DOLLAR TREE Equity Valuation & Analysis

DOLLAR TREE Equity Valuation & Analysis

Table of Content

Executive Summary 2 Financial Analysis 40

Industry Analysis 3 Liquidity Ratios 40

Accounting Analysis 4 Profitability Ratios 48

Financial Analysis 4 Capital Structure Ratios 56

Valuations 5 Financial Statement Analysis 61

Income Statement 62

Business and Industry Analysis 7 Balance Sheet 63

Company Overview 7 Cash Flow Statement 65

Industry Overview 8

Five Forces Model 9 Analysis of Valuations 66

Rivalry Among Existing Firms 10 Weighted Average Cost of Capital 67

Threat of New Entrants 15 Method of Comparables 69

Threat of Substitute Products 17 Intrinsic Valuations Methods 77

Bargaining Power of Customers 18

Bargaining Power of Suppliers 20 Appendices 89

Value Chain Analysis Competitive

Strategies 21

Firm Competitive Advantage Analysis 23 References 118

Accounting Analysis 25

Key Accounting Policies 25

Potential Accounting Flexibility 28

Actual Accounting Strategy 29

Quality of Disclosure 32

Qualitative 32

Quantitative (Screening Ratios) 32

Revenue Diagnostics 33

Expense Diagnostics 34

Potential Red Flags 39

Executive Summary

Investment Recommendation: Overvalued, Sell 6/1/07

DLTR – NasdaqGS(6/1/07) - $42.41 EPS Forecast

52 week range: $26.22 - $42.21 2007 2008 2009 2010 2011 Initial 2.29 2.57 2.88 3.22 3.61

Revenue: (1/31/2007) $3969.40 2007 2008 2009 2010 2011 Revised Market Capitalization – (yahoo.finance) $4.36B 3.27 3.41 3.56 3.69 3.81

Shares Outstanding $99.66M Ratio comparison DLTR DG FDO NDN

3-mth Avg Daily Trading Volume: 1,275,050 Trailing P/E 38.5 54.54 22.46 95.76

Percent Institutional Ownership: 94% Forward P/E 22.02 25.30 18.73 43.59

Book Value per Share: (Equity/Shares) $11.72 PEG 1.77 1.95 1.59 2.41

ROE: .16 P/B 3.89 3.82 3.95 1.68

ROA: .11

Valuations Estimates

Cost of Capital est. R2 Beta Ke Actual Price (6/1/07): $42.21 3-Month .0013 .097 .058 Ratio Based Valuations

6-Month .3520 1.7129 .1722 Trailing P/E 71.23

2-Year .3563 1.7187 Forward P/E 40.73

5-Year .3543 1.7159 .1719 PEG 18.01 10-Year .3574 1.7209 .0217 P/B 42.58 Kd .05425 P/EBITDA 17.42 WACC 15.9% P/FCF 47.20 EV/EBITDA 33.15

Altman Z-Score Intrinsic Valuations Initial Revised

2002 2003 2004 2005 2006 Free Cash Flows 46.73 46.63 Initial 9.95 8.37 6.44 6.11 6.76 Residual Income 12.98 9.55 Revised 5.02 5.58 4.27 4.01 4.31 LR ROE 4.36 26.47

Recommendation – Overvalued Firm

Industry Analysis

“Dollar Tree Stores, Inc. is a customer-oriented, value driven variety store, operating at a one dollar price point. The company’s mission will be consistent with controlled and profitable growth” (Mission Statement, dollartree.com). They are

categorized in the Discount Variety Industry. Dollar Tree was established in Dalton, GA in 1986. Currently, their headquarters is located in Chesapeake, VA. As of 2007, there are 3,219 Dollar Stores in 48 states. This number has grown from 2,914 in just one year.

Dollar Tree’s direct competitors discussed in this valuation paper are Family Dollar, Dollar General, and 99 Cent Only store. In the discount variety industry, firms compete on cost rather than on quality. The industry is currently growing at 2.38%. Dollar Tree has 19% of the market share in terms of total revenue.

From the Five Forces Model we determined that rivalry among existing firms and the threat of substitute products are very high in this particular industry. This is mainly due to the low consumer loyalty that is associated with undifferentiated products. Similar products also yield low switching costs which increases the threat of substitute products. The threat of new entrants, the bargaining power of customers, and the bargaining power of suppliers are all low in the discount variety industry. The low threat of new entrants is due to the preexisting relationships that must exist with the suppliers. The threat of bargaining power of customers and suppliers are low because the products are undifferentiated. Also, because the prices are already so low, there is no need to bargain for a lower price.

Dollar Tree’s key success factors are economies of scale, low cost distribution, and tight cost control. Following these factors, Dollar Tree is trying to grow their customer base and become more of a leading force in the Discount Variety Industry. One way in which they are trying to achieve this is by acquiring other stores, opening new stores, and be selling perishable items in their stores in order to make Dollar Tree a one-stop venue for their customers.

Accounting Analysis

An accounting analysis analyzes a firm’s accounting practices and determines if the employed accounting practices reflect the true or attainable transparent information about the firm. The accounting analysis can help in valuing the firm and can help spot potential “red flags”.

The key accounting policies should agree with the key success factors which include: economies of scale, low-cost distribution, and tight cost control. Dealing with economies of scale, Dollar Tree experienced a very notable increase in revenue with the increase in their retail outlets. The disclosure of leases is another important aspect that falls under key accounting policies. Most of Dollar Tree’s stores are under operating leases. Dollar Tree expenses these as rent expense and does not report the future obligation on their balance sheet.

The flexibility in GAAP, Generally Accepted Accounting Principles, can lead to distortions in the financial statements. However, Dollar Tree’s information is

transparent and they provide a fairly high amount of disclosure about their firm’s position. Dollar Tree is aggressive in their accounting practices with their operating leases. This has a significant effect on both their net income and to their Balance Sheet.

In computing the ratio diagnostics, we did not identify any real “red flags”. One thing that might need to be looked into as a potential “red flag” is Dollar Tree’s

operating leases. These leases are amortized on a straight line basis over the term of the leases. As a result of Dollar Tree not capitalizing their leases, their liabilities were understated by $920M as compared to their total reported liabilities in 2006 of $705.6M.

Financial Analysis, Forecast Financials and Cost of Capital Estimation

In the process of assessing the outlook of a firm, analysts make estimates regarding the firm’s liquidity, profitability, and capital structure based on financial statements, present and forecasted. By making these estimates, analysts can

benchmark the firm being analyzed against the other firms in the industry. These ratios are then used to forecast a firm’s financial statements for the next ten years. Once a Beta is calculated, analysts can use Capital Asset Pricing Model (CAPM) to estimate cost of equity for the firm. Then, a cost of capital for the firm can be determined using the weighted average cost of capital (WACC).

