Valued at 1 April, 2007

Transcription

1 Valued at 1 April, 2007 Matthew Lewis: matthew.lewis@ttu.edu Tyler Page: tyler.page@ttu.edu Alex Segreti: alexander.l.segreti@ttu.edu Andrea Spencer: andrea.spencer@ttu.edu Stephen Wiggins: stephen.wiggins@ttu.edu

2 Table of Contents Executive Summary 3 Business & Industry Analysis. 7 Five Forces Model 8 Rivalry Among Existing Firms 9 Threat of New Entrants 10 Threat of Substitute Products 11 Bargaining Power of Buyers 12 Bargaining Power of Suppliers 13 Competitive Advantage Analysis 14 Key Success Factors 14 Accounting Analysis 16 Key Accounting Policies 16 Accounting Flexibility 18 Accounting Strategy 20 Quality of Disclosure 21 Revenue Manipulation Diagnostics 23 Expense Manipulation Diagnostics 26 Potential Red Flags 29 Undo Accounting Distortions 30 Ratio Analysis Forecast Financials 31 Liquidity Analysis 31 Profitability Analysis 37 Capital Structure Analysis 44 Extended Ratio Analysis 46 SGR and IGR Analysis 47 Forecasting 47 Valuation Analysis 61 Cost of Equity 61 Cost of Debt 66 WACC 67 Method of Comparables 68 Intrinsic Valuation Models 72 Altman Z-Score 78 Analyst Recommendation 79 Appendix 80 Works Cited 84 1

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4 Executive Summary Investment Recommendation: Overvalued, Sell 04/1/2007 BBBY NASDAQ $ week range $ $43.32 Revenue (2006) $5,809,562,000 Market Capitalization $11.75 Billion Shares Outstanding 283,380,000 3-month Avg. Daily Trading Volume 2,332,640 Institutional Ownership 83.40% Insider Ownership 3.70% Book Value Per Share (mrq) $9.35 ROE 25.99% ROA 17.90% Est. 5 year EPS Growth Rate 9.00% Cost of Capital Est. R2 Beta Ke Ke Estimated 13.01% 10-Year % 7-Year % 5-Year % 1-Year % 3-Month % Published 1.76 Kd BBBY: 5.74% Revised: 2.66% WACC BBBY: 12.03% Revised: 10.3% Altman Z-Score BBBY: 8.05 EPS Forecast FYE 03/ (A) 2007(E) 2008(E) 2009(E) EPS Ratio Comparison BBBY Industry Trailing P/E Forward P/E P/B P/EBITDA Valuation Estimates: Actual Price (04/01/2007) $40.40 Comparable Valuations Trailing P/E $44.38 Forward P/E $53.41 P/B $21.64 P/EBITDA $50.46 Intrinsic Valuations Actual Revised Discounted Dividends N/A N/A Free Cash Flows $60.42 $ Residual Income $16.07 $15.22 Abnormal Earnings Growth $3.92 $4.54 3

5 Recommendation Overvalued Firm Sell Business, Industry Overview and Analysis Bed Bath & Beyond is one of the largest home furnishings and domestic merchandise retailers in the country. They have expanded from two stores in 1971 to over 800 stores located in 46 states and Puerto Rico. This industry is classified as highly competitive. The key players are Bed Bath & Beyond, Linens- N-Things, Williams Sonoma, and Pier 1. The home furnishings industry is also comprised of discount merchandise firms such as, Wal-Mart and Target. These firms have the ability to steal some of the market share since a consumer can find a variety of items in one store, and often at a lower price. However, the key firms prosper since they have a greater variety of home furnishing products and usually more knowledgeable associates. Overall, it is difficult to enter this industry with a history of established firms. A firm must obtain a large amount of capital and resources to be able to enter and compete with this developed industry. Substitute products in this industry are a relatively moderate threat. Firms in this industry usually carry similar products at similar prices, making it easy for a consumer to switch back and forth between firms. Customers have a lot of bargaining power in the industry. This means that firms in the industry have to compete on price, resulting in smaller profit margins. Finally, suppliers for the industry have a relatively low bargaining power over firms. Firms and consumers both benefit from lower inventory costs, the result of an overabundance of suppliers. Accounting Analysis An accounting analysis is performed to evaluate a firm s accounting practices in comparison to the realities of their current and prospective financial position. The 10-k released each year by Bed Bath & Beyond contains vital information identifying the firm s key accounting policies. Bed Bath & Beyond 4

