Canada Hardware Case Study Company Background Canada Hardware Incorporated (CHI) has been operating in Canada for over 40 years, with hundreds of stores located in every province and territory in Canada. The company has focused almost exclusively in Canada, figuring that its national reputation and knowledge of regional consumer preferences are one of the company's key strengths. Acquisitions have been a key part of the company's success, with CHI purchasing the Sports company Sports Geniuses 15 years ago and the apparel company Mike's Warehouse over 20 years ago. With these acquisitions, the company has continued to be able to diversify its revenue stream and grow its operations despite limiting itself geographically to Canada. CHI was able to keep most of the management from companies it acquired, as CHI focuses on the acquisition of strong companies with experienced management who are passionate about their roles but require the financial power of CHI to truly achieve their executive vision. CHI organizes itself into three segments: hardware, apparel, and sporting goods. Hardware stores (under the banner Canada Hardware) offer auto, hardware goods, home, and other supplies. Apparel stores (under the Mike's Warehouse banner) predominantly offer clothes for men over the age of 30. The sporting goods stores operate under the banner Sports Geniuses and sell sports equipment, apparel, and accessories. The company's mission statement, extracted from the company's annual report, is included below: "Our mission is to provide customers with quality goods and services, operate efficient and profitable stores that generate the expected return to shareholders, and innovate with new technology and ideas to provide our customer with competitive prices, superior service, and novel experiences." The company had its initial public offering (IPO) seven years ago and has paid a steady dividend since then. It trades on the Toronto Stock Exchange under the ticker CHI.TO. Discussion with Chief Executive Officer (CEO) Tony Stark, CEO of CHI, has been concerned with the future of CHI, particularly for the next fiscal year (2023). He has asked you to help in preparing a financial forecast for the next year. Tony does not expect there to be much change in the hardware segment, with revenue growing in line with Real GDP which has been forecasted to grow between 1.5% and 2.3% for 2023. Inflation is expected to remain low at 1%, with the influence on prices ultimately being passed on to the consumer. The Sporting Goods segment is expected to be 20% of total CHI revenue (including inflation), as CHI has partnered with the NHL to sell more NHL jerseys and equipment in Sports Genius stores. CHI has just started experimenting with these strategic partnerships, and feels that there are more opportunities available in the Canadian market. CHI has also started expanding its sports offerings to offer more hiking, weightlifting, and nutritional products to take advantage of Canadians growing health and active conscious preferences. This has been built into the 20% of revenue assumption. Total CHI revenue is expected to grow 10% (includes inflation). Gross margin is expected to decrease from 2022, due to higher promotional activity to boost sales volume. "We have been very successful in developing our own products internally," boasted Mr. Stark. "This has allowed us to continue to drive down product costs and develop high brand reputations for some of our brands including our Fathercraft drills and Katcheno kitchen appliances." Mr. Stark does not believe that gross profit margin will reach 2022's high, but also does not believe it will go below 2021's gross profit margin. CHI had increased its marketing expenses significantly in 2020, hiring more staff and running more advertising campaigns. "We have done well with our core customers in maintaining their loyalty, especially through our rewards program," explained Tony Stark. "However, we have had issues with attracting new customers from the millennial and Gen Z segment, especially with our focus on more traditional advertising on television, radio, and print. This year, we want to increase our marketing breadth with several digital campaigns including social media. We have also partnered with Canadian celebrities in our attempt to attract more youth to our stores, so we expect marketing costs to be at 12% of our sales for the year." CHI invested heavily in online and digital operations in 2022, include new proprietary technology developed internally by CHI's research department. "This year, we had to focus more on the digital game and experience," informed Tony. "The retail landscape has changed. People are shopping more and more online, but they still want to come into the store if they get an experience there! We spent an enormous amount of money in 2022 developing new technology to improve the store experience and also be able to understand our 12 million customers in our loyalty program. We now leverage that data from our customers that we get from every purchase they make while collecting loyalty points, allowing us to better serve them. No other retailer in Canada has the loyalty or frequency of customers that we do, with our loyalty customers spending twice as much on the average purchase as non-loyalty members. This investment cost us on the bottom line, but I expect R&D expenses to return to historical norms in 2023." Employee turnover has also been a significant issue in the last few years at CHI, especially in the apparel segment. CHI has lost some key employees at the retail store level who have left for international competitors that have more perks and better pay. The minimum wage hikes in several Provinces are expected to significantly impact employee costs, but Tony Stark already had plans brewing for better employee compensation before the government regulations set in. "The minimum wage hikes provide us an opportunity to emphasize the importance of our front-line employees," lectured