Dollar Tree is a fairly liquid company in relation to its competitors and the industry average. Its Current Ratio and Quick Asset Ratio are above the industry average, which says that it is able to pay off its current liabilities better than the industry as a whole. Its Days Supply Inventory is higher than the industry average which means that it takes them longer, on average, to move merchandise than the competition. Its Inventory Turnover, and Working Capital Turnover are lower than the industry average. As far as profitability goes, Dollar Tree is very profitable in

comparison with the industry. Operating Profit Margin, Net Profit Margin, Return on Assets, and Return on Equity are all areas that Dollar Tree rises above the industry as a whole. The only area of profitability that Dollar Tree lacks in is Asset Turnover. Dollar Tree’s capital structure is about like the industry average, which says that they are able to support their debt just about as well as the industry as a whole.

When forecasting, analysts make assumptions to determine the future years’ growth or decline. Dollar Tree’s Forecast for the years 2007 through 2016 were computed using our financial analysis using ratios and average growth rates. As Dollar Tree’s net income from each prior year was added back into the following year’s retained earnings, Total Assets and total Equity increased exponentially. The huge addition to Retained Earnings year by year had to be compensated for by sacrificing Total Liabilities.

Valuations

According to our overall valuations, Dollar Tree’s stock price is overvalued. Many people value a company based on stock price. Investors base their purchasing or selling decision on the stock price. It is the analysts job to determine whether or not the published price of the stock is overvalued, undervalued, or fairly valued. There are

two main methods used to determine whether the stock price is overvalued, undervalued, or fairly valued. These Methods are Method of Comparables and the Intrinsic Valuation Method.

The ratios that the Method of Comparables uses the Trailing & Forecast Price-Earnings, Price to Book, Dividend Yield, P.E.G., Price over EBITDA, Price over Free Cash Flow per Share, and Enterprise Value over EBITDA. Each Ratio is then averaged for the competitors. After taking the average, price for Dollar Tree is determined by setting Dollar Tree’s ratios equal to the average and solving for price. The P.E.G, P/EBITDA, and Enterprise Value/EBITDA, ratios show that this firm is overvalued. Trailing P/E, forward P/E, and P/B ratio, supports Dollar Tree as being ‘fairly valued’ firm. Price/Free Cash Flows ratio proves that Dollar Tree is slightly undervalued. Using the Method of Comparables doesn’t really show us whether Dollar Tree is overvalued, undervalued, or fairly valued.

The Intrinsic Valuation Method uses the Discounted Dividends models, Discounted Free Cash flows model, The Residual Income Method, Residual Income Perpetuity, and Abnormal Earnings Approach. From our model analysis we concluded that Dollar Tree is overvalued. We felt that the only two of these models that are accurate were the Residual Income and the Abnormal Earnings. The Residual Income Model and the Abnormal Earnings Model showed that the price should be lower than the published price, therefore being overvalued. The Free cash flow model was to variable in the estimation of stock prices to determine whether it is over, under, or fairly valued. The Discounted Dividends Model doesn’t apply to Dollar Tree since they don’t pay dividends.

Business & Industry Analysis

Company Overview

Dollar Tree Stores Inc. (DLTR) which was established in Dalton, GA in 1986,

operates in the Discount Variety Stores Industry. While the corporate headquarters is located at Chesapeake, VA, they have distribution centers in Georgia, Oklahoma, Utah, Washington, Mississippi, Illinois, California, and Pennsylvania. “Dollar Tree Stores, Inc. is a customer-oriented, value driven variety store, operating at a one dollar price point. It will operate profitably, empower its associates to share in its opportunities, rewards and successes; and deal with others in an honest and considerate way. The company's mission will be consistent with controlled and profitable growth” (Mission Statement Dollartree.com). Dollar Tree also has stores registered under the names of Dollar Bills, Deal$, and Dollar Express; most of them were brought in through acquisitions and mergers. The corporation has approximately 3,219 stores in 48 states as of February 3, 2007 in comparison with just 2,914 in the prior year (Dollar Tree 10K 2006). Because the company believes in effectively utilizing all available selling space, the future growth strategy of the company includes the continuation of putting in new larger stores in underrepresented markets. These underrepresented markets are stated in the Dollar Tree 2007 10-K as the Midwest region of the US. It is Dollar Tree’s strategy to place their retail locations in strip malls as to attract and share common customers with other mall tenants. “We primarily focus on opening new stores in strip shopping centers anchored by mass merchandisers, whose target customers we believe to be similar to ours, and in neighborhood centers anchored by large grocery retailers” (Dollar Tree 2007 10-K). Dollar Tree’s products are lines of merchandise in consumable areas including: basic foods, candy, health and beauty products, toys, house wares, greeting cards, and apparel. Also, the stores carry different products seasonally for holidays such as Easter, Christmas, and Halloween. A specific growth strategy is to start including large freezers that will carry consumer refreshments to attract a wider customer base

(Dollar Tree 10-K 2006). This demonstrates that the company acknowledges the importance of growth in their industry and is implementing new expansion plans.

http://moneycentral.msn.com

Industry Overview

The retail industry is large. Hence, it can be broken down into many sub-industries which include: discount variety stores, specialty retail stores, and up-scale retail stores. The sub industry in which Dollar Tree competes is that of Discount Variety Stores. This sub-industry concentrates on providing retail based on cost rather than quality. This discount variety store industry includes Dollar Tree and its competitors, Dollar General Corp. (DG), 99 Cent Only Stores (NDN), and Family Dollar Stores Inc. (FDO). It is important to note that the focus of the firms in this industry is to compete

2002 2003 2004 2005 2006 Assets $1,304.2390 $1,501.5190 $1,792.6720 $1,798.4000 $1,873.3000 Sales $160.7890 $2,799.8720 $3,126.0000 $3,393.9000 $3,969.4000 Stock Price $24.57 $30.07 $28.77 $23.94 $30.10 Comparable Sales Growth 17.20% 18.70% 11.60% 8.60% 16.90%

on cost. Although Wal-Mart (WMT) and Target (TGT) are also listed as Discount Variety competitors, they are indirect competitors to Dollar Tree because they carry a larger variety of products, focus more on quality, and are more flexible in the price rage in which they operate when compared with Dollar Tree. The discount variety store

industry can be defined partly by the ways in which the retailers obtain their products. According to the 99 Cent Only 10-K, “Portions of purchases are acquired at prices substantially below original wholesale cost through closeouts, manufacturer overruns, and other special-situation merchandise transactions.” This results in the companies using different supplier’s products at different times of the year. The direct competitors previously stated compete on cost. As compared with the industry, Dollar Tree was valued on the stock market as the least valuable from late 2002 to the middle of 2004. Its value rose steadily from then on and its price is currently valued the second highest, only behind Dollar General Corp.’s stock. Currently, Dollar Tree is third in Market Cap with 4.17 Billion Dollars behind Family Dollar Stores Inc. and Dollar General Corp (Yahoo Finance 2007). Dollar Tree currently ranks third in number of locations behind Family Dollar Stores Inc. with 6,300 stores and Dollar General Corp. with 8,260. (Dollar General & Family Dollar 10K’s 2006). Overall, the industry reached a peak in growth in mid-2003 with an average growth of approximately 19.25% to a low in mid-2006 with an inverse growth of approximately -37.5% (Per own calculations from the

moneycentral.msn.com graph). The industry grew at a rate of 2.38% over the past year and Dollar Tree had a 19% share of the market in terms of total revenue in 2006

(Yahoo Finance 2007). It should be noted that industry numbers were only provided for the year 2006.

