Equity Valuation & Analysis of GUESS INC.

Chris Yelverton Christopher.w.yelverton@ttu.edu Toan Le Toan.le@ttu.edu Eric Lundblad Eric.lundblad@ttu.edu Mike Wallace Michael.wallace@ttu.edu Mark Chapman markjchapman@sbcglobal.net

Table of Contents
Executive Summary Industry Analysis Company Overview Industry Overview Five Forces Model Value Chain Analysis Accounting Analysis Financial Analysis Core Sales Manipulation Diagnostics Core Expense Manipulation Diagnostics Forecasting CAPM Estimation WACC Estimation Method of Comparables Discount Dividend Model Discounted Free Cash Flows Model AEG Residual Income Valuation Model Long Run ROE Income Model Z Score Appendix 4 8 8 10 11 27 33 46 46 49 53 68 70 71 76 78 80 83 86 88

Executive Summary
Investment Recommendation: Company Is Slightly Undervalued, Buy
GES NYSE (06/30/07): $44.86 52 week range: $51.15 - $19.50 Market Capitalization: 4.49B Shares Outstanding: 93.54M Avg. Daily Trading Volume: 1.73M ROE: 30% ROA: 15% Valuation Estimates Actual Price (06/30/2007): $48.04 Ratio Based Valuations Cost of Capital Estimate 3-Month 6-Month 2-Year 5-Year 10-Year R2 .055 .045 .078 .117 .163 Beta .10 .10 .15 .29 .48 Ke 5.99 6.02 6.40 7.49 9.00 Intrinsic Valuations Altman Z-Score: 9.41 Discounted Dividends Free Cash Flows Residual Income LR ROE AEG Actual $3.40 $52.13 $70.92 $15.53 $15.53 Revised $73.66 $71.85 $103.80 N/A $137.47 Trailing P/E Forward P/E P/B P/EBIT P/FCF $10.19 $24.00 $25.78 $28.30 $44.80 Ratio Comparison Trailing P/E Forward P/E P/B GES 28.2 34.8 10.16 AEO 16.8 15.71 4.10 GAP 14.6 30.29 3.06

Industry Analysis
Guess was founded in 1981 and currently operates as a Delaware corporation. Guess Inc. (GES) is a component of the specialty retail industry which is a segment of the overall retail industry. Guess Jeans designs, markets, distributes, and licenses lifestyle collections of contemporary apparel and accessories for men, women, and children that reflect American lifestyle and European fashion sensibilities (Guess Inc. 2006 10-K). Their target customer is a style-conscious consumer primarily between the ages of 18 and 32 which is a highly desirable demographic group that is believed to have significant disposable income. Guess currently operates 336 stores in North America and 386 additional stores internationally. To compete in the specialty retail industry firms must be conscious of several key success factors. Guess direct competitors include GAP, Abercrombie and Fitch, and American Eagle Outfitters. These firms were chosen for comparisons because they are traded publicly and have highly accessible financial data. Firms in the specialty retail industry compete by differentiating their products from competitors. While it is important to maintain competitive prices, the main focus in this industry is not cost leadership. The primary factor that separates firms in the specialty retail industry is creating a distinguished image that customers value. Another factor that can help gain a competitive advantage is providing a product of superior quality. Success is also dependent on the variety of products that a firm provides. Competitors in the industry strive to expand product lines, develop new product lines, and sell additional accessories.

Accounting Analysis

To be able to efficiently analyze a firm, an investor must next do a very extensive accounting analysis to determine which key accounting strategies a firm is using to affect their net income. First, key accounting policies are discussed and then checked to determine if they coincide with the firms key success factors in the five forces model. Due to GAAP standards and regulations, firms are allowed a lot of flexibility on how they report on their financials. One of the areas that firms are allowed a lot of flexibility in the specialty retail industry is the reporting of inventory. One area that allows a lot of flexibility is the ability to use off the balance sheet transactions to record operating leases. This allows a company to understate their liabilities as well as manipulate their cash flows from operations. By capitalizing the lease an analyst is able to see the true value of firms liabilities and use them to value the firm accordingly. In the specialty retail industry almost every firm uses operating leases as opposed to capital leases. The operating lease enables the firm to receive tax benefits be expensing lease payments as well as allowing them to decrease liabilities. The capitalization of Guesss operating leases allows investors to gain a better understanding of their true financial standing, and that is recognizing almost 3.5 million in liabilities that did not show up under operating leases. Guesss sales and expense ratio diagnostics did not appear to raise any potential red flags for the company. Guess seems to be operating efficiently in their niche and is relatively close to the industry average in this area. We believe that this is a clear red flag. The fact that a company is able to understate its liabilities significantly distorts its accounting numbers and can portray its companys financials in a more appealing manner.

Financial Analysis and Forecasting

To compare Guess financial performance and gauge their future outlook relative to competitors we performed a series of liquidity, profitability, and capital structure ratios for Guess and each of the mentioned competing firms. These ratios also allow us to calculate an industry average which is useful as a benchmark measure. The results of the financial analysis are then used to forecast Guess financial statements 10 years out. Next you must estimate a beta for the firm using the CAPM model, and the cost of equity can be determined using regression analysis. Ultimately the cost of capital can be calculated using the weighted cost of capital formula. As far as the liquidity analysis goes Guess had been right at the industry average. And for the profitability analysis they were among the industry leaders, which means, they will continue to yield high profits in the future years of operations. Using the current dividends of 6 cents paid out in 2006, we were able to successfully forecast dividends out to 2011. We forecasted out other line items such as earnings on the income statement by using an estimated sales growth rate of that peaked at 28%. From that point, we gradually reduced the growth rate and started heading it towards the industry average. This method of growth is backed up by the very strong sales numbers that Guess has seen in recent years. We believe that Guess will continue to grow at this strong rate. Cash flow from investments and operations using the financial analysis derived from our published statements. This allowed us to get a reasonable estimate on future earnings that helped us further value the firm until our perpetuity year of 2017.

Valuation

Almost all aspects of a company can be analyzed to determine if the company is over or under valued based upon their share price. Ultimately this is what investors look at to determine if they would like to invest in the firms stock. There are various models used to determine the valuation of the stock prices. The first being the method of comparables, it is the quickest and easiest method to implement but is not very reliable because the price per share is ultimately determined upon an industry average. Second, the intrinsic valuation models are more theory based and take into account the estimated of the companies next ten years of forecasted financials. There was also a revised section where we took into account the companys use of operating leases as opposed to capital leases. In conclusion, it was determined after running all of the valuation models that Guess is an extremely overvalued company.

Industry Analysis Company Overview

Guess Inc. (GES) designs distributes and licenses one of the worlds leading lifestyle collections of contemporary apparel and accessories for men, women, and children that reflect the American lifestyle and European fashion sensibilities. Furthermore, Guess Inc. also grants licenses to manufactures and distribute a broad range of products that compliment their apparel lines (Guesss 2006 10-K). Since Guess inception in 1981, Guess has targeted males and females between the ages of 18 and 32 because they believe that this group is full of style conscious consumers with enough disposable income to pay for a brand name.

Guess is headquartered in Los Angeles, California where it operates its retail, wholesale, and European Licensing business segments. Guess uses three main distribution channels to sell their products which includes; using their own stores, through a network of wholesale accounts, and the Internet. Through these distribution channels, Guess offers a full apparel line of both denim and cotton jeans, pants, overalls, skirts, dresses, shorts, blouses, shirts, jackets, and knitwear. In addition, Guess also offers accessories that promote and complement its image which includes eyewear, watches, handbags, kids clothing, footwear, and fragrances that are also distributed through these channels. Currently, Guess operates 336 stores in the United States and Canada, 24 stores in Europe and 3 stores in Mexico. Guess is very focused on constantly growing and expanding their operations in the retail industry. During 2006 they opened a total of 32 new stores and are planning to open 48 news stores in the year 2007. Guess total revenue for 2006 totaled 1.19 billion dollars and net earnings totaled 123.2 million dollars. The table below demonstrates Guess recent success in growth through sales and the increase in total assets. 2002 Total Assets Sales $583,139 $636,585 $729,262 $936,092 $1,185,184 $349,532 2003 $362,765 2004 $424,304 2005 $633,374 2006 $836,925

** Assets and Sales in thousands**

Total Sales for the 2006 fiscal year was $1,185,184,000.00 which was a 21.02% increase from the previous year. This increase in sales was nearly 4.2 percentage points better than their closest competitor (AE 16.9%). This trend seems to be holding true so far in 2007 with Guess having a sales growth rate of 26.6% which is 6.3 percentage points better than American Eagle. (20.3%) (Moneycentral.msn.com)

The graph bellow depicts how Guess stock price has performed over the past five years. For comparison purposes, the graph also includes how its competitors have faired during the same time frame, as well as the S&P 500. During this time frame, Guess has been recognized as one of the biggest gainers with a return of 1162 %.( Richards & Hanson)

Industry Overview

Source: http://moneycentral.msn.com

Guess competes with several other companies in the Retail Apparel Industry, which is in the service sector of the economy. This industry by nature is very fragmented, thus it is very difficult to compete in. With in this industry, there are four sub-markets in which apparel retailers compete in:

First, there are large discount stores which compete by attracting a large amount of consumers. Consumers are drawn to these companies because of their low prices. But with these low prices, come inferior products and non-existent customer service. Firms in this sub-market include Wal-Mart, Target, and K-Mart.

The next sub-market is composed of mass merchandisers. Consumers are drawn to them because they offer quality products at reasonable prices with fair customer service. Participants in this market are primarily department stores like Kohls, JC Penney, and Mervyns. Another sub-market in the retail apparel industry is the upscale mass merchandiser. These companies offer luxurious products and superior customer service. Consumers of this division are willing to pay a premium for products and service because of the prestige and status that is associated with shopping at these companies. Firms associated in this market include Neiman Marcus, Nordstroms, and Sacs 5th Avenue. The final sub-market in the retail apparel industry is the specialty retail division. What makes this division so unique is that the retailers also provide their own clothing line and accessories to sell. They offer quality differentiated products at reasonable prices with fair customer service with their own flare. This is the division in which Guess competes in. Consumers of this division typically range from male and female teens to adults in their early 30s. Consumers are attracted to this division because they are brand image conscious and like the differentiated products that firms produce. Companies in this division are direct rivals to Guess and include Abercrombie and Fitch, American Eagle, and Gap.

Five Forces Model

The five forces model is a strategic market analyzing tool that enables firms to analyze their specific industry and use its knowledge to create a competitive edge over competing firms in the industry. The five forces model uses five competitive forces to determine attractiveness to the industry, and the ability to generate a profit. The five forces is composed of the threat of substitute products, the threat of new entrants, rivalry among existing firms, and the 10

competitive bargaining power of both buyers and suppliers. The apparel industry is a highly competitive industry, divided into smaller sub-markets such as mens and womens clothing, and accessory apparel.

Rivalry Among Existing Firms

Rivalry among existing firms is one of the biggest sources of competition in an industry, with firms all competing for the available profits created in the market. The analysis of the existing firms allows a company to evaluate the level of competition between the major players with in an industry and come to a decision on how to create a competitive advantage. In being a specialty retail entity, we compete with numerous apparel manufacturers and distributors, both domestically and internationally, as well as several well-known designers, including some that have recently entered or re-entered the designer denim market (GUESS?, INC. 10k). Guess Jeans Inc. competes on several different platforms in the retail industry, allowing them to be very versatile in tapping into the fashion market. Guess retail and outlet stores compete with a wide variety of other specialty retailers, such as Gap, Abercrombie & Fitch, and American Eagle. Among these firms, there are several factors that determine the degree of competition between existing players in this industry.

Industry Growth

Industry growth helps a corporation determine the available share of the market, as well as the level of competition with in the industry. If an industry is steadily growing, companies do not have to compete for each others market share. The apparel industry is a constantly growing market, with new fashions and styles

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leading the way to new, evolving product markets. In 2006, GUESS opened a total of 32 new stores in the United States and Canada alone, as well as increasing their average retail outlet square footage by 5.3%. This shows that the demand in the market is still high enough to satisfy their needs for growth and increasing profits. As a multi-national corporation, Guess is also continuing growth in countries outside the United States. In 2006 alone, they opened 125 stores of all concepts, in countries outside of the U.S. This graph compares the most recent five-year cumulative shareholder return of the Company with the S&P 500 Index as well as the S&P 1500 Retail Index. The return used to demonstrate this investment was calculated based on a $100 dollar investment on December 31,2001, with dividends, if any, reinvested (GUESS?, INC. 10K).

2001

2002

2003

2004

2005

2006

Guess?, Inc.. S&P 1500 Apparel Retail Index S&P 500 Index

100.00 55.87 100.00 99.41 100.00 77.90

160.93 136.25 100.25

167.33 474.67 160.32 174.90 111.15 116.61

845.73 191.64 135.03

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As you can see, the S&P Apparel Retail Index has been steadily increasing since 2001, with Guess significantly outperforming the index in the recent years. This demonstrates to us that the Apparel industry is growing, allowing firms not to engage in price competition. The following graph shows the sales growth for the industry with in the past five years. Based on the information, the industry is still experiencing growth from year to year.
Percentage Sales Grwoth
10.00% 8.00% Percent 6.00% 4.00% 2.00% 0.00% 2002 2003 2004 2005 2006
Series1

Series1 8.65% 8.98% 6.49% 5.54% 5.32% Years

We can also see that the industry is growing by assessing the assets of the companies. By doing this, you can analyze the changes in total assets which equates to growth or decay for firms in an industry. The graph bellow shows that most of the firms within this industry are growing. However, Gap assets have been decreasing for the past three years.

