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An Equity Valuation and Analysis of Havertys Furniture Companies, Inc.

Casey Noble casey.noble@ttu.edu

Joel Dunn joel.dunn@ttu.edu

Kimberly Edge kimberly.edge@ttu.edu

Lauren Heine Lauren.heine@ttu.edu

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Table of Contents Executive Summary………………………………………………………………………………3

Business & Industry Analysis…………………………………………………………………8

Company Overview…………………………………………………………………….8

Industry Overview………………………………………………………………………9

Five Forces Model…………………………………………………………………………………11

Rivalry Among Existing Firms……………………………………………………….12

Threat of New Entrants……………………………………………………………….17

Threat of Substitute Products………………………………………………………23

Bargaining Input and Output Markets…………………………………………..25

Bargaining Power of Customers………………………………………….25

Bargaining Power of Suppliers……………………………………………29

Value Chain Analysis…………………………………………………………………………….33

Firm Competitive Analysis……………………………………………………………………..38

Accounting Analysis………………………………………………………………………………43

Key Accounting Policies……………………………………………………………….43

Accounting Flexibility………………………………………………………………….49

Actual Accounting Policy……………………………………………………………..51

Quality of Disclosure…………………………………………………………………..54

Quantitative Analysis of Disclosure……………………………………………….55

Sales Manipulation Diagnostic……………………………………………56

Expense Manipulation Diagnostic……………………………………….61

Potential Red Flags……………………………………………………………………..68

Undo Accounting Distortions……………………………………………………….70

Financial Analysis, Financial Forecasts, and Cost of Capital Estimation………71

Financial Ratio Analysis……………………………………………………………….71

Liquidity Analysis………………………………………………………………………..71

Profitability Analysis……………………………………………………………………78

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Capital Structure Analysis…………………………………………………………….86

Growth Rate Analysis…………………………………………………………………..92

Internal Growth Rate…………………………………………………………92

Sustainable Growth Rate……………………………………………………93

Financial Statement Forecasting…………………………………………………..94

Cost of Capital Estimation……………………………………………………………98

Cost of Equity…………………………………………………………………..98

Cost of Debt……………………………………………………………………..99

Weighted Average Cost of Capital………………………………………100

Equity Valuations………………………………………………………………………………….101

Methods of Comparable………………………………………………………………101

Intrinsic Values…………………………………………………………………………………….106

Discount Dividend Model……………………………………………………………..107

Free Cash Flow Model…………………………………………………………………109

Residual Income Model……………………………………………………………….110

Long Run Return on Equity Residual Income Model……………………….113

Abnormal Earnings Growth Model………………………………………………..115

Analyst Recommendation……………………………………………………………………..118

Appendix…………………………………………………………………………………………….120

Reference Page……………………………………………………………………………………157

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Executive Summary

HVT: NYSE (4/01/2008) $11.00 Altman's Z-score

52 week range $7.21 - $13.53 2002 2003 2004 2005 2006

Revenue $787.06 M 3.84 3.7 3.72 3.84 3.96 Market Capitalization $202.2 M Shares Outstanding $22.328M Valuation Estimates Book Value Per Share 13.003 Actual Price (4/01/2008)- $11 Institutional Ownership (%) 114.90% Financial Based Valuations

ROE 0.60% Trailing P/E: $1.13

ROE (restated) -13.71% Forward P/E:

$17.02

ROA 0.37% P.E.G:

$10.98

ROA (restated) -7.36% P/B:

$34.43

P/EBITDA:

$2.23 Back Door Cost of Capital Method P/FCF:

$25.59

Cost of Equity 11.38% EV/EBITDA:

$144.60

Cost of Debt 4.74% Dividend Yield:

$12.36 Weighted Average Cost of Capital 8.62% Intrinsic Valuations:

Published Beta -0.74% Discounted Dividends:

$3.39

Free Cash Flow:

$26.84

Residual income:

$5.28

Abnormal earnings growth:

$4.07

LR ROE:

$2.74

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Industry Analysis

Havertys Furniture Companies Inc. (HTV) is one of the top home furnishing

retailers in the nation. Today, there are over 120 stores throughout 17 states and they

sustain continued success. Havertys sells residential furniture, accessories, and bedding

and maintains a wide selection of products and breadth of styles in the middle to upper-

middle price ranges. In 2005, Havertys introduced a Havertys brand furniture line by

outsourcing many foreign and exotic materials. Now, nearly all the merchandise offered

is Havertys brand product. Havertys initial direct competitors included Ethan Allen, Pier

One, Bed Bath and Beyond, and William-Sonoma. The home furnishing industry is

highly fragmented. The 25 largest furniture store retailers only account for 22% of the

industry’s sales and 50 of the largest companies only account for around 30% of the

market (First Research). Due to this vast segmentation we had to reevaluate our

competitors. Stores like Dillards and Bed Bath and Beyond sell more than just furniture.

When comparing these types of firms to Havertys we found that we often

underperformed. However, when compared to firms that just sold furniture like Ethan

Allen and PierOne Imports we were more on par with the industry average. Because the

industry is far from homogeneous, it is a mixed industry, competing on both cost

leadership and differentiation strategies. Havertys competitive advantages include

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brand image, customer service, and distribution which lends itself to competing mostly

on a differentiation strategy. The home furnishings industry has high industry

competition, high rivalry among existing firms, high threat of new entrants, and a

moderate threat of substitutes. The industry also has high bargaining power of both

customers and suppliers. As mentioned before, the home furnishing industry’s key

success factors are cost leadership and differentiation. Slight differences in competition

strategies can positively or negatively affect the success of a firm. The goal of each firm

is to increase product differentiation while keeping costs at a minimum. In doing this, a

firm is able to grab a larger share of the home furnishings industry.

Accounting Analysis

Analysis of accounting policies and procedures is done to establish the flexibility

of accounting policies, to establish and critique key accounting policies, and to scrutinize

the level of disclosure. This process is aimed at pinpointing the any possible distortions

caused by accounting procedures, as well as assess the quality of disclosure of the

government required annual disclosure. The source used in this process is the 10-k.

Specifically, the balance sheet, income statement, statement of cash flows, and finally,

any footnotes having to do with accounting policy. In the end key accounting policies

should be aligned with the firm’s key success factors in order to create value. The

flexible accounting policies for Havertys, as with most firms in the home furnishings

industry, revolve primarily around operating leases. The showrooms these firms need

are very large and often firms in this industry use operating leases. However, Havertys

operating leases are significant enough that their financials should be restated to

capitalize their operating leases. This discrepancy, when adjusted, can impact their

financial statements greatly. After our restatements you can see vast changes in:

assets, liabilities, stockholder’s equity, retained earnings and net income. By capitalizing

these leases an investor will get a better picture of the firm. Another major flexibility for

firms in the industry is post retirement benefit plans. Because the firm chooses the

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discount rate to use when estimating the plans, potential error loom in the distance.

Just one percent off on a discount rate can cost the firm upwards of $1.5 million,

severely impairing a firm’s ability to pay its plan expense (Haverty’s 10-k). Another

accounting flexibility is the firm’s ability to choose a defined benefit or a defined

contribution retirement plan to its employees. A defined benefit plan can cripple a firm

if the proper discount rate is not used when calculating returns. The degree to which

Havertys discloses information on decisions it makes to come up with its calculations is

high. They do a good job describing how they calculate their number so the investor

can understand how the company makes money. The footnotes and the appendices

give ample amounts of information on how they came up with their numbers. Havertys

is a transparent company, which is beneficial with flexibility in their leases and

retirement plans.

Financial Analysis, Forecast Financials, and Cost of Capital

The financial analysis consists of financial ratios used to evaluate the liquidity,

profitability, and capital structure of a company. Investors and Analysts use these ratios

to help compare a firm to its competitors and help in forecasting the firm’s financial

statements. Ratios are the key tools used when evaluating a firm’s profitability and

growth to find its value. Liquidity ratios measure the firm’s liquid assets used to help

pay-off the firms current liabilities. The liquidity ratios are composed of the current

ratio, the quick asset ratio, the inventory ratio, the days inventory ratio, and the

working capital turnover. Havertys seems to maintain a healthy liquidity with a few

problems in operating efficiency, but its moving in the right direction. There are six

profitability ratios: gross profit margin, operating income margin net profit margin,

asset turnover, return on equity, and return on assets. We used these ratios to

determine that Havertys will struggle to have positive growth rates and profitability. The

capital structure ratios consist of; debt to equity ratio, times interest earned, and debt

service margin. These ratios show how firms raise funds for capital expenditures.

Accurately forecasting a firm’s financial statements is important because it will enable

you to get a glimpse of what the structure of that firm may look like in the future. Most

forecasts are done by using industry averages or ratios derived from a firm’s past

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financial statements. A few forecasted ratios that we derived are; CFFO/net Sales ratio

of 5.98%, current ratio of 1.71, asset turnover rate of 1.78 (steady in 2010). To

estimate the cost of capital we first computed the cost of equity (11.38%). There are

two different method used to compute the cost of equity- the Regression Analysis and

the Back Door Method. We initially tried to estimate it by running regressions, but this

proved to give us inadequate information for calculating the cost of equity. We then

turned to the Back Door Method, which proved to be sufficient. Next, we calculated the

weighted average cost of debt (4.47%). To achieve this, we multiplied the short term

and long term debt of the company by appropriate interest rates. Once we had both the

cost of equity and the cost of debt, we could compute the Weighted Average Cost of

Capital (8.62%) by plugging these two factors into the WACC formula.

Valuation

After the industry analysis, accounting policies, and financial ratios are examined,

an analyst can determine a firm’s share price through equity valuations. Using the

method of comparables and various intrinsic models of valuations an analyst can

conclude if a firm share price is fairly valued, undervalued, or overvalued. The first

valuation model used to formulate a share price for Havertys was the method of

comparables. The Method of Comparables utilizes ratios that are then compared to

ratios of firms throughout the industry. Using comparable ratios is an easy way to place

a firm within an industry, but it lacks explanatory power and intellectual value is difficult

to add. However, these ratios did not reveal whether or not Havertys is fairly valued or

not. Only the PEG and dividend Yield models suggest that Havertys is fairly valued,

while Price to Book, Enterprise Value to EBITDA, Forward P/E, and the Price to Free

Cash Flow show Havertys to be undervalued. Still, Trailing price to Earnings and Price to

EBITDA show Havertys to be overvalued. In order to get a more accurate valuation we

needed to calculate a second set of valuation models. The second set of valuation

models we used were the intrinsic valuation models. These models include the Dividend

Discount Model, Free Cash Flow Model, Residual Income Model, Long Run Residual

Income Model, and the Abnormal Earnings Growth Model. These models range in

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degrees of reliability based on the sensitivity they have to errors in growth rates,

WACCBT, and cost of equity. The free cash flow model and the dividend discount model

are especially sensitive and should not always be relied upon. However, the residual

income model, the long run residual income model, and the abnormal earnings growth

model are used by most analysts because of their liability. They are less sensitive to

errors in the estimated growth rates and cost of equity. In order to run these models

we assumed a cost of capital of 11.28%, a WACCBT of 8.62%, and a cost of debt of

4.47%. Using these rates we were able to determine that the price per share for

Havertys is overvalued. The Free Cash Flow Model was the only intrinsic model to show

that Havertys stock price was undervalued. However, as we mentioned before this

model is not very reliable and sensitive to error. For this reason we based our decision

off of the other four models to conclude that Havertys is overvalued.

Business and Industry Analysis

Company Overview

Havertys Furniture Companies Inc. (HTV) is one of the top home furnishing

retailers in the nation. Over 120 years ago, J.J.Haverty founded Haverty Furniture

Collection in downtown Atlanta, Georgia. A few years later the firm spread throughout

the South and Midwest and in 1929 they became publicly traded. Today there are over

120 stores throughout 17 states and they sustain continued success. Havertys also

provides its customers a, “revolving charge credit plan with credit limits determined

through our on-line credit approval system and an additional credit program outsourced

to a third party finance company” (Havertys 10K). Havertys headquarters remains in

Atlanta, Georgia.

Havertys sells residential furniture, accessories, and bedding and maintains a

wide selection of products and breadth of styles in the middle to upper-middle price

ranges. With the introduction of the Havertys Collections in 2005, nearly all the

merchandise offered is Havertys brand product. The graph below shows the breakdown

of revenue generated from the different products sold in 2006.

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Industry Overview

The home furnishing industry is highly fragmented. The 25 largest furniture store

retailers only account for 22% of the industry’s sales and 50 of the largest companies

only account for around 30% of the market (First Research). Several of the larger home

furnishing retailers include Havertys, Ethan Allen, and Pier One, with most of them

grossing less than $1 million in a year.

In the beginning of this valuation project we included Dillards, Bed, Bath &

Beyond, Williams-Sonoma, PierOne Imports, and Ethan Allen as competitors in our

industry. However, throughout our evaluation of Havertys we concluded that not all of

the companies are actually direct competitors of Havertys. Stores like Dillards and Bed

Bath and Beyond sell more than just furniture. When comparing these types of firms to

Havertys we found that we often underperformed. However, when compared to firms

that just sold furniture like Ethan Allen and PierOne Imports we were more on par with

the industry average.

Many retailers within this industry operate similarly. Like Havertys, the typical

furniture store includes living room, bedroom, kitchen and office furniture, with a

possible mattress and children’s section. The industry considers these “case goods.”

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“Most store operations include sales management, merchandising, inventory

management, and credit financing” (First Research).

Most profit within the home furnishing industry comes from merchandising and

marketing. Many firms rely on discounts, special offers, and sales to boost revenue

since furniture is not a necessary good, but a specialty good. This also causes home

furnishings sales to be highly sensitive to economic changes. Home furnishing sales are

known to be strongly associated with sales in the housing market. Their has recently

been a weakness in the housing industry, which in turn is putting a noticeable strain on

home furnishing retailers, causing many to go bankrupt. Kathy Shwiff of the Wall Street

Journal writes explaining the recent fall in house prices. “These are tough times for U.S.

homeowners... The decline was the largest since April 1991; prices have dipped for 23

consecutive months” (Home Prices Fall. Homeowners in a bind).

One way in which home furnishing retailers are combating this problem is

through purchasing cheaper imported goods, which has caused a major influx of these

imports into the market. Also, many retailers are turning to in-store brands and internet

retailing, which allow them to “price-down” their merchandise and increase growth. The

adoption of two competitive advantage strategies; cost leadership and differentiation,

are also allowing firms to keep afloat during this economic downturn.

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Five Forces Model The Five Forces model is an implement that forms an industry and investigates

its profitability. These competitive forces help illustrate the industry’s strengths and

weaknesses. The forces can be classified into two categories: the degree of actual and

potential competition, and the bargaining power in input and output markets. The first

category includes the rivalry among existing firms, the threat of new entrants, and the

threat of substitutes. The second category consists of the bargaining power of

customers and the bargaining power of suppliers. The purpose of this section is to

depict the furniture industry’s structure and profitability.

Havertys Furniture Companies, Inc. Home Furnishing Industry

Industry Competition HIGH

Rivalry Among Existing Firms HIGH

Threat of New Entrance HIGH

Threat of Substitute Products MODERATE

Bargaining Power of Customers HIGH

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Rivalry among Existing Firms

It is extremely important to evaluate the rivalry among existing firms when

investigating an industry’s profitability. The furniture industry is a highly competitive

and sensitive market. Rivalry among existing firms has many factors affecting it, such

as industry growth, level of concentration, differentiation, economies of scale, fixed and

variable costs, excess capacity, and exit barriers.

Industry Growth:

The first step to measuring the rivalry among existing firms is to determine the

industry’s growth rate. The furniture industry currently includes nearly 20,000

companies. Due to the fact that this industry relies heavily on economic conditions, the

furniture industry has a slow growth rate. The growth rate has been unstable

throughout the last five years (as indicated in the graph below). When the growth rate

is unstable or slow, it is more difficult for a company to obtain the limited market share.

The low level of growth rate highly increases the amount of competition in existing

firms. Some firms have been forced to turn to bankruptcy from the unstable economic

conditions.

Bargaining Power of Suppliers HIGH

Competitive Advantage BRAND, IMAGE, CUSTOMER SERVICE, & DISTRIBUTION

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*Information from First Research

As Shown in the graph above, the highest peak of furniture sales was in 2004

and lowest in 2003. The graph includes all members of the furniture industry; including

stores such as Havertys, JC Pennys, Dillards, Crate & Barrel, Sears, Ethan Allen, Wal-

Mart, and private “mom and pop” stores. Household furniture sales are closely linked to

home sales, and office furniture sales are closely linked to the employment rate and the

development of new businesses. The industry forecast for the next five years is

expected to grow at an annual compounded rate of five percent (firstresearch.com).

Furniture Store Net Sales

2002 2003 2004 2005 2006

Havertys 703,959 744,635 784,162 827,658 859,101

Bed Bath &

Beyond

2,927,962 3,665,164 4,477,981 5,147,678 5,809,562

Pier One 1,548,556 1,754,867 1,868,243 1,897,853 1,776,701

Ethan Allen 907,264 955,107 949,012 1,066,390 1,005,312

Measured in Thousands ($)

* Information provided Company’s 10-K

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The chart above shows the publicly traded stores that are strictly related to

furniture. By comparing the two charts above to each other, you’ll see how the net

sales of the stores that are strictly related to furniture compare to the growth rate of

the entire industry. The chart below compares the sales growth between Ethan Allen

and Havertys. Ethan Allen is Havertys most direct competitor.

Sales Growth (%)

2002 2003 2004 2005 2006

Havertys 3.80% 5.78% 5.31% 5.55% 3.80%

Ethan Allen 0.35% 5.27% -0.64% 12.37% -5.73%

Concentration:

Since the furniture industry has numerous firms and is price aggressive, it is a

low concentrated industry. A low concentrated industry increases the level of

competition between the existing firms. There are a total 20,000 firms in the United

States furniture retailing industry. The 50 largest companies hold only 30 percent of

market share, making it a highly fragmented industry (firstresearch.com). The large

majority of companies operate a single store. The most commonly known large

companies include Bed Bath & Beyond, Pier 1 Imports, Ethan Allen, and Havertys.

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*Information provided by Company’s 10-K

The chart above provides three of the top fifty firm’s market share over the past

five years. Pier One consists most of the market, while Havertys consumes the least

amount the market share. The market share is derived for each of the company’s net

sales.

Differentiation:

There is no brand loyalty in the furniture industry, so firm’s have to differentiate

themselves from other’s to make profit and decrease the competiveness. Firms can

achieve this by having a specialty store, specialty products, high or low prices, or

certain styles or trends that attract consumers. Chains, such as Ikea, Dillard’s and Crate

& Barrel, have grown as companies because they emphasized on style rather than

price. Nearly 10 percent of the firms have license agreements to use famous names

(firstresearch.com). Firms often use these licenses or specialty products to gain profits.

House plans over the next few years are expected to include more multi-purpose

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rooms, such as media rooms and exercise rooms. To decrease competiveness, firms are

deciding to specialize in a particular type of furniture. Pottery Barn has opened a

Pottery Barn Kids. This is a specialty store that obtains only to children’s needs. There

are not as many Furniture stores directly for children, so by doing this they have

differentiated themselves from other furniture stores.

Switching Costs:

Switching costs are known as the “negative costs that a consumer incurs as a

result of changing suppliers, brands or products” (investopedia.com). Switching costs

are mainly due to monetary reasons, but also can be based upon psychological and

time issues. Customers are willing to take their business to different companies, making

the furniture industry have low switching costs.

