Equity Analysis and Valuation

Trevor Barnes

Braden Barnett

Blaine Laurea

Timmy Wijaya

Tina Welch

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Table of Content

Executive Summary ............................................................................................................ 7

Industry overview ........................................................................................................... 7

Accounting analysis ......................................................................................................... 9

Financial Analysis ...........................................................................................................10

Valuation Summary ........................................................................................................13

Company Overview ...........................................................................................................14

Brief History ..................................................................................................................14

Present Status ...............................................................................................................15

Industry Benchmarks ........................................................................................................16

Five Forces Model ..........................................................................................................17

Rivalry among Existing Firm ............................................................................................19

Industry Growth Rate .....................................................................................................19

Concentration ................................................................................................................21

Differentiation ...............................................................................................................23

Switching Costs .............................................................................................................24

Learning and Scale Economies ........................................................................................24

Fixed – Variable Costs ....................................................................................................25

Exit Barriers ..................................................................................................................27

Conclusion ....................................................................................................................27

Threat of new entrants ......................................................................................................28

Economies of scale ........................................................................................................28

Access to Channels of distribution ...................................................................................29

Government regulation ...................................................................................................30

Conclusion ....................................................................................................................30

Threat of Substitutes .........................................................................................................31

Bargaining Power of Buyers ............................................................................................31

Differentiation ...............................................................................................................32

Conclusion ....................................................................................................................33

Bargaining Power of suppliers ............................................................................................33

Switching Costs .............................................................................................................33

Differentiation ...............................................................................................................34

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Importance of Product for Costs and Quality ....................................................................35

Number of Suppliers ......................................................................................................36

Conclusion ....................................................................................................................36

Analysis of Key Success Factors for Value Creation in the Industry ........................................37

Cost Leadership vs. Differentiation ..................................................................................37

Corporate Strategies that Create Value ............................................................................39

Zep, Inc.’s Competitive Advantages .................................................................................40

Economies of Scale ........................................................................................................41

Lower Input Costs..........................................................................................................44

Customer Service and Product Quality .............................................................................44

Introduction to Accounting Analysis ....................................................................................45

Key Accounting Policies ..................................................................................................46

Type One Accounting Policies .........................................................................................47

Economies of Scale ........................................................................................................47

Lower Input costs ..........................................................................................................49

Customer Service and Product Quality .............................................................................50

Type Two Accounting Policies .........................................................................................51

Goodwill ........................................................................................................................51

Operating Leases ...........................................................................................................53

Conclusion ....................................................................................................................53

Assess Degree of Potential Accounting Flexibility..................................................................54

Operating Leases ...........................................................................................................55

Goodwill ........................................................................................................................56

Research and Development ............................................................................................57

Conclusion ....................................................................................................................58

Actual Accounting Strategy .............................................................................................58

Accounting for Operating Leases .....................................................................................59

Accounting for Goodwill ..................................................................................................60

Conclusion ....................................................................................................................60

Qualitative Disclosure ........................................................................................................60

Operating Leases and Capitalized Operating Leases ..........................................................61

Ineffective Internal Controls of Accounting Policies ...........................................................62

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Conclusion ....................................................................................................................63

Quantitative Measures of Accounting Quality ....................................................................64

Identifying Potential Red Flags ...........................................................................................64

Goodwill ........................................................................................................................64

Operating Leases ...........................................................................................................65

Research and Development ............................................................................................66

Conclusion ....................................................................................................................66

Undoing Accounting Distortion ...........................................................................................67

Operating Lease ............................................................................................................67

Goodwill ........................................................................................................................69

Financial Statements Restated ........................................................................................69

Balance Sheet ...............................................................................................................75

Income Statement .........................................................................................................80

Conclusion ....................................................................................................................80

Financial Analysis ..............................................................................................................81

Liquidity Analysis ...........................................................................................................81

Current Ratio .................................................................................................................82

Quick Asset Ratio ...........................................................................................................83

Inventory Turnover ........................................................................................................84

Accounts Receivable Turnover ........................................................................................85

Accounts Receivable Days ..............................................................................................86

Cash to Cash Cycle ........................................................................................................87

Working Capital Turnover ...............................................................................................88

Conclusion ....................................................................................................................89

Profitability Ratios .............................................................................................................89

Introduction ..................................................................................................................89

Gross Profit Margin ........................................................................................................90

Operating Profit Margin ..................................................................................................91

Net Profit Margin ...........................................................................................................92

Asset Turnover ..............................................................................................................93

Return on Assets ...........................................................................................................94

Return on Equity............................................................................................................95

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Conclusion ....................................................................................................................96

Capital Structure Ratios .....................................................................................................96

Introduction ..................................................................................................................96

Debt to Equity ...............................................................................................................96

Times Interest Earned ....................................................................................................98

Altman Z Score ..............................................................................................................99

Conclusion .................................................................................................................. 100

Growth Rates.................................................................................................................. 100

Introduction ................................................................................................................ 100

Internal Growth Rate ................................................................................................... 101

Sustainable Growth Rate .............................................................................................. 102

Conclusion .................................................................................................................. 103

Financial Forecasting ....................................................................................................... 103

Income Statement ....................................................................................................... 104

Dividends Forecasting .................................................................................................. 105

Balance Sheet ............................................................................................................. 110

Statement of Cash Flows .............................................................................................. 115

Cost of Capital Estimation ................................................................................................ 117

Cost of Debt ................................................................................................................ 117

Cost of Equity .............................................................................................................. 119

Backdoor Cost of Equity ............................................................................................... 123

Weighted Average Cost of Capital (WACC) ..................................................................... 123

Method of Comparables ................................................................................................... 126

Trailing P/E ratio .......................................................................................................... 126

Forward P/E Ratio ........................................................................................................ 127

Price to book ratio ....................................................................................................... 128

Dividend to Price ......................................................................................................... 129

Price Earnings Growth Ratio.......................................................................................... 129

Price/ EBITDA.............................................................................................................. 130

Enterprise Value to EBITDA .......................................................................................... 131

Conclusion .................................................................................................................. 133

Discounted Dividends Model ......................................................................................... 134

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Discounted Free Cash Flows Model ................................................................................ 135

Abnormal Earnings Growth (AEG) .................................................................................. 137

Residual Income .......................................................................................................... 139

Long-Run Residual Income (LRRI)................................................................................. 141

Final Recommendation ................................................................................................. 143

Sources .......................................................................................................................... 145

Appendix ........................................................................................................................ 146

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Observed price (5/1/2015) $17.07 2010 2011 2012 2013 2014

52 Week Range $13.61- $17.66 Initial Scores 4.18 4.50 4.16 3.88 3.85

Revenue $696.49 (in millions) Revised Scores 4.19 4.20 4.00 3.24 3.56

Market Cap $393,448 (in millions)

Shares Outstanding 23,049.09

As-Stated Re-Stated As-Stated Re-Stated

Book Value per Share 3.39 0.88 Trailing P/E 49.88 N/A

Return on Equity 4.34% -9.04% Forward P/E 18.47 N/A

Return on Assets 1.51% -2.43% Dividends to Price 1.18 1.18

PEG Ratio 1.84 N/A

Price to Book 5.04 19.40

Adj. R^2 Beta Size Adj. Ke Price to EBITDA 12.00 10.44

3 Month 16.87% 1.13 13.92% EV/EBITDA 10.72 21.51

1 Year 16.84% 1.13 13.91%

2 Year 16.83% 1.13 13.91%

7 Year 16.79% 1.13 13.90% As-Stated Re-Stated

10 Year 16.81% 1.13 13.91% Discounted Dividends 2.17 N/A

As-stated Re-Stated Free Cash Flows N/A N/A

Backdoor Ke 5.94% 5.99% Resdiual Income 4.57 3.37

WACCBT 10.32% 9.96% Long Run Residual Income 7.50 5.12

Beta (Yahoo Finance) 0.63 N/A Abnormal Earnings Growth 2.98 2.36

Lower Bound Expected Value Upper Bound

Cost of Equity (Ke) 3.37% 8.11% 12.85%

Size Adjusted Ke 6.27% 11.01% 15.75%

WACCBT 5.16% 8.31% 11.45%

Cost of Capital

Zep Incorporated - NYSE (4/1/2015) Altman Z-Scores

Method of Compareables Valuation

Intrinsic Valuations

Analyst Recommendation: Sell (Overvalued)

April 1, 2015

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Executive Summary

Industry overview

Zep, Inc. (ZEP) is a producer of maintenance and cleaning chemical supplies and

products located in Atlanta GA. While analyzing the cleaning chemicals industry we

determined firms primarily use cost leadership and differentiation as a means to gain a

competitive advantage. The key success factors for this industry are economies of

scale, lower input costs, and customer service/product quality. The cleaning chemicals

industry can been described by the five forces model as shown below.

Five Forces Model:

Rivalry Among Existing Firms

HIGH

Threat of New Entrants

MIXED

Threat of Substitutes

LOW

Bargaining Power of buyers

HIGH

Bargaining Power of Supplier

LOW

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When analyzing the level of rivalry among existing firms in the cleaning

chemicals industry, we found it important to consider components such as the industry

growth, brand recognition, and issuance of new products. Due to the fact that this

industry is a saturated market, the rivalry among existing firms is high. Another factor

that needs to be considered when analyzing the industry is the threat of new entrants.

As shown in the chart above, there is a mixed threat of new entrants. Although the

industry is relatively saturated, there are still opportunities for new competitors to enter

the market. The ease at which new entrants can enter the market is affected by several

factors including economies of scale, access to channels of distribution, and restrictive

government policy. In the cleaning chemicals industry, the threat of substitute products

is low. The reason for this is because there is not a wide variety of ways to product

cleaning chemicals. This causes companies in this industry to purchase a significant

amount of patents for their formulas.

After analyzing the switching costs within the cleaning chemicals industry, we

have come to the conclusion that the bargaining power of buyers is high. Buyers’ in this

market have ability to switch from one product to another with little or no penalty. On

the other hand we found that, the bargaining power of the suppliers is low due to the

high number of companies in this industry. There are numerous suppliers in this

industry and when firms are choosing a supplier, the key elements are focused on price,

delivery and quality.

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Accounting analysis

A company’s key accounting policies and their level of transparency with GAAP

significantly influences the accounting analysis of the firm. Companies may be able

report financial statements in a way that are more attractive to investors and

shareholders while still complying with GAAP regulations. However the numbers that

companies disclose might not accurately describe how the company is really doing. The

issue with this is that the entire industry might be doing similar things to their financial

statements, which can cause difficulty when trying to conduct a thorough and accurate

analysis.

Key accounting policies are broken down into type one and type two accounting

policies, which are directly related to the key success factors of the business. Both type

one and type two accounting policies can cause a high level of distortion in a company’s

financials and can materially affect the outcome of the final valuation of the firm.

The type one accounting policies are directly related to the reporting practices of

the companies that are in the same industry as Zep, Inc. with regard to key success

factors. We found the key success factors for Zep, Inc. to be economies of scale, lower

input costs, and customer service/ product quality. These factors not only apply to Zep,

Inc., but they also apply to the other companies in our sample industry.

Type two accounting policies are items on financial statements that can

potentially affect or sway our opinion about a company. There are numerous ways to

report these items and in many cases, they can be used to distort financial statements

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and alter people’s perspective on a company. Zep, Inc. and other companies in the

cleaning products industry have goodwill and operating leases as material items on their

financial statements.

The quality of a firm’s disclosure can potentially have either positive or negative

effects. We have found possible material misstatements and a low level of disclosure as

seen in the recent reporting by Zep Inc., do not point to fraud but rather raise red flags

that thorough investors will want to examine these items with more detail. The lack of

transparency and the management’s declaration of ineffective internal accounting

controls leads us to be to question the reliability and usefulness of their financial

reports. Our solution to the uncertainty found in Zep, Inc.’s financial statements was to

restate the potentially distortive items on their balance sheet and income statement.

This was performed to ensure the most accurate valuation of the company. We found

the potential red flags for Zep, Inc. to be capitalized operating leases and goodwill.

Financial Analysis

Financial analysis is arguable the most important part of a business valuation. It

can be defined as “the arrangement of financial data for the purpose of making

conclusions about a firm or industry’s performance over time.” We analyze Zep, Inc.

with both as-stated and restated financials in this analysis. The benchmark companies

that we use include Church and Dwight, Ecolab, and Clorox. In this analysis, we draw

conclusions and compare the companies based on each firm’s growth rates and their

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profitability, liquidity and capital structure ratios. Liquidity ratios allow us to determine

the firm’s ability to meet their short term liabilities using their current assets.

Profitability ratios show the amount of which a firm’s revenues exceed their costs,

which tells us about the industry’s rates of return, margins, and operating efficiencies.

Capital structure ratios show the level of equity and debt that a firm shows on their

balance sheet. This information is useful for investors who want to quantify the level of

risk of the firm they are investing in.

The ratios that we calculated for the liquidity ratios include the current ratio,

quick ratio, accounts receivable turnover, days’ sales outstanding, inventory turnover,

inventory days, cash to cash cycle, and working capital turnover. After calculating and

reviewing the financial analysis ratios we have determined that Zep Inc. is performing

below average. Many of the ratios including quick asset, inventory turnover, accounts

receivable turnover and working capital turnover have shown negative trends meaning

they are either too high or too low compared to the industry benchmarks.

Our profitability analysis includes sales growth, gross profit margin, operating

profit margin, asset turnover, return on assets, and return on equity. These profitability

ratios further indicate that Zep, Inc. is performing below average. The ratios for

operating profit margin, net profit, return on assets and return on equity have shown

significantly lower numbers compared to industry benchmark. Zep only had positive

values for gross profit and asset turnover.

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The capital structure analysis includes the debt to equity ratio, times interest

earned, and Altman’s z-score. Zep, Inc. has a cause for concern in their capital

structure ratios. Zep had the highest Debt to Equity ratio in the industry, the lowest

Times Interest Earned ratio in the industry, and the only company showing a downward

trend in their Altman Z score.

For our growth rate analysis, we calculated both the internal and sustainable

growth rates. The internal growth rate shows a company’s ability to grow without

financing their operations with the help of outside sources that are not affiliated with

the company. A low growth rate means that the firm is unable to grow with only the

assets that are currently on the balance sheet. The sustainable growth rate is the rate

at which a company can continue to grow while maintaining their current capital

structure. Although Zep’s growth rates resemble the industrial trends, it is important to

note that Zep’s growth rates were the lowest in the industry. This represents a cause of

concern because it shows that Zep has both the worst, internal and substantial growth

rates in the industry.

After conducting our ratio analysis, we forecasted Zep, Inc.’s financial statements

in order to make predictions about their future. We did this by using growth rates based

on their performance in the past so that we could accurately predict where the firm is

headed.

The last part of the financial analysis was to calculate Zep, Inc.’s cost of capital.

This includes cost of debt, cost of equity, and the weighted average cost of capital. The

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cost of debt that we calculated was 3.5% as-stated and 3.28% on a restated basis.

Zep, Inc.’s cost of equity was calculated to be 11.005% and 13.91% on an as-stated

and restated basis, respectively. With these numbers, we calculated a 95% confidence

interval for the after tax weighted average cost of capital of 4.47% to 10.80% as-stated

and 4.44% to 10.77% on a restated basis.

Valuation Summary

After our analysis of the industry, the accounting analysis, and the financial

analysis, we were able to compile it all and come up with a final valuation for Zep, Inc.

the two methods that were used in our final valuation were the method of comparables

and the intrinsic value method. Due to the fact that the method of comparables has a

high level of uncertainty, we will only be using it as a comparison. However, the

intrinsic value methods are much more accurate in valuing a company’s stock.

The closing price for a share of Zep, Inc.’s stock as of April 1, 2015 was $17.07.

For this analysis, we will take a 10% analyst position and determine whether Zep, Inc.’s

stock price was undervalued, fairly valued, or overvalued. From there we will give our

final recommendation for investors to buy or sell the stock. We set our lower and upper

bounds for the stock price to be $15.36 and $18.78, respectively. To be considered

undervalued, the price would have to be greater than $18.78. For the stock to be

considered overvalued, the price would have to be less than $15.36. Otherwise, the

stock is to be considered fairly valued.

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The intrinsic value models are the more accurate models out of the two options.

The models included in the intrinsic value model are discounted free cash flow,

discounted dividends, residual income, long-run residual income, and abnormal

earnings growth. We found Zep, Inc. to be overvalued on both an as stated and

restated basis after running the intrinsic value models. Due to the fact that the residual

income and abnormal earnings growth models hold the highest level of explanatory

power, we relied on them most heavily in our valuation. After extensive research and

analysis, we have come to the conclusion that Zep, Inc. is overvalued as of April 1,

2015 and recommend anyone who currently holds shares of their stock to sell.

Company Overview

Brief History

Zep Incorporated is a cleaning chemical manufacturer who operates out of their

headquarters in Atlanta, Georgia. The company started selling janitorial supplies in 1937

and has since grown in to a multinational corporation, and produces and distributes

their products in North America, Europe, and Asia.

The company has grown primarily through mergers and acquisitions. In 1997 a

producer of home and garden chemicals, Enforcer Products Inc, was purchased leading

to the Zep Commercial product line offered by retailers like The Home Depot. “ In 2001,

the Zep®, Selig™, Enforcer® and National Chemical® brands were maintained under

NSI Chemicals Group which later became Acuity Specialty Products, Inc., a business

segment of Acuity Brands, Inc., during Acuity’s spin off from National Services

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Industries, Inc.” (1) By 2007 Acuity Brands Inc. initiated plans to break off Acuity

Specialty Products, Inc. from its sister company and renaming the now independent,

publicly traded company Zep Inc. More acquisitions have taken place in even more

recent years and will be discussed later in our analysis, however it is important to note

that the resulting additional debt has surged and expenses in the form of interest

payments are currently weighing on earnings.

Present Status

Today Zep Inc. offers maintenance and cleaning solutions provided by well-

known brands including Zep®, Zep Professional®, Zep Commercial®, Zep Vehicle

Care®, Zep Automotive®. In recent years Zep Vehicle Care® has become an

increasingly important sector of their overall business. Other recognizable name brands

owned by Zep Inc. include Armor All Professional®, Rain-X®, and Black Magic®.

Only a few years ago Zep products were offered in around 2,000 retail stores

worldwide. That number now totals over 11,000 as Zep Inc. continues its strategy to

integrate supply chains and increase new sales to once again achieve organic revenue

growth. The worldwide market for maintenance and cleaning products and services is

estimated at $75 billion with $18 billion coming from the United States. For the fiscal

year ending on August 31st, 2014, the company realized $696.5 million dollars in net

sales that generated $8.4 million in net income. Eighty three percent of the sales are

attributed business in North American markets. Over the past five years Zep has

experienced an 8.3% compound annual growth rate of revenue, and has stated in their

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most recent 10k intentions to increase annual revenue to $1B within the next five years.

Due to recent acquisitions, Zep Inc. has experienced a CAGR of 10.3% with regards to

total asset value. (10k)

5-Year Revenue Growth// 8.3% CAGR

Industry Benchmarks

According to Zep Inc., their business operates within three specific segments of

the cleaning products industry. Janitorial and Sanitation (Jan/San) contributes as the

largest of the three, followed by transportation, then Industrial Maintenance and Repair

Operations “MRO”. Each market will be evaluated more thoroughly in the sections to

follow. Many of the chemicals Zep produces can be easily replicated, therefore it is

somewhat easy for competitors to create a generic version. This is important to note,

and sheds some light as to why the cleaning products industry is highly fragmented.

Due to the wide range of products and services provided by Zep it is impossible to find

501.1

568.5 646 653.5 698.6

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100

200

300

400

500

600

700

800

FY 09 FY 10 FY 11 FY 12 FY 13

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an identical competitor. However many companies compete for market share within the

spectrum of Zep’s business.

For this analysis we will benchmark Zep against three companies they have listed

in their 10k as competitors in the cleaning products industry, Ecolab Inc., Clorox

Company, and Church and Dwight Inc. Co. Jan/San and MRO markets will be

specifically important when comparing these firms. We believe that transportation

market is a key segment of Zep Inc. and is one of the areas setting them apart from

other firms in the industry. In December of 2012, Zep “completed the acquisition of

Ecolab’s Vehicle Care division (‘‘EVC’’). The combination of EVC, Niagara and (their)

existing North American Sales and Service vehicle wash operations created a new

platform that (Zep) refers to as ‘‘Zep Vehicle Care’’ or ‘‘ZVC’’ (10k) ZVC produces and

distributes maintenance and cleaning chemicals to car wash and fleet wash operators

through direct sales, and targets everyday consumers with their product lines in retail

stores. Products from brands like Armor All® and Rain-X® can charge a premium price

from superior quality and brand recognition.

Five Forces Model

We used the five forces model as an analytical tool to see the competition among

firms in the industry. The five forces includes rivalry among existing firms, threat of new

entrants, threat of substitutes, bargaining power of consumers and bargaining power of

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suppliers. In this model, we can group the competition of each different force into high,

medium, and low. This analysis will improve the understanding of the chemical cleaning

industry. Which will enable us to give a better analysis.

Cleaning Chemical

Industry

Level of

Competition

Rivalry Among Existing

FirmHigh

Threat of New Entrants Medium

Threat of Substitutes Low

Bargaining Power of

ConsumerHigh

Bargaining Power of

SupplierLow

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Rivalry among Existing Firm

To get a better understanding of the cleaning chemical industry, we need to

understand the rivalry among existing firms in the industry. We need to know where

ZEP stands among the competition. We observed the rivalry from the industry growth

rate, concentration, differentiation, switching cost, fixed and variable cost, and learning

and scale economist.

Industry Growth Rate

Industry growth rate can be defined as an overall business growth in the

industry, in this case the cleaning chemical industry. We can see the growth by looking

at the revenue each year. In a competitive industry like cleaning chemical, the growth

mostly comes from increasing sales and very depended on the economic condition (ZEP

10K). When the economy is strong, the demand for cleaning chemicals and services is

increasing.

The firms in the industry rely on the brand recognition and new products for

their growth. Some companies also acquired other companies to grow their business.

For example, ZEP acquired a part of Ecolab in 2013 to increase their market share in

the automotive cleaning. Ecolab also merged with Nalco Holding Company to increase

their sales. Every company we use in the benchmark, except for Clorox, also spends

significant amount of money for their research and development department to make

sure that they could come up with new products.

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Year ZEP CHD CLX ECL

2010 15.00% 4.07% 1.54% 3.20%

2011 13.63% 2.71% -5.48% 11.64%

2012 1.17% 6.18% 4.53% 74.14%

2013 5.52% 6.28% 2.83% 11.95%

2014 1.00% 9.32% -0.57% 7.75%

Percentage change is sales

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When comparing ZEP with the benchmark industries, it is unfair to compare only

the sales number because the other three companies have much bigger market share.

To compare the growth in the industry, we analyzed their growth in sales each year. As

we can see every company grows at the same pace except for Ecolab in 2013. Their

jump in the sales number is attributed to their merger with other company. Clorox is

the only company who had negative growth in sales over the past five years. Even

though Clorox has a recognizable brand, they did not have any new product releases in

the past five years which slowed down their growth. Church and Dwight had increasing

growth due to their new product releases such as Oxyclean.

In conclusion, growth in the cleaning chemical industry relies heavily on brand

recognition and new product development. The jump in sales growth from Ecolab

happened because their acquisition and Church and Dwight grow because they are able

to keep producing new products.

Concentration

Market concentration is the total number of firms in the industry and their

respective shares of the industry. The cleaning chemical industry is very competitive. As

mentioned in the ZEP 10K that the top four companies only have total market share of

25 percent. Also high availability of substitute and high pressure from big retailers that

makes the competition very tight and companies should make sure that they are

competing on price.

