Pacific Sunwear of California, Inc. Equity Valuation and Analysis As of November 1, 2007
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Pacific Sunwear of California, Inc. Equity Valuation and Analysis As of November 1, 2007 Brigette Parnell [email protected] Stacy Schroeder [email protected]
Transcript of Pacific Sunwear of California, Inc. Equity Valuation and Analysis As of November 1, 2007
Pacific Sunwear of California, Inc. Equity Valuation and Analysis
As of November 1, 2007
Brigette Parnell [email protected]
Stacy Schroeder [email protected]
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Table of Contents
Executive Summary 2 Business Analysis 3-6 Industry Analysis 7-11 Five Forces Model 12-24 Value Creation in the Industry 25-27 Competitive Advantage 27-30 Accounting Analysis 31-49 Financial Analysis, Forecasting Financials, And Cost of Capital Estimation 50-83 Analysis of Valuations 84-99 Credit Risk Analysis 100 Analyst Recommendation 101 References 102 Appendix 103-120
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Executive Summary
Investment Recommendation: Overvalued, Sell 11/1/07
PSUN - NYSE (11/1/2007): $15.64 EPS Forecast52 Week Range: $13.00 - $23.11 2007 2008 2009 2010Revenue (2/3/2007): $1,447,204,000.00 0.75 0.96 0.97 1.23Market Capitalization: $1.12 Billion Shares Outstanding: 69,895,000 Valuations Estimates3-Month ave. Daily Trading Volume: 1,925820 Actual Price (11/1/2007): $15.64 Percent Institutional Ownership: 117.6% Ratio Based ValuationsBook Value Per Share: $6.81 Trailing P/E $10.63ROA: 2.72% Forward P/E $13.18ROE: -5.49% P/B $23.10
PEG $8.11Cost of Capital est. R2 Beta Ke P/EBITDA $8.54Estimated 1.64 15% EV/EBITDA $4.393-Month 0.122 1.64 15.15 P/FCF N/A1-Year 0.123 1.64 15.153-Year 0.122 1.64 15.15 Intrinsic Valuations Actual Revised5-Year 0.121 1.64 15.15 Free Cash Flows N/A N/A7-Year 0.122 1.64 15.15 Residual Income $5.58 $1.4210-Year 0.122 1.64 15.15 LR ROE $5.60 N/AKd: 5.8% AEG $4.91 $2.27WACC: 12.73%
Ratio Comparison PSUN AE ANFAltman Z-Score Trailing P/E 27.95 17.47 15.452002 2003 2004 2005 2006 Forward P/E 20.91 12.35 14.927.9 5.93 8.68 8.02 9.87 P/B 2.20 3.63 4.64Revised Z-Score 2006 1.91 PEG 1.86 .82 1.00
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Recommendation: Overvalued Firm
Industry Analysis
In order to value a firm, one must have an understanding of the industry in
which it competes. The specialty retail industry embodies the high competition of
aggressive firms. Looking at the industry as a whole will allow one to better understand
and interpret individual company standings and market tactics. It encompasses all of
the important, background information that will be used to develop well thought out
inferences and conclusions that will be used to forecast Pacific Sunwear’s financial
future. We will take an in-depth look at the specialty retail industry and use these tools
to assess Pacific Sunwear. Knowledge about the company’s strategic market
movements and competition will be gained. The reader will become aware of Pacific
Sunwear’s degree of actual and potential competition, and be able to determine where
they think the company stands in the marketplace. An overview of Pacific Sunwear
will be given in order to provide an informed framework for the firm and its future.
Accounting Analysis
The next step in financial statement analysis is the accounting analysis.
“The purpose of accounting analysis is to evaluate the degree to which a firm’s
accounting captures its underlying business reality,”(Business Analysis and Valuation,
4th Edition). Firms have flexibility and choice when it comes to accounting. Since a
large portion of accounting is chosen at the firm’s discretion, outside auditing is
required. While a portion of accounting is flexible, the rest is mandated and regulated.
“The Securities Exchange Commission (SEC) has the legal authority to set accounting
standards, “(Business Analysis and Valuation, 4th Edition). The SEC created the
Financial Accounting Standards Board (FASB) in 1973. FASB created and enforces the
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Generally Accepted Accounting Principles (GAAP). All firms are required to comply with
GAAP. Uniform accounting guidelines were created to help ensure the quality and
accuracy of financial documents.
Corporate firms use accrual accounting. Accrual accounting can be defined as,
“An accounting method that measures the performance and position of a company by
recognizing economic events regardless of when cash transactions occur,”
(www.invesopedia.com). This means that the accounting method is event based verses
cash based and relies on expected economic outcomes. Accrual accounting requires
estimates. Well informed, knowledgeable managers are the individuals who determine
the amount of future cash flows. These anticipated amounts are reflected on all three
of the financial statements: the balance sheet, the income statement, and the
statement of cash flows. Thus, the managers estimated amounts and entries can have
an effect profit, revenues, expenses, assets, liabilities, and equity. It is imperative that
managers do their absolute best to predict future values. It is quite common to
discover estimation error. Managers can over and understate many different accounts.
Often this is done by accident, but some managers falsify these documents. Different
methods of distortion are used on financial statements depending upon the desired
outcome. In order to ensure a firm’s accounting accuracy, outside auditing is required
for all firms. After the Enron scandal, The Sarbanes-Oxley Act was implemented to
reduce the gap between firms and outside auditors. Auditors are used to verify the
correctness and integrity behind a firm’s financial statements. If auditors become
influenced by a firm, it makes it much more difficult for the auditors to come across and
report accounting errors. Legal liability is also a factor that influences managers’
decisions. Managers that have the imminent threat of being tied up in a lawsuit are
going to dot their i’s and cross their t’s in order to stay within complacent accounting
boundaries.
Although regulation and external auditing add to the validity of accounting
information, it is still biased and affected by outside “noise.” The three sources of noise
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and bias which affect accounting data are as follows: introduction by rigidity in
accounting rules, forecasting errors, and systematic reporting choices made by
corporate managers to achieve specific objectives. (Business Analysis and Valuation, 4th
Edition). Noise is created by the type of transactions a firm performs. Further noise is
created when managers make forecasting errors. These errors can effect all three
financial statements. Noise and bias are encountered when managers make decisions
regarding policies and estimates associated with accounting based covenants,
management compensation, corporate control contests, tax considerations, regulatory
considerations, capital market considerations, stakeholder considerations, and
competitive considerations.
Measuring the amount of information a firm discloses is key when performing an
accounting analysis. Managers have the power to disclose the information they deem
appropriate, in compliance with guidelines and regulations. Each firm determines to
what extent they chose to disclose information and make their financial history available
to the public. The desired level of disclosure is completely discretionary to each
individual firm.
Financial Analysis, Forecast Financials, and Cost of Capital Estimation
In order to better understand the financial state of a company, how profitable a
company may be, or perhaps the growth of the company, the financial statements of
the company must be analyzed and interpreted. We will incorporate financial factors,
such as liquidity, profitability, and capital structure. These factors will help find the
firms growth compared to the industry as a whole. They will also contribute to
computing a more accurate forecast for the firm’s financial future and growth. Keep in
mind that forecasts are educated estimates based on historical costs and prices, current
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financial information, and market trends, and are not free of error. However, the more
ratios that are calculated and compared, the more accurate the forecasts will be.
Analysis of Valuations
Several valuation methods can be used to derive the share price of a firm. We
will use various methods to value stock to determine if Pacific Sunwear’s share price is
overvalued, fairly-valued, or undervalued. Some methods tend to be more accurate
than others due to inconsistency in formulas, theory, etc. The first valuations we will
look at are the Methods of Comparables, which are composed of recent data from
Pacific Sunwear and the specialty retail industry as a whole. From this information we
will derive an industry average. The next sets of valuations, the Intrinsic Valuation
Models, tend to be more reliable than the Methods of Comparables. They combine both
WACC before tax and the cost of equity (Ke). The Intrinsic Valuation Models include
the Dividends Discount Model, Discounted Free Cash Flow, Residual Income, Long-Run
Residual Income Perpetuity, and the Abnormal Earnings Growth Model.
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Industry Analysis
Company Overview
Pacific Sunwear is a firm that competes in the specialty retail industry. Pacific
Sunwear opened its first mall store in Santa Monica in 1981 and continues to seek out
locations in malls around the country. Thus began the company’s transition from small
surf shop to a specialty retailer. Another major part of Pacific Sunwear’s early success
was the relationships the company formed with clothing companies. While Pacific
Sunwear was developing a new strategy, surfers all over southern California were
coming up with their own clothing brands like Gotcha, Billabong, and Quicksilver. These
clothing companies formed strong bonds with Pacific Sunwear, and the company grew
from 21 stores in 1987 to 1,199 stores today. (Pacific Sunwear 10-K 2006)
Pacific Sunwear has continued to evolve and now sells a variety of surf and skate
clothing, accessories, and shoes in all 50 states and Puerto Rico. “We offer many name
brands best known by our target customers,” (Pacific Sunwear 10-K). Pacific Sunwear
offers a wide selection of well-known board sport inspired name brands, such as
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Billabong/ Element, Quiksilver/ Roxy/ DC Shoes, Volcom, Hurley and O’Neill,” (Pacific
Sunwear 2006 10-K). The main competitors of Pacific Sunwear are Abercrombie &
Fitch, Hot Topic, and American Eagle.
“Pacific Sunwear’s total sales consist of approximately 67% name brand sales
and 33% proprietary brand sales,” (www.gannononinvesting.com). Mens’ apparel in
general during 2006 accounted for nearly 38% of total sales, while womens’ apparel
accounted for approximately 30%.
From the initial public offering in 1993, Pacific Sunwear has experienced positive
annual growth. In 2001, sales totaled $685 million and have increased to nearly $1.5
billion by the end of 2006. (PacSun 10-K 2006)
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Although the annual sales growth has continued to be positive, over the past
four years, the growth has begun to slow down, decreasing annually.
2003 2004 2005 2006
Sales growth 22.9% 18.16% 13.09% 4.03%
In comparison to the specialty retail industry, Pacific Sunwear does not display
the same trends. The specialty retail industry continues to increase annual total sales
until a decrease in 2006.
Industry 2003 2004 2005 2006
Sales growth 13.72% 15.72% 29.26% 18.19%
In the past five years, Pacific Sunwear’s stock price performance has been
growing at a gradual rate. Recent data has shown that Pacific Sunwear may have hit
their peak and are beginning to level out. In order to prevent this plateau from
occurring, Pacific Sunwear is shifting its concentration from expansion to its already
existing stores. Some downsizing may occur from this shift.
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Industry Overview
The specialty retail industry was created for unique consumers who know what
products they want to purchase and the prices they are willing to pay for these
products. The industry is composed of large, well known corporations that compete on
price and thrive on creating a lucrative, niche market. “400,000 specialty retail stores
operate in the US, with combined annual sales of $350 billion,”
(www.firstresearch.com). The industry is broken down into the following categories:
“shoes and clothing($125 billion), electronics and appliances($85 billion), jewelry($25
billion), sporting goods($25 billion), books($15 billion), toys, music, luggage, and pet
supplies,”(www.firstresearch.com).
Specialty Retail Industry Profile
7.10%
35.70%24.30%
7.10%
4.30% Jewlery
Shoes & Clothing
Electronic & Appliances
Sporting Goods
Books, Toys Luggage, &Pet Supplies
While department stores can offer some of the same name brands found in
specialty stores, specialty stores offer a much wider selection of these brands and
products. Specialty stores are often destination stores, truly setting them apart in the
overall retail industry.
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Net Income AmongstCompetitors for the Past 5 Years
0
100,000
200,000
300,000
400,000
500,000
2002 2003 2004 2005 2006
Years
In T
hous
ands Pacific Sunwear
Abercrombie & FitchHot TopicAmerican Eagle
Industry Analysis
The specialty retail industry is composed of firms with a variety of sizes and
structures. Firms must first compete on price and then develop their own personal
marketing strategy and competitive advantage. In order for firms to achieve positive
growth and industry leadership, it is necessary to follow the five forces model. The five
forces model is used to analyze industry structure and profitability. To measure the
degree of actual and potential competition, the following must be analyzed: rivalry
among existing firms, the threat of new entrants, and the threat of substitute products.
Then, attention must be given to the bargaining power of both the consumers and
suppliers. A firm must research and apply each of these aspects in order to gain
success in the specialty retail industry. Below is a graph which compares the net
income of Pacific Sunwear and their competing firms over the past five years. This
demonstrates the difficulty of entrance and survival in the industry. Further, it
demonstrates the volatility of the specialty retail market.
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Five Forces Model
It is important to understand the unique strategy of companies competing within
a given industry. Historically, five forces have shaped the profitability of firms. The Five
Forces Model is used to understand the structure of an industry and interpret the level
of competition and bargaining power required to withstand the correlating pressure and
nature of the industry. The model is then used to draw conclusions about the effect of
competition and bargaining power on the industry’s profitability. The three forces that
shape competition in an industry are rivalry among existing firms, threat of new
entrants, and the threat of substitute products. The two forces behind bargaining power
are suppliers and customers. The five forces model is used to demonstrate relationships
between these forces and their impact on a firm’s competitive strategy.
Rivalry Among Existing Firms High
Threat of New Entrants Low
Threat of Substitute Products Moderate
Bargaining Power of Consumers Moderate
Bargaining Power of Suppliers Low
Rivalry Among Existing Firms
“In most industries the average level of profitability is primarily influenced by the
nature of rivalry among existing firms,” (Business Analysis and Valuation, Edition Four).
Rivalry can be classified as either aggressive or conservative. Aggressive rivalry
competes on price. If the competition becomes too aggressive, firms are eventually
forced to lower their prices too close to marginal cost, thus, sacrificing profitability.
Conservative rivalry requires firms to shift their concentration away from pricing and
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develop a new strategy which focuses on other differentiating aspects of their products
or services such as brand image or innovation.
In the specialty retail industry, demand for products is driven by the gains in
consumer income. With this in mind, large competitors can offer lower prices while
smaller competitors compete on quality and merchandise selection. Pacific Sunwear is
a medium sized firm in the specialty retail industry. Therefore, Pacific Sunwear
incorporates both differentiation and cost leadership to gain their competitive
advantage over other firms. “Unlike department stores which offer the convenience of
shopping for different products in one location, specialty retailers offer a much larger
selection of items with in a product category,”(www.firstresearch.com). As a specialty
retailer, Pacific Sunwear has a significant customer base that buys small volumes of
products at one time. A wide merchandise selection must be offered at each Pacific
Sunwewar location to satisfy the consumer needs and to maximize profitability. Pacific
Sunwear’s main competitors include: Abercrombie and Fitch, American Eagle, and Hot
Topic.
Industry Growth
Knowing your company’s annual growth speed is vital. If the industry is growing
rapidly, firms do not have to poach other firms’ market share for personal growth gain.
The firms are able to compete using their company’s competitive advantage. On the
other hand, if the industry is stagnant, the only way for firms to grow, or even sustain
their current growth rate, is to compete on price. This makes it even more difficult for
new firms to enter into the specialty retail industry. Growth in the specialty retail
industry “grew steadily during the 2002-2006 period, with a compound annual growth
rate around five percent,” (www.reuters.com). In order for firms to acquire a market
share in the specialty retail industry, a focus must be directed towards sales and or
markdowns.
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Concentration
The degree of industry concentration relies on two aspects: the number of firms
in the market and the size of the firms. Low concentration yields a large number of
firms with high competition, while high concentration yields a smaller number of firms
with less competition. Specialty retail, specifically Pacific Sunwear, is characterized by
low concentration due to the multitude of large, highly competitive firms in the industry.
These firms rely on price, brand recognition, product quality, and merchandise selection
to retain market share. “Where a brand carried in Pacific Sunwear stores is also carried
elsewhere, it is always much more visible in the Pacific Sunwear stores, because the
target market for Pacific Sunwear and the target market for the brands it carries are
very similar, and the image Pacific Sunwear projects is relatively undiluted. Other
retailers run a greater risk of striking a discordant note,”(www.gannononinvesting.com).
Switching Costs and Differentiation
Switching costs deal with the degree to which firms can convince consumers to
continue or convert their business with a company. The specialty retail industry targets
the same consumers. Therefore it is imperative that firms have the ability to retain
their current customers and gain others in the future. Since these consumers make up
the same target market, firms must be able to distinguish themselves and create true
brand recognition. Switching costs also have to do with the company itself. If a
company can easily change the business they are in, their switching costs are low.
However, for most businesses, switching costs are high. It is very difficult for a firm to
enter into a new industry due to the excessive amount of costs. Therefore, Pacific
Sunwear cannot easily leave the specialty retail industry because the firm does not have
the potential to become a different type of business. The costs exceed the benefits of
changing industries and would be too high for the company to withstand. Pacific
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Sunwear is able to create and maintain customer loyalty through the constant quest for
innovation and development of new products. These factors contribute to the
differentiation of the company.
Differentiation determines how a firm handles their competition. Pacific
Sunwear differentiates their products by using a merchandising strategy that offers
their own personal brand juxtaposed with 83 other name brands.(www.pacsun.com)
Brand recognition and brand loyalty are key to the success of Pacific Sunwear. In order
for a firm to achieve the competitive strategy of differentiation three goals must be
accomplished. First, the firm must identify the value adding properties of a product or
service that are desired by consumers. Then, the firm must take its market position
and create a method to better serve their consumers. Lastly, the firm must compete on
price against rival firms to maintain customer loyalty. When all three of these goals are
achieved, the firm has successfully differentiated itself from other firms in the
marketplace.
Fixed and Variable Costs and Scale Economies
“Fixed costs are expenses whose total does not change in proportion to the
activity of a business, within the relevant time period or scale of production
(www.wikipedia.org).” Fixed costs for this industry are costs that the business must
incur in order to operate. These costs include rent, salary expense, administrative
expenses and utilities. “Variable costs are expenses that change in proportion to the
activity of a business. In other words, variable cost is the sum of marginal costs
(www.wikipedia.org).” Fixed and variable costs combine to create total costs. Variable
costs for the specialty retail industry are related to sales or the production level. The
variable costs for the specialty retail industry are inventory, goods available for sale,
and cost of goods sold. In the specialty retail industry, fixed costs are readily identified
with the space in which is occupied. The majority of specialty retailers, including Pacific
Sunwear and its competitors, (i.e. Abercrombie & Fitch, American Eagle, and Hot Topic)
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lease their retail space. Thus, these firms endure the fixed costs of utility expense and
rent. Pacific Sunwear incurred operating lease obligations of 111 million dollars in less
than one year. The selling, general and administrative expenses for 2007 totaled
$385,802. (Pacific Sunwear 10-K) Costs of goods sold, including buying, distribution,
and occupancy costs, for Pacific Sunwear totaled 1.01 million dollars, resulting in an
approximate estimation of the firm’s annual, incurred variable costs.
Excess Capacity and Exit Barriers
Excess capacity is a concern for all retailers. It is even more of a concern to
those involved in specialty retail. Firms experience excess capacity in a situation where
current demand is below potential supply. Excess capacity is an indicator of the overall
position of the industry. While a large amount of excess capacity can be fatal to a firm,
this can be perceived in a positive manner through the eyes of consumers because it
negates the possibility of price inflation. In order for firms to fill this capacity, price cuts
must be made. A prime example is mark-downs. Mark-downs are also viewed as
positive by consumers. Although, price cuts can be damaging to the firm, it is far more
costly to exit the industry entirely, especially for those with specialty products. Pacific
Sunwear has invested too much time and money for exiting the industry to be an
option. Despite the large number of assets the firm holds, it would be far too costly for
the firm to enter into another industry. The firm has acquired these assets due to their
2006 Same-Store Sales Company Ticker August July June May April March February
Abercrombie & Fitch ANF 6.00% 3.00% -4.00% 3.00% 6.50% 31.00% 31.00%
American Eagle AEOS 11.00% 7.00% 11.00% 11.00% 19.00% 3.00% 6.00%
Hot Topic HOTT -6.00% -5.50% -3.40% -6.00% -6.50% -
12.70% N/A
Pacific Sunwear PSUN -9.40% -
10.60% -2.70% -2.60% -
14.00% -
10.90% N/A http://www.123jump.com
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specialization. The firm has created brand recognition and gained loyal customers.
Both of these important qualities would disappear if Pacific Sunwear attempted to enter
into another market. These exit barriers force Pacific Sunwear to remain in the
specialty retail market.
