Pep Boys-Manny, Moe, and Jack
Equity Analysis and Valuation
Kevin Biser
LeAnn Carmona
Fabian Garcia
Brendan Grey
Kevin Tavarez
Brian Timme
1 Table of Contents Executive Summary.............................................................................................................. 9 Industry Analysis ..................................................................................................................................... 10 Accounting Analysis ................................................................................................................................ 12 Financial Analysis .................................................................................................................................... 14 Valuation Analysis ................................................................................................................................... 16 Company Overview ............................................................................................................ 17 Industry Overview.............................................................................................................. 19 Five Forces Model .............................................................................................................. 20 Rivalry Among Existing Firms .................................................................................................................. 22 Industry Growth Rate.......................................................................................................................... 23 Concentration ..................................................................................................................................... 25 Differentiation..................................................................................................................................... 28 Switching Costs ................................................................................................................................... 29 Scale Economies.................................................................................................................................. 29 Learning Economies ............................................................................................................................ 32 Fixed‐Variable Cost ............................................................................................................................. 32 Excess Capacity ................................................................................................................................... 33 Exit Barriers ......................................................................................................................................... 34 Conclusion........................................................................................................................................... 35 Threat of New Entrants........................................................................................................................... 36 Scale Economies.................................................................................................................................. 36 First Mover Advantage........................................................................................................................ 37 Distribution Access.............................................................................................................................. 38 Relationships....................................................................................................................................... 38 Legal Barriers ...................................................................................................................................... 39 Conclusion........................................................................................................................................... 39 Threat of Substitute Products ................................................................................................................. 40 Relative Price and Performance.......................................................................................................... 40 Costumer’s Willingness to Switch ....................................................................................................... 41 Conclusion........................................................................................................................................... 41 Bargaining Power of Costumers.............................................................................................................. 42 2 Switching Costs ................................................................................................................................... 42 Differentiation..................................................................................................................................... 42 Importance of Product for Costs and Quality ..................................................................................... 43 Number of Costumers......................................................................................................................... 43 Volume per Costumer......................................................................................................................... 44 Conclusion........................................................................................................................................... 44 Bargaining Power of Suppliers ................................................................................................................ 45 Differentiation..................................................................................................................................... 45 Switching costs.................................................................................................................................... 46 Importance of Product for Cost and Quality....................................................................................... 46 Number and volume of suppliers ....................................................................................................... 47 Conclusion........................................................................................................................................... 48 Closing Thoughts on the 5 Forces Model................................................................................................ 48 Key Success Factors for the Industry ................................................................................... 48 Cost Leadership....................................................................................................................................... 49 Economies of scale.............................................................................................................................. 50 Efficient Production ............................................................................................................................ 51 Simpler Product Design....................................................................................................................... 51 Low Input Cost .................................................................................................................................... 52 Low‐Cost Distribution ......................................................................................................................... 52 Little Research and Development or Brand Advertising..................................................................... 53 Differentiation......................................................................................................................................... 53 Superior Customer Service ................................................................................................................. 53 Conclusion............................................................................................................................................... 54 Firm Competitive Advantage Analysis .................................................................................. 54 Economies of Scale ................................................................................................................................. 55 Efficient Production ................................................................................................................................ 56 Simpler product design ........................................................................................................................... 57 Low input cost......................................................................................................................................... 58 Low‐Cost Distribution ............................................................................................................................. 60 Little Research and Development or Brand Advertising......................................................................... 61 Conclusion............................................................................................................................................... 62 3 Key Accounting Policies ...................................................................................................... 63 Type One Key Accounting Policies .......................................................................................................... 64 Economies of Scale ............................................................................................................................. 64 Low cost distribution........................................................................................................................... 65 Low Input Cost .................................................................................................................................... 65 Conclusion........................................................................................................................................... 66 Type Two Accounting Policies................................................................................................................. 66 Goodwill .............................................................................................................................................. 67 Operating Leases................................................................................................................................. 68 Defined Benefit Pension Plans ............................................................................................................ 69 Conclusion........................................................................................................................................... 70 Accounting Flexibility .......................................................................................................... 70 Goodwill .................................................................................................................................................. 71 Operating Leases..................................................................................................................................... 71 Benefit Pension Plan ............................................................................................................................... 72 Conclusion............................................................................................................................................... 73 Evaluate Accounting Strategy.............................................................................................. 73 Operating Leases..................................................................................................................................... 74 Defined Benefit Pension Plan.................................................................................................................. 75 Goodwill .................................................................................................................................................. 75 Conclusion............................................................................................................................................... 76 Quality of Disclosure........................................................................................................... 76 Qualitative Analysis................................................................................................................................. 77 Economies of Scale ............................................................................................................................. 77 Low Input Costs................................................................................................................................... 78 Operating Leases................................................................................................................................. 78 Benefit Pension Plan ........................................................................................................................... 78 Conclusion........................................................................................................................................... 79 Quantitative Analysis .............................................................................................................................. 79 Sales Manipulation Diagnostics .............................................................................................................. 80 Net Sales/Cash from Sales .................................................................................................................. 81 Net Sales/Net Accounts Receivable .................................................................................................... 83 4 Net Sales/Inventory ............................................................................................................................ 85 Conclusion........................................................................................................................................... 87 Expense diagnostic Analysis.................................................................................................................... 88 Asset Turnover .................................................................................................................................... 88 Cash Flow from Operations/Operating Income.................................................................................. 90 Cash Flow from Operations/ Net Operating Assets............................................................................ 92 Total Accruals/Change in Sales ........................................................................................................... 94 Pension Expense/SG&A ...................................................................................................................... 97 Other Employment Expenses/SG&A................................................................................................. 100 Expense Manipulation Conclusion.................................................................................................... 103 Identify Potential “Red Flags”.............................................................................................103 Operating Leases................................................................................................................................... 104 Defined Benefit Pension Plan................................................................................................................ 105 Conclusion............................................................................................................................................. 106 Undoing Accounting Distortions..........................................................................................107 Operating Leases................................................................................................................................... 107 2005‐2009 Amortization Tables........................................................................................................ 109 Financial Statements............................................................................................................................. 112 Balance Sheet.................................................................................................................................... 113 Income Statement............................................................................................................................. 114 Restated Financial Statements ............................................................................................................. 115 Restated Balance Sheet .................................................................................................................... 121 Restated Income Statement ............................................................................................................. 123 Financial Analysis, Forecast Financials, and Cost of Capital Estimation ..................................124 Financial Analysis ..............................................................................................................125 Liquidity Ratios...................................................................................................................................... 125 Current Ratio..................................................................................................................................... 126 Quick Asset Ratio .............................................................................................................................. 127 Inventory Turnover ........................................................................................................................... 129 Day Supply of Inventory.................................................................................................................... 130 Accounts Receivable Turnover.......................................................................................................... 132 Day Supply of Receivables ................................................................................................................ 133 5 Cash to Cash Cycle ............................................................................................................................ 134 Working Capital Turnover ................................................................................................................. 135 Liquidity Ratio Analysis Conclusion................................................................................................... 136 Profitability Analysis.............................................................................................................................. 137 Gross Profit Margin ........................................................................................................................... 138 Operating Profit Margin.................................................................................................................... 139 Net Profit Margin .............................................................................................................................. 141 Asset Turnover .................................................................................................................................. 142 Return on Assets ............................................................................................................................... 144 Return on Equity ............................................................................................................................... 145 Profitability Analysis Conclusion ....................................................................................................... 146 Capital Structure Analysis ..................................................................................................................... 147 Debt to Equity ................................................................................................................................... 148 Time Interest Earned......................................................................................................................... 149 Debt Service Margin.......................................................................................................................... 151 Altman’s Z‐Score ............................................................................................................................... 152 Capital Structure Analysis Conclusion............................................................................................... 154 Growth Rate.......................................................................................................................................... 154 Internal Growth Rate ........................................................................................................................ 155 Sustainable Growth Rate .................................................................................................................. 156 Financial Analysis conclusion ................................................................................................................ 157 Financial Forecasting .........................................................................................................157 Income Statement................................................................................................................................ 158 Common Size Income Statement (As‐Stated)........................................................................................... 1 Balance Sheet....................................................................................................................................... 162 Common Size Total Assets .................................................................................................................... 165 Restated Income Statement................................................................................................................ 166 Restated Common Size Income Statement .......................................................................................... 168 Restated Balance Sheet ....................................................................................................................... 169 Common Size Balance Sheet................................................................................................................. 171 Statement of Cash Flows ...................................................................................................................... 172 Restatement of Cash Flows................................................................................................................... 176 6 Estimating Cost of Capital ..................................................................................................179 Cost of Debt .......................................................................................................................................... 179 Cost of Equity ........................................................................................................................................ 184 Size Adjusted Cost of Equity ............................................................................................................. 189 Alternative Cost of Equity (Backdoor Method)................................................................................. 190 Weighted Average Cost of Capital ........................................................................................................ 191 Method of Comparables.....................................................................................................195 Trailing Price to Earnings Ratio ............................................................................................................. 195 Forecasted Price to Earnings Ratio ....................................................................................................... 196 Price to Book Ratio................................................................................................................................ 197 Dividend to Price Ratio ......................................................................................................................... 198 Price to Earnings to Growth (P.E.G) Ratio............................................................................................. 198 Price to EBITDA Ratio ............................................................................................................................ 199 Price to Free Cash Flows ....................................................................................................................... 200 Enterprise Value/ EBITDA ..................................................................................................................... 201 Conclusion............................................................................................................................................. 201 Intrinsic Valuation Models ..................................................................................................202 Discounted Dividends Model ................................................................................................................ 204 Discounted Free Cash Flow Model ....................................................................................................... 206 Residual Income Model ........................................................................................................................ 209 Long Run Residual Income Model......................................................................................................... 212 Abnormal Earnings Growth Model ....................................................................................................... 216 Analyst Recommendations .................................................................................................221 Appendix ..........................................................................................................................223 Sales and Expense Diagnostic Ratios .................................................................................................... 223 Financial Ratios ..................................................................................................................................... 226 Liquidity Ratios.................................................................................................................................. 226 Profitability Ratios............................................................................................................................. 227 Capital Structure Ratios .................................................................................................................... 228 Altman’s Z‐Score ............................................................................................................................... 229 Growth Rate.......................................................................................................................................... 229 Regressions ........................................................................................................................................... 231 7 3 Month Regression .......................................................................................................................... 231 1 Year Regression.............................................................................................................................. 233 2 Year Regression.............................................................................................................................. 236 5 Year Regression.............................................................................................................................. 238 10 Year Regression............................................................................................................................ 241 Method of Comparables ....................................................................................................................... 244 Intrinsic Valuation Models .................................................................................................................... 245 Discounted Dividends Model ............................................................................................................ 245 As Stated Discounted Free Cash Flows Model.................................................................................. 246 Restated Discounted Free Cash Flows Model................................................................................... 247 As Stated Residual Income Model .................................................................................................... 248 Restated Residual Income Model ..................................................................................................... 249 As Stated Long Run Residual Income Model .................................................................................... 250 Restated Long Run Residual Income Model ..................................................................................... 251 As Stated AEG Model ........................................................................................................................ 252 Restated AEG Model ......................................................................................................................... 253 References .......................................................................................................................254 8 Executive Summary Analyst Recommendation: Sell (Overvalued)
June 1st 2010
Pep Boys‐NYSE (6/1/2010) $11.94
52 Week Range
Market Capitalization
Shares Outstanding
Book Value Per Share
Return on Equity
Return on Assets
Estimated
3 Month
1 Year
2 Year
5 Year
10 Year
Backdoor Ke
WACCbt
Published Beta
Ke
Size Adjusted Ke
WACCbt
7.76 ‐ 13.42
438.12M Initial Scores
52.47M Revised Scores
2007
1.616
1.616
As Stated Restated
Financial Based Valuations $8.67
$8.73
As Stated Restated
5.44%
5.40% Trailing P/E
21.66 37.13
1.48%
1.13% Forward P/E
105.27
N/A
Dividends to Price
N/A
N/A
Price to Book
1.02
1.46
Cost of Capital
Adj. R^2
Beta Size Adj. Ke
P.E.G Ratio
N/A
N/A
0.2661
1.786
18.63
Price to EBITDA
25.99 21.66
0.2662
1.785
18.61
EV/EBITDA
37.06 30.89
0.2662
1.786
18.62
Price to FCF
3.55
2.79
0.2664
1.789
18.64
0.2663
1.79
18.65
Intrinsic Valuations
As Stated Restated
Discounted Dividends
$0.68
N/A
As Stated Restated
N/A
N/A
Free Cash Flows
$0 $6.20
8.23%
9.02%
Residual Income
$1.22 $0.89
1.66
N/A
Long Run Residual Income
$6.16 $6.09
Abnormal Earnings Growth
2.58
4.04
lower Bound Center Value Upper Bound
7.45%
15.94%
24.43%
10.15%
18.64%
27.13%
5.55%
8.23%
10.91%
9 Altmans Z‐Scores
2005 2006
1.68
1.78
1.768 2.567
2008
1.63
1.426
2009
1.86
2.499
Industry Analysis Pep Boys is an auto parts retail chain that operates throughout southern United
States, but is most predominant in California. Pep Boys provides replacement auto parts
and accessories along with a tire service center. In the auto parts industry Pep Boys
competes with AutoZone, Advance Auto, and O’Reilly Auto Parts. The industry is very
competitive, and allows for very little differentiation. A cost leadership strategy must be
effectively and efficiently implemented for success in the auto parts industry. In the
auto parts industry firms must utilize low cost distribution, low input costs, economies
10 of scales, and other cost control measures in order control marginal costs and improve
profitability. A close look at the five competitive forces model which explains the forces
that drive the competition in the industry with help us find the keys for success in the
auto parts industry. The summary table below shows the five forces model for the auto
parts industry.
Five Forces Model
Rivalry Among Existing Firms
High
Threat of New Entrants
High
Threat of Substitute Products
Moderate
Bargaining Power of Customers
High
Bargaining Power of Suppliers
Low
The auto parts industry has high levels of rivalry among existing firms. This is
due low levels of differentiation, and low levels of concentration throughout the
industry. Because of the low differentiation in product lines firms are forced to compete
on price to lure in business. The threat of new entrants is high this is because of low
government regulations, and moderate economies of scale. The industry already
competes on price, so potential entrants with have to very quickly gain economies of
scale in order to not get priced out. The auto parts industry has moderate threat of
substitute products because of the ongoing need for personal transportation and the
specific nature of auto parts. Customer loyalty is very low because of the industry’s
homogeneous product lines. Bargaining power of the customers is high because of little
loyalty and similar product lines, which leads to customers seeking out the lowest
prices. Bargaining power of suppliers is low because the products bought by these firms
are very firm specific.
A look at the five forces model provided us a better understanding of the auto
parts industry as a whole. The analysis explained that the firms compete on cost
11 leadership through low prices. The factors we found needed to accomplish cost
leadership are low distribution costs, low input costs, and economies of scale.
Accounting Analysis Evaluation of Pep Boys accounting policies is essential to accurately access Pep
Boys’ true financial standings. GAAP accounting policies allow for flexibility which
companies can use to distort their financial reporting, good or bad for the need of the
company. In order to clarify the true nature of Pep Boys’ financials we must evaluate
Pep Boys accounting policies, and determine their level of disclosure. Low disclosure
can mask their true accounting numbers this can hinder the valuation process making
revenues, expenses, assets, and liabilities unclear. Firms which use GAPPs flexibility,
and have low disclosure should be investigated thoroughly to detect any red flags,
which could change the overall value of the firm.
In analyzing Pep Boys’ we identified Type one key accounting policies that relate
with the company’s key success factors. Pep Boys’ is in the auto parts industry which is
a cost leadership industry their Type One key accounting policies consist of low input
costs, low cost distribution, and economies of scale. We have analyzed these key
accounting policies for Pep Boys and found that they adequately disclose their
information, more so than many of their competitors.
Type Two key accounting policies consist of accounting procedures which allow
for flexibility. Flexibility allowed in accounting can be used to distort a firm’s financials
and mislead potential investors. Pep Boys Type Two accounting policies effected by
their financials are operating leases, and pension plan. These potential red flags
warrant further investigation because operating leases can withhold a substantial
amount of liabilities off the books. Since operating leases and defined benefit plan
change the composition of the financial statement, we capitalized all of Pep Boys’
operating leases and restated their financials. The restated financial gave us a more
accurate portrayal of Pep Boys actual financial position. The graph below shows how
Pep Boys Operating leases are over the 10% threshold of their long term debt.
12 OPERATING LEASE-TO-LONG TERM DEBT TEST (IN THOUSANDS) “PEP BOYS”
BALANCE
PRESENT VALUE OF OPERATING LEASES
$ 776,285
LONG TERM DEBT
$ 307,280
PERCENTAGE
252%
Pep Boys use of their defined benefit plan gives them significant flexibility in their
accounting policies. With GAAP accounting firms are given the freedom to approximate
the discount rate for all future expenses. This means that a company has the ability to
deflate future expenses and by extension give faulty financials. The flexibility allowed by
GAAP for defined benefit plans needs to be checked, and disclosure is a must. Pep Boys
defined benefit plan is poorly reported and information is hidden. We managed to pull
some information on their defined benefit plan which was halted in 1994, but is still
used by certain employees hired before 1992. The graph below shows Pep Boys
expenses for their SERP account plan, and Defined benefit plan.
CONTRIBUTION EXPENSE FOR (SERP) ACCOUNT PLAN
2007
2008
2009
$440
$163
$790
(Pep Boys 10k)
DEFINED BENEFIT PENSION PLAN (CONTINUED FOR EMPLYOEES HIRED BEFORE FEBRUARY 1, 1992)
2008
2009
2010
$3,612
$8,476
2,515
(Pep Boys 10k)
Due to the poor quality of disclosure, and convoluted financial reporting these
graphs might prove useless, but we feel they show a red flag that needs to be
investigated more closely. Through our accounting analysis, we have explored Pep Boys
13 accounting disclosure and found it to be low. The relevant information is hidden or
nonexistent the lack of disclosure is a major concern when valuing the company. We
have restated these potential red flags to get a more accurate view of Pep Boys true
value.
Financial Analysis During our financial analysis we accessed Pep Boys liquidity, profitability, and
capital structure. With ratio analysis, we were able to evaluate industry trends over the
past five years, and compare Pep Boys to the results. This allowed us to get a better
picture of how Pep Boys stacks up against their competition.
The liquidity ratios that we analyzed were current ratio, quick asset ratio,
inventory turnover, receivables turnover, days’ supply of inventory, cash to cash cycle,
and working capital turnover. With these ratios were we better able to access Pep Boys
liquidity, and understand if they had the means to pay for short term obligations. A
higher level of liquidity is preferred by investors, because of their ability to turn assets
into cash. The graph below shows an overview of our findings for each ratio; overall we
feel that Pep Boys liquidity was high compared to the competition.
LIQUIDITY RATIO ANALYSIS (Pep Boys-to-Industry)
RATIO
PERFORMANCE
TREND
Current Ratio
Underperforming
Stable
14 Quick Asset Ratio
Average
Decreasing
Inventory Turnover
Outperforming
Stable
Day Supply of Inventory
Outperforming
Stable
Receivables Turnover
Outperforming
Volatile
Days Sales Outstanding
Average
Stable
Cash to Cash Cycle
Outperforming
Stable
Working Capital Turnover
Average
Stable
Overall
Outperforming
Stable
After we had completed the liquidity analysis we conducted a profitability
analysis to further understand Pep Boys. Profitability ratios measure a firm’s ability to
make a profit by analyzing their financials. The ratios we used for profitability include:
gross profit margin, operating profit margin, net profit margin, asset turnover, return on
assets, and return on equity. With these ratios we are able to see how effectively Pep
Boys is turning their revenues into profit compared to their competition.
Pep Boys profitability unlike their liquidity is poor, and underperforming the
industry by a wide margin. When using Pep Boys restated financials to work out their
ratios the margin between them and the industry average widens. In an industry that
competes on low costs this spells hard times for Pep Boys because they are not as
effective at controlling their costs. The table below shows our findings for each of
profitability measures.
PROFITABILITY RATIO ANALYSIS (Pep Boys-to-Industry)
Ratio
Performance As Stated
Performance Restate
Trend
Gross Profit Margin
Underperforming
N/A
Stable
15 Operating Profit Margin
Outperforming
Underperforming
Upward
Net Profit Margin
Underperforming
Underperforming
Upward
Asset Turnover
Underperforming
Underperforming
Stable
Return on Asset
Underperforming
Underperforming
Upward
Return on Equity
Underperforming
Underperforming
Stable
Overall
Underperforming
Underperforming
Upward
The final financial analysis we measured was capital structure. Capital structure
is used to evaluate how a company finances their investments and how they finance
their operating activities. The ratios we used for the capital structure analysis are, debt
to equity ratio, times interest earned, debt service margin, and Altman’s Z-score. With
our analysis we found that once again Pep Boys’ is underperforming the industry
average in their capital structure analysis. Pep Boys level of long term debt is higher
than that of the industry mostly brought on by their excessive use of operating leases.
The table below shows all our findings for capital structure ratios.
Ratio
Debt to Equity
Time Interest Expense
Debt Service Margin
Altman’s Z-Score
Overall
Trend
Stable
Stable
Stable
Volatile
Stable
Performance
Below
Below
Below
Below
Below
Valuation Analysis We have evaluated the auto parts industry, and analyzed Pep Boys key
accounting policies, found their cost of capital, forecasted the financial statement out 10
years into the future. This information will allow us to properly estimate the value of
Pep Boys. We maintain a 15% analyst position. The results of our valuation will be
compared to Pep Boys observed share price of $11.94 which was observed on June 1st
of 2010. With this position we will make a verdict on the value of Pep Boys as either
being undervalued, fairly valued, or overvalued.
Using two distinct valuation methods; intrinsic valuation models, and method
comparables we will ultimately put a value to Pep Boys equity. The intrinsic valuation
model and sensitivity analysis, are forward looking and value a company based on its
16 performance in these measures. The method of comparables compares industry ratios
in order to forecast share prices.
In all we found the intrinsic valuation model to hold the most insight when
valuing Pep Boys. The intrinsic valuation models we used to value Pep Boys are the AEG
model, residual income model, free cash flows model, and the discounted dividends
model. With extensive research, and information each of our intrinsic valuation models
showed that Pep Boys is overvalued both in an as stated and restated basis. A main
indicator of our recommendation came from our AEG model which we feel is very
explanatory because of its emphasis on growth. Overall through our culmination of
work we have ultimately concluded that Pep Boys’ is currently overvalued. Through our
research we also feel that Pep Boys’ is in danger of being bought out by the
competition.
Company Overview The Pep Boys-Manny, Moe & Jack (Pep Boys) was founded in 1921 in
Philadelphia, Pennsylvania by Emanuel (Manny) Rosenfeld, Maurice (Moe) Strauss, and
W. Graham (Jack) Jackson. The store was originally named “Pep Auto Supplies” but it
was given an official name of “The Pep Boys-Manny, Moe & Jack” in 1923 after Moe
Strauss traveled to California and noticed that several successful West Coast companies
used their owners’ first names (PepBoys.com).
In the 1980’s, Pep Boys implemented a new business strategy that slowly
moved away from what the company was founded on, which was serving only “do-ityourself” (DIY) customers and moved towards serving “do-it-for-me” (“DIFM”, which
includes service labor, installed merchandise and tires) customers. Due to this change in
business strategy, Pep Boys is the only national chain offering automotive service, tires,
parts and accessories (Pep Boys 10-K). Pep Boys’ stores stock about 25,000 car parts
and accessories, including tires, chemicals, tools, and operate over 6,000 service bays
for parts installation, repair, and vehicle inspection.
Pep Boys is headquartered in Philadelphia, Pennsylvania and currently has a total
of 587 stores at year-end 2009 operating in 35 states and Puerto Rico and has more
17 than 17,000 employees. Pep Boys operates approximately 11,686,000 of gross square
feet of retail space, including service bays. The Supercenters average approximately
20,700 square feet, Service & Tire Centers average 6,800 square feet and the Pep
Express stores average 9,500 square feet. At year-end 2009, 94% of Pep Boys stores
were Supercenters, which serve both “do-it yourself” and “do-it-for-me” customers (Pep
Boys 10-K).
Total Assets (In Millions)
Pep Boys
2005
2006
2007
2008
2009
828.06
768.14
749.76
715.56
716.08
(Statistics
provided from Pep Boys 10-K)
The above chart shows total assets from Pep Boys balance sheet over the past
five years. The chart shows that the firm has steadily decreased acquired assets over
the past five years, until 2009 when total assets only showed a marginal increase. This
downward trend in total assets suggests a reduction in the firms overall growth over
the last five years.
Pep Boys (PBY) is traded on the NYSE and has a current market cap of $594.2
million. Pep Boys’ primary competitors include AutoZone Inc. (AZO), Advance Auto Parts
Inc. (AAP), and O'Reilly Automotive Inc. (ORLY). Pep Boys manages to differentiate
itself from other discount retailers from other auto parts stores by providing service for
“do-it-for-me” customers as well as parts and accessories for “do-it-yourself” customers
in all of their stores. Another aspect of Pep Boys’ business strategy that differentiates
the firm from their competitors is their focus on value. “Pep Boys Does Everything. For
Less.” is designed to convey to customers the breadth of the automotive services and
merchandise that we offer and our value proposition (Pep Boys 10-K). Compared to
their competitors, Pep Boys is considerably smaller in both revenues and assets.
However, due to the change in their business strategy, Pep Boys continues to capture
market share in their industry.
18 Industry Overview The auto parts industry provides automotive repair, and maintenance services.
The industry’s main competitors are, AutoZone Inc., O’Reilly Automotive Inc., and
Advance Auto Parts Inc. The industries main focus, is on selling automotive tires, parts,
and accessories, all geared towards enhancing, and sustaining automotive efficiency.
Auto Parts Store Industry - Sales Analysis (In Millions)
Net Sales
Pep Boys
2004
2005
2006
2007
2008
2009
2,269.97
2,235.23
2,243.86
2,138.08
1,927.79
1,910.94
-1.53%
0.39%
-4.71%
-9.84%
-0.87%
5,710.88
5,948.36
6,169.80
6,522.71
6,816.82
1.31%
4.16%
3.72%
5.72%
4.51%
4,264.97
4,616.50
4,844.40
5,142.26
5,412.62
13.12%
8.24%
4.94%
6.15%
5.26%
2,045.32
2,283.22
2,522.32
3,576.55
4,847.06
18.83%
11.63%
10.47%
41.80%
35.52%
14,256.40
15,091.94
15,674.60
17,169.31
18,987.44
6.40%
5.86%
3.86%
9.54%
10.59%
Percentage
Change
Net Sales
AutoZone
5,637.03
Percentage
Change
Advance
Auto Parts
O'Reilly
Auto Parts
Net Sales
3,770.30
Percentage
Change
Net Sales
1,721.24
Percentage
Change
Total Sales
13,398.54
Percentage
Change in
Sales
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The chart above shows the Net sales for the last six years, and also provides a
look at the percent change of sales in each company over the last five years. This
allows us to gain a perspective of the total percent change in the industry over the last
five years, taking into account that these are the top four firms, in the industry. If one
were to take a close look one can see a majority of the overall change in the industry
19 was added by O’Reilly, who had a 41.80% change between 2007-2008. This was likely
a result of the acquisition of CSK Auto in 2008 adding over 1500 stores primarily located
in western United States (O’Reilly 10k).
The auto parts industry of late has seen positive numbers as shown in the graph,
much to the contrary of the effects that were thought to occur after the government’s
cash for clunkers program (WSJ.com). This could have been offset by the recent down
economy, with the idea that automotive consumers would save more by fixing an
keeping an old vehicle, rather than buying a new one. This industry is much needed
with respect to the amount of vehicles used in the United States. With pressure of
competition coming from mechanics, the increasing complexity of technology
implemented within the vehicles, smaller work room within vehicles themselves for nonexperts. This makes for an ever more competitive road for auto parts stores. This will in
turn make the auto parts store industry compete for profits with low prices, and lower
costs, in order to fill capacity, and make modest revenues.
Five Forces Model The Five Forces Model, developed by Michael E. Porter, summarizes the five
factors which affect the performance of a company (Palepu). These forces include
Rivalry Among Existing Firms, Threat of New Entrants, Threat of Substitute Products,
Bargaining Power of Buyers, and Bargaining Power of Suppliers. The weight of the five
forces determines the potential profit of the firms involved. If the weights of the five
forces are high, then there is a minimal chance for abnormal profits, without an overall
cost leadership status. On the other side of the spectrum, if the weights of the five
factors are low then there will be a optimal opportunity for abnormal profits, leading to
an overall differentiation strategy, for setting a firm apart. In summary the essential
point of the five forces model is to identify key success factors in the industry,
furthermore the elements of the industry that must be mastered in order to gain a
competitive advantage. (Porters Five forces Model, Ezine Articles) These factors can
20 then be compared to Pep Boys industry and environmental factors, to achieve a clearer
picture of their situation in the auto parts store industry.
The first of the five forces, Rivalry Among Existing Firms is explained by the
competitive nature of existing firms vying for position, and profits within the industry.
More competitive industries must aggressively push for positioning often leading to a
bare minimum price close to marginal cost. Factors that contribute to rivalry among
existing firms are industry growth rate, concentration and balance of competitors,
degree of differentiation, and switching costs, learning economies and the ratio of fixed
to variable costs, and excess capacity and exit barriers.
The second of the five forces, Threat of New Entrants can be described as the
ease or difficulty with which new start up, or converted firms can get into an existing
industry. Factors contributing to the threat of new entrants are economies of scale, first
mover advantages, access to channels of distribution, and relationships, and legal
barriers.
The third of the five forces model is the Threat of Substitute Products or
services. These are described, as alternative options for consumers, this can even be a
different product fulfills the same need. An example would be MP3 player to hold music
in place of a compact disc. This can also be related to products that affect demand,
(Electric Cars / Fossil fuels), (Porters five forces model Ezine Articles). Other Factors
that affect this are relative price and performance, and buyer’s willingness to switch.
The fourth of the five forces model, Bargaining Power of Customers is mainly
brought on by the customer’s ability to negotiate, the bargaining power of the customer
is even more powerful when the products are standard, and there are substitutes
readily available. Other factors which influence customer bargaining power are, price
sensitivity, and relative bargaining power.
The fifth and final of the five forces model, Bargaining Power of Suppliers is
described as the ability of suppliers to impose conditions on a market has direct
correlation to customer bargaining power. The smaller the number of suppliers, and the
higher the switching cost, swings the bargaining power into the direction of the
suppliers. Factors which contribute to suppliers power are, number of suppliers, strong
21 brand image, and highly differentiated products. All of these lead to increased switching
cost, which directly contribute to suppliers’ power over firms.
The Five-factor model is a key tool in assessing and analyzing a market industry’s
environment, and to help decide on the ability for success in an industry. The model
helps bring to light key success factors, and provide valuable insight when analyzing
companies’ potential. When a successful evaluation of the five factors model has been
completed we will be able to determine the level of competition in the auto parts retail
industry, and determine the key success factors for being profitable. This will allow us
to assess Pep Boys use of these key success factors, and to what extent they are being
realized. The five factor model allows three degrees of competition: High, Moderate,
and Low competition. In a highly competitive industry firms will focus on cost
leadership. In a low competition industry, firms will focus solely on differentiation
strategy. In the case moderate competition, the industry will focus on cost leadership
strategies, and try to differentiate themselves. The following table is an overview of the
finding on the level of competition from the five factors model for the auto parts store
industry.
Five Forces Model
Rivalry Among Existing Firms
High
Threat of New Entrants
High
Threat of Substitute Products
Moderate
Bargaining Power of Customers
High
Bargaining Power of Suppliers
Low
Rivalry Among Existing Firms When evaluating the potential of a business, it is not only necessary to assess
the firm, but the industry segment with which the firm operates. This will allow for a
complete analysis of a firms position. An important factor to analyze while assessing an
industry is the competition between rival or existing firms. The level of competition
between rival firms can have a copious impact on the potential for profit in that
22 industry, but also greatly affect the strategy with which to choose. High competition
within an industry can force rival firms into price wars. This can lead to pushing prices
below the marginal cost significantly decreasing the sales margin. Rivalry in an industry,
can also lead to differentiation, in an attempt to attract customers, and separate
themselves from the rival firms. With the exploration of an industries factors such as,
growth rate, concentration and balance of competitors, degree of differentiation and
switching costs, learning economies, the ratio of fixed to variable costs, and excess
capacity an exit barriers, investors can properly assess a firms place in the market, and
future potential.
Industry Growth Rate To properly assess the potential success for a firm in auto parts retail industry,
the growth rate of the auto parts industry must be calculated. With the knowledge of
the industry’s growth rate, we can conclude that either there are excess market shares
available allowing existing firms low competition for those market shares, or in the case
of slow or no industry growth rate that existing firms must compete for market shares
by cutting prices and aggressively taking market shares away from other existing firms.
An analysis of the auto parts industry growth rate had mixed results with a major
growth slowdown between 2007 and 2008, but stronger growth rates in 2009, and
2010. The decrease in growth rate could be attributed to great recession that took
place in those years.
23 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The auto part retail industry overall has seen positive growth, but the rate at
which the industry is growing has been relatively low. This will cause existing firms in
the industry to compete with one another for scarce market shares, in order to increase
revenues.
Auto Parts Store Industry‐Percent Change in Sales
Company
2005
2006
2007
2008
2009 5yr Avg Trend
Pep Boys
4.817
1.579 ‐4.714 ‐9.9835 ‐0.874 ‐1.835 Decreasing
Advance Auto
8.242
4.936
6.148
5.525
4.532
5.876 Increasing
AutoZone
6.213
4.386
5.719
4.509
3.925
4.95 Increasing
O'Reilly
18.828 11.631 10.471 41.791 35.523 23.649 Increasing
(Pe
p Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
A look at the percent change in sales of the top competitors in the industry show
mostly positive change, excluding Pep Boys. O’Reilly has had an exceptional increase in
sales. These increases although not considerably high could be, an effect of the recently
crippled economy, leaving more automotive customers open to fixing an existing
24 vehicle, rather than purchasing a new one. This could also be due lower oil prices
“crude-oil prices have tumbled roughly 20% since early April to close at about $70 a
barrel” (WSJ.com). This would suggest that customers are looking for low price options
for saving money, and could be an indicator that the industry is geared towards lower
prices, and competition could cause cannibalization, forcing similar firms into price
wars. The fact that O’Reilly has experienced such greater percent change in sales could
also suggest that the Industry could be driven by differentiation, and specialized parts,
giving the firm with the correct diversification of low costs, and specialty needed parts,
a competitive advantage. This difference in sales could also mean that O’Reilly has
already been crowned the low price leader, taking precious market shares away from
the industry.
Pep Boys recently presented at the 2010 Morgan Joseph Best Idea Conference,
and gave some forward looking statements regarding the companies, intentions. “Pep
Boys announced that it will present an overview of the vision -- to be the automotive
solutions provider of choice for the value-oriented customer” (WSJ.com). This could
suggest new strategies, and methods of obtaining market shares. Overall with the lack
of growth, and slow sales, these findings suggest that the industry is geared towards
low prices, and high competition.
Concentration The concentration level of an industry or number of firms in the industry can
greatly influence the degree to which those firms can set prices, and coordinate
competitive moves. The more concentrated an industry the more the existing firms will
have to jockey for position, which will ultimately lead to severe price competition. Once
the concentration level of the industry is established, investors can make a proper
assessment of the potential for success of a firm, or the methods need to succeed in
the industry. In the Auto Parts retail industry there are many established competitors,
with a total industry market capitalization of 21 billion dollars. (Yahoo Finance) The
market leader in terms of market capitalization is AutoZone, followed closely by O’Reilly,
25 and Advance Auto with market caps in the several billion dollar capacity. Closing out the
top four competitors is Pep Boys, with a modest market capitalization of about 500
million (AutoZone, O’Reilly, Advance Auto Pep Boys 10K). This leaves around 1.5 billion
dollars of the Auto Parts Retail Industry Market Capitalization, to smaller auto stores
around the nation competing for customers, and market shares.
MARKET SHARE
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The graph above which represents the percent of market shares each of the four
main competitors in the auto parts store industry own. The Graph shows AutoZone is by
far the market share leader with over 50% more shares than any other of the
competitors in the industry. There has not been a lot of movement in market shares
except in 2009 where O’Reilly gained 7.3% of the auto parts industry market shares,
and AutoZone lost 7.1% of the industry shares. This suggests that O’Reilly has found a
way into the industry leaders dominating control of market shares. This is a small
example of the competitive industry, and the fight for market shares. As the years
26 continue, it will be interesting to see if O’Reilly can keep eating into the market shares,
and gain ground on AutoZone. The graph also shows that the overall concentration in
the industry is low, giving way to the explanation of a price competitive industry.
To accurately assess the overall concentration of the auto parts industry it is
necessary to analyze the number of new stores that the industry is opening or closing.
This will hint towards the overall size of these firms giving a better representation of the
market share. In a cost leadership strategy, being where you can reach the most
consumers is imperative to keeping overall costs low.
PERCENT CHANGE IN NEW STORES
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The graph above shows the percent change in the number of stores over the
past 5 years, for the auto parts industry competitors. As you can see the statistics show
about a 4% positive change in the number of stores persists, even with the extreme
increase in the number of stores for O’Reilly in 2008, after acquiring CSK Auto (O’Reilly
10k). AutoZone, the Industry leader in market share, can attribute this to the number of
stores they operate which is 4,417, O’Reilly, and Advance Auto have about 3,300 stores
open in the United States along with Pep Boys adding about 587 stores. This shows a
very fragmented industry, with low concentration with consumer options, because of
27 the sheer volume of auto parts stores. This leads to the firms in the industry having to
compete with each other for the customers, with aggressive low cost, raising the
competition level for revenues, and shares of the market.
Differentiation Differentiation in financial analysis is the ability of a company or firm, to set them
apart from their competition, and avoid exact replication of products, and services. The
differentiation of products, and services if achieved will allow the company to charge a
premium for that product and, or service, because customers are willing to pay more
for a preferred product or, service. If products are not different, but similar, then
customers will be willing to buy the product purely on low price.
The goal of this discussion will be to assess the differentiation throughout this
industry. The auto parts store industry generally sells a similar range of products for the
automobile, an example of some of the products offered are: wiper blades, batteries,
auto body paint, floor mats, coolant, alternators, and everything in between (Pep Boys,
AutoZone, Advance Auto, O’Reilly 10K). Differentiating yourself in this industry is very
difficult, because of the standardization, and similarity of products offered by the
competitors of the auto parts industry.
There is opportunity for differentiation; O’Reilly differentiates themselves by
offering a line of brand name, and private label products for domestic and imported
automobiles (O’Reilly 10k). AutoZone uses sheer product volume, to differentiate
themselves by offering the most automotive accessories under one roof. Pep Boys uses
their tire change service to differentiate from the competition. There is still a limited
amount of ways for differentiation in the industry, leading to price competition among
the firms, and the need for lower prices, and lower costs. With little loyalty, and the
standardization of products these companies will have to win over customers with low
prices.
28 Switching Costs The cost of switching from a firms current operation, to that of another
enterprise, and the ease with which that firms assets, can be used to perform other
business opportunities, explain switching costs. A firm whose assets are industry
specific, and specialized for only a specific use, will have a hard time switching to
another industry or selling off existing assets because of this specialization. To switch
industry’s or sell existing assets takes a match in the use of the asset, or a buyer willing
to acquire those assets, and the more specialized the asset the harder time you will
have finding a match of needs.
A look at this industry’s assets, and possible buyers, and matches of asset needs
will tell if there are high or low switching costs associated with the auto parts industry.
This will give us a better understanding of whether the industry firms are price takers,
or price setters. A majority of the products sold in this industry are not manufactured by
the firms, but bought from suppliers. This means that there is not a lot of specialized
heavy equipment for producing products, or highly trained, and educated employees.
The industry switching costs are relatively low because of these facts, but the service
side of some firms in the industries is specialized for example Pep Boys, tire change
service. This could allow us to assume that there is a mix of specialized and
unspecialized assets. Therefore, companies can sell off their existing assets, or switch
industries without a huge loss. This reduces competition in the industry because firms
do not have to stay in the industry, and compete with existing firms because of high
switching costs.
Scale Economies Economies of scale lower the firm’s costs by increasing the size or scale of their
operations. The auto parts retail industry achieves this by merchandising in mass
quantities, and by quickly turning over inventory, in the attempt to fill capacity. In the
auto parts retail industry the largest firms will have the best chance of achieving
economies of scales because sheer size will allow these firms to sell more merchandise,
29 which increases inventory turnover driving down costs. Large economies of scale allow
firms to cut costs, with every additional unit of product sold. The firms with the most
locations and access to the greatest number of customers will be able to maximize
sales, and turnover more inventory, leading to greater profit.
For firms competing in the auto parts retail industry to achieve economies of
scale, they must sell the most merchandise and turnover the most inventory to reduce
marginal costs. This is best done by reaching the most consumers, and by achieving
efficient distribution, hedging risk, and overall reducing every cost in the process to the
lowest possible. AutoZone recently had a profit of 17%, which could be attributed to
their impressive economies of scale (WSJ.com). Two good measures to calculate
economies of scale are to compare a firm’s total assets, and sales to property plant and
equipment. This measure will help assess the overall industries use of economies of
scale.
Total Assets (in thousands)
Company
2005
2006
2007
2008
2009
Pep Boys
1,821,753
1,767,199
1,583,920
1,552,389
1,449,086
Advance Auto
2,542,149
2,682,681
2,805,566
2,964,065
3,072,963
AutoZone
1,929,459
2,118,927
2,270,455
5,257,112
5,354,357
O’Reilly
1,718,896
1,977,496
2,279,737
4,193,317
4,781,471
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Qs)
The graph above which illustrates the total assets for the top four companies in
the auto parts retail industry over the last five years. The trend over the past five years
is interesting while Pep Boys has seen a steady decline over the five years, AutoZone,
and O’Reilly have very impressively increased their total asset value over 50% during
the last five years, and slowly turning the auto parts retail industry into a two firm take
over. It will be interesting to see if the trend continues or if Pep Boys or Advance Auto
will catch up. With the results of the graph we can conclude that both O’Reilly and
30 AutoZone have potential dominance in economies of scale. To fully understand this idea
we should also look into the ratio of sales to total assets.
TOTAL ASSETS TO SALES
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The graph above shows the total assets to sales ratio of the four main
competitors over the last five years. This ratio is a measure of firm’s efficiency in
managing its assets in relation to sales revenue. The higher this ratio, the smaller the
investment required to generate sales revenue (Business Dictionary.com) Shown in the
graph above, AutoZone had a clear advantage from 2005-2007, but the playing fields
are more even in 2009, with an industry average of about 1.25 dollars of sales revenue
generated for every 1 of total assets. The consistency of the ratio throughout the
industry shows that these firms are pretty evenly matched on asset to sales revenue
giving way to the idea that these companies really do have to compete very
competitively for revenues, and are about even on efficiency of assets to generate
revenue.
For the auto parts retail industry to achieve economies of scale they must
compete on all levels for efficiency of asset allocation, they must use efficiency in all
facets of their companies for this to be realized. As shown from total assets if these
companies wish to make a profit they must drive down costs, and achieve the highest
total asset turnover, and sell as many products as possible to reach a high level of
31 economies of scale.
Learning Economies A learning economy is an industry where knowledge is the key factor of success.
These are highly sophisticated and highly technical industries, where a high degree of
knowledge is need to be in the industry, or stay competitive within the industry. The
auto parts market discloses no research and development within the industry (Pep
Boys, AutoZone, Advance Auto, O’Reilly, 10K). There is rarely a drastic change in
automotive accessories, or a highly technical change in the makeup of a combustible
engine, perhaps the emergence of electric cars, or hybrids will change this but for now
the learning curve is minimal. Firms within this company compete on inventory
turnover, efficient distribution, and bulk sales.
Fixed­Variable Cost A key factor in determining the process, to which a company will compete, be
that on cost leadership, or differentiation is determined by the company’s fixed-variable
cost. Fixed costs are those cost that do not change as production or sales change within
relevant range. Variable costs are those cost that are directly proportional to sales or
production (Business dictionary.com) This is important, because firms with a low fixed
to variable cost ratio can cut back production, and or sales in hard times and still make
a profit. Firms that do this are generally more comfortable in hard times. Firms with
high fixed to variable cost, must sell, or produce over there marginal cost to make any
kind of profit, and are often hit hard in down times, or as sales drop. A look at the fixed
to variable cost ratio of the firms in the auto parts retail industry will give us a good
understanding of the type of company they are from, based from their fixed to variable
cost ratio.
32 Company
2005
Pep Boys
Fixed Variable Cost Ratio
2006
2007
2008
2009
-1.262
-1.197
-1.392
3.621
.268
AutoZone
-.038
.313
.164
.181
.067
Advance Auto
.016
.104
.072
.010
1.456
O’Reilly
.045
.075
.061
.051
.155
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
If one were to look at the table above, it would reveal that the auto parts retail
industry has relatively high fixed costs as expected. Although these results may not be
exact they are close enough to get some relevant information on the industry’s average
fixed-variable cost structures. By comparing the annual change in sales and operating
expenses to calculate the slope of the total cost formula. This gives us a rough estimate
of the fixed to variable costs of each of the four competitors in the auto parts retail
industry. When outliers are removed, and the average is taken, it solidifies the notion
that the auto parts retail industry has high fixed costs. This tells you that the company
must sell more products to compensate for those fixed cost. This leads us to the
conclusion that this industry must compete on price in order to attract customers, and
turnover inventory.
Excess Capacity Excess capacity is a situation where actual production is below where it could
potentially be, or for what is optimal for the firm. This happens when demand for a
product is below what the firm at full capacity could potentially provide to the
market. This is important to analyze because a company with excess capacity could lose
a considerable amount of money if not able to meet the high fixed costs that we have
already confirmed to be in this industry. Problems with excess capacity are mostly due
to a decrease in demand for a particular good or service. Because of this, excess
capacity only moderately affects the auto parts store industry.
33 This industry sells automotive parts that are generally needed on a consistent
basis because of the popularity of automobiles for transportation of products and
individuals. Looking at yearly changes in same store sales can show this. In the auto
parts retail industry a benchmark of same store sales can be used to compare.
Percentage Change in Same Store
Company
2005
2006
2007
2008
2009
Pep Boys
.52%
-1.23%
-2.36%
-6.33%
-1.54%
AutoZone
2.33%
4.89%
5.1%
2.33%
2.41%
Advance Auto
1.12%
1.36%
1.98%
2.11%
1.45%
O’Reilly
2.33%
1.45%
3.66%
9.63%
6.23%
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The chart shows the percent change in same store sales by company. The
industry has shown some growth over the last five years. Other than Pep Boys whose
same store sales have been declining over the past five years, the industry has been
growing at a very steady rate. Potential unexpected increases have occurred for
AutoZone, and O’Reilly, but we suspect they were a result of acquisitions AutoZone and
O’Reilly obtained during those times, and therefore expected increases (AutoZone,
O’Reilly 10k). In all, the sales have been very predictable. This is important because it
allows us to assume that these firms can accurately account for sales forecasts,
allowing them a good chance of not having excess capacity.
Exit Barriers An exit barrier is any part of an industry or business hindering a firm from exiting
the industry. These can be regulations, or excessive costs which make it almost
impossible to exit an industry without losing excessive assets, and or more severe
punishments. These barriers are generally experienced in a highly specialized industry,
with industry specific assets, such as the steel industry which has extensive regulations
34 prohibiting exit (Palepu). In the auto parts retail industry, aspects that prevent exit are
things such as lease obligations, binding contracts and company specific defined
benefits plans.
PAYMENTS DUE FOR CONTRACTAL OBLIGATIONS
Company
1 year
2-3 years
4-5 years
Over 5 years
Pep Boys
81,601
80,488
77,677
395,190
AutoZone
690,707
870,347
1,503,698
2,228,404
Advance Auto
287,320
310,146
480,224
933,557
O’Reilly
442,337
400,342
972,444
704,882
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
If one were to look at the chart above they would see that the companies in the
auto parts retail industry are highly invested in their businesses. The average payment
due after five years for the four competitors is 1,065,508. This means that the
companies in this industry are obligated to stay in the industry. This shows us that in
order to make profits and stay in this industry, these firms must compete heavily for
revenues. The exit barrier here, which we have analyzed, is payments for contractual
obligations. Many of these firms have obligations for payment of leased buildings for a
very extended time, such as Pep Boys, who has 89 of their stores under lease for 15
years (Pep Boys 10k). This will give way to price competition among the industry
leaders because of high exit barriers.
Conclusion Overall the auto parts retail industry is very competitive and has high degrees of
competition among existing firms. The industry shows low levels of differentiation,
switching cost, concentration, and learning economies. These indicators in the fivefactor model point to firms which must reduce costs, and increase turnover, and market
shares in order to increase profits. We also found that the industry has a high fixed to
35 variable cost ratio, and high exit barriers. These factors of the five forces model point to
an industry that must sell increased numbers of products just to break-even. This also
shows that the industry has high exit barriers because of extended contractual
obligations, and long term leases. The auto parts retail industry has a high degree of
competition which ultimately means that they are price takers, having to appeal to mass
amounts of consumers, and push massive amounts of inventory to achieve moderate
profits. This is a very hard industry to excel in, but with the right customer base,
efficiency of costs, and modest sales numbers, it can be achieved.
Threat of New Entrants The threat of new entrants is one of the three potential sources of competition.
In the auto parts retail industry, if the level of competition is high, this could deter new
entrants. The ease of entrants isn’t the main concern, but rather, if the new entrants
are able to stay in the industry as well. Some of the things new entrants need to
consider are the scale of economies, the first mover advantage, the distribution access,
relationships and legal barriers.
Scale Economies Economies of scale arise when a firm produces a certain amount of goods that
will eventually decrease the average cost per good. This will inherently be a
disadvantage for the new entrants of any industry. Below is a graph that takes the
total cost of goods(cogs) sold divided by the total plant, property, and equipment(ppe)
for the year. This graph shows us that for Advance Auto Parts, as much capitol they
may have, their cost of goods sold are relatively higher than its competitors with Pep
Boys close behind. Being that Advance Auto Parts and Autozone are the biggest
competitors in this industry, they’re cogs/ppe ratios are drastically different. Ultimately,
this graph leads us to conclude that economies of scale do not play a huge role in the
automotive retail parts industry.