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ZEP 10K also mentioned that there are low barriers of entry for new

competitors; however it is not completely easy because larger firms will have the

advantage of economies of scale. Creation of a new working cleaning chemical products

also takes a lot of money in the Research and Development department and to get it

recognize by customers it will need more money for advertising and marketing.

Here is the market share from each company in the last five years

2010 2011 2012 2013 2014

CHD 17.88% 17.82% 13.99% 14.03% 13.82%

CLX 36.14% 33.91% 26.19% 24.71% 23.43%

ECL 42.05% 44.08% 56.69% 58.23% 59.84%

ZEP 3.93% 4.19% 3.13% 3.03% 2.92%

Market Share

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We could not find the market share data available on the internet, thus we

created our own market with ZEP and its three other competitors using the total of

revenue they receive every year. The graph shows that Ecolab has the highest market

share among four companies with Clorox as the second and Zep has the lowest market

share in the competition. The market also grows every year which means that

competition is not trying to get each other’s market share. In conclusion, the market

growth every year would make the competition too hard because they could rely on the

whole market growth to increase their market share.

Differentiation

Differentiation among firms in the cleaning chemical industry forces companies

to develop new strategies in order to obtain and attract customers. The Zep 10k states,

“We believe we have transformed our business over the past five years by developing a

multi-channel and multi-brand approach designed to serve our customers the way they

want to be served.” By looking at the 10ks of other companies in the industry, we found

that companies follow the same strategy. In Clorox’s 10k, we found that the market is

highly competitive. Most of Clorox’s products compete with other nationally advertised

brands within each category and with “private label” brands.

2010 2011 2012 2013 2014

Market 14,481.43 15,424.77 20,882.13 22,760.28 23,865.59

Growth 0.07 0.35 0.09 0.05

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Switching Costs

Switching cost is defined as the cost for a firm to change into another industry.

After examining the 10ks, we found that most companies in the cleaning chemical

industry own many manufacturing plants and machineries which are very expensive.

According to Clorox’s 10k, Clorox owns or leases 24 manufacturing facilities in North

America and 15 internationally. These manufacturing plants are usually designed for

specific production of cleaning products that will make switching cost very expensive in

the cleaning chemical industry. The firms in the industry might be able to switch to

another chemical industry; however, it will still require purchase of new machines that

will lead to spending a lot of money for research development and marketing costs. We

found that Clorox and Church and Dwight spent a combined $186.8 million dollars in

research development and marketing costs in 2014.

Learning and Scale Economies

In the highly competitive cleaning chemical industry, economies of scale plays

huge role for companies to maintain their profit. Economies of scale can be defined as

the higher volume a company produces items, the lower average cost each product

would be. Zep’s 10k states that the market for chemical cleaning is highly competitive

25

and fragmented, with the competition primarily based on product quality and price. Due

to a very competitive nature of the industry, companies should compete on price, which

relates to lowering cost. To accommodate the level of competition, companies should

be able to cut production cost down.

As an effort to reduce cost, ZEP spent $5.2 million in restructuring fees to

reduce complexity and simplification of product-line. They also did seven acquisitions to

improve their distribution channels to reach customers. Church and Dwight also

mentioned that they have “maintain tight controls on overhead costs.” Clorox also

implement their own cost saving targets by improving their distribution efficiencies and

overhead reductions.

Because of the tight competition, economies of scales and cost efficiency have

been very important for these companies to maintain their revenue and net income.

Failure to reduce cost and improve distribution could lead companies to suffer financial

losses and affect companies’ financial results.

Fixed – Variable Costs

Fixed – variable cost ratio is used to analyze the degree of operating leverage of

a firm. Operating leverage of a firm defined two major parts of analysis, which are how

much fixed cost compared to variable cost and how much each additional sale

generates profit to the firm.

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The higher the ratio, it means that each additional sale generate higher revenue

for the firm because the firm relies much of their production to fixed cost. This could be

a two-sided coin because decreasing sales could lead to loss in income because firms

should be able to cover fixed cost before making profits. The lower the ratio means that

each sale does not contribute much to revenue because of higher cost of goods sold

which mean that a firm could easily reduce or increase their production based on

economic condition and demand from consumers.

Here is the fixed – variable cost ratio for the past five years:

(Source Data Table)

The result in the chart shows that these companies have similar fixed – variable

cost ratio which means that they are similar in terms of their costing system for

production. Firms in the chemical cleaning industry averaged a fixed variable cost ratio

of 2. The rates of the firms illustrate that the industry spends most of their cost on fixed

Year ZEP

Church

and

Dwight

Clorox Ecolab

2010 2.07 1.94 1.93 2.23

2011 1.96 1.92 1.87 2.29

2012 1.93 1.90 1.82 2.22

2013 2.00 1.90 1.85 2.08

2014 2.00 1.91 1.83 2.08

27

cost and increasing number of sales will increase their profit once they cover their fixed

cost. This also means that these firms rely on sales volume to generate their profit

which will increase competition on the industry.

Exit Barriers

Exit barriers are defined as the cost required if a company decides to leave the

industry. The cost associated with exit barrier could be related to the selling of assets.

In terms of cleaning chemical industry, the exit barrier could be very high because of

the specialized plants and machines that they own for their production. Selling of these

assets will not be easy because each machine is specialized to make a specific product.

Due to this high cost of exit barrier, not many firms will leave the industry and it will

add the competition amongst them because they have to keep producing to cover the

fixed cost that they already incurred.

Conclusion

Based on the analysis, the rivalry among existing firms in the industry is highly

competitive. With a lot of competition, these companies always try to drive the cost of

production down as well as rely on volume for the sales. With high concentration and

not so much room for product differentiation, there is small room of error if these

companies still want to grow their business.

28

Threat of new entrants

Treat of new entrants can add price pressure and cap the potential market share

an existing firm currently controls. Understanding the effects potential new entrants can

have on business operations is important for our analysis, so we can determine if Zep

Inc. has price setting or price taking capabilities. The ease at which new entrants can

enter the market is affected by several factors including economies of scale, access to

channels of distribution, and restrictive government policy. The institutional

maintenance and cleaning chemicals market is a highly competitive industry

Economies of scale

Economies of scale are cost advantages that a firm obtains due to size, output,

or scale of operation. Meaning the larger the company is the lower per unit cost will be

giving the company the ability to control price. This is especially important in highly

competitive industries where firms are competing on costs. We have observed

economies of scale to be present in the cleaning chemicals industry.

29

Access to Channels of distribution

Access to Channels of distribution and Relationships is another factor affecting

new entrants. Competitors in cleaning and chemical supply market are constantly trying

to expand channels of distribution. Currently the industry is utilizing a multi-step

distribution process with different sectors of the market being distributed in different

ways. Automotive cleaning supplies are being distributed directly to both vehicle wash

and fleet wash operators as well as to automotive aftermarket retailers such as

Advanced Auto Parts, Auto Zone, and Napa Auto Manufactures. Industrial maintenance

products are distributed through direct sales and service and through distributors such

as Fastenal Company and W.W Grainger. Lastly janitorial and sanitation cleaning

supplies are distributed with a combination of all direct sales, distributors and retailers

like Wal-Mart, Home Depot, Tractor Supply etc. Another way the industry is trying to

expand channels of distribution is through acquisition of existing corporations. For

example Zep Inc. has gone through seven acquisitions since 2007. The latest was in

2012 when they acquired Ecolab’s Vehicle Care Division which expanded their Vehicle

division to 25% of their operation. Clorox, Ecolab lab have also reported serval

acquisitions over the past few years. New entrants will have a harder time when first

entering the market and building up these channels of distribution.

30

Government regulation

Restrictive government regulation is the last factor that can affect potential new

entrants. Firms are subject to various laws and regulations under the Toxic Substance

Control Act. Which gives the EPA authority to track test and ban chemicals they find to

be damaging to the environment. Firms are also subject to fees and fines to ensure

compliance. Environment regulations on health and safety are high in this market and

may be difficult for small firms entering to comply with increased regulations. Industry

leaders all report the risk of potential fees and legal litigation if compliance is not meet.

However we do not feel government regulations alone will prevent new entrants from

coming into the market.

Conclusion

After analyzing the data we concluded the cleaning and maintenance supply

chemical industry has mixed barriers of entry. While product formulas may be easy to

replicate new entrants will still have a harder time competing with larger companies

controlling cost and purchasing inputs until they are able to capture more of the market

share away from existing competitors. Distribution channels will also take time to

develop the right relationships between buyers will also be a challenge and lastly

establishing a new product as a trusted and reliable brand with take time with

consumers. The implications of this are

31

Threat of Substitutes

A substitute is an alternative that customers can use in place of an existing

product or service. Substitutes are not variations of the same product from competitors

but usually from a totally different industry. Substitutes have to be readily available in

order for them to affect the industry. In the case of maintenance cleaning supplies few

true substitutes exist. Customers could either decide not to use cleaning products,

which is unlikely since maintaining a clean environment is important for all areas of life.

Secondly, customers could make their own cleaning sprays and detergents, which

would require time and money as well as basic knowledge of what chemicals are safe to

use. With so many brands cleaning products out on the market we feel it is unlikely for

customers to go without the necessary cleaning products like soaps, detergents, and

anti-bacterial. We also believe it is unlikely for the majority of customers to take the

time and cost associated to make their own variations of products. In conclusion we

found the threat of substitutes in the cleaning and maintenance industry to be low. So

in conclusion we determined the industry to have low treat of substitutes making

companies price setters in this area.

Bargaining Power of Buyers

Bargaining power of buyers is the influence that buyers have on the industry

relative to price changes. How buyers will react to changes in price could potentially

harm a corporation. Understanding the power of buyers in an industry is important for

companies so they know what strategies will be best to keep costs down. Buyers in the

32

market for cleaning and maintenance supplies essentially have low switching because

there are countless affordable products available including generic brands with similar

chemical components. Buyers in the market for cleaning and chemical products are big

box retailers like Walmart, Home Depot, Auto Zone, etc. their size gives them the ability

to negotiate prices that are favorable for them. In order to stay competitive companies

like Zep Inc, Church and Dwight, Clorox, and Ecolab have to rely on brand recognition

that represents quality in order to maintain their market share.

Differentiation

Differentiation is the difference in one product or service compared to another, in

cleaning products most of the basic components are the same. For the cleaning

chemical industry the main ingredients are polymers, resins and solvents. With mixed

barriers to enter the market and increased generic brands competitors rely heavily on

the quality of the products and brand recognition to differentiate themselves from

competitors. Brand recognition can be anything form packaging a product a certain way

to protecting the name the products is known by. Companies like Zep Inc., Clorox,

Church and Dwight and Ecolab invest heavily in legal measures like patents and

trademarks for their products. The industry also spends large percentage of sales on

marketing for new and existing product lines. All this is done in attempt to separate

products from the competition.

33

Conclusion

We have determined the bargaining power of buyers for the cleaning and

maintenance chemical industry to be high. Buyers such as distributor and retailers have

a large variety to choose from when deciding which product to offer at their stores. This

also means customers will have many options when purchasing products at stores and

will be sensitive to changes in price if companies have not done and good job

establishing themselves as a trusted and reliable brand.

Bargaining Power of suppliers

Bargaining power of suppliers is the influence suppliers are able to exert on

businesses by lowering quality, raising prices, and reducing the availability of products.

Suppliers in the chemical cleaning industry have relatively low bargaining power due to

the high amount of companies within this industry. There are numerous suppliers within

the chemical cleaning market and it seems that when choosing a supplier, the key

elements are focused on pricing, delivery, and quality.

Switching Costs

Switching costs between a firm and supplier is the cost of a firm to switch from

one supplier to another. Switching costs between suppliers vary among different

34

industries, but in the chemical cleaning industry there are a good amount of suppliers

and there is not one company with an overwhelming control of the market share of this

industry. Most companies get their raw materials from various suppliers under specific

contracts. Clorox generally uses supply and forward purchase contracts to ensure

availability and help ensure the pricing of raw materials (1). Ecolab purchases raw

materials from various third party suppliers using annual contracts and purchase orders

(2). Unlike its competitors in the chemical cleaning industry, Zep Inc. purchases most of

their chemical and packaging raw materials on the open market, while constantly

monitoring and investigating alternative suppliers and materials based on numerous

attributes including quality, service, and price(3).

Differentiation

When it comes to production differentiation dealing with chemical cleaning, there

is barely if any difference between suppliers. Most suppliers in the cleaning industry

compete with each other using price, delivery time, and quality. Zep’s supplier

relationship manual states, “Our sourcing decisions will be made based upon supplier’s

capability, service, quality, product and service innovation, total cost, cash cycle, and

support of lean initiatives(5).” Zep’s competitors in the industry have similar supplier

manuals, in which all the suppliers compete with each other based upon similar

requirements. This causes most suppliers to be well organized, punctual, and gives the

company an advantage when negotiating with suppliers. Companies like Ecolab and

Clorox obtain their raw materials and packaging through annual based contracts, while

Zep Inc. make their purchases on the open market for a specified period of time.

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Importance of Product for Costs and Quality

Product cost and quality are very important for firms in the chemical cleaning

industry. Many companies rely on their suppliers to always deliver the highest quality

products always on time. Having a product not meeting requirements or quality can

seriously hurt a company. This can be a problem for suppliers if not handled

appropriately. According to the Ecolab supplier manual, suppliers are responsible for

ensuring that the products and/or services provided to Ecolab meet established

requirements and assume full responsibility for the quality of these products or services.

Ecolab reserves the right to reject product or services which do not meet above stated

requirements (4). In addition, companies such as Clorox require monitoring and

certifications of suppliers. Clorox’s business partner code of conduct states, business

partners must designate one or more of its management staff to be responsible for

assessing and monitoring its compliance with the Code. From time to time, we ask

business partners to execute certifications of their compliance with the principles in the

Code. Failure to promptly return executed certifications is a violation of the Code and

may lead to termination of the business relationship with Clorox (6).

Companies in the chemical cleaning industry are always looking for the highest

quality product for the lowest price, but sometimes it is not always possible due to

certain controllable and uncontrollable risks. After analyzing the 10-k reports of Zep and

its’ competitors, most companies engage in annual contracts to lock in specific prices

for products in sufficient quantities to avoid risks such as shortages and high demand.

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Number of Suppliers

There are a large number of suppliers for the chemical cleaning industry both in

the United States and internationally. This causes high competition between suppliers’

prices, service, and quality. Quality is so important among suppliers, that most

companies even have a conflict minerals policy agreement in which suppliers are

expected to supply only products that are “DRC conflict-free.” This policy conveys that

suppliers are required to supply only the highest legal quality products within this

industry. With little to no switching costs, companies can easily choose alternative

suppliers to do business with. This makes suppliers vulnerable when negotiating with

companies.

Conclusion

The bargaining power of suppliers in the cleaning chemical industry can be

considered to be relatively low. There are little to no switching costs due to the large

number of suppliers. The product differentiation between suppliers is consistently

similar. Suppliers compete on price, quality, and service in order to get business. The

chemical cleaning industry is filled with a large number of suppliers and manufacturers

that contribute to a very competitive industry.

37

Analysis of Key Success Factors for Value Creation in the Industry

Cleaning products are needed in order to maintain a safe and sanitary

environment for consumers to live and work. For Example, the chemicals inside of a

product can cause health complications such as skin deterioration and eye irritation.

Also, the disposal of certain chemicals poses issues for the environment. Companies

wanting to enter and succeed in this competitive market must set themselves apart

from the competition.

Cost Leadership vs. Differentiation

The key to success for any company is determined by the strategies that it uses

to gain competitive advantage within its industry. The two basic options that firms have

when picking a strategy are cost leadership and differentiation. Due to the fact that

barriers to entry are low and the possibilities for substitute products are high, the best

strategy for a company in the cleaning products industry is to obtain cost leadership.

The main focus of cost leadership is to lower the cost of manufacturing products

so that it can be sold at a better price than the competition. Cost leadership comes from

having efficient production, lower input costs, low-cost distribution, economies of scale,

and a tight cost control system. However, differentiation is also a key component in

having success in this industry as well.

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Companies that use the differentiation strategy are more geared toward making

their product more unique and higher quality and also providing superior customer

service in order to set themselves apart from the competition. The cleaning products

industry, however, does not produce products that are substantially different from one

another. This makes for a very high volume of competition and forces companies to

turn slightly more to the cost leadership strategy.

The key factors for success in the cleaning products industry are lower input

costs, economies of scale, and superior product quality and customer service. Although

the main strategic focus for companies in the cleaning products industry should

predominantly rely on cost leadership, differentiation can play a key role in determining

the overall success of the firm. Zep, Inc. owns over 600 patents on their products and

formulas, which we will go into greater depth about later. (10k) This shows how

important product differentiation is to their business.

In addition to product differentiation, superior customer service and high product

quality goes a long way with most customers not only in the cleaning products industry,

but also in almost any other industry as well. This industry has a very high level of

competition. Therefore, it is vital for companies to be innovative and continually use the

best strategies to give themselves the greatest competitive advantage and help them

ultimately expand and enter into more markets.

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Corporate Strategies that Create Value

The steps taken by corporate to successfully implement its strategy are essential

in gaining competitive advantage. Corporate actions that promote the healthy growth of

a company in the cleaning products industry include minimizing manufacturing and

distribution costs, investing in new innovative ways to produce products, producing high

quality products and service, and continually expand by acquiring more resources.

By implementing new ways to manufacture products, companies can reduce the

cost of making them. When the cost of producing a product is reduced, it allows firms

to have a lower selling price. By having a lower selling price, sales are likely to increase.

When sales increase, it provides more capital to use for acquiring more resources,

ultimately allowing for more sustainable growth.

Another way that companies can decrease fixed costs in the cleaning chemicals

industry is by utilizing economies of scale. They can do this by producing more products

over a broader spectrum. This reduces the per-unit fixed costs by applying the costs to

a greater amount of goods. In addition to reducing costs, it is necessary for the

company to do its best to try to differentiate its product from the competition even

though the two products are bound to have very similar contents and qualities across

the industry. One way that companies can do this in the cleaning products industry is

establishing brand name recognition.

Although cleaning products are necessary for a healthful indoor environment, the

chemicals used in many products can pose a very serious threat to both personal health

40

and to the external environment. Therefore, if a firm can come up with a cost effective

way to produce a product similar to that of the competition that is safer to use, then

they can gain a competitive edge. This is another reason why we see that Zep, Inc.

owns substantial amount of patents on their formulas and products.

Zep, Inc.’s Competitive Advantages

With low barriers to entry and many possibilities for substitute products,

companies in the cleaning products industry face a high level of competition. To have

success in this industry, must continually find ways to reduce costs and find new

innovative ways to create a better product while continuing to expand. Zep Inc. has

found a competitive advantage in their ability to provide sales and service through

multiple channels. Consumers in most markets are more likely to be loyal to a certain

brand or company if they receive good customer service. Zep, Inc. stated that

“customers who purchase from their sales and service organization value the

combination of sales and service, which includes expertise regarding application uses,

safety aspects, product selection, specific formulations, inventory management,

customer associate training and equipment”(10k). Zep Inc. is clearly confident that their

customer service helps set them apart from the competition. They also state in their

2014 10k that these services reduce the total cost for their customers as far as

maintenance and cleaning goes.

41

Zep Inc. is continuing to grow the availability of their products into various

retailers around not only the United States, but also other countries around the world.

They began to really utilize economies of scale when they started an acquisition

strategy in 2010.

Economies of Scale

Zep Inc. began to use economies of scale in 2010 when they acquired Amrep,

Inc., ("Amrep"). Amrep was “a leader in maintenance chemicals for the automotive

aftermarket as well as the janitorial market sold through distributors” (10k). This

improved manufacturing operations. Later that year, they acquired some assets and

liabilities from Waterbury, Inc. which helped them both strengthen their position in the

retail market and establish a presence in the industrial distributions market.

Also, in October of 2010, Zep Inc. acquired a company that helped expand sales

in the vehicle washing market named Niagara National, LLC. In 2012, Zep Inc.

strengthened their global presence by acquiring Hale Group Limited. This pushed them

into the U.K.’s maintenance and cleaning chemicals market. In June of 2012, they

began to target the retail and distribution channels in Europe by acquiring another

United Kingdom based company called Mykal Industries Limited. In addition to the

foreign acquisition, late in 2012, Zep Inc. took over Ecolab’s vehicle care division. Based

out of Minnesota, it is now a “leading provider of vehicle care products, including soaps,

polishes, sealants, wheel and tire treatments and air fresheners to professional car

washes, convenience stores, auto detailers, and commercial fleet wash customers.”

(10k) It is commonly referred to as “Zep Vehicle Care” or “ZVC.” “ZVC provides car,

42

truck and fleet wash operators with high efficiency products for their wash tunnels and

facilities.” (10k)

All of these acquisitions were part of Zep Inc. utilizing economies of scale. By taking

over various companies and sectors across the U.S. and Europe, they were able to

expand operations and enter into new markets. This ultimately resulted in higher cash

flows from operations and allowed them to apply costs to a bigger variety of products.

From looking at the statement of cash flows from 2012 to 2013, it is evident that cash

flows from investing activities went from $-42,779 to $-128,739. We believe this is a

direct result from the Ecolab vehicle care acquisition.

43

Statement of Cash flows

Period Ending 31-Aug-14 31-Aug-13 31-Aug-12

Net Income 8,400 15,192 21,909

Operating Activities, Cash Flows Provided

By or Used In

Depreciation 22,122 19,931 14,330

Adjustments To Net Income 19,192 7,578 5,941

Changes In Accounts Receivables -3,823 -4,355 2,097

Changes In Liabilities 121 11,083 -9,904

Changes In Inventories -9,502 2,885 -9,141

Changes In Other Operating Activities -14,239 -2,298 -2,625

Total Cash Flow From Operating Activities 22,271 50,016 22,607

Investing Activities, Cash Flows Provided By

or Used In

Capital Expenditures -9,597 -12,068 -18,356

Investments 4,650 - -12,500

Other Cash flows from Investing Activities 2,553 -116,671 -11,923

Total Cash Flows From Investing Activities -2,394 -128,739 -42,779

Financing Activities, Cash Flows Provided By

or Used In

Dividends Paid -4,505 -3,536 -3,512

Sale Purchase of Stock 2,234 1,207 738

Net Borrowings -2,905 70,658 19,600

Other Cash Flows from Financing Activities - - -

Total Cash Flows From Financing Activities -7,986 77,509 16,821

Effect Of Exchange Rate Changes 10 103 -355

Change In Cash and Cash Equivalents 11,901 -1,111 -3,706

44

Lower Input Costs

Input costs can seriously impact a company in the cleaning products industry. To

remain competitive, the firm must be able to sell goods for a reasonable price and still

make a profit. Zep, Inc. uses a variety of polymers and resins, fragrances, water,

solvents and other petroleum-based materials, and packaging materials (10k). Due to

the fact that many of the raw materials that are used in their products are petroleum-

based, the price fluctuates greatly with the market price of oil. Also, the products used

that are agricultural commodities are rather volatile and subject to fluctuate. ” The

fluctuations could materially adversely affect our financial condition and results of

operations” (10k). If the price of raw materials increases, Zep, Inc. will most likely not

be able to recover losses by increasing selling price due to the highly competitive nature

of the industry. If the selling price of the products is increased based on the increase in

costs that are out of the companies control, there will most likely decrease in demand

for the company’s’ products. When demand for Zep, Inc.’s products goes down, they

will be unable to sustain themselves, let alone any kind of growth.

