Valuation & Analysis

Transcription

1 Valuation & Analysis Clay Mauldin Alex Orr Kevin Beck Chance Turner Dane Chambless 1

2 TABLE OF CONTENTS Executive Summary 3 Overview of Dillard s, Inc. 6 Industry Overview & Analysis 10 Value Chain Analysis 14 Competitive Advantage Analysis 15 Accounting Analysis 17 Ratio Analysis 25 CrossSectional Analysis 26 Financial Statement Forecasting 45 Cost of Capital Estimates 46 Method of Comparables 48 Intrinsic Valuation Models 51 Credit Risk Analysis and ZScore 55 Appendix 1 57 Appendix 2 63 Appendix 3 73 References 77 2

3 Executive Summary Investment Recommendation: Overvalued, Sell (4/1/07) Dillards DDS NYSE EPS Forecast 52Week Range FYE Revenue (2006) 7,810,067 EPS 235, , , ,301 Market Cap Billion Shares Outstanding 81,533 Ratio Comparison Dillard s Industry Trailing P/E Dividend Yield 0.49% Forward P/E Average Trading Vol. 1,175,270 Forward PEG Altman ZScore: M/B DDS 3.32 Book Value Per Share Valuation Estimates ROE 5.23% Actual Current Price 34.40** ROA 2.13% Est. 5year EPS Growth Rate 5.05% Ratio Based Valuations P/E Trailing Cost of Capital Est. P/E Forward R2 Beta Ke Enterprise Value Ke Estimated 3Month % Intrinsic Valuations 1Year % 5Year % Discounted Dividends Year % Free Cash Flows Year % Residual Income Published 0.95 Abnormal Earnings Growth 8.91 Kd 6.80% WACC 8.58% 3

4 Dillard s is one of the largest department store retailers in the nation. The firm specializes in offering a broad selection of men s and women s clothing and accessories, as well as cosmetics, furniture, and cookware. Dillard s has several direct and indirect competitors in the industry including; Federated Department Stores, Saks, Inc., JC Penney, Nordstrom s, and Neiman Marcus. Dillard s competes in the industry by maintaining its competitive advantage of offering brand name products at competitive prices with greater customer satisfaction. The accounting strategies of Dillard s are important when valuing the firm. Through accounting disclosures in the 10K, Dillard s exhibits a moderately conservative approach towards accounting. Dillard s accounting policies are displayed accurately, as well as honestly throughout the firm s 10K. Changes in policies are effectively communicated to outside parties. Dillard s uses accounting policies that are common of the industry, as well as policies that adhere to Dillard s key success factors. Inventories are stated at cost and managers have the accounting flexibility to enforce mark ups and mark downs in accordance with the firm s current sales. This allows the firm to maximize revenues from inventories and liquidate overstocked merchandise. Dillard s recently raised their pension rate in an effort to prevent understating pension expense. This is a conservative move by management not common within the industry. JC Penny s, Dillard s main competitors uses similar accounting strategies that reflect a consistency within the industry. Dillard s uses conservative strategies to reflect accurate information to shareholders. This honest approach is consistent throughout Dillard s financial statements. Dillard s continues its honesty with more than satisfactory disclosures in the footnotes of their SEC statements that show investors and auditors accurate details of the accounting policies used. By calculating the core financial ratios, we are able to directly compare Dillard s performance with other competitors within their industry. We computed ratios to determine the liquidity, profitability, and the capital structure of the firm. 4

5 Dillard s debt service margin is favorably higher than their competitors which exhibits their ability to control their debt. The steady increase in the debt service margin for the firm indicates that Dillard s has less pressure to use its cash flows from operations to finance its liabilities. Dillard s has also worked towards a lower debt to equity ratio as well. A declining debt to equity ratio year to year would be a favorable impact for the company. The debt to equity ratio states that a firm has a certain amount of liabilities for every dollar of owners equity. The main reason why this is possible is due to Dillard s ability to lower their total liabilities. Dillard s also showed high rates of return on equity between 2004 and 2005 because total assets and total liabilities declined at a constant rate to keep equity equal to the previous year. This illustrates a higher profitability by maintaining a constant level of equity invested into the firm. Our forecast valuations for Dillard s were calculated 10 years into the future, to ultimately evaluate Dillard s future performance. Through our forecasting, we were able to determine that Dillard s is maintaining constant stable growth. The values we forecasted helped us with the intrinsic value calculations. Then, through our valuations, we were able to conclude if Dillard s was under, over, or fairly valued compared to its current market price. After each of the intrinsic values was computed, we came to the conclusion that Dillard s is highly overvalued. The discounted dividends model was the poorest valuation to predict the estimated value per share. This model was inaccurate because dividends do not do a fair job of evaluating the market price of a firm. The residual income, abnormal earnings growth, and the free cash flows models were the primary valuation models that we relied on in determining Dillard s overall value. All three models consistently showed that Dillard s current stock price is inflated by around 20. 5