36 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
You can also create economies of scale through research and development and
investments in brand image. Considering that economies of scale are not a large factor
in this industry, there wouldn’t be a reason to invest in these for that reason alone. You
can also speculate that the reason this industry doesn’t have any economies of scale is
because they don’t invest in any research and development and very little in brand
image.
First Mover Advantage As the old saying says, first come first served, the auto parts retail industry as
well as any industry has or may have advantages for taking initiative. This makes it
difficult for new entrants because first movers have the advantage to create products
that may not be easily substituted. First movers also have an advantage in that they
may reach certain suppliers that provide material required for their products at a
cheaper price before other firms. Some licenses may not be as easily obtained, firms
37 who moved first could decide to obtain patents, or create laws and regulations that
impede potential new entrants.
As for the auto retail parts industry, there are no valuable licenses, patents or
exclusive arrangements to buy cheaper raw materials. This is expected since this
industry operates in a cost leadership strategy. With this in mind there is no real first
mover advantage in this industry.
Distribution Access The access to distribution is another barrier new entrant’s face in their effort to
enter an industry. While existing firms have established channels of distribution, new
entrants are faced with the difficulty of trying to find a distribution channel. It is difficult
for new entrants to create immediate relationships with current distributors because of
trust issues regarding the ability of the new entrants to gain a stable customer base. To
better explain this, transportation companies may not trust a potential customer
because they do not know if the new customer has a stable business to continue
operating with them. Another possible hurdle is that new entrants may not have the
ability to establish relationships and will therefore be forced to create a new channel of
distribution, which can be costly, and time intensive. In the auto parts retail industry,
the distribution access is relevant because all parts the industry firms sell are distributed
in some manner.
The Pep Boys 10K states that, “the Company has not experienced difficulty in
obtaining satisfactory sources of supply and believes that adequate alternative sources
of supply exist, at substantially similar cost, for the type of merchandise sold in its
store.” So there is evidence that there are plenty sources of supply. With these facts
there would not be an obstacle to obtain access to channels.
Relationships The relationship between firms in the auto parts retail industry and their
suppliers plays a vital role in the success and longevity of companies within the
38 industry. When there are existing relationships between firms and suppliers, new
entrants often find it difficult to gain and maintain a relationship with a supplier within
their industry. Although relationships between firms within an industry are important, in
the highly competitive automotive retail industry, relationships are not as important.
Due to the wide variety of suppliers, if a firm cannot maintain a good relationship with a
supplier due to a previous relationship that supplier has with another firm; the option to
move to a different supplier is always present.
Another reason why relationships are not as important in the auto retail industry
is because the amount of contractual agreements with suppliers is minimal. For the
industry, the only material contractual agreements are to purchase oil for their “do it for
me” segment of service.
Legal Barriers Legal barriers are barriers that have the possibility of hindering prospective firms
of the industry to be profitable. Barriers such as patents and copyrights hinder
profitability in research-intensive industries, while licensing agreements limit entry to
communication and medical service industries (Palepu & Healy). Most barriers that this
industry faces are environmental protection, product quality regulations, building and
zoning requirements, and copyrights for private label products (AutoZone 10-K).
Although companies such as Pep Boys and O’Reilly’s sells private label products in their
retail stores, a firm can still be successful without a private label product of their own.
Despite the fact that regulation barriers could be very costly to a company if not
followed properly, they do not serve as a major barrier to entry as a licensing
agreement or patent would. Due to the low amount of legal barriers, the threat of new
entrants is large, thus creating a highly competitive industry.
Conclusion After evaluating the components of the threat of new entrants, we have
concluded that the threat of new entrants is significantly high. With scale of economies
39 being very low, no first mover advantage, plentiful distribution accesses, no legal
barriers to cross, there is a great threat for new entrants into this industry. These
conclusions are somewhat typical of a high cost leadership industry like the auto retail
parts.
Threat of Substitute Products Substitutes are the alternative products or services produced by another firm
that are not necessarily identical but perform the same functions as the existing
products or services (Papelu & Healy). In the automotive parts retail industry for
example, some of the substitutes the current firms are faced with are that customers
may prefer to buy a new vehicle. An article in the Wall Street Journal posted on June 3rd
of 2010, states that car sales in the U.S. has increased in the month of May for the
seventh straight month. Public transportation is another possible substitute although it
does not necessarily serve the functions of an auto parts and service firm but it serves
the purpose of transporting people from one point to the other. On May 26th 2010, the
Wall Street Journal posted an article in which it said that a proposed $2 billion were to
be allocated in public transportation systems to reduce fares and restore some of the
transportation service systems that were closed earlier this year. Some other risks
encountered in this industry are “the deferment of maintenance service and gas prices
being too high (Pep Boys 10-K).” The fact that gas prices have been somewhat high in
recent years, although not a direct substitute to the auto parts industry, it leads to
consumers reconsideration on whether to use their vehicle or use other means of
transportation. The threat of substitutes relies on the relative price and performance of
similar products and the willingness of customers to switch.
Relative Price and Performance When comparing similar products or services, relative price and performance are
the factors that differentiate one product or service from another. For example, when
you go to the grocery store in search of a product and find that of a recognized brand
40 but next to it, is the generic version of that product, a person is indecisive on whether
to choose the brand product or the generic since they both serve the same purpose.
Because price or performance or sometimes both differentiate similar products,
consumers are then forced to closely weigh these factors in order to come to a
conclusion. In the current economic crisis, it is understandable that consumers are not
as concerned with the performance of the product when presented with comparable
products. It is therefore relative price that has the advantage over performance when
having to choose between similar items.
Costumer’s Willingness to Switch Consumers’ willingness to switch depends on the prices and service quality they
have received with the firm. For example in the automotive parts and service industry,
if a customer is charged with a price that is not reasonable they can opt to not buy the
product and lose loyalty to that firm. The same happens with the quality of service, if a
customer is not treated fairly the likelihood of that customer to return lessens.
Consumers, by default, tend to make the most out of every dollar and since the option
to shop at their desired store is available, their willingness to switch increases. The
availability of competition, therefore, drives customers to accept alternative products or
services.
Conclusion In conclusion, the threat of substitute products is mixed when comparing Pep
Boys with the other companies in the same industry. The substitutions of products like
the usage of public transportation or the option of buying a new vehicle are threats to
consider in the automotive parts and service industry. Customers deferring the
maintenance of their vehicles and high prices are also risks firms face in this industry.
Although AutoZone, Advance Auto Parts, and O’Reilly Auto Parts have better name
recognition, Pep Boys provides customers not only with parts but also with vehicle
maintenance service in mostly all locations to better please customers.
41 Bargaining Power of Costumers The bargaining power of customers is defined by the power customers have over
firms in terms of setting the tone of the industry. In this segment, the suppliers are Pep
Boys and the rest of the industry, and the customers are the consumers of the auto
retail industry. An example to better understand this concept is that where an industry
composed of several firms is dependent on their customers, the firms within that
industry compete to attract the customer to their firm. However, in order to do this they
have to provide customers with products which they can afford, by driving down costs.
This essentially gives the bargaining power to the customer. However, if the
competition were to be limited then the firm would take advantage of their uniqueness
and set a desired but reasonable price and therefore the bargaining power would be
vested upon the firm and not the customers.
Switching Costs Switching costs are costs incurred when changing from one supplier or market to
another. Switching costs can influence customers in their decision on whether or not to
engage with the product at hand or compare prices with competing providers. The
higher the switching costs the less likely the customer is willing to go to a different
store to find the same product for a small reduction in price. In the auto parts retail
industry, the low switching costs, due to the vicinity of the auto parts providers, allows
higher competition between the firms within the industry.
Differentiation Differentiation is defined, as providing a product or service that is distinct in
some important respect valued by the customer (Papelu & Healy). With that being said,
the differentiation in a firm’s product or service is an important factor in creating image
and reputation for the company. Without getting too technical, it is then reasonable to
say that the more unique a product or service the higher the cost to acquire that
42 product or service. Similarly, low differentiation between products or services calls for
higher competition within the industry. This increase in level of competition ultimately
drives prices down. The lower the prices are, the higher the bargaining power
customers have. Moreover, one can conclude that there is an inverse relationship
between level of differentiation and bargaining power to customers.
The auto retail industry is one of high price competition, which is the complete
opposite of diversification. The only diversification qualities that the auto retail industry
instills are the two-part segment of “do it yourself” and “do it for me.” This
incorporates buying auto parts to install yourself or you can have someone install it for
you. There aren’t many auto shop stores have this in-store. Not only do they have the
“do it yourself” and “do it for me,” but the industry also has advertising expenses which
elevates their brand image to a certain extent.
Importance of Product for Costs and Quality The importance of products for costs and quality can be defined as the need or
value costumers have on those products or service in relation to the costs and quality.
Although quality is an important reason for customers to buy a product, it is the price
that primarily catches the attention of customers when in search of their desired
product. It is logical to think that customers will be willing to pay a higher price for a
good that is essential to them. In the auto parts retail industry, parts are essential to
restore the life of their vehicles, which is favorable to the industry. However, alternative
solutions exist like the usage of public transportation as mentioned before or the
postponement of the maintenance. Providers are then forced to maintain low prices to
bring in more costumers in order to prevent them from switching firms on the basis of
price.
Number of Costumers The number of costumers has an impact on the industry, as it is customers that
drive sales for firms. Analyzing the number of sales gives a better idea of the impact
43 customers have in this industry. The following chart shows the change in sales during
the same period of fiscal 2009 in comparison to fiscal 2008.
Company
Percentage Change in Sales
Pep Boys
+6.8
AutoZone
+4.5
O’Reilly
+2.6
Advanced Auto Parts
+5.3
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Although the numbers do not fully reflect the number of customers in the
market, it illustrates better how customers are evenly distributed in the industry,
creating competition between firms. Due to the high competition in the auto parts retail
industry, customers have the bargaining power over firms.
Since the number of customers is directly related to the change in sales and that
the auto retail industry has high competition, the number of customers that each
company brings in is the main objective to create revenue. As you can see, Pep Boys
has increased its revenue which indirectly implies that they are gaining more customers
compared to the rest of the industry.
Volume per Costumer The volume per customer is the contributions a single costumer makes to a firm.
The volume per customer is important to firms because if the customer is loyal and
heavily contributes to the firm, it becomes almost a responsibility to provide that
customer with the best service in order to not lose the contribution and/or loyalty.
Conclusion In conclusion, the bargaining power of customers relies on the switching costs,
the differentiation and the number and volume of customers. If switching costs are not
44 too high, consumers tend to analyze the competitors’ products creating a higher level of
competition and higher bargaining power on customers. Differentiation, on the other
hand, has an inverse relationship with the bargaining power of customers. The lower
the level of differentiation is, the higher the level of competition and the higher the
bargaining power of the customer. And last but not least, the number and volume of
customers is also a factor that determines the bargaining power of customers. The
higher the number of customers, the less the product price is.
Bargaining Power of Suppliers We will now turn our attention to the bargaining power of suppliers. In the
subsequent sections, the buyer will be of the auto parts industry and suppliers are the
ones that the auto parts industry buys their products. Pep Boys buys from about 200
different suppliers with none accumulating more than 20% of its raw materials.
The simplest way to define the factors for the bargaining power of suppliers
would be to take the mirror image of the bargaining power of customers. When there
are only few companies and few substitutes in the market, suppliers are extremely
powerful. In the case of a large amount of companies and substitutes in the market,
suppliers are a lot less powerful. In addition, suppliers can also be powerful when their
product is critical to the success of a business and its products, as well as when there is
a threat of forward integration (Palepu & Healy).
What the overall power of suppliers means to the buyers, is that the suppliers
can negotiate the prices at which they want to sell their products to them. One way to
drive down this price would be to diversify the amount of merchandise bought from
each supplier.
Differentiation Differentiation is an important fact to consider when determining the amount of
bargaining power a supplier has in the industry. If ones product or service is not
differentiated by significant amounts, retailers of that industry will look for their
45 products through a competitor due to the simple factor of price. Since there are many
suppliers in the auto parts retail industry and the differentiation of merchandise is low,
companies have the ease of finding alternative sources of supply. In addition to finding
alternative sources of supply, suppliers are forced to sell their products at reasonable
prices; therefore, minimizing the overall bargaining power of the suppliers.
Since most of the products that Pep Boys and its competitors buy are not
differentiated, there is reason to believe that the buyers have more reason to purchase
the cheaper product. If there is no differentiation involved, then the buyers will seek
out the better “deal” that is available to them. This insinuates that the bargaining
power of buyers is high compared to other industries.
Switching costs Switching costs are another determinant of buyers to move from one competitor
to the other. The lower the switching costs, the more likely it is for buyers in an
industry to partake in price competition. Due to the large number of suppliers, buyers
are always trying to find the fairer price for their products, and if the price in which they
are receiving is not suitable, they can easily transition to competitor suppliers.
Pep Boys states in its 10-K that, “in the past, the Company has not experienced
difficulty in obtaining satisfactory sources of supply and believes that adequate
alternative sources of supply exist, at substantially similar cost, for the types of
merchandise sold in its store.” This shows that the buyer (Pep Boys) has different
options available to them if needed be. The bargaining power of the buyer is therefore
high in this case.
Importance of Product for Cost and Quality The importance of quality and cost of products in the industry is very high. The
growth and sustainability of the businesses in the industry depend highly on the
relationship they have with their suppliers and the willingness of the suppliers to sell
quality products at favorable prices (Advance Auto Parts 10-K). Retailers are always
46 searching for high quality products for their customers to use on their automobiles to
ensure customer safety. With Pep Boys being retail and service industry, their company
is not willing to attach low quality products to their customer’s vehicles. If there is a
lack of quality in products, customers of the auto parts retail industry could be at a
higher risk for defects in their products. High quality products are offered in a wide
variety of name brand products, and as well as private label names (Pep Boys 10-K). In
addition to retailers always searching for high quality products, they are also searching
for lower costs due to the wide variety of suppliers in the industry. The bargaining
power of the supplier diminishes with this factor and the prices of products are often
dictated by the retailer and not the supplier.
With this we have concluded that the bargaining power of buyer’s is somewhat
neutral because of the many suppliers available but the quality of the product is of
essence.
Number and volume of suppliers Since there are a large number of automobile retail suppliers, buyers are known
to buy from as much as 400 suppliers in one year (O’Reilly 10-K). Below is a chart of
Pep Boys and its competitors’ percentage of total purchases from one supplier.
Company
Percentage of Total Purchases
O’Reilly
24%
Pep Boys-Manny, Moe & Jack
18%
AutoZone
10%
Advance Auto Parts
9%
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The chart shows that although O’Reilly depends more on one supplier than the
other companies, no single company is dependent on one supplier. With the never
ending possibility to switch between competitive suppliers, the bargaining power of
suppliers in the auto parts retail industry is minimal.
47 Conclusion Overall, automobile retail suppliers have minimal bargaining power. There are
well over 400 suppliers from which retails can purchase their products; therefore, the
prices are determined by the retailers and not the suppliers. In addition, retailers often
create good relationships with their suppliers, so suppliers are often willing to sell their
products for the price at which the retailers want. Due to the fact that there are many
suppliers, retailers are often searching for good quality products at minimal price. If the
retailer is able to purchase the products for less, they can create a larger net profit and
have greater pricing power over their competitors.
Closing Thoughts on the 5 Forces Model After evaluating the auto parts retail industry using the five forces model, we
have concluded that the industry is a highly competitive. One factor determining the
high level of competition is the lack of differentiation of products within the industry.
Second, the threat of new entrants causes a greater amount of competition among
firms due to the lack of legal barriers set for the industry. In addition, the competitive
firms within the industry cause higher competitiveness because it is easy for customers
to switch among the competitors for substitute products. By customers being able to
switch among substitute products, firms have to rely on price differentiation and lower
costs to gain an advantage in the market.
Key Success Factors for the Industry The profitability of a firm is not only determined by the structure of the industry
but also by the strategies it uses to position itself in the industry (Palepu and Healy). A
firm can gain a sustainable competitive advantage by implementing business strategies
found under cost leadership and differentiation.
Cost leadership focuses on lowering unit cost in order to provide the same
products as its competitors, but at a lower price. This concept is crucial in highly
48 competitive industries. The auto parts retail industry is a cost leadership industry that
focuses on economies of scale, lower input cost, and low cost distribution.
Differentiation is not as focused on lowering unit cost. Firms that implement
differentiation focus on providing a unique product or service through product and
service quality or variety, high investments, and creativity.
These strategies are usually viewed as mutually exclusive, and a firm that
attempts to use both is seen as “stuck in the middle” and is not expected to earn high
profits (Palepu and Healy). However, a firm that entirely ignores the opposing strategy
will strain to gain a competitive advantage in their industry.
(Palepu and Healy 2008)
Cost Leadership Cost leadership is the easiest way for a firm to gain a competitive advantage.
Highly completive industries typically operate using the cost leadership strategy. Cost
leadership is achieved through effectively using economies of scale and scope, efficient
49 production, having a simple product design, lowering input cost, having low cost
distribution, little to no research and development or brand advertising, and maintaining
a tight cost control system (Palepu and Healy). If a firm can effectively implement cost
leadership, it would be able to gain above average profitability by simply charging the
same price as its competitors. Furthermore, firms with an effective cost leadership
strategy can make its competitors lower their prices for the same product and accept
smaller returns or choose to exit the industry (Palepu and Healy). According to Pep
Boys 10-K, the auto parts retail industry is a highly competitive industry.
It would be impossible to gain a competitive advantage in the auto parts retail
industry by strictly focusing on differentiation as a business strategy. The auto parts
retail industry is an industry in which all the competitors offer a variety of the same
products. Therefore, firms must focus on controlling cost and using cost leadership in
order to keep their product price competitive. “The competitive environment in the
automotive parts retail industry may force us to reduce prices below our desired pricing
level” (Advance Auto Parts 10-K). Another quote taken from AutoZone’s 10-K states,
“The sale of automotive parts, accessories and maintenance items is highly competitive
and is based on many factors including price.” We can clearly see that competitors in
this industry recognize the fact that they must keep their prices low in order to compete
with others in their industry.
Economies of scale In order to maintain the tight cost control system, firms in the auto parts retail
industry must effectively use economies of scale to drive down unit cost. Economies of
scale are achieved through expansion in order to drive down variable cost. Expansion
can be reached through new store openings or through mergers and acquisitions.
Expansion through the opening of new stores and acquisitions helps the company
succeed. “The addition of new stores, along with strategic acquisitions, has played a
significant role in our growth and success” (Advance Auto Parts 10-K). In the retail
industry, firms do not create their own product but purchase them from suppliers.
50 Suppliers make deals with companies when they buy products in bulk. The larger a firm
is the more they can buy in bulk and the cheaper these product will be which in turn
drives down variable cost. According to pepboys.com Pep Boys had recently opened
their 500th store in 1998. Not only is this a huge accomplishment, but this 500th store
was opened in Puerto Rico. Since then Pep Boys has 27 different stores in Puerto Rico
and its cumulative store openings are a staggering 562.
Efficient Production When a company operates efficiently, they are able to run at maximum capacity
while at the same time cutting cost. In a cost leadership industry, operating as
efficiently as possible is crucial. Firms in the auto parts retail industry use a variety of
computer systems to help them operate efficiently. These computer systems maintain
and keep track of inventory. The systems help to save time by allowing the employees
to quickly view the amount of inventory on hand and help get the customers the correct
parts needed for their vehicle.
Many of the inventory systems are coordinated with the POS systems, also
known as point of sale systems and SKU, stock keeping unit. Together, these systems
keep track of the amount of products being sold and the amount left in inventory and
can automatically reorder any product that has reached a firm’s inventory on hand
standard low.
Firms are able to gain the maximum profits, save time, and operate efficiently by
using these systems. Operating efficiently helps companies to lower cost. When a
company is able to lower cost they can lower their prices and still maintain the same
profitability. These lower prices give them a competitive advantage and force their
competitors to meet their price and operate as efficiently or accept lower profit margins.
Simpler Product Design Since the auto parts industry is a retail industry, the firms in it do not have say in
the product design. The firms instead use the layout and look of their store to
51 implement this concept. Many firms have a standard layout and design concept of their
stores. This helps to make stocking the shelves and finding products much easier. They
also can use things like signs and banners to help customers more easily find the
products they are looking for. These simple, standardized layouts allow the firm to run
more effectively. If the customers have a better knowledge of what they wish to
purchase, the store runs much smoother than without the standardized layout.
Low Input Cost Much like economies of scale, low input cost can be achieved through firm
growth and purchases in bulk. Low input cost is exactly what cost leadership is about,
minimizing cost while still being able to grow and expand. When a company expands
they take on operating or capital leases as well as the variable cost associated with
stocking the new shelves. If a company can at least maintain the same unit cost after
expansion, then they are keeping the same input cost and growing their company at
the same time.
In the auto retail industry, the companies are price setters as opposed to price
takers with their suppliers. This is typical of high competition industries. Since the auto
retail industries are price setters, the companies will directly drive down the costs of
inputs for their products.
Low­Cost Distribution Reducing variable cost is important for reducing the total cost of providing a
product. Variable cost consists of materials, labor, and overhead. Distribution cost is a
large part of the overhead. Firms strive to expand their company, however, a growing
company also means larger distribution cost.
As mentioned before, the auto retail industry has an advanced target level of instore inventory. This helps the distribution centers run more efficiently which in turn,
cuts the cost of distribution down.
52 Another way to cut the cost of distribution is freight charges. The more
distribution centers, then there will be fewer amounts of freight charges. The average
amount of stores that the industry services is about 73 stores per distribution center.
This seems as if it’s a large number but the majority of auto retail stores are
concentrated in high population areas such as California, New York, and Texas.
Little Research and Development or Brand Advertising Industries using cost leadership will have little to no research and development
nor brand advertising. The auto parts retail industry is just like this. The goal of cost
leadership is to minimize input cost. Firms using cost leadership simply do not have the
extra money needed to invest in research and development or make high investments
in brand advertising. This is due to the fact that firm using cost leadership are trying to
develop large economies of scale and in order to do so they must invest highly in
properties which puts all their money into capital and operating leases. Firms in this
industry rely on their suppliers to do any research and development in order to provide
them with unique or new products.
Differentiation Although the auto parts retail industry is a cost leadership industry, the products
they offer are a commodity and firms must find some way of standing out.
Differentiation can be achieved through superior product quality and variety, superior
customer service, more flexible delivery, and investments in brand image or research
and development. The auto parts retail industry focuses on superior customer service.
Superior Customer Service Offering superior customer service is the only way a company can differentiate
themselves while keeping cost low at the same time. The auto parts retail industry
takes customer service seriously and offers various ways of helping customers.
53 Firms in this industry use a computer system to assist customers in getting the
right parts for their type of vehicle. These systems help the employees determine the
correct part for a vehicle based on make, model, and year without wasting any time
making phone calls or searching through catalogs or the internet. Many of the systems
also give the employee advice to give to the customer on how to properly install the
part they are purchasing. Systems like this increase firm reliability and satisfaction with
the firm because the employee can quickly help the customer and offer advice.
Conclusion In order to be successful in the auto parts retail industry and gain a competitive
advantage, a firm must effectively use cost leadership in order to cut cost and make
themselves stand out from their competitors. When a firm is able to keep a tight cost
control system, they are able to dictate prices, forcing their competitors to lower their
price. If the competitors do not lower their price, they face the possibility of losing
customers or cut cost themselves, in order to maintain the same profit margin. Costs
are cut through economies of scale, lower input cost, and low distribution cost;
effectiveness is achieved through effective production and simple product or store
design; money is not piled into research and development or brand advertising; and
lastly a company distinguishes themselves through superior customer service. The auto
parts retail industry is a highly competitive and cost leadership industry with a small
focus on differentiation.
Firm Competitive Advantage Analysis In order to classify Pep Boys as a cost leadership or differentiated strategy, one
must analyze the corporation to its core. Thus far, we have gathered a sufficient
amount of information to conclude that Pep Boys participates in a highly competitive
industry. “The company encounters competition from nationwide and regional chains
and from local independent merchants” (Pep Boy 10-K). Considering that Pep Boys has
an array of competition from small independent merchants to large corporations like
54 O’Reilly Auto parts, AutoZone, and Advance Auto parts, it is hard to visualize Pep Boys
competing in a highly differentiated industry. In order to compete in a highly
competitive industry, you must therefore take a cost leadership strategy. Similar to
Wal-Mart, Pep Boys brand image positions itself as Pep Boys “Does Everything. For
Less.” (Pep Boys 10-K).
Economies of Scale We will now discuss how each corporation has implemented the strategy of
gaining economies of scale. The easiest and best way to find this evidence is through
tracking the amount of stores each corporation in the auto parts retail industry has
opened throughout a period of time. To do this, we have taken the past five years of
Pep Boys and its competitors store openings and closings, and compared the facts with
each other to value Pep Boys on how well it executes this strategy. Below is a chart that
shows the net opening and closing of stores for Pep Boys, O’Reilly, AutoZone and
Advance Auto Parts.
Net Store Closures and Openings
Company
2005
2006
2007
2008 2009
Pep Boys
0
-31
0
0
25
O'Reilly
221
170
190
113
136
AutoZone
172
179
162
159
137
Advance Auto Parts
158
185
158
90
21
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Since 2005, O’Reilly, AutoZone, and Advance Auto Parts have all slowed in the
number of net new stores being opened and Pep Boys finally began opening new stores
in 2009. In order for Pep Boys to gain more of a competitive advantage it must
continue to grow and reach the numbers that its competitors are capable of achieving.
What this chart does not reflect is any mergers or acquisitions companies may have. In
2008, O’Reilly acquired CSK, Checker’s Auto Parts, which added an additional 1,342
stores, offices, or distribution centers (O’Reilly’s 10-K). This acquisition allowed O’Reilly
55 to gain a competitive advantage over Pep Boys and compete evenly against AutoZone
and Advance Auto Parts.
From the information gathered we conclude that throughout the past five years
O’Reilly Auto parts, AutoZone, and Advance Auto Parts have done a great job in
creating economies of scale, while Pep Boys has lacked in this cost leadership strategy.
On a lighter note, Pep Boys has shown that they have improved this strategy by
creating more stores than ever in 2009. According to Pep Boys’ 10-K “capital
expenditures are expected to be approximately $50,000,000 which includes the addition
of 20 to 40 service only shops and the general improvement of our existing stores.”
This shows that Pep Boys is starting to head in the right direction to eventually improve
their economies of scale.
Efficient Production An efficient production line is one that operates successfully with the least
amount of time and effort used in the process. When accounting for inventory, the auto
parts retail industry as a whole has a great method for this. Each store has a point of
sale (POS) database that targets the minimum amount of inventory for its merchandise
that is needed. There is no labor involved which in turn reduces the cost of goods sold
in an “efficient” manner. As mentioned before, Pep Boys, AutoZone, and Advance Auto
Parts use this to ultimately lower the cost of a good sold.
To show Point of sale, we have gathered information on the turnover ratio. The
turnover ratio is calculated by the cost of goods sold divided by the average of
beginning and ending inventories. Below is a chart of Pep Boys and its competitors
with regards to the turnover ratio.
56 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
It is clear that Pep Boys is underperforming in its inventory handling process
compared to the rest of the industry. AutoZone and Advance Auto Parts are leading
with O’Reilly Auto Parts closely behind.
Simpler product design Due to Pep Boys having a simpler product design, they are able to lower
production costs, and ultimately increase market share. By gaining market share and
having lower costs, an advantage is gained over their competitors. Pep Boys uses a
general store layout that they implement into all of their stores to make it as customer
friendly as possible. A customer friendly store is defined by Pep Boys in their 10-K as
being well lit, well-designed and easily navigated. By doing this, customers who know
specific items they want to buy can walk in to the store and make purchases as quickly.
If products were not laid out and labeled in a customer friendly fashion, retail
associates of Pep Boys would have to help every customer and by doing so could
ultimately damage the quality of service given to each customer.
57 In addition, most products sold in Pep Boys stores are packaged into square or
rectangular boxes that makes them easy to shelf. The firm also incorporates an
electronic inventory system that automatically sends data to distribution centers when
products are low in quantity at retail stores. By doing this, Pep Boys can have smaller
amounts of excess products on hand to minimize clutter within stores.
Low input cost As stated before, low input cost is the process of expanding as a firm, by
minimizing costs through purchasing products in bulk and firm growth at the same
time. The following charts shows that input costs have remained relatively constant
over the past five years, even though companies have expanded. We can determine
this conclusion by looking at total cost of goods sold and the square footage of each
retail store.
Total Cost of Goods Sold
Dollars
Pep Boys
Advance Auto Parts
Autozone
O'Reilly
2005
1,345,144
2,301,799
2,918,334
1,152,815
4,000,000
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
2006
1,377,552
2,472,203
3,009,835
1,276,511
2007
1,305,952
2,585,665
3,105,554
1,401,859
2008
1,129,162
2,743,131
3,254,645
1,948,627
Total COGS
2005
2006
2007
2008
2009
Year
Pep Boys
Advance Auto Parts
Autozone
O'Reilly
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
58 2009
1,084,804
2,768,397
3,400,375
2,520,534
Pep Boys
Advance Auto Parts
Autozone
O'Reilly
Total Square Footage of Stores
2006
2007
2005
12,207,000
12,167,000
12,167,000
20,794,000
22,163,000
23,332,200
23,368,673
24,713,361
26,044,193
9,800,000
11,000,000
12,400,000
2008
11,514,000
23,998,200
27,291,420
23,200,000
2009
11,514,000
24,153,600
28,550,326
24,200,000
Square Footage
Total Square Footage
30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000 ‐
2005
2006
2007
2008
2009
Year
Pep Boys
Advance Auto Parts
Autozone
O'Reilly
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Pep Boys
Advance Auto Parts
Autozone
O'Reilly
Industry Average
2005
0.1102
0.1107
0.1249
0.1176
0.1159
Cost of Good Sold per Square Foot
2006
2007
0.1132
0.1073
0.1115
0.1108
0.1218
0.1192
0.1160
0.1131
0.1157
0.1126
59 2008
0.0981
0.1143
0.1193
0.0840
0.1039
2009
0.0942
0.1146
0.1191
0.1042
0.1080
0.1400 COGS/Sq. Foot
0.1200 COGS/Sqaure Foot
0.1000 0.0800 0.0600 0.0400 0.0200 ‐
2005
2006
2007
2008
2009
Year
Pep Boys
Advance Auto Parts
Autozone
O'Reilly
Industry Average‐
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The above charts and graphs show us, over the last five years, the total cost of
goods sold, the total square footage of retail space of each store, and the cost of goods
sold per square foot. We can see a relation between the first two sets of charts and
graphs. As the firm begins to expand or shrink the cost of goods sold follows. However,
if we look at the last chart and graph, we can see that the cost of goods sold, remained
relatively constant and all are close to the industry average. O’Reilly’s cost of goods sold
per square foot in 2007 appears to have fallen dramatically compared to its
competitors, which was due to the acquisition of Checkers Auto Parts and the addition
of approximately 10,800,000 square feet. This figure is an outlier. Overall the industry
average has slowly decreased showing that firms in the auto parts retail industry are
lowering their unit cost while expanding their business.
Low­Cost Distribution Low-cost distribution consists on the company’s ability to reduce variable costs.
Minimizing the distribution overhead costs incurred by the company is an efficient way
to reduce variable costs. The placement of distribution centers is crucial and much care
should be taken to determine the best location for them, in order to serve existing
60 stores and be strategically placed in order to serve future stores. According to Pep Boys’
10-K, they lease or own 11 distribution centers which serve anywhere from 10 stores to
167 stores. Warehousing costs are also a component under the overhead costs that
could be reduced. Fortunately for Pep Boys, “warehousing cost declined due to lower
out-bound freight costs to stores” (Pep Boys 10-k). The importance of having a lowcost distribution is vital in that lowering variable costs is a potential approach for a
company to maximize profits.
Little Research and Development or Brand Advertising Pep Boys, AutoZone, Advance Auto Parts, and O’Reilly reported no research and
development cost and any advertising cost is hidden in the selling, general, and
administrative expenses. We are led to conclude that no research and development
costs are incurred by Pep Boys, because the focus is set on only selling products and
not actually creating new ones.
It is very important for firms to keep an impression held by consumers to be of
positive nature. In order to hold this concept true, companies invest in brand image.
When companies invest in brand image it is typically not considered a cost leadership
strategy, but of a differentiated strategy instead. The following graph shows the trend
of advertising/marketing expenses of the auto parts retail industry for fiscal years 2007,
2008, and 2009.
61 Advertising/ Marketing Expenses
*in thousands
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
While Pep Boys, AutoZone, and Advance Auto Parts are slowly cutting
advertising/marketing expenses to cut costs, it is clear to see that O’Reilly Auto Parts is
heading in a more differentiated path than its competitors. As for cost leadership, Pep
Boys, AutoZone, and Advance Auto Parts are all neck to neck when cutting recent costs
for advertising/marketing expenses. It is also obvious that cost leadership for brand
image is not a factor in O’Reilly Auto Parts competitive plan while nearly doubling their
expenses.
It is reported in Pep Boys 10-K that they will continue to promote Pep Boys
through television and radio. A new feature that Pep Boys wishes to promote in the
future is “a loyalty program designed to reward these customers who make Pep Boys
their first choice for all of their automotive aftermarket purchases.” The other
competitors don’t have a loyalty program so this will hopefully increase their value
overall.
Conclusion After reviewing the results given thus far, Pep Boys has shown that it has a
competitive advantage in differentiation by having a service aspect to their business
62 strategy. However, the main focus of the industry is cost leadership and after analyzing
the statistics, Pep Boys does not have a competitive advantage in this key success
factor due to economies of scale. Pep Boys has shown little growth over the previous
five years while AutoZone, Advance Auto Parts, and O’Reilly’s have all grown at a
steady pace. Pep Boys does have a better cost of sales ratio per square foot, but this is
irrelevant due to the firm’s small economies of scale. With all other competitors also
trying to get a competitive advantage in cost leadership, Pep Boys has shown minimum
effort in trying to develop a better competitive advantage.
Key Accounting Policies After identifying the key success factors, the next step in evaluating the firm is to
analyze its key accounting policies. According to Palepu and Healy, “the purpose of
accounting analysis is to evaluate the degree to which a firm’s accounting captures its
underlying business reality” (Palepu and Healy). The Securities and Exchange
Commission, SEC, the Financial Accounting Standards Board, FASB, and the Generally
Accepted Accounting Principles, GAAP have helped to set the rules and standards to
which firms must present their financial information. However, much flexibility is given
to the level of disclosure. Firms may choose to supply sufficient information so that
investors are able to fully understand the current condition the company is in, or they
may choose to hold back information to make the company seem better. Firms also
have flexibility in determining the accounting policy that best suits their company.
There are two types of accounting policies, Type One and Type Two. Type One
policies focus on the relationship between the key success factors of the business, and
daily activities of firms within an industry. The key success factors for Pep Boys’ include:
economies of scale, low cost distribution, and low input cost. The amount of disclosure
a firm gives for these items can directly affect the value of a firm, as well as the way
interpretations analysts perceive to be true for the firm. Type Two accounting policies
are factors within financial statements that can be distorted by managers of a firm.
Managers are able to distort information with Type Two policies, because the policies
grant firms flexibility in their reporting formats causing distortion. Within the auto parts
63 retail industry, potential problems from Type Two policies occur from operating leases,
goodwill, and pension plans. Due to the fact that managers are able to minimize
disclosure in Type Two policies to ensure investors stay with their firm, it is crucial that
we analyze these policies to determine whether or not misrepresentation of a firm is
occurring. By analyzing Type One and Type Two policies, a more realistic picture of the
firm can be gained
Type One Key Accounting Policies The type one key accounting policies are directly related to the key success
factors of the firm. Now that we have evaluated the 10-Ks of Pep Boys and its
competition, we can analyze the amount of disclosure given over their key success
factors found under cost leadership. We will look to see if they disclose ample
information on an absolute and relative basis over their economies of scale, low cost
distribution, and low input cost.
Economies of Scale As we have learned, the purpose of cost leadership is to drive down cost through
expansion, this is known as economies of scale. By looking through the financial
statements, we can see if Pep Boys is achieving economies of scale. To do so we can
look at total assets, net property and equipment, and the amount of store closures or
openings. The amount of total assets can give us an indication of the size of the firm.
Larger firms typically have more assets. On January 28, 2006, Pep Boys had $1,821,753
(in thousands) worth of total assets. As of January 30, 2010, Pep Boys total assets had
fallen to $1,499,086 (in thousands), and every year in between total assets fell. A
company effectively implementing economies of scale should have probably seen an
increase in these numbers. To get a better idea, we can look and the amount of net
property and equipment. The total net property and equipment as of January 30, 2010
was $706,450 (in thousands) which is down from $947,389 (in thousands) in early
64 2006. Again, this would lead us to believe that economies of scale are not being used
effectively.
Although Pep Boys total assets and net property and equipment have gone
down, they are expanding their company. From 2008 to 2009, Pep Boys opened 25 new
stores with plans to open 40 in 2010 and 80 in 2011. Since Pep Boys uses operating
leases, there is not sufficient disclosure regarding the actual worth of the properties,
which could under value the company.
Low cost distribution Low cost distribution requires the company to cut variable cost in order to
maximize profitability. These costs include the cost of freight taken on by its distribution
process. As the company grows, so will the costs of distribution, therefore it is
important to cut cost whenever possible. Distribution center location is very important
as to service as many stores as possible, while maintaining fuel efficiency in the
shipment process. Pep Boys has seven distribution centers, serving 47 to 167 stores
and four warehouses, serving 10 to 30 stores. An exact number was not given, but Pep
Boys states that most of the merchandise is distributed from its warehouses and
distribution centers. Pep Boys uses dedicated contract carriers to get products delivered
to its stores. Although Pep Boys provides the amount of warehouses and method of
delivery, it does not provide enough information on the cost of delivery of the exact
amount of products delivered from its warehouses. The level of disclosure for
distribution cost is low.
Low Input Cost Low input cost is another key accounting policy that Pep Boys focuses on.
Lowing input cost is effective in maximizing profit. We can clearly see that Pep Boys has
effectively minimized input cost by looking at its 10-K. If we were to look strictly at the
amount of merchandise and service revenue, it would appear that Pep Boys profitability
has gone down. Since January 2006, total revenues have dropped by $298,036 from
65 $2,208,974 on January 28th, 2006 to $1,910,938 on January 30th, 2010 (dollar amounts
in thousands). However, moving down the income statement allows us to see that Pep
Boys has been able to cut cost and increase profitability despite the decrease in sales.
Pep Boys has decreased both the cost of goods sold and the selling, general, and
administrative expenses. Cost of goods sold decreased from $1,462,356 in January of
2009 to $1,424,831 in January of 2010 (dollar amounts in thousands). This change in
cost of goods sold lead to an increase in gross profit by $20,675 (in thousands) from
2009 to 2010. Selling, general, and administrative expenses have decreased from
$519,600 in January of 2006 to $430,261 in January of 2010. The change was drastic
and lead to a big difference in operating income, going from net losses to a positive net
operating income of $57,059. Pep Boys has done a good job of disclosing information to
show us that they are implementing low input cost accounting policies.
Conclusion Type one accounting policies are tied to the key success factors of the firm and
are crucial to the success of the firm. It is necessary that companies fully disclose
financial information in order for analysts to get a true picture of the firm; however,
with the leeway in GAAP, managers have the ability to dictate the amount of disclosure.
Pep Boys’ level of disclosure is acceptable as compared to the disclosure of their
competitors.
Type Two Accounting Policies Type two accounting policies are those policies that will have an impact during
the restatement of financials. They are also the items on financial statements that have
the most flexibility, and with this flexibility managers are able to influence the final
results of the financials of their company. Managers are able to influence the end
results because they can choose which type of accounting method they want to use,
causing a distortion of ending results. Type two accounting policies include research
and development, goodwill, operating leases, and benefit pension plans.
66 The policies that we will be analyzing in the next section will be goodwill,
operating leases and benefit pension plans, because the 10-K that Pep Boys provides
does not show any other existing type two accounting policies. After analyzing the
policies, we should be able to conclude whether or not the company is misleading its
investors in their financials. If misleading is occurring, the firm should then opt to
restate their financials to reveal a more accurate result.
Goodwill Goodwill is an intangible asset that increases when one firm buys another for
more than the fair value price. It can also be looked at as the extra money paid for the
company being purchased after the assets and liabilities are taken over by the
purchaser. Due to the fact that goodwill is an intangible asset, if its proportion of
tangible to intangible assets is too large, a firm can be overvalued. The amount of
goodwill impairment for a firm each year is determined by managers, and is thus
subjected to distortion. Although goodwill impairment is determined by the managers of
a firm, a general rule is that if goodwill exceeds 10% of total fixed assets, additional
impairment must occur. If a company has a large amount of goodwill, investors should
question the validity to the amount of assets a company has because with a large
amount of goodwill, there is a window for a large amount of distortion. The table below
illustrates the effect the failure of impairing goodwill will have on financial statements of
a firm.
Over Stated
Assets
Liabilities
Equity
Revenue
Expenses
Net Income
Overstated
NONE
Overstated
NONE
Understated
Overstated
Goodwill
By looking at the chart, one can see that if goodwill is overstated, assets, equity,
and net income will be overstated, while expenses are understated and there is no
effect on liabilities and revenues.
67 In 2009, Pep Boys acquired all assets and certain liabilities of Florida Tire, Inc.,
“a privately held automotive service and tire business located in the Orlando Florida
area consisting of 10 service locations” (Pep Boys 10-K). After the purchase was
complete, Pep Boys recorded net assets of $4,354, including goodwill of $2,549 (Pep
Boys 10-K). Since the amount of goodwill that Pep Boys has acquired from Florida Tire,
Inc. is less than 10% of total fixed assets, additional impairment is not necessary.
Operating Leases When using GAAP, companies are given the choice of operating leases or
capitalized leases to record their fixed assets. Often times operating leases are chosen
to record the fixed assets, because the leases offer more flexibility when recording
changes in technology and capacity needs. There is also a tax benefit; however, it is
greater to the lessor than the lessee. In an operating lease, the lessor grants the
authority to the lessee to use the asset and when that time has expired, the lessee
must return the asset.
In the auto parts retail industry, firms prefer to use operating leases over capital
leases in order to minimize the amount of liability recorded on their balance sheets. The
chart below displays the amount of payment and how soon the payment must be made
by each company.
Future Operating Lease Payments (in thousands)
Company
Pep Boys
O’Reilly
AutoZone
Advance Auto
<1 Year
1-3 years
4-5 years
Thereafter
$81,601
$158,165
$141,329
$395,190
$214,087
$377,053
$278,242
$632,140
$177,781
$319,650
$251,149
$809,447
$287,320
$477,947
$373,847
$933,557
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Total
$776,285
$1,501,522
$1,558,027
$1,232,698
Based on the chart, it is clear to see that there is a large amount of liability that
is not being recorded on the balance sheet. According to Pep Boys’ 10-K, the company
does not have capital leases; however, the three other companies have reported capital
leases in their 10-K documents. The choice of lease classification is a vital policy in the
68 illusion to investors of having less accumulated debt. Typically it is less experienced
investors that are naïve to the debt a company has, but if a more accurate calculation
of liabilities is desired, a person must convert the leases into debt equivalent and
calculate the debt, interest and depreciation.
Defined Benefit Pension Plans The importance of a pension plan is to give retired employees a constant cash
flow of money after ending their work with a firm. It is also a way for companies to
attract new employees to the company. When discussing pension plans, companies
typically choose between a benefit plan and a contribution plan. A key difference
between the two plans is that with a benefit plan, the assets of all benefactors are
grouped into one account, but in a contribution plan, each benefactor has their
separate account.
Pep Boys has an unfunded Supplemental Executive Retirement Plan (SERP) that
provides retirement and death benefits to key employees designated by the firm’s
Board of Directors. Originally Pep Boys implemented a defined benefit plan as a sector
of their pension plan, but in 2008, Pep Boys chose to terminate their defined benefit
plan of SERP and only implement a defined contribution plan (Pep Boys 10-K). The
benefit of terminating the benefit plan is that Pep Boys now has a more accurate
forecast of the expenses they will accrue with the contribution plan. The defined benefit
plan is less accurate in determining future payment because it is based on a predicted
discount value that must be calculated through estimation.
The pension plan expense for Pep Boys is determined by using a discount rate of
6.5% and a return on assets of 6.7%. To determine theses rates, the firm “evaluated
input from [their] actuaries” for the return on asset percentage, and based their
percentage of the discount rate on “a model bond portfolio with durations that match
the expected payment pattern of the plans” (Pep Boys’ 10-K). In 2008, Pep Boys
contributed $19,918,000 to their pension plans to fund obligations to retirement and for
the termination of the defined benefit section of SERP (Pep Boys’ 10-K)
69 The amounts of pension plan expense for 2007, 2008, and 2009 are $6,425,000,
$11,925,000, and $7,532,000 respectively. There was a settlement in 2008 for the
amount of $6,005,000, which caused the pension plan expense to be so high for that
year. If the settlement had not occurred, the expense for the year 2008 would have
been $5,920,000, revealing a more normal fluctuation in pension plan expense. In the
next section, there will be visual representation of the pension plan expense so that
persons see more clearly the drastic increase in Pep Boys’ pension plan expense for
2008.
Conclusion Type Two key accounting policies are a major contribution to the accounting
analysis of a firm. It is important that this data is not distorted in any way, in order to
accurately determine the true value of a firm. By identifying the two type key
accounting policies for a firm, it reveals which areas are open to manager manipulation.
The data in these areas should be further evaluated to determine if re calculation is
necessary to reveal true numbers and accurate value of the firm. As shown above,
goodwill, operating leases and defined pension plans were evaluated in the type two
key accounting policies of Pep Boys and are possibilities of distortion in the financials of
the company.
Accounting Flexibility Financial statements are used to convey the business activities of the firm in the
clearest way possible as to be useful to a wide range of people. Under US GAAP
however, flexibility is given to the manager and they are able to manipulate accounting
policies to make the firm appear as they wish. This leads to information that may give a
true picture of the firm or information that may be hiding important information.
Typically, more flexibility allows for a firm to properly show the underlying factors of
their financial because some accounting standards and policies can make the firm
appear less attractive. Areas where there could be concern are goodwill, operating
70 leases, and pension benefit plans. Inspecting the type two accounting policies will allow
us to see the amount of flexibility given to firms in the auto parts retail industry.
Goodwill Goodwill is an intangible that is recorded when one firm buys another for above
market value. The difference between the market value and the price, at which the firm
acquired the other, is the value that is recorded as goodwill. Due to the fact that is not
a physical asset, it is often distorted in financials of a firm. If goodwill is not properly
accounting for and impaired each year, it will reveal higher assets, equity, and net
income for a firm that is not factual.
There is flexibility in the amount of goodwill that has to be impaired each year,
because the amount to be impaired is determined at the value managers give to the fair
value of goodwill. Although the managers decide the fair value of goodwill for the year
and determine amount of impairment, creating a large amount of flexibility, a rule is
that if goodwill exceeds 10% of fixed assets, it must be impaired.
Operating Leases There is a great amount of accounting flexibility when recording fixed assets,
because managers have the choice of choosing between operating and capital leases to
record their assets. As stated before, operating leases are more beneficial to firms
because it allows the company to exclude their fixed assets from their financial
statements. Rather than fixed assets being recorded as an asset and liability, it is
recorded as an expense. By doing this, a company appears to be more creditworthy to
investors. Due to the amount of flexibility given through leases, the US accounting
standards board has set forth a criteria that determines whether or not a lease must be
recorded as a capital or operating lease.
71 Criteria for Capital Leases
1. The lease transfers ownership of the property to the lessee by the end of the term.
2. The lease contains a bargain purchase option.
3. The lease exceeds 75% of the life of the asset.
4. The present value of the lease term exceeds 90% of the fair market value.
When one of the four statements above is met, a lease must be recorded as a
capital lease. Despite the fact that the accounting board has established criteria for
accounting for their fixed asset as an asset on the balance sheet, no regulations are set
for recording the asset as a liability. Managers have also learned ways to disguise
values to ensure that their company does not meet the criteria. Managers are intrigued
to ensure they can report assets as operational leases because at times it can secure
job security and other benefits enacted by the company. Although regulations are set
by the accounting board, there is still a great amount of accounting flexibility in
operating leases.
Benefit Pension Plan Benefit pension plans play a vital role in attracting new employees to a company,
and are designed to help retired employees maintain income after ending their work at
the company. As stated before, the type main types of pension plans are a defined
benefit plan, and a defined contribution plan. The pension plan that Pep Boys’
implements is a defined contribution plan, that allocates money into a separate account
for qualifying employees. Qualifying employees to the benefit contribution plan are
employees named by the firm’s Board of Directors.
The benefit pension plans are listed as a liability for a firm. It is a liability that
takes the present of all future cash flows to retired employees; therefore, needing a
discount rate. The discount rate that is used in the determination of the present value
of the cash flows is determined by the managers of a firm. It is of high importance that
72 the manager of a firm chose wisely when estimating a discount rate, because it is used
to determine the pension liabilities stated and affects the firm’s performance. According
to Pep Boys’ 10-K of 2010, the firm is using a 6.10% discount rate, which is a decrease
of the previous rate of 7.00%. “The Company selected the discount rate [that would]
reflect a rate commensurate with a model bond portfolio with durations that match the
expected payment patterns of the plans” (Pep Boys’ 10-K). Since managers are given accounting flexibility when determining a discount rate
for the pension plans, bias can arise and deception to investors can occur. By setting a
discount rate too low, an understatement of liabilities will occur, resulting in the
overstatement of net income. Also, if a firm chooses to only release the minimum
amount of financial documents required by the Financial Accounting Standards Board,
quality information for a firm will be hard to determine. By minimizing the amount of
financial documents released to the public, investors will have no way of determining
the true amount of liabilities a firm has.