Five Forces Model

The Five Forces Model is a tool which helps in analyzing the industry structure and average profitability. With this model, a company can top their rival firms by

gaining a better understanding of their particular industry. This model aids in classifying an industry. This allows us to determine industry value drivers. The five forces include:

rivalry among existing firms, threat of new entrants, threat of substitute products, bargaining power of customers, and bargaining power of suppliers. The first three forces analyze the competition within an industry. The last two provide information on the relationship between the bargaining power of the buyers and the suppliers. Overall, the Five Forces Model is a very informative, easy to understand business model that analyzes where and how value of a particular industry can be created. If a company knows where and how their value is created, they can put their time and money into those activities and areas in order to experience more rapid growth within their industry.

DISCOUNT VARIETY INDUSTRY

Rivalry Among Existing Firms Very High

Threat of New Entrants Low

Threat of Substitute Products Very High

Bargaining Power of Customers Low

Bargaining Power of Suppliers Low

Rivalry Among Existing Firms

Rivalry within this industry tells us that to be successful a company must

compete on cost. Existing firms tend to have preexisting relationships with both buyers and sellers. To overcome these relationships, a firm must be willing and able to have the lowest prices since there is little product differentiation.

The discount variety store industry experiences a moderate level of concentration and a very high level of rivalry amongst existing firms. The amount of concentration is determined by the number of firms, or the saturation, in the industry. The rivalry among all of the competing firms is aggressive because there is such a low amount of consumer loyalty. Since the firms compete on price rather than quality, they all must focus on keeping prices down by minimizing their costs. There is not a need for much

differentiation in this industry because they are competing on low cost and not necessarily on quality and brand name.

Industry Growth Rate

For investors, this typically represents the compounded annualized rate of growth of a company's revenues, earnings, dividends and even macro concepts - such as the economy as a whole (http://www.investopedia.com). In short, historical growth rates can be very helpful in forecasting a company’s or an industry’s future growth. This growth rate also shows how their activities have lead to or hindered company expansion. It also shows how well management decisions have translated into sales.

Sales Growth Rate

2002 2003 2004 2005 2006 Mean: Dollar Tree 16.81% 10.43% 7.89% 14.50% 12.41% Dollar General 12.75% 11.23% 10.30% 10.74% 6.41% 10.28% Familiy Dollar 11.95% 12.37% 10.07% 9.32% 8.91% 10.52% 99 Cent Only 21.38% 18.66% 12.21% 76.44% 32.17% Mean: 15.36% 14.77% 10.75% 9.32% 26.56%

Industry Sales Growth past 5 years: 15.69%

Sales Growth 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 2002 2003 2004 2005 2006 Year Dollar Tree Dollar General Familiy Dollar 99 Cent Only

According to our calculations, the discount variety industry averaged a 15.69% sales growth rate over the last 5 years. This is a relatively high sales growth rate. The reason for this number is due to the large number of new and acquired stores within each company in the industry. The missing values in years 2002 and 2005 are due to incomplete financial statements. Dollar Tree and 99 Cent Only changed their filing dates in these years.

Since there is a relatively high growth rate in an industry with undifferentiated products, there is extreme competition for market share. Discount Variety Stores must focus on taking competition away from other stores in order to grow. Obviously there are an abundance of buyers willing to spend money in this industry. The companies must come up with different ways to attract the buyers to their stores and to make the buyers choose them over their competitors. In order for an individual firm to

continually gain market share from its rivals, they must focus on keeping their prices as low as, if not lower, than their competitors’ prices. In this industry, the company with the lowest prices usually has the most customers. More buyers also translates into a greater chance for the company to grow. As long as a company is able to grow their customer base, they can afford to acquire other stores and build new stores. This all contributes to a company’s growth rate. To keep their prices low, Discount Variety stores must minimize costs in order to have bargaining power in the market. We will talk more about this in the coming paragraphs.

Concentration

Concentration is measured by the number of firms in an industry and their sizes relative to the industry as a whole. The concentration ratio is a percentage of an industry’s four largest firm’s market share. In an industry with a high concentration a single company can control prices.

Market Share (# of Stores) Year: 2002 2003 2004 2005 2006 Dollar Tree 2263 2513 2735 2914 3217 Family Dollar NA 5066 5481 5908 6208 Dollar General 6113 6700 7320 7929 8229 99 Cent Only NA 154 194 225 232 2003 Family Dollar 35% Dollar Tree 17% 99 Cent Only 1% Dollar General 47% 2004 Family Dollar 35% Dollar Tree 17% 99 Cent Only 1% Dollar General 47% 2005 Family Dollar 35% Dollar Tree 17% 99 Cent Only 1% Dollar General 47% 2006 Family Dollar 35% Dollar Tree 18% 99 Cent Only 1% Dollar General 46%

In the discount variety store industry there are many companies competing for the same market share. The discount variety industry is an oligopoly with no collusion. This means that the stores have the ability to work with each other when setting their prices. Although they have this power, they will not do this due to the highly

competitive and low cost nature in this industry. This low level of concentration can eventually lead to price wars (Palepu 2004). Currently, Dollar General holds the highest percentage of market share in the industry with over 8000 stores. They have

Over the past 5 years, they have steadily held 35% of the industry’s market share. Dollar Tree, Family Dollar, & 99 Cent Only Store do not hold a huge market share individually, but remain in the top competing companies in the industry.

Switching Costs and Differentiation

Whenever switching costs are low, the buyers have the ability to easily move

their business to another supplier. The more differentiated the products are, the more likely the company is to experience high customer retention. In the discount variety industry there is very little product differentiation and the switching costs are low. Low switching costs also give way to high price competition between similar businesses. Ratio of Fixed to Variable Costs

A fixed cost is one that does not change over the course time. An example of this is a lease payment. A $1000 lease payment will not be any higher or any less than $1000. A variable cost is subject to change in relation to economic fluctuations and specific business activities. In this sector, the ratio of fixed to variable costs can have a large effect on product prices. There are low fixed costs and high variable costs.

Their fixed costs are mostly made up by their lease payments. With over 3200 stores, there are a lot of these types of payments being made. In the Discount Variety Industry, most retail locations are set up on five to seven year leases. Dollar General, Family Dollar, and Dollar Tree all have distribution centers. These distribution centers are all owned by their prospective companies.

Another fixed cost incurred in this sector is salaries expense. The employees will receive a set wage regardless of economic fluctuations.

Like most other companies, those in the discount variety industry are affected by varying fuel costs. They ship their products from their distribution centers to the

individual stores via truck. Trucks use a lot of fuel. When the fuel prices spike, the store experience a higher variable cost.

Excess Capacity and Exit Barriers

Excess capacity is when the economic demand is less than what a company can actually produce. From the consumer’s point of view, excess capacity could be a good thing. When their demand is lower than supply, there tends to be little or no inflation. On the other hand, “a company with sizable excess capacity can often lose a

considerable amount of money if it is not able to meet the high fixed costs that are

associated with producers” (www.investopedia.com).