Net Sales Retail Industry
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3500
2002 2003 2004 2005 2006
Years
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ands Pacific Sunwear
Abercrombe & FitchHot TopicAmerican Eagle
Conclusion
The specialty retail industry is extremely competitive. This is due to the rivalry
present among existing firms and the different strategies firms use to obtain and
maintain market share. Therefore, firms must be competitive in nature and use their
competitive advantages to the fullest in order to gain an effective market share.
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Total Assets For Past 5 Years
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500,000
1,000,000
1,500,000
2,000,000
2,500,000
2002 2003 2004 2005 2006
Years
In T
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ands Pacific Sunwear
Abercrombie & FitchHot TopicAmerican Eagle
Threat of New Entrants
Profitability is the determining factor which attracts new entrants into the
industry. The largest threats new companies hold to existing firms are the potential to
take over a portion of their consumer market, profit margins, and market share.
Although these potential threats could pose damaging results for existing firms, the new
entrants must face difficult entry obstacles. New entrants are competing against large,
established firms with more capacity, capability, and flexibility. No legal barriers stand
in the way of entering firms, but the competition they are up against acts as a sufficient
barrier.
Economies of Scale
“As a company grows and production units increase, a company will have a
better chance to decrease its costs. According to theory, economic growth may be
achieved when economies of scale are realized,” (www.investopedia.com). As a result,
a company can reduce its input costs while increasing production output. PacSun is a
player in a large, highly competitive and high dollar industry. This exhibits a difficult
and narrow path for new entrants. Entering into an industry characterized by large
companies with many different locations requires a significant amount of capital and
other resources. A small, unrecognized specialty retailer does not have the capability to
initially compete on this level due to the need for large amounts of capital which is
represented in the graph below.
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Distribution Access and Relationships
Gaining distribution access is extremely difficult for new entrants. This is due to
the already existing relationships between firms and distributors. Furthermore, the
success rate for new entrants is rather low. Therefore distributors are weary to do
business with new companies when they have already established successful
relationships with leading firms. Distributors are much more concerned with doing
business for larger companies. The benefits received by the distributor and the
company are reciprocal. Small companies do not have anything to offer to the
distributors, except risk. Their merchandise needs are much smaller.
Pacific Sunwear has established many concrete relationships with their
distributors. Pacific Sunwear has contracts with the following: Billabong, Quiksilver, DC
Shoes, and Volcom. Not only does Pacific Sunwear have a contract with Billabong, but
it is the largest Billabong retailer. This emphasizes the importance of the strong, secure
relationship between the two companies.
Conclusion
The specialty retail industry is full of large firms. While the threat of new
entrants is valid, it is low. The size of existing specialty retail firms is a difficult obstacle
for new, smaller firms to overcome. New firms lack capital, name recognition, and
access to suppliers. The level of competition is often too high for new firms to survive.
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Threat of Substitute Products
In any industry, the threat of substitute products exists. However, because
specialty retail industry encompasses such a vast merchandise selection, the threat of
substitute products is moderate. Consumers in the specialty retail industry rely heavily
on brand name and brand recognition. These brand names are not found everywhere,
and replacing the brand with a different one is often unacceptable. If consumers chose
to shop elsewhere, they might also chose to sacrifice their selection.
Relative Price and Performance
Price and performance share a direct relationship. Consumers perceive high
price as high quality. High prices require high performance. If a firm is not very cost
competitive and does not offer quality products, then consumers will chose to make
their product selections elsewhere. If firms charge a large dollar amount, then a
superior good must be offered in exchange. This is what creates a reputable company
and brand name. Firms in the specialty retail industry are under a lot of pressure to
produce quality products and charge accurate prices.
For Pacific Sunwear, price and performance go hand in hand. The specialty retail
industry is highly competitive. In any high competition environment, price always plays
an essential role. Quality is a benefit that Pacific Sunwear adamantly supports. All of
Pacific Sunwear’s merchandise is shipped to its headquarters in Anaheim, California,
where it is inspected before being distributed to the nation’s Pacific Sunwear stores.
Approximately thirty percent of Pacific Sunwear’s merchandise is a proprietary brand,
sold only in Pacific Sunwear stores. Because Pacific Sunwear’s business relies so
heavily on brand recognition, the quality of all of the merchandise must be ensured.
This allows Pacific Sunwear to not rely completely on cost and pricing as a competitive
advantage due to the selection and quality of products available.
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Buyers Willingness to Switch
In the overall specialty retail industry, buyers’ willingness to switch is often high.
Consumers are easily persuaded to switch to different stores as long as the product is
the same. However, for Pacific Sunwear customers this willingness is not as high.
While Pacific Sunwear does have strong competitors, none of these competitors fall into
the same, distinct niche that Pacific Sunwear has developed, thus creating loyal
customers. While some of the brands that Pacific Sunwear offers are available in other
mall locations, no others can compete with their total selection and variety of apparel,
accessories, and shoes.
Conclusion
The specialty retail industry relies on its outstanding and differentiated products
to increase sales and growth. While firms must concentrate on their own products, it is
important that they keep an eye on competing firms as well. The threat of substitute
products is a pending concern for the specialty retail industry. Firms must create
distinct, competitive products that will retain their loyal customers’ business and
interest.
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Bargaining Power of Consumers
Consumers have a direct effect on the profitability of a firm. Therefore, it is
important for firms to create a solid relationship with their customers. Firms either sell
to consumers or distribute to other firms. It is important to look at both sides of the
bargaining equation to gain an overall understanding of the importance of the
relationship between the consumer, the firm and bargaining power. Price sensitivity
and the relative bargaining power are the two main influences over the bargaining
power of consumers. Depending upon the degree of sensitivity relative to price, the
consumer will determine how important it is to bargain on price. The more important
that price is to the consumer, the more price sensitive the good and the consumer are.
The extent to which a consumer can control price is known as the relative bargaining
power. If a consumer is able to drive the price down, they are said to have high
bargaining power. In order for a consumer to obtain high bargaining power, they must
entail a strong bargaining position. The specialty retail industry is price sensitive. The
consumer has many options when it comes to purchasing products, thus yielding buyer
power. The firm must take the initiative to attract new customers and sustain current
and loyal ones.
Price Sensitivity and Relative Consumer Bargaining Power
Specialty retail industry consumers experience different levels of price sensitivity.
Buyers do not experience as much price sensitivity with products which are
differentiated. Price sensitivity increases as differentiation decreases. This is due to a
lack of selection and an increase in cost competition between firms. Perception is also
a key factor in determining price sensitivity. If a consumer finds a product to be
extremely important, necessary, or desirable, the price will become less sensitive.
Furthermore, the sensitivity is determined by the consumers’ actual bargaining power.
If the consumer has a high level of bargaining power, they are able to persuade and
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influence the product price. If the consumer lacks bargaining power, the price will not
decrease. Price sensitivity and relative consumer bargaining power are relative to
switching costs. If consumers are unable to use a substitute product, then the
switching costs are high and not price sensitive. This is because the consumer does not
have any alternatives and will be forced to pay the initial product price. However, if
substitute products are available, firms will compete on price and consumers with high
bargaining power will be able to drive down the cost of the product.
Pacific Sunwear’s consumers have moderate bargaining power. This bargaining
power is demonstrated with mark-downs and seasonality. While Pacific Sunwear does
offer more than just swimsuits and surfboards, many of their products are seasonal.
Consumers can wait until the end of the summer to purchase a swimsuit for seventy
five percent off. Although they sacrifice having a new swimsuit for the summer, the
consumer is able to obtain one at a mark-down price. Yet when a consumer waits for
mark-downs, they risk finding a small selection of colors, sizes, and brands, three
essential differentiation factors for Pacific Sunwear. Although the consumer does have
some power, so does Pacific Sunwear. The firm competes on merchandise selection
and brand recognition. Often items will disappear off of shelves before mark-downs are
even considered. If items are not purchased at full price, consumers run the risk of
loosing their potential product selection. Also, certain brands do not go on sale. Brand
recognition is a dominant Pacific Sunwear strategy and if consumers are not willing to
pay full price, then they will have to sacrifice their brand choice.
Conclusion
The specialty retail industry houses a variety of price sensitivities and bargaining
powers. It is difficult to pinpoint these characteristics because they vary by the
individual and the desired product.
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Bargaining Power of Suppliers
In any given industry, the amount of bargaining power that a supplier possesses
is crucial to both the supplier and the firm. If the bargaining power for the supplier is
high, then few firms exist in the industry, and the supplier is free to set prices
accordingly. On the other hand, if the bargaining power is low, then many firms exist
in the industry, and the bargaining power shifts from the supplier to the firm, and the
firm is now able to set the prices.
Price Sensitivity and Bargaining Power of Suppliers
In the specialty retail industry, firms with high supplier bargaining power
dominate the playing field. However, if firms that have low supplier bargaining power
often struggle. Firms with high supplier bargaining power are more price sensitive than
firms with lower bargaining power. Firms with high supplier bargaining power are able
to drive the prices that they want from their suppliers. Firms that have little supplier
bargaining power are unable to influence suppliers’ prices. Therefore smaller firms are
less price sensitive because they simply take the price that their suppliers offer.
However large, established firms with high bargaining power are more price sensitive
and work hard to achieve the lowest purchasing price. Suppliers are able to offer
cheaper prices to these large firms because their business is crucial to the suppliers’
survival. In a market with few substitute products, it is vital to the supplier and the firm
to form a strong relationship. In a highly competitive market like the specialty retail
industry, suppliers and firms collaborate and make exclusive contracts in order to avoid
the difficulty of bargaining and price setting.
Conclusion
Suppliers help to set the standards for the specialty retail industry. If a firm is
unable to work well with their suppliers, then profit maximization will be even more
25
difficult to obtain. If a firm’s merchandise is too expensive or the volume is too small,
then the firm must work to improve supplier relations, or their firm is in risk of failure.
Value Creation in the Industry
As noted previously, the specialty retail industry is a highly competitive, multi-
million dollar industry. It is characterized by high rivalry among existing firms, low
threat of new entrants, moderate threat of substitute products, moderate bargaining
power of consumers, and low bargaining power of suppliers. Once the five forces are
analyzed, a firm must determine their strategies for creating competitive advantages.
The two strategies associated with competitive advantage are cost leadership and
differentiation. The specialty retail industry incorporates both strategies, while the
domineering focus is directed toward differentiation. Cost leadership focuses on
competing on cost by offering the same product at a lower cost. Differentiation
provides a distinct and distinguishable product that is valued by the consumer by its
attributes.
Competitive Strategies
Firms develop competitive strategies in order to obtain a competitive advantage.
A competitive advantage in the marketplace helps a firm to achieve profit maximization.
The specialty retail industry uses such competitive strategies as: innovation, superior
product quality and variety, and investment in brand image.
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Innovation
Firms that are capable of continually creating new and innovative products tend
to dominate the specialty retail industry. Consumers are always looking for a new and
better product. It is the firm’s responsibility to be proactive and listen to their
consumers’ needs. Consumers find new, innovative products exciting. Innovation helps
to attract new customers and retain the existing ones. Innovation allows a firm to
change and evolve, moving forward into the future in a positive direction.
Product Variety and Quality
Product variety is a must for the specialty retail industry. One product is not
suitable for every consumer. Products need to be available in different shapes, sizes,
and colors. Options are important to the consumer. Specialty retail firms should offer
different brands in order to attract the consumer and keep their satisfaction. The firm
must pay close attention to what products and brands are doing well in their store.
While offering a variety of products, specialty retailers also need to ensure product
quality. This will influence a firm’s decision on determining which strategies to use
when developing their competitive advantage. If a firm decides to strictly use cost
leadership, a means of cutting costs will have to be reached in order for the firm to be
able to provide quality and variety. Often, when a firm decides to rely on cost
leadership, the firm risks decreasing product quality and or variety. Thus, for a
specialty retailer to gain a competitive advantage, both strategies must be incorporated.
Investment in Brand Image
Image is a huge part of the specialty retail industry. The overall image of a store
is what attracts consumers. Consumers chose to shop at specialty retailers. They often
have to go to a mall or a specific destination just to shop there. Therefore, specialty
retailers have to be able to portray their firm in the manner they want to be viewed by
27
their consumers. A strong brand image will pave the way for a successful future. This
is often one of the most difficult parts of competition new firms entering into the
specialty retail market will undergo. Creating a brand image is not an easy fete for a
firm. However the benefits that brand image bring to a firm are definitely worth the
investment costs. Brand image represents the company as a whole. It is how
consumers envision the firm and the brand. Consumers have to want to incorporate a
differentiated brand into their lives. It is up to the firm to invest wisely in the brand
image in order to retain customer loyalty. Firms with their own proprietary brand are
able to create a lasting brand image. Firms that offer a proprietary brand along with a
large merchandise selection of other brands are able to attract different types of
consumers. Brand image and brand recognition are two of the leading competitive
advantages used in the specialty retail industry.
Conclusion
The goal of the firms in the specialty retail industry is to match its strengths and
key factors to success. If a firm concentrates on monitoring quality and improving
efficiency to instill a competitive advantage, it will be on the way to becoming a leading
competitor in the specialty retail industry. Competition on product variety and
specialization in establishing relationships with suppliers and marketing many different
products will enable a firm to create a truly differentiated product market. The
combination of the latter will allow a specialty retailer to successfully use their
competitive strategies to use innovation, to ensure product variety and quality, and to
create a significant and unique brand image.
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Competitive Advantage Analysis
The first step in achieving a competitive advantage is to distinguish a firm’s
competitive strategy. The firm must identify the strengths and weaknesses which will
enable the firm to determine whether to use cost leadership, differentiation, or a
combination of the two. Once these factors have been identified, it is up to the firm to
implement these strategies into their market plan. After implementation it is necessary
for the firm to identify key success factors in order to maintain their chosen competitive
advantage.
Pacific Sunwear uses a combination of cost leadership and differentiation. Cost
leadership is used due to the extensive amount of competition between the large firms
in the specialty retail industry. Differentiation is used because the industry is
specialized. Pacific Sunwear focuses mainly on differentiation to sell their products.
The competitive advantages used to successfully do so are merchandise selection,
brand recognition, and price.
Merchandise Selection
Pacific Sunwear offers a broad selection of casual apparel, accessories, and
footwear. Over 83 different brands, in addition to their own proprietary brand, are
available both in store and on-line. Not only are these brands offered, but Pacific
Sunwear is generally these companies’ largest distributor and customer. This has
inspired these smaller companies to continue to innovate and develop new products so
that Pacific Sunwear will continue to provide these firms with exposure. Pacific
Sunwear’s competitors, such as Abercrombie and Fitch, Aeropostale, American Eagle,
and The Gap, only offer proprietary brands. A large, diversified merchandise selection
really sets Pacific Sunwear apart from their competitors.
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Brand Recognition
The name Pacific Sunwear has a brand recognition all in its own. Pacific
Sunwear stores are found in all 50 states and Puerto Rico. The stores are mall based
and extremely popular for their targeted demographic(12-24). (PacSun 10-K, 2006). All
of the merchandise offered in Pacific Sunwear stores are name brand. While these
brands are able to purchased to elsewhere, other stores are lacking in selection. Pacific
Sunwear conveniently houses all of their offered brands under one roof. Brand
recognition is often what attracts new customers to the stores. Even if the consumer is
not familiar with the name Pacific Sunwear, perhaps they are familiar with one of the 83
brands carried in store. When consumers are able to purchase a product of their brand
loyalty and preference, the consumer is likely to become a repetitive shopper. Brand
recognition has proven to be one of Pacific Sunwear’s leading competitive advantages
due the amount and quality of the brand names offered.
Customer Service
Pacific Sunwear has been geared to a professional non intrusive customer
service. As the company is focused on the teen market “It is a main concern to treat
the younger customers with the same amount of respect as the do with the adult
customers in other retail stores.”(Pacific Sunwear 2006 10-K) The company trains their
employers to make you feel welcome to their store and refrain from giving unsolicited
advice. The Pacific Sunwear stores make for a great social atmosphere by focusing on
the store set up and appropriate music for the setting.
30
Conclusion
The success of a firm depends upon their competitive advantage. Competitive
advantage is what sets a firm apart from the rest. Developing a well-thought out and
strategic competitive advantage is key for the specialty retail industry due the high
amount of competition and large firms. Pacific Sunwear can attribute their consecutive
annual growth to their distinct and successful competitive advantages.
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Accounting Analysis
The next step in financial statement analysis is the accounting analysis.
“The purpose of accounting analysis is to evaluate the degree to which a firm’s
accounting captures its underlying business reality,”(Business Analysis and Valuation,
4th Edition). The accounting analysis is made of six precise and crucial steps. The
steps of the accounting analysis are as follows:
Step One Identify Principle Accounting
Policies
Step Two Assess Accounting Flexibility
Step Three Evaluate Accounting Strategy
Step Four Evaluate the Quality of Disclosure
Step Five Identify Potential Red Flags
Step Six Undo Accounting Distortions
Key Accounting Policies
The first step in the Accounting Analysis is to identify principal accounting
policies. In order for Pacific Sunwear to identify these key accounting policies, they
must establish that their accounting practices are directly linked to their key success
factors. Within the Five Forces Model, we identified Pacific Sunwear’s key success
factors as economies of scale and investment in brand image. Even though
differentiation exists in the specialty retail industry, firms try to distinguish themselves
from their competitors in any way they can. Therefore, investment in brand image is
extremely important in helping firms gain a competitive advantage in the specialty retail
industry. Consumers can remember names of stores more easily when their favorite
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well known name brand is sold there. However, gaining access to these well known
name brands can be costly, and keeping costs low is needed for survival in the specialty
retail industry. Therefore, some companies keep costs low in other ways. Accounting
Flexibility within GAAP allows companies to either distort their financial statements so
that their numbers are more appealing, or state them clearly.
One key accounting policy for Pacific Sunwear is reporting long term assets such
as buildings. Companies can either report buildings under capital leases or operating
leases. Capital leases reflect asset ownership and appear on the balance sheet under
long term assets, therefore increasing total assets and owner’s equity. It also allows for
the asset to be depreciated accordingly. An operating lease, however, is treated like
rent. Therefore companies can expense the lease payments while decreasing their
liabilities. Operating leases distort the financial statements and, in some cases, are
extremely difficult to undue because most firms do not disclose ample information on
these future obligations; which can be very far in the future. Pacific Sunwear uses
operating leases, in turn, decreasing their liabilities and distorting their costs to appear
low. For Pacific Sunwear, this is incredibly significant because to the shareholders, the
firm appears to be cost efficient, when in reality their operating leases total to
approximately $710 million (Pacific Sunwear 10-K). If Pacific Sunwear treated these as
capital leases, their liabilities would be extremely high, resulting in a rising concern for
the firm’s shareholders.
Another key accounting policy for Pacific Sunwear is the Recognition of Revenue.
Sales are recognized when customers purchase items in the physical retail store or
when items are delivered and accepted by their online customers. We estimate future
returns by customers through past data. In the past, Pacific Sunwear’s return rates
have meet those that were anticipated. However, if these numbers increase
significantly, Pacific Sunweaer’s operational results could be negatively affected. Also,
Pacific Sunwear records all gift cards as “current liabilities and recognize a sale when a
customer redeems a gift card. The amount of the gift card liability is determined taking
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into account our estimate of the portion of gift cards that will not be redeemed or
recovered (“gift card breakage”). Gift card breakage is recognized as revenue after
24 months, at which time the likelihood of redemption is considered remote based on
our historical redemption data” (Pacific Sunwear 2006 10-K). This is very important for
outsiders to know because in the event that any of these numbers change significantly
beyond Pacific Sunwear’s expectations, it could dramatically affect the balance sheet.
Conclusion
Regardless of what industry a firm competes in, it is imperative that each firm
attempt to coordinate their key success factors with their key accounting policies. If
these are not closely linked with one another, “red flags” arise, and accountants (and
even outsiders) must further analyze these policies. The only way to avoid these “red
flags” is by creating transparent annual reports with a high amount of disclosure. It is
important for outsiders to remember that GAAP provides flexibility in accounting
analysis. Thus, firms are able to either distort their numbers to appear more appealing
or state them clearly.