Conclusion The level of flexibility a firm is given can lead to distortions in their accounting
numbers. Flexibility can tempt the manager to use aggressive accounting strategies in
order to increase profits. In addition, they can use accounting strategies to keep
liabilities off the books or decrease these liabilities in order to distort the performance of
the company to appear stronger than reality. When levels of distortion meet a standard
criteria restatement of the financials will be needed. Restatements of the financials help
to give investors a true picture of the firm compared to the information given in the
original financial statements.
Evaluate Accounting Strategy Because managers have intimate knowledge of their firms’ businesses, they are
entrusted with the primary task of making the appropriate judgments in portraying
myriad business transactions (Palepu & Healy). However, since managers have the
73 opportunity of receiving incentives to exercise their accounting discretion, it is likely that
they report untrue information. Bonuses for reaching a target profit level are an
example that can lead managers to overstate the financials of the firm. The possibility
of managers not disclosing complete information for the sake of the firm is also likely,
for example, not showing certain information that impedes analysts from capturing the
poor performance of the firm.
Two of the accounting strategies firms can use to report the financial status of
the firm are, the aggressive approach and the conservative approach. The aggressive
approach is the strategy used to overstate the financials of the firm by incorrectly
recognizing revenue to please investors (financialdictionary.com). The conservative
approach, on the other hand, understates net income, assets and equity and overstates
liabilities. Conservative accounting can be as misleading as aggressive accounting when
trying to report in an unbiased manner (Palepu & Healy).
Operating Leases As previously mentioned when using GAAP, companies are given the choice of
operating leases or capitalized leases to record their fixed assets. Pep Boys use the
aggressive approach in their operating leases and list insignificant amounts of capital
leases. Although this approach affects the financials of the company, other competitors
also utilize the aggressive approach. The following table illustrates the companies’ use
of the aggressive approach.
Future Operating and Capital Lease Payments
Pep Boys
AutoZone
O’Reilly
Advance
$165,654
$54,764
$10,455
N/A
$776,285
$1,558,027
$1,501,522
$1,232,698
Capital
Leases
Operating
Leases
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
74 By looking at the table above, companies in this industry lean more towards
operating leases rather than the capital leases, as reflected by the numbers. Advance
Auto Parts did not provide information about their capital leases.
Defined Benefit Pension Plan The defined benefit pension plans are compensations given to retired employees
as a form of appreciation for all their years of work with that company. Pep Boys as well
as AutoZone, Advance Auto Parts and O’Reilly Auto Parts provide important information
regarding their benefit pension plans in their 10-K’s. However since the number defined
as benefit pension plans is an estimation of future payments made to retired
employees, one can assume that numbers may hide relevant information.
After reviewing Pep Boys’ 10-K it is clear to see that the firm has a low level of
disclosure. The firm does not disclose any scenarios about the benefit pension plan;
therefore, this enables us from valuing the post retirement liabilities Pep Boys has
accrued. Although in the 10-Ks provided by Pep Boys, there is an amount of pension
expense per year stated in their financials, it is hard for investors to accurately
determine future amount of liabilities for the company. There is reason for concern of
investors due to the lack of quality of information and the amount of disclosure given by
Pep Boys.
Goodwill Goodwill is an intangible asset that is recognized as the difference between the
costs of a acquiring another firm and the actual value of the firm acquired. The amount
of goodwill for Pep Boys is minimal, as they have only acquired one company in the
past five years. When analyzing Pep Boys 10-K, the numbers show that goodwill is only
$2,549,000. The following table provides the goodwill to property, plant and equipment
ratio of Pep Boys along with AutoZone, O’Reilly Auto Parts and Advance Auto Parts.
75 Pep Boys
2009 Goodwill to PPE
O'Reilly Auto
AutoZone
Parts
0.0016
0.4311
Advance Auto Parts
0.1285
0.0423
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
As shown in the table above, the goodwill for Pep Boys not as material as it was
for competitors. O’Reilly’s goodwill was the highest of all; meaning that they made more
acquisitions than the others.
Conclusion After analyzing Pep Boys in depth, it can be concluded that the company uses
the aggressive accounting strategy approach to report their financials. The best proof of
this is found in the manner in which they report their operating leases and how they
moderately report capital leases. Goodwill is not a great part of Pep Boys’ financials as it
only represents $2,549,000 of $1,593,125,000 in property, plant and equipment. As for
benefit pension plans, numbers show the present value of future payments made to
retired employees.
Quality of Disclosure When analyzing financial statements of a firm, the quality of disclosure and
transparency of a company is very important. The transparency of a company is
determined by the quality information the firm chooses to disclose. Under Generally
Accepted Accounting Principles (GAAP) firms are only required to disclosure minimum
amounts of information resulting in the lack of ease at which one has to assess the true
value of a firm. It is the managers’ decision as to whether or not they choose to
disclose the true value of their firm by releasing important information, or they can
choose to make it difficult to value by withholding information.
Conservative accounting is very helpful when determining the true value of a
firm because firms using the conservative approach disclosure quality information, while
76 firms using an aggressive approach do not. When trying to assess the value of a firm
using an aggressive accounting measure, it is often difficult to get a true picture of the
firm because they fail to disclose quality information needed for a true valuation. Pep
Boys in some areas provides quality information; however, in certain areas the firm fails
to disclose sufficient information. When a firm discloses insufficient information in
financial reporting, further analysis may need to take place to determine a true value of
the company.
Qualitative Analysis Quality of disclosure is an important indicator of the performance of a firm. As
long as managers are meeting minimum requirements of GAAP, they are allowed to
disclose as much information on their financial statements as they want. Although a
high level of disclosure is beneficial to investors, too much information is not as
beneficial. Companies often disclosure important information in their financials, but they
can also include useless information to try to hide the defects the firm has. It is
important to interpret the accounting policies of the firm, in addition to determining
whether or not the information presented in the footnotes of the financial documents is
useful and relevant.
Economies of Scale In order for Pep Boys to lead the competition in the auto parts retail industry,
establishing an economies of scale is essential. As stated before, economies of scale is
the idea of cutting costs by increasing purchase in order to receive cheaper rates. In
order to determine if a firm is utilizing its economies of scale efficiently, we can look at
items such as properly, plant and equipment in Pep Boys’ financials. In addition to Pep
Boys disclosing the amount of PPE for the firm for the current year and previous years,
they also disclose how the numbers are calculated. Despite this information being
disclosed, Pep Boys does not disclose its plans for expansion to make their economies
of scale more efficient; therefore, the level of disclose for economies of scale is low.
77 Low Input Costs Low input costs are a Type One accounting policy that needs to be disclosed
properly on a firm’s financials. Low input costs are important to a firm because it lets
shareholders know where the firm stands financially and in what direction the firm is
heading. Pep Boys is not very effective in disclosing their low input costs. The only
information that we have been able to gather from their 10-K is the cost of their raw
materials. Although GAAP does not require that a company disclose low input costs, it is
not wise for a firm to not disclose the information. By Pep Boys choosing to not disclose
low input costs, it seems as if they are hiding information from stockholders and
preventing them from being better informed about the firm.
Operating Leases The operating lease disclosure for Pep Boys is moderately low. Although they
give us a table stating the amount of operating leases that were accumulated for the
year, they do not present us with a rate at which to capitalize these lease. Instead we
had to use the rate that was used in the firm’s pension plan to capitalize. Pep Boys also
discussing contractual agreements; however the information is lacking detail. Typically
the more information stated in a firm’s 10-K about their operating leases, the better it
gives in regard to giving a firm a true value.
Benefit Pension Plan Pep Boys discloses a moderate amount of information regarding their pension
plan. After reviewing Pep Boys’ 10-K we have noticed that the discount rate at which
their pension plan is based on, in addition to how the rate was determined. The firm
also discloses information on previous pension plans that they incorporated and
reasoning behind the decision to not utilize those specific pension plans. In addition,
Pep Boys also gives information in order for the public to better understand the pension
plans. Although the firm gives information and qualifications to enroll in the pension
78 plans, the only qualifications Pep Boys states in their 10-K is that persons eligible for
the pension plan are deemed eligible by the Board of Directors of the firm. As a result
we have concluded that the disclosure of the pension plan implemented by Pep Boys is
at a moderate level.
Conclusion After analyzing the amount of disclosure in various categories of Pep Boys, we
have concluded that as a whole the level of disclosure Pep Boys has is low. The firm
does not disclosure an efficient amount of information about key aspects in their firm,
preventing stockholders to grasp the true financial position of the firm. It also seems
that after analyzing the 10-K of Pep Boys that they are only willing to disclose minimal
information as mandated by GAAP.
Quantitative Analysis The purpose of a quantitative analysis of a firm is to determine potential red
flags in areas where accounting distortions have been caused by managers. The two
types of diagnostics that will be done on Pep Boys are the sales manipulation
diagnostics and expense diagnostics. The ratios contained in the sales manipulation
diagnostics compare net sales with cash from sales, accounts receivable, unearned
revenues, warranty liabilities and inventory. The results from his diagnostic can show a
red flag for overstating revenue or can signal a “big bath.” The ratios contained in the
expense diagnostics are the asset turnover, CFFO/ OI, and CFFO/NOA. The results from
these diagnostics can show a red flag for understating expenses. By computing the
different financial ratios of Pep Boys and the auto parts retail industry, one can gain a
better picture of the industry trend, as well as identify accounting distortions that
impact Pep Boys financial statements.
79 Sales Manipulation Diagnostics When reviewing the financial statements of a firm, manager manipulation is a
large concern due to the fact that it can dramatically change the firm’s financial position
within an industry. The reasoning behind manager manipulations is because they are
often compensated based on their firm’s profit. Compensation they receive can be with
bonuses or more often stock options. The stocks increase in value when profits of the
firm increase; therefore, managers have a higher incentive to manipulate financials to
show a greater firm value.
The sales ratios that will be include in his sales manipulation diagnostics include:
net sales/cash from sales, net sales/accounts receivable, and net sales/inventory. All of
the stated equations will be presented in raw form and changed form. By using the
financial statements of Pep Boys and its competitors within the industry, we will be able
to determine trends within the industry. Drastic outliers or the trend differences of Pep
Boys and the industry could determine sales manipulation in the financials of the firm.
When analyzing the ratios in the raw form, it is important to pay close attention
to the size of change from one year to the next compared to the industry, as these
ratios are based on individual years. If the change is drastically smaller or larger than
the rest of the industry, this can draw a red flag and raise question as to whether or not
distortion has occurred in the firm’s net income. The important factor when analyzing
change form ratios is whether or not the ratio is negative or positive. If the ratio for a
firm is positive, this supports the increases and decrease relative to the industry. If the
ratio were to be negative, this raises concern about possible distortion between
increases and decrease in sales and the change in cash from sales, accounts receivable
or inventory. If three or more of Pep Boys’ ratios are outliers compared to the industry
or have a negative sign, this is a huge red flag that the potential for Pep Boys’ financial
statements are high.
80 Net Sales/Cash from Sales The Net Sales/Cash from Sales ratio is important when analyzing the relationship
between cash flow from sales and the actual sales amount. It is also used to determine
whether or not the sales that are being recorded by a firm are backed up by cash that it
should be receiving from those recorded sales. Generally, a favorable net sales/ cash
from sales ratio will be extremely close to one. If a ratio for a firm were drastically
larger than one, this is reason to draw a red flag because this indicates an
overstatement of sales that cannot be backed with cash from those sales. On the other
a ratio drastically lower than one is also another reason to draw a red flag, because it
demonstrates that the firm is unable to collect cash generated by their sales. The two
graphs below illustrate the net sales/ cash from sales ratio of Pep Boys and its
competitors.
2005 2006 2007 2008 2009 O'Reilly Advance Pep Boys AutoZone Auto Parts Auto Parts 1.000 0.994 0.991 1.002 0.998 0.997 1.006 0.999 1.003 0.999 1.003 1.002 1.000 0.978 0.998 0.998 1.000 0.999 0.992 1.001 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
81 Industry Average 0.997 1.000 1.002 0.993 0.998 By viewing the graph and table from above, one can see that Pep Boys along
with its competitors in the auto parts retail industry have had favorable net sales/cash
from sales ratios over the past five years. The industry average ranges from .993 to
1.002 while Pep Boys’ ratio ranges from .998-1.00. Although all of the firms within the
industry have had favorable ratios, Pep Boys’ ratio has been the most favorable with
ratios equaling 1.00 three out of the five years. Overall there is no reason for concern
about manipulation with respect net sales/cash from sales ratio within the auto parts
retail industry.
2005 2006 2007 2008 2009 Pep Boys O'Reilly Auto AutoZone Advance Industry Avg.
Parts Auto Parts 0.07 11.48 0.74 1.05 3.34 1.15 1.02 1.58 0.97 1.18 1.50 1.02 0.93 1.07 1.13 1.05 0.93 0.92 0.92 0.96 1.00 1.06 0.87 1.07 1.00 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The change form of net sales/ cash from sales ratio is informative in relation to
positive and negative ratios. Consistent positivity occurs in an ideal firm, meaning that
82 when increase in total sales occurs, increase in cash collections follow. In the change
form, the ratios for Pep Boys have ranged from .067 to 1.49. These results do not
cause reason for concern within the industry standards. There are no firms within the
industry that have a negative ratio, causing red flags for accounting distortions;
however, for the year 2005, O’Reilly had a very large ratio. The reasoning behind this
result could be a caused by an overstatement of sales.
Net Sales/Net Accounts Receivable The ratio of net sales/net accounts receivable is used to determine if a firm is
collecting the cash on revenues they have accumulated over the current year. The
greater the ratio of net sales/net accounts receivable, the better it is for a firm. The
greater ratio shows that a firm is capable of collecting the cash for their revenues. This
ability will allow the firm to reinvest the cash into the company and create a potential
for firm growth. The graphs below illustrate the raw and change form ratio of net
sales/net accounts receivable.
83 2005 2006 2007 2008 2009 Pep Boys 73.35 61.35 76.81 72.60 66.87 (Pep Boys,
O'Reilly Auto AutoZone Advance Parts Auto 27.70 48.40 45.05 28.17 74.02 47.58 29.94 103.06 57.00 21.55 91.56 52.90 28.35 53.68 58.48 O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average 48.62 52.78 66.70 59.65 51.84 As one can see by viewing the graph and table above, Pep Boys has had a
steady change in net sales/accounts receivables over the past five years. The firm has
been above the industry average and has demonstrated that they have no inability to
collect cash for their revenues. O’Reilly Auto Parts however has been an outlier and well
below the industry average. This demonstrates an inability by O’Reilly’s to collect cash
on their revenues, thus creating a larger accounts receivable account. Another firm that
causes concern by this ratio is AutoZone. In 2007, they begin to have a large decrease
in accounts receivable compared to an increase in sales. Pep Boys’ ratio does not signal
distortion since they have followed industry trend
84 2005 2006 2007 2008 2009 Pep Boys O'Reilly Auto AutoZone Advance Parts Auto Parts 323.26 25.08 1.49 ‐67.62 ‐6.99 33.06 ‐6.30 149.15 ‐5.40 74.69 ‐10.83 ‐18.82 1030.77 12.90 31.05 24.39 338.71 254.05 5.27 ‐58.41 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average 70.55 42.23 9.91 274.78 134.91 As stated before, the change form is used to determine whether or not the firm’s
ratio is changing positively or negatively compared with respect to net sales. Although
O’Reilly was the outlier on the raw ratios, it is the only firm that does not draw a red
flag for distortion in the changed form. The three other firms in the industry have
negative ratios, most of which occur in different years. This clearly shows that Pep Boys
and many of its competitors draw a red flag causing reason to believe that accounting
manipulation has occurred.
Net Sales/Inventory The net sales/inventory ratio is important because it shows if a firm is keeping
large amounts of unused inventory. The greater the ratio results are, the more
favorable it is for a firm, because it demonstrates that a firm is selling more than it is
keeping in unused inventory. In addition, the ratio should be positive, because we use
the logic that as sales increase, inventory restock should increase because a firm must
re stock the amount of inventory sold. Below are the raw and changed form of the net
sales/inventory ratio of Pep Boys and its competitors in the auto retail industry.
85 Raw Form: Net Sales/Inventory
2005 2006 2007 2008 2009 Pep Boys 3.77 3.63 3.74 3.81 3.41 (Pep Boys,
O'Reilly Auto AutoZone Advance Parts Auto Parts 2.82 3.43 3.12 2.81 3.22 3.16 2.86 3.07 3.17 2.28 3.03 3.17 2.53 3.09 3.32 O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average 3.29 3.21 3.21 3.07 3.09 By viewing the graph above, one can see that the entire industry has had
favorable ratios, with Pep Boys being the most favorable of all. The results of the ratio
indicate that the industry is being sufficient in restocking their inventory after sales
have occurred. By Pep Boys being atop the competition, this demonstrates that the firm
is operating with low levels of inventory and selling at a higher rate than other firms
within the industry. Although Pep Boys is leading the industry in net sales/inventory,
there is no reason to draw concern since the separation between Pep Boys and its
competitors is minimal.
86 \
2005 2006 2007 2008 2009 O'Reilly Advance Pep Boys Auto Parts AutoZone Auto Parts 2.84 3.21 0.72 2.98 ‐2.92 2.74 1.30 3.67 ‐4.11 3.46 1.39 3.44 2.91 1.53 2.47 3.17 ‐52.5 3.70 5.16 30.11 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average 2.44 1.19 1.04 2.52 ‐3.38 By viewing the change ratio data, it is clear to see that there is a major red flag
that should be drawn in regards to Pep Boys. Pep Boys is the only firm within the
industry that has negative ratios, some of which are in back to back years. As for the
rest of the industry, there is no reason for concern as they are all performing around
the same amount.
Conclusion Overall Pep Boys has multiple red flags concerning their net sales and the ratios
used to determine manager manipulation. The area that shows the greatest concern is
in regards to inventory. In the change form there were three negative signs, two of
which were in back to back years. This causes reason to believe that there is a
distortion and overstatement of revenues by the firm. With the information we have
87 collected, we can conclude that the quality of disclosure presented by Pep Boys is
unacceptable and reason for the concern of accounting policies within the firm.
Expense diagnostic Analysis While the sales diagnostic analysis is concerned with a company manipulated net
sales of a firm, the expense diagnostic analysis will show the potential for expenses of a
firm being over or understated. Managers have the desire to understate expenses,
because it results in a greater net income in the same way the overstatement of net
sales. In the next few sections we will analyze different ratios to determine whether or
not Pep Boys and/ or its competitors have distorted their information. The ratios used in
the expense diagnostic analysis include: asset turnover, CFFO/OI, CFFO/NOA, total
accruals/ change in sales, pension expense/SG&A, and other employment
expenses/SG&A. In the same way the sales diagnostic ratios were presented in the raw
and changed form, the expense diagnostic ratios will also be presented in both forms
for Pep Boys and the auto parts retail industry. Also in comparison to the sales
diagnostic analysis, the important factor in the raw ratios is the year to year change,
while in the change form, the important factor is the sign change.
Asset Turnover The importance of the asset turnover is that it determines whether or not a firm
is utilizing their assets efficiently to generate sales. It also determines if a firm is
properly or improperly depreciating their assets. An unusually low asset turnover ratio
indicates that a firm is not properly impairing their assets or not sufficiently depreciating
their assets.
88 2005 2006 2007 2008 2009 O’Reilly Advance Pep Boys Auto Parts AutoZone Auto Parts 1.23 1.43 1.46 1.94 1.20 1.33 1.40 1.82 1.25 1.28 1.36 1.81 1.21 1.57 1.36 1.83 1.22 1.16 1.30 1.83 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average 1.51 1.44 1.42 1.49 1.37 By viewing the data from above, it is clear to see that the industry as a whole
has been performing at about the same rate. The industry average for asset turnover
ranges from 1.37 to 1.51, while Pep Boys has been slightly below average ranging from
1.20-1.25 over the five year period. Although the firm has been performing slightly
below average, the change in year to year ratios is minimal causing no concern for
accounting distortions.
89 2005 2006 2007 2008 2009 O’Reilly Advance Pep Boys Auto Parts AutoZone Auto Parts 3.39 1.33 0.32 4.09 ‐1.46 0.84 0.71 1.04 ‐0.82 0.91 0.79 1.61 2.44 3.48 1.27 2.42 1.15 0.66 0.65 1.72 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average 2.28 0.28 0.62 2.40 1.04 By viewing the graph and data above, one can see that Pep Boys asset turnover
ratio in the change form is reason to believe manipulation is occurring. In 2006 and
2007, the firm had negative ratios while the other firms within the industry had positive
ratios for all of the previous five years.
Cash Flow from Operations/Operating Income The importance of the CFFO/OI ratio is that it links the statement of cash flows
and the income statement together enabling the ratio to be used to observe the firm’s
cash management strategies. The ratio is also used to determine how much income the
firm is generating in comparison to the amount of money that is collected in the current
90 year. Since the operating income is affected by the expenses that are acquired by a
firm yearly, this ratio is a good determinant of how well a company is accounting for
their expenses and net income from for each year.
2005 2006 2007 2008 2009 O'Reilly Advanced Pep Boys AutoZone Auto Parts Auto Parts .58 .84 .66 .80 3.43 .66 .81 .83 4.46 .98 .80 .99 ‐1.64 .89 .82 1.15 .02 .53 .79 1.54 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average .72 1.43 1.81 .31 .72 As one can see by viewing the graph, all firms within the industry with the
exception of Pep Boys have had favorable ratios. Pep Boys has had a very volatile ratio
over the five year period, while the rest of the industry is performing around the same
rate. The extreme volatility by Pep Boys from year to year is reason to raise concern
about the accounting policies of the firm.
91 2005 2006 2007 2008 2009 O'Reilly Auto Advanced Pep Boys Parts AutoZone Auto Parts ‐1.86 ‐0.22 ‐0.43 0.77 0.95 ‐0.93 5.15 ‐1.8 4.10 4.87 0.49 5.92 0.75 0.03 1.10 ‐6.8 0.05 ‐0.07 0.058 5.67 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average ‐0.44 0.84 3.85 ‐1.23 1.43 By viewing the change form ratios for the auto parts retail industry, one can wee
that there is reason to raise concern for manipulation with respects to O’Reilly Auto
Parts and Advance. O’Reilly has had three negative ratios within the five year period,
while Advance had had two. Although Advance has had two negative ratios, greater
concern is with O’Reilly due to the fact that their ratios are in back to back years. Pep
Boys has performing around the industry average with one year having a negative ratio.
Although there was one year of a negative ratio, this is no reason for concern since the
firm recovered in the next year and has failed to dip below zero since.
Cash Flow from Operations/ Net Operating Assets The CFFO/NOA ratio is important because it demonstrates the capability of a firm
to generate cash flow from with its operating assets. With the ratio we will also be able
to see the effects on a firm from depreciating their assets properly and improperly. A
much smaller ratio than normal will be the result of improper depreciation by a firm.
92 Reason for concern in regards to this ratio would be if the ratio is fairly volatile over
time.
O'Reilly Advanced Industry Pep Boys Auto Parts AutoZone Auto Parts Average 2005 0.58 0.30
0.33
0.36 0.39
2006 3.43 0.21
0.40
0.34 1.10
2007 4.46 0.27
0.39
0.39 1.38
2008 ‐1.64 0.21
0.40
0.45 ‐0.15
2009 0.02 0.17
0.39
0.64 0.30
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
By viewing the data above, we can see that Pep Boys is the only firm within the
industry that has an extremely volatile ratio. Pep Boys’ competitors have remained fairly
consistent over the five year period and raise no concern for manipulation. Although in
three years the CFFO/NOA for Pep Boys is much greater than the ratio for its
competitors, the volatility is reason to be concerned.
93 2005 2006 2007 2008 2009 O'Reilly Advanced Pep Boys Auto Parts AutoZone Auto Parts 2.64 ‐0.09 0.07 0.54 ‐41.0 ‐0.16 1.55 0.09 ‐3.19 0.54 0.17 1.45 0.32 0.003 0.68 2.96 2.25 ‐0.05 0.05 7.62 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Industry Average 0.79 ‐9.89 ‐0.26 0.99 2.47 When analyzing the change form for the CFFO/NOA ratio, the important factor in
the result is the sign of the number. Although AutoZone and Advance Auto have
positive ratios for the past five years, Pep Boys and O’Reilly Auto Parts have multiple
years, some at which are back to back negative ratios. The negative ratios suggest that
the two firm’s assets are increase while their cash flow from operating expense is
decreasing (a negative correlation). From this analysis is it reasonable to believe that
distortion has occurred in Pep Boys and O’Reilly’s accounting procedures.
Total Accruals/Change in Sales The total accruals to change in sales ratio is important because it determines if
the amount of accruals are supported by the stated sales. The calculation for this
94 equation is computed by subtracting net income from CFFO and then dividing that
number by the percentage change in sales. If the ratio reveals an unexplained
decrease, this means expenses are understated while an unexplained increase means
that expenses are overstated. The result from overstated expenses would be an
understated net income. By calculating this ratio for the past five years, we can
conclude if the expenses have been distorted. Below is a graph illustrating the total
accruals/change in sales ratio in its raw for, of Pep Boys and its competitors over the
past five years.
2005
2006
2007
2008
Advance
-0.02
-0.022
-0.036
-0.047
O'Reilly
-0.021
-0.003
-0.042
-0.031
AutoZone
-0.014
-0.043
-0.04
-0.043
Pep Boys
-0.12
0.0004
-0.57
0.0052
-0.04375
-0.0169
-0.172
-0.02895
Industry Average
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
95 2009
-0.079
0.005
-0.039
-0.041
-0.0385
If one were to look at the graph above, it is clear to see that Pep Boys’ ratio is a
clear outlier. As the rest of the industry is performing around the same pace, Pep Boys
has two extremely low ratios. All of the firms within the industry have very minimal
accruals to change in sales ratios and this indicates that they are overstating their
expenses, resulting in a decreased net income.
Like many over the other expense manipulation diagnostic ratios, the total
accruals to change in sales ratio must also be calculated in change form. The change
form ratio is listed below.
The change form ratio is important because it can determine whether or not the
change in accruals is supported by the change in sales. As long as the change in
accruals and change in sales have a positive relationship with one another, the ratio will
be positive. If a negative ratio is calculated with this ratio, a red flag must be drawn for
the firm. The graph below illustrates the change form ratio for Pep Boys and its
competitors within the industry.
96 2005
2006
2007
2008
-0.022
-0.061
-0.307
-0.230
0.137
0.145
-0.408
-0.007
0.043
-0.085
0.018
-0.743
-0.052
-2.641
4.068
0.638
0.027
-0.660
0.843
-0.085
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Advance
O'Reilly
AutoZone
Pep Boys
Industry Average
2009
-0.698
0.106
-0.066
0.407
-0.063
As one can see by viewing the data above, it is clear to see that a red flag should
be drawn for all firms within the auto parts retail industry. This is a result of the
consistent negative ratios calculated with the financials of each firm. Similarly to the
raw form data, Pep Boys is still an obvious outlier for the results. Since all of the firms
have negative ratios this demonstrates that total accruals and the change in sales do
not have a positive relationship.
Pension Expense/SG&A The importance of the pension expense to selling general and administrative
expense ratio is that it is used to determine the amount of pension that contribution to
all SG&A expenses. A lower ratio is more favorable to a company because it shows that
97 the firm is not spending a lot of money on their retired employees. Like other expenses,
the higher percentage that pension adds to total SG&A expense the less net income will
be. Below is as graph illustrating the pension expense/SG&A ratio for Pep Boys and its
competitors.
Advance
O'Reilly
AutoZone
Pep Boys
Industry Average
2005
0.004
0
0.015
0.008
2006
0.002
0
0.005
0.008
2007
0.002
0
0.001
0.014
2008
0.002
0
0.001
0.025
2009
0.001
0
0.012
0.015
0.009
0.005
0.006
0.009
0.009
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
As one can see by looking at the data above, the auto parts retail industry
overall had very low ratios. This indicates that the firm’s pension expense do not
accumulate for a lot of their SG&A expenses. Unfortunately O’Reilly Auto Parts did not
disclosure information about their pension expense; therefore, a ratio could not be
98 computed. Based on the graph, Pep Boys pension expense to SG&A expense ratio does
not raise a red flag for distortion.
Below is the graph illustrating the results of the pension expense to SG&A ratio
of Pep Boys and its competitors in the change form.
Pension Expense/ SG&A (change)
Advance
O'Reilly
AutoZone
Pep Boys
Industry
Average
2005
-0.002
N/A
0.035
-0.011
0.007
2006
-0.012
N/A
-0.158
0.014
-0.052
2007
-0.007
N/A
-0.085
0.128
0.012
2008
-0.001
N/A
-0.006
-0.066
-0.024
2009
-0.003
N/A
0.256
0.100
0.118
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
By looking at the data provided from the change form pension expense to SG&A
ratio, further knowledge of possible distortion is given. For every firm, except O’Reilly, a
99 negative ratio is calculated in at least two years. Although it seems that Pep Boys is
staying consistent with the industry, a full analysis cannot be provided about the
industry, due to the lack of information from all firms. Despite the fact that a full
analysis cannot be provided, there is no reason to raise concern for Pep Boys, as they
are staying with the trend of the other firms within the industry.
Other Employment Expenses/SG&A The final expense manipulation ratio is other employment expenses to SG&A. It
is an important ratio because it helps show how much expense is accumulated into this
category in comparison to normal expenses. It is similar to the pension expense ratio;
however, other employment expenses refer to different post retirement benefits such
has life insurance and healthcare. The ratio is calculated by summing up all other
employment expenses and dividing it by SG&A. Like the pension expense ratio, it is
favorable for a firm to have a small other employment expenses/ SG&A ratio as well. A
small number is desired because it shows that despite the fact that the firm is spending
money on employees, it does not take away a large amount of cash flows. If the
outcome of the ratios is greater than one, then this illustrates that a firm has overstated
their expenses, resulting in the understatement of net income. Below is the graph
illustrating the ratio in its raw form.
100 Advance
O'Reilly
AutoZone
Pep Boys
Industry Average
2005
2006
2007
2008
2009
0.004
0.010
0.005
0.006
0.006
0.004
0.009
0.005
0.006
0.006
0.004
0.008
0.005
0.006
0.006
0.005
0.003
0.005
0.007
0.005
0.004
0.004
0.005
0.007
0.005
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
One visible characteristic of the data provided above is that all firms within the
industry have positive other expense to SG&A ratios. In addition the rates are very
small, with the highest ratio of .01 being for O’Reilly in 2005. Pep Boys has had a very
consistent ratio over years, in addition to its competitors. This shows that all firms are
staying with the trend of the industry and there is no
As in all previous expense diagnostic ratios, the change form of other expense to
SG&A ratio must also be computed. The equation to calculate this ratio is listed below.
101 Similar to the raw form ratio, if the sales at time t are smaller than in year t-1, the ratio
computed will be negative. Below is the graph illustrating the other expense to SG&A
ratio it its change form.
2006
2007
2008
2005
Advance
0.000
0.005
0.005
0.011
O'Reilly
N/A
-0.002
0.005
-0.006
AutoZone
-0.001
0.002
0.011
0.010
Pep Boys
0.015
0.007
0.019
0.003
Industry Average
0.005
0.005
0.012
0.008
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
2009
0.001
0.005
0.002
0.003
0.002
As one can see from viewing the graph and data above, Pep Boys does not have
any negative ratios, indicating that their sales at time t-1 are larger than their sales at
time t. However, for AutoZone in 2005, and O’Reilly in 2006 and 2008, the ratio
calculated for their firm was negative. This clearly indicates that their sales at time t
were less than those of time t-1. Although some ratios are negative for O’Reilly and
AutoZone, the amounts are small that it does not draw reason for concern. Overall the
102 auto parts retail industry has been performing at consistent rates; therefore, this gives
no reason for us to raise a red flag for the distortion of financials.
Expense Manipulation Conclusion Overall the ratio used in the expense manipulation diagnostic show a clear
picture of Pep Boys financial position. The ratios in which Pep Boys draws in more
concern about manipulation is in ratio involving net sales. Pep Boys is not generating
enough sales to make their company profitable results in negative ratios in the change
form. Often times Pep Boys was the outlier for the firm falling well outside of the
industry average—whether it be below or above the average. After analyzing the
expense manipulation diagnostic ratios it is reasonable to believe that Pep Boys has
many manipulations in their accounting policies.
Identify Potential “Red Flags” Potential red flags are signs of misrepresented and misleading information within
the financial statements of a firm. These red flags help analysts identify questionable
accounting practices used within the firms reporting. Conservative firms can use their
accounting discretion to mislead financial information. An example of misleading in
financial information would be when a company writes off all of their expenses and
goodwill in one year to make the following time period seem more profitable.
Aggressive firms can use their accounting discretion to distort their financial statements
to make their firm seem more profitable or, have better returns for their shareholders.
It is our job to find red flags, and discover the reason that the red flag has
occurred. If there is no explanation for the red flag such as a stock market crash, or
industry trend, that could be an identifier for major concern about the firm. Common
red flags that can be encountered when performing financial analysis’ are: unexplained
changes in accounting strategy, unexplained transactions that boost profit, unusual
increases in accounts receivable in relation to sales increases, unusual increases in
inventories in relation to sales increases, and an increasing gap between a firm's
103 reported income and its cash flow from operating activities (Palepu). These red flag
categories can be directly implemented into accounting strategies that produce
goodwill, foreign currency, operating leases, research and development. When a
potential red flag has been identified the analyst must undo the distortion in order to
get a clear perspective on the current standing of the situation.
Operating Leases Pep Boys’ major red flag that has been found is their use of operating leases,
which is a tactic, used by many firms to keep part of their liabilities off the books. Using
the ratio, present value of all future operating lease payments to total long term debt,
gives a clear indication of a need for restatement. If this ratio exceeds 10% then the
accounting needs to be restated in order to get a clear picture of the firm’s current
situation.
OPERATING LEASE-TO-LONG TERM DEBT TEST (IN THOUSANDS) “PEP BOYS”
BALANCE
PRESENT VALUE OF OPERATING LEASES
$ 776,285
LONG TERM DEBT
$ 307,280
PERCENTAGE
252%
(Pep Boys’ 10-K)
As one can see from the chart, Pep Boys’ use of operating leases heavily
outweighs their long term debt. Operating leases identifies a major red flag with Pep
Boys financial reporting. The 252% is well over the 10% threshold needed for
restatement of operating leases. Pep Boys’ use of operating leases, allows them to
withhold nearly $777 million worth of liabilities off their books. This is a much needed
restatement for financial analysts in order to get the true picture of Pep Boys’ financials.
The use of operating leases in the auto parts industry is common; many of these
firms can keep millions off of their books using this method. The graph below shows the
104 four competitors in the auto parts industry and how they stack up against each other in
percentage of operating leases to long term debt.
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
The graph puts Pep Boys percentage of operating leases to long term debt into
perspective, compared to Advance Auto it looks like very little, but the 252% is still very
substantial, and needs to be taken into account and looked at very closely.
Defined Benefit Pension Plan Pep Boys’ used a defined benefit plan until 2008, when it was terminated, paying
$14,441 to stop that portion of their Supplement Executive Retirement Plan (SERP),
they also recorded a $6,005 settlement charge. The financials of the defined benefit
plan seem very hidden, and confusing. There seems to be many side parts, and
continued uses of the terminated plan (Pep Boys 10k). The company continues to
maintain the non-qualified defined contribution portion of the SERP plan for key
employees designated by the board of directors (Pep Boys 10k). The graph below
shows contribution expenses for the account plan.
105 CONTRIBUTION EXPENSE FOR (SERP) ACCOUNT PLAN
2007
2008
2009
$440
$163
$790
(Pep Boys’ 10-K)
DEFINED BENEFIT PENSION PLAN (CONTINUED FOR EMPLYOEES HIRED BEFORE FEBRUARY 1, 1992)
2008
2009
2010
$3,612
$8,476
2,515
(Pep Boys’ 10-K)
The two tables are very confusing, and the substantial difference in payout of
plans per year is a concerning “red flag.” The information revealed in Pep Boys 10-K is
very minimal, and the information is convoluted. The reason for the large increase in
payout from 2008-2009 in table one, and the large increase in payout from 2009-2010
in table two is not explained by Pep Boys. This can greatly influence the financial
standing of Pep Boys, and because of the nature of the information given, or not given
in this case is reason for speculation, and further analysis.
Conclusion The two major red flags found for Pep Boys were their use of operating leases,
and suspect reporting on their defined benefits plan. As discussed before, Pep Boys’ use
of operating leases, which exceeded the threshold of 10% of their long term debt, is
subject for concern, and restatement. The other potential red flag discussed was Pep
Boys’ lack of reporting on their defined benefit plan, and lack of information provided
concerning the large differences in payout towards (SERP), and their continued defined
benefit plan. Overall, Pep Boys releases quality information about their firm’s financials,
but these red flags need to be investigated properly to get a true picture of Pep Boys’
financial standing.
106 Undoing Accounting Distortions After identifying potential red flags, financials must be restated to undo the
distortions caused by the red flags themselves. This is a very important step in the
accounting analysis process because undoing distortions helps to prevent misleading
figures that skew a firm's financials and allow investors to find the true value of the
firm. When identifying potential red flags for Pep Boys, operating leases exceeded more
than 10% of the firm's long-term debt causing there to be a distortion in the firm's
financials. It is important to remove the distortion resulting from operating leases in
order to get the true, unbiased financials that will lead to a clear picture on how the
firm actually operates.
Operating Leases It is important to capitalize all operating leases a firm possesses when they
account for more than 10% of long term debt. Capitalizing leases will give the analyst
and investor an accurate value the firm is worth. It is necessary to capitalize all
operating leases for Pep Boys, as their operating leases severely outweigh its long term
debt.
When capitalizing a firms operating leases, it is required that a discount rate be
used to accurately discount the value of future payments. Pep Boys did not have any
capital leases to accurately find an appropriate rate with, so consequently the discount
rate contained in the defined benefit pension plan was the most appropriate way to
discount future payments. The defined benefit pension plan used a discount rate of
5.7%, 5.9%, 6.5%, 7.0%, and 6.1% from 2005-2009, respectively. The depreciation
was calculated by using the trial and error method to compare which year had the best
progression with previous payments in past years. Using this method, depreciation
came out to twelve years in all years except for 2007, in which eleven years was used.
By using this information in conjunction with Pep Boys' 10-K, enough information is
107 provided to restate the firms financials. The following table summarizes the
amortizations of Pep Boys' operating leases.
108 2005­2009 Amortization Tables 2005 Rate:
5.70%
Year
Period
Payment
PV Factor
PV Payment
Year
Period
BB
Interest
Payment
EB
Change In Loan
Depreciation
31,117
Total CL Expense
$
52,402
OL-CL
$ 9,528
2006
1
$ 61,930
0.946073794
$ 58,590.35
2006
1
$ 373,408
$ 21,284
$ 61,930
$ 332,762
$
(40,646)
$
2007
2
$ 60,114
0.895055623
$ 53,805.37
2007
2
$ 332,762
$ 18,967
$ 60,114
$ 291,616
$
(41,147)
$
31,117
$
50,085
$ 10,029
31,117
$
47,739
$ 9,096
2008
3
$ 56,835
0.846788669
$ 48,127.23
2008
3
$ 291,616
$ 16,622
$ 56,835
$ 251,403
$
(40,213)
$
2009
4
$ 46,925
0.801124569
$ 37,592.77
2009
4
$ 251,403
$ 14,330
$ 46,925
$ 218,808
$
(32,595)
$
31,117
$
45,447
$ 1,478
2010
5
$ 40,369
0.75792296
$ 30,596.59
2010
5
$ 218,808
$ 12,472
$ 40,369
$ 190,911
$
(27,897)
$
31,117
$
43,589
$ (3,220)
2011
6
$ 33,835
0.71705105
$ 24,261.42
2011
6
$ 190,911
$ 10,882
$ 33,835
$ 167,958
$
(22,953)
$
31,117
$
41,999
$ (8,164)
2012
7
$ 33,835
0.678383207
$ 22,953.10
2012
7
$ 167,958
$ 9,574
$ 33,835
$ 143,696
$
(24,261)
$
31,117
$
40,691
$ (6,856)
31,117
$
39,308
$ (5,473)
2013
8
$ 33,835
0.641800575
$ 21,715.32
2013
8
$ 143,696
$ 8,191
$ 33,835
$ 118,052
$
(25,644)
$
2014
9
$ 33,835
0.607190704
$ 20,544.30
2014
9
$ 118,052
$ 6,729
$ 33,835
$ 90,946
$
(27,106)
$
31,117
$
37,846
$ (4,011)
31,117
$
36,301
$ (2,466)
2015
10
$ 33,835
0.574447213
$ 19,436.42
2015
10
$ 90,946
$ 5,184
$ 33,835
$ 62,295
$
(28,651)
$
2016
11
$ 33,835
0.543469454
$ 18,388.29
2016
11
$ 62,295
$ 3,551
$ 33,835
$ 32,010
$
(30,284)
$
31,117
$
34,668
$ (833)
(32,010)
$
31,117
$
32,942
$
2017
12
$ 33,835
Total:
0.514162208
$ 503,018
$ 17,396.68
2017
12
$ 32,010
$ 1,825
$ 33,835
$
(0)
$
893
$ 373,407.85
2006 Rate:
5.90%
Year
Period
Payment
PV Factor
PV Payment
Year
Period
BB
Interest
Payment
EB
Change In Loan
Depreciation
2006
1
$57,670
0.944287063
$ 54,457.03
2006
1
$ 351,594
$ 20,744
$ 57,670
$ 314,668
$
(36,926)
$
29,300
$
50,044
$ 7,626
2007
2
$53,788
0.891678058
$ 47,961.58
2007
2
$ 314,668
$ 18,565
$ 53,788
$ 279,445
$
(35,223)
$
29,300
$
47,865
$ 5,923
(30,657)
$
29,300
$
45,787
$ 1,357
29,300
$
43,978
$ (430)
2008
3
$47,144
0.842000055
$ 39,695.25
2008
3
$ 279,445
$ 16,487
$ 47,144
$ 248,789
$
Total CL Expense
OL-CL
2009
4
$43,548
0.795089759
$ 34,624.57
2009
4
$ 248,789
$ 14,679
$ 43,548
$ 219,919
$
(28,869)
$
2010
5
$41,179
0.750792973
$ 30,916.90
2010
5
$ 219,919
$ 12,975
$ 41,179
$ 191,716
$
(28,204)
$
29,300
$
42,275
$ (1,096)
2011
6
$34,221
0.708964092
$ 24,261.46
2011
6
$ 191,716
$ 11,311
$ 34,221
$ 168,806
$
(22,910)
$
29,300
$
40,611
$ (6,390)
29,300
$
39,259
$ (5,038)
2012
7
$34,221
0.66946562
$ 22,909.78
2012
7
$ 168,806
$ 9,960
$ 34,221
$ 144,544
$
(24,261)
$
2013
8
$34,221
0.632167725
$ 21,633.41
2013
8
$ 144,544
$ 8,528
$ 34,221
$ 118,851
$
(25,693)
$
29,300
$
37,828
$ (3,607)
29,300
$
36,312
$ (2,091)
2014
9
$34,221
0.596947804
$ 20,428.15
2014
9
$ 118,851
$ 7,012
$ 34,221
$ 91,643
$
(27,209)
$
2015
10
$34,221
0.563690089
$ 19,290.04
2015
10
$ 91,643
$ 5,407
$ 34,221
$ 62,829
$
(28,814)
$
29,300
$
34,706
$ (485)
29,300
$
33,006
$ 1,215
29,300
$
31,206
$ 3,015
2016
11
$34,221
0.532285259
$ 18,215.33
2016
11
$ 62,829
$ 3,707
$ 34,221
$ 32,314
$
(30,514)
$
2017
12
$34,221
0.502630084
$ 17,200.50
2017
12
$ 32,314
$ 1,907
$ 34,221
$
$
(32,314)
$
Total:
$ 482,876
$ 351,594.02
109 0
2007 Rate:
6.50%
Year
Period
Payment
PV Factor
PV Payment
Year
Period
BB
Interest
Payment
EB
Change In Loan
Depreciation
37,972
Total CL Expense
$
65,123
OL-CL
$ 3,117
2006
1
$68,240
0.938967136
$ 64,075.12
2006
1
$ 417,696
$ 27,150
$ 68,240
$ 376,606
$
(41,090)
$
2007
2
$60,572
0.881659283
$ 53,403.87
2007
2
$ 376,606
$ 24,479
$ 60,572
$ 340,513
$
(36,093)
$
37,972
$
62,452
$ (1,880)
37,972
$
60,106
$ (2,830)
2008
3
$57,276
0.827849092
$ 47,415.88
2008
3
$ 340,513
$ 22,133
$ 57,276
$ 305,371
$
(35,143)
$
2009
4
$54,890
0.777323091
$ 42,667.26
2009
4
$ 305,371
$ 19,849
$ 54,890
$ 270,330
$
(35,041)
$
37,972
$
57,821
$ (2,931)
2010
5
$53,625
0.729880837
$ 39,139.86
2010
5
$ 270,330
$ 17,571
$ 53,625
$ 234,276
$
(36,054)
$
37,972
$
55,544
$ (1,919)
37,972
$
53,200
$ (4,806)
2011
6
$48,394
0.685334119
$ 33,166.06
2011
6
$ 234,276
$ 15,228
$ 48,394
$ 201,110
$
(33,166)
$
2012
7
$48,394
0.643506215
$ 31,141.84
2012
7
$ 201,110
$ 13,072
$ 48,394
$ 165,788
$
(35,322)
$
37,972
$
51,044
$ (2,650)
2013
8
$48,394
0.604231188
$ 29,241.16
2013
8
$ 165,788
$ 10,776
$ 48,394
$ 128,170
$
(37,618)
$
37,972
$
48,749
$ (355)
37,972
$
46,303
$ 2,091
2014
9
$48,394
0.567353228
$ 27,456.49
2014
9
$ 128,170
$ 8,331
$ 48,394
$ 88,107
$
(40,063)
$
2015
10
$48,394
0.532726036
$ 25,780.74
2015
10
$ 88,107
$ 5,727
$ 48,394
$ 45,440
$
(42,667)
$
37,972
$
43,699
$ 4,695
2016
11
$48,394
0.50021224
$ 24,207.27
2016
11
$ 45,440
$ 2,954
$ 48,394
$
$
(45,440)
$
37,972
$
40,926
$ 7,468
Year
Period
Total:
$ 584,967
0
$ 417,695.56
2008 Rate:
7.00%
Year
Period
Payment
PV Factor
PV Payment
BB
Interest
Payment
EB
Change In Loan
Depreciation
43,829
Total CL Expense
$
80,646
OL-CL
$ (3,543)
2006
1
$77,103
0.934579439
$ 72,058.88
2006
1
$ 525,949
$ 36,816
$ 77,103
$ 485,663
$
(40,287)
$
2007
2
$74,294
0.873438728
$ 64,891.26
2007
2
$ 485,663
$ 33,996
$ 74,294
$ 445,365
$
(40,298)
$
43,829
$
77,826
$ (3,532)
2008
3
$72,063
0.816297877
$ 58,824.87
2008
3
$ 445,365
$ 31,176
$ 72,063
$ 404,478
$
(40,887)
$
43,829
$
75,005
$ (2,942)
43,829
$
72,143
$ (2,151)
2009
4
$69,992
0.762895212
$ 53,396.56
2009
4
$ 404,478
$ 28,313
$ 69,992
$ 362,799
$
(41,679)
$
2010
5
$65,948
0.712986179
$ 47,020.01
2010
5
$ 362,799
$ 25,396
$ 65,948
$ 322,247
$
(40,552)
$
43,829
$
69,225
$ (3,277)
2011
6
$59,794
0.666342224
$ 39,843.27
2011
6
$ 322,247
$ 22,557
$ 59,794
$ 285,010
$
(37,237)
$
43,829
$
66,386
$ (6,592)
2012
7
$59,794
0.622749742
$ 37,236.70
2012
7
$ 285,010
$ 19,951
$ 59,794
$ 245,167
$
(39,843)
$
43,829
$
63,780
$ (3,986)
43,829
$
60,991
$ (1,197)
2013
8
$59,794
0.582009105
$ 34,800.65
2013
8
$ 245,167
$ 17,162
$ 59,794
$ 202,535
$
(42,632)
$
2014
9
$59,794
0.543933743
$ 32,523.97
2014
9
$ 202,535
$ 14,177
$ 59,794
$ 156,918
$
(45,617)
$
43,829
$
58,007
$ 1,787
43,829
$
54,813
$ 4,981
2015
10
$59,794
0.508349292
$ 30,396.24
2015
10
$ 156,918
$ 10,984
$ 59,794
$ 108,109
$
(48,810)
$
2016
11
$59,794
0.475092796
$ 28,407.70
2016
11
$ 108,109
$ 7,568
$ 59,794
$ 55,882
$
(52,226)
$
43,829
$
51,397
$ 8,397
2017
12
$59,794
0.444011959
$ 26,549.25
2017
12
$ 55,882
$ 3,912
$ 59,794
$
$
(55,882)
$
43,829
$
47,741
$ 12,053
Total:
$ 777,958
$ 525,949.36
110 0
2009 Rate:
6.10%
Year
Period
Payment
PV Factor
PV Payment
Year
Period
BB
Interest
Payment
EB
Change In Loan
Depreciation
46,287
Total CL Expense
$
80,169
OL-CL
$ 1,432
2006
1
$81,601
0.942507069
$ 76,909.52
2006
1
$ 555,443
$ 33,882
$ 81,601
$ 507,724
$
(47,719)
$
2007
2
$80,488
0.888319575
$ 71,499.07
2007
2
$ 507,724
$ 30,971
$ 80,488
$ 458,207
$
(49,517)
$
46,287
$
77,258
$ 3,230
2008
3
$77,677
0.837247479
$ 65,034.87
2008
3
$ 458,207
$ 27,951
$ 77,677
$ 408,481
$
(49,726)
$
46,287
$
74,238
$ 3,439
46,287
$
71,204
$ 1,985
2009
4
$73,189
0.789111667
$ 57,754.29
2009
4
$ 408,481
$ 24,917
$ 73,189
$ 360,209
$
(48,272)
$
2010
5
$68,140
0.743743324
$ 50,678.67
2010
5
$ 360,209
$ 21,973
$ 68,140
$ 314,042
$
(46,167)
$
46,287
$
68,260
$ (120)
2011
6
$56,456
0.70098334
$ 39,574.72
2011
6
$ 314,042
$ 19,157
$ 56,456
$ 276,742
$
(37,299)
$
46,287
$
65,443
$ (8,987)
2012
7
$56,456
0.660681753
$ 37,299.45
2012
7
$ 276,742
$ 16,881
$ 56,456
$ 237,168
$
(39,575)
$
46,287
$
63,168
$ (6,712)
46,287
$
60,754
$ (4,298)
2013
8
$56,456
0.622697223
$ 35,154.99
2013
8
$ 237,168
$ 14,467
$ 56,456
$ 195,179
$
(41,989)
$
2014
9
$56,456
0.586896534
$ 33,133.83
2014
9
$ 195,179
$ 11,906
$ 56,456
$ 150,629
$
(44,550)
$
46,287
$
58,193
$ (1,737)
46,287
$
55,475
$
2015
10
$56,456
0.553154132
$ 31,228.87
2015
10
$ 150,629
$ 9,188
$ 56,456
$ 103,361
$
(47,268)
$
2016
11
$56,456
0.52135168
$ 29,433.43
2016
11
$ 103,361
$ 6,305
$ 56,456
$ 53,210
$
(50,151)
$
46,287
$
52,592
$ 3,864
2017
12
$56,456
0.491377643
$ 27,741.22
2017
12
$ 53,210
$ 3,246
$ 56,456
$0
$
(53,210)
$
46,287
$
49,533
$ 6,923
Total:
$ 776,287
$ 555,442.93
111 981
Financial Statements The following financial statements are Pep Boys' balance sheets and income
statements (as stated) from the past five years. They are directly off Pep Boys' 10-K
and have not been altered or restated in any way. By comparing the original,
untouched financial statements with the restated financial statements, it is easy to see
what is exactly distorted by potential red flags. Investors will be able to view the
distortive effects and be able to make more of an educated evaluation about the firm's
financials.
