kmart case

EVALUATION OF AN EQUITY RESEARCH REPORT ON KMART CORPORATION

Bertera MariaCervenka ElizabethGuazzo LucaSammartano LauraSciuto Damiano

Università della Svizzera Italiana – Financial Statement Analysis

Agenda

Kmart: history and data overview

Weaknesses of analysts’ report

Converting forecasts into a valuation

Application of models

Conclusions

Università della Svizzera Italiana –Financial Statement Analysis

IntroductionKmart is a chain of discount department stores in the following countries: United States, Puerto Rico, Us Virgin Island, Australia and Guam… It is principally a grocery store.

The first store opened in 1962.

1990’s: Kmart was renovated and a new logo was introduced; Kmart Super Center offered full service grocery stores and generalmerchandise (KSC ranged in size from 13,000 to 18,000 m2)

1997: The company opened the first Big Kmart store. Since that time, a lot of stores were renovated as Big Kmart, focusing on home fashions and children’s apparel and consumables.

January, 2002: Kmart filed for Chapter 11 bankruptcy protection; Kmart’s Chairman and President were involved in a series ofscandals, as Enron;

March, 2003 Kmart emerged from bankruptcy, thanks to an Hedge Fund thatbought Kmart bonds. The firm was restructurated with new stores,becoming Kmart Holding Corporation.


Kmart nowadaysCurrently Kmart is a chain of discount department stores that are usually free standing or located in strip malls.

They carry electronics, music, movies, bedding, hardware, sporting goods, health and beauty products, toys, clothing, office suppliers, and a lots of other different products.

Big Kmart carries everything a regular Kmart does, but with an emphasis on home decor, children’s clothing and more food items.

Kmart Super Center is a chain of hypermarkets that carries everything as a regular Kmart, but with a full grocery section.

Inside stores, Kmart has put also K-Cafè: a restaurant that has soft prezles, hot dogs, drinks and coffee.


Kmart Analysts’ forecast 2000-2001 (1)

The analysts forecast for 2000 and 2001 are based on data from fiscal year 1999.

With these data and their forecasts, they recomanded to BUY Kmart shares, considering them undervalued.

Data from fiscal year 1999, value in million of $:


Earnings 518

Dividends 0

Common equity 5,979

Debt 2,706

Cash Flow from Operations 1,427

Cash Investments 795

Kmart Analysts’ forecast 2000-2001 (2)

Current market price: $17After 2001: increase of EPS at 6% per yearFrom 1999: FREE CASH FLOW will grow at 6% per yearBeta: 1.15Required rate of return: 12% per year


Earnings per share (Eps) 1.05 1.23 1.41

Book Value per share 12.12 14.02 15.43

Share outstanding 493.4 493.4 493.4

Price to book ratio 1.40 1.36 1.38

Price-earnings ratio 16.2 17.1 20.0

A1999 E2000 E2001

Weaknesses of analysts’ report (1)

Lack of data.Focus on P/E, without information about origin ofvalues.Absence of explicit reference to the model used.Limits of “Method of Comparables” (inferred):

- difficulty to identify comparable firms. - the choice of multiple leads to different valuations.- no sense of P/E in case of losses.


Price Earnings Ratio

P/E = Market Value per Share / Earnings per Share (EPS)

The Price Earnings Ratio of a stock measures the expectationsof investors about the future earnings growth of thecompany.

i.e. A high P/E suggests investors believe in higher earningsgrowth for the future, compared to lower P/E companies.

It’s strongly recommended to compare the P/E ratioswith the company’s own historical P/E. (trend analysis).


Weaknesses of analysts’ report (2)

Inconsistency of growth rate with respect to P/E:

Earnings growth rate = 6% < Required rate of return = 12%

When the forecasts imply a cum-dividend earnings growth lower thenthe required return, the expected price-earnings must be belownormal P/E.

forward P/E ratio = 1/ required return = 1/0.12 = 8.33 normal trailing P/E ratio = (1+ required return)/required return =9.33

Therefore, we expect for 2001 a P/E < 9,33 or 8,33.