6 OVERVIEW OF DILLARD S, INC. Dillard s, Inc. is among the nation s largest fashion apparel and home furnishings retailers in the department store industry. The 330 Dillard s store locations offer a broad selection of name brand men s and women s clothing, accessories, cosmetics, cookware, and home furniture. Dillard s was incorporated in Delaware in 1964 after the first store opening in Over the next fortytwo years, the firm has expanded over twentynine states with fiftyone stores being located in the western U.S., 124 in the eastern region, and the remaining 155 located in the central region of the U.S. Competitors Dillard s operates in the high end retail department store industry. Its direct competitors include Federated Department Stores, Saks Inc, Nordstrom s, Neiman Marcus, and JC Penney. However, the broad array and diversity of department store products allows for many indirect competitors, such as large and local retail, outlet, and furniture stores to challenge as substantial threats to firms within the industry. Under these conditions, the industry is a highly volatile and competitive sector characterized by reputation, advertising, price, and quality. Dillard s focuses primarily on extensive customer service and maintaining brand loyalty through exclusive upscale contemporary choices. Market Capitalization Currently, Dillard s holds a market capitalization of 2.8 billion compared to an overall industry capitalization of billion. Dillard s ranks second among the direct top competitors in market capitalization. Federated benefits from a much larger capitalization at billion due to the coalition between Macy s and Bloomingdale s Department Stores under the same umbrella corporation. Sears, Kohl s, and TJX Companies actually acquire a larger share of the market capitalization but are not considered to be direct competitors of Dillard s. 6

7 5 year Sales Volume & Growth Dillard s sales depend greatly on the success of the last quarter of the fiscal year due to the holiday season. Sales for the fourth quarter on average are approximately onethird of annual sales. Overall, total salves volume has decreased from with a slight increase in 2005 by approximately 36,000. Along with sales, assets have decreased significantly over the past five years by a total of about 1.5 million in total asset deduction. Table 1: Dillard s Year Net Sales () Total Assets () %Change in Net Sales %Change in Total Assets ,154,911,000 7,199,309, ,910,996,000 7,074,599,000 (3.00) ,598,934,000 6,675,932,000 (3.94) ,528,572,000 5,691,581,000 (0.93) ,560,191,000 5,516,919, In recent years, Saks, Inc. has shown a steady decrease in net sales and total assets with the exception of Nordstrom s total assets and net sales have grown considerably in recent years. Neiman Marcus also shows growth in these two categories. 7

8 Table 2: Saks, Inc. Year Net Sales () Total Assets () %Change in Net Sales %Change in Total Assets ,581,236,000 5,050,611, ,070,568,000 4,595,521,000 (7.76) (9.01) ,055,055,000 4,579,356,000 (0.26) (0.35) ,437,277,000 4,709,014, (2.83) ,953,352,000 3,850,725,000 (7.52) (18.23) Table 3: JC Penny s Year Net Sales () Total Assets () %Change in Net Sales %Change in Total Assets ,384,000,000 17,787,000, ,513,000,000 18,300,000, ,096,000,000 14,127,000, (2.28) ,781,000,000 12,461,000, (11.7) ,903,000,000 12,673,000,

9 Table 4: Nordstrom, Inc. Year Net Sales () Total Assets () %Change in Net Sales %Change in Total Assets ,607,687,000 4,084,356, ,656,000 4,185,269, ,448,678,000 4,569,233, ,131,388,000 4,605,390, ,772,860,000 4,921,349, Table 5: Neiman Marcus Year Net Sales () Total Assets () %Change in Net Sales %Change in Total Assets ,015,534,000 1,785,870, ,948,332,000 1,907,546,000 (2.22) ,080,353,000 2,034,430, ,524,771,000 2,617,648, ,821,924,000 2,660,660,

10 Stock Price Performance The stock price for the firm since the beginning of January 2003 seems to be on a steady climb after an apparent volatility in the year of After studying the industry, the three main competitors seem to be following the same price trend. 5 FORCES MODEL The five forces model is the basis of assessing the profit potential of the industry in which a firm is competing. The factors that affect profitability in the industry include the degree of actual and potential competition. This is classified by rivalry among existing firms, threat of new entrants, threat of substitute products, and bargaining power in input and output markets described by bargaining power of buyers and suppliers. Rivalry Among Existing Firms The highend retail industry is a very competitive industry. Firms must find a way to differentiate themselves from their highend competitors. The industry has been growing over time and existing firms have become larger and larger. Due to the size of the large firms, they dominate the market. Nordstrom Inc. holds a market share in this industry at Billion. Federated Department Stores holds a Billion market share. This market is dominated by the main firms of the industry, Nordstrom s Inc, Federated, Saks, Dillard s and Neiman Marcus. The 10