112 Balance Sheet 2005-2009 (As Stated)
2005
ASSETS
Current Assets:
Cash and cash equivalents
Accounts receivable, less allowance for uncollectible accounts
Merchandise inventories
Prepaid expenses
Other
Assets held for disposal
Total Current Assets
Property and Equipment—at cost:
Land
Buildings and improvements
Furniture, fixtures and equipment
Construction in progress
Total Property and Equipment
Less accumulated depreciation and amortization
Total Property and Equipment—Net
Deferred Income Taxes
Other
Total Assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable
Trade payable program liability
Accrued expenses
Deferred income taxes
Current maturities of long-term debt and obligations under capital
lease
Total Current Liabilities
Long-term debt and obligations under capital leases, less current
maturities
Convertible long-term debt
Other long-term liabilities
Deferred income taxes
Deferred gain from asset sales
Total Liabilities
Stockholders’ Equity:
Common stock, par value $1 per share: Authorized 500,000,000
shares
Additional paid-in capital
Retained earnings
Accumulated other comprehensive loss
Less cost of shares in treasury
Less cost of shares in benefits trust
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
2006
2008
2009
$48,281
$36,434
$616,292
$40,952
$85,446
$652
$828,057
$21,884
$29,582
$607,042
$39,264
$70,368
$768,140
$20,926
$29,450
$561,152
$43,842
$77,469
$16,918
$749,757
$21,332
$28,831
$564,931
$25,390
$62,421
$12,653
$715,558
$39,326
$22,983
$559,118
$24,784
$65,428
$4,438
$716,077
$257,802
$916,580
$671,189
$15,858
$1,861,429
$914,040
$947,389
$46,307
$1,821,753
$251,705
$929,225
$684,042
$3,464
$1,868,436
$962,189
$906,247
$24,828
$67,984
$1,767,199
$213,962
$858,699
$699,303
$3,992
$1,775,956
$995,177
$780,779
$20,775
$32,609
$1,583,920
$207,608
$822,950
$685,707
$2,576
$1,718,841
$978,510
$740,331
$77,708
$18,792
$1,552,389
$204,709
$826,804
$695,072
$1,550
$1,728,135
$1,021,685
$706,450
$58,171
$18,388
$1,499,086
$261,940
$11,156
$290,761
$15,417
$265,489
$13,990
$292,280
$28,931
$245,423
$14,254
$292,623
-
$212,340
$31,930
$254,754
$35,848
$202,974
$34,099
$242,416
$29,984
$1,257
$580,531
$3,490
$604,180
$2,114
$554,414
$1,453
$536,325
$1,079
$510,552
$467,239
$119,000
$57,481
$2,937
$535,031
$60,233
-
$646,657
$595,264
$400,016
$72,183
$86,595
$472,199
$352,382
$70,322
$170,204
$422,704
$306,201
$73,933
$165,105
$380,134
$68,557
$288,098
$481,926
($3,565)
$181,187
$59,264
$594,565
$1,821,753
$68,557
$289,384
$463,797
($9,380)
$185,389
$59,264
$567,755
$1,767,199
$68,557
$296,074
$406,819
($14,183)
$227,291
$59,264
$470,712
$1,583,920
$68,557
$292,728
$358,670
($18,075)
$219,460
$59,264
$423,156
$1,552,389
$68,557
$293,810
$374,834
($17,691)
$276,217
$443,295
$1,499,086
113 2007
Income Statement 2005-2009 (As Stated)
Merchandise Sales
2005
$ 1,852,067
2006
$ 1,876,290
2007
$1,749,578
$
Service Revenue
$
$
395,871
$ 388,497
$ 358,124
$
Total Revenues
$ 2,235,226
$ 2,272,161
$2,138,075
$1,927,788
$ 1,910,938
Costs of Merchandise Sales
$ 1,371,195
$ 1,336,336
$1,305,952
$1,129,162
$ 1,084,804
Costs of Service Revenue
$
$
364,069
$ 345,886
$ 333,194
$
Total Costs of Revenues
$ 1,723,908
$ 1,700,405
$1,651,838
$1,462,356
$ 1,424,831
Gross Profit from Merchandise Sales
$
480,872
$
539,954
$ 443,626
$ 440,502
$
448,815
Gross Profit from Service Revenue
$
30,446
$
31,802
$
$
24,930
$
37,292
383,159
352,713
42,611
2008
1,569,664
2009
$ 1,533,619
377,317
340,027
Total Gross Profit
$
511,318
$
571,756
$ 486,237
$ 465,432
$
486,107
Selling, General and Administrative Expenses
$
522,501
$
551,031
$ 518,378
$ 485,044
$
430,261
Net Gain From Sale of Assets
-
$
15,297
$
15,151
$
9,716
$
1,213
Operating (Loss) Profit
$
$
$
(11,183)
3,897
49,040
$
$
$
36,022
7,023
49,342
$ (16,985)
$
5,246
$ 51,293
$
$
$
(9,896)
1,967
27,048
$
$
$
57,059
2,261
21,704
$
(56,326)
$
(6,297)
$ (63,032)
$ (34,977)
$
37,616
$
(20,553)
$
(4,297)
$ (25,594)
$
(6,139)
$
13,503
Effect of Change in Accounting Principle
Earnings (Loss) from Discontinued Operations, Net of Tax
$
$
(35,773)
266
$
$
(2,000)
(738)
$ (37,438)
$ (3,601)
$ (28,838)
$ (1,591)
$
$
24,113
(1,077)
Cumulative Effect of Change in Accounting Principle, Net of Tax
$
(2,021)
$
189
-
-
-
Net (Loss) Earnings
$
(37,528)
$
(2,549)
$ (41,039)
$
Non-operating Income
Interest Expense
Net (Loss) Earnings from Continuing Operations Before Income Taxes and
Cumulative Effect of Change in Accounting Principle
Income Tax (Benefit) Expense
Net (Loss) Earnings from Continuing Operations Before Cumulative
114 (30,429)
$
23,036
Restated Financial Statements Both the balance sheet and income statement must be restated do to Pep Boys'
use off balance sheet accounting concerning operation leases. The first step is to
capitalize the operating leases using the amortization table from earlier to create a trial
balance that will report the capitalization of the operating lease onto the financial
statements. Next, completing the restated balanced sheet and income statement will
remove the distortions that the leases put in the financial statements. Pep Boys' leases
takes up 45.42% of the firm’s long term debt, so there was an effect on both the
balance sheet and the income statement. However, Pep Boys chose not to include their
operating leases in their as-stated financial statements, causing a major effect in the
restatements of the firm’s financial statements. Another issue that was observed was
that Pep Boys’ restated trial balances did not balance in the years 2005-2007, which
was fixed by adding in a retained earnings plug. Removing financial distortions, such as
operating leases, can give an investor a clear window into the financial standing of the
firm.
115 Trial Balance: 2005-2009
2005 As Stated
Debit
Credit
2005 Adjustments
Debit
Credit
2005 Restated Ending Balance
Debit
Credit
ASSETS
Total Current Assets
$828,057
$828,057
Land
$257,802
$257,802
Buildings and improvements
$916,580
$916,580
Furniture, fixtures and equipment
$671,189
$671,189
Construction in progress
$15,858
Property and Equipment—at cost:
$15,858
Capitalized Lease Asset Rights (net)
$373,408
Less accumulated depreciation and amortization
Deferred income taxes
Other
$373,408
$914,040
$914,040
$0
$0
$46,307
$46,307
LIABILITIES AND STOCKHOLDERS’ EQUITY
Total Current Liabilities
$580,531
$580,531
Long-term debt & obligations under capital leases, less current maturities
$467,239
$467,239
Convertible long-term debt
$119,000
$119,000
Other long-term liabilities
$57,481
$57,481
Deferred income taxes
$2,937
$2,937
Capitalized Lease Liabilities
$373,408
$373,408
Stockholders’ Equity:
Common Stock: Authorized 500,000,000 shares; Issued & Outstanding
$68,557
$68,557
Additional paid-in capital
$288,098
$288,098
Retained earnings
Accumulated other comprehensive loss
$481,926
$481,926
$3,565
$3,565
Less cost of shares in treasury—12,427,687 shares and 12,152,968 shares
$181,187
$181,187
Less cost of shares in benefits trust—2,195,270 shares
$59,264
$59,264
Balance Sheet Check Figure
$2,979,809
Total Sales
$2,979,809
$373,408
$373,408
$3,353,217
$2,235,226
$3,353,217
$2,235,226
Costs and Expenses:
Total Cost of Revenues
Selling. General and Administrative Expenses
$1,723,908
$1,723,908
$522,501
Non Operating Income
$522,501
$3,897
$3,897
Capitalized Leased Operating Expense
Depreciation of Capitalized Leases
Capitalized Lease Interest Expense
Interest Expense
$49,040
Income Taxes (Benefit) Expense
Income (Loss) from discontinued operations
Cumulative Effect of a Change in Accounting Principle
First TB Pass
$49,040
$20,553
$20,553
$266
$266
$2,021
$5,277,279
Income Summary
$2,021
$5,239,751
$5,650,687
$37,528
$5,613,159
$37,528
Change In Net Income
Trial Balance
$5,277,279
116 $5,277,279
$746,816
$746,816
$5,650,687
$5,650,687
Trial Balance: 2005-2009
2006 As Stated
Debit
Credit
2006 Adjustments
Debit
Credit
2006 Restated Ending Balance
Debit
Credit
ASSETS
Total Current Assets
$768,140
$768,140
Property and Equipment—at cost:
Land
$251,705
$251,705
Buildings and improvements
$929,225
$929,225
Furniture, fixtures and equipment
$684,042
$684,042
Construction in progress
$3,464
$3,464
Capitalized Lease Asset Rights (net)
$351,954
Less accumulated depreciation and amortization
$31,117
$320,837
$962,189
$962,189
Deferred income taxes
$24,828
$24,828
Other
$67,984
$67,984
LIABILITIES AND STOCKHOLDERS’ EQUITY
Total Current Liabilities
$604,180
$604,180
Long-term debt & obligations under capital leases, less current maturities
$535,031
$535,031
$60,233
$60,233
Convertible long-term debt
Other long-term liabilities
Deferred income taxes
Capitalized Lease Liabilities
$40,646
$351,954
$311,308
Stockholders’ Equity:
Common Stock: Authorized 500,000,000 shares; Issued & Outstanding
$68,557
Additional paid-in capital
$289,384
Retained earnings
$463,797
Accumulated other comprehensive loss
$68,557
$289,384
$9,529
$473,326
$9,380
$9,380
Less cost of shares in treasury
$185,339
$185,339
Less cost of shares in benefits trust
$59,264
$59,264
Balance Sheet Check Figure
$2,983,371
Total Sales
$2,983,371
$392,600
$392,600
$3,304,208
$2,272,161
$3,304,208
$2,272,161
Costs and Expenses:
Total Cost of Revenues
Selling. General and Administrative Expenses
$1,700,405
$1,700,405
$551,031
$551,031
Net Gain From Sales on Assets
$15,297
Non-Operating Income
$7,023
$15,297
$7,023
Capitalized Leased Operating Expense
$61,930
Depreciation of Capitalized Leases
$31,117
$31,117
Capitalized Lease Interest Expense
$21,284
$21,284
Interest Expense
$49,342
Income Taxes (Benefit) Expense
Income (Loss) from discontinued operations
Income Statement Check Figure
$49,342
$4,297
$738
$189
$2,301,516
Income Summary
$2,298,967
$189
$52,401
$61,930
$2,353,917
$2,549
Change In Net Income
Trial Balance
$4,297
$738
Cumulative Effect of a Change in Accounting Principle
$5,284,887
$5,284,887
$2,360,897
$2,549
$9,529
117 $61,930
$454,530
$9,529
$454,530
$5,667,654
$5,667,654
Trial Balance: 2005-2009
2007 As Stated
Debit
Credit
2007 Adjustments
Debit
Credit
2007 Restated Ending Balance
Debit
Credit
ASSETS
Total Current Assets
$749,757
$749,757
Property and Equipment—at cost:
Land
$213,962
$213,962
Buildings and improvements
$858,699
$858,699
Furniture, fixtures and equipment
$699,303
$699,303
Construction in progress
$3,992
$3,992
Capitalized Lease Asset Rights (net)
$417,696
Less accumulated depreciation and amortization
$29,300
$388,396
$995,177
$995,177
Deferred income taxes
$20,775
$20,775
Other
$32,609
$32,609
LIABILITIES AND STOCKHOLDERS’ EQUITY
Total Current Liabilities
$554,414
$554,414
Long-term debt & obligations under capital leases, less current maturities
$400,016
$400,016
$72,183
$72,183
Convertible long-term debt
Other long-term liabilities
Deferred income taxes
Deferred gain from asset sales
$86,595
Capitalized Lease Liabilities
$86,595
$36,926
$417,696
$380,770
Stockholders’ Equity:
Common Stock: Authorized 500,000,000 shares; Issued & Outstanding
$68,557
$68,557
Additional paid-in capital
$296,074
$296,074
Retained earnings
$406,819
$7,626
$414,445
Accumulated other comprehensive loss
$14,183
$14,183
Less cost of shares in treasury
$227,291
$227,291
Less cost of shares in benefits trust
$59,264
$59,264
Balance Sheet Check Figure
$2,879,835
Total Sales
$2,879,835
$454,622
$454,622
$3,268,231
$2,138,075
$3,268,231
$2,138,075
Costs and Expenses:
Total Cost of Revenues
Selling. General and Administrative Expenses
$1,651,838
$1,651,838
$518,373
$518,373
Net Gain From Sales on Assets
$15,151
Non-Operating Income
$5,246
$15,151
$5,246
Capitalized Leased Operating Expense
$57,670
Depreciation of Capitalized Leases
$29,300
Capitalized Lease Interest Expense
$20,744
Interest Expense
Income (Loss) from discontinued operations
$29,300
$20,744
$51,293
Income Taxes (Benefit) Expense
$57,670
$51,293
$25,594
$25,594
$3,601
$3,601
Cumulative Effect of a Change in Accounting Principle
Income Statement Check Figure
$2,225,105
Income Summary
$2,184,066
Change In Net Income
Trial Balance
$57,670
$2,275,149
$5,104,940
$5,104,940
$2,241,736
$41,039
$7,626
118 $50,044
$41,039
$512,292
$7,626
$512,292
$5,551,006
$5,551,006
Trial Balance: 2005-2009
2008 As Stated
Debit
Credit
2008 Adjustments
Debit
Credit
2008 Restated Ending Balance
Debit
Credit
ASSETS
Total Current Assets
$715,558
$715,558
Property and Equipment—at cost:
Land
$207,608
$207,608
Buildings and improvements
$822,950
$822,950
Furniture, fixtures and equipment
$685,707
$685,707
Construction in progress
$2,576
$2,576
Capitalized Lease Asset Rights (net)
$525,949
Less accumulated depreciation and amortization
$37,972
$487,977
$978,510
$978,510
Deferred income taxes
$77,708
$77,708
Other
$18,792
$18,792
LIABILITIES AND STOCKHOLDERS’ EQUITY
Total Current Liabilities
$536,325
$536,325
Long-term debt & obligations under capital leases, less current maturities
$352,382
$352,382
Convertible long-term debt
Other long-term liabilities
$70,322
$70,322
Deferred income taxes
$170,204
$170,204
Capitalized Lease Liabilities
$41,090
$525,949
$484,859
Stockholders’ Equity:
Common Stock: Authorized 500,000,000 shares; Issued & Outstanding
$68,557
$68,557
Additional paid-in capital
$292,728
$292,728
Retained earnings
$358,670
$3,118
$361,788
Accumulated other comprehensive loss
$18,075
$18,075
Less cost of shares in treasury
$219,460
$219,460
Less cost of shares in benefits trust
$59,264
$59,264
Balance Sheet Check Figure
$2,827,698
Total Sales
$2,827,698
$567,039
$567,039
$3,315,675
$1,927,788
$3,315,675
$1,927,788
Costs and Expenses:
Total Cost of Revenues
Selling. General and Administrative Expenses
$1,462,356
$1,462,356
$485,044
$485,044
Net Gain From Sales on Assets
$9,716
Non-Operating Income
$1,967
$9,716
$1,967
Capitalized Leased Operating Expense
$68,240
$68,240
Depreciation of Capitalized Leases
$41,090
$41,090
Capitalized Lease Interest Expense
$27,150
$27,150
Interest Expense
$27,048
Income Taxes (Benefit) Expense
Income (Loss) from discontinued operations
$27,048
$6,139
$6,139
$1,591
$1,591
Cumulative Effect of a Change in Accounting Principle
Income Statement Check Figure
$1,976,039
Income Summary
$1,945,610
$68,240
$68,240
$2,044,279
$30,429
$2,013,850
$30,429
Change In Net Income
Trial Balance
$4,803,737
119 $4,803,737
$635,279
$635,279
$5,359,954
$5,359,954
Trial Balance: 2005-2009
2009 As Stated
Debit
Credit
2009 Adjustments
Debit
Credit
2009 Restated Ending Balance
Debit
Credit
ASSETS
Total Current Assets
$716,077
$716,077
Property and Equipment—at cost:
Land
$204,709
$204,709
Buildings and improvements
$826,804
$826,804
Furniture, fixtures and equipment
$695,072
$695,072
Construction in progress
$1,550
$1,550
Capitalized Lease Asset Rights (net)
$555,443
Less accumulated depreciation and amortization
$43,829
$511,614
$1,021,685
$1,021,685
Deferred income taxes
$58,171
$58,171
Other
$18,388
$18,388
LIABILITIES AND STOCKHOLDERS’ EQUITY
Total Current Liabilities
$510,552
$510,552
Long-term debt & obligations under capital leases, less current maturities
$306,201
$306,201
Convertible long-term debt
Other long-term liabilities
$73,933
$73,933
Deferred income taxes
$165,105
$165,105
Capitalized Lease Liabilities
$40,287
$555,443
$515,156
Stockholders’ Equity:
Common Stock: Authorized 500,000,000 shares; Issued & Outstanding
$68,557
$68,557
Additional paid-in capital
$293,810
$293,810
Retained earnings
$374,836
$3,542
$371,294
Accumulated other comprehensive loss
$17,691
$17,691
Less cost of shares in treasury
$276,217
$276,217
Less cost of shares in benefits trust
Balance Sheet Check Figure
$2,814,679
Total Sales
$2,814,679
$599,272
$599,272
$3,326,293
$1,910,938
$3,326,293
$1,910,938
Costs and Expenses:
Total Cost of Revenues
Selling. General and Administrative Expenses
$1,424,831
$1,424,831
$430,261
$430,261
Net Gain From Sales on Assets
$1,213
Non-Operating Income
$2,261
$1,213
$2,261
Capitalized Leased Operating Expense
$77,103
Depreciation of Capitalized Leases
Capitalized Lease Interest Expense
$77,103
$40,287
$40,287
$36,816
$36,816
Interest Expense
$21,704
$21,704
Income Taxes (Benefit) Expense
$13,503
$13,503
Income (Loss) from discontinued operations
$1,077
$1,077
Cumulative Effect of a Change in Accounting Principle
Income Statement Check Figure
Income Summary
$1,891,376
$1,914,412
$77,103
$77,103
$23,036
$1,968,479
$1,991,515
$23,036
Change In Net Income
Trial Balance
$4,729,091
120 $4,729,091
$676,375
$676,375
$5,317,808
$5,317,808
Restated Balance Sheet (2005-2009)
ASSETS Current Assets: Cash and cash equivalents 2004 2005 2006 2007 2008 2009 $82,758 $48,281 $21,884 $20,926 $21,332 $39,326 Accounts receivable, less allowance for uncollectible accounts $30,994 $36,434 $29,582 $29,450 $28,831 $22,983 Merchandise inventories $602,760 $616,292 $607,042 $561,152 $564,931 $559,118 Prepaid expenses $45,349 $40,952 $39,264 $43,842 $25,390 $24,784 Other $96,065 $85,446 $70,368 $77,469 $62,421 $65,428 $665 $652 $16,918 $12,653 $4,438 $858,591 $828,057 $768,140 $749,757 $715,558 $716,077 Assets held for disposal Total Current Assets Property and Equipment—at cost: Land $261,985 $257,802 $251,705 $213,962 $207,608 $204,709 Buildings and improvements $916,099 $916,580 $929,225 $858,699 $822,950 $826,804 Furniture, fixtures and equipment $633,098 $671,189 $684,042 $699,303 $685,707 $695,072 Construction in progress $40,426 $15,858 $3,464 $3,992 $2,576 $1,550 Total Property and Equipment $1,851,608 $1,861,429 $1,868,436 $1,775,956 $1,718,841 $1,728,135 Less accumulated depreciation and amortization $906,577 $914,040 $962,189 $995,177 $978,510 $1,021,685 Total Property and Equipment—Net $945,031 $947,389 $906,247 $780,779 $740,331 $706,450 Net Operating Lease Asset Rights $349,764 $344,261 $320,837 $388,396 $487,977 $511,614 $24,828 $20,775 $77,708 $58,171 Other $63,401 $46,307 $67,984 $32,609 $18,792 $18,388 Total Non‐Current Assets $1,358,196 $1,337,957 $1,319,896 $1,222,559 $1,324,808 $1,294,623 Total Assets Deferred Income Taxes $2,216,787 $2,166,014 $2,088,036 $1,972,316 $2,040,366 $2,010,700 LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities: $310,981 $261,940 $265,489 $245,423 $212,340 $202,974 $11,156 $13,990 $14,254 $31,930 $34,099 Accrued expenses $306,671 $290,761 $292,280 $292,623 $254,754 $242,416 Deferred income taxes $19,406 $15,417 $28,931 $35,848 $29,984 Current maturities of long‐term debt and obligations under capital lease $40,882 $1,257 $3,490 $2,114 $1,453 $1,079 Total Current Liabilities $677,940 $580,531 $604,180 $554,414 $536,325 $510,552 Long‐term debt and obligations under capital leases, less current maturities $352,682 $467,239 $535,031 $400,016 $352,382 $306,201 Convertible long‐term debt $119,000 $119,000 Other long‐term liabilities $37,977 $57,481 $60,233 $72,183 $70,322 $73,933 Deferred income taxes $25,968 $2,937 $86,595 $170,204 $165,105 Net Liability of Capitalized Operating Leases $349,764 $334,480 $311,308 $380,770 $484,859 $515,156 Total Liabilities $1,570,947 Accounts payable Trade payable program liability Deferred gain from asset sales $1,563,331 $1,561,668 $1,510,752 $1,493,978 $1,614,092 Commitments and Contingencies Stockholders’ Equity: Common stock, par value $1 per share: Authorized 500,000,000 shares $68,557 $68,557 $68,557 $68,557 $68,557 $68,557 Additional paid‐in capital $284,966 $288,098 $289,384 $296,074 $292,728 $293,810 Retained earnings $536,780 $491,707 $473,326 $414,445 $361,788 $371,294 ($167) Common stock subscriptions receivable Accumulated other comprehensive loss ($4,852) ($3,565) ($9,380) ($14,183) ($18,075) ($17,691) Less cost of shares in treasury $172,564 $181,187 $185,389 $227,291 $219,460 $276,217 Less cost of shares in benefits trust $59,264 $59,264 $59,264 $59,264 $59,264 ‐ Total Stockholders’ Equity $653,456 $594,565 $577,284 $478,338 $426,274 $439,753 Total Liabilities and Stockholders’ Equity $2,216,787 $2,166,014 $2,088,036 $1,972,316 $2,040,366 $2,010,700 121 122 Restated Income Statement (2005-2009)
Merchandise Sales
Service Revenue
Total Revenues
Costs of Merchandise Sales
Costs of Service Revenue
Total Costs of Revenues
Gross Profit from Merchandise Sales
Gross Profit from Service Revenue
Total Gross Profit
Depreciation of Capital Lease Asset Rights
Selling, General and Administrative Expenses
Net Gain From Sale of Assets
Operating (Loss) Profit
Non-operating Income
Interest Expense
Interest Expense from Lease
Operating Lease Expense
(Loss) Earnings from Continuing Operations Before Income Taxes and
Cumulative Effect of Change in Accounting Principle
Income Tax (Benefit) Expense
Net (Loss) Earnings from Continuing Operations Before Cumulative
Effect of Change in Accounting Principle
Earnings (Loss) from Discontinued Operations, Net of Tax
Cumulative Effect of Change in Accounting Principle, Net of Tax
Net (Loss) Earnings
2005
$ 1,852,067
$ 383,159
$ 2,235,226
$ 1,371,195
$ 352,713
$ 1,723,908
$ 480,872
$ 30,446
$ 511,318
$ 522,501
$ (11,183)
$
3,897
$ 49,040
-
2006
$ 1,876,290
$ 395,871
$ 2,272,161
$ 1,336,336
$ 364,069
$ 1,700,405
$ 539,954
$ 31,802
$ 571,756
$ 31,117
$ 551,031
$ 15,297
$
4,905
$
7,023
$ 49,342
$ 21,284
$ (61,930)
2007
$ 1,749,578
$ 388,497
$ 2,138,075
$ 1,305,952
$ 345,886
$ 1,651,838
$ 443,626
$ 42,611
$ 486,237
$ 29,300
$ 518,378
$ 15,151
$
(46,290)
$
5,246
$ 51,293
$ 20,744
$ (57,670)
2008
$ 1,569,664
$ 358,124
$ 1,927,788
$ 1,129,162
$ 333,194
$ 1,462,356
$ 440,502
$ 24,930
$ 465,432
$ 41,090
$ 485,044
$
9,716
$
(50,986)
$
1,967
$ 27,048
$ 27,150
$ (68,240)
2009
$ 1,533,619
$ 377,317
$ 1,910,938
$ 1,084,804
$ 340,027
$ 1,424,831
$ 448,815
$ 37,292
$ 486,107
$ 40,287
$ 430,261
$
1,213
$ 16,772
$
2,261
$ 21,704
$ 36,816
$ (77,103)
$
$
(56,326)
(20,553)
$
$
3,232
(4,297)
$
$
(55,411)
(25,594)
$
$
(34,977)
(6,139)
$
$
37,616
13,503
$
$
$
$
(35,773)
266
(2,021)
(37,528)
$
$
$
$
7,529
(738)
189
6,980
$
$
(29,817)
(3,601)
$
$
(28,838)
(1,591)
$
$
24,113
(1,077)
$
(33,418)
$
(30,429)
$
23,036
123 Income Statement Restatement Evaluation
Pep Boys’ income statement was impacted by the distortive accounting policies
concerning operating leases. Pep Boys did not record their operating lease impairments,
causing their income statement to not reveal it’s true value and affected the income
statement by decreasing net income in most years.
Since the lease payment is
credited to lease expense and another portion goes to lease expense, the remainder
reduces the lease liability on the balance sheet. After reviewing the restated income
statement, it is very apparent that the restated financials led to a decrease in retained
earnings every year. Pep Boys’ could have very well taken a “big bath”, by intentionally
understated assets and overstating liabilities, to try to appear that they could do well in
the future.
Financial Analysis, Forecast Financials, and Cost of Capital Estimation To determine the true value of a firm such as Pep Boys, financial analysis,
forecasting, and cost of capital estimation must take place. The financial analysis step
uses ratios to compare the financial position of Pep Boys and its competitors in the auto
parts retail industry. Ratio analysis is used to compare the different aspects of a firm’s
performance, and to allow for reasonable forecasting of the firm’s financial statements.
With these ratios, we will be able to estimate the future performance of a firm through
general trends. We will also be able to use the forecasted statements to predict how
the firm will perform in the foreseeable future, and estimate the value of the firm in
long term potential and longevity. Once a firm’s forecasting is completed, the data can
then be used to estimate the cost of capital. The estimation of the cost of capital in
addition to the two other main segments and the knowledge of previous industry
analysis, a true value of Pep Boys can be obtained.
124 Financial Analysis A financial analysis enables viewers to have a better understanding of the true
value of a firm. Ratios make the cross comparison of firms in an industry possible,
because of the differences in size and operations without ratios the comparison would
be distorted, and have a relative amount of noise (un-needed information). Ratios such
as liquidity, profitability, and capital structure, allow for useful means to compare, and
evaluate a firm. We will use these ratios, to analyze Pep Boys and its competitor’s
against the industry average to get an accurate estimate of Pep Boys’ value.
Liquidity Ratios Ratio’s which measure liquidity are used in order to understand how easily a firm
can pay for existing liabilities with cash or other short term assets. Liquidity ratios give
an idea of how easily a firm can convert these assets and other holding into cash. Firms
need to hold an acceptable level of cash or liquid assets for many reasons. Daily
operations require a certain amount of cash for things such as giving change to
customers, or paying for unanticipated needs. Firms must also hold a sufficient amount
of liquid assets to pay for maturing liabilities, not holding the needed amount of liquidity
can cause a firm to obtain cash by selling assets at a considerable discount.
Firms with high liquidity can pay for liability obligations, but could be suffering
from inflation loss, and improper investment strategy. Using the industry average will
allow us to understand general firm liquidity needs, and show who is using the proper
mix of investment and liquidity. The most common measures of liquidity are current
ratio, quick asset ratio, inventory turnover, receivables turnover, and working capital
turnover. With these measures, we will have a better understand of Pep Boys liquidity,
and be able to see how they stack up with the industry.
125 Current Ratio Current ratio is a measure of liquidity derived by dividing the current assets by
current liabilities. The current ratio is a very common ratio to judge liquidity. Although
this ratio is a very good measure of liquidity it is not the only ratio that provides a
measure of liquidity. We will look into the other liquidity ratios in later sections. Banks,
creditors, and investors prefer a current ratio between one and two; this means that
the firm will have sufficient current assets, or available cash to pay for maturing
liabilities. If a firm has a current ratio under one, it would be necessary for a firm to use
income from current operations to pay for their current liabilities. The graph below
illustrates the current ratio for Pep Boys and its competitors, as well as the industry
average.
CURRENT RATIO
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
126 If one were to look at the graph above, it is clear see that the auto parts industry
as a whole stays consistent, hovering around 1.40. When computing a current ratio, the
greater the number, the better it is for a firm. The greater number demonstrates that a
firm has the ability to pay off liabilities in the current period. The industry leader by far
is O’Reilly, whose current ratio is around 2. This current ratio is well above the industry
average. Pep Boys has had a fair current ratio over the past five years and has stayed
consistent with the industry average for this time period. By Pep Boys having a current
ratio ranging from 1.27 to 1.43, it shows that they are able to pay for their current
liabilities without using income from current operations. The ratio also shows that Pep
Boys is keeping an expectable level of assets, to liabilities, while properly investing their
assets.
Quick Asset Ratio The quick asset ratio, also known as the acid test ratio is another common
liquidity measure used by investors. The ratio includes only the most liquid assets: cash,
short term investments, and accounts receivables. This ratio excludes inventory
because it is not as liquid as the other components of the ratio. The ratio assumes that
the accounts receivable are extremely liquid because they can be sold quickly if needed.
Similar to the current ratio, you compute the quick asset ratio by dividing the quick
assets by total current liabilities. The importance of computing the quick asset ratio is to
determine whether or not a firm will be able to handle an unexpected economic
downturn. In addition, a higher quick asset ratio is preferred, as in the case of a current
ratio. If the results of the quick asset ratio are above one, this shows that under the
worst possible scenario, a firm will have the ability to pay their liabilities without the
addition of selling of inventory.
127 QUICK ASSET RATIO
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Pep Boys’ quick asset ratio is right between the competitions, following almost
exactly the industry average. Once again, O’Reilly is firmly above the competition in
their quick asset ratio, showing there liquidity over the competition. In 2009 however
the whole industry converges to a similar ratio. A trend that is not so positive is the fact
that all the competitors seem to be on a decline, regarding their current ratio. The
decline could be a sign that the firms are being more efficient in keeping the correct
amount of current assets to pay off liabilities, and investing the other assets to fight
inflation, and improve profits. Pep Boys quick asset ratio is very steady and seems to be
almost the industry average. The low numbers for this ratio are most likely attributed to
the fact that the auto parts industry relies highly on selling inventory for their assets.
From the information above we feel that Pep Boys liquidity is adequate show by their
almost perfect alignment with the industry average.
128 Inventory Turnover The inventory turnover ratio is a measure of how a firm can balance cost of
goods sold, and inventory. Inventory turnover ratio is found by dividing the cost of
goods sold by inventory. A high inventory turnover ratio mean that the firm is managing
their inventory effectively, by forecasting needs, and not keeping a lot of excess
inventory. A low inventory turnover ratio could mean that the firm is managing its
inventory ineffectively, or keeping having more inventory than need for fiscal year. The
inventory turnover ratio is an essential measure for the auto parts industry since selling
the inventory is the primary component of their revenues.
INVENTORY TURNOVER
(Pep Boys, AutoZone, Advance Auto, O’Reilly 10k)
By viewing the graph above, it is clear to see that Pep Boys is ahead of the
industry with respect to inventory turnover. The ratio for Pep Boys inventory turnover
over the past five years ranges from 2.55 to 2.94 demonstrating that the firm is capable
129 of managing inventory properly. The auto parts retail industry a highly competitive
industry requiring efficient use of inventory in order to keep cost to a minimum, and
gain a competitive advantage. When Pep Boys operating leases are taken into account
their liabilities raise, which raises their cost of goods sold, and lowers their inventory
turnover ratio. These lowered inventory turnover ratio would suggest that Pep Boys is
lagging in their inventory turnover, which could be one factor attributing to their trailing
company. As a whole, the competitors of Pep Boys have remained consistent and over
the five year period and are performing similarly to each other.
Day Supply of Inventory Day supply of inventory ratio measures the time is takes a firm to sell its
inventory. The ratio is computed by dividing the number of days in a year 365 by the
inventory turnover ratio. Similar to the inventory turnover ratio, the day supply of
inventory is a measure of a firm’s efficiency with managing its inventory. In the auto
parts industry inventory is a very important asset, and selling those assets is essential
to the industry’s revenue flow, and overall success. We will analyze this ratio to
understand Pep Boys inventory efficiency and see how they stack up against industry as
a whole.
130 DAY SUPPLY OF INVENTORY
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Pep Boys’ day supply of inventory is severely below the competition, and this a
positive number. The auto parts industry relies on selling its inventory as quickly as
possible in order to recognize revenues. The industry overall has been very slow,
staying around a 200 day to turnover its inventory. Although the industry has had an
overall slow turnover rate, the rate has been steady over the past five years. Therefore,
firms find this a positive outcome, because forecasting future needs is made easy by
the lack of volatility in turnover. A closer look into why Pep Boys Day supply of
inventory is so much lower than the average needs to be recognized. A possible reason
for Pep Boys’ dominance could be that Pep Boys is the only firm that reports the service
sector of their company which affects cost of goods sold. In all the day supply of
inventory is higher for the industry than expected, but shows Pep Boys’ is in the right
direction.
131 Accounts Receivable Turnover Accounts receivable turnover is a measure of a firm’s effectiveness in collecting
debt. This activity ratio is a measure of a firm’s asset use and effectiveness. The
formula for finding accounts receivable turnover is sales divided by accounts
receivables. A larger ART shows a firm is efficient in turning their outstanding
receivables into cash, or cash equivalent (liquid assets). A lower ART demonstrates a
need for to adjust receivables collection process.
The auto parts industry is primarily a retail industry which collects cash at point
of sale. The auto parts industry keeps low accounts receivables because of the need for
cash quickly, and because of the industry need for selling large volumes of inventory to
make marginal profits. An analysis into the industry accounts receivable turnover will
allow us a look at another liquidity measure.
ACCOUNTS RECEIVABLE
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
132 Pep Boys is above the industry average with respect to accounts receivable
turnover. The industry as a whole does not deal with accounts receivables to a great
extent, but with the information given we can see that they do a good job of turning
these receivables into liquid assets, better than most of their competitors.
Day Supply of Receivables The day supply of receivables ratio is used to clarify the accounts receivable
turnover ratio by taking 365 divided by the accounts receivable turnover ratio. The ratio
will show the amount of days it takes a firm to collect its accounts receivables. The
fewer days that it takes a firm to collect on its accounts receivables the better, this is
because the cash flow from the accounts receivables makes the firm more liquid, an
able to pay expiring liabilities.
DAY SUPPLY OF RECEIVABLES
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
133 If one were to look at the graph above one could see that Pep Boys again is
above the industry average, taking fewer days to collect on their accounts receivables
than their competitors. O’Reilly is far behind the competition, but making strides
towards aligning with the rest of the industry. Again Accounts receivables are only a
small part of the auto parts industry, but part of the companies. In all Pep Boys collects
on their accounts receivables in about 5 days allowing them to reinvest in the firms
operations, and provide more liquidity for their company.
Cash to Cash Cycle The cash to cash cycle displays the amount of days it takes a firm to collect cash
from their accounts receivables and sell their inventory. As one might expect the
quicker a firm can sell of their inventory, and then collect the cash from these sales the
better, and the more liquid the firm can be. The cash to cash cycle is computed by
adding the days sales outstanding ratio and the day’s supply of inventory ratio. The
lower the ratio the better for this represents greater efficiency and liquidity for the firm.
This ratio will allow us to see how Pep Boys compares to the competition.
134 CASH TO CASH CYCLE
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
If one were to look at the graph above, you can see that Pep Boys cash to cash
cycle is considerable lower than the other three main competitors. Having a lower ratio
for the cash to cash cycle is a positive notion, and again shows Pep Boys above average
liquidity, compared to the industry. Pep Boys is taking an average of 140 days to sell
their inventory and then collect on these sales, where as the industry average is around
205 days. The cycle reflects all the previous liquidity ratios, and reaffirms that Pep Boys
has sufficient liquidity.
Working Capital Turnover The working capital turnover ratio explains the relation between sales and
working capital. To calculate working capital turnover divide sales by working capital.
The ratio for finding working capital is total current assets minus total current liabilities.
This is an important liquidity ratio because it explains how well a firm uses working
capital to produce higher sales volume. In terms of working capital turnover a higher
turnover ratio is a good sign, showing that a firm is efficiently managing their working
135 capital in relation to sales. A look at the individual firm’s ratio and auto parts industry as
a whole will give us a good benchmark for Pep Boys working capital turnover efficiency.
WORKING CAPITAL TURNOVER
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Pep Boys falls behind AutoZone, and the industry average for working capital
turnover. However when AutoZone is taken out of the mix Pep Boys is on the industry
average and unlike AutoZone, has a very steady ratio through the five years. Pep Boys
working capital tells us that although their numbers are not as high as AutoZone, they
are average at using their working capital to produce sales. The overall steady numbers
provided by Pep Boys should encourage investors because of low volatility; on the
contrary AutoZone’s substantial drop in 2009 is reason for concern.
Liquidity Ratio Analysis Conclusion When we compared Pep Boys liquidity ratios to their competitors, we found that
they seem to be above the industry average on almost every liquidity measure we
analyzed. There is a general trend with each of the competitors throughout the
136 industry. O’Reilly was lagging in almost every liquidity measure we computed,
AutoZone, and Advance Auto were in the middle of the pack in most ratios, and
surprisingly Pep Boys had the highest liquidity in most measures.
Pep Boys was not perfect in their liquidity, and can still improve on many of
these ratios. The primary ratios that Pep Boys’ can improve are the current ratio, and
the quick asset ratio. Improving on Pep Boys’ current ratio and quick asset ratio could
be achieved by lowering their current liabilities, and raising their current assets. By
lowering their current liabilities and raising their current assets Pep Boys can improve
their liquidity and efficiency in these segments. Overall Pep Boys is very liquid compared
to auto parts industry outpacing the average in most liquidity measures. The graph
below will visually relate our findings on Pep Boys’ liquidity to their competitors in each
of the measures analyzed.
LIQUIDITY RATIO ANALYSIS (Pep Boys-to-Industry)
RATIO
PERFORMANCE
TREND
Current Ratio
Underperforming
Stable
Quick Asset Ratio
Average
Decreasing
Inventory Turnover
Outperforming
Stable
Day Supply of Inventory
Outperforming
Stable
Receivables Turnover
Outperforming
Volatile
Days Sales Outstanding
Average
Stable
Cash to Cash Cycle
Outperforming
Stable
Working Capital Turnover
Average
Stable
Overall
Outperforming
Stable
Profitability Analysis Profitability Analysis is a tool investors use to determine the efficiency with
which a firm is turning net sales into net income. Profitability Analysis can show
137 investors the efficiency with which a firm is using its resources to produce profits. These
analyses can be used to determine profit and earning trends for the firm and ultimately
give a better understanding of the true value of the firm. The most common profitability
analysis used by investors are gross profit margin, net profit margin, operating profit
margin, return on assets, return on equity, and asset turnover. The auto parts industry
is highly competitive, firms in this industry compete on cost leadership, and in order to
compete firms must control costs, and maintain precise margins. In the following
paragraphs we will use these analyses to compare Pep Boys profitability to their
competitors.
Gross Profit Margin Gross profit margin is a measure of a firm’s product profitability and measures
remaining money from sales after deducting the cost of goods sold. This ratio is
computed by dividing sales by gross profit. Since gross profit is computed by
subtracting cost of goods sold from net sales, a greater ratio demonstrates that a firm
is able to maintain a low cost of goods sold relative to net sales. If a firm has a low
gross profit margin compared to the industry, it shows that they are not keeping their
costs low in relation to its competitors, resulting in a profitability advantage to the
competition. Using industry benchmarks to compare gross profit margin, will give a
good idea of how well the firm is performing in this profitability measure. The graph
below illustrates the gross profit margin for Pep Boys and its competitors over a five
year period.
138 GROSS PROFIT MARGIN
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
If one looks at the graph above it is clear that Pep Boys is far below the
competition, and has a below average gross profit margin over the past five years. The
graph shows that Pep Boys cost of goods sold is much higher than their competitors.
Pep Boys is inefficient with their inventories, receiving higher product costs than the
competition. In an industry dominated by the need to control sales costs, Pep Boys is
severely lagging its competitors handicapping any attempt at providing lower cost to its
customer than the rest of the industry. Pep Boys must be more efficient managing
product cost in order to decrease cost of goods sold, and improve profitability.
Operating Profit Margin Operating profit margin is found by diving operating income by sales. To find
operating income you subtract selling, general, and administrative expenses (SG&A)
from gross profit. The operating profit margin provides investors a measure of how
139 efficient the firm is with respect to their expenses. A higher operating profit margin is
preferred because this demonstrates that the firm is efficiently keeping their selling,
general, and administrative expenses low. Since Pep Boys uses operating leases, the
SG&A expenses change between the as stated and restated basis so we will analyze
both examples.
OPERATING PROFIT MARGIN
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
As one can see by viewing the graph above, the operating profit margin for Pep
Boys over the past five years has been well below the industry average, while its
competitors have only been slightly below or above the industry average. The industry
average ranges from 8.45% to 9.82% over the five year period, with Pep Boys’
percentage averaging .50%. On restated basis Pep Boys operating profit margin drops
by about 1.5%, averaging around -1%. The effect on capitalizing Pep Boys’ operating
leases adds an amount of depreciation expense which lowers Pep Boys operating
margins, and overall profitability. Although capitalizing operating leases lowers the
140 overall profitability of the firm, the amount of change in operating profit margin is
minimal. Over the five year period, the fluctuations of the operating profit margin for
Pep Boys has been slightly above stable, but not extremely volatile. The rest of the
industry has had a more stable operating profit margin, and it is clear to see that the
ratio for Pep Boys is out of the norm for the industry.
Net Profit Margin The net profit margin is computed by dividing net sales by net income. This ratio
helps determine how profitable a company is because it gives investors a direct
relationship between sales, and income. A higher net profit margin is desired because
this means that more sales dollars are being transformed into profits. We will compare
Pep Boys to the industry average over the past five years, as well as Pep Boys restated
net profit margin to see how this affects their profitability.
141 NET PROFIT MARGIN
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
By viewing the graph above, we can see that Pep Boys is the lowest performing
firm within the auto parts retail industry with respect to net profit margin. Over the
course of the past five years, Pep Boys has had a negative net profit margin for the
majority of the time, while the competitors of Pep Boys have never fallen below a net
profit margin of 4%. Although Pep Boys has been underperforming the rest of the
industry, there is reason for an optimistic mind because the net profit margin had a
dramatic increase from 2008 to 2009 on a restated basis. Pep Boys profit margin
although improving is still far below the industry average hindering their profitability.
Asset Turnover The asset turnover ratio is a very informative calculation to use when valuing a
firm. Asset turnover is found by dividing total sales by total assets. This ratio explains
142 how the firm is generating sales through asset use. This ratio also shows how many
sales are made for every dollar worth of asset the company owns. We use a lag ratio to
calculate asset turnover, which means that you take the current year’s sales and divide
by the previous year’s total assets. A lag ratio is used because sales are generated from
the firms pre-existing asset. A comparison of Pep Boys asset turnover rate to that of the
industry will allow further asses Pep Boys profitability.
ASSET TURNOVER
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
If one looks at the graph above you can see that Pep Boys asset turnover ratio
is below average holding around 1.25. The industry average is around 1.4, and the
leader is Advance Auto with around a 1.8. Pep Boys is producing around 1.25 sales
dollars for every dollar of assets. As we expected Pep Boys restated asset turnover is
143 lower than their as stated because of their use of operating leases. This is reason for
concern because Pep Boys need to do a better job of turning their assets into sales
dollars. If Pep Boys can be more efficient with their asset turnover they can improve
their profitability.
Return on Assets The return on assets ratio is calculated by dividing net income in the current year
by total assets in the previous year. Similar to the asset turnover ratio a lag is needed
to properly compute the asset. The return on asset ratio explains the link between
assets and actual profits. This ratio is explains a more specific part of profitability than
the asset turnover ratio. A higher return on asset ratio is preferred, because this shows
the amount of net income generated through every asset dollar. A look at Pep Boys
return on asset ratio compared to their competitors will give us a better understanding
of Pep Boys Profitability.
RETURN ON ASSETS
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
144 Pep Boys is once again lagging far behind the industry average in return on
assets. The industry as a whole is very steady holding around 10% return on
assets. Pep Boys has had negative returns most of the years, the only relief is that in
2009 they are positive, and sloping upward towards the competition. If this trend
continues then possibly Pep Boys can catch up to the competition which as we stated
before is very steady.
On a restated basis Pep Boys return on assets is only slightly higher. When Pep
Boys financials are restated with their capital leases the ratio raises and this is expected
because it raises both net income and total assets. This explains that Pep Boys is not as
efficient as the competition with their cost structure, and this hurts their net income.
For Pep Boys to improve profitability they need to improve their return on assets.
Return on Equity Return on equity is a very important profitability measure. Return on equity is
computed by dividing net income by total equity. This is similar to return on assets
except that equity is used instead of total assets. The return on equity is a lag ratio
similar to previous ratios, therefore the numerator is in the current year, and the
denominator is from the previous year. The return on equity ratio is very important to
shareholders or owners of the company. This is because it show how their contributions
are being used to generate profit. A look at Pep Boys return on equity compared to the
industry will provide a good benchmark to judge their Profitability. The graph below will
discuss the industry and Pep Boys return on equity.
145 RETURN ON EQUITY
(P
ep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Pep Boys is once again below the competition they are averaging around
negative 1.0% return on equity. All the competitors with the exception of AutoZone
have stable and average returns. The only positive that can be taken away from this
statistic in Pep Boys behalf is that their 2009 return is about 5% and has been slowly
increasing. Pep Boys restated return on equity provides almost an exact replica of their
as stated. This graph shows that Pep Boys is not using shareholders wealth to generate
profits as efficiently as their competitors. Although Pep Boys return on equity is on a
positive slope this is a very disturbing 5 year ratio.
Profitability Analysis Conclusion 146 The Profitability Analysis conducted for Pep Boys was very disturbing, showing
very real flaws in the company. Pep Boys was behind the competition is almost every
Profitability measure we conducted. Pep Boys seems to have had a much needed
improvement in 2009 in regards to almost every profitability measure. In the auto parts
industry these trends need to continue every year for Pep Boys in order for them to be
more profitable, and gain market shares in the industry. Pep Boys substantial difference
in profitability compared to their competition is a primary reason for concern of Pep
Boys being bought out by one of their much more stable and profitable competitors. In
all we concluded that Pep Boys is severely underperforming in Profitability compared to
the industry. In a highly competitive cost leadership industry poor profitability makes it
difficult to lower prices and gain market shares. Below is a look at Pep Boys overall
Profitability Analysis broken down into each ratio we computed.