Areas of Accounting Flexibility
Financial Statements provide investors with an overview of the company’s
profitability and provide investors with the information they need to decide whether to
invest or not. “The objective of financial statements is to provide information about the
financial strength, performance and changes in financial position of an enterprise that is
useful to a wide range of users in making economic decisions. This information should
be “understandable, relevant, reliable and comparable” (www.wikipedia.com). Financial
statements must be written to where an outsider with reasonable amount of knowledge
34
of the business and economic world is able to understand. GAAP provides financial
statements with a certain amount of flexibility. This flexibility gives firms the
opportunity to distort some of the financial reports therefore making their company
seem more appealing to invest in. Some of the ways Pacific Sunwear has flexibilities
with GAAP are discussed below.
Operating v. Capital Leases
The largest area of flexibility for Pacific Sunwear, and one of GAAP’s major
weaknesses, is deciding to classify its leases as operating rather than capital. This can
provide very misleading information to an outsider. Operating leases are treated as
rent and do not affect the assets or liabilities on the balance sheet. The owner of the
building only leases the right to use the building for business purposes. Operating
leases are more like contracts in that they mature and when they reach their maturity
date the lessee has the option of releasing or not. Because there is no ownership rights
being transferred, operating leases will only show up on the company’s income
statement under operating expenses. Therefore, this considerably understates the
company’s balance sheet. This causes a nice chain reaction in that it causes net income
and retained earnings to be overstated and the firm’s liabilities to be understated.
Because of net income and retained earnings being overstated, this causes the
company to look more profitable then it actually is and may cause more investors to
invest in the company if they do not look closely.
On the other hand, capital leases do have an affect on the company’s balance
sheet. Capital leases affect both the assets and liabilities of a company. They are
added to the assets under property, plant, and equipment (because it’s a building) and
they are added to the liabilities under lease payments because they pay of the lease
month by month. The lessee in this case is acquiring some of the benefits of owning
the building (such as depreciation) and some of the risks as well (such as taxes). When
the lease is paid off full ownership rights are transferred from the lessor to the lessee.
35
Capital leases are recognized immediately and that is the main reason why in the
special retail industry firms opt to use operating leases. However, GAAP allows
flexibility when it comes to firms choosing which lease to use. Therefore, either lease
would be appropriate.
Evaluation of Long-Lived Assets
GAAP allows firms a vast amount of flexibility in accounting for the impairment of
long-lived assets. Asset impairment write-offs “differ from most financial statement
information because of greater discretion as to their magnitude and timing”
(www.bnetresearchcenter.com). Firms can use this discretion of GAAP to help manage
earnings. Pacific Sunwear assesses their impairment when “undiscounted expected
future cash flows derived from an asset or asset group are less then its carrying
amount” (Pac Sun 10K, 2007). The impairments are recognized in Operating Earnings.
Pacific Sunwear uses their best judgment to estimate impairments. An outsider must
be careful when looking at this because Pacific Sunwear is just estimating based on
past performances and some current information, therefore, the slightest change could
affect their reported earnings and their assessment of recoverability.
Same-Store Sales
For Pacific Sunwear, stores are deemed comparable on the first day of the month
following the one-year anniversary. This is an important indicator of current company
performance. It also ties into how Pacific Sunwear recognizes their revenue. These
same-store sales “are important in achieving operating leverage of certain expenses”
(Pac Sun 10K, 2007). If same-store sales are positive the results could generate
operating leverage of expenses, but if same-store sales are negative the results could
negatively impact operating leverage. These results have a direct impact on net sales,
cash, and working capital. It is also a key driver of operating margin which shows the
36
ability to control operating expenses. GAAP allows flexibility in this area because of the
flexibility in the recognition of revenue. Firms can record their revenue either when
they actually make the sale, or when they actually receive the money. This in turn
affects same-store sales. This will be investigated in further sections as to its impact on
the value of the firm.
Conclusion
All financial reporting activities are regulated by GAAP; however, GAAP does
allow for flexibility in how these financials are reported. The reason GAAP allows for
flexibility is that it was meant for firms to provide more transparent information to
outsiders, but it tends to also allow firms to distort their financial reports to make them
look better off. Pacific Sunwear uses this flexibility to their advantage by recording their
leases as operating, which in turns increases their net income making their company
look more valuable.
Accounting Strategy
Under the generally accepted accounting principles of the United States, firms
are required to make estimates that may affect values on the balance sheet, or income
statement. Thus, poor estimates may overstate or understate the value of the firm.
Pacific Sunwear’s strategy has some accounting flexibility like all firms in the specialty
retail industry. Pacific Sunwear’s accounting flexibility leads to conservative or
aggressive accounting methods. The strategy for Pacific Sunwear is to use these
methods to demonstrate a transparent economic value of the firm.
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One example of aggressive accounting Pacific Sunwear uses is operating leases.
Rent is expensed over a straight line which keeps the company form having millions of
dollars of liabilities on its books. This is normal practice for the specialty retail industry.
Recently, Pacific Sunwear has begun to expense pre-opening rent in accordance with
FASB Staff Position 13-1; meaning that construction is included in the rent cost. Before
adopting this method, rent expense was capitalized during the cost of construction and
amortized over the life of the lease; which means that Pac Sun is expensing less of its
leases in the beginning of the period and could lead to higher income as well as
understated liabilities.
Another aspect of Pacific Sunwear’s accounting strategy is their use of
markdowns. Managers must markdown merchandise periodically that does not sell.
Inventories include items that have been marked down to management’s best estimate
of their fair market value at that time. There is some pressure here on managers to not
markdown the merchandise completely and, therefore, overstate the value of inventory.
The decision to use markdowns is solely based on the items current sale price and the
age of the item. If at anytime the actual results differ from the estimates, further
markdowns may have to be recorded. This could in turn reduce Pacific Sunwear’s gross
margins and operating results.
All firms in the specialty retail industry make estimates about inventory
markdowns. Pacific Sunwear discloses the most information about how management
marks down merchandise that does not sell immediately. Abercrombie and Fitch, Hot
Topic, and American Eagle Outfitters, do not state in their 10-Ks that their estimates
have been historically accurate. Due to their large amounts of leases, Pacific Sunwear
can enhance their operating income by not claiming their liabilities on their operating
leases. All of the adjustments made to Pacific Sunwear’s accounting standards over the
past few years are based on adopting changes in the accounting code. There is no
reason to believe that Pacific Sunwear has large accounting distortions relative to the
rest of the specialty retail industry.
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Quality of Disclosure
Qualitative
For firms that are publicly traded, it is required to report economic standings on
a regular basis. Firms are required to produce an annual report known as a 10-K. It is
an audited, year-end report with consolidated financials and managerial input. We used
multiple 10-Ks to analyze Pacific Sunwear and its competitors.
The level of disclosure with Pacific Sunwear’s 10-K is semi-transparent. When it
comes to the liabilities of the company, we feel Pacific Sunwear did not disclose all
information because otherwise the company would not appear as desirable to potential
investors. Pacific Sunwear was very manipulative when it came to the disclosure of
their liabilities. For example, Pacific Sunwear does not go into detail on exactly which
methods, whether it be through capital or operating leases, they use to record their
assets. They simply state, “certain equipment” or “certain operations” require different
leases. This is a significant factor that could dramatically affect the value of the firm.
Pacific Sunwear’s operating leases totaled $111 million, consequently this is the amount
by which their current liabilities are understated. Capital leases are a relatively small
amount of Pacific Sunwear’s obligations; however, for an analyst (or even an outsider)
this is a difficult problem to overcome if you are trying to obtain a clear idea of the
firm’s financial position. This problem does not occur solely in Pacific Sunwear’s 10-K’s,
we found the same lack of disclosure from their competitors as well. Therefore, we
determined that this concept is not a significant factor in determining the value of the
firm in the specialty retail industry.
One way that Pacific Sunwear is transparent in their financials is the way they
break down their percentages of sales of the different departments. The graph
following is from the Pacific Sunwear 10-K with the breakdown.
39
Total Company
2004 2005 2006
Guys’ apparel 37% 36% 38%
Girls’ apparel 30% 31% 30%
Accessories 19% 19% 19%
Footwear 14% 14% 13%
Total 100% 100% 100%
Information such as this helps analysts and outsiders see where the company is
and where it is heading. For instance, this chart shows that Pacific Sunweaer is more
male clientele, so they should focus more on the male aspect of the store.
Another aspect that Pacific Sunwear is transparent in is the seasonality of their
business. They explain why sales are usually higher in the second half of the fiscal year
than the first half; giving Christmas and back-to-school selling periods as being the
main cause. This is very useful information because it allows one to see the
fluctuations from quarter to quarter. Pacific Sunwear’s 10-K also provides explanations
for fluctuations throughout the quarter.
Conclusion
Based on this, we concluded Pacific Sunwear is semi-transparent. The only
items not subject to disclose are factors dealing with their financials; whether it is the
type of leases they use or even the fact that they do not go into detail on their income
statement. However, these are all discretions found throughout the specialty retail
industry, not just with Pacific Sunwear. Based on past 10-K’s, Pacific Sunwear has
progressively disclosed more and more information in their financials, but they still lack
some vital information that outsiders would find very useful. More regulated accounting
40
practices can account for this. Overall Pacific Sunwear does a fair job of disclosing
business activities.
Quantitative
Unlike qualitative analysis, quantitative analysis is a simple way of measuring.
“Quantitative analysis can be done for a number of reasons, such as
measurement, performance evaluation or valuation of a financial instrument”
(www.investopedia.com); although quantitative analysis is a powerful tool, it should not
be looked at without looking at the qualitative analysis as well. Also, quantitative
analysis should be done prior to the qualitative analysis. It is based on facts where the
company states the numbers and the analyst publishes them in understandable, written
terms.
The following section will discuss two manipulation diagnostics that will help
evaluate the revenues and expenses of the firm and its competitors: core sales
manipulation and core expense manipulation diagnostics.
Core Sales Manipulation Diagnostics
Sales/Cash from Sales
0.97
0.98
0.99
1
1.01
1.02
1.03
2002 2003 2004 2005 2006
Years
PSUNAEANF
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As shown in the graph, most firms in the specialty retail industry do a decent job
of collecting cash from sales, meaning there is a relatively small amount of cash from
sales in accounts receivable. The ratio should be close to 1, and as shown above,
Pacific Sunwear never goes above 1.01. The only firm that ever drops below one
happens to Abercrombie and Fitch in 2003, and they restore themselves back to normal
in 2004. Overall, Pacific Sunwear and the rest of the industry exhibit similar and
favorable trends of cash-to-cash conversion. Hot Topic was not able to be included due
to lack of information given and therefore we did not include them in this diagnostic.
Sales/Accounts Receivables
050
100150200250300350400
2002 2003 2004 2005 2006
Years
PSUNAEANF
In the graph above, one can see that most firms in the specialty retail industry
have small amounts of credit sales; excluding Pacific Sunwear in 2003. This gives firms
more cash to invest in operating activities. Principally this means that overall sales are
independent of credit sales. Based on this graph, however, Pacific Sunwear has had
the highest credit sales in the specialty retail industry. Overall, this industry does a fair
job of collecting cash from sales. And once again, Hot Topic could not be included due
to lack of information in their financials.
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Sales/Inventory
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Sales divided by inventory represents how well a firm’s inventory can produce
revenue. The industry as a whole has relatively stable inventory turnover year after
year; however, Pacific Sunwear has the lowest. This means that Pacific Sunwear is not
turning their inventory into revenue as quickly as the other companies. Pacific
Sunwear having the lowest inventory turnover does make sense because they are the
industry lagers. However, having the lowest inventory turnover is not always a
problem, especially considering that Pacific Sunwear has the most consistent inventory
turnover throughout the specialty retail industry; which is a very good thing. There are
no indicators that sales have been overstated with respect to inventory, as shown
through the consistency of the inventory turnover for Pacific Sunwear. Overall, the
specialty retail industry does a fair job at turning inventory into revenue.
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Core Expense Manipulation Diagnostics
CFFO/OI
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
From looking at the graph above, one can tell that the specialty retail industry
does a superior job at matching cash flow from operations to operating income. Pacific
Sunwear even takes the lead in this category in 2006. This is most likely due to the
major decrease in operating income and an increase in cash flow from operations in
2006 due to store closings.
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Total Accruals/Change in Sales
0.002.004.006.008.00
10.0012.0014.0016.00
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Generally in the specialty retail industry, total accruals are very small with
regards to change in sales; that is with the exception of American Eagle in 2003. The
majority of this is due to the fact that most firms in the specialty retail industry record
off balance sheet accounting when reporting long-term debt. Therefore, their accrued
expenses are severely limited. Because of this, this ratio does little or nothing at all
when trying to distinguish firms in the specialty retail industry.
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Asset Turnover
-
0.50
1.00
1.50
2.00
2.50
3.00
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
When first looking at this graph, one would say that the asset turnover ratio for
the specialty retail industry was fairly consistent from year to year. Pacific Sunwear
even has the most stable and one of the highest rates of asset turnover. However, this
information is misleading due to the fact that most firms in the specialty retail industry
keep a vast amount of assets off their balance sheets through operating lease
accounting. Because of this, the asset turnover ratio in the specialty retail industry is
relatively high.
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Potential “Red Flags”
When looking at the accounting practices of a firm, it is important to identify any
indicators of questionable accounting. These “red flags” should lead analysts to look
closer at items that could be distorted. Ratio analysis is commonly used to compare
accounting practices across an industry.
At first glance, the ratio diagnostics for Pacific Sunwear did not show any
noticeable “red flags”. It appears that Pacific Sunwear is operating efficiently, just like
the rest of the specialty retail industry. However a deeper look into the financials of
Pacific Sunwear raises some concerns. For instance, Pacific Sunwear has a present
value of operating leases of $111 million. After these leases are capitalized, Pacific
Sunwear is hiding over $1 billion in liabilities. This is a major “red flag” to any investors
looking at Pacific Sunwear financials.
Because of this “red flag”, some of the ratio diagnostics will change drastically.
The Asset Turnover ratio (sales/total assets) will decrease because of the increase in
long-term assets. Also, the total accruals over change in sales will have a dramatic
change because of the increase in accrued liabilities. With these drastic changes on
both sides of the balance sheet, the structure of the firm has changed as well. Now,
Pacific Sunwear is financed more by debt than equity.
With this “red flag” in the operating leases, we decided that Pacific Sunwear is
not transparently disclosing all the information to represent the firm’s true value. Even
though Pacific Sunwear has disclosed some useful information, they do not fully
disclose the financial standing of the firm to the best of their ability.
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Undoing Accounting Distortions
When “red flags” are identified an analyst must undo the distortions to gain a
transparent view of the company. Throughout this analysis we have heavily focused on
conservative accounting practice of using operating leases. Because of these “red
flags” these operating leases need to be capitalized. In the chart below, it shows that
with Pacific Sunwear using operating leases they have understated their liabilities by
over $1 billion. This should be accounted for on the balance sheet by an increase in
both liabilities and long-term assets.
The use of operating leases has major effects on the following ratios: Asset
Turnover, Total Accruals/Change in Sales, and Debt to Equity. By restating these leases
as capital leases over the next 14 years, we have tried to give a more transparent view
of Pacific Sunwear’s financial standing.
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Capitalization of Operating Leases using Discount Rate of
7%
YEAR OPERATING LEASES PV FACTOR PRESENT VALUE
2006 $128,100 .9346 $119,720
2007 $111,000 .8734 $96,952
2008 $111,021 .8163 $90,626
2009 $107,823 .7629 $82,258
2010 $103,753 .7130 $73,974
2011 $95,349 .6663 $63,535
2012 $80,918 .6227 $50,392
2013 $211,493 .5820 $123,091
2014 $211,493 .5439 $115,038
2015 $211,493 .5083 $107,512
2016 $211,493 .4751 $100,479
2017 $211,493 .4440 $93,905
2018 $211,493 .4150 $87,762
2019 $211,493 .3878 $82,021
$1,287,265
49
Asset Turnover
Before capitalizing Pacific Sunwear’s operating leases, their asset turnover ratio
was 1.87. The reason for this fairly decent ratio in assets was because Pacific Sunwear
was able to keep over $1 billion of their assets off the balance sheet through their
operating leases. After capitalizing these leases the new Asset Turnover ratio for Pacific
Sunwear is .702. Much lower then the stated 1.87 they have when using operating
leases. With this new asset turnover ratio, it shows that Pacific Sunwear is not as
efficient at turning their assets into sales as they appear to be.
Total Accruals/Change in Sales
Much like the rest of the specialty retail industry, Pacific Sunwear has small total
accruals over change in sales ratio. This is due to the firms in the specialty retail
industry performing off balance sheet activities and thus creating small long-term
liabilities. Pacific Sunwear currently has a total accruals over change in sales ratio of a
.99. However, after the leases have been capitalized it changes the total accruals over
change in sales ratio to a negative .35. This means that Pacific Sunwear is
overwhelmed by their long-term debt so any profit made from year to year gets
invested into that.
Debt to Equity
For the purposes of investing, the specialty retail industry almost always uses
operating leases; otherwise, the company would look undesirable. This in turn keeps
the debt to equity ratio low, which in the eyes of the investor, is a good thing.
Currently, Pacific Sunwear has a debt to equity ratio of .54. With capitalizing the leases
we have gained a more accurate debt to equity ratio of 3.09, which means that Pacific
Sunwear has a higher percentage of debt than compared to equity than it originally
stated.
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Conclusion
Due to the inconsistencies within Pacific Sunwear’s 10K, they do not disclose full
transparent financials. Pacific Sunwear discloses much information on recognizing
revenue and the seasonality of their business. However the area on which they are
worst at disclosing is in regards to their operating leases. Through this accounting
analysis we concluded that Pacific Sunwear’s accounting policies are tied in with their
key success factors. And as for the transparency of their financials, we decided that the
disclosure is consistent with that of the rest of the specialty retail industry.
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Financial Analysis, Forecast Financials, and Cost of Capital
Estimation
In order to better understand the financial state of a company, how profitable a
company may be, or perhaps the growth of the company, the financial statements of
the company must be analyzed and interpreted. This section takes a look at financial
factors, such as liquidity, profitability, and capital structure. These factors will help find
the firms growth compared to the industry as a whole and also help to more accurately
forecast future growth opportunities in the company’s industry. Just a reminder, that
these forecasts are just estimates and are not free of error. However, the more ratios
used the more accurate the forecasts. Before we can forecast to the best of our ability,
you must include the accounting distortions that were discussed in the previous section
to gain the current true value of the firm.
Ratio Analysis
Two factors determine the value of a firm: profitability and growth. Ratio
Analysis, therefore, is used to “evaluate the strengths and weaknesses of a company
and its operating trend” (www.answers.com). Ratio analysis compares both past and
present financial statements to evaluate three essential performance indicators
(liquidity, profitability, and capital structure) used to value the firm. This will also work
as a way to benchmark the firm against industry competitors. “Ratios are calculated
from current year numbers and are then compared to previous years, other companies,
the industry, or even the economy to judge the performance of the company”
(www.answers.com). These ratios will show where the firm has a competitive
advantage and where it is lacking. If the ratios seem to show consistency where the
52
company is lacking then that may be a sign of the firm having inefficient operations
with regards to the firm’s key success factors.
Liquidity Analysis
Liquidity ratios help give a picture of the company’s short-term financial
situation. It refers “to the cash equivalence of assets and the firm’s ability to maintain
sufficient near-cash resources to meet its obligations in a timely manner” (Hand-out,
pg.49). The ratios evaluated to determine liquidity are: Current Ratio, Quick Asset
Ratio, Inventory Turnover, Receivables Turnover, and Working Capital Turnover. We
will now attempt to asses these liquidity ratios for Pac Sun and compare to their
competitors in the special retail industry.
Current Ratio
Current Ratio
00.5
11.5
22.5
33.5
4
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
The current ratio attempts to measure the firm’s ability to repay its current
liabilities with its current assets. A current ratio between one and three is commonly
53
where firms in the specialty retail industry are located. As a current ratio increases, so
does a firm’s ability to cover their current liabilities with their current assets. Thus, the
higher the current ratio, the better it is for the firm. If the firm’s current ratio is less
than one, then the firm is lacking a sufficient supply of resources. If this situation
occurs, it is quite a concern for the firm. During the years 2003 through 2005, the
current ratio for Pacific Sunwear exceeded three. However, in 2006, the current ratio
for Pacific Sunwear decreased, returning the firm to the industry standard.
