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1QEEconomic Attributes Framework Applied to the Specialty Retailing Apparel Industry. Apply the economic attributes framework discussed in the chapter to the specialty retailing apparel industry, which includes such firms as Gap, Limited Brands, and Abercrombie Fitch. (Hint: Access Gales Business Company Resource Center, Global Business Browser, or Standard Poors Industry Surveys to obtain the needed information.)Identification of Commodity Businesses. A recent article in Fortune magazine listed the following firms among the top ten most admired companies in the United States: Dell, Southwest Airlines, Microsoft, and Johnson Johnson. Access the websites of these four companies or read the Business section of their Form 10-K reports (www.sec.gov). Describe whether you would view their products or services as commodities. Explain your reasoning.Identification of Company Strategies. Refer to the websites and the Form 10-K reports of Home Depot (www.homedepot.com) and Lowes (www.lowes.com). Compare and contrast their business strategies.5QE6QEEffect of Industry Economics on Balance Sheets. Access the investor relations or corporate information section of the websites of American Airlines (www.aa.com), Intel (www.intel.com), and Disney (http://disney.com). Study the business strategies of each firm. Examine the financial ratios below and indicate which firm is likely to be American Airlines, Intel, and Disney. Explain your reasoning.Effect of Business Strategy on Common-Size Income Statements. Access the investor relations or corporate information section of the websites of Apple Computer (www.apple.com) and Dell (www.dell.com). Study the strategies of each firm. Examine the following common-size income statements and indicate which firm is likely to be Apple Computer and which is likely to be Dell. Explain your reasoning. Indicate any percentages that seem inconsistent with their strategies.9QEEffect of Industry Characteristics on Financial Statement Relations. Effective financial statement analysis requires an understanding of a firms economic characteristics. The relations between various financial statement items provide evidence of many of these economic characteristics. Exhibit 1.22 (pages 6061) presents common-size condensed balance sheets and income statements for 12 firms in different industries. These common-size balance sheets and income statements express various items as a percentage of operating revenues. (That is, the statement divides all amounts by operating revenues for the year.) Exhibit 1.22 also shows the ratio of cash flow from operations to capital expenditures. A dash for a particular financial statement item does not necessarily mean the amount is zero. It merely indicates that the amount is not sufficiently large enough for the firm to disclose it. Amounts that are not meaningful are shown as n.m. A list of the 12 companies and a brief description of their activities follow. A. Amazon.com: Operates websites to sell a wide variety of products online. The firm operated at a net loss in all years prior to that reported in Exhibit 1.22. B. Carnival Corporation: Owns and operates cruise ships. C. Cisco Systems: Manufactures and sells computer networking and communications products. D. Citigroup: Offers a wide range of financial services in the commercial banking, insurance, and securities business. Operating expenses represent the compensation of employees. E. eBay: Operates an online trading platform for buyers to purchase and sellers to sell a variety of goods. The firm has grown in part by acquiring other companies to enhance or support its online trading platform. F. Goldman Sachs: Offers brokerage and investment banking services. Operating expenses represent the compensation of employees. G. Johnson Johnson: Develops, manufactures, and sells pharmaceutical products, medical equipment, and branded over-the-counter consumer personal care products. H. Kelloggs: Manufactures and distributes cereal and other food products. The firm acquired other branded food companies in recent years. I. MGM Mirage: Owns and operates hotels, casinos, and golf courses. J. Molson Coors: Manufactures and distributes beer. Molson Coors has made minority ownership investments in other beer manufacturers in recent years. K. Verizon: Maintains a telecommunications network and offers telecommunications services. Operating expenses represent the compensation of employees. Verizon has made minority investments in other cellular and wireless providers. L. Yum! Brands: Operates chains of name-brand restaurants, including Taco Bell, KFC, and Pizza Hut. REQUIRED Use the ratios to match the companies in Exhibit 1.22 with the firms listed above.Effect of Industry Characteristics on Financial Statement Relations. Effective financial statement analysis requires an understanding of a firms economic characteristics. The relations between various financial statement items provide evidence of many of these economic characteristics. Exhibit 1.23 (pages 6263) presents common-size condensed balance sheets and income statements for 12 firms in different industries. These common-size balance sheets and income statements express various items as a percentage of operating revenues. (That is, the statement divides all amounts by operating revenues for the year.) Exhibit 1.23 also shows the ratio of cash flow from operations to capital expenditures. A dash for a particular financial statement item does not necessarily mean the amount is zero. It merely indicates that the amount is not sufficiently large for the firm to disclose it. A list of the 12 companies and a brief description of their activities follow. A. Abercrombie Fitch: Sells retail apparel primarily through stores to the fashionconscious young adult and has established itself as a trendy, popular player in the specialty retailing apparel industry. B. Allstate Insurance: Sells property and casualty insurance, primarily on buildings and automobiles. Operating revenues include insurance premiums from customers and revenues earned from investments made with cash received from customers before Allstate pays customers claims. Operating expenses include amounts actually paid or expected to be paid in the future on insurance coverage outstanding during the year. C. Best Buy: Operates a chain of retail stores selling consumer electronic and entertainment equipment at competitively low prices. D. E. I. du Pont de Nemours: Manufactures chemical and electronics products. E. Hewlett-Packard: Develops, manufactures, and sells computer hardware. The firm outsources manufacturing of many of its computer components. F. HSBC Finance: Lends money to consumers for periods ranging from several months to several years. Operating expenses include provisions for estimated uncollectible loans (bad debts expense). G. Kelly Services: Provides temporary office services to businesses and other firms. Operating revenues represent amounts billed to customers for temporary help services, and operating expenses include amounts paid to the temporary help employees of Kelly. H. McDonalds: Operates fast-food restaurants worldwide. A large percentage of McDonalds restaurants are owned and operated by franchisees. McDonalds frequently owns the restaurant buildings of franchisees and leases them to franchisees under long-term leases. I. Merck: A leading research-driven pharmaceutical products and services company. Merck discovers, develops, manufactures, and markets a broad range of products to improve human and animal health directly and through its joint ventures. J. Omnicom Group: Creates advertising copy for clients and is the largest marketing services firm in the world. Omnicom purchases advertising time and space from various media and sells it to clients. Operating revenues represent commissions and fees earned by creating advertising copy and selling media time and space. Operating expenses includes employee compensation. K. Pacific Gas Electric: Generates and sells power to customers in the western United States. L. Procter Gamble: Manufactures and markets a broad line of branded consumer products. REQUIRED Use the ratios to match the companies in Exhibit 1.23 with the firms listed above.Effect of Industry Characteristics on Financial Statement Relations: A Global Perspective. Effective financial statement analysis requires an understanding of a firms economic characteristics. The relations between various financial statement items provide evidence of many of these economic characteristics. Exhibit 1.24 (pages 6667) presents common-size condensed balance sheets and income statements for 12 firms in different industries. These common-size balance sheets and income statements express various items as a percentage of operating revenues. (That is, the statement divides all amounts by operating revenues for the year.) A dash for a particular financial statement item does not necessarily mean the amount is zero. It merely indicates that the amount is not sufficiently large for the firm to disclose it. A list of the 12 companies, the country of their headquarters, and a brief description of their activities follow. A. Accor (France): Worlds largest hotel group, operating hotels under the names of Sofitel, Novotel, Motel 6, and others. Accor has grown in recent years by acquiring established hotel chains. B. Carrefour (France): Operates grocery supermarkets and hypermarkets in Europe, Latin America, and Asia. C. Deutsche Telekom (Germany): Europes largest provider of wired and wireless telecommunication services. The telecommunications industry has experienced increased deregulation in recent years. D. E.ON AG (Germany): One of the major public utility companies in Europe and the worlds largest privately owned energy service provider. E. Fortis (Netherlands): Offers insurance and banking services. Operating revenues include insurance premiums received, investment income, and interest revenue on loans. Operating expenses include amounts actually paid or amounts it expects to pay in the future on insurance coverage outstanding during the year. F. Interpublic Group (U.S.): Creates advertising copy for clients. Interpublic purchases advertising time and space from various media and sells it to clients. Operating revenues represent the commissions or fees earned for creating advertising copy and selling media time and space. Operating expenses include employee compensation. G. Marks Spencer (U.K.): Operates department stores in England and other retail stores in Europe and the United States. Offers its own credit card for customers purchases. H. Nestl (Switzerland): Worlds largest food processor, offering prepared foods, coffees, milk-based products, and mineral waters. I. Roche Holding (Switzerland): Creates, manufactures, and distributes a wide variety of prescription drugs. J. Sumitomo Metal (Japan): Manufacturer and seller of steel sheets and plates and other construction materials. K. Sun Microsystems (U.S.): Designs, manufactures, and sells workstations and servers used to maintain integrated computer networks. Sun outsources the manufacture of many of its computer components. L. Toyota Motor (Japan): Manufactures automobiles and offers financing services to its customers. REQUIRED Use the ratios to match the companies in Exhibit 1.24 with the firms listed above.Value Chain Analysis and Financial Statement Relations. Exhibit 1.25 (page 68) presents common-size income statements and balance sheets for seven firms that operate at various stages in the value chain for the pharmaceutical industry. These common-size statements express all amounts as a percentage of sales revenue. Exhibit 1.25 also shows the cash flow from operations to capital expenditures ratios for each firm. A dash for a particular financial statement item does not necessarily mean the amount is zero. It merely indicates that the amount is not sufficiently large for the firm to disclose it. A list of the seven companies and a brief description of their activities