PROFITABILITY RATIO ANALYSIS (Pep Boys-to-Industry)
Ratio
Performance As
Performance Restate
Trend
Stated
Gross Profit Margin
Underperforming
N/A
Stable
Operating Profit Margin
Outperforming
Underperforming
Upward
Net Profit Margin
Underperforming
Underperforming
Upward
Asset Turnover
Underperforming
Underperforming
Stable
Return on Asset
Underperforming
Underperforming
Upward
Return on Equity
Underperforming
Underperforming
Stable
Overall
Underperforming
Underperforming
Upward
Capital Structure Analysis The analysis of capital structure is used to determine a firm’s financing. The
ratios used in capital structure analysis are debt to equity, time interest expense, and
debt to service. These ratios can inform investors how much debt a firm has, and how
well a firm can pay its long term debt. In addition, the ratios are used in determining
147 the amount of financial leverage a firm has. When a company has high leverage, this
can mean that a firm is borrowing to invest in future operations and the firm can
potentially grow. The capital structure analysis also determines whether or not a firm is
able to properly finance their assets, while paying their liabilities.
Debt to Equity The debt to equity ratio is a determinant in the credit risk a firm has. The ratio
for debt to equity is shown below.
Firms prefer to finance through equity that they have acquired, therefore they
desire a low debt to equity ratio. Ratios that are as close to one as possible are
favorable, while ratios greater than 1.5 are problematic and reason for concern for a
firm. The higher the ratio, the great risk a firm has to paying back the principal
payment and interest they have acquired when borrowing. The graph below illustrates
the debt to equity ratios of Pep Boys (on a raw and restated basis) and its competitors
in the auto part retail industry.
Debt to Equity
148 2005 2006 2007 2008 2009 Pep Boys Advance Pep Boys Restated O'Reilly’s Auto AutoZone Industry 2.06 2.63
0.5
1.76
9.86 3.545 2.11 2.62
0.45
1.6
8.64 3.2 2.36 3.12
0.43
1.74
10.92 3.8625 2.67 3.79
0.84
1.76
21.89 6.79 2.38 3.57
0.78
1.4
‐13.28 ‐2.18 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
As one can see from the graph above, all of the firm’s within the auto parts retail
industry have similar debt to equity ratios, except AutoZone. Pep Boys’ raw data debt to
equity ratios range from 2.06 to 2.67 over the five year period, while with the restated
data the ratios range from 2.63 to 3.79. although Pep Boys is staying on track with
most of its competitors in the industry, the high debt to equity ratio is problematic and
reveals that the majority of their assets are being financed through debt and not equity.
Time Interest Earned The time interest earned is another ratio used in analyzing the capital structure.
The ratio for time interest earned is listed below.
Time interest earned= Net earnings before interest & taxes/ Interest expense
The interest acquired by a firm for current and long term debt is a yearly
expense that must be paid, and the number of times interest is earned is an indicator
on how the yearly interest expense is being paid. In addition, it reveals how much
income is being used by financing debt rather than contributing to retained earnings.
Unlike the debt to equity ratio, the higher the time interest earned, the better it is for a
firm. A higher ratio is favorable because it reveals the ease at which a firm is able to
pay for their yearly interest expense. The graph below illustrates the time interest
earned ratio of Pep Boys and its competitors.
149 Time Interest Earned
Pep Boys
2005
2006
2007
2008
2009
Pep Boys O'Reilly
Advance AutoZone Industry
Restated
Auto
Avg.
-0.15
-0.74
49.60
-12.61
9.52 11.58969
0.87
0.24
65.31
-11.21
9.36 16.08222
-0.23
-0.8
82.59
-11.96
8.86 19.81536
-0.29
-1.81
11.57
-12.3
9.63 2.153603
2.73
0.88
11.00
-19.47
8.26 0.62979
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
As one can see by viewing the graph above, Pep Boys has stayed consistent over
the past five years with their time interest earned ratio; however, for three out of the
five years they have had a negative ratio . Even with the restated date for the time
interest ratio, Pep Boys’ ratio is still negative in three of the five years. The only
difference is that when the ratio turned negative, the net earnings before interest and
taxes (NIBIT) was more negative in the restatement than when using the raw data.
When the ratio returned to being positive, the NIBIT was a les positive number than the
150 raw data causing a smaller ratio. O’Reilly Auto Parts is the clear front runner within the
industry with their time interest earned ranging from 11 to 82.59. This shows that while
they are keeping a lot of income in their received earnings account, both Pep Boys for
most of the past five years and Advance Auto in 2009 was not able to cover their
interest expense.
Debt Service Margin The debt service margin is a ratio that is used to determine how well a firm can
pay for their current principal due on their long term debt by using the cash provided by
operations. The ratio for debt to service margin is listed below
Debt Service Margin= CFFOt /Note Payable (current)t-1
The higher the ratio for debt service margin, the better it is for a firm. The
greater ratio means that a firm has more money to finance its current long term debt
payment. A problematic ratio is a ratio less than one, because this shows that a firm
does not have enough money to afford their payment on the current debt.
Debt Service Margin
151 Pep Boys O'Reilly 0.13 Pep Boys Restatement
0.13 AutoZone 349.13 Advance Auto 0.52 2005 2006 ‐0.12 ‐0.12 2.47 0.51 2.22 2007 0.35 0.35 968.99 0.6 5.06 2008 0.20 0.20 11.79 0.6 2.11 2009 ‐0.16 ‐0.16 35.08 0.72 N/A 1.23 (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
As shown from the graph above and the previous graphs, Pep Boys is consistent
with most firms in their industry when comparing the debt to service margin ratio.
O’Reilly’s has a huge ratio amount for their debt to service margin and strays away from
the industry by a tremendous amount in 2007. For the most part, all firms within the
industry were consistent with each other, with the exception of year 2005 and 2007 in
which O’Reilly’s debt service margin ratio sky rocketed. The reasoning behind AutoZone
not having a 2009 debt service margin ratio is because there were not current notes
payable for 2008
Altman’s Z­Score Altman’s Z-score is a credit rating equation that is used to determine whether or
not a firm is at risk for filing bankruptcy. According to Palepu, a good Z-score rating is
above a 2.67, the moderate range if between 1.81 and 2.67, and a company is at most
risk for filing bankruptcy is their Z-Score is below a 1.81. The calculation for Altman’s Zscore is from the equation below
1.2(working capital/total assets) +
1.4(retained earnings/total assets) +
3.3(earnings before interest and taxes/total assets) +
0.6(market value of equity/book value of total liabilities) +
1(asset turnover ratio) = Altman's Z-Score
152 The graph below illustrates the Z-scores for Pep Boys and its competitors.
Altman’s Z-score
Pep Boys 2005 2006 2007 2008 2009 Pep Boys O'Reilly Advance AutoZone Industry Restated Auto 1.68 1.768
6.374
4.26
3.4 3.9285
1.78 2.567
6.224
4.09
3.16 3.8135
1.61 1.616
5.826
4.2
3.27 3.7265
1.63 1.4237
3.075
4.6
2.99 3.07375
1.86 2.499
3.589
4.7
2.8 3.23725
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
As one can see by viewing the graph above, Pep Boys and AutoZone are the two
companies who’s Z-Scores is below the industry average. Although Pep Boys and
AutoZone are both below the industry Z-Score average, Pep Boys is the only firm within
the industry that has a high risk of bankruptcy. The raw data shows that from 2005 to
2008, Pep Boys Z-Score was below a 1.81 and in 2009, the Z-Score increased to 1.86.
When financials for Pep Boys were conducted and new Z-Scores were calculated, the zscores for the company were above a 1.81 for only 2 years, with its highest score being
a 2.567 in 2006. By the calculations, it can be concluded that Pep Boys is on the verge
153 of bankruptcy or by out. Overall, the firms within the auto parts retail industry, with the
exception of Pep Boys have a good Z-score; therefore, banks are more willing to invest
in them.
Capital Structure Analysis Conclusion To conclude the capital structure analysis, it is clear that Pep Boys has before
below the industry. Pep Boys has maintained stable in all of the ratios that we have
discussed in this section, but unfortunately have not performed to the standards of the
industry and are subject to bankruptcy with the low Z-score. Over the years, Pep Boys
has shown that although they do not have as high a debt to equity ratio as its
competitor, AutoZone, they still have not minimized their ratio and shown and that
prefer to finance with equity. Instead, they have increased their debt to finance the
company. With such volatility among the industry in the Z-Score area, it is challenging
to analyze the relationships between the two. However, Pep Boys’ data reveals that
they are a type of outlier within the industry. Due to the extremely low Z-score of Pep
Boys and their lack of inability to use equity for financing, investors are un-attracted to
investing in the firm.
Ratio
Debt to Equity
Time Interest Expense
Debt Service Margin
Altman’s Z-Score
Overall
Capital Structure Ratio Analysis
Trend
Performance
Stable
Below
Stable
Below
Stable
Below
Volatile
Below
Stable
Below
Growth Rate The growth rates are used to determine whether or not a firm can maintain and/
or increase its future growth. Knowing and being able to interpret the growth rates aid
a firm in forecasting. The two growth rates that we will be discussing in the next
section are internal growth rate and sustainable growth rate.
154 Internal Growth Rate The internal growth rate is a measure of the maximum amount a company can
grow by only using internal financing. It also refers to the amount a firm can increase
their total assets by not taking out additional debt. Companies that do not pay
dividends to their stockholders have an internal growth rate equal to their return on
assets ratio. The internal growth rate calculation is shown below
IGR= ROA * [1- (DIVIDENDS/NET INCOME]
Pep Boys 2005 2006 2007 2008 2009 1.7% 8.5% 1.6% 1.8% ‐2.1% Pep Boys Restated 1.5% ‐1.2% 1.5% 1.4% 1.2% O'Reilly 1.2% 1.2% 1.1% 0.9% 1.0% Advance AutoZone Industry Auto 10.7% 1.5% 3.8% 8.1% 1.4% 4.8% 8.0% 1.4% 3.0% 7.7% 1.4% 2.9% 8.3% 1.3% 2.1% (Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
Over the past five years, one can see that Pep Boys and O’Reilly Auto Parts have
been below the industry IGR average. A reason for this is that Pep Boys and O’Reilly
give dividends to their stockholders, and Advance Auto and AutoZone do not. By Pep
Boys having a negative IGR in 2009, this shows that they are clearly unable to increase
155 their assets with internal finance. This finding is discouraging to investors and is cause
for Pep Boys to acquire more debt in hopes of increase total assets.
Sustainable Growth Rate The sustainable growth rate is similar to the internal growth rate, but the
distinct factor between the two is that sustainable growth rate includes the capital
structure of a firm. This ratio is a measure of the maximum a firm can increase their
assets with internal and external financing at an efficient rate. The sustainable growth
rate is shown below.
SGR= IGR * [1 + (liabilitiest-1 / equityt-1)]
Pep Boys 2005 2006 2007 2008 2009 Pep Boys O'Reilly Advance AutoZone Industry Restated Auto 4.9% 1.9%
1.8%
29.2%
16% 51.6%
26.0% ‐4.2%
1.7%
22.4%
2.6% 52.7%
3.4% 3.8%
1.6%
20.7%
13.1% 9.7%
2.2% 4.5%
1.2%
20.7%
16.2% 10.1%
‐3.6% 4.5%
1.8%
22.9%
29.8% 12.7%
(Pep Boys, O’Reilly, AutoZone, Advance Auto 10-Ks)
156 The SGR for Pep Boys is very volatile on an as stated and restated basis, and is
on a decline. These rates are to be expected since the SGR follows trends of the IGR
and when observing the IGR graph a table, one can see that the percentage was on the
decline. This is also an indicator that Pep Boys cannot have firm growth, even with
additional external financing like its competitors. It is realistic to conclude that the SGR
of Pep Boys in future years will decline more and will prevent the firm even more from
future growth.
Financial Analysis conclusion By completing a financial analysis of the auto parts retail industry, a better view
of Pep Boys’ position, as well its competitors are established. In both the liquidity and
profitability analysis performed on the companies, Pep Boys underperformed in the
industry. The underperformance raises question as to whether or not Pep Boys will be
able be a profitable company within the next few years. As stated in their 10-k, the firm
has only recorded a net profit in two out of the last five years. Overall Pep Boys has
underperformed in their industry and has shown that they are subject to bankruptcy
due to the facts that they cannot generate profit through internal and external
financing, pay interest expenses for the year, pay principal on their debt, and previous
factors that we have discussed throughout this section. The financial analysis process is
a key determinant of forecasting a firm’s financials.
Financial Forecasting To approximate the intrinsic value of a firm, assumptions must be made
concerning the future growth of the firm. Financial forecasting relies on the information
gained from the business strategy analysis, accounting analysis, and financial analysis
to make reasonable financial assumptions (Palepu). While these reasonable
assumptions are not exact, a financial forecast does not take into account unanticipated
events and how these events impact a firm’s financial statements. However, by using
information from the industry and the firm’s ratio, an accurate estimation can be made.
157 Pep Boys’ forecasted financial statements, including restated financial statements, for
the next ten years will be estimated and thoroughly analyzed.
Income Statement The forecasted income statement is a very important piece of a firm’s valuation,
because it directly affects the balance sheet and the statement of cash flows. The
forecasted income statement provides external users with future sales growth of the
firm. An accurate projection of sales growth is important because unreasonable sales
growth projections can lead to skewed projected financials.
When estimating future sales growth, past performance along with current
economic outlook must be taken into account. The factors used to determine sales
growth include the firms past 10-Ks and 10-Qs. Pep Boys’ fiscal year ends at the end of
January, therefore one quarter of the fiscal year has already ended and information
provided in the firms most recent 10-K can give insight on what to expect for 2010 and
beyond. After performing analysis on Pep Boys’ most recent 10-Q and 10-Ks, a
projection of -1.25% per year can be given to sales growth with reasonable certainty.
While the economy is slowly recovering from the events over the past couple years, Pep
Boys showed a near constant decline in growth prior to recession and exhibited a major
decline in sales during the recession. This was taken into effect as a major component
in the sales forecasting model.
After formulating the forecast for sales growth, the common-sized income
statement can be used to estimate other line items located in the income statement.
The percentage of each line item, compared to sales, can be used to find future
forecasts of items like cost of goods sold and operating profit, just to name a few. In
our forecasting, cost of goods sold is forecasted to be 75% of sales, which results in a
gross profit margin of 25%. The next line item that must be forecasted is Selling,
General and Administrative Expenses, which came out to 24% of total sales. Given the
previous information, operating profit will be forecasted as 1% of total sales. After
reviewing the firm’s most current 10-Q, net income stayed just below last year’s net
158 income, therefore, net income was projected at 1.20% of sales in 2010. With Pep Boys
having declining sales each of the last five years, it is likely to believe that Pep Boys will
not be able to maintain the growth that is shown in net income the last two years. We
believe that in 2011, sales will keep falling and costs will stay steady causing net
income to fall to .25% of sales, and then keeping steady at -.25% for all years
thereafter. The accuracy of the forecasted income statement is key given it is used as
the basis of our future valuation model.
159 Income Statement (As-Stated)
2004
2005
2006
2007
2008
2009
Merchandise Sales
$1,863,015
$1,852,067
$1,876,290
$1,749,578
$1,569,664
$1,533,619
Service Revenue
$409,881
$383,159
$395,871
$388,497
$358,124
$377,317
Total Revenues
$2,272,896
$2,235,226
$2,272,161
$2,138,075
$1,927,788
$1,910,938
Costs of Merchandise Sales
$133,296
$1,371,195
$1,336,336
$1,305,952
$1,129,162
$1,084,804
Costs of Service Revenue
$317,142
$352,713
$364,069
$345,886
$333,194
$340,027
Total Costs of Revenues
$1,650,438
$1,723,908
$1,700,405
$1,651,838
$1,462,356
$1,424,831
Gross Profit from
Merchandise Sales
$529,719
$480,872
$539,954
$443,626
$440,502
$448,815
Gross Profit from Service
Revenue
$92,739
$30,446
$31,802
$42,611
$24,930
$37,292
Total Gross Profit
$622,458
$511,318
$571,756
$486,237
$465,432
Selling, General and
Administrative Expenses
$547,336
$522,501
$551,031
$518,378
Net Gain From Sale of
Assets
$0
$0
$15,297
Operating (Loss) Profit
$75,122
($11,183)
$36,022
Non-operating Income
$1,824
$3,897
Interest Expense
$35,965
Net (Loss) Earnings from
Continuing Operations
Before Income Taxes and
Cumulative Effect of
Change in Accounting
Principle
Income Tax (Benefit)
Expense
Average
Assume
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
100%
$1,887,051
$1,863,463
$1,840,170
$1,817,168
$1,794,453
$1,772,022
$1,749,872
$1,727,999
$1,706,399
$1,685,069
75.00%
$1,415,288
$1,397,597
$1,380,127
$1,362,876
$1,345,840
$1,329,017
$1,312,404
$1,295,999
$1,279,799
$1,263,802
$486,107
25.00%
$471,763
$465,866
$460,042
$454,292
$448,613
$443,006
$437,468
$432,000
$426,600
$421,267
$485,044
$430,261
24.00%
$452,892
$15,151
$9,716
$1,213
($16,985)
($9,896)
$57,059
1.00%
$18,871
$18,635
$18,402
$18,172
$17,945
$17,720
$17,499
$17,280
$17,064
$16,851
$7,023
$5,246
$1,967
$2,261
$49,040
$49,342
$51,293
$27,048
$21,704
$40,981
($56,326)
($6,297)
($63,032)
($34,977)
$37,616
$35,965
($20,553)
($4,297)
($25,594)
($6,139)
$13,503
Effect of Change in
Accounting Principle
$25,666
($35,773)
($2,000)
($37,438)
($28,838)
$24,113
Earnings (Loss) from
Discontinued Operations,
Net of Tax
($2,087)
$266
($738)
($3,601)
($1,591)
($1,077)
($2,021)
$189
$0
$0
$0
($37,528)
($2,549)
($41,039)
($30,429)
$23,036
$22,645
$4,659
($4,600)
($4,543)
($4,486)
($4,430)
($4,375)
($4,320)
($4,266)
($4,213)
Net (Loss) Earnings from
Continuing Operations
Before Cumulative
Cumulative Effect of
Change in Accounting
Principle, Net of Tax
Net (Loss) Earnings
$23,579
160 Common Size Income Statement (As­Stated) Common Size Income Statement
2004
Sales Growth
Merchandise Sales
Service Revenue
Total Revenues
Costs of Merchandise Sales
Costs of Service Revenue
Total Costs of Revenues
Gross Profit from Merchandise
Sales
Gross Profit from Service
Revenue
Total Gross Profit
Selling, General and
Administrative Expenses
Net Gain From Sale of Assets
Operating (Loss) Profit
Non-operating Income
Interest Expense
Net (Loss) Earnings from
Continuing Operations Before
Income Taxes and
Cumulative Effect of Change
in Accounting Principle
Income Tax (Benefit) Expense
Net (Loss) Earnings from
Continuing Operations Before
Cumulative Effect of Change in
Accounting Principle
2005
2006
2007
2008
2009
Average
Assume
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
-3.32%
-1.25%
-1.25%
-1.25%
-1.25%
-1.25%
-1.25%
-1.25%
-1.25%
-1.25%
-1.25%
-1.25%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
75.38%
75.00%
75.00%
75.00%
75.00%
75.00%
75.00%
75.00%
75.00%
75.00%
75.00%
75.00%
-1.66%
1.65%
-5.90%
-9.84%
-0.87%
81.97%
82.86%
82.58%
81.83%
81.42%
80.25%
18.03%
17.14%
17.42%
18.17%
18.58%
19.75%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
5.86%
61.34%
58.81%
61.08%
58.57%
56.77%
13.95%
15.78%
16.02%
16.18%
17.28%
17.79%
72.61%
77.12%
74.84%
77.26%
75.86%
74.56%
23.31%
21.51%
23.76%
20.75%
22.85%
23.49%
4.08%
1.36%
1.40%
1.99%
1.29%
1.95%
27.39%
22.88%
25.16%
22.74%
24.14%
25.44%
24.62%
25.00%
25.00%
25.00%
25.00%
25.00%
25.00%
25.00%
25.00%
25.00%
25.00%
25.00%
24.08%
23.38%
24.25%
24.25%
25.16%
22.52%
23.94%
24.00%
24.00%
24.00%
24.00%
24.00%
24.00%
24.00%
24.00%
24.00%
24.00%
24.00%
0.00%
0.00%
0.67%
0.71%
0.50%
0.06%
3.31%
-0.50%
1.59%
-0.79%
-0.51%
2.99%
1.01%
1.00%
1.00%
1.00%
1.00%
1.00%
1.00%
1.00%
1.00%
1.00%
1.00%
1.00%
0.08%
0.17%
0.31%
0.25%
0.10%
0.12%
1.58%
2.19%
2.17%
2.40%
1.40%
1.14%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
1.80%
-2.52%
-0.28%
-2.95%
-1.81%
1.97%
1.58%
-0.92%
-0.19%
-1.20%
-0.32%
0.71%
-0.51%
-0.25%
1.20%
0.25%
-0.25%
-0.25%
-0.25%
-0.25%
-0.25%
-0.25%
-0.25%
-0.25%
1.13%
-1.60%
-0.09%
-1.75%
-1.50%
1.26%
Earnings (Loss) from
Discontinued Operations, Net of
Tax
-0.09%
0.01%
-0.03%
-0.17%
-0.08%
-0.06%
Cumulative Effect of Change in
Accounting Principle, Net of Tax
0.00%
-0.09%
0.01%
0.00%
0.00%
0.00%
1.04%
-1.68%
-0.11%
-1.92%
-1.58%
1.21%
Net (Loss) Earnings
161 Balance Sheet The next step after forecasting the income statement is to forecast the balance
sheet. The forecast from the balance sheet will provide investors and analysts with a
growth model for assets, liabilities, and equity. Since sales are the basis of forecasting,
we must find a way to link sales onto the balance sheet. Asset Turnover, which involves
both sales and total assets, is the best ratio to link sales to the balance sheet and
serves as a starting point for balance sheet forecasts. By analyzing past profitability
ratios, an asset turnover ratio of 85.00 will be used to forecast total assets. In order to
break down each asset, a common size asset table will be needed. This will provide us
with a breakdown of both current assets and non-current assets as a percentage of
total assets. After forecasting the future values of Pep Boys current and non-current
assets, it is necessary to forecast certain items of total assets. By using the liquidity
ratios, we are able to find future forecast value for Accounts Receivable and
Merchandise inventory by using A/R Turnover and Inventory Turnover, respectively.
Using these ratios, A/R Turnover was calculated as 85.00 and Inventory Turnover had a
value of 2.70. These values will be used to forecast the next ten years as these
numbers have held stable over the past five years.
After the asset forecasts are complete, the next step is to forecast both debt and
equity. Given that the totals of liabilities and equity are directly related to total assets, it
is possible to forecast current and noncurrent liabilities. Since the value of equity is
what we are mostly concerned with, we will not worry about the precision of liabilities.
In order to estimate retained earnings, the forecasted net income from the income
statement will be used, along with dividend payments. Over the past ten years, Pep
Boys maintained a dividend payout of .068 cents per share. However, in January 2009
the firm declared a decrease in the dividend payout by lowering it to .03 cents per
share. Pep Boys has continued to payout .03 cents per share since adopted the new
dividend payout. Since the dividend has held steady over 5 quarters after the old
dividend lasted ten years, there is no reason to believe that there will be a change in
dividend payout.
162 Now that stockholders equity and assets have been forecasted, the accounting
equation, Assets=Liabilties+Equity, can be used to forecasts total liabilities. After
finding total liabilities, we are able to find total current liabilities by using the current
ratio of 1.34 to find the value for current liabilities. It is now possible to find non-current
liabilities by subtracting current liabilities by total liabilities. Given the information just
formulated and the accounting equations, we are able to forecast the balance sheet
over ten years.
163 Balance Sheet
2004 2005 2006 2007 2008 2009 $82,758 $48,281 $21,884 $20,926 $21,332 $39,326 $30,994 $36,434 $29,582 $29,450 $28,831 $22,983 Merchandise inventories $602,760 $616,292 $607,042 $561,152 $564,931 $559,118 Prepaid expenses Other Assets held for disposal $45,349 $96,065 $665 $40,952 $85,446 $652 $39,264 $70,368 $0 $43,842 $77,469 $16,918 $25,390 $62,421 $12,653 $24,784 $65,428 $4,438 Inventory Turnover Total Current Assets $858,591 $828,057 $768,140 $749,757 $715,558 $716,077 Property and Equipment—at cost: Land Buildings and improvements Furniture, fixtures and equipment Construction in progress Total Property and Equipment Less accumulated depreciation and amortization Total Property and Equipment—
Net Deferred Income Taxes Other Total Assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities: Accounts payable $261,985 $916,099 $257,802 $916,580 $251,705 $929,225 $213,962 $858,699 $207,608 $822,950 $204,709 $826,804 $633,098 $671,189 $684,042 $699,303 $685,707 $695,072 $40,426 $1,851,608 $15,858 $1,861,429 $3,464 $1,868,436 $3,992 $1,775,956 $2,576 $1,718,841 $1,550 $1,728,135 $906,577 $914,040 $962,189 $995,177 $978,510 $1,021,685 $945,031 $947,389 $906,247 $780,779 $740,331 $706,450 $63,401 $1,867,023 $46,307 $1,821,753 $24,828 $67,984 $1,767,199 $20,775 $32,609 $1,583,920 $77,708 $18,792 $1,552,389 $310,981 $261,940 $265,489 $245,423 ASSETS Current Assets: Cash and cash equivalents Accounts receivable, less allowance for uncollectible accounts Ratio Assume 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 A/R Turnover 85.00 $22,201 $21,923 $21,649 $21,378 $21,111 $20,847 $20,587 $20,329 $20,075 $19,824 2.70 $524,181 $517,629 $511,158 $504,769 $498,459 $492,228 $486,076 $480,000 $474,000 $468,075 CA/TA 0.45 $670,847 $662,461 $654,180 $646,003 $637,928 $629,954 $622,080 $614,304 $606,625 $599,042 2.75 $677,623 $669,153 $660,788 $652,528 $644,372 $636,317 $628,363 $620,509 $612,752 $605,093 $58,171 $18,388 $1,499,086 PPE(net) Turn ATO 1.25 $1,490,771 $1,472,136 $1,453,734 $1,435,563 $1,417,618 $1,399,898 $1,382,399 $1,365,119 $1,348,055 $1,331,204 $212,340 $202,974 Trade payable program liability $11,156 $13,990 $14,254 $31,930 $34,099 Accrued expenses Deferred income taxes Current maturities of long‐term debt and obligations under capital lease $306,671 $19,406 $290,761 $15,417 $292,280 $28,931 $292,623 $254,754 $35,848 $242,416 $29,984 $40,882 $1,257 $3,490 $2,114 $1,453 $1,079 Current Ratio 1.34 $500,632 $494,374 $488,194 $482,092 $476,066 $470,115 $464,238 $458,435 $452,705 $447,046 Total Current Liabilities Long‐term debt and obligations under capital leases, less current maturities Convertible long‐term debt Other long‐term liabilities Deferred income taxes Deferred gain from asset sales Total Non‐current Liabilities Total Liabilities Commitments and Contingencies Stockholders’ Equity: Common stock, par value $1 per share: Authorized 500,000,000 shares Additional paid‐in capital Retained earnings Common stock subscriptions receivable Accumulated other comprehensive loss Less cost of shares in treasury Less cost of shares in benefits trust Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity $677,940 $580,531 $604,180 $554,414 $536,325 $510,552 $352,682 $467,239 $535,031 $400,016 $352,382 $306,201 $119,000 $37,977 $25,968 $119,000 $57,481 $2,937 $60,233 $72,183 $86,595 $70,322 $170,204 $73,933 $165,105 $535,627 $646,657 $595,264 $558,794 $592,908 $545,239 TL‐CL $525,431 $509,628 $503,239 $496,945 $490,745 $484,638 $478,622 $472,698 $466,862 $461,116 $1,213,567 $1,227,188 $1,199,444 $1,113,208 $1,129,233 $1,055,791 TE‐TA $1,026,063 $1,004,002 $991,433 $979,037 $966,811 $954,753 $942,861 $931,133 $919,568 $908,162 $68,557 $68,557 $68,557 $68,557 $68,557 $68,557 $284,966 $536,780 $288,098 $481,926 $289,384 $463,797 $296,074 $406,819 $292,728 $358,670 $293,810 $374,836 $396,248 $399,675 $393,842 $388,067 $382,348 $376,686 $371,079 $365,527 $360,029 $354,584 ‐$167 ‐$4,852 ‐$3,565 ‐$9,380 ‐$14,183 ‐$18,075 ‐$17,691 $172,564 $181,187 $185,339 $227,291 $219,460 $276,217 $59,264 $59,264 $59,264 $59,264 $59,264 $653,456 $594,565 $567,755 $470,712 $423,156 $443,295 $464,707 $468,134 $462,301 $456,526 $450,807 $445,145 $439,538 $433,986 $428,488 $423,043 $1,867,023 $1,821,753 $1,767,199 $1,583,920 $1,552,389 $1,499,086 $1,490,771 $1,472,136 $1,453,734 $1,435,563 $1,417,618 $1,399,898 $1,382,399 $1,365,119 $1,348,055 $1,331,204 164 Common Size Total Assets 2004
2005
2006
2007
2008
2009
AVERAGE
4.43%
2.65%
1.24%
1.32%
1.37%
2.62%
2.27%
1.66%
2.00%
1.67%
1.86%
1.86%
1.53%
Assume
ASSETS
Current Assets:
Cash and cash equivalents
Accounts receivable, less
allowance for uncollectible
accounts
0.04%
0.04%
0.00%
1.07%
0.82%
0.30%
45.99%
45.45%
43.47%
47.34%
46.09%
47.77%
1.76%
34.93%
2.16%
4.52%
0.38%
46.02%
14.03%
14.15%
14.24%
13.51%
13.37%
13.66%
13.83%
49.07%
50.31%
52.58%
54.21%
53.01%
55.15%
52.39%
33.91%
36.84%
38.71%
44.15%
44.17%
46.37%
Construction in progress
2.17%
0.87%
0.20%
0.25%
0.17%
0.10%
40.69%
0.63%
Total Property and Equipment
99.17%
102.18%
105.73%
112.12%
110.72%
115.28%
107.53%
Less accumulated
depreciation and amortization
48.56%
50.17%
54.45%
62.83%
63.03%
68.15%
57.87%
Total Property and
Equipment—Net
49.67%
1.93%
2.38%
53.98%
100.00%
32.28%
33.83%
34.35%
35.43%
36.39%
37.30%
Prepaid expenses
2.43%
2.25%
2.22%
2.77%
1.64%
1.65%
Other
5.15%
4.69%
3.98%
4.89%
4.02%
4.36%
Merchandise inventories
Assets held for disposal
Total Current Assets
Property and Equipment—at
cost:
Land
Buildings and improvements
Furniture, fixtures and
equipment
50.62%
52.00%
51.28%
49.29%
47.69%
47.13%
Deferred Income Taxes
0.00%
0.00%
1.40%
1.31%
5.01%
3.88%
Other
3.40%
2.54%
3.85%
2.06%
1.21%
1.23%
Total Non-Current Assets
Total Assets
54.01%
54.55%
56.53%
52.66%
53.91%
52.23%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
165 46%
Restated Income Statement Now that the original forecasts for the original income statement has been
completed, it is now time to forecast the restated income statement. Capitalizing
operating leases will affect deprecation, lease interest expense, lease operating
expense, and most importantly net income. Interest expense was found to be 1.90%
percent of sales by observing the current trend from the past five years. Next, the
depreciation and operating lease expense was found by taking an average over the last
five years and using trial and error to see which value worked best.
The net income was affected by the amount the same amount that the capitalized lease
was affected. After the restatement adjustments, net income in the 2010 was .70%,
then -.25% in 2011. After 2011, the net income remains steady at
-0.75% for all
years thereafter. All other values used to forecast identical to the as-stated income
statement forecast.
166 Restated Income
Statement
2004 2005 2006 2007 2008 2009 Average Assume 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 $1,863,015 $1,852,067 $1,876,290 $1,749,578 $1,569,664 $1,533,619 $409,881 $383,159 $395,871 $388,497 $358,124 $377,317 $2,272,896 $2,235,226 $2,272,161 $2,138,075 $1,927,788 $1,910,938 100.00% $1,887,051 $1,863,463 $1,840,170 $1,817,168 $1,794,453 $1,772,022 $1,749,872 $1,727,999 $1,706,399 $1,685,069 $133,296 $1,371,195 $1,336,336 $1,305,952 $1,129,162 $1,084,804 $317,142 $352,713 $364,069 $345,886 $333,194 $340,027 $1,650,438 $1,723,908 $1,700,405 $1,651,838 $1,462,356 $1,424,831 75.00% $1,415,288 $1,397,597 $1,380,127 $1,362,876 $1,345,840 $1,329,017 $1,312,404 $1,295,999 $1,279,799 $1,263,802 $529,719 $480,872 $539,954 $443,626 $440,502 $448,815 $92,739 $30,446 $31,802 $42,611 $24,930 $37,292 $622,458 $511,318 $571,756 $486,237 $465,432 $486,107 25.00% $471,763 $465,866 $460,042 $454,292 $448,613 $443,006 $437,468 $432,000 $426,600 $421,267 $29,147 $31,117 $29,300 $41,090 $40,287 1.70% $32,080 $31,679 $31,283 $30,892 $30,506 $30,124 $29,748 $29,376 $29,009 $28,646 $547,336 $522,501 $551,031 $518,378 $485,044 $430,261 24.00% $452,892 $447,231 $441,641 $436,120 $430,669 $425,285 $419,969 $414,720 $409,536 $404,417 $15,297 $15,151 $9,716 $1,213 $75,122 ‐$40,330 $4,905 ‐$46,290 ‐$50,986 $16,772 1.00% $18,871 $18,635 $18,402 $18,172 $17,945 $17,720 $17,499 $17,280 $17,064 $16,851 $1,824 $3,897 $7,023 $5,246 $1,967 $2,261 $35,965 $49,040 $49,342 $51,293 $27,048 $21,704 $20,111 $21,284 $20,744 $27,150 $36,816 1.90% $35,854 $35,406 $34,963 $34,526 $34,095 $33,668 $33,248 $32,832 $32,422 $32,016 ‐$59,039 ‐$61,930 ‐$57,670 ‐$68,240 ‐$77,103 ‐3.10% ‐$58,499 ‐$57,767 ‐$57,045 ‐$56,332 ‐$55,628 ‐$54,933 ‐$54,246 ‐$53,568 ‐$52,898 ‐$52,237 $40,981 ‐$46,545 $3,232 ‐$55,411 ‐$34,977 $37,616 $15,315 ‐$20,553 ‐$4,297 ‐$25,594 ‐$6,139 $13,503 $25,666 ‐$25,992 $7,529 ‐$29,817 ‐$28,838 $24,113 Earnings (Loss) from Discontinued Operations, Net of Tax ‐$2,087 $266 ‐$738 ‐$3,601 ‐$1,591 ‐$1,077 Cumulative Effect of Change in Accounting Principle, Net of Tax ‐$2,021 $189 $23,579 ‐$27,747 $6,980 ‐$33,418 ‐$30,429 $23,036 $13,209 ‐$4,659 ‐$13,801 ‐$13,629 ‐$13,458 ‐$13,290 ‐$13,124 ‐$12,960 ‐$12,798 ‐$12,638 Merchandise Sales Service Revenue Total Revenues Costs of Merchandise Sales Costs of Service Revenue Total Costs of Revenues Gross Profit from Merchandise Sales Gross Profit from Service Revenue Total Gross Profit Depreciation of Capital Lease Asset Rights Selling, General and Administrative Expenses Net Gain From Sale of Assets Operating (Loss) Profit Non‐operating Income Interest Expense Interest Expense from Lease Operating Lease Expense (Loss) Earnings from Continuing Operations Before Income Taxes and Cumulative Effect of Change in Accounting Principle Income Tax (Benefit) Expense Net (Loss) Earnings from Continuing Operations Before Cumulative Effect of Change in Accounting Principle Net (Loss) Earnings 167 Restated Common Size Income Statement Sales Growth 2004 2005 Merchandise Sales 2006 ‐1.66% 1.65% 2007 2008 2009 ‐5.90% ‐9.84% Average Assume 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 ‐0.87% ‐3.32% ‐1.25% ‐1.25% ‐1.25% ‐1.25% ‐1.25% ‐1.25% ‐1.25% ‐1.25% ‐1.25% ‐1.25% ‐1.25% 81.97% 82.86% 82.58% 81.83% 81.42% 80.25% Service Revenue 18.03% 17.14% 17.42% 18.17% 18.58% 19.75% Total Revenues 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 5.86% 61.34% 58.81% 61.08% 58.57% 56.77% Costs of Service Revenue 13.95% 15.78% 16.02% 16.18% 17.28% 17.79% Total Costs of Revenues 72.61% 77.12% 74.84% 77.26% 75.86% 74.56% 75.38% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% Gross Profit from Merchandise Sales 23.31% 21.51% 23.76% 20.75% 22.85% 23.49% Costs of Merchandise Sales Gross Profit from Service Revenue Total Gross Profit Depreciation of Capital Lease Asset Rights 4.08% 1.36% 1.40% 1.99% 1.29% 1.95% 27.39% 22.88% 25.16% 22.74% 24.14% 25.44% 24.62% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 1.30% 1.37% 1.37% 2.13% 2.11% 1.66% 1.70% 1.70% 1.70% 1.70% 1.70% 1.70% 1.70% 1.70% 1.70% 1.70% 1.70% 24.08% 23.38% 24.25% 24.25% 25.16% 22.52% 23.94% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% Net Gain From Sale of Assets 0.00% 0.00% 0.67% 0.71% 0.50% 0.06% Operating (Loss) Profit 3.31% ‐1.80% 0.22% ‐2.17% ‐2.64% 0.88% ‐0.37% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% Non‐operating Income 0.08% 0.17% 0.31% 0.25% 0.10% 0.12% Interest Expense 1.58% 2.19% 2.17% 2.40% 1.40% 1.14% Selling, General and Administrative Expenses Interest Expense from Lease 0.90% 0.94% 0.97% 1.41% 1.93% 1.23% 1.90% 1.90% 1.90% 1.90% 1.90% 1.90% 1.90% 1.90% 1.90% 1.90% 1.90% Operating Lease Expense ‐2.64% ‐2.73% ‐2.70% ‐3.54% ‐4.03% ‐3.13% ‐3.10% ‐3.10% ‐3.10% ‐3.10% ‐3.10% ‐3.10% ‐3.10% ‐3.10% ‐3.10% ‐3.10% ‐3.10% (Loss) Earnings from Continuing Operations Before Income Taxes and Cumulative Effect of Change in Accounting Principle 1.80% ‐2.08% 0.14% ‐2.59% ‐1.81% 1.97% Income Tax (Benefit) Expense 0.67% ‐0.92% ‐0.19% ‐1.20% ‐0.32% 0.71% 1.13% ‐1.16% 0.33% ‐1.39% ‐1.50% 1.26% Net (Loss) Earnings from Continuing Operations Before Cumulative Effect of Change in Accounting Principle Earnings (Loss) from Discontinued Operations, Net of Tax ‐0.09% 0.01% ‐0.03% ‐0.17% ‐0.08% ‐0.06% Cumulative Effect of Change in Accounting Principle, Net of Tax 0.00% ‐0.09% 0.01% 0.00% 0.00% 0.00% Net (Loss) Earnings 1.04% ‐1.24% 0.31% ‐1.56% ‐1.58% 1.21% ‐0.31% ‐0.25% 0.70% ‐0.25% ‐0.75% ‐0.75% ‐0.75% ‐0.75% ‐0.75% ‐0.75% ‐0.75% ‐0.75% 168 Restated Balance Sheet The process of capitalizing Pep Boys’ operating leases has an immense effect on
the makeup of the balance sheet. After capitalizing operating leases, assets and
liabilities have increased greatly causing for a restated forecast throughout the balance
sheet. In the assets section, current assets will stay the same while noncurrent assets
will greatly increase in size. In the liabilities section, operating lease expense and lease
interest expense must be accounted for, once again causing a large increase in
noncurrent liabilities as well as total liabilities. Since total assets are increase, we must
update the asset turnover ratio to a smaller value than on the as-stated balance sheet.
Given the increase to total assets, the new asset turnover ratio that we will use to
project total assets will be .94. In the common size balance sheet, operating lease asset
rights was calculated be projecting the upward trend from the previous five years.
Retained earnings is calculated the same way as the as-stated balance sheet however
the new net income must be pulled from the restated income statement. All other
projections are calculated the same identical way as they were calculated in the asstated balance sheet. By forecasting the balance sheet on a restated basis and showing
the effects of leases, we are able to see a clear, un-skewed picture that shows the true
financial position of Pep Boys.
169 Restated Balance Sheet
2004 2005 2006 2007 2008 2009 $82,758 $48,281 $21,884 $20,926 $21,332 $39,326 $30,994 $36,434 $29,582 $29,450 $28,831 $22,983 A/R TO 85.00 $22,201 $21,923 $21,649 $21,378 $21,111 $20,847 $20,587 $20,329 $20,075 $19,824 $602,760 $616,292 $607,042 $561,152 $564,931 $559,118 INV TO 2.70 $524,181 $517,629 $511,158 $504,769 $498,459 $492,228 $486,076 $480,000 $474,000 $468,075 $45,349 $40,952 $39,264 $43,842 $25,390 $24,784 Other Assets held for disposal $96,065 $665 $85,446 $652 $70,368 $77,469 $16,918 $62,421 $12,653 $65,428 $4,438 Total Current Assets $858,591 $828,057 $768,140 $749,757 $715,558 $716,077 CA/TA 0.38 $753,315 $743,898 $734,600 $725,417 $716,350 $707,395 $698,553 $689,821 $681,198 $672,683 Land $261,985 $257,802 $251,705 $213,962 $207,608 $204,709 Buildings and improvements $916,099 $916,580 $929,225 $858,699 $822,950 $826,804 Furniture, fixtures and equipment $633,098 $671,189 $684,042 $699,303 $685,707 $695,072 Construction in progress $40,426 $15,858 $3,464 $3,992 $2,576 $1,550 $1,851,608 $1,861,429 $1,868,436 $1,775,956 $1,718,841 $1,728,135 Less accumulated depreciation and amortization $906,577 $914,040 $962,189 $995,177 $978,510 $1,021,685 Total Property and Equipment—Net $945,031 $947,389 $906,247 $780,779 $740,331 $706,450 PPE Turn 2.75 $677,623 $669,153 $660,788 $652,528 $644,372 $636,317 $628,363 $620,509 $612,752 $605,093 Net Operating Lease Asset Rights $349,764 $344,261 $320,837 $388,396 $487,977 $511,614 Common Size 27.00% $535,250 $528,559 $521,952 $515,428 $508,985 $502,623 $496,340 $490,136 $484,009 $477,959 $24,828 $20,775 $77,708 $58,171 Other Total Non‐Current Assets $63,401 $1,358,196 $46,307 $1,337,957 $67,984 $1,319,896 $32,609 $1,222,559 $18,792 $1,324,808 $18,388 $1,294,623 TA‐CA $1,229,093 $1,213,729 $1,198,557 $1,183,575 $1,168,781 $1,154,171 $1,139,744 $1,125,497 $1,111,428 $1,097,536 Total Assets ASSETS Current Assets: Cash and cash equivalents Accounts receivable, less allowance for uncollectible accounts Merchandise inventories Prepaid expenses Property and Equipment—at cost: Total Property and Equipment Deferred Income Taxes Ratio Assume 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 $2,216,787 $2,166,014 $2,088,036 $1,972,316 $2,040,366 $2,010,700 ATO 0.94 $1,982,408 $1,957,627 $1,933,157 $1,908,993 $1,885,130 $1,861,566 $1,838,297 $1,815,318 $1,792,626 $1,770,219 LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities: Accounts payable Trade payable program liability Accrued expenses Deferred income taxes Current maturities of long‐term debt and obligations under capital lease $310,981 $306,671 $19,406 $261,940 $11,156 $290,761 $15,417 $265,489 $13,990 $292,280 $28,931 $245,423 $14,254 $292,623 $212,340 $31,930 $254,754 $35,848 $202,974 $34,099 $242,416 $29,984 $40,882 $1,257 $3,490 $2,114 $1,453 $1,079 Total Current Liabilities $677,940 $580,531 $604,180 $554,414 $536,325 $510,552 Current Ratio 1.50 $502,210 $495,932 $489,733 $483,611 $477,566 $471,597 $465,702 $459,881 $454,132 $448,455 Long‐term debt and obligations under capital leases, less current maturities $352,682 $467,239 $535,031 $400,016 $352,382 $306,201 Convertible long‐term debt $119,000 $119,000 Other long‐term liabilities $37,977 $57,481 $60,233 $72,183 $70,322 $73,933 Deferred income taxes $25,968 $2,937 $86,595 $170,204 $165,105 $349,764 $1,563,331 $334,480 $1,561,668 $311,308 $1,510,752 $380,770 $1,493,978 $484,859 $1,614,092 $515,156 $1,570,947 TLE‐TE $1,521,242 $1,493,036 $1,474,398 $1,456,009 $1,437,865 $1,419,963 $1,402,300 $1,384,874 $1,367,681 $1,350,718 Deferred gain from asset sales Net Liability of Capitalized Operating Leases Total Liabilities Commitments and Contingencies Stockholders’ Equity: Common stock, par value $1 per share: Authorized 500,000,000 shares Additional paid‐in capital $68,557 $68,557 $68,557 $68,557 $68,557 $68,557 $284,966 $288,098 $289,384 $296,074 $292,728 $293,810 $536,780 $491,707 $473,326 $414,445 $361,788 $371,294 Common stock subscriptions receivable ($167) Accumulated other comprehensive loss ($4,852) ($3,565) ($9,380) ($14,183) ($18,075) ($17,691) Less cost of shares in treasury $172,564 $181,187 $185,389 $227,291 $219,460 $276,217 Less cost of shares in benefits trust $59,264 $59,264 $59,264 $59,264 $59,264 ‐ Total Stockholders’ Equity $653,456 $594,565 $577,284 $478,338 $426,274 $439,753 $461,165 $464,592 $458,759 $452,984 $447,265 $441,603 $435,996 $430,444 $424,946 $419,501 $2,216,787 $2,166,014 $2,088,036 $1,972,316 $2,040,366 $2,010,700 $1,982,408 $1,957,627 $1,933,157 $1,908,993 $1,885,130 $1,861,566 $1,838,297 $1,815,318 $1,792,626 $1,770,219 Retained earnings Total Liabilities and Stockholders’ Equity 170 Common Size Balance Sheet ASSETS
Current Assets:
Cash and cash equivalents
Accounts receivable, less allowance for
uncollectible accounts
Merchandise inventories
Prepaid expenses
Other
Assets held for disposal
Total Current Assets
Property and Equipment—at cost:
Land
Buildings and improvements
Furniture, fixtures and equipment
Construction in progress
Total Property and Equipment
Less accumulated depreciation and
amortization
Total Property and Equipment—Net
Net Operating Lease Asset Rights
Deferred Income Taxes
Other
Total Non-Current Assets
Total Assets
2004
2005
2006
2007
2008
2009
AVERAGE
3.73%
2.23%
1.05%
1.06%
1.05%
1.96%
1.85%
1.40%
1.68%
1.42%
1.49%
1.41%
1.14%
1.42%
27.19%
2.05%
4.33%
0.03%
38.73%
28.45%
1.89%
3.94%
0.03%
38.23%
29.07%
1.88%
3.37%
0.00%
36.79%
28.45%
2.22%
3.93%
0.86%
38.01%
27.69%
1.24%
3.06%
0.62%
35.07%
27.81%
1.23%
3.25%
0.22%
35.61%
28.11%
1.75%
3.65%
0.29%
37.07%
11.82%
41.33%
28.56%
1.82%
83.53%
11.90%
42.32%
30.99%
0.73%
85.94%
12.05%
44.50%
32.76%
0.17%
89.48%
10.85%
43.54%
35.46%
0.20%
90.04%
10.18%
40.33%
33.61%
0.13%
84.24%
10.18%
41.12%
34.57%
0.08%
85.95%
11.16%
42.19%
32.66%
0.52%
86.53%
40.90%
42.20%
46.08%
50.46%
47.96%
50.81%
46.40%
42.63%
15.78%
0.00%
2.86%
61.27%
100.00%
43.74%
15.89%
0.00%
2.14%
61.77%
100.00%
43.40%
15.37%
1.19%
3.26%
63.21%
100.00%
39.59%
19.69%
1.05%
1.65%
61.99%
100.00%
36.28%
23.92%
3.81%
0.92%
64.93%
100.00%
35.13%
25.44%
2.89%
0.91%
64.39%
100.00%
171 40.13%
19.35%
1.49%
1.96%
62.93%
100.00%
Assume
37%
27.00%
Statement of Cash Flows The final and most difficult statement to forecast is the statement of cash flows.
This statement is also the least accurate document to be forecasted. This financial
statement consist of cash flows from operations (CFFO), cash flows from investing
activities (CFFI), and cash flows from financing activities (CFFI). The statement of cash
flows is difficult to forecast due to it consisting of many irregular activities and it being
difficult to link it back to the other financial statements. We will not be forecasting every
line item for this statement but will focus on forecasting the totals of each section.
The first section to be forecasted is the cash flows from operations. To do this
we must first evaluate three ratios that help link this document to the income
statement. These three ratios are CFFO/sales, CFFO/net income, and CFFO/operating
income. We need to pick the ratio that contains the least volatility. Once outliers are
removed, the ratio that’s provides the best average for forecasting cash flows from
operations is CFFO/sales. The average of the CFFO/sales ratios is .0328 however after
looking at previous ratio values we will adjust this number to .035 and use it along with
forecasted sales to predict future CFFO.
The next item we will forecast is cash flows from investing activities. Cash flows
from investing activities presents cash outflows and inflows from the acquisition and
sale of long term assets. Since this item deals with long term assets we will use two
proxies, change in non-currents assets and change in gross plant, property, and
equipment, to determine the best measure for forecasting CFFI. The measure that most
accurately reflects the cash flows is the change in gross plant, property, and equipment
so we will use this proxy to link CFFI to the balance sheet and forecast CFFI. We can
see that CFFI is averagely 2.07 times larger than PPE and after reviewing past numbers
we adjusted this number to 2.05 and will use it to forecast CFFI.