Customer Service and Product Quality

In order to succeed in any business it is vital to deliver a quality product and

exceptional service. Although it may be more difficult to put out a significantly higher

quality product, this is still true for companies in the cleaning products industry. If a

company can produce quality products and provide good customer service, it will go a

long way in establishing brand name recognition. Zep, Inc. is constantly updating its

services and product lines with the customer’s demands in mind using various new

45

technologies. Their product lines consist of three main categories which are automotive

cleaning and maintenance; equipment repair and maintenance and Jan/San products

(10k). What gives Zep, Inc.’s products their quality is inside of the formulations. These

formulations are mainly trade secrets. In order to protect Zep, Inc.’s products from

being easily mimicked, they must invest in patents. According to their balance sheet,

intangible assets account for about half of Zep, Inc.’s total assets. Within these

intangible assets are nearly 600 patents that are either pending or owned by Zep, Inc.

It is reasonable to say that without these patents, the quality of their products could be

much more easily matched and Zep, Inc. would have a difficult time staying in business.

In addition to maintaining a quality product, customer service is a vital component to

success. Since 2010, Zep, Inc. has been expanding into new markets in the U.S. and

Europe. This expansion has significantly improved the level of service that the company

has been able to deliver. Having more locations and distribution centers has helped

Zep, Inc. maintain better relationships with their customers.

Introduction to Accounting Analysis

After our discussion of the overview of the cleaning chemicals industry, we will

continue on to our accounting analysis. Throughout the accounting analysis, we will

discuss the key accounting policies, evaluate the accounting strategies, assess the

degree of accounting flexibility, and identify items on the financial statements that can

potentially be misleading. We will first discuss the key accounting policies, which are

directly related to the key success factors that were previously mentioned. Once we

46

identify the key accounting policies, we will assess the degree of potential accounting

flexibility. The degree of accounting flexibility is otherwise known as the ability of an

industry to choose accounting policies. Next, we will evaluate the actual accounting

strategy, which involves how a company actually presents their financial statements

based on the degree of accounting flexibility. We will then identify any items on their

financial statements that can potentially be misleading. Once all we have gathered all of

the information, we will use it to undo anything that is potentially distortive on the

financial statements.

Key Accounting Policies

Analyzing key accounting policies gives more clarity and allows you to better

understand both the company and the industry as a whole due to the fact that only

looking at the financial statements can sometimes be misleading. The information on a

company’s financial statements can sway an analyst’s opinion about a company

because the accrual accounting basis records based on expected instead of actual

outcomes. There are two different types of key accounting policies. The type one

policies look at the industry as a whole and are closely related to the key success

factors mentioned earlier. Type two policies deal with potentially misleading items such

as leases and intangible assets. Understanding these key accounting policies is essential

to fully understanding both the Industry as a whole and Zep, Inc. and will allow us to

form a more accurate conclusion about the company.

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Type One Accounting Policies

The type one accounting policies are directly related to the reporting practices of

the companies that are in the same industry as Zep, Inc. with regard to key success

factors. In the following sections, we will discuss the level of disclosure of Zep, Inc.’s

type one accounting policies. We previously discussed that the key success factors for

the cleaning products industry are economies of scale, lower input costs, and delivering

exceptional service and product quality. These factors not only apply to Zep, Inc., but

they also apply to the other companies in our sample industries.

Economies of Scale

Companies in the cleaning products industry can gain a competitive advantage

by applying costs over a broader spectrum through economies of scale. According to

their 2014 10k, Zep, Inc. currently operates out of nine manufacturing centers around

North America and Europe. They also have completed seven acquisitions since

becoming a public company in 2007 which allowed them to expand into the European

market. The competition that Zep, Inc. faces is significantly larger than they are. As

shown on the chart below, the competition has significantly more manufacturing

facilities and locations. This gives the competition a competitive advantage, but Zep,

Inc. has been growing and making acquisitions since 2010 in an attempt to better

utilize economies of scale.

48

Below is a table displaying the percent change in net sales for Zep, Inc. and

three of their competitors. From looking at the chart, it is evident that most of the

companies have seen an increase in net sales over the last five years. We believe that

this is a result of increasing size of operations, which allows companies to gain a cost

advantage over the competition.

Percent Change in Net Sales

2010 2011 2012 2013 2014

Zep, Inc. 13.48% 13.63% 1.17% 5.52% 1%

Ecolab Inc. -46.27% 12.01% 65.16% 14.16%

-

Clorox Company -3.96% -0.06% 4.53% 2.83% -0.57%

Church and Dwight

Inc. 2.71% 6.18% 6.23% 9.32%

-

0

5

10

15

20

25

30

35

40

45

50

Zep, Inc. Ecolab Inc. Clorox Company Church andDwight Inc.

Manufacturing facilities

Manufacturing facilities

49

Since 2010, Zep, Inc. has been able to increase revenues and expand operations

by acquiring more facilities. This has also allowed them to enter into new markets such

as car care with their new sector, Zep Vehicle Care. If Zep, Inc. is able to continue to

expand and acquire new facilities, they should continue to be able to grow revenues

and become more and more competitive. However, since 2012 growth has decreased

substantially, which is a cause for concern for Zep, Inc.’s future.

Lower Input costs

We stated earlier that the competition in the cleaning products industry is high

as well as the threat of substitute products. In order to remain competitive, firms must

find new and innovative ways to reduce input costs. This is rather difficult to do due to

the fact that many of the raw materials used to make the products are petroleum based

and fluctuate with the market price of oil. This also makes it more difficult for

companies to predict future price of the raw materials used to make products. Below is

a bar graph displaying the percentage of net sales that cost of goods sold accounts for

within Zep, Inc. and its competitors. You will see that Ecolab and Church and Dwight

have no data due to the fact that they have not yet disclosed all of their financials for

2014 yet. We will compare various profitability ratios of each company later on that will

allow us to compare Zep, Inc.’s performance against the benchmark companies.

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Customer Service and Product Quality

It is vital for any company, as well as companies in the cleaning products

industry, to deliver excellent service and product quality. Zep, Inc. stated in their 10k

that their competition is primarily based on product quality and customer service. They

also stated that in they have over 4000 different formulas in their portfolio and that

they must continually adapt and change them in order to meet the needs of their

customers and maintain good relations with them. Their product portfolio consists of

“three major categories, including automotive cleaning and maintenance, equipment

repair and maintenance, and Jan/San products” (10k). In addition to a staff of chemists

and technical support who develop new products they also “license new products and

technologies from third parties and engage others to assist with product development”

(10k). In order to retain the value of their formulas, which are mainly trade secrets as

previously stated, Zep, Inc. either owns or has pending over 600 foreign and domestic

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

Zep, Inc. CloroxCompany

Ecolab Inc. Church andDwight Inc.

Cost Percent of Net Sales 2014

Cost Percent of Net Sales 2013

Cost Percent of Net Sales 2012

51

patents. These patents are disclosed as intangible assets on the balance sheet. Last

year, intangible assets accounted for nearly half of Zep, Inc.’s total assets.

Type Two Accounting Policies

Type two accounting policies are items on financial statements that can

potentially affect or sway our opinion about a company. There are numerous ways to

report these items and in many cases, they can be used to distort financial statements

and alter our perspective on the company being evaluated. These items include, but are

not limited to, goodwill, leases, benefit plans, and R&D. Zep, Inc. and other companies

in the cleaning products industry have goodwill and operating leases as material items

on their financial statements.

Goodwill

Goodwill is recorded on the balance sheet as an intangible asset. It basically is

the premium that a company would have to pay in order to acquire another firm based

on another intangible asset or competitive advantage. The issue with goodwill is that

often times instead of properly disclosing its impairment; companies will keep it on their

books as an asset for much longer than the competitive advantage of having it would

last. Last year, Zep, Inc. recorded $242.3 million in intangible assets, which accounted

for approximately 44% of their total assets. Out of the intangible assets, they recorded

$121 million in goodwill, which accounted for 22% of total assets. Zep, Inc. states in

their 10k that they “test goodwill for impairment on an annual basis (as of the

beginning of our fiscal fourth quarter) and, if certain events or circumstances indicate

that an impairment loss may have been incurred, on an interim basis.” They estimate

52

the fair value of the reporting unit by considering market capitalization and other

factors to see if the carrying value of the unit is likely to exceed the fair value. If the

carrying value exceeds the fair value, they then calculate the impairment charge.

However, if fair value is greater than carrying value, there is no further testing required.

Companies do not always properly impair goodwill, which can potentially be deceiving.

Below is a chart showing how Zep, Inc. should have recorded the impairment of

goodwill.

53

Operating Leases

There are two different ways to report operating leases and still comply with

GAAP. Capital leases are reported as a capitalized asset and are depreciated over the

life of the lease. When operating leases are recorded, there is a lot of room for error

and it can potentially lead to an understatement of a company’s lease obligations.

Operating leases are reported as expenses, such as rent, on the income statement.

Zep, Inc. “leases certain of our buildings and equipment under non-cancelable

operating lease agreements. Certain of these operating lease agreements contain rent

escalation clauses” (10k). They also stated that “We expense rent on a straight-line

basis over the life of our leases, which commences on the date we have the right to

control leased property” (10k). In order to report their lease obligations, most

companies in the cleaning chemicals industry use operating leases.

Conclusion

In order to gain the best understanding of financial statements it is crucial to

understand type one and type two accounting policies. We have identified type one

polices for Zep to be correlated with KSF’s identified earlier as economies of scale, lower

input cost, and customer service and product quality. The level of disclosure is

moderate for these type one accounting policies as some information about input costs

seem to be hard to find. Type two accounting policies can potentially distort analyst

abilities to value the company and are identified for Zep as goodwill and operating

54

leases. These will later be restated for Zep, Inc. in our analysis in order to properly

reflect any distortions and to provide more clarity for this valuation.

Assess Degree of Potential Accounting Flexibility

Not all firms have equal flexibility in choosing their accounting policies and

estimates. Some firms’ accounting choice is severely constrained by accounting

standards and conventions (1). When managers have lower flexibility in choosing

accounting policies and estimates, accounting data tends to be less informative on

understanding the firm’s economics. However, when a manager has higher flexibility,

accounting data has the potential to be informative and help on understanding the

firm’s economics. Most importantly, for accounting data to be informative, it is

dependent on how the manager chooses to exercise their flexibility.

Companies in the cleaning chemicals industry have flexibility in how they report

their Operating leases, goodwill, employee benefit plans, and research and

development. For Zep Inc., Operating leases, goodwill, and research and development

will be the target of accounting flexibility for this analysis. This is because operating

leases, goodwill, and research and development are important factors for companies

within the cleaning chemicals industry.

55

Operating Leases

In an operating lease, the lessor (or 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 lessor. 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 (2). In the cleaning chemicals industry, operating leases are used by

almost all companies. Operating leases are supposed to be capitalized when they

account for more than 20% of long term liabilities. Zep Inc. used operating leases, as

illustrated below, which affected no more than 25% of its total long term liabilities.

Year

Cap OL

Liability

Total LT

Liabilities Percentage

2010 $26,282 $103,839 25.31%

2011 $14,538 $137,092 10.60%

2012 $8,954 $153,628 5.83%

2013 $1,943 $216,030 0.90%

2014 ($4,798) $217,903 -2.20%

Zep Inc. leases certain buildings and equipment under non-cancelable operating

lease agreements, with some of these lease agreements containing rent escalation

clauses. The operating leases are then expensed as rent on a straight-line basis over

the life on the operating leases. Zep Inc. recorded $9.4 million in operating leases in

2012, $10.8 million in 2013, and $11.7 million in 2014.

56

Goodwill

Goodwill is an intangible asset that arises when a company acquires another

business. The amount of goodwill is the cost to purchase the business minus the fair

market value of the tangible assets, the intangible assets that can be identified, and the

liabilities obtained in the purchase. The amount in the Goodwill account will be adjusted

to a smaller amount if there is an impairment in the value of the acquired company as

of a balance sheet date (3). The recognition of an impairment on Zep’s goodwill could

have a material adverse effect on our results of operations and financial position, but

not their cash flow from operations (4).

In 2014, Zep Inc. reported $121 million of goodwill, which accounts for 22% of

total assets. Below is a graph illustrating Zep’s “As Stated” and “Re Stated” goodwill

from the beginning year of 2010 until the year ended 2014.

57

Research and Development

Research and development is in which business can experience future growth by

developing new products or processes to improve and expand their operations. In the

cleaning chemical industry, research and development play an essential role.

Companies devote significant resources and attention to product development, process

technology and basic research to develop differentiated products with new and

distinctive features and to provide increased convenience and value to its customers.

Zep Inc. research and development costs ranged from $1.4 to $1.6 million from

2012-2014. The research and development costs are expensed as incurred, and are

recorded under Selling, Distribution, and Administrative expenses. However compared

to its competitors, Zep’s research and development costs are not close.

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

2010 2011 2012 2013 2014

Zep Inc. Goodwill

As stated Re stated

58

Conclusion

There are a significant amount of ways for a company to report their financial

statements and earnings. In the cleaning chemical industry, companies have a good

amount of flexibility in how managers report certain figures. Companies with high

research and development costs possess more business value and significant

advantages over competitors.

Actual Accounting Strategy

A firms accounting strategy is made up of two components, disclosure level that

the company releases to shareholders/public and whether a firm is using aggressive or

conservative accounting measures. GAAP sets a minimum level of disclosure that all

firms have to meet however managers can exercise flexibility in reporting as discussed

0

50

100

150

200

250

300

350

400

Zep Inc. Clorox Church & Dwight

R&D Costs

59

before. A firm with high disclosure means a company is giving all the information GAAP

requires and then extra information to explaining business activities. Low disclosure is

when a company just meets the minimum requirements and then gives no more

information into the accounting practices it is uses to measure value. Level of disclosure

is very important in the valuation of a company. To accurately value a firm an analyst

must be able to understand how companies are potentially altering the financial

statements. The second component is aggressive accounting measures are when

management of the firm is understating accounts and overstating financial performance

in the form of net income, revenues and equity. Conservative accounting is when a

company is transparent in their accounting efforts meaning they are not overstating and

in some cases understating the value to reflect future losses.

In the maintenance and cleaning chemical industry firms have flexibly in

reporting research and development, goodwill, operating/ capital leases and pension

plans. In analyzing Zep’s actual accounting measures we looking for areas of low

disclosure and aggressive accounting measures compared to industry. For this analysis

we will focus on operating/ leases and goodwill, because R&D for Zep only represents a

small amount it will not be included also Zep does not offer pension plans to employees

so that does not affect the value of the firm.

Accounting for Operating Leases

Flexibility in reporting capital and operating leases can alter the value of a

company. Under GAAP companies can structure leases in such way that leases are

60

classified as operating leases, recording transactions as an operating expense and

reported off the balance sheet. We found this to be the case with ZEP and in order to

show the true value of risks and commitments on the balance sheet they needed to be

re-classified as capital leases. Capital leases recognize the present value of minimum

lease payments and are then recorded as assets.

Accounting for Goodwill

Goodwill represents an intangible asset that usually comes from acquisition of

other companies. Goodwill can be thought of as the excess that a company paid over

the actual value. Instead of reporting a loss companies can increase good will since it is

subjective to management judgment. Zep Inc., has acquired several smaller firms over

the past several years and is reporting of goodwill has increases however Zep has not

written off or impaired good will indicating aggressive accounting practices.

Conclusion

Firm’s flexibility in accounting can lead to misrepresenting financial statements

and overstating income. In analyzing Zep actual accounting practices we found them to

be a low disclosure company and signs of aggressive accounting practices.

Qualitative Disclosure

Investors and researchers of financial information rely on SEC filings of financial

statements and supplementary notes which are all provided by management of the

61

organization. In accordance with GAAP regulations, there is only a “minimal” level of

required disclosure in financial statements. This leads to a degree of flexibility in

management’s decision of what to include in annual reports. Most often times, the

omission of information is not intended to confuse of misguide readers, but instead, left

out of reports in attempt to keep proprietary information confidential. One example

would be grouping together customer lists or relationships as one item under intangible

assets rather than listing them individually. This means that it is up to the reader to

understand the accounting policies within the organization and industry as a whole, and

make a judgment regarding the quality of disclosure as this will affect the valuation of a

business. For Zep Inc., we have found that some areas of financial reporting are low in

disclosure.

Operating Leases and Capitalized Operating Leases

A review of Zep’s financials will find that nowhere on the balance are payments

due on capital leases shown as an expense. This is a common occurrence on

consolidated balance sheets as the obligations are grouped into long term debt or

current debt, depending on date of maturity. However the numbers are often shown in

separately in supplementary notes along with information about the nature of the

contractual leases as seen in one of their competitors, Ecolab. None of the other

mentioned competitors bring up capital leases in there 10k and where Zep does, they

are shown grouped together with long term debt rather than separately listed. This

indicates a low level of disclosure across the industry for this particular item. For

operating leases Ecolab, Clorox, and Zep list their off balance sheet operating lease

62

payments grouped as due with one year, due within 3-5, and due after five years.

Church and Dwight do a better job of disclosing when payments for operating leases

are due by showing them on a yearly basis for the next five years, with the fifth year

including all payments due after 2019.

Ineffective Internal Controls of Accounting Policies

Corporations employ many techniques like auditing and internal control positions

that are tasked with assuring their accounting disclosures are accurate, reliable, and

submitted in a timely manner. As of the period ending August 31st 2014, Zep

management has concluded and disclosed in their 10k a material weakness in their

financial statement closing procedures. “Specifically, the account reconciliation review

control is not being performed at the required precision to detect misstatements and

therefore it is reasonably possible that an aggregation of undetected immaterial errors

could result in a subsequent material misstatement.” (10K) Included in the 10k is the

attestation report from Ernst and Young LLP, Zep’s independent registered public

accounting firm. After their external auditing of Zep, they have also noted an inability of

Zep’s internal controls to maintain financial records in a reliable and fair manner. They

mention that until these material weaknesses are corrected there will continue to be a

chance of material misstatements in financial reporting of Zep Inc. In addressing this

issue, Zep will begin to add additional resources to improve internal controls and such

as continued training and hiring new accounting experts. They also plan to enact new

processes to prevent possible misstatements before they reach the general journal by

63

eliminating most manual journal entries, and requiring a signoff by management to use

such a practice.

Conclusion

Possible material misstatements and a low levels of disclosure as seen in the

recent reporting by Zep Inc., do not point to fraud but rather raise red flags that

thorough investors will want to examine these items with more detail. The lack of

transparency and the management’s declaration of ineffective internal accounting

controls leads us to be to question the reliability and usefulness of their financial

reports. In order to achieve the most accurate valuation possible our research has lead

us to restating items included on Zep’s balance sheet and income statement which will

be shown in later sections of this report.

64

Quantitative Measures of Accounting Quality

This section will analyze potential red flags in ZEP’s financial reports. This is

important to understand because it will help investors to make their investment decision

based on actual firm’s condition rather than reported condition.

Identifying Potential Red Flags

Identifying potential red flags will help to direct the analyst to areas of potential

concern (3-13). These red flags occurred because of business reasons or questionable

accounting (3-13). When a firm uses aggressive accounting strategy, we need to

identify the potential red flags. For ZEP, Inc, we will be analyzing goodwill, operating

leases, and research and development as potential red flags.

Goodwill

Goodwill is a potential red flag because it is an intangible asset that becomes

impaired when the carrying value is greater than the market or fair value. From ZEP’s

10K, they did not impair their goodwill for the past 6 years (10K). Goodwill should be

impaired if it is more than 20 percent of the firm’s property plant and equipment.

65

Based on the table above, goodwill is not properly impaired in the last five years

and we will restate goodwill account later in this section.

Operating Leases

ZEP, Inc has most of their leases are stated as operating lease in their financial

statements. Based on their accounting treatment, such as not properly recording

interest payment and depreciation, their liabilities have been understated.

Based on the table above, operating leases increases the non-current liabilities in

2010 by 25 percent which is big enough distortion to restate. Even in the following

Years 2010 2011 2012 2013 2014

as stated 103,839$ 137,182$ 153,628$ 216,030$ 217,903$

re stated 130,121$ 151,720$ 162,582$ 217,973$ 213,105$

Change 25.3% 10.6% 5.8% 0.9% -2.2%

Operating Leases

Years 2010 2011 2012 2013 2014

Interest expense 1,957$ 1,393$ 1,397$ 908$ 997$

Net Income 13,504$ 17,401$ 21,909$ 15,192$ 8,400$

Percentage 14.5% 8.0% 6.4% 6.0% 11.9%

Interest expense adjustment

2010 2011 2012 2013 2014

PP&E 66,874.00$ 67,868.00$ 80,921.00$ 82,328.00$ 75,361.00$

Goodwill 53,764.00$ 84,418.00$ 84,604.00$ 121,102.00$ 121,005.00$

Percentage 80% 124% 105% 147% 161%

66

Years 2010 2011 2012 2013 2014

R & D expense 1,500.0$ 1,500.0$ 1,500.0$ 1,500.0$ 1,500.0$

Operating Income 23,852$ 33,217$ 38,280$ 32,789$ 32,796$

Percentage 6.29% 4.52% 3.92% 4.57% 4.57%

R & D expense

years, the carryover effect from 2010 restatement would affect their net income

because of the treatment of unrecorded interest expense. Their unrecorded interest

expense would overstate their net income by average of 9.3 percent. We will restate

their operating lease later in this section.

Research and Development

Companies in cleaning chemical industry rely on research and development to

keep innovating for a new product, but sometimes the company did not properly treat

research and development account. The mistreatment could lead to distortion to the

accounting report. In the ZEP’s 10K, they mentioned that they spent $1.4 million to

$1.6 million in research and development expense in the past three years. The amount

of the expense is not big enough to create distortion because it is less than 20 percent

of operating income; thus, we will not restate research and development.

Conclusion

After looking through goodwill, operating leases, and research and development,

we decided to restate two items. These restatements would provide better

understanding of their financial condition. We will cover the restatement of balance

sheet and income statement in the next section.

67

Undoing Accounting Distortion

From the earlier section, we decided to restate some financial data. The

restatement will reduce accounting distortions within the financial statement. For ZEP,

we need to adjust operating leases and goodwill.

Operating Lease

As stated in the key accounting policy section, operating leases have a lot of

room for error. Also, it might affect balance sheet and income statement in significant

way. To calculate the operating leases, we have to find the rate of interest to find the

present value of the operating leases. The rate used should be the same rate they use

for capital lease. After finding the rate for each year, we calculated the present value of

operating lease should be capitalized each year. We also come up with the amortization

table to see the interest expense and amortization effect each year. The following are

the charts to calculate operating leases

2010Beginning

Bal

Accrued

IntPayment Ending Bal

Interest

Expense

Deprec.

Expense

Total Cap

OL Op

Expenses

Expense

under Op

Lease

Treatment

1 26,281.55$ 1,392.92$ 7,708.00$ 19,966.47$ 1,392.92$ 3,754.51$ 5,147.43$ 7,708.00$

2 19,966.47$ 1,058.22$ 6,150.00$ 14,874.70$ 1,058.22$ 3,754.51$ 4,812.73$ 6,150.00$

3 14,874.70$ 788.36$ 5,486.00$ 10,177.05$ 788.36$ 3,754.51$ 4,542.87$ 5,486.00$

4 10,177.05$ 539.38$ 4,312.00$ 6,404.44$ 539.38$ 3,754.51$ 4,293.89$ 4,312.00$

5 6,404.44$ 339.44$ 3,612.00$ 3,131.87$ 339.44$ 3,754.51$ 4,093.94$ 3,612.00$

6 3,131.87$ 165.99$ 1,691.50$ 1,606.36$ 165.99$ 3,754.51$ 3,920.50$ 1,691.50$

7 1,606.36$ 85.14$ 1,691.50$ 0.00$ 85.14$ 3,754.51$ 3,839.64$ 1,691.50$

68

2011Beginning

Bal

Accrued

IntPayment Ending Bal

Interest

Expense

Deprec.