Forecasted P/E 2001 = 20 NOT REASONABLE!!!


Converting forecasts into a valuationapplying models

Analysis through “cost-benefit” approach,given a two-years horizon.


Investment of the same initial amount ofmoney in the market at the r.r.r. of 12%.

Return from investingin a share of Kmart Vs.

(Pt2 - Pt0) / Pt2 (1+r)t2

Value from Price-Earnings calculated bythe Analyst

Target price2001:

P*=$28.20

Expected % gross return

over 1999 – 2001:

65.9%

Excess return that the stock could provide

becomes: 40.46%

BUY


2001

* *20 201.41

* 20*1.41 $28.20

P PEPS

P

= → =

→ = ⇒

2001 1999

1999

* 28.20 1717

0.6588 65.9%

P PP

⎛ ⎞− −⎛ ⎞=⎜ ⎟ ⎜ ⎟⎝ ⎠⎝ ⎠

= ⇒

( ) ( )21.659 1.12 1.659 1.2544

0.4046 40.46 %

⎡ ⎤− = −⎣ ⎦= ⇒

Value from Price-to-Book calculated bythe Analyst

Target price

(P*)2001:$21.30

Expected % gross return over 1999 –

2001:25.30%

Excess return that the stock could provide

becomes: -0.14%


2001

** **1.38 1.3815.43

** 1.38*15.43 $21.30

P PBPS

P

= → =

→ = ⇒

2001 1999

1999

** 21.30 1717

0.2529 25.30%

P PP

⎛ ⎞− −⎛ ⎞=⎜ ⎟ ⎜ ⎟⎝ ⎠⎝ ⎠

= ⇒

( ) ( )21.2530 1.12 1.2530 1.2544

0.0014 0.14 %

⎡ ⎤− = −⎣ ⎦=− ⇒−

Price-to-Book from our valuation


From the Residual Earnings valuation we know that the following relationship must hold:

1BPS BPS +EPSt t t tnetDPS−= −

2000 1999 2000BPS * BPS EPS 12.12 1.23 13.35= + = + =2001 2000 2001BPS * BPS EPS 13.35 1.41 14.76= + = + =

2001

'' ''1.38 1.3814.76

'' 14.76*1.38 $20.37

P PBPS

P

= → =

→ = ⇒

2001 1999

1999

'' 20.37 1717

0.1982 19.82%

P PP

⎛ ⎞− −⎛ ⎞=⎜ ⎟ ⎜ ⎟⎝ ⎠⎝ ⎠

= ⇒

CASH DIVIDEND+

STOCK ISSUE-

STOCK REPURCHASE

( )21.1982 1.12⎡ ⎤−⎣ ⎦

0.0562 5.62 %− ⇒−

RE method applying the new book value


BPS+

Total PV or RE+

PV of CV


BPS+

Total PV or RE+

PV of CV

RE method applying the old book value

AEG method


( )01 * .EPS Tot PVofAEG PVofCVr⎛ ⎞ + +⎡ ⎤⎜ ⎟ ⎣ ⎦⎝ ⎠

Reverse Engineering


Analyst Vs. AEG

The actual market price per share is $17 and the growth rate ofthis share intrinsic to the market is 8%. Thus, concerning ourvaluation, we recommend to SELL K-Mart because the real valueof the share, calculated through the AEG model ($15.1260), islower than the one ($17) assessed by market.


Value of FCF – Method I°- II°


Raccomandation through the FCF analysis


1• Compared to a current market price of $17, this result is in line

with a HOLD recommendation.

2• This valuation is not in line with the previous ones,

nevertheless we are confident, relying on RE and AEG models, in supporting the SELL recommendation.

3

• As a matter of fact, the free cash flow analysis presents some evident limitations since investments are treated as a loss of value. Indeed, FCF is considered a liquidation concept because firms manage to increase it by cutting of investments.

Conclusion


THANKS FOR YOUR ATTENTION!


kmart case

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