follow. A. Wyeth: Engages in the development, manufacture, and sale of ethical drugs (that is, drugs requiring a prescription). Wyeths drugs represent primarily mixtures of chemical compounds. Ethical-drug companies must obtain approval of new drugs from the U.S. Food and Drug Administration (FDA). Patents protect such drugs from competition until other drug companies develop more effective substitutes or the patent expires. B. Amgen: Engages in the development, manufacture, and sale of drugs based on biotechnology research. Biotechnology drugs must obtain approval from the FDA and enjoy patent protection similar to that for chemical-based drugs. The biotechnology segment is less mature than the ethical-drug industry, with relatively few products having received FDA approval. C. Mylan Laboratories: Engages in the development, manufacture, and sale of generic drugs. Generic drugs have the same chemical compositions as drugs that had previously benefited from patent protection but for which the patent has expired. Generic-drug companies have benefited in recent years from the patent expiration of several major ethical drugs. However, the major ethical-drug companies have increasingly offered generic versions of their ethical drugs to compete against the generic-drug companies. D. Johnson Johnson: Engages in the development, manufacture, and sale of over-thecounter health care products. Such products do not require a prescription and often benefit from brand recognition. E. Covance: Offers product development and laboratory testing services for biotechnology and pharmaceutical drugs. It also offers commercialization services and market access services. Cost of goods sold for this company represents the salaries of personnel conducting the laboratory testing and drug approval services. F. Cardinal Health: Distributes drugs as a wholesaler to drugstores, hospitals, and mass erchandisers. Also offers pharmaceutical benefit management services in which it provides customized databases designed to help customers order more efficiently, contain costs, and monitor their purchases. Cost of goods sold for Cardinal Health includes the cost of drugs sold plus the salaries of personnel providing pharmaceutical benefit management services. G. Walgreens: Operates a chain of drugstores nationwide. The data in Exhibit 1.25 for Walgreens include the recognition of operating lease commitments for retail space. REQUIRED Use the ratios to match the companies in Exhibit 1.25 with the firms listed above.Starbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonalds had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Apply Porters five forces framework to the specialty coffee retail industry.Starbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. How would you characterize the strategy of Starbucks? How does Starbucks create value for its customers? What critical risk and success factors must Starbucks manage?1CIC1DICStarbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Accounts receivable are reported net of allowance for uncollectible accounts. Why? Identify the events or transactions that cause accounts receivable to increases and decrease. Also identify the events or transactions that cause the allowance account to increase and decrease.1FICStarbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Deferred income taxes appear as a current asset on the balance sheet. Under what circumstances will deferred income taxes give rise to an asset?Starbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Accumulated other comprehensive income includes unrealized gains and losses from marketable securities and investments in securities as well as unrealized gains and losses from translating the financial statements of foreign subsidiaries into U.S. dollars. Why are these gains and losses not included in net income on the income statement? When, if ever, will these gains and losses appear in net income?Starbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Starbucks reports three principal sources of revenues: (1) company-operated stores, (2) licensing, and (3) foodservice and other consumer products. Using the narrative information provided in this case, describe the nature of each of these three sources of revenue.1JICStarbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Starbucks reports income from equity investees on its income statement. Using the narrative information provided in this case, describe the nature of this type of income.Starbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Why does net income differ from the amount of cash flow from operating activities?1MICStarbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Why does Starbucks show an increase in inventory as a subtraction when computing cash flow from operations?1OICStarbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Starbucks includes short-term investments in current assets on the balance sheet, yet it reports purchases and sales of investment securities as investing activities on the statement of cash flows. Explain why changes in investment securities are investing activities while changes in most other current assets (such as accounts receivable and inventories) are operating activities.Starbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. Starbucks includes changes in short-term borrowings as a financing activity on the statement of cash flows. Explain why changes in short-term borrowings are a financing activity when most other changes in current liabilities (such as accounts payable and other current liabilities) are operating activities.1RIC1SICStarbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffee-blended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Star-bucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9,775 billion from 10,383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Star-bucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, reinvigorating the Star-bucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Star-bucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 9.5% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but closed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to reach customers where they work, travel, shop, and dine. To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Star-bucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012. Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonald's had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Diedrich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafs system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 40 to a low of under 8 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 42 and 62 per share, and was currently trading at 50 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 1.79), an earnings multiple that is well above the industry average. Kim further discovered that the capital markets and analysts have mixed opinions on the SBUX stock value. Kim found one-year-ahead price targets from 24 analysts, ranging from a low of 49 to a high of 65, with a mean (median) price target of 59 (60). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 2.15 for fiscal 2013 and 2.62 for fiscal 2014. Financial Statements Exhibit 126 presents comparative balance sheets. Exhibit 1.27 presents comparative income statements, and Exhibit 1.28 (pages 7677) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. The dollar amount shown for cash and cash equivalents (see Exhibit 1.26) increased between the end of fiscal 2011 and the end of fiscal 2012, yet the percentage of total assets comprising these assets declined (see Exhibit 1.29). Explain.1UICStarbucks The first case at the end of this chapter and numerous subsequent chapters is a series of integrative cases involving Starbucks. The series of cases applies the concepts and analytical tools discussed in each chapter to Starbucks financial statements and notes. The preparation of responses to the questions in these cases results in an integrated illustration of the six sequential steps in financial statement analysis discussed in this chapter and throughout the book. Introduction They dont just sell coffee; they sell the Starbucks Experience, remarked Deb Mills while sitting down to enjoy a cup of Starbucks cappuccino with her friend Kim Shannon. Kim, an investment fund manager for a large insurance firm, reflected on that observation and what it might mean for Starbucks as a potential investment opportunity. Glancing around the store, Kim saw a number of people sitting alone or in groups, lingering over their drinks while chatting, reading, or checking e-mail and surfing the Internet through the stores wi-fi network. Kim noted that in addition to the wide selection of hot coffees, French and Italian style espressos, teas, and cold coffeeblended drinks, Starbucks also offered food items and baked goods, packages of roasted coffee beans, coffee-related accessories and equipment, and even its own line of CDs. Intrigued, Kim made a mental note to do a full financial statement and valuation analysis of Starbucks to evaluate whether its business model and common equity shares were as good as their coffee. Growth Strategy Kims research quickly confirmed her friends observation that Starbucks is about the experience of enjoying a good cup of coffee. The Starbucks 2012 Form 10-K (page 3) asserts the following: Our retail objective is to be the leading retailer and brand of coffee in each of our target markets by selling the finest quality coffee and related products, and by providing each customer a unique Starbucks Experience. The Starbucks Experience is built upon superior customer service as well as clean and well-maintained company operated stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. The Starbucks experience strives to create a third placesomewhere besides home and work where a customer can feel comfortable and welcomethrough friendly and skilled customer service in clean and personable retail store environments. This approach enabled Starbucks to grow rapidly from just a single store near Pikes Place Market in Seattle to a global company with 18,066 locations worldwide at the end of fiscal 2012. Of that total, Starbucks owned and operated 9,405 stores (7,857 stores in the Americas; 882 stores in the Europe, Middle East Africa (EMEA) region; and 666 stores in the China and Asia Pacific (CAP) region). In addition, licensees owned and operated a total of 8,661 stores (5,046 stores in the Americas; 987 stores in the EMEA region; and 2,628 stores in the CAP region). Most of Starbucks stores at the end of fiscal 2012 were located in the United States, amounting to one Starbucks retail location for every 28,000 U.S. residents. However, Starbucks was clearly not a company content to focus simply on the U.S. market, as it was extending the reach of its stores globally, with thousands of stores outside the United States. At the end of fiscal 2012, Starbucks owned and operated stores in a number of countries around the world, including 878 stores in Canada, 593 stores in the United Kingdom, and 408 stores in China. Starbucks success can be attributed in part to its successful development and expansion of a European ideaenjoying a fine coffee-based beverage and sharing that experience with others in a comfortable, friendly environment with pleasant, competent service. Starbucks imported the idea of the French and Italian caf into the busy North American lifestyle. Ironically, Starbucks successfully extended its brand and style of a caf into the European continent. On January 16, 2004, Starbucks opened its first coffeehouse in Francein the heart of Paris at 26 Avenue de IOperaand had a total of 67 stores in France by the end of 2012. The success of Starbucks retail coffeehouse concept is illustrated by the fact that by the end of 2012, Starbucks had opened over 1,100 company-operated and licensed locations in Europe, with the majority of them in the United Kingdom. Not long ago, Starbucks CEO Howard Schultz stated that his