Expense

Total Cap

OL Op

Expenses

Expense

under Op

Lease

Treatment

1 20,853.36$ 1,397.17$ 8,536.00$ 13,714.53$ 1,397.17$ 3,584.07$ 4,981.25$ 8,536.00$

2 13,714.53$ 918.87$ 5,487.00$ 9,146.41$ 918.87$ 3,584.07$ 4,502.94$ 5,487.00$

3 9,146.41$ 612.81$ 4,739.00$ 5,020.21$ 612.81$ 3,584.07$ 4,196.88$ 4,739.00$

4 5,020.21$ 336.35$ 3,051.00$ 2,305.57$ 336.35$ 3,584.07$ 3,920.43$ 3,051.00$

5 2,305.57$ 154.47$ 1,595.00$ 865.04$ 154.47$ 3,584.07$ 3,738.54$ 1,595.00$

6 865.04$ 57.96$ 923.00$ 0.00$ 57.96$ 3,584.07$ 3,642.03$ 923.00$

2012Beginning

Bal

Accrued

IntPayment Ending Bal

Interest

Expense

Deprec.

Expense

Total Cap

OL Op

Expenses

Expense

under Op

Lease

Treatment

1 22,407.51$ 907.50$ 8,370.00$ 14,945.02$ 907.50$ 3,734.59$ 4,642.09$ 8,370.00$

2 14,945.02$ 605.27$ 6,835.00$ 8,715.29$ 605.27$ 3,734.59$ 4,339.86$ 6,835.00$

3 8,715.29$ 352.97$ 4,103.00$ 4,965.26$ 352.97$ 3,734.59$ 4,087.56$ 4,103.00$

4 4,965.26$ 201.09$ 2,255.00$ 2,911.35$ 201.09$ 3,734.59$ 3,935.68$ 2,255.00$

5 2,911.35$ 117.91$ 1,900.00$ 1,129.26$ 117.91$ 3,734.59$ 3,852.50$ 1,900.00$

6 1,129.26$ 45.74$ 1,175.00$ 0.00$ 45.74$ 3,734.59$ 3,780.32$ 1,175.00$

2013Beginning

Bal

Accrued

IntPayment Ending Bal

Interest

Expense

Deprec.

Expense

Total Cap

OL Op

Expenses

Expense

under Op

Lease

Treatment

1 22,859.38$ 996.67$ 8,695.00$ 15,161.05$ 996.67$ 3,809.90$ 4,806.57$ 8,695.00$

2 15,161.05$ 661.02$ 6,007.00$ 9,815.08$ 661.02$ 3,809.90$ 4,470.92$ 6,007.00$

3 9,815.08$ 427.94$ 4,600.00$ 5,643.01$ 427.94$ 3,809.90$ 4,237.83$ 4,600.00$

4 5,643.01$ 246.04$ 2,409.00$ 3,480.05$ 246.04$ 3,809.90$ 4,055.93$ 2,409.00$

5 3,480.05$ 151.73$ 2,090.00$ 1,541.78$ 151.73$ 3,809.90$ 3,961.63$ 2,090.00$

6 1,541.78$ 67.22$ 1,609.00$ (0.00)$ 67.22$ 3,809.90$ 3,877.12$ 1,609.00$

2014Beginning

Bal

Accrued

IntPayment Ending Bal

Interest

Expense

Deprec.

Expense

Total Cap

OL Op

Expenses

Expense

under Op

Lease

Treatment

1 23,816.36$ 497.76$ 8,923.00$ 15,391.12$ 497.76$ 4,763.27$ 5,261.03$ 8,923.00$

2 15,391.12$ 321.67$ 7,206.00$ 8,506.79$ 321.67$ 4,763.27$ 5,084.95$ 7,206.00$

3 8,506.79$ 177.79$ 5,123.00$ 3,561.59$ 177.79$ 4,763.27$ 4,941.06$ 5,123.00$

4 3,561.59$ 74.44$ 2,441.00$ 1,195.02$ 74.44$ 4,763.27$ 4,837.71$ 2,441.00$

5 1,195.02$ 24.98$ 1,220.00$ 0.00$ 24.98$ 4,763.27$ 4,788.25$ 1,220.00$

69

Goodwill

As stated in the key accounting policy section, ZEP did not do any impairment in

the past five years. Due to high degree of competition in the cleaning chemical industry,

we assumed that the goodwill should last for maximum five years. Here is the

calculation of goodwill that should be impaired for the last five years.

Financial Statements Restated

After calculating how much goodwill and operating leases should be restate, we

have to restate last five years the balance sheet and income statement with trial

balance to see how it affects the financial statement. The following are the last five

years restatement of balance sheet with trial balance.

Years New Goodwill 2010 2011 2012 2013 2014

2009 31940 6388 6388 6388 6388 6388

2010 21734 4346.8 4346.8 4346.8 4346.8

2011 30744 6148.8 6148.8 6148.8

2012 186 37.2 37.2

2013 36498 7299.6

2014 -97

should do 6388 10734.8 16883.6 16920.8 24220.4

did 0 0 0 0 0

adjust 6388 10734.8 16883.6 16920.8 24220.4

70

as stated re statedAt December 31: 2010 Dr Cr 2010

Assets

Cash and cash equivalents 25,257$ 25,257$

Account receivable 90,827$ 90,827$

Less doubtful acct

Inventories 53,192$ 53,192$

Insurance receivable

Deferred income taxes 9,049$ 9,049$

Prepaids and other current asset 9,779$ 9,779$

Total Current asset 188,104$ 188,104$

PP&E 66,874.00$ 66,874$

Cap OL Rights 26,282$ 26,282$

Goodwill 53,764.00$ 6,388$ 47,376$

Identifiable intangible 30,271.00$ 30,271$

Other long term asset 3,835.00$ 3,835$

Total Asset 342,848$ 362,742$

Liabilities

Current maturities long term 15,000$ 15,000$

Account payable 51,390$ 51,390$

Accrued compensation 21,322$ 21,322$

Other accrued liab 29,124$ 29,124$

Total current liab 116,836$ 116,836$

Long term debt 77,150$ 77,150$

Cap OL Liability 26,282$ 26,282$

Deferred income taxes 2,140$ 2,140$

Other long term liab 24,549$ 24,549$

Total liab 220,675$ 246,957$

Stockholder eqity

Common stock 213$ 213$

Paid-in capital 85,316$ 85,316$

Retained earnings 25,052$ 6,388$ 18,664$

Accumulated OCI 11,592$ 11,592$

Total SE 122,173$ 115,785$

Total liab and SE 342,848$ 362,742$

71

as stated re statedAt December 31: 2011 Dr Cr 2011

Assets

Cash and cash equivalents 7,219$ 7,219$

Account receivable 95,681$ 95,681$

Less doubtful acct

Inventories 61,147$ 61,147$

Insurance receivable

Deferred income taxes 9,189$ 9,189$

Prepaids and other current asset 9,896$ 9,896$

Total Current asset 183,132$ 183,132$

PP&E 67,868$ 67,868$

Cap OL Rights 20,853$ 3,755$ 17,099$

Goodwill 84,418$ 17,123$ 67,295$

Identifiable intangible 65,136$ 65,136$

Other long term asset 3,215$ 3,215$

Total Asset 403,769$ 403,745$

Liabilities

Current maturities long term 15,000$ 15,000$

Account payable 56,821$ 56,821$

Accrued compensation 18,161$ 18,161$

Other accrued liab 27,482$ 27,482$

Total current liab 117,464$ 117,464$

Long term debt 104,650$ 104,650$

Cap OL Liability 6,315$ 20,853$ 14,538$

Deferred income taxes 6,224$ 6,224$

Other long term liab 26,308$ 26,308$

Total liab 254,646$ 269,184$

Stockholder eqity

Common stock 216$ 216$

Paid-in capital 92,925$ 92,925$

Retained earnings 38,970$ 14,562$ 24,408$

Accumulated OCI 17,012$ 17,012$

Total SE 149,123$ 134,561$

Total liab and SE 403,769$ 403,745$

72

as stated re statedAt December 31: 2012 Dr Cr 2012

Assets

Cash and cash equivalents 3,513$ 3,513$

Account receivable 93,522$ 93,522$

Less doubtful acct

Inventories 71,451$ 71,451$

Insurance receivable

Deferred income taxes 7,681$ 7,681$

Prepaids and other current asset 22,333$ 22,333$

Total Current asset 198,500$ 198,500$

PP&E 80,921$ 80,921$

Cap OL Rights 22,408$ 7,339$ 15,069$

Goodwill 84,604$ 34,006$ 50,598$

Identifiable intangible 65,707$ 65,707$

Other long term asset 5,555$ 5,555$

Total Asset 435,287$ 416,350$

Liabilities

Current maturities long term 15,000$ 15,000$

Account payable 53,461$ 53,461$

Accrued compensation 17,334$ 17,334$

Other accrued liab 27,947$ 27,947$

Total current liab 113,742$ 113,742$

Long term debt 124,250$ 124,250$

Cap OL Liability 13,454$ 22,408$ 8,954$

Deferred income taxes 8,574$ 8,574$

Other long term liab 20,804$ 20,804$

Total liab 267,370$ 276,324$

Stockholder eqity

Common stock 218$ 218$

Paid-in capital 97,481$ 97,481$

Retained earnings 57,367$ 27,891$ 29,476$

Accumulated OCI 12,851$ 12,851$

Total SE 167,917$ 140,026$

Total liab and SE 435,287$ 416,350$

73

as stated re statedAt December 31: 2013 Dr Cr 2013

Assets

Cash and cash equivalents 2,402$ 2,402$

Account receivable 104,476$ 104,476$

Less doubtful acct

Inventories 68,633$ 68,633$

Insurance receivable

Deferred income taxes 8,002$ 8,002$

Prepaids and other current asset 13,051$ 13,051$

Total Current asset 196,564$ 196,564$

PP&E 82,328$ 82,328$

Cap OL Rights 22,859$ 11,073$ 11,786$

Goodwill 121,102$ 50,927$ 70,175$

Identifiable intangible 129,929$ 129,929$

Other long term asset 17,835$ 17,835$

Total Asset 547,758$ 508,617$

Liabilities

Current maturities long term 25,000$ 25,000$

Account payable 56,366$ 56,366$

Accrued compensation 25,226$ 25,226$

Other accrued liab 41,167$ 41,167$

Total current liab 147,759$ 147,759$

Long term debt 184,908$ 184,908$

Cap OL Liability 20,916$ 22,859$ 1,943$

Deferred income taxes 12,782$ 12,782$

Other long term liab 18,340$ 18,340$

Total liab 363,789$ 365,732$

Stockholder eqity

Common stock 221$ 221$

Paid-in capital 102,573$ 102,573$

Retained earnings 69,023$ 41,084$ 27,939$

Accumulated OCI 12,152$ 12,152$

Total SE 183,969$ 142,885$

Total liab and SE 547,758$ 508,617$

74

as stated re statedAt December 31: 2014 Dr Cr 2014

Assets

Cash and cash equivalents 14,303$ 14,303$

Account receivable 108,010$ 108,010$

Less doubtful acct

Inventories 75,950$ 75,950$

Insurance receivable 13,106$ 13,106$

Deferred income taxes 10,452$ 10,452$

Prepaids and other current asset 6,254$ 6,254$

Total Current asset 228,075$ 228,075$

PP&E 75,361$ 75,361$

Cap OL Rights 23,816$ 14,883$ 8,933$

Goodwill 121,005$ 75,148$ 45,857$

Identifiable intangible 121,643$ 121,643$

Other long term asset 10,127$ 10,127$

Total Asset 556,211$ 489,997$

Liabilities

Current maturities long term 20,006$ 20,006$

Account payable 65,874$ 65,874$

Accrued compensation 19,720$ 19,720$

Other accrued liab 39,329$ 39,329$

Total current liab 144,929$ 144,929$

Long term debt 186,880$ 186,880$

Cap OL Liability 28,615$ 23,816$ (4,798)$

Deferred income taxes 13,931$ 13,931$

Other long term liab 17,092$ 17,092$

Total liab 362,832$ 358,034$

Stockholder eqity

Common stock 224$ 224$

Paid-in capital 108,432$ 108,432$

Retained earnings 72,918$ 61,416$ 11,502$

Accumulated OCI 11,805$ 11,805$

Total SE 193,379$ 131,963$

Total liab and SE 556,211$ 489,997$

75

Balance Sheet

The restatement effect of the balance sheet shows apparent effect as ZEP

overstated their asset in the past five years as well as understated their liabilities on the

four out of last five years. The changes of total asset and liabilities will affect the ratios

used to value the company. The following are the restatement of income statement

with trial balance for the past five years.

as stated re statedAt December 31: 2010 Dr Cr 2010

Statements of Income

Net Sales 568,512$ 568,512$

Cost of products Sold 285,335$ 285,335$

Gross Profit 283,177$ 283,177$

Selling, Distribution, and Adm Exp 247,759$ 247,759$

Restructuring Charges 8,213$ 8,213$

Acquisition and Integration Costs 3,353$ 3,353$

Loss (Gain) on Asset Disposal

Operating Profit 23,852$ 23,852$

Other Expense (Income)

Interest Expense 1,957$ 1,957$

Provision for loan loss

Accelerated debt issuance 428$ 428$

Bargain purchase gains

Goodwill Impairment (adjust) 6,388$ 6,388$

Miscellaneous expense (244)$ (244)$

Total other Expense 2,141$ 8,529$

Income before Income taxes 21,711$ 15,323$

Provision for Income taxes 8,207$ 8,207$

Net Income 13,504$ 7,116$

Income summary 6,388$

76

as stated re statedAt December 31: 2011 Dr Cr 2011

Statements of Income

Net Sales 645,972$ 645,972$

Cost of products Sold 343,095$ 343,095$

Gross Profit 302,877$ 302,877$

Selling, Distribution, and Adm Exp 268,438$ 3,755$ 7,708$ 264,485$

Restructuring Charges 1,469$ 1,469$

Acquisition and Integration Costs 429$ 429$

Loss (Gain) on Asset Disposal (676)$ (676)$

Operating Profit 33,217$ 37,170$

Other Expense (Income)

Interest Expense 6,562$ 1,393$ 7,955$

Provision for loan loss

Accelerated debt issuance

Bargain purchase gains

Goodwill Impairment (adjust) 10,735$ 10,735$

Miscellaneous expense (40)$ (40)$

Total other Expense 6,522$ 18,650$

Income before Income taxes 26,695$ 18,521$

Provision for Income taxes 9,294$ 9,294$

Net Income 17,401$ 9,227$

Income summary 8,174$

77

as stated re statedAt December 31: 2012 Dr Cr 2012

Statements of Income

Net Sales 653,533$ 653,533$

Cost of products Sold 352,737$ 352,737$

Gross Profit 300,796$ 300,796$

Selling, Distribution, and Adm Exp 260,806$ 3,584$ 8,536$ 255,854$

Restructuring Charges

Acquisition and Integration Costs 1,210$ 1,210$

Loss (Gain) on Asset Disposal 500$ 500$

Operating Profit 38,280$ 43,232$

Other Expense (Income)

Interest Expense 5,493$ 1,397$ 6,890$

Provision for loan loss

Accelerated debt issuance

Bargain purchase gains (2,095)$ (2,095)$

Goodwill Impairment (adjust) 16,884$ 16,884$

Miscellaneous expense 1,046$ 1,046$

Total other Expense 4,444$ 22,725$

Income before Income taxes 33,836$ 20,507$

Provision for Income taxes 11,927$ 11,927$

Net Income 21,909$ 8,580$

Income summary 13,329$

78

as stated re statedAt December 31: 2013 Dr Cr 2013

Statements of Income

Net Sales 689,576$ 689,576$

Cost of products Sold 365,034$ 365,034$

Gross Profit 324,542$ 324,542$

Selling, Distribution, and Adm Exp 283,075$ 3,735$ 8,370$ 278,440$

Restructuring Charges 5,159$ 5,159$

Acquisition and Integration Costs 3,519$ 3,519$

Loss (Gain) on Asset Disposal

Operating Profit 32,789$ 37,424$

Other Expense (Income)

Interest Expense 8,958$ 908$ 9,866$

Provision for loan loss

Accelerated debt issuance

Bargain purchase gains

Goodwill Impairment (adjust) 16,921$ 16,921$

Miscellaneous expense 744$ 744$

Total other Expense 9,702$ 27,530$

Income before Income taxes 23,087$ 9,894$

Provision for Income taxes 7,895$ 7,895$

Net Income 15,192$ 1,999$

Income summary 13,193$

79

as stated re statedAt December 31: 2014 Dr Cr 2014

Statements of Income

Net Sales 696,489$ 696,489$

Cost of products Sold 369,697$ 369,697$

Gross Profit 326,792$ 326,792$

Selling, Distribution, and Adm Exp 293,361$ 3,810$ 8,695$ 288,476$

Restructuring Charges (456)$ (456)$

Acquisition and Integration Costs 1,091$ 1,091$

Loss (Gain) on Asset Disposal

Operating Profit 32,796$ 37,681$

Other Expense (Income)

Interest Expense 11,819$ 997$ 12,816$

Provision for loan loss 5,269$ 5,269$

Accelerated debt issuance

Bargain purchase gains

Goodwill Impairment (adjust) 24,220$ 24,220$

Miscellaneous expense 1,610$ 1,610$

Total other Expense 18,698$ 43,915$

Income before Income taxes 14,098$ (6,234)$

Provision for Income taxes 5,698$ 5,698$

Net Income 8,400$ (11,932)$

Income summary 20,332$

80

Income Statement

From the charts above, we can see how the restatement of goodwill and

operating leases affects ZEP’s net income from year to year. In the 2014 restated

income statement, their net income becomes negative which shows the reason why ZEP

did not impair goodwill and capitalize operating lease. We need to change three lines

item for the readjustment. In the selling, distribution, and administrative expense, we

put actual capitalization of operating leases and depreciation expense. In the interest

expense, we added interest paid for operating leases. And also, we added goodwill

impairment line to account for impaired goodwill. Overall, the restated income

statement showed the effect of goodwill and operating lease that would affect

investors’ valuation of the company.

Conclusion

The differences of as stated and restated income statement and balance sheet

show how much distortions they have in their accounting policy because of their

treatment of goodwill and operating leases.

81

Financial Analysis

Financial analysis is used to measure the overall performance of the firm. It is

broken down in two components ratio analysis and cash flow analysis. Ratio analysis is

important because it compares performance across time and against the industry

average, and serves as the foundation for making future forecasts. Cash flow analysis

examines the firm’s liquidity and assess the management of operating, investment, and

financing cash flows. In this section we will use ratio analysis and cash flow analysis to

evaluate the performance of Zep. Inc.’s liquidity, efficiency, profitability and capital

structure. We will analyze the information to make reasonable future forecasts and

estimate the weight average cost of capital.

Liquidity Analysis

Liquidity measures how quick a firm is able to convert assets into cash, this

shows how well a company meets its short term debt obligations. Liquidity ratios are

often used to determine the amount of credit risk that a company possesses and can be

used by lenders to enforce debt covenants that require firms to maintain a certain level

of leverage. The main liquidity ratios we will examine in this section are current ratio,

quick ratio, inventory turnover, inventory days, accounts receivable, accounts receivable

days, and cash to cash cycle.

82

Current Ratio

The current ratio is the key measure for a company’s short term liquidity in a

normal environment. It is computed by dividing current assets by current liabilities and

shows the firm’s ability to cover its short term debt obligations. Analysis consider a

current ratio of more than 1.0 to indicate a firm’s ability to cover its liabilities from cash

and cash equivalent assets. The industry showed healthy current ratios over the past

five years except for Clorox who has had a below average ratio for the past five years.

Zep’s current ratio was above average four out of the last five years ranging from a

ratio of 1.60 to 1.57 in 2014.

2010 2011 2012 2013 2014

ZEP 1.60 1.55 1.74 1.33 1.57

CHD 1.45 1.97 1.29 1.71 1.14

CLX 0.91 0.94 0.67 1.25 0.85

ECL 1.41 1.70 1.60 1.35 1.11

Industry Avg 1.34 1.54 1.32 1.41 1.17

0.00

0.50

1.00

1.50

2.00

2.50

2010 2011 2012 2013 2014

Current ratio

ZEP

CHD

CLX

ECL

83

2010 2011 2012 2013 2014

ZEP 0.99 0.88 0.85 0.72 0.84

CHD 0.94 1.35 0.89 1.27 0.82

CLX 0.38 0.57 0.41 0.78 0.53

ECL 0.94 1.24 1.11 0.83 0.65

Quick Asset Ratio

Quick ratio, also known as the acid-test ratio, uses a firms most liquid assets to

calculate liquidity under a distressed environment. Therefore In order to calculate the

quick ratio inventories are subtracted from current assets and divided by current

liabilities. Since inventories are the least liquid assets, removing them gives a better

picture than current ratio on how liquid the company really is in a distressed

environment. A higher quick ratio indicates a healthier liquidity position. The chart for

Zep and its competitors shows a downward curve dropping below one over the past five

years, meaning Zep and other firms hold a significant amount in inventories which are

harder to convert to cash.

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

2010 2011 2012 2013 2014

Quick Asset Ratio

ZEP

CHD

CLX

ECL

84

Inventory Turnover

Inventory turnover indicates how many times a company’s existing inventory is

sold in a given period, It is important to show liquidity and improve profitability. It is

calculated by taking cost of goods sold (COGS) divided by inventory. Typically, a higher

inventory turnover ratio shows strong sales while a low turnover ratio indicates excess

inventory and reduced operating efficiency. The industry ratio has remain fairly

constant over the five year period. Zep shows a decreasing inventory turnover for the

last three years, making it the lowest compared the industry. However, for this ratio

Zep is most comparable with EcoLab. Clorox and Church & Dwight operate in a larger

segment of the market making their ratios less measurable against Zep’s.

2010 2011 2012 2013 2014

ZEP 6.15 6.00 5.32 5.21 5.11

CHD 6.94 7.75 7.36 7.13 7.43

CLX 8.35 8.29 8.26 8.25 8.28

ECL 6.41 4.58 6.01 6.01 5.51

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

2010 2011 2012 2013 2014

Inventory Turnover

ZEP

CHD

CLX

ECL

85

Accounts Receivable Turnover

Accounts receivable turnover measures how many times the firm collects the

outstanding credit sales for accounts. A higher accounts receivable can indicate a

company’s ability to generate cash flow and meet current debt obligations. It also

shows if the company’s credit policy is up to par or lacking. The industry again shows

market segmentation in collections with Clorox and Church and Dwight reporting the

highest ratios and Zep and Ecolab significantly lower. Low A/R turnover can indicate

problems with credit policy. Over the Five year period Zep’s A/R turnover slightly

improved from 6.46 in 6.56.

0.00

2.00

4.00

6.00

8.00

10.00

12.00

2010 2011 2012 2013 2014

Accounts Receivable Turnover

ZEP

CHD

CLX

ECL

2010 2011 2012 2013 2014

ZEP 6.46 6.93 6.91 6.97 6.56

CHD 11.43 11.09 10.29 10.09 10.10

CLX 10.20 9.82 9.93 9.73 9.93

ECL 6.04 4.39 5.48 5.53 5.50

86

Accounts Receivable Days

Accounts receivable days ratio displays how many days it takes from the sale of

products to collection of revenues generated. Typically, Investors prefer to see a lower

A/R days because it is an indication of how quickly companies collect those revenues. In

this particular case, Zep Inc. has a higher than average accounts receivable days ratio

making it less efficient than Clorox, Church and Dwight, and Ecolab. Graphed below are

the A/R days for the previous five years of each company.

