Sally Chin Monique Harper Marmeline Petion Eric Yaker

Advanced Financial Analysis Final Group Project The North Face, Inc. December 5, 1999

Table of Content
SECTION I
Industry Analysis
Overview Industry Trends Competitive Landscape

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3 4 5

SECTION II
Company Analysis
Background Strategy-SWOT Analysis Strategy-Porter’s Five Forces 6 6 7 9

SECTION III
Accounting Analysis
Cash Flow Analysis Quality of Earnings Earnings Manipulation 10 10 10 11

SECTION IV
Financial Analysis
Dupont Decomposition DCF Assumptions WACC Calculation DCF Results Multiples EBO Valuation Dupont Decomposition 12 12 12 13 13 13 14 14

SECTION V
Conclusion
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Appendix A Appendix B Appendix C Appendix D Appendix E Appendix F Appendix G

Accounting Analysis Beneish Model DCF Model DCF Sensitivity Multiple Valuation EBO Valuation EBO Sensitivity

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Industry Analysis
Overview The US apparel industry is large, mature, and highly fragmented and its sales are driven by economic conditions, demographic trends, and pricing. The average American spends about $800 a year on apparel. This translates into a market of about $215 billion for a population of close to 270 million. The market is divided into two tiers: national brands and other apparel. National brands are produced by about 20 sizable companies and currently account for some 30% of all US wholesale apparel sales. The second tier accounts for 70% of apparel and is comprised of small brand and private label products. As can be expected for a mature industry, growth for the sector is relatively small and companies within the industry have to constantly find ways to reduce costs, which explains the outsourcing of manufacturing to Asia and the Caribbean. As a result the industry has benefited from an increase in offshore manufacturing and favorable prices for raw materials, thereby reducing overall operating costs. The technical outdoor apparel segment is one segment of the highly fragmented apparel industry, which has managed to create a niche of its own. Professional climbers and outdoor enthusiasts are the primary consumers of this segment of the industry. In recent years however, these products have become increasingly popular among a broader group of consumers. This growth is due to an increase in outdoor recreational activities and adventure travel by the general population. There has also been a shift in consumer preferences, leading to a growing demand for highly functional products. The last and most important trend is the fact that there is now a growing acceptance of outdoor apparel as casual wear. Another positive for the industry as a whole is the fact that the U.S. economy as a whole has experienced modest inflation, low unemployment, and a booming stock market. The effects of these factors have trickled down to the apparel industry in the form of increased spending. On the negative side, the apparel industry is extremely competitive and highly fragmented. Due to the fact that the industry is characterized by simple technologies, low fixed assets per employee, and ease of expansion, barriers to entry are relatively insignificant. Though it is easy to enter the market, it is very hard to remain a viable competitor, as profit margins are very slim in such a competitive environment. Consumers also have considerable power over apparel and have expressed no loyalty to a particular brand. Such consumer behavior has increased costs for the

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companies operating in the industry, as they constantly have to spend money on advertising to build brand awareness. Industry Trends ! Increased Number of Teenagers/Aging Population The apparel industry will change with demographic trends. It is expected that over the next ten years, the number of both younger and older households will increase, while the number of middle households will contract. Companies are accustomed to servicing the middle group, and will now have to find new strategies to meet the new faces of the consumers. There is good news associated with the shift in demographic trends as the teenager and young adult markets provide new profit opportunities. On the other hand, the aging segment of the population with more disposable income at its reach is also a good niche for companies. Also, older individuals will have more time for leisure/outdoor activities increasing their need for casual clothes. 1998 Number (Thous.) 19,117 39,396 19,426 17,451 18,568 20,189 22,579 21,811 18,813 15,707 22,662 34,823 270,542 U.S. Population Projections 1998 2005 2005 % of Number % of Total (Thous.) Total 7.1 19,127 6.7 14.6 40,147 14.0 7.2 20,997 7.3 6.5 19,960 7.0 6.9 18,057 6.3 7.5 18,249 6.4 8.4 19,802 6.9 8.1 22,363 7.8 7.0 21,988 7.7 5.8 19,518 6.8 8.4 29,606 10.4 12.9 36,970 12.9 100.4 286,784 100.2 2015 Number (Thous.) 21,174 40,795 21,194 21,876 20,836 20,248 18,872 18,726 19,594 21,602 39,650 45,832 310,399 2015 % of Total 6.8 13.2 6.8 7.1 6.7 6.5 6.1 6.0 6.3 7.0 12.8 14.8 100.1