Quick Asset Ratio
Quick Asset Ratio
0
0.5
1
1.5
2
2.5
2002 2003 2004 2005 2006
Years
PSUNAEANF
The Quick Asset Ratio measures those short-term assets that can be used
immediately to repay the current liabilities. As the graph indicates, Pacific Sunwear was
in the lead with the Quick Asset ratio in 2003, but after that Pacific Sunwear has
gradually decreased. The main reason for this decrease is that Pacific Sunwear was not
selling enough inventory and therefore was forced to close down some stores. Pacific
54
Sunwear will most likely start to see a gradual increase in the Quick Asset Ratio.
Compared to the rest of the industry, the Quick Asset Ratio is relatively low for the
special retail industry and it seems it is likely to stay that way.
Accounts Receivables Turnover
Receivables Turnover
0
100
200
300
400
2002 2003 2004 2005 2006
Years
PSUNAEANF
Receivables Turnover helps evaluate a firm’s effectiveness in extending credit. It
also helps you see how efficiently the firm is using their assets; the higher the
receivables turnover the better. In the case of Pacific Sunwear, it is leading the
industry with the receivables turnover ratio. Even though it has slowly been declining
ever since 2003, it is still the industry leader. A high receivables turnover ratio means
the company is operating primarily on a cash basis. This is shown through the low
amounts tied up in Pacific Sunwear’s accounts receivables.
55
Days Supply of Receivables
Days Supply of Receivables
02468
2002 2003 2004 2005 2006
Years
PSUNAEANF
Days Supply of Receivables tells you how long a company takes to collect its
accounts receivables. It is also the second half of the cash-to-cash cycle. For any other
industry this number is typically above 20 days, but in the specialty retail industry, it
never gets above 10 days. In this case, the lower the days supply of receivables the
better. And for Pacific Sunwear they are leading the industry as was shown in the
receivables turnover ratio.
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Inventory Turnover
Inventory Turnover
012345678
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Inventory Turnover allows one to see how efficient a firm is with their inventory;
or to put nicely, how quickly they sell their inventory. The quicker they sell their
inventory the more efficient the company is. Compared to the rest of the industry,
Pacific Sunwear has maintained a stable inventory turnover. The industry started off
high but now the special retail industry seems to be leveling out to Pacific Sunwear
numbers. Also, the rest of the industry seems to have been fluctuating, while Pacific
Sunwear is staying constant. So in this case, Pacific Sunwear is where they should be.
Because Pacific Sunwear’s inventory turnover has been stable, it shows they are
operating on an efficient basis.
57
Days Supply of Inventory
Days Supply of Inventory
0
50
100
150
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Days Supply of Inventory shows how long a firm has their inventory in storage or
in other words how quickly do they sell their inventory. This is the first half of the cash-
to-cash cycle. Excluding Abercrombie, most firms in the specialty retail industry have a
days supply of inventory anywhere from 50-80 days. Of all the firms in the specialty
retail industry, Pacific Sunwear has been the most consistent. Because we now have
both parts to the cash-to-cash cycle we can figure how long it takes Pacific Sunwear to
turn its resource inputs into actual cash. In 2006 the Days Supply of Inventory was
74.8 days and the days supply of receivables was 2.71 days. So the total cash-to-cash
cycle for Pacific Sunwear is 77.51 days.
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Working Capital Turnover
Working Capital Turnover
0
2
4
6
8
10
12
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Working Capital Turnover measures how effectively a company is using their
working capital (current assets – current liabilities) to generate sales. Working capital is
used to purchase inventory and fund any operations, which is then converted into
revenue. An increase in working capital can arise from two things happening. First,
working capital can increase due to a decrease in current assets, or second, working
capital can increase due to an increase in sales. In 2002-2005 Pacific Sunwear’s
Working Capital Turnover has been somewhat below that of the rest of the specialty
retail industry. But in 2006, Pac Sun was able to increase their Working Capital
Turnover due to both an increase in sales and a large decrease in current assets.
Therefore, Pacific Sunwear raised their Working Capital Turnover from 4.57 in 2005 to
7.43 in 2006. This shows that Pacific Sunwear is able to generate their working capital
into sales rather efficiently.
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Days Supply of Working Capital Turnover
Days Supply of Working Capital Turnover
0.00
50.00
100.00
150.00
200.00
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
To derive this ratio you divide the working capital turnover by 365. In this case
the lower the number the better, because it means they are able to turn their working
capital into sales faster than the rest of the industry. For Pacific Sunwear, we were
above the industry average until 2006. When 2006 came around Pacific Sunwear
dropped down to the industry average of about 50 days.
Conclusion
To determine the liquidity of a firm, one must evaluate these ratios (Current
Ratio, Quick Asset Ratio, Inventory Turnover, and Working Capital Turnover) as a
whole. Also, these ratios provide an understanding of how efficient a company’s cash
to cash cycle is. Overall, Pacific Sunwear has a positive outlook when look at the
liquidity ratios, but compared to the rest of the industry, Pacific Sunwear seems to be
right on par with its competitors.
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Profitability Analysis
Profitability Analysis ratios measure a firms ability to generate profit. More
importantly, profitability ratios are “a class of financial metrics that are used to assess a
business's ability to generate earnings as compared to its expenses and other relevant
costs incurred during a specific period of time. For most of these ratios, having a higher
value relative to a competitor's ratio or the same ratio from a previous period is
indicative that the company is doing well” (www.investopedia.com). There are six
ratios used to determine a company’s profitability: Gross Profit Margin, Operating Profit
Margin, Net Profit Margin, Asset Turnover, Rate of Return on Assets, and Rate of Return
on Equity. The first three ratios concentrate on evaluating operating efficiency while
the last three ratios actually measure profit.
Gross Profit Margin
Gross Profit Margin
0%10%20%30%40%50%60%70%80%
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
61
Gross Profit Margin is the percentage of earnings that remains from sales after
the firm subtracts out the cost of goods sold. A high Gross Profit Margin indicates the
firm is able to earn a reasonable profit on sales. Keeping overhead costs under control
will also help generate a higher Gross Profit Margin. From 2002-2005, Pacific Sunwear
seem to be right on queue with the rest of the industry, but in 2006, Pac Sun fell below
the industry. This is due to too many stores being open that are not successful and will
be fixed by some of these stores closing. Although Pac Sun is below the industry
average, the store closings will help increase their Gross Profit Margin back up to where
the rest of the industry is.
Operating Profit Margin
Operating Profit Margin
0%
5%
10%
15%
20%
25%
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
62
Operating Profit Margin is a measure of how effective a firm is at managing their
cost and expenses relative to their normal operations (www.investowords.com). It
gives an idea of how much a firm makes on a given dollar; therefore, the higher the
Operating Profit Margin the better. From 2002-2005 Pac Sun was above the overall
industry but then in 2006 Pac Sun had a drastic decrease. Their Operating Profit
Margin fell from 14% in 2005 to 4% in 2006. This means that Pac Sun was unable to
keep their operating costs low and would be considered inefficient in this area,
especially compared to the specialty retail industry as a whole. With the exception of
Hot Topic, the industry has been at an average of 11.75%. So as indicated in the
graph above, Pac Sun is drastically below the industry average.
Net Profit Margin
Net Profit Margin
0%
2%
4%
6%
8%
10%
12%
14%
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
63
Net Profit Margin is an indication of how well a company is at converting revenue
into profit. It is also an indication of if the company is effective at cost control. The
industry average for the Net Profit Margin is roughly 7.75%. Up until 2006, Pac Sun
was above average, with the exception of Abercrombie, compared to the rest of the
industry; however, in 2006, Pac Sun decreased from 9% to 4%. Pac Sun was not the
only company to decrease during 2006. Hot Topic also has had a decrease since 2003
from 8% all the way down to 3% in 2006. Overall for Pac Sun, this is a negative factor
and indicates the company is not great at controlling costs. It is also an indication that
the company is having trouble generating their revenue into profit. Part of this is due
to the fact that some stores have been not as successful and are in the process of
being closed. Hopefully this will gradually increase Pac Sun’s net profit Margin back to
the industry average of 7.75%.
Asset Turnover
Asset Turnover
0
0.5
1
1.5
2
2.5
3
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Asset Turnover is an indication of the firm’s asset productivity or, to put simply,
how well a firm can turn their assets into sales; therefore, the higher the number the
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better. “It also indicates pricing strategy: companies with low profit margins tend to
have high asset turnover, while those with high profit margins have low asset turnover”
(www.investopedia.com). Overall, Pac Sun has been relatively high compared to the
rest of the industry. This means that Pac Sun is very efficient at transforming their
assets into sales even though they are below the industry in both sales and total assets.
Pac Sun still manages to be more productive with the amount of assets they purchase.
This is a positive indicator of Pac Sun’s profitability.
Return on Assets
Return on Assets
0%5%
10%15%20%25%30%35%
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Return on Assets gives an idea of how well a company is at turning their assets
into earnings. It takes into consideration a firm’s Asset Turnover and Net Profit Margin.
65
The average for Return on Assets in the specialty retail industry is roughly around 13%.
As shown in the graph above, Pac Sun is way below the industry average at 5% in
2006. However during 2002-2005 Pac Sun was consistent with the rest of the industry.
The reason for the decrease for Return on Assets in 2006 was due to Net Income’s
drastic decrease from $126,212 to $39, 621. Because of this decrease in Net Income,
Pac Sun fell below the industry average in regards to Return on Assets. Overall this is a
negative indicator of Pac Sun’s profitability.
Return on Equity
Return on Equity
0%10%20%30%40%50%60%
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
Return on Equity measures “the profitability of the owner’s interest in total
assets” (Hand-out in class, pg.54). Return on Equity will increase if profits increase, so
in this case, the larger the Return on Equity the better. From 2002-2005, Pac Sun was
pretty consistent with the rest of the specialty retail industry. Due to the decrease in
profits in 2006 Return on Equity also decreased from 19% in 2005 to 5% in 2006. This
is a negative factor of Pac Sun’s profitability.
66
Conclusion
After determining all the profitability ratios, Pacific Sunwear was following the
trends of the specialty retail industry. However, in 2006, Pacific Sunwear’s profitability
took a turn for the worst. Both ROE and ROA dropped tremendously, which are
negative indicators of profitability. With the help of store closings, Pacific Sunwear
should be able to increase their profitability to that of the specialty retail industry.
Capital Structure Ratios
Capital structure ratios are used to demonstrate how a firm obtains assets.
Assets are obtained using different financial processes and resources. Three key capital
structure ratios reveal how these assets are acquired. These ratios include: Debt to
Equity Ratio, Times Interest Earned Ratio, and Debt Service Margin Ratio. The Debt to
Equity Ratio compares the firm’s total liabilities to total stockholders equity. If a firm’s
assets are backed completely by their liabilities, this results in a risky firm. This
situation can make it very difficult for the firm to pursue any further lending due to a
high level of credit risk. The Times Interest Earned Ratio determines whether a firm is
able to cover their interest expenses with their operating income. This too is an
indicator of credit risk that may be applicable to a firm. The Debt Service Margin Ratio
measures the amount of current cash flows from operations and compares this to the
installments due on long term debt. A firm must be able to provide adequate cash
flows from operations to pay for their current portion of debt. Below, is a more in-
depth analysis of these ratios and their economic effect on both Pacific Sunwear and
the specialty retail industry as a whole.
67
Debt to Equity Ratio
Debt to Equity Ratio
0
0.2
0.4
0.6
0.8
1
1.2
2002 2003 2004 2005 2006
years
PSUNAEANFHOTT
The Debt to Equity Ratio is an important component to evaluating the risk factor
of a firm. As the Debt to Equity Ratio increases, so does the risk level. Abercrombie
and Fitch has the highest Debt to Equity Ratio of the four firms. In 2004, their debt to
equity level reached 1.01, or over one hundred percent. Pacific Sunwear’s debt to
equity level is relatively close to industry average. The performance between Pacific
Sunwear and Hot Topic is almost equivalent in the years 2004 and 2005. Pacific
Sunwear appears to have an acceptable Debt to Equity Ratio compared to industry
standards, however this ratio is distorted. Pacific Sunwear uses operating leases, which
significantly undervalues the amount of total liabilities to the firm. Therefore, when
assessing credit risk for Pacific Sunwear, capital leases and the corresponding distortion
to the Debt to Equity Ratio need to be taken highly into consideration.
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Times Interest Earned and Debt Service Margin
In regards to the Times Interest Earned Ratio and Debt Service Margin Ratio, our
results are not applicable. Both can be excellent indicators of how firm acquires assets,
however due to a lack of information, we are unable to draw any conclusions from
these ratios. The Times Interest Earned Ratio compares operating income and interest
expense. We were not able to find any interest expenses or current portions of long
term debt for other firms in our industry, and therefore, could not determine these
industry ratios. The Times Interest Earned ratios for Pacific Sunwear are as follows:
T.I.E Ratio 2002 2003 2004 2005 2006
PSUN 2.62 2.63 2.62 2.57 2.42
Although these numbers are very consistent, little information can be drawn. In
regards to the Times Interest Earned Ratio, bigger is better. A ratio that falls in
between four and seven percent is considered to be good. Pacific Sunwear falls below
this benchmark, and we were unable to determine where the rest of the industry lies.
As for the Debt Service Margin, we were unable to find any current portions of
long-term debt for Pacific Sunwear of its competitors and therefore could not compute
this ratio.
Conclusion
Capital Structure Ratios have the potential to reveal crucial information about a
firm. Disclosure of such information is left to the discretion of the firm. In the specialty
retail industry, such disclosure is a common trend. Factors that influence firms to chose
69
not to reveal their amounts of interest expense and the current portion of long-term
debt include operating leases and insufficient cash flows.
Additional Ratio Analysis
IGR/SGR Analysis
IGR/SGR Analysis
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
2002 2003 2004 2005 2006
Years
Firm IGRInd. Ave. IGRFirm SGRInd. Ave. SGR
The Internal Growth Rate (IGR) is the maximum level of growth a firm can
obtain without seeking help from outside financial resources. IGR is determined by
multiplying a firm’s Return on Asset Ratio by one plus the Dividend Payment Ratio.
Pacific Sunwear is a non-dividend paying firm, and therefore the firm’s Return on Asset
Ratio is equivalent to the IGR. When comparing Pacific Sunwear to its competitors in
the specialty retail industry, Pacific Sunwear has a higher IGR than the industry
average. Two out of Pacific Sunwear’s direct competitors, ANF and AE, began paying
dividends in 2004. As a result, Pacific Sunwear is able to offset their liabilities with their
assets above the industry standard. The Sustainable Growth Rate (SGR) is the actual
rate at which, once surpassed, the firm must borrow additional funds in order to
70
continue growth into the future. SGR is calculated by multiplying IGR by one plus the
Debt to Equity Ratio. Until 2005, Pacific Sunwear’s SGR was higher than the industry
average. In 2006 Pacific Sunwear’s SGR decreased by 72.46%. As a result, Pacific
Sunwear will be closing some of their less successful store locations.
Sales/Non-Current Asset Ratio
Sales/Non-Current Assets
0
1
2
3
4
5
6
7
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
The Sales/Non-Current Ratio compares a firm’s total annual net sales to the total
non-current assets found on the balance sheet in order to determine the effect that
long term assets have on current sales. The higher the ratio is, the better the effect.
The specialty retail industry has a 3.81 average Sales/Non-Current Asset ratio. This is
an average calculated over the past five years. During this time, Pacific Sunwear’s
Sales/Non-Current Asset ratio has fluctuated between 3.3, at its lowest, and 3.9 at its
peak. The average for Pacific Sunwear over the past five years is 3.582. Pacific
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Sunwear’s Sales/Non-Current Asset ratios have been consistent over the past years, but
still fall a bit short of the industry as a whole.
Operating Cash Flow Ratio
Operating Cash Flow
0.000.200.400.600.801.001.201.401.601.80
2002 2003 2004 2005 2006
Years
PSUNAEANFHOTT
The Operating Cash Flow Ratio is calculated by dividing cash flow from
operations by current liabilities. This ratio indicates whether a firm can adequately
cover their current liabilities through their liquid assets received from operations.
Therefore, a ratio of one or above is desirable. Pacific Sunwear meets the criteria in
the years 2004 through 2006. This ratio can provide investors with information on how
well a firm can pay off their current debt using cash earned from operations.
72
Financial Forecasting
In order to properly forecast a firm’s future financial position, a comprehensive,
in-depth analysis of the firm and the industry is needed. The income statement,
balance sheet, and statement of cash flows are all necessary to forecast to produce an
accurate look into the future. Financial patterns of Pacific Sunwear must be compared
internally and externally to the industry in order to achieve the most effective
predictions. While forecasting always has future costs, it is important to the firm to be
as accurate as possible to defer as many unforeseen financial difficulties and obstacles
that the firm may face in the coming years. To do so, an analysis and comparison of
the financial statements from the past five years from Pacific Sunwear and the firm’s
competitors, American Eagle, Abercrombie and Fitch, and Hot Topic were performed.
This enabled us to forecast based upon the trends and past performance found in the
financial statements of Pacific Sunwear and other members of the retail industry. It is
important to forecast in conjunction with the firm’s position in the overall industry. The
numbers and trends have been forecasted for the next ten years. The income
statement was our preliminary step in forecasting. After the completion of the income
statement we went on to forecast the balance sheet and lastly the statement of cash
flows.
Income Statement
The first financial statement needed to forecast is the income statement. To
begin forecasting, we estimated an annual growth rate based on past performance. In
2006, Pacific Sunwear experienced a dramatic decrease in sales growth due to an
overpopulation of stores. In order for Pacific Sunwear to redirect their focus, the firm
chose to shut down the less successful stores. In 2007 Pacific Sunwear will introduce a
new addition to their line called 1,000 Steps. This new innovative store sells only
footwear, which is one of the firm’s top merchandise sellers. Based upon these actions,
73
we forecasted that the firm would again see a gradual increase in growth. The growth
rate begins in 2007 at two percent and increases two percent annually while leveling off
at ten percent to fit into the industry average. We used this growth rate to predict net
sales. From this point we derived a forecasting schedule using various formulas to
predict gross margin, cost of goods sold, operating income, and net income.
Income Statement (Revised)
Adjustments had to be made to Pacific Sunwear’s Income Statement after the
capitalizing of their operating leases. Only one major revision was necessary. The
present value of the total value of the capital lease assets was given an interest rate of
5.8%. This number was then added to interest expense. With this revision, it
decreased net income, and in Pacific Sunwear’s case, decreased net income into the
negative amounts.