vision and ultimate goal for Starbucks was to have 20,000 Starbucks retail locations in the United States, to have another 20,000 retail locations in international markets worldwide, and to have Starbucks recognized among the worlds leading brands. Kim Shannon wondered whether Starbucks could ultimately achieve that level of global penetration because she could name only a few such worldwide companies. Among those that came to mind were McDonalds, with more than 34,000 retail locations in 118 countries; Subway, with more than 34,000 locations in 90 countries; and Yum! Brands, with more than 40,000 restaurants in 130 countries under brand names such as KFC, Pizza Hut, and Taco Bell. Growth in the number of retail stores had been one of the primary drivers of Starbucks growth in revenues. The most significant area of expansion of the Starbucks model in recent years has been the rapid growth in the number of licensed retail stores. At the end of fiscal 1999, Starbucks had only 363 licensed stores, but by the end of fiscal 2012, the number of licensed stores had mushroomed to 8,661. Recent Performance Performance in recent years caused Kim to question whether Starbucks had already reached (or perhaps exceeded) its full potential. She wondered whether it could generate the impressive growth in new stores and revenues that it had created in the past. In fiscal year 2008, Starbucks opened 1,669 net new retail locations (698 net new company-owned stores and 971 new licensed stores), but this number was well below the initial target of 2,500 new stores and well below the 2,571 new stores opened in 2007. Late in 2008, Starbucks announced a plan to close approximately 600 underperforming stores in the United States as well as 64 underperforming stores in Australia. The store closings triggered restructuring charges that reduced Starbucks operating income by 266.9 million in 2008. During fiscal 2009, they increased the restructuring plan to close a total of approximately 800 U.S. stores (an increase of 200), and managed to close 566 U.S. stores during the year. They also announced a plan to close 100 stores in various international markets. The 2009 store closings triggered additional restructuring charges that reduced Starbucks operating income by 332.4 million in 2009. In 2009, for the first time in company history, Starbucks net store growth was negative, with a net of 474 stores closed in the United States (92 stores opened net of 566 closed) and only 89 net new international stores opened (130 stores opened net of 41 closed), for a net total closure of 385 company operated stores. In fiscal 2009, total revenues fell to 9.775 billion from 10.383 billion in fiscal 2008. Fiscal 2009 marked the first year of revenue decline (5.9%) in company history. Prior to 2009, Starbucks had generated impressive revenue growth rates of 10.3% in fiscal 2008; 20.9% growth in fiscal 2007; and 22.2% in fiscal 2006. Starbucks revenue growth is not just driven by opening new stores; it is also driven by sales growth among existing stores. Through 2007, Starbucks could boast of a streak of 16 consecutive years in which it achieved comparable store sales growth rates equal to or greater than 5%, but that string was broken with negative 3% comparable store sales growth in 2008. Unfortunately, things got worse in 2009, because Starbucks company-operated stores generated a negative 6% growth in comparable U.S. store sales, a negative 2% growth in comparable international store sales, and a negative 6% growth in comparable store sales overall. In response to the downturn in Starbucks business, in January, 2009, Howard Schultz returned from retirement and reassumed his role as president and CEO of Starbucks in order to restructure the business and its potential for growth. Focal points of his transformation plan included taking a more disciplined approach to new store openings, re invigorating the Starbucks Experience, developing and implementing even better service and quality, while cutting operating and overhead costs. In addition, the transformation plans included introducing more new beverage and food offerings, such as baked goods, breakfast items and chilled and other foods. A key to Starbucks profit growth lies in increasing same store sales growth via new products. Starbucks regularly introduces new specialty coffee-based drinks and coffee flavors, as well as iced coffee-based drinks, such as the very successful line of Frappuccino drinks and Shaken Iced Refreshment drinks. Under Schultzs renewed leadership, comparable store sales growth rebounded impressively, to 7% growth among U.S. stores and 6% among international stores. Starbucks store openings were very conservative in 2010, owing in part to the difficult economic conditions in the primary markets. In the United States, Starbucks only opened a net 3 new stores in 2010opening 60 licensed stores while closing 57 company-owned stores. Internationally, Starbucks opened 220 new stores in 2010opening 235 licensed stores while closing 15 company-owned stores. Overall revenue growth also rebounded, reaching 10.7 billion (up 95% from 2009). Starbucks continued this modest new store growth trajectory into 2011. Among company-owned stores, Starbucks opened 49 but closed 51 in the United States and opened 180 but dosed 36 international stores. Starbucks licensees opened 345 new stores internationally and 133 new stores in the United States. Unfortunately, because Borders Bookstores went bankrupt in 2011, it closed the 475 Starbucks stores that it had licensed. This caused a net negative growth of 342 licensee closings in 2011 in the United States. Overall revenue again sustained healthy growth, with total revenues reaching 11.7 billion (up 9.3% from 2010). Kim was even more encouraged with Starbucks growth in fiscal 2012. During that period, Starbucks opened a total of 1,063 new stores. Of those, Starbucks opened 234 company-owned and 270 licensed stores in the Americas. In the EMEA region, Starbucks opened 10 company-owned and 101 licensed stores, as well as 154 company-owned and 294 licensed stores in the CAP region. Overall revenue reached 13.3 billion (up 14% from 2011). Starbucks also continues to expand the scope of its business model through new channel development in order to "reach customers where they work, travel, shop, and dine." To further expand the business model, Starbucks terminated its licensing and distribution agreement with Kraft Foods and now manages its own marketing and distribution of Starbucks whole bean and ground coffee to grocery stores and warehouse club stores. By the end of fiscal 2012, Starbucks whole bean and ground coffees were available throughout the United States in approximately 39,000 grocery and warehouse club stores. Further, Starbucks sells whole bean and ground coffee through institutional foodservice companies that service business, education, office, hotel, restaurant, airline, and other foodservice accounts. For example, in 2012 Starbucks (and their subsidiary, Seattles Best Coffee) were the only superpremium national brand coffees promoted by Sysco Corporation to such foodservice accounts. Finally, Starbucks had formed partnerships to produce and distribute bottled Frappuccino and DoubleShot drinks with PepsiCo and premium ice creams with Unilever. Despite Starbucks past difficulties with store closings, restructuring charges, and negative comparable store sales growth rates, Kim could see some very positive aspects of Starbucks financial performance and condition. She noted that Starbucks had been profitable in 2008 and 2009, despite the difficulties. She also noted that Starbucks generated record high profits in 2010, 2011, and 2012, suggesting the restructuring and turnaround efforts were proving successful. The restructuring plan was seemingly complete and had helped Starbucks to reduce costs. Further, she noted that Starbucks operating cash flows had remained fairly strong throughout this period. With its positive operating cash flows, Starbucks had retired all of the 713 million in commercial paper and short-term borrowings during 2009, initiated the first dividend in company history in 2010, resumed repurchasing common shares in 2010, and had grown the combined balances in cash and short-term investments over 2.0 billion by fiscal year-end 2012 Product Supply Starbucks purchases green coffee beans from coffee-producing regions around the world and custom roasts and blends them to its exacting standards. Although coffee beans trade in commodity markets and experience volatile prices, Starbucks purchases higher-quality coffee beans that sell at a premium to commodity coffees. Starbucks purchases its coffee beans under fixed-price purchase contracts with various suppliers, with purchase prices reset annually. Starbucks also purchases significant amounts of dairy products from suppliers located near its retail stores. Starbucks purchases paper and plastic products from several suppliers, the prices of which vary with changes in the prices of commodity paper and plastic resin. Competition in the Specialty Coffee Industry After some reflection, Kim realized that Starbucks faced intense direct competition. Kim could think of a wide array of convenient retail locations where a person can purchase a cup of coffee. Kim reasoned that Starbucks competes with a broad scope of coffee beverage retailers, including fast-food chains (for example, McDonalds), doughnut chains (for example, Krispy Kreme, Dunkin Donuts, and Tim Hortons), and convenience stores associated with many gas stations, but that these types of outlets offer an experience that is very different from what Starbucks offers. In particular, Kim was aware that McDonalds had started to expand development of its McCaf shops, which sold premium coffee drinks (lattes, cappuccinos, and mochas) in McDonalds restaurants. It appeared to Kim that the McCaf initiative was intended to be a direct competitive challenge to Starbucks business. Kim also identified a number of companies that were growing chains of retail coffee shops that could be compared to Starbucks, including firms such as Panera Bread Company; Die-drich Coffee; New World Restaurant Group, Inc.; and Caribou Coffee Company, Inc. (a privately held firm). However, these firms were much smaller than Starbucks, with the largest among them being the Panera Bread Company, with approximately 1,700 bakery-cafes system-wide at the end of 2012. On the other end of the spectrum, Kim was aware that Starbucks faced competition from local independent coffee shops and cafs. Kim recognized that despite facing extensive competition, Starbucks had some distinct competitive advantages. Very few companies were implementing a business strategy comparable to that of Starbucks, with emphasis on the quality of the experience, the products, and the service. In addition, only the fast-food chains and the doughnut chains operated on the same scale as Starbucks. Finally, Starbucks had developed a global brand that was synonymous with the quality of the Starbucks experience. Recently, Interbrand ranked the Starbucks brand as one of the worlds top 100 most valuable brand names, estimating it to be worth in excess of 4 billion. The Valuation Controversy In beginning to research Starbucks share price (ticker: SBUX), Kim realized that it had experienced a wild ride over the past five years, following a very similar pattern to Starbucks earnings performance during that time. Starbucks had been one of the hottest companies in the capital market, in large part due to Its impressive growth in sales and earnings, up until December of 2006. SBUXs share price had appreciated dramatically, generating cumulative returns that far exceeded those of the SP 500 over that period. The market for Starbucks shares cooled beginning in early 2007, with share prices falling from a high of nearly 540 to a low of under 58 in November of 2008. Since that low point, Starbucks share price began a dramatic recovery. Over the calendar year 2012, SBUX stock price ranged between 542 and 562 per share, and was currently trading at 550 per share, implying a PE ratio of over 28 (based on trailing 12 months earnings per share of 51.79), an earnings multiple that is well above the industry average. Kim further discovered thatw the capital markets and analysts have mixed opinions on the SBUX stock value Kim found one-year-a head price targets from 24 analysts, ranging from a low of 549 to a high of 565, with a mean (median) price target of 559 (560). She found that 30 analysts issued investment recommendations for SBUX: eleven recommend strong buy, ten recommend buy, nine recommend hold, and no analysts recommend sell. The consensus analysts earnings per share forecasts are 52.15 for fiscal 2013 and 52.62 for fiscal 2014. Financial Statements Exhibit 1.26 presents comparative balance sheets, Exhibit 1.27 presents comparative income statements, and Exhibit 128 (pages 76-77) presents comparative statements of cash flows for Starbucks for the four fiscal years ending September 30, 2012. How has the revenue mix of Starbucks changed from 2009 to 2012? Relate these changes to Starbucks business strategy.1WIC2AICNike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain.Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Nike reports property, plant, and equipment on its balance sheet and discloses the amount of depreciation for each year in its statement of cash flows. Why doesnt depreciation expense appear among its expenses on the income statement?Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Identify the portion of Nikes income tax expense of 469.8 million for 2009 that is currently payable to governmental entities and the portion that is deferred to future years. Why is the amount currently payable to governmental entities in 2009 greater than the income tax expense?Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Why do accounts receivable appear net of allowance for doubtful accounts? Identify the events or transactions that cause the allowance account to increase or decrease.2FIC2GIC2HIC2IIC2JIC2KICNike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Why does Nike subtract deferred income taxes from net income when calculating cash flow from operations for 2009?Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Why does Nike subtract increases in accounts receivable to net income when calculating cash flow from operations for 2009?2NIC2OIC2PIC2QICNike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Compute the amount of cash collected from customers during 2009.Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Compute the amount of cash payments made to suppliers of merchandise during 2009.2TICNike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Identify the reasons for the change in retained earnings during 2009.2VIC2WICNike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. What are the likely reasons for the increase in the selling and administrative expenses to sales percentages between 2007 and 2009?2YICNike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. What are the likely reasons for the increase in the selling and administrative expenses to sales percentages between 2007 and 2009? What is the likely explanation for the relatively small percentages for notes payable and long-term debt?2AAICNike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. Refer to the statement of cash flows for Nike in Exhibit 133. Cash flow from operations exceeded net income during all three years. Why?Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. How has Nike primarily financed its acquisitions of property, plant, and equipment during the three years?Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. What are the likely reasons for the repurchases of common stock during the three years?Nike: Somewhere between a Swoosh and a Slam Dunk Nike, Inc.s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel. This case uses Nikes financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements. Industry Economics Product Lines Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nikes dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running). Growth There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear). Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear. The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nikes footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market. Production Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars. Marketing Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory. Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing. Financing Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities. Nike Strategy Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the companys philosophy and driving force behind its success as follows: Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, must-have products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences. To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products. Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its Futures ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nikes risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nikes products. Nike sources all of its footwear and approximately 95% of its apparel from other countries. The following exhibits present information for Nike: Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009 Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009 Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009 Exhibit 1.34: Excerpts from the notes to Nikes financial statements Exhibit 1.35: Common-size and percentage change income statements Exhibit 1.36: Common-size and percentage change balance sheets Identify the time at which Nike recognizes revenues. Does this timing of revenue recognition seem appropriate? Explain. REQUIRED Study the financial statements and notes for Nike and respond to the following questions. The dividends paid by Nike increased each year (343.7 million in 2007, 412.9 million in 2008, and 466.7 million in 2009). Given that Nike repurchased its stock each year, what is the likely explanation for the increasing amount of dividends?1QEAsset Valuation and Income Recognition. Asset valuation and recognition of net income closely relate. Explain, including conditions when they do not.Trade-Offs among Acceptable Accounting Alternatives. Firms value inventory under a variety of assumptions, including two common methods: last-in first-out (LIFO) and first-in first-out (FIFO). Ignore taxes, assume that prices increase over time, and assume that a firms inventory balance is stable or grows over time. Which inventory method provides a balance sheet that better reflects the underlying economics, and why? Which method provides an income statement that better reflects the underlying economics, and why?Income Flows versus Cash Flows. The text states, Over sufficiently long time periods, net income equals cash inflows minus cash outflows, other than cash flows with owners. Demonstrate the accuracy of this statement in the following scenario: Two friends contributed 50,000 each to form a new business. The owners used the amounts contributed to purchase a machine for 100,000 cash. They estimated that the useful life of the machine was five years and the salvage value was 20,000. They rented out the machine to a customer for an annual rental of 25,000 a year for five years. Annual cash operating costs for insurance, taxes, and other items totaled 6,000 annually. At the end of the fifth year, the owners sold the equipment for 22,000, instead of the 20,000 salvage value initially estimated. (Hint: Compute the total net income and the total cash flows other than cash flows with owners for the five-year period as a whole.)5QE6QE7QE8QEComputation of Income Tax Expense. A firms income tax return shows 50,000 of income taxes owed for 2009. For financial reporting, the firm reports deferred tax assets of 42,900 at the beginning of 2009 and 38,700 at the end of 2009. It reports deferred tax liabilities of 28,600 at the beginning of 2009 and 34,200 at the end of 2009. a. Compute the amount of income tax expense for 2009. b. Assume for this part that the firms deferred tax assets are as stated above for 2009 but that its deferred tax liabilities were 58,600 at the beginning of 2009 and 47,100 at the end of 2009. Compute the amount of income tax expense for 2009. c. Explain contextually why income tax expense is higher than taxes owed in Part a and lower than taxes owed in Part b.Computation of Income Tax Expense. A firms income tax return shows income taxes for 2009 of 35,000. The firm reports deferred tax assets before any valuation allowance of 24,600 at the beginning of 2009 and 27,200 at the end of 2009. It reports deferred tax liabilities of 18,900 at the beginning of 2009 and 16,300 at the end of 2009. a. Assume for this part that the valuation allowance on the deferred tax assets totaled 6,400 at the beginning of 2009 and 7,200 at the end of 2009. Compute the amount of income tax expense for 2009. b. Assume for this part that the valuation allowance on the deferred tax assets totaled 6,400 at the beginning of 2009 and 4,800 at the end of 2009. Compute the amount of income tax expense for 2009.Costs to Be Included in Historical Cost Valuation. At a cost of 200,000, Assume In-N-Out Burger acquired a tract of land for a restaurant site. It paid attorneys 7,500 to conduct a title search and to prepare the required legal documents for the purchase. State real estate transfer taxes totaled 2,500. Building permits totaled 1,200. Compute the acquisition cost of the land.Effect of Valuation Method for Nonmonetary Asset on Balance Sheet and Income Statement. Assume Walmart acquires a tract of land on January 1, 2009, for 100,000 cash. On December 31, 2009, the current market value of the land is 150,000. On December 31, 2010, the current market value of the land is 120,000. The firm sells the land on December 31, 2011, for 180,000 cash. REQUIRED Ignore income taxes. Indicate the effect on the balance sheet and income statement of the preceding information for 2009, 2010, and 2011 under each of the following valuation methods (Parts ac). a. Valuation of the land at acquisition cost until sale of the land (Approach 1) b. Valuation of the land at current market value but including unrealized gains and losses in accumulated other comprehensive income until sale of the land (Approach 2) c. Valuation of the land at current market value and including market value changes each year in net income (Approach 3) d. Why is retained earnings on December 31, 2011, equal to 80,000 in all three cases despite the reporting of different amounts of net income each year?13PC14PC15PCDeferred Tax Assets. Components of the deferred tax asset of Biosante Pharmaceuticals, Inc., are shown in Exhibit 2.14. The company had no deferred tax liabilities. REQUIRED a. At the end of 2008, the largest deferred tax asset is for net operating loss carryforwards. (Net operating loss carryforwards [also referred to as tax loss carryforwards] are amounts reported as taxable losses on tax filings. Because the tax authorities generally do not pay corporations for incurring losses, companies are allowed to carry forward taxable losses to future years to offset taxable income. These future tax benefits give rise to deferred tax assets.) As of the end of 2008, what is the dollar amount of the companys net operating loss carryforwards? What is the dollar amount of the deferred tax asset for the net operating loss carryforwards? Describe how these two amounts are related. b. Biosante has gross deferred tax assets of 28,946,363. However, the net deferred tax assets balance is zero. Explain. c. The valuation allowance for the deferred tax asset increased from 21,818,084 to 28,946,363 between 2007 and 2008. How did this change affect the company's net income?Interpreting Income Tax Disclosures. The financial statements of ABC Corporation, a retail chain, reveal the information for income taxes shown in