11 only way to gain market share is to take it away from other players. With an increasing demand for designer products firms must rely on their credibility and authenticity of their products. The major firms also face competition from smaller stores. These stores compete on reputation, fashion, advertising, price, quality, service, and credit availability. However, it is anticipated that the most intense competition will continue to be on price. Switching costs in the industry are relatively low. Most firms sell the same brands and models. This allows consumer switching cost to be very low. This causes firms to rely heavily on personal customer service as well as price to hold their market share. All of the main firms in the industry have expanded their sales to the internet. This is way of offering more personal customer service. Internet sales have helped these firms increase net sales and have given larger firms an edge against smaller retail competitors. With all of the competitive advantages held by larger firms in the industry they mainly compete with one another. For this reason, we conclude that the rivalry among existing firms in the highend retaildepartment store industry is very high. Firms in this industry must be large to maintain and must find a way to differentiate themselves from competitors. Threat of New Entrants Economies of scale are important in determining business strategy when entering a new industry. When there are large economies of scale, new entrants face a difficult decision to enter such a competitive industry. They either have to invest in a large capacity which may not be immediately utilized or enter with less than optimum capacity. It is very difficult for a new firm to compete with Dillard s, Saks, Nordstrom s, or Neiman Marcus. In the high end retaildepartment store industry supply surpassed demand. This excess capacity favors larger firms that can sustain operations with reduced margins. Larger firms usually have substantially larger marketing budgets; which provides them with a competitive advantage. The large direct competitors in the industry produce large economies of scale. This puts smaller firms at a disadvantage because they are not able to 11

12 obtain prices offered to larger firms by suppliers. An advantage to new entrants is the possibility of utilizing the internet. Online companies avoid rental and facility cost which can allow for competitive pricing. However, the inability to offer consumers a tangible product before purchase can decrease the attractiveness of online shopping. Internet sales still struggle to come anywhere close to store sales in the industry. Since the industry is driven by high price competition it is extremely hard to generate a first mover advantage. Many larger firms have exclusive rights to manufactures. For example, Dillard s holds exclusive agreements with Antonio Melani, Gianni Bini, and Daniel Cremieux. These exclusive rights are the result of an initial action to establish market share. The relationships between large high end firms and manufacturer s make it very hard for new entrants to access channels of distribution and break into the market. It is because of this that we conclude the threat of new entrants to be very low. Threat of Substitute Products The highend retail Industry is definitely one that competes on price. There is a high degree of a customer s willingness to substitute products. Most all of Dillard s competitors carry the same lines of clothing. This causes little variation in the products that consumers are looking for. It proves that Dillard s, and other firms, have to compete on price, or they will experience a loss in customer base and market share. For example, designer label clothing commands a price premium even if it is not superior in terms of basic functionality because customers place a value on the image offered by designer labels. So, in order for firms to keep their customers, they must keep prices at a competitive level along with a high degree of customer service. In this industry, there will not be much of a difference in the price between competing stores. Therefore, as stated before, Dillard s will have to provide their customers with all of the extras that come with shopping at their store. In recent quote, William T. Dillard said, Our 12

13 companies main goal in this business is not to provide the lowest price products. That is not our goal at all. Our goal is to beat our competitors with superior customer relations and an outstanding product. The threat of substitute product in this industry is very high. Without offering the customer service, customers will easily be willing to switch products. Bargaining Power of Buyers There are two factors that determine the power of buyers including price sensitivity and relative bargaining power. Price sensitivity refers to the extent to which buyers care to bargain on price. Relative bargaining is the extent to which they will succeed in forcing the price down. As stated before, this highend industry competes heavily on price. However, since some firms introduce their products as being differentiated, customers are not that sensitive to price increases. Most all of Dillard s products are clothing lines that are offered by all of their competitors. This causes a high degree of price sensitivity which drives prices down. Considering these factors, it is easy to see that buyers have quite a bit of bargaining power. One factor that might lessen the amount of bargaining power is the wide variety of products Dillard s carries. With all of these factors considered, we consider the bargaining power of buyers to be relatively high. Bargaining Power of Suppliers The bargaining power of suppliers can prove to be a very powerful tool when there are only a few companies and few substitutes available to their customers. This is not the situation with the high end retail industry. The numerous amounts of competing firms and various product lines restrict supplier s ultimate power. The supplier s need the big name firms to maintain, more than the big firms need the single supplier. Firms develop relationships with suppliers to receive low prices. High prices from suppliers result in high prices to the consumer, and lower margins to firms like Saks, Neiman Marcus, and Nordstrom, Inc. Since firms compete on price, developing relationships with these large firms is 13