74
PSUN Income StatementIn Thousands
PACIFIC SUNWEAR OF CALIFORNIA, INC.CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
Income Statement 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Net sales 847,150.00 1,041,456.00 1,129,762.00 1,391,473.00 1,447,204.00 1,477,595 1,539,654 1,570,684 1,668,985 1,727,752 1,835,884 1,900,527 2,019,472 2,090,580 2,221,419Cost of goods sold, including buying, distribution and occupancy costs 554,829.00 668,807.00 781,828.00 884,982.00 1,001,807.00 1,013,630.36 1,050,044 1,064,924 1,124,896 1,157,594 1,222,699 1,258,149 1,328,813 1,367,239 1,443,923Gross margin 292,321.00 372,649.00 447,934.00 506,491.00 445,397.00 463,964.92 489,610.06 505,760 544,089 570,158 613,185 642,378 690,659 723,341 777,497
Selling, general and administrative expenses 211,101.00 244,422.00 277,921.00 309,218.00 385,802.00 Operating income 81,220.00 128,227.00 170,013.00 197,273.00 59,595.00 76,835 96,998 116,231 141,864 165,864 196,440 209,058 222,142 229,964 244,356
Interest income, net (594.00) 732.00 1,889.00 5,673.00 4,620.00 Income before income tax expense 80,626.00 128,959.00 171,902.00 202,946.00 54,215.00
Income tax expense 30,960.00 48,759.00 64,998.00 76,734.00 24,594.00 Net income 49,666.00 80,200.00 106,904.00 126,212.00 39,621.00 52,274 66,787 68,133 85,748 88,768 109,010 112,849 136,067 140,858 167,445Comprehensive income 49,666.00 80,200.00 106,904.00 126,212.00 39,621.00 Net income per share, basic 0.67 1.05 1.41 1.69 0.56 Net income per share, diluted 0.66 1.02 1.38 1.67 0.56 Weighted average shares outstanding, basic 73,932.00 76,596.00 75,828.00 74,759.00 70,801.00 Weighted average shares outstanding, diluted 75,146,991.00 78,845,651.00 77,464,115.00 75,713,793.00 71,170,181.00 Provided by http://sec.gov Sales Growth 23% 8% 23% 4% 2% 4% 6% 8% 10% 10% 10% 10% 10% 10%
Common Size I/S 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Net Sales 100% 100% 100% 100% 100%Cost of Goods Sold 65.5% 64.2% 69.2% 63.6% 69.2% 69% 68% 68% 67% 67% 67% 66% 66% 65% 65%
Gross Margin 34.5% 35.8% 39.6% 36.4% 30.8% 35.4% 31.00% 32.00% 33.00% 34.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00%Selling, General, and Administrative Expenses 24.9% 23.5 22.6 22.2 26.7
Operating Income 9.6% 12.3% 15.0% 14.2% 4.1% 11.0% 5.20% 6.30% 7.40% 8.50% 9.60% 10.70% 11% 11% 11% 11%Interest Income 0.1 0.2 0.4 0.3
Income before income tax expense 9.52% 12.4 14 14.6 4.4Income tax expense 4.7 5.3 5.5 1.7
Net Income 5.86% 7.70% 9.46% 9.07% 2.74% 3.54% 4.34% 4.34% 5.14% 5.14% 5.94% 5.94% 6.74% 6.74% 7.5%
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PSUN Income StatementIn Thousands
PACIFIC SUNWEAR OF CALIFORNIA, INC.CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
Income Statement (Revised) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Net sales 847,150.00 1,041,456.00 1,129,762.00 1,391,473.00 1,447,204.00 1,477,595 1,539,654 1,570,684 1,668,985 1,727,752 1,835,884 1,900,527 2,019,472 2,090,580 2,221,419Cost of goods sold, including buying, distribution and occupa 554,829.00 668,807.00 781,828.00 884,982.00 1,001,807.00 1,013,630.36 1,050,044 1,064,924 1,124,896 1,157,594 1,222,699 1,258,149 1,328,813 1,367,239 1,443,923Gross margin 292,321.00 372,649.00 447,934.00 506,491.00 445,397.00 463,964.92 489,610.06 505,760 544,089 570,158 613,185 642,378 690,659 723,341 777,497
Selling, general and administrative expenses 211,101.00 244,422.00 277,921.00 309,218.00 385,802.00 Operating income 81,220.00 128,227.00 170,013.00 197,273.00 59,595.00 76,835 96,998 116,231 141,864 165,864 196,440 209,058 222,142 229,964 244,356
Interest income, net (594.00) 732.00 1,889.00 5,673.00 79,281.00 Income before income tax expense 80,626.00 128,959.00 171,902.00 202,946.00 (19,686.00)
Income tax expense 30,960.00 48,759.00 64,998.00 76,734.00 24,594.00 Net income 49,666.00 80,200.00 106,904.00 126,212.00 (44,280.00) (33,389) (22,474) (22,927) (11,010) (11,398) 2,576 2,667 18,989 19,658 38,660Comprehensive income 49,666.00 80,200.00 106,904.00 126,212.00 114,282.00 Net income per share, basic 0.67 1.05 1.41 1.69 0.56 Net income per share, diluted 0.66 1.02 1.38 1.67 0.56 Weighted average shares outstanding, basic 73,932.00 76,596.00 75,828.00 74,759.00 70,801.00 Weighted average shares outstanding, diluted 75,146,991.00 78,845,651.00 77,464,115.00 75,713,793.00 71,170,181.00
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Balance Sheet
To link the forecasts from the income statement to the balance sheet, we
used the Asset Turnover Ratio. Based on past performance, Pacific Sunwear’s
asset turnover has been consistent. We assumed an asset turnover of 1.8. We
used this number to derive a forecast of total assets by using the Asset Turnover
Ratio and divided our forecasted sales for 2007 by our estimated asset turnover
rate of 1.8, resulting in a forecast of total assets. Due to the consistency of the
percentage of current assets to total assets, we used the average percentage of
44 percent to forecast 2007 current assets. This percentage will grow annually
and level off at 47 percent. We used this same pattern to derive estimates for
stockholder’s equity and retained earnings. We then plugged total liabilities to
the accounting equation to arrive at these forecasts.
Balance Sheet (Revised)
Several revisions were required on the balance sheet to adjust for the
capitalization of Pacific Sunwear’s operating leases. Both assets and liabilities
needed to be adjusted. $1.1 billion was added to the total assets in 2006 to
account for the restatement of their lease obligations. This was matched by both
and increase to current and non-current liabilities. The end result to Pacific
Sunwear’s balance sheet adjustments was an equal increase in both assets and
liabilities.
77
PSUN Spliced Balance SheetIn Thousands
PACIFIC SUNWEAR OF CALIFORNIA, INCCONSOLIDATED BALANCE SHEETS
ASSETS 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016CURRENT ASSETS:
Cash and cash equivalents 36,438.00 109,640.00 64,308.00 95,185.00 52,267.00 Marketable securities N/A 147,751.00 79,223.00 74,944.00 31,500.00
Merchandise inventories 123,433.00 N/A 175,081.00 215,140.00 205,213.00 Other current assets N/A N/A 34,206.00 41,485.00 46,255.00 TOTAL CURRENT ASSETS 182,633.00 353,537.00 352,818.00 426,721.00 335,235.00 361,190 384,914 401,397 435,791 451,135 479,370 496,249 527,307 545,874 580,037PROPERTY AND EQUIPMENT, NET 201,513.00 272,869.00 304,222.00 355,822.00 420,886.00 OTHER ASSETS 15,597.00 N/A 20,738.00 25,018.00 17,122.00 Total Non-Current Assets 217,110.00 290,950.00 324,960.00 380,840.00 438,008.00 459,696 470,450 471,205 491,423 508,727 540,566 559,600 594,622 615,560 654,085TOTAL ASSETS 399,743.00 644,487.00 677,778.00 807,561.00 773,243.00 820,886 855,363 872,602 927,214 959,862 1,019,935 1,055,849 1,121,929 1,161,433 1,234,122
LIABILITIES AND SHAREHOLDERS’ EQUITYCURRENT LIABILITIES:
Accounts payable 28,456.00 38,668.00 38,753.00 47,550.00 66,581.00 Other current liabilities N/A N/A 56,557.00 74,921.00 73,952.00 TOTAL CURRENT LIABILITIES 73,328.00 110,539.00 95,310.00 122,471.00 140,533.00
LONG-TERM LIABILITIES:
Deferred lease incentives N/A 56,996.00 67,683.00 81,440.00 89,371.00 Deferred rent 10,574.00 24,325.00 26,826.00 28,748.00 30,619.00 Deferred income taxes 3,015.00 11,515.00 16,137.00 12,584.00 463.00 Other long-term liabilities N/A N/A 13,793.00 15,528.00 8,904.00 TOTAL LONG-TERM LIABILITIES 24,024.00 105,216.00 124,434.00 138,300.00 129,357.00 TOTAL LIABILITIES 97,352.00 215,755.00 219,744.00 260,771.00 269,890.00 265,259 232,950 182,056 150,920 94,800 45,862 256,699 186,711 85,357 -9,399Commitments and contingencies (Note 8) SHAREHOLDERS’ EQUITY:
Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued Common stock, $.01 par value; 170,859,375 shares authorized; 69,560,077 a 742.00 784.00 749.00 737.00 696.00 Additional paid-in capital 92,761.00 138,877.00 61,310.00 23,866.00 5,786.00 Retained earnings 208,888.00 289,071.00 395,975.00 522,187.00 496,874.00 549,148 615,934 684,067 769,815 858,583 967,594 1,080,442 1,216,510 1,357,368 1,524,813
TOTAL SHAREHOLDERS’ EQUITY 302,391.00 428,732.00 458,034.00 546,790.00 503,353.00 555,627 622,413 690,546 776,294 865,062 974,073 799,150 935,218 1,076,076 1,243,521TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY 399,743.00 644,487.00 677,778.00 807,561.00 773,243.00 820,886 855,363 872,602 927,214 959,862 1,019,935 1,055,849 1,121,929 1,161,433 1,234,122
78
PSUN Balance SheetIn Thousands
PACIFIC SUNWEAR OF CALIFORNIA, INCCONSOLIDATED BALANCE SHEETS
Balance Sheet (Revised)ASSETS 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
CURRENT ASSETS:
Cash and cash equivalents 36,438.00 109,640.00 64,308.00 95,185.00 52,267.00 Marketable securities N/A 147,751.00 79,223.00 74,944.00 31,500.00
Merchandise inventories 123,433.00 N/A 175,081.00 215,140.00 205,213.00 Other current assets N/A N/A 34,206.00 41,485.00 46,255.00 TOTAL CURRENT ASSETS 182,633.00 353,537.00 352,818.00 426,721.00 335,235.00 926,128 986,958 1,029,223 1,117,412 1,156,757 1,229,153 1,272,433 1,352,068 1,399,676 1,487,275PROPERTY AND EQUIPMENT, NET 201,513.00 272,869.00 304,222.00 355,822.00 420,886.00 OTHER ASSETS 15,597.00 N/A 20,738.00 25,018.00 17,122.00 Total Non-Current Assets 217,110.00 290,950.00 324,960.00 380,840.00 1,725,273.00 1,178,708 1,206,282 1,208,218 1,260,060 1,304,428 1,386,066 1,434,871 1,524,673 1,578,358 1,677,140TOTAL ASSETS 399,743.00 644,487.00 677,778.00 807,561.00 2,060,508.00 2,104,837 2,193,240 2,237,441 2,377,472 2,461,185 2,615,219 2,707,304 2,876,741 2,978,034 3,164,415
LIABILITIES AND SHAREHOLDERS’ EQUITYCURRENT LIABILITIES:
Accounts payable 28,456.00 38,668.00 38,753.00 47,550.00 66,581.00 Other current liabilities N/A N/A 56,557.00 74,921.00 73,952.00 Current portion on LTD and capital leases 90,109.00 TOTAL CURRENT LIABILITIES 73,328.00 110,539.00 95,310.00 122,471.00 230,642.00
LONG-TERM LIABILITIES:
Deferred lease incentives N/A 56,996.00 67,683.00 81,440.00 1,197,156.00 Deferred rent 10,574.00 24,325.00 26,826.00 28,748.00 30,619.00 Deferred income taxes 3,015.00 11,515.00 16,137.00 12,584.00 463.00 Other long-term liabilities N/A N/A 13,793.00 15,528.00 8,904.00 TOTAL LONG-TERM LIABILITIES 24,024.00 105,216.00 124,434.00 138,300.00 1,236,679.00 TOTAL LIABILITIES 97,352.00 215,755.00 219,744.00 260,771.00 1,557,155.00 736,693 767,634 783,104 832,115 861,415 915,327 947,556 1,006,859 1,042,312 1,107,545Commitments and contingencies (Note 8) SHAREHOLDERS’ EQUITY:
Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued Common stock, $.01 par value; 170,859,375 sha 742.00 784.00 749.00 737.00 696.00 Additional paid-in capital 92,761.00 138,877.00 61,310.00 23,866.00 5,786.00 Retained earnings 208,888.00 289,071.00 395,975.00 522,187.00 496,874.00 1,361,665 1,419,127 1,447,858 1,538,878 1,593,292 1,693,413 1,753,269 1,863,403 1,929,243 2,050,391
TOTAL SHAREHOLDERS’ EQUITY 302,391.00 428,732.00 458,034.00 546,790.00 503,353.00 1,368,144 1,425,606 1,454,337 1,545,357 1,599,771 1,699,892 1,759,748 1,869,882 1,935,722 2,056,870TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY 399,743.00 644,487.00 677,778.00 807,561.00 2,060,508.00 2,104,837 2,193,240 2,237,441 2,377,472 2,461,185 2,615,219 2,707,304 2,876,741 2,978,034 3,164,415
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Statement of Cash Flows
When forecasting out the statement of cash flows we began by
forecasting out net income. Because of the severe decrease to net income in
2006, we decided that Pacific Sunwear’s net income would rise gradually until
reaching a 7.5% growth rate. Using this projecting net income, we used
CFFO/NI to determine the average amount by which CFFO grew. Because 2006
was abnormal to the rest of the years we excluded it from the average. We
derived a CFFO/NI of 1.23. We multiplied this number by net income and
derived our forecasted CFFO. The same concept was applied to CFFI.
Statement of Cash Flows (Revised)
Because of the changes in net income after the operating leases were
capitalized, CFFO and CFFI had to be adjusted as well. We still used the same
CFFO/NI of 1.23. We just multiplied this number by the new net income and
derived the new forecasted CFFO. And once again the same concept was
applied to CFFI.
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PACIFIC SUNWEAR OF CALIFORNIA, INC.In Thousands CONSOLIDATED STATEMENTS OF CASH FLOWS
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $27,566 $49,666 $80,200 $106,904 $126,212 52,274 66,787 68,133 85,748 88,768 109,010 112,849 136,067 140,858 167,445Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 27,146 40,254 45,149 51,685 63,161Stock compensation — — — — —Asset impairment — — — — —Loss on disposal of equipment 7,451 5,184 2,753 3,692 300Tax benefits related to stock-based compensation 2,708 1,038 15,810 8,235 8,378Excess tax benefits related to stock-based compensation — — — — —Change in operating assets and liabilities:
Merchandise inventories (19,819) (20,921) (24,318) (27,330) (40,380)Other current assets — — (7,149) (4,295) (6,608)Other assets — — (2,484) (2,657) (4,280)Accounts payable 5,861 (9,037) 10,212 85 8,797Other current liabilities — — 24,332 (9,877) 18,138Deferred lease incentives — (5,522) 4,273 10,687 13,376Deferred rent 1,548 436 (112) (1,199) (1,377)Other long-term liabilities — — 12,338 7,082 (1,452)
Net cash provided by operating activities 58,362 89,488 161,004 143,012 184,265 64,429 82,316 83,975 105,686 109,408 134,357 139,088 167,705 173,610 206,379
CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (92,936) (53,288) (49,568) (81,992) (109,174)Purchases of available-for-sale short-term investments — — (436,875) (1,159,375) (792,550)Maturities of available-for-sale short-term investments — — 403,675 1,150,125 774,700Purchases of held-to-maturity short-term investments — — (33,035) (40,695) (20,988)Maturities of held-to-maturity short-term investments — — — 36,957 43,150Net cash used in investing activities (92,936) (53,288) (115,803) (94,980) (104,862) (57,128) (72,989) (74,460) (93,711) (97,011) (119,133) (123,328) (148,702) (153,938) (182,994)
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PACIFIC SUNWEAR OF CALIFORNIA, INC.In Thousands CONSOLIDATED STATEMENTS OF CASH FLOWS
Statement of Cash Flows(Revised) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2001 2012 2013 2014 2015 2016CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $27,566 $49,666 $80,200 $106,904 $126,212 (33,389) (22,474) (22,927) (11,010) (11,398) 2,576 2,667 18,989 19,658 38,660Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 27,146 40,254 45,149 51,685 63,161Stock compensation — — — — —Asset impairment — — — — —Loss on disposal of equipment 7,451 5,184 2,753 3,692 300Tax benefits related to stock-based compensation 2,708 1,038 15,810 8,235 8,378Excess tax benefits related to stock-based compensation — — — — —Change in operating assets and liabilities:
Merchandise inventories (19,819) (20,921) (24,318) (27,330) (40,380)Other current assets — — (7,149) (4,295) (6,608)Other assets — — (2,484) (2,657) (4,280)Accounts payable 5,861 (9,037) 10,212 85 8,797Other current liabilities — — 24,332 (9,877) 18,138Deferred lease incentives — (5,522) 4,273 10,687 13,376Deferred rent 1,548 436 (112) (1,199) (1,377)Other long-term liabilities — — 12,338 7,082 (1,452)
Net cash provided by operating activities 58,362 89,488 161,004 143,012 184,265 (41,068) (27,643) (28,200) (13,542) (14,020) 3,168 3,280 23,356 24,179 47,552
CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (92,936) (53,288) (49,568) (81,992) (109,174)Purchases of available-for-sale short-term investments — — (436,875) (1,159,375) (792,550)Maturities of available-for-sale short-term investments — — 403,675 1,150,125 774,700Purchases of held-to-maturity short-term investments — — (33,035) (40,695) (20,988)Maturities of held-to-maturity short-term investments — — — 36,957 43,150Net cash used in investing activities (92,936) (53,288) (115,803) (94,980) (104,862) 36,394 24,497 24,990 12,001 12,424 (2,808) (2,907) (20,698) (21,427) (42,139)
82
Cost of Capital Estimation
To determine the cost of capital, one must combine a firm’s cost of debt
and cost of equity. Pacific Sunwear’s cost of debt is 5.8 percent. This number
can be found in the 2006 10-K. The cost of equity is not published, and,
therefore, must be estimated. The cost of equity is estimated by performing a
regression analysis. A firm’s monthly return must be compared to the overall
industry return. In order to obtain the most accurate estimate, one needs to
calculate the market risk premium. We collected data from the St. Louis Federal
Reserve website and calculated the monthly return on the risk free rate for the
following treasury bills: three month, one year, three year, five year, seven year,
and ten year. We subtracted these monthly returns from the market monthly
returns of the S&P 500, resulting in accurate monthly market risk premiums. We
compared the market risk premiums to Pacific Sunwear’s monthly firm return to
perform our regression. Each treasury bill was regressed for five points on the
yield curve: 72 months, 60 months, 48 months, 36 months, and 24 months.
Regression Analysis
Beta
3-Month 1-Year 3-Year 5-Year 7-Year 10-Year
72 Months 1.25 1.25 1.23 1.23 1.23 1.26
60 Months 1.64 1.64 1.64 1.64 1.64 1.64
48 Months .68 .68 .68 .67 .67 .67
36 Months .77 .76 .76 .75 .75 .75
24 Months 1.26 1.26 1.26 1.25 1.26 1.26
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Adjusted R^2
3-Months 1-Year 3-Year 5-Year 7-Year 10-Year
72 Months .102 .1 .1 .099 .099 .1
60 Months .122 .123 .122 .121 .122 .122
48 Months .001 .001 .001 .0006 .0009 .0007
36 Months 0 0 0 0 0 0
24 Months .01 .01 .01 .009 .01 .01
Ke
3-Month 1-Year 3-Year 5-Year 7-Year 10-Year
72 Months 12.5 12.5 12.36 12.36 12.36 12.36
60 Months 15.15 15.15 15.15 15.15 15.15 15.15
48 Months 8.62 8.62 8.62 8.56 8.57 8.57
36 Months 9.24 9.17 9.17 9.1 9.1 9.1
24 Months 12.57 12.57 12.57 12.5 12.57 12.57
After running the regression, we were able to determine Pacific Sunwear’s
beta by using the highest adjusted r-squared. The 60 month point on the yield
curve for the one year treasury produced the highest adjusted r-squared of .123.
According to our regression analysis, beta is 1.64. The published beta on Yahoo
Finance is .75. Our regression analysis estimated beta to be over two times
larger than the published number. Beta measures the volatility of a firm. Firm’s
which have a beta lower than one are assumed to have lower risk and be less
volatile. Firm’s whose beta is greater than one are considered to be more
volatile, sensitive, and risky. With respect to our estimate of beta, Pacific
Sunwear is more volatile than the industry.
84
We estimated beta in order to determine the firm’s cost of equity, and
then the cost of capital. The cost of equity is found by using the CAPM formula.
Beta is multiplied by the market risk premium and added to the risk free rate.
The result is the cost of equity. The market risk premium used for each
regression came directly from the St. Louis Federal Reserve website. We used 4
percent for the risk free rate and our estimated beta of 1.64. Thus the effective
cost of equity for Pacific Sunwear is 15 percent.
WACC Estimation
To estimate WACC, we needed to have a cost of debt, cost of equity, and
the market value of debt and equity. The cost of debt for Pacific Sunwear is
5.8% which was stated in the most recent 10K. Also given, was the book value
of debt of $269,890 million and since the book value and market value are very
similar we used this number. To estimate the value of the firm we used the
share price as of November 1, 2007 and multiplied it by the number of shares
outstanding (69,895 million). We used are estimated cost of equity which we
found during our regression analysis of 15%. Using all these figures, we were
able to compute Pacific Sunwear’s WACC before tax of 12.73%.
WACC Estimation (Revised)
Because the capitalization of operating leases has no effect on equity, the
only revision that needed to be made to WACC was the value of debt. When the
leases were capitalized, the value of debt increased $1.1 billion. With this
change, the new estimated WACC before tax is 19.56%. This is obviously an
extremely high number for WACC before tax and is unrealistic.