6 must be efficient managing operating costs, maintaining sufficient inventory levels, and must possess strong expansion initiatives. In keeping with generally accepted accounting principles (GAAP), Bed Bath & Beyond follows aggressive accounting policies. The quality of disclosure that a 10-k provides is of high importance to potential investors. Bed Bath & Beyond inadequately discloses line item information within financial statements, and fails to go beyond what is already there. This lack of disclosure appears to be the industry standard, and requires a more meticulous evaluation of the numbers presented in the financial statements. Screening ratios are utilized to express any possible manipulations to revenues or expenses. Red flags could be raised from negative trends in these ratios that could possibly indicate inflated revenues or expenses being booked as assets. Bed Bath & Beyond does not show any alarming trends in revenue manipulation because they have the net income to support increases in sales. However, Bed Bath & Beyond does have a declining CFFO/OI ratio. This is a concern because operating expenses should increase with revenues. The greatest concern about Bed Bath & Beyond s accounting policies is their use of operating leases. Operating Leases are a form of off-balance sheet transactions, and expressed as only an operating expense. If these leases were capitalized, Bed Bath & Beyond would be forced to include approximately 2.13 billion in longterm liabilities and leased assets on the balance sheet. Financial Analysis and Forecast In valuing a firm, financial ratios can show how successful the firm operates. Financial ratios can be broken down into three categories: liquidity, profitability, and capital structure ratios. Liquidity ratios consist of seven ratios that each explain Bed Bath & Beyond s ability to pay back current liabilities and debt. After compiling results, Bed Bath & Beyond s overall liquidity appears to have a declining trend. This could directly affect their financial position and competitive advantages in the industry. Profitability ratios provide an idea about 5

7 the historical profitably, as well as, the ability to continue to efficiently generate profits for the firm. The six ratios used in evaluating profitability, have steadily increased over the past five years for Bed Bath & Beyond. Increases in net income and efficient management practices have contributed to this steady increase in profitability. Finally, the capital structure analysis examines the percentage of the firm s value that is comprised of debt and equity. We were only able to utilize the debt to equity ratio because Bed Bath & Beyond does not posses any notes payable or interest expense. Forecasting Bed Bath & Beyond s financial statements for ten years allowed us to get an idea of where the company will be in the future. On the income statement, sales and net earnings forecasts doubled which caused equity to outgrow total assets. In order to account for this growth in the firm, total assets had to be increased in proportion to equity. The firm was then forecasted after the operating leases were capitalized and adjusted on the balance sheets. Analysis Evaluations In order to come up with an opinion on the value of the firm, we utilized four intrinsic valuation models. The inconsistency of numbers in the financial statements distorted the results from the valuation models. The residual income ad AEG model resulted in the lowest intrinsic values, whereas the method of comparables and free cash flow models were more accurate. The outcomes of these ratios lead us to believe that Bed Bath & Beyond is an overvalued firm. 6

8 Business & Industry Analysis Company Overview Bed Bath & Beyond is one of, if not, the largest retailer for home furnishings and domestic merchandise. The firm was established in 1971 with two stores promoting the sales of bath accessories and bed linens. Since then, Bed Bath and & Beyond has currently expanded into 809 stores in 46 states, and Puerto Rico. Headquartered in Union, New Jersey, Bed Bath & Beyond believes that they are only growing stronger in the home furnishings industry among companies such as Williams-Sonoma Incorporated, Pier 1 Incorporated, and Linens-N-Things. There are numerous factors that Bed Bath & Beyond must be aware of in order to maintain leadership in the already established industry. Their low prices and assortment of product lines must go hand in hand with the constantly changing trends, consumer preferences, and spending habits that can easily limit expansion and profitability. The firm carries an array of home furnishings products that include bedding, bath décor, kitchen appliances, and various types of furniture. Five Year Inventory Summary $1, $1, Millions $1, $ $ $ $ Bed Bath and Beyond Pier One Linens-n-Things Williams Sonoma $ Years 7

9 Bed Bath & Beyond has steadily increased its inventory over the past five years, and attained an billion dollar market capitalization. This is credited primarily to new store expansion and efficiency of operations. Competitors in the industry such as Williams-Sonoma Inc., and Pier 1 Inc., trail with the following market caps: 3.84 billion, and 596 million. Comparable figures for Linens-N- Things are unavailable since it is a privately held company. Over the past five years, the total inventory of Bed Bath & Beyond has increased from 754 million in 2002, to 1.3 billion dollars in These numbers support the company s goals to expand operations and store space. During fiscal 2006, the company is planning on opening 80 new Bed Bath & Beyond stores. As a leader in the industry, the company s shares of stock have increased just over eight dollars since March 2002, from 34 dollars in March 2002, to dollars on April 1, Five Forces Model In order to analyze the profit potential of Bed Bath & Beyond, it is important to understand the industry in which the firm competes. There are five areas that need to be examined in order to understand where Bed Bath & Beyond stands in the Home Furnishings Industry. The following table summarizes the results from the analysis of the five forces as they pertain to Bed Bath & Beyond. Home Furnishings Industry Rivalry Among Firms Highly Competitive Threat of New Entrants Low Threat Threat of Substitute Products Moderate Threat Bargaining Power of Buyers Very High (High Customer Power) Bargaining Power of Suppliers Very Low (Low Supplier Power) 8