When merchandise surplus occurs, operating efficiency slows, forcing firms to slash prices. This is commonly referred to as excess capacity.

Exit barriers can prove to be very threatening in a period of economic or industry decline. Different factors may force a company to continue operations during

period of low returns. These factors include “economic, strategic, & emotional factors”

(http://www.acad.poly.edu).

Dollar Tree avoids these exit barriers because of their non-specialized assets and their short lease periods, which are typically five-seven years.

The competitive nature of the discount variety industry requires that these businesses compete on price rather than on quality or differentiation. This industry consists of a high level of concentration, low switching costs, low fixed to variable cost ratio, and few exit barriers. All of these considerations yield extreme competition between existing firms.

Threat of New Entrants

When entering into a new industry is made relatively easy, the existing firms automatically experience price constraints. However, in differentiated industries, the existing firms are not held to the same constraints. Most discount variety stores operate off of huge discounts from their suppliers which they in turn pass on to their customer. This industry is not easily accessible to new businesses because of the preexisting relationships that must exist with the suppliers.

Economies of Scale

As a firm increases in size, its costs per unit decline. This is an example of economies of scale. To achieve the economies of scale new entrants must come up with large amounts of capital (Palepu 2004). Since the discount variety sector is already saturated, the large amount of capital may not be easily attainable for new entrants. This capital is required to start a viably competitive company that will be eligible for bulk discount from suppliers.

Distribution Access and Supplier Relationships

Because there are only so many suppliers who offer these bulk discounts, only a limited number of stores are allowed access to the discount. Good, pre-existing

relationships with suppliers are essential in this industry. It is not likely that new entrants would have the ability develop a mutually benefiting relationship with the suppliers like that of huge conglomerates like Family Dollar and Dollar Tree.

Firms like Big Lots, gain most, if not all, of their inventory from brand name close outs. In order to get these branded items at close out prices, they must form some type of contractual agreement with the supplier. Dollar General sells branded items like Pepsi, Colgate, and Tide. Because Dollar Tree sells their products at a fixed price of $1.00, they are not able to carry branded items. Also, most brands want to make sure that their item will sell. This might hinder them from supplying new, unknown

businesses. Legal Barriers to Entry

One legal barrier that the discount variety industry might face is that of foreign importation. Because 40% of Dollar Tree’s products are imported from other countries, an embargo placed on a certain foreign country’s goods could substantially affect their supply chain. Other legal problems that could arise include raw material shortages, labor strikes, shipment issues, and political unrest.

New firms looking to enter the discount variety industry face a plethora of obstacles like preexisting relationships with suppliers, economies of scale, and the possibility of legal barriers.

The Threat of Substitute Products

Substitute products are a huge threat in the discount variety industry. Most of these vendors carry relatively the same products at a similar price. This leads to nonexistent switching costs. Buyers of discount products tend to be very disloyal and highly price sensitive. This threat of substitute products is typical of the highly

competitive nature in this type of industry. Buyer’s Willingness to Switch

Due to the responsive demand relative to price, buyers show no particular allegiance to any one store. Similar products found in directly competing stores allows the buyer to pick and choose where they will buy from due to small price differences. Increased prices or obsolete inventory may cause customers to shop elsewhere. Dollar Tree’s one major advantage in that its customer can always count on the prices

remaining at $1.00.

Relative Price and Performance

Because the price point Dollar Tree is aiming for is so low, consumers are willing to accept poor service in exchange for the low prices. Performance is not the same as differentiated retail stores because the products are not substitutable. Dollar Tree is the highest performing store charging a flat rate of $1.00 per item. Discount variety stores must also continually reiterate to their customers that low price does not necessarily mean low quality. This allows the companies in this sector to engage in price wars in order to try and win over the competitor’s customers.

Bargaining Power of Buyers

The power relationship which exists between the buyers and company is known in the five forces model as the bargaining power of buyers. This point of the model deals with who holds the leverage to bargain or state their demands onto the other. This relationship is important because it determines how the company must operate and relate with its buyers. If the company holds the power, it can charge high prices for its products. If the buyers hold the power, the company must compete on low cost. This relationship also works when the company is the buyer of suppliers’ products, which is when the company effectively becomes the customer.

Switching costs

The cost of switching from Dollar Tree to Dollar General or Family Dollar would result in higher cost of certain products. The only other switching alternative would be to switch to 99 Cents Only store which has fewer locations than Dollar Tree. The overall cost of switching for the buyer is low, but can be higher depending on the

product. Switching cost is important because it tells the company how much power they can have over the buyer. In this industry, since the switching costs are very low, the buyer has most of the power. This means that the industry must be very competitive to retain their customers.

Differentiation

The products offered at all of the direct competitors are basically the same as Dollar Tree’s products. There is a small amount of differentiation in products offered between the stores. There is a differentiation in the quantity offered. These small differences in the product and quantity offered is why Dollar General and Family Dollar charge more. Buyers are price sensitive when there is an undifferentiated product. Because the stores essentially offer the same products, they must compete on pricing.

This causes the industry to be more competitive. Economics says the more competitive a market is, the lower the prices are, and the better it is for the buyer.

Importance of Product for Costs and Quality

The cost of products are important because cost is what stores like 99 Cent Only & Dollar Tree compete on. The cost of 99 Cent Only store and Dollar Tree’s products are lower than that of Dollar General and Family Dollar. Quality is not as important because they do not compete on quality. The quality offered at their stores are

comparable to the quality of the products offered at the other Discount Variety stores. This in turn means that the industry can not compete on quality, but rather must compete on cost. Quality must be considered somewhat, but only very little when compared with cost.

Number of Buyers

The number of buyers is very important to Discount Variety stores. They are able to sell everything at around dollar because of the costs for one, but the quantity that they sell. The more buyers they have, the more quantity they sell. This means that the companies in the market are all competing to have the most buyers. Family Dollar generally sells to more than 2000 people each week. While this amount of traffic can generate business for the surrounding stores, the surrounding stores can bring in business for Family Dollar as well (www.familydollar.com). Real estate and store location is an important factor to consider when thinking about the number of buyers. The reason for this is that the better location you have as the buyer, the more likely the shoppers are to choose your store. If products are offered at the same price, and we presume buyers to be rational, then they will choose the store most convenient to them. Because of this competition for the buyers, or the competition for market share, the industry must be more competitive. This means that they must compete on low cost.

Volume per Buyer

Volume per buyer is important because it determines how much income your company is making. If a buyer comes to a store and makes a very small purchase, then the company has not done a good job of providing more or what the customer needs or wants. The goal of the company should be to provide all the products that the buyer needs to purchase at that point in time. If this happens, then the volume per buyer will increase which means an increase in overall sales. Within the total sales for the retailer, the individual buyer makes up only a very small percent of the total. The buyer is

considered to be a very small volume buyer. Due to this, the buyer has very little power over the retailer. If the buyer threatens to go somewhere else, unless the retailer meets their demands, the retailer will simply let them switch. This is not to say that the buyers desires are not important to the company, but the company is not going to take on a loss just to meet a few customers demands.