14 essential to suppliers. Many large firms operate under the belief that they should never be dependent on one supplier. For example, last year Dillard s ordered no more than 5% of its inventory from a single supplier. With all of these factors considered, we believe the bargaining power of suppliers to be relatively low. Competitive Force Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Buyers Bargaining Power of Suppliers Conclusion Very High Low High High Low VALUE CHAIN ANALYSIS High end retail department stores compete in a highly competitive market based on price. Although their retail department stores are in shopping malls, they have to compete on national and local levels. Competitors compete on many different strategies including differentiation and outstanding customer service. Firms in this industry must find a way to differentiate themselves in order to gain profits. Dillard s sells its products slightly cheaper than other high end stores like Nordstrom s or Saks. Nordstrom s and Saks attempt to make the shopping experience more elegant and enjoyable. They appeal to the consumer who is willing to spend a little more in order to have a lavish shopping experience. All high end retailers in this industry make sure that their products are of the highest quality. Firms really focus on enhancing in the instore experience to add value to their products. 14

15 High end retailers also focus on offering a wide selection of merchandise. The more merchandise they have, the more people they can appeal to. Many of the firms in the industry offer the same types of products. A firm can stand out when its merchandise selection exceeds that of a competing firm. Again switching cost is low, so presentation and a large merchandise selection can add value to a firm. COMPETITIVE ADVANTAGE ANALYSIS Dillard s believes that they are in a strong competitive position with regard to a various number of factors. These factors include location, reputation, assortment, advertising, price, quality, service, and credit availability. Dillard s is constantly seeking new ways to separate itself from the rest of their competition. They try to position their stores in such a way that attract new customers, who are excited about the manner in which Dillard s operates its stores. Dillard s can also compete by obtaining new clients, while working to maintain its existing clientele. They constantly work to expand and improve their product lines for their customers. Due to the expansive pricing budget of its competitors, Dillard s has had to reduce prices and reduce margins. The retail merchandise business has fluctuated due to some of the changes in the local and national economic conditions and has changed consumer preferences and spending patterns. Dillard s differentiation allows them to provide more distinct products and services that are valued by their customers. They invest heavily in brand image, offer superior product quality, and have superior customer service. In all 330 stores, Dillard s provides its customers brand names such as Polo, Coach, and Daniel Cremieux. Throughout every department in each Dillard s store, employees try to foster a brand image of strength, status, and reliability. According to a poll on Dillard s customer service has been ranked in the top five in its industry since Dillard s upholds their superior 15

16 customer service name by offering twentyfour hour online support as well as customer service departments in each store. Dillard also allows other independent firms to run certain departments where specialization, focus, and expertise is critical. Throughout our history Dillard s has been able to acquire knowledge in each of their trade areas and customer bases, which gives consumers full knowledge of the product they are buying. Dillard s has expanded and integrated vertically by establishing a vast source of suppliers. In doing so, it has afforded itself not only the opportunity to provide a higher quality of products, but also greater control over the merchandise it sells. Another competitive advantage of Dillard s is the issuance of all proprietary credit cards to their customers and the making of all credit card loans. As a customer, ownership of a card provides them the ability to receive monthly discounts on a variety of discount products. This also bodes well for Dillard s having a steady inflow of frequent customers. In November of 2004, Dillard National Bank was bought out by GE Consumer Finance whose already established company acquired all of the existing credit card accounts. In conjunction with the sale, Dillard s experienced an income of 83.9 million. According to Dillard s 10k, they became a more focused retailer and used the proceeds generated from the sale and ongoing compensation to strengthen their balance sheet and return value to their shareholders. Dillard s dedication to their customer service, competitive pricing, and variety of products will continue to keep them competitive in the industry. Dillard s is always looking to expand by opening new stores, keeping its product lines up to date, and keeping its name associated with superior quality. 16

17 Accounting Analysis It is important for any company s accounting practices to reflect the goals of the company. Investors should be able to easily decipher and interpret the information disclosed by the company. Companies in each industry compete with different strategies and different policies. How they account for these policies financially is of great interest to the investor. A goal of accounting analysis is to see if the firm s accounting practices capture current and prospective financial actions of the company. We will also look at how these financial actions relate and support Dillard s key success factors. Dillard s, in the department store industry, competes on product quality, competitive pricing, and extensive customer service. We have identified the following key success factors whose fluctuations have a significant impact on its operating results. As stated in our five forces model, Dillard s is a company that competes on price and differentiation. Dillard s offers quality merchandise at a slightly lower cost than its other high end competitors. Using mark downs Dillard s is able to manage its inventory and avoid being overstocked. Managers must also watch spending on SG&A. Dillard s, having a lower marketing budget than most of it s competitors, must find a way to sell it s merchandise while incurring minimal SG&A expenses. Maintaining revenues, cash flows, and store growth are also key factors necessary for the continued success of Dillard s. Key Accounting Policies The fashion industry has escalated over the last five years. An increase in demand for designer brand products has sent department stores sales very high. Since Dillard s relies on their highquality products, their revenues are steadily increasing. Consumers are willing to pay a good price for a quality product. Dillard s recognizes revenue at the point of sale. The company also recognizes 17