10 Rivalry Among Existing Firms Industry growth A company s profitability is directly related to the competition between existing firms in the industry. The retail industry has always been known to be extremely competitive. The home furnishings industry, which Bed Bath & Beyond is classified under, is currently growing. Although the industry is expanding, firms must still compete for market share among each other. The growth is steady in this industry due to the constant demand for household products. This demand gradually increases as consumer s needs increase. This creates high competition in price, customer service, and the market share of the company definitely plays a role in its ability to compete. Concentration There are many different firms in the home furnishings industry. The big competitors include Linens-N-Things, Pier 1, Williams Sonoma, and Bed Bath & Beyond. Many other firms compete in this industry in an indirect manner; examples include discount stores such as Target and Wal-Mart. The high level of competition results in a largely fragmented industry, and severe price competition. Differentiation The extent to which firms in an industry can avoid head on competition depends on the extent to which they can differentiate their products and services (Palepu 2-3). This is a challenge in this industry because many of the products are undifferentiated. Market share and store image are extremely important because consumers are going to shop at a place they recognize. Fixed/Variable Costs It is common in the industry to have high fixed costs. Many companies rely on the use of operating leases for retail locations, merchandising, and 9

11 inventory. These are fixed rents for certain periods of time. The yearly operating leases are discussed in detail in a later section, but the average rent was 340 million dollars per year. Variable costs in the industry generally come from inventory. Many companies try to maintain large quantities of inventory, and are vulnerable to the risk of excess volume if current consumer preferences were to change. Threat of New Entrants Scale Economies Growing industries tend to attract new entrants because they are seen as having profit potential. In the home furnishings industry, the threat of new entrants is classified as being very low because of economies of scale. The industry growth is driving down the average price of products. New entrants would have to be extremely large in order to gain market share due to the highly concentrated industry. Bed Bath & Beyond is just one of many firms operating in this industry. There are several other firms that can compete on the same level of Bed Bath & Beyond like Linen-N-Things, and Williams-Sonoma. In addition, they all must compete with all other major discount and department stores such as Wal-Mart and Target. Economies of scale are clearly a deterrent for new firms that attempt to enter the industry. If new firms were to enter, they would probably suffer from the cost disadvantage, or face the choice of investing in a large capacity. 10

12 Assets $4, $3, Millions $3, $2, $2, $1, $1, $ $ Bed Bath and Beyond Pier One Linens-n-Things Williams Sonoma Years The above graph shows the total assets of firms already established in the home furnishing industry. A potential entrant s assets would have to range from 850 million to over three billion dollars in order to compete. First Mover Advantage The first mover in the industry would have an advantage because they would be ahead of the competition. They would have time to control the market, and build a reputation with consumers. Early firms would also have a cost advantage over new entrants because of their size, number of stores, and a developed distribution channel. Since the retail market is highly competitive, the first mover of the industry will gain more market share and have lower costs due to better relationships with suppliers. The threat of new entrants in the home furnishings industry is minimal. This is due to the fact that a potential entrant would be disadvantaged with large initial investments, economies of scale, and first mover advantage. Threat of Substitute Products Relative Price and Performance The threat of substitute products can impact the profit potential in an industry. In the home furnishings industry, the threat is moderate because many 11

13 items perform the same functions and are priced similarly. There are many discount stores which sell these items, but many consumers choose the specialty stores. Access to distribution channels is easy to obtain. A new entrant would not have difficulty establishing a relationship with a supplier, but a new entrant may not be able to get favorable terms with a supplier. Therefore, their cost would be too high, prices of their goods would be higher, and they would not be able to compete in the industry. Buyer s Willingness to Switch The consumers within this industry are focused on purchasing products at the lowest possible price. For this reason, their willingness to switch between firms in the industry is very high. The buyers have flexibility to choose between firms in the industry, resulting in further depletion of prices. Bargaining Power of Buyers When considering customer power, two main factors come into play. One of which is the bargaining power of the purchaser. In this industry, customers have high bargaining power because of the intense concentration of similar competitors. Bargaining power is developed when companies in the industry are attempting to attract customers to purchase from them and not revert to other retailers. The other factor would be price sensitivity. Bargaining power and price sensitivity go hand in hand. The retailers in this industry must have some level of price sensitivity in order to get those customers. This tends to be difficult because home furnishing products are undifferentiated. Differentiation Retail firms in this industry all carry similar inventories, causing the products and firms to be undistinguishable. This permits the customers to pit the firms against each other in price competition. The firm that competes at the lowest cost is going to gain the customer for the same product that they could 12