Economies of Scale:

Economies of scale is the increase in the size of a firm, which in turn decreases

the average cost of each unit of production. There are two different types of economies

of scale: external and internal. External economies of scale is when the cost per unit

depends on the industry as a whole. Internal economies of scale is when the cost per

unit depends on the firm as an individual (ivestopedia.com). An industry with high

economies of scale is highly competitive. In many industries, the size of the firm

establishes its success and profitability. In the furniture retailing industry, only 30

percent of the market share belongs to the top 50 firms, leaving 70 percent to the

smaller companies. This makes it to where smaller companies can co-exist and compete

with large firms. The furniture industry has high economies of scale and is exceedingly

competitive.

Fixed-Variable Costs:

Variable costs and fixed costs can impact the level of competition in an industry.

The furniture industry has high fixed costs. The cost of selling furniture is high itself.

Firms can experience different degrees of variable costs. The type of variable costs you

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will find in this industry is things involved with the inventory, such as cost of goods sold

and gross profit. The fixed costs that you will find involved in this industry are the

operating leases and inventory. The inventory remained a consistent average 24% for

Havertys throughout 2002 to 2006. Due to the fact that most furniture stores own

distribution centers, the fixed costs increase in this industry.

Excess Capacity:

Excess capacity occurs when consumer demand is less than the supply. When

this happens, firms are recommended to cut their product prices to fill capacity. Due to

the low real estate demand, there is an excess capacity in the furniture industry. The

large quantity of stores and small demand of furniture products is also a causing factor.

This increases the level of competition in the furniture industry among all the

companies.

Sales Growth (%)

2002 2003 2004 2005 2006

Havertys 3.80% 5.78% 5.31% 5.55% 3.80%

Ethan Allen 0.35% 5.27% -0.64% 12.37% -5.73%

Pier One Imports 9.71% 13.32% 6.46% 1.58% -6.34%

Bed Bath & Beyond 22.17% 25.18% 22.19% 14.96% 12.86%

*Information provided by Company’s 10-K

The chart above shows the growth rate of the firm’s net sales. If a firm’s sales

are declining, it means that the demand is less than the supply, which creates excess

capacity. In 2005, the net sales begin to decline and continue in 2006. In cases like

this, the firms are recommended to have a sale to increase their net sales. Due to the

lack of demand, the furniture industry has high excess capacity.

Exit Barriers:

Exit barriers make it difficult to exit an industry and make it risky to enter. This

happens when companies have high cost or specialized assets that make it difficult to

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leave. The furniture retailing industry does not face high exit barriers, although it is

much easier for a smaller firm to leave the industry than it is for a large firm to leave.

In September 2007, the Texas-based home furnishing chain Bombay Co, filed for

Chapter 11 bankruptcy protection (firstresearch.com). Many other small Furniture stores

have been forced to follow this trend due to the downward consistency in the Real

Estate market. Due to the fact that so many companies are going bankrupt, this shows

that the furniture industry has low exit barriers.

Conclusion:

In the furniture industry, there is a high rate of rivalry among existing firms. The

industry is extremely competitive and sensitive. The existing firms are experiencing slow

growth rate, low concentration, difficulty differentiating their products, decreases in

demand, high economies of scale, and high fixed costs.

Threat of New Entrants

The threat of new entrants is degree of harm potential firms can cause by

entering an industry. It is exceptionally high when an industry illustrates a history of

substantial profits. Firms will scramble to penetrate a high profit industry in hopes of

gaining a portion of those profits and market share. However, there are a few things

firms must consider before deciding to enter an industry. In order to gain market share,

new entrants will have to overcome many barriers of entry including: Economies of

Scale, First Mover Advantage, Access to Channels of Distribution, Relationships and

Legal Barriers. Fortunately, for those interested in the 85.3 billion dollar home

furnishings industry, there are very few barriers to entry. Although this means a

possible easy entrance for potential firms, it also results in existing firms having a high

risk of diminishing revenues and profits.

Economies of Scale

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Economies of scale involve the increase in the size of a firm which in turn

decreases the average cost of each unit of production. In an industry with large

economies of scale and high competition, potential firms may not have what it takes to

compete. The furniture industry has both high economies of scale, intensely

competitive, and vastly segmented. Many firms are included under the home

furnishings industry including: Dillard’s, Ethan Allen, Havertys, CostCo and Pier One

Imports. However, not all of these firms sell just furniture causing major differences in

the amount of total assets each firm holds. However, being this segmented does break

down a barrier to entry for potential firms especially because major players in the

industry only hold a total 30% of the market share. That leaves 70% to smaller

economies of scale firms that new entrants can take advantage of.

=

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The above graphs illustrate the range of total assets over the past five years of

top companies in the highly segmented furniture company. The first graph shows the

total assets of department stores, wholesale clubs and large retail chains. The second

shows total assets of retailers who only sell furniture. These graphs show that

companies with assets in the billions can coexist and successfully compete with firms

who have much smaller amounts of assets. When potential new entrants evaluate

economies of scale they would not find it difficult to compete due to the vast range of

total assets shown by existing competitors. Although the may not be able to compete

with department stores and large chains who have assets in the billions, they could

successfully take on smaller chains and local retailers.

First Mover Advantage

First mover advantage is the “advantage gained by the initial occupant of a

market segment” (about.com). The first firm to enter an industry can gain control of

resources that followers may not be able to match. This can include the ability to set

industry standards and establish exclusive selling agreements with suppliers. This could

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not only lead to extreme brand loyalty with suppliers but with consumers as well. In the

past, being a first mover would not have given you a tremendous advantage in the

home furnishings industry. Consumers did not show extreme loyalty to one store or

another because not one furniture store had everything they needed. It would not be

unusual for consumers to visit multiple stores in search of the cheapest prices and the

exact style they are looking for. However, stores like Furniture Row are now gaining

notice from consumers for consolidating all types of furnishing in to one giant mega

store. Furniture Row understands that consumers don’t have time to shop for

furnishings piece by piece so they have combined specialty home furnishings, mattress

and linens all under one roof (FurnitureRow.com). Not only is this one-stop shopping for

consumers but companies like Furniture Row have tremendous buying power which

allows them to offer products at a cheaper rate. These first mover firms have the

potential to take a large portion of the market share and establish brand loyalty with

suppliers and consumers.

Channels of Distribution

Historically the high cost of developing a new channel of distribution would be a

challenge that potential entrants to the industry would have to face. However, with the

furniture industry experiencing major changes it is not impossible for potential firms to

compete. The furniture industry is showing an increased trend of shifting to the internet

to distribute their product. “Internet sales, although a still a small fraction of total sales,

are increasing rapidly because prices are discounted by 30 to 40 percent”

(firstresearch.com). These discounts are due to the elimination of showrooms and sales

staff. Acquiring stores in high traffic areas, advertising, and paying employees

commission create high operating costs for firms. The graph below shows the average

salary a firms pays to employees per hour.

Average Hourly Earnings & Annual Wage Increase

Bureau of Labor Statistics

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*Provided by FirstResearch.com

Although slowly increasing employee wages is a huge operating cost firms must

face. Employees must be trained and very knowledgeable hence their almost $15.00 an

hour wage. Internet companies on the other hand, can get away with paying

employees minimum wage because consumers only contact them in the case of a

problem with an order. The high cost of a physical showroom is also eliminated in favor

of a virtual showroom for employees to browse. Overall, this new channel of distribution

opens the door for new entrants to easily gain market share.

Another factor for potential new entrants to consider is the location of their

distribution channels. Furniture companies usually offer same day or next day delivery

service. It is really important to have strategically placed distribution centers so firms

can keep costs low. Haverty’s for example just recently reconfigured their distribution

channel to a combination of three distribution centers, three home delivery centers and

approximately 14 local market cross-docks (Havertys 10k). This has significantly

decreased the cost and time involved in home deliveries of furniture. It has allowed for

lower inventory levels, less warehouse space, fewer workers, and the ability to enter

new markets without adding local market warehouses (Havertys 10K). Potential new

entrants would need to have well placed distribution centers so they can not only

significantly cut costs but compete with other firms who can ship their merchandise

quickly.

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Relationships

New entrants to the home furnishing industry will not find it to difficult to create

relationships that will help them gain market share. It is undeniable that many

companies like Havertys with over 100 years of experience have an overwhelming

advantage. Over time they have been able to establish strong relationships with

manufacturers and create customer loyalty. In the past these relationships allowed

firms immense buying power and the ability to lower prices. However, with the industry

moving in to newly chartered waters such as importing goods and internet sales,

existing and potential firms will both have to create new relationships with

manufacturers.

Legal Barriers

Potential new firms must also consider the legal barriers of an industry before

trying to enter. Fortunately for firms looking to enter the home furnishings industry it is

thus far unregulated. Although, for companies who offer credit financing standard state

and federal regulations against deceptive sales practices and laws that regulate the use

of credit financing can be an issue (Firstresearch.com). Also with the industry importing

more and more goods there is a possibility of import policy having a bigger impact on

retailers in the future.

Conclusion

The threat of new entrants in to the home furnishings industry is very high

because there are very few barriers to entry. In this industry large firms can coexist

with smaller ones due to the fact that companies can be profitable without a large

amount of assets and a significant initial investment. There is also potential for new

firms to enter without worrying about not having established relationships with

suppliers and not being the first mover in the industry. There is also room for new firms

to create a channel of distribution. However, firms might have to watch out for legal

barriers in the future. Overall, the threat of new entrants is high and existing firms have

a high risk of diminishing revenues.

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Threat of Substitute Products

Substitute products can be an intimidating threat to any company because it

increases the company’s susceptibility to decreased profits. Once you know the threat

of substitute products, you are able to more effectively compete in the market.

Relative Price and Performance

The threat of a substitute within an industry is determined by the similarity of

pricing and the function it serves. Within the home furnishings industry, the threat of

substitutes is moderate because all furniture generally serves the same purpose, yet it

has a wide range of pricing.

There are many specialty furniture stores which charge a hefty price tag;

however, the 25 largest retail furniture companies only account for 22% of the

industry’s total sales. The remaining 78% of the industry belongs to mixed market

companies including, “individual local market retailers, larger multiple market

operations, department stores, manufacturers’ stores, ‘lifestyle’ retailers, and wholesale

clubs” (Havertys 10-K). So why do these mixed market retailers carry the majority of

the market? Most of these mixed market companies are able to price their items at a

discount. Also, a customer shopping for shoes may not have to even go to another

store to buy that table they have been looking for.

Buyers’ Willingness to Switch

A customer’s willingness to switch depends on what the individual values. Many

of these incentives include customer service, product quality, range of styles, price,

ease of purchase, the overall experience, and special promotions. Because of the lower

price and ease of purchase, a customer’s willingness to switch among mixed market

retailers which carry furniture is high. However, the small percentage of the industry

which includes the 25 largest furniture retailers heavily depends on the repeat

customer, making their customer’s willingness to switch low. Because these furniture

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retailers do not dabble in a mixed market, they are firmly established and are able to

offer their customer a quality, style, customer service, and experience which cannot be

found in many mixed market retailers. Between the 25 largest furniture retailers and

the mixed market retailers, the customer’s willingness to switch is moderate.

Conclusion

The way a firm competes is ultimately what determines the resulting danger of

substitute products. There are two ways a firm can compete in the market, low cost

leadership and differentiation. When describing their competition, Havertys explains

that their merchandise, “appeals to customers who are somewhat more affluent than

those of most other competitive price-oriented furniture store chains” (Havertys 10K).

While Havertys competes through low cost leadership, with its integrity of “everyday

low pricing”, it heavily relies on their customer service and brand name to obtain a

competitive edge. Havertys prides itself on having friendly and knowledgeable

employees, accessible financing, and easy and prompt delivery. Havertys also recently

introduced the Havertys Collections brand which carries one-of-a-kind products. This

customer service and brand name is what allows Havertys to obtain a niche within the

industry with which it can overcome the threat of substitutes.

Bargaining Power in Input and Output Markets

While the competition within an industry establishes the possibility and degree of

a firm within that specific industry to experience atypical earnings, markets determine

profitability in the industry. The bargaining power of the industry itself with respect to

the entities supplying goods and services, and the customers purchasing the finished

product are the other factors contributing to buying power. This power to bargain is the

fundamental aspect of the industry’s potential to continue to generate profits. The

home furnishings industry does not stray from this model, but depending on firm’s

place, philosophy, and target market within the industry, the route taken to generating

profits varies immensely. The furniture retailing industry generates massive amounts of

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revenue $45 billion, spread among 20,000 companies nation wide.

(www.firstresearch.com)

Bargaining Power of Customers

Bargaining power of customers is the power that consumers have over firms as

far as price is concerned. It is important because if the customers of an industry have a

lot of bargaining power, they can set the price and make it hard for firms to turn a

profit. A major goal of the home furnishings industry must be to gain an accurate view

of its customer’s power over the industry as a whole. But in order to obtain an

understanding of customer’s power, the industry must know the demographics of its

customers in order to better understand their tendencies. Without a thorough

understanding of who purchases an industry’s products, the industry is helpless in

determining what customers want, as well as who they are, and what they can afford.

The home furnishings industry is an industry has two primary target markets.

According to www.firstreseacrch.com they are the Baby Boomers (ages 40-55), and

their children. The industry explains its focus on the Baby Boomers because they are

said to be at “peak earnings and have paid off their mortgages”. Likewise, their children

are a target of the home furnishings industry because they have a large proportion of

discretionary income and relatively few financial obligations (www.firstresearch.com).

Therefore any change in the economy in a downward trend would severely impair this

industry’s ability to make a profit. Also, one of their target markets, the Baby Boomers

is getting older and during this stage, fewer will continue to buy new furniture. This

could hurt the industry’s profits as well and could cause them to look elsewhere for a

new market.

There are two main aspects of the bargaining power of customers that unite to

establish the power of customers with respect to the industry. These factors are

expressed by: price sensitivity, and relative bargaining power. In the case of the U.S.

furniture retailing industry, it experiences pressure from and extends pressure to

customers. Industry analysis done by First Research® on the furniture retail industry

suggests that gross margins with respect to profit are “high” nearing 50 percent. This

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suggests that customers have little power over firms on price (www.firstresearch.com).

However, many firms in the industry have chosen to enter into the market that has little

differentiation in order to compete on a low cost approach. This is an interesting

strategy because the selling expenses in the industry are extremely high due to the

amount of space needed to showcase the product, and the cost of paying sales people.

It is estimated that net income as a percentage of sales in the furniture retail

industry ranges between zero and 5 percent (www.firstresearch.com). This is true for

Havertys as well as most of its competitors. Thus, firms in this particular industry have

such a small margin for error, that selling undifferentiated products as a low cost

provider is extremely risky and requires precise and well researched financial decisions.

This approach could mean that bargaining power is slowly changing hands to the

customers and firms in this industry are risking it all in order to meet those new

demands. Or it could mean that firms in the industry are breaking the mold of the

classic furniture retailing business which involved locally owned businesses. Because

furniture sales are connected tremendously to home sales, one might contend that

customers as a whole do have some bargaining power, but that power comes at a cost

to everyone, since both are affected by the stability or the lack of stability of the

economy.

Price Sensitivity

Price sensitivity is the first factor that determines the customers bargaining

power. It is characterized by the degree to which customers will be willing to negotiate

on price. Price sensitivity occurs primarily within markets that the Industry’s products

have become undifferentiated and the switching costs for the customers are nominal.

For the firms in the home furnishings industry that sell the higher end merchandise,

price sensitivity is fairly low. However, firms in the industry that sell low end

merchandise experience relatively high price sensitivity. As stated previously, the

industry gross margin, according to www.firstresearch.com, is almost 50 percent,

primarily to cover the enormous cost of selling these items, including showroom space,

and advertising, as well as low inventory turnover. At first glance, this might seem like

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price sensitivity would be low, but with further investigation it appears that firms in the

industry, especially the firm’s aspiring to be low cost leaders where brand loyalty

disappears, fight it out over price and credit terms. Furniture is a fairly big ticket item

and for companies like Havertys and Ethan Allan rely on brand loyalty and customer

service rather than pricing. Conversely, with firms such as Ikea and Bed Bath and

Beyond, price sensitivity does come into play. Therefore, price sensitivity of customers

does play a major role in this particular industry since the 50 largest firms in the

industry only account for approximately 30 percent of the revenue according to the

industry analysis done by First Research (www.firstresearch.com). A majority of the

sales are fought out by locally owned furniture stores that are trying to appeal provide

low cost leadership.

Relative Bargaining Power

Relative bargaining power may be realized only when customers of a product can

obtain a strong bargaining position against firms in an industry. This bargaining position

is established by the number of patrons relative to the firms in that specific industry.

Other factors can include, but are not limited to, volume of purchases made by a sole

client, switching costs, and the quantity of alternative products obtainable by the client.

This relative bargaining power is split between patrons and firms within the

home furnishings industry. There are over 20,000 firms competing in this industry, and

most of them are small, single store operations. Customers have many choices when

choosing furniture, but prices in general must go up across time. This is due to the

nature of the products sold in this industry. The primary raw material used in the

creation of the finished product is and will most likely continue to be wood. Moreover,

forest reserves are declining. The rate at which they can be re-planted and harvested

again cannot keep up with ever increasing demand. Thus, wood laminates and other

alternatives are becoming more prevalent because they are less costly, less harmful in

terms of the environment. This trend to be green could be a way for firms in the

industry to find cheaper, less damaging materials.

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Switching costs are low for consumers, but can be high for firms, especially ones

that focus on one brand or style. However, these firms are usually insulated from price

sensitivity because of the higher end merchandise they sell. Relative bargaining power

within this industry, especially in the near future will be overshadowed by the

continuing sub-prime mortgage defaults, and the ever decreasing home sales. In the

long run relative bargaining power of customers within this industry will be fairly high

primarily due to their lower switching costs. The implications of this for firms are very

important as far as their profit drivers are concerned because the more power the

customer has, the less a firm can charge. Firms in the industry will have to take

opportunities when they present themselves and find them when they don’t in order to

be profitable in this industry.

Conclusion

Although there are a multitude of factors that effect different ends of the home

furnishings industry, it appears that the power of the buyer has become an increasingly

large factor in the industry. Firms in this industry must regain power over their buyers

to be able to withstand an economic downturn like the one being experienced right

now.

Bargaining Power of Suppliers

The home furnishings industry is supplied by a few recognizable brand names

like Havertys and Ethan Allan, and an large amount of low cost furniture producers like

Ikea. Together they make up the home furnishing industry’s suppliers. These suppliers

have gone the way of many industry suppliers over the past few years, and the

suppliers with well recognized names are attempting to enter the industry themselves.

These companies are attempting to cut out the middle man in an attempt to make

higher profits and over power smaller entities within the industry to gain market share.

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In order to turn a profit, an industry must haggle with suppliers that the firm

must acquire its raw materials, labor, finances, and other miscellaneous elements.

Understanding whether the industry has the power over its suppliers, as is the case for

much of the large retail industry, is fundamental to valuing actual realizable profit

growth for the industry. The better the industry can haggle over prices, the better the

potential for higher profits industry wide. As stated previously, the buyers of the home

furnishings industry have a substantial amount of power, therefore firms in the industry

need to have power over suppliers in order to be very profitable. Unfortunately for the

firms in the industry, suppliers are deciding to enter the industry themselves. By doing

this, the suppliers are positioning themselves in direct competition to their old clients,

and are forcing them to go elsewhere for product.

Bargaining power of the supplier is considered high when there are few

companies in an industry and they have few substitutes, or because their product is

highly differentiated. Subsequently, suppliers can actually control industry prices and

possibly manipulate distribution agendas to maintain dominance. Conversely, if there

are many suppliers with low product differentiation, the firms of an industry can have

power over its suppliers. In the home furnishings industry, there are many suppliers for

low end furniture, but few for higher end merchandise. Therefore, depending on what

type of furniture a firm sells, it could experience high bargaining power, or low

bargaining power.