18 an allowance for sales returns that are recorded as a component of net sales in the period in which the related sales are recorded. Dillard s is also very profitable in their sale of gift cards. This is an effective strategy to help Dillard s predict future revenues and anticipated inventory sales. Preparing for fashion and industry trends plays a huge role in Dillard s attempts to manage its inventory. According to our key success factors Dillard s must control its inventory. Dillard s mainly uses upscale merchandise at a low cost which helps maintain lower inventories. Since Dillard s is part of the department store industry, inventory management is essential. This requires Dillard s to have low input cost in inventory. In addition, Dillard s incurs low distribution cost to transport their products from manufactures to consumers. Keeping just enough inventory to display in stores helps avoid expenses incurred with stock piling inventory. Roughly 98% of Dillard s inventory is accounted by using the Retail Inventory LIFO method. The remaining 2% of the inventory is valued by the retail inventory method (RIM). RIM is a method used by retailers to value inventory with a physical count by converting retail prices to cost. This method requires Dillard s to keep the total cost and retail value of goods purchased and available for sale, and also sales for the period. Additionally, RIM will result in valuing inventories at LCM if markdowns are currently taken as a reduction of the retail value. Dillard s merchandise inventory has steadied between 1.6 and 1.8 million over the last five years. In comparison with two industry competitors, this figure fits right in the middle. JC penny reported inventory at 3.4 million in 2006, and Saks, Inc. reported inventory around 800,000. Revenue is accounted for at the point of sale. Allowance for sales returns are recorded under nets sales in the period in which the sales are recorded. The firm s provision for sales returns varies upon prior evidence of its return rate. The allowance for sales returns during 2006, 2005, and 2004 was 7.7 million, 7.6 million, and 6.3 million respectively. Gift cards and other credit accounts are also 18

19 recognized during the time of sale, and the liability is decreased upon redemption. Any remaining balance of the liability is amortized over a 36 month period and recorded as a reduction of cost of sales. Property and Equipment is stated at cost and is depreciated using the straight line method of its estimated useful life. The buildings owned by the firm have an estimated useful life of 2040 years. Furniture, fixtures, and other equipment only utilize a useful life of 310 years. Depreciation for 2006 was estimated at 300 million which only differed slightly from 2005 s actual depreciation of 302 million. This minor differentiation between the estimated and actual cost of 2005 and 2006 shows that Dillard s tends to keep its depreciation in accordance with the previous year s actual depreciation cost. The related rental expense of 62 operating lease stores is recognized over the lease term under a straightline basis. The difference between the amounts charged to expense and the rent paid are recognized as deferred rent liability. Currently, a balance of 200 million remains in operating leases and 31 million remains is capital leases as of Cash flow from operations is a primary source of liquidity that is adversely affected when the industry faces market driven challenges and new existing competitors seek areas of growth to expand their business. If the firm does not sell sufficient quantities of merchandise, they respond by taking markdowns. If they have to reduce prices, the cost of goods sold on the income statement will equally rise, thus reducing income. Dillard s success is also dependent upon brand image and predicting customer s fashion preferences. Dillard s will need to identify suitable markets and locations to ensure success when opening new stores. Dillard s did raise the discount rate the company uses for determining future pension obligations. The rate increased to 5.6% in 2006 from 5.5% in The increase in amounts set back for pension funds is a conservative move by 19

20 Dillard s. Many firms in the industry have had problems when under estimating pension obligations. Dillard s is attempting to prevent any unexpected loss in revenues as a result of under estimating future pension expenses. Accounting Flexibility The FASB imposes certain accounting standards and policies in accordance with Generally Accepted Accounting Principles (GAAP). However, GAAP allows a broad view of flexibility for managers of a firm to report an accurate fair market value of estimations on several accounting policies. Dillard s has a great deal of flexibility when reporting its inventory. This is ideal for the industry because of the ever changing demand for department store merchandise. Dillard s success depends greatly on selling of retail merchandise. Retail sales are the key operating cash component providing 98.1% and 96.3% of total revenues over the past two years (Dillard s 10k). If sufficient quantities of inventory are not sold Dillard s uses markdowns. Retail markdowns increase Dillard s cost of goods sold, but it is necessary inorder to liquidate inventory. Since Dillard s competes on the basis of high quality, investing in high amounts of inventory reduces the rate of product failure. To account for this Dillard s uses a flexible accounting system for inventories. Using the LIFO inventory method for 98% of inventories allows Dillard s to value most of their inventory at the lower of cost or market. LCM allows managers the flexibility to adjust the inventory account to show loss on inventory. The remaining 2% of the inventory is valued by the RIM method. The RIM includes significant management judgments such as merchandise markups and markdowns, which significantly impact the ending inventory and the resulting gross margins. Decisions based on LIFO and RIM provides an inventory valuation that will not surprise the company if losses are incurred. This is a conservative 20