14 find elsewhere. In the home furnishings industry, it is hard to differentiate products. This causes an industry-wide problem and many companies find it difficult to prevent their consumer sales from going to their competitors. Bargaining Power of Suppliers Suppliers are considered to have power when there are few firms and substitutes in the industry. Therefore, the supplier power is extremely low within the home furnishings industry. The four major firms that exist in this environment are able to intimidate the suppliers in order to achieve the lowest cost on a product. Suppliers rely on the major companies in this industry to help them generate profits. Therefore, suppliers prefer a retailer with a substantial amount of customer traffic. The firms in this industry attempt to leverage themselves against suppliers to get the lowest cost, which in turn will lower costs to the consumer. Switching costs Since the industry contains many suppliers, the cost of switching suppliers is affordable. Suppliers are constantly competing to have their products on the shelves at these retailers. Therefore, suppliers do not have much bargaining power. Since limited power exists on the suppliers behalf, switching costs for firms in this industry are relatively non-existent. Number of Suppliers Suppliers are plentiful in the home furnishings industry. One firm recorded having approximately 4,300 suppliers. The largest supplier accounted for only 4% of total merchandise purchases. According to Bed Bath & Beyond s 10-k, the top ten leading suppliers account for a minimal total of 18% for merchandise purchases. If suppliers were to increase their costs, buyers have the power and freedom to turn to other suppliers at lower costs. 13

15 Competitive Advantage Analysis Industry Classification The home furnishings and domestic merchandise retail industry is very competitive. A person can go to almost any store and get items they need for their home. Bed Bath & Beyond, Linens-N-Things, and Pier 1 tend to offer more specialty items that are less likely found in discount stores like Target and Wal- Mart. These home furnishing stores also provide many advantages beyond specialty items, such as, limited crowds, and a timely shopping experience. As of now, Bed Bath & Beyond leads the industry in sales followed by Linens-N-Things, Williams-Sonoma, and Pier 1. Firms in this industry present their merchandise in a distinct manner that maximizes the customers shopping experience; whereas, stores such as Target and Wal-Mart, have domestic merchandise in select isles throughout their stores. Key success factors for the industry Cost leadership The main success factor in this industry is cost leadership. Since there are many different competitors, the company that can supply name brand or similar products for the lowest price will attract more customers. Most cities will contain several home furnishing companies, expressing the ease of going to another company to purchase the product. Differentiation Today the industry s top goal is to maintain quality goods and everyday low pricing. They do this by observing competitor s prices often to ensure their prices are matched, if not lower. Superior customer service also drives the success of the industry. The firm with employees most knowledgeable about the goods the store carries, and where they are located throughout the store, have an advantage over the other competitors. Another goal is to have their isles set 14

16 up where customers can easily see the many goods that appeal to them and the wide-selection the firms in the industry offers. Merchandise assortment sets firms in the home furnishings industry apart from department stores. Many home furnishing companies carry the same type of goods as the department stores, but a wider variety of brands, gadgets, and prices. Today the competitors of this industry carry linens, kitchen goods, beauty care, furnishings, and other house wares. Having more of these goods drive more customers to these stores for unique or hard to find products that you may not find at a department store. Store personnel are encouraged to tailor each store to the city in which it is located. This means that items will vary based on demographics, climate, and constantly changing trends. 15

17 Accounting Analysis Key Accounting Policies An accounting analysis is performed to evaluate a firm s accounting practices in comparison to the realities of their current and prospective financial position. In other words, do the firm s accounting actions define or explain the numbers represented in the financial statements? Before an analysis can begin, one must first identify the firm s key success factors and risks. Bed Bath & Beyond operates in a highly competitive home furnishings industry and must focus on managing operating costs, maintaining sufficient inventory levels in an industry with changing customer preferences, and strong expansion initiatives. Judgment is used in areas such as the inventory valuation, impairment of long lived assets, goodwill, stock-based compensation, and future operating lease obligations (BBBY 10-k). This freedom can lead management to more aggressive accounting practices in order to meet the firm s key success factors. Bed Bath & Beyond follows the retail inventory method in the valuation of inventory, which is common in this industry. Under this method, inventory is stated at lower of cost or market. Inventory Turnover Output BBBY WSM LNT PIR Industry Year 16

18 Over the past five years, Bed Bath & Beyond s inventory levels have steadily increased from 750 million to 1.3 billion dollars in The rapid growths in these values are the result of large number of new store openings. Their efficiency in moving inventory is calculated by the inventory turnover ratio. The industry as a whole has seen a decline in this efficiency from 2002 to However, it has recovered from the decline in 2005 and Bed Bath & Beyond bases a large portion of profitability upon expansion of new stores. Since it would be extremely costly to own each of these buildings, the firm conducts business through operating leases on their retail stores, warehouses, and office facilities. Operating leases are lease agreements with scheduled rent over a period of time. A benefit of an operating lease is that there is not a liability on the balance sheet. Instead, the lease is shown as an expense on the income statement ( Stern.nyu.edu). The terms of Bed Bath & Beyond leases range from 5-20 years, usually with renewal options at increased rates. They are also responsible for paying insurance, taxes, and various maintenance charges (BBBY 10-k). Operating Leases can lead to grossly underestimated liabilities on the financial statements. Managers can use this aggressive form of accounting to mislead investors on the true elements of the balance sheet. Bed Bath & Beyond chooses to store majority of its merchandise in the retail store themselves. This directly correlates with their key success factor of maintaining adequate inventory to meet customers needs. The firm also has two distribution centers and twelve warehouses to store excess inventory, and fulfill a portion of its internet orders. This means that inventory is usually shipped directly from manufacturers to Bed Bath & Beyond stores. In addition, the firm manages two E-Fulfillment centers that serve as distribution centers specifically for internet orders. 17