Within the home furnishings industry, firms are subject to the power of suppliers

like Thomasville and Stickley. There are relatively few suppliers of high quality furniture

and brand image can be very important to the customer that can afford such items.

Also, suppliers have an edge because many of the big suppliers like Ethan Allan have

decided to open their own showrooms and sell their furniture directly to the public,

effectively bypassing the middle man and driving costs down while they enjoy a much

larger profit; this new phenomenon, however, primarily only affects the higher end

furniture merchandisers.

Price Sensitivity

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In this part of the model price sensitivity is again a factor that can attribute

bargaining power to one entity or the other. In this case it is suppliers and the home

furnishings industry. Price sensitivity can be very high in this industry especially with

respect to the low cost leadership side. Switching costs are low for the firms in this

arena, and that gives them power over the suppliers.

However, at the higher end side of the industry where brand name matters,

firms can have little power over their suppliers. This is especially true over the past

couple of years since the manufacturers them selves have begun to market their

products including the afore mentioned Ethan Allan example. This has hurt some

companies and caused them to think outside the box. Companies like Havertys foresaw

this phenomenon, according to their 10-K, and created their own brand name.

According to their 10-K, Havertys has competed with their main competitors by

outsourcing about 60% of the production of their goods to China.

Since the majority of the companies in this industry are small local stores we are

forced to conclude that the home furnishings industry is forced by its suppliers to pay

higher prices because most of these smaller stores can buy in the bulk like a big

corporation could and receive a lower price. Therefore, due to the large number of

small firms in this particular industry, the suppliers tend to have the upper hand and

retain bargaining power over the firms.

Relative Bargaining Power

The relative bargaining power of an industry has the potential of greatly affecting

the final price of goods to the customer. In this time of economic recession, bargaining

power is extremely important, but it is important in any economic situation. For low end

home furnishings retailers relative buying power of the supplier is fairly low because

firms have many sellers to choose from to get essentially the same product. But if a

firm conducts business in a market in which brand name is a major factor, relative

bargaining power for the supplier is high and the firm is subject to the decisions of the

supplier, on price, when getting their product. This has the potential of severely

impairing a firms profits due to the fact that they actually make so little on what they

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sell. This is particularly true with suppliers who have decided to open their own show

rooms and sell their furniture directly to the customers.

The majority of the merchandise sold in the industry is lower end merchandise,

but the majority of the revenue gained in this industry is realized in high end, low

turnover type merchandise like bedroom sets and china cabinets rather than lamps and

accents. Due to this fact, it is difficult to attribute bargaining power to the industry as a

whole, because the industry is so fragmented between high and low end merchandise.

However, one could feasibly contend that the suppliers have more bargaining power

relative to firms in the home furnishings industry. For retailers focusing on high end

merchandise, switching costs are very high, while undifferentiated merchandise enjoys

low switching costs. Another reason that suppliers have higher relative bargaining

power is that due to retail consolidation, fewer styles are in production. This means that

firms are getting less and less choice in the merchandise they can purchase to sell

unless they design their own, which is impossible for a majority of the small firms who

primarily populate the industry, but lack the ability to produce their own furniture.

Conclusion

The bargaining power of suppliers in the home furnishings industry plays a major

role in the cost structure, and the ability of firms to be profitable organizations. The

furniture retail industry faces fairly high supplier bargaining power due to the fact that

most of the firms in this industry are small single store operations. Recently, suppliers

are beginning to open their own show rooms effectively cutting out the middle man.

When suppliers need the firms in this industry less, firms will be weeded out and many,

if they cannot differentiate themselves could eventually cease to exist. Some firms do

have bargaining power over their suppliers, unfortunately, their sales do not make up a

large enough portion of the revenues created by this industry to warrant it much power

over its suppliers on an industry level. Due to the fragmenting in this industry between

the high and low end furniture sales, one could contend that they make up two distinct

industries. Also, manufacturers that have entered the industry on their own could be

considered to be in their own industry. In subsequent sections the valuation the firm

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will give a more definitive answer to this idea. However, as the industry is now,

depending on the type of merchandise sold buying power of suppliers will have a

possibly major impact on cost structure and the ability to make a profit.

Value Chain Analysis

The home furnishings industry is highly concentrated, and experiences high

competition among its 20,000 firms. The ability of a firm to characterize itself within the

industry by accurately recognizing its strengths and its deficiencies is crucial to survival

in this particular industry. Success is realized in this industry by a firm playing off its

strengths in order to gain market share in gain a competitive advantage. Finding this

competitive advantage and then sticking with it is the best way to continue growth at

the firm level, as well as at the industry level.

As is the case for most industries, firms in the home furnishings industry will

attempt to gain their competitive advantage by one of two strategies: cost leadership

and differentiation. Although industry tradition has focused on cost leadership, some

firms are now thriving due to their unique abilities to create differentiation even in low

end the lower end merchandising sector of the home furnishings industry. The industry

is highly fragmented, extremely competitive, and includes a diverse group of

competitors ranging from “national department stores, regional or independent

specialty stores, to dedicated franchises of furniture manufacturers” (Havertys 10-K).

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Cost Leadership

Traditionally, cost leadership has been the focus of most of the home furnishings

industry. Interestingly, the top 50 firms in the industry only account for 30 percent of

the revenues generated (www.firstresearch.com). This discrepancy suggests that no

one company has a majority of the market share, and that competition is exceptionally

fierce in this particular industry. With few entrance barriers, this industry is wide open

to new competitors with new cost-cutting strategies. Moreover, industry suppliers have

noticed the low entrance barriers and concluded the same. Furniture manufacturers

such as Ethan Allan have entered the industry and have the potential to wreak havoc

on smaller firms, as well as retailers who carry their product line.

Now more than ever, cost leadership is a top priority for the home furnishings

industry because of the downturn in the economy. This industry attempts to market

luxury products and is subject to the volatility of the housing market. Thus, times will

be harder.

Low input costs

Input costs include those costs that are associated with the cost of doing

business. For the home furnishings industry, the most notable example of the lowering

of input costs is the internet. Many companies in the industry sell exclusively on the

internet and that significantly reduces costs because they don’t utilize costly showrooms

or warehouses, but order directly from the manufacturer (www.firstresearch.com). Also,

many of the traditional firms in the industry have utilized the internet to gain name

recognition and to display their products with very little cost associated, and virtually

unlimited exposure to their target markets.

Efficient Production

Efficiency has been a focus in American business for a several years, and home

furnishings industry does not break the mold. Efficiency within this industry is

imperative. The gross margin in this industry is close to 50 percent (www.first

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research.com), but the high costs of maintaining a large showroom, low product

turnover, distribution costs, and advertising expenses soon take up most of the

revenue. That coupled with credit sales on the rise and price cutting to draw customers,

this industry actually has very little margin for managerial error.

Suppliers entering the industry have also done much to spur the focus on

efficient business in the home furnishings industry. Firms like the Havertys Furniture

Companies Inc., according to their 10-K, have been forced to turn to outsourcing the

manufacturing of their products to places like China in order to compete within the

industry. Subsequently, severe changes in exchange rates or tariffs have the potential

to lower gross profit on items received from overseas according to the Havertys 10-K.

Another major aspect of efficient production to be considered, especially in the

U.S., is the ability to obtain cost effective marketable products that comply with

Government standards. According to the article Safety Push Focuses on Retailers, The

Consumer Product Safety Commission is beginning to “shift “its strategy in order to

maintain safe products as the bulk of manufacturing is done overseas. The shift would

be to focusing on the quality and safety of the goods entering the U.S. and causing

firms that outsource manufacturing to be held more accountable for the quality and

safety of their products. This directly effects the home furnishings industry due to the

fact that about 30 percent of its goods are now manufactured in China

(www.firstresearch.com). Another article in the Wall Street Journal entitled Some

Stalled Safety Rules For Products May Be Enacted, suggests that The Product Safety

Commission will make several new safety rules including “tougher flammability

standards for upholstered furniture.” The ability of the industry to efficiently adhere to

the new standards is necessary to maintain profitability.

Low-cost Distribution

In order to obtain low-cost distribution at the industry level, the firms in that

industry must be capable of acquiring sufficient technology systems, supply chains,

labor forces, and warehouse capacity. The home furnishings industry’s profitability relies

much on its ability to distribute its products efficiently and at a low cost. Virtually all of

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the sales in this industry require the product to be delivered to the customer’s home.

According to the Wall Street Journal, oil prices rose 45.3 percent in 2007 alone. With

demand not decreasing, it is getting harder for firms in the industry that rely so heavily

on distribution to make a profit. Companies will attempt to pass the price increases

along to the customer, but that can last only so long.

Efficient management information systems and Information Technology

infrastructure are another major component of low-cost distribution. Firstly, if the

implementation of an efficient management information system in attainable, it will cut

costs caused by unnecessary wages, and more importantly, human error. Since these

systems are used to monitor point-of-sale, credit operations and distribution systems,

the efficiency, reliability, and sharing capabilities of these systems is of utmost

importance to low-cost distribution.

Differentiation

For a majority of the home furnishings industry, the strategy taken to gain a

competitive advantage is differentiation of their product. Differentiation occurs when a

product is supplied by a single entity that is incomparable and it sold at a lower cost

than the price a premium customer will pay. Differentiation is attempted and achieved

in this particular industry via three strategies, or a combination of them. The three

strategies are Superior customer service, more flexible delivery, and investment in

brand image.

Superior Customer Service

The home furnishings industry is a customer service oriented industry. From the

research and development of the products, to the sales person on the showroom floor,

to the set-up and delivery crew, all are run with a focus on customer service. One major

way that the home furnishings industry has explicitly show its focus on customer service

emphasis within the differentiation approach is the fact that the industry as a whole is

moving from focus on their product to style (www.firstresearch.com). The industry

tries to provide experienced sales associates to customers by providing competitive

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wages, schedule flexibility, and good commissions according to

(www.firstresearch.com). The sales associated are also continually trained to offer

patrons advice and accurate information about the products.

More Flexible Delivery

Value in the U.S. is assessed primarily on speed of delivery. Customers of the

home furnishings industry are no different. They require instant gratification. Therefore

many firms in the industry are focused on timely delivery. Some firms like Havertys are

continuing to make that a priority and hopefully an advantage by building more

distribution centers. In 2005 Havertys built a new distribution center effectively

ensuring the capability of overnight delivery of products to its customers (Haverty’s 10-

K). According to a slaes associate here in Lubbock, firms like Bob Mills furniture are

also trying to simplify distribution with Oklahoma City as its hub for supplying Lubbock

and Amarillo instead of trying to get warehouse space in all three cities. In our society

this is a legitimate avenue for competitive advantage and gaining market share.

Investment on Brand Image

Making one’s brand a highly recognizable and desirable one costs a firm time,

money, and marketing skills. Now that manufacturers are entering the industry, brand

image is becoming more important to the industry as a whole. In order to thwart

competitors some firms are opting to create their own brand in order to gain a brand

image advantage. Firms like Havertys, Ethan Allan, and Ashley furniture have created

their own brand to market so as not to support the suppliers who have entered the

industry. As stated previously, the industry trend is moving from emphasis on product

to an emphasis on style. This gives companies with their own brand a special

opportunity to differentiate themselves and possibly gain an advantage over other firms

in the industry.

Conclusion

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Firms in the home furnishings industry use both cost leadership and

differentiation strategies in order to gain a competitive advantage. In other words this

industry uses a mix of the cost leadership and differentiation strategies. On the cost

leadership side they use lower input costs, efficient production, and low-cost

distribution to gain an advantage. On the differentiation side firms in the industry use

superior customer service, more flexible delivery, and investment in brand image to

create an advantage.

Firm Competitive Advantage Analysis For Havertys to compete in the furniture industry they must achieve and sustain

competitive advantage. To do this they must use two competitive strategies, cost

leadership and differentiation. Cost leadership is the ability of a firm to offer the same

product as its competitors but at a lower cost. Differentiation is directed more towards

providing a distinct product that will set them apart from their competitors. In order for

Havertys to be profitable they must use these strategies to accurately position

themselves in the industry. Like most high end firms in the home furnishings industry,

Havertys tends to rely on differentiation strategies to distinguish themselves. However,

they do still use cost leadership especially now with the economy going towards a

recession.

Cost Leadership

Cost Leadership is the ability of a firm to offer the same product as its

competitors but at lower cost. Firms can do this with efficient production, lower input

costs, and lower cost distribution. In a highly segmented industry, such as the home

furnishing industry, low prices are not always a major competitive advantage. While

firms like Walmart and Ikea market their furniture as good quality at low prices, others

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such as Pottery Barn and Havertys sell their superior quality furniture for higher prices.

In fact Havertys clearly states that they do not market themselves as a low cost retailer.

Instead they provide their customers with a wide selection of products and styles

primarily in the middle to upper-middle price ranges (Havertys 10K).

However, with the recent changes in the economy many high end retailers will

have to reevaluate their price positions. Furniture is a discretionary spending item which

makes the stability of the economy an important factor in profits. As of now the

economy has suffered a significant downturn and consequently so has the housing

market. According to the Wall Street Journal, “declining home values can put a chill on

consumer spending, which makes up 70% of U.S. economic activity; people feel less

wealthy and spend less, analysts say.” Needless to say this decline in the housing

market has had a huge effect on the home furnishings industry. Havertys will have to

adopt a few cost leadership strategies in order to keep their net sales and profitability

from declining.

Efficient Production

One way Havertys has lowered costs is by focusing their attention on efficient

production. The production of furniture involves many costly aspects such as elaborate

technology systems, labor forces, warehouse space to hold inventory and

transportation. These high costs have led the industry to shift to importing finished

goods. Havertys has also moved toward this trend and is importing to lower their costs

of production. During 2006, approximately 60% of Havertys purchases were for goods

not produced domestically (Havertys 10K). Havertys is able to import the same quality

product at a cheaper price allowing them to price down their merchandise. They are

also currently working with select Asian manufacturers to increase the level of “direct”

import purchases in 2007 (Havertys 10K). They believe that this will allow substantial

cost savings which will be important with the economy moving towards a recession.

Establishing these relationships and using their ability to import wisely will be an

advantage for Havertys to keep their sales afloat.

Lower Input Costs

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With the industry moving towards selling their merchandise on the internet lower

input costs have become available. Havertys is one of many stores that have utilized

the internet to lower input costs. Although they do not sell their merchandise over the

internet they do have a sort of “virtual showroom” for customers to browse and check if

an item is available at their local Havertys. This has significantly lowered input costs

such as advertising for the firm. Their entire product line is now only a click away for

consumers. The company hopes to bring more functionality to their website in 2008

which will allow even lower input costs (Havertys 10-K).

Low Cost Distribution

Havertys can also cut costs with lowering their cost of distribution. According to

their 10K Havertys has made “significant investments in their distribution infrastructure

by using a combination of three distribution centers, three home delivery centers and

approximately 14 local market cross-docks.” This recent change in their distribution

channel has provided many low cost distribution benefits for Havertys. It has allowed

for lower inventory levels, less warehouse space, fewer workers, and the ability to enter

new markets without adding local market warehouses (Havertys 10K). All of these

things are cost savers for the firm and allow them to be able to price down their

merchandise. This is becoming increasingly important due to the rising prices of oil.

According to an article in the Wall Street Journal, “oil prices surged from just over $10 a

barrel a decade ago to $100 January 2, 2008.” This is why firms find it so important to

strategically place distribution centers around the country. Not only does it allow them

to ship to their customer quickly but cuts down on gas prices for their delivery trucks.

Differentiation

Differentiation is a strategy that is based on the ability of a firm to offer a unique

product that will set them apart from their competitors. The home furnishings industry

creates competitive advantage mainly with the use of differentiation. In order to do this

a firm will have to identify attributes of their product that customers will value, position

themselves to meet their target customer, and achieve differentiation at a cost lower

than what customers will pay for their unique product. Havertys has done this

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successfully with the use of superior customer service, more flexible delivery, and large

investments in brand image. With the economy nearing a recession retailers are finding

themselves in trouble if they don’t start to focus on competitive advantage strategies

such as differentiation. An article in the Wall Street Journal explains how “Retailers

turned in their worst monthly sales results in nearly five years, and big chains appeared

to be girding themselves for a prolonged slowdown in consumer spending.” This makes

it even more important for retail chains such as Havertys to differentiate their products

from their competitors to keep stores open and sales up.

Superior Customer Service

If Havertys could pick their strongest competitive advantage it would be their

superior customer service. With over 100 years in the industry Havertys has developed

and maintained a very knowledgeable labor force. To attract and retain qualified

personnel Havertys offers competitive salaries and also enrolls employees in their own

training program. These programs include classes on product knowledge, selling and

management skills classes (Havertys 10K). They find this necessary because they

primarily promote internally. For this reason they find that training and assessment of

their associates is essential to their growth (Havertys 10K). Large employee turnover

can be costly for firms especially if put through rigorous training programs. Havertys

has definitely found a way to maintain their labor force and educate them on the

industry and specifically their products. There is no doubt that when shopping at

Havertys customers will have a knowledgeable source available to them to assist in

their purchasing.

More Flexible Delivery

Havertys prides itself on its ability to deliver their furniture to their customers in

a short time frame. This has become increasingly easy with their recent investment in a

new distribution infrastructure. They have recently moved from five regional

warehouses and 46 local market warehouses to a combination of three distribution

centers, three home delivery centers and approximately 14 local market cross-docks

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(Havertys 10k). This has significantly decreased the cost and time involved in home

deliveries of furniture. It has allowed for lower inventory levels, less warehouse space,

fewer workers, and the ability to enter new markets without adding local market

warehouses (Havertys 10K). These are all very important in distinguishing Havertys

from its competitors, especially the ability to enter new markets easier. Large costs

come with holding inventory near local markets for fast delivery. With these

warehouses strategically placed it becomes cost free to enter in to a new area which

will help the growth of the company tremendously.

Investment in Brand Image

Brand name recognition is very important in an industry that has over 20,000

firms competing for market share. In order to establish brand image Havertys has made

large investments including the introduction of their own furniture line Havertys

Collections. “These furnishings were developed initially in 2000 with manufacturers

whose names do not carry the same level of customer recognition as Havertys”

(Havertys 10K). This has given Havertys the leverage of overall brand awareness and

the ability to sell these certain manufacturer’s products exclusively.

Conclusion

Havertys has successfully used cost leadership and differentiation to gain a

competitive advantage in the home furnishings industry. They have recently used

efficient production, lower input costs, and lower cost distribution to compete on cost

leadership. This has become increasingly important due to the economy downturn.

They have also focused on customer service, more flexible delivery, and large

investments in brand image. Havertys best sums up their differentiation strategy by

stating on their 10K that they “believe that the quality of the merchandise we offer and

our knowledgeable sales associates, coupled with the ability to deliver purchases within

a short time-frame, are very important to our ability to maintain customer satisfaction.”

All of these strategies coupled together have led to greater competitive advantage and

the ability to successfully compete with other firms in their industry.

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Accounting Analysis

In order to properly assess the legitimacy of a company’s stock price, analysis of

their accounting policies and procedures is necessary. Because GAAP (Generally

Accepted Accounting Principles) provides leeway for firms in their interpretation and

computation of their accounting numbers, it is essential to evaluate the accounting

policies implemented by the company that lead to the numbers one sees on their

financial statements. Publicly traded companies are required by law to issue information

to the public about is financial standing. This includes a form 10-k which houses a bulk

of the financial information and manager’s divulgence about the goals, and practices of

a company. However, some companies freely give more information than do others.