21 approach that allows managers to be prepared for changing revenues and is flexible enough to handle markups and markdowns. Actual Accounting Strategy Firms can manipulate their financial appearance using the flexibility of GAAP. They can influence performance data as well as change the firm s financial standing. Accounting strategies range from aggressive to conservative and are utilized by firms as they desire. Dillard s uses conservative approaches in their financial reporting. Dillard s management believes RIM values inventory at the lower of cost of market. However, the RIM approach does require management to make quite a few assumptions. Managers must correctly anticipate future markups and markdowns, which can greatly impact the ending inventory valuation as well as the resulting gross margins. Dillard s past accounting estimates can fluctuate but are usually caused by factors beyond the firm s control. Sales and operating results vary from quarter to quarter affected mainly by variations in timing and volume of sales. Changes in cost of availability of material and labor, as well as changes in shipping cost of supplies also contribute to Dillard s inconsistent estimates. In 2004 Dillard s sold its private label credit card business to GE finance for 1.1 billion. GE assumed 400 million of longterm securitization liabilities. The sale of Dillard s credit card debts reduced its account receivable by nearly 1.2 billion. However the transaction could have taken place to achieve certain accounting objectives. We believe that the selling of the credit card company was a major effort to reduce expenses, to increase net income for the year In 2002 Dillard s experienced a loss when it adopted Statement of Financial Accounting Standards No. 142, Goodwill and other Intangible Assts (Dillards 10K). Net 21

22 income hit a record low for the past five years. Below are some expense reductions that occurred as a result of selling the credit card company: SG&A Expense (53,700,000) Payroll (15,000,000) Advertising (17,600,000) Communications (10,000,000) Insurance (8,300,000) Net income was reported as million as opposed to 9.3 million in This increase could show that the selling of the credit card company was a decision by management to increase net income to take investor attention away from the past and excite them about the future. This is a more aggressive move that shows management is hoping for future growth. Their actions are an effort to demonstrate prosperity on the financial reports of the firm. Dillard s also capitalizes its operating leases to consider them as assets during the accounting period. By doing this Dillard s can represent a more promising outlook by failing to disclose some of the debt associated with operations. This technique is commonly used in the industry. Dillard s chooses to use the Last in First Out method as well as the RIM method to account for excessive inventories. Dillard s accounting strategy is necessary when competing on the basis of high quality. Dillard s has also been working toward increasing net income since The selling of Dillard s credit card company in 2004 could be a significant effort to decrease expenses to report increased net income. Dillard s uses a conservative strategy coupled with aggressive movements to help show the future prosperity that the company hopes for. 22

23 Quality of Disclosure Quality of Disclosure is an effort by the company to release information to investors that allows them to see for themselves the details of the company. Companies must be careful not to release information that could hurt the company if accessible to the public. The quality of disclosure is a measure of the accuracy of the financial statements to that of the actions of the company. The firm provides adequate disclosure in its letter to shareholders. The letter clearly lays out the firm s industry conditions, its competitive position, and plans for the future. The letter to the shareholders is intended to give shareholders insight as to the goals and upcoming actions of the company. The letter also explains financial documents with footnotes. The letter offers an easy understanding of the progress of the companies operations and finances. Dillard s is very forthcoming with their information on a qualitative and quantitative level concerning the particular Market risk that they are currently facing. The company is very clear that they are particularly responsive to the fact that their obligations have given them concerning current interest rate changes. Dillard s is also very open with the public stock holders concerning personal evaluations that the company s key staff member made dealing with the effectiveness of the company s disclosure controls and procedures consistent to the Securities Exchange Act. Dillard s state s that after all the evaluations have taken place, their disclosure controls and procedures are at an assuring level. We believe this to be true. As for overall quality, Dillard s policies and procedures are correct and productive. 23

