloping trend. The opposition in industry trend further shows the advanced profitability of Tractor Supply coming out of the recession. When comparing the operating profit margin with the operating expense ratio, the graph depicts that these are indeed negatively related for Tractor Supply and the industry as a whole. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO HD LOW Industry 22.68% 23.68% 23.73% 23.80% 24.45% 22.58% 20.22% 20.20% 22.05% 25.03% 20.74% 20.84% 20.75% 22.07% 23.75% 22.00% 21.58% 21.56% 22.64% 24.41% When comparing values, Tractor Supply has been able to successfully maintain a stable operating expense ratio, allowing the operating profit margin to increase as revenues increase. The industry as a whole is portraying an upward sloping expense 124 Page

125 ratio indicating more income is going towards expenses. By 2009, all companies in the industry have increased by at least 1%. Tractor Supply s ability to stabilize their expense ratio allows for higher chances of increasing profitability in the future, while its competitor s expense ratios will seemingly continue to increase. Net Profit Margin Net profit margin portrays net income as a percentage of sales. This ratio portrays a company s ability to effectively manage expenses to increase net income. The higher the net profit margin, the larger percentage of sales is attributed to net income. The ability to increase net profit margin by properly managing expenses allows a company to become more profitable. Since capitalizing leases allows for a higher net income, we will look at both the as stated and restated net profit margin for Tractor Supply. (Tractor Supply, Home Depot, Lowe s 10-K) TSCO TSCO(restated) HD LOW Industry 4.14% 3.84% 3.56% 2.72% 3.60% 3.73% 3.92% 3.56% 2.65% 3.61% 6.84% 7.16% 6.34% 5.68% 3.17% 5.97% 6.41% 6.62% 5.82% 4.55% 5.17% 5.33% 5.02% 4.22% 3.73% 125 P age

126 As indicated by the graph, much like gross profit margin, Tractor Supply s as stated net profit margin also performs below industry average. However, as the industry continues to decline, Tractor Supply is starting to increase. Tractor Supply s restated net profit margin varies only slightly from it s as stated margin. Although it has performed below industry average from 2005 to 2008, by 2009 it has increased to only 0.13% below the industry average. This indicates that Tractor Supply is emerging out of the current economic recession more quickly than its competitors and the industry as a whole. Asset Turnover Asset turnover a lag ratio similar to ROA but instead of using net income, current year sales is used as the numerator. This demonstrates how much revenue a firm generates for every dollar in assets it possesses. This ratio is the best way to connect and compare the balance sheet to the income statement, as it uses two of the major components from each statement. This is a great indicator of how well a firm is utilizing all of its assets and turning them into sales revenue. The graph below shows the industry s asset turnover ratio for the past 5 years. Asset Turnover (Tractor Supply, Home Depot, Lowe s 10-K) Company P age

127 Tractor Supply Company Tractor Supply Company (restated) Home Depot Lowe's The chart shows that Tractor Supply Company s as stated asset turnover is over 50% higher than that of either Home Depot or Lowe s. Only when using the restated data does Tractor Supply go back down to being on par with the rest of the industry. However, if an analyst restated Home Depot and Lowe s as well, the effect of capitalizing the firms operating leases would surely have the same effect, and Tractor Supply Company s asset turnover ratio would still be much higher. For every dollar of assets that Tractor Supply Company owns, it generates right around three dollars in revenue per year, much more favorable than either Home Depot or Lowes asset turnover ratio. This shows that Tractor Supply Company is more efficiently utilizing its assets than the rest of the competition. Return on Assets Return on assets (ROA) is a ratio the measures the relationship between net income and total assets. This ratio is considered a lag ratio as the total assets on the denominator of the ratio is calculated using previous years data. This is because the firm uses the previous year s assets to generate the current year s revenues. This ratio expresses that for every dollar of assets, a certain dollar amount of net income is earned. This shows how efficiently a firm is using its assets to generate a profit. The higher the number is, the more profits the firm is generating from its assets. The graph below illustrates each firm s profit margins in comparison. 127 P age

128 Return on Assets (Tractor Supply, Home Depot, Lowe s 10-K) Company Tractor Supply Company Tractor Supply Company (restated) Home Depot Lowe's The chart shows that the industry s return on assets ratio has been moving together for the most part. Since the housing crisis, the industry as a whole has experienced some significant losses, and this can be seen by looking at the declining ROA ratio. In general, Lowe s and Home Depot have historically had a slightly higher ROA ratio. In the past year however, Tractor Supply Company made a big jump with its ROA ratio being 5 to 6 percentage points above either Lowe s or Home Depot. This could be attributed to the fact that Tractor Supply has a wider product variety, selling agricultural and rural products on top of its home improvement sector, although they did take a big hit during the housing crisis as well. When Looking at Tractor Supply Company s restated ROA ratio, it is significantly lower than the firm s as stated financial data. This is because the restated balance 128 P age