Therefore, another goal of accounting analysis assesses the degree of transparency

with which managers portray the financial standing of the company, its policies and

procedures. The overall process of accounting analysis involves six stages of evaluation

to assist in determining the quality of disclosure with respect to the accounting

practices and the financial statements. These six stages include: identifying key

accounting policies, assess accounting flexibility, evaluate accounting strategy, evaluate

the quality of disclosure, identify potential red flags, and undo accounting distortions

(Palepu & Healy).

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Key Accounting Policies

Once a firm derives its industry analysis and is able to assess what business

practices will create value in their industry, it can determine its own key success factors

with respect to its core competencies in order to compete in that industry and gain

market share. The purpose of stage one of the accounting analysis is to assess the

extent to which a firm proactively creates its key accounting policies (KAPs) in order

accomplish key success factors (KSFs). The alignment of KAPs with KSFs is integral to

creating value and validity as a firm.

In a previous section, Haverty’s KSFs were expounded. The key accounting

policies are directly related to those success factors and are used to gain a competitive

advantage within their industry and add value to the company. The key success factors

for firms in the home furnishings industry are stated as: efficient production, lower

input costs, low cost distribution, superior customer service, and investment in brand

image. The implementation of key accounting policies that directly apply to the home

furnishings industry’s identified KSFs create value for the industry, as well as, for

investors.

Efficient Production

Efficient production of product has been achieved by “foreign sourcing” the

production of product to places like Asia and Mexico (Haverty’s 10-k); China being the

main country of production of out sourced furniture. In the4 past five years furniture

imports from China have doubled to $12 billion (www.firstresearch.com). Imports

currently hold about 30 percent of the U.S. furniture market. Some companies like

Ethan Allen produce their own furniture, as well as import it. Haverty’s current

purchases 70 percent of its merchandise, which is currently imported through both

domestic agents, and directly from Asian manufactures. While most companies in this

industry do not want to obtain all imported merchandise directly from foreign

manufacturers, there are significant cost reduction capabilities of decreasing

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dependence on U.S. agents to acquire merchandise. Below is a chart from Haverty’s 10-

k showing how focused this firm must be in its attempts to lower cost.

Percentage of Net Sales

Percentage Change in Dollars from

Prior Year 2006 2005 2004 2006 2005 Net sales 100.0% 100.0% 100.0% 3.8% 5.5%Cost of sales 50.4 52.2 51.7 0.2 6.5 Gross profit 49.6 47.8 48.3 7.7 4.5 Credit service charge revenue 0.3 0.4 0.6 (19.5) (22.1) Provision for doubtful accounts 0.1 0.1 0.1 (35.1) 81.1 Selling, general and administrative expenses 47.1 45.6 44.5 7.2 8.3 Income before income taxes 3.0 2.9 4.6 8.8 (34.4) Net income 1.9 1.8 2.9 6.3 (33.5) With net income only being around two percent of sales, tight cost control is imperative

to the health of the company.

Lower Input Costs

Achieving lower input costs is another major success factor of firms in the home

furnishings industry. Utilization of the internet for brand awareness and e-commerce is

the most notable avenue explored by firms in the industry. Nearly all firms in the home

furnishings industry have a World Wide Web address. The internet is an extremely cost

effective advertising and direct-to-customer selling entity. This low cost advertising

vehicle has virtually unlimited marketing capabilities. While most firms in the industry

do not use the internet for direct-to-customer selling, increasing amounts of firms are

beginning to implement explore, and utilize this potential. However, internet sales

make up a very minute portion of sales in the industry.

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One of the biggest costs for a firm in the home furnishings industry is showroom

floor space. It is vital to sell the merchandise, and it is very costly. Therefore, firms in

the industry must know how well their showroom floor space pays off during the year.

This helps asses how well the limited space is utilized on a profit basis. Below is a chart

of the net sales per weighted average square foot throughout the company.

2006 2005 2004 Retail square footage at December 31 (in thousands) 4,208 4,144 4,068 % Change in retail square footage 1.5% 1.9% 3.8%Annual net sales per weighted average square foot $ 206 $ 202 $ 199

(Information from Haverty’s 10-k)

Charts like these are important to firms because the help firms see on a per square foot

basis, how much merchandise they sell.

Another aspect of costs that pertain to selling costs are the costs of the buildings

housing the merchandise. These site are either own by the company, or leased. The

industry standard is to acquire most of the showroom space via operating leases. Below

is a chart from Haverty’s 10-k showing the amount of owned and leased property. This

data is in line with in with most of the industry.

Retail

Locations

Local Market Area

Cross-docks(c)

Regional Distribution

Facilities Owned(a)

47 1 3 Leased(b)

73 13 3 Total 120 14 6

(a) Includes capital leases on two retail stores and includes the four retail stores and a distribution center consolidated under FIN 46.

(b) The leases have various termination dates through 2025 plus renewal options. (c) Of the local market area cross-docks, 9 are attached to retail locations.

Because the home furnishings industry is primarily a big ticket industry, much of

the merchandise sold with in it is on credit. Some firms, like Ashley Furniture make

ridiculous financing opportunities to their customers like no interest and no payments

until 2013. This strategy is good for moving merchandise, but risky in the fact that

terms like that will bring you allowance for bad debt much higher. Firms like Haverty’s

do not offer such incentives to purchase their merchandise, but they do offer no

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interest for up to 24 months. Although Haverty’s has its own financing subsidiary, they

also choose to use a third party finance company to finance some of their sales. They

have chosen to use their third party financer more in the past few years. Below is a

chart showing the choice of financing for sales of their merchandise.

Year Ended December 31, 2006 2005 2004

Credit Service Charge Revenue $ 2,823 $ 3,506 $ 4,502 Amount Financed as a % of Sales:

Havertys 16.3% 20.7% 21.1 % Third Party 26.2 18.5 20.8

42.5% 39.2% 41.8 % % Financed by Havertys:

No Interest for 12 Months 26.3% 27.8% 42.9 % No Interest for > 12 Months 49.3 47.0 29.7 No Interest for < 12 Months 10.4 11.7 14.3 Other 14.0 13.5 13.1

100.0% 100.0% 100.0 %

As is the case with many firms in the home furnishings industry, receivables accounts

for nearly half of their total sales (first research).

Low Cost Distribution

The accounting policies used attempting to achieve low cost distribution is quite

similar across the industry. One of the main concerns is of course fuel prices. While

most if this cost is passed on to the customer, some of this cost must be absorbed by

the company. Companies across the industry continue to closely monitor their regional

warehouses and distribution centers for way to cut costs. Haverty’s consolidated its

regional five warehouses and forty-six local market warehouses to three distribution

centers, three home delivery centers and fourteen local market cross-docks (Haverty’s

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10-k). These must all be placed strategically so that all of firms are within a certain,

pre-determined distance of a distribution center, or local cross-dock.

Efficient management information systems and Information Technology

infrastructure are another major component of low-cost distribution. When

consolidating warehouses and creating new home delivery centers and local cross

docks, it is imperative that the information systems implemented create value by

streamlining orders and shipments and give real time information on the whereabouts

of inventory.

Superior Customer Service

The primary way to ensure good employees stay with a firm is to offer them

good benefits. Incentives for quality service are a good way for firms to encourage a

desired behavior and build a loyal workforce. Firms in the home furnishings industry are

no different. In past years, many firms like Haverty’s offered define benefit plans to

virtually all of their employees, but do to rising costs, such offerings are a rarity. At the

end of 2005 Haverty’s ended its defined benefit plan for new employees. However, any

one hired on or before December 31, 2005 was able to receive such an offer. Thus the

company must account for the payment of retired employees that no longer add value

to the company.

Investment in Brand Image

Investment in brand image often requires a relatively large portion of a firm’s

resources. For a firm selling merchandise in the medium to medium-high price range

like Haverty’s, advertising expense is substantial; requiring 7.2 percent of sales in 2006

and 2005 and 7.4 percent in 2004 (Haverty’s 10-k). This money is spent in a variety of

ways form television adds to tabloids. Companies with good brand image like Haverty’s

also put out things like a catalog to showcase their merchandise. But in order to choose

which type of product to advertise most aggressively, a firm must know which part of

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their merchandise sells the best. Below is a diagram that showcases how Haverty’s

merchandise contributed to total sales. 2006 2005 2004

Merchandise: Living Room Furniture 47.6% 48.3% 48.7% Bedroom Furniture 22.1 21.6 21.8 Dining Room Furniture 12.4 13.4 13.1 Bedding 9.8 9.3 9.4 Accessories and Other

7.8 7.0 6.4 Credit Service Charges 0.3 0.4 0.6

100.0% 100.0% 100.0%

Accounting Flexibility

The ability to which a firm can pick and choose accounting policies within the

Generally Accepted Accounting Principles that best suit the bias of a firm’s management

is known as accounting flexibility. . This simply means that a firm can legally arrive at

certain accounting numbers in several different ways. Usually the method that puts the

company in the best position, at least on paper, is chosen. This flexibility is changed

regularly according to the prerogatives of the FASB, the body responsible for creating

and maintaining GAAP. For Haverty’s, the accounting flexibility resides in three main

areas: operating vs. capital leases, post retirement benefit plans, and self insurance.

Operating Leases v. Capital Leases

Arguably the largest accounting flexibility a firm has is with the classification of

its leases as operating or capital. An operating lease is a lease that offers no vested

interest in the rights of ownership of the asset to the lessee. These leases are not

capitalized. Therefore there is no ownership that appears on the balance sheet of a

firm, only the income statement where expenses are recognized. This becomes very

attractive to firms because they can show a substantially lower amount of liabilities by

creating an operating lease. This, although not a material misstatement legally

speaking, is often very misleading to uneducated investors.

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On the other hand capital leases are different in nature because they are

associated with rights of ownership. These leases are used to convey certain rights

ownership of an asset of the lessee. These rights of ownership are positive because

they allow a firm to collect money back from interest expense, as well as amortization

and depreciation for each and every year of ownership. However, capital leases are also

associated with risk because of ownership. Firms within the home furnishings industry

typically use a mixture of these leases with operating leases being the most prevalent.

The accounting flexibility in the firm’s ability to choose their desired type of lease can

be either good or bad.

Haverty’s goes along with the industry standard and has about 61 percent

of its leases as operating leases (Haverty’s 10-k). This means that over half of their

showroom costs do not appear on their balance sheet. Were these operating leases

capitalized, both assets and liabilities would be approximately 240,400 than they are

stated on their current 10-k.

Post-Retirement Benefit Plans

As stated previously, until December 31, 2005 Haverty’s offer to its employees a

defined benefit compensation plan for its post-retirement benefits. This means that

each employee will receive a set amount for the remainder of his/her life after

retirement. The degree of accounting flexibility in this particular area is quite

substantial. The firm is allowed to choose the discount rate. Below is a chart describing

the choice of discount rate using a weighted average approach.

2006 2005

Discount rate 5.75% 5.75% Expected long-term return on plan assets 7.50% 7.50% Rate of compensation increase 3.50% 2.75% Source: Haverty’s 10-k

According to Havtery’s 10-k “A one-percentage-point decrease in the discount

rate would have increased 2006 expense for the defined benefit pension plan by

approximately $1.5 million, a 46% change” conversely “a one-percentage-point

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increase would have decreased expense by $0.1 million, a 5% change and would

decrease the curtailment charge by $5.3 million.” In addition “a one-percentage-point

change in the expected return on plan assets would impact 2006 expense for the

defined benefit pension plan by approximately $0.6 million, an 18% change.” Now the

firm offers a 401k to employees with matching policies that vary by the amount put up

by the employee. Below is a chart that describes the net costs of the pension plans.

Defined Benefit Plan

Supplemental Plans

S l t l Pl

(In thousands) 2006

2005

2004

2006 2005 2004

Service cost-benefits earned during the period

$

3,343

$ 3,030

$

2,529

$ 74

$

68

$

57

Interest cost on projected benefit obligation

3,630 3,344 3,138

183

157

168

Expected return on plan assets (4,452) (4,119) (3,915) — — —

Amortization of prior service cost

123

142

133

34

5

5

Amortization of actuarial gain 389 15 — 15 9 8

Net periodic cost 3,033 2,412 1,885 306 239 238

Curtailment loss 208 — — — — —

Net pension costs $ 3,241 $ 2,412 $ 1,885 $ 306 $ 239 $ 238

(source: Haverty’s 10-k)

Self Insurance

Many firms in the home furnishings industry choose to insure themselves for

certain possible obligations and losses. The most notable areas a firm chooses to self

insure in are “worker’s compensation, general liability, and vehicle claims” (Haverty’s

10-k). These costs are discounted and recorded as a liability by the firm, but there is

flexibility in that again, discount rates are assumed. According to Haverty’s 10-k “a one-

percentage-point change in the actuarial assumption for the discount rate would impact

2006 expense for insurance by approximately $77,000, a 1.5% change.” A material

mistake in these assumptions might not be material, but with margins as close as they

are within this particular industry, they realistically could be.

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Actual Accounting Strategy

When evaluating a firm’s actual accounting strategy, it is understandable to assume

it requires the manager to make executive estimations or assumptions within the

financial statement. Depending on management’s degree of disclosure and flexibility,

the company can either show a more favorable picture of the company or a more

realistic view of the company.

As we explain in the following paragraphs, Havertys is a high disclosure company

and employs a conservative reporting strategy, which provides investors with a more

transparent view of the firm.

Operating Leases vs. Capital Leases

Havertys financial statements provide a high level of disclosure. However, their

use of operating leases, rather than capital leases, allows them to keep leases off the

books. Instead, it is reported as an operating expense on the income statement. Also,

many companies choose to use operating leases to avoid the risk associated with

owning the property.

Over 60% of Havertys’ properties are leased, and while they fully disclose their

actions using operating leases in their 10-k, this does give the firm a more favorable

stance. If Havertys were to reclassify their operating leases into capital leases, it would

significantly increase their debt, making them look less attractive to potential and

existing investors. This reveals Haverty’s aggressive accounting flexibility regarding their

leases.

The following graph, from Havertys 10-K, summarizes their contractual obligations and

commercial commitments as of December 31, 2006 (in thousands):

Payments Due or Expected by Period

(in thousands)

Total

Less than

1 Year

1-3

Years

4-5

Years

After 5 Years

Long-term debt and lease obligations $ 37,849

$ 10,334

$ 21,441

$ 693

$ 5,381 Operating leases 304,606 30,761 59,132 47,656 167,057 Scheduled interest on long-term debt 8,082 2,626 2,866 759 1,831

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Other liabilities 12,600 12,600 — — — Purchase obligations 57,700 57,700 — — —

Total contractual obligations $ 420,837 $ 114,021 $ 83,439 $ 49,108 $ 174,269

Estimating Accounts Receivable

Estimating the collectible amount of accounts receivable is another area where

management is required to use judgment. When a company estimates the accounts

receivable, a considerable difference in the estimated and actual write-offs will give the

firm an erroneous view of the firm’s profitability. Many firms might be tempted to

tamper with the appropriate discount rate in order to create a more favorable outlook

for the firms’ investors.

If write-offs for a period are underestimated, then the company would have higher

expected earnings. This increase would be reflected in an increase in stock price,

creating a more favorable view of the company. The opposite holds true if write-offs are

overstated.

While there is temptation to tamper with the expected default rate on accounts

receivable, Havertys attempts to apply a reasonable and accurate default rate.

According to Haverty’s 10-K, it reevaluates its expected default rate at the end of each

quarter based on the status of portfolio balance, portfolio quality, historical charge-offs,

and reasonable charge-off forecasts. Also, accounts are generally written off after nine

months without receiving full payment and even sooner in the case of bankruptcy.

Havertys gives full disclosure of activities regarding estimating accounts receivable in

their 10-K and uses a conservative accounting policy in estimating the expected default

rate.

Impairment of Long-term Assets

Havertys also gives full disclosure of their activities regarding impairment of long-

term assets. In general, when assets are written-off, earnings are directly charged.

Deferring write-downs, however, would not only overstate assets, but overstate

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earnings. However, Havertys uses a conservative strategy in attempting to accurately

impair long-term assets.

An asset should be impaired if its realizable value falls below its book value.

Haverty’s 10-K states, “If the estimated future cash flows are less than the carrying

amount of the asset, an impairment loss calculation is prepared... An impairment loss is

recorded for the portion of the asset’s carrying value that exceeds the asset’s estimated

fair value.”

Other than this, Haverty’s reserve for impairment of long-term assets is based upon,

“general economic conditions, economic conditions in specific markets including the

impact of new competition, the fair market value of owned properties, our ability to

sublease facilities and the accuracy of our related estimates” (Haverty’s 10-K).

Pension Plans

Pension plan costs require assumptions for future wage and benefit rates, worker

retirement rates, life expectancy of retirees, and the discount rate. If these forecasts

are too low, Havertys’ benefit obligations (a liability) as well as their expenses will be

understated, resulting in overstated earnings. Havertys’ 10-K states that these

assumptions are reviewed annually and “compared with external benchmarks to ensure

that they appropriately account for our future pension and retirement benefit

obligations.” While it is difficult to determine if these are fair and accurate

assumptions, many of Havertys competitors share a similar discount rate regarding

pension plans (around 5.75%).

Self insurance

Havertys is self insured because of losses regarding worker’s compensation, general

liability, and vehicle claims, and their reserve is based on their historical claims data.

This estimate is discounted and recorded as a liability. Management might have

incentive to underestimate these reserves, which would lead to overstated earnings;

however, since the discounted estimate is based off of actual historical data, it is safe to

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assume the rate is not manipulated. This shows Haverty’s conservative accounting

strategy regarding their estimate on insurance reserves.

Quality of Disclosure

All publicly traded companies are required to disclose information regarding their

finances in a report called a 10-K. Information in this 10-K will reveal the internal well-

being of the company and its quality of disclosure is crucial in determining a fair and

true evaluation of the firm. To determine the quality of disclosure within the report, we

must evaluate management’s accounting strategy. While companies must disclose

certain financial information, they hold the ability to divulge their strategic accounting

methods. Some firms choose to take advantage of their accounting flexibility and report

higher earnings, which is more favorable to potential investors, while others choose to

report with accuracy being the main goal. As we determined in the previous

paragraphs, Havertys is a high disclosure company.

Apart from strategically using operational leases over capital leases, which

reduce their debt, Havertys leans toward a more conservative accounting policy. This

conservative accounting policy, along with providing high disclosure of their accounting

information, provides the potential investor with a transparent and more comfortable

view of the firm’s operations.

Quantitative Analysis of Disclosure

There are two techniques used to analyze financial statements to determine

whether they have been manipulated. These two methods are known as the Sales

Manipulation Diagnostic and the Expense Manipulation Diagnostic. Both of these

methods have a set of ratios used to conclude if a company has tampered with their

financial statements. If there is a major change in a ratio that does not follow the

industry trend, there is speculation of manipulation and it should be further inspected.

The Sales Manipulation Diagnostic ratios consist of comparing a company’s net

sales to other accounting features found in each company’s 10-K. The features that are

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used in a sales manipulation diagnostic are composed of the cash from sales, net

accounts receivables, inventory, and unearned revenues. These ratios are formulated to

determine if a company changed some factors around the net sales to embody their

performance.

The Expense Manipulation Diagnostic signifies whether a company incorrectly

reports their financial statement by understating their assets or liabilities. Some of the

features that are included in the expense manipulation diagnostic consist of the asset

turnover, accruals, and expenses.