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Total Assets
Assets(thousands of 12000000 10000000 8000000 6000000 4000000 2000000 0 2002 2003 2004 Year Gap Abercrombie & Fitch American Eagle Guess 2005 2006

Sources: www.gap.com, www.ae.com, www.abercrombie.com, www.guess.com

Gaps diminishing assets correlates with the loss of market share that Gap has also experienced over the past few years. This can also explain the very strong growth that Guess and its other competitors have experienced over this five year span. To help illustrate this situation, we used total sales to see how much of their market share has been relinquished to its competitors over the past five years. The graphs bellow illustrates the situation.

dollars)

Total

Market Share 2002

Market Share 2006

9% 8%

3%

5% 14%

12%

69%
80%

Sources: www.gap.com, www.ae.com, www.abercrombie.com, www.guess.com

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In 2002, Gap held 80% of the market share, while American Eagle held 8%, Abercrombie & Fitch held 9%, and Guess occupied 3% of the market share. Four years later, Gap had relinquished 11% of its market share to its rivals. American Eagle has increased its market share to 12%, while Abercrombie & Fitch increased to 14%, and Guess saw an increase to 5%. In 2007 we saw a significant slowdown in the retail/apparel industry. Many economists argue that the downturn in the housing market as well as rising gas prices has affected consumer spending, decreasing sales on non-commodity items. April was rough also for mall-based specialty stores. Gap Inc. reported a 16% same-store sales decline. Abercrombie & Fitch Co. said results will fall below analysts' forecasts. American Eagle missed Wall Street expectations, with a 10% decline in same-store sales, but it reaffirmed its first-quarter earnings outlook of 34 to 35 cents a share (James Covert, WSJ, May 11, 2007). American Eagle credits their late increase due to the coming summer months, a time when new fashions and styles are released into the market. These numbers demonstrate the cyclical nature of the retail market. Increases and decreases in net sales can be affected industry wide by availability of consumer spending as well as other fashion related issues such as weather.

This graph shows the Net Sales (in Millions) of some of the leading competitors in the retail industry today. With all but one of the companies reporting a loss, it 15

is easy for us to analyze and foresee events in the economy that would lead to slowdowns in the retail industry.

Concentration and Balance of Competitors

The number of firms that compete in an industry and their relative sizes determine the degree of concentration in an industry (Palepu 2-3). The amount of concentration that is present in an industry influences whether competing firms will co-ordinate their pricing to avoid price competition between firms. Retailers are commonly positioned close to each other, either in shopping malls or large strip centers. This highly concentrates the industry, with individual retailers each competing for customers in a similar area. When an industry is highly concentrated, it is dominated by a few key players, allowing them to influence the market and help prices to remain fairly stable. When the market is in low concentration, there is no large firm to establish pricing standards, and firms will begin to compete on a lowest cost basis. As previously mentioned, there are many different sub-markets in the apparel market. Guess as well as their competitors try to differentiate themselves from that type of genre, and focus more on the high end side of the clothing spectrum. This specialty clothing sector of the market is less concentrated. This allows them to focus on a client basis that relies more on brand name value, and the quality and style associated with this sector.

Degree of Differentiation and Switching Costs

The degree of differentiation between products refers to the similarities those different items in the same market share. If a product line can differentiate itself

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from the other items in its genre, it can separate itself and not allow themselves to become a common substitute for other items in its industry. When Guess focuses on its customer base, individuals range in age from 18-32. They also target both males and female consumer. In addition, Guess targets a style-conscious customer that they believe to posses a significant disposable income. By focusing on superior quality and features that can help a customer focus on brand recognition, their product is able differentiate itself from other products and avoid price competition. Guess accomplishes this by encompassing business wear as well as the latest styles appealing to a slightly older customer base. This marketing strategy helps differentiate themselves from their most common competitors Abercrombie & Fitch and American Eagle. These companies seem to focus on a slightly younger, more laid back genre ranging from the ages of 15-25 (americaneagle.com; abercrombie.com). These companies do not do a good job at differentiating themselves from one another. The lack of differentiation is evident because it is difficult to distinguish products from Abercrombie & Fitch, American Eagle, and Aeropostle. Abercrombie also faces additional problems because it has not been successful at differentiating itself from the other apparel lines that they offer such as Hollister and RUEHL. This has caused lower than expected sales for the first quarter of 2007(MacNeally). Switching costs relate to the cost the consumer will undertake in switching between different items in the same market. Because of the nature of this industry, switching costs for customers is generally low. In a market where success is dominated by new and evolving fashion trends, a company is forced to remain competitive by introducing new fashions and clothing styles. Consumers of this market tend to switch between competitors in an industry quite frequently; this forces competition for the target market to remain high. Since 17

the beginning, Guess has focused on superior product quality and style. They believe the customer views a slightly higher price as a sign of quality, tending to focus more on innovations in style and quality then to compete on a price basis.

Fixed-Variable Costs/Scale Economies

The methods a firm uses in its production and sales operations determines the amount of money a company invests in developing its products, which is directly related to consumer prices paid. In the specialty retail industry, fixed costs tend to be low, with variable costs remaining high. This remains true at Guess for many reasons. Because of the cyclical nature of the business, certain times of the year can remain stagnant while others can significantly increase in sales. Guess handles this by striving to keep fixed costs relatively low. They do this by choosing not to purchase land sites for stores, but to instead engage in operating leases. Outsourcing is also a significant part of this strategy. Together, these methods allow them to retain a reasonably low fixed to variable cost ratio. According to Guess 10-K, they were able to lower their Selling, General, and Administrative cost down 230 basis points. They credited this improvement because of better leveraging of fixed cost in all areas. By outsourcing product manufacturing and leasing retail sites, they keep their fixed costs low at times when the apparel market is down, allowing them to pick up production and increase spending only at times when the market demands it. These measures are common in the retail industry, with Abercrombie & Fitch, Gap, and American Eagle all leasing their retail sites, with most commonly being located in shopping malls and large retail centers. By utilizing these strategies

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retailers significantly reduce the markets competitive pressures as well as price competition in the market.

Excess Capacity and Exit Barriers

Exit Barriers exist in an industry when companies have specific merchandise and machinery that is difficult to liquidate, making it more costly to exit the industry than to remain in and accept a loss. Because of the constant changing of fashion styles accompanied with the different styles of clothing associated with the seasons, liquidating inventory is a common practice of retail stores. This problem is solved by large sales and discount promotions, usually 4 times a year. This gives a company the chance to halt production, not replenishing inventory, and to exit the industry. The increased competition affects negatively the other incumbents. Incumbents profits are potentially lower than in a true competitive market. These frequent opportunities for turnover accompanied by the common practice of outsourcing production make the barriers of exit relatively low. Excess Capacity deals with the notion that when supply grows in excess of demand, companies must reduce prices and compete amongst each other for market shares. This also leads the problem of unsold merchandise, resulting in a loss of profit. Inventory liquidation, via large sales and discount promotions, are also used to combat this problem. When the market seems slow, for instance at a period in between seasons, retail companies will simply liquidate inventory for a lower cost, generating less profits or sometimes breaking even. In the clothing specialty retailer industry is a great amount of competition because every clothing company is constantly changing their image and clothing styles to reflect the current trends of seasonality or ever day wear. For instance, if you into an typical clothing company in the spring time, they might have a sales rack selling jackets, sweaters, etc. from the previous fall season on sale for considerably less

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then what you could have bought it for in the actual fall season. Companies in this industry must rely on inventory management to produce a profit. If they dont sell enough of their products then they will have to use an excess capacity strategy by selling their products for less then what originally predicted. If you find your company constantly having to use excess capacity in selling your products then you will find that you will have to close down your store or relocate. In this industry you see a lot of store closure or relocation in places like malls, shopping centers, etc. mostly due to this excess capacity concept. In conclusion, the degree among the competition of existing firms in the specialty retail industry is very high. Close competitors are marketing to similar customer bases, in close proximity to each other. This forces them to create profits by differentiating themselves through style and image. These firms are also competing among each other regarding price, yet in the specialty retail subsidiary of the apparel market, price competition is not as highly focused on in relation to cost competitive retailers such as Wal-Mart and Target.

Threat of New Entrants

The threat of new entrants deals with the idea that large profits in an industry will attract new firms into the industry, shaving away profits from the existing players in the market. There are several factors that decipher the level of competition an industry has in regards to new entrants entering a market and reducing a companys market share.

Economies of Scale/Learning Economies

Companies that enter into a new market must compete with the smaller manufacturers as well as the large staple companies in the industry. This could

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be difficult on many levels for a company that is trying to generate a profit early on in its company life. Economies of scale deals with the idea that as a company begins to produce more and more of a product, the price per unit of each item will effectively drop as a result of a mass scale production operation. As we know, decreasing the price of production for an item allows a company to reduce its prices more, competing on a cost basis and forcing companies to lower their prices as well to stay competitive. This situation could be very difficult for a start up company to overcome because they will have to possess a large amount of initial equity to be able to enter into the market a competitive force. A company could try to enter the market with less than optimum capacity, but this will force them to compete on a level of product quality and consumer knowledge. This is a difficult task in an industry where gaining a successful customer base requires knowledge of customer styles, expectations, and the nature of the business. The graph bellow shows total assets for Guess and its competitors over the past five years. Based on this information, a start up company would have to possess a large amount of assets to compete with existing firms. Based on these numbers, it would probably be unrealistic for a start up firm to possess that much in assets.

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Total Assets
Assets(thousands of 12000000 10000000 8000000 6000000 4000000 2000000 0 2002 2003 2004 Year Gap Abercrombie & Fitch American Eagle Guess 2005 2006

Guess was formed in 1981 and possess 26 years of experience. This experience has given them valuable knowledge of their customers, information regarding business and manufacturing prices, and learning what works and what does not. Seasoned firms use their knowledge of cyclical demands as well as new and upcoming fashions to create and maintain a strong customer base resulting in profit. New entrants into a market will struggle to adapt to find the right customer base and learn what it takes to be successful in the specialty-retail industry.

First-Mover Advantage

Since its conception in 1981, Guess Jeans has been a well recognized retailer in the apparel industry. In the fashion industry brand recognition is a prevailing factor that leads to the success of a company. This will inherently lead to a firstmover advantage among companies in the industry. As a retailer becomes seasoned in the market, it will gather a customer base that identifies the brand name as being cool, stylish and as having exceptional quality. All of these factors

dollars)

Total

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will result in brand loyalty and a strong customer base. It will be very difficult for a start up company that has just entered into the market to compete with retailers such as Guess, Abercrombie & Fitch, American Eagle, and Gap who are recognized by consumers by their brand name and trademark style.

Access to Channel Distributions and Relationships

Since many retailers in the industry today outsource their manufacturing responsibilities, it is very important that a company have access to these distribution channels and obtain a positive professional relationship with them. When outsourcing a product, quality will obviously become an issue a firm has to deal with because even though they are not directly behind the creation of their product, it is ultimately the retailers responsibility to produce a quality product that is in line with the companies brand name, and that will be attractive to the consumer. Without positive relationships with suppliers, a company can fail to put out a quality product that is necessary to generate product in the specialty market. Shipments must be timely and correct to compete with the cyclical changes in fashion as well as the constantly changing clothing lines of similar competitors. A new entrant into the industry will have to correctly identify a reliable supplier and maintain a relationship with them that will allow them to market a quality product and to remain efficient. New entrants face this dilemma because there are limited suppliers in the market place. So when there is a new entrant in the market, they are competing with bigger firms who have bigger accounts with these suppliers. Suppliers will want to please their bigger clients first. As a result, new entrants will find it harder to get their products in a timely manner. In addition, their quality of product might suffer because suppliers will rush to get their products to them in a timely manner.

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Legal Barriers

The retail industry has almost no legal barriers to entry. Trademarks of companies tend to be the most restrictive barriers to new entrants. These trademarks do not allow a company to mimic or reproduce products that are directly related to a companies trademarked logo. This allows a company to remain new and innovative in the industry, and not to be threatened by competitors attempting recreate another retailers clothing line. In conclusion, the threat of new entrants into the specialty-retail sector of the apparel market is relatively low. New entrants into the market will have to deal with the difficult issues of economies of scale, a large first-mover advantage, as well as attaining efficient and reliable distribution channels.

The Threat of Substitute Products

Obviously in an industry such as clothing, substitute products will be very evident in the market. Retailers in the specialty-retailing sector of the apparel market will have to differentiate themselves from the rest of the pack, and look at factors such as relative price and performance, as well as a buyers willingness to switch from one product to another. Guess focuses on differentiated product designs and styles they believe will separate themselves from the rest of the retail industry. Because consumers tend to relate a higher product cost to a higher product quality, Guess focuses more on exceptional product quality rather than creating a lower cost. Another factor that might influence a customer purchasing substitute products is the manner in which they shop for their products. Guess not only sells its

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products in a traditional retail locations, but also offer their products via the internet. This new selling channel will become more prevalent in future years as the general population begins to trust the internet more and becomes more computer savvy. This idea is supported by the fact that online sales have continued to increase from year to year. This is different from our competitors in the industry such as American Eagle and Abercrombie. Although they are categorized as specialty-retailers, they focus more on relaxed, leisure clothing, which can sometimes be associated with a slightly lesser cost. Guess chooses to focus on a customer base that is willing to spend a higher price for the latest designs in fashion and the highest clothing quality. In conclusion, the threat of substitute products in the clothing industry is high because of the extreme variety a consumer can choose when purchasing clothing. For an industry to be successful in retailing, they must focus on brand image and quality to gather and retain a customer base and create a profit.

Bargaining Power of Buyers

Bargaining power of buyers is determined by two things in the Specialty Retail industry, price sensitivity and relative bargaining power. In the Specialty retail industry companies suck as Guess customers or buyers are very price sensitive because they can easily switch over to competitors apparel if they offer they same item at a lower price. So price wars among the retail industry can get very severe at times. Due to the fact that one single buyer in a retail industry does not consumer a significant amount of the companies apparel, losing a couple of customers due to price changes will not harm the company. Basically companies in the retail industry need to constantly make an effort to keep up with changing

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trends in fashion and preferences among certain age groups to ensure that they can compete on a competitive level and maintain a significant amount of market share in their industry. Furthermore, since one single buyer does not consume massive amounts of inventory they have little to none relative bargaining power over the suppliers. This is also true because the switching cost is very low for the buyer. In essence, in the specialty retail industry the customer has very low bargaining power because the individual suppliers i.e. the stores are forced to compete on cost due to low switching cost.