129 sheet includes the present value of Tractor Supply Company s operating leases and capitalizes them, adding a significant amount of assets to the company s balance sheet. This would surely be the same for Lowe s and Home Depot. Overall, Tractor Supply Company s ROA has lagged behind its competitors a couple of percentage points in the past, but have recently turned around and surpassed its competition. Return on Equity Return on Equity (ROE) is another lag ratio in which the previous year s equity is compared to the current year s net income. Similar to ROA, ROE gives the reader insight into how well the firm is creating profits using its investor resources. This ratio is especially important to shareholders, as it shows how well the company is using their investment to generate additional profits. Return on Equity also illustrates how a firm is internally generating profits using its retained earnings from the previous year. A high ratio indicates the firm s ability to capably allocate its investments and retained earnings and generate them into profit. On the other hand, if the ratio is low, it indicates poorly utilized equity. Return on Equity (Tractor Supply, Home Depot, Lowe s 10-K) Company P age

130 Tractor Supply Company Tractor Supply Company (restated) Home Depot Lowe's The graph shows that there has been an overall drop in the past 5 years. Again, Tractor Supply Company seems to lag behind the competition all the way up through However, they again surpass the competition in 2009 for the same possible reasons that ROA has turned around as well. Overall, it seems like Tractor Supply Company has begun to get a leg up on the competition in recent years, greatly improving over its previous four years ROE ratios. Profitability Analysis Conclusion Profitability analysis for Tractor Supply Company did not return a positive result. Although in several ratios Tractor Supply performed in range of its competitors, overall it performed below its competitors. Ratio Performance Trend Gross Profit Margin Underperforming Slightly declining Net Profit Margin Underperforming Stable Operating Profit Margin Underperforming Stable Operating Expense Ratio Underperforming Stable ROA Average Slightly declining ROE Average Declining Asset Turnover Outperforming Stable Overall Underperforming Stable As seen by the table listed above, Tractor Supply only outperformed its competitors in one ratio, asset turnover. In this instance, Tractor Supply was able to more efficiently use its assets to generate sales than both Home Depot and Lowe s. Although the majority of Tractor Supply s profitability ratios managed to stay fairly stable, they were still slightly below their competitors. However, the fact that their ratio trends managed to stay stable while its competitors continued on a downward slope 130 Page

131 could mean that in the future Tractor Supply could begin to outperform its competitors. In the home improvement and hardware industry, coming out of the recession more quickly could be a strong advantage for any company and as indicated by the profitability ratios, Tractor Supply is already turning around from the recession while its competitors still continue to struggle. Capital Structure Ratios Capital Structure is the mix of a firm s long-term debt, specific short-term debt, and equity. Firms use capital structure to finance their activities for expansion and growth. Debt can be issued in various ways whether through issuing bonds or longterm notes payable, working capital, as well as common and preferred stock. Investors should consider the mixture of the firm s long and short-term debt as well as equity. This is vital to valuing a firm because it provides insight on how risky a firm is. Generally companies that have more debt are riskier than those that have relatively low debt. However, debt is not all bad; in fact a company that does not have enough debt implies that the firm is not growing or expanding which is a cause for concern for investors. On the other hand too much debt is also a cause for concern for investors, because the company could go bankrupt or not be able to meet their contractual obligations, thus hurting the profitability of shareholders. Therefore it is important to find the proper amount of debt in order to maximize shareholders benefits, and at the same time minimize risk. The following section determines debt to equity ratio, times interest earned, debt service margin and Altman s Z-score. Debt to Equity Debt to Equity ratio measures the amount of relative amounts the firm is using and is calculated by total liabilities divided by shareholders equity. The ratio is the amount per dollar shareholders have invested that is being used as debt to finance the firm s growth. A ratio greater than one indicates the firm uses a large amount of debt to finance growth. This could be costly to shareholders because the additional interest expense can cause volatile earnings, but also can generate more earnings. A ratio less than one indicate the firm uses more equity to finance the firm s growth. If a firm has 131 P age

132 a ratio greater than one they are considered risky due to the possibility of volatile earnings. Tractor Supply s debt to equity ratio over the past five years has remained under one indicating the company uses most of equity to finance operations. However, the restated almost doubles the ratio implying that the firm may use too much debt to finance their operations. Since the firm has remained under one earnings are less volatile and investor s view the firm with minimal risk. This shows that Tractor Supply can maintain leverage better when compared to Home Depot, whose ratio has been extremely volatile in the past three years. Debt to Equity Tractor Supply Tractor Supply Restated Home Depot Lowes Industry average P age

133 (Tractor Supply, Home Depot, Lowe s 10-K) Times Interest Earned Times interest earned indicates how many times a firm can cover their interest charges before taxes. The ratio is calculated by using earnings before interest and taxes divided by the interest expense on debt. If a firm is unable to meet their debt obligations it could ultimately result in bankruptcy. A high ratio could imply that the firm does not have enough debt or the firm is paying off too much debt that could be used for growth and expansion. This idea is based on the fact that firms could yield a higher return by investing its earnings into other projects and borrow at a lower cost of capital than what the firm is currently paying to meet debt obligations. Tractor Supply has managed to maintain a higher ratio than the industry average over the past five years. However, the ratio was lower in 2006 and 2007 when the company was growing excessively and they acquired a small chain of stores. Over the recent years in 2008 and 2009 the company has been paying off debt allowing the ratio to climb, while still maintain growth. However, the restated ratio falls almost 80% due to the fact that operating leases where included on the balance sheet causing earnings to decrease. 133 P age

134 Overall, the firm remains at a relatively healthy rate, when compared to other firms in the industry. Times Interest Earned Tractor Supply Tractor Supply Restated Home Depot Lowes N/A Industry average (Tractor Supply, Home Depot, Lowe s 10-K) 134 P age