2010 2011 2012 2013 2014

ZEP 59.36 60.82 68.79 70.04 71.37

CHD 52.56 47.10 49.71 51.20 49.11

CLX 43.70 44.05 44.30 44.22 44.06

ECL 56.98 79.67 60.90 60.75 66.28

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

1 2 3 4 5

Days Supply Inventory

ZEP

CHD

CLX

ECL

87

2010 2011 2012 2013 2014

ZEP 115.82 113.51 121.77 122.44 127.05

CHD 84.51 80.00 85.26 87.38 85.25

CLX 79.47 81.21 81.15 81.74 80.81

ECL 117.39 162.75 127.69 126.75 132.66

Cash to Cash Cycle

Cash to cash cycle, or cash conversion cycle, measures the amount of time, in

days, that each net input dollar is tied up in the production and sales process before

being converted back into cash through sales. This ratio looks at the amount of time

needed to sell inventory, collect receivables and the length of time the company has

before outstanding payables come due. A low cash to cash cycle is preferred as it

indicates less time capital is tied up in the business cycle. The industry average shows

segmentation of Ratios. Again, Zep and Ecolab will be more alike for this ratio being

that they operate with in the same segment of the market. In 2011 Ecolab experienced

a spike from 120 to 160 days but has since come back into line with Zep. Zep’s cash on

cash ratio has increased over the five year period making it less efficient.

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

180.00

2010 2011 2012 2013 2014

Cash to cash cycle

ZEP

CHD

CLX

ECL

88

Working Capital Turnover

Working capital turnover shows how well a firm can finance sales from working

capital, it is calculated by taking sales and dividing by working capital. Working capital is

simply current assets minus current liabilities. A higher number indicates a strong

position. Over the five year period the industry moved in the same direction with the

exception of Clorox, which fluctuated sharply. We have attributed this fluctuation to

Clorox’s reporting negative stock holder’s equity making the ratio move out of line in

period and doubled from 2013 to 2014.

(70.00)

(60.00)

(50.00)

(40.00)

(30.00)

(20.00)

(10.00)

-

10.00

20.00

30.00

40.00

2010 2011 2012 2013 2014

Working Capital Turnover

ZEP

CHD

CLX

ECL

2010 2011 2012 2013 2014

ZEP 8.02 8.07 9.99 7.80 14.13

CHD 12.79 7.52 14.03 6.87 25.92

CLX (33.55) (60.83) (7.98) 19.66 (23.01)

ECL 11.17 3.05 6.44 10.96 27.41

89

Conclusion

After calculating and reviewing the financial analysis ratios we have determined

that Zep Inc. is performing below average. Many of the ratios including quick asset,

inventory turnover, accounts receivable turnover and working capital turnover have

shown negative trends meaning they are either too high or too low compared to the

industry benchmarks.

Profitability Ratios

Introduction

Profitability ratios analyze a company’s ability to generate earnings relative to

sales, assets and equity. These ratios will help determine the short and long term

success or failure of a company. In this analysis we will examine gross profit margin,

operating profit margin, net profit margin, asset turnover, return on assets and return

on equity for Zep Inc. and benchmark competitors. We will use this information to help

forecast future vales and further understand the financial position of Zep Inc. in

reference to the industry.

90

2010 2011 2012 2013 2014

ZEP 49.81 46.89 46.03 47.06 46.92

CHD 44.71 44.17 44.20 45.02 44.06

CLX 44.31 43.45 42.14 42.90 42.21

ECL 50.51 48.88 45.23 45.37 46.23

Gross Profit Margin

Gross profit margin is used to measure the profitability of a company. It is

calculated by taking revenue minus cost of goods sold over total revenue. A higher

percentage means a company has more profit left over to cover other expenses. Gross

profit is most useful for comparing the firm across time with itself and industry

benchmarks. In general gross profit margin should remain stable from year to year

unless the industry is experiencing drastic changes. Industry averages for this analysis

have remained fairly stable over the five year period. Ecolab’s ratio has shown an

inverse relationship compared with the industry. Zep Inc.’s gross profit margin has

increased slowly over the past three years and shown a slight decline at the end of

2014 still they are reporting the highest gross profit.

36.00

38.00

40.00

42.00

44.00

46.00

48.00

50.00

52.00

2010 2011 2012 2013 2014

Gross Profit Margin

ZEP

CHD

CLX

ECL

91

Operating Profit Margin

Operating profit margin, like gross profit margin, can be used to examine how

well a company can generate cash. It represents the amount of revenues remaining

after operating expense have been taken out, and can be calculated by dividing

operating income by total revenue. A high operating profit margin can indicate a

company has good cost control or sales are increasing faster than costs. Industry

averages over all have increase over the past five years, while Zep Inc. has reported

the lowest operating profit margin over the past five years. Zep went from reporting the

highest gross profit to lowest operating profit which indicates higher than average

operating costs. Zep’s restated ratio is negative for all of the past five years.

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

2010 2011 2012 2013 2014

Operating Profit Margin

ZEP CHD CLX ECL ZEP RE

2010 2011 2012 2013 2014

ZEP 4.20 5.14 5.86 4.76 4.71

CHD 17.18 17.92 18.66 19.48 19.44

CLX 18.51 12.67 16.51 17.34 17.28

ECL 13.25 11.09 10.89 11.78 13.69

ZEP RE -0.015 -0.029 -0.035 -0.04 -0.01

92

Net Profit Margin

Net profit margin is calculated by taking net income and dividing it by net sales.

It is an important value to analyze because revenues reaming after interest and taxes

are paid can be distributed back to shareholders through dividends or reinvested in the

company. Companies that have a high net profit margin are said to be generating more

income per dollars of sales. The graph and table below show the net profit over the last

five years. Church and Dwight and Clorox have shown strong net profit margin returns

while Ecolab and Zep have shown significantly lower percentages. Zep’s net profit has

declined for the last five years and is at its lowest 1.21. When we look at Zep’s restated

ratio they decline even further into the negatives for the last year.

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

2010 2011 2012 2013 2014

Net Profit Margin

ZEP CHD CLX ECL ZEP RE

2010 2011 2012 2013 2014

ZEP 2.38 2.69 3.35 2.20 1.21

CHD 10.46 11.26 11.97 12.35 12.55

CLX 11.52 10.65 9.89 10.17 9.98

ECL 8.71 6.80 5.94 7.30 8.42

ZEP RE 0.013 0.014 0.013 0.003 -0.017

93

Asset Turnover

Asset turnover represents the dollar amount of revenue generated for every

dollar of sales. It is calculated by dividing sales by total assets. Higher asset turnover

shows efficiency in using assets meaning the company is generating more revenue per

dollar of assets. The industry average for this ratio has been declining over the past five

years. Church and Dwight and Ecolab’s ratio has dropped below one. Zep’s ratio has

also declined from 1.92 to 1.26 in 2014. However, Zep still has the highest industry

ratio even after we look at the restated ratio.

0

0.5

1

1.5

2

2.5

2010 2011 2012 2013 2014

Asset Turnover

ZEP CHD ECL ZEP RE

2010 2011 2012 2013 2014

ZEP 1.92 1.73 1.56 1.40 1.26

CHD 0.85 0.91 0.81 0.76 0.76

ECL 1.23 0.59 0.66 0.71 0.73

ZEP RE 1.57 1.6 1.57 1.36 1.42

94

Return on Assets

Return on assets (ROA) shows the percentage profit generated by a company’s

total assets. The calculation is net income by total assets at the beginning of the year or

end of last year. When a company increases its revenue it is important review changes

relative to ROA to insure that growth is adding not only to revenues but to net income

as well. In general higher ROA is preferred, if a company finds that sales are increasing

but ROA is decrease it may indicated an inefficiency. Ratios average for the industry are

not following a trend Clorox is reporting the highest ROA while Zep is reporting the

lowest ROA over the last five years. Zep’s ROA has declined even further over the past

two years from 3.09 to 1.52. When we look at the restated ratio Zep’s position is worse

off.

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

2010 2011 2012 2013 2014

Return On Assets

ZEP CHD CLX ECL ZEP RE

2010 2011 2012 2013 2014

ZEP 4.56 4.66 5.22 3.09 1.52

CHD 8.93 10.21 9.70 9.44 9.58

CLX 13.22 12.79 12.70 13.20 13.02

ECL 10.72 4.01 3.94 5.20 6.15

ZEP RE 1.96 2.29 2.06 0.39 -2.43

95

Return on Equity

Return on Equity is a way to examine what stockholder or equity partners are

receiving. The ratio is computed by taking net income and dividing by owners’ equity. It

is relevant to compare return on equity to industries return on equity. An increasing

ROE represents increase in efficiency of shareholder’s equity. Industry return on equity

has be volitaly overt the past five year period. Church and Dwight has increased ROE

slightly while Ecolab had a sharp decline in ROE in 2011 and has slowly brought it back

up. Zep has the lowest return on equity for past five years and has sharply declined

since 2012. The restated ratio for Zep is way below the industry average and negative

for 2014.

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00

2010 2011 2012 2013 2014

Return On Equity

ZEP CHD ECL ZEP RE

2010 2011 2012 2013 2014

ZEP 11.67 12.83 13.82 8.63 4.45

CHD 15.59 15.83 17.06 18.09 18.81

ECL 25.68 11.87 11.98 14.42 16.41

ZEP RE 6.15 6.86 6.13 1.40 -9.04

96

Conclusion

Zep’s financial ratios further indicate that they are preforming below average.

The ratios for operating profit margin, net profit, return on assets and return on equity

have shown significantly lower numbers compared to industry benchmark. Zep only had

positive values for gross profit and asset turnover. When we look at the restated ratios

Zep performance is less than ideal.

Capital Structure Ratios

Introduction

A mix of a company's long-term debt, specific short-term debt, common equity

and preferred equity. The capital structure is how a firm finances its overall operations

and growth by using different sources of funds (1). An ideal capital structure is one that

provides enough cushions to shareholders so that they can leverage the debt-holders

funds but it should also provide surety to debt holders of the return of their principal

and interest. Since capital structure ratios reveal these facts, analyst pay careful

attention to them (2). The three main capital structure ratios that will be discussed in

this section are the Debt to Equity, Times Interest Earned, and Altman’s Z score.

Debt to Equity

The Debt to Equity ratio is a capital structure ratio that is a measure of a

company’s financial leverage by dividing its total liabilities by stockholder’s equity. This

ratio shows what proportion of debt and equity a company uses to finance their assets.

97

2010 2011 2012 2013 2014 Average

ZEP 1.39 1.40 1.59 1.98 1.88 1.65

CHD 0.57 0.53 0.99 0.85 1.08 0.81

ECL 1.29 2.22 1.89 1.67 1.66 1.75

ZEP RE 2.13 2.00 1.97 2.56 2.71 2.28

INDUSTRY 0.93 1.37 1.44 1.26 1.37 1.28

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Debt to Equity

ZEP CHD ECL ZEP RE INDUSTRY

Below are the industry’s Debt to Equity ratios and their averages.

Clorox had negative stockholder’s equity in 2011 and 2012 due to the purchase of

treasury stock. Clorox’s negative equity effective the graph so in order to accurately

measure industry debt to equity we removed it from the graph. Below is the new graph.

Church and Dwight has the lowest ratio in the industry because they did not have

2010 2011 2012 2013 2014 Average

ZEP 1.39 1.40 1.59 1.98 1.88 1.65

CHD 0.57 0.53 0.99 0.85 1.08 0.81

CLX 53.88 -49.41 -33.26 28.53 26.65 5.28

ECL 1.29 2.22 1.89 1.67 1.66 1.75

ZEP RE 2.13 2.00 1.97 2.56 2.71 2.28

INDUSTRY 0.93 1.37 1.44 1.26 1.37 1.28

-60.00

-40.00

-20.00

0.00

20.00

40.00

60.00

Debt to Equity

ZEP CHD CLX ECL ZEP RE INDUSTRY

98

2010 2011 2012 2013 2014 Average

ZEP 12.19 5.06 7.16 3.58 2.19 6.04

CHD 16.05 57.85 39.75 22.58 23.81 32.01

CLX 7.63 5.58 7.33 7.99 9.36 7.58

ECL 11.33 8.29 3.54 4.75 6.34 6.85

ZEP RE 12.06 4.67 6.43 3.72 2.40 5.86

INDUSTRY 11.67 23.91 16.87 11.78 13.17 15.48

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00Times Interest Earned

ZEP CHD CLX ECL ZEP RE INDUSTRY

enough equity. Zep has one of the highest ratios in the industry with an average of

1.65 while the industry average is 1.28. By having the highest debt to equity ratio, Zep

has shown to be the most aggressive firm in the industry financing its growth with debt.

Zep’s debt to equity ratio increased after restating their financials due to the

capitalization of operating leases. Zep is taking on more risk the industry average.

Times Interest Earned

The Times Interest Earned ratio measures the amount of income that can be

used to cover future interest expenses. In other words, this ratio measures a firm’s

ability to pay interest and debt payments. A higher ratio is more favorable, because it

shows that a company has a greater ability to pay its interest payment in a timely

manner. Below is Zep’s Times Interest Earned along with its’ competitors and industry

average.

99

2010 2011 2012 2013 2014 Average

ZEP 4.18 4.50 4.16 3.88 3.85 4.11

CHD 8.00 8.90 6.61 7.36 7.14 7.60

CLX 4.51 4.07 3.69 4.76 4.66 4.34

ECL 5.67 2.57 3.86 3.61 4.48 4.04

ZEP RE 4.19 4.20 4.00 3.24 3.56 3.84

INDUSTRY 6.06 5.18 4.72 5.24 5.43 5.33

0.001.002.003.004.005.006.007.008.009.00

10.00

Altman Z Score

ZEP CHD CLX ECL ZEP RE INDUSTRY

Church and Dwight has the highest Times Interest Earned compared to its

competitors. This is because Church and Dwight has the highest earnings before

interest and taxes. Zep has the lowest ratio due to their EBIT decreasing and their

interest expense increasing the past five years. Even after restating their financials, Zep

still has the lowest ratio in the industry.

Altman Z Score

The Altman Z Score is a ratio that computes a credit score based on 5 financial

ratios. A score below 1.8 means the company is probably headed for bankruptcy, while

companies with scores above 3.0 are not likely to go bankrupt. The lower/higher the

score, the lower/higher the likelihood of bankruptcy (3). The formula is Z=1.2(Working

Capital/Total Assets) +1.4(Retained Earnings/Total Assets) +3.3(EBIT/Total Assets)

+.6(Market Value of Equity/Total Liabilities) + (Sales/Total Assets). Below are the

industry’s Altman Z scores and their averages.

100

The industry shows pretty similar Z scores with the exception of Church and

Dwight, whose score is almost double compared to the other firms. All the firms within

the industry appear to be safe from bankruptcy except Zep. Zep’s Altman Z score has

decreased over the past 5 years, indicating that Zep could be in danger of bankruptcy

in the next few years. Even after restating Zep’s financials, Zep still has the lowest

Altman Z score compared to its competitors, indicating that Zep is the closest company

to reaching bankruptcy in the industry.

Conclusion

Compared to its’ competitors, Zep shows some concern in their Capital Structure

ratios. Zep had the highest Debt to Equity ratio in the industry, the lowest Times

Interest Earned ratio in the industry, and the only company showing a downward trend

in their Altman Z score. It is important to note that Zep’s numbers worsened in all three

ratios after restating their financials.

Growth Rates

Introduction

In this Section we are going to look at internal growth rates and sustainable

growth rates. The internal growth rate is the level at which growth from general

101

2010 2011 2012 2013 2014 Average

ZEP 3.36 3.71 4.37 2.36 0.70 2.90

CHD 7.45 7.32 5.90 5.65 5.63 6.39

CLX 6.98 5.79 5.25 5.34 4.28 5.53

ECL 7.64 2.48 2.55 3.61 4.34 4.12

ZEP RE 2.66 2.88 2.46 0.51 -5.29 0.64

Industry 7.36 5.20 4.56 4.87 4.75 5.35

-6.00-4.00-2.000.002.004.006.008.00

10.00

Internal Growth Rate

ZEP CHD CLX ECL ZEP RE Industry

business operations can continue to fund and grow the company. The sustainable

growth rate is a measure of how much a firm can grow without issuing new capital.

Internal Growth Rate

Internal growth rate is the highest level of growth achievable for a business

without obtaining outside financing (4). In other words, it’s the growth a firm can

achieve by reinvesting its earnings. Internal growth rate (IGR) is found by multiplying

Return on Assets (ROA) by the retention ratio (1-Dividend payout ratio).

Zep’s internal growth rate the past five years showed a downward trend similar

to that of its competitors. Ecolab is the only firm in the industry that showed an upward

trend in its internal growth rate. Zep’s five year average is the lowest compared to its

102

2010 2011 2012 2013 2014 Average

ZEP 8.73 10.29 11.62 6.64 2.09 7.87

CHD 13.60 10.85 10.50 10.97 11.20 11.42

ECL 18.45 7.46 7.85 10.11 11.68 11.11

Industry 13.59 9.53 9.99 9.24 8.32 10.14

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

Sustainable Growth Rate

ZEP CHD ECL Industry

competitors which shows Zep’s Return on Assets has been constantly decreasing. After

restating their financials, Zep has the lowest internal growth rate in the industry and

shows that Zep cannot grow without outside financing.

Sustainable Growth Rate

A sustainable growth rate (SGR) is the maximum growth rate that a company

can sustain without having to increase financial leverage. In essence, finding a

company's sustainable growth rate answers the question: how much can this company

grow before it must borrow money (5). Sustainable growth rate (SGR) is found by

multiplying Return on Equity (ROE) by the retention ratio (1-dividend payout ratio).

103

Illustrated by the graph above, the SGR for Zep showed positive growth from

2010 to 2012. SGR decreased the next two years causing Zep’s five year average to be

the lowest in the industry. The decrease in SGR was caused by a decrease in Return on

Equity for the years 2013 and 2014. We chose not to include Clorox, because their

numbers are significantly higher compared to the other firms.

Conclusion

According to our analysis of internal growth rates, Ecolab is the only firm that

experienced an upward trend in its internal growth rate. Other firms in the industry had

a constant downward trend over the five years. Despite Clorox’s extremely high SGR,

the other three firms’ SGR were consistent with the industrial average. Although Zep’s

growth rates resemble the industrial trends, it is important to note that Zep’s growth

rates were the lowest in the industry. This represents a cause of concern because it

shows that Zep has both the worst, internal and substantial growth rates in the

industry.

Financial Forecasting

Financial forecasting is an important element to find the value of the firm. We

forecasted the income statement, balance sheet and statements of cash flow by using

trends, ratios and assumptions. We realized that the short term forecast is more

important because it is hard to find reliable numbers for longer terms. We forecasted

the ZEP’s financial statements for the next ten years

104

Income Statement

We started the forecast from the income statement because many numbers from

the balance sheet and statement of cash flow are directly related to it. We made sure

that we used logical assumptions based on the past five years trends as a basis of our

forecast. As a starting point, we determined the sales growth for the past five years.

Over the last five years, ZEP is growing at a decreasing rate. They also mentioned in

their 10K about the fire in one of their manufacturing site that might lead to their

inability to meet customers’ demand. We forecasted their sales growth in 2015 to be

1.3 percent. We forecast their growth to reach 2.3 percent in 2019 and will be stable

afterwards.

After we made the projection of sales growth, we created a common sized

income statement. A common size income statement shows items as a percentage of

revenues. The common size income statement helped us to see trends in the

forecasting process. The gross profit margin of ZEP is showing a very stable trend. We

predict their gross profit margin will fluctuate around 1 percent over the next ten years,

we started with 46.9 percent then decrease a little bit to 46.2 percent and increase to

47.1 percent then stable at 46.9 percent. In terms of the expenses, we saw an

increasing trend. In the as stated income statement, we projected that their other

expenses will increase from 1.8 percent in 2015 and max out at 2.2 percent from 2020

until 2024. In the restated income statement, the other expenses are larger. We

projected their other expenses from 4 percent in 2015 and increasing to 5 percent from

105

2021 until 2024. The significant difference is because in the restatement we have

goodwill impairment and interest expense from capitalized operating leases.

The difference in the expenses leads to different forecast from as stated and the

restated income statement. In the as stated income statement, the net income will

increase from 1.4 percent in 2015 to 2.5 percent from 2021 to 2024. In the

restatement, we forecasted that their net income would only increase by .3 percent in

2015 and reach up to 1.4 percent in 2020 and on. Using the forecasting numbers in the

income statement, we continue to forecast balance sheet and statements of cash flow.

Dividends Forecasting

Forecasting dividend is important to find the value of the firm. ZEP is increasing

their dividend payment in the last five years regardless of their income. We forecasted

that they will increase their dividend over the next ten years. In the forecast, their

dividend goes up each year from 22 cents per share in 2016 up to 28 cent per share in

2019 and then stable afterwards.