Bargaining Power of Suppliers

In the specialty retail industry firms attempt to buy their goods at the lowest price possible, and this gives suppliers very little bargaining power over the buyers because the buyers can opt to change suppliers very easily due to the large volume of suppliers willing to offer the goods at a lower price. There are so many different retail suppliers that buyers can have produce their product that might offer a lower price that the supplier has relatively low bargaining power over the buyer. Because Guess is a widely recognized brand name they do not have to compete on quality but more so on cost and trying to differentiate themselves from their competitors. The suppliers want to offer the lowest price they can due to the easy with witch the buyer can switch suppliers. So the suppliers are very price sensitive and this gives bargaining power to the buyer because they dont have to rely on one single supplier. Overall, the specialty retail industry has to compete on price most of all due to all the reasons stated above.

Value Chain Analysis

Firms in the specialty retail industry compete on differentiation. To be successful while following a differentiation strategy the firm must accomplish three things.

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First, it needs to identify one or more attributes of a product that customers value. It must then position itself to meet these customer needs in a unique way. Finally, firms must achieve differentiation while maintaining a cost below the price premium that customers are willing to pay. Because the industry is highly competitive firms must also take into account some cost leadership strategies to maximize their potential advantage. There are several key success factors which are vital to achieving and sustaining a competitive advantage in the specialty retail industry.

Key Success Factors Differentiation

The primary factor that separates firms in the specialty retail industry is a distinguished image that customers value. Firms are able to accomplish this by investing resources in their brand image. By creating a reputable image and distinct design, firms are able to capture and retain a certain customer base. Because firms in this industry are not competing solely on cost leadership it is imperative that they invest in developing a unique product image to differentiate themselves from competitors. Another factor is the ability to produce a product of superior quality. The products created must have a high perceived quality to gain any kind of competitive advantage in the specialty retail industry. There are general market expectations for a certain level of quality within the industry. Without meeting or exceeding these standards a firm cannot expect to compete. The ability to develop a superior product variety is another important success factor. There is an opportunity to achieve further competitive advantage by

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offering a larger variety of products. Firms accomplish this through the expansion of current product lines, creation of new product lines, and selling additional accessories. Engaging in such a strategy allows firms to expand their customer base and further serve their current customer base.

Cost Leadership

Because the specialty retail industry is highly competitive and fragmented, firms that follow a differentiation strategy cannot ignore the cost leadership dimension. There is a price premium that will turn customers away from firms in the industry, so it is important to find ways to reduce production costs where possible. Areas that firms can focus on are low-cost distribution and efficient production. This can allow a firm to reduce production costs without sacrificing the product quality or brand equity that is necessary in a differentiation strategy.

Firm Competitive Advantage Analysis

Since its founding in 1981 as a small California jeans company, Guess has developed into one the most familiar brand names in the fashion industry. The specialty retail clothing and apparel industry has been classified as one of the most highly competitive industries due to many swift variations of consumer wants and interests. Guess believes that its success depends in large part upon its ability to anticipate, gauge and respond to changing consumer demands and fashion trends in a timely manner and upon the continued appeal to consumers of the Guess image. (GUESS?, Inc. 2007 10-K)

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Brand Image
The best way of achieving competitive advantage in this industry is to possess a strong attribute in differentiating your products from your competitors. They have achieved this by continually leveraging what they want their brand image to represent. With their headquarters in Los Angeles, CA, they are constantly visiting dominant fashion locations where their marketing teams can see what the new styles are and get a glimpse of where they think the industry is headed. Guess puts most of its effort into new product innovation and differentiation. They have done this by utilizing a retail strategy that focuses on opening more retail stores, while at the same time, constantly improving the quality of the stores that already exist. The constant improvement of stores will keep the brand image consist with the current trends of the period. This is a very simple, but effective strategy of maintaining, capturing, and retaining a susceptible customer base. Guess has also correlated their brand image into an expansion and growth plan. This expansion plan can be a way of building brand awareness and executing market penetration. During 2006, we opened a total of 32 new stores in the U.S. and Canada consisting of eight new full-price retail stores, seven factory outlet stores, 11 MARCIANO stores and six Guess Accessories stores, while closing 11 stores. Guess expects to open approximately 48 new stores in 2007, consisting of 15 full-price retail, four factory outlet, 13 MARCIANO stores, three Guess Accessories and 13 G by Guess stores.(GUESS?, Inc. 10-K) Internationally, Guess acquires licensees and distributors in Europe, South America, Asia, Africa and the Middle East. If Guess can effectively establish itself as a defiant manufacturer and distributor, it can take advantage of economies of scale and further expand its operations abroad. Guess needs to be competitive with constant expansion and growth. The more exposure in the market, the more consumers will want to buy your products. 29

Superior Product Quality

Guess strives to offer products that are superior in quality. To ensure that products meet the desired standards Guess has implemented a quality control program. This program allows them to monitor the quality of the fabrics being used prior to the production of a final product, and inspect prototypes of each product before initiating production runs. Another aspect of the program is random quality control checks during and after production before garments leave the contractor. There are also final random quality checks after the products have been received by the distribution centers. Guess believes that this policy of inspection is important in maintaining quality and consistency in its products. The quality control program allows Guess to produce a product of superior quality which conforms to their strategy of differentiation.

Superior Product Variety

To achieve product variety Guess is placing additional emphasis on their Accessories line and their MARCIANO line. Guess plans to direct greater attention to these lines in existing stores as well as open additional stores that exclusively feature these products. This strategy targets current Guess customers while also aiming to capture new customers. By focusing on developing superior product variety, Guess has enabled them to significantly expand. In 2006 there were six Guess Accessories and 11 MARCIANO stores opened. The previous year there were six Guess Accessories and nine MARCIANO stores opened. Another way that Guess is expanding their product variety is introducing a new mid-tier brand concept. G by Guess targets a more price conscious demographic. In early 2007 Guess will open the first G by Guess store in North America. By the end of the year the expectation is to have approximately 32 G 30

by Guess locations. The product variety that Guess has pursued is essential to the differentiation strategy that is necessary to gain a competitive advantage in the specialty retail industry.

Efficient Production
To increase efficiency Guess has made improvements in their product sourcing. In the past year, changes streamlined processes, provide calendar alignment, and increase the timeliness of delivery. This globalization of operations will enable us to begin integrating our European, North American and Asian-based supply chains. This, in turn, supports our long term strategy of developing a global core product assortment, through collaboration between our U. S. and Italy based design teams. (GUESS?, Inc. 10-K) To assist the design process, Guess has formed a Product Development team that dictates calendar deadlines, assortment plans, and financial goals. These steps have allowed Guess to increase the efficiency and lower the cost of production.

Low-Cost Distribution

Guess primary distribution center is located in Louisville, Kentucky. The site is near the United Parcel Services national transit hub. (GUESS?, Inc. 10-K) This had allowed the company to reduce shipping time and costs of distributing goods to the Eastern part of the United States. Guess projects that it will continue to reduce operating cost by reducing handling costs in this facility. The company has also updated software systems in the Montreal and Los Angeles distribution facilities to align with the systems used in the primary facility. This has resulted in further operating efficiencies. The goal of these actions is to reduce future processing and freight costs. (GUESS?, Inc. 10-K)

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Looking Forward

Guess has been successful at creating a distinguished brand and valued product lines within the specialty retail industry. By differentiating themselves from competitors and maintaining competitive prices they have achieved a competitive advantage. This has allowed Guess to expand domestically and internationally. In 2006 Guess increased retail average square footage by 5.3%. Sales in 2006 were up 12.8% from the previous year. They plan to open 108 new stores in 2007 and further expand through international acquisitions. They are regularly implementing new strategy and innovation to increase and sustain their competitive advantage in this highly competitive industry.

Accounting Analysis
To thoroughly and properly analyze a firm and be able to value it with a high degree of certainty, one must perform an accounting analysis to understand the true underlying meaning of the numbers and ratios present in the financial statements. The process of accounting analysis involves six key steps. First, you need to identify the Key accounting policies which entails understanding the policies and estimates the firm uses to implement their key success factors to their business. A firms industry characteristics and competitive advantage strategy both determine what makes up their key success factors and risks. One of the goals of a company should be to evaluate their key success factors and risks and how they plan to take advantage of success factors and to avoid risks. As for a company like Guess in the Retail Sector Inventory Management is a major key success factor.

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Second, the degree of accounting flexibility needs to be assessed and this directly relates to the amount of flexibility allowed through (GAAP) standards. A company with a high degree of flexibility might be able to present their financial statements in a more clear way in relation to their key success factors, and vice versa if there is not a sufficient amount of flexibility. The third step involved is evaluating the actual accounting strategy that the managers of the firm use. From the previous step we know that managers have the ability to manipulate financial figures. For this reason we must carefully examine the accounting strategy that the firm implements. The fourth step is to evaluate the quality of disclosure because the extent to which managers can disclose their information can vary greatly across companies making financials either transparent or very difficult to use in assessment of the firm. The fifth step is to identify potential red flags such as unexplained increases or decreases on the financial statements. This is done bye looking at the 10-Qs for a company. Many companies will defer expenses in the fourth quarter to the first quarter of the following year. By doing this, companies incomes will be overstated. Last, as an analyst if distortions are discovered they need to attempt to undo the red flags to enhance the credibility and true underlying meaning of the companies financials.

Key Accounting Policies

In determining a companys key accounting policies it is imperative the companies key success factors match up with the key accounting policies that they company uses. As previous discussed in our companies five forces model a company in the specialty retail industry like Guess has to create value through tight cost control or cost leadership. There are many ways that a company can manipulate their financials to make it seem as if costs are being lowered, which looks pretty to investors, but as an analyst it must be explored to find the actual 33

reason for cost being lowered. Flexibility in (GAAP) enables this type of problem to occur. There are four distinctive qualities that are used in valuating a firms accounting policy, each one bring more light to how the firms accounting is effecting their overall performance. These qualities include reporting for Inventory methods, Depreciation methods, Goodwill treatments, and Property, plant, and equipment (PPE) valuations. For evaluating inventory methods, you want to find out which method for accounting for inventory the company actually used. Decipher whether the company decided to use FIFO, LIFO, Weighted Average, etc. for their inventory analysis. Out of these methods, you need to decide under which method the company has the most flexibility to make their company look the best to an investor. If they used one method over the other determined what the company is really worth by working another method to compare it to the companys desired method. Using the depreciation method of a company is also another way to determine where there is flexibility for a company to make themselves look good. Whether a company used straight-line method, declining balance method, or sum-of-years digits method can make a big difference in determining how a company is really performing. Once you determine which one they used, I would as beginning investor would find out why the company picked that method, compare it all the other methods and see how the company is performing. Goodwill is the difference between the purchase price and the book value of an acquired companys assets. All U.S. firms are required to capitalize and amortize goodwill against income for financial statements and deny them any tax deductions for the amortization. Some companies get around this policy by 34

conducting a comprehensive estimation to determine assets being acquired by both tangible and intangible. Then a depreciation deduction can be rationalized with an established individual value and a limited life. Some companys use this method and some of them use the GAAP standard for accounting for goodwill, the only way to determine whether the company is doing this or not is to look at their journal entries on the financial statements. Property, Plant, and Equipment (PPE) are the physical assets the company owns but can't quickly convert to cash. Depending on the type of business, this may make up a large portion of total assets. Whether it does or not depends on how the company allocates for its PPE. Identify, whether it possesses a lot of land and separate assets used in agricultural activity or if its productive assets held by entities in the other industries. These qualities are very important in evaluating a company. Using these methods will shine light on how a company makes itself look to investors and what characteristics it does not want you know about. Another key accounting policy is how a company reports on its building assets, which can be either of the two options, capital or operating leases. Capital leases will increase a companys asset which directly increases owners equity on the balance sheet. The use of operating leases is a more aggressive approach because it attempts to decrease liabilities. In guesss case they use both operating and capital leases. Their operating leases only recognize the current years rent as a liability rather than the life of the asset, so for the next five years using a discount rate of 8.5% investors are seeing that liabilities are understated by 4million making the company look like it is in better financial condition than it really is. In other words this should be the true present value of the future payments. Another key accounting policy is how a company reports on its building assets, which can be either of the two options, capital or operating leases. Capital leases

35

will increase a companys asset which directly increases owners equity on the balance sheet. The use of operating leases is a more aggressive approach because it attempts to decrease liabilities. In guesss case they use both operating and capital leases. The use of operating leases has a major influence on how companies financial appear to investors. By capitalizing all of Guesss operating leases we have determined that Guess must make an adjustment of $388,532 to their liability section of the balance sheet. The discount factor that we used was 3.8% which is not stated in the companies 10-K. This is probably because the number observed is even lower than the risk-free rate which would never feasibly happen. This forecast will give investors a more honest picture of Guesss true financial standing in the future.

Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Operating Lease PMT 77,515 72,251 66,752 56,164 46,762 22,820 22,820 22,820 22,820 22,820 22,820

PV Factor 0.963 0.928 0.894 0.861 0.830 0.799 0.770 0.742 0.715 0.689 0.663 TOTAL

PV 74677.26 67057.78 59685.97 48380.31 38806.66 18244.48 17576.57 16933.11 16313.21 15716 15140.66 388,532

Areas of Accounting Flexibility

All companies are required to prepare their consolidated financial statements in conformity with Generally Accepted Accounting Principles. This requires management to make estimates and assumptions which affects the amounts of assets, liabilities, revenues and expenses during the reporting period. Accounting rules allow flexibility because it is difficult to restrict management

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discretion without reducing the information content of accounting data. For this reason it is possible for corporate managers to introduce noise and bias into data through their accounting decisions. Managers have a variety of incentives to exercise their discretion to achieve certain objectives. Guess has disclosed significant accounting polices which they believe involve a higher degree of judgment and complexity. These disclosed policies are those for which GAAP has left room for accounting flexibility and managers have choices in the way that they disclose financial information. In the following areas Guess is less constrained by accounting standards and conventions. Guess recognizes retail operations at the point of sale and wholesale operations revenue from the sale of merchandise when products are shipped. There is room for accounting flexibility within GAAP standards when it comes to the way that management recognizes sales returns. Guess accrues for estimated sales returns and other allowances in the period in which the related revenue is recognized. To recognize the impact of returns, Guess estimates the amount of goods that will be returned based on historical experience and reduces sales and cost of sales accordingly based on historical return experience. The change in sales returns accruals decreased gross profit by $3.3 million at December 31, 2006 (Guess 2006 10-K). Management can manipulate the amount of allowance for returns to affect the net income. An understated allowance for returns results in overstated sales and thus overstated net income. Guess leases their showrooms, advertising, licensing, sales and merchandising offices, remote distribution and warehousing facilities and retail and factory outlet store locations under non-cancelable operating lease agreements expiring on various dates through January 2018 (GUESS? Inc. 10-K). Guess reports both operating leases and capital leases however capital leases only account for 4.4% of their total lease agreements. When a lease is capitalized the building is booked as an asset and the firm can recognize depreciation and amortization 37

benefits. The benefit of having a large percentage of lease agreements remain operating leases is that the expenses incurred are not fully recognized. This understatement of expenses leads to an overstated net income and more appealing financial outlook for the firm. The decision not to capitalize leases allows the firm to understate liabilities, receive tax benefits, and overstate equity. This aggressive accounting strategy allows managers to distort balance sheet entries to make a companies financials look more appealing to investors. Guess assesses the impairment of its long-lived assets such as goodwill, intangible assets, and property and equipment which requires the company to make assumptions and judgments regarding the carrying value of these assets on an annual basis, or more frequently if events or changes in circumstances indicate that the assets might be impaired (GUESS? Inc. 10-K). If the assets are considered to be impaired, the impairment is recognized as the amount by which the carrying value of the assets exceeds the fair value of those assets. There is a great deal of flexibility in this policy because managers have discretion in assigning carrying value to impaired assets. As of December 2006 Guess reported goodwill of approximately $28 million and gross intangible assets as of December 2006 were $24.8 million. Assessing the value of goodwill is highly subjective because the company determines the fair value to be reported and compares it to its carrying amount. Management is capable of overstating assets or understating expenses which both result in overstatement of net income and equity. Since there is a certain degree of flexibility allowed in GAAP standards, these policy choices provide managers with an opportunity to significantly impact the numbers reported on the performance of a firm. Without this flexibility however, accounting data are likely to be less informative for understanding the firms economics. For these reasons we must critically evaluate the firms actual accounting strategy to accurately evaluate their financial outlook. 38

Accounting Strategy
Using the methods demonstrated in the key accounting policies, the accounting strategy focuses on accounting flexibility and how they use this flexibility to either communicate their firms economic situation or to hide their true performance. Because of GAAP, managers have flexibility in their accounting methods. They can use various accounting methods to help communicate the companys financial health, or they can use it to distort true performance. The methods in which they use are conservative, moderate, or aggressive by nature. A firm that uses a conservative accounting approach will not have as high a net income as a firm with an aggressive approach. This is because firms that have an aggressive accounting approach will manipulate anything to get their income as high as they can. The approach that Guess uses is a combination of aggressive and conservative accounting methods which correlate into their accounting strategy. When reporting their inventory, most companies use the First In First Out Method (FIFO). This means as a business purchases its inventory, holds the inventory, and finally sells the inventory the first group of purchases will be taken off the books first. (Mangan 2000) This method is considered to be aggressive because it artificially inflates net income in an inflationary economy. On the other hand, American Eagle uses the retail method. In this method, markdowns are fully accounted for in the month in which they have been taken. It assumes most of the markdowns apply to good sold and therefore that few of those goods are a part of the ending inventory. (www.cfpsa.com) This method is considered moderate by nature. Like many retailers in our industry, Guess offers its customers the opportunity to purchase gift cards for friends, family, and loved ones. In 2005, Guess accounted

39

for 8,460 of store credits and gift certificates. In 2006, Guess accounted for 10,705 of store credits and gift certificates which means there was a 2,245 increase in store credits and gift certificates in the year of 2005. The Company defers all revenues related to gift certificates cards and store credits until they are redeemed for merchandise. Based on prior redemption experience, the Company does not recognize unredeemed balances prior to two years from the date of issuance. The breakage income is subsequently recognized ratably into operating income over a four-year period. Once this benchmark is met, the unused portions are recognized into the operating income over a four year period. This is considered a conservative method of accounting because revenues are not recorded until they can be matched with their expenses. One of Guess buildings is tied down to a capital lease and the remaining of their facilities are tied down into operating leases. A capital lease is where the value of the building is booked as an asset and the asset is depreciated over the lifetime of the building. The lease payments are booked as a liability and decrease over the life of the asset. Capital leases give more information on the financial statements because it books all future lease payments for the asset as a liability. If Guess had all of their facilities on a capital lease, it would paint a much more accurate picture of how the company is doing financially. Capital leases recognize expenses sooner than equivalent operating leases. In an operating lease, the owner transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the owner. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet. In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each 40

year. In general, capital leases recognize expenses sooner than equivalent operating leases ( pages.stern.nyu.edu). However, Guess chooses to put the majority of their facilities into operating leases. By using the operating leases, Guess only has to recognize the current years rent as a liability. Guess has the future contractual rights to the properties for at least 15 years thus these expenses should be classified as a liability. By choosing operating leases over capital leases, Guess is allowed to keep a present value amount of about $338 million of liability off of its balance sheet. This practice of using operating leases is not just isolated to one firm in this industry. As a matter of fact, Gap, Abercrombie & Fitch, and American Eagle all use operating leases for their respected facilities. In operating leases, the lease expense is treated as operating expense in the income statement, so it stays off of the balance sheet. This is very significant to the effect that it is not reported on the balance sheet and ultimately does not affect any value on it. The value stated on the balance sheet is larger with the lease not stated on it then it would be stated if the lease was to be added onto it. This accounting method is considered to be very aggressive in nature, and is used by retailers in this industry because it makes the companies in this industry much more attractive to lenders and investors. As you can see, the accounting methods in which a company uses can have a substantial impact on the financial statements. Just by choosing to use operating leases over a capital leases for their facilities, Guess was able to understate their liabilities by over $338 million dollars. In addition, the FIFO method in which Guess employs with its inventory produces a net income that is overstated. Overall the various accounting methods Guess deploys make their accounting strategy aggressive because of activities in reporting their inventory methods, gift certificates, depreciation methods, goodwill treatment, property, plant, and equipment, and their operating and capital leases. 41

Quality of Disclosure

Guess is a publicly traded company which means it must report its financial standings to the SEC yearly in a document called the 10-K. The 10-K is a collection of all the companies financial statements and managements discussion and analysis which is audited before being handed over to the SEC. Managers determine how easy or hard it is for anyone to assess the firms accounting quality. They possess considerable power over what they determine should be disclosed and what should not be disclosed on the financial statements. The quality of disclosure is very important because accounting rules require a certain amount of information to disclose, but the information that the mangers of the company discloses is exactly what you want to see. You must determine whether this information is biased or not.

Qualitative

Qualitative information is individual narrative reports of experiences. Qualitative information is gathered with methods that are personal, direct, and open-ended, with very few constraints on what the answers to the questions may be. These methods include formal research methods. It was found that Guess does a very good job of presenting their information in their 10-K through their financials and management discussion and analysis in a very clear manner. Most companies in the retail industry use operating leases. Guess does a good job of disclosing clearly whether they function using operating or capital leases. Most companies if they do use both will attempt to only make the operating leases clear so that liabilities do not look as high, but Guess was very credible in this area of disclosure.

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Furthermore, the quality of disclosure regarding how they account for sales return reserves, pension benefit plan, and valuation of goodwill, everything is clearly disclosed and supported with more than enough information for an investor to gain a fair and true understanding of the business and its operations. Another item that increases Guesss credibility when it comes to reporting their financial statements is they paint a very clear understanding of why there were increases or decreases in different line items on the financials due to changes in (GAAP), or changes in the operations of the company. The only item that might seem slightly sketchy is they method they use to account for inventory, which is, first in first out. This is considered an aggressive approach as opposed to last in last out if there is inflation over the previous fiscal year. And there is inflation of around 3.5% with almost every year that passes. So the use of the FIFO method we assume is being used to increase revenues. On the contrary, FIFO is acceptable to use under (GAAP) due to the flexibility, so the company cannot be looked down upon for using this method in its entirety.

Quantitative

Quantitative information is very important to look at when evaluating a firm. This type of information usually falls under a few categories in a companys activities. Social security, personal retirement accounts, payroll taxes, pensions, stock trends, and bonds all fall under being analyzed as quantitative information. Quantitative data and analysis is assessed using pure form data and numbers to draw conclusions on the quality and disclosure of a companys financials. The conclusions drawn are more accurate because the decisions are based upon factual numbers. The ratios on the graphs below will help to gain a better understanding of core sales manipulation and core expense manipulation to better understand the business and its competitors.

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Potential Red Flags

From the information provided by Gaps quarterlys, it can be established that Guess is making large fourth-quarterly adjustments on their books. When Guess filed their 10-Q on 11/09/05, they reported an increase to selling, general, and administrative expenses of $23.5 million, or 46.9%, equaling $79.0 million in the three months ended October 1, 2005, from $53.7 million in the comparable 2004 period, primarily attributable to the increase in European operations. On their 05/11/06 10-Q filing, they reported another increase of $10.5 million, or 15.7%, to $77.6 million in the first quarter ended April 1, 2006, from $67.1 million in the comparable 2005 period, primarily due to increased costs in the European operations, the incremental costs to run an average of 25 net new stores in North America and additional compensation expenses, including the impact of expensing options in accordance with the new accounting rules. This also suggests that Guess could have been forced to make adjustments to their end of the year results due to increased pressure from their external auditors. If Guess is consistently making drastic fourth-quarter adjustments to their financial statements, this means their accountants are operating under an aggressive accounting management of interim reporting.

Undoing Accounting Distortions

When an analyst sorts through all of the financial statements, they will normal find errors in reporting or aggressive accounting practices that affect the balance sheet, income statement, or statement of cash flows. Once the analysis is done, the analyst must make changes as they see fit to get a more accurate assessment of the company.

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As stated above, the only main issue that needed to be adjusted was converting the operating leases to a capital lease. In conclusion Guess Jeans Inc. remains competitive in regards to this ratio, and reveals to us that it is consistent with the industry in regards to relating its cash flow from operations to its net operating assets, and investing in operating assets wisely. This would not be considered a red flag in their accounting policies.

Financial Analysis Core Sales Manipulation Diagnostics

Sales manipulations diagnostics are a series of ratios designed to let you know if you can believe a companies net income. More specifically, it enables you to compare net sales to various revenue related accounts, such as, cash from sales, net account receivables, and inventory. The following ratios were used to analyze Guess and their competitors over the past five years. The tables provide an industry average and compare Guess against their competitors in the industry. This can help to identify potential red flags and help to gain a clearer understanding of the current accounting policies in place. Most of the companies in this industry do a good job of collecting cash from their sales. In the specialty retail industry most of revenue over the past five years analyzed comes from cash over those same years. For Guess a third party takes on the responsibility of guesss accounts receivables and Guess, is compared with the cash. Therefore, accounts receivables directly related to customers never appears on the balance sheet. Thus, the Net Sales/Cash from Sales ratio stays relatively close to one. Out of all the firms in the specialty industry that we compared to Guess, Guess has the highest amount of credit sales. If they had the lowest amount of credit

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sales they would have more cash to use in operating activities. But overall as a whole the specialty retail industry does a relatively good job of collecting cash on sales. The net sales/inventory ratio for the past five years has increased then decreased or leveled out. This pattern is fairly consistent with the industry; Guess is the industry leader in this area of analysis. This means that their inventory is stable and cost efficient.

Core Sales Manipulation Diagnostics

Net Sales/Cash from Sales

1.06 Net Sales/Cash from Sales 1.04 1.02 1

0.98 0.96 2002 American Eagle Guess Jeans Inc. 2003 2004 2005 2006 Year Abercrombie and Fitch GAP

Most of the companies in this industry do a good job of collecting cash from their sales. In the specialty retail industry most of revenue over the past five years analyzed comes from cash over those same years. For Guess a third party takes on the responsibility of guesss accounts receivables and Guess, is compared with the cash. Therefore, accounts receivables directly related to customers never appears on the balance sheet. Thus, the Net Sales/Cash from Sales ratio stays relatively close to one.

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Net Sales/Net Accounts Recievable Net Sales/Net Accounts Recievable 250 200 150 100 50 0 2002 2003 2004 Year Abercrombie and Fitch American Eagle Corporation Guess Jeans Inc. 2005 2006

Out of all the firms in the specialty industry that we compared to Guess, Guess has the highest amount of credit sales. If they had the lowest amount of credit sales they would have more cash to use in operating activities. But overall as a whole the specialty retail industry does a relatively good job of collecting cash on sales.

Net Sales/Inventory 15 10 5 0 2002 2003 2004 Year Guess Jeans Inc. American Eagle Abercrombie and Fitch GAP 2005 2006

The net sales/inventory ratio for the past five years has increased then decreased or leveled out. This pattern is fairly consistent with the industry;

Net Sales/Inventory

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Guess is the industry leader in this area of analysis. This means that their inventory is stable and cost efficient.

Core Expense Manipulation Diagnostics

While the sales manipulation diagnostics are used to measure the accuracy of net income, the expense manipulation ratios are a series of ratios that measure aggregate expenses. These ratios help analyst test the accuracy of aggregate expenses of a company.