19 Accounting Flexibility All publicly-traded firms are required to submit a variety of reports to the SEC each year. Ideally, the numbers represented in the reports are in agreement with GAAP (generally accepted accounting principles). However, some managers have a certain degree of flexibility, or leniency in the disclosure of their financial reports. For example, in the event of inventory valuation, the manager can use methods such as LIFO, FIFO, or a weighted-average cost. As previously stated, majority of the home furnishings industry uses lower of cost or market to value their inventory. When Bed Bath & Beyond acquired Christmas Tree Stores in 2003, they chose to value CTS s inventory using the FIFO method. This gives the firm the opportunity to control inventory valuation of particular acquisitions within the company. If the firm chooses to increase cost of goods sold, to lessen income taxes, a LIFO valuation would be implemented. The FIFO method could be implemented if the firm is focused on decreasing expenses. Alterations in valuation must be monitored over the years because an inconsistency in policy could raise concerns. Managers within the industry also have the flexibility to report balance sheet values in two separate books: one for financial reporting purposes, and one for income tax purposes. There could easily be a difference between the income reported to shareholders, and the income reported to the IRS. In 2006, Bed Bath & Beyond claimed a net current deferred income tax asset of 70.1 million dollars and a net non current deferred income tax liability of 16.3 million dollars (BBBY 10-k). This aggressive accounting policy allows managers to stray from the industry standard of straight-line-depreciation and use an accelerated depreciation process to receive tax benefits. The choice of using operating leases over capital leases is another area which firms have flexibility. Firms often choose to lease long term assets rather than purchase them as is the case with Bed Bath & Beyond; they choose to operate using only operating leases. Operating leases are common among the industry. This can lead to a deceptive view of the company s financial position 18

20 because this can greatly understate the balance sheet (Stern.nyu.edu). If Bed Bath & Beyond and Linens-N-Things were to capitalize these leases it would create liabilities of 2.13 and 1.7 billion dollars. Bed Bath & Beyond s use of operating leases classifies them as a firm that uses aggressive accounting policies. In thousands Year Bed Bath & Beyond Capitalization of Operating Leases Operating Lease PV Factor* PV Capital Lease , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,731 Totals: ,093,674 3,067,143 2,125,927 *Values Discounted at 8% PV The capitalization of Bed Bath & Beyond s operating leases is shown above, and Linens-N-Things are shown in the table below. The discount rate, 8%, was found to be the home furnishings industry standard. This discount rate seems to accurately reflect the industry and the type of debt. By discounting the capital leases payments, we found that to get a more accurate look at Bed Bath & Beyond they should actually record liabilities of 2.13 billion dollars. This would also alter earnings and ratios previously computed. In order to receive debt financing, many lenders will require that the firm remain below a certain level of total liabilities in order to control risk. The revised financial statements 19

21 incorporating this change in liabilities are presented in the undo accounting distortions section. In thousands Linens-N-Things Capitalization of Operating Leases Year Operating Lease PV Factor* PV Capital Lease PV , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,813 85,604 Totals: 2,469,245 1,672,046 2,469,245 1,710,561 *Values Discounted at 8% Accounting Strategy Bed Bath & Beyond strives to offer quality merchandise at everyday low prices; maintain a wide assortment of merchandise, and to emphasize dedication to customer service and satisfaction (BBBY 10-k). These objectives are closely related to the business strategies of Linens-N-Things, Pier 1, and Williams- Sonoma. Linens-N-Things hopes to offer a broad selection of high quality brand names at everyday values, provide knowledgeable sales assistance, and maintain low operating costs (Linens N Things 10-K). To maintain a high competitive presence in the industry, each firm will adopt similar accounting strategies and principles. Unfortunately, high levels of aggressive accounting in the industry, force employers to reduce disclosure, therefore, lessen the firm s transparency. Managers attempt to stretch the limits of GAAP principles to communicate their firm s economic situation or to hide true performance 20