106

As stated income statements and as stated common size income statement

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Statements of Income

Sales Growth 14% 1% 6% 1% 1.3% 1.6% 1.9% 2.0% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3%

Net Sales 568,512.00$ 645,972.00$ 653,533.00$ 689,576.00$ 696,489.00$ 705,543.36 716,832.05 730,451.86 745,060.90 762,197.30 779,727.84 797,661.58 816,007.79 834,775.97 853,975.82

Cost of products Sold 285,335.00$ 343,095.00$ 352,737.00$ 365,034.00$ 369,697.00$ 374,643.52 385,655.64 391,522.20 394,137.21 404,726.76 414,035.48 423,558.30 433,300.14 443,266.04 453,461.16

Gross Profit 283,177.00$ 302,877.00$ 300,796.00$ 324,542.00$ 326,792.00$ 330,899.83 331,176.41 338,929.66 350,923.68 357,470.53 365,692.35 374,103.28 382,707.65 391,509.93 400,514.66

Selling, Distribution, and Adm Exp 247,759.00$ 268,438.00$ 260,806.00$ 283,075.00$ 293,361.00$

Restructuring Charges 8,213.00$ 1,469.00$ 5,159.00$ (456.00)$

Acquisition and Integration Costs 3,353.00$ 429.00$ 1,210.00$ 3,519.00$ 1,091.00$

Loss (Gain) on Asset Disposal (676.00)$ 500.00$

Operating Profit 23,852.00$ 33,217.00$ 38,280.00$ 32,789.00$ 32,796.00$ 31,043.91 32,257.44 33,600.79 35,762.92 38,109.86 38,986.39 39,883.08 40,800.39 41,738.80 42,698.79

Other Expense (Income)

Interest Expense 1,957.00$ 6,562.00$ 5,493.00$ 8,958.00$ 11,819.00$

Provision for loan loss 5,269.00$

Accelerated debt issuance 428.00$

Bargain purchase gains (2,095.00)$

Miscellaneous expense (244.00)$ (40.00)$ 1,046.00$ 744.00$ 1,610.00$

Total other Expense 2,141.00$ 6,522.00$ 4,444.00$ 9,702.00$ 18,698.00$

Income before Income taxes 21,711.00$ 26,695.00$ 33,836.00$ 23,087.00$ 14,098.00$

Provision for Income taxes 8,207.00$ 9,294.00$ 11,927.00$ 7,895.00$ 5,698.00$

Net Income 13,504.00$ 17,401.00$ 21,909.00$ 15,192.00$ 8,400.00$ 9,877.61 11,469.31 13,148.13 14,901.22 18,476.14 18,901.09 19,941.54 20,400.19 20,869.40 21,349.40

Statement of Retained Earnings

Beg. Retained Earnings 25,052 38,970 57,367 69,023 72,918 78,186 85,045 93,122 102,491 114,974 127,421 140,909 154,855 169,271 184,166

+Net Income 17,401 21,909 15,192 8,400 9,878 11,469 13,148 14,901 18,476 18,901 19,942 20,400 20,869 21,349 21,840

-Common Dividends (4,510) (3,540) (3,510) (3,480) (4,610) (4,610) (5,071) (5,532) (5,993) (6,454) (6,454) (6,454) (6,454) (6,454) (6,454)

Plug 1,027 28 (26) (1,025) 0 0 0 0 0 0 0 0 0 0

=End. Retained Earnings 38,970 57,367 69,023 72,918 78,186 85,045 93,122 102,491 114,974 127,421 140,909 154,855 169,271 184,166 199,552

107

Statements of Income 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Net Sales 100.00% 100.00% 100.00% 100.00% 100.00%

Cost of products Sold 50.19% 53.11% 53.97% 52.94% 53.08% 53.10% 53.80% 53.60% 52.90% 53.10% 53.10% 53.10% 53.10% 53.10% 53.10%

Gross Profit 49.81% 46.89% 46.03% 47.06% 46.92%

Selling, Distribution, and Adm Exp 43.58% 41.56% 39.91% 41.05% 42.12%

Restructuring Charges 1.44% 0.23% 0.00% 0.75% -0.07%

Acquisition and Integration Costs 0.59% 0.07% 0.19% 0.51% 0.16%

Loss (Gain) on Asset Disposal 0.00% -0.10% 0.08% 0.00% 0.00%

Operating Profit 4.20% 5.14% 5.86% 4.75% 4.71% 4.40% 4.50% 4.60% 4.80% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00%

Other Expense (Income) 0.00% 0.00% 0.00% 0.00% 0.00%

Interest Expense 0.34% 1.02% 0.84% 1.30% 1.70%

Provision for loan loss 0.00% 0.00% 0.00% 0.00% 0.76%

Accelerated debt issuance 0.08% 0.00% 0.00% 0.00% 0.00%

Bargain purchase gains 0.00% 0.00% -0.32% 0.00% 0.00%

Miscellaneous expense -0.04% -0.01% 0.16% 0.11% 0.23%

Total other Expense 0.38% 1.01% 0.68% 1.41% 2.68% 1.80% 2.00% 2.05% 2.10% 2.10% 2.20% 2.20% 2.20% 2.20% 2.20%

Income before Income taxes 3.82% 4.13% 5.18% 3.35% 2.02%

Provision for Income taxes 1.44% 1.44% 1.83% 1.14% 0.82%

Net Income 2.38% 2.69% 3.35% 2.20% 1.21% 1.40% 1.60% 1.8% 2.0% 2.4% 2.4% 2.5% 2.5% 2.5% 2.5%

108

Restated income statements and common size restated income statement

Statements of Income 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Sales Growth 14% 1% 6% 1% 1.3% 1.6% 1.9% 2.0% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3%

Net Sales 568,512$ 645,972$ 653,533$ 689,576$ 696,489$ 705,543 716,832 730,452 745,061 762,197 779,728 797,662 816,008 834,776 853,976

Cost of products Sold 285,335$ 343,095$ 352,737$ 365,034$ 369,697$

Gross Profit 283,177$ 302,877$ 300,796$ 324,542$ 326,792$

Selling, Distribution, and Adm Exp 247,759$ 264,485$ 255,854$ 278,440$ 288,476$

Restructuring Charges 8,213$ 1,469$ 5,159$ (456)$

Acquisition and Integration Costs 3,353$ 429$ 1,210$ 3,519$ 1,091$

Loss (Gain) on Asset Disposal (676)$ 500$

Operating Profit 23,852$ 37,170$ 43,232$ 37,424$ 37,681$

Other Expense (Income)

Interest Expense 1,957$ 7,955$ 6,890$ 9,866$ 12,816$

Provision for loan loss 5,269$

Accelerated debt issuance 428$

Bargain purchase gains (2,095)$

Goodwill Impairment (adjust) 6,388$ 10,735$ 16,884$ 16,921$ 24,220$ 17,832 13,486 7,337 7,300

Miscellaneous expense (244)$ (40)$ 1,046$ 744$ 1,610$

Total other Expense 8,529$ 18,650$ 22,725$ 27,530$ 43,915$

Income before Income taxes 15,323$ 18,521$ 20,507$ 9,894$ (6,234)$

Provision for Income taxes 8,207$ 9,294$ 11,927$ 7,895$ 5,698$

Net Income 7,116$ 9,227$ 8,580$ 1,999$ (11,932)$ 2,116.63 3,010.69 3,652.26 7,450.61 9,146.37 10,916.19 11,167.26 11,424.11 11,686.86 11,955.66

Statement of Retained Earnings

Beg. Retained Earnings 25,052 28,685 34,400 39,444 36,938 20,396 17,903 15,842 13,963 15,420 18,113 22,575 27,288 32,258 37,491

+Net Income 7,116 9,227 8,580 1,999 (11,932) 2,117 3,011 3,652 7,451 9,146 10,916 11,167 11,424 11,687 11,956

-Common Dividends (4,510) (3,540) (3,510) (3,480) (4,610) (4,610) (5,071) (5,532) (5,993) (6,454) (6,454) (6,454) (6,454) (6,454) (6,454)

Plug 1,027 28 (26) (1,025) 0 0 0 0 0 0 0 0 0 0

=End. Retained Earnings 28,685$ 34,400$ 39,444$ 36,938$ 20,396$ 17,903 15,842 13,963 15,420 18,113 22,575 27,288 32,258 37,491 42,993

109

Statements of Income 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Net Sales 100.00% 100.00% 100.00% 100.00% 100.00% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Cost of products Sold 50.19% 53.11% 53.97% 52.94% 53.08% 53.10% 53.80% 53.60% 52.90% 53.10% 53.10% 53.10% 53.10% 53.10% 53.10%

Gross Profit 49.81% 46.89% 46.03% 47.06% 46.92% 46.900% 46.200% 46.400% 47.100% 46.900% 46.900% 46.900% 46.900% 46.900% 46.900%

Selling, Distribution, and Adm Exp 43.58% 40.94% 39.15% 40.38% 41.42%

Restructuring Charges 1.44% 0.23% 0.00% 0.75% -0.07%

Acquisition and Integration Costs 0.59% 0.07% 0.19% 0.51% 0.16%

Loss (Gain) on Asset Disposal 0.00% -0.10% 0.08% 0.00% 0.00%

Operating Profit 4.20% 5.75% 6.62% 5.43% 5.41% 5.40% 5.60% 5.60% 5.60% 5.60% 5.60% 5.60% 5.60% 5.60% 5.60%

Other Expense (Income) 0.00% 0.00% 0.00% 0.00% 0.00%

Interest Expense 0.34% 1.23% 1.05% 1.43% 1.84%

Provision for loan loss 0.00% 0.00% 0.00% 0.00% 0.76%

Accelerated debt issuance 0.08% 0.00% 0.00% 0.00% 0.00%

Bargain purchase gains 0.00% 0.00% -0.32% 0.00% 0.00%

Goodwill Impairment (adjust) 1.12% 1.66% 2.58% 2.45% 3.48%

Miscellaneous expense -0.04% -0.01% 0.16% 0.11% 0.23%

Total other Expense 1.50% 2.89% 3.48% 3.99% 6.31% 4.00% 4.20% 4.40% 4.50% 4.70% 4.80% 5.00% 5.00% 5.00% 5.00%

Income before Income taxes 2.70% 2.87% 3.14% 1.43% -0.90%

Provision for Income taxes 1.44% 1.44% 1.83% 1.14% 0.82%

Net Income 1.25% 1.43% 1.31% 0.29% -1.71% 0.30% 0.42% 0.5% 1.0% 1.2% 1.4% 1.4% 1.4% 1.4% 1.4%

110

Balance Sheet

After we forecast the income statement, we need to forecast the balance sheet.

We use asset turnover ratios to connect income statement and balance sheet. ZEP is

showing decreasing trend in their asset turnover ratio in the last two years which can

be explained with the fire in one of their facilities. We would expect ZEP to increase

their asset turnover ratio in the future because the fire would only affect them for a

short period of time. We forecasted their asset turnover ratio from 1.25 in 2015 and

maxed out at 1.6 in 2021. After having the number for total asset, we use the common

size balance sheet to forecast the other items in the assets. Then, we use the liquidity

ratios to forecast current assets and current liabilities. From the common size balance

sheet, we saw a trend of decreasing total current assets from 2010 to 2013 but then it

goes up again in 2014. So we assume that they will increase their current assets in the

future. We forecasted that their current assets will go up from 42 percent and maxed

out at 42.5 percent from 2019 and on.

In terms of forecasting the retained earnings, we added the previous year

retained earnings with current net income and subtract the dividend payment. The

change in the shareholder equity is the same with the change in the retained earnings.

After getting the shareholder equity, we calculated their total liabilities by subtract the

shareholder equity from total liability and shareholder equity. Then we use the common

size balance sheet to forecast total non-current liability and total current liability.

111

As stated Balance Sheet and Common Size Balance Sheet

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Assets

Cash and cash equivalents 25,257.00$ 7,219.00$ 3,513.00$ 2,402.00$ 14,303.00$

Account receivable 90,827.00$ 95,681.00$ 93,522.00$ 104,476.00$ 108,010.00$

Less doubtful acct

Inventories 53,192.00$ 61,147.00$ 71,451.00$ 68,633.00$ 75,950.00$ 73,172.56 75,323.37 76,469.18 76,979.92 79,048.20 80,866.30 82,726.23 84,628.93 86,575.40 88,566.63

Insurance receivable 13,106.00$

Deferred income taxes 9,049.00$ 9,189.00$ 7,681.00$ 8,002.00$ 10,452.00$

Prepaids and other current asset 9,779.00$ 9,896.00$ 22,333.00$ 13,051.00$ 6,254.00$

Total Current asset 188,104.00$ 183,132.00$ 198,500.00$ 196,564.00$ 228,075.00$ 240,431.86$ 247,184.91$ 243,577.60$ 234,103.46$ 233,918.35$ 231,321.86$ 221,852.12$ 226,954.72$ 232,174.68$ 237,514.69$

PP&E 66,874.00$ 67,868.00$ 80,921.00$ 82,328.00$ 75,361.00$

Goodwill 53,764.00$ 84,418.00$ 84,604.00$ 121,102.00$ 121,005.00$

Identifiable intangible 30,271.00$ 65,136.00$ 65,707.00$ 129,929.00$ 121,643.00$

Other long term asset 3,835.00$ 3,215.00$ 5,555.00$ 17,835.00$ 10,127.00$

Total Non current asset

Total Asset 342,848.00$ 403,769.00$ 435,287.00$ 547,758.00$ 556,211.00$ 572,456.81$ 584,361.49$ 573,123.77$ 544,426.64$ 537,743.33$ 531,774.38$ 510,004.87$ 521,734.98$ 533,734.89$ 546,010.79$

Liabilities

Current maturities long term 15,000.00$ 15,000.00$ 15,000.00$ 25,000.00$ 20,006.00$

Account payable 51,390.00$ 56,821.00$ 53,461.00$ 56,366.00$ 65,874.00$

Accrued compensation 21,322.00$ 18,161.00$ 17,334.00$ 25,226.00$ 19,720.00$

Other accrued liab 29,124.00$ 27,482.00$ 27,947.00$ 41,167.00$ 39,329.00$

Total current liab 116,836.00$ 117,464.00$ 113,742.00$ 147,759.00$ 144,929.00$ 153,141.31$ 157,442.62$ 155,144.97$ 149,110.48$ 148,992.58$ 147,338.76$ 141,307.08$ 144,557.14$ 147,881.96$ 151,283.24$

Long term debt 77,150.00$ 104,650.00$ 124,250.00$ 184,908.00$ 186,880.00$

Deferred income taxes 2,140.00$ 6,224.00$ 8,574.00$ 12,782.00$ 13,931.00$

Other long term liab 24,549.00$ 26,308.00$ 20,804.00$ 18,340.00$ 17,092.00$

Total Non current liab 103,839.00$ 137,182.00$ 153,628.00$ 216,030.00$ 217,903.00$ 220,668.89$ 221,412.95$ 204,395.74$ 172,363.89$ 153,315.35$ 136,553.13$ 107,327.75$ 101,861.61$ 96,121.30$ 90,100.52$

Total liab 220,675.00$ 254,646.00$ 267,370.00$ 363,789.00$ 362,832.00$ 373,810.20$ 378,855.57$ 359,540.71$ 321,474.37$ 302,307.93$ 283,891.89$ 248,634.84$ 246,418.75$ 244,003.26$ 241,383.76$

Stockholder eqity

Common stock 213.00$ 216.00$ 218.00$ 221.00$ 224.00$

Paid-in capital 85,316.00$ 92,925.00$ 97,481.00$ 102,573.00$ 108,432.00$

Retained earnings 25,052.00$ 38,970.00$ 57,367.00$ 69,023.00$ 72,918.00$ 78,185.61$ 85,044.92$ 93,122.05$ 102,491.27$ 114,974.41$ 127,421.50$ 140,909.03$ 154,855.23$ 169,270.63$ 184,166.02$

Accumulated OCI 11,592.00$ 17,012.00$ 12,851.00$ 12,152.00$ 11,805.00$

Total SE 122,173.00$ 149,123.00$ 167,917.00$ 183,969.00$ 193,379.00$ 198,646.61$ 205,505.92$ 213,583.05$ 222,952.27$ 235,435.41$ 247,882.50$ 261,370.03$ 275,316.23$ 289,731.63$ 304,627.02$

Total liab and SE 342,848.00$ 403,769.00$ 435,287.00$ 547,758.00$ 556,211.00$ 572,456.81$ 584,361.49$ 573,123.77$ 544,426.64$ 537,743.33$ 531,774.38$ 510,004.87$ 521,734.98$ 533,734.89$ 546,010.79$

112

Assets 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Cash and cash equivalents 7.37% 1.79% 0.81% 0.44% 2.57%

Account receivable 26.49% 23.70% 21.49% 19.07% 19.42%

Less doubtful acct 0.00% 0.00% 0.00% 0.00% 0.00%

Inventories 15.51% 15.14% 16.41% 12.53% 13.65%

Insurance receivable 0.00% 0.00% 0.00% 0.00% 2.36%

Deferred income taxes 2.64% 2.28% 1.76% 1.46% 1.88%

Prepaids and other current asset 2.85% 2.45% 5.13% 2.38% 1.12%

Total Current asset 54.87% 45.36% 45.60% 35.89% 41.01% 42.0% 42.3% 42.5% 43.0% 43.5% 43.5% 43.5% 43.5% 43.5% 43.5%

PP&E 19.51% 16.81% 18.59% 15.03% 13.55%

Goodwill 15.68% 20.91% 19.44% 22.11% 21.76%

Identifiable intangible 8.83% 16.13% 15.10% 23.72% 21.87%

Other long term asset 1.12% 0.80% 1.28% 3.26% 1.82%

Total Non Current Asset 45.13% 54.64% 54.40% 64.11% 58.99% 58.00% 57.70% 57.50% 57.00% 56.50% 56.50% 56.50% 56.50% 56.50% 56.50%

Total Asset 100.00% 100.00% 100.00% 100.00% 100.00% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Liabilities

Current maturities long term 6.80% 5.89% 5.61% 6.87% 5.51%

Account payable 23.29% 22.31% 20.00% 15.49% 18.16%

Accrued compensation 9.66% 7.13% 6.48% 6.93% 5.44%

Other accrued liab 13.20% 10.79% 10.45% 11.32% 10.84%

Total current liab 52.94% 46.13% 42.54% 40.62% 39.94% 39% 38% 38% 38% 38% 38% 38% 38% 38% 38%

Long term debt 34.96% 41.10% 46.47% 50.83% 51.51%

Deferred income taxes 0.97% 2.44% 3.21% 3.51% 3.84%

Other long term liab 11.12% 10.33% 7.78% 5.04% 4.71%

Total Non current liab 47.06% 53.87% 57.46% 59.38% 60.06% 61.00% 62.00% 62.00% 62.00% 62.00% 62.00% 62.00% 62.00% 62.00% 62.00%

Total liab 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Stockholder equity

Common stock 0.17% 0.14% 0.13% 0.12% 0.12%

Paid-in capital 69.83% 62.31% 58.05% 55.76% 56.07%

Retained earnings 20.51% 26.13% 34.16% 37.52% 37.71%

Accumulated OCI 9.49% 11.41% 7.65% 6.61% 6.10%

Total SE 100.00% 100.00% 100.00% 100.00% 100.00%

113

Restated Balance Sheet and Common Size Balance Sheet

At December 31: 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Assets

Cash and cash equivalents 25,257$ 7,219$ 3,513$ 2,402$ 14,303$

Account receivable 90,827$ 95,681$ 93,522$ 104,476$ 108,010$

Less doubtful acct

Inventories 53,192$ 61,147$ 71,451$ 68,633$ 75,950$

Insurance receivable 13,106$

Deferred income taxes 9,049$ 9,189$ 7,681$ 8,002$ 10,452$

Prepaids and other current asset 9,779$ 9,896$ 22,333$ 13,051$ 6,254$

Total Current asset 188,104$ 183,132$ 198,500$ 196,564$ 228,075$ 240,431.86 246,750.07 252,875.07 261,734.62 270,867.94 277,097.90 283,471.16 289,990.99 296,660.79 303,483.98

PP&E 66,874$ 67,868$ 80,921$ 82,328$ 75,361$

Cap OL Rights 26,282$ 17,099$ 15,069$ 11,786$ 8,933$

Goodwill 47,376$ 67,295$ 50,598$ 70,175$ 45,857$ 28,025.00 14,539.40 7,202.60 (97.00)

Identifiable intangible 30,271$ 65,136$ 65,707$ 129,929$ 121,643$

Other long term asset 3,835$ 3,215$ 5,555$ 17,835$ 10,127$

Total Asset 362,742$ 403,745$ 416,350$ 508,617$ 489,997$ 572,456.81 583,333.49 595,000.16 608,685.16 622,684.92 637,006.68 651,657.83 666,645.96 681,978.82 697,664.33

Liabilities

Current maturities long term 15,000$ 15,000$ 15,000$ 25,000$ 20,006$

Account payable 51,390$ 56,821$ 53,461$ 56,366$ 65,874$

Accrued compensation 21,322$ 18,161$ 17,334$ 25,226$ 19,720$

Other accrued liab 29,124$ 27,482$ 27,947$ 41,167$ 39,329$

Total current liab 116,836$ 117,464$ 113,742$ 147,759$ 144,929$

Long term debt 77,150$ 104,650$ 124,250$ 184,908$ 186,880$

Cap OL Liability 26,282$ 14,538$ 8,954$ 1,943$ (4,798)$

Deferred income taxes 2,140$ 6,224$ 8,574$ 12,782$ 13,931$

Other long term liab 24,549$ 26,308$ 20,804$ 18,340$ 17,092$

Total liab 246,957$ 269,184$ 276,324$ 365,732$ 358,034$

Stockholder eqity

Common stock 213$ 216$ 218$ 221$ 224$

Paid-in capital 85,316$ 92,925$ 97,481$ 102,573$ 108,432$

Retained earnings 18,664$ 24,408$ 29,476$ 27,939$ 11,502$ 20,396$ 17,903$ 15,842$ 13,963$ 15,420$ 18,113$ 22,575$ 27,288$ 32,258$ 37,491$

Accumulated OCI 11,592$ 17,012$ 12,851$ 12,152$ 11,805$

Total SE 115,785$ 134,561$ 140,026$ 142,885$ 131,963$ 115,421$ 112,928$ 110,867$ 108,988$ 110,445$ 113,138$ 117,600$ 122,313$ 127,283$ 132,516$

Total liab and SE 362,742$ 403,745$ 416,350$ 508,617$ 489,997$ 572,456.81 583,333.49 595,000.16 608,685.16 622,684.92 637,006.68 651,657.83 666,645.96 681,978.82 697,664.33

114

At December 31: 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Assets

Cash and cash equivalents 6.96% 1.79% 0.84% 0.47% 2.92%

Account receivable 25.04% 23.70% 22.46% 20.54% 22.04%

Less doubtful acct 0.00% 0.00% 0.00% 0.00% 0.00%

Inventories 14.66% 15.14% 17.16% 13.49% 15.50%

Insurance receivable 0.00% 0.00% 0.00% 0.00% 2.67%

Deferred income taxes 2.49% 2.28% 1.84% 1.57% 2.13%

Prepaids and other current asset 2.70% 2.45% 5.36% 2.57% 1.28%

Total Current asset 51.86% 45.36% 47.68% 38.65% 46.55% 42.0% 42.3% 42.5% 43.0% 43.5% 43.5% 43.5% 43.5% 43.5% 43.5%

PP&E 18.44% 16.81% 19.44% 16.19% 15.38%

Cap OL Rights 7.25% 4.24% 3.62% 2.32% 1.82%

Goodwill 13.06% 16.67% 12.15% 13.80% 9.36%

Identifiable intangible 8.35% 16.13% 15.78% 25.55% 24.83%

Other long term asset 1.06% 0.80% 1.33% 3.51% 2.07%

Total Non Current Asset 48.14% 54.64% 52.32% 61.35% 53.45% 58.00% 57.70% 57.50% 57.00% 56.50% 56.50% 56.50% 56.50% 56.50% 56.50%

Total Asset 100.00% 100.00% 100.00% 100.00% 100.00%

Liabilities

Current maturities long term 6.07% 5.57% 5.43% 6.84% 5.59%

Account payable 20.81% 21.11% 19.35% 15.41% 18.40%

Accrued compensation 8.63% 6.75% 6.27% 6.90% 5.51%

Other accrued liab 11.79% 10.21% 10.11% 11.26% 10.98%

Total current liab 47.31% 43.64% 41.16% 40.40% 40.48% 39% 38% 38% 38% 38% 38% 38% 38% 38% 38%

Long term debt 31.24% 38.88% 44.97% 50.56% 52.20%

Cap OL Liability 10.64% 5.40% 3.24% 0.53% -1.34%

Deferred income taxes 0.87% 2.31% 3.10% 3.49% 3.89%

Other long term liab 9.94% 9.77% 7.53% 5.01% 4.77%

Total non current liab 52.69% 56.36% 58.84% 59.60% 59.52%

Total liab 100.00% 100.00% 100.00% 100.00% 100.00% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Stockholder eqity

Common stock 0.18% 0.16% 0.16% 0.15% 0.17%

Paid-in capital 73.68% 69.06% 69.62% 71.79% 82.17%

Retained earnings 16.12% 18.14% 21.05% 19.55% 8.72%

Accumulated OCI 10.01% 12.64% 9.18% 8.50% 8.95%

Total SE 100.00% 100.00% 100.00% 100.00% 100.00%

Total liab and SE

Statement of Cash Flows

The last part of the forecasting is to forecast the statement of cash flow. There

are three parts of cash flow which are cash flow from operations (CFFO), cash flow

from investing (CFFI) and cash flow from financing (CFFF). CFFO and CFFI are two

parts that we are focus to forecast.

To forecast CFFO, we compared three different ratios: CCFO/sales,

CFFO/operating income, and CFFO/net income. We used CFFO/sales because it is the

least volatile among three. The ratio gives us CFFO of $35,277,270 in 2015 and goes up

to 42,689,790 in 2024. For CFFI, we are trying to find the best explanation of cash flow

in investing. First we calculated PP&E/sales which gives us a relatively stable number.

From the ratio, we forecasted their PP&E, and then from the growth in PP&E we

assumed the same growth for CFFI.

