Expansion and Earnings Growth through Organic and Inorganic Means - Essay Example

?Question Principle activities (504/500 words) (a) iiNET Limited (IIN) is the third largest internet service provider (ISP) in Australia with 8% market share. Established in 1993, the company has more than 1300 employees and supports 753,000 broadband, telephone and dial-up customers. IIN’s business focus is on ADSL-based internet access, reselling Telstra ADSL1 and VOIP services for businesses. The company has its own high-speed ADSL2+ Broadband network that reaches four million customers across Australia. IIN was the first ISP to offer the product, Naked DSL to customers. Naked DSL was named the product of the year by the Australian PC Magazine. IIN has grown both organically through innovative product development and inorganically by merging with many smaller ISPs. (b) The company has experienced strong growth through the launch of telephony products and deployment of DSLAM infrastructure. With a range of telephony services that include add-on voice and broadband services, IIN offers their own telephone service resulting in a lower line rental price for its customers. In 2006, IIN introduced its DSLAM infrastructure into telephone exchanges across