Age Group Under 5 5 to 14 15 to 19 20 to 24 25 to 29 30 to 34 35 to 39 40 to 44 45 to 49 50 to 54 55 to 64 65 & over All ages

! Rising Income Baby boomers are experiencing a rise in income associated with the bull market. Increased gain in personal income has led to an increase in personal consumption expenditures with individuals in higher income brackets spending more money. It is important to note that consumers are spending more in general but are very reluctant to spend significant amounts of money on one particular item. Pricing is very important to these savvy consumers and companies now need to create extremely sophisticated advertising mechanisms as a way to justify the increased expenditures. ! Changes in Lifestyles

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Consumers are becoming more active outdoors as can be seen with their increased participation in a variety of outdoors activities such as camping, hiking, and backpacking. A 1997 survey by the Travel Industry Association of America indicated that one-half of U.S adults, or 74 million people, have taken an adventure travel trip in the past five years. ! Dressing Differences The US has experienced a shift toward casual attire both at home and in the work place increasing the amount on money spent on such items. A growing number of employers have implemented casual dress days, which has significantly benefited the apparel industry. ! Globalization With fierce competition, companies have turned to foreign companies as a way to boost sales, cut costs and increase operating efficiencies. This has led to the expansion of offshore manufacturing, which is highly influenced by trade regulations. In addition, many companies have elected to increase sales operations overseas in an effort to boost revenues. ! Financial Trend There is one glimpse of bad news lingering in the industry however. Even with increases in revenue and favorable demographic trends, pressure on margins has intensified. With intensifying

competition and price conscious consumers, companies within the industry find it hard to generate high profit margins. It is expected however that branded products will fare better in the market in terms of healthier profits, as they will be able to shift sales abroad.

Competitive Landscape
The main competitors for North Face are LL Bean, K2, Lost Arrow, and Columbia Sportswear. Both LL Bean and Lost Arrow are privately held companies and we were not able to

retrieve much information for comparison. Columbia Sportswear is the number one US skiwear seller and one of the world’s largest outerwear companies. The company also makes rugged footwear, sportswear, gloves and caps. Columbia went public in March of 1997 and has been quite successful since then. In 1998 sales were $427.3 million with NI of $32.7 million. The company’s ROE was 17.9%, ROA was 8.4% and revenue growth was 20.9%. The company is barely leveraged with a long-term debt/equity ratio of 0.15. Columbia has benefited from the Asian crisis due to the fact that most of its items are made in Asia. In other words, the company has seen a decrease in cost due to the crisis, but its revenue stream has not been affected. The company also has a strong international reach as it sells its products in

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more than 30 countries. Columbia is deemed to be very risky by the market with a beta of 2.3. As of November 30, 1999, the stock was trading at $20.25. K2 is a Los Angeles based company whose product line includes fishing rods, mountain bikes, sports apparel, activewear, outdoor gear, surf apparel and skis. The company also has a fairly strong industrial business segment selling plastic and fiberglass based product. The company’s strategy has been to acquire sports equipment makers with strong brand names and a leading share of a niche market. In 1998 sales were $574.5 million and NI was $3.9 million. Industry pressures on margin is apparent with K2 as its profit margin declined to 2.9% in 1998 from 6.3% in 1997. Though K2 is doing better financially than North Face, the company is also fighting a battle to remain competitive. ROA is 4.1% and ROE is 8%, long-term debt/equity ratio is .47 but the company is deemed less risky as its beta is only 0.1. As of November 30, 1999, the stock price was $7.38.

