Kohl’s Corporation was organized in 1988 and is a Wisconsin corporation. The company operates family-oriented department stores that sell moderately priced apparel, footwear and accessories for women, men and children; soft home products such as sheets and pillows; and housewares. Stores generally carry a consistent merchandise assortment with some differences attributable to regional preferences. As of February 2, 2008, the company operated 929 stores in 47 states. (Source: Company 2007 Form 10-K)

Originally founded in 1938 by William T. Dillard, Dillard’s, Inc., now operates 326 stores in 29 states. The company’s store base is diversified, with the character and culture of the community served determining the size of facility and, to a large extent, the merchandise mix. In general, stores offer a wide selection of merchandise including fashion apparel for women, men and children, accessories, cosmetics, home furnishings and other consumer goods. Most stores are located in suburban shopping malls but customers may also purchase merchandise online. (Source: Company 2007 Form 10-K)

Learning Objectives

• Read and compare financial statements for two companies in the same industry. • Consider how different strategic choices lead to different financial statement relationships. • Perform an analysis of financial information using common-size balance sheets and income statements, ratios, and other techniques.

• Critically evaluate two companies based on financial information.

• Evaluate a financial analysis to form investment recommendations. Refer to the 2007 financial statements and notes of Kohl’s Corporation and Dillard’s, Inc.

Analysis

a. Describe the industry in which these two companies operate and assess the competitive environment. What current economic factors affect the companies’ operations? Who are the main competitors in this industry? What threats do the companies face? What opportunities? How are the two companies similar? How are they different?

b. Consider the income statements of both companies. Are there any unusual or nonrecurring items that need to be considered in your analysis? That is, are the earnings of high quality? Are the earnings persistent?

c. Prepare common-sized income statements and balance sheets for each company for fiscal 2007 and 2006. To common size the income statement, divide each item by net sales. To common size the balance sheet, divide each item by total assets.

A company’s financial performance can be analyzed in many ways. Return on equity (ROE) is a widelyused measure of financial performance that compares the profit the company made during the period (net income) to the resources invested and reinvested in the company by shareholders (stockholders’ equity). The DuPont model systematically breaks ROE into components. One form of the DuPont model is:

Stockholders’ equity is reported on the balance sheet and excludes any reported minority interest or non-controlling interest.

Note that once the common terms cancel in the second equation (the DuPont model), the right-hand side of the ROE equation collapses down to the first equation: Net income divided by the firm’s Stockholders’ equity. Reading from left to right in the second equation, the first right-hand side ratio represents the fraction of pretax earnings that the shareholders keep. One minus that ratio is the average tax rate so the ratio decreases as the tax rate goes up.

The second ratio represents the fraction of EBIT (i.e., operating profit) that the firm keeps after financing costs so the ratio decreases as the net cost of debt increases. The third ratio represents operating return on sales or the operating profit earned on each unit of revenue. The fourth term is the asset turnover ratio, a measure of overall efficiency in asset use. The product of the third and fourth terms is operating return on assets.

The final ratio captures the leverage of the firm—a measure of how the firm has paid for its assets. The ratio increases as the firm takes on more debt (that is, for a fixed level of equity, more assets must mean more debt). Note that the final term is equal to 1 + (Average total liabilities / Average stockholders’ equity).

Normally, analysis of the financial statements begins with operating return on sales and asset turnover (thus, operating return on assets). Then it turns to leverage (liquidity and solvency) and the cost of leverage. Finally, a review of the tax burden is conducted. The ROE analysis can be followed up with an analysis of the company’s cash flows.

d. Compute return on equity (ROE) for both companies for fiscal 2007 and 2006. Calculate the five components of ROE and verify that their product equals ROE. Remember to use average total assets and average stockholders’ equity in your ratio calculations. e. Refer to the common-sized income statement you prepared in part c and your ROE decomposition from part d.

Assess the companies’ asset efficiency. Which firm is more efficient in its use of assets? Consider efficiency in terms of total asset turnover, receivables turnover (and average collection period), inventory turnover (and average holding period), payables turnover (and average time to payment), cash conversion cycle (i.e., receivables days + inventory days – payables days), and fixed asset turnover.

g. Assess the companies’ liquidity and solvency. Are the companies likely to meet their debts as they come due? Consider ratios such as the current ratio, the quick ratio, and the debt-equity ratio. Also consider interest costs and the times interest earned ratio. Is there any “off-balance-sheet” financing that will constrain future cash flow? You should explicitly consider operating leases at both companies. Assume that the discount rate implicit in the capital leases is the appropriate discount rate for capitalizing the operating leases. Further, assume that the lease payments due in 2013 and beyond will be paid evenly over 20 years for Kohl’s and paid entirely in 2013 for Dillard’s. h. Assess the cash flow of each company. Are cash flows from operations a source or a use of cash? How are operations and investments being financed? What differences do you note? i.

As a potential investor, would you be interested in seeking additional information about either of these companies? What sort of information would you want? Would you invest in either company?

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