24 Sales and Core Expense Manipulation Diagnostics YEAR SALES/AR SALES/INV SALES/TA CFFO/OI The only standout change in the sales diagnostics appears in net sales over accounts receivables. Net Sales over accounts receivables experienced quite a jump in This is due to Dillard s selling their credit card company. The ratio shows a huge decrease into accounts receivable. This boosted the firm s financial position by collecting on accounts receivable immediately. The company s net income has been consistently higher since the sale of the credit card company. Potential Red Flags When working on financial valuation of a company, a certain amount of time and energy must be spent looking for any suspicious accounting principles. When searching for potential red flags, we researched Dillard s 10K statements over the last four years. During the research, we paid particular attention to their income statements, balance sheets, and cash flow statements. Dillard s shows sound financial statements with no unusual increases or decreases in any of their inventory, cash equivalents, or tax income. A look into the quarterly reports from past Dillard s 10Q show that fourth quarter earnings are continually larger than the other three quarters in the year. This increase in sales and earnings can be attributed to the holiday season. One area we did decide to look into a little further was the company s Accounts Receivables. Looking back to the Accounts Receivable in 2003 shows you that 24

25 Dillard s had a balance of 1.3 billion dollars. This seemed strange when looking at the current 10K because it shows Accounts Receivables with a balance of 12.5 million. This was all a result of Dillard s selling their credit cards to GE Consumer Finance. GE acquired our proprietary credit card business, which previously owned and securitized the accounts receivable generated by the proprietary credit card accounts. The sale of the Company s credit card business significantly strengthened its liquidity and financial position. The Company had cash on hand of 300 million as of January 28, 2006 and reduced outstanding debt and capital leases by million during fiscal After identifying this information, there were no more potential red flags discovered. Undo Accounting Distortions After evaluating Dillard s accounting practices, no major adjustments took place. As far as we can tell, Dillard s is not trying to hide or manipulate any numbers to deceive their shareholders and potential lenders. They do an adequate job describing what they are doing and why. The red flag mentioned previously is slightly suspicious, but Dillard s contributes the discrepancy to the sale of their credit card program. Not only did the numbers match, but they explained why there were a few minor increases and decreases. Dillard s discloses all of their information in many of their reports, proving they have laid everything out for investors to see. They provide the investors with footnotes, and memos that clearly explain why events occurred the way they did. We see no need for Dillard s to adjust any of their accounting information. Financial Ratios Introduction For the next part of our evaluation of Dillard s Inc, we are going to assess the company s performance by calculating several financial ratios. In order to make a proper assessment, we will perform a ratio analysis for the past 5 years. By calculating the ratios with information we get from the financial statements, we can evaluate our company s performance individually. We also can determine 25

26 where Dillard s ranks in the department store industry by evaluating their competitors and the industry as a whole. By looking at these ratios, we can get an indepth look at Dillard s past and present performance, and then take that information and utilize it to make the logical forecasts for the next ten years. In order to give investors an insight into the company, we must paint a clear picture of the company through the successive analysis. Ratio Analysis In order to properly evaluate the financial condition of a company, financial statements must be analyzed and interpreted. Financial statement analysis provides information that is necessary to evaluate the financial dimensions of management performance, detect emerging trends, and to help explain relationships contained in the basic financial statements (Dr. Moore s Notes.) Our analysis of Dillard s and its competitors will focus on the three major areas: liquidity, profitability, and capital structure. We will be conducting our analysis by using 16 ratios that fall under the three major areas of liquidity, profitability, and capital structure. By using these ratios we will be able to create an industry comparison for Dillard s and its competitors. We will compute our ratios for up to five years in order to provide for a fair level of comparison. Trend (Time Series) Analysis/Cross Sectional Analysis Liquidity The first category of ratios we will be using deal with liquidity. Liquidity refers to a firm s ability to generate cash flow and to pay back their short term financial obligations in a timely fashion. The first ratio we will be discussing is the current ratio. The current ratio is found by dividing current assets by current liabilities. Both of these are found on the company s balance sheet. 26

27 Current Ratio=Current Assets/Current Liabilities Dillards Federated Saks Industry Average Above are the current ratio calculations of Dillard s, Federated, and Saks. We also calculated the industry average, excluding Dillard s. The current ratio is a valuable calculation because it states that for each dollar of liabilities a company has, they must have current assets to match it. Current assets consist of cash, cash equivalents, accounts receivable, inventory, marketable securities, and prepaid expenses. The higher the current ratio, the more liquid a firm is. This cross sectional graph above shows the industry average and it compares it to Dillard s, Federated, and Saks. The industry average from stays right around two. Dillard s in the first two years of our calculations had a current ratio above three. This is well above the industry average and could mean that Dillard s is not efficiently utilizing their current assets. We can contribute the drop in the ratio in the last three years because of the sale of their credit card corporation in 2004, which significantly declined their accounts receivables. From 2003 to 2006 Dillard s current assets declined each year, while their current liabilities remained about the same. This is another reason why Dillard s current ratio started to decline in the last three years of our calculation. In the last three years Dillard s is much closer to the industry average, each year it is about two tenths of a percentage point higher. For example, in 2005 Dillard s had a current 27