22 (Palepu 3-6). The use of operating leases in the industry provides off balance sheet transactions that could easily go unnoticed by the average shareholder. The home furnishings industry does not exhibit a great amount of seasonality. However, there is a substantial increase in sales in the months of August, November, and December (BBBY 10-k). This is why Bed Bath & Beyond chooses their fiscal year to end on the last Saturday nearest February 28 th. This is a strategy they use in order to begin and end the accounting year in virtually the same position, a month with a consistent level of sales from year to year. Quality of Disclosure Shareholders rely on the company s 10-k to research information about the firm, and to decide whether or not to invest in the company. The quality of disclosure that a 10-k provides is of high importance. It can show the firm s true operations and value through financial statements, footnotes, and supplemental disclosure. The quality of disclosure and transparency of the firm lie in the managers hands of that company. This is because the managers have control over what to disclose in their 10-k while following the guidelines of FASB, SEC and GAAP. In order to get a good idea of one company s disclosure, one should research the industry first. The home furnishings industry as a whole is very aggressive when it comes to reporting the accounting. Aggressive accounting is not always a good thing. Sometimes it can lead to inadequate disclosures to make the company appear better financially. Also, overall the industry has an extremely limited disclosure. The industry s 10-ks are inadequate on the amount of information disclosed, compared to companies in the technology and manufacturing fields. After having a general idea of the home furnishings industry, Bed Bath & Beyond s level of disclosure can be better understood when reviewing the 10-k. Bed Bath & Beyond practices aggressive accounting along with their competitors; and because of their large market share, they are often seen as being more 21

23 aggressive relative to other firms in the industry. When first looking at their 10-k, one might think that the disclosure and information provided is efficient and useful, but in reality it is not. The numbers represented in Bed Bath & Beyond s income statement, balance sheet, and statement of cash flows, are all extremely vague. For example, there is no concise explanation of what makes up other assets in the condensed balance sheet. It gives the basic points, but does not go much deeper than surface level. There are many components on these financial statements that are missing. An effective valuation of a firm is difficult when the amount of information disclosed is limited. Quantitative To further discuss the quality of disclosure in the industry, a series of sales and expense manipulation ratios are provided in the table below. These ratios are a key indicator in the identification of possible distortions in the accounting practices. Due to a lack of information, the Net Sales/Unearned Revenue, Net Sales/Warranty Liabilities, and Other Employee Expenses/SG&A ratios were not utilized in the analysis to follow. Screening Ratio Analysis Pier One Revenue Manipulation Ratios Sales/Cash from Sales Sales/Net Accounts Receivable Sales/Inventory Expense Manipulation Ratios Sales/Assets CFFO/OI CFFO/NOA Williams Sonoma Revenue Manipulation Ratios Sales/Cash from Sales Sales/Net Accounts Receivable Sales/Inventory

24 Expense Manipulation Ratios Sales/Assets CFFO/OI CFFO/NOA Linens-n-Things Revenue Manipulation Ratios Sales/Cash from Sales Sales/Net Accounts Receivable Sales/Inventory Expense Manipulation Ratios Sales/Assets CFFO/OI CFFO/NOA Bed Bath & Beyond Revenue Manipulation Ratios Sales/Cash from Sales Sales/Net Accounts Receivable N/A N/A N/A N/A N/A Sales/Inventory Expense Manipulation Ratios Sales/Assets CFFO/OI CFFO/NOA Revenue Manipulation Diagnostics These ratios are used to discuss the validity of revenues reported by the firm. Distortions can result from manager s accounting flexibility, compensation incentives, or inflated numbers during less profitable quarters. Unusual increases in these ratios could suggest that sales are not being supported by cash inflows. 23

25 Sales/Cash From Sales Output Year Pier One Williams Sonoma Linens-n-Things Bed Bath & Beyond Sales/Cash from Sales ratio explains the amount of cash collected from customers compared to total sales. Bed Bath & Beyond has a constant ratio of 1.0 because the firm offers no options for customers to purchase on account. The firm s competitors average ratio is 1.02, which means accounts receivables are a small portion of their total sales. The industry standard is receiving cash at the time of sale. Pier 1 s ratios are consistently higher than the industry average, because they are more differentiated and higher priced. Pier 1 s increase in 2006 could raise some questions concerning their reported sales. Their consistent declines in sales and net income over the past three years could cause managers to dishonestly boost sales. There should be no fluctuation in Bed Bath & Beyond s ratio until the acceptance of accounts receivable is needed to remain competitive in the industry. 24

26 Sales/Net Accounts Receivables Output Pier One Williams Sonoma Linens-n-Things Bed Bath & Beyond Year Higher accounts receivables are often associated with a greater amount of perceived risk due to uncollectible accounts. Sales/Net Accounts Receivable shows the portion of sales that is purchased on account. Bed Bath and Beyond does not utilize accounts receivable, this is a bonus when trying to minimize risk. In this industry, cash is king. Linens-N-Things is establishing credibility in the industry by cutting their accounts receivable in half since 2003, and require more cash payments. Cash in previous two ratios support the validity of Linens-N- Things revenues. If this ratio were to increase without support from increase in cash collected from customers, questions could be raised concerning the percentage of sales that has been accrued rather than earned. 25