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Net Income (Loss) 8,400.00$ 15,190.00$ 21,910.00$ 17,400.00$ 13,500.00$

Depreciation/Amortization & Depletion 22,120.00$ 19,930.00$ 14,330.00$ 14,200.00$ 10,270.00$

Net Change from Assets/Liabilities (27,440.00)$ 7,320.00$ (19,570.00)$ 1,710.00$ 4,660.00$

Net Cash from Discontinued Operations -$ -$ -$ -$ -$

Other Operating Activities 19,190.00$ 7,580.00$ 5,940.00$ 3,700.00$ 5,600.00$

Net Cash From Operating Activities 22,270.00$ 50,020.00$ 22,610.00$ 37,000.00$ 34,020.00$ 35,277.17 35,841.60 36,522.59 37,253.04 38,109.86 38,986.39 39,883.08 40,800.39 41,738.80 42,698.79

CFFO/NI 1.65 2.87 1.03 2.44 4.05

CFFO/Op Income 0.93 1.51 0.59 1.13 1.04

CFFO/Sales 0.04 0.08 0.03 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05

Property & Equipment (8,270.00)$ (12,050.00)$ (18,360.00)$ (7,980.00)$ (9,780.00)$ (9,172.06) (10,250.70) (10,591.55) (10,952.40) (11,432.96) (11,695.92) (11,964.92) (12,240.12) (12,521.64) (12,809.64)

Acquisition/Disposition of Subsidiaries -$ (116,690.00)$ (11,920.00)$ (76,070.00)$ (63,740.00)$

Investments 4,350.00$ -$ -$ -$ -$

Other Investing Activities 1,530.00$ -$ (12,500.00)$ -$ -$

Net Cash from Investing Activities (2,390.00)$ (128,740.00)$ (42,780.00)$ (84,040.00)$ (73,510.00)$ (68,940.53) (77,047.94) (79,609.92) (82,322.14) (85,934.24) (87,910.73) (89,932.67) (92,001.12) (94,117.15) (96,281.84)

Change in nc 66,513.00$ 13,810.00$ 102,127.00$ (15,350.00)$

Change in capex-ish stuff 65,893.00$ 16,150.00$ 114,407.00$ (23,058.00)$

PP&E/sales 1.45% 1.87% 2.81% 1.16% 1.40% 1.30% 1.43% 1.45% 1.47% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50%

Change in cffi/change in nc -193.56% -309.78% -82.29% 478.89%

Cost of Capital Estimation

In order to accurately value Zep, Inc., we must first estimate the cost of

financing the firm. To get a good estimate for the cost of capital, we must first

understand that it is derived by either debt or equity. Debt is the borrowing of money

and paying back the principal plus interest at a later date. Equity is a form of ownership

in a company and does not require any principal or interest to be paid to the investors.

The investor earns a return through the growth of shares and through any dividends

that they receive from owning shares. We will calculate an expected rate of return on a

source of capital that can be compared to competitors called the weighted average cost

of capital, or WACC. Once WACC is calculated, we will take that rate and discount Zep,

Inc.’s Financials. Next, we will go into depth about the cost of debt and the cost of

equity for Zep, Inc.

Cost of Debt

The cost of debt is a weighted average of interest rates for debt owned by a

company. Zep, Inc. disclosed in their 10-K that this interest rate was 3.5% for their long

term liabilities. The tables below show cost of debt calculations for Zep, Inc. as stated

and restated. To obtain the interest rate for capitalized operating leases, we took total

rent expenses and divided by the total sales, found on the 10-ks from each year, and

we got a percentage for each year. We then took the average of our results.

118

Zep, Inc.’s Cost of Debt - As stated

Interest Bearing

Liabilities

Amount

(Thousands)

Interest

Rate

Weight Source Weight*Rate Kd

Long Term Debt $207,156 3.50% 100% 10-k

Zep

3.50%

3.50% Weighted Cost of

Debt

Zep, Inc.'s Cost of Debt - Restated

Interest Bearing

Liabilities

Amount

(Thousands)

Interest

Rate

Weight Source Weight*Rate Kd

Long Term Debt $207,156 3.50% 89.26% 10-k

Zep

3.124%

Capitalized

Operating

Leases

$24,913 1.47% 10.74% 10-K

Zep

0.158%

$232,069 3.28% Weighted Cost of

Debt

For the restated amounts, we assigned a weight to both long term debt and

capitalized operating leases in relation to the total amount of long term obligations. The

weights are then multiplied by the interest rates respectively and are added together.

The interest rate for the capitalized operating leases is an average of the last five years.

We looked in each of the 10-k’s and found a rate for each year, then took the average

of all of them. As a result, the weighted average cost of debt that we calculated is

119

3.28%, which is only slightly less than the as stated weighted average cost of debt,

which is 3.50%.

Cost of Equity

A firm’s cost of equity can be calculated by using the Capital Asset Pricing Model,

otherwise known as the CAPM. This formula is shown below.

Ke = Rf + B (MRP) + SP

This formula uses the risk free rate (Rf), Beta (systematic risk), the market risk

premium (MRP), and the firm’s size premium (SP). The result of this equation is also

referred to the size adjusted cost of equity. We found the risk free rate by finding the

yields for 3-month, 1-year, 2-year, 7-year, and 10-year treasury bonds on the St. Louis

Federal Reserve website. We had to convert the given yields into monthly rates because

they were given as yearly rates on the website. We did this by simply dividing each rate

by 1200. After converting the rates, we found that the appropriate rate to be used as

the risk free rate would be 2%. Both the size premium and the market risk premium

rates that were used can be found in the Business Valuation textbook. We found the

market risk premium to be understated due to government influence on interest rates.

Therefore, we used 8% as our market risk premium for our valuation. The size

premium is determined by the market value of the firm, also known as market cap. The

table below presents the various size premiums for the different sizes of companies. It

shows that Zep, Inc. is a Part of the second decile and has a size premium of 2.9%.

120

A simple definition of Beta is that it is a measure of risk, specifically market risk

that affects a company. We used regression analysis to calculate the beta for Zep, Inc.

This helped us to observe the relationship between the overall market return and the

holding period return for Zep, Inc. We used the returns from the S&P 500 as the market

returns. We were able to calculate twenty-five betas that range from .53 to 1.13 by

using the data from 24, 36, 48, 60, and 72 month periods. We calculated the two factor

cost of equity by adding the size premium to the previously calculated cost of equity.

The regression charts also include lower and upper bound costs of equity which serve

as a 95% confidence interval. These upper and lower bounds are calculated by using

the upper and lower limits of beta that are given after running the regressions.

Size Decile Market Value of Largest Company

% of Market Represented by Decile

Average Annual Stock Return (%) Beta

Size Premium

1(smallest) 235.6 1 21 1.41 6.4

2 477.5 1.3 17.2 1.35 2.9

3 771.8 1.7 16.5 1.3 2.7

4 1212.3 2.2 15.4 1.24 1.9

5 1776 2.6 15 1.19 1.8

6 2509.2 3.5 14.8 1.16 1.8

7 3711 4.3 13.9 1.12 1.2

8 6793.9 7.4 13.6 1.1 1

9 15079.5 13.6 12.9 1.03 0.8

10(largest) 314622.6 62.3 10.9 0.91 -0.4

121

3 Month Regression

Month Beta Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 factor Ke Ke LB Ke UB

72 1.1273 0.5352 1.719 16.870% 8.000% 2.000% 11.018% 2.900% 13.918% 6.282% 15.752%

60 0.639 0.0675 1.2506 7.760% 8.000% 2.000% 7.112% 2.900% 10.012% 2.540% 12.005%

48 0.7045 -0.08798 1.497 6.370% 8.000% 2.000% 7.636% 2.900% 10.536% 1.296% 13.976%

36 0.5341 -0.6182 1.6865 2.460% 8.000% 2.000% 6.273% 2.900% 9.173% -2.946% 15.492% 24 0.8503 -0.7595 2.4602 4.930% 8.000% 2.000% 8.802% 2.900% 11.702% -4.076% 21.682%

1 yr

Regression

Month Beta Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 factor

Ke Ke LB Ke UB

72 1.1264 0.5342 1.7186 16.840% 8.000% 2.000% 11.011% 2.900% 13.911% 6.274% 15.749%

60 0.6591 0.0676 1.2566 7.770% 8.000% 2.000% 7.273% 2.900% 10.173% 2.541% 12.053%

48 0.7042 -0.0882 1.4966 6.360% 8.000% 2.000% 7.634% 2.900% 10.534% 1.294% 13.973%

36 0.5336 -0.6185 1.6859 2.464% 8.000% 2.000% 6.269% 2.900% 9.169% -2.948% 15.487%

24 0.8494 -0.7601 2.4591 4.920% 8.000% 2.000% 8.795% 2.900% 11.695% -4.081% 21.673%

2 yr

Regression

Month Beta Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 factor

Ke Ke LB Ke UB

72 1.1259 0.5336 1.7182 16.829% 8.000% 2.000% 11.007% 2.900% 13.907% 6.269% 15.746%

60 0.6598 0.0683 1.2513 7.780% 8.000% 2.000% 7.278% 2.900% 10.178% 2.546% 12.010%

48 0.7042 -0.0882 1.4967 6.360% 8.000% 2.000% 7.634% 2.900% 10.534% 1.294% 13.974%

36 0.5343 -0.6176 1.6862 2.470% 8.000% 2.000% 6.274% 2.900% 9.174% -2.941% 15.490%

24 0.8508 -0.7576 2.4594 4.940% 8.000% 2.000% 8.806% 2.900% 11.706% -4.061% 21.675%

7 yr

Regression

Month Beta Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 factor

Ke Ke LB Ke UB

72 1.1251 0.5325 1.17177 16.790% 8.000% 2.000% 11.001% 2.900% 13.901% 6.260% 11.374%

60 0.6618 0.0702 1.2535 7.820% 8.000% 2.000% 7.294% 2.900% 10.194% 2.562% 12.028%

48 0.705 -0.0871 1.4973 6.380% 8.000% 2.000% 7.640% 2.900% 10.540% 1.303% 13.978%

36 0.5367 -0.61552 1.6889 2.490% 8.000% 2.000% 6.294% 2.900% 9.194% -2.924% 15.511%

24 0.8566 -0.7508 2.4641 5.010% 8.000% 2.000% 8.853% 2.900% 11.753% -4.006% 21.713%

10 yr

Regression

Month Beta Beta LB Beta UB R^2 MRP Rf Ke Size pr 2 factor

Ke Ke LB Ke UB

72 1.1256 0.5332 1.7181 16.810% 8.000% 2.000% 11.005% 2.900% 13.905% 6.266% 15.745%

60 0.6619 0.0703 1.2535 7.830% 8.000% 2.000% 7.295% 2.900% 10.195% 2.562% 12.028%

48 0.705 -0.087 1.4971 8.380% 8.000% 2.000% 7.640% 2.900% 10.540% 1.304% 13.977%

36 0.5366 -0.616 1.6893 2.480% 8.000% 2.000% 6.293% 2.900% 9.193% -2.928% 15.514%

24 0.8562 -0.7524 2.4648 5.007% 8.000% 2.000% 8.850% 2.900% 11.750% -4.019% 21.718%

122

From the regression highlighted above, we get a beta of about 1.13 with a upper

and lower bound of 1.72 and .53, respectively. We chose to use the ten year regression

because it has the most data overall. Therefore, we believe that it will give us the most

accurate results. Specifically, we have chosen the 72 month regression because it has

the highest R- squared value, which is 16.81%. This means that 16.81% of the overall

risk can be attributed to systematic risk and the remaining 83.19% is firm specific.

According to Yahoo Finance, Zep, Inc.’s beta is .63, which is within our confidence

interval. Also, you will notice by looking at the regressions that the betas that we have

estimated drop significantly once they get to the 60 month time period. This tells us

that something happened about six years ago that has caused the firm to be much less

risky than they were before.

By using the CAPM, we have calculated the cost of equity to be 13.9% after the

size adjustment. This cost of equity can also be seen as an investor’s required rate of

return that they expect to earn on their investments in Zep, Inc. The Upper and lower

limits for the cost of equity show that the required rate of return, or cost of equity, can

fall between 6.27% and 15.75% with a 95% confidence level.

123

Backdoor Cost of Equity

The backdoor cost of equity uses ratios from a company’s financial statements to

calculate the cost of equity rather than relying on historical prices to determine it. The

formula to find the backdoor cost of equity is shown below.

Price/Book = 1 + (ROE + Ke) / (Ke – g)

This formula is referred to as the price to book ratio. It is the measure of the

market price to the book value of the company. ROE stands for the long run return of

equity of the firm and g is the growth rate. Ke, as stated previously, is the backdoor

cost of equity. For this calculation, the return on equity is 8%, the growth rate is

3.66%, and the price to book ratio is 1.86. The result of this calculation is that the

backdoor cost of equity is 5.99%, which is within our 95% confidence interval.

Weighted Average Cost of Capital (WACC)

A company’s weighted average cost of capital is calculated by multiplying the

company’s weighted amount of debt or equity by its respective cost. The equation is

shown below.

124

WACC= WeightDebt*CostDebt + WeightEquity*CostEquity

WACCAfter Taxes= WeightDebt*CostDebt + WeightEquity*CostEquity (1- Tax Rate)

WACC - Stated Amount

(thousands) Weight Rate Weight*Rate WACC bt/at

Market Liability $207,156.00 34.49% 3.50% 1.21%

Market Equity $393,448.00 65.51% 13.91% 9.11%

Market Value of Firm $600,604.00 10.32%

WACCbt

9.60% WACCat

tax rate 40.40%

WACC - ReStated

Amount (thousands)

Weight Rate Weight*Rate WACC bt/at

Market Liability $232,069.00 37.10% 3.28% 1.22%

Market Equity $393,448.00 62.90% 13.91% 8.75%

Market Value of Firm $625,517.00 9.96%

WACCbt

9.24% WACCat

tax rate 40.40%

The weight is determined by the market cap or market value of equity at the

date of valuation, which is 4/1/2015 for our analysis. On this day, Zep, Inc. had a stock

price or $17.07 and 23,049,091 shares outstanding. This gives Zep, Inc. a market cap,

or market value, of $393,448,000 as of April 1, 2015. Zep, Inc. states in their 2014 10-k

that the market value of their liabilities is $207,156,000. The restated balance of the

market value of liabilities includes capitalized operating leases. The restated weighted

average cost of capital estimation is slightly less than the as stated amounts. The

125

market value of liabilities holds slightly more weight in the re stated amounts than in

the as stated amounts and the interest rate is also smaller in the re statement. The

restated weighted average cost of capital is 9.96%, but the effective WACC is 9.24%

after taxes are factored in. The tax rate was found in Zep, Inc.’s 10-k.

The WACC can be thought of as the rate that Zep, Inc. can finance operations

through equity and debt. Although the restatements show a slight change in the

weighted average cost of capital, we do not believe that this change is large enough to

materially affect our valuation of the Zep, Inc. The WACC can be misleading in some

cases, so we calculated a lower and upper bound for it with a 95% confidence level as

shown below.

WACC-UB ReStated

Amount (thousands)

Weight Rate Weight*Rate WACC bt/at

Market Liability $207,156 34.49% 3.28% 1.131%

Market Equity $393,448.00 65.51% 15.75% 10.318%

Market Value of Firm

$ 600,604.00

11.45% WACCbt

Tax Rate= 40.40% 10.77% WACCat

WACC-LB ReStated

Amount (thousands)

Weight Rate Weight*Rate WACC bt/at

Market Liability $232,069 37.10% 3.28% 1.217%

Market Equity $393,448.00 62.90% 6.27% 3.944%

Market Value of Firm

$ 625,517.00

5.16% WACCbt

Tax Rate= 40.40% 4.44% WACCat

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Method of Comparables

This section uses a variety of different ratios to compare Zep, Inc.’s stock price

per share against the competition. We took an industry average of each ratio not

including Zep, Inc. and adjusted Zep, Inc. to that number. The benchmark companies

that were used in this analysis include Clorox, Church and Dwight, and Ecolab, Inc.

We used the closing price as of April 1st, 2015, which was $17.07. We set a lower

limit and upper limit of $15.36 and $18.78, respectively (10% in each direction).

Anything below the lower limit means that Zep, Inc. is overvalued. Any number that is

over the upper limit means that they are undervalued.

Trailing P/E ratio

The trailing P/E ratio indicated the number of years’ worth of profits that you are

paying for a stock. Generally speaking, it is better to have a lower trailing P/E. To

obtain this ratio, we took the closing share price on April 1st and divided that number by

the firm’s earnings per share from the most recent year for each of the companies.

Once we obtained the ratios for each of the firms, we took an industry average, which

excluded Zep, Inc. We then recalculated Zep, Inc.’s share price and compared it with

the rest of the companies. Below is a table showing the comparisons for each company.

PPS EPS Trailing P/E Adjusted PPS

Zep 17.07 0.34 49.88 18.67

Zep Restated 17.07 -0.52 N/A 2.55

CLX 109.93 3.99 27.53

ECL 114.38 3.87 29.53

CHD 85.4 3.07 27.82

Avg. 103.237 3.65 28.29

Trailing P/E

127

We set the upper and lower limits for Zep, Inc.’s to be $18.78 and $15.36,

respectively. After adjusting both the as stated and restated financials for Zep, Inc. we

found that they are overvalued on both an as - stated and restated basis. We found

that on an as - stated basis, Zep is undervalued by $1.60, which falls within our upper

and lower bounds for the stock price. On a restated basis, they are overvalued by

$14.52. Based on this observation, we have come to the conclusion that Zep, Inc.

overstates itself. However, this ratio alone is not enough evidence for us to conclude

that Zep, Inc. is overvalued by more than fourteen dollars.

Forward P/E Ratio

The forward price to earnings ratio is similar to the trailing price to earnings ratio

in the way it is calculated, which is by taking the price per share and dividing it by

earnings per share. However, the two ratios differ due to the fact that that the forward

price to earnings ratio uses forecasted price per share and earnings per share instead.

Due to the fact that forecasting is not 100 percent accurate, these results may not

perfectly reflect what the actual results will be in the future and will depend entirely on

how accurately we were able to forecast Zep, Inc.’s financials. Also, we used Yahoo

Finance to gather statistics from the competition because we did not forecast their

financial statements ourselves. Our results are shown below.

128

Based off of the industry average forward price to earnings ratio, Zep, Inc. has

an adjusted price per share of $9.76 as-stated and $2.04 restated. Both of these prices

are below our upper and lower bounds which means that according to this ratio, as of

April 1, 2015, the firm is overvalued.

Price to book ratio

Price to book ratio is a calculation of price per share to book value of equity per

share. A low P/b ratio may indicate a company being undervalued while a high P/B ratio

may indicate a company being overvalued. For the industry average price to book we

took the average of Ecolab and Church and Dwight given us industry average of 5.03.

For this ratio we excluded Clorox because its ratio was too high and would have caused

a skewed average. We used Zep’s stock price as of April 1st and multiplied it by the

industry average P/B ratio giving us an adjusted price per share of 17.07 which is the

same as the April 1st stock price meaning it is fairly value and a adjusted restated price

per share of 4.43 which would indicate Zep as being overvalued

PPS EPS Forward P/E Adjusted PPS

Zep 17.07 0.92 18.47 9.76

Zep Restated 17.07 -0.52 N/A 2.04

CLX 109.93 4.97 22.54

ECL 114.38 4.88 22.1

CHD 85.4 3.76 23.46

Avg. 103.237 4.55 22.7

Forward P/E

129

Dividend to Price

Dividend to price is calculated by taking the dividends per share over the price

per share. We calculated the industry average of Clorox, Ecolab and Church and Dwight

to be 1.70. We then used Zep’s DPS and multiplied it by the industry average to get an

adjusted price per share of 11.82 indicating the Zep is again overvalued. For the

restated we used the same numbers since we did not restate dividends for our forecast.

Price Earnings Growth Ratio

The Peg ratio is calculated by using the trailing price to earnings ratio divided by

the long term annualized average growth rate of earnings. The PEG ratio that indicates

an over or underpriced stock varies by industry and by company type, though a broad

DPS PPS D/P Avg. Adjusted PPS

Zep 20.14 17.07 1.18 1.70 11.82

Zep Restated 20.14 17.07 1.18 11.82

CLX 111.03 109.93 1.01

ECL 301.96 114.38 2.64

CHD 124.68 85.4 1.46

Divided to Price

Company PPS BPS P/B Avg. Adjusted PPS

Zep 17.07 3.39 5.04 5.03 17.07

Zep Restated 17.07 0.88 19.40 4.43

CLX 109.93 2.14 51.37

ECL 114.38 24.49 4.67

CHD 85.4 15.84 5.39

Price to book

130

rule of thumb is that a PEG ratio below one is desirable (1). Below are Zep’s ratios

compared to its competitors in the industry.

Trailing P/E Growth PEG

Adjusted

PPS

Zep 49.88 27.10% 1.84 17.75

Zep Restated

N/A

N/A N/A N/A

CLX 27.53 6.90% 3.99

ECL 29.53 14.10% 2.09

CHD 27.82 9.20% 3.02

Avg. 28.29 10.07% 2.81

For Zep’s earning per share growth rate, we used our forecasted earnings per

share and calculated the percent change for each year. Zep’s EPS growth was 27.1%

as-stated and was a negative number on a re-stated basis. Due to the fact that the

earnings per share growth was negative on a restated basis, we were unable to

compute a restated trailing P/E and an adjusted price per share for the stock.

Price/ EBITDA

The price to EBITDA ratio is a measure of the market value of equity, or market

cap, divided by the earnings before interest, tax, depreciation, and amortization. In

order to calculate the market cap, we took the number of shares outstanding for each

company and multiplied it by the price per share as of April 1st, 2015. We took

information from each of the companies’ 10 Ks and in order to calculate each ratio.

Below is a chart comparing Zep, Inc.’s ratios to the rest of the industry.

131

According to this ratio, Zep, Inc. is undervalued on both an as-stated and

restated basis. Neither of the adjusted prices per share that were calculated fall within

the upper and lower bounds that we set. To get this number, we took an industry

average of the other companies and computed an adjusted market cap. From there we

divided the adjusted market cap by the number of shares outstanding in order to get

the adjusted price per share. Although this particular ratio states that Zep, Inc. is

undervalued, we believe that when taxes, interest, depreciation, and amortization is

accounted for there will be a much different result.

Enterprise Value to EBITDA

The Enterprise Value to EBITDA ratio is a comparison of enterprise value and

earnings before interest, taxes, depreciation and amortization. A lower ratio may

indicate that a company may be undervalued. The EV to EBITDA ratio is calculated by

taking a firms’ enterprise value and dividing it by their EBITDA. The enterprise value is

found by adding together both the market value of liabilities and equity, then

Market Cap EBITDA Price/ EBITDA Adjusted PPS

Zep 393,448.00$ 32,796.00$ 12.00 23.53

Zep Restated 393,448.00$ 37,681.00$ 10.44 27.03

CLX 14,420,613.05$ 966,000.00$ 14.93

ECL 33,758,097.41$ 1,955,000.00$ 17.27

CHD 11,163,603.08$ 641,200.00$ 17.41

Avg. 16.54

132

subtracting out the firm’s cash assets. EBITDA is defined as earnings before interest,

taxes, and amortization. We took information from each of the companies’ 10 Ks in

order to calculate the EV/EBITDA ratio. Below are the ratios for Zep and its’

competitors.

After calculating the EV/EBITDA ratio, we found that Zep’s re-stated ratio is

significantly different than their as-stated ratio. Zep’s re-stated ratio indicates that the

company is not as undervalued as the as-stated financials suggest. We calculated Zep’s

adjusted price per share by taking the EV/EBITDA industry average and multiplied it by

Zep’s EBITDA. We then divided that number by the total number of shares outstanding.