The Company
! Background The North Face, Inc whose name refers to the most treacherous side of a mountain in the Northern Hemisphere, was started in 1965 as a retail store by Doug Tompkins and is devoted to mountaineering equipment and supplies. Throughout the 70s and the 80s, the company was very successful, as its product innovation was the best in the industry. Its design of geodesic dome tents and synthetic bags set the industry standards for these items. During the late 1980s the company made a fatal move by entering the manufacturing side of the business. The company experienced a severe downturn leading to its acquisition by Odyssey Holdings International (OHI). Unfortunately for North Face, OHI declared bankruptcy in 1993 and North Face was sold at auction to J.H. Whitney & Company. Three years later the company went public. The company’s problems have persisted throughout the late 1990s. Accounting problems plagued the company, which has led to consecutive financial restatements. The restatement for 1998 lowered previously reported earnings by 62%. Though the company is in severe financial difficulties, its customers seem to be somewhat oblivious to its misfortune. For the six months ending June 1999, sales rose 19% and in 1998 sales grew by 18.6%. North Face’s product line consists of high-end outerwear, skiwear, and equipment for mountaineers. The company makes Tekware, which is a synthetic sportswear line for men and women who are active outdoors. The company also makes rugged shoes and owns the right to La Sportiva rock climbing and mountaineering footwear in the US. The company’s goal is to increase brand awareness by projecting a high quality, technically sophisticated and authentic image that appeals to professionals and serious outdoor enthusiasts. To successfully promote its products, the company employs a series of world class athlete in its

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advertising. North Face’s products are sold primarily through specialty outdoor, premium-sporting goods. In 1996, the company introduced the Summit Shop concept, which is a store within a retail store dedicated to selling North Face products. ! Sales by Segments Sales Breakdown

Other 22%

Tekware 13% Equipment 15%

Outerwear 50%

Strategy Insight-SWOT Analysis ! Strengths To truly value and analyze the future prospects of North Face, we felt it necessary to gain an ins...

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13.007 13.01 13.087 13.09 13.18 13.181 13.19 13.2 13.29 13.65 13.67 13.670 130 132 133 133.2 134 135 136 1371 138 139 13935 14 14.0 14.27 14.37 14.370 14.6 14.8 140 141 143 144 145 14534 146 147 148 15 15.190 15.20 15.90 150 151 154 15626 157 158 159 16 16.150 16.19 16.28 16.69 16.81 16.88 16.91 161 164 165 167 168 17 17.015 17.02 17.10 17.274 17.37 17.9 17.9375 171 172 173 174 175 176 177 178 18 18.36 18.590 18.6 18.78 180 182 183 184 185 186 187 189 19 19.00 19.75 190 191 192 193 194 196 1965 198 1980s 199 1990s 1993 1996 1997 1998 1999 1999e 2 2.097 2.0972 2.167 2.22 2.258 2.3 2.331 2.3312 2.48 2.483 2.591 2.5914 2.646 2.66 2.74 2.8806 2.881 2.9 2.98 20 20.25 20.9 200 2000 2000e 2001 2002 2003 2004 20044 2005 2006 2007 2008 2009 2010 2015 203 205 207 21 21.6 210 211 212 21339 214 215 217 219 22 22.60 220 224 225 226 227 228 229 23 23.1 23.16 23.39 230 232 232644/123210 233 235 236 238 239 24 240 244 247 248 249 25 25.0 25.1250 25.47 251 259 26 26.72 260 261 262 263 264 267 27 27.74 270 271 272 273 275 276 277 278 28 284 285 286 29 29.04 290 292 293 294 297 298 299 3 3.0 3.18 3.38 3.52 3.72 3.9 3.94 30 30.20 300 301 302 304 308 309 31 310 311 313 314 31475 317 318 32 32.7 32.88 320 321 325 327 329 33 330 334 335 337 339 34 341 342 343 344 348 349 35 35.81 350 351 352 353 354 355 3592 36 360 362 363 364 369 37 37.02 37.21 37.6 37.8 37.800 371 373 374 375 376 38 38.0 38.02 38.09 38.37 381 381.1 383 384 385 386 39 393 394 396 399 4 4.1 4.35 4.37 4.40 4.679 4.75 4.8750 4.91 4.92 40 400 401 404 405 406 407 409 41 411 412 414 416 42 420 422 423 424 426 427 427.3 43 430 432 433 43366 435 439 44 445 447 448 449 45 45.14 45.3 45.5 45.5938 450 450.1 451 452 453 453.2 456 457 45704/232644 458 46 46.6 460 4621 463 469 47 470 471 473 474 48 4801 482 483 485 49 491 492 495 496 497 498 499 5 5.00 5.06 5.76 5.8 50 502 503 505 507 508 509 51 511 512 516 518 519 52 520 523 524 526 527 528 53 533 534 535 537 539 54 54.6 54.600 540 542 544 546 55 550 555 56 561 563 565 566 568 57 573 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