Cash flows from financing activities are made up of equity transactions such as dividend
payout, stock options, and the purchase of treasury stock. This is the next and hardest
item to forecast because we do not know exactly what the company will do in terms of
issuing new stock and buying additional treasury stock, and these items to not occur
172 regularly. Therefore we will simply forecast CFFF based on forecasted dividend payouts.
The dividend payout table below shows the forecasted dividends for Pep Boys, which
will be used to forecast cash flows from financing activities
Dividends per share
oustanding shares
Dividend payout
Dividend Payout In thousands
Forecasted Dividend Payout
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
0.12
0.12
0.12
0.12
0.12
0.12
0.12
0.12
0.12
0.12
41076000 41076000 41076000 41076000 41076000 41076000 41076000 41076000 41076000 41076000
4,929,120 4,929,120 4,929,120 4,929,120 4,929,120 4,929,120 4,929,120 4,929,120 4,929,120 4,929,120
4,929.12 4,929.12 4,929.12 4,929.12 4,929.12 4,929.12 4,929.12 4,929.12 4,929.12 4,929.12
173 CONSOLIDATED STA TEMENTS OF CA SH FLOWS (A s Stated)
The Pep Boys-Manny, Moe & Jack and Subsidiaries
(dollar amounts in thousands)
As Stated Cash Flows
2005
2006
2007
2004
Cash Flows from Operating Activities:
Net (Loss) Earnings
$
A djustments to Reconcile Net (Loss) Earnings to Net
Cash (Used in) Provided by Continuing Operations:
Net (earnings) loss from discontinued operations
Depreciation and amortization
A mortization of deferred gain from asset sales
Cumulative effect of change in accounting principle, net of tax
A ccretion of asset retirement obligation
Loss on defeasance of convertible debt
Stock compensation expense
Inventory impairment
Gain from debt retirement
Cancellation of vested stock options
Deferred income taxes
Deferred gain on sale leaseback
Reduction in asset retirement liability
Gain from sales of assets
Loss on impairment of assets
Gain from derivative valuation
Excess tax benefits from stock based awards
Increase in cash surrender value of life insurance policies
Other
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable, prepaid
expenses and other
Decrease (increase) in merchandise inventories
Increase (decrease) in accounts payable
(Decrease) increase in accrued expenses
Increase (decrease) in other long-term liabilities
Net Cash Provided (Used in) by Continuing Operations
Net Cash Used in Discontinued Operations
Net Cash Provided by (Used in) Operating Activities
Cash Flows from Investing Activities:
Cash paid for master lease property
Cash paid for property and equipment
Proceeds from sales of assets
Proceeds from sales of assets held for disposal
(Repayment) proceeds from life insurance policies
A cquisition of Florida Tire, Inc.
Other
Premiums paid on life insurance policies
Net cash used in continuing operations
Net cash provided by discontinued operations
Net Cash Used in Investing A ctivities
Cash Flows from Financing Activities:
Net borrowings under line of credit agreements
Net payments under line of credit agreements
Excess tax benefits from stock based awards
Net borrowings on trade payable program liability
Net payments on trade payable program liability
Payments for finance issuance costs
Proceeds from lease financing
Proceeds from issuance of notes
Reduction of long-term debt
Reduction of convertible debt
Payments on capital lease obligations
Dividends paid
Repurchase of common stock
Other
Proceeds from issuance of common stock
Proceeds from exercise of stock options
Proceeds from dividend reinvestment plan
Net Cash (Used in) Provided by Financing Activities
Net (Decrease) Increase in Cash and Cash Equivalents
Cash and Cash Equivalents at Beginning of Year
Cash and Cash Equivalents at End of Year
Cash paid for interest, net of amounts capitalized
Cash received from income tax refunds
Cash paid for income taxes
Supplemental Disclosure of Cash Flow Information:
Non-cash investing activities:
Changes in accrued purchases of property and equipment
Write off of equipment and recognition of insurance
receivable
Non-cash financing activities:
Equipment capital leases
Repurchase of common stock not settled
CFFO/Sales
CFFO/Net Income
CFFO/Operating Income
Proxy 1-Change in non current assets
Proxy 2 -Change in plant, property, and equipment (gross)
-CFFI/Change in PPE
23,579
$ (37,528) $
2,087
76,620
(292)
79,887
135
2,021
109
1,184
2,049
26,853
(130)
(11,848)
(3,540)
(3,389)
(17,753)
(49,198)
(24,387)
25,853
(1,272)
48,183
(2,732)
45,451
(88,068)
18,021
(15,297)
840
(5,568)
(95)
(2,143)
(30,429) $
2,575
(6,248)
(28,187)
(6,258)
13,446
(15,151)
7,199
9,268
(9,716)
3,427
177
(1,213)
2,884
360
23,904
(3,779)
(33,083)
(34,993)
(11,992)
(38,586)
(921)
(39,507)
(50,212)
17,542
(43,116)
162,712
(117,121)
(34,762)
210,635
(24,669)
30,045
2010
$
22,645
2011
$
4,659
2012
$
2013
(4,600) $
Forecasted Cash Flows
2014
2015
(4,543) $
(4,486) $
2016
(4,430) $
2017
(4,375) $
2018
(4,320) $
2019
(4,266) $
(4,213)
1,077
70,529
(12,325)
2,743
(1,579)
13,087
(20,066)
10,083
(3,224)
50,801
1,983
52,784
Projection
Avg.
A ssume
23,036
(3,460)
(4,928)
(828)
24,045
9,250
3,549
(4,165)
2,093
93,688
(1,258)
92,430
2009
1,591
73,207
(10,285)
9,756
32,803
(1,056)
(8,316)
(85,945)
4,043
6,913
24,655
(41,039) $
3,601
81,036
(1,030)
(189)
269
755
3,051
15,166
(13,532)
(49,041)
(18,864)
16,760
(36,887)
(1,500)
(38,387)
345
7,175
7,039
(9,640)
(13,238)
2,384
87,826
(603)
87,223 CFFO/net sales
0.035
66,047
65,221
64,406
63,601
62,806
62,021
61,246
60,480
59,724
58,977
(43,214)
14,776
15,588
(2,695)
(500)
(1,778)
(71,825)
13,327
(58,498)
(605)
(50,939)
916
(50,023)
(57,339)
57,985
(7,216)
11,156
(5,500)
(5,150)
(2,217)
200,000
(189,991)
(31,000)
(1,040)
(15,676)
(39,718)
200,000
(183,459)
121,000
(2,263)
(119,000)
(227)
(14,757)
$
$
$
$
$
15,698
$
6,138
$
345
$
789
1,413
0.0200
1.93
0.61
N/A
N/A
N/A
(48,569)
95
2,834
(383)
(14,686)
(15,562)
$
$
$
$
3,071
961
53,933
(34,477)
82,758
48,281 $
50,602 $
10,097
1,770 $
(0.0172)
1.02
3.43
14,736
(9,821)
5.09
149,641
(379)
149,262
(57,339)
8,102
108,854
6,887
1,119
34,821
21,774
60,984
82,758
30,019
23,290
48,732
$
738
88,476
(27,792)
(1,815)
(4,826)
4,200
(2,549) $
2008
74,340
4,386
78,726
570,094
(545,617)
205,162
(223,345)
249,704
(273,566)
142,884
(142,620)
(85)
4,827
196,680
(179,004)
(6,936)
8,661
192,324
(190,155)
(165,695)
(14,177)
(58,152)
5,537
(26,798)
(14,111)
(11,990)
(6,286)
878
722
894
(61,488)
(203,004)
(26,397)
(958)
48,281
21,884
21,884 $
20,926
$
46,245 $
44,129
$
$1
$
59
632 $
3,147 $
$
3,691
$
$
84
7,311
0.0407
(36.26)
2.57
(5,363)
(7,007)
8.18
$
(31,633)
1,762
(29,871) change in PPE
1,985
0.0247
(1.29)
(3.11)
164,896
92,480
1.61
$
(0.0205)
1.30
3.99
(2,668)
57,115
1.38
$
72,068
$
21,176
$
20,911
$
20,650
$
20,392
$
20,137
$
19,885
$
19,636
$
19,391
$
19,149
$ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12)
611
(38,813)
406
20,926
21,332 $
26,548 $
$
1,330 $
1,214
2.5
$
$ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12)
(39,358)
17,994
21,332
39,326
24,509
921.00
4,768
1,738
0.0456
3.79
1.53
0.0328
174 53,822
(9,294)
3.21 2.07
Common Size Statement Cash Flows (As Stated)
2004
2005
2006
2007
2008
2009
52%
98%
‐3%
‐78%
77%
26%
5%
169%
0%
0%
0%
0%
3%
0%
0%
0%
59%
0%
0%
‐26%
0%
0%
0%
‐8%
0%
1%
‐208%
0%
‐5%
0%
0%
‐5%
0%
0%
0%
72%
0%
5%
13%
‐11%
0%
0%
9%
0%
1%
96%
0%
0%
0%
1%
3%
0%
0%
‐1%
‐9%
0%
0%
‐17%
1%
‐6%
0%
‐2%
0%
7%
154%
‐2%
0%
0%
0%
18%
62%
0%
0%
‐53%
0%
0%
‐29%
14%
18%
0%
‐9%
‐2%
‐4%
‐185%
26%
0%
0%
0%
‐7%
0%
9%
0%
16%
0%
0%
25%
‐9%
0%
0%
0%
‐1%
1%
81%
‐14%
0%
0%
0%
3%
0%
‐7%
0%
15%
0%
0%
‐1%
3%
0%
0%
0%
0%
‐39%
‐108%
‐54%
57%
‐3%
106%
‐6%
100%
‐40%
35%
128%
49%
‐44%
96%
4%
100%
26%
10%
4%
‐5%
2%
101%
‐1%
100%
‐3%
25%
‐38%
19%
‐6%
96%
4%
100%
‐61%
10%
84%
89%
30%
98%
2%
100%
8%
8%
‐11%
‐15%
3%
101%
‐1%
100%
0%
151%
‐31%
0%
0%
0%
172%
‐8%
‐14%
‐49%
0%
88%
‐31%
0%
43%
0%
‐29%
109%
0%
20%
‐149%
‐44%
268%
0%
20%
3%
123%
‐23%
100%
1%
102%
‐2%
100%
0%
100%
0%
100%
0%
100%
0%
100%
0%
94%
6%
100%
0%
145%
‐49%
0%
0%
9%
2%
0%
106%
‐6%
100%
23%
0%
108%
0%
79%
0%
‐281%
269%
‐529%
575%
‐634%
695%
‐21%
0%
‐16%
0%
574%
‐546%
‐89%
‐3%
‐45%
‐114%
0%
313%
20%
3%
100%
21%
0%
‐10%
0%
371%
‐340%
0%
‐1%
‐27%
‐29%
0%
0%
6%
2%
100%
‐5%
0%
4%
0%
‐197%
4%
194%
0%
24%
0%
0%
0%
‐1%
‐1%
100%
‐70%
70%
0%
‐2%
0%
0%
0%
82%
7%
29%
‐3%
0%
0%
0%
100%
‐507%
461%
18%
‐22%
0%
0%
0%
69%
36%
0%
‐2%
0%
0%
0%
100%
‐489%
483%
0%
0%
0%
0%
0%
30%
16%
0%
‐2%
0%
0%
0%
100%
Cash Flows from Operating Activities:
Net (Loss) Earnings
Adjustments to Reconcile Net (Loss) Earnings to Net
Cash (Used in) Provided by Continuing Operations:
Net (earnings) loss from discontinued operations
Depreciation and amortization
Amortization of deferred gain from asset sales
Cumulative effect of change in accounting principle, net of tax
Accretion of asset retirement obligation
Loss on defeasance of convertible debt
Stock compensation expense
Inventory impairment
Gain from debt retirement
Cancellation of vested stock options
Deferred income taxes
Deferred gain on sale leaseback
Reduction in asset retirement liability
Gain from sales of assets
Loss on impairment of assets
Gain from derivative valuation
Excess tax benefits from stock based awards
Increase in cash surrender value of life insurance policies
Other
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable, prepaid
expenses and other
Decrease (increase) in merchandise inventories
Increase (decrease) in accounts payable
(Decrease) increase in accrued expenses
Increase (decrease) in other long‐term liabilities
Net Cash Provided (Used in) by Continuing Operations
Net Cash Used in Discontinued Operations
Net Cash Provided by (Used in) Operating Activities
Cash Flows from Investing Activities:
Cash paid for master lease property
Cash paid for property and equipment
Proceeds from sales of assets
Proceeds from sales of assets held for disposal
(Repayment) proceeds from life insurance policies
Acquisition of Florida Tire, Inc.
Other
Premiums paid on life insurance policies
Net cash used in continuing operations
Net cash provided by discontinued operations
Net Cash Used in Investing Activities
Cash Flows from Financing Activities:
Net borrowings under line of credit agreements
Net payments under line of credit agreements
Excess tax benefits from stock based awards
Net borrowings on trade payable program liability
Net payments on trade payable program liability
Payments for finance issuance costs
Proceeds from lease financing
Proceeds from issuance of notes
Reduction of long‐term debt
Reduction of convertible debt
Payments on capital lease obligations
Dividends paid
Repurchase of common stock
Other
Proceeds from issuance of common stock
Proceeds from exercise of stock options
Proceeds from dividend reinvestment plan
Net Cash (Used in) Provided by Financing Activities
175 Restatement of Cash Flows The restated statement of cash flows’ forecast is much like the as stated
forecast. The process of capitalizing operating leases change the amount of net income
and therefore changed the cash flow from operations however we will still be using the
ratio CFFO/sales to forecast cash flows from operations. The restated CFFO/sales ratio
gave us an average of .066 and it was adjusted to .055 for the purpose to forecasting
cash flow from operations. After evaluating the two proxies again we found that the
change in gross plant, property, and equipment most closely links CFFI and the balance
sheet. There was no change in CFFI or gross PPE on a restated basis so we will again
use 2.05 to forecast CFFI. Finally, the dividends paid is also not affected by the
restatements, and the same dividend payout as the stated forecast will be used to
forecast cash flows from financing activities.
176 CONSOLIDATED STATEMENTS OF CASH FLOWS (restated)
The Pep Boys-Manny, Moe & Jack and Subsidiaries
(dollar amounts in thousands)
2004
Cash Flows from Operating Activities:
Net (Loss) Earnings
Adjustments to Reconcile Net (Loss) Earnings to Net
Cash (Used in) Provided by Continuing Operations:
Net (earnings) loss from discontinued operations
Depreciation and amortization
Amortization of deferred gain from asset sales
Cumulative effect of change in accounting principle, net of tax
Accretion of asset retirement obligation
Loss on defeasance of convertible debt
Stock compensation expense
Inventory impairment
Gain from debt retirement
Cancellation of vested stock options
Deferred income taxes
Deferred gain on sale leaseback
Reduction in asset retirement liability
Gain from sales of assets
Loss on impairment of assets
Gain from derivative valuation
Excess tax benefits from stock based awards
Increase in cash surrender value of life insurance policies
Other
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable, prepaid
expenses and other
Decrease (increase) in merchandise inventories
Increase (decrease) in accounts payable
(Decrease) increase in accrued expenses
Increase (decrease) in other long-term liabilities
Net Cash Provided (Used in) by Continuing Operations
Net Cash Used in Discontinued Operations
Net Cash Provided by (Used in) Operating Activities
Cash Flows from Investing Activities:
Cash paid for master lease property
Cash paid for property and equipment
Proceeds from sales of assets
Proceeds from sales of assets held for disposal
(Repayment) proceeds from life insurance policies
Acquisition of Florida Tire, Inc.
Other
Premiums paid on life insurance policies
Net cash used in continuing operations
Net cash provided by discontinued operations
Net Cash Used in Investing Activities
Cash Flows from Financing Activities:
Net borrowings under line of credit agreements
Net payments under line of credit agreements
Excess tax benefits from stock based awards
Net borrowings on trade payable program liability
Net payments on trade payable program liability
Payments for finance issuance costs
Proceeds from lease financing
Proceeds from issuance of notes
Reduction of long-term debt
Reduction of convertible debt
Payments on capital lease obligations
Dividends paid
Repurchase of common stock
Other
Proceeds from issuance of common stock
Proceeds from exercise of stock options
Proceeds from dividend reinvestment plan
Net Cash (Used in) Provided by Financing Activities
CFFO/Sales
CFFO/Net Income
CFFO/Operating Income
Proxy 1-Change in non current assets
Proxy 2 -Change in plant, property, and equipment (gross)
-CFFI/Change in PPE
$
23,579
2,087
76,620
Restated Cash Flows
2006
2007
2005
$
(37,528) $
(292)
79,887
2,021
(2,549) $
738
88,476
109
1,184
2,049
269
755
3,051
26,853
(130)
(27,792)
(1,056)
(8,316)
(1,815)
(4,826)
4,200
(3,540)
(3,389)
Projection
Avg.
Assume
2009
(30,429) $
23,036
3,601
81,036
(1,030)
1,591
73,207
(10,285)
1,077
70,529
(12,325)
9,756
32,803
2,743
2,575
2010
2011
2012
(4,659) $
2013
(13,801) $
(13,629) $
2014
2015
(13,458) $
(13,290) $
2016
(13,124) $
2017
2018
(12,960) $
(12,798) $
2019
$
13,209
$
(12,638)
0.055
$
103,788
$
102,490
$
101,209
$
99,944
$
98,695
$
97,461
$
96,243
$
95,040
$
93,852
$
92,679
2.5
$
72,068
$
21,176
$
20,911
$
20,650
$
20,392
$
20,137
$
19,885
$
19,636
$
19,391
$
19,149
(189)
135
(11,848)
(41,039) $
2008
(15,297)
840
(5,568)
(95)
(2,143)
(3,460)
(6,248)
(28,187)
(6,258)
13,446
(15,151)
7,199
9,268
(9,716)
3,427
177
(1,213)
2,884
(4,928)
(828)
360
(17,753)
(49,198)
(24,387)
25,853
(1,272)
48,183
(2,732)
93,634
15,166
(13,532)
(49,041)
(18,864)
16,760
(36,887)
(1,500)
(75,274)
24,045
9,250
3,549
(4,165)
2,093
93,688
(1,258)
186,118
(1,579)
13,087
(20,066)
10,083
(3,224)
50,801
1,983
103,585
23,904
(3,779)
(33,083)
(34,993)
(11,992)
(38,586)
(921)
(78,093)
(88,068)
18,021
(85,945)
4,043
6,913
24,655
(50,212)
17,542
(43,116)
162,712
(117,121)
(34,762)
210,635
(24,669)
30,045
15,588
345
7,175
7,039
(9,640)
(13,238)
2,384
87,826
(603)
175,049 CFFO/net sales
(43,214)
14,776
(2,695)
(500)
(1,778)
(71,825)
13,327
(58,498)
(605)
(50,939)
916
(50,023)
8,102
57,985
(48,569)
11,156
95
2,834
(7,216)
(57,339)
149,641
(379)
149,262
74,340
4,386
78,726
570,094
(545,617)
205,162
(223,345)
249,704
(273,566)
142,884
(142,620)
(85)
4,827
196,680
(179,004)
(6,936)
8,661
192,324
(190,155)
(165,695)
(14,177)
(58,152)
5,537
(26,798)
(14,111)
(11,990)
(6,286)
722
894
(61,488)
(57,339)
(5,500)
(5,150)
(2,217)
200,000
(189,991)
(31,000)
(1,040)
(15,676)
(39,718)
200,000
(183,459)
121,000
(2,263)
(119,000)
(227)
(14,757)
108,854
6,887
1,119
34,821
(383)
(14,686)
(15,562)
3,071
961
53,933
878
(31,633)
1,762
(29,871) change in PPE
$ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12)
611
(203,004)
(38,813)
(39,358)
0.04
3.97
1.25
(0.03)
2.01
6.73
0.08
(73.02)
5.17
0.05
(2.52)
(6.10)
(0.04)
2.57
7.89
0.09
7.60
3.07
N/A
N/A
N/A
20,239.024
(9,821)
5.09
18,060.976
(7,007)
8.18
97,337.000
92,480
1.61
(102,249.000)
57,115
1.38
30,185.000
(9,294)
3.21
177 $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12) $ (4,929.12)
0.066
2.07
Common Size Statement Cash Flows (Restated)
2004
2005
2006
2007
2008
2009
25.18%
0.00%
0.00%
2.23%
81.83%
0.00%
0.00%
0.14%
0.00%
1.26%
0.00%
0.00%
0.00%
28.68%
‐0.14%
0.00%
‐12.65%
0.00%
0.00%
0.00%
‐3.78%
0.00%
0.00%
0.00%
‐18.96%
‐52.54%
‐26.05%
27.61%
‐1.36%
51.46%
‐2.92%
100.00%
49.86%
0.00%
0.00%
0.39%
‐106.13%
0.00%
‐2.68%
‐0.14%
0.00%
‐2.72%
0.00%
0.00%
0.00%
36.92%
0.00%
2.41%
6.41%
‐5.58%
0.00%
0.00%
4.50%
0.00%
0.00%
0.00%
‐20.15%
17.98%
65.15%
25.06%
‐22.27%
49.00%
1.99%
100.00%
‐1.37%
0.00%
0.00%
0.40%
47.54%
0.00%
‐0.10%
0.14%
0.41%
1.64%
0.00%
0.00%
‐0.57%
‐4.47%
0.00%
0.00%
‐8.22%
0.45%
‐2.99%
‐0.05%
‐1.15%
0.00%
0.00%
0.00%
12.92%
4.97%
1.91%
‐2.24%
1.12%
50.34%
‐0.68%
100.00%
‐39.62%
0.00%
0.00%
3.48%
78.23%
‐0.99%
0.00%
0.00%
0.00%
9.42%
31.67%
0.00%
0.00%
‐27.21%
0.00%
0.00%
‐14.63%
6.95%
8.95%
0.00%
‐4.76%
‐0.80%
0.00%
0.00%
‐1.52%
12.63%
‐19.37%
9.73%
‐3.11%
49.04%
1.91%
100.00%
38.97%
0.00%
0.00%
‐2.04%
‐93.74%
13.17%
0.00%
0.00%
0.00%
‐3.51%
0.00%
4.43%
0.00%
8.01%
0.00%
0.00%
12.44%
‐4.39%
‐0.23%
0.00%
0.00%
‐0.46%
0.00%
0.00%
‐30.61%
4.84%
42.36%
44.81%
15.36%
49.41%
1.18%
100.00%
13.16%
0.00%
0.00%
0.62%
40.29%
‐7.04%
0.00%
0.00%
0.00%
1.47%
0.00%
‐3.57%
0.00%
7.68%
0.00%
0.00%
‐0.69%
1.65%
0.00%
0.00%
0.00%
0.20%
0.00%
0.00%
4.10%
4.02%
‐5.51%
‐7.56%
1.36%
50.17%
‐0.34%
100.00%
0.00%
150.55%
‐30.81%
0.00%
0.00%
0.00%
0.00%
3.04%
122.78%
‐22.78%
100.00%
0.00%
171.81%
‐8.08%
‐13.82%
‐49.29%
0.00%
0.00%
1.21%
101.83%
‐1.83%
100.00%
0.00%
87.57%
‐30.59%
0.00%
43.02%
0.00%
0.00%
0.00%
100.00%
0.00%
100.00%
0.00%
‐28.89%
109.01%
0.00%
20.13%
0.00%
0.00%
0.00%
100.25%
‐0.25%
100.00%
‐148.77%
‐44.16%
267.55%
0.00%
19.80%
0.00%
0.00%
0.00%
94.43%
5.57%
100.00%
0.00%
144.67%
‐49.47%
0.00%
0.00%
9.02%
1.67%
0.00%
105.90%
‐5.90%
100.00%
23.27%
0.00%
0.00%
‐20.72%
0.00%
‐15.80%
0.00%
574.37%
‐545.62%
‐89.03%
‐2.99%
‐45.02%
‐114.06%
0.00%
312.61%
19.78%
3.21%
100.00%
107.51%
0.00%
0.00%
20.68%
0.00%
‐9.55%
0.00%
370.83%
‐340.16%
0.00%
‐0.71%
‐27.23%
‐28.85%
0.00%
0.00%
5.69%
1.78%
100.00%
78.99%
0.00%
‐0.15%
‐4.61%
0.00%
3.61%
0.00%
‐196.79%
3.68%
193.53%
0.37%
24.00%
0.00%
0.00%
0.00%
‐1.17%
‐1.45%
100.00%
‐280.83%
268.77%
0.00%
‐70.38%
70.25%
0.04%
‐2.38%
0.00%
0.00%
0.00%
81.62%
6.98%
28.65%
‐2.73%
0.00%
0.00%
0.00%
100.00%
‐528.59%
575.44%
0.00%
‐506.74%
461.20%
17.87%
‐22.31%
0.00%
0.00%
0.00%
69.04%
36.36%
0.00%
‐2.26%
0.00%
0.00%
0.00%
100.00%
‐634.44%
695.07%
0.00%
‐488.65%
483.14%
0.00%
0.00%
0.00%
0.00%
0.00%
30.46%
15.97%
0.00%
‐1.55%
0.00%
0.00%
0.00%
100.00%
Cash Flows from Operating Activities:
Net (Loss) Earnings
Adjustments to Reconcile Net (Loss) Earnings to Net
Cash (Used in) Provided by Continuing Operations:
Net (earnings) loss from discontinued operations
Depreciation and amortization
Amortization of deferred gain from asset sales
Cumulative effect of change in accounting principle, net of tax
Accretion of asset retirement obligation
Loss on defeasance of convertible debt
Stock compensation expense
Inventory impairment
Gain from debt retirement
Cancellation of vested stock options
Deferred income taxes
Deferred gain on sale leaseback
Reduction in asset retirement liability
Gain from sales of assets
Loss on impairment of assets
Gain from derivative valuation
Excess tax benefits from stock based awards
Increase in cash surrender value of life insurance policies
Other
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable, prepaid
expenses and other
Decrease (increase) in merchandise inventories
Increase (decrease) in accounts payable
(Decrease) increase in accrued expenses
Increase (decrease) in other long‐term liabilities
Net Cash Provided (Used in) by Continuing Operations
Net Cash Used in Discontinued Operations
Net Cash Provided by (Used in) Operating Activities
Cash Flows from Investing Activities:
Cash paid for master lease property
Cash paid for property and equipment
Proceeds from sales of assets
Proceeds from sales of assets held for disposal
(Repayment) proceeds from life insurance policies
Acquisition of Florida Tire, Inc.
Other
Premiums paid on life insurance policies
Net cash used in continuing operations
Net cash provided by discontinued operations
Net Cash Used in Investing Activities
Cash Flows from Financing Activities:
Net borrowings under line of credit agreements
Net payments under line of credit agreements
Excess tax benefits from stock based awards
Net borrowings on trade payable program liability
Net payments on trade payable program liability
Payments for finance issuance costs
Proceeds from lease financing
Proceeds from issuance of notes
Reduction of long‐term debt
Reduction of convertible debt
Payments on capital lease obligations
Dividends paid
Repurchase of common stock
Other
Proceeds from issuance of common stock
Proceeds from exercise of stock options
Proceeds from dividend reinvestment plan
Net Cash (Used in) Provided by Financing Activities
178 Estimating Cost of Capital It is necessary to find an appropriate discount in order to properly value a firm.
The discount rate, or Weighted Average Cost of Capital (WACC), is needed to calculate
the realistic valuation of a firm. It is very important to estimate an accurate WACC
because if the WACC is unrealistically high, then the firm’s value will be understated and
if the WACC is unreasonably low, then the firm’s value will be overstated. The formula
for WACC is given below.
⎛ Vd ⎞
⎛ Ve ⎞
K
WACC = ⎜
+
d
⎜⎝ V + V ⎟⎠ K e
⎝ Vd + Ve ⎟⎠
d
e
WACC is estimated by using the two main factors, the cost of equity (Ke) and
cost of debt (Kd). It is important to note that when using WACC, cost of equity will
always be greater than cost of debt because of the principle of risk versus reward. The
principle states that those who hold debt investments are guaranteed payments,
therefore reducing risk. Another value used in the WACC equation is value of equity
(Ve), or the market value of equity, and value of debt (Vd), also known as the book
value of liabilities. By using the WACC formula, cost of debt and cost of equity can be
used to estimate the best and most accurate cost of capital.
Cost of Debt A firm’s cost of debt is simply the weighted average interest rate of all current
and non-current outstanding liabilities. If the cost of dent does not properly weigh all
outstanding debt, then the WACC will not be accurate and causing the firm’s value to
be misstated. Therefore, it is critical to make sure that all of Pep Boys’ outstanding
liabilities are given proper interest rates and are correctly weighted.
179 Pep Boys As Stated Weighted Average Cost of Debt (WACD) Current Liabilities:
Accounts payable
Trade payable program
liability
Accrued expenses
Deferred income taxes
Current maturities of
long-term debt and
obligations under capital
lease
Total Current Liabilities
Long-term debt and
obligations under capital
leases, less current
maturities
Convertible long-term debt
Other long-term liabilities
Deferred income taxes
Deferred gain from asset
sales
Total Non-current
Liabilities
Total Liabilities
Source of Rate
St. Louis Fed- 3 mo
AA Non Financial
Commercial Paper
St. Louis Fed- 3 mo
AA Non Financial
Commercial Paper
St. Louis Fed- 3 mo
AA Non Financial
Commercial Paper
St. Louis Fed- 10-yr
Constant Maturity
Pep Boys' 10-K Senior
Notes
2009
Interest Rate $202,974
0.28%
19.22%
0.05%
$34,099
0.28%
3.23%
0.01%
$242,416
0.28%
22.96%
0.06%
$29,984
3.42%
2.84%
0.10%
$1,079
7.50%
0.10%
0.01%
$510,552
Weight WACD 48.36%
Pep Boys' 10-K Senior
Notes
$306,201
7.50%
29.00%
2.18%
Pep Boys' 10-K based
off Pension Rate
$73,933
7.00%
7.00%
0.49%
$165,105
3.42%
15.64%
0.53%
St. Louis Fed- 10-yr
Constant Maturity
$545,239
$1,055,791
51.64%
100.00% 3.432% Kd
Due to Pep Boys’ very limited disclosure regarding interest rates of their
financials, it was important to best estimate an interest rate for each line item of
outstanding liabilities. By looking through Pep Boys’ 10-K, an interest rate of 7.50%
could be assigned to both long-term debt and current maturities. Other long-term debt
was given a rate of 7.00% by looking at the interest rates of pensions, which is also
located in the 10-K. However, none of the remaining outstanding liabilities accounts
were provided by the firm, so the remaining interest rates must be correctly
180 approximated. The accounts payable, trade payable, and accrued expenses accounts
were determined to be .28% by using the 3-month AA Non-financial commercial paper
rate that is provided by the St. Louis Fed. For deferred income taxes and deferred gain
from asset sales, it was determined that the 10-year constant maturity rate (3.42%)
would be appropriate. One the correct interest rates are determined, the weights of
each account must be determined by dividing each account by total liabilities. After
calculating both the rates and weights of each account, Pep Boys’ has a weighted
average cost of debt (WACD) of 3.43%.
Breakdown of WACD by Applied Interest Rate
Percentage of
Source of Rate
Rate
Total Debt
WACD
St. Louis Fed- 3 mo AA Non Financial
Commercial Paper
45.42%
0.28%
0.13%
St. Louis Fed- 10-yr Constant Maturity
Pep Boys' 10-K based off Pension Rate
Pep Boys' 10-K Senior Notes
Weighted Average Cost of Debt
18.48%
3.42%
0.63%
7.00%
29.10%
7.00%
7.50%
0.49%
2.18%
3.43%
The best way to examine the WACD is by comparing it to the ratio of current
liabilities to long-term liabilities. For Pep Boys, 48.36% of the liabilities are current
liabilities and because this number is smaller than what it liked, the weighted average
cost of debt is higher, which tells us that Pep Boys is less efficient at utilizing a lower
interest rate. By looking at the chart above, it is easy to see that only 45.42% of Pep
Boys’ debt is able to capitalize the extremely low rate of .28%, which is very
insignificant compared to the total weighted average cost of debt of 3.43%. The
remainder of the debt can only capitalize large interest rates of 3.42%, 7.00%, and
7.50%, which accounts for 96.20% of the total WACD.
It was necessary to restate Pep Boys’ financials to account for capitalizing the
operating leases that were impairing the as-stated financials. When including these
181 capitalized leases, they influence a major change in WACD. By keeping the capitalized
operating leases off the books, a lower WACD was achieved because a major liability
was kept of the books. After restating the financials, a new WACD must be determined
that includes the liabilities from capitalizing the operating leases the Pep Boys’ has. The
next page illustrates a chart showing the new WACD with operating leases.
182 Pep Boys Restated Weighted Average Cost of Debt (WACD)
Current Liabilities:
Accounts payable
Trade payable program
liability
Accrued expenses
Deferred income taxes
Current maturities of
long-term debt and
obligations under capital
lease
Total Current Liabilities
Long-term debt and
obligations under capital
leases, less current
maturities
Convertible long-term
debt
Other long-term
liabilities
Deferred income taxes
Deferred gain from asset
sales
Net Liability of
Capitalized Operating
Leases
Total Liabilities
Source of Rate
St. Louis Fed- 3 mo
AA Non Financial
Commercial Paper
St. Louis Fed- 3 mo
AA Non Financial
Commercial Paper
St. Louis Fed- 3 mo
AA Non Financial
Commercial Paper
St. Louis Fed- 10-yr
Constant Maturity
2009
Interest
Rate
Weight
WACD
$202,974
0.28%
12.92%
0.04%
$34,099
0.28%
2.17%
0.01%
$242,416
0.28%
15.43%
0.04%
$29,984
3.42%
1.91%
0.07%
$1,079
7.50%
0.07%
0.01%
Pep Boys' 10-K
Senior Notes
$510,552
32.50%
Pep Boys' 10-K
Senior Notes
$306,201
7.50%
19.49%
1.46%
Pep Boys' 10-K
based off Pension
Rate
$73,933
7.00%
4.71%
0.33%
St. Louis Fed- 10-yr
Constant Maturity
$165,105
3.42%
10.51%
0.36%
Pep Boys' 10-K
based off Pension
Rate
$515,156
7.00%
32.79%
2.30%
$1,570,947
100.00% 4.60% Kd
After restating the operating leases, Pep Boys’ long-term debt is increased, and
since long-term debt uses a higher interest rate it has a major affect on the weighted
average cost of debt. Operating leases represented 32.79% of total liabilities, and after
combining the weight with an interest rate of 7.00% provided from Pep Boys’ 10-K
183 pension rate, Operating leases add 2.30% to the weighted average cost of debt. After
restatements, the WACD increased to 4.58%, which is an increase of 1.15% over the as
stated weighted average cost of debt. This restated weighted average cost of debt is an
accurate measure over the as stated weighted average cost of capital because it
accounts for the operating leases, therefore not skewing the WACD and eventually lead
to an accurate calculation of the weighted average cost of capital.
Cost of Equity Cost of Equity is the minimum rate that a firm must offer shareholders to
compensate for waiting for their returns, and for bearing some risk. Equity of
companies is much more risky than of debt. This is because return on equity is not
guaranteed to the investor, where debt has legally binding contracts that enforce
payments. The formula for computing cost of equity is as follows:
(
K e = R f + βi Rm − R f
)
For Pep Boys, the Capital Asset Pricing Model (CAPM) is the easiest method of
finding Cost of Equity (Ke). According to the formula, an appropriate risk free rate (Rf)
must be estimated by taking an average on the returns from U.S. Treasury bonds,
which are considered virtually risk-free. In our CAPM model, a risk free rate of 3.42%
will be used to determine the cost of equity. For market risk premium, a rate of 7% will
be assumed, which is near the historical average of return above the risk free rate from
the Standard & Poor’s 500 (Palepu). The firm’s beta (βJ), represents the systematic
undiversifiable portion of risk and its corresponding return. The beta is measured
relative to the market, with the market itself holding a beta of one. A beta can be
estimated by using regression analysis, which is explained in the next paragraph.
Beta can be estimated using regression analysis after all previous assumptions
regarding market risk premium are estimated. To better improve beta estimation
184 accuracy, five different points from the yield curve were used in the regression analysis.
The points used on the yield curve were 24, 36, 48, 60, 72 months, and by running the
regression analysis on each of these points, the stability of beta can be tested. If the
results of each regression analysis are similar to each other, then the beta is stable. The
following tables show the results for Pep Boys’ regression analysis for all five points in
the yield curve.
185 3 Month Treasury Regression MRP Rf 7 3.42 time (months) 72 60 48 36 24 beta 1.672 1.649 1.671 1.655 1.786 Ke with +2.7 Adjusted R size adjustment squared 0.218 17.83 0.222 17.67 0.219 17.82 0.223 17.70 0.266 18.63 beta LB 0.942 0.868 0.779 0.643 0.574 Ke LB with +2.7 size adjustment 12.71 12.20 11.57 10.62 10.14 beta UB 2.403 2.431 2.563 2.666 2.999 Ke UB with +2.7 size adjustment 22.94 23.14 24.06 24.78 27.11 1 year Treasury Regression MRP Rf 7 3.42 time (months) 72 60 48 36 24 beta 1.672 1.648 1.669 1.653 1.785 Ke with +2.7 size Adjusted R squared adjustment 0.219 17.82 0.222 17.66 0.220 17.81 0.223 17.69 0.266 18.61 beta LB 0.942 0.867 0.778 0.642 0.574 Ke LB with +2.7 size adjustment 12.72 12.19 11.57 10.62 10.14 beta UB 2.402 2.429 2.561 2.664 2.996 Ke UB with +2.7 size adjustment 22.93 23.12 24.04 24.77 27.09 2 year Treasury Regression MRP Rf 7 3.42 time (months) 72 60 48 36 24 beta 1.672 1.647 1.669 1.653 1.786 Ke with +2.7 Adjusted R size squared adjustment 0.219 17.83 0.222 17.65 0.219 17.80 0.222 17.69 0.266 18.62 beta LB 0.942 0.866 0.777 0.640 0.574 Ke LB with +2.7 size adjustment 12.71 12.18 11.56 10.60 10.14 beta UB 2.403 2.428 2.560 2.665 2.998 Ke UB with +2.7 size adjustment 22.94 23.12 24.04 24.77 27.11 5 year Treasury Regression MRP Rf 7 3.42 time (months) 72 60 48 36 24 beta 1.669 1.642 1.665 1.651 1.789 Ke with +2.7 Adjusted R size adjustment squared 0.218 17.80 0.221 17.62 0.218 17.77 0.221 17.67 0.266 18.64 beta LB 0.938 0.861 0.773 0.636 0.576 Ke LB with +2.7 size adjustment 12.69 12.15 11.53 10.57 10.15 beta UB 2.399 2.424 2.557 2.665 3.002 Ke UB with +2.7 size adjustment 22.91 23.09 24.02 24.77 27.13 10 year Treasury Regression MRP Rf 7 3.42 time (months) 72 60 48 36 24 beta 1.664 1.637 1.661 1.648 Adjusted R squared 0.217 0.220 0.217 0.220 Ke with +2.7 size adjustment 17.77 17.58 17.75 17.65 beta LB 0.934 0.856 0.769 0.632 beta UB 2.395 2.419 2.553 2.663 Ke LB with +2.7 size adjustment 12.66 12.11 11.50 10.55 Ke UB with +2.7 size adjustment 22.88 23.05 23.99 24.76 1.790 0.266 18.65 0.576 3.004 10.15 27.15 186 After regression analysis has been run for each treasury return at each point of
the yield curve, the results can be analyzed and beta stability can be tested. The
regression analysis yielded 25 different beta results, and by comparing the betas of
each investment horizon, the stability of beta can be determined. An important statistic
to determine the most stable and accurate beta is the highest adjusted R2. The higher
the R2, the better job the beta does at portraying overall risk for the firm. Therefore,
the beta that corresponds with the highest R2 will be the most optimal beta.
Beta Results for all Regressions 3 month 1 year 2 year 5 year 10 year 24 months 36 months 48 months 60 months 72 months 1.786 1.785 1.786 1.789 1.655
1.653
1.653
1.651
1.671
1.669
1.669
1.665
1.649
1.648
1.647
1.642
1.672 1.672 1.672 1.669 1.790 1.648
1.661
1.637
1.664 The chart above illustrates the breakdown of all the calculated betas, which
allows for an easy assessment across each time period. The best beta that is chosen
for Pep Boys to represent risk is 1.79. This beta was determined by taking the highest
adjusted R2, which was found in the 5-year regression with a 24-month investment
horizon.
βi For each Point on Yield Curve Point 3 Month 1 Year 2 year 5 year 10 year Months 24
24
24
24
24
Beta Adjusted R² 1.786
0.2661 1.785
0.2662 1.786
0.2662 1.789
0.2664 1.790
0.2663 The above chart shows that the highest adjusted R2 was found using the 5-year
Treasury with a 24-month investment timeline. Given this information, it can be
187 determined that .2664 or 26.64% explains overall risk. Therefore, this R2 means that
73.36% of Pep Boys’ cost of equity is determined by risk related the market as a whole.
It is also important to note that the selected beta is well within a reasonable range of
the other points on the yield curve. Since the selected beta falls between 1.785 and
1.790, then the selected beta is stable and is in close proximity to the firms published
beta of 1.66, meaning our calculated beta is in relative agreement with other analyst’s
projections of beta. The selected beta of 1.789 will be used when calculating CAPM, as
it gives us the highest explanatory power and will be the most accurate calculation for
Pep Boys’ cost of equity (Ke) because it lies well within a reasonable range of other
calculated betas.
After recognizing the 5-year treasury with a 24-month investment timeline as the
most accurate measurement of beta, CAPM analysis can now be performed to compute
Pep Boys’ cost of equity (Ke). By inserting the selected beta of 1.789, the risk-free rate
(Rf) of 3.42%, and a market risk premium of 7.00% into the CAPM formula to calculate
cost of equity (Ke).
Type Ke Ke‐Upper Bound Ke‐Lower Bound Pep Boys Cost of Equity Formula KE=.0342+1.789(.07) KEUB=.0342+3.002(.07) KELB=.0342+.5756(.07) Return 15.94% 24.43% 7.45% The chart above shows how the cost of equity for Pep Boys is calculated at three
different intervals through the use of CAPM. Cost of equity (Ke) using the beta with the
highest adjusted R2 computed to 15.94%. The other two Cost of Equity formulas (KEUB
and KELB) were calculating by using the Lower and Upper Bound Betas found in the
regression analysis, which were formulated at .5756 and 3.002 respectively. By
inserting these values into CAPM, it is safe to say that it is 95% certain that Pep Boys’
Cost of Equity will lie between 7.45% and 24.43%. By using the information found in
the regression analysis and CAPM, the cost of equity for Pep Boys has been estimated
and can be applied to solve for the firms weighted average cost of capital (WACC).
188 Size Adjusted Cost of Equity After all calculations have been completed by using CAPM, it is necessary to
gather a more accurate interpretation of the returns that can be expected for Pep Boys.
The best way to achieve a more precise cost of equity is to add size premium to CAPM.
To determine the proper size premium to be added to cost of equity, the firm’s market
cap can be found by multiplying the current outstanding shares by the market value per
share. The market cap can then be analyzed and assigned to a certain decile depending
on its size. For Pep Boys, the market cap is currently at $480.10 million.
Now that a market cap has been established, it is required to assign Pep Boys’
market cap to a decile, which will provide us with an appropriate size premium that can
be added to CAPM to better estimate cost of equity. Each decile takes into a historical
average of the average risk and return that are observed, and each decile is organized
by the size of a firm’s market cap. Since Pep Boys currently has a market cap of
$480.10 million, it falls and the second decile between $265.0 million and $586.4 million
and thus receives a 2.7% size premium addition. This 2.7% size premium is added to
CAPM when calculating size adjusted cost of equity.
Pep Boys Size Adjusted Cost of Equity Formula KE=.0342+1.789(.07)+2.7 KEUB=.0342+3.002(.07)+2.7 KELB=.0342+.5756(.07)+2.7 Type Ke Ke‐Upper Bound Ke‐Lower Bound Return 18.64% 27.13% 10.15% The newly computed Size Adjusted Cost of Equity is more precise than the
regular cost of equity because it takes into account risk associated with the size of the
firm. After the size adjustment, cost of equity rose to 18.64%, and with Lower and
Upper Bound Ke having increased to 10.15% and 27.13% respectively, it can be
assumed that we can be 95% confident that Pep Boys’ cost of equity will fall in this
range. The size adjusted cost of equity of 18.64% can be used as a reasonable
estimate for Ke.
189 Alternative Cost of Equity (Backdoor Method) Another method of determining a firm’s cost of equity is by using the Alternative
(Backdoor) Cost of Equity method. This method uses much more firm specific
information, like the firm’s current price-to-book ratio and its calculated return on
equity, when calculating cost of equity for a firm. Below is the formula for the
Alternative Cost of Equity (Backdoor) method.
ROE − K e
⎛ Price ⎞
−
1
=
⎜⎝
⎟
Ke − g
Book ⎠
In this formula, the firms Price-to-Book is the current Market-to-Book ratio,
Return on Equity (ROE) is an average of the forecasted return on equity over the next
ten years, and g is the firm’s growth in book value forecasted over the next ten years
for Pep Boys. Due to Pep Boys’ use of operating leases, the backdoor method can be
very deceptive. This misleading information will cause the Alternative Cost of Equity
(Backdoor) Method to be calculated both “As Stated” and Restated.
Alternative (Backdoor) Cost of Equity As Stated Restated Book Value of Equity (Thousands) Price P/B ROE 410.10M 443,295 0.92512 ‐2.88%
410.10M 439,753 0.93257 ‐1.96%
Growth (G) ‐30% ‐30% Ke ‐26.89% ‐26.91% The results from the Alternative Cost of Equity method can now be compared to
the 95% confidence level range from our CAPM Cost of equity. It can easy be observed
that the Alternative (Backdoor) Cost of Equity method falls well below the CAPM 95%
confidence level range of 7.45% and 24.43% on both an as stated and restated basis.
These numbers do not support Pep Boys’ stock price, making this model irrelevant
when valuing Pep Boys.
190 Weighted Average Cost of Capital After estimating both cost of debt and cost of equity, the only value needed to
calculate the weighted average cost of capital are the weights of both debt and equity.
Pep Boys currently has a market cap of $480.10 million, which will be used as the
market value of equity. Since market value of debt is very similar to the book value of
debt, the book value will be used in the calculations for Pep Boys.
For WACCAT, a tax rate needs to be established. The major difference between
WACCBT and WACCAT is that WACCAT takes into account the tax rate that a firm is taxed
at. The tax rate can be found in Pep Boys’ most recent 10-K at a value of 30%. WACCBT
and WACCAT are formulated below:
⎛ Vd ⎞
⎛ Ve ⎞
K
WACCBT = ⎜
+
d
⎜⎝ V + V ⎟⎠ K e
⎝ Vd + Ve ⎟⎠
d
e
⎛ Vd ⎞
⎛ Ve ⎞
K d (1 − T ))+ ⎜
Ke
WACC AT = ⎜
(
⎟
⎝ Vd + Ve ⎠
⎝ Vd + Ve ⎟⎠
One aspect of WACC that will never change is that cost of equity (Ke) will always
be greater than cost of debt (Kd) due to the return that is necessary for higher risk
associated with the asset. Another facet that holds true regarding WACC is that WACCBT
will always be greater than WACCAT because when multiply by (1-T), a number less
than one will be found, thus decreasing WACCAT.
There are multiple WACC formulas that will need to be solved for. The first is the
normal WACC formula, followed by the WACC of the upper and lower bounds, and the
last WACC formula that will be calculated is the size adjusted formula. Since the
alternative cost of equity falls outside the range of the upper and lower bounds, it will
not be calculated for WACC. When calculating WACC, cost of equity does not change on
an as stated or restated basis, nor does it change for before or after taxes. This is
191 because the cost of equity analysis is based on CAPM data, which isn’t affected by any
variables. Cost of debt will change WACC on a restated basis due to the fact of Pep
Boys’ increase in liabilities from operating leases. Pep Boys’ after tax WACC will be
lower than before tax WACC because of tax shielding that was explained earlier.
When finding the upper and lower bound WACC, it is 95% certain that the true
WACC will lie in the range below. For WACCBT, we are 95% certain that WACC will fall in
the range of 4.70% and 10.06% on an as stated basis, and 5.50% and 10.85% on a
restated basis. For WACCAT, we are 95% confident that after tax WACC will fall between
4.00% and 9.35%, and between the values of 4.40% and 9.76% on a restated basis.
After computing the WACC, it is now necessary to calculate the effect of the size
adjustment premium into the size adjustment WACC. By assuming a 2.7% size
premium, the range that we are 95% sure that WACCBT will fall between increased to
5.55% and 10.91% on an as stated basis, and 6.35% to 11.71% on a restated basis.
For WACCAT, we can say with 95% certainty that WACC will fall in the range of 4.85%
to 10.21% on an as stated basis, and 5.25% to 10.61% on a restated basis. The
restated size adjusted WACC of 9.03% will be used as the value of WACC, as it provides
the most accurate discount rate because it gives the true picture of the firm and implies
all tangible factors used to value a firm, like the distortive nature of operating leases
and size premium of the firm. The following charts show how WACC is calculated under
both the CAPM method and the size adjusted method.