Sales Manipulation Diagnostic

Sales manipulation diagnostics are used to compare past financial activities to

the present financial activities to depict any possible discrepancies within the company’s

accounting system. Comparing this financial information can enable investors to verify

if a company has manipulated their data. Below we have used several ratios related to

sales to compare Havertys to their top four competitors. To compute these ratios we

have received the net sales over the past five years and divided by cash from sales,

accounts receivables, inventory, and unearned revenue.

Net Sales/ Cash from Sales

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*

Information provided by company’s 10-K

The net sales to cash from sales ratio shows how much cash is collected from

the sales in a period. In order to calculate the cash from sales, you need to subtract the

increase of accounts receivable from the net sales or add the decrease of accounts

receivable from the net sales. The ratio trend is around 1:1. In the chart above, you can

see Havertys has progressed towards the ratio trend each year. If a company were to

be below the average of one, it would intend that the company has received more cash

than the sales recorded. The first three years shown in the chart, Havertys’ sales have

been understated compared to the industry trend. Overall, sales are supported by the

cash collected.

Net Sales/ Accounts Receivable

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*

Information provided by company’s 10-K

The net sales to net accounts receivable ratio shows the amount of accounts

receivables and/or credit a company receives from its sales. If a company’s ratio is

lower, such as Havertys, the company receives more credit and less upfront cash.

Havertys is low because they are purely a furniture store, so they receive more

accounts on credit due to the high price of furniture. On the opposing side, Pier One

has an incredibly high ratio. Pier One also sells other items rather than solely furniture,

so they collect more cash. The ratio also has a moderately steady trend that increases.

Pier One does not follow this trend though. Havertys’ sales are supported by credit

rather than cash.

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*

Information provided by company’s 10-K

The chart above shows Havertys compared to their direct competitor, Ethan

Allen. Both of these companies sell furniture primarily. Havertys has a potential “red

flag” in their ratio trend. As you can see, their ratio doubled in the five years shown.

This could be from manipulation or from the possibility of Havertys increasing their

current liability term from one year to two or three years. This means that instead of

the money due within one year, it could be extended to be paid off within two to three

years. The furniture industry relies heavily upon accounts receivables supporting their

sales.

Net Sales/ Inventory

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*

Information provided by company’s 10-K

The net sales to inventory ratio is a consistently steady trend. This ratio shows

how much the inventory supports the revenue. A higher ratio is preferred over a lower

ratio. When the ratio is higher, it means the company is proficiently using their

inventory to maximize their sales. As you can see above, Havertys’ ratio is one of the

highest of its competitors. The furniture industry’s ratios tend to be low in general. One

reason why these ratios are low is because furniture companies have to pay costs for

centralized storage facilities. Havertys has multiple warehouses where they store their

furniture, which makes the cost of inventory higher and the ratio lower.

Net Sales/ Unearned Revenue

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*

Information provided by company’s 10-K

The net sales to unearned revenue ratio is used to obtain a companies quota.

Unearned revenue is a liability where the customer deposits money before the services

are rendered. Havertys ratio trend is sensitive but in line with the industry’s trend. The

average ratio for the furniture industry is around 30. Below are the effects of not

recording a firm’s unearned revenue:

Assets = Liabilities + Equity Revenues - Expenses = Income

N O U O N 0

Sales/ Warranty Liabilities

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The net sales to warranty liability ratio does not apply to the furniture stores

provided. The products that are provided within the furniture firms have warranty

through their brand name. This makes the furniture stores not responsible for their

product’s warranty, leaving them with no liabilities.

Conclusion

After performing the sales manipulation diagnostic on Havertys and their top

competitors, we have found that Havertys could have manipulated their net sales to net

account receivables ratio. As we previously stated, it also could be caused from a

change in the time period of current accounts receivables. Other than that one potential

“red flag,” Havertys followed the industry trend and stayed consistent with its

competitors. It is important to compare net sales with other factors when examining a

company. The furniture industry heavily relies on their sales and inventory.

Expense Manipulation Diagnostic

Core expense diagnostics are a set of ratios used to determine if a firm has

manipulated their financial reports. Based on this set of ratios we are able to compare

Havertys and its competitors over a five year period. If Havertys or its competitor’s

diagnostic ratios show substantial fluctuations then it is imperative that the firm be

examined more thoroughly. By doing so investors can determine if a company has

manipulated their expenses, determine the reliability of a firm’s financial statements,

and possibly expose a trend that is being shared by the home furnishings industry.

Asset Turnover

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*

Information provided by company’s 10-K

The asset turnover ratio shows a firm’s ability to efficiently use assets to acquire

sales (About.com). This ratio is found by dividing net sales by total assets. The graph

above shows Havertys and its competitors’ asset turnover for the past five years. Like

many of its competitors, Havertys’ ratio decreased slightly to 1.69 in 2003 and then

continued a steady increase until 2006 where it reached 1.83. The reason why it is so

important to evaluate a firm based on this ratio is because it is fairly simple for

managers to improperly record expenses as assets on their financial statements. In the

retail industry, it is common for firms to use operating leases. These leases are usually

recorded off the books unlike capital leases. If a firm decides to record a capital lease

when an operating lease is appropriate, then assets can be overstated. This can

significantly alter the outcome of this ratio and signal manipulation. However, Havertys’

financials properly disclose its operating leases leading us to believe it is not trying to

understate its expense and manipulate its financial statements.

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Cash Flow From Operations/ Operating Income

*

Information provided by company’s 10-K

The cash flow from operations to operating income ratio illustrates the

relationship between the amounts of cash generated from operating activity and the

amount of operating income recorded on the income statement (Wikipedia.org). The

above graph illustrates this ratio for Havertys and its competitors. The retail industry

does have a tendency for this ratio to be large due to the high cost of selling the

product, including showrooms, advertising, and commissions to sales staff (First

Research). These selling, general and administrative costs all decrease operating

income which in turn increases the size of the ratio. According to the graph, Havertys’

CFFO/OI ratio has declined from 1.99 in 2002 to 1.18 in 2006. This declining ratio is a

great result for Havertys and will put the firm closer to the industry average. A possible

explanation for this is better management of its selling, general and administrative

expenses. This will allow an increase in operating income thus decreasing the ratio over

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time. Overall, Havertys has struggled to support operating income by cash flow from

operations, but is showing signs of improvement. From this we have determined that

the figures shows no signs of manipulation.

Cash Flow From Operations/ Net Operating Assets

*

Information provided by company’s 10-K

The cash flow from operation to net operating assets ratio shows the return on

operating assets which include property, plant, and equipment. The graph above shows

Havertys’ ratio declining from .65 in 2002 to .12 in 2006. This decrease is consistent

with the CFFO/OI, which is a good indicator that Havertys is not manipulating its

expenses. When there is a manipulation of operating income it will most likely leave a

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trail that can be tracked by looking at net operating assets. If a firms operating income

is decreasing so should its net operating assets. If not, that is a “red flag” that the

company has manipulated its financial statements. Another factor that must be

considered is operating leases which are used widely in the retail industry. If a firm

decides to record a capital lease when an operating lease is appropriate then assets can

be overstated. This manipulation would cause net operating assets to increase and the

ratio to be much smaller. Havertys reported operating leases of $304,606 thousand in

2006. If the company would have reported those as capital leases, net operating assets

would have been overstated. The proper disclosure of operating leases and the

decrease in the ratio are key indicators that they have not manipulated this part of their

financial statements

Total Accruals/Change in

Sales

* Information provided by company’s 10-K

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The Total Accruals to Net Sales ratio illustrates how the total accruals of a firm

match a company’s net income. It is found by subtracting net income from cash flow

from operations and dividing it by the change in sales. The graph above shows this

ratio for Havertys and its competitors over the past five years. A large ratio is common

in the retail industry and can be explained by sales on credit. “Because furniture is often

expensive, credit availability is an important aspect of sales, especially at the lower end

of the market, where more than 50 percent of sales are financed. Many retailers offer

their own financing, but many have arrangements with third parties” (First Research).

This can lead to a high ratio because sales are on credit therefore recorded in the

accounts receivable section of the balance sheet. As you can see from the graph

Havertys’ ratio is decreasing at a very slow rate along with its competitors. From this we

can conclude that there are no signs of manipulation.

Pension Expense/ Selling, General, & Administrative Expense

*

Information provided by company’s 10-K

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The pension expense ratio compares selling, general, and administrative

expenses to pension expenses incurred by a firm. The graph above illustrates this ratio

for Havertys and Pier One who are the only ones out of our study who have a defined

benefit plan. Havertys’ defined benefit pension plan covers all employees hired on or

before December 31, 2005 and are based on years of service and the employee’s final

average compensation (Havertys 10-K). This ratio has remained relatively steady

changing only from .018 to .015 from 2002-2006. Therefore, there are no signs of

expense manipulation.

Conclusion

After conducting the expense manipulation diagnostic for Havertys and its

competitors over the past five years, we found that Havertys ratios are consistent with

the industry. The company has even have outdone its competitors by steadily

decreasing cash flow from operations to operating income. This means they are using

better management skills to decease their operating costs. Overall, from the results of

the expense manipulation diagnostic we can conclude that Havertys has not

manipulated their financial statements to over or under report their earnings.

Potential Red Flags

Recognition of potential “red flags” is one of the most important steps in the

accounting analysis. These “red flags” are often the result of a firms own management

who manipulate their financial records to seem more appealing to investors. However,

this manipulation often leaves a trail or “red flags” that can be uncovered by analysts.

One of the easiest ways to discover these discrepancies is to use the sales and expense

manipulation diagnostics that were used in the previous section. These ratios will

automatically tell an analyst if a company’s financial records are distorted and where

the source of the distortion is. It is very important that firms recognize any “red flags”

because discrepancies can cause investors to doubt the reliability of a firm’s financial

reports.

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Diagnostic Ratio’s

Diagnostic ratios are an easy way to determine any discrepancies of a firm’s

financial statements. After conducting both the sales and expense diagnostics we can

assume that Havertys has not intentionally manipulated there financial statements. All

of Havertys’ ratio results except one were consistent with other competitors in the

home furnishings industry. As previously stated, Havertys has a potential “red flag”

when comparing their net sales to net accounts receivable ratio. The ratio doubles

within the five year period. However, this could be from an extension in the time frame

current accounts receivables are due.

Operating Leases

A common manipulation of expenses occurs with the improper recording of

leases. If a company records a capital lease when an operating lease is appropriate

then assets can be overstated. However, if they record an operating lease when a

capital lease is appropriate then assets can be understated. It is especially important to

investigate this in the home furnishings industry where operating leases are widely

used. Havertys 10k reports $304,606,000 in operating leases in 2006 that are not

recorded on the balance sheet. Havertys initial operating lease terms are from five to

thirty years. They also require that Havertys pay all maintenance, property taxes and

insurance costs (Havertys 10K). This information would signal an investigation in to

Havertys to make sure they are not manipulating their expenses. After reevaluating

Havertys leases it is determined that in order to truly reflect the company’s financial

position the operating leases should be shown as both an asset and a liability on the

balance sheet. In the next section, undo accounting distortions, we will calculate the

amount of operating leases that should be added to the financial statements and the

impact it has on them. This same process of investigation should be used by analysts

whenever the recording of leases is involved.

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Post- Retirement Benefit Plans

The disclosure of post – retirement benefit pans can often manipulate a firm’s

financial records. Havertys, however, discloses their defined benefit plan in great detail

in their 10K. Their benefit plan is for all employees who were hired before December

31, 2005 and are based on years of service and the employee’s final average

compensation. The table they provide in their 10K also discloses their current and

future benefit obligations, return on plan assets and the discount rate used. They have

also adopted FASB SFAS No. 158 which is an amendment on how employers should

account for defined benefit and other postretirement plans (Havertys 10K). This amount

of detailed disclosure is encouraged and can lead to the reduction in potential “red

flags” for a firm.

Conclusion

After a thorough investigation of Havertys diagnostic ratios, operating leases,

and post-retirement pension plan there are very few red flags for the firm. The net

sales to net accounts receivable ratio and the recording of operating leases could be a

concern for investor. However, Havertys has gone above and beyond in the disclosure

of their operating leases and defined benefit plan. They even have recently adopted

new FASB accounting standards to better disclose information on their financial records.

Undo Accounting Distortions

The final step in the accounting analysis is to undo any accounting distortions. If

an investigation determines that there is manipulation analysts must go back and

reevaluate the impact of those distortions. After conducting the sales and expense

diagnostics for Havertys and its competitors in the home furnishings industry over five

years, there are no major red flags that would indicate the need for a reevaluation. The

company has adopted many FASB accounting policies to increase its financial

statements reliability.

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However, we did find that operating leases were significant enough to reevaluate

the firm and add those obligations back on to their balance sheet. Fortunately, Havertys

10-K provided us with the beginning balance, interest rate and five initial payments to

help us discount operating leases back to present value for 2003-2007. To undo the

distortion, Havertys’ financial statements will be adjusted to increase assets and

liabilities related to these operating lease obligations. Refer to the appendices which

shows our calculations.

Once the calculations were available the 2003 -2017 balance sheets, income

statement, and statement of cash flows were restated to reflect the changes. The

impact of capitalizing the lease obligations are shown on the restated financial

statement in the appendix. You will be able to see the dramatic effect on net income,

total assets, total liabilities, shareholders equity and cash flow from operations.

Financial Analysis, Forecasting Financials, and Cost of Capital Estimation

When valuing a firm it is important to collect information from the firm, its

competitors, and the industry as a whole. Using the information found in trend and

benchmark analysis of liquidity, profitability, and capital structure ratios we are able to

construct a ten year forecast for Haverty’s financial statements. Lastly, we used CAPM,

regression analysis, and information on interest rates and pricing to estimate Havertys

cost of debt and equity.

Financial Ratio Analysis

Using ratios to compute a firm’s liquidity, profitability, and capital structure can

give you crucial information when evaluating a company. These ratios help compare a

firm to its competitors and help in forecasting the firm’s financial statements. Ratios are

the key tools used when evaluating a firm’s profitability and growth to find its value.

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Liquidity Analysis

Liquidity refers to the firm’s ability to its short term obligations. Liquidity ratios

measure the firm’s liquid assets used to help pay-off the firms current liabilities. If these

ratios are too low it might indicate that the company does not have enough liquid

assets to meet its short term obligations and if the ratios are too high, it might suggest

that the firm is holding too many liquid assets which is preventing them from expanding

the business.

Generally, the higher the ratios are better. However, these ratios must be

analyzed in the context of the entire industry to develop a clear picture of the firm’s

liquidity. The ratios used to evaluate Haverty’s operating efficiency include current ratio,

quick asset ratio, inventory turnover, and working capital turnover.

Current Ratio

Current Ratio 2003 2004 2005 2006 2007 Havertys 2.46 1.81 1.69 1.76 1.93 Bed Bath and Beyond 2.34 2.56 2.40 2.04 2.36 Ethan Allen 2.68 2.16 1.97 2.91 2.60 Pier One 2.72 2.49 2.33 2.68 2.23 Williams-Sonoma 1.47 1.55 1.67 1.83 1.75

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Industry 2.33 2.11 2.01 2.24 2.17

The current ratio is an indication of the company’s ability to meet short-term

obligations with its short term assets. This is important because a good current ratio is

a good indicator of the firm’s health and operating efficiency.

The chart and graph above follows the current ratios for Havertys and its

competitors over the past five years. Current ratio is calculated by dividing the year’s

end current assets by the current liabilities and it is generally understood that the ratio

should be above 1.

Over the past five years, Havertys maintained an average current ratio of 1.91.

This demonstrates that Havertys was able to pay-off their short-term debts even

though it falls short of the industry average of 2.17.

Over the past five years Havertys has generally become less liquid mainly

because of its decreasing current assets. This decrease in current assets is mainly due

to decreasing inventories. However, in 2006 the current ratio begins to grow due to

decreases in current liabilities. This is largely due to decreases in customer deposits and

accounts payable and accrued liabilities.

While evaluating liquidity, it is important to take their cash flows into

consideration. Operating cash flows give a general picture of the firm’s financial health.

Analysts are not concerned with Haverty’s current ratio because they believe their

capital resources are sufficient to fund capital expenditures, working capital

requirements, scheduled debt payments, dividends to our stockholders, and stock

repurchases (Havertys 10-K).

Quick Asset Ratio

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Quick Asset Ratio 2003 2004 2005 2006 2007 Havertys 1.44 0.99 0.87 0.75 0.82 Bed Bath and Beyond 0.91 1.13 1.97 0.66 1.04 Ethan Allen 1.21 0.79 0.58 1.61 1.51 Pier One 1.36 1.16 1.07 1.40 0.96 Williams-Sonoma 0.72 0.64 0.81 0.95 0.78 Industry 1.13 0.94 1.06 1.07 1.02

The chart and graph above shows the quick asset ratios for Havertys and its

competitors over the past five years. The quick asset ratio is very similar to the current

ratio, in that it evaluates the firm’s ability to meet short term obligations. However, it

only accounts for those assets which are liquid within a period of two days. These quick

assets include cash and cash equivalents, marketable securities, and accounts

receivable and exclude any inventory. To derive the quick asset ratio, subtract

inventories from current assets and divide by current liabilities.

This ratio is important because it gives the investor a more strenuous look at the

health and efficiency of a company. The assets used to compute this ratio are the asset

that would most likely be used to cover short-term obligations is case of an emergency.

Over the past five years Havertys had an average quick asset ratio of 0.97 and is

not significantly different than the competitors. However, the ratio steadily falls. In

2006, Havertys felt the pressure to increase storage space due to lack of sufficient

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space which resulted in poor sales volume. This increased inventories $17.1 million. In

previous years, Havertys was cutting back on inventory volume, which accounts for the

higher quick asset ratio. The decrease in the ratio demonstrates Havertys need of

expansion and their ability to meet demand and should not alarm investors.

Inventory Turnover

Inventory T/O 2003 2004 2005 2006 2007 Havertys 3.57 3.66 4.01 3.47 3.85 Bed Bath and Beyond 2.34 2.57 2.57 2.55 2.51 Ethan Allen 2.31 2.64 2.62 2.77 2.63 Pier One 3.00 2.91 3.07 3.18 3.19 Williams-Sonoma 4.39 4.07 4.12 4.04 3.67 Industry 3.12 3.17 3.28 3.20 3.17

Inventory turnover is a measure of a firm’s operating efficiency and is calculated

by dividing cost of goods sold by inventory. Inventory turnover shows how many times

a firm’s inventory is sold and replaced over a year. Havertys has an average inventory

turnover ratio of 3.71 which is higher than the industry average of 3.19.

Generally, a high ratio implies strong sales and good inventory control. In

Haverty’s case, it means low inventories and inefficiency. As mentioned before,

Havertys had a shortage of storage space which accounts for their low inventories. In

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2006, Haverty’s increased their storage space and inventories which accounts for the

dramatic decrease in their inventory ratio from 2005. Also, low inventories may in part

account for their low sales in comparison to their competitors. After increasing storage

space in 2006, the inventory turnover ratios dropped to a more efficient rate.

Although a high inventory turnover may suggest a healthy demand and liquidity,

for the most part their turnover merely suggests operating inefficiency.

Days Inventory

Days Inventory 2003 2004 2005 2006 2007 Havertys 102.24 99.73 91.02 105.19 94.81 Bed Bath and Beyond 155.68 142.00 141.99 142.95 145.42 Ethan Allen 158.01 138.26 139.31 131.77 138.78 Pier One 121.67 125.43 118.89 114.78 114.42 Williams-Sonoma 83.14 89.68 88.59 90.35 99.46 Industry 124.15 119.02 115.96 117.01 118.58

The chart and graph above demonstrates the day’s supply of inventory for

Havertys and its competitors. Day’s supply of in inventory is calculated by dividing the

number of days in a year by the inventory turnover ratio. In other words, it’s the

number of days it takes before a company can turn its inventory into revenue.