Declining Asset Turnover

2.50 Sales/Assets 2.00 1.50 1.00 0.50 0.00 2002 2003 2004 2005 2006

Abercrombie and Fitch 1.60356023 1.23465457 1.49977851 1.5559496 1.47600494 Guess Jeans Inc. American Eagle GAP 1.66834224 1.75481372 1.71872525 1.4779451 1.41611733 1.97364633 1.63014283 1.46069946 1.44612054 1.40600327 1.8 1.46 1.48 Year Abercrombie and Fitch Guess Jeans Inc. American Eagle GAP 1.62 1.82

The asset turnover ratio measures net sales divided by total assets. This ratio is useful to determine the amount of sales that are generated from each dollar of assets. Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover. For companies in the retail industry you would expect a very high turnover ratio mainly because of

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competitive pricing (www.investopedia.com). Over the past 5 years Guess has seen very slight fluctuations in their asset turnover ratio. This movement is very consistent with the industry average and is not worthy of a red flag.

Changes in CFFO/OI
10

CFFO/OI

5 0 -5 -10

2002

2003

2004

2005

2006

Guess Jeans Inc. American Eagle GAP

-1.30400247 1.129059946 0.610200103 1.415062165 -0.12128754 -4.11800851 -5.18794666 1.437898785 4.916230902 5.849040991 1.61 1.39 1.39 Year 1.28 1.55

Abercrombie and Fitch 1.352801787 2.618552876 4.937040413 0.152770588 1.114683751

Guess Jeans Inc.

American Eagle

Abercrombie and Fitch

GAP

The cash flow from operations ratio is used to determine the extent to which cash flow differs from the reported level of operating income. It is a check on the quality of a companys earnings. It is better measure of a companys profits than earnings, because a company can show positive net earnings and still not be able to pay its debts. If this ratio is substantially less than one or decreasing cash flow problems are likely (www.valuebasedmanagement.com). Guess cash flow from operations ratio has been up and down over the past 5 years. In 2002 and 2006 the ratio was negative. This is a potential red flag because it indicates that Guess cash resources are poor.

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Changes in CFFO/NOA
60 40 20 0 -20 -40 -60 -80 2002 Guess Jeans Inc. Abercrombie and Fitch American Eagle 2003 2004 2005 2006

CFFO/NOA

2.44047894 -2.4014167 46.372549 2.18065396 -0.5461861 2.154012 0.20836339 1.42552071 0.23544932 0.46139465 10.7250718 2.57865153 30.0769294 -62.432619 5.50418359 Year

Guess Jeans Inc.

Abercrombie and Fitch

American Eagle

Cash flow from Operations is the main source of cash generation for a corporation. It demonstrates the amount of cash that a company generates internally, as opposed to external activities such as financing and investing. By dividing this number by Net Operating Assets, such as property plant and equipment and other working assets, we can analyze how much cash flow from operations is being generated for every dollar unit that is being spent on working assets. American Eagles ratio has drastically decreased following 2004 while Abercrombie and Fitch has remained almost constant in the past four years. Guess Jeans Inc. has performed well in this category, maintaining a level ratio with our competitors from 2002-2003, and then separating itself from the pack in 2004-2005, then again leveling out with our competitors in the following years. The systematic declining of the ratios from 2004-2005 reveals a possible industry wide slow-down of the market, this could explain the common decrease in cash flow from operations.

50

Total Accruals
Total Accruals/Change in Sales 15 10 5 0 -5 Guess Jeans Inc. American Eagle GAP

2002

2003

2004

2005

2006

0.225262222 -1.02271452 -0.85231503 -0.70203065 -0.56696722 0.972523619 1.055836134 0.577103379 0.680413587 -0.7660309 -0.02 -0.03 -0.03 Year -0.07 -0.05

Abercrombie and Fitch 5.651425322 12.12997432 5.096521537 3.053371633 5.128882532

Guess Jeans Inc.

Abercrombie and Fitch

American Eagle

GAP

The total accruals are defined as earnings before discontinued operations and extraordinary items less operating cash flows. An increase in accruals from one period to the next may indicate management is attempting to manipulate earnings through its discretionary authority over accrual policy. This ratio shows that as sales increase/decrease, the amount of accruals should be consist with the number of sales received throughout the year. Looking at the graph, it can be stated that Abercrombie and Fitchs Total Accruals/Change in Sales plotted line ratio has considerably higher ratios then American Eagle and Guess. This suggests that they either acquire more sales then American Eagle and Guess each year or they possess a lot more accruals then they can account for sales. American Eagle and Guess Total Accrual/Change in Sales ratios seem to be in a relevant of range of each other implying they are very competitive of each other and their accruals do not outweigh their account for sales by a substantial amount.

51

Forecasting
Since value is determined by all future cash flows provided by company, forecasting is crucial when determining the firms present value. The best way to forecast future performance is to comprehensively produce an earnings, cash flow, and balance sheet forecasts. To make these forecasts more accurate, it is essential to look at the firms financial statements for the past five years to see if there are any trends that have developed over time. We also looked at several ratios to assist us in our forecast. After looking into the past, we can look into the firms future with more certainty. We forecasted Guess financial statements for the next ten years.

Income Statement
When beginning to forecast Guess financial statements, we started off by forecasting their income statement. The first item of concern was forecasting sales. Historically, Guess has been increasing sales by an average of 18.61% each year since 2002. This growth rate is on par with how the industry has been doing during this time frame. However, stronger than expected sales during the first quarter of 2007 has shifted many analyst opinions about Guess growth potential for the remaining of 2007 and the future. During the first quarter, sales for Guess have increase by 26.6%. With these optimistic numbers, analysts have predicted that Guess would continue its strong performance and beat Wall Streets expectations for the year (Nag & Chakrabarty). Keeping with the current trends, we grew Guess sales by 27% for the remainder of 2007. For the next five years, we predict that Guess will continue to experience this rapid rate of growth until sales grows to 29.5% in 2011. We believe that Guess will experience this growth for the next five years as it opens more stores and gains more market share. After these five years, Guess will have increased its market share from 5% to about 11% and American Eagle and Abercrombie & Fitch 52

would have a market share of about 20% each. Gaps market share would have decreased by 20% in five years. Since everyone is on a more level playing field five years down the road, we believe that Guess growth will slow down and head toward the industry growth rate of 15%. When forecasting Cost of Goods Sold (COGS), we noticed that COGS amount for about 56% of total sales. However, this number has been decreasing over the past six years. Keeping in line with what some of the competitors COGS is as a percentage of sales, we predict that Guess will continue to head toward the industry norm of about 51% over the next ten years. When forecasting earnings from operations, we noticed that on the common size income statement for Guess that earnings from operations have increased over the past three years to 16.29% of total sales in 2006. We expect this trend to continue until earnings from operations reaches about 24%. This falls in line with what the industry leaders like Gap and Abercrombie & Fitch maintain. When forecasting interest expense, we calculated that interest expense would increase over the next five years due to the fact that many new stores are expected to be opened in the near future. After that, we believe that their interest expense would go back down to levels that they have recently enjoyed. To get net income, we noticed that net income was about 10% of total sales. We applied this method when computing net income. The following depicts our prediction:

53

INCOME STATEMENT Net revenue: Product sales Net royalties Total Sales Cost of product sales Gross profit Selling, general and administrative expenses Earnings from operations Other expense (income): Interest expense Interest income Other, net Earnings before income tax expense and minority interest Income tax expense Minority interest Net earnings Earnings per share (Note 19) Basic Diluted Weighted average shares outstanding Basic Diluted

2001

Actual Financial Statements 2002 2003 2004

Forecast Financial Statements

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

640,700 36,920 677,620 447,825 229,795 201,527 23,829 12,705 (100) 482 13,087

544,081 39,058 583,139 383,806 199,333 202,930 (8,526) 9,444 (313) (825) 8,306

596,806 39,779 636,585 416,430 220,155 197,130 20,600 7,974 (134) (26) 7,814

682,020 47,242 729,262 455,278 273,984 218,502 55,482 5,653 (619) (265) 4,769 50,713 21,147

887,782 1,119,945 48,310 65,239 936,092 1,185,184 1,493,332 1,889,065 2,397,223 3,044,473 3,836,037 4,718,325 5,661,990 6,681,148 555,223 665,805 806,698 994,593 1,283,713 1,650,105 2,077,214 2,504,015 3,043,320 3,491,568 380,869 519,379 673,084 875,065 1,140,423 1,486,393 1,920,805 2,414,492 2,959,672 3,559,224 279,059 326,356 101,810 193,023 290,154 392,737 536,259 720,018 843,161 1,026,236 1,211,666 1,389,679 6,741 (2,626) 4,115 97,695 38,882 58,813 1 1 88,774 90,118 7,450 (5,947) (4,477) (2,974) 195,997 72,715 114 123,168 1 1 90,618 92,074
Forecast Financial Statements

7,750,132 8,835,150 4,018,443 4,427,294 4,206,202 4,883,421 1,600,402 1,802,371 69,751 62,730

10,072,071 5,058,194 558,496,359 2,059,739 6,949,729

11,648

18,324

28,767

47,189

64,445

68,416

69,076

71,488

6,242 0 0 43,656 43,958

(11,282) (0) (0) 43,392 43,392

7,286 0 0 43,279 43,558

29,566 0 0 88,020 89,088

164,267

213,464

281,674

362,292

464,160

580,354

719,073

865,209 1,011,392 1,161,822

1,329,513

COMMON SIZE INCOME STATEMENT Total Sales Cost of product sales Gross profit Selling, general and administrative expenses Earnings from operations Other expense (income): Interest expense Interest income Other, net Earnings before income tax expense and minority interest Income tax expense Minority interest Net earnings

2001 100.00% 66.09% 33.91% 29.74% 3.52% 1.87% -0.01% 0.07% 1.93%

Actual Financial Statements 2002 2003 2004 100.00% 65.82% 34.18% 34.80% -1.46% 1.62% -0.05% -0.14% 1.42% 100.00% 65.42% 34.58% 30.97% 3.24% 1.25% -0.02% 0.00% 1.23% 100.00% 62.43% 37.57% 29.96% 7.61% 0.78% -0.08% -0.04% 0.65% 6.95% 2.90%

2005 100.00% 59.31% 40.69% 29.81% 10.88% 0.72% -0.28% 0.44% 10.44% 4.15% 6.28%

2006 100.00% 56.18% 43.82% 27.54% 16.29% 0.63% -0.50% -0.38% -0.25% 16.54% 6.14% 0.01% 10.39%

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

100.00% 54.02% 45.07% 19.43% 0.78%

100.00% 52.65% 46.32% 20.79% 0.97%

100.00% 53.55% 47.57% 22.37% 1.20%

100.00% 54.20% 48.82% 23.65% 1.55%

100.00% 54.15% 50.07% 21.98% 1.68%

100.00% 53.07% 51.17% 21.75% 1.45%

100.00% 53.75% 52.27% 21.40% 1.22%

100.00% 52.26% 53.27% 20.80% 1.07%

100.00% 51.85% 54.27% 20.65% 0.90%

100.00% 50.11% 55.27% 20.40% 0.71%

0.92%

-1.93%

1.14%

4.05%

11.00%

11.30%

11.75%

11.90%

12.10%

12.30%

12.70%

12.95%

13.05%

13.15%

54

Income Statement (Revised)

The income sheet above would have been sufficient if Guess did not use operating leases. So, we must adjust the income statement to reflect this discrepancy. To do this, we took the earnings from operations and subtracted depreciation and interest expense. By doing this, operating expenses decrease more than loss from interest and depreciation. Thus, the overall result was an increase in net income. The following depicts this situation.

55

INCOME STATEMENT REVISED Net revenue: Product sales Net royalties Total Sales Cost of product sales Gross profit Selling, general and administrative expenses Earnings from operations Other expense (income): Depreciation Expense Interest expense Interest income Other, net Earnings before income tax expense and minority interest Income tax expense Minority interest Net earnings Earnings per share (Note 19) Basic Diluted Weighted average shares outstanding Basic Diluted

2001

Actual Financial Statements 2002 2003 2004

Forecast Financial Statements

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

640,700 36,920 677,620 447,825 229,795 201,527 23,829

544,081 39,058 583,139 383,806 199,333 202,930 (8,526)

596,806 39,779 636,585 416,430 220,155 197,130 20,600

682,020 47,242 729,262 455,278 273,984 218,502 55,482

887,782 1,119,945 48,310 65,239 936,092 1,185,184 1,493,332 1,889,065 2,397,223 3,044,473 3,836,037 4,718,325 5,661,990 6,681,148 555,223 665,805 806,698 994,593 1,283,713 1,650,105 2,077,214 2,504,015 3,043,320 3,491,568 380,869 519,379 673,084 875,065 1,140,423 1,486,393 1,920,805 2,414,492 2,959,672 3,559,224 279,059 326,356 101,810 193,023 290,154 392,737 536,259 720,018 843,161 1,026,236 1,211,666 1,389,679 35,321 14,764 35,321 12,380 35,321 10,105 35,321 7,952 35,321 6,120 35,321 4,576 35,321 3,882 35,321 3,163

7,750,132 8,835,150 4,018,443 4,427,294 4,206,202 4,883,421 1,600,402 1,802,371 35,321 2,416 35,321 1,640

10,072,071 5,058,194 558,496,359 2,059,739 35,321 835

12,705 (100) 482 13,087

9,444 (313) (825) 8,306

7,974 (134) (26) 7,814

5,653 (619) (265) 4,769 50,713 21,147

6,741 (2,626) 4,115 97,695 38,882 58,813 1 1 88,774 90,118

7,450 (5,947) (4,477) (2,974) 195,997 72,715 114 123,168 1 1 90,618 92,074

6,242 0 0 43,656 43,958

(11,282) (0) (0) 43,392 43,392

7,286 0 0 43,279 43,558

29,566 0 0 88,020 89,088

240,069

345,036

490,833

676,745

801,720

986,339 1,172,463 1,351,195 1,562,665 1,765,410

2,023,583

COMMON SIZE INCOME STATEMENT Total Sales Cost of product sales Gross profit Selling, general and administrative expenses Earnings from operations Other expense (income): Interest expense Interest income Other, net Earnings before income tax expense and minority interest Income tax expense Minority interest Net earnings Earnings per share (Note 19) Basic Diluted Weighted average shares outstanding Basic Diluted