Enterprise Value EBITDA EV/ EBITDA Adjusted PPS

Zep 815,487.00$ 32,796.00$ 10.72 20.98

Zep Restated 810,689.00$ 37,681.00$ 21.51 24.11

CLX 18,333,613.05$ 966,000.00$ 13.91

ECL 46,447,997.41$ 1,955,000.00$ 14.24

CHD 13,308,403.08$ 641,200.00$ 16.09

Avg. 14.75

133

Conclusion

Overall, Zep, Inc. presented themselves as fairly valued on an as- stated basis.

However, after we restated their financials, we found that they are overvalued on

almost all of the ratios that were used in this analysis. The only ratios that found Zep,

Inc. to not be overvalued were the price to EBITDA and the enterprise value to EBITDA.

We believe that once taxes, interest, depreciation, and amortization are factored in,

Zep, Inc. will be considered overvalued.

Method of Comparables

Ratio As- Stated Restated

Trailing P/E Fairly Valued Overvalued

Forward P/E Overvalued Overvalued

P/B Fairly Valued Overvalued

D/P Overvalued Overvalued

PEG Fairly Valued N/A

P/EBITDA Undervalued Undervalued

EV/EBITDA Undervalued Undervalued

Comclusion Fairly Valued Overvalued

134

Discounted Dividends Model

We use discounted dividend model as the first valuation method. In this method,

we discounted future dividend payments with the cost of equity. This model has low

explanatory power on the company’s valuation because it fails to account for growth in

retained earnings. Also, this model made assumption that the terminal value is

perpetuity. Based on these flaws, the model will show that the firm is overvalued.

We started the valuation method by getting the forecasted dividend payment

from our forecasted statement of cash flow from 2015 – 2024. With the assumption

that the number of shares outstanding held constant in the future, we divided the

forecasted dividend payment to get dividend per share number. After that, we

calculated the present value of future dividends by discounting it with cost of capital.

The second part of this valuation is we have to find the present value of the terminal

perpetuity dividend by finding its present value in year 10. Then we discounted the

value back to year 1 with the cost of capital. We added the two values together to find

the intrinsic value of ZEP. We need to calculate the price at April 1st, so we multiplied

the intrinsic value by future value factor using cost of capital. The observed stock price

at April 1st is $17.07, and here is the table of sensitivity analysis to show the effect of

changing cost of capital and growth rate.

135

The sensitivity analysis table shows that ZEP is overvalued, when we conditioned

ourselves as 10 a percent analyst. The highest price calculated form the sensitivity

analysis was $4.36. As mentioned earlier in this section, this valuation method could not

explain well ZEP’s stock price.

Discounted Free Cash Flows Model

Another intrinsic value model that was used in valuing the stock for Zep, Inc. is

the discounted free cash flows model. This model uses cash flows from operating

activities and cash flows from investing activities (CFFO and CFFI respectively). In order

to obtain the information that was needed for this model, we took the forecasted cash

flows from operations and cash flows from investing activities that we previously

calculated.

Once the CFFO and CFFI were calculated, we then calculated the free cash flows

from assets by taking the difference between cash flows from operations and cash

flows from investing activities. We were able to calculate the market value of assets for

the company once we took the present value of the free cash flows from assets. To

obtain the market value of the assets, we added the total present value of year by year

Growth rate

0.00 0.01 0.02 0.03 0.04

9.00 3.19 3.38 3.61 3.93 4.36

12.00 2.39 2.47 2.56 2.68 2.82

ke 13.91 2.06 2.11 2.17 2.24 2.32 LB < > UB

16.00 1.78 1.82 1.85 1.89 1.94 15.363 Fair Value 18.777

18.00 1.58 1.6 1.63 1.65 1.69

10% Analyst

136

free cash flows to the free cash flow perpetuity. From here, we subtracted the book

value of debt and preferred stock from the market value of assets in order to get the

market value of equity. Once we had the market value of equity, we divided it by the

number of shares outstanding and multiplied that number by a time consistency factor

in order to get an estimated stock price for the firm. Because the cash flows are an

after tax number, we used the restated before tax WACC to discount the cash flows and

avoided double taxation.

For this model, we used a various amount of growth rates along with the WACC

before tax in an attempt to create a model with reasonable results. We used five

different growth rates to perform the sensitivity analysis and we took a position as a

10% analyst. Taking this position gave us an upper bound and a lower bound for the

stock price by multiplying Zep, Inc.’s stock price of $17.07 by .9 for the lower bound

and by 1.1 for the upper bound. This gave us a lower bound stock price of $15.36 and

an upper bound of $18.78.

We found that this model did not value the company efficiently at all. Due to the

fact that the cash flows from investing activities are all negative, it caused our

sensitivity analysis to produce all negative stock prices. This is happening because Zep,

Inc. is having a consistent outflow of cash every year. Shown below is the sensitivity

analysis table that was used.

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Abnormal Earnings Growth (AEG)

Abnormal Earnings Growth Model (AEG) has a high degree of explanatory power.

Mathematically, this method is comparable to the residual income method. The inputs

for this method are forecasted net income and dividends paid. This model compares

forecasted earnings to a benchmark value, in this model called “normal” income.

We calculated “normal” income by taking previous year net income and

multiplied by one plus cost of equity. Then we calculated the cumulative dividend

earnings by adding net income and dividend reinvested earnings, with the assumption

that the reinvested dividend will give us return of our cost of equity. Similar with

residual income, we expect the abnormal earnings growth to approach zero and thus

we will use negative growth rate in the perpetuity.

Next, we calculated the present value of ZEP’s future abnormal earnings by

discounting each year with the cost of equity. We also calculated the present value of

the perpetuity growth by dividing the terminal value with cost of equity minus growth

rate. We added up the present value of net income and abnormal earnings to get value

0 0.01 0.02 0.03 0.04 g

5% N/A N/A N/A N/A N/A

7% N/A N/A N/A N/A N/A

WACC bt 9.96% (45.62) (45.11) (45.05) (46.66) (48.00) LB < > UB

12% N/A N/A N/A N/A N/A 15.363 Fair Value 18.777

14% N/A N/A N/A N/A N/A

Ke

10% Analyst

138

at December 31st 2014. Because we need the value at April 1st, we grow the value by 3

month. To see the result, we use sensitivity analysis with changes in cost of equity and

growth rate for both as stated and restated financial statements. Then we compare it

with 10 percent analyst range which put the lower bound at 15.36 and the upper bound

at 18.78.

As stated abnormal earnings growth valuation

Restated abnormal earnings growth valuation.

From the sensitivity analysis, we can see that there is not much price fluctuation

compared to other valuation models. We need to calculate the restated value to

account for operating leases and goodwill. The model shows that our company is

overvalued for both as stated and restated net income data. Because this model has

high explanatory power, we will use this model to decide the valuation of our company.

Growth rate

-0.10 -0.20 -0.30 -0.40 -0.50

9.00 4.19 4.31 4.36 4.40 4.42

12.00 3.17 3.34 3.43 3.49 3.53

ke 13.91 2.70 2.88 2.98 3.04 3.08 LB < > UB

16.00 2.30 2.47 2.57 2.63 2.67 15.363 Fair Value 18.777

18.00 2.00 2.15 2.25 2.31 2.35

10% Analyst

Growth rate

-0.10 -0.20 -0.30 -0.40 -0.50

9.00 5.24 5.19 5.17 5.15 5.14

12.00 3.04 3.09 3.11 3.13 3.14

ke 13.91 2.26 2.32 2.36 2.38 2.39 LB < > UB

16.00 1.70 1.76 1.79 1.81 1.83 15.363 Fair Value 18.777

18.00 1.33 1.38 1.41 1.43 1.45

10% Analyst

139

Residual Income

Residual income is described as the earnings left over after subtracting the

opportunity cost of capital. The residual income model provides the highest explanatory

power of the five intrinsic models which we will lead to significant component of our

valuation. This model shows low sensitivity to changes in the perpetuity decay rate and

the inputs used are more reliable than discounted dividends of free cash flows.

To calculate residual income a benchmark net income must be calculated, which

is the net income recognized by the company if they are able to meet their cost of

equity required by shareholders. Subtracting the benchmark income from the observed

net income gives us residual income. Because of changes to net income from operating

leases this is done on an as stated and restated basis. Using forecasted values the

annual book value of equity was found by taking the 2014 book value of equity and

adding in the 2015 net income, subtracting the amount of dividends to be paid out in

2015. This is done for the next 10 years. In each year of our model the residual income

is reported as negative value, meaning they are not earning enough cash to satisfy

investors and destroying value.

The year by year change in residual income is shown as increasingly negative

over time. To reflect this trend we multiplied the 2024 residual income by 1.09 and then

divided this number by the cost of equity minus the growth rate giving us the value of

the perpetuity. This number must be discounted back to time zero dollars to give us the

terminal value perpetuity. From here the market value of equity can be calculated by

140

adding the sum of the present value of year by year residual income, plus the terminal

value perpetuity, and the book value of equity. Now, with the market value of equity for

Zep calculated, we divided by shares outstanding, then grown forward three months to

give us a time consistent share price value.

For the sensitivity analysis of this model we varied the cost of equity and the

growth rates. This growth rate for this model is different than free cash flows and

discounted dividend models. The values are negative because of the fact that residual

income will be equal to zero as the both the benchmark and observed net income

approach equilibrium.

Below are the tables showing the sensitivity analysis for the model, and both the

as stated and restated figures are shown to be significantly overvalued.

As Stated

Perpetuity Growth

-10% -20% -30% -40% -50%

9.00% 6.88 7.14 7.27 7.34 7.39

12.00% 4.89 5.25 5.44 5.56 5.64

13.91% 4.02 4.38 4.57 4.7 4.78

16.00% 3.29 3.63 3.82 3.94 4.02

18.00% 2.75 3.06 3.24 3.35 3.44

Ke

10% Analyst

LB < > UB

15.363 Fair Value 18.777

141

Restated

Perpetuity Growth

-10% -20% -30% -40% -50%

9.00% 4.73 4.75 4.76 4.77 4.77

12.00% 3.79 3.87 3.91 3.93 3.95

13.91% 3.21 3.31 3.37 3.40 3.42

16.00% 2.59 2.7 2.77 2.81 2.84

18.00% 1.99 2.13 2.2 2.25 2.29

Ke

10% Analyst

LB < > UB

15.363 Fair Value 18.777

Long-Run Residual Income (LRRI)

The long run residual income uses three variables, roe, cost of equity, and

growth rates to see the effect of each variable. This valuation also uses negative growth

rate with the assumption that the company will not outperform its cost of equity. This

valuation method has better explanatory power compared to free cash flow. The input

we use is the book value of equity and then we calculated the market value of equity by

this equation:

MVE= BVE [ 1 + ((ROE – Ke)/(Ke – g)) ]

After calculating the market value of equity, we find the share value by dividing it

with the number of shares outstanding. Then we grow it to find the value at April 1st

2015. Here are the sensitivity analysis for the price of the firm.

142

In the sensitivity analysis, we calculated the cost of equity of lower bound of 9 percent

and upper bound of 18 percent. We limit the ROE range from 4 percent to 12 percent. And we

also limit the growth from negative 10 percent to negative 50 percent. Because the input use is

the shareholder equity, we have to do the restated valuation as well to account for operating

leases and goodwill.

Hold g constant at -30%

ROE

4% 6% 8% 10% 12%

9.00% 7.47 7.91 8.35 8.79 9.23

12.00% 6.99 7.4 7.81 8.22 8.63

Ke 13.91% 6.71 7.11 7.5 7.9 8.29 LB < > UB

16.00% 6.44 6.81 7.19 7.57 7.95 15.363 Fair Value 18.777

18.00% 6.19 6.56 6.92 7.29 7.65

10% Analyst

Hold ROE constant at 8%

g

-10% -20 -30% -40% -50%

9.00% 8.12 8.28 8.35 8.4 8.43

12.00% 7.06 7.55 7.81 7.97 8.07

Ke 13.91% 6.53 7.16 7.5 7.72 7.87 LB < > UB

16.00% 6.03 6.77 7.19 7.46 7.65 15.363 Fair Value 18.777

18.00% 5.62 6.44 6.92 7.24 7.46

10% Analyst

Hold Ke constant at 13.91%

g

-10% -20 -30% -40% -50%

4% 5.08 6.13 6.71 7.07 7.32

6% 5.8 6.65 7.11 7.4 7.59

ROE 8% 6.53 7.16 7.5 7.72 7.87 LB < > UB

10% 7.25 7.67 7.9 8.04 8.14 15.363 Fair Value 18.777

12% 7.98 8.18 8.29 8.36 8.41

10% Analyst

143

Based on the sensitivity analysis that we did, the valuation method shows that our

company is overvalued in both as stated and restated financials.

Final Recommendation

When valuing a firm, the first step is to research the firm to better understand its

business strategies, the industry in which the firm operates in, and their competition.

For this valuation, Zep’s competitors are Clorox, Church and Dwight, and Ecolab. By

using the Five Forces Model, we were successfully able to gather data on the chemical

cleaning industry and learned how the firms within this industry operate.

Hold g constant at -30%

ROE

4% 6% 8% 10% 12%

9.00% 5.10 5.40 5.70 6.00 6.30

12.00% 4.77 5.05 5.33 5.61 5.89

Ke 13.91% 4.58 4.85 5.12 5.39 5.66 LB < >UB

16.00% 4.39 4.65 4.91 5.17 5.43 15.363 Fair Value 18.777

18.00% 4.23 4.48 4.72 4.97 5.22

10% Analyst

Hold ROE constant at 8%

g

-10% -20 -30% -40% -50%

9.00% 5.54 5.65 5.70 5.73 5.75

12.00% 4.82 5.15 5.33 5.44 5.51

Ke 13.91% 4.45 4.88 5.12 5.27 5.37 LB < >UB

16.00% 4.11 4.62 4.91 5.09 5.22 15.363 Fair Value 18.777

18.00% 3.84 4.40 4.72 4.94 5.09

10% Analyst

Hold Ke constant at 13.91%

g

-10% -20 -30% -40% -50%

4% 3.46 4.19 4.58 4.83 5.00

6% 3.96 4.54 4.85 5.05 5.18

ROE 8% 4.45 4.88 5.12 5.27 5.37 LB < >UB

10% 4.95 5.23 5.39 5.49 5.55 15.363 Fair Value 18.777

12% 5.54 5.58 5.66 5.71 5.74

10% Analyst

144

After obtaining the industry information, we then focused on the accounting

policies of Zep and identified any potential red flags that were present in their policies.

We found the Zep relies heavily on its operating leases and goodwill. We then

capitalized its operating leases, impaired the goodwill and created a restated balance

sheet that properly reflected Zep’s financials. Afterwards, we used trends in Zep’s

financials and ratios to forecast the balance and income sheet for the next ten years.

For our final recommendation, we will use all of our research and analysis to put

together comparable and intrinsic valuation models. The method of comparable will be

used for comparison purposes only and we will determine our value of Zep from the

results of our intrinsic models. Every intrinsic model we used resulted in Zep being

overvalued. In addition, only the Price/EBITDA and EV/EBITDA models were the only

models that showed Zep was undervalued. Based on this, our recommendation for

those holding stock in Zep is to sell because it is overvalued.

145

Sources

1. Zep Inc. 2014 10-k

2. Ecolab 2014 10-k

3. Church and Dwight 2014 10-K

4. Clorox 2014 10-K

5. Business Analysis Valuation: Using Financial Statements, 5th edition

6. Zepinc.com

7. Csimarket.com

8. Finance.yahoo.com

9. Ecolab.com

10. Churchanddwight.com

11. Clorox.com

12. Thecloroxcompany.com

13. Morningstar.com

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Appendix

as stated re stated as stated re stated as stated re stated as stated re stated as stated re stated

At December 31: 2010 Dr Cr 2010 2011 Dr Cr 2011 2012 Dr Cr 2012 2013 Dr Cr 2013 2014 Dr Cr 2014

Assets

Cash and cash equivalents 25,257$ 25,257$ 7,219$ 7,219$ 3,513$ 3,513$ 2,402$ 2,402$ 14,303$ 14,303$

Account receivable 90,827$ 90,827$ 95,681$ 95,681$ 93,522$ 93,522$ 104,476$ 104,476$ 108,010$ 108,010$

Less doubtful acct

Inventories 53,192$ 53,192$ 61,147$ 61,147$ 71,451$ 71,451$ 68,633$ 68,633$ 75,950$ 75,950$

Insurance receivable 13,106$ 13,106$

Deferred income taxes 9,049$ 9,049$ 9,189$ 9,189$ 7,681$ 7,681$ 8,002$ 8,002$ 10,452$ 10,452$

Prepaids and other current asset 9,779$ 9,779$ 9,896$ 9,896$ 22,333$ 22,333$ 13,051$ 13,051$ 6,254$ 6,254$

Total Current asset 188,104$ 188,104$ 183,132$ 183,132$ 198,500$ 198,500$ 196,564$ 196,564$ 228,075$ 228,075$

PP&E 66,874.00$ 66,874$ 67,868$ 67,868$ 80,921$ 80,921$ 82,328$ 82,328$ 75,361$ 75,361$

Cap OL Rights 26,282$ 26,282$ 20,853$ 3,755$ 17,099$ 22,408$ 7,339$ 15,069$ 22,859$ 11,073$ 11,786$ 23,816$ 14,883$ 8,933$

Goodwill 53,764.00$ 6,388$ 47,376$ 84,418$ 17,123$ 67,295$ 67,295$ 84,604$ 34,006$ 50,598$ 121,102$ 50,927$ 70,175$ 121,005$ 75,148$ 45,857$

Identifiable intangible 30,271.00$ 30,271$ 65,136$ 65,136$ 65,707$ 65,707$ 129,929$ 129,929$ 121,643$ 121,643$

Other long term asset 3,835.00$ 3,835$ 3,215$ 3,215$ 5,555$ 5,555$ 17,835$ 17,835$ 10,127$ 10,127$

Total Asset 342,848$ 362,742$ 403,769$ 403,745$ 435,287$ 416,350$ 547,758$ 508,617$ 556,211$ 489,997$

Liabilities

Current maturities long term 15,000$ 15,000$ 15,000$ 15,000$ 15,000$ 15,000$ 25,000$ 25,000$ 20,006$ 20,006$

Account payable 51,390$ 51,390$ 56,821$ 56,821$ 53,461$ 53,461$ 56,366$ 56,366$ 65,874$ 65,874$

Accrued compensation 21,322$ 21,322$ 18,161$ 18,161$ 17,334$ 17,334$ 25,226$ 25,226$ 19,720$ 19,720$

Other accrued liab 29,124$ 29,124$ 27,482$ 27,482$ 27,947$ 27,947$ 41,167$ 41,167$ 39,329$ 39,329$

Total current liab 116,836$ 116,836$ 117,464$ 117,464$ 113,742$ 113,742$ 147,759$ 147,759$ 144,929$ 144,929$

Long term debt 77,150$ 77,150$ 104,650$ 104,650$ 124,250$ 124,250$ 184,908$ 184,908$ 186,880$ 186,880$

Cap OL Liability 26,282$ 26,282$ 6,315$ 20,853$ 14,538$ 13,454$ 22,408$ 8,954$ 20,916$ 22,859$ 1,943$ 28,615$ 23,816$ (4,798)$

Deferred income taxes 2,140$ 2,140$ 6,224$ 6,224$ 8,574$ 8,574$ 12,782$ 12,782$ 13,931$ 13,931$

Other long term liab 24,549$ 24,549$ 26,308$ 26,308$ 20,804$ 20,804$ 18,340$ 18,340$ 17,092$ 17,092$

Total liab 220,675$ 246,957$ 254,646$ 269,184$ 267,370$ 276,324$ 363,789$ 365,732$ 362,832$ 358,034$

Stockholder eqity

Common stock 213$ 213$ 216$ 216$ 218$ 218$ 221$ 221$ 224$ 224$

Paid-in capital 85,316$ 85,316$ 92,925$ 92,925$ 97,481$ 97,481$ 102,573$ 102,573$ 108,432$ 108,432$

Retained earnings 25,052$ 6,388$ 18,664$ 38,970$ 14,562$ 24,408$ 57,367$ 27,891$ 29,476$ 69,023$ 41,084$ 27,939$ 72,918$ 61,416$ 11,502$

Accumulated OCI 11,592$ 11,592$ 17,012$ 17,012$ 12,851$ 12,851$ 12,152$ 12,152$ 11,805$ 11,805$

Total SE 122,173$ 115,785$ 149,123$ 134,561$ 167,917$ 140,026$ 183,969$ 142,885$ 193,379$ 131,963$

Total liab and SE 342,848$ 362,742$ 403,769$ 403,745$ 435,287$ 416,350$ 547,758$ 508,617$ 556,211$ 489,997$

Statements of Income

Net Sales 568,512$ 568,512$ 645,972$ 645,972$ 653,533$ 653,533$ 689,576$ 689,576$ 696,489$ 696,489$

Cost of products Sold 285,335$ 285,335$ 343,095$ 343,095$ 352,737$ 352,737$ 365,034$ 365,034$ 369,697$ 369,697$

Gross Profit 283,177$ 283,177$ 302,877$ 302,877$ 300,796$ 300,796$ 324,542$ 324,542$ 326,792$ 326,792$

Selling, Distribution, and Adm Exp 247,759$ 247,759$ 268,438$ 3,755$ 7,708$ 264,485$ 260,806$ 3,584$ 8,536$ 255,854$ 283,075$ 3,735$ 8,370$ 278,440$ 293,361$ 3,810$ 8,695$ 288,476$

Restructuring Charges 8,213$ 8,213$ 1,469$ 1,469$ 5,159$ 5,159$ (456)$ (456)$

Acquisition and Integration Costs 3,353$ 3,353$ 429$ 429$ 1,210$ 1,210$ 3,519$ 3,519$ 1,091$ 1,091$

Loss (Gain) on Asset Disposal (676)$ (676)$ 500$ 500$

Operating Profit 23,852$ 23,852$ 33,217$ 37,170$ 38,280$ 43,232$ 32,789$ 37,424$ 32,796$ 37,681$

Other Expense (Income)

Interest Expense 1,957$ 1,957$ 6,562$ 1,393$ 7,955$ 5,493$ 1,397$ 6,890$ 8,958$ 908$ 9,866$ 11,819$ 997$ 12,816$

Provision for loan loss 5,269$ 5,269$

Accelerated debt issuance 428$ 428$

Bargain purchase gains (2,095)$ (2,095)$

Goodwill Impairment (adjust) 6,388$ 6,388$ 10,735$ 10,735$ 16,884$ 16,884$ 16,921$ 16,921$ 24,220$ 24,220$

Miscellaneous expense (244)$ (244)$ (40)$ (40)$ 1,046$ 1,046$ 744$ 744$ 1,610$ 1,610$

Total other Expense 2,141$ 8,529$ 6,522$ 18,650$ 4,444$ 22,725$ 9,702$ 27,530$ 18,698$ 43,915$

Income before Income taxes 21,711$ 15,323$ 26,695$ 18,521$ 33,836$ 20,507$ 23,087$ 9,894$ 14,098$ (6,234)$

Provision for Income taxes 8,207$ 8,207$ 9,294$ 9,294$ 11,927$ 11,927$ 7,895$ 7,895$ 5,698$ 5,698$

Net Income 13,504$ 7,116$ 17,401$ 9,227$ 21,909$ 8,580$ 15,192$ 1,999$ 8,400$ (11,932)$

Income summary 6,388$ 8,174$ 13,329$ 13,193$ 20,332$

Total debit credits 39,058$ 39,058$ 57,613$ 57,613$ 85,617$ 85,617$ 106,423$ 106,423$ 142,874$ 142,874$