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Havertys day’s supply of inventory is consistent with the industry. Between 2003

and 2007, Havertys has decreased the days in inventory by 7.43 days while the industry

has decreased by 5.57 days.

Days’ supply of inventory is inversely related to inventory turnover. Usually, a

smaller number is better and means fewer days until you sell inventories and receive

sales revenue.

In Haverty’s case, the smaller than average days’ sales of inventory represents

their small inventory space. In other words, it takes fewer days to sell there inventory

because they have a smaller amount of inventory to sell.

Working Capital Turnover

Working Capital T/O 2003 2004 2005 2006 2007 Havertys 4.89 7.16 9.16 9.07 9.12 Bed Bath and Beyond 3.75 3.73 4.21 5.65 4.26 Ethan Allen 4.23 6.01 7.28 3.84 4.28 Pier One 4.18 4.32 4.91 3.66 4.65 Williams-Sonoma 11.77 11.24 8.92 7.83 7.88 Industry 5.76 6.49 6.90 6.01 6.04

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The graph and chart above shows the working capital turnover ratios for

Havertys and its competitors. Working capital turnover is derived by dividing sales by

working capital (current assets-current liabilities). It is a measure of the depletion of

working capital to the generation of sales over a given period (www.investopedia.com).

Working capital is the money used to fund operations and purchase inventory. The

higher the working capital turnover, the better, because it means that the company is

generating a lot of sales compared to the money it uses to fund the sales

(www.investopedia.com).

Over the span of five years, both the industry working capital turnover and

Havertys working capital turnover steadily increase. The reason for Haverty’s increase in

working capital turnover is explained by the steadily increasing sales and decreasing

working capital. Since working capital is invested in operations or inventory, it make

since that the more working capital is spent, the more sales revenue is generated.

Liquidity Conclusion

Overall, Havertys seems to maintain a healthy liquidity with a few problems in

operating efficiency. For the most part, Havertys also follows the industry trends, which

is a good indication of financial health. Havertys main concern lies in their small

inventory. Unreasonably low inventories can be just as damaging to a firm’s profitability

as unreasonably high inventories. Although their low inventory has not dramatically

affected their sales yet, it is a key concern in maintaining financial health in the future.

In 2006, Havertys took notice of this potential problem and increased their storage

space and inventories which allowed for a more efficient inventory turnover rate.

Overall, Havertys seems to maintain a healthy liquidity and their operating efficiency is

moving in the right direction.

Profitability Analysis

In this section we have evaluated Havertys against its competitors in the home

furnishings industry using six profitability ratios. These include gross profit margin,

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operating income margin, net profit margin, asset turnover, return on equity, and

return on assets.

“A firm’s growth and profitability are influenced by its product market and

financial market strategies. The product market strategy is implemented through the

firm’s competitive strategy, operating policies, and investment decisions”

(Palepu&Healy). For us to determine if Havertys is effectively implementing their

product market strategy we will use the six profitability ratios mentioned above. This

will not only allow us to determine if Havertys will have positive growth and profitability,

but, will also allow us to see if they are able to compete with other firms in their

industry.

Gross Profit Margin

Gross Profit Margin 2003 2004 2005 2006 2007Havertys 49.10% 48.28% 47.79% 49.60% 49.67%Pier One 40.30% 40.30% 40.50% 40.60% 39.90%Williams Sonoma 40.31% 40.32% 40.52% 37.20% 39.90%Bed Bath and Beyond 41.43% 41.91% 42.47% 42.79% 42.85%Ethan Allen 49.53% 48.27% 48.58% 50.73% 52.38%

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Gross Profit Margin “is an indication of the extent to which revenues exceed

direct costs associated with sales” (Palepu&Healy). It is calculated by first subtracting

the cost of goods sold from revenues to find gross profit. Then gross profit is divided by

the currents year’s revenue. The graph above shows this ratio for Havertys and its

competitors in the home furnishing industry over the past five years. According to

Investopedia.com “a high gross profit margin indicates that a business can make a

reasonable profit on sales, as long as it keeps overhead costs in control.” In other

words, firms can measure basic product profitability and determine if production costs

need to be adjusted. According to the graph Havertys and its competitors show a

definite trend of maintaining a gross profit margin between 40-50%. This indicates that

the prices of each firm’s products may slightly differ but that all of the competitors run

a relatively equal production process.

Operating Income Margin

OPERATING INCOME MARGIN 2003 2004 2005 2006 2007Havertys 4.84% 3.84% 2.19% 2.52% -0.17%Havertys Restated 1.77% 2.49% 0.41% 0.43% -2.73%Pier One 11.66% 10.30% 5.38% -2.41% -13.94%

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Williams Sonoma 13.87% 14.49% 16.98% 8.94% 8.79%Bed Bath and Beyond 9.44% 14.28% 15.39% 15.13% 13.44%Ethan Allen 13.31% 13.38% 13.59% 13.38% 11.05%

The graph above illustrates Havertys and its competitors operating profit margin

over the past five years. Operating Income Margin is calculated by dividing operating

income for a given year by total revenue. This percentage will allow a firm to tell if they

are effectively controlling costs contributed to operating activities and ultimately if they

are able to cover their fixed costs. “A business that has a higher operating margin than

its industry’s average tends to have lower fixed costs and a better gross margin, which

gives management more flexibility in determining prices” (about.com). Unfortunately for

Havertys their ratio falls well below the industry average. This is due to a steep decline

in operating income with sales staying relatively constant. In 2007 selling, general and

administrative costs were higher than the firm’s operating income leading to Havertys’

operating profit margin to be negative. From this information investors are able to tell

that Havertys does not currently have control over their operating costs and may

struggle to cover their fixed costs. The graph also shows that the restated operating

income margin for Havertys has the same trend as it does before restatement. This

leads us to conclude that operating leases did not have a dramatic impact on this ratio.

Net Profit Margin

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NET PROFIT MARGIN 2003 2004 2005 2006 2007Havertys 3.25% 2.63% 1.82% 2.04% 0.24%Havertys Restated 1.77% 1.10% -1.18% -2.41% -4.41%Pier One 7.37% 6.53% 3.31% -2.24% -14.02%Williams Sonoma 5.27% 5.71% 6.10% 5.57% 5.60%Bed Bath and Beyond 8.24% 8.92% 9.81% 9.86% 8.98%Ethan Allen 8.19% 8.32% 8.36% 8.04% 6.89%

Net Profit Margin illustrates the profit a firm makes on its operating activities.

This percentage is calculated by dividing net income for a given year divided by total

revenue. A high ratio therefore indicates that a firm is efficiently converting their

revenue in to profit. However, “in some cases, lower profit margins represent a pricing

strategy. Some businesses, especially retailers, may be known for their low-cost, high-

volume approach. In other cases a low net profit margin may represent a price war

which is lowering profits” (About.com). Havertys’ net profit margin is slightly under the

industry average but declining at a steady rate much like its competitors.

Although Havertys is not known for its low-cost merchandise, their low ratio

could be attributed to pricing wars. Since the home furnishings industry is directly

related to the housing market, retailers are experiencing low and even negative sales

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growth. Retailers are left to come up with ways to sell their inventory including reducing

their sales prices. Havertys, PierOne, and Williams-Sonoma all sell merchandise priced

in the upper middle range. These three competitors’ net profit margins are the lowest in

the industry and have declined over the past five years. This could indicate that they

are involved in a price war to try to boost their own sales growth.

Again, Havertys restated net profit margin does not signal any signs of operating

leases having a huge impact on the ratio.

Asset Turnover

ASSET TURNOVER 2003 2004 2005 2006 2007Havertys 1.83 1.81 1.76 1.86 1.67 Havertys Restated 0.65 0.63 0.56 0.55 0.54 Pier One 2.03 1.86 1.73 1.65 1.39

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Williams Sonoma 2.37 2.18 2.13 2.21 1.88 Bed Bath and Beyond 2.22 2.05 1.80 1.82 1.96 Ethan Allen 1.32 1.31 1.45 1.70 1.24

The graph above shows the Asset Turnover for Havertys and its competitors over

the past five years. This ratio is calculated by dividing sales in the current year by total

assets from the previous year. The asset turnover ratio allows manager to tell if a firm

is efficiently using their assets. “Companies with low profit margins tend to have high

asset turnover, while those with high profit margins have low asset turnover”

(investopedia.com). This is also true for Havertys whose profit margins are below the

rest of the industry, but whose asset turnover is equal if not higher than its

competitors. From the graph it is easy to determine the industry trend of an asset

turnover between 1.7 and 2.2. The graph also shows a steady decrease in the ratio by

all of the competitors over the past five years.

The asset turnover for Havertys restated does cause some concern. While it is

decreasing along with the industry, the ratio is much lower than that of its competitors.

This is largely due to the significant amount of capital lease rights that were added back

to total assets. This paired with sales staying consistent shows the dramatic impact

capitalizing Havertys operating leases has on their financial statements.

Return on Assets

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ROA 2003 2004 2005 2006 2007 Havertys 6.22% 5.00% 3.19% 3.46% 0.37% Havertys Restated 2.30% 1.98% -2.07% -2.10% -7.36% Pier One 15.00% 12.13% 5.75% -3.70% -19.46% Williams Sonoma 12.50% 12.43% 13.00% 10.96% 10.54% Bed Bath and Beyond 18.34% 18.25% 17.63% 15.78% 17.57% Ethan Allen 10.78% 10.86% 12.12% 13.64% 8.52%

The graph above illustrates Asset Profitability for Havertys and its competitors

over a five year period. This ratio allows managers to determine how much profit a firm

can generate for each dollar of assets invested (pelpu&healy). This ratio is found by

dividing net income of the current year by total assets of the previous year. “The ROA

figure gives investors an idea of how effectively the company is converting the money it

has to invest into net income. The higher the ROA number, the better, because the

company is earning more money on less investment” (investopedia.com). Havertys’

ROA is noticeably smaller than its competitors in the home furnishing industry. Once

again this is largely due to their drastically decreasing operating income over the past

five years. Until Havertys can gain more control over their operating expenses they will

be unable to effectively invest their money into net income.

The restated ROA ratio for Havertys shows that the impact on net income and

total assets from adding back operating leases. Havertys was already struggling with

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operating income and the capitalization of their operating leases did not help. This

capitalization has further decreased net income and increased total assets. This is main

cause for the ROA to be negative from 2005-2007.

Return on Equity

ROE 2003 2004 2005 2006 2007 Havertys 11.32% 8.96% 5.53% 5.73% 0.60% Havertys Restated 6.22% 3.06% -3.44% -2.10% -13.71% Pier One 20.10% 17.26% 9.11% 14.52% -12.00% Williams Sonoma 23.36% 24.41% 23.77% 19.97% 18.56% Bed Bath and Beyond 27.61% 27.51% 25.36% 22.91% 26.27% Ethan Allen 14.53% 14.89% 17.39% 18.28% 16.58%

The graph above illustrates the Return on Equity for Havertys and its competitors

over a five year period. This ratio allows managers to determine how well firms are

using the funds invested by their shareholders to generate returns (Pelpu & Healy).

ROE is found by dividing net income for the current year by shareholder’s equity of the

previous year. According to the text Business Analysis & Valuation, “over a long period

of time, largely publicly traded firms in the U.S generate ROE’s in the range of 11 to 13

percent.” Havertys ROE did fall in to this category in 2003 with 11.32% but was then

quickly pushed out when their ratio dropped drastically to .6% in 2007.

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This decline is largely due to net income dropping from $25,331 in 2003 to

$1,758 in 2006 while stockholder’s equity remained relatively constant. PierOne

Imports, Williams-Sonoma, Bed Bath and Beyond also followed this declining ROE

trend. This is unfortunate because the higher a firms’ ROE compared to the industry the

better and the more likely that the firm can create cash internally (about.com). From

the graph Ethan Allen seems to be an example of this keeping their ROE relatively

stable and high compared to the other competitors giving them an advantage in today’s

slowing economy.

Conclusion

From these six profitability ratios we were able to determine that Havertys will

struggle to have positive growth and profitability. This is largely due to their growing

operating expenses. If they do not gain control over these expenses Havertys will

struggle to cover fixed costs and have low asset profitability. They will also have a hard

time creating cash internally due to the large amount of operating expenses that have

drastically decreased operating income.

Capital Structure Analysis

The capital structure analysis determines the way a firm finances its assets based

on its liabilities and stockholders’ equity. The ratios used for analyzing are: Debt to

Equity Ratio, Times Interest Earned, Debt Service Margin, Altman Z-Score, Internal

Growth Rate, and Sustainable Growth Rate.

Debt to Equity Ratio

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Debt to Equity 2003 2004 2005 2006 2007Havertys 0.72 0.73 0.66 0.61 0.51Ethan Allen 0.36 0.49 0.45 0.95 0.96Pier One 0.51 0.54 0.62 0.98 1.54Williams-Sonoma 0.44 0.50 0.40 0.30 0.31Bed Bath & Beyond 0.51 0.44 0.45 0.49 0.50Industry Average 0.51 0.54 0.52 0.67 0.76HVT (restated) 0.64 0.70 0.69 0.70 0.68

The Debt to Equity Ratio is calculated by dividing total liabilities by total

shareholders equity. This ratio is used to indicate how much of debt and equity are

used to finance the firm’s assets. When a firm finances most of its assets through

equity, the ratio has a tendency to be lower. Firms that have a lower debt to equity

ratio are inclined to have poor credit ratings, and firms with a higher ratio are inclined

to have better credit ratings. Havertys’ debt to equity ratio is slowly declining, while the

industry trend is slowing increasing.

Times Interest Earned

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Times Interest Earned 2003 2004 2005 2006 2007Havertys 10.89 10.32 17.29 -7.29 -1.49Ethan Allen 185.21 197.20 169.49 15.03 9.45Pier One 87.95 110.16 56.63 -16.40 -14.04Williams-Sonoma 140.38 116.20 178.77 176.39 145.47Bed Bath & Beyond 42.52 62.67 42.21 24.48 20.46Industry Average 93.39 99.31 92.88 38.44 31.97

Times Interest Earned is computed by dividing a firm’s earnings before interest

and taxes (EBIT) by their interest expense. This ratio shows how many times a firm can

cover its interest charges on a pretax basis (investopedia.com). A high ratio can signify

an unwanted amount of debt. The industry has a declining Times Interest Earned Ratio.

Havertys has the lowest ratio of the competing firms. Williams-Sonoma has an inverse

relationship with the industry’s trend.

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Debt Service Margin

Debt Service Margin 2003 2004 2005 2006 2007Havertys 6.52 3.94 1.56 2.13 3.78Ethan Allen 112.78 128.32 21.93 54.83 282.95Pier One NA NA NA -0.67 1.08Williams-Sonoma 43.04 28.22 33.87 14.87 16.39Bed Bath & Beyond NA NA NA NA NA Industry Average 32.47 32.10 11.47 14.23 60.84

Debt Service Margin is calculated by dividing the operating cash flow of one year

by the current maturities of long term debt in the previous year. This ratio shows the

ability of a firm to repay its current portion of their long term debt. A higher ratio is

more preferable than a lower ratio. Havertys and Pier One have the lowest ratios out of

the competing firms above. Havertys debt service margin has been steady over the past

five years.

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Credit Analysis

Altman Z-Score 2003 2004 2005 2006 2007Havertys 3.84 3.70 3.72 3.84 3.96Ethan Allen 5.57 5.82 6.01 4.46 4.32Pier One 4.79 4.54 4.33 2.88 2.41Williams-Sonoma 5.57 5.49 5.77 5.02 4.88Bed Bath & Beyond 9.93 8.87 8.44 8.19 7.54Industry Average 5.94 5.68 5.65 4.88 4.62

Altman Z-Score, developed by Edward Altman in 1968, was developed to predict

the chance of a firm going bankrupt (Wikipedia.com). When a firm has a score of 1.81

or lower, the model predicts bankruptcy. When the firm has a score of 2.67 to 2.9, this

warns the firm of bankruptcy (investopedia.com). A score of 3.0 or higher ensures the

firm that they are financially healthy. As seen in the chart above, we have compared

Havertys’ Altman Z-Score with their top four competing firms. Pier One Imports is in the

low risk area of possibly going bankrupt. The industry trend is slowly declining. This

could be due to the fact of the economy and low house market. Possible manipulation

takes place for firms that use Altman Z-Score. The model is computed by the following

formula:

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1.2(a) + 1.4(b) + 3.3(c) + .6(d) + 1.0(e)

Where:

a = (Net Working Capital / Total Assets)

b = (Retained Earnings / Total Assets)

c = (Earnings before Interest and Taxes / Total Assets)

d = (Market Value of Equity / Book Value of Total Liabilities)

e = (Sales / Total Assets)

Conclusion

The capital structure analysis of Havertys is on-average close to the industry’s

analysis. Typically, Havertys was below the industry level for most of the ratios. Due to

the fact of the housing market’s declining economy, many firms have been forced to go

bankrupt. The Altman Z-Score graph is showing this illustration of the downward

economy.

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Growth Rate Analysis

Internal Growth Rate

IGR 2003 2004 2005 2006 2007Havertys 4.97% 3.95% 1.99% 2.16% -0.89%Ethan Allen 9.06% -6.18% 9.07% 9.95% 5.47%Pier One 12.74% 9.38% 5.64% 9.89% 13.97%Williams-Sonoma NA NA NA NA 9.19%Bed Bath & Beyond NA NA NA NA NA Industry Average 5.35% 1.43% 3.34% 4.40% 5.55%Havertys (restated) 1.25% 0.70% -3.28% -3.40% -8.63%

Internal growth rate is the “highest level of growth achievable for a business

without obtaining outside financing” (invetsopedia.com). IGR is calculated by

multiplying the company’s return on assets (ROA) by one minus the dividend payout

policy. Havertys internal growth rate is declining into the negatives. Not only does

Havertys have a low return on assets, but they pay dividends too, which causes the IGR

to be low. The Havertys’ restated IGR shows a downward trend into the negatives.

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Sustainable Growth Rate

SGR 2003 2004 2005 2006 2007Havertys 8.55% 6.84% 3.29% 3.47% -1.34%Ethan Allen 12.34% -9.24% 13.13% 19.41% 10.72%Pier One 19.25% 14.43% 9.13% 19.61% 35.45%Williams-Sonoma NA NA NA NA 9.55%Bed Bath & Beyond NA NA NA NA NA Industry Average 8.03% 2.41% 5.11% 8.50% 10.87%Havertys (restated) 2.05% 1.19% -5.52% -5.80% -14.27%

The sustainable growth rate is the “maximum growth rate that a firm can sustain

without having to increase financial leverage” (investopedia.com). This means that SGR

measures the amount a firm can grow without borrowing any money. This rate is

computed by multiplying IGR by 1 plus the Debt to Equity ratio. In 2007, once again,

Havertys growth rate is in the negatives. Havertys rates have been decreasing

throughout the past five years, opposite of the industry average. Once again, Havertys

restated SGR follows the trend of the original SGR by declining into the negatives.

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Financial Statement Forecasting

Accurately forecasting a firm’s financial statements is important because it will

enable you to get a glimpse of what the structure of that firm may look like in the

future. Most forecasts are done by using industry averages or ratios derived from a

firm’s past financial statements. Forecasts are not easy to compute and if not done

properly can result in high costs for a firm. This is because “managers [rely on]

forecasts to formulate business plans and provide performance targets; analysts [use]

forecasts to help communicate their view of the firm’s prospects to investors; and

bankers and debt market participants [use] forecasts to assess the likelihood of loan

repayment”(Palepu&Healy). If there are large forecasting errors, especially in the

beginning of the forecasting period, it can cause all of these people to improperly carry

out their job.