27 Sales/Inventory Output Year Pier One Williams Sonoma Linens-n-Things Bed Bath & Beyond This ratio explains the amount inventory in respect to net sales, and the firm s ability to move merchandise efficiently and effectively. Bed Bath & Beyond maintains a high level of sales and inventory, which places their ratio right with the industry average. This is beneficial to the firm because they have sufficient inventory to sustain their growth, and avoid excess obsolete inventory in the future. Bed Bath & Beyond has maintained a constant ratio of about 4.47 over the past three years. We can conclude that their increase in inventory supports their continuous increase in sales. Williams-Sonoma stands out in the industry because they keep a small inventory relative to their amount of sales. Expense Manipulation Diagnostics The expense diagnostic ratios are analyzed in order to reveal discrepancies in how a company allocates expenses. Declining expense ratios raise a red flag to the possibilities of a firm booking expenses as assets. 26

28 Sales/Assets 2.5 Output Pier One Williams Sonoma Linens-n-Things Bed Bath & Beyond Year All of the companies are centered around the industry average. Part of this is because the industry chooses to use operating leases, increasing expenses, and remains an off balance sheet transaction. This leaves similar assets on the books for all the companies because they rely on leasing their properties rather than owning them. This tends to make the ratios in this industry higher relative to one that capitalizes their leases. 27

29 CFFO/OI Output Pier One Williams Sonoma Linens-n-Things Bed Bath & Beyond Year This ratio is somewhat alarming in the first few years for the industry because on average it is decreasing. This is due to high operating income, which is a possibility because they were not showing enough expenses. This ratio is also a check on the companies earnings because it is used to determine the extent that cash flows differ from reported operating income (valuebasedmanagement.net). Bed Bath & Beyond seems to have a decreasing ratio because they are not taking enough expenses out of operating income. In theory, expenses should be growing parallel to sales, which are supported by an increasing cash flow from operations. 28

30 CFFO/NOA Output Pier One Williams Sonoma Linens-n-Things Bed Bath & Beyond Year Bed Bath & Beyond is the only firm that produces an increasing trend over the past five years. This ratio explains that every dollar invested in net operating assets generates 26 cents in operating cash flows. Clearly, Bed Bath & Beyond stands out as the industry leader in a ratio that contains some industry outliers. Potential Red Flags When looking over a company s 10-k and financial statements, it is important to take notice when numbers or statements do not seem correct. Many companies distort their numbers to make them look financially better to try to influence shareholders into investing in their company. Usually, when looking over the companies annual report, one could find something that is alarming and unusually reported. These occurrences are known as red flags. When one finds red flags it is necessary to assess these problems. Computing ratios are a good indicator if red flags exists. The above ratios are Bed Bath and Beyond s sales and expense manipulation ratios. We conclude that the sales ratios do not seem to have any alarming results. All of the sales ratios are clearly supported by increases in cash. In a retail industry, it is imperative that cash is closely related to the increases in revenues. None of 29

31 the expense ratios seem to be decreasing in value with the exception of CFFO/OI. This could raise concerns that expenses are not being recorded accurately or correctly allocated with the growing revenues. Another area for concern with the corporation s accounting strategy is their strict use of operating leases. At the end of 2005 Bed Bath & Beyond had a total of around $3.1 billion dollars in current and future obligations, all of which registered under operating lease agreements. According to their 10-k, offices, warehouses, manufacturing facilities, and equipment are all capital items that are being expensed as a part of an operating lease rather than being capitalized and recorded in the corporation s financial statements. Undo Accounting Distortions As mentioned in the accounting flexibility section as well as the red flags section, Bed Bath & Beyond chose not use any capital leases. For comparison purposes, we converted their operating leases over to capital leases, and discounted the payments by 8% to find the present value. After discounting the payments, we concluded that Bed Bath & Beyond should add about $2.13 billion dollars to their value of long term liabilities, increasing the value from $1.12 billion to approximately $3 billion. Therefore, the current values of long term liabilities are extremely understated. The financial statements reflecting this increase in liabilities are included in the forecasting section that follows. 30

32 Ratio Analysis & Forecast Financials Ratio Analysis Profitability and growth are two key components in the valuation of a firm. Ratio analysis offers a measure of financial performance and efficiency management for a firm. After the ratios are reviewed, they can be utilized in forecasting the financial statements. The critical analysis of these two measures can help us better understand historically where the firm has been, and where speculated trends will lead the firm in the future. Financial ratio analysis can be categorized into liquidity, profitability, and capital structure analysis. The relationships explained in the analysis of the financial statements will compare Bed Bath & Beyond s position to competitors in the home furnishing industry, as well as, the firm s past performance. Trend and Cross Sectional Analysis Once the ratios have been computed for the past five years, their results are analyzed for any emerging trends. The trends are then used to logically forecast various aspects of the firm s financial statements. Since trends are speculated, the firm s future performance will be subject to the one that defines the trends. A cross-sectional analysis is one that facilitates examining the relative performance of a firm within its industry, holding industry-level factors constant (Palepu 5-1). Bed Bath & Beyond s performance will be compared to other competitors in the industry to observe how established the firm is in the industry. Liquidity Ratios Liquidity Ratios provide valuable insight on Bed Bath & Beyond s ability to meet its short-term liabilities. The ratios used in this analysis are the current ratio, quick asset ratio, inventory turnover, and working capital turnover. Bed Bath & Beyond does not have any accounts receivables, so the accounts 31