2001 100.00% 66.09% 33.91% 29.74% 3.52% 1.87% -0.01% 0.07% 1.93%

Actual Financial Statements 2002 2003 2004 100.00% 65.82% 34.18% 34.80% -1.46% 1.62% -0.05% -0.14% 1.42% 100.00% 65.42% 34.58% 30.97% 3.24% 1.25% -0.02% 0.00% 1.23% 100.00% 62.43% 37.57% 29.96% 7.61% 0.78% -0.08% -0.04% 0.65% 6.95% 2.90%

Forecast Financial Statements

2005 100.00% 59.31% 40.69% 29.81% 10.88% 0.72% -0.28% 0.44% 10.44% 4.15% 6.28% $0.66 $0.65 $88,774 $90,118

2006 100.00% 56.18% 43.82% 27.54% 16.29% 0.63% -0.50% -0.38% -0.25% 16.54% 6.14% 0.01% 10.39% $1.36 $1.34 $90,618 $92,074

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

100.00% 54.02% 45.07% 19.43% 0.78%

100.00% 52.65% 46.32% 20.79% 0.97%

100.00% 53.55% 47.57% 22.37% 1.20%

100.00% 54.20% 48.82% 23.65% 1.55%

100.00% 54.15% 50.07% 21.98% 1.68%

100.00% 53.07% 51.17% 21.75% 1.45%

100.00% 53.75% 52.27% 21.40% 1.22%

100.00% 52.26% 53.27% 20.80% 1.07%

100.00% 51.85% 54.27% 20.65% 0.90%

100.00% 50.11% 55.27% 20.40% 0.71%

0.92% $0.14 $0.14 $43,656 $43,958

-1.93% ($0.26) ($0.26) $43,392 $43,392

1.14% $0.17 $0.17 $43,279 $43,558

4.05% $0.34 $0.33 $88,020 $89,088

11.00%

11.30%

11.75%

11.90%

12.10%

12.30%

12.70%

12.95%

13.05%

13.15%

56

Statement of Cash Flows

To compute cash flows from operation, we took net income and added back depreciation. It is essential to add back depreciation because it is an accounting method to account for the loss of value of an asset. This is necessary because cash does not physically leave the firm. By doing this, you can get a more accurate description of Guess cash flow. So to project that depreciation and amortization expense will go up proportionately with the rate that Guess is expanding their operations. For this reason we analyzed the trend over the past five years and predict that depreciation and amortization expense will be 3.5% of total sales. This number is consistent with the amount of depreciation incurred over the past several years. The following demonstrates our findings.

57

58

Cash Flow Statement 2001 Cash flows from operating activities:

Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization of property and equipment Amortization of intangible assets Stock-based compensation expense Deferred income taxes Net (gain) loss on disposition of long-term assets and property and equipment Other items, net Minority interest Changes in operating assets and liabilities: Receivables Inventories Prepaid expenses and other assets Accounts payable and accrued expenses Long-term deferred rent and lease incentives Long-term deferred royalties Other long-term liabilities Net cash provided by operating activities 6,242

Actual Financial Statements 2002 2003 2004

-11,282 7,286 29,566

Forecast Financial Statements

2005
58,813

2006
123,168

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

182933

268654

373562

466314

596957

673900

923233

1167603

1287165

1514891

1329513

39,751

37,727

34,924

34,975

32,364

35,309

41,481

52,267

66,117

83,903

106,557

134,261

165,141

198,170

233,840

271,255

309,320

0
1,271 N/A 1,480 797 211 N/A -6,117 48,115 9,868

0
252 N/A -8,867 8,152 362 N/A 5,063 422 -370

0
20 N/A 5,013 3,034 1,639 N/A 2,835 12,153 -6,717 6,796 N/A N/A N/A 62,474

0
467 968 -1,244 136 2,665 N/A -21,313 1,201 -1,871 23,624 10,335 4,250 N/A 83,759

0
2,275 1,175 -25,658 1,195 -2,729 N/A 18,145 -25,009 3,505 40,116 3,406 39,174 2,544 149,316

0
2,745 6,739 -5,441 -970 -369 114 -52,073 -25,177 -4,128 53,983 2,548 -1,418 3,223 138,253

-29,838
N/A N/A N/A 71,780

-1,870
N/A N/A N/A 29,589

224,415

320,921

439,679

550,217

703,514

808,161

1,088,374

1,365,772

1,521,005

1,786,145

1,638,833

59

Statement of Cash Flows (Revised)

To revise the statement of cash flows, we had to add the depreciation expense that correlated with the operating lease. We also had to use the net income from the revised income statement. The result is that cash flows increased because of the increase in net income. The following illustrates our findings:

60

Cash Flow Statement REVISED 2001 Cash flows from operating activities:
Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization of property and equipment Amortization of intangible assets Stock-based compensation expense Deferred income taxes Net (gain) loss on disposition of long-term assets and property and equipment Other items, net Minority interest Changes in operating assets and liabilities: Receivables Inventories Prepaid expenses and other assets Accounts payable and accrued expenses Long-term deferred rent and lease incentives Long-term deferred royalties Other long-term liabilities Net cash provided by operating activities 6,242

Actual Financial Statements 2002 2003 2004

-11,282 7,286 29,566

Forecast Financial Statements

2005
58,813

2006
123,168

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

240,069

345,036

490,833

676,745

801,720

986,339 1,172,463 1,351,195 1,562,665 1,765,410 2,023,583

39,751

37,727

34,924

34,975

32,364

35,309

29,619

29,619

29,619

29,619

29,619

29,619

29,619

29,619

29,619

29,619

29,619

0
1,271 N/A 1,480 797 211 N/A -6,117 48,115 9,868

0
252 N/A -8,867 8,152 362 N/A 5,063 422 -370

0
20 N/A 5,013 3,034 1,639 N/A 2,835 12,153 -6,717 6,796 N/A N/A N/A 62,474

0
467 968 -1,244 136 2,665 N/A -21,313 1,201 -1,871 23,624 10,335 4,250 N/A 83,759

0
2,275 1,175 -25,658 1,195 -2,729 N/A 18,145 -25,009 3,505 40,116 3,406 39,174 2,544 149,316

0
2,745 6,739 -5,441 -970 -369 114 -52,073 -25,177 -4,128 53,983 2,548 -1,418 3,223 138,253

-29,838
N/A N/A N/A 71,780

-1,870
N/A N/A N/A 29,589

269,688

374,655

520,452

706,364

831,339

1,015,958

1,202,082

1,380,814

1,592,284

1,795,029

2,053,202

61

Balance Sheet
The first item that we forecasted on the balance sheet was total assets. To forecast this, we used our sales to assets ratio to determine assets. We used 1.42 that we computed for the ratio and carried it out for the forecasted years. To accomplish this, we just divided total forecasted sales by 1.42. The next thing that we forecasted was stockholders equity. We accomplished this by taking net income and dividing by our R.O.E. R.O.E. for the industry has been consistently around 30% for the industry. By doing this, we were also able to get total liabilities. Because A=L+E, we just now take assets minus equity to get total liabilities. When forecasting total current assets, we noticed that total current assets were about 65% of total assets in recent history. We believe that this trend will continue because many firms in the industry are hovering around 61-63% over the past few years as well. Since these numbers have maintained consistent over the past few years, we will continue to forecast current assets as 65% of total assets. The same principle was used when forecasting current liabilities. Current liabilities have historically averaged around 65% of liabilities varying within a few percentage points. When forecasting accounts payable, historical data suggest that there is not a trend because they are up and down from year to year. However this data gives us a nice range when estimating future accounts payable. In years past, accounts payable has range from 24% of current liabilities to 30%. We then chose to go with the median of 27%. The following demonstrates our findings:

62

63

BALANCE SHEET 2001

ASSETS Current assets: Cash and cash equivalents Receivables, net Inventories Prepaid expenses and other current assets Deferred tax assets Total current assets Property and equipment, net Goodwill Other intangible assets, net Long-term deferred tax assets Other assets Total Noncurrent Assets Total Assets LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Current installments of notes payable, long-term debt and capital lease obligations Accounts payable Accrued expenses Total current liabilities Notes payable, long-term debt and capital lease obligations, excluding current installments Long-term deferred rent and lease incentives Long-term deferred royalties Other long-term liabilities Total Noncurrent Liabilities Total Liabilities Stockholders equity

ACTUAL FINANCIAL STATEMENTS 2002 2003 2004

Forecast Financial Statements

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

31,870
40,500 96,105 10,141 10,420 189,036 145,385

31,753
35,437 95,683 11,278 14,836 188,987 128,097

0 0 0
28,042 173,427

0 0 0
32,448 160,545

67,163 32,602 83,530 13,341 9,499 210,644 114,403 11,610

106,003 53,915 82,329 14,516 10,600 271,023 113,944 11,610

0 16,244 9,864
152,121 362,765

0 16,984 10,833
153,371 424,304

362,463

349,532

171,549 81,762 122,037 16,231 16,439 408,018 144,007 20,623 11,282 37,226 12,218 225,356 633,374

220,344 133,406 165,232 21,741 18,169 558,892 164,262 28,004 18,532 43,084 24,151 278,033 836,925

201,389

248,505

324,469

421,938

497,604

602,085

749,217

821,028

964,946 1,054,618 1,184,532

683,826

865,040

1,118,929 1,460,061 1,843,999 2,244,416 2,659,778 3,151,723 3,673,843 4,198,895 4,752,315

367,816 465,288 1,051,642 1,330,327

569,256 683,935 857,435 1,078,348 1,327,539 1,553,310 1,783,996 2,023,042 2,340,693 1,688,185 2,143,995 2,701,434 3,322,764 3,987,317 4,705,034 5,457,839 6,221,937 7,093,008

7,609
47,933 38,231 93,773 80,119

80,138 44,460 42,963 167,561 1,480

13,931 44,888 52,056 110,875 54,161

13,430
58,158

35,051 87,711 94,464 217,226 53,199

34,357 117,339 132,200 283,896 18,018

133,074 328,305

163,352 408,456

198,255 494,594

250,696 618,087

312,054 763,495

375,322

429,977

489,262

560,603

634,581

670,647

61,211 132,799 41,396

918,292 1,059,280 1,202,013 1,379,905 1,554,030 1,766,037

N/A N/A
10,647 90,766 184,539 177,924

N/A N/A
14,211 15,691 183,252 166,280

14,947 N/A N/A 69,108 179,983 182,782

25,282 N/A
4,250 70,928 203,727 220,577

28,688 43,423 2,545 127,855 345,081 288,293

31,236 35,008 32,955 117,217 401,113 431,060

175,783 504,087 547,555

210,324 618,780 711,548

254,678 318,268 390,737 469,958 531,128 618,992 706,627 795,166 895,261 749,273 936,354 1,154,233 1,388,251 1,590,408 1,821,005 2,086,532 2,349,196 2,661,298 938,912 1,207,641 1,547,201 1,934,513 2,396,909 2,884,029 3,371,307 3,872,741 4,431,710

64

Balance Sheet Revised

To revise the balance sheet, we had to add the operating leases as a capital lease asset, and add it as a liability as lease obligations and current lease obligations. This caused an increase of both liabilities and assets. Also, the capital asset was depreciated using strait line depreciation over the next 11 years. The following chart demonstrates our findings.

65

BALANCE SHEET REVISED 2001

ASSETS Current assets: Cash and cash equivalents Receivables, net Inventories Prepaid expenses and other current assets Deferred tax assets Total current assets Property and equipment, net Capital Lease Assets Goodwill Other intangible assets, net Long-term deferred tax assets Other assets Total Noncurrent Assets Total Assets LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Current installments of notes payable, Current Lease Obligations Accounts payable Accrued expenses Total current liabilities Notes payable, long-term debt and capital lease obligations, excluding current installments Long-term deferred rent and lease incentives Long-term deferred royalties Other long-term liabilities Total Noncurrent Liabilities Total Liabilities

ACTUAL FINANCIAL STATEMENTS 2002 2003 2004

Forecast Financial Statements

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

31,870
40,500 96,105 10,141 10,420 189,036 145,385

31,753
35,437 95,683 11,278 14,836 188,987 128,097

67,163 32,602 83,530 13,341 9,499 210,644 114,403 11,610

106,003 53,915 82,329 14,516 10,600 271,023 113,944 11,610

171,549 81,762 122,037 16,231 16,439 408,018 144,007 20,623 11,282 37,226 12,218 225,356 633,374

220,344 133,406 165,232 21,741 18,169 558,892 164,262 388,532

325,781

265,910

209,262

161,050

120,408

102,164

83,226

63,569

43,164

21,985

0 0 0
28,042 173,427

0 0 0
32,448 160,545

0 16,244 9,864
152,121 362,765

0 16,984 10,833
153,371 424,304

362,463

349,532

28,004 18,532 43,084 24,151 278,033 836,925

1,059,101

1,339,762

1,700,158

2,159,201

2,720,593

3,346,330

4,015,596

4,738,403

5,496,547

6,266,064

7,143,313

7,609
47,933 38,231 93,773 80,119

80,138 44,460 42,963 167,561 1,480

13,931 44,888 52,056 110,875 54,161

13,430
58,158

35,051 87,711 94,464 217,226 53,199

34,357 117,339 132,200 283,896 18,018

59,871 118,268 178,139 325,781

56,648 144,621 361,621 265,910

48,212 174,432 435,161 209,262

40,642 220,082 542,607 161,050

18,244 273,102 668,193 120,408

18,938 327,411 801,070 102,164

19,657 372,483 917,642 83,226

20,405 421,841 1,036,375 63,569

21,179 482,395 1,187,399 43,164

21,985 544,943 1,334,515 21,985

0 582,738 1,534,544 0

61,211 132,799 41,396

N/A N/A
10,647 90,766 184,539

N/A N/A
14,211 15,691 183,252

14,947 N/A N/A 69,108 179,983

25,282 N/A
4,250 70,928 203,727

28,688 43,423 2,545 127,855 345,081

31,236 35,008 32,955 117,217 401,113

258,869

189,644

64,049

-96,616

48,194

58,534

107,386

234,420

287,663

381,365

398,036

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Valuation
In this section we will use various types of methods to value the stock price of Guess, and we will compare them to the specialty retail industry as a whole to determine if the stock price is accurate, overvalued, or undervalued. The first valuation analysis that will be done is the method of comparables; it is made up of the companys most recent financial data, and then compared against their competitors to arrive at an industry average and then compare it to Guesss current stock price. The best thing about the comparables method is that it is quick and easy to implement, other than that method is not very reliable because the estimated price is calculated by using the industry average. Next, the best method to use for accuracy is the theoretical valuation models. The two main components that are used in these valuations are the cost of equity, and the WACC, which we have previously calculated. More specifically the models that we use to determine the present value of our financial data are the dividends discount model, discounted free cash flow model, residual income, and long-run residual income perpetuity, all of which will be discussed in great detail.