One of the most important ways to lower forecasting error is to begin with the

income statement. You must begin by carefully choosing a sales growth percentage

because this is what the rest of your forecast will be based off of. Once sales growth is

established then it is relatively easy to predict an appropriate asset turnover. With the

use of this ratio the income statement will then be able to be forecasted. Then the

statement of cash flows follows. With the use of

ratio trends and five years of Havertys past financial statements we were able to conduct a

forecast for the firm.

Havertys also has lease obligations that we discussed in the “Red Flags” section

that required us to restate their financial statements. The effect of these changes can

be seen in the appendix where we provided forecasting for both the actual reported

data and the restated data. We will discuss the impact in each of the appropriate

sections.

Income Statement

We first began by compiling Havertys’ income statements for the past five years.

Then we created a common sized income statement by dividing each line item in the

income statement by net sales. This allowed us to identify percentage trends in each

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line item, such as gross profit, cost of goods sold and total expenses, which we then

used to forecast out those items for the next ten years.

The next step was to identify a relevant sales growth percentage. This

estimation is vital to a successful forecast and is especially important for this particular

industry. The home furnishing industry is directly dependent on the success of the

housing market. Unfortunately, the housing market hit an all time low in 2007 and is

expected to decline well in to 2008. Therefore, to come up with an appropriate sales

growth rate we would have to factor in the state of the housing market. To help

determine this rate we used the chart below published by the National Association of

Realtors.

% change 2006 2007 2008 2009

Existing

Home Sales

-8.5 -12.8 -4.8 4.2

New Single

Family

Home Sales

-18.1 -26.4 -23.7 7.2

With the help of this table we were able to establish a sales growth of -15% in 2008,

4.5% in 2009, 6% in 2010 and then a steady increase of 7%.

To determine a percentage trend for selling, general & administrative costs we

looked at the common size balance sheet. Even though sales decreased in 2007 these

operating expenses did not decrease. For that reason we decided to use a higher

percentage of 48% than the average 46.25%.

Next, we had to determine an appropriate asset turnover ratio. This would help

to determine total assets on the balance sheet. The tables below show the calculations

for 2008 and the Asset turnover for 2003-2007.

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Asset Turnover 2008 = Forecasted Sales 2008/ Total Assets 2007

1.58= $666,921 / $421,937

Asset Turn. 2003 2004 2005 2006 2007

1.83 1.81 1.76 1.86 1.67

As you can see the asset turnover calculated for 2008 is much lower than that in

previous years. This is largely due to the decrease in sales stemming from the decline in

the housing market. Since housing sales are forecasted to increase in 2009 we decided

to slowly increase our asset turnover from 1.58 to 1.65 then to a steady 1.78 in 2010.

Doing this will allow us to include the changes in the housing industry and give us a

more accurate forecast.

On the restated income statement we added the operating lease expense and

subtracted the depreciation to give us a new operating income. Then the capital

interest expense was subtracted to give us a new net income. From the restatement

you can see a significant change in net income for years 2003-2017.

Balance Sheet

As mentioned above we were able to forecast an appropriate asset turnover ratio

for Havertys until 2017. This allowed us to forecast total assets on the balance sheet by

dividing the estimated sales by the estimated asset turnover ratio. We also created a

common size balance sheet by dividing each asset line item by total assets, each

liability line item by total liabilities, and each shareholder’s equity by total shareholder’s

equity. Just like in the income statement this allowed us to identify percentage trends

to help forecast line items.

One of these percentage trends allowed us to forecast current assets using at

estimated value of 50%. In order to forecast current liabilities we decided to calculate

out the current ratio from 2003-2007. From this set of ratios we estimated out a 1.71

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current ratio to find 2008-2017. Using the forecasts for current liabilities and the current

ratio we were able to reasonably forecast current liabilities.

The next step was to determine retained earnings and shareholder’s

equity. To find retained earnings we first had to forecast the dividend payments. The

table below shows the forecasted dividends for 2008-2017. Even though net income

was reported as $1758 in 2007, Havertys still paid $59719 in dividends. We decided

that we should decrease dividends for 2008 to reflect the decline in the housing market

then increase at a steady rate from 2009 on.

Dividends 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

$5904 $5939 $6,067 $6,293 $6,519 $6,744 $6,970 $7,196 $7,422 $7,647

Using these dividends we were able to forecast retained earnings (RE(t-1) + NI (t) –

Div (t)) and shareholders’ equity (SE (t-1) + NI (t) – Div(t)).

The last step of the balance sheet was to forecast total liabilities. This was simply

done by subtracting the forecasts of shareholders’ equity from total assets.

On the restated balance sheet we added capital lease rights and capital lease

obligations to the appropriate sections. This caused a dramatic increase in our total

assets. Simultaneously the decrease in net income decreased our shareholder’s equity.

The impact from this was an increase in our total liabilities.

Statement of Cash Flows

The two most important items to forecast on the statement of cash flows is cash

flow from operations and cash flow from investing activities. In order to make the most

accurate forecast for CFFO you must calculate the three following equation: CFFO/Net

Sales, CFFO/ Net Income, CFFO/ Operating Income. Out of these three you should pick

the ratio with the most structure or take the weighted average of all three. One with

the most structure for Havertys was CFFO/ Net Sales. We took the average ratios and

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decided upon 5.98%. To forecast CFFO you simple multiply the forecasted sales for a

given yar and multiply it times the CFFO/net Sales ratio of 5.98%.

In order to calculate cash flow from investing activities you must determine the

net change in assets for each year. We were able to forecast out property, plant, and

equipment and used its percentage change to forecast the cash flow from investing

activities.

For the restatement of the statement of cash flows, we inserted out new net

income in year 2003-2007 and recalculated the cash flow from operations. This change

also changed the CFFO/Sales ratio we used to forecast out CFFO for 2008-2017. The

new ratio of .48% was then used to forecast out the new CFFO to accurately reflect the

capitalization of out lease obligations.

Cost of Capital Estimation

The most common way to measure cost of capital is by the Weighted Average

Cost of Capital (WACC). This calculation conveys each “category of capital

proportionately weighted” (investopedia.com). In order to find the cost of capital you

must compute many formulas, such cost of equity and cost of debt. These formulas are

shown below.

Cost of Equity

The first step of calculating cost of capital is to find the cost of equity. There are

two different ways to achieve this: the Capital Asset Pricing Model (CAPM) and the Back

door method.

The Capital Asset Pricing Model involves computing the cost of capital with the

following variables; risk free rate, beta, and market risk premium. We gathered

information for the risk free rates on a 3 month, 6 month, 2 year, 5 year, and 10 year

Treasury Bills. To get the market return we used the S&P 500 closing prices. The

market risk premium equals the market return minus the selected treasury risk free

rates.

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After obtaining the risk free rate and the market risk premium, the next step is to

compute beta. To compute beta we ran 25 regressions using the 5 risk free rates from

the Treasury Bills over intervals of 24 months, 36 months, 48 months, 60 months, and

72 months. After running the regression, the adjusted R squared tells you the percent

of data beta covers. The larger the adjusted R square, the better. In Havertys’

regressions, the adjusted R square was under ten percent (refer to the appendix). Due

to the fact that this does not give much information, we must do the Back Door Method

to compute the Cost of Equity.

The Back Door Method consists of the following factors: Return on equity, price

to book ratio, and the growth rate on earnings. The Back Door Method is more efficient

for Havertys to compute cost of equity. According to Havertys’ 10-K; the return on

equity is .62%, the price to book ratio is .82, and the growth rate on earnings is -

48.40%. This gives us an estimation of 11.38% for our cost of equity.

Back Door Method = ROE + [(P/B)-1]g

(P/B)

Cost of Debt

The cost of debt is the firm’s long term and current debt. The cost of debt is

calculated by using various interest rates associated with Havertys’ debt found in their

10-K. To get the cost of debt, we took every liability variable and matched them with

their interest rate. We multiplied their interest rate by the weighted average, which is

each liability as an individual divided by all the liabilities as a total.

For the current liabilities without a given interest rate (accounts payable, accrued

liabilities, and customer deposits), we pulled 2.58% from a 3-month non-financial

commercial paper rate from the St. Lewis Federal Reserve website. The other interest

rates were provided for us through Havertys’ 10-K. (Refer to Appendix for

computations). The weighted average cost of debt is 4.74%

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Weighted Average Cost of Capital (WACC)

The WACC shows how much interest a firm must pay for every dollar it finances

(investopedia.com). There are many factors that affect the weighted average cost of

capital. The WACC formula is shown below with all the factors that affect it:

Where: Havertys:

Re = cost of equity Re= 11.38%

Rd = cost of debt Rd= 4.74%

E = market value of the firm's equity E= 202,200

D = market value of the firm's debt D= 143,092

V = E + D V= 345,292

E/V = percentage of financing that is equity E/V= .58559

D/V = percentage of financing that is debt D/V= .414409

Tc = corporate tax rate (For after tax WACC)

*Information provided by Investopedia.com

By all the data we have collected, we can compute WACC. The problem above

shows a step by step process to compute WACC. Havertys’ weighted average cost of

capital is 8.62%.

Conclusion

Based on the data above, we have found the cost of equity (11.38%), the cost of

debt (4.47%), and the weighted average cost of capital (8.62%). We have presented

many methods to use, such as the CAPM, the back door method, and the WACC before

and after tax.

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Equity Valuations

In determining a firm’s equity value, analysis as well as investors may use

several different methods, models, and theories. These tools when paired with

intellectual contributions from analysts or investors can potentially give a fairly accurate

view of a firm’s true value. However, this view is solely that of the individual and is not

the only reasonably justifiable explanation. The value of a firm’s equity can be arrived

at by the use of two distinct models; the Method of Comparables, or by use of Intrinsic

Valuation Models. The Method of Comparables utilizes ratios that are then compared to

ratios of firms throughout the industry. Using comparable ratios is an easy way to place

a firm within an industry, but it lacks explanatory power and intellectual value is difficult

to add. On the other hand, one can use theory based Intrinsic Valuation Models. These

models are more difficult to configure, and requires an understanding in finance to pull

together figures from the financial statements in order to calculate a share price.

Together, these methods can give an investors and analysts a better understanding of a

firm’s value. Both of these methods will be employed in order to determine whether

Havertys is over, under, or fairly valued.

Method of Comparables

Trailing Price to Earnings

Trailing Price Earnings

PPS EPS P/E Industry

Avg. HVT Price

HVT $11.00 $0.08 134.18 13.83 $1.13 ETH $29.43 $2.46 11.96 WSM $25.68 $1.70 15.11 BBBY $31.27 $2.17 14.41 PIR $6.90 ($1.92) -3.59

*Information for competitors was gotten form yahoo Finance

The chart above shows the Havertys share price using the trailing price to

earnings method. The industry average was computed by dividing each firm’s

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Price/Share by their Earnings/Share, adding it all together and dividing by 3. We divided

by three because we dicided not to use Pier One Imports for this method due to their

negative EPS. This method suggests Havertys is overvalued, but the low share price is

due to Havertys having extremely low Earnings per Share. This method unfortunately

does not give even a remotely accurate view of the company’s value primarily due to

havertys net income being extremely volatile.

Forward Price to Earnings

Forward Price Earnings

PPS EPS P/E Industry

Avg. HVT Price

HVT $11.00 $1.06 10.38 16.06 $17.02 ETH $29.43 $2.32 12.66 WSM $25.68 $1.51 16.98 BBBY $31.27 $1.93 16.18 PIR $6.90 $0.37 18.42

*Information for competitors was gotten form yahoo Finance

This method of equity valuation is quite similar to that of the trailing price to

earnings except it is calculated using forecasted earnings data. Again we left out Pier

One because their EPS was still negative, which would have thrown off our calculation.

With the forecasted EPS of $1.06 multiplied by the forecasted industry average, this

model suggests that Havertys is undervalued. However, there are no financial theories

that suggest price (a backward looking measure) and projected earnings (a forward

looking measure) have any true ties.

Price to Book

Price to Book

PPS BPS P/B Industry

Avg. HVT Price

HVT $11.00 $13.00 0.85 2.65 $34.43 ETH $29.43 $13.14 2.24 WSM $25.68 $10.52 2.44 BBBY $31.27 $9.42 3.32 PIR $6.90 $2.66 2.59

*Information for competitors was gotten form yahoo Finance

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Above is the chart explaining price to book ratios for Havertys and its

competitors. The PPS/Book Price per Share results in the P/B ratio. To get an industry

average we added all the competitors P/B ratios and divided them by four. Pier One

was used this time because its P/B was within industry standards. The industry

standard P/B of $2.39 multiplied by Havertys P/B resulted in a price of $34.43. That

suggests that Havertys is underpriced. This however, is not necessarily the case since

Havertys P/B ratio is significantly lower than the industry because its BPS is actually

higher than its PPS. The fact that Havertys P/B ratio is so different from the others

could lead one to believe that Havertys is actually not in the same industry as it’s so

called competitors.

Price Earnings Growth

Price Earnings Growth

PPS EPS P/E PEG Industry

Avg. HVT Price

HVT $11.00 $0.08 134.18 487.66 4.87 $10.98 ETH $29.43 $2.46 11.96 12.36 WSM $25.68 $1.70 15.11 1.41 BBBY $31.27 $2.17 14.41 1.44 PIR $6.90 ($1.92) -3.59 4.26

*Information for competitors was gotten form yahoo Finance

In the caption above we have calculated the price earnings growth

computations. This model is derived by finding an industry average PEG by dividing the

P/E by the growth rate for each firm then adding them all up and dividing by three

because we did not use Pier One because their P/E was negative. We then divided

Havertys P/E by the industry PEG, which was obtained from yahoo finance, then

multiplied that number by havertys EPS and got a price of $10.98 which suggests that

Havertys is fairly priced. However, since Havertys PEG ratio is so much higher than the

industry average due to a large forecasted earnings growth rate, this model is not the

best in terms of explanatory power, and since Havertys’ growth rate on earnings is so

much higher, one could contend again that Havertys is in a different industry from the

other companied featured here.

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Price to EBITDA

Price to EBITDA

PPS EBITDA P/

EBITDA Industry

Avg. HVT Price

HVT $11.00 $22.18 0.50 0.10 $2.23 ETH $29.43 $137.36 0.21 WSM $25.68 $455.18 0.06 BBBY $31.27 $995.79 0.03 PIR $6.90 ($21.70) (0.32)

*Information for competitors was gotten form yahoo Finance

EBITDA is an acronym that stands for Earnings before interest, taxes,

depreciation and amortization. This calculation again pegs Havertys to the industry

average. Price divided by EBITDA renders P/EBITDA. The industry average was

calculated without Pier One because it had a negative EBITDA and would have skewed

the information. Multiplying the industry average by Havertys EBITDA give us a share

price of $2.23 which suggests that Havertys is overvalued.

Enterprise Value to EBITDA

Enterprise to EBITDA

EV EBITDA EV/

EBITDA Industry

Avg. HVT Price

HVT $224.56 $22.18 10.12 6.52 $144.60 ETH $952.50 $137.36 6.93 WSM $2,076.00 $455.18 4.56 BBBY $8,029.00 $995.79 8.06 PIR $783.47 ($21.70) (36.10)

*Information for competitors was gotten form yahoo Finance

Above is a chart showing the enterprise value to EBITDA. Enterprise value is

composed of the book value of liabilities plus the firm’s market value of equity minus

the firm’s cash and investments. The industry average was derived by averaging

competitors EV/EBITDA ratios. Pier One was not used because cause of the negative

value of its enterprise to EBITDA value. Havertys does not compare well to ther firms in

the industry with respect to enterprise value; even Pier One has a higher enterprise

value, therefore the model shows Havertys to be severely undervalued.

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Dividend Yield

Dividend Yield

PPS DPS P/DPS Industry

Avg. HVT Price

HVT $11.00 0.068 161.76 182.04 $12.38 ETH $29.43 0.220 133.77 WSM $25.68 0.112 230.31 BBBY $31.27 N/A N/A PIR $6.90 N/A N/A

*Information for competitors was gotten form yahoo Finance

According to financial theory, the value of a firm is the present value of future

cash flows. Dividends are a steady cash flow stream that can be used to measure value

of a firm. With the dividend yield model, the dividends of competitors are used as a

benchmark to determine how well a stock is priced. Only two of Havertys’ competitors

pay dividends, but the average obtained from those companies multiplied by Havertys

dividends per share DPS shows that Havertys is slightly undervalued at $12.32.

However, that is well within the 20% margin used in out intrinsic valuation sensitivity

analysis.

Price to Free Cash Flow

Price to Free Cash Flow

PPS FCF P/FCF Industry

Avg. HVT Price

HVT $11.00 28.98 0.38 0.88 $25.59 ETH $29.43 50.45 0.58 WSM $25.68 18.31 1.40 BBBY $31.27 47.09 0.66 PIR $6.90 -122.80 -0.06

*Information for competitors was gotten form yahoo Finance

Free Cash Flow (FCF) is derived by adding or subtracting Cash Flows from Investing

Activity from Cash Flows from Operations. We divide the price of a stock by their FCF to

get a price to free cash flow. We take the average of Havertys competitors (excluding

Pier One because it has a negative P/FCF) and multiply that by Havertys FCF to get a

price. The price $25.59 suggests that Havertys is undervalued.

108 | P a g e

Conclusion

Careful analysis of the computations in this section does not reveal weather or

not Havertys is fairly valued or not. Only the PEG and dividend Yield models suggest

that Havertys is fairly valued, while Price to Book, Enterprise Value to EBITDA, Forward

P/E, and the Price to Free Cash Flow show Havertys to be undervalued. Still, Trailing

price to Earnings and Price to EBITDA show Havertys to be overvalued. These models

however, are only numbers that are pegged to other numbers. In order to really get an

accurate view of the value of the company, one must also look at intrinsic information.

These calculations can be done by any layperson, and numbers used are pegged to

publicly available numbers. Doing these calculations adds absolutely no intellectual

value to the hypothesis. Also it is not possible to put such diverse outputs together to

determine the value of a stock.

Intrinsic Valuations

“Valuations is the process of converting forecasts into an estimate of the value

of the firm’s assets or equity” (Palepu&Healy). The way they differ from multiples based

ratio analysis because they are done using personal estimations. Intrinsic valuations are

focused only on the firm being valued and use financial data to figure their calculations.

These models are not only used internally for capital budgeting and strategic planning,

but also by security and credit analysts outside the firm (Palepu&Healy). This is why it

is so important to accurately forecast out all three of the financial statements. If not

done accurately, it can be extremely detrimental to the firm. The five theory based

models we used to value Havertys includes: Discounted Dividends model, the Free Cash

Flow Model, the Residual Income model, the Long Run Residual Income Model, and the

Abnormal Earnings Growth Rate. Together, these models should give a fairly accurate

view of the firm’s actual value compared to the information obtained with the method

of comparables.

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Discounted Dividends Model

The Discounted Dividend Model is used to value a firm because it is assumed

that the price of a stock is the present value of future earnings. Discounting dividends

to their present value will give an insight to the actual value of the firm. This model is

fairly simple and has problems. It assumes that the company will continue forever,

however all firms are subject to business and systematic risk. Therefore there is the

potential that a firm could always cease to exist at some point in time. Also, it is

incapable of valuing a company that does not pay dividends, and it only has an

adjusted R2 of about 5%. Thus, the discounted dividends model has only about 5%

explanatory power for the stock price.