Tony Stark. "Now, all the retailers are on a level playing field, as the new wages are higher than what most retailers were paying their employees. We can afford to pay employees this amount or more without cutting front-line jobs, which is what our competitors have been doing. I hope better wages will help solve some of our customer service issues, as the number of customer complaints per product sold has risen over the last few years." "However, we will have to make our corporate structure a little bit leaner due to the wage hikes and the weakening economy out West and in the East. I anticipate there to be some restructuring at the corporate office as we look for more efficiency. My estimate is that general & administrative costs will be 14% of 2023 revenue." Depreciation & amortization costs are expected to increase 50% in 2023 due to higher capital expenditures on software, in-store development, and new equipment purchases. In order to support some of these costs, CHI will take on another $1.5B in debt at the same interest rate as its current long-term debt holdings that mature in 2027. CHI is also selling several properties to a real estate developer as it rationalizes its store fleet, and expects to record a one-time gain of $250M from the sale in 2023. Mr. Stark suggests that you take the average tax rate over the past five years for the forecast when calculating the taxes owed to get to net income. Investment Proposals Tony Stark also wants you to assess two potential investment proposals the CHI investment team is considering. "We know that customers like our products," said Mr. Stark. "But due to the sheer size of our network and amount of products that we carry, there are several issues that we keep encountering including misplaced inventory items, overstocking or understocking of items, lost shipments, misplaced orders, and so on! This has led to lost sales and lower customer service ratings by our loyalty members. With the expansion of our omni-channel initiatives, we need to ensure we have state-of-the art capabilities in our inventory optimization and tracking processes, as well as enough capacity to handle our inventory demands." The CHI investment team is considering purchasing a distribution company that includes several trucks and warehouses. CHI has been mostly reliant on third-party distributors for its product, but now feels that bringing distribution in-house will help cut costs in the long-run, especially as the competitive landscape has increased, particularly with apparel as more international retailers enter into Canada. Suppliers have also been raising their prices as consumer demand for more environmental products and sustainable supply chains has led to increasing material prices. US suppliers are also worried about the impact of NAFTA negotiations, as is CHI which relies heavily on US manufacturers for special materials available in some of its premium products including its RX Racer bikes, the leading bicycle brand sold in Canada. CHI is also considering expanding into the restaurant/food business. "Many retailers have been pursuing food offerings as a traffic driver to get customers off their computers and into the store," exclaimed Mr. Stark. "You see that with Urban Outfitters and its purchase of the Vetri pizza chain, with anchors expanding their food offerings like Bar Verde in Nordstrom, and generally in most malls which are reducing their apparel percentage and increasing their food share. I think if we can develop or acquire a restaurant to be placed within or beside our stores, that could be a profitable operation, although I have yet to make a proper strategic assessment on how it fits with our company's mission." Qualitative & Quantitative Analysis To help with your assessment of CHI's current state and the investment proposals, Mr. Stark recommends that you develop a SWOT analysis as well as perform financial statement analysis. "SWOT stands for strengths, weaknesses, opportunities, and threats," explained Mr. Stark. "It is a standard tool used in internal and external assessment, with a focus on qualitative factors. Strengths are anything that a company does well, while weaknesses are areas of improvement. Strengths and weaknesses are internal to the firm, meaning that CHI can have substantial control over them. Opportunities and threats are external to CHI, meaning that these are environmental changes that are outside of our control but could be working for or against our favour. Government regulation is an example of an externality that could be an opportunity or a threat, depending on your business or point of view." "Financial statement analysis involves the use of ratios to evaluate the performance, financial health, and efficiency of a company among other things," carried on Mr. Stark. "I would like you to analyze the liquidity, profitability, efficiency (asset utilization), and solvency (debt ratios) of CHI, and to fully explain what the trend in these ratios are indicating about my company's historical performance. Ratios can be used to tell a story what story are they telling you?" Tax Assessment Finally, Mr. Stark has one last request he needs help understanding the tax consequences of disposal for an old piece of equipment. Prepare a CCA schedule for tax depreciation of a set of equipment purchased three years ago on January 1, 2020 for $270,000 (assume Class 46 with CCA rate of 30% and the class qualifies for the accelerated investment incentive that allows 1.5 times the prescribed rate in the first year only). Calculate the tax consequence if all the equipment were to be sold at the beginning of this year (i.e., end of 2022) for either $90,000 or $120,000. The equipment is the only asset in the class. Utilize the average tax rate that Canada Hardware had in the last five years in your analysis of the tax impact. Financial Statements Canada Hardware Statement of Financial Position (Balance Sheet) Canada Hardware Statement of Financial Position (Income Statement)