Exhibit 2.15. REQUIRED a. Assuming that ABC had no significant permanent differences between book income and taxable income, did income before taxes for financial reporting exceed or fall short of taxable income for 2013? Explain. b. Did income before taxes for financial reporting exceed or fall short of taxable income for 2014? Explain. c. Will the adjustment to net income for deferred taxes to compute cash flow from operations in the statement of cash flows result in an addition or a subtraction for 2013? For 2014? d. ABC does not contract with an insurance agency for property and liability insurance; instead, it self-insures. ABC recognizes an expense and a liability each year for financial reporting to reflect its average expected long-term property and liability losses. When it experiences an actual loss, it charges that loss against the liability. The income tax law permits self-insured firms to deduct such losses only in the year sustained. Why are deferred taxes related to self-insurance disclosed as a deferred tax asset instead of a deferred tax liability? Suggest reasons for the direction of the change in amounts for this deferred tax asset between 2012 and 2014. e. ABC treats certain storage and other inventory costs as expenses in the year incurred for financial reporting but must include these in Inventory for tax reporting. Why are deferred taxes related to inventory disclosed as a deferred tax asset? Suggest reasons for the direction of the change in amounts for this deferred tax asset between 2012 and 2014. f. Firms must recognize expenses related to postretirement health care and pension obligations as employees provide services, but claim an income tax deduction only when they make cash payments under the benefit plan. Why are deferred taxes related to health care obligation disclosed as a deferred tax asset? Why are deferred taxes related to pensions disclosed as a deferred tax liability? Suggest reasons for the direction of the change in amounts for these deferred tax items between 2012 and 2014. g. Firms must recognize expenses related to uncollectible accounts when they recognize sales revenues, but claim an income tax deduction when they deem a particular customers accounts uncollectible. Why are deferred taxes related to this item disclosed as a deferred tax asset? Suggest reasons for the direction of the change in amounts for this deferred tax asset between 2012 and 2014. h. ABC uses the straight-line depreciation method for financial reporting and accelerated depredation methods for income tax purposes. Why are deferred taxes related to depreciation disclosed as a deferred tax liability? Suggest reasons for the direction of the change in amounts for this deferred tax liability between 2012 and 2014.Interpreting Income Tax Disclosures. Prepaid Legal Services (PPD) is a company that sells insurance for legal expenses. Customers pay premiums in advance for coverage ever some specified period. Thus, PPD obtains cash but has unearned revenue until the passage of time over the specified period of coverage. Also, the company pays various costs to acquire customers (such as sales materials, commissions, and prepayments to legal firms who provide services to customers). These upfront payments are expensed over the specified period that customers contracts span. Exhibit 2.16 provides information from PPDs income tax note. REQUIRED a. Assuming that PPD had no significant permanent differences between book income and taxable income, did income before taxes for financial reporting exceed or fall short of taxable income for 2007? For 2008? Explain. b. Will the adjustment to net income for deferred taxes to compute cash flow from operations in the statement of cash flows result in an addition or a subtraction for 2007? For 2008? c. PPD must report as taxable income premiums collected from customers, although the company defers recognizing them as income for financial reporting purposes until they are earned over the contract period. Why are deferred taxes related to deferred revenue disclosed as a deferred tax asset instead of a deferred tax liability? Suggest reasons for the direction of the change in amounts for this deferred tax asset between 2007 and 2008. d. Firms are generally allowed to deduct cash costs on their tax returns, although they might defer some of these costs for financial reporting purposes. As noted above, PPD defers various costs associated with obtaining customers. Why are deferred taxes related to this item disclosed as a deferred tax liability? Suggest reasons for the direction of the change in amounts for this deferred tax asset between 2007 and 2008. e. Like most companies, PPD uses the straight-line depreciation method for financial reporting and accelerated depredation methods for income tax purposes. Why are deferred taxes related to depredation disclosed as a deferred tax liability? Suggest reasons for the direction of the change in amounts for this deferred tax liability between 2007 and 2008. f. Based only on the selected disclosures from the income tax footnote provided in Exhibit 2.16 and your responses to Parts d and e above, do you believe that PPD reported growing or declining revenue and profitability in 2008 relative to 2007? Explain.Interpreting Income Tax Disclosures. The financial statements of Nike, Inc., reveal the information regarding income taxes shown in Exhibit 2.17. REQUIRED a. Assuming that Nike had no significant permanent differences between book income and taxable income, did income before taxes for financial reporting exceed or fall short of taxable income for 2007? Explain. b. Did book income before taxes for financial reporting exceed or fall short of taxable income for 2008? Explain. c. Will the adjustment to net income for deferred taxes to compute cash flow from operations in the statement of cash flows result in an addition or a subtraction for 2008? d. Nike recognizes provisions for sales returns and doubtful accounts each year in computing income for financial reporting. Nike cannot claim an income tax deduction for these returns and doubtful accounts until customers return goods or accounts receivable become uncollectible. Why do the deferred taxes for returns and doubtful accounts appear as deferred tax assets instead of deferred tax liabilities? Suggest possible reasons why the deferred tax asset for sales returns and doubtful accounts increased between 2007 and 2008. e. Nike recognizes an expense related to deferred compensation as employees render services but cannot claim an income tax deduction until it pays cash to a retirement fund. Why do the deferred taxes for deferred compensation appear as a deferred tax asset? Suggest possible reasons why the deferred tax asset increased between 2007 and 2008. f. Nike states that it recognizes a valuation allowance on deferred tax assets related to foreign loss carryforwards because the benefits of some of these losses will expire before the firm realizes the benefits. Why might the valuation allowance have decreased slightly between 2007 and 2008? g. Nike reports a large deferred tax liability for Intangibles. In another footnote, Nike states, During the fourth quarter ended May 31, 2008 the Company completed the acquisition of Umbro Plc (Umbro). As a result, 378.4 million was allocated to unamortized trademarks, 319.2 million was allocated to goodwill and 41.1 million was allocated to other amortized intangible assets consisting of Umbros sourcing network, established customer relationships and the United Soccer League Franchise. Why would Nike report a deferred tax liability associated with this increase in intangible assets on the balance sheet? h. Nike recognizes its share of the earnings of foreign subsidiaries each year for financial reporting but recognizes income from these investments for income tax reporting only when it receives a dividend. Why do the deferred taxes related to these investments appear as a deferred tax liability? i. Why does Nike recognize both deferred tax assets and deferred tax liabilities related to investments in foreign operations?Analyzing Transactions. Using the analytical framework, indicate the effect of the following related transactions of a firm. a. January 1: Issued 10,000 shares of common stock for 50,000. b. January 1: Acquired a building costing 35,000, paying 5,000 in cash and borrowing the remainder from a bank. c. During the year: Acquired inventory costing 40,000 on account from various suppliers. d. During the year: Sold inventory costing 30,000 for 65,000 on account. e. During the year: Paid employees 15,000 as compensation for services rendered during the year. f. During the year: Collected 45,000 from customers related to sales on account. g. During the year: Paid merchandise suppliers 28,000 related to purchases on account. h. December 31: Recognized depreciation on the building of 7,000 for financial reporting. Depreciation expense for income tax purposes was 10,000. i. December 31: Recognized compensation for services rendered during the last week in December but not paid by year-end of 4,000. j. December 31: Recognized and paid interest on the bank loan in Part b of 2,400 for the year. k. Recognized income taxes on the net effect of the preceding transactions at an income tax rate of 40%. Assume that the firm pays cash immediately for any taxes currently due to the government.21PCStarbucks The financial statements of Starbucks Corporation are presented in Exhibits 1.261.28 (see pages 7477). The income tax note to those financial statements reveals the information regarding income taxes shown in Exhibit 2.18. REQUIRED Assuming that Starbucks had no significant permanent differences between book income and taxable income, did income before taxes for financial reporting exceed or fall short of taxable income for 2012? Explain.1BIC1CIC1DIC1EIC1FICStarbucks The financial statements of Starbucks Corporation are presented in Exhibits 1.26-1.28 (see pages 74-77). The income tax note to those financial statements reveals the information regarding income taxes shown in Exhibit 2.18. REQUIRED Starbucks uses the straight-line depreciation method for financial reporting and accelerated depreciation for income tax reporting. Like most firms, the largest deferred tax liability is for property, plant, and equipment (depreciation). Explain how depreciation leads to a deferred tax liability. Suggest possible reasons why the amount of the deferred tax liability related to depreciation increased between 2011 and 2012.Need for a Statement of Cash Flows. The accrual basis of accounting creates the need for a statement of cash flows. Explain.Articulation of the Statement of Cash Flows with Other Financial Statements. Describe how the statement of cash flows is linked to each of the other financial statements (income statement and balance sheet). Also review how the other financial statements are linked with each other.Classification of Interest Expense. Under U.S. GAAP, the statement of cash flows classifies cash expenditures for interest expense as an operating activity but classifies cash expenditures to redeem debt as a financing activity. Explain this apparent paradox.4QEClassification of Changes in Short-Term Financing. The statement of cash flows classifies changes in accounts payable as an operating activity but classifies changes in short-term borrowing as a financing activity. Explain this apparent paradox.Classification of Cash Flows Related to Share-Based Compensation. One reason companies use stock options to compensate employees is to conserve cash. Under current tax law, companies get to deduct compensation when the employees actually exercise options. Explain how the cash flow savings from stock option exercises affect the statement of cash flows.Treatment of Non-Cash Exchanges. The acquisition of equipment by assuming a mortgage is a transaction that firms cannot report in their statement of cash flows but must report in a supplemental schedule or note. Of what value is information about this type of