In order to come up with a share price for Havertys, we took our forecasted

dividends and got forecasted DPS for each year forecasted. Then we multiplied each of

them by their respective present value factor. Getting the PV factor was accomplished

by:

PV Factor = 1/(1+ke) ^Number of periods out from base year

Then we added up all the year by year PV dividends, which totaled: $1.68

The next step was to find the terminal value perpetuity of the dividends. In order

to do this we needed a growth rate so we averaged the dividend growth rate during our

forecasted time frame.

The forecasted dividend growth for Havertys is as follows:

1 2 3 4 5 6 7 8 9 10 AVG -4% -4% 4% 4% 4% 3% 3% 3% 3% 3% 3%

The value of the dividends after the forecasted time is as follows:

Present Value Continuing Perpetuity = 1.42 = [.35/(.1138-.03)] * PV Factor

Where Ke using the Back Door Method is 11.38% and a 3% growth.

Next we added the two up to get: 1.68 + 1.42 =3.10, but that price is the value at

December 31, 2007, and we need the price as of April 1, 2008 in order to accurately

compare it to the observed price.

The time consistent price is: $3.10 * (1+.1138)^(3/12) = $3.39

110 | P a g e

The observed stock price on April 1, 2008 was $11.00. When compared to the $3.39

from the discounted dividends model, it appears that the firm is overpriced. However,

this model has the least explanatory power of all the intrinsic model valuations.

Perpetuity Growth Rate (g) 0.00% 1.50% 3.00% 4.50% 6.00%

7.00% $4.86 $5.59 $6.88 $9.70 $20.99 9.00% $3.77 $4.12 $4.65 $5.54 $7.30

10.00% $3.39 $3.65 $4.02 $4.59 $5.58 11.38% $2.98 $3.15 $3.39 $4.50 $4.26 13.00% $2.61 $2.73 $2.87 $3.08 $3.36 Co

st o

f Eq

uity

14.00% $2.43 $2.52 $2.63 $2.78 $2.99

Undervalued Greater than $12.54

Overvalued Less than $9.46

Fairly Valued Between 12.54-9.46

Actual Share Price 4/1/2008: $11.00

The chart above shows the sensitivity Analysis for Havertys using the discounted

dividends model. The chart explains how much variation in price can be achieved in

different growth rates and different costs of equity. According to the chart, a growth

rate of 4% and a Ke of 7% would suggest that Havertys observed price is appropriate.

However, any lower growth, or higher cost of equity would make the firm overvalued at

its current price. The only area that could suggest that the firm is undervalued is if the

growth and Ke were almost identical. This is a small possibility due to the amount of

dividend growth projected for the firm in the second, third, and fourth projected years

where forecast errors are still small.

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Free Cash Flows Model

The Free Cash Flow Model is used to determine the value of equity by calculating

the present value of future free cash flows generated by a firm. The future cash flows

are determined through our forecasted financial statements. These free cash flows

represent the funds that a firm has to pay debt and equity holders. In order to calculate

free cash flows you must use the following equation:

Free Cash Flow = CFFO Activities +/- CFFI Activities

When determining the equity value of Havertys using the Free Cash Flow

Model, we began by forecasting the firms free cash flows and discounting them back to

the present using a present value factor. This can be done using the same formula in

the Discount Dividends Model. However, instead of using the cost of equity we used

their WACCBT of 8.62% in our calculations of each year’s present value factor.

Each year’s free cash flow values were then multiplied by their present value

factors (1/ (1+WACCBT)^t) to give us the annual present value of free cash flows.

Adding the annual present value of free cash flows gave us a total present value of free

cash flows of $226,194thousand. The continuous terminal value perpetuity and its

present value was then calculated using the following equations:

• Continuous TV Perpetuity = FCFyr 11/ (WACCBT – FCF growth rate)

$1018663= $57249 / (.0862 - .03)

• PV of Terminal Perpetuity = Cont. TV Perpetuity x PV Factoryr 10

$44559 = 1018663 x 0.4374

Havertys total firm value was determined to be $706,781 by adding the total present

value of annual free cash flows and the present value of the terminal perpetuity. Since

the book value of debt for Havertys is $143,092, we subtracted this value from our

calculated firm value to get the firms market value of equity of $563,689. This value

was then divided by 21,444 thousand shares outstanding to get a share price of $26.29.

This value was then converted into a 04/01/08 share price by multiplying it by one plus

112 | P a g e

the WACCBT raised to the remaining 3 months over 12 giving us an implied share price

of $26.84.

Perpetuity Growth Rate (g) 0.00% 1.00% 3.00% 5.00% 9.00%

4.00% $55.71 - - - - 5.00% $42.28 $51.01 - - - 7.00% $27.43 $30.85 $42.82 - -

8.62% $20.41 $22.32 $26.84 $40.46 - 10.00% $15.37 $16.54 $19.89 $27.39 - W

ACC

(BT)

12.00% $11.18 $11.85 $13.63 $17.56 $35.56 PPS as of April 1,2008 Undervalued Greater than $12.54

$11.00 Overvalued Less than $9.46

Fairly Valued Between 12.54-9.46

Actual Share Price 04/01/2008 = $11.00

The above chart is the sensitivity analysis for Havertys using the Free Cash

Flow valuation model. We decided to grow WACCBT from 4% to 12% and the growth

rate from 0% to 9%. The chart will then illustrate how much variation in price can be

achieved when using different growth rates and different WACCBT. The share prices

generated in our sensitivity analysis show that for the most part the company is being

undervalued. However, when using a 12% WACCBT, a growth rate of 0%-1% will result

in the firm being fairly valued. The chart also illustrates how vast the company will be

undervalued if given a low WACCBT and a high growth rate.

Residual Income Model

Another intrinsic valuation method that can be used is the Residual Income

Model. One of the reasons analysts use this particular model is because of how little

impact an estimation error has on the equity valuation. For our equity valuation of

Havertys using the Residual Income Model, we began by compiling the future book

113 | P a g e

value of equity values, forecasted earnings, and forecasted dividends. In order to derive

a share price, residual income needed to be calculated and discounted back to the

current time period.

The first thing we had to determine was the benchmark income. This is found by

taking the beginning book value in a given year and multiplying it by the derived cost of

equity. Then you take the benchmark income and subtract it from the same year’s

actual net income for each year. The formulas shown below are how to calculate

normal and residual income:

Normal Income = BVE(t-1) x Cost of Equity

Residual Income = Earnings(t) – Actual Net Income(t)

2009 2010 2011 2012 2013 2014 2015 2016

RI 25078 23431 21262 22173 22686 21872 20182 21010 20726

Change

in RI

2169 -940 513 813 576 463 -178 284

The present value of each year’s residual income was then determined by

calculating the present value factor equation that was used in the previous models

(using a cost of equity of 11.38). Once the present value of each year’s annual residual

income was determined, they were added to give us a present value of annual residual

incomes of $64,466. We then calculated the continuous terminal value perpetuity and

its present value. The formulas below are what we used to determine the continuous

perpetuity and the present values of the perpetuity

Continuous TV Perpetuity = Residual Incomeyr 11/ (Ke – RI Growth Rate)

PV of Terminal Perpetuity = Cont. TV Perpetuity x PV Factoryr 10

The total present value of annual residual income and the present value were then

added to Havertys book value of equity and divided by 22,328 of the firms outstanding

114 | P a g e

shares. This gave us an estimated price per share of $5.14 which we multiplied by

1+.1138 ^ 3/12. This generated a share price of $5.28 for Havertys on 04/01/08. This

is almost $6.00 under the implied share price so we conducted a sensitivity analysis to

further investigate.

Growth Rate

0.00% -10.00% -20.00% -30.00% -45.00% 7.00% $7.01 $8.51 $8.90 $9.08 $9.22 9.00% $5.17 $6.76 $7.25 $7.49 $7.69

10.00% $4.55 $6.07 $6.58 $6.83 $7.04 11.38

% $3.90 $5.28 $5.79 $6.05 $6.26 Cost

of

Equi

ty

13.00% $3.22 $4.53 $5.01 $5.27 $5.48 14.00% $3.04 $4.15 $4.60 $4.85 $5.07

Undervalue

d Greater than $12.54

Overvalued Less than $9.46

Fairly Valued Between 12.54-9.46

The diagram above shows cost of equity and residual income growth rates that

were used to determine different share prices for Havertys. After conducting the

sensitivity analysis for the Residual Income Model, we noticed that share prices were

overvalued for any given cost of equity or growth rate. However, these prices only

range from $9.22 to $3.04, showing that there is little volatility. As described above,

this is exactly why analysts use this model to value firms. The estimations of the two

variables cause very little change showing that estimation error does not significantly

impact the model.

Long Run Return on Equity Residual Income Model

115 | P a g e

The Long Run Residual Income Model is used to calculate a firm’s equity value

by using information found in the Residual Income Model. Analysts use this model to

determine the present value of a firm’s equity. In order to begin this model we

determined our book value of equity to be $278,845 thousand which was found on the

balance sheet. Using this we were able to forecast out our BV or Equity for the

remaining years. Then we computed the long run return on equity and growth rate

numbers. This was done by using the following formulas:

ROE = Net Income in current year / Book Value of Equity in previous year

Growth = (Current year’s equity – previous year’s equity) / Previous year

ROE 2% 3% 4% 3% 3% 4% 4% 4% 4% 5%% change in BVE

-2% 1% 1% 1% 1% 1% 2% 2% 2% 2%

Shown above is Havertys’ long run return on equity and growth rates over a ten year

period. Using this table we established a ROE of 4% and a growth rate of 2%.

We then used BV of equity, long run ROE rate, ROE growth rate and the Cost of Equity

to determine the estimated market value of equity. This is illustrated in the equation

below.

Value of Firm= BVE (1+ ((LR ROE – Ke / (Ke – LR Growth of Equity))

From this formula we were able to calculate that the value of the firm to be $59,445

thousand. To get an estimated price per share we divided the MVE by the 22328 shares

outstanding. This value was then multiplied by (1+ke) ^ 93/12) to give us a share price

of $2.74 as of April 1, 2008.

Long Run Return on Equity

116 | P a g e

2.00% 3.00% 4.00% 6.00% 8.00%

7.00% - $ 2.54 $ 5.08 $10.16 $15.24

9.00% - $ 1.78 $ 3.65 $ 7.29 $10.94

10.00% - $ 1.60 $ 3.12 $ 6.39 $ 9.37

11.38% - $ 1.37 $ 2.74 $ 5.47 $ 8.21

Cost

of

Equi

ty

13.00% - $ 1.17 $ 2.34 $ 4.68 $ 7.02

14.00% - $ 1.08 $ 2.15 $11.00 $ 6.45

Undervalued Greater than $12.54

Overvalued Less than $9.56

Fairly Valued Between

12.54-9.56

Long Run Growth Rate in Equity

0.00% 1.00% 2.00% 4.00% 5.00% 0.00% - - - - -

2.00% - $ 1.24 - - -

3.00% - $ 2.47 $ 1.37 - -

4.00% - $ 3.71 $ 2.74 - -

Long

Run

Ret

urn

on E

quity

6.00% - $ 6.18 $ 5.33 $ 3.48 $ 2.01

8.00% - $ 8.65 $ 8.21 $ 6.95 $ 6.03

Undervalued Greater than $12.54

Overvalued Less than $9.56

Fairly Valued Between

12.54-9.56

Cost of Equity

117 | P a g e

7.00% 9.00% 11.38% 13.00% 14.00% 0.00% $7.26 $5.67 $4.51 $3.96 $3.69 1.00% $6.35 $4.79 $3.71 $3.12 $2.98 2.00% $5.08 $3.65 $2.74 $2.34 $2.15

4.00% - - - - -

Long

Run

Gro

wth

Rat

e in

Equ

ity

5.00% - - - - -

7.00% - - - - -

Undervalued Greater than $12.54

Overvalued Less than $9.56

Fairly Valued Between

12.54-9.56

Actual Share Price 04/01/08 = $11.00

The above charts are sensitivity analyses for the Long Run Return on Equity Residual

Income Model for Havertys. In this particular sensitivity analysis, we used had to use

three different variables to evaluate the fluctuations in share prices. These included

long run return on equity, long run equity growth rate, and cost of equity. As you can

see from all three graphs, the share price of Havertys is significantly overvalued.

Abnormal Earnings Growth Model

The Abnormal Earnings Growth Model (AEG) consists of finding the future

utilized earnings and the above normal earnings experienced by a firm. It is very similar

to the Residual Income model; however, you do not use previous year’s data to

compute your share price. You can find Abnormal Earnings Growth by taking the

difference between the cum-dividend earnings and normal income. This value then

needs to be discounted back to the present for the share price calculation. This model is

also considered a very accurate valuation because it is not as sensitive to cost of capital

and growth rates.

In our equity valuation of Havertys using the Abnormal Earnings Growth

Model, we began by implementing our forecasted earnings. From this we used the

following equations to find out AEG YBY.

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Drip Income = Dividend(t-1)x Ke

Cum-Dividend Earnings = Drip Income(t) + Earnings(t)

Normal /Benchmark Income = Earnings(t-1)* (1 + Ke)

AEG = Normal Income - Cum-Dividend

2 3 4 5 6 7 8 9 10Annual AEG

1,647 2,169 910 -513 813 576 464 -178 399

RI check 1,647 2,169 -910 -513 813 576 464 -178 284

Using the derived cost of equity of 11.28% and a growth rate of -12% we were

able to determine the estimated price per share of $3.96. However this must be

multiplied by (1+Ke)^(3/12) just like in the previous models to calculate the price per

share of $4.07 as of April 1, 2008

Negative Growth Rate

0.00% -10.00%-

20.00% -30.00%-

40.00% 7.00% $7.93 $7.10 $6.89 $6.79 $6.73 9.00% $5.70 $5.32 $5.21 $5.15 $5.12

10.00% $4.98 $4.72 $4.63 $4.59 $4.56 11.38% $4.23 $4.07 $4.01 $3.97 $3.95 Co

st o

f Eq

uity

13.00% $3.59 $3.49 $3.45 $3.43 $3.41 14.00% $3.29 $3.21 $3.17 $3.16 $3.15

PPS at April 1, 2008 Undervalued Greater than $12.54

$11.00 Overvalued Less than $9.46

Fairly Valued Between 12.54-9.46

Actual Share Price 04/01/08= 11.00

119 | P a g e

The chart above is a sensitivity analysis for the Abnormal Earnings Growth Model in our

equity valuation of Havertys. As discussed before, this model is very reliable because of

the insignificant impact of changing costs of equity and growth rates. The sensitivity

analysis also illustrates that Kroger’s share price is overvalued regardless of the changes

in costof equity and growth rates. Much like the Residual Income Value, the change in

price from 7.93 – 3.15 is very small showing why this is such an accurate model to use.

Conclusion

After calculating all of the Valuation Models an analyst should be able to tell if a

firm is undervalued, overvalued, or fairly valued. In the case of Havertys, we have

concluded that their share price of $11.00 on April 1, 2008 was significantly overvalued.

The Free Cash Flow model was the only valuation model that showed Havertys share

price to be undervalued. However, the Free Cash Flow Model does have significant

flaws to consider. Therefore, we based our assumption after conducting the AEG and RI

Models which are much more reliable.

Analyst’s Recommendation

120 | P a g e

The consensus is that Havertys is overvalued. This conclusion is based off of

industry analysis, accounting analysis, financial analysis, equity analysis, method of

comparables, and intrinsic valuation models.

When conduction our industry, financial, and equity valuations we heavily relied

upon Havertys’ competitors. Ethan Allen, Pier One, and Williams-Sonoma were chosen

as Havertys’ competition because of customer base and the fact they only sell home

furnishings.

Havertys operating leases raise concern about discrepancies in accounting

policies. Significant operating leases should be added back to the financial statements

to depict the firm in a more accurate light. Although most of Havertys’ competitors use

operating leases, it still causes discrepancies which negatively affect out valuation

models. Expense manipulation ratios were restated as well as the financial statements.

Suring our equity valuation, we calculated liquidity ratios, profitability ratios, and capital

structure ratios which allow us to compare Havertys’ financial performance to its

competitors and the industry. Most of these ratios point out that Havertys is performing

under the industry and competitors. One concern raised was inefficient inventory

handling. Havertys insufficient storage space accounts for their inefficiency in inventory

handling. This inefficiency negatively affects sales. Operating income is another area in

which Havertys is struggling. From the profitability ratios we were able to determine

that Havertys might struggle with covering their fixed costs if they do not get control of

their operating income.

When forecasting out ten years of financials, we were forced to make several

assumptions about Havertysfinancial data. The home furnishings industry is closely

related to the housing market. Due to the current housing slump we used conservative

estimates to forecast sales growth, asset turnover, and the current ratio.

The method of comparables used in evaluating Havertys’ equity shows varied

results. Havertys was shown to be fairly values, undervalued, and overvalued. However,

the method of comparables alone cannot accurately judge the validity of Havertys’ stock

price. Intrinsic valuations were also necessary in order to judge the value of the firm.

121 | P a g e

Four of the five intrinsic models illustrated that Havertys was overvalued. Therefore, we

humbly suggest that current stockholders consider selling their share of Havertys Inc.

122 | P a g e

Reference Page

1. First Research Industry Profile: Furniture Stores http://www.firstresearch.com

2. Havertys Furniture Companies, Inc.

2002-2006 Annual Reports http://www.havertys.com

3. Yahoo! Finance

http://www.finance.yahoo.com

4. MSN Money http://moneycentral.msn.com

5. Business Analysis and Valuations: Using Financial Statements 4th Ed Palepu and

Healy 6. Wikipedia.com 7. Investopedia.com 8. about.com

Wall Street Journal Articles: 1. (2007, Dec. 26). Home Prices Fall, Homeowners in a Bind. Wall Street Journal.

Retrieved February 3, 2008 from the Wall Street Journal Online Web site: http://blogs.wsj.com/developments/2007/12/26/home-prices-fall-homeowners-in-a-bind/

2. Bater, Jeff. (2008, Jan. 2). Home Sales Rise, But Gaines Aren’t Likely to Continue.

Wall Street Journal. p. A2. Retrieved February 2, 2008, from the Wall Street Journal Online Web site: http://online.wsj.com/article/SB119910662197259261.htm

3. Campoy, Ana. (2007, Dec.4). Pricey Diesel Compounds Worries. Wall Street Journal.

p. A12. Retrieved Jan 25, 2008 from the Wall Street Journal Online Web site: http://online.wsj.com/article/SB119672854525012439.html

4. Cummins, Chip, Neil King Jr. and Russell Gold. (2008, Jan. 3). Oil Hits $100, Jolting

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Markets. Wall Street Journal. p. A1. Retrieved February 6, 2008 from the Wall Street Journal Online Web site: http://online.wsj.com/article/SB119932015772763671.html

5. Kingsbury, Kevin and Amy Merrick. (2008, Feb. 8). Retail Squeeze Felt Far Beyond

Malls. Wall Street Journal. p. B1. Retrieved February 10, 2008 from the Wall Street Journal Online Web Site: http://online.wsj.com/article/SB120238618499550605.html

6. McQueen, M.P. (2008, Jan. 8). Safety Push Focuses on Retailers. Wall Street Journal.

p. A3. Retrieved February 8, 2008, from the Wall Street Journal Online Web site: http://online.wsj.com/article/SB119976060860973901.html

7. McQueen, M.P. (2008, Jan. 12). Some Stalled Safety Rules For Products May be

Enacted. Wall Street Journal. p. A2. Retrieved February 3, 2008, from the Wall Street Journal Online Web site: http://online.wsj.com/article/SB120011105356285949.html