Bargaining Power of the Suppliers

There are many suppliers that supply these Discount Variety stores with their products. They consist of major brands such as Angel Soft bath tissue, Dole bananas, 2-liter Coke Classic, Kleenex, Imperial canned nuts, Reynolds wrap, Eveready batteries, and candy such as Reese's, Butterfinger and Snickers. Many of the Discount Retail stores, such as Dollar General, Dollar Tree, Family Dollar, and 99 Cents Only store, share some of the same suppliers. Discount variety stores also carry their own private labels. Some of Dollar Store’s brands include Cobblestone Corners, April Bath & Shower spa line, Max Grey socks, Voila and Boutique in gift wrap, Victoria's Garden in garden decor, Royal Norfolk in linens and Cooking Concepts in kitchen gadgets

(http://findarticles.com). Brand preference among customers helps to set Dollar Tree apart from its competitors.

Consumer-products giants like Clorox, Dial, and Procter & Gamble have begun to develop items especially for Dollar Tree. For example, when Dollar Tree wanted a new line of cleaning supplies early last year, Dollar Tree worked closely with P&G designers to produce 18-ounce bottles of Dawn dish soap to sell at $1. The bottles were smaller than Dawn's standard 20-ounce size. Last fall, when a rival canceled an order for

Pringles potato chips, Dollar Tree bought 2 tons of the products at pennies on the dollar and sold it all in a few weeks. Dollar Tree’s CEO, Sasser, says, "We take things off manufacturers' hands, and everyone's happy” (www.cnn.com). These are examples of how Dollar Tree gets brand name goods at a low cost. This allows them to sell these quality goods at a lower price than other discount stores like Wal-Mart. This gives the suppliers a lower amount of bargaining power since these Discount Retail stores are selling such a high volume. The suppliers need these Discount Retail stores to sell higher volumes of their products.

Value Chain Analysis Competitive Strategies

There are two primary scales on which firms compete. Those are cost leadership and differentiation. The competitive strategy that is utilized by this Discount Variety Industry is cost leadership. The reason for this is that most of the products sold in this industry are considered commodities. The firms in this industry aim to “supply the same product or service [as their competitors] at a lower cost” (Palepu, p. 2-8). The way in which these firms implement the cost leadership strategy is through economies of scale and scope, low-cost distribution, and tight cost control.

Economies of Scale

The Discount Variety industry strives to keep their costs as low as possible. One contributing factor to this is by bulk purchasing. As the firms evolve, they begin to build and maintain strong relationships with their suppliers. Both, supplier and buyer, benefit from these relationships financially. These discount variety stores are signing

long-term contracts with their suppliers. These contracts negotiate future price arrangements which can bare both negative and positive connotations. The negative side is that being locked into these contracts might keep the discount stores from being able to buy items from other suppliers. On the contrary, this legal relationship with a supplier might allow the buyers to reap the benefits of special discounts that they would not otherwise have access to. Since most of these companies experience such high economies of scale when opening up new stores, they begin to expand too much and this can defeat the purpose of these economies of scale. One firm, Dollar General, has recently had to close over 400 stores throughout the country because they just can not sustain themselves in their current markets (“Dollar Stores feel the pinch” 2006).

Low-Cost Distribution

In the past, left over inventories from seasonal merchandise and other similar products have been stored until the next year. Most discount variety entities are now selling those left-over items at clearance prices in order to avoid accumulating excess inventory. Currently, Dollar General is working towards implementing a new inventory management system.

Tight Cost Control

Discount Variety stores have always had tight cost control systems. Cost has always been an important factor in being successful in this line of business. One way that these stores are looking to control costs is by closing their underperforming stores and by upgrading their existing stores. Also, they are looking to improve the customer base of their already existing stores rather than opening new stores. Family Dollar, in particular, has opened over 2000 new stores in the last three years

(www.familydollar.com). Another cost cutting measure discount variety stores are taking advantage of is that of finding the lowest priced rental and lease locations. As previously mentioned, Family Dollar has a Facilities and Energy Management

Little Brand Advertising

Discount Variety Stores are one of only a few markets in the economy that can flourish with little or no advertising. Since these discount variety stores have become such a huge staple of strip and outdoor shopping centers, they are easy for people to recognize and shop at. Most thrive simply by repeat customers; therefore, it is not yet beneficial to spend millions on advertising when people already know of the discounted bargains awaiting them.

Firm Competitive Advantage Analysis

The Future of Dollar Tree

Dollar Tree is continually trying to maintain the same growth rate as the industry as a whole. Because they are expecting to increase the selling per square footage, they are adding actual square footage to their existing stores as well as opening new, larger stores. Dollar Tree is trying to widen their customer base by carrying perishable items. This will allow them to add the title of “grocery store” or “convenient store” to their repertoire. (Dollar Tree 10-K 2006)

Economies of Scale

Since Dollar Tree has an established network of suppliers, the corporation is able to benefit from economies of scale. They are able to achieve their low selling price of $1.00 by buying their products in bulk from the supplier. They also buy wholesale items. The relationships they have developed between Dollar tree and its suppliers are only from their years of doing business together. Despite their history with their

suppliers, Dollar Tree refuses to make any long-term contractual agreements with the suppliers (Dollar Tree 10K 2006). Dollar Tree is also benefiting from economies of scale when it comes to building new stores. As Dollar Tree is able to network with builders throughout the country to establish relationships, the time it takes to construct and supply a new store is considerably lessened. It takes less time, from start to finish, to

open a new store than it used to because they benefit from these economies, and are able to more efficiently duplicate a store that is already established.

Low Cost Distribution

One huge factor as to the means of Dollar Tree’s success is its low cost

distribution methods. The difference between profitability and no profitability for a firm, can mean being able to efficiently distribute its products to its stores. Dollar Tree

implements the automatic replenishment system. This is a big factor in their keeping their distribution costs at a minimum. The automatic replenishment system is utilized among all of the 3,219 stores. It utilizes nine distribution centers throughout the United States. Individual stores manage a computerized selection of inventory and as items are sold they are in real-time added to the stores next shipment. All of these items are sent to the distribution centers from across the globe and disbursed to the thousands of stores by means of the automatic replenishment system. This efficient means of distribution saves time and money and eliminates inventory surpluses and shortages (Dollar Tree 10K 2006).

Tight Cost Control

Dollar Tree’s cost control strategy is attributed to their “successful purchasing strategy, which includes: disciplined, targeted, merchandise margin goals by category.” (Dollar Tree 10K 2006). Dollar Tree purchases only high quality merchandise. By doing this they are able to cut back on avoid mark-downs and clearance items. In an effort to control the cost of each item, Dollar Tree does not allow individual suppliers to have a huge amount of pricing power over them by not purchasing more than 10% of their total yearly inventory from any one company (Dollar Tree 10K 2006).