transaction? What is the reason for its exclusion from the statement of cash flows?Computing Cash Collections from Customers. Caterpillar manufactures heavy machinery and equipment and provides financing for purchases by its customers. Caterpillar reported sales and interest revenues of 51,324 million for Year 1. The balance sheet showed current and noncurrent receivables of 15,752 million at the beginning of Year 1 and 18,448 million at the end of Year 1. Compute the amount of cash collected from customers during Year 1.Computing Cash Payments to Suppliers. Lowes Companies, a retailer of home improvement products, reported cost of goods sold of 31,729 million for Year 1. It reported merchandise inventories of 7,611 million at the beginning of Year 1 and 8,209 million at the end of Year 1. It reported accounts payable to suppliers of 3,713 million at the beginning of fiscal Year 1 and 4,109 million at the end of fiscal Year 1. Compute the amount of cash paid to merchandise suppliers during Year 1.Computing Cash Payments for Income Taxes. Visa Inc., a credit card company, reported income tax expense of 1,648 million for Year 1, comprising 1,346 million of current taxes and 302 million of deferred taxes. The balance sheet showed income taxes payable of 122 million at the beginning of Year 1 and 327 million at the end of Year 1. Commute the amount of income taxes paid in cash during Year 1.Interpreting the Relation between Net Income and Cash Flow from Operations. Combined data for three years for two firms follows (in millions). One of these firms is Amazon.com, a rapidly growing Internet retailer, and the other is Kroger, a retail grocery store chain growing at approximately the same rate as the population. Identify each firm and explain your reasoning.Interpreting the Relation between Net Income and Cash Flow from Operations. Three years of combined data for two firms follows (in millions). The two firms experienced similar growth rates in revenues during the three-year period. One of these firms is Accenture Ltd., a management consulting firm, and the other is Southwest Airlines, a provider of airline transportation services. Identify each firm and explain your reasoning.Interpreting Relations among Cash Flows from Operating, Investing, and Financing Activities. Three years of combined data for two firms follows (in millions). One of these firms is FedEx, a relatively high-growth firm that provides courier services, and the other is Kellogg Company, a more mature consumer foods processor. Identify each firmand explain your reasoning.Interpreting Relations among Cash Flows from Operating, Investing, and Financing Activities. Three years of combined data for two firms follows (in millions). One of these firms is eBay, an online retailer with a three-year growth in sales of 337.3%, and the other is TJX Companies, Inc., a specialty retail store with a three-year growth in sales of39.3%. Identify each firm and explain your reasoning.Interpreting the Statement of Cash Flows. The Coca-Cola Company (Coca-Cola), like PepsiCo, manufactures and markets a variety of beverages. Exhibit 3.18 presents a statement of cash flows for Coca-Cola for three years. REQUIRED Discuss the relations between net income and cash flow from operations and among cash flows from operating, investing, and financing activities for the firm over the three-yearperiod. Identify characteristics of Coca-Cola's cash flows that you would expect for a maturecompany.Interpreting the Statement of Cash Flows. Texas Instruments primarily develops and manufactures semiconductors for use in technology-based products for various industries. The manufacturing process is capital-intensive and subject to cyclical swings in the economy. Because of overcapacity in the industry and a cutback on spending for technologyproducts due to a recession, semiconductor prices collapsed in Year 1 and commenced a steadycomeback during Years 2 through 4. Exhibit 3.19 presents a statement of cash flows for Texas Instruments for Year 0 to Year 4. REQUIRED Discuss the relations between net income and cash flows from operations and among cash flows from operating, investing, and financing activities for the firm over the five-year period.Interpreting the Statement of Cash Flows. Tesla Motors manufactures high performance electric vehicles that are extremely slick looking. Exhibit 3.20 presents the statement of cash flows for Tesla Motors for 20102012. REQUIRED Discuss the relations among net income, cash flows from operations, cash flows from investing activities, and cash flows from financing activities for the firm over the three-year period. Describe what stage of life cycle these relations suggest for Tesla Motors. Why are negative operating cash flows less than the net losses? Where is Tesla obtaining cash, and what are theydoing with it? What do you think will happen with cash flows in 2013?Interpreting the Statement of Cash Flows. Gap Inc. operates chains of retail clothing stores under the names of Gap, Banana Republic, and Old Navy. Exhibit 3.21 presents the statement of cash flows for Gap for Year 0 to Year 4. REQUIRED Discuss the relations between net income and cash flow from operations and among cash flows from operating, investing, and financing activities for the firm over the five-year period.19PC20PCInterpreting the Statement of Cash Flows. Montgomery Ward operates a retail department store chain. It filed for bankruptcy during the first quarter of Year 12. Exhibit 3.24 presents a statement of cash flows for Montgomery Ward for Year 7 to Year 11. The firm acquired Lechmere, a discount retailer of sporting goods and electronic products, during Year 9. It acquired Amoco Enterprises, an automobile club, during Year 11. During Year 10, it issued a new series of preferred stock and used part of the cash proceeds to repurchase a series of outstanding preferred stock. The other subtractions in the operating section for Year 10 and Year 11 represent reversals of deferred tax liabilities. REQUIRED Discuss the relations between net income and cash flow from operations and among cash flows from operating, investing, and financing activities for the firm over the five-year period. Identify signals of Montgomery Ward's difficulties that might have led to its filing for bankruptcy.Extracting Performance Trends from the Statement of Cash Flows. The Apollo Group is one of the largest providers of private education, and runs numerous programs and services, including the University of Phoenix. Exhibit 3.25 provides the statement of cash flows for 2012. REQUIRED Discuss the relations between net income and cash flow from operations and among cash flows from operating, investing, and financing activities for the firm, especially for 2012. Identify signals that might raise concerns for an analyst.Interpreting a Direct Method Statement of Cash Flows. Aer Lingus is an international airline based in Ireland. Exhibit 3.26 provides the statement of cash flows for Year 1 and Year 2, which includes a footnote from the financial statements. Year 2 was characterized by weakening consumer demand for air travel due to a recession and record high fuel prices. In addition, Year 2 includes exceptional items totaling 141 million, which reflect a staff restructuring program for early retirement (118 million), takeover defense costs due to a bid by Ryanair (18 million), and other costs (5 million). REQUIRED a. Based on information in the statement of cash flows, compare and contrast the cash flows for Years 1 and 2. Explain significant differences in individual reconciling items and direct cash flows. b. The format of Aer Lingus statement of cash flows is the direct method, as evidenced by the straightforward titles used in the operating section. How is this statement different from the presentation that Aer Lingus would report using the indirect method?24PCPreparing a Statement of Cash Flows from Balance Sheets and Income Statements. Nojiri Pharmaceutical Industries develops, manufactures, and markets pharmaceutical products in Japan. The Japanese economy experienced recessionary conditions in recent years. In response to these conditions, the Japanese government increased the proportion of medical costs that is the patients responsibility and lowered the prices for prescription drugs. Exhibits 3.28 and 3.29 present the firms balance sheets and income statements for Years 1 through 4. REQUIRED a. Prepare a worksheet for the preparation of a statement of cash flows for Nojiri Pharmaceutical Industries for each of the years ending March 31, Year 2 to Year 4. Follow the format of Exhibit 3.14 in the text. Notes to the financial statements indicate the following: (1) The changes in Accumulated Other Comprehensive Income relate to revaluations of Investments in Securities to market value. The remaining changes in Investments in Securities result from purchases and sales. Assume that the sales occurred at no gain or loss. (2) No sales of property, plant, and equipment took place during the three-year period. (3) The changes in Other Noncurrent Assets are investing activities. (4) The changes in Employee Retirement Benefits relate to provisions made for retirement benefits net of payments made to retired employees, both of which the statement of cash flows classifies as operating activities. (5) The changes in Other Noncurrent Liabilities are financing activities. b. Prepare a comparative statement of cash flows for Year 2, Year 3, and Year 4. c. Discuss the relations among net income and cash flow from operations and the pattern of cash flows from operating, investing, and financing transactions for Year 2, Year 3, and Year 4.26PCPreparing a Statement of Cash Flows from Balance Sheets and Income Statements. BTB Electronics Inc. manufactures parts, components, and processing equipment for electronics and semiconductor applications in the communications, computer, automotive, and appliance industries. Its sales tend to vary with changes in the business cycle because the sales of most of its customers are cyclical. Exhibit 3.32 presents balance sheets for BTB as of December 31, Year 7 through Year 9, and Exhibit 3.33 presents income statements for Year 8 and Year 9. REQUIRED a. Prepare a worksheet for the preparation of a statement of cash flows for BTB Electronics Inc for Years 8 and 9. Follow the format of Exhibit 3.14 in the text. Notes to the firms financial statements reveal the following (amounts in thousands): (1) Depreciation expense was 641 in Year 8 and 625 in Year 9. No fixed assets were sold during these years. (2) Other Assets represents patents. Patent amortization was 25 in Year 8 and 40 in Year 9. BTB sold a patent during Year 9 at no gain or loss. (3) Changes in Deferred Income Taxes are operating activities. b. Discuss the relations among net income and cash flow from operations and the pattern of cash flows from operating, investing, and financing activities.1AIC1BIC1CIC1DIC1EIC1FIC1GIC1HIC2AIC2BIC2CIC2DIC2EIC2FIC3ICCommon-Size Analysis. Common-size analysis is a simple way to make financial statements of different firms comparable. What are possible shortcomings of comparing two different firms using common-size analysis?Earnings per Share. Firm A reports an increase in earnings per share; Firm B reports a decrease in earnings per share. Is this unconditionally informative about each firms performance? If not, why is earnings per share so commonly discussed in the financial press?3QEProfit Margin for ROA versus ROCE. Describe the difference between the profit margin for ROA and the profit margin for ROCE. Explain why each profit margin is appropriate for measuring the rate of ROA and the rate of ROCE, respectively.Concept and Measurement of Financial Leverage. Define financial leverage. Explain how financial leverage works to the benefit of the common shareholders.Advantages of Financial Leverage. A company president remarked, The operations of our company are such that we can take advantage of only a minor amount of financial leverage. Explain the likely reasoning the