85
Analysis of Valuations
Several valuation methods can be used to derive the share price of a firm.
Using these methods to value stock we will determine if Pacific Sunwear’s share
price is overvalue, fairly-valued, or undervalued. The first valuations we will look
at are the Methods of Comparables, which are composed of recent data on not
only Pacific Sunwear but the specialty retail industry as well. From this
information we will derive an industry average. The next sets of valuations, the
intrinsic valuation models, tend to be more reliable than the methods of
comparables. They combine both WACC before tax and cost of equity (ke). The
intrinsic valuation models include Dividends Discount Model, Discounted Free
Cash Flow, Residual Income, Long-Run residual Income Perpetuity, and the
Abnormal Earnings Growth Model.
However, we will not use the Discounted Dividends Model to value Pacific
Sunwear because they do not pay any dividends so it is irrelevant to the
company. Also, because Pacific Sunwear used operating leases rather than
capital leases, we will use these models twice; once for the original financial
data, and the other for the revised financial data. This will show how much of a
difference the use of operating leases has on share price.
Method of Comparables
The Method of Comparables takes an industry average to try and derive
some share price for your company. All numbers used during these comparables
are most recent data for Pacific Sunwear and its competitors. By obtaining an
industry average for the specialty retail industry we can then estimate a price per
86
share for Pacific Sunwear and compare to determine if they are overvalued, fairly
valued, or undervalued.
Forward to Price Earnings
PPS EPS P/E Industry
Average
Pac Sun’s
Share
Price
PSUN $15.64 .75 $20.91 $17.62 $13.18
AE $22.60 1.83 $12.35
ANF $74.02 4.96 $14.92
HOTT $7.42 .29 $25.59
To find the Forward Price to Earnings you need your forecasted earnings
per share (EPS) and your current price per share (PPS). To find the EPS for our
competitors we took it off of Yahoo Finance for simplicity. For better
understanding of this ratio, it is better to have a lower P/E ratio because it
means there are areas for potential earnings. The industry average was
computed by taking the three competitors P/E and dividing by 3. We then
multiplied the industry average of $17.62 by Pacific Sunwear’s EPS to derive a
share price of $13.18. Given that as of November 1, 2007 the share price for
Pacific Sunwear was $15.64, this model states that Pacific Sunwear is overvalued
given the models share price of $13.18.
87
Trailing Price to Earnings
PPS EPS P/E Industry
Average
Pac Sun’s
Share
Price
PSUN $15.64 .56 27.95 $18.99 $10.63
AE $22.60 1.29 17.47
ANF $74.02 4.79 15.45
HOTT $7.42 .31 24.05
To get the trailing price per share, we used the same PPS as before, but
used the most current EPS. We then divided PPS by EPS and derived P/E for
Pacific Sunwear and its competitors. To get the industry average we took the
three competitors P/E, added them together and then divided by three. This
derived the industry average of $18.99. We then multiplied the industry average
by the EPS for Pacific Sunwear and got an estimated PPS of $10.63. Considering
Pacific Sunwear’s actual PPS is $15.64 and we have an estimated $10.63 under
this model, it concludes that the share price is overvalued for Pacific Sunwear.
Pacific Sunwear has the highest P/E out of the specialty retail industry which is
not a good sign for potential earnings growth.
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Price to Book
PPS BPS P/B Industry
Average
Pac Sun’s
Share
Price
PSUN $15.64 7.11 2.20 3.25 $23.10
AE $22.60 6.23 3.63
ANF $74.02 15.96 4.64
HOTT $7.42 5.01 1.48
To find the price to book (P/B) ratio we took the current share price (PPS)
and divided it by the Book Value per share (BPS). We then took the average of
the three competitors in the specialty retail industry and estimated a P/B industry
average of 3.25. We then multiplied this number by the Book Value per share to
get an estimated PPS of $23.10. This differs from the previous ratios because it
shows Pacific Sunwear as being undervalued. Because of this, you can see why
some of these ratios are more accurate than others. You can also see that
Pacific Sunwear is undervalued by looking at the P/B and comparing it to the rest
of the specialty retail industry. Pacific Sunwear’s P/B is on the lower end of the
industry and therefore is undervalued when using this ratio.
89
Price Earnings Growth
PPS EPS PEG Industry
Average
Pac Sun’s
Share
Price
PSUN $15.64 .56 1.86 .97 $8.11
AE $22.60 1.29 .82
ANF $74.02 4.79 1
HOTT $7.42 .31 1.08
To compute the price earnings growth (PEG) ratio you need the
companies P/E and divide it by the next year earnings growth rate. For Pacific
Sunwear, the next year earnings growth rate is 15%. Once we derived the PEG
ratios for Pacific Sunwear and its competitors, we took an industry average. We
then multiplied that industry average by Pacific Sunwears estimated earnings
growth rate of 15%. This number was then multiplied by Pacific Sunwear’s EPS
to derive an estimated share price of $8.11. Compared to Pacific Sunwear’s
current price per share we see that they are once again overvalued.
90
Price to EBITDA (in millions)
PPS EBITDA P/EBITDA Industry
Average
Pac Sun’s
Share
Price
PSUN $15.64 .112 139.64 76.28 $8.54
AE $22.60 .719 31.43
ANF $74.02 .889 83.26
HOTT $7.42 .065 114.15
Under this method, it uses the current price per share and the earnings
before interest, taxes, depreciation, and appreciation (EBITDA). Both of which
should be stated in the companies 10K. For Pacific Sunwear’s competitors we
just took EBITDA off of Yahoo Finance. Once the P/EBITDA was computed for
Pacific Sunwear and its competitors we took the industry average (remember
that it does not include Pacific Sunwear). Then we multiplied the industry
average by Pacific Sunwear’s EBITDA to arrive at an estimated $8.54 share price,
which reconfirms that Pacific Sunwear is overvalued.
91
Enterprise Value to EBITDA
EV EBITDA EV/EBITDA Industry
Average
Pac Sun’s
Share
Price
PSUN 217,639 112,000 1.94 5.65 $4.39
AE 4,210,000 719,000 5.86
ANF 6,690,000 889,000 7.53
HOTT 231,990 65,000 3.57
To find a company’s enterprise value (EV), you need to value its price per
share plus its book value of liabilities minus cash and cash equivalents. After
doing this for Pacific Sunwear, we got an enterprise value of $217,639 million.
For the rest of the competitors we got their EV off of Yahoo Finance. After
deriving EV/EBITDA we got an industry average of 5.65. We then multiplied this
average by Pacific Sunwear’s EBITDA and subtracted out their book value of
liabilities and added in cash and cash equivalents. By dividing this number by
the total shares outstanding, we got an estimated share price $4.39. As you can
tell, through this model Pacific Sunwear is way overvalued compared to the
actual share price of $15.64.
92
Price to Free Cash Flows
In order to estimate price to free cash flow, you have to determine the
FCF for the company; which means you add cash flow from operations to cash
flows from investing. We tried to find the industry average just like for the other
methods and derive an estimated share price for Pacific Sunwear. However, due
to inconsistencies in these ratios, we deemed this method inappropriate. If we
would use this ratio, it estimated a share price of .25 cents which is way too
unreliable.
Conclusion
By using these methods of comparables it is obvious that Pacific Sunwear
is overvalued. With the exception of the price to book ratio, every estimated
share price was lower than the actual share price given. However, valuing a
company just based on these ratios is not a good idea. As you can see from the
above tables these ratios are very inconsistent. You should use these ratios plus
other valuation models in order to get a more accurate idea of share price.
Intrinsic valuation models are a good place to get a truer price per share.
93
Intrinsic Valuation Models
Intrinsic Valuations give a more realistic share price than the methods of
comparables. The models that are used in the following section are Discounted
Free Cash Flows (FCF), Residual Income (RI), Long-Run Residual Income
Perpetuity (LR RI), Abnormal Earnings Growth (AEG). To restate, we did not do
the Discounted Dividends model because Pacific Sunwear does not pay any
dividends nor do they plan to. The share prices we estimated through these
models are priced as of November 1, 2007 compared to the actual share price of
$15.64. Also, for each model is a revised version due to the operating leases
being capitalized. Following each model is a description to its relevance in
valuing the firm.
Discounted Free Cash Flows
Sensitivity Analysisg
0 0.05 0.06 0.08 0.090.07 0.24$ 3.59$ 8.29$ N/A N/A0.08 N/A 1.42$ 2.72$ N/A N/A overvalued <14.076
WACC(BT) 0.09 N/A 0.37$ 0.91$ 5.23$ N/A fairly valued +/-10%0.11 N/A 3.66$ N/A 0.12$ 0.87$ undervalued >17.20
0.1273 N/A N/A N/A N/A N/A N/A0.13 N/A N/A N/A N/A N/A
Actual PPS: $15.64
In order to compute the FCF model, we needed the forecasted cash flow
from operations and forecasted cash flow from investing. We also needed the
WACC before tax that we computed earlier. To begin, you must subtract CFFO
from CFFI. This will give you your annual free cash flow. Using the WACC
before tax we estimated a present value factor, which we multiplied by the
annual free cash flow to derive your present value of free cash flows. With these
numbers you add them up to get your total present value of annual free cash
94
flows which calculated to $69,945. In order to get the continuing (terminal)
value perpetuity we needed to divide the present value of free cash flows in
2016 by WACC before tax minus the growth rate. This value was then
discounted back to present value by multiplying it by 2016’s present value factor.
We then added the total present value of annual free cash flows to the present
value of the continuing value perpetuity to derive a value of the firm of $86,668.
After getting the value of the firm we then subtracted out the book value of
liabilities and divided that number by the number of shares outstanding as of
right now. This gave us a share price in the negatives, and therefore, it is
irrelevant. Normally after arriving at this share price you would make it time
consistent, so we forecasted it out ten months. This share price was also
negative and therefore irrelevant.
Looking at the sensitivity analysis above, the majority of the share prices
were deemed irrelevant because they were negative. Pacific Sunwear’s share
price using the FCF model is always overvalued. Therefore, you can conclude
from this model that Pacific Sunwear’s estimated share price is overvalued
compared to the actual share price of $15.64.
Discounted Free Cash Flow (Revised)
Sensitivity Analysisg
0 0.05 0.06 0.08 0.090.07 N/A N/A N/A N/A N/A0.08 N/A N/A N/A N/A N/A overvalued <14.076
WACC(BT) 0.09 N/A N/A N/A N/A N/A fairly valued +/-10%0.11 N/A N/A N/A N/A N/A undervalued >17.20
0.1273 N/A N/A N/A N/A N/A N/A0.13 N/A N/A N/A N/A N/A
Actual PPS: $15.64
95
The only revisions that needed to made to the FCF model was the
forecasted CFFO and CFFI. Because of the revisions, the share price stayed
negative and, therefore could not be used. In this sense, the FCF model is
irrelevant for Pacific Sunwear after their leases are capitalized. The reason the
share prices are all negative here is because the CFFO went into the negatives
for the first few years of forecasting.
Residual Income
Sensitivity Analysisg
-0.1 -0.2 -0.3 -0.4Ke 0.11 $5.48 $5.67 $5.77 $5.84
0.13 $5.53 $5.70 $5.79 $5.84 overvalued <14.0760.15 $5.58 $5.72 $5.80 $5.85 fairly valued +/-10%0.17 $5.61 $5.74 $5.81 $5.86 undervalued >17.200.19 $5.65 $5.76 $5.82 $5.87 N/A
Actual PPS: $15.64
Out of the five valuation models, the Residual Income model is said to be
the most accurate. It is based off the forecasted earnings rather than
perpetuities giving it more reliability. To calculate RI, we first found the ending
book value of equity (shareholder’s equity) in 2006 and forecasted it out for the
next 10 years. To get normal earnings we multiplied the book value of equity by
the cost of equity (Ke). We then subtracted the normal earnings from the
earnings per share; but because we are trying to value the firm on a per total
dollar basis the earnings per share is really your net income. This number gives
you the residual income, which for Pacific Sunwear is negative. Using the Ke as
the discount rate we were able to calculate the present value factor. We
multiplied this present value factor by the residual income to obtain the present
value of residual income. Adding up all the present values of residual income
gives you your total present value of annual residual income. The RI in 2016
was used for the continuing value perpetuity which was divided by cost of equity
96
minus the growth rate. This number was then discounted back to present value.
From here we derived the market value of equity which we then divided it by the
number of shares outstanding. This gave us an estimated share price of $4.96,
but we had to make it time consistent so we forecasted it out ten months to
arrive at a new estimated share price of $5.58.
The sensitivity analysis above proves that the share price is not sensitive
to discount rates and growth values. Everything was overvalued establishing
even more proof that Pacific Sunwear is an overvalued company.
Residual Income (Revised)
Sensitivity Analysisg
-0.1 -0.2 -0.3 -0.4Ke 0.11 $1.32 $1.52 $1.62 $1.68
0.13 $1.37 $1.54 $1.63 $1.69 overvalued <14.0760.15 $1.42 $1.56 $1.64 $1.69 fairly valued +/-10%0.17 $1.45 $1.58 $1.66 $1.70 undervalued >17.200.19 $1.49 $1.60 $1.67 $1.71 N/A
Actual PPS: $15.64
One major revision that took place in the residual income model after the
leases were capitalized was the change in earnings per share (or net income).
With net income changed it decreased everything even further. Normal Earnings
went down and therefore residual income became more negative. After the
calculations were done (same as before) the new share price was $1.26 but in
order to make it time consistent we forecasted it out ten months. The new
estimated share price after the capitalizing of leases is $1.42. This is a major
decrease from what it was previously ($5.58). Once again, however, everything
was overvalued, which further emphasizes the fact that Pacific Sunwear is
overvalued.
97
Long-Run Residual Income Perpetuity
Sensitivity Analysis
Ke: .15 g0.02 0.04 0.06 0.08
0.07 3.11$ 2.21$ 0.90$ N/A overvalued <14.0760.09 4.36$ 3.68$ 2.70$ 1.16$ fairly valued +/-10%
ROE 0.11 5.60$ 5.15$ 4.50$ 3.47$ undervalued >17.200.13 6.85$ 6.62$ 6.29$ 5.78$ N/A0.15 8.09$ 8.09$ 8.09$ 8.09$
Actual PPS: $15.64
Sensitivity Analysis
ROE: .11 g0.02 0.04 0.06 0.08 overvalued <14.076
0.11 8.09$ 8.09$ 8.09$ 8.09$ fairly valued +/-10%0.13 6.62$ 6.29$ 5.78$ 4.85$ undervalued >17.20
Ke 0.15 5.60$ 5.15$ 4.50$ 3.47$ N/A0.17 4.85$ 4.36$ 3.68$ 2.70$ 0.19 4.28$ 3.78$ 3.11$ 2.21$
Actual PPS: $15.64
Sensitivity AnalysisG: .02
ROE0.11 0.13 0.15 0.17 overvalued <14.076
0.11 8.09$ 9.89$ 11.69$ 13.49$ fairly valued +/-10%0.13 6.62$ 8.09$ 9.56$ 11.03$ undervalued >17.20
Ke 0.15 5.60$ 6.85$ 8.09$ 9.34$ N/A0.17 4.85$ 5.93$ 7.01$ 8.09$ 0.19 4.28$ 5.24$ 6.19$ 7.14$
Actual PPS: $15.64
Through the Residual Income Model we derive the Long-Run Residual
Income Perpetuity. Three things determine this model: Ke, ROE, and growth.
ROE was calculated by net income divided by book value of equity. We then
98
took the average of this number for all ten years and got an estimated ROE of
11%. To calculate the growth rate we just used the change in ROE from year to
year and took the average of that change; which gave us a growth rate of about
2%. Through these numbers we calculated an intrinsic price of $4.99, but we
forecasted it ten months to make it time consistent. So the time consistent
share price under this model is $5.60. This just further reiterates the fact that
Pacific Sunwear is an overvalued firm.
Through the sensitivity analysis above you can further see the point that
Pacific Sunwear is an overvalued firm. No matter how much we changed the
growth rate, cost of equity, and ROE, Pacific Sunwear stays overvalued. It does
not even reach the 10% range to get into fairly valued. The only for Pacific
Sunwear to reach the fairly valued region is raising the ROE to about 20% which
is not feasible. Overall, the sensitivity analysis helps confirm the point that Pacific
Sunwear is an overvalued firm.
Abnormal Earnings Growth
Sensitivity Analysis
g(0.10) (0.20) (0.30) (0.40)
0.11 9.79$ 9.65$ 9.57$ 9.53$ overvalued <14.0760.13 6.95$ 6.93$ 6.92$ 6.92$ fairly valued +/-10%
Ke 0.15 4.91$ 4.97$ 5.00$ 4.46$ undervalued >17.200.17 3.38$ 3.48$ 3.53$ 3.57$ N/A0.19 2.20$ 2.32$ 2.38$ 2.43$
Actual PPS: $15.64
Abnormal Earnings growth model is calculated by using a company’s
earnings and dividends. Also, a good thing about this model is that you can
check it with RI. The change is residual income per year should be equal to your
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abnormal earnings growth. Cumulative dividend earnings is calculated by the
current years EPS plus the drip income. Because Pacific Sunwear has no
dividends the drip income is zero and therefore the cumulative dividend earnings
for Pacific Sunwear are equal to its EPS. From the cumulative dividend earnings
we subtract the normal earnings (previous years EPS times one plus Ke) to
derive the abnormal earnings growth. We then multiply this number by the
present value factor to get the present value of abnormal earnings growth. The
year ten AEG is also used for the perpetuity and is then discounted back to
present value. For AEG (just like RI) the growth rate should be negative to
slowly bring it back to zero. After discounting back the perpetuity to its present
value, we then add both present values along with the EPS for 2007 and divide
by Ke. Then we forecasted this number out by the ten months to make it time
consistent and we derived an intrinsic share price of $4.91.
The sensitivity analysis is very clear (much like the rest of the sensitivity
analysis’) that Pacific Sunwear is an overvalued firm. No matter how much the
growth rate increases it never even reaches a fairly valued firm. Because AEG
and RI check with one another, these two models are the best representations to
show that Pacific Sunwear is overvalued.
Abnormal Earnings Growth (Revised)
Sensitivity Analysis
g(0.10) (0.20) (0.30) (0.40)
0.11 2.98$ 2.43$ 2.14$ 1.97$ overvalued<14.0760.13 2.56$ 2.15$ 1.93$ 1.80$ fairly value+/-10%
Ke 0.15 2.27$ 1.96$ 1.78$ 1.67$ undervalue>17.200.17 2.06$ 1.81$ 1.67$ 1.58$ N/A0.19 1.89$ 1.70$ 1.58$ 1.51$
Actual PPS $15.64
100
The same revisions that were made to the Residual Income will be made
to the AEG model. Earnings decreased when we capitalized the operating leases,
leading to a major decrease in AEG; the lower the AEG, the lower the intrinsic
share price. This reiterates what the rest of the models concluded that Pacific
Sunwear is an overvalued firm.
Conclusion
After all the valuation models were complete, the overall evaluation of
Pacific Sunwear’s share price was that it is overvalued. We also decided that the
FCF model was irrelevant because the majority of the share prices were
negative. This was inconsistent with that of the rest of the valuation models.
The intrinsic valuation models all come to the same conclusion; that Pacific
Sunwear is overvalued anywhere from .90 cents to $13.49.
101
Credit Risk Analysis
Accurate credit ratings are crucial to the borrowing capability of a firm.
To properly assess the associated credit risk a firm possesses, five ratios are
used to determine the Altman Z-Score. The Altman Z-Score measures the
potential for a firm to file bankruptcy. The higher the score, the less likely a firm
is to default. Firm’s that attain Altman Z-Scores which rank above a three are
deemed as having low credit risk. Those firms which score between 1.8 and 3
are considered to be in a “grey” area, or more credit risky. Pacific Sunwear’s
Altman-Z Scores are as follows:
Altman Z-Scores
2002 2003 2004 2005 2006
Scores 7.9037 5.9341 8.6832 8.0246 9.8688
Pacific Sunwear’s Altman Z-Scores are well above the three point mark.
However, these numbers are distorted due to operating leases. After capitalizing
Pacific Sunwear’s leases, the new Altman Z-Score for 2006 is 1.91. Capitalization
reverses the understatement of long-term liabilities. Now that long-term
liabilities are at an accurate level, the Altman Z-Score is in the grey area. This is
due to the firm’s heavier debt than equity financing.