33 receivable turnover ratio must be omitted from the analysis. The current ratio and quick asset ratio will explain if the firm needed to liquidate, would its current assets cover the current liabilities in a timely manner. The other ratios will explain the efficiency in sustaining comfortable levels of liquidity. Liquidity Analysis Current Ratio Quick Asset Ratio Inventory Turnover Days Supply Inventory Working Capital Turnover Overall, Bed Bath & Beyond s liquidity is declining. Over the past five years, there have been declines in current ratio, quick asset ratio, but the efficiency in moving inventory has increased by The decline in liquidity ratios has negatively affected its position below the industry average in some areas, and the competitive advantage that they once had Current Ratio Current Ratio 3.5 Ouput Year BBBY WSM LNT PIR Industry 32

34 The current ratio is computed by taking the current assets of a year and dividing it by the current liabilities of that same year. The ratio shows that for every one dollar of debt the firm will have so much in assets to cover that debt. Bed Bath & Beyond s current ratio shows a little variance over the last five years, but in the last three years, it is showing a decrease. That means from 2004 to 2006 Bed Bath & Beyond has become not as liquid as it has been in previous years. Its ability to pay off its short-term debt has been decreasing. Compared to the industry Bed Bath & Beyond has been staying above the industry average, except for in While the industry has been increasing their current ratio, Bed Bath & Beyond s has been decreasing. They have been paying off their short-term debt and moving more to an equity financed company. We believe that Bed Bath & Beyond will continue to decrease its current ratio since assets are shrinking and liabilities are growing, while its competitors will continue to increase theirs Quick Asset Ratio Quick Ratio Output Year BBBY WSM LNT PIR Industry 33

35 To compute the quick asset ratio an analyst takes the companies quick assets and dividing them by current liabilities. A company s quick assets are those that are turned into cash when needed. These include cash, securities, and accounts receivables. The quick asset ratio shows how fast a company can convert its immediate cash to pay off short-term debt. This ratio will tell us that for every dollar of current liabilities there is $0.66 of quick assets to cover that debt. From 2002 to 2004 Bed Bath & Beyond increased its quick asset ratio considerably from $0.84 to $1.13. That tells us in those years they were more quick assets supplied for every dollar of current liabilities. From 2004 to 2006 Bed Bath & Beyond s quick asset ratio began to decrease because current liabilities were increasing while quick assets stayed relatively steady. This shows that company has been losing its liquidity over the last 3 years. Bed Bath & Beyond was keeping its quick asset ratio close to most of its competitors, but since 2004 they have been increasing their quick assets while Bed Bath & Beyond has been decreasing theirs. They are now well below the industry average for quick assets and the decrease over the last few years leads us to believe that they will continue to decrease quick assets and increase current liabilities. 34

36 Inventory Turnover Days Supply Inventory Inventory Turnover Output BBBY WSM LNT PIR Industry Year Inventory turnover is calculated by taking the firm s cost of goods sold and dividing them by their current inventory supply. A firm in this industry would like this number to be relatively high. A higher inventory turnover means that the firm gets more inventories out of the store or warehouse to make room for new inventory. Bed Bath & Beyond s inventory increased from 2.28 in 2002 to 2.57 in In 2005, the inventory turnover stayed the same and in 2006, it shows a slight decrease. In the last three years, the inventory turnover has not moved very much, which shows that as they increase their inventory supply their cost of goods sold are increasing as well. It seems as though the overall trend is that inventory turnover is increasing and that is good for Bed Bath & Beyond. As long as this number grows, Bed Bath & Beyond will be able to get rid of more inventory to make room for newer goods. Day s supply of inventory is computed by taking the number of days in the year and dividing it by the inventory turnover ratio. This will tell you how many 35

37 days it takes a firm to sell its inventory. Bed Bath & Beyond has been decreasing their days supply of inventory which is favorable to them. They are keeping products on the shelves fewer days each year. From 2002 to 2006, they have dropped their supply of inventory by more than Two weeks. That tells us consumers are buying more of their products every year, which makes space for newer inventory to be kept on hand. Compared to the industry average Bed Bath & Beyond has been keeping a slow pace with the rest of their competitors. That shows that they are moving with the industry. While many of its competitors are increasing their days supply of inventory Bed Bath & Beyond is not. Many of its competitors are keeping products on hand a few days longer each year compared to their last year, while Bed Bath & Beyond has been decreasing theirs at a slow pace. We believe that this shows Bed Bath & Beyond has favorable improvements over its competitors when it comes to inventory supply Working Capital Turnover Working Capital Turnover Output Year BBBY WSM LNT PIR Industry 36