company president had in mind to support this statement.7QE8QE9QENucor, a steel manufacturer, reported net income for 2008 of 1,831 million on sales of 23,663 million. Interest expense for 2008 was 135 million, and noncontrolling interest was 314 million for 2008. The income tax rate is 35%. Total assets were 9,826 million at the beginning of 2008 and 13,874 million at the end of 2008. Compute the rate of ROA for 2008 and disaggregate ROA into profit margin for ROA and asset turnover components.Phillips-Van Heusen, an apparel manufacturer, reported net income (amounts in thousands) for Year 4 of 58,615 on sales of 1,460,235. It declared preferred dividends of 21,122. Preferred shareholders equity totaled 264,746 at both the beginning and end of Year 4. Common shareholders equity totaled 296,157 at the beginning of Year 4 and 364,026 at the end of Year 4. Phillips-Van Heusen had no noncontrolling interest in its equity. Total assets were 1,439,283 at the beginning of Year 4 and 1,549,582 at the end of Year 4. Compute the rate of ROCE for Year 4 and disaggregate it into profit margin for ROCE, assets turnover, and capital structure leverage ratio components.TJX, Inc., an apparel retailer, reported net income (amounts in thousands) of 609,699 for Year 4. The weighted average of common shares outstanding during Year 4 was 488,809 shares. TJX, Inc., subtracted interest expense net of tax saving on convertible debt of 4,482. If the convertible debt had been converted into common stock, it would have increased the weighted-average common shares outstanding by 16,905 shares. TJX, Inc., has outstanding stock options that, if exercised, would increase the weighted average of common shares outstanding by 6,935 shares. Compute basic and diluted earnings per share for Year 4, showing supporting computations.Boston Scientific, a medical device manufacturer, reported net income (amounts in millions) of 1,062 on sales of 5,624 during Year 4. Interest expense totaled 64. The income tax rate was 35%. Average total assets were 6,934.5, and average common shareholders equity was 3,443.5. The firm did not have preferred stock outstanding or noncontrolling interest in its equity. a. Compute the rate of ROA. Disaggregate ROA into profit margin for ROA and assets turnover components. b. Compute the rate of ROCE. Disaggregate ROCE into profit margin for ROCE, assets turnover, and capital structure leverage ratio components. c. Calculate the amount of net income to common shareholders derived from the excess return on creditors capital and the amount from the return on common shareholders capital.Valero Energy, a petroleum company, reported net income of 1,803.8 on revenues of 54,618.6 for Year 4. Interest expense totaled 359.7, and preferred dividends totaled 12.5. Average total assets for Year 4 were 17,527.9. The income tax rate is 35%. Average preferred shareholders equity totaled 204.3, and average common shareholders equity totaled 6,562.3. All amounts are in millions. a. Compute the rate of ROA. Disaggregate ROA into profit margin for ROA and assets turnover components. b. Compute the rate of ROCE. Disaggregate ROCE into profit margin for ROCE, assets turnover, and capital leverage ratio components. c. Calculate the amount of net income to common shareholders derived from the excess return on creditors capital, the excess return on preferred shareholders capital, and the return on common shareholders capital.Exhibit 4.22 presents selected operating data for three retailers for a recent year. Macys operates several department store chains selling consumer products such as brand-name clothing, china, cosmetics, and bedding and has a large presence in the bridal and formalwear markets (under store names Macys and Bloomingdales). Home Depot sells a wide range of building materials and home improvement products, which includes lumber and tools, riding lawn mowers, lighting fixtures, and kitchen cabinets and appliances. Supervalu operates grocery stores under numerous brands (including Albertsons, Cub Foods, Jewel-Osco, Shaws, and Star Market). Exhibit 4.22 REQUIRED a. Compute the rate of ROA for each firm. Disaggregate the rate of ROA into profit margin for ROA and assets turnover components. Assume that the income tax rate is 35% for all companies. b. Based on your knowledge of the three retail stores and their respective industry concentrations, describe the likely reasons for the differences in the profit margins for ROA and assets turnovers.Microsoft Corporation (Microsoft) and Oracle Corporation (Oracle) engage in the design, manufacture, and sale of computer software. Microsoft sells and licenses a wide range of systems and application software to businesses, computer hardware manufacturers, and consumer retailers. Oracle sells software for information management almost exclusively to businesses. Exhibit 4.23 presents selected data for the two firms for three recent years. Exhibit 4.23 REQUIRED a. Calculate the accounts receivable turnover ratio for Microsoft and Oracle for Year 1, Year 2, and Year 3. b. Suggest possible reasons for the differences in the accounts receivable turnovers of Microsoft and Oracle during the three-year period. c. Suggest possible reasons for the changes in the accounts receivable turnover for the two firms over the three-year period.17PC18PCTexas Instruments (TI) designs and manufactures semiconductor products for use in computers, telecommunications equipment, automobiles, and other electronics-based products. The manufacturing of semiconductors is highly capital-intensive. Hewlett-Packard Corporation (HP) manufactures computer hardware and various imaging products, such as printers and fax machines. Exhibit 4.26 presents selected data for TI and HP for three recent years. Exhibit 4.25 Exhibit 4.26 REQUIRED a. Compute the fixed assets turnover for each firm for Years 1, 2, and 3. b. Suggest reasons for the differences in the fixed assets turnovers of TI and HP. c. Suggest reasons for the changes in the fixed assets turnovers of TI and HP during the three-year period.JCPenney operates a chain of retail department stores, selling apparel, shoes, jewelry, and home furnishings. It also offers most of its products through catalog distribution. During fiscal Year 5, it sold Eckerd Drugs, a chain of retail drugstores, and used the cash proceeds, in part, to repurchase shares of its common stock. Exhibit 4.27 presents selected data for JCPenney for fiscal Year 3, Year 4, and Year 5. REQUIRED a. Calculate the rate of ROA for fiscal Year 3, Year 4, and Year 5. Disaggregate ROA into the profit margin for ROA and total assets turnover components. The income tax rate is 35%. b. Calculate the rate of ROCE for fiscal Year 3, Year 4, and Year 5. Disaggregate ROCE into the profit margin for ROCE, assets turnover, and capital structure leverage components. c. Suggest reasons for the changes in ROCE over the three years. d. Compute the ratio of ROCE to ROA for each year. e. Calculate the amount of net income available to common stockholders derived from the use of financial leverage with respect to creditors capital, the amount derived from the use of preferred shareholders capital, and the amount derived from common shareholders capital for each year. f. Did financial leverage work to the advantage of the common shareholders in each of the three years? Explain. Exhibit 4.2721PCSelected data for General Mills for 2007, 2008, and 2009 appear below (amounts in millions). REQUIRED a. Compute the rate of ROCE for 2007, 2008, and 2009. b. Compute basic EPS for 2007, 2008, and 2009. c. Interpret the changes in ROCE versus EPS over the three-year period.23PCHasbro is a leading firm in the toy, game, and amusement industry. Its promoted brands group includes products from Playskool, Tonka, Milton Bradley, Parker Brothers, Tiger, and Wizards of the Coast. Sales of toys and games are highly variable from year to year depending on whether the latest products meet consumer interests. Hasbro also faces increasing competition from electronic and online games. Hasbro develops and promotes its core brands and manufactures and distributes products created by others under license arrangements. Hasbro pays a royalty to the creator of such products. In recent years, Hasbro has attempted to reduce its reliance on license arrangements, placing more emphasis on its core brands. Hasbro also has embarked on a strategy of reducing fixed selling and administrative costs in an effort to offset the negative effects on earnings of highly variable sales. Exhibit 4.30 presents the balance sheets for Hasbro for the years ended December 31, Years 1 through 4. Exhibit 4.31 presents the income statements and Exhibit 4.32 presents the statements of cash flows for Years 2 through 4. Exhibit 4.30 Exhibit 4.31 Exhibit 4.32 REQUIRED a. Exhibit 4.33 presents profitability ratios for Hasbro for Year 2 and Year 3. Calculate each of these financial ratios for Year 4. The income tax rate is 35%. b. Analyze the changes in ROA and its components for Hasbro over the three-year period, suggesting reasons for the changes observed. c. Analyze the changes in ROCE and its components for Hasbro over the three-year period, suggesting reasons for the changes observed. Exhibit 4.33Fitch sells casual apparel and personal care products for men, women, and children through retail stores located primarily in shopping malls. Its fiscal year ends January 31 of each year. Financial statements for Abercrombie Fitch for fiscal years ending January 31, Year 3, Year 4, and Year 5 appear in Exhibit 4.34 (balance sheets), Exhibit 4.35 (income statements), and Exhibit 4.36 (statements of cash flows). These financial statements reflect the capitalization of operating leases in property, plant, and equipment and long-term debt, a topic discussed in Chapter 6. Exhibit 4.37 (page 312) presents financial statement ratios for Abercrombie Fitch for Years 3 and 4. Selected data for Abercrombie Fitch appear here. Exhibit 4.34 REQUIRED a. Calculate the ratios in Exhibit 4.37 for Year 5. The income tax rate is 35%. b. Analyze the changes in ROA for Abercrombie Fitch during the three-year period, suggesting possible reasons for the changes observed. c. Analyze the changes in ROCE for Abercrombie Fitch during the three-year period, suggesting possible reasons for the changes observed. Exhibit 4.35 Exhibit 4.36 Exhibit 4.3726PCStarwood Hotels (Starwood) owns and operates many hotel properties under well-known brand names, including Sheraton, W, Westin, and St. Regis. Starwood focuses on the upper end of the lodging industry. Choice Hotels (Choice) is primarily a franchisor of several hotel chains, including Comfort Inn, Sleep Inn, Clarion, EconoLodge, and Rodeway Inn. Choice properties represent primarily the midscale and economy segments of the lodging industry. Exhibit 4.39 (page 315) presents selected profitability ratios and other data for Starwood, and Exhibit 4.40 (page 315) presents data for Choice. (Note that ROCE is not meaningful for Choice because of negative common shareholders equity due to open market share repurchases, not accumulated deficits. As of the end of 2008, Choice had repurchased over one-third of all common shares issued: 34,640,510 out of 95,345,362 shares.) One of the closely followed metrics in the lodging industry is occupancy rate, which gives an indication of the capacity utilization of available hotel rooms. A second measure is the ADR (average daily rate), which measures the amount actually collected for an average room per night. Finally, REVPAR (revenue per available room) also is an important measure, which measures periodto-period growth in revenues per room for comparable properties (adjusted for properties sold or closed or otherwise not comparable across years). The interaction of occupancy rate and ADR is REVPAR. Exhibit 4.39 Exhibit 4.40 REQUIRED Analyze the changes and the differences in the profitability of these two hotel chains to the deepest levels available given the data provided. Compare and contrast the ROAs and ROCEs