28 ratio of 2.19, while the industry average was In all five years Dillard s current ratio is above the industry average. In the first two years, we would say that Dillard s had an excess of assets that could have been utilized more efficiently elsewhere. But, from 0406 they are above the industry average and have better liquidity than Federated, and are about equal to Saks. The next ratio we will discuss is the quick asset ratio. This is calculated by dividing the firm s quick assets by current liabilities. Quick assets consist of cash, securities, and accounts receivable. Quick Asset Ratio=Quick Assets/Current Liabilities Dillards Federated Saks Industry Average Up until the most recent year, Dillard s quick asset ratio stayed above the industry average. Once again the ratio in the first couple of years in our calculation is well above the industry average. Then in the last couple of years it declined heavily and is right around the average. As we discussed earlier, this happened because of their heavy drop in their accounts receivable resulting from the sale of their credit card corporation in Saks quick asset ratio stays consistent from Based on our calculation, Federated s ratio is very inconsistent. From it increased heavily, then after 2004 it started to 28

29 decline heavily. All three companies experienced unfavorable changes in the last two years. The Inventory Turnover ratio is found by dividing cost of goods sold by inventory. The ratio determines how many times the firms inventory is sold and replaced over a period of time. The Days Supply of Inventory is found by dividing 365 by the inventory turnover. This ratio tells you the number of days inventory stays with the company before it is sold. Inventory Turnover=Cogs/Inventory Dillards Federated Saks Industry Average

30 Days Supply of Inventory=365/Inventory Turnover Dillards Federated Saks Industry Average Dillard s inventory turnover exceeds the industry average each year. It also exceeds both of its competitors each year until 2006, when Saks has a higher turnover. A strong inventory turnover creates a good day s supply of inventory. Dillard s inventory average for five years is The turnover decreased each year, which translates into a negative impact for the company. Each year Dillard s inventory stayed with the company longer than the previous year. As you can see in the Days Supply of Inventory graph, it increased from around 103 days in 2002 to 131 days in This is consistent with its competitors and the industry average. Dillard s maintains a competitive advantage over the industry each year by about an average of 15 to 16 days. Although Dillard s inventory turnover is experiencing a negative impact from 2002 to 2006, so are its competitors. We conclude from these calculations that Dillard s, along with the industry s, cost of goods sold is remaining constant, but the inventory is increasing each year. Although sales have remained constant, this could be a result of more merchandise being produced each year, but fewer sales associated with the increased inventory. 30

31 The accounts receivable turnover is calculated by dividing sales by accounts receivable. The accounts receivable turnover tells you how long it takes a company to turn its receivables into cash. We encountered some problems in computing the receivables turnover. First, when Dillard s sold their credit card company in 2004, it left the company with a small amount of receivables in 2005 and This is the reason our receivables turnover in the last two years of our calculations is so high. Saks did not disclose any financial information on its accounts receivables; therefore we cannot make any calculations involving accounts receivable with that company. Therefore we cannot have an industry average for these two calculations. The industry average is simply the ratios of Federated. Accounts Receivable Turnover=sales/accounts receivable Dillard s Federated Saks n/a Days Sales Outstanding=365/A/R Turnover Dillard s Federated Saks n/a From 2002 to 2004 Dillard s experienced an unfavorable change in its accounts receivable turnover. It went from 7.59 to 6.38, thus increasing their day s sales outstanding by about 9 days. Federated also experienced an unfavorable change in that same time period. Their turnover went from 6.58 to 4.75, which increased their day s sales outstanding by about 11 days. Both of these companies experienced negative impacts because of a decrease in sales in this time period. The day s sales outstanding for Dillard s in the last two years are misrepresented because of the unusually high account receivables turnovers. This significantly 31

32 low number in day s sales outstanding is attributed to the huge decline in accounts receivable from 2004 to Working Capital Turnover=Sales/Working Capital Dillards Federated Saks Industry Average The working capital turnover is a useful measure in determining how a company is using its working capital to generate sales. For example, in 2002 Dillard s has a working capital turnover of This states that for each dollar in working capital there are a 4.32 sales as a result. Working capital is found by subtracting current liabilities from current assets. Dillard s has experienced a favorable impact since 2002 in its working capital turnover. In order, for this to take place, one of three things must happen. Current assets have to decrease, current liabilities have to increase, or more sales must be generated. Dillard s sales and current liabilities have remained fairly constant from 2002 to Dillard s current liabilities have decreased throughout the five year time span and this is the reason its working capital turnover is increasing. Once again this is a result of the sale of its credit card corporation which heavily decreased the company s accounts receivable. In computing current assets, accounts receivable is one of its inputs. 32