Accounting Analysis

An accounting analysis is performed to analyze a firm’s accounting practices and to determine if the employed accounting practices reflect the true or attainable

transparent information about the firm. Firms often “window dress” their financial statements to make them look more appealing to investors. Thus, after analyzing, the analyst must decide if the reported financials are believable, or if they must be

rewritten to paint a better picture. During the accounting analysis, many ratios are considered. These ratios aid in better valuing the firm and possibly help in spotting a “potential red flag”. An improper accounting analysis may lead to a distorted value of a firm in comparison to its competitors. Normally, financial analysts follow a set of steps to perform an accounting analysis of a firm. These steps start with first identifying the key accounting policies. Next, the analyst assesses the degree of potential accounting flexibility. After that, they evaluate the actual accounting strategy used by the firm. Then, the analyst evaluates the quality of disclosure, both quantitatively and

qualitatively, which shows the transparency of the firm’s financial statements. After the analyst evaluates the quality of disclosure, they identify all potential “red flags” or inconsistencies in the reporting. This leads the analyst to the final step, where they undo any significant accounting distortions discovered during their analysis of the firm.

Key Accounting Policies

The key success factors are closely related to the key accounting policies deployed by the firm. The key success factors are closely related and usually agree with the key accounting policies. As stated earlier in the Five Forces Model, Dollar Tree’s key success factors includes: economies of scale, low-cost distribution, and tight cost control. Due to the nature of this industry, cost becomes the most important factor

for firms. If a competitor were to get a product at the lowest cost, this would have a direct effect on the profit of the firms.

Net Sales v/s No. of Stores

$160.79 $2,799.87 $3,126.00 $3,393.90 $3,969.40 2002 2003 2004 2005 2006

Year No. Of Stores Net Sales (in millions) 2002 2263 $ 160.79

2003 2513 $ 2,799.87

2004 2735 $ 3,126.00

2005 2914 $ 3,393.90

2006 3219 $ 3,969.40

Economies of Scale e\affect discount retail industry in a different pattern than that of a manufacturing industry. In the case of Dollar Tree, there is a notable increase in revenue with the increase in their retail outlet. According to Dollar Tree’s 2007 10-K, “From 2002 to 2006 net sales increased at a compounding annual growth rate of 14.3%.” This growth results from the opening of new stores, and mergers and acquisitions. A $54.1 million acquisition of 138 Deal$ stores and its inventory was completed in 2006. This shows that Dollar Tree is concerned about its growth and market capitalization. Also, this proves that the firm has been successful in

Disclosure of leases also comes under key accounting policies in this industry. Leases can be disclosed in two forms: capital lease and operating lease. Capital leases have the economic characteristics of an asset and affects the Balance Sheet directly. An operating lease is usually expensed as rent expense in the Income Statement and the future obligation is not reported to the Balance Sheet. In its acquisitions and mergers, Dollar Tree has acquired 21 new leases due to bankruptcy proceedings of other

discount retailers and in 2006 and 2005, they acquired favorable lease rights for operating leases for retail locations from third parties, including the acquired favorable lease rights in its acquisition of 138 Deal$ stores (Dollar Tree 10-K). The leases will expire in 2016, which makes these leases carry a future cash obligation. Dollar Tree also carries some capital leases. According to Dollar Tree 10-K, they amortize their leasehold improvements and to amortize the assets held under capital leases over the estimated useful lives of the respective assets. Firms can also use intangible assets to increase the reported assets. Dollar Tree also uses intangible assets called “Favorable Lease Rights” and “Non-competition agreements” which affects their total reported assets. While these two intangible assets are amortized over their useful life, Goodwill is an intangible asset that is not amortized.

Dollar Tree experiences some risk in the area of foreign currency. Although this risk accounts for less than 1% of purchases in euros, it is still subject to some risk.

As stated earlier in this section, key success factors are closely related and usually agree with the key accounting policies. If they do not match, then an analyst should see it as a “red flag”. Flexibility of GAAP can lead to distortion in the financial statements. Overall, we noticed that Dollar Tree’s financial information is transparent and they provided a fair amount of disclosures about the firm’s position. However, we also noticed that the level of disclosure has decreased in recent years, but the notes to the financial statements provide a good amount of information about the firm.

Potential Accounting Flexibility

SEC (Security & Exchange Commission) regulates the accounting practices of all the firms in United States. GAAP (Generally Accepted Accounting Principles) are utilized by the firms to report their financial statements. Since GAAP allows the firms to be flexible in choosing the method of reporting, it becomes essential for an analyst to analyze the firm’s flexibility in accounting choices to check for any intentional or unintentional distortions. GAAP allows the firm flexibility so that management can disclose the information in a way which provides a better understanding of the firm.

There is one more area of accounting flexibility in the case of inventory in this industry. This flexibility deals with valuation of outdated, damaged, or unwanted

inventory. Dollar Tree has choices in disclosing these activities. They can either choose to impair their inventory or keep the inventory without making any changes.

Impairment would reduce the inventory and increase the expense; thus, it would provide a true understanding of the firm’s asset. On the other hand, if no changes are made the company would be overstating the value of its inventory which would lead to overstatement of their balance sheet.

The second flexibility deals with intangible assets. Dollar Tree reports Goodwill, Non-Competition agreements, and Favorable lease rights as its intangible assets. Also, they have implemented SFAS No. 144 to tackle with impairment and amortization issues (Dollar Tree 10-K). Goodwill is usually impaired upon revaluation by the management at the end of each fiscal year. It becomes the management option to determine the value of impairment. Thus, an unjustified valuation can affect the assets in the balance sheet and the expenses in the income statement. Since, Dollar Tree has a valuable amount of mergers and acquisition, one must be very careful when analyzing the goodwill of the firm, as distortions in goodwill can effect the firm’s total value.

Finally, the big area of flexibility which was noticed is accounting for leases. Dollar Tree has the choice of booking their leases as an operating lease or a capital lease. An operating lease is written off as a rent expense in the income statement. This

means that it does not show the true future cash obligation undertaken by the firm. The second choice is recording the leases, as a capital lease. By capitalizing the leases, the firm discloses the leases as an asset as well as a liability to show the future cash obligation tied up with the lease. The firm can also depreciate the asset as well as amortize any loan taken for the purchase of the lease. Dollar Tree chooses to report these leases as an operating lease; hence, a detailed study is performed in the sections below.

Dollar Tree has cushion when choosing their reporting methods. These choices are all legal and are accepted by the GAAP. As stated earlier, the flexibility in accounting is meant to allow the management to disclose financial statements in a way that the true image of the business can be shown.

Actual Accounting Strategy

Dollar Tree does a fairly good job of disclosing many of its accounting policies that they use for reporting their financial statements. As compared with the standard of conservative accounting practices and the accounting practices of the industry, Dollar Tree is mostly moderate with their accounting standards and with preparation of financial statements. Dollar Tree mostly follows conservative accounting policies, however, they also utilizes aggressive policies in the same areas as the rest of the industry.

All of the companies in the industry use the straight line method of depreciation. This is a standard way of allocating the depreciation expense of the assets over their

Accounting Policy

Strategy Significant Effect to Net Income?

Significant Effect to Balance Sheet?