CAPM Estimation
To begin the valuation process we determined the cost of equity based on the Capital Asset Pricing Model. First we ran a multiple series regression analysis. The data used in the regression analysis included historical stock prices monthly from May 2000 through May 2007, the historical S&P 500 prices for the same period, and Treasury Bill rates for five separate time horizons on the yield curve. Based on the information that we gathered from the Federal Reserve Bank of St. Louis website, we were able to estimate the risk free rate of return and market risk premium used in our computations. By running a regression analysis using the 3 month, 6 month, 2 year, 5 year, and 10 year Treasury Bill rates we were able to examine a wide range of estimated Betas for the company. The 67

information provided by the regression allowed us to compute the cost of equity for the firm. We used the Beta obtained in the 10 year Treasury Bill 72 month computation because it had the highest adjusted R squared value and thus the most explanatory power. With an estimated Beta of 0.48, a risk free rate of 5.20%, and a market risk premium of 8.00% we computed the cost of equity for Guess at 9.00%.

Beta 3 Month Treasury 72 months 60 months 48 months 36 months 24 months 0.09897 0.06914 0.07138 0.10773 0.03311 6 Month Treasury 0.10261 0.06899 0.07094 0.1116 0.02629 R^2 3 Month Treasury 72 months 60 months 48 months 36 months 24 months 0.05517 0.01332 -0.00161 0.01087 -0.0284 6 Month Treasury 0.0447 0.01219 -0.00322 0.012329 0.000718 Ke 3 Month Treasury 72 months 60 months 48 months 36 months 24 months 5.99176 5.75312 5.77104 6.06184 5.46488 6 Month Treasury 6.02088 5.75192 5.76752 6.0928 5.41032 2 Year Treasury 6.4 5.97904 5.96896 6.34832 5.23848 5 Year Treasury 7.49352 6.818 6.88648 7.23328 5.63344 10 Year Treasury 9.0048 7.99888 8.65824 8.96744 7.13464 2 Year Treasury 0.07826 0.00829 0.00648 0.02322 -0.02608 5 Year Treasury 0.11657 0.04197 0.04582 0.06439 -0.02837 10 Year Treasury 0.16302 0.09028 0.10753 0.06595 -0.0137 2 Year Treasury 0.15 0.09738 0.09612 0.14354 0.00481 5 Year Treasury 0.28669 0.20225 0.21081 0.25416 0.05418 10 Year Treasury 0.4756 0.34986 0.43228 0.47093 0.24183

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WACC Estimation

To estimate the weighted average cost of capital we had to obtain Guess market value of debt and cost of debt as well as the market value of equity and cost of equity computed above. In Guess most recent 10-K the debt balance was disclosed as $86.50 million. Also disclosed in the 10-K was that the average effective interest rate on Guess debt is 6.20%. We calculated the value of equity by multiplying the observed share price of $48.87 by the number of shares outstanding, $93.54 million. Adding the total value of debt and value of equity we get that the total value of the firm is $4.28 billion. We used the initial cost of equity value of 9.00% calculated using the regression analysis. With these values we were able to compute a before tax WACC of 9.00%. Stated in Guess most recent 10-K the corporate tax rate is 37.1%. We computed the after tax WACC using this tax rate to be 8.89%.

Conclusion
The Beta that we computed for Guess was 0.48 which is less than a third of the published Beta of 1.68 according to Google finance. Our calculations show that Guess is three times less risky than analysts estimate. Our forecasted data shows that Guess will be steadily growing and outperforming the industry average over the next 10 years. This is one factor that could have led to the reduced risk shown by our Beta value. Guess has an annual return on equity of 30% which is much higher than the WACC of 9.02%. This shows that for each dollar invested in capital by Guess, 20 cents of value is added for shareholder.

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Method of Comparables
The method of comparables is the quickest and easiest method to calculate, because all youre doing is taking each competitor individually then combining them for an industry average. The forward price to earnings ratio uses the current financial data of Guess and their competitors and the trailing price to earnings ratio uses last years financial data.

Forward Price to Earnings

Industry PPS GES GPS ANF AEO 47.34 19.39 76.92 26.56 EPS 1.36 0.64 4.62 1.69 P/E 34.80 30.29 16.64 15.71 Avg. 20.88 GES PPS 28.39

In calculating the forward P/E ratio we divided all of the Price per share by Earnings per share. Then to arrive at the industry average we took the sum of the competitors, excluding Guess, and divided it by the total. Guesss share price was calculated by multiplying the industry average by Guesss EPS. It is clearly obvious that guesss share price is overvalued using this method because 28.39 is extremely less than 47.34. Furthermore, since Guess has a higher P/E ratio than the industry average there is not a projected positive outlook for future earnings growth.

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Trailing Price to Earnings

Industry PPS GES GPS ANF AEO 18.61 3.5 57.07 21.67 EPS 0.66 0.24 3.83 1.29 P/E 28.2 14.6 14.9 16.8 Avg. 15.43 GES PPS 10.19

The only difference in the forward and trailing P/E ratios is that forward uses current financial data where as trailing uses last years financial data. This model is calculated in the exact same way as the forward model to arrive at the industry average and share price of our company. This model once again shows that Guess is overvalued because they have their PPS at 18.61 and the model shows that it should be at 10.19. and like before guess has a higher P/E than the industry which is not good for future earnings growth.

Dividends to Price
Industry PPS GES GPS ANF AEO 47.34 19.39 76.79 26.56 DPS 0.24 0.32 0.72 0.32 D/P 0.01 0.02 0.01 0.01 Avg. 0.01 GES Share Price 24.00

In the dividends to price model, the companies dividends per share are compared to the current market price per share. Then each of the companies dividends per share are divided by the current market price per share. You then average these values and Guesss dividends per share are divided by this amount. It is clear that using this model presents the same conclusion that

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Guesss Price per share is over valued because they are saying it is worth 44.86 and the model presents the number which is significantly lower.

Price to Book
Industry PPS GES ANF AEO GPS 47.34 76.79 26.56 19.39 BPS 4.66 15.96 6.48 6.34 P/B 10.16 4.81 4.10 3.06 Average 5.53 GES Share Price 25.78

In the price to book model we took price per share and divided it by the book value of equity, this process is completed for Guess along with their competitors in the industry. Next, we took the industry average and multiplied it by the book value of equity for Guess to arrive at their share price. This method is showing again that Guesss share price is way overvalued. This also directly reflects Guess price to book value being overvalued as compared to the industry average.

Price to Sales
Price Per Share Guess Jeans Abercrombie American Eagle Gap 26.56 19.39 2,794.409 15,943.000 0.00950 0.00122 47.34 76.79 Sales 1,119.945 3,318.158 P/Sales 0.04227 0.02314 Industry Average 0.01903 GES 21.32

The price to sales method is calculated by dividing the price per share by the total sales for each year, this is done for Guess and their competitors. Then the industry average is calculated only with the competitors P/Sales ratio. Last the

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average is multiplied by Guesss sales to arrive at the new share price stated which is 21.32. This like the rest of the method of comparables valuation models shows that guesss share price is overvalued.

P/EBIT FORECAST

In addition to the Price-Book Ratio, there is the Price-Earnings before Interest & Taxes EBIT forecast. In this formula, we take the firms current price and divide it by its EBIT. This formula is used in developing which company or companies are being stated at an under or overvalued price.
Industry Average $13.50

GES ANF AEO GPS

Price Per Share 47.34 76.79 26.56 19.39

EBIT $2.095 $7.630 $2.876 $1.599

P/EBIT $22.59 $10.06 $9.24 $12.12

GES 28.30

Guess jeans has a stated price per share of 47.34 and an EBIT of 2.095. When the price per share is divided by its EBIT, we come up with a Price-EBIT of $22.59. This number is considerably higher then the rest of the industry competitors. This is a potential red flag for me because when I see a number like this one, I start to wonder of the firms actual position in the industry and whether they are being overvalued. When we compare Guess P/EBIT number to the industry, we discover that not only has Guess out performed the industrys average but its price is $9.09 over the average. With an actual price of $28.30, Guess has been considerably overvalued compared to its current price.

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P/FCF Per Share

In the Price-Future Cash Flows per Share forecast, we bring into light the effect of how Cash Flows from Operating, Investing, and Financing effects the current price of the firm. We start off by taking the price per share of a firm and using it to compare it to its cash flows. We then, add up the cash flows from operating and investment and subtract out cash flows from financing activities to arrive at FCF Future Cash Flows. We use the future cash flows to divide it against how many shares of the company currently possesses to get the FCF/Share. The next stage is to use the price per share and divide it against the FCF/Share to get the Price/FCF per share. Once we get all of these Price/FCF per share from each firm in the industry, we use them to compare them to each other in performance. The last step is to find out what the industry average so Guess can rank itself against the overall average of the industry, so they can tell whether they are performing over or under what the industry is.

PPS GES ANF AEO GPS 47.34 76.79 26.56 19.39 FCF PShr $2.04 $11.11 $5.63 $0.37

GES ANF AEO GPS

CFFO $138,253,000 $582,171,000 $749,268,000 $1,250,000,000 Price/FCF PShr $23.23 $6.91 $4.72 $53.09

CFFI $71,537,000 $473,764,000 $651,121,000 $150,000,000 Ind. Avg. $21.99

CFFF $19,189,000 $77,135,000 $168,761,000 $1,102,000,000 GES Shr Price 44.80

FCF $190,601,000 $978,800,000 $1,231,628,000 $298,000,000

As you can see, Guess is once again being overvalued the current price that it is selling for. I am a little less nervous though with this overvalue because the amount is not as large as the previous P/EBIT forecast that performed above. Under this forecast, Guess is only overvalued by $2.54 margin compared to the $22.59 P/EBIT we evaluated above. This shows that in this category Guess Cash Flows from Operating, Investing, and Financing activities were the lowest in the

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industry. By having lower cash flows Guess has a more believable price per share value relative to their cash flow activities. The other competitors are drastically overstated in this forecast which means they have higher movement of cash flows then Guess does. In conclusion, after running all of the method of comparable models to determine how the company was valued it is evident hat Guess is an overvalued company. This method is often used because it is quick and easy to implement but it lacks certain information from a companys financials that would be helpful in determining the value of a company, such as, the statement of cash flows and various items on the balance sheet. It is also less reliable because Guesss estimated share price in each model is determined by using their competitors average in the industry. The last reason this method is considered a less reliable valuation model is that the raw data used in method of comparables is current information, and it fails to look at historical information dating back more than one year.

Discounted Dividends Model

The dividends discount valuation model uses the expected dividends paid out to shareholders by a company to value the firm. As a firms earnings increase over time, investors anticipate that dividends will also increase. Investors use this model to calculate the PV of these payments and use it as a measure of value for the firm. The problem with using this model arises when companies do not pay annual dividends, or choose to re-invest the companies earnings back into the firm to increase growth within the company.

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Actual Stock Price

$44.86 0.09 0.1 0 $4.26 $3.92 $3.40 $3.00 $2.69

Perpetuity Growth Rate 0.02 0.04 $4.99 $6.30 $4.50 $5.45 $3.78 $3.27 $2.89 $4.34 $3.65 $3.16

0.06 $9.37 $7.36 $5.29 $4.21 $3.53

0.08 $24.69 $13.08 $7.18 $5.14 $4.09

Initial Cost of Equity

0.12 0.14 0.16

_________ --Overvalued Guess Jeans Inc. paid out a .06 cent quarterly dividend in June 18 and February 22, 2006, which we forecasted to project a .24 cent increase in dividends per year. Since these are the first dividends that have been paid out by Guess Jeans, we deemed it justifiable to forecast out their future dividends at .06 cents per quarter, or .24 cents a year. We also assumed that Guess Jeans will pay out dividends indefinitely, given that they continue to remain profitable. This allows us to use perpetuity to determine the stock following year 10 of our forecast. Using sensitivity analysis we can use our initial cost of equity of 9% and adjust our growth rates to determine the value of the stock in the dividend discount model. This model shows that Guess Jeans stock is extremely over-valued, with the closest estimated price coming within $20.17 of the observed share price in the market. We believe that this model poorly demonstrates the price of the stock for a few reasons. One reason is that investors place intrinsic value of the stock based on the idea of increased earnings, and profit based on increased value of the stock. The second reason is that dividends paid out by a company are not guaranteed, thus valuing a stock based on future dividends that are uncertain places far too much trust in a number that can increase, decrease or fail to exist at all.