102
Analyst Recommendation
After performing an extensive analysis on Pacific Sunwear and the
specialty retail industry, we conclude that Pacific Sunwear’s stock price is
overvalued, and informed investors should sell. The results from our valuation
models, excluding the Free Cash Flow Model, indicated that the firm’s stock price
is overvalued. The Free Cash Flow Model is not applicable to our analysis
because it derived negative results. It is impossible to have a negative share
price, therefore the model is irrelevant to this firm and valuation analysis.
To further confirm that Pacific Sunwear is overvalued was the Methods of
Comparables. With the exception of the Price to Book ratio, all other methods
stated Pacific Sunwear as being extremely overvalued. After the capitalization of
leases, Pacific Sunwear became even further overvalued. Therefore, we
conclude Pacific Sunwear as an overvalued firm and investors should sell.
103
References
1. www.answers.com
2. www.investopedia.com
3. www.investowords.com
4. www.shop.pacsun.com
5. www.firstresearch.com
6. www.retailindustry.about.com
7. www.reuters.com
8. www.yahoo.finance.com
9. www.123jump.com
10. www.wikipedia.com
11. www.pacsun.com
12. www.gannononinvesting.com
13. PacSun 10-K, 2006
14. Abercrombie and Fitch 10-K, 2002-2006
15. American Eagle 10-K, 2002-2006
16. Hot Topic 10-K, 2002-2006
104
Appendix
Current Ratio
2002 2003 2004 2005 2006PSUN 2.49 3.2 3.7 3.48 2.39AE 3.01 2.54 3.06 3.06 2.6
ANF 2.84 2.42 1.58 1.93 2.14HOTT 3.18 3.77 2.6 2.23 2.64
Quick Asset Ratio
2002 2003 2004 2005 2006
PSUN N/A 1.32 1.84 0.75 0.08AE 1.47 0.77 0.87 0.45 0.19
ANF 0.28 1.70 0.91 1.02 1.12HOTT 0.54 0.24 0.66 0.80 0.78
Inventory Turnover
2002 2003 2004 2005 2006
PSUN 4.49 4.53 4.47 4.11 4.88AE 6.61 6.98 5.19 4.79 4.72
ANF 6.52 5.8 3.22 2.57 2.59HOTT 7.13 6.78 6.99 6.87 6.8
Accounts Receivable Turnover
2002 2003 2004 2005 2006
PSUN N/A 357.15 217.43 171.17 134.81AE 100.89 57.31 54.31 64.83 89.15
ANF 152.53 237.29 77.36 66.56 76.74HOTT N/A N/A N/A N/A N/A
Days Supply of Receivables
2002 2003 2004 2005 2006
PSUN N/A 1.02 1.68 2.13 2.71AE 3.62 6.37 6.72 5.63 4.09
ANF 2.40 1.54 4.72 5.48 4.76HOTT N/A N/A N/A N/A N/A
105
Days Supply of Inventory
2002 2003 2004 2005 2006PSUN 81.2 80.57 81.7 88.7 74.8AE 55.21 52.28 70.28 76.27 77.34
ANF 56.02 62.91 113.36 141.78 140.66HOTT 51.16 53.81 52.22 53.12 53.67
Working Capital Turnover
2002 2003 2004 2005 2006
PSUN 7.75 4.29 4.39 4.57 7.43AE 4.81 4.3 2.46 2.61 3.15
ANF 4.09 3.87 8.48 6.11 5.71HOTT 4.91 4.03 7.53 10.27 8.23
Days Supply of Working Capital
2002 2003 2004 2005 2006
PSUN 47.1 85.2 83.2 79.8 49.1AE 75.86 84.91 148.18 141.1 115.98
ANF 89.13 94.38 43.04 59.71 63.96HOTT 74.35 90.48 48.5 35.55 44.32
Gross Profit Margin
2002 2003 2004 2005 2006
PSUN 35% 36% 40% 36% 31%AE 40% 39% 38% 47% 46%
ANF 41% 42% 66% 66% 67%HOTT 38% 38% 36% 33% 33%
Operating Profit Margin
2002 2003 2004 2005 2006
PSUN 9.60% 12.30% 15% 14.20% 4.10%AE 12% 11% 9% 19% 20%
ANF 20% 19% 17% 19% 20%HOTT 12% 13% 10% 4% 3%
Net Profit Margin
2002 2003 2004 2005 2006
PSUN 5.90% 7.70% 10% 9.10% 2.70%AE 8% 6% 4% 11% 13%
ANF 12% 12% 11% 12% 13%HOTT 8% 8% 6% 3% 2%
106
Asset Turnover
2002 2003 2004 2005 2006PSUN 2.12 1.62 1.67 1.72 1.87AE 1.85 1.48 1.08 1.18 1.17
ANF 1.60 1.23 1.50 1.56 1.48HOTT 2.16 1.93 2.36 2.42 2.36
Return on Assets
2002 2003 2004 2005 2006
PSUN 17.90% 20.06% 16.59% 18.62% 4.91%AE 14% 9% 4% 13% 15%
ANF 20% 15% 16% 19% 19%HOTT 17% 16% 14% 7% 4%
Return on Equity
2002 2003 2004 2005 2006
PSUN 23.30% 26.52% 24.93% 27.56% 7.25%AE 18% 14% 6% 18% 21%
ANF 26% 24% 32% 34% 30%HOTT 21% 22% 21% 11% 6%
Debt to Equity
2002 2003 2004 2005 2006
PSUN 3.90 3.58 3.48 3.65 3.30AE 4.36 3.44 3.10 3.57 2.94
ANF 4.05 2.71 2.91 3.30 2.87HOTT 3.07 5.55 4.80 4.23 4.39
Times Interest Earned
2002 2003 2004 2005 2006
PSUN 2.62 2.63 2.62 2.57 2.42AE N/A N/A N/A N/A N/A
ANF N/A N/A N/A N/A N/AHOTT N/A N/A N/A N/A N/A
Sales/Non-Current Assets
2002 2003 2004 2005 2006
PSUN 3.90 3.58 3.48 3.65 3.30AE 4.36 3.44 3.10 3.57 2.94
ANF 4.05 2.71 2.91 3.30 2.87HOTT 3.07 5.55 4.80 4.23 4.39
107
Operating Cash Flow
2002 2003 2004 2005 2006PSUN 0.80 0.81 1.69 1.17 1.31AE 1.24 0.65 0.76 1.05 1.04
ANF 1.64 1.10 1.02 0.92 1.14HOTT 1.02 1.27 1.44 1.24 0.96
IGR/SGR Analysis
2002 2003 2004 2005 2006
PSUN 0.179 0.200 0.166 0.186 0.049AE 0.170 0.130 0.125 0.146 0.144
ANF 0.236 0.300 0.246 0.276 0.076HOTT 0.220 0.192 0.218 0.236 0.271
108
Three Month Regression
SUMMARY OUTPUT 3 month treas
Regression StatisticsMultiple R 0.33780639R Square 0.11411316Adjusted R Square 0.10145763Standard Error 0.12192515Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.134042374 0.134042 9.016864 0.003707342Residual 70 1.040601943 0.014866Total 71 1.174644317
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.00516747 0.014450496 0.357598 0.72172 -0.023653132 0.033988078 -0.023653132 0.033988078X Variable 1 1.24821299 0.415681731 3.002809 0.003707 0.419161926 2.077264046 0.419161926 2.077264046
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.37056444R Square 0.13731801Adjusted R Square 0.12244418Standard Error 0.11656474Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.125440895 0.125441 9.23219 0.003562205Residual 58 0.788065627 0.013587Total 59 0.913506522
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.0108849 0.015731345 -0.691924 0.491746 -0.042374611 0.020604807 -0.042374611 0.020604807X Variable 1 1.64184531 0.540355852 3.038452 0.003562 0.560205559 2.723485054 0.560205559 2.723485054
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.15059414R Square 0.0226786Adjusted R Square 0.00143248Standard Error 0.1016368Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.011026521 0.011027 1.067423 0.306929658Residual 46 0.475181753 0.01033Total 47 0.486208274
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00605119 0.015265765 -0.39639 0.69365 -0.036779584 0.024677196 -0.036779584 0.024677196X Variable 1 0.68020552 0.658372764 1.033162 0.30693 -0.6450301 2.005441137 -0.6450301 2.005441137
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.15290104R Square 0.02337873Adjusted R Square -0.00534543Standard Error 0.10909321Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.009686548 0.009687 0.813905 0.373315375Residual 34 0.404645161 0.011901Total 35 0.414331709
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00808454 0.018800742 -0.430012 0.6699 -0.046292243 0.030123166 -0.046292243 0.030123166X Variable 1 0.76727865 0.850484328 0.902167 0.373315 -0.961113448 2.495670743 -0.961113448 2.495670743
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.23038508R Square 0.05307729Adjusted R Square 0.01003534Standard Error 0.11586728Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.016555354 0.016555 1.233153 0.278785022Residual 22 0.295354974 0.013425Total 23 0.311910327
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.01539662 0.024428401 -0.630275 0.535007 -0.066058017 0.035264787 -0.066058017 0.035264787X Variable 1 1.26331211 1.137633135 1.110474 0.278785 -1.095994596 3.622618821 -1.095994596 3.622618821
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One Year Regression
SUMMARY OUTPUT One year T-Bill
Regression StatisticsMultiple R 0.337807215R Square 0.114113715Adjusted R Square 0.101458196Standard Error 0.121925111Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.134043026 0.134043 9.016914 0.003707253Residual 70 1.040601291 0.014866Total 71 1.174644317
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.005457072 0.014440582 0.377898 0.70665 -0.023343761 0.03425791 -0.02334376 0.034257906X Variable 1 1.247269504 0.41536639 3.002818 0.003707 0.418847373 2.07569164 0.418847373 2.075691636
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.370688924R Square 0.137410279Adjusted R Square 0.122538042Standard Error 0.116558505Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.125525186 0.125525 9.239382 0.003550181Residual 58 0.787981336 0.013586Total 59 0.913506522
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.010534402 0.015696848 -0.671116 0.504811 -0.041955056 0.02088625 -0.04195506 0.020886252X Variable 1 1.640879526 0.539827778 3.039635 0.00355 0.560296833 2.72146222 0.560296833 2.72146222
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.150629754R Square 0.022689323Adjusted R Square 0.001443439Standard Error 0.101636237Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.011031736 0.011032 1.06794 0.306813966Residual 46 0.475176537 0.01033Total 47 0.486208274
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.005894806 0.015224245 -0.387199 0.700395 -0.03653962 0.02475001 -0.03653962 0.024750008X Variable 1 0.679799085 0.657820213 1.033412 0.306814 -0.644324307 2.00392248 -0.64432431 2.003922477
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.152504953R Square 0.023257761Adjusted R Square -0.005469952Standard Error 0.109099965Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.009636428 0.009636 0.809593 0.374569447Residual 34 0.404695281 0.011903Total 35 0.414331709
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.007940263 0.018764821 -0.423146 0.674853 -0.046074967 0.03019444 -0.04607497 0.03019444X Variable 1 0.764630984 0.849803409 0.899774 0.374569 -0.962377318 2.49163928 -0.96237732 2.491639285
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.230318845R Square 0.05304677Adjusted R Square 0.010003442Standard Error 0.115869145Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.016545836 0.016546 1.232404 0.278927102Residual 22 0.295364492 0.013426Total 23 0.311910327
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.015286636 0.024404627 -0.626383 0.53751 -0.065898735 0.03532546 -0.06589873 0.035325463X Variable 1 1.261594891 1.136431784 1.110137 0.278927 -1.095220368 3.61841015 -1.09522037 3.61841015
110
Three Year Regression
SUMMARY OUTPUT 3 Year
Regression StatisticsMultiple R 0.336181125R Square 0.113017749Adjusted R Square 0.100346574Standard Error 0.122000507Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.132755656 0.132756 8.919279 0.00388677Residual 70 1.041888661 0.014884Total 71 1.174644317
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.006020705 0.01443257 0.417161 0.677837 -0.0227641 0.03480556 -0.022764149 0.034805558X Variable 1 1.239329068 0.414974829 2.986516 0.003887 0.41168788 2.06697026 0.41168788 2.066970257
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.370421735R Square 0.137212262Adjusted R Square 0.122336611Standard Error 0.116571883Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.125344296 0.125344 9.22395 0.00357603Residual 58 0.788162226 0.013589Total 59 0.913506522
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.010006374 0.015650938 -0.639347 0.525115 -0.0413351 0.02132238 -0.041335129 0.021322382X Variable 1 1.640852929 0.540270408 3.037096 0.003576 0.55938422 2.72232164 0.559384217 2.722321642
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.149967994R Square 0.022490399Adjusted R Square 0.00124019Standard Error 0.10164658Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.010935018 0.010935 1.058361 0.30896849Residual 46 0.475273256 0.010332Total 47 0.486208274
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.005715447 0.015184728 -0.376394 0.708354 -0.0362807 0.02484982 -0.03628072 0.024849825X Variable 1 0.677125816 0.658191683 1.028767 0.308968 -0.6477453 2.00199694 -0.647745305 2.001996938
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.1514695R Square 0.022943009Adjusted R Square -0.005793961Standard Error 0.109117542Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.009506016 0.009506 0.79838 0.37785961Residual 34 0.404825693 0.011907Total 35 0.414331709
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.007878901 0.018758743 -0.420012 0.677119 -0.0460013 0.03024345 -0.046001254 0.030243451X Variable 1 0.758628936 0.849033257 0.893521 0.37786 -0.9668142 2.4840721 -0.96681423 2.484072101
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.230431716R Square 0.053098776Adjusted R Square 0.010057811Standard Error 0.115865963Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.016562057 0.016562 1.23368 0.27868502Residual 22 0.295348271 0.013425Total 23 0.311910327
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.015432865 0.024435999 -0.631563 0.534181 -0.06611 0.0352443 -0.066110025 0.035244295X Variable 1 1.259881507 1.134301339 1.110711 0.278685 -1.0925155 3.61227849 -1.092515481 3.612278495
111
Five Year Regression
SUMMARY OUTPUT SUMMARY OUTPUT
Regression Statistics Regression StatisticsMultiple R 0.334072834 Multiple R 0.334072834R Square 0.111604658 R Square 0.111604658Adjusted R Square 0.098913296 Adjusted R Square 0.098913296Standard Error 0.122097651 Standard Error 0.122097651Observations 72 Observations 72
ANOVA ANOVAdf df SS MS F Significance F
Regression 1 Regression 1 0.131095778 0.1310958 8.7937495 0.004130999Residual 70 Residual 70 1.043548539 0.0149078Total 71 Total 71 1.174644317
Coefficients Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.006477982 Intercept 0.006477982 0.014432078 0.44886 0.65491918 -0.022305889 0.035261854 -0.022305889 0.035261854X Variable 1 1.23261781 X Variable 1 1.23261781 0.415663025 2.9654257 0.004131 0.403604058 2.061631562 0.403604058 2.061631562
SUMMARY OUTPUT SUMMARY OUTPUT
Regression Statistics Regression StatisticsMultiple R 0.368664774 Multiple R 0.368664774R Square 0.135913715 R Square 0.135913715Adjusted R Square 0.121015676 Adjusted R Square 0.121015676Standard Error 0.116659574 Standard Error 0.116659574Observations 60 Observations 60
ANOVA ANOVAdf df SS MS F Significance F
Regression 1 Regression 1 0.124158065 0.1241581 9.1229263 0.003750232Residual 58 Residual 58 0.789348457 0.0136095Total 59 Total 59 0.913506522
Coefficients Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00944097 Intercept -0.009440972 0.015617761 -0.604502 0.54786734 -0.040703318 0.021821373 -0.040703318 0.021821373X Variable 1 1.635302638 X Variable 1 1.635302638 0.54141596 3.0204182 0.00375023 0.551540853 2.719064423 0.551540853 2.719064423
SUMMARY OUTPUT SUMMARY OUTPUT
Regression Statistics Regression StatisticsMultiple R 0.147731432 Multiple R 0.147731432R Square 0.021824576 R Square 0.021824576Adjusted R Square 0.000559893 Adjusted R Square 0.000559893Standard Error 0.101681192 Standard Error 0.101681192Observations 48 Observations 48
ANOVA ANOVAdf df SS MS F Significance F
Regression 1 Regression 1 0.010611289 0.0106113 1.02632971 0.316321544Residual 46 Residual 46 0.475596984 0.0103391Total 47 Total 47 0.486208274
Coefficients Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00551614 Intercept -0.005516138 0.015155045 -0.36398 0.71754044 -0.036021661 0.024989385 -0.036021661 0.024989385X Variable 1 0.668474452 X Variable 1 0.668474452 0.659844138 1.0130793 0.31632154 -0.659722889 1.996671793 -0.659722889 1.996671793
SUMMARY OUTPUT SUMMARY OUTPUT
Regression Statistics Regression StatisticsMultiple R 0.149061746 Multiple R 0.149061746R Square 0.022219404 R Square 0.022219404Adjusted R Square -0.00653885 Adjusted R Square -0.006538849Standard Error 0.109157941 Standard Error 0.109157941Observations 36 Observations 36
ANOVA ANOVAdf df SS MS F Significance F
Regression 1 Regression 1 0.009206204 0.0092062 0.77262706 0.385575732Residual 34 Residual 34 0.405125505 0.0119155Total 35 Total 35 0.414331709
Coefficients Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00776438 Intercept -0.007764378 0.018752043 -0.414055 0.68143432 -0.045873114 0.030344359 -0.045873114 0.030344359X Variable 1 0.748749367 X Variable 1 0.748749367 0.851827216 0.8789921 0.38557573 -0.982371807 2.47987054 -0.982371807 2.47987054
SUMMARY OUTPUT SUMMARY OUTPUT
Regression Statistics Regression StatisticsMultiple R 0.228845443 Multiple R 0.228845443R Square 0.052370237 R Square 0.052370237Adjusted R Square 0.009296156 Adjusted R Square 0.009296156Standard Error 0.115910528 Standard Error 0.115910528Observations 24 Observations 24
ANOVA ANOVAdf df SS MS F Significance F
Regression 1 Regression 1 0.016334818 0.0163348 1.21581788 0.28209943Residual 22 Residual 22 0.29557551 0.0134353Total 23 Total 23 0.311910327
Coefficients Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.01541083 Intercept -0.01541083 0.024451094 -0.630272 0.53500941 -0.066119296 0.035297636 -0.066119296 0.035297636X Variable 1 1.254365853 X Variable 1 1.254365853 1.137600989 1.1026413 0.28209943 -1.104874188 3.613605895 -1.104874188 3.613605895
112
Seven Year Regression
SUMMARY OUTPUT 7 YEAR TREAS
Regression StatisticsMultiple R 0.334362987R Square 0.111798607Adjusted R Square 0.099110015Standard Error 0.122084322Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.131323598 0.131324 8.810955 0.0040966Residual 70 1.043320719 0.014905Total 71 1.174644317
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.006772635 0.014423141 0.469567 0.640124 -0.02199341 0.035538683 -0.021993414 0.035538683X Variable 1 1.232186258 0.415111601 2.968325 0.004097 0.40427229 2.060100229 0.404272287 2.060100229