Operating Leases Aggressive Yes Yes

useful life. This results in a fair and transparent report for the expense account which results in a fair amount for net income on the Income Statement. It should be noted though, that in 2004 Dollar Tree re-estimated the useful life of their assets which resulted in a 4 million dollar increase in net income (Dollar Tree 2006 10-K, Dollar Tree 2004 K, Dollar General 2006 K, Family Dollar 2006 K, 99 Cent Only 2006 10-K).

Capitalization of Operating Leases using a 8% Discount Rate

Year T PMT Beginning Balance Interest Expense Payment PV Factor PV Payment Ending Balance 2007 1 284.2 927.74 74.22 284.20 0.93 263.15 717.76 2008 2 246 717.76 57.42 246.00 0.86 210.91 529.18 2009 3 207.2 529.18 42.33 207.20 0.79 164.48 364.32 2010 4 161.5 364.32 29.15 161.50 0.74 118.71 231.96 2011 5 110.6 231.96 18.56 110.60 0.68 75.27 139.92 2012 6 66.8 139.92 11.19 66.80 0.63 42.10 84.31 2013 7 40.35 84.31 6.74 40.35 0.58 23.54 50.71 2014 8 24.37 50.71 4.06 24.37 0.54 13.17 30.39 2015 9 14.72 30.39 2.43 14.72 0.50 7.36 18.11 2016 10 8.891 18.11 1.45 8.89 0.46 4.12 10.66 2017 11 5.37 10.66 0.85 5.37 0.43 2.30 6.15 2018 12 3.243 6.15 0.49 3.24 0.40 1.29 3.40 2019 13 1.959 3.40 0.27 1.96 0.37 0.72 1.71 2020 14 1.183 1.71 0.14 1.18 0.34 0.40 0.66 2021 15 0.715 0.66 0.05 0.71 0.32 0.23 0

* (Discount Rate calculated from www.pages.stern.nyu.edu)

This table shows our operating lease schedule. The Dollar Tree 10-K discloses these lease payments up to the year 2012. From this year on it discloses that the remaining value of the leases totals 167.5 million. For this value we decreased it back by a percentage matching the decrease in payments from 2007 to 2011. The sum of the payments of 2012 to 2021 equals the 167.5 million disclosed in the 10-K.

One area of accounting that Dollar Tree might be considered to have shown aggressive practices is on the recording of their leases. Dollar Tree holds 3200 retail stores; most of these are in the form of leases. These leases are an off-balance sheet asset. These leases are defined as operating leases which means that no significant disclosure is performed on the balance sheet. However, the lease payments are

expensed as rent expense, which does affect the balance sheet in the retained earnings section. Since these leases are not reported on the Balance Sheet, both assets and liabilities become understated. This accounting strategy allows Dollar Tree to avoid showing $.92 billion in assets and liabilities on the Balance Sheet. This accounting practice is commonly used by all of the other competitors in the industry as well. (Dollar Tree 2006 10-K, Dollar General 2006 10-K, Family Dollar 2006 10-K, 99 Cent Only 2006 10-K).

Another area that Dollar Tree would be considered to have aggressive

accounting policies is its recording of intangible assets. Dollar Tree performs annual tests to determine the value of its goodwill. This gives management of Dollar Tree a direct power over the amount of Goodwill that they impair each year. This is important because if they believe the net income to be lower one year, then they can choose not to impair any goodwill to show a higher net income. Vice-versa, they can also choose to impair the goodwill in the opposite case when they what to save on taxes. The way in which the company records its non-competition agreements with former executives is also aggressive. Instead of treating the agreements as a current asset, they should treat the agreements as an expense because the agreements provide no direct, nor any future benefits to the company. The agreements have already been paid for, and are only an assumption of what would be a future asset. Therefore, it should be expensed. These accounting procedures are definitely aggressive; however, they are not very significant to affect any financial statements as they only represent 7.8% of the firm’s total assets. In comparison with the industry, Dollar Tree does a good job in disclosing its intangible assets, as many of its competitors only list their intangible assets on the Balance Sheet and fail to disclose how they value them. (Dollar Tree 2006 10-K, Dollar General 2006 10-K, Family Dollar 2006 10-K, 99 Cent Only 2006 10-K).

Quality of Disclosure

Qualitative

Dollar Tree has consistently done a good job of disclosing much of their accounting information in their 10-K. They openly talk about their operating leases, goodwill, inventory, and write offs of inventory. It should be noted though that the transparency of their 10-K reporting has declined over the years. For example, they used to list the intangible assets (Non-competition agreements, Favorable Lease Rights, and Goodwill) individually on the balance sheet, but they are now only disclosed as combined intangible assets. A possible reason that they would have gone to this form of accounting policy is to follow the similar reporting procedures as of their competitors in the industry. However, Dollar Tree does disclose most of this information in the notes to the financial statements. A specific example of something being disclosed in the notes is goodwill. Also, it should be noted that Dollar Tree’s managers do have some incentive for altering their financial statements. Dollar Tree provides its managers with stock options; so the better the financial statements look, the higher the stock price is leading to more money money cashed in from these stock options. Also, Dollar Tree is involved in a revolving credit facility where they have a huge credit balance with an outside lender. They must keep certain financial ratios up in order to continue having this credit balance to borrow from. These incentives may also be one of the reasons for the declining amount of transparency in the financial statement because they need the room to alter the statements in order to keep the ratios up.

Quantitative

Quantitative approaches in general vary greatly. Some act as “screening” ratios. Others predict future stock returns. Quantitative approaches play a more important role in security analysis today than they did a decade or two ago. (Palepu 9-5)

the reported revenue and expenses. Quantitative analysis is a useful tool in predicting or measuring different aspects reported in a company’s financial statements.

Revenue diagnostics

Revenue diagnostics include: net sales/cash from sales, net sales/net accounts receivable, net sales/unearned revenues, net sales, warranty liabilities, net

sales/inventory. Notice that in each one of these ratios reported net sales is the numerator. The reason for this is that these ratios determine whether or not the varying denominator entries support the reported sales.

Net sales ratio: (net sales/inventory)

This revenue diagnostic ratio determines the extent to which net sales is supported by inventory. A bigger ratio is better but companies want it to remain constant. A large spike in the net sales ratio would be a red flag. This would indicate that the inventory is not supported by the reported net sales.

Net Sales / Inventory

0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General

This ratio is important in the discount variety industry because when dealing with commodities it is essential to maintain the lowest inventory possible. This will prevent working capital from being clogged up by inventory. Family Dollar, Dollar Tree, and

Dollar General had a steadily increasing ratio. However in 2005, Dollar Tree maintained the highest position. This means that they led the industry in being more efficient with their inventory. Dollar Tree has implemented an inventory management method which allows them to keep an efficient level of inventory. The sudden spike in Dollar Tree’s ratio was due to a sudden drop in sales from 2001 to 2002. In 2003, net sales went back up to the normal range. They do not keep an excess of inventory which would translate into extra warehousing inventory related expenses. 99 Cents Only Store has experienced volatile net sales to inventory ratio. The sudden drop in net sales could be justified due to a shortage of inventory.