of both companies. Do the results match your prior expectations given the type of lodging for which each company specializes?Select data for Avis and Hertz for 2012 follow. Based only on this information and ratios that you construct, speculate on similarities and differences in the operations and financing decisions of the two companies based on similarities and differences in the ratios.29PCIntegrative Case 1.1 introduced the industry economics of coffee shops and the business strategy of Starbucks to compete in this industry. Exhibit 1.26 presents balance sheets for Starbucks for the years ending 20092012. Exhibit 1.27 presents its income statements and Exhibit 1.28 presents the statement of cash flows for the same years. Exhibit 1.29 presents common-size balance sheets and Exhibit 1.30 presents common-size income statements for Starbucks. Before beginning preparation of Integrative Case 4.1, we recommend that you review Integrative Case 1.1 in Chapter 1. Part A of Integrative Case 4.1 analyzes changes in the profitability of Starbucks. REQUIRED a. Exhibit 4.43 presents profitability ratios for Starbucks for fiscals 2010 and 2011. Using the financial statement data in Exhibits 1.26 and 1.27, compute the values of these ratios for fiscal 2012. The income tax rate is 35%. For accounts receivable turnover, use only specialty revenues for the numerator, because the accounts receivable are primarily related to licensing and food service operations, not the retail operations. Use cost of sales, including occupancy costs, for the numerator of the inventory turnover, because Starbucks does not disclose separately the cost of products sold (the appropriate numerator) and occupancy costs. b. What are the most important reasons for Starbucks ROA fluctuation during the three-year period? Analyze the financial ratios to the maximum depth possible with the information given. Using the nomenclature from the schematic in Exhibit 4.21 (page 298), Exhibit 4.44 (page 320) provides information for analyzing profitability at Level 1, Level 2, and Level 3. Exhibit 4.44 presents additional information for Starbucks at a business segment level to permit analysis at Level 4. Differences between the sum of segment expenses and total expenses reflect corporate-level expenses not allocated to the individual segments. Additionally, if necessary, access Starbucks annual report or form 10-K, which you should be able to access at the companys investor relations website. c. What are the most important reasons for Starbucks ROCE fluctuation during the three-year period? Exhibit 4.431ABIC1ACIC1BAIC1BBIC2AAIC2ABIC2ACIC2ADICWalmart and Carrefour follow similar strategies. Walmart consistently outperforms Carrefour on ROA. Using information in Exhibits 4.53 and 4.56, suggest reasons for these differences in operating profitability.Walmart and Carrefour follow similar strategies. Walmart consistently outperforms Carrefour on ROA. Using information in Exhibits 4.53 and 4.56, suggest reasons for these differences in operating profitability.2BCIC2BDIC2BEIC1QE2QEA firm has experienced an increasing current ratio but a decreasing operating cash flow to current liabilities ratio during the last three years. What is the likely explanation for these results?A firm has experienced a decrease in its current ratio but an increase in its quick ratio during the last three years. What is the likely explanation for these results?5QEA firm had the following values for the four debt ratios discussed in the chapter: Liabilities to Assets Ratio: less than 1.0 Liabilities to Shareholders Equity Ratio: equal to 1.0 Long-Term Debt to Long-Term Capital Ratio: less than 1.0 Long-Term Debt to Shareholders Equity Ratio: less than 1.0 a. Indicate whether each of the following independent transactions increases, decreases, or has no effect on each of the four debt ratios. (1) The firm issued long-term debt for cash. (2) The firm issued short-term debt and used the cash proceeds to redeem long-term debt (treat as a unified transaction). (3) The firm redeemed short-term debt with cash. (4) The firm issued long-term debt and used the cash proceeds to repurchase shares of its common stock (treat as a unified transaction). b. The text states that analysts need not compute all four debt ratios each year because the debt ratios are highly correlated. Does your analysis in Requirement a support this statement? Explain.7QE8QE9QE10QEMarket equity beta measures the covariability of a firms returns with all shares traded on the market (in excess of the risk-free interest rate). We refer to the degree of covariability as systematic risk. The market prices securities so that the expected returns should compensate the investor for the systematic risk of a particular stock. Stocks carrying a market equity beta of 1.20 should generate a higher return than stocks carrying a market equity beta of 0.90. Nonsystematic risk is any source of risk that does not affect the covariability of a firms returns with the market. Some writers refer to nonsystematic risk as firm-specific risk. Why is the characterization of nonsystematic risk as firm-specific risk a misnomer?Altmans bankruptcy risk model utilizes the values of the variables at a particular point in time (balance sheet variables) or for a period of time (income statement values). An alternative would be to use changes in balance sheet or income statement amounts. Why might the levels of values in Altmans model be more appropriate than changes for predicting bankruptcy?Calculating and Interpreting Risk Ratios. Refer to the financial statement data for Hasbro in Problem 4.24 in Chapter 4. Exhibit 5.15 presents risk ratios for Hasbro for Year 2 and Year 3. Exhibit 5.15 REQUIRED a. Calculate the amounts of these ratios for Year 4. b. Assess the changes in the short-term liquidity risk of Hasbro between Year 2 and Year 4 and the level of that risk at the end of Year 4. c. Assess the changes in the long-term solvency risk of Hasbro between Year 2 and Year 4 and the level of that risk at the end of Year 4.Refer to the financial state-ment data for Abercrombie Fitch in Problem 4.25 in Chapter 4. Exhibit 5.16 presents risk ratios for Abercrombie Fitch for fiscal Year 3 and Year 4. Exhibit 5.16 REQUIRED a. Compute the amounts of these ratios for fiscal Year 5. b. Assess the changes in the short-term liquidity risk of Abercrombie Fitch between fiscal Year 3 and fiscal Year 5 and the level of that risk at the end of fiscal Year 5. c. Assess the changes in the long-term solvency risk of Abercrombie Fitch between fiscal Year 3 and fiscal Year 5 and the level of that risk at the end of fiscal Year 5.Refer to the profitability ratios of Coca-Cola in Problem 4.26 in Chapter 4. Exhibit 5.17 presents risk ratios for Coca-Cola for 20062008. As we did within the chapter for PepsiCo, we utilize Coca-Colas footnote disclosures to extract the amount of trade accounts payable included within the line item accounts payable and accrued expenses. Exhibit 5.17 REQUIRED a. Assess the changes in the short-term liquidity risk of Coca-Cola between 2006 and 2008. b. Assess the changes in the long-term solvency risk of Coca-Cola between 2006 and 2008. c. Compare the short-term liquidity ratios of Coca-Cola with those of PepsiCo discussed in the chapter. Which firm appears to have more short-term liquidity risk? Explain. d. Compare the long-term solvency ratios of Coca-Cola with those of PepsiCo discussed in the chapter. Which firm appears to have more long-term solvency risk? Explain.Delta Air Lines, Inc., is one of the largest airlines in the United States. It has operated on the verge of bankruptcy for several years. Exhibit 5.18 presents selected financial data for Delta Air Lines for each of the five years ending December 31, 2000, to December 31, 2004. Delta Air Lines filed for bankruptcy on September 14, 2005. We recommend that you create an Excel spreadsheet to compute the values of the ratios and the Altmans Z-score in Requirements a and b, respectively. REQUIRED a. Compute the value of each the following risk ratios. (1) Current ratio (at the end of 20002004) (2) Operating cash flow to current liabilities ratio (for 20012004) (3) Liabilities to assets ratio (at the end of 20002004) (4) Long-term debt to long-term capital ratio (at the end of 20002004) (5) Operating cash flow to total liabilities ratio (for 20012004) (6) Interest coverage ratio (for 20002004) b. Compute the value of Altmans Z-score for Delta Air Lines for each year from 20002004. c. Using the analyses in Requirements a and b, discuss the most important factors that signaled the likelihood of bankruptcy of Delta Air Lines in 2005.17PC18PC19PC20PC21PC22PCCompute the values of each of the ratios in Exhibit 5.27 for Starbucks for 2012. Starbucks had 749.3 million common shares outstanding at the end of fiscal 2012, and the market price per share was 50.71. For days accounts receivable outstanding, use only specialty revenues in your calculations, because accounts receivable are primarily related to licensing and food service operations, not the retail operations.1BIC3AIC3BIC1QE2QE3QE4QEAssume that a corporation needs to enter the private debt market to raise funds for plant expansion. The corporation expects debt covenants to place restrictions on the levels of its current ratio and total-liabilities-to-assets ratio. Considering the accounts that comprise these ratios, give examples of accounting estimates, accounting judgments, and structured transactions that the lender should examine closely.6QE7QE8QE9QECheckpoint Systems is a leading provider of source tagging, handheld labeling systems, retail merchandising systems, and bar-code labeling systems. In a press release, Checkpoint stated the following: GAAP reported net loss for the fourth quarter of 2004 was 29.3 million, or 0.78 per diluted share, compared to net earnings of 4.5 million, or 0.13 per diluted share, for the fourth quarter 2003. Excluding impairment and restructuring charges, net of tax, the Companys net income for the fourth quarter 2004 was 0.30 per diluted share, compared to 0.27 per diluted share in the fourth quarter 2003. Calculate the amount of the impairment and restructuring charges Checkpoint reported in 2004 and 2003. Discuss why the firm reported earnings both including and excluding impairment and restructuring charges.11QEFinancial accounting rules require firms to assess whether they will recover carrying amounts of long-lived assets and, if not, to write down the assets to their fair value and recognize an impairment loss in income from continuing operations. Impairment charges often appear as a separate line item on the income statement of companies that experience reductions in the future benefits originally anticipated from the long-lived assets. Conduct a search to identify a firm (other than those given in this chapter) that has recently reported an impairment charge. Discuss how the firm (a) reported the charge on the income statement, (b) determined the amount of the charge, and (c) used cash related to the charge.13QE14QE15QE16PC17PC18PC19PC20PC21PC22PC23PC24PC1AIC1BIC1CIC2IC3AIC3BIC3CIC3DIC3EIC3FIC1QE2QEFollowing is the shareholders equity section of All-Wood Doors on a day a. Use the financial statement template below to show the financial statement effects of the following dividend events. (Assume that the events are independent.) (1) Cash dividend declaration and payment of 1 per share (3) Property dividend declaration and payment of shares representing a short-term investment in Screen Products, Ltd., with a fair value of 10,000 (3) 10% stock dividend (4) 100% stock dividend (5) 3-for-1 stock split (6) 1-for-2 reverse stock split b. Which events changed the book value of common equity? Under what conditions will these events lead to future increases and decreases in ROE?4QE5QE6QE7QE8QE9QE10QE11QE12QE13QE14QE15QE16PC17PC18PC19PC20PC21PC22PC23PC1AIC1BIC1CIC1DIC1EIC2AIC2BIC2CIC2DIC2EIC2FIC3AIC3BIC1QE2QE3QE4QE5QE6QE7QE8QE9QE10QE11QE12QE13QE14QE15PC16PC17PC18PC19PC20PC21PC22PC23PC24PC