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Discounted Free Cash Flows Model

The term free cash flows describes the money that is able to generate that allows it to maintain, or expand its asset base. This money is important in that it helps increase shareholder wealth through investing the money into operations, new products, paying dividends and also repaying company debt. Although a positive Free Cash Flows is desirable, a negative cash flow does not always indicate a struggling company. For instance a company could have recently made a large investment in machinery or operating space, and this investment could prove to have a high return and be profitable for a company. Free Cash Flows is calculated by taking operating cash flows and subtracting capital expenditures. We then use the Weighted Average Cost of Capital as our discount factor to provide us with a present value in the PV formula. In this case we used .089, the After Tax WACC of Guess Jeans Inc. We used the after tax WACC because cash from operations and cash from investments was stated on the Statement of Cash Flows as being before tax. The Free Cash Flows that are used for Guess Jeans was found by forecasting the companies Cash Flow from Operations out to 2016, followed by our terminal year. We then multiplied each of the ten years by the discount factor, next summing the present values to come to a total Present Value of the Annual Free Cash Flows. The sum of these numbers was $4,873,660,568. We then found the perpetuity by forecasting out the Free Cash Flows for the year 2017, this being our terminal year, and then dividing it by our WACC minus the growth rate. This number was then discounted back to its present value by multiplying it by the year 10 present value factor. We next found the value of the firm by adding the present value of the annual free cash flows to the present value of the terminal perpetuity. Subtracting the book value of equity from the value of the firm, we come to Guess Jeans market value of equity. The value of this equity divided by the firms 93,540,000 shares outstanding gives us a value of $65.18 per share.

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0 0.089 0.0927 0.11 0.12 0.13 0.14 < $40.00 > $50.00 $40.00$50.00 53.51 52.13 46.33 43.39 40.71 38.24

0.02 54.31 52.83 46.73 43.69 40.94 38.42 Overvalued Undervalued Fair Priced

0.04 55.75 54.06 47.37 44.15 41.27 38.67

0.06 59.19 56.79 48.51 44.91 41.8 39.05

0.08 77.89 68.14 51.17 46.42 42.74 39.68

Actual Stock Price

$44.86

When performing the sensitivity analysis, it reveals that according to the Discounted Free Cash Flows model, Guess Jeans stock is undervalued when maintaining a constant .0927 WACC. By adjusting our WACC upwards, and relating it to theoretical yet reasonable growth rates, we can conclude that given these possible growth rates in the market our stock will remain fair valued, except in the cases where our WACC reached .14. This information displays to us that given the current weighted average cost of capital, and expectations of our growth rate, Guess Jeans will maintain a stock price that is slightly undervalued and fairly valued in relation to the expectations of the market and the companies Free Cash Flows. This model seems to estimate Guess Jeans stock price fairly well, and will give an investor a reliable insight as to the value of the firm.

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Discounted Free Cash Flows-REVISED

0 0.089 0.0927 0.11 0.12 0.13 0.14 < $40.00 > $50.00 $40.00$50.00 $ $ $ $ $ $ 73.66 71.85 64.22 60.33 56.77 53.49 $ $ $ $ $ $ 0.02 74.45 72.55 64.63 60.64 57.00 53.67 0.04 75.89 73.78 65.26 61.09 57.33 53.92 0.06 79.33 76.51 66.40 61.85 57.86 54.30 0.08 98.03 87.85 69.06 63.36 58.81 54.93

$ $ $ $ $ $

$ $ $ $ $ $

$ $ $ $ $ $

Overvalued Undervalued Fair Priced

After revising the free cash flow model to include the capitalization of the operating leases, there were a few changes regarding the sensitivity analysis of the stock. The cash flow of operations was increased which caused an increase in the present values of the annual and perpetuity cash flows. Even with the increase in cash flow from operations, Guess still is deemed undervalued relative to the discounted free cash flows method.

Abnormal Earnings Growth Model

0.09 0.11 0.13 0.15 0.17

-0.5 $33.96 $27.79 $23.51 $20.38 $17.98

-0.4 $28.41 $23.25 $19.67 $17.05 $15.04

-0.3 $20.02 $16.38 $13.86 $12.01 $10.60

-0.2 $5.84 $4.78 $4.04 $3.50 $3.09

0 N/A N/A N/A N/A N/A

< $40.00 > $50.00 $40.00-$50.00 N/A Negative Stock Price

Overvalued Undervalued Fair Priced Actual Stock Price $44.86

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The Abnormal Earnings Growth Model is calculated using a companys reported earnings and dividends. By taking the current years earnings and adding the D.R.I.P. income (previous years dividends x Ke) we find the companies Cumulative Dividend Earnings. We next find our normal income by multiplying our previous years earnings by (1+.09) and subtract it from our cumulative dividend earnings to reach our annual AEG adjustment. We confirmed our annual AEG adjustment by relating it to the change per year in residual income. The number matched up from years 2007-2017, proving we were using a correct AEG adjustment. We again use our Ke (cost of equity) to find our present value discount factor. Multiplying this PV factor by our AEG gives us our present value AEG. Next, we use our year 10 AEG for the AEG perpetuity, using our cost of equity (Ke) minus the growth rate to discount it back to year 10. We use a negative growth rate that will bring the perpetuity back to zero over time. Finally, we add up both of our calculated present values as well as our base year earnings of $123,168,000 and divide it by our Ke, bringing it back to the value in 2007. This leads us to an estimated price per share of Guess Jeans stock at $117.08. Obviously it is not possible to value a stock at less than 0, but we can use this model to implement new growth rates in our sensitivity analysis to value the stock even more efficiently. Despite our negative estimated price, when applying the arbitrary growth rates, we realize that our observed share price is extremely overvalued in relation to the AEG model. Only when using a -.5 growth rate and our estimated cost of equity, does our stock come within ten dollars of our observed price, at $33.96. The AEG model is the most reliable of the valuation models, using earnings as well as dividends to find the intrinsic value of the firm. In this case, it has proved to us that the value of Guess Jeans stock is overvalued in the market.

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Abnormal Earnings Growth Model-Revised

-0.5 $137.47 $112.48 $95.17 $82.48 $72.78 -0.4 $147.33 $120.54 $102.00 $88.40 $78.00 -0.3 $162.24 $132.74 $112.32 $97.34 $85.89 -0.2 $187.42 $153.35 $129.76 $112.45 $99.22 0 $405.72 $331.96 $280.89 $243.43 $214.79

0.09 0.11 0.13 0.15 0.17

< $40.00 > $50.00 $40.00$50.00

Overvalued Undervalued Fair Priced

The difference between the revised AEG and the previous model is because of the capitalization of operating leases, this lead to a huge increase in our annual AEG adjustment due to increased earnings. Comparing our annual AEG adjustment to the change per year in residual income allows us to confirm that our assumptions are correct, and that our forecasted statements are correctly relating to each other. We encountered an overall underestimated price per share when performing a sensitivity analysis on our new AEG model. Using this revised AEG Model, all of the prices per share were underestimated compared to the AEG model presented in the previous model. This difference is caused by the recognition of operating leases as capital leases.

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Residual Income Valuation

The Residual Income Valuation Model is an accentual variable involved in determining the true nature and performance of a firm. It uses key components like, Earnings Per Share, Dividends Per Share, Book value Per Share, Cash Flows From Operating activities, and Cash Flows From Financing activates to forecast out to 11 years its potential earnings. We use these components to valuate normal (Benchmark) Earnings, Residual Income (actual), Present Value Factor, PV of Annual Residual Income, Total PV of Annual Residual Income, Continuing (Terminal) Value Perpetuity, PV of Terminal Value Perpetuity, Initial Book Value of Equity, and Estimated Price Per Share. Free Cash Flows Model and Residual Income Model possess some similar and different qualities when forecasting a company. They both start their models off by forecasting out EPS, DPS, BPS, CFFO, and CFFF of the company. While the Free Cash Flows model primarily focuses on the measurement of firms ability to use their free cash flows to generate or expand their asset base, Residual Income Valuation Model focuses on the actual earnings of income and how they perform in one year compared to a benchmark of the previous years income. Theoretically, you always would want your actual year income to be higher then the previous years income and from looking at our spreadsheet it can be determined that Guess actual income will be higher then its benchmark for all the years forecasted. Residual Income Model measures how your income has performed and will perform in the future and we also use income in this model to determine how valuable the company shares will be in the upcoming years. Once we calculated this items, we use them for evaluating where the current price per share is over, under, or fairly priced compared to its actual performance. These different items are plugged into different growth rates and

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different initial cost of equitys to establish at which specific points there are overvalued, undervalued, or fairly priced shares of the company.

0 0.09 0.11 0.12 0.13 0.14 >50.00 40.00-50.00 <40.00 $69.51 48.36 41.01 35.09 30.27

-0.02 $78.67 52.06 43.36 36.56 31.15

-0.04 $95.18 57.87 46.88 38.68 32.38 Undervalued Fair Priced Overvalued

-0.06 $133.68 68.33 52.76 42 34.23

-0.08 $326.22 92.74 64.5 47.99 37.31

This spreadsheet demonstrates, using variable changes of cost of equity and negative growth rates, where the shares seem to be overvalued, fairly priced, and undervalued. This is evidence to suggest that the majority of the Guess shares seem to be overvalued which could be bad thing because it means that the company is not what you think it is worth. There appear to be couples of shares that seem to be fairly priced that possess a 0.12 Initial Cost of Equity and a 0, -0.02, & -0.04 Perpetuity Growth Rates. Other fairly priced shares are shares that have a .11 and .13 cost of equity and have a 0, -0.06, -0.08 growth rates. These shares present a lot more relevance to the shareholders then an overvalued share because you know that this current time period this firm is functioning in a respectable way. Guess also have a few shares that function at a below par level 0.13 and 0.14 Cost of Equity standard, but the majority of the shares are priced at an undervalued price. Guess is overall an undervalued firm.

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Residual Income Valuation-Revised

The revised residual income is much like the previous model in that it uses the same key components used in the first model. The revised residual income model uses revised earnings to calculate the estimated price per share then the previous model did. These revised earnings played an enormous model in the drastic change of the estimated price per share. The earnings increased the entire estimated price per shares for all of the shares in the sensitivity analysis.

0 0.09 0.11 0.12 0.13 0.14 103.08 70.68 59.40 50.32 42.93

-0.02 118.32 77.30 63.86 53.35 44.98

-0.04 145.77 87.72 70.56 57.71 47.84

-0.06 209.80 106.46 81.71 64.57 52.14

-0.08 529.98 150.21 104.02 76.91 59.29

<40.00 40.00-50.00 >50.00

Overvalued Fairly Priced Undervalued

As you can see from the spreadsheet, most of the shares in the sensitivity analysis are undervalued. This is due to the increase in earnings per year. The increase in earnings makes; the book value of equity increase, the normal (Benchmark) Earnings increase, the residual income increase, the Total PV and PV of Annual Residual Income increase, and the estimated price per share increase. With the majority of the shares been understated there are a few shares that are stated at a fair price. With the first residual income model having an undervalued rating, the revised model comes up with the same rating of undervalued.

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Long Run Return on Equity Residual Income Model

The Long Run Return on Equity Residual Income Model (LR ROE RI) is a model that is derived from the Residual Income Model. If the regression analysis results prove unreliable, this model can also be very useful in calculating the cost of equity. However, we did not have to use this model for this purpose. This model determines intrinsic value based of the following formula: Po= BVE( 1 + (ROE-Ke)/(Ke-g)) This valuation model is determined by the book value of equity (BVE), return on equity (ROE), cost of equity (Ke), and growth (g). Since this model only contains one constant and three variables, our sensitivity analysis has to be expanded to account for the variations. Bellow are the different prices for Guess stock holding one of the three variables constant.

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Growth 0 ROE 0.2 0.25 0.3 0.35 0.4 Ke at 9 % ROE 0.2 Ke 0.08 0.09 0.105 0.12 0.135 Growth at 4% Growth 0 Ke 0.08 0.09 0.105 0.12 0.135 ROE at 30% <$40 >$50 $40-$50 Over Valued Under Valued Fair Valued 17.47 15.53 13.31 11.64 10.35 0.02 21.74 18.64 15.35 13.05 11.34 0.04 30.28 24.23 18.64 15.14 12.75 0.06 55.91 37.27 24.85 18.63 14.91 0.07 107.16 53.58 30.62 21.43 16.49 18.64 14.91 11.47 9.32 7.84 0.25 24.46 19.57 15.05 12.23 10.3 0.3 30.28 24.23 18.64 15.14 12.75 0.35 36.11 28.89 22.22 18.05 15.2 0.4 41.93 33.55 25.8 20.96 17.65 10.35 12.94 15.53 18.12 20.71 0.02 11.98 15.31 18.64 21.96 25.29 0.04 14.91 19.57 24.23 28.89 33.55 0.06 21.74 29.5 37.27 44.86 52.8 0.07 30.28 41.93 53.58 65.23 76.88

Based on this information, it seems to be that Guess stock is over valued. Out of a possible 75 times, 65 times it showed that Guess stock price was over valued. That is 87% of the time. On the other hand, it came back fairly value 3 times and undervalued 7 times. 86

It is unnecessary to run a revised Long Run R.O.E. Model because it would not change. Operating leases would not affect BVE, ROE, Ke, or growth

Conclusion
Based on the overall results of the valuation models, we believe that Guess current stock price is slightly undervalued. Guess has consistently outperformed industry averages over recent history, and we expect continue growth to exceed industry over the next few years.

Credit Risk Analysis

Altmans Z-Score formula for a measurement of the financial health of a company and is a powerful tool that forecasts the probability of a company entering bankruptcy. A Z-Score of 3.0 or above bankruptcy for the firm is not likely. If the Z-Score is 1.8 or less then bankruptcy is likely. A higher Z-Score is more desirable. We calculated the Z-Score for Guess to be 9.41 which is well above the 3.0 benchmark that says that the firm is in no risk of bankruptcy.

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