Conclusion

The only revenue diagnostic ratio that applies to Dollar Tree is the net sales ratio, because they do not have any accounts receivable, unearned revenue, or warranty liabilities to speak of. Also most other companies in the discount variety industry do not have the above mentioned accounts.

Expense diagnostic ratios

Much like the revenue diagnostic ratios, the purpose of expense diagnostic ratios is to assess the believability of the numbers reported on the financial statements. Expense diagnostic ratios include: Asset Turnover, Changes in CFFO/OI, Changes in CFFO/NOA, Total accruals/Change in sales, Pension expense/SG&A, Other employment expenses/SG&A. The expense ratios tell analysts and investors how well a company manages its expenses.

Asset Turnover: (Net sales/Total Assets)

The asset turnover ratio is computed by dividing net sales by the average of the total assets from the current year and the previous year. This ratio helps to determine if the reported total assets support the reported net sales. A higher asset turnover

means that the firm is very efficient is using its assets. Also, a company with a very high asset turnover tends to have a low profit margin.

(www.beginnersinvest.about.com)

Asset Turnover (Sales/Assets)

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised

Discount variety stores normally operate under operating leases rather than capital leases. A capital lease would normally appear as an asset in the balance sheet when compared to operating leases which are expensed to rent expense in the income statement. The asset turnover ratio tells us how well a company uses its assets to increase its revenue. Dollar General operates more stores than any of its direct

competitors. This explains why their sales are more than the other stores. This tells us that their assets contribute to increasing net sales. Also, it can be seen from this graph that Dollar Tree is catching up with their competitors and one reason for this steady growth in this ratio could be explained by the new mergers and acquisitions which Dollar Tree had in the recent years. Upon revision to Dollar Tree’s books from Capital Lease corrections, our asset turnover ratio declined. This can be attributed to an increase in Total Assets.

Cash Flows From Operations (CFFO): CFFO/NOA

Cash flows from operations are the cash that is generated from operating activities. This is calculated using revenues and expense from the balance sheet.

Expenses are subtracted from the revenues; this yields the number know as Operating Cash flow on the statement of cash flows. Essentially this is the cash that pays a company’s bills. (www.investopedia.com)

Operating assets include things in the line item Plant, Property, and Equipment on the balance sheet. The ratio, CFFO/NOA, shows investors how well PPE are utilized in relation to cash flows. As ratios increase, this indicates the firm is increasing the utilization of its PPE.

CFFO/NOA 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised

Change in CFFO/NOA (0.20) (0.10) 0.00 0.10 0.20 0.30 0.40 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised

By looking at the graphs we can infer that both Dollar Tree and Dollar General allocate their PPE to cash flows well. The steady increase in their CFFO is a reflection

of an increase in cash flow due to the acquisition of new buildings. Once Dollar Tree’s books were revised the CFFO/NOA increased the ratio. The ratio reflects the change in CFFO as a result from the change in Net Income.

Cash Flows From Operations/Operating Income: (CFFO/OI)

CFFO, once again, is the cash that is generated from operating activities and it is found on the balance sheet. Operating income is also known as EBIT, earning before interest and taxes. Operating income is found on the income statement. This can be used to measure and firm’s profitability. CFFO/OI will tell investors if a firm’s reported operating income matches up to their reported cash generated by operating activities.

Change in CFFO/OI (1.20) (1.00) (0.80) (0.60) (0.40) (0.20) 0.00 0.20 0.40 0.60 0.80 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised CFFO/OI 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised

Throughout the past five years the discount variety sectors, CFFO divided by operating income have been relatively steady. However in 2005, 99 Cent Only Stores have experienced a rapid succession of increased CFFO. This could be the result of a low operating income. Revisions to the Dollar Tree books yielded a increase in CFFO from net income and inherently changed the ratio to a higher number.

Total Accruals/Change in Sales:

Accruals are expenses for which invoices have not been received at the end of an accounting period (moneyterms.co). Accruals reported on the financial statements include: accounts payable, accounts receivable, goodwill, future tax liability and future interest expense, among others. Accrual based accounting provides a better, more accurate view of a firm’s financial standing at a given point and time. It allows a company to account for expenses which have not actually been paid and revenue that has not yet been received. These accrued revenues and expenses will take place within a year.

This ratio will help explain if a company does a lot of business in terms of credit. Investors might view a higher number of accounts receivable and accounts payable as a bad thing.

Total Accruals/Change in Sales

-0.80 -0.70 -0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10 2002 2003 2004 2005 2006 Family Dollar Dollar Tree Dollar General 99 Cent Only Store

Through the five year period Dollar Tree has had a decrease in accruals/change in sales. This means that the firm is selling less to customers on credit and making more sales in cash. As compared with the industry, Dollar Tree’s ratio is average. This is a good thing because the nature of the industry requires that most purchases by

customers be made on a cash basis.

Potential “Red Flags”

Part of analyzing financial statements includes the daunting task identifying detrimental information within the companies’ financial statements. The only significant accounting item that can be classified as a “red flag” for Dollar Tree is that of operating leases. According to the company’s 10K, the operating leases are amortized on a straight line basis over the term of these leases. Other possible “red flags” are so

irrelevant that they need not be corrected. Intangibles, like goodwill, have increased by $14.6M in the year 2006. However, this increase can be justified by the 138 Deal$ stores that were acquired during the year. This looks like a potential “red flag”, but it can be justified.

Undo Accounting Distortions

As part of an investors accounting analysis one must be able to take an unbiased and fair look at their financial statements. Unfortunately, for most investors, ulterior motives begin to play a huge part in distorting the financial statements. Managers of the firms sometimes have reasons to tweak these statements to make themselves and their constituents look better, even though it is not the best for the firm. One of the potential “red flags” was that they failed to capitalize their lease expense payments. This resulted in liabilities being understated by $.92 billion on the balance sheet.

Financial Analysis

Performing a ratio analysis is very helpful in charting a company’s performance over time. The analysis yields a benchmark which is a useful tool in comparing

different companies within the same industry. When looking at a set of financial

statements you have the power to “evaluate the financial condition of the company and the results of its operations (Financial Statement Analysis handout). The ratios are divided into three classifications: Liquidity Ratios, Profitability Ratios, and Capital Structure Ratios. Different ratios pull information from different financial statements. This allows for cross-examination of the statements.

Included in the final portion of a ratio analysis is the financial forecasting. A forecast is a prediction of a company’s future performance based on their historical performance. Financial forecasting is done by examining the companies past balance sheets, income statements, and statement of cash flows.

Liquidity Ratios:

Liquidity ratios evaluate how quickly a company can turn their assets into cash in order to meet their current debts. These ratios include: current ratio, quick asset ratio, accounts receivable turnover, inventory turnover, and working capital turnover.

Current Ratio: (current assets/current liabilities)

The current ratio can be used by an investor to assess the ratio of current assets to current liabilities. The presence of a high relation of current assets to current

liabilities would yield a higher ratio than one with a high amount of current liabilities in relation to current assets.