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.369700193R Square 0.136678233Adjusted R Square 0.121793375Standard Error 0.116607954Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.124856457 0.124856 9.182367 0.00364669Residual 58 0.788650065 0.013597Total 59 0.913506522
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00916327 0.015583847 -0.587998 0.558816 -0.04035773 0.02203119 -0.040357729 0.02203119X Variable 1 1.641358158 0.541659082 3.030242 0.003647 0.55710971 2.725606604 0.557109711 2.725606604
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.148713225R Square 0.022115623Adjusted R Square 0.000857267Standard Error 0.101666064Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.010752799 0.010753 1.040326 0.31308018Residual 46 0.475455475 0.010336Total 47 0.486208274
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00545125 0.015130952 -0.360271 0.720293 -0.03590828 0.025005777 -0.035908278 0.025005777X Variable 1 0.672683463 0.659517002 1.019964 0.31308 -0.65485539 2.000222314 -0.654855387 2.000222314
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.150589754R Square 0.022677274Adjusted R Square -0.00606751Standard Error 0.10913238Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.009395914 0.009396 0.788918 0.38066833Residual 34 0.404935795 0.01191Total 35 0.414331709
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00776168 0.018735802 -0.41427 0.681279 -0.04583741 0.030314055 -0.045837406 0.030314055X Variable 1 0.75475961 0.849753117 0.88821 0.380668 -0.97214649 2.481665707 -0.972146487 2.481665707
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.230738054R Square 0.053240049Adjusted R Square 0.010205506Standard Error 0.115857319Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.016606121 0.016606 1.237147 0.27802866Residual 22 0.295304206 0.013423Total 23 0.311910327
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.01541813 0.024428803 -0.631145 0.534448 -0.06608037 0.035244108 -0.066080366 0.035244108X Variable 1 1.261527904 1.1341911 1.112271 0.278029 -1.09064046 3.613696269 -1.090640461 3.613696269
113
Ten Year Regression
SUMMARY OUTPUT 10 year treas
Regression StatisticsMultiple R 0.334062641R Square 0.111597848Adjusted R Square 0.098906389Standard Error 0.122098119Observations 72
ANOVAdf SS MS F Significance F
Regression 1 0.131087778 0.1310878 8.793145 0.00413221Residual 70 1.043556539 0.014908Total 71 1.174644317
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.007030565 0.014419003 0.4875902 0.627364 -0.02172723 0.03578836 -0.02172723 0.035788359X Variable 1 1.231250878 0.415216328 2.9653238 0.004132 0.40312803 2.05937372 0.403128035 2.059373722
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.36943029R Square 0.136478739Adjusted R Square 0.121590441Standard Error 0.116621426Observations 60
ANOVAdf SS MS F Significance F
Regression 1 0.124674218 0.1246742 9.166847 0.00367343Residual 58 0.788832304 0.0136006Total 59 0.913506522
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.0088277 0.015558103 -0.5674022 0.572631 -0.03997063 0.02231523 -0.039970629 0.022315225X Variable 1 1.64145256 0.542148619 3.0276801 0.003673 0.5562242 2.72668092 0.556224199 2.726680922
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.148254765R Square 0.021979475Adjusted R Square 0.000718159Standard Error 0.101673141Observations 48
ANOVAdf SS MS F Significance F
Regression 1 0.010686603 0.0106866 1.033778 0.31459113Residual 46 0.475521671 0.0103374Total 47 0.486208274
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00533572 0.015107406 -0.3531856 0.725563 -0.03574535 0.02507391 -0.035745348 0.025073912X Variable 1 0.671066235 0.660011947 1.0167486 0.314591 -0.65746889 1.99960136 -0.657468887 1.999601358
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.150365641R Square 0.022609826Adjusted R Square -0.00613694Standard Error 0.109136146Observations 36
ANOVAdf SS MS F Significance F
Regression 1 0.009367968 0.009368 0.786517 0.3813858Residual 34 0.404963741 0.0119107Total 35 0.414331709
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.00769279 0.018719548 -0.4109494 0.683688 -0.04573549 0.03034991 -0.045735485 0.030349913X Variable 1 0.754010812 0.850204676 0.886858 0.381386 -0.97381296 2.48183459 -0.973812963 2.481834587
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.230873817R Square 0.053302719Adjusted R Square 0.010271025Standard Error 0.115853485Observations 24
ANOVAdf SS MS F Significance F
Regression 1 0.016625669 0.0166257 1.238685 0.27773809Residual 22 0.295284659 0.013422Total 23 0.311910327
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.01536687 0.024415599 -0.6293875 0.535577 -0.06600173 0.03526798 -0.066001725 0.035267979X Variable 1 1.262590637 1.134441501 1.1129623 0.277738 -1.09009703 3.6152783 -1.090097027 3.615278302
114
Free Cash Flow WACC(BT) 0.1273 Kd 0.058 Ke 0.15
0 1 2 3 4 5 6 7 8 9 10 112006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS (Earnings Per Share) 0.75 0.96 0.97 1.23 1.27 1.56 1.61 1.95 2.02 2.40DPS (Dividends Per Share) 0 0 0 0 0 0 0 0 0 0BPS (Book Value Equity per Share) 7.86 8.60 9.56 10.53 11.76 13.03 14.59 16.21 18.15 20.17 22.56Cash From Operations 64,429 82,316 83,975 105,686 109,408 134,357 139,088 167,705 173,610 206,379Cash Investments (57,128) (72,989) (74,460) (93,711) (97,011) (119,133) (123,328) (148,702) (153,938) (182,994)Book Value of Debt and Preferred Stock 164,970
Annual Free Cash Flow 7,300 9,327 9,515 11,975 12,397 15,224 15,760 19,003 19,672 23,385PV Factor 0.8871 0.7869 0.6980 0.6192 0.5493 0.4873 0.4322 0.3834 0.3401 0.3017PV of Free Cash Flows 6,476.01 7,339.63 6,642.02 7,415.27 6,809.58 7,418.06 6,812.12 7,286.15 6,690.94 7,055.67Total PV of Annual Free Cash Flows 69,945.45Continuing (Terminal) Value Perpetuity 55,425.54PV of Terminal Value Perpetuity 16,723.02Value of Firm 86,668.48Book Value of Liabilities 164,970Estimated Market Value of Equity -78,301.52Number of Shares 69,895 Sensitivity AnalysisEstimated Price per Share (end of 1987) -1.12 gTime Consistent: -1.22 0 0.05 0.06 0.08 0.09Observed Share Price 15.64 0.07 0.24$ 3.59$ 8.29$ N/A N/AInitial WACC 0.1273 0.08 N/A 1.42$ 2.72$ N/A N/A overvalued <14.076Perpetuity Growth Rate (g) 0 WACC(BT) 0.09 N/A 0.37$ 0.91$ 5.23$ N/A fairly valued +/-10%
0.11 N/A 3.66$ N/A 0.12$ 0.87$ undervalued >17.200.1273 N/A N/A N/A N/A N/A N/A
0.13 N/A N/A N/A N/A N/A
Actual PPS: $15.64
115
Free Cash Flow (Revised) WACC(BT) 0.07 Kd 0.058 Ke 0.15
0 1 2 3 4 5 6 7 8 9 10 112006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS (Earnings Per Share) 0.75 0.96 0.97 1.23 1.27 1.56 1.61 1.95 2.02 2.40DPS (Dividends Per Share) 0 0 0 0 0 0 0 0 0 0BPS (Book Value Equity per Share) 7.86 8.60 9.56 10.53 11.76 13.03 14.59 16.21 18.15 20.17 22.56Cash From Operations (41,068) (27,643) (28,200) (13,542) (14,020) 3,168 3,280 23,356 24,179 47,552Cash Investments 36,394 24,497 24,990 12,001 12,424 (2,808) (2,907) (20,698) (21,427) (42,139)Book Value of Debt and Preferred Stock 164,970
Annual Free Cash Flow -4,674 -3,146 -3,210 -1,541 -1,596 361 373 2,658 2,752 5,412PV Factor 0.9346 0.8734 0.8163 0.7629 0.7130 0.6663 0.6227 0.5820 0.5439 0.5083PV of Free Cash Flows -4,368.65 -2,748.15 -2,620.14 -1,175.93 -1,137.73 240.31 232.52 1,547.25 1,496.97 2,751.39Total PV of Annual Free Cash Flows -5,782.16Continuing (Terminal) Value Perpetuity 39,305.57PV of Terminal Value Perpetuity 19,980.96Value of Firm 14,198.80Book Value of Liabilities 164,970Estimated Market Value of Equity -150,771.20Number of Shares 69,895 Sensitivity AnalysisEstimated Price per Share (end of 1987) -2.16 gTime Consistent: -2.34 0 0.05 0.06 0.08 0.09Observed Share Price 15.64 0.07 N/A N/A N/A N/A N/AInitial WACC 0.1273 0.08 N/A N/A N/A N/A N/A overvalued <14.076Perpetuity Growth Rate (g) 0 WACC(BT) 0.09 N/A N/A N/A N/A N/A fairly valued +/-10%
0.11 N/A N/A N/A N/A N/A undervalued >17.200.1273 N/A N/A N/A N/A N/A N/A
0.13 N/A N/A N/A N/A N/A
Actual PPS: $15.64
116
Residual Income WACC(BT) 0.1273 Kd 0.058 Ke 0.15
0 1 2 3 4 5 6 7 8 9 10 112006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net Income 52,273.80 66,786.54 68,132.52 85,748.49 88,767.79 109,010.41 112,848.79 136,067.23 140,858.31 167,445.30Total Dividends Paid 0 0 0 0 0 0 0 0 0 0Total Book Value of Equity 503,353 555,627 622,413 690,546 776,294 865,062 974,073 1,086,921 1,222,989 1,363,847 1,531,292 Cash From Operations 64,429 82,316 83,975 105,686 109,408 134,357 139,088 167,705 173,610 206,379Cash Investments (57,128) (72,989) (74,460) (93,711) (97,011) (119,133) (123,328) (148,702) (153,938) (182,994)Book Value of Debt and Preferred Stock 164,970
Net Income 52,273.80 66,786.54 68,132.52 85,748.49 88,767.79 109,010.41 112,848.79 136,067.23 140,858.31 167,445.30"Normal" (Benchmark) Earnings 75,502.95 83,344.02 93,362.00 103,581.88 116,444.15 129,759.32 146,110.88 163,038.20 183,448.29 204,577.03Residual Income (Annual) -23,229.15 -16,557.48 -25,229.48 -17,833.39 -27,676.36 -20,748.91 -33,262.09 -26,970.98 -42,589.97 -37,131.73 -32,000.00PV Factor 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25PV of Annual Residual Income -20,199.26 -12,519.84 -16,588.79 -10,196.30 -13,760.04 -8,970.33 -12,504.45 -8,816.86 -12,106.73 -9,178.40Total PV of Annual Residual Income -124,840.99Continuing (Terminal) Value Perpetuity -128,000.00PV of Terminal Value Perpetuity -31,639.64Initial Book Value of Equity 503,353.00Market Value of Equity 346,872.37Estimated Price per Share (end of 2006) 4.96ROE year by year 0.0941 0.1073 0.0987 0.1105 0.1026 0.1119 0.1038 0.1113 0.1033 0.1093Time consistent PPS 5.58 gr 14.05% -8.05% 11.95% -7.10% 9.06% -7.23% 7.16% -7.17% 5.88% 0.11Observed Share Price 15.64Initial Cost of Equity (You Derive) 0.15Perpetuity Growth Rate (g) -0.1 g avg gr 2.06%
Sensitivity Analysisg
-0.1 -0.2 -0.3 -0.4Ke 0.11 $5.48 $5.67 $5.77 $5.84
0.13 $5.53 $5.70 $5.79 $5.84 overvalued <14.0760.15 $5.58 $5.72 $5.80 $5.85 fairly valued +/-10%0.17 $5.61 $5.74 $5.81 $5.86 undervalued >17.200.19 $5.65 $5.76 $5.82 $5.87 N/A
Actual PPS: $15.64
117
Residual Income (Revised) WACC(BT) 0.1273 Kd 0.058 Ke 0.15
0 1 2 3 4 5 6 7 8 9 10 112006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net Income (33,389) (22,474) (22,927) (11,010) (11,398) 2,576 2,667 18,989 19,658 38,660Total Dividends Paid 0 0 0 0 0 0 0 0 0 0Total Book Value of Equity 503,353 469,964 447,490 424,562 413,552 402,154 404,730 407,397 426,386 446,044 484,704 Cash From Operations 64,429 82,316 83,975 105,686 109,408 134,357 139,088 167,705 173,610 206,379Cash Investments (57,128) (72,989) (74,460) (93,711) (97,011) (119,133) (123,328) (148,702) (153,938) (182,994)Book Value of Debt and Preferred Stock 164,970
Net Income -33,389.12 -22,474.23 -22,927.16 -11,010.18 -11,397.86 2,575.87 2,666.57 18,989.24 19,657.87 38,659.52"Normal" (Benchmark) Earnings 75,502.95 70,494.58 67,123.45 63,684.37 62,032.85 60,323.17 60,709.55 61,109.53 63,957.92 66,906.60Residual Income (Annual) -108,892.07 -92,968.81 -90,050.61 -74,694.55 -73,430.71 -57,747.30 -58,042.98 -42,120.30 -44,300.05 -28,247.09 -32,000.00PV Factor 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25PV of Annual Residual Income -94,688.75 -70,297.78 -59,209.74 -42,706.85 -36,508.04 -24,965.75 -21,820.50 -13,769.20 -12,592.84 -6,982.25Total PV of Annual Residual Income -383,541.70Continuing (Terminal) Value Perpetuity -128,000.00PV of Terminal Value Perpetuity -31,639.64Initial Book Value of Equity 503,353.00Market Value of Equity 88,171.66Estimated Price per Share (end of 2006) 1.26ROE year by year -0.0710 -0.0502 -0.0540 -0.0266 -0.0283 0.0064 0.0065 0.0445 0.0441 0.0798Time consistent PPS 1.42 gr -29.31% 7.52% -50.70% 6.46% -122.46% 2.84% 580.41% -1.04% 80.98% 0.00Observed Share Price 15.64Initial Cost of Equity (You Derive) 0.15Perpetuity Growth Rate (g) -0.1 g avg gr 52.74%
Sensitivity Analysisg
-0.1 -0.2 -0.3 -0.4Ke 0.11 $1.32 $1.52 $1.62 $1.68
0.13 $1.37 $1.54 $1.63 $1.69 overvalued <14.0760.15 $1.42 $1.56 $1.64 $1.69 fairly valued +/-10%0.17 $1.45 $1.58 $1.66 $1.70 undervalued >17.200.19 $1.49 $1.60 $1.67 $1.71 N/A
Actual PPS: $15.64
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Book Value of Equity 503,353 Sensitivity AnalysisLong Run Return on Equity 0.2000Long Run Growth Rate in Equity 0.02 Ke: .15 gCost of Equity 0.11 0.02 0.04 0.06 0.08
0.07 3.11$ 2.21$ 0.90$ N/A overvalued <14.076Estimated Price per Share (end of 2006) 1006706 0.09 4.36$ 3.68$ 2.70$ 1.16$ fairly valued +/-10%
14.40 ROE 0.11 5.60$ 5.15$ 4.50$ 3.47$ undervalued >17.20Time Consistent Price 16.18 0.13 6.85$ 6.62$ 6.29$ 5.78$ N/AObserved Share Price (November 1, 2007) 15.64 0.15 8.09$ 8.09$ 8.09$ 8.09$
Long Run Residual Income Perpetuity Actual PPS: $15.64
Sensitivity Analysis
ROE: .11 g0.02 0.04 0.06 0.08 overvalued <14.076
0.11 8.09$ 8.09$ 8.09$ 8.09$ fairly valued +/-10%0.13 6.62$ 6.29$ 5.78$ 4.85$ undervalued >17.20
Ke 0.15 5.60$ 5.15$ 4.50$ 3.47$ N/A0.17 4.85$ 4.36$ 3.68$ 2.70$ 0.19 4.28$ 3.78$ 3.11$ 2.21$
Actual PPS: $15.64
Sensitivity AnalysisG: .02
ROE0.11 0.13 0.15 0.17 overvalued <14.076
0.11 8.09$ 9.89$ 11.69$ 13.49$ fairly valued +/-10%0.13 6.62$ 8.09$ 9.56$ 11.03$ undervalued >17.20
Ke 0.15 5.60$ 6.85$ 8.09$ 9.34$ N/A0.17 4.85$ 5.93$ 7.01$ 8.09$ 0.19 4.28$ 5.24$ 6.19$ 7.14$
Actual PPS: $15.64
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AEG WACC(AT) 0.1273 Kd 0.058 Ke 0.15
0 1 2 3 4 5 6 7 8 9 10 112006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS (Earnings Per Share) 52,274 66,787 68,133 85,748 88,768 109,010 112,849 136,067 140,858 167,445DPS (Dividends Per Share) 0 0 0 0 0 0 0 0 0 0BPS (Book Value Equity per Share) 503,353 555,627 622,413 690,546 776,294 865,062 974,073 1,086,921 1,222,989 1,363,847 1,531,292 Cash From Operations 64,429 82,316 83,975 105,686 109,408 134,357 139,088 167,705 173,610 206,379Cash Investments (57,128) (72,989) (74,460) (93,711) (97,011) (119,133) (123,328) (148,702) (153,938) (182,994)
Annual Income 66,787 68,133 85,748 88,768 109,010 112,849 136,067 140,858 167,445Drip Income 0 0 0 0 0 0 0 0 0Cumulative Dividend Income 66,787 68,133 85,748 88,768 109,010 112,849 136,067 140,858 167,445"Normal" Annual Income (Benchmark) 60,115 76,805 78,352 98,611 102,083 125,362 129,776 156,477 161,987Annual AEG 6,672 -8,672 7,396 -9,843 6,927 -12,513 6,291 -15,619 5,458 -1,545PV Factor 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28PV AEG (Annual) 5,801.45 -6,557.27 4,863.05 -5,627.75 3,444.16 -5,409.79 2,365.06 -5,105.88 1,551.57Residual Income Check Figure: 6,671.66 -8,671.99 7,396.09 -9,842.97 6,927.45 -12,513.18 6,291.12 -15,619.00 5,458.24Total PV of AEG -4,675.40Core Perpetuity Earnings 52,274.00 -6,179PV of Terminal Value -1,756.44Total PV of AEG -6,431.83Total Earnings Perpetuity 45,842Capitalization Rate (Ke) 0.15 Sensitivity AnalysisEstimated Price per Share (end of 1987) 4.37Time Consistent PPS (Nov.,1,2007) 4.91 gObserved Share Price 15.64 (0.10) (0.20) (0.30) (0.40)Perpetuity Growth Rate (g) -0.1 0.11 9.79$ 9.65$ 9.57$ 9.53$ overvalued <14.076
0.13 6.95$ 6.93$ 6.92$ 6.92$ fairly valued+/-10%Ke 0.15 4.91$ 4.97$ 5.00$ 4.46$ undervalued>17.20
0.17 3.38$ 3.48$ 3.53$ 3.57$ N/A0.19 2.20$ 2.32$ 2.38$ 2.43$
Actual PPS: $15.64
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AEG (Revised) WACC(AT) 0.1273 Kd 0.058 Ke 0.15
0 1 2 3 4 5 6 7 8 9 10 112006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS (Earnings Per Share) (33,389) (22,474) (22,927) (11,010) (11,398) 2,576 2,667 18,989 19,658 38,660DPS (Dividends Per Share) 0 0 0 0 0 0 0 0 0 0BPS (Book Value Equity per Share) 503,353 469,964 447,490 424,562 413,552 402,154 404,730 407,397 426,386 446,044 484,704 Cash From Operations 64,429 82,316 83,975 105,686 109,408 134,357 139,088 167,705 173,610 206,379Cash Investments (57,128) (72,989) (74,460) (93,711) (97,011) (119,133) (123,328) (148,702) (153,938) (182,994)
Annual Income -22,474 -22,927 -11,010 -11,398 2,576 2,667 18,989 19,658 38,660Drip Income 0 0 0 0 0 0 0 0 0Cumulative Dividend Income -22,474 -22,927 -11,010 -11,398 2,576 2,667 18,989 19,658 38,660"Normal" Annual Income (Benchmark) -38,397 -25,845 -26,366 -12,662 -13,108 2,962 3,067 21,838 22,607Annual AEG 15,923 2,918 15,356 1,264 15,683 -296 15,923 -2,180 16,053 8,961PV Factor 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28PV AEG (Annual) 13,846.31 2,206.58 10,096.86 722.61 7,797.43 -127.83 5,985.92 -712.56 4,563.25Residual Income Check Figure: -0.11 -0.10 -0.09 -0.07 -0.06 -0.06 -0.05 -0.04 -0.04Total PV of AEG 44,378.56Core Perpetuity Earnings 52,274.00 35,842PV of Terminal Value 10,188.59Total PV of AEG 54,567.16Total Earnings Perpetuity 21,178Capitalization Rate (Ke) 0.15Estimated Price per Share (end of 1987) 2.02Time Consistent PPS (Nov.,1,2007) 2.27Observed Share Price 15.64Perpetuity Growth Rate (g) -0.1
Sensitivity Analysis
g(0.10) (0.20) (0.30) (0.40)
0.11 2.98$ 2.43$ 2.14$ 1.97$ overvalued<14.0760.13 2.56$ 2.15$ 1.93$ 1.80$ fairly value+/-10%
Ke 0.15 2.27$ 1.96$ 1.78$ 1.67$ undervalue>17.200.17 2.06$ 1.81$ 1.67$ 1.58$ N/A0.19 1.89$ 1.70$ 1.58$ 1.51$
Actual PPS $15.64
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