192 Weighted Average Cost of Capital Before Taxes CAPM Method Cost of Debt Weight of Debt Cost of Equity Weight of Equity WACC WACCBT As Stated 3.43% 68.44%
15.94%
31.56% 7.38%
WACCBT Restated 4.60% 76.59%
15.94%
23.41% 8.18%
Lower Bound WACCBT As Stated 3.43% 68.44%
15.94%
31.56% 4.70%
Lower Bound WACCBT Restated 4.60% 76.59%
15.94%
23.41% 5.50%
Upper Bound WACCBT As Stated 3.43% 68.44%
15.94%
31.56% 10.06%
Upper Bound WACCBT Restated 4.60% 76.59%
15.94%
23.41% 10.86%
Tax Rate WACC Weighted Average Cost of Capital After Taxes CAPM Method Cost of Debt WACCAT As Stated WACCAT Restated Lower Bound WACCAT As Stated Lower Bound WACCAT Restated Upper Bound WACCAT As Stated Upper Bound WACCAT Restated Weight of Debt Cost of Equity 3.43% 68.44%
15.94%
31.56%
30% 6.68%
4.60% 76.59%
15.94%
23.41%
30% 7.08%
3.43% 68.44%
15.94%
31.56%
30% 4.00%
4.60% 76.59%
15.94%
23.41%
30% 4.40%
3.43% 68.44%
15.94%
31.56%
30% 9.35%
4.60% 76.59%
15.94%
23.41%
30% 9.76%
193 Weight of Equity Weighted Average Cost of Capital Before Taxes Size Adjusted Method Cost of Debt Weight of Debt Cost of Equity Weight of Equity WACC WACCBT As Stated 3.43% 68.44%
18.64%
31.56% 8.23%
WACCBT Restated 4.60% 76.59%
18.64%
23.41% 9.03%
Lower Bound WACCBT As Stated 3.43% 68.44%
18.64%
31.56% 5.55%
Lower Bound WACCBT Restated 4.60% 76.59%
18.64%
23.41% 6.35%
Upper Bound WACCBT As Stated 3.43% 68.44%
18.64%
31.56% 10.91%
Upper Bound WACCBT Restated 4.60% 76.59%
18.64%
23.41% 11.71%
Weighted Average Cost of Capital After Taxes CAPM Method Cost of Debt WACCAT As Stated WACCAT Restated Lower Bound WACCAT As Stated Lower Bound WACCAT Restated Upper Bound WACCAT As Stated Upper Bound WACCAT Restated Weight of Debt Cost of Equity Tax Rate WACC 3.43% 68.44%
18.64%
31.56% 30%
7.53%
4.60% 76.59%
18.64%
23.41% 30%
7.93%
3.43% 68.44%
18.64%
31.56% 30%
4.85%
4.60% 76.59%
18.64%
23.41% 30%
5.25%
3.43% 68.44%
18.64%
31.56% 30%
10.21%
4.60% 76.59%
18.64%
23.41% 30%
10.61%
194 Weight of Equity Method of Comparables The method of comparables is often used to determine the value of the
firm. Analysts prefer to use this method because the numbers are easily found,
at least for publicly traded companies, and the computations within this method
are fairly simple. However there are some weaknesses in this method since the
numbers only serve for one-year and no trends or pattern can be found to better
analyze the route of the firm. Another flaw in the method is that often inputs
needed for the computations result in negative share prices and need to be
discarded for more realistic comparisons to occur. The method of comparables
consists of the trailing price to earnings ratio, the price to earnings forecasted
ratio, the price to book ratio, the dividends to price ratio, the price to earnings
trailing to growth ratio, the price to earnings before interest, taxes, depreciation
and amortization (EBITDA), the price to free cash flows ratio and the enterprise
value to EBITDA ratio.
In analyzing Pep Boys, a 15% analyst position is going to be used with a
starting date of June 1, 2010. The observed price at the starting date is $11.94.
This results in a lower bound of $10.15 and an upper bound of $13.73. This
means that any value under the lower bound value represents Pep Boys being
overvalued and any value above the upper bound means the firm is undervalued.
Any results found between the lower and upper bound is considered fairly
valued. Pep Boys required inputs are taken from the firm’s 10-K and the
forecasts our forecasted results. The competitors’ information comes from
analysts’ estimates found in Yahoo! Finance.
Trailing Price to Earnings Ratio The trailing price to earnings ratio or trailing P/E ratio is calculated by
dividing the price per share by the addition of the previous year’s earnings per
share. In order to compute Pep Boys comparable values, an industry average
needs to be calculated. The industry average does not include Pep Boys or else
195 the comparison with the industry is not valid and may result in higher or lower
industry averages.
The next step is to multiply the industry average just
calculated by Pep Boys’ earnings per share to arrive at the comparables PPS.
P/E Trailing
Company
PPS
EPS
P/E
Industry
Trailing
Avg.
Pep Boys As Stated
11.94
0.55
21.66
Pep Boys Restated
11.94
0.32
37.13
Advance
50.18
3.02
16.62
O'Reilly
47.56
2.47
19.26
193.22
13.92
13.88
AutoZone
Comparables
Pep Boys PPS
16.58
9.14
5.33
The industry average calculated to price Pep Boys’ stock is $16.58.
Comparing the comparables results for Pep Boys of $9.14 on an as stated basis
and $5.33 on a restated basis to the current observed price per share shows that
Pep Boys is overvalued in both the as stated and restated basis.
Forecasted Price to Earnings Ratio The forecasted price to earnings ratio or forward P/E ratio is calculated by
dividing the price per share by the forecasted earnings per share. The forecasted
earnings per share are obtained from the previously forecasted income
statement. This method is not as accurate as the trailing P/E method due to the
inaccuracy of the earnings per share forecasted. Pep Boys’ competitors’ forward
P/E data is collected from analysts’ estimates found in Yahoo! Finance.
196 P/E Forecast
Comparables
Industry
Company
PPS
EPS
P/E Forecast
Pep Boys As Stated
11.94
0.11
105.27
Pep Boys Restated
11.94
N/A
N/A
Advance
50.18
4.01
12.51
O'Reilly
47.56
3.18
14.96
193.22
16.43
11.76
AutoZone
Avg.
Pep Boys PPS
13.08
1.48
N/A
The P/E forecast table above shows the average industry value of 13.02
used to price Pep Boys’ forward stock. However, the firm has low earnings per
share and an outlier P/E forecast of 105.27 for the as stated and negative
forecasted earnings for the restated that results in negative earnings per share.
Since Pep Boys does not have reliable comparables it cannot be properly
compared to the industry or the observed price per share of $11.94.
Price to Book Ratio The price to book ratio is calculated by dividing the price per share by the
book value per share. The book value per share is the book value of equity
divided by the number of shares outstanding. To find the comparable PPS for
Pep Boys, an industry average needs to be calculated. The industry average
excludes AutoZone because no P/B was found in the analysts’ estimates of
Yahoo! Finance. As mentioned before the industry average does not include Pep
Boys for valid comparisons with the competitors’ average.
197 Price/Book
Comparables
Industry
Company
PPS
BPS
P/B
Pep Boys As Stated
11.94
11.71
1.02
Pep Boys Restated
11.94
8.18
1.46
Advance
50.18
12.74
3.94
O'Reilly
47.56
20.15
2.36
N/A
N/A
AutoZone
193.22
Avg.
Pep Boys PPS
3.15
36.87
25.76
The industry average of 3.15 is multiplied by the book value per share to
arrive at the comparables PPS of $36.87 for the as stated and $25.76 for the
restated basis. The values are well above the observed price meaning that Pep
Boys is undervalued for both the as stated and restated basis.
Dividend to Price Ratio The dividend to price ratio is calculated by dividing the dividends per
share by the price per share. However not all firms pay dividends and therefore
provides the most evident of the flaws found in the method of comparables.
Unfortunately, that is the case of Pep Boys’ competitor, which do not pay
dividends. It is therefore unnecessary to provide Pep Boys’ D/P since it cannot be
compared to the industry D/P and makes the inputs questionable.
Price to Earnings to Growth (P.E.G) Ratio The PEG ratio values a firm by dividing the previously trailing price to
earnings ratio by the growth rate in earnings. This ratio analyzes both current
earnings and forward growth opportunities in earnings. Taking the forecasted net
income and analyzing the growth for at least a period of five years provides a
more accurate value calculate the growth rate. The forecasted net income for
198 Pep Boys shows a negative growth for the most part and therefore results in an
unrealistic PEG ratio. For that reason it is irrelevant to provide a table that does
not include the firm being valued.
Price to EBITDA Ratio This ratio is calculated by dividing price by earnings before interest, taxes,
depreciation and amortization (EBITDA). Since price is provided in a per share
basis and EBITDA is provided in the numeral form, two approaches can be taken.
Either multiply the PPS by the number of shares outstanding or diving EBITDA by
the number of shares outstanding to arrive at equal units of comparison. The
industry average needs to be computed to calculate the comparables for Pep
Boys.
Price/EBITDA
Company
Market Cap.
EBITDA
Comparables
P/EBITDA
Pep Boys As Stated
490,447,440
18,871,000
25.99
Pep Boys Restated
490,447,440
22,644,000
21.66
Advance
4,390,000,000
640,130,000
6.86
O'Reilly
6,570,000,000
744,810,000
8.82
AutoZone
9,080,000,000
1,450,000,000
6.26
Industry
Pep Boys
Avg.
PPS
7.31
3.36
4.03
The industry average is calculated to be 7.31. To arrive at the Pep Boys’
comparables the EBITDA was divided by the number of shares then multiplied by
the industry average. The P/EBITDA for Pep Boys in both the as stated and
restated basis are considered outliers compared to the competitors’ P/EBITDA.
The reason for this is that forecasted earnings are decreasing. Pep Boys’
199 comparison to the observed price is found to be overvalued for both the as
stated and the restated basis.
Price to Free Cash Flows This ratio is calculated by dividing the price per share by the free cash
flows. The free cash flows (FCF) are derived from the addition of cash flows from
operating activities and the cash flows from investing activities. These two
measures can be found in the previously forecasted as stated and restated
statements of cash flows. The statement of cash flows is considered the toughest
financial statement to forecast compared to the balance sheet and the income
statement. It is therefore predictable that the following data is not completely
accurate.
Price/Free Cash Flows
Company
Market Cap.
FCF
P/FCF
Pep Boys As Stated
490,447,440
138,115,000
3.55
Pep Boys Restated
490,447,440
175,856,000
2.79
Advance
4,390,000,000
277,422,000
15.82
O'Reilly
6,570,000,000
80,389,000
81.73
AutoZone
9,080,000,000
324,672,000
27.97
Comparables
Industry
Pep Boys
Avg.
PPS
21.90
73.64
93.76
The P/FCF industry average, in this case, does not include O’Reilly
because of the incomparable P/FCF of 81.73. The comparables are calculated by
dividing the FCF by the number of shares outstanding and multiplying it by the
industry average. The values are way higher than the observed price of $11.94,
meaning the firm is undervalued.
200 Enterprise Value/ EBITDA
EV/EBITDA ratio is computed by dividing the enterprise value by the
earnings before interests, taxes, depreciation and amortization. In order to
calculate this ratio, it is required to first find the enterprise value. The enterprise
value equals the market cap plus the book value of liabilities minus short-term
investments plus cash. Again in order to compute the comparables for Pep Boys,
the industry average EV/EBITDA must be found.
Enterprise Value/ EBITDA
Company
Pep Boys As Stated
Pep Boys Restated
Advance
O'Reilly
EV
699,399,800
699,399,800
4,576,929,500
7,395,963,300
EBITDA
18,871,000
22,644,000
640,130,000
744,810,000
EV/EBITDA
37.06
30.89
7.15
9.93
AutoZone
11,803,000,000
1,450,000,000
8.14
Industry
Avg.
8.41
Comparables
Pep Boys
PPS
3.86
4.64
The EV/EBITDA industry average is 8.41. This industry average is multiplied
by Pep Boys’ EBITDA per share to find the enterprise value. The EV as stated
price for Pep Boys is $3.86 and the restated is $4.64. When comparing these
prices to the observed price for June 1, 2010 of $11.94, one can conclude that
the firm is overvalued.
Conclusion Although the method of comparables is a useful tool to value a firm, many
flaws found within the ratios make it hard to rely on the resulting information.
After closely analyzing Pep Boys, one can conclude that the firm, overall, is
overvalued. The following table better illustrates the outcomes from each of the
comparable ratios.
201 Method of Comparables
Ratio
As Stated
Restated
Trailing P/E
Overvalued
Overvalued
Forecasted P/E
N/A
N/A
P/B
Undervalued
Undervalued
D/P
N/A
N/A
PEG
N/A
N/A
P/EBITDA
Overvalued
Overvalued
P/FCF
Undervalued
Undervalued
EV/EBITDA
Overvalued
Overvalued
Overall
Overvalued
Overvalued
For the majority of the ratios, the results fell below the June 1, 2010 market
price per share of $11.94 and the 15% analyst position taken. However, lets not
forget that the method of comparables considers only one year of data and the
valuations for the firm may change in future years.
Intrinsic Valuation Models Although the method of comparables that was show in the previous
section allows an opportunity to value stocks, the method has serious accuracy
and relevancy issues. This method allows getting an overall method to pricing
but due to outliers and skewed numbers, the method presents numerous flaws.
In this section we will be focusing on determining stock prices of Pep Boys
through intrinsic valuation models. By companies within the finance world, the
intrinsic valuation models are considered more valuable and favorable than the
method of comparables for many reasons. One reason for these models to be
more favorable is that these models have theory behind them. When companies
have theory behind their models, it allows for better accuracy and representation
of the firm’s value. In addition, these models forecast longer periods of time. The
intrinsic valuation models forecast ten years of data for a firm, while the method
of comparables only forecasts one year. The last reason that these models are
202 more favorable is that they hold the time value of money. By using the present
value of the numbers from the valuation, we will be able to see a more realistic
valuation of Pep Boys.
There intrinsic valuation models consist of five models, all of which we will
be using to value Pep Boys. These models include: discounted dividends model,
discounted free cash flow, residual income, long run residual income, and the
abnormal earnings growth model. Each one of these models has a different
explanatory rate that is based upon the theory behind them, and although some
models have a lower level of explanatory power, they are still considered
favorable above the method of comparables. Of the five models, the abnormal
earnings growth model and the residual income model are the two models that
hold the highest amount of explanatory power by reporting the highest adjust
R2. By performing the intrinsic valuation models of Pep Boys, we will be able to
see a clearer picture of the firm’s value.
After the models have been calculated, we will be perform a sensitivity
analysis on the firm to determine who much it is influence to minor changes at
different rates. The sensitivity analysis will be calculated using the estimated
growth rate and the cost of equity for Pep Boys. This analysis is extremely
important because it takes into account forecasting errors. By using a wide range
of estimated numbers, we will be able to take into account forecasting errors and
see the effect of changing growth rates. In order to classify the valuation model
results as overvalued, fairly valued, or undervalued, boundaries must be set for
each classification. A 15% analyst position will be held when classifying the
valuation model results. We took the 15% analyst position into account when
setting boundaries for each classification. At June 1, 2010 the observed share
price was at $11.94, therefore, we have concluded that a price is fairly valued if
between $10.15 and $13.73. If the sensitivity analysis gives us a price below
$10.15, we will classify it as overvalued, and it there if a share price above
$13.73, it will be classified as overvalued. Overall, the intrinsic valuation models
203 will be used as the basis of our analyst recommendations since they are the most
accurate and favorable models available.
Discounted Dividends Model The discounted dividends model is the first of the five intrinsic valuation
models that we will be using. Unfortunately this model is extremely flawed
because it only takes into to account dividend streams and not the effect capital
gains yield has on a firm’s stock price. Typically this model considers firms to be
overvalued due to its flaws, and it only has an explanatory power of about 5%.
Reasoning behind the low amount of explanatory power is that not all publically
traded companies pay dividends to their shareholders, and ones that do can play
very small amounts. The model also assumes that the growth rate for dividend
payments in perpetuity is a smooth and constant rate. A smooth and constant
rate is very unrealistic and in reality the growth for dividend payments is a stair
stepped change. This meaning that firms will hold their payment at a constant
amount for long periods of time and increase by a small amount periodically. A
third reason for the low explanatory power of this model is that it places a large
amount of value in the perpetuity portion of the model. Forecasts are unreliable
in the long term, and for a firm to have a high level of explanatory power, a lot
of value needs to be focused on the current value of the firm.
When beginning the discounted dividend model, we found that Pep Boys
has kept their dividends constant and with forecasting are expecting to keep the
rate constant for the next ten years. Due to the amount of distortion that can
come from the forecasting of future dividends, it is important that the dividends
for each year be discounted back to their present value. The discounting is
calculated by using the estimated cost of equity, and once the present value of
each year are added together, the completion of the dividend stream has
occurred. After the completion of the dividend stream, we must approximate Pep
Boys payments from year eleven to infinity. The value of the perpetuity is
204 calculated by using the discount rate at year ten. By using the discount rate at
time ten, the distortion from forecasting errors from the previous ten years is
lessened, and the distortion of the smooth growing perpetuity from the eleventh
year to infinity. Once the year by year discounted dividend amounts are added
together along with the discounted amount of the perpetuity, the result will be
the calculation of the 2009 year end amount of Pep Boys’ share price. Since we
are using the observed share price of at June 1, 2010, we must grow the
December 31, 2009 price by five months in order to calculate a time consistent
price. This calculation is computed by utilizing the cost of capital initially derived
from regression analysis. We are now able to complete a sensitivity analysis of
the firm by creating a table containing various costs of equity and growth rates.
The results from the sensitivity analysis will then be compared to Pep Boys’
actual closing price of $11.94 on June 1, 2010.
Discounted Dividends Sensitivity Analysis
Growth Rate
0%
1%
2%
3%
4%
5%
6%
$
$
$
$
$
1.27
1.67
1.89
10.15% 1.22
$ 1.33 $ 1.42 1.52
$
$
$
$
$
1.07
1.28
1.37
12.00% 1.04
$ 1.11 $ 1.15 1.21
Cost
$
$
$
$
$
of
15.00% 0.84
0.85
$ 0.87 $ 0.89 0.91
0.94
0.98
$
$
$
$
$
equity 18.64% 0.68
0.69
$ 0.70 $ 0.71 0.72
0.73
0.74
$
$
$
$
$
0.59
0.61
0.61
22.00% 0.58
$ 0.59 $ 0.60 0.60
$
$
$
$
$
0.52
0.53
0.53
25.00% 0.52
$ 0.52 $ 0.52 0.53
$
$
$
$
$
0.48
0.49
0.49
27.13% 0.48
$ 0.48 $ 0.48 0.49
overvalued<10.149
10.149<fairly valued<13.731
undervalued>13.731
15% Analyst
When we apply our 15% analyst position to the discounted dividends sensitivity
analysis of Pep Boys, the firm is continuously overvalued. It is clear to see that
the range of price ranges from $0.48, when using a growth rate of 0% and a
205 cost of equity of 27.13% to $.189 when using a cost of equity of 10.15% and a
growth rate of 6%. This outcome results from the combined effects of low
forecasted dividend yield of the firm and the fact that the discounted dividends
model often overvalues companies. After considering the assumptions that one
must apply in order to conduct this model and the inadequacy of it, it is reason
to believe that the discounted dividends model does not give proper
representation for a firm. However, overall the model has reported Pep Boys to
be highly overvalued.
Discounted Free Cash Flow Model The second intrinsic valuation model that we will use to value Pep Boys is
the discounted free cash flow model. This model incorporates forecasted cash
flow from operations and cash flow from investing activities. When using this
model it is assumed that the free cash flow of Pep Boys is assumed to be its cash
flow from operations (CFFO) minus its cash flow from investing activities (CFFI).
This assumption is created with the accounting equation; market value of equity
equals the market value minus the market value of their liabilities. We will also
assume that Pep Boys’ market value of liabilities is equal to their book value of
liabilities.
Similar to the discounted dividends model, the discounted free cash flow
model requires that the present value of year by year dividends be calculated, in
addition to the present value of the perpetuity from year eleven to infinity. The
discount rate that will be used to calculate that present value of dividend
payments, is the before tax weighted average cost of capital (WACCBT). It is
important to use the WAACBT and not the after tax WACC (WACCAT), to ensure
that double taxation does not occur. Since the forecasted statements of CFFO
and CFFI are calculated with after tax amounts, using the WACCAT will cause
distortion.
206 Once the year by year dividend payments are brought back to their
present value and summed together, the perpetuity‘s value from years eleven
through infinity are calculated using WAACBT. The summed present values of
year by year dividends must then be added to the present value of the
perpetuity to find the market value of Pep Boys’ assets. Now that we have
determined the market value of both Pep Boys’ assets and liabilities, we can now
determine the market value of the firm’s equity. The market value of Pep Boys is
calculated by subtracting their market value of equity from their market value of
assets (MVA-MVL).
Since we now know the MVE of Pep Boys, we can calculate the price per
share for Pep Boys at 2009 year end. This is calculated by taking MVE and
dividing it by the number of shares outstanding for the firm. Similarly to the
discounted dividends model, a time consistent price must be computed for the
FCF model. We calculate this by compounding the price for five months, to arrive
at a price at June 1, 2009 to compare to the observed price of $11.94. We are
now able to complete a sensitivity analysis of the firm by creating a table
containing various costs of equity and growth rates.
Weighted
Average
Cost
of Capital
Discounted Free Cash Flows (As Stated) Sensitivity Analysis
Growth Rate
0%
1%
2%
3%
4%
5%
5.55% $10.04 $14.33 $21.04 $
33.00 $ 60.41 $ 187.47
6%
$ 7.51 $10.97 $16.17 $
24.84 $ 42.16 $ 94.14
7%
$ 3.02 $ 5.28
8.23%
$
- $ 0.38
9%
$
$
10%
$
$
10.91% $
$
overvalued<10.149
$ 8.45 $
13.19 $ 21.10
$ 2.27 $
4.88 $ 8.72
$
$
1.36 $ 4.01
$
$
$
$
$
$
10.149< fairly valued <13.731
15% Analyst
overvalued fairly valued and undervalued at various growth and discount rates.
$
$
-
$ 36.93 $ 84.39
$ 14.94 $ 26.74
$
7.97 $ 14.59
$
2.06 $
5.69
$
$
0.67
undervalued>13.731
The results of our sensitivity analysis shows that Pep Boys is classified as
207 6%
Although all three classifications occur during FCF sensitivity analysis, Pep Boys is
classified as overvalued the most amount of times. The cause of the inability to
put a share price at certain growth and discount rates is that the results came to
be a negative number and since share prices cannot be anything lower than
zero, no value was given. We can also see that the perpetuity is very sensitive to
a change in growth rate, because as the growth rate increases, the value placed
on the perpetuity also increases.
Discounted Free Cash Flows (Restated) Sensitivity Analysis
Growth Rate
0%
1%
2%
3%
4%
5%
6.34% $ 18.65 $ 22.08 $ 27.90 $ 38.64 $ 56.70 $101.70
7% $ 14.93 $ 17.89 $ 22.32 $ 28.97 $ 40.05 $ 62.20
Weighted
Average
Cost
of Capital
8%
9.02%
10%
11%
11.70%
$
9.99 $ 12.16
$
6.20 $ 7.73
$
3.26 $ 4.39
$
0.78 $ 1.62
$
$
overvalued<10.149
$ 15.05 $ 19.10 $ 25.17 $ 35.30 $ 55.54
$ 9.70 $ 12.33 $ 16.00 $ 21.50 $ 30.63
$ 5.80 $ 7.62 $ 10.04 $ 13.43 $ 18.53
$ 2.66 $ 3.95 $ 5.62 $ 7.84 $ 10.95
$ 0.82 $ 1.86 $ 3.17 $ 4.87 $ 7.17
10.149< fairly valued <13.731 undervalued>13.731
15% Analyst
Since Pep Boys is a firm that contains information in their financials about
operating leases and other items that affect the CFFO of the firm, the sensitivity
analysis must also be completed on a restated basis. For this analysis, the cash
flow from investing activities was the only account restated. Similarly to the as
stated sensitivity analysis, the model is highly sensitive to changes in growth
rates and the cost of capital. The as stated analysis ranges from a price of $0 to
$187.47; however, the restated analysis reveals prices ranging from $0 to
$411.40.
The fact that extreme value is placed on the perpetuity and not the
current value of the firm is high problematic and distorts the reliability of the
model. Due to these problems the FCF model has an average explanatory power
ranging from 10%-15%. In order to have a more reliable model, we must use a
208 6%
$411.40
$128.65
model that incorporates the current assets of a firm and not only its CFFO. For
the above reasons, our final valuation of Pep Boys will not be highly impacted by
the discounted free cash flow model.
Residual Income Model One of the most accurate and useful valuation models is the residual
income model. The residual income model has a high degree of explanatory
power. This model has such a high explanatory power for several reasons. This is
the only model that directly takes into account the current state and net worth of
the company by factoring in the current book value of equity. Most of its value
comes from the present value of year by year residual income rather than the
perpetuity. Forecasting from current or short term items allows for more
accurate computation of the present value of those forecasts. Another reason
this model has a high explanatory power is due to it not responding as volatile to
changes in the growth rate. Unlike previous valuation models, the inputs to
residual income are forecasted with much less error helping to improve its
explanatory power. This high accuracy and low volatility of residual income
makes it a good valuation model.
Residual income is calculated through the difference in net income and
the benchmark net income. The sum of the present value of year by year
residual incomes and the terminal value of the perpetuity added to the current
book value of equity then gives us the market value of equity. To begin this
valuation we first need to calculate the book value of equity for each year. This is
done by taking the previous year’s book value of equity, adding the current
year’s net income, and taking out any dividends paid. Once this is done for every
year we are then able to calculate the benchmark net income. Benchmark net
income is the amount of profit that stock holders are expecting the company to
make. This is found by taking the previous year’s book value of equity and
multiplying it by the firm’s cost of equity. Now that benchmark net income has
been found, a comparison between the actual profits and the expected profits
209 can be done. This difference between these two numbers is the residual income.
If a firm is creating value then residual income will be positive, signaling that
more profit was creating than expected. Vice versa, if the residual income comes
up negative then firm did not meet its benchmark and is destroying value. It’s
then necessary to discount the year by year residual income to the present
value.
The next step needed to find the market value of equity is to find the
terminal value of the perpetuity. The approximate residual income used in the
perpetuity was found using 90% of year ten residual income. It is important that
this number be calculated using year ten residual income in order to maintain as
much accuracy as possible. We can then grow out the perpetuity by dividing it by
the difference in cost of equity and the growth rate and then discount it back to
present value. However, unlike previous valuation models, the growth rates for
residual income will be negative in order to . The market value of equity is then
found though the sum of current book value of equity, present value of year by
year residual incomes, and present value of the perpetuity. The market value is
then divided by the number of shares outstanding and adjusted to reflect a time
consistent price for June 1st, 2010.
Like in the previous valuation models, sensitivity analysis is the next step
for valuation. Similar to the previous sensitivity analysis, this is done by
observing the time consistent price with changes in the cost of equity and
growth rates inputs.
210 Residual Income (As Stated) Sensitivity Analysis
Growth Rate
-10%
-20%
$ 2.56
$ 2.13
Cost of
$ 1.62
equity
$ 1.22
$ 0.96
$ 0.80
$ 0.71
overvalued<10.149 10.149<
10.15%
12%
15%
18.64%
22%
25%
27.13%
-30%
-40%
-50%
$
3.18 $ 3.50 $ 3.69 $ 3.81
$
2.66 $ 2.95 $ 3.12 $ 3.24
$
2.04 $ 2.26 $ 2.41 $ 2.51
$
1.51 $ 1.69 $ 1.80 $ 1.88
$
1.18 $ 1.32 $ 1.41 $ 1.47
$
0.97 $ 1.07 $ 1.15 $ 1.20
$
0.85 $ 0.94 $ 1.00 $ 1.05
fairly valued <13.731 undervalued>13.731
15% Analyst
The as stated residual income sensitivity analysis shows that Pep Boys’ is
highly overvalued. The highest time consistent price comes from the lowest cost
of equity of 10.15% and the lowest growth rate of -50%. This value of $3.81 is
far out of the 15% analyst range making Pep Boys’ highly overvalued. The low
values come from the fact that forecasted financials show that net income will be
continually negative and Pep Boys will continue to pay out dividends. This
assumption is supported by evidence from the past when Pep Boys made
negative profits and still paid out dividends. This continued process has created
largely negative residual incomes which show us that Pep Boys is constantly
destroying the value of their firm which leads to the low time consistent per
share prices. Since the time consistent price never reaches the fair value of
$10.149, the lower bound of the 15% analyst, no matter the growth rate or cost
of equity, we can say that Pep Boys is overvalued on a stated basis.
211 Residual Income (Restated) Sensitivity Analysis
Growth Rate
-10%
-20%
Cost of
equity
10.15%
12%
15%
18.64%
22%
25%
27.13%
$
$
$
$
$
$
$
overvalued<10.149
-30%
-40%
-50%
1.67 $ 2.30 $ 2.61 $ 2.80 $
2.93
1.43 $ 1.95 $ 2.22 $ 2.39 $
2.50
1.13 $ 1.52 $ 1.73 $ 1.87 $
1.96
0.89 $ 1.16 $ 1.32 $ 1.42 $
1.49
0.74 $ 0.93 $ 1.05 $ 1.13 $
1.19
0.63 $ 0.78 $ 0.87 $ 0.94 $
0.98
0.57 $ 0.69 $ 0.77 $ 0.83 $
0.87
10.149< fairly valued
undervalued>13.731
15% Analyst
The restated residual income sensitivity analysis closely follows that of the
stated sensitivity analysis. Again the highest time consistent price came from a
cost of equity of 10.15% and a growth rate of -50%, with a price of $2.93. This
price is lower than the price given by the stated residual income and remains the
highly overvalued valuation no matter the cost of equity or growth rate. This is
again due to the value destruction caused by negative net incomes and paying
out dividends. Our restated residual income again allows us to again conclude
that Pep Boys is overvalued.
The sensitivity analysis for residual income on a stated and restated basis
concludes that Pep Boys’ is highly overvalued. Even the lower bound cost of
equity and low growth rate could not provide a fairly valued price. As previously
stated, the residual income valuation model is considered very effective and will
have a significant effect on our final recommendation.
Long Run Residual Income Model Much like most of the valuations, long run residual income values the firm by
first finding the market value of equity. A major difference between the residual
income model and the long run residual income model is its calculation of the
market value of equity. Residual income utilizes the present value of year by year
residual incomes and the perpetuity then adding it to the book value of equity.
212 Long run residual income does not use year by year present values or the
perpetuity making this model much easier to compute a valuation. This model
determines a market value based on estimated cost of capital, long run return on
equity, growth rate and current book value of equity. However, like residual
income, long run will also use negative growth rates. This model does not hold
as much explanatory power as residual income but still has useful application
and its inputs can be easily identified. For Pep Boys, a stated and restated
valuation will be done utilizing both the state and restated balance sheet and
income statement to provide a long run return on equity. Although in either
circumstance we will use the stated book value of equity. The formula below
demonstrates how the long run residual income will use the inputs to determine
market value.
Like the other models, after computing the market value of equity,
dividing by shares outstanding, and adjusting for a time consistent price, a
sensitivity analysis will be done. However, unlike the other models, the sensitivity
analysis for long run residual income will be comprised of three inputs. One input
will be held constant and the other two will change then two more analysis will
be done rotating the constant input and two variables.
213 As Stated Long Run Residual Income Sensitivity Analysis
ROE
Cost of Equity Constant at 18.64%
Growth Rate
-10%
-20%
-30%
-1.07% $ 3.56 $ 5.60 $ 6.80 $
1.13% $ 4.44 $ 6.25 $ 7.31 $
1.95% $ 4.77 $ 6.49 $ 7.50 $
2.77% $ 5.09 $ 6.73 $ 7.70 $
3.59%
4.41%
5.44%
overvalued<10.149
10.15%
12.00%
15.00%
Cost of
18.64%
equity
22.00%
25.00%
27.13%
overvalued<10.149
-40%
7.58
8.01
8.17
8.33
$
$
$
$
-50%
8.14
8.51
8.65
8.78
$ 5.42 $ 6.97 $ 7.89 $
8.49 $ 8.93
$ 5.75 $ 7.22 $ 8.08 $
8.65 $ 9.06
$ 6.16 $ 7.52 $ 8.32 $
8.85 $ 9.23
10.149<fairly valued<13.731 undervalued>13.731
15% Analyst
ROE Constant at 5.44%
Growth Rate
-10%
-20%
-30%
$ 8.54 $ 9.41 $ 9.84
$ 7.87 $ 8.91 $ 9.46
$ 6.98 $ 8.22 $ 8.90
$ 6.16 $ 7.52 $ 8.32
$ 5.56 $ 6.98 $ 7.86
$ 5.13 $ 6.57 $ 7.49
$ 4.86 $ 6.31 $ 7.25
10.149<fairly valued<13.731
15% Analyst
-40%
-50%
$ 10.10 $ 10.27
$
9.79 $ 10.02
$
9.34 $ 9.64
$
8.85 $ 9.23
$
8.45 $ 8.88
$
8.13 $ 8.59
$
7.91 $ 8.40
undervalued>13.731
Growth Rate Constant at -10%
ROE
-1.07% 1.13% 1.95% 2.77%
3.59% 4.41% 5.44%
10.15% $
4.94 $ 6.16 $ 6.61 $ 7.06 $
7.52 $ 7.97 $ 8.54
12.00% $
4.55 $ 5.67 $ 6.09 $ 6.51 $
6.92 $ 7.34 $ 7.87
15.00% $
4.04 $ 5.03 $ 5.40 $ 5.78 $
6.15 $ 6.52 $ 6.98
Cost of 18.64% $
3.56 $ 4.44 $ 4.77 $ 5.09 $
5.42 $ 5.75 $ 6.16
equity 22.00% $
3.22 $ 4.01 $ 4.31 $ 4.60 $
4.90 $ 5.19 $ 5.56
25.00% $
2.97 $ 3.70 $ 3.97 $ 4.24 $
4.51 $ 4.79 $ 5.13
27.13% $
2.81 $ 3.50 $ 3.76 $ 4.02 $
4.28 $ 4.54 $ 4.86
overvalued<10.149
10.149<fairly valued<13.731
undervalued>13.731
15% Analyst
214 Restated Long Run Residual Income Sensitivity Analysis
Cost of Equity Constant at 18.64%
Growth Rate
-10%
-20%
-30%
$ 2.68 $
4.92 $ 6.24
$ 3.26 $
5.35 $ 6.58
$ 3.83 $
5.77 $ 6.92
ROE
$ 4.40 $
6.19 $ 7.25
$ 4.96 $
6.61 $ 7.58
$ 5.53 $
7.03 $ 7.92
$ 6.09 $
7.45 $ 8.25
overvalued<10.149 10.149<fairly valued<13.731
15% A nalyst
-3.23%
-1.75%
-0.32%
1.11%
2.54%
3.97%
5.40%
-40%
-50%
$ 7.11 $ 7.72
$ 7.39 $ 7.97
$ 7.67 $ 8.20
$ 7.95 $ 8.44
$ 8.22 $ 8.68
$ 8.50 $ 8.91
$ 8.77 $ 9.15
undervalued>13.73
ROE Constant at 5.4%
Growth Rate
-10%
-20%
-30%
$ 8.45 $
9.31 $ 9.75
$ 7.78 $
8.82 $ 9.37
$ 6.91 $
8.14 $ 8.82
Cost of
$ 6.09 $
7.45 $ 8.25
$ 5.51 $
6.92 $ 7.79
equity
$ 5.07 $
6.51 $ 7.42
$ 4.81 $
6.25 $ 7.19
overvalued<10.149 10.149<fairly valued<13.731
15% A nalyst
10.15%
12.00%
15.00%
18.64%
22.00%
25.00%
27.13%
-40%
-50%
$ 10.01 $ 10.18
$ 9.71 $ 9.93
$ 9.26 $ 9.56
$ 8.77 $ 9.15
$ 8.38 $ 8.80
$ 8.06 $ 8.52
$ 7.84 $ 8.33
undervalued>13.73
Growth Rate Constant at -10%
ROE
-0.32% 1.11%
-3.23% -1.75%
10.15% $ 3.71
12.00% $ 3.42
15.00% $ 3.04
Cost of
equity
$ 4.53
$ 4.17
$ 3.70
$
$
$
5.31
4.89
4.34
$ 6.10
$ 5.61
$ 4.98
$ 2.68 $ 3.26 $ 3.83 $ 4.40
$ 2.42 $ 2.95 $ 3.46 $ 3.97
$ 2.23 $ 2.72 $ 3.19 $ 3.66
$ 2.11 $ 2.58 $ 3.02 $ 3.47
overvalued<10.149
10.149<fairly valued<13.731
15% Analyst
18.64%
22.00%
25.00%
27.13%
215 2.54%
$ 6.88
$ 6.34
$ 5.63
$
$
$
$
3.97% 5.44%
$
$
$
7.67
7.06
6.27
$ 8.47
$ 7.80
$ 6.93
4.96 $ 5.53 $ 6.11
4.48 $ 4.99 $ 5.52
4.13 $ 4.60 $ 5.09
3.92 $ 4.36 $ 4.82
undervalued>13.731
As with previous valuation models, the long run residual income model
consistently gives us overvalued share price as the sensitivity analysis results on
both a stated and restated basis. The valuation model only put out a fairly valued
price twice both for the same sensitivity analysis of holding ROE constant and
varying cost of equity and growth rate. On an as stated basis the model gave a
share price at $10.27 with ROE held at 5.44%, lower bound cost of equity of
10.15% and the lowest growth rate of -50%. On a restated basis the model gave
a fair value share price of $10.18 with ROE held at 5.4%, lower bound cost of
equity 10.15%, and a growth rate of -50%. Again we can conclude that Pep
Boys’ stock is highly overvalued.
Abnormal Earnings Growth Model The abnormal earnings growth (AEG) model is very much alike the residual
income model because both share some of the same line items like net income
and dividends paid forecasted out ten years from now. These two models are
also similar in that they both compare their net income to a benchmark or also
known as the equilibrium or normal income. However different adjustments from
those in residual income need to be made when using the AEG valuation model.
The AEG valuation model values the price of the firm by adding the core net
income plus the present value of a constant perpetuity, a forward earnings
perpetuity, divided by the number of shares outstanding which is then discounted
by the initial cost of equity. The core value is represented by the first year’s
forecasted net income. Prior to arriving to the process just mentioned, lets step
back for a moment and follow the steps chronologically.
The first step is to find the dividends reinvested (DRIP) on both the stated
and restated basis. The DRIP is calculated as follows:
Once the DRIP is found for all forecasted periods, it is added to the net
income for the same year to get the cumulative dividends earnings. The
216 following step is to find the benchmark income by multiplying (1+ Ke) with the
previous period’s net income. Subtracting the benchmark or normal income from
the net income for that year gives the abnormal earnings growth as a result.
Then the present value of factor needs to be calculated using the formula below.
Once the present value of factor is found, it is multiplied by the AEG of that
same period to arrive at the present value of AEG. The advantage of residual
income being similar to AEG is that it provides a check figure to revise the results
obtained on AEG. The check figure consists of subtracting the annual residual
income from the previous year from the current annual residual income. The
following line of the model represents the core net income, or the first year’s
forecasted net income. The total present value of AEG is the next line, which is
simply the sum of all the present value AEGs. The continuing terminal value is
the step that follows and it consists of the forward AEG forecasted for the last
period divided by the cost of equity less the growth rate. The continuing terminal
value is then discounted to present value. The total present value of AEG is then
adjusted by adding the present value of the terminal value to the previously
calculated present value of AEG. The new total present value of AEG is then
added to the core net income. This result is dividend by the number of shares
outstanding to get a per share basis. It is then divided by the cost of capital to
arrive at the intrinsic value of the firm on a per share basis.
The following spreadsheet excerpt better illustrates the step of the AEG
valuation process. The table within the spreadsheet represents the time
consistent prices at the different growth rates and at the different cost of equity
rates. The table shows how the firm is overvalued in the as stated basis. No
major effect is presented by the change in growth rates and the change in cost
of equity values.
217 As Sated Abnormal Earnings Growth Valuation
Net Income
(Thousands)
Total Dividends
(Thousands)
Dividends
Reinvested at 22%
(Drip)
Cum-Dividend
Earnings
0
1
2
3
4
5
6
7
8
9
10
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
22645
4659
-4600
-4543
-4486
-4430
-4375
-4320
-4266
-4213
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
Normal Earnings
Abnormal Earning
Growth (AEG)
5743.06
-3516.02
-3458.51
-3401.73
-3345.65
-3290.27
-3235.59
-3181.59
-3128.27
27626.43
5683.56
-5612.52
-5542.36
-5473.08
-5404.67
-5337.11
-5270.40
-5204.52
-21883.37
-9199.58
2154.01
2140.64
2127.43
2114.39
2101.52
2088.81
2076.25
PV Factor
0.82
0.67
0.55
0.45
0.37
0.30
0.25
0.20
PV of AEG
Residual
Income Check
Figure
-7540.64
1447.20
1178.86
960.32
782.32
637.34
519.25
423.06
-9199.58
2154.01
2140.64
2127.43
2114.39
2101.52
2088.81
2076.25
-21883.37
Core Net Income
22645
Total PV of AEG
Continuing
(Terminal) Value
PV of Terminal
Value
-1,592.28
Total PV of AEG
Total Average Net
Income Perp (t+1)
Divide by shares to
Get Average EPS
Perp
Capitalization Rate
(perpetuity)
Intrinsic Value Per
Share
(01/30/2010)
time consistent
implied price
06/01/2010
Jun 1 2010
observed price
Ke
g
3593.510825
732.22
-860.06
Growth Rate
21,784.55
0.53
-10%
-20%
-30%
-40%
-50%
10.15%
$5.14
$4.97
$4.88
$4.83
$4.80
22.00%
12%
$4.45
$4.33
$4.26
$4.22
$4.19
Cost of
15%
$3.68
$3.59
$3.55
$3.52
$3.50
equity
18.64%
$3.04
$2.99
$2.96
$2.94
$2.93
22%
$2.63
$2.60
$2.58
$2.56
$2.55
$11.94
25%
$2.35
$2.33
$2.31
$2.30
$2.29
22.00%
27.13%
$2.19
$2.17
$2.15
$2.15
$2.14
2.41
2.58
-30%
Overvalued<10.149
10.149< fairly valued <13.731
218 Undervalued>13.731
1,868.63
Since net income was restated when forecasted it is then necessary to
create a restated AEG valuation. Under the restated AEG valuation the same
steps are followed but the results differ from those in the as stated AEG
valuation. The difference rests on the change in the net income forecasted in the
restated income statement and the cost of equity also changes in the
restatement. For Pep Boys, the restated cost of equity is 10.15% compared to
22% in the as stated basis.
219 Restated Abnormal Earnings Growth Valuation
0
Net Income (Thousands)
Total Dividends (Thousands)
Dividends Reinvested at 10.15%
(Drip)
1
2
3
4
5
6
7
8
10
2020
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
13209
-4659
-13801
-13629
-13458
-13290
-13124
-12960
-12798
-12638
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
500.31
500.31
500.31
500.31
500.31
500.31
500.31
500.31
500.31
Cum-Dividend Earnings
-4158.35
-13300.97
-13128.45
-12958.09
-12789.86
-12623.74
-12459.69
-12297.69
-12137.71
Normal Earnings
14550.11
-5131.51
-15202.10
-15012.08
-14824.43
-14639.12
-14456.13
-14275.43
-14096.99
-18,708.46
-8,169.46
2,073.65
2,053.98
2,034.56
2,015.38
1,996.45
1,977.74
1,959.28
0.9079
0.8242
0.7482
0.6793
0.6167
0.5599
0.5083
0.4614
-$7,416.67
$1,709.10
$1,536.89
$1,382.08
$1,242.90
$1,117.77
$1,005.26
$904.11
-8169.46
2073.65
2053.98
2034.56
2015.38
1996.45
1977.74
1959.28
Abnormal Earning Growth (AEG)
PV Factor
PV of AEG
Residual Income Check Figure
Core Net Income
Total PV of AEG
-18708.46
13209
$1,481.44
Continuing (Terminal) Value
3516.149519
PV of Terminal Value
1,622.52
Total PV of AEG
Total Average Net Income Perp
(t+1)
Divide by shares to Get Average
EPS Perp
3,103.96
Capitalization Rate (perpetuity)
Growth Rate
$16,313.32
0.40
10.15%
-10%
-20%
-30%
-40%
-50%
10.15%
$4.64
$4.31
$4.14
$4.04
$3.97
12%
$4.85
$4.56
$4.40
$4.31
$4.25
Cost of
15%
$5.12
$4.88
$4.75
$4.66
$4.61
equity
18.64%
$5.36
$5.17
$5.07
$5.00
$4.95
Intrinsic Value Per Share
(01/30/2010)
time consistent implied price
12/31/2009
4.04
22%
$5.52
$5.38
$5.29
$5.23
$5.19
Dec. 31 2009 observed price
$11.94
25%
$5.64
$5.53
$5.45
$5.40
$5.37
10.15%
27.13%
$5.71
$5.62
$5.55
$5.51
$5.48
Ke
3.91
Overvalued<10.149
g
10.149< fairly valued <13.731
-40%
220 9
Undervalued>13.731
1,763.35
Again the table within the spreadsheet shows that time consistent price
per share but this time on a restated basis with slightly different results. The
change in values within the table is due to the change in the growth rate used,
as labeled in the x-axis, as well as the different cost of equity values used, as
labeled in the y-axis. As found in the table Pep Boys seems to be overvalued
regardless of the change in growth rates and cost of equity values used.
Analyst Recommendations To properly value a company we must retrieve ample information about
the company their competitors, and the industry. The auto parts industry has
many factors to consider first we found the main competitors in the industry
which are AutoZone, Advance Auto, and O’Reilly. With knowledge of the
competitors we then performed an analysis of the Five Forces Model, which gave
us an inside look at the auto parts industry and how Pep Boy’s stack up against
their competition.
With knowledge of the auto parts industry, we were able to explore Pep
Boys key accounting policies and find if and to what extent Pep Boys uses
distortive accounting allowed by GAAP. We found that Pep Boys aggressively
uses operating leases, and a defined benefit plan which allows them to keep
large amounts of liabilities off the books. In order to get the true picture of Pep
Boys financials we capitalized the operating leases, and restated their finances.
We forecasted out Pep Boys financials ten years from prevailing trends found in
Pep Boys 10k, and ratio analysis.
To give a proper recommendation about Pep Boys value, we account for
all of the analysis and information we have found about the auto parts industry.
The accounting policies, ratio analysis, and forecasted financials, method of
comparables, and intrinsic value models allow us to properly value the firm. The
results of residual income model, the AEG model, and the long run residual
income model is highly important in a proper valuation because a firms future is
221 what investors, invest in. The outcome of our intrinsic valuation model were
dependent a 15% analyst position based of the June 1st 2010 closing price of
$11.94. A review of our intrinsic value models which all came back overvalued
we will stand by our analysis and recommend investors sell Pep Boys stock
because Pep Boys is overvalued.
222 Appendix Sales and Expense Diagnostic Ratios Net Sales/Cash from Sales Raw Form
2005
2006
2007
2008
2009
Pep boys
1
0.998
1.003
1
1
Net Sales/Cash from Sales Change Form
O'Reilly AutoZone Advance Auto Parts Industry Average
0.994 0.991
1.002
0.997
0.997 1.006
0.999
1
0.999 1.003
1.002
1.002
0.978 0.998
0.998
0.993
0.999 0.992
1.001
0.998
2005
2006
2007
2008
2009
2005
2006
2007
2008
2009
O'Reilly AutoZone
27.7
48.4
28.17 74.02
29.94 103.06
21.55 91.56
28.35 53.68
Advance Auto
45.05
47.58
57
52.9
58.48
Industry Average
48.62
52.78
66.7
59.65
51.84
2005
2006
2007
2008
2009
Net Sales/Inventory Raw Form
2005
2006
2007
2008
2009
Pep Boys
3.77
3.63
3.74
3.81
3.41
Pep Boys
323.26
‐6.99
‐5.4
1030.77
338.71
O'Reilly AutoZone Advance Auto Parts Industry Average
25.08
1.49
‐67.62
70.55
33.06
‐6.3
149.15
42.23
74.69
‐10.83
‐18.82
9.91
12.9
31.05
24.39
274.78
254.05
5.27
‐58.41
134.91
Net Sales/Inventory Change Form
O'Reilly AutoZone Advance Auto Parts Industry Average
2.82
3.43
3.12
3.29
2.81
3.22
3.16
3.21
2.86
3.07
3.17
3.21
2.28
3.03
3.17
3.07
2.53
3.09
3.32
3.09
2005
2006
2007
2008
2009
223 Industry Avg.
3.34
1.18
1.13
0.96
1
Net Sales/Net Accounts Receivable Change Form
Net Sales/Net Accounts Receivable Raw Form
Pep Boys
73.35
61.35
76.81
72.6
66.87
Pep Boys O'Reilly AutoZone Advance Auto Parts
0.07
11.48
0.74
1.05
1.15
1.02
1.58
0.97
1.5
1.02
0.93
1.07
1.05
0.93
0.92
0.92
1
1.06
0.87
1.07
Pep Boys O'Reilly AutoZone Advance Auto Parts Industry Average
2.84
3.21
0.72
2.98
2.44
‐2.92
2.74
1.3
3.67
1.19
‐4.11
3.46
1.39
3.44
1.04
2.91
1.53
2.47
3.17
2.52
‐52.5
3.7
5.16
30.11
‐3.38
Asset Turnover Raw Form
2005
2006
2007
2008
2009
Asset Turnover Change Form
Pep Boys illy Auto AutoZone Advance Auto Parts Industry Average
1.23
1.43
1.46
1.94
1.51
1.2
1.33
1.4
1.82
1.44
1.25
1.28
1.36
1.81
1.42
1.21
1.57
1.36
1.83
1.49
1.22
1.16
1.3
1.83
1.37
2005
2006
2007
2008
2009
Cash Flow from Operations/Operating Income Raw Form
Cash Flow from Operations/Operating Income Change Form
Pep Boys illy Auto AutoZone Advanced Auto Parts Industry Average
2005
2006
2007
2008
2009
0.58
3.43
4.46
‐1.64
0.02
0.84
0.66
0.98
0.89
0.53
0.66
0.81
0.8
0.82
0.79
0.8
0.83
0.99
1.15
1.54
2005
2006
2007
2008
2009
0.72
1.43
1.81
0.31
0.72
Cash Flow from Operations/ Net Operating Assets Raw Form
Pep Boyseilly Auto P AutoZone Advanced Auto Parts Industry Average
‐1.86
‐0.22
‐0.43
0.77
‐0.44
0.95
‐0.93
5.15
‐1.8
0.84
4.1
4.87
0.49
5.92
3.85
0.75
0.03
1.1
‐6.8
‐1.23
0.05
‐0.07
0.058
5.67
1.43
Cash Flow from Operations/ Net Operating Assets Change Form
Pep Boys O'Reilly AutoZone Advanced Auto PartsIndustry Average
2005
0.58
0.3
0.33
0.36
0.39
2006
3.43
0.21
0.4
0.34
1.1
2007
4.46
0.27
0.39
0.39
1.38
2008
‐1.64
0.21
0.4
0.45
‐0.15
2009
0.02
0.17
0.39
0.64
0.3
2005
2006
2007
2008
2009
224 Pep Boyseilly Auto P AutoZone Advance Auto Parts Industry Average
3.39
1.33
0.32
4.09
2.28
‐1.46
0.84
0.71
1.04
0.28
‐0.82
0.91
0.79
1.61
0.62
2.44
3.48
1.27
2.42
2.4
1.15
0.66
0.65
1.72
1.04
Pep Boyseilly Auto P AutoZone Advanced Auto Parts Industry Average
2.64
‐0.09
0.07
0.54
0.79
‐41
‐0.16
1.55
0.09
‐9.89
‐3.19
0.54
0.17
1.45
‐0.26
0.32
0.003
0.68
2.96
0.99
2.25
‐0.05
0.05
7.62
2.47
Total Accruals/Change in Sales Raw Form
2005
2006
2007
2008
Advance
‐0.02 ‐0.022
‐0.036
‐0.047
O'Reilly ‐0.021 ‐0.003
‐0.042
‐0.031
AutoZone ‐0.014 ‐0.043
‐0.04
‐0.043
Pep Boys
‐0.12 0.0004
‐0.57
0.0052
‐0.172
‐0.02895
Industry A ‐0.04375 ‐0.0169
Advance
O'Reilly
AutoZone
Pep Boys
Industry A
Advance
O'Reilly
AutoZone
Pep Boys
Industry A
2005
0.004
N/A
0.015
0.008
0.009
Pension Expense/SG&A Raw Form
2006
2007
2008
0.002
0.002
0.002
N/A
N/A
N/A
0.005
0.001
0.001
0.008
0.014
0.025
0.005
0.006
0.009
Other Employment Expenses/SG&A Raw Form
2005
2006
2007
2008
0.004 0.004
0.004
0.005
0.01 0.009
0.008
0.003
0.005 0.005
0.005
0.005
0.006 0.006
0.006
0.007
0.006 0.006
0.006
0.005
Advance
O'Reilly
AutoZone
Pep Boys
Industry A
Total Accruals/Change in Sales Change Form
2005
2006
2007
2008
‐0.022 ‐0.061
‐0.307
‐0.23
0.137
0.145
‐0.408
‐0.007
0.043 ‐0.085
0.018
‐0.743
‐0.052 ‐2.641
4.068
0.638
0.027
‐0.66
0.843
‐0.085
2009
‐0.698
0.106
‐0.066
0.407
‐0.063
0.001
N/A
0.012
0.015
0.009
Advance
O'Reilly
AutoZone
Pep Boys
Industry A
Pension Expense/SG&A Change Form
2006
2007
2008
‐0.012
‐0.007
‐0.001
N/A
N/A
N/A
‐0.158
‐0.085
‐0.006
0.014
0.128
‐0.066
‐0.052 0.012
‐0.024
2009
‐0.003
N/A
0.256
0.1
0.118
2009
0.004
0.004
0.005
0.007
0.005
Other Employment Expenses/SG&A Change Form
2005
2006
2007
2008
Advance
0
0.005
0.005
0.011
O'Reilly N/A
‐0.002
0.005
‐0.006
AutoZone ‐0.001
0.002
0.011
0.01
Pep Boys
0.015
0.007
0.019
0.003
Industry A
0.005
0.005
0.012
0.008
2009
0.001
0.005
0.002
0.003
0.002
2009
‐0.079
0.005
‐0.039
‐0.041
‐0.0385
2009
225 2005
‐0.002
N/A
0.035
‐0.011
0.007
Financial Ratios Liquidity Ratios Pep Boy AutoZone Advance Auto O'Reilly Industry Avg Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Current Ratio 2005 2006 2007 2008 2009 1.43 1.27
1.35
1.33
1.4 1.07 1.03
0.99
1.03
0.95 1.36 1.45
1.37
1.32
1.29 1.88 2.31
2.08
1.78
1.81 1.43 1.52
1.45
1.37
1.36 Inventory Turnover 2005 2006 2007 2008 2009 2.8 2.8
2.94
2.59
2.55 1.75 1.63
1.55
1.51
1.54 1.68 1.69
1.69
1.69
1.7 1.59 1.57
1.59
1.24
1.32 1.96 1.9
1.94
1.76
1.78 Accounts Receivable Turnover 2005 2006 2007
2008
Pep Boys 61.35 76.81 72.6 66.87
AutoZone 48.29 74.02 103.04 91.56
Advance Auto 56.4 47.57 57
52.9
O'Reilly 15.6 17.72 19.04 21.57
Industry Avg 45.41 54.03 62.92 58.225
2009
83.15
53.88
58.48
28.35
55.96
226 Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Quick Asset Ratio 2005
2006
2007
0.18
0.21
0.12
0.11
0.08
0.06
0.12
0.12
0.08
0.33
0.37
0.34
0.185
0.19
0.15
Days Supply of Inventory 2005
2006
2007
130.49 130.3
124
208.1 223.9 235.9
216.78
216 215.9
229.65 232.45 229.58
196.3 200.7 201.35
Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Day Supply of Receivables 2005 2006 2007 2008
5.95
4.75
5.03
5.46
7.6
4.9
3.5
4
6.47
7.67
6.4
6.9
23.39
20.6 19.17 16.92
10.85
9.48 8.525
8.32
Pep Boy AutoZone Advance Auto O'Reilly Industry Avg 2008
0.15
0.12
0.099
0.19
0.14
2009
0.11
0.08
0.13
0.16
0.12
2008
2009
141.01 143.23
241.1
237
215.97 215.15
241.3 277.05
209.84 218.1
2009
4.39
6.8
6.24
12.88
7.5
Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Cash to Cash Cycle 2005 2006 2007
136.44 135.05 129.03
215.7 228.8 239.4
223.25 223.72 222.3
253.04 253.05 248.75
207.1 210.16 209.87
2008
2009
146.47 147.26
245.1 243.8
222.87 221.39
258.77 289.77
218.3 225.7
Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Working Capital Turnover 2005 2006 2007
9.03 13.86 10.95
48.27 92.42 63.38
10.49
9.26
10.6
4.81
4.03
4.4
18.15 29.89 22.33
2008
10.76
97.38
11.62
4.365
31.03
2009
9.3
‐47.01
10.6
4.87
‐5.56
Profitability Ratios Pep Boys AutoZone Advance Auto O'Reilly Industy Avg Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Pep Boys Restate Gross Profit Margin 2005 2006 2007
22.88% 25.16% 22.74%
48.90% 49.40% 49.70%
46.00% 46.40% 46.60%
44% 44% 44%
40.45% 41.24% 40.76%
2008
24.14%
50.10%
46.70%
46%
41.74%
2009
25.44%
50.10%
48.90%
48%
43.11%
Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Pep Boy Restate Net Profit Margin 2005 2006 2007
2008 2009 ‐1.68% ‐0.11% ‐1.92% ‐1.58% 1.21% 10% 9.60% 9.70% 9.80% 9.60% 5.50% 5% 4.90% 4.60%
5% 8% 8% 8%
5%
6% 5% 6% 5%
4%
5% ‐1.24% 0.31% ‐1.56% ‐1.58% 1.21% Pep Boys AutoZone Advnace Auto O'Reilly Industry Avg Pep Boys Restate 227 Operating Profit Margin 2005 2006
2007
2008
2009 ‐0.50% 1.59% ‐0.79% ‐0.51% 2.99% 17.10%
17% 17.10% 17.20% 17.30% 9.60% 8.70% 8.60% 8.10% 8.40% 12%
12%
12%
9%
11% 9.55% 9.82% 9.23% 8.45% 9.92% ‐1.80% 0.22% ‐2.17% ‐2.64% 0.88% Asset Turnover 2005 2006
1.2
1.25
1.35
1.31
1.94
1.82
1.19
1.15
1.42
1.38
1
0.99
2007
1.21
1.28
1.81
1.11
1.35
1
2008
1.22
1.24
1.83
0.85
1.29
0.97
2009 1.23 1.28 1.83 1.01 1.34 1.1 Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Pep Boys Restate Return on Assets 2005 2006 2007
2008
2009 ‐2.01% ‐0.14% ‐2.32%
‐2% 1.48% 13.50% 12.60% 12.40% 12.20% 12.40% 10.70% 9.10% 8.90% 8.50% 9.10% 11.00% 10% 10%
8%
7% 8.29% 7.89% 7.25% 6.70% 7.50% ‐1.25% 0.32% ‐1.60% ‐1.54% 1.13% Pep Boys AutoZone Advance Auto O'Reilly Industry Avg Pep Boys Restate Return on Equity 2005
2006
2007
2008
2009 ‐5.74% ‐0.43% ‐7.23% ‐6.46% 5.44% 146%
121%
148%
279%
25% 32.50% 22.40% 25.50% 23.30% 25.10% 17%
16%
14%
12%
13% 47.44% 39.70% 45.10% 76.96% 17.13% ‐4.25% 1.17% ‐5.79% ‐6.36% 5.40% Capital Structure Ratios Debt to Equity 2005 2006 2007 2008 2009 Pep Boys 2.06 2.11 2.36 2.67 2.38 2005 2006 2007 2008 2009 Pep Boys ‐0.15 0.87 ‐0.23 ‐0.29 2.73 Pep Boys Restated O'Reilly Advance Auto AutoZone Industry
2.63 0.5 1.76 9.86 3.545 2.62 0.45 1.6 8.64 3.2 3.12 0.43 1.74 10.92 3.8625 3.79 0.84 1.76 21.89 6.79 3.57 0.78 1.4 ‐13.28 ‐2.18 Pep Boys Restated ‐0.74 0.24 ‐0.8 ‐1.81 0.88 Time Interest Earned Advance O'Reilly
Auto 49.6 ‐12.61 65.31 ‐11.21 82.59 ‐11.96 11.57 ‐12.3 11 ‐19.47 228 AutoZone
9.52 9.36 8.86 9.63 8.26 Industry Avg. 11.59 16.08 19.82 2.15 0.63 Debt Service Margin 2005 2006 2007 2008 2009 Pep Boys 0.13 ‐0.12 0.35 0.2 ‐0.16 Pep Boys Restated O'Reilly
0.13 349.13 ‐0.12 2.47 0.35 968.99 0.2 11.79 ‐0.16 35.08 Advance Auto 0.52 0.51 0.6 0.6 0.72 AutoZone
1.23 2.22 5.06 2.11 N/A Altman’s Z­Score Pep Boys 2005 1.68
2006 1.78
2007 1.61
2008 1.63
2009 1.86
Altman’s Z‐Score Advance Pep Boys Restated O'Reilly Auto AutoZone Industry
1.77
6.374
4.26
3.4
3.93
2.57
6.224
4.09
3.16
3.81
1.62
5.826
4.2
3.27
3.73
1.42
3.075
4.6
2.99
3.07
2.50
3.589
4.7
2.8
3.24
Growth Rate IGR 2005 2006 2007 2008 2009 Pep Advance Pep Boys Restated O'Reilly Auto AutoZone Industry Boys 1.70%
1.50% 1.20%
10.70%
1.50%
3.80%
8.50%
‐1.20% 1.20%
8.10%
1.40%
4.80%
1.60%
1.50% 1.10%
8.00%
1.40%
3.00%
1.80%
1.40% 0.90%
7.70%
1.40%
2.90%
‐2.10%
1.20% 1.00%
8.30%
1.30%
2.10%
229 SGR 2005 2006 2007 2008 2009 Pep Advance Boys Pep Boys Restated O'Reilly Auto AutoZone Industry
4.90%
1.90% 1.80%
29.20%
16% 51.60%
26.00%
‐4.20% 1.70%
22.40%
2.60% 52.70%
3.40%
3.80% 1.60%
20.70%
13.10%
9.70%
2.20%
4.50% 1.20%
20.70%
16.20% 10.10%
‐3.60%
4.50% 1.80%
22.90%
29.80% 12.70%
230 Regressions 3 Month Regression 72 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.478896351
R Square
0.229341715
Adjusted R Square 0.218332311
Standard Error
0.13848866
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
F
Significance F
0.399528413 0.3995 20.83144
2.0864E‐05
1.342537629 0.0192
1.742066042
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.005906505
0.016329815 0.3617 0.718665 ‐0.026662284 0.038475294 ‐0.026662284 0.038475294
1.672347743
0.366409704 4.5641 2.09E‐05 0.941566642 2.403128844 0.941566642 2.403128844
60 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.485165702
R Square
0.235385758
Adjusted R Square 0.222202754
Standard Error
0.143864227
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.369548484 0.3695 17.85524 8.53626E‐05
1.200421112 0.0207
1.569969596
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.016533987
0.018597971 0.889 0.377664 ‐0.020693898 0.053761871 ‐0.020693898 0.053761871
1.649408119
0.390341953 4.2255 8.54E‐05 0.868053812 2.430762425 0.868053812 2.430762425
231 48 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.485903017
R Square
0.236101742
Adjusted R Square 0.219495258
Standard Error
0.160354687
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.365582014 0.3656 14.21744 0.000463305
1.182826779 0.0257
1.548408792
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.020742513
0.023201456 0.894 0.375966 ‐0.025959594 0.067444621 ‐0.025959594 0.067444621
1.670932326
0.443147301 3.7706 0.000463 0.778923088 2.562941565 0.778923088 2.562941565
36 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.495326321
R Square
0.245348164
Adjusted R Square 0.223152522
Standard Error
0.175242388
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.339463764 0.3395 11.05389 0.002129347
1.044136416 0.0307
1.38360018
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.01867159
0.029528381 0.6323 0.531403 ‐0.041337299 0.078680479 ‐0.041337299 0.078680479
1.654667864
0.497683547 3.3247 0.002129 0.643253213 2.666082515 0.643253213 2.666082515
232 24 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.545921964
R Square
0.298030791
Adjusted R Square
0.2661231
Standard Error
0.195649283
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.357538056 0.3575 9.340406 0.005787287
0.842130123 0.0383
1.199668179
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.052716169
0.040233057 1.3103 0.20362 ‐0.030722085 0.136154423 ‐0.030722085 0.136154423
1.786479634
0.584541289 3.0562 0.005787 0.574215204 2.998744065 0.574215204 2.998744065
1 Year Regression 72 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.479259708
R Square
0.229689868
Adjusted R Square
0.218685438
Standard Error
0.138457375
Observations
72
ANOVA
df
Regression
SS
1
Residual
70
1.341931123
Total
71
1.742066042
Coefficients Standard Error
Intercept
X Variable 1
MS
Significance F
2.05226E-05
0.01917
t Stat
P-value
Lower 95%
Upper 95%
Lower 95.0% Upper 95.0%
0.00630426
0.016329195 0.386073 0.700614
-0.026263293 0.038871813 -0.026263293 0.038871813
1.672115417
0.365998341 4.568642 2.05E-05
0.942154752 2.402076082 0.942154752 2.402076082
233 F
0.400134919 0.400135 20.87249
60 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.485224904
R Square
0.235443207
Adjusted R Square
0.222261194
Standard Error
0.143858822
Observations
60
ANOVA
df
Regression
SS
1
MS
F
0.369638677 0.369639 17.86094
Residual
58
1.200330918 0.020695
Total
59
1.569969596
Coefficients Standard Error
t Stat
P-value
Significance F
8.51676E-05
Lower 95%
Upper 95%
Lower 95.0% Upper 95.0%
Intercept
0.016860361
0.018601443 0.906401 0.368474
-0.020374472 0.054095195 -0.020374472 0.054095195
X Variable 1
1.648013426
0.389949656 4.226221 8.52E-05
0.867444388 2.428582463 0.867444388 2.428582463
48 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.485975018
R Square
0.236171718
Adjusted R Square
0.219566756
Standard Error
0.160347342
Observations
48
ANOVA
df
Regression
SS
1
0.365690365
MS
0.36569 14.22296
Residual
46
1.182718427 0.025711
Total
47
1.548408792
Coefficients Standard Error
F
t Stat
P-value
Significance F
0.000462271
Lower 95%
Upper 95%
Lower 95.0% Upper 95.0%
Intercept
0.021060948
0.023206404 0.907549 0.368847
-0.025651121 0.067773016 -0.025651121 0.067773016
X Variable 1
1.669473324
0.442674485 3.771334 0.000462
0.778415815 2.560530832 0.778415815 2.560530832
234 36 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.495209087
R Square
0.245232039
Adjusted R Square
0.223032982
Standard Error
0.175255871
Observations
36
ANOVA
df
Regression
SS
1
Residual
34
Total
35
MS
F
0.339303094 0.339303 11.04696
Significance F
0.002135345
1.044297086 0.030715
1.38360018
Coefficients Standard Error
t Stat
P-value
Lower 95%
Upper 95%
Lower 95.0% Upper 95.0%
Intercept
0.019088991
0.029549545 0.645999 0.522616
-0.040962909 0.079140892 -0.040962909 0.079140892
X Variable 1
1.653165893
0.497387769 3.323696 0.002135
0.642352336 2.663979449 0.642352336 2.663979449
24 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.545981615
R Square
0.298095924
Adjusted R Square
0.266191193
Standard Error
0.195640206
Observations
24
ANOVA
df
Regression
SS
1
MS
F
0.357616194 0.357616 9.343314
Residual
22
0.842051985 0.038275
Total
23
1.199668179
Coefficients Standard Error
t Stat
P-value
Significance F
0.005780877
Lower 95%
Upper 95%
Lower 95.0% Upper 95.0%
Intercept
0.053292434
0.040254398 1.323891 0.199131
-0.030190077 0.136774945 -0.030190077 0.136774945
X Variable 1
1.784762444
0.583888527 3.056684 0.005781
0.573851759 2.995673129 0.573851759 2.995673129
235 2 Year Regression 72 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.479134932
R Square
0.229570283
Adjusted R Square 0.218564144
Standard Error
0.138468122
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
F
Significance F
0.399926594 0.399927 20.85839 2.06393E‐05
1.342139448 0.019173
1.742066042
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.006561343
0.016332709 0.40173 0.689106 ‐0.026013218 0.039135905 ‐0.026013218 0.039135905
1.672363478
0.366176385 4.567098 2.06E‐05 0.942047715 2.40267924 0.942047715 2.40267924
60 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.484742872
R Square
0.234975652
Adjusted R Square 0.221785577
Standard Error
0.143902803
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.368904629 0.368905 17.81458 8.67673E‐05
1.201064966 0.020708
1.569969596
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.017048872
0.018609752 0.916126 0.363394 ‐0.020202594 0.054300338 ‐0.020202594 0.054300338
1.646996522
0.390215829 4.220732 8.68E‐05 0.865894681 2.428098363 0.865894681 2.428098363
236 48 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.485520964
R Square
0.235730606
Adjusted R Square 0.219116054
Standard Error
0.160393636
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.365007344 0.365007 14.1882 0.000468828
1.183401449 0.025726
1.548408792
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.021274495
0.023217443 0.916315 0.364281 ‐0.025459794 0.068008784 ‐0.025459794 0.068008784
1.668580465
0.442979355 3.766723 0.000469 0.776909286 2.560251645 0.776909286 2.560251645
36 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.494543238
R Square
0.244573014
Adjusted R Square 0.222354573
Standard Error
0.175332366
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.338391266 0.338391 11.00766 0.002169694
1.045208914 0.030741
1.38360018
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.019462843
0.029580637 0.657959 0.514995 ‐0.040652244 0.07957793 ‐0.040652244 0.07957793
1.652665181
0.498123922 3.317779 0.00217 0.640355582 2.664974781 0.640355582 2.664974781
237 24 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.545988525
R Square
0.298103469
Adjusted R Square 0.266199081
Standard Error
0.195639154
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.357625246 0.357625 9.343651 0.005780135
0.842042933 0.038275
1.199668179
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.053942203
0.040281454 1.339132 0.1942 ‐0.029596419 0.137480826 ‐0.029596419 0.137480826
1.786307853
0.584383574 3.056739 0.00578 0.574370504 2.998245202 0.574370504 2.998245202
5 Year Regression 72 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.478255919
R Square
0.228728724
Adjusted R Square 0.217710563
Standard Error
0.138543727
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
F
Significance F
0.398460543 0.398461 20.75925 2.14786E‐05
1.343605499 0.019194
1.742066042
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.007328839
0.016349553 0.448259 0.655351 ‐0.025279315 0.039936993 ‐0.025279315 0.039936993
1.668698172
0.366245245 4.556232 2.15E‐05 0.938245072 2.399151272 0.938245072 2.399151272
238 60 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.483546178
R Square
0.233816906
Adjusted R Square 0.220606853
Standard Error
0.144011743
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.367085433 0.367085 17.69992 9.08591E‐05
1.202884162 0.020739
1.569969596
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.017769286
0.018634842 0.953552 0.344268 ‐0.019532403 0.055070975 ‐0.019532403 0.055070975
1.642293311
0.390359771 4.207127 9.09E‐05 0.860903338 2.423683284 0.860903338 2.423683284
48 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.484526856
R Square
0.234766274
Adjusted R Square 0.218130758
Standard Error
0.160494794
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.363514163 0.363514 14.11235 0.000483479
1.18489463 0.025759
1.548408792
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.022179608
0.023251877 0.953885 0.345128 ‐0.024623992 0.068983207 ‐0.024623992 0.068983207
1.664894173
0.4431869 3.756641 0.000483 0.772805226 2.55698312 0.772805226 2.55698312
239 36 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.493336262
R Square
0.243380667
Adjusted R Square 0.221127157
Standard Error
0.175470682
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.336741535 0.336742 10.93673 0.002233192
1.046858645 0.03079
1.38360018
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.020707041
0.029666589 0.697992 0.489929 ‐0.039582722 0.080996803 ‐0.039582722 0.080996803
1.650530212
0.499090954 3.307073 0.002233 0.636255368 2.664805056 0.636255368 2.664805056
24 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.546125493
R Square
0.298253054
Adjusted R Square 0.266355466
Standard Error
0.195618307
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.357804698 0.357805 9.350332 0.005765443
0.841863481 0.038267
1.199668179
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.055708967
0.040356687 1.380415 0.181325 ‐0.027985678 0.139403612 ‐0.027985678 0.139403612
1.788881278
0.585016337 3.057831 0.005765 0.575631658 3.002130897 0.575631658 3.002130897
240 10 Year Regression 72 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.477306439
R Square
0.227821437
Adjusted R Square 0.216790315
Standard Error
0.138625191
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
F
Significance F
0.396879989 0.39688 20.65261 2.24209E‐05
1.345186053 0.019217
1.742066042
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.008103698
0.016369003 0.495064 0.622106 ‐0.024543248 0.040750644 ‐0.024543248 0.040750644
1.664193816
0.366198416 4.544514 2.24E‐05 0.933834115 2.394553517 0.933834115 2.394553517
60 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.482428403
R Square
0.232737164
Adjusted R Square 0.219508495
Standard Error
0.144113181
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.365390271 0.36539 17.59339 9.48406E‐05
1.204579324 0.020769
1.569969596
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.018518418
0.018661173 0.99235 0.325149 ‐0.018835978 0.055872815 ‐0.018835978 0.055872815
1.637206234
0.39032701 4.194448 9.48E‐05 0.855881839 2.418530629 0.855881839 2.418530629
241 48 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.483605568
R Square
0.233874345
Adjusted R Square 0.21721944
Standard Error
0.1605883
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.362133093 0.362133 14.04237 0.000497424
1.186275699 0.025789
1.548408792
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.023093306
0.023288065 0.991637 0.326562 ‐0.023783137 0.06996975 ‐0.023783137 0.06996975
1.660747662
0.443183358 3.747315 0.000497 0.768665845 2.552829479 0.768665845 2.552829479
36 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.492272587
R Square
0.2423323
Adjusted R Square 0.220047956
Standard Error
0.175592205
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.335291014 0.335291 10.87455 0.002290492
1.048309166 0.030833
1.38360018
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.021891119
0.029751489 0.735799 0.466899 ‐0.038571181 0.08235342 ‐0.038571181 0.08235342
1.647755007
0.499674189 3.297659 0.00229 0.632294886 2.663215127 0.632294886 2.663215127
242 24 month
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.546039857
R Square
0.298159526
Adjusted R Square 0.266257686
Standard Error
0.195631342
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.357692495 0.357692 9.346155 0.005774625
0.841975684 0.038272
1.199668179
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.05728706
0.040437574 1.416679 0.170582 ‐0.026575335 0.141149455 ‐0.026575335 0.141149455
1.789603136
0.585383197 3.057148 0.005775 0.575592695 3.003613577 0.575592695 3.003613577
243 Method of Comparables Company
Pep Boys As Stated
Pep Boys Restated
Advance
O'Reilly
AutoZone
PPS
Company
Pep Boys As Stated
Pep Boys Restated
Advance
O'Reilly
AutoZone
PPS
Company
Pep Boys As Stated
Pep Boys Restated
Advance
O'Reilly
AutoZone
Market Cap.
490,447,440
490,447,440
4,390,000,000
6,570,000,000
9,080,000,000
Company
Pep Boys As Stated
Pep Boys Restated
Advance
O'Reilly
AutoZone
Company
Pep Boys As Stated
Pep Boys Restated
Advance
O'Reilly
AutoZone
Company
Pep Boys As Stated
Pep Boys Restated
Advance
O'Reilly
AutoZone
P/E Trailing
P/E Trailing Industry Avg.
0.55
21.66
16.58
0.32
37.13
3.02
16.62
2.47
19.26
13.92
13.88
P/E Forecast
EPS
P/E Forecast Industry Avg.
0.11
105.27
13.08
N/A
N/A
4.01
12.51
3.18
14.96
16.43
11.76
Price/EBITDA
EBITDA
P/EBITDA
Industry Avg.
18,871,000
25.99
7.31
22,644,000
21.66
640,130,000
6.86
744,810,000
8.82
1,450,000,000
6.26
EPS
11.94
11.94
50.18
47.56
193.22
11.94
11.94
50.18
47.56
193.22
Comparables
Pep Boys PPS
1.48
N/A
Comparables
Pep Boys PPS
3.36
4.03
Price/Free Cash Flows
Comparables
Market Cap.
FCF
P/FCF
Industry Avg. Pep Boys PPS
490,447,440
138,115,000
3.55
21.90
73.64
490,447,440
175,856,000
2.79
93.76
4,390,000,000
277,422,000
15.82
6,570,000,000
80,389,000
81.73
9,080,000,000
324,672,000
27.97
Enterprise Value/ EBITDA
Comparables
EV
EBITDA
EV/EBITDA Industry Avg. Pep Boys PPS
699,399,800
18,871,000
37.06
8.41
3.86
699,399,800
22,644,000
30.89
4.64
4,576,929,500
640,130,000
7.15
7,395,963,300
744,810,000
9.93
11,803,000,000
1,450,000,000
8.14
Price/Book
Comparables
PPS
BPS
P/B
Industry Avg. Pep Boys PPS
11.94
11.71
1.02
3.15
36.87
11.94
8.18
1.46
25.76
50.18
12.74
3.94
47.56
20.15
2.36
193.22 N/A
N/A
244 Comparables
Pep Boys PPS
9.14
5.33
Intrinsic Valuation Models Discounted Dividends Model Discounted Dividends Approach
Perp
Relevant Valuation Item
0
1
2
3
4
5
6
7
8
9
10
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
DPS (Dividends Per Share)
PV Factor
PV Annual Dividend
PV of YBY Dividends
TV Perpetuity
Model Price (01/30/2010)
Time Consistent Price
0.12
0.12
0.12
0.12
0.12
0.12
0.12
0.12
0.12
0.7105
0.09
0.5988
0.07
0.5047
0.06
0.4254
0.05
0.3586
0.04
0.3023
0.04
0.2548
0.03
0.2147
0.03
0.1810
0.02
0.53
0.12
0.64
0.68
Observed Share Price (6/1/2010)
$11.94
Initial cost of equity (Ke)
18.64%
Perpetuity Growth rate
0.12
0.8429
0.10
0.64
0%
Discounted Dividends Sensitivity Analysis
0%
10.15% $ 1.22
12.00% $ 1.04
Cost of 15.00% $ 0.84
equity 18.64% $ 0.68
22.00% $ 0.58
25.00% $ 0.52
27.13% $ 0.48
overvalued<10.149
1%
3%
$ 1.27 $ 1.33 $ 1.42
$ 1.07 $ 1.11 $ 1.15
$ 0.85 $ 0.87 $ 0.89
$ 0.69 $ 0.70 $ 0.71
$ 0.59 $ 0.59 $ 0.60
$ 0.52 $ 0.52 $ 0.52
$ 0.48 $ 0.48 $ 0.48
10.149<fairly valued<13.731
15% Analyst
245 Growth Rate
2%
4%
5%
6%
$ 1.52 $ 1.67 $ 1.89
$ 1.21 $ 1.28 $ 1.37
$ 0.91 $ 0.94 $ 0.98
$ 0.72 $ 0.73 $ 0.74
$ 0.60 $ 0.61 $ 0.61
$ 0.53 $ 0.53 $ 0.53
$ 0.49 $ 0.49 $ 0.49
undervalued>13.731
11
0.12
As Stated Discounted Free Cash Flows Model Discounted Free Cash Flow
As Stated
(numbers in thousands)
0
2009
Cash Flow From Operations
Cash Flow From Investing Activities
FCF Firm's Assets
PV Factor
PV YBY Free Cash Flows
1
2
3
4
2010
2011
2012
2013
66,047
65,221 64,406 63,601
72,068
21,176 20,911 20,650
138,114
0.902
124,528
Total PV YBY FCF
FCF Perp
Market Value of Assets (01/30/2010)
Book Value Debt & Preferred Stock
Market Value of Equity
divide by Shares to Get PPS at 01/30
Time consistent Price (06/01/2010)
Oberved Share Price (06/01/2010)
WACC(BT)
Perp Growth Rate
86,397
0.813
70,236
85,317
0.733
62,535
84,251
0.661
55,679
5
6
2014
2015
62,806
62,021
20,392
20,137
83,197
0.596
49,574
82,157
0.537
44,139
7
2016
61,246
19,885
81,130
0.484
39,300
8
9
2017
2018
60,480
59,724
19,636
19,391
80,116
0.437
34,991
539,875
542,341
1,082,216
1,055,791
26,425
0.64
$
0.67
$11.94
41076
41076000
Discounted Free Cash Flows (As Stated) Sensitivity Analysis
0%
Weighted
Average Cost
of Capital
$ 10.04 $ 14.33
$ 7.51 $ 10.97
$ 3.02 $ 5.28
$ $ 0.38
$ $ $ $ $ $ overvalued<10.149
5.55%
6%
7%
8.23%
9%
10%
10.91%
Growth Rate
2%
3%
1%
$ 21.04
$ 16.17
$ 8.45
$ 2.27
$ $ $ 10.149<
246 78,126
0.355
27,739
1,527,495
10.91%
6.00%
Shares Outstanding at 1/30/2010
79,115
0.394
31,155
10
11
2019 PERP
58,977
19,149
4%
$
33.00 $ 60.41
$
24.84 $ 42.16
$
13.19 $ 21.10
$
4.88 $ 8.72
$
1.36 $ 4.01
$
$
$
$
fairly valued <13.731
15% Analyst
5%
6%
$ 187.47 $
$ 94.14 $
$ 36.93 $ 84.39
$ 14.94 $ 26.74
$
7.97 $ 14.59
$
2.06 $
5.69
$
$
0.67
undervalued>13.731
75,000
Restated Discounted Free Cash Flows Model Discounted Free Cash Flow
Restated
(numbers in thousands)
0
2009
Cash Flow From Operations
Cash Flow From Investing Activities
$
FCF Firm's Assets
PV Factor
PV YBY Free Cash Flows
1
2
3
4
5
6
7
8
9
2010
2011
2012
2013
2014
2015
2016
2017
2018
103,788 $102,490 $101,209 $99,944 $98,695 $97,461 $96,243 $95,040 $93,852
72,068
21,176
20,911
20,650
20,392
20,137
19,885
19,636
19,391
175,855
0.895
157,435
Total PV YBY FCF
FCF Perp
Market Value of Assets (01/30/2010)
Book Value Debt & Preferred Stock
Market Value of Equity
divide by Shares to Get PPS at 01/30
Time consistent Price (06/01/2010)
Observed Share Price (06/01/2010)
WACC(BT)
Perp Growth Rate
123,666
0.801
99,116
122,120
0.718
87,625
119,086
0.575
68,485
117,598
0.515
60,545
116,128
0.461
53,526
114,676
0.413
47,320
113,243
0.369
41,834
730,338
609,232
1,339,570
1,055,791
283,779
6.91
$
7.17
$11.94
111,827 105,000
0.331
36,984
1,842,105
11.70%
6.00%
Shares Outstanding at 1/30/2010
41076
41076000
Discounted Free Cash Flows (Restated) Sensitivity Analysis
0%
Weighted
Average Cost
of Capital
6.34%
7%
8%
9.02%
10%
11%
11.70%
1%
$ 18.65 $ 22.08
$ 14.93 $ 17.89
$
9.99 $ 12.16
$
6.20 $ 7.73
$
3.26 $ 4.39
$
0.78 $ 1.62
$
$
overvalued<10.149
247 120,594
0.642
77,466
10
11
2019 PERP
$ 92,679
19,149
Growth Rate
2%
3%
4%
5%
6%
$ 27.90 $ 38.64 $ 56.70 $ 101.70 $411.40
$ 22.32 $ 28.97 $ 40.05 $ 62.20 $128.65
$ 15.05 $ 19.10 $ 25.17 $ 35.30 $ 55.54
$ 9.70 $ 12.33 $ 16.00 $ 21.50 $ 30.63
$ 5.80 $ 7.62 $ 10.04 $ 13.43 $ 18.53
$ 2.66 $ 3.95 $ 5.62 $ 7.84 $ 10.95
$ 0.82 $ 1.86 $ 3.17 $ 4.87 $ 7.17
10.149< fairly valued <13.731 undervalued>13.731
15% Analyst
As Stated Residual Income Model Residual Income
(items in thousands)
0
2009
Net Income
Total Dividends
Book Value Equity
443295
Annual Normal Income (Benchmark)(NI*)
Annual Residual Income
pv factor
YBY PV RI
Book Value Equity
Total PV of YBY RI
Terminal Value Perpetuity
MVE 01/30/2010
divide by shares
Model Price on 01/30/2010
time consistent Price
443295
-391764
-11791
39740
41076
0.97
1.05
Observed Share Price (06/01/2010)
Initial Cost of Equity (You Derive)
Perpetuity Growth Rate (g)
shares outstanding
41076000
$11.94
27.13%
-50%
41076
1
2
3
2010
2011
2012
22645
4659
-4600
4929
4929
4929
461010 460740 451210
4
5
2013
2014
-4543
-4486
4929
4929
441738 432323
120266 125072 124999
-97621 -120413 -129599
0.7866 0.6187 0.4867
-76789 -74504 -63075
122413 119844
-126956 -124330
0.38283 0.3011
-48603 -37440
7
2016
-4375
4929
413660
8
2017
-4320
4929
404411
9
10
2018
2019
-4266
-4213
4929
4929
395216 386074
117289 114750
-121719 -119125
0.2369
0.1863
-28832
-22196
112226
-116546
0.1466
-17081
109717 107222
-113983 -111435
0.1153 0.0907
-13140 -10105
-130029
Residual Income (As Stated) Sensitivity Analysis
-10%
$ 2.56
$ 2.13
Cost of
$ 1.62
$ 1.22
equity
$ 0.96
$ 0.80
$ 0.71
overvalued<10.149 10.149<
10.15%
12%
15%
18.64%
22%
25%
27.13%
248 6
2015
-4430
4929
422964
Growth Rate
-20%
-30%
-40%
-50%
$
3.18 $ 3.50 $ 3.69 $ 3.81
$
2.66 $ 2.95 $ 3.12 $ 3.24
$
2.04 $ 2.26 $ 2.41 $ 2.51
$
1.51 $ 1.69 $ 1.80 $ 1.88
$
1.18 $ 1.32 $ 1.41 $ 1.47
$
0.97 $ 1.07 $ 1.15 $ 1.20
$
0.85 $ 0.94 $ 1.00 $ 1.05
fairly valued <13.731 undervalued>13.731
15% Analyst
Perp
11
-100291
Restated Residual Income Model Residual Income
(items in thousands)
0
2009
Net Income
Total Dividends
Book Value Equity
1
2
3
2010
2011
2012
13209
-4659 -13801
4929
4929
4929
439753 448033 438445 419715
Annual Normal Income (Benchmark)(NI*)
Annual Residual Income
pv factor
YBY PV RI
81970
-68761
0.843
-57957
Book Value Equity
Total PV of YBY RI
Terminal Value Perpetuity
MVE 01/30/2010
divide by shares
Model Price on 01/30/2010
time consistent Price
439753
-365005
-40149
34599
41076
0.842
0.89
Observed Share Price (06/01/2010)
Initial Cost of Equity (You Derive)
Perpetuity Growth Rate (g)
shares outstanding
41076000
$11.94
18.64%
-10%
41076
83513
-88172
0.710
-62642
81726
-95528
0.599
-57205
5
2014
-13458
4929
382770
6
2015
-13290
4929
364550
7
8
2016
2017
-13124 -12960
4929
4929
346497 328608
9
2018
-12798
4929
310881
10
2019
-12638
4929
293314
78235
-91864
0.505
-46368
74776
-88234
0.425
-37539
71348
-84638
0.359
-30352
67952
-81076
0.302
-24506
61253
-74051
0.215
-15902
57948
-70586 -63528
0.181
-12776
64587
-77547
0.255
-19757
-221814
Residual Income (Restated) Sensitivity Analysis
Growth Rate
-10%
-20%
Cost of
equity
10.15%
12%
15%
18.64%
22%
25%
27.13%
overvalued<10.149
249 Perp
11
4
2013
-13629
4929
401157
$
$
$
$
$
$
$
-30%
-40%
-50%
1.67 $ 2.30 $ 2.61 $ 2.80 $ 2.93
1.43 $ 1.95 $ 2.22 $ 2.39 $ 2.50
1.13 $ 1.52 $ 1.73 $ 1.87 $ 1.96
0.89 $ 1.16 $ 1.32 $ 1.42 $ 1.49
0.74 $ 0.93 $ 1.05 $ 1.13 $ 1.19
0.63 $ 0.78 $ 0.87 $ 0.94 $ 0.98
0.57 $ 0.69 $ 0.77 $ 0.83 $ 0.87
10.149< fairly valued
undervalued>13.731
15% Analyst
As Stated Long Run Residual Income Model Long Run Residual Income
(As Stated)(items in thousands)
book value of equity(01/30/10) $443,295
Cost of Equity Constant at 18.64%
ROE
5.44%
Growth Rate
Ke
18.64%
-10% -20% -30%
-40%
g
-10%
-1.07% $ 3.56 $ 5.60 $ 6.80 $ 7.58
1.13% $ 4.44 $ 6.25 $ 7.31 $ 8.01
MVE
238983
1.95% $ 4.77 $ 6.49 $ 7.50 $ 8.17
41076 ROE
2.77% $ 5.09 $ 6.73 $ 7.70 $ 8.33
divide by shares
Model Price
Time Consistent Price
Observed Share Price(06/01/10)
5.818
6.16
3.59%
4.41%
5.44%
overvalued<10.149
$11.94
10.15%
12.00%
15.00%
Cost of 18.64%
equity 22.00%
25.00%
27.13%
overvalued<10.149
$ 5.42 $ 6.97 $ 7.89
$ 5.75 $ 7.22 $ 8.08
$ 6.16 $ 7.52 $ 8.32
10.149<fairly valued<13.731
15% Analyst
ROE Constant at 5.44%
Growth Rate
-10% -20% -30%
$ 8.54 $ 9.41 $ 9.84
$ 7.87 $ 8.91 $ 9.46
$ 6.98 $ 8.22 $ 8.90
$ 6.16 $ 7.52 $ 8.32
$ 5.56 $ 6.98 $ 7.86
$ 5.13 $ 6.57 $ 7.49
$ 4.86 $ 6.31 $ 7.25
10.149<fairly valued<13.731
15% Analyst
$
$
$
$
-50%
8.14
8.51
8.65
8.78
$ 8.49 $ 8.93
$ 8.65 $ 9.06
$ 8.85 $ 9.23
undervalued>13.731
-40% -50%
$ 10.10 $ 10.27
$ 9.79 $ 10.02
$ 9.34 $ 9.64
$ 8.85 $ 9.23
$ 8.45 $ 8.88
$ 8.13 $ 8.59
$ 7.91 $ 8.40
undervalued>13.731
Growth Rate Constant at -10%
ROE
-1.07% 1.13% 1.95% 2.77% 3.59% 4.41% 5.44%
10.15% $ 4.94 $ 6.16 $ 6.61 $ 7.06 $ 7.52 $ 7.97 $ 8.54
12.00% $ 4.55 $ 5.67 $ 6.09 $ 6.51 $ 6.92 $ 7.34 $ 7.87
15.00% $ 4.04 $ 5.03 $ 5.40 $ 5.78 $ 6.15 $ 6.52 $ 6.98
Cost of 18.64% $ 3.56 $ 4.44 $ 4.77 $ 5.09 $ 5.42 $ 5.75 $ 6.16
equity 22.00% $ 3.22 $ 4.01 $ 4.31 $ 4.60 $ 4.90 $ 5.19 $ 5.56
25.00% $ 2.97 $ 3.70 $ 3.97 $ 4.24 $ 4.51 $ 4.79 $ 5.13
27.13% $ 2.81 $ 3.50 $ 3.76 $ 4.02 $ 4.28 $ 4.54 $ 4.86
overvalued<10.149
10.149<fairly valued<13.731
undervalued>13.731
15% Analyst
250 Restated Long Run Residual Income Model Long Run Residual Income
(Restated)(items in thousands)
book value of equity(1/30/10) $439,753
Cost of Equity Constant at 18.64%
ROE
5.44%
Growth Rate
Ke
27.13%
-10%
-20% -30%
-40%
-50%
g
-10%
-3.23% $ 2.68 $ 4.92 $ 6.24 $ 7.11 $ 7.72
-1.75% $ 3.26 $ 5.35 $ 6.58 $ 7.39 $ 7.97
MVE
182865
-0.32% $ 3.83 $ 5.77 $ 6.92 $ 7.67 $ 8.20
divide by shares
41076 ROE
1.11% $ 4.40 $ 6.19 $ 7.25 $ 7.95 $ 8.44
Model Price
4.452
2.54% $ 4.96 $ 6.61 $ 7.58 $ 8.22 $ 8.68
Time Consistent Price
4.82
3.97% $ 5.53 $ 7.03 $ 7.92 $ 8.50 $ 8.91
5.40% $ 6.09 $ 7.45 $ 8.25 $ 8.77 $ 9.15
overvalued<10.149 10.149<fairly valued<13.731 undervalued>13.73
Observed Share Price(06/1/10) $11.94
15% Analyst
ROE Constant at 5.4%
Growth Rate
-10%
-20%
-30%
$ 8.45 $ 9.31 $ 9.75
$ 7.78 $ 8.82 $ 9.37
$ 6.91 $ 8.14 $ 8.82
$ 6.09 $ 7.45 $ 8.25
$ 5.51 $ 6.92 $ 7.79
$ 5.07 $ 6.51 $ 7.42
$ 4.81 $ 6.25 $ 7.19
overvalued<10.149 10.149<fairly valued<13.731
15% Analyst
10.15%
12.00%
15.00%
Cost of 18.64%
equity 22.00%
25.00%
27.13%
-40%
-50%
$ 10.01 $ 10.18
$ 9.71 $ 9.93
$ 9.26 $ 9.56
$ 8.77 $ 9.15
$ 8.38 $ 8.80
$ 8.06 $ 8.52
$ 7.84 $ 8.33
undervalued>13.73
Growth Rate Constant at -10%
-3.23% -1.75%
10.15% $ 3.71
12.00% $ 3.42
15.00% $ 3.04
$ 2.68
$ 2.42
$ 2.23
$ 2.11
overvalued<10.149
Cost of
equity
18.64%
22.00%
25.00%
27.13%
251 ROE
-0.32% 1.11%
$ 4.53 $
$ 4.17 $
$ 3.70 $
2.54%
5.31 $ 6.10 $ 6.88 $
4.89 $ 5.61 $ 6.34 $
4.34 $ 4.98 $ 5.63 $
$ 3.26 $ 3.83 $ 4.40
$ 2.95 $ 3.46 $ 3.97
$ 2.72 $ 3.19 $ 3.66
$ 2.58 $ 3.02 $ 3.47
10.149<fairly valued<13.731
15% Analyst
$
$
$
$
3.97% 5.44%
7.67 $ 8.47
7.06 $ 7.80
6.27 $ 6.93
4.96 $ 5.53 $ 6.11
4.48 $ 4.99 $ 5.52
4.13 $ 4.60 $ 5.09
3.92 $ 4.36 $ 4.82
undervalued>13.731
As Stated AEG Model year
Net Income (Thousands)
Tot al Dividends (Thousands)
0
1
2
3
4
5
6
7
8
9
10
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
22645
4659
-4600
-4543
-4486
-4430
-4375
-4320
-4266
-4213
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
1084.41
Dividends Reinvest ed at 22%(Drip)
Cum-Dividend Earnings
5743.06
-3516.02
-3458.51
-3401.73
-3345.65
-3290.27
-3235.59
-3181.59
-3128.27
Normal Earnings
27626.43
5683.56
-5612.52
-5542.36
-5473.08
-5404.67
-5337.11
-5270.40
-5204.52
Abnormal Earning Growt h (AEG)
-21883.37 -9199.58
2154.01
2140.64
2127.43
2114.39
2101.52
2088.81
2076.25
PV Fact or
PV of AEG
Residual Income Check Figure
Core Net Income
22645
Tot al PV of AEG
-1,592.28
0.82
0.67
0.55
0.45
0.37
0.30
0.25
0.20
-7540.64
1447.20
1178.86
960.32
782.32
637.34
519.25
423.06
-21883.37 -9199.58
2154.01
2140.64
2127.43
2114.39
2101.52
2088.81
2076.25
Cont inuing (Terminal) Value
3593.5108
PV of Terminal Value
732.22
Tot al PV of AEG
-860.06
Tot al Average Net Income Perp (t +1)
Divide by shares t o Get Average EPS
Capit alizat ion Rat e (perpet uit y)
Growt h Rat e
21,784.55
-10%
0.53
2.41
2.58
Jun 1 2010 observed price
$11.94
Ke
22.00%
g
-30%
-50%
5.14
$
4.97
$
4.88
$
4.83
$
4.45
$
4.33
$
4.26
$
4.22
$
4.19
15% $
3.68
$
3.59
$
3.55
$
3.52
$
3.50
18.64% $
3.04
$
2.99
$
2.96
$
2.94
$
2.93
22% $
2.63
$
2.60
$
2.58
$
2.56
$
2.55
25% $
2.35
$
2.33
$
2.31
$
2.30
$
2.29
27.13% $ 2.19
$
2.17 $
2.15
overvalued<10.149
10.149< f airly valued <13.731
$
equit y
252 -40%
12% $
Cost of
t ime consist ent implied price 06/ 01/ 2
-30%
10.15% $
22.00%
Int rinsic Value Per Share (01/ 30/ 2010
-20%
4.80
2.15 $
2.14
undervalued>13.731
1,868.63
Restated AEG Model year
Net Income (Thousands)
Tot al Dividends (Thousands)
0
1
2
3
4
5
6
7
8
9
10
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
13209
-4659
4929.12
4929.12
Dividends Reinvest ed at 10.15%(Drip)
500.31
-13801
4929.12
-13629
-13458
-13290
-13124
-12960
-12798
-12638
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
4929.12
500.31
500.31
Cum-Dividend Earnings
-4158.35 -13300.97
-13128.45
-12958.09
-12789.86
-12623.74
-12459.69
-12297.69
-12137.71
Normal Earnings
14550.11
-15202.10
-15012.08
-14824.43
-14639.12
-14456.13
-14275.43
-14096.99
-8,169.46
2,073.65
2,053.98
2,034.56
2,015.38
1,996.45
1,977.74
1,959.28
0.9079
0.8242
0.7482
0.6793
0.6167
0.5599
0.5083
0.4614
-$7,416.67
$1,709.10
$1,536.89
$1,382.08
$1,242.90
$1,117.77
$1,005.26
$904.11
-8169.46
2073.65
2053.98
2034.56
2015.38
1996.45
1977.74
A bnormal Earning Growt h (AEG)
-18,708.46
PV Fact or
PV of A EG
Residual Income Check Figure
Core Net Income
Tot al PV of AEG
-18708.46
-5131.51
500.31
500.31
500.31
500.31
500.31
$1,481.44
3516.1495
PV of Terminal Value
1,622.52
Tot al PV of AEG
3,103.96
Growt h Rat e
Tot al A verage Net Income Perp (t +1 $16,313.32
Divide by shares t o Get Average EP
-10%
0.40
10.15%
Cost of
Int rinsic Value Per Share (01/ 30/ 201
3.91
t ime consist ent implied price 12/ 31/ 2
4.04
Dec. 31 2009 observed price
Ke
$11.94
10.15%
equit y
-30%
-40%
-50%
4.64
$
4.31
$
4.14
$
4.04
$
3.97
12% $
4.85
$
4.56
$
4.40
$
4.31
$
4.25
15% $
5.12
$
4.88
$
4.75
$
4.66
$
4.61
18.64% $
5.36
$
5.17
$
5.07
$
5.00
$
4.95
22% $
5.52
$
5.38
$
5.29
$
5.23
$
5.19
25% $
5.64
$
5.53
$
5.45
$
5.40
$
5.37
27.13% $
5.71
$
5.62
$
5.55
$
5.51
$
5.48
10.149< f airly valued <13.731
-40%
253 -20%
10.15% $
overvalued<10.149
g
1959.28
13209
Cont inuing (Terminal) Value
Capit alizat ion Rat e (perpet uit y)
500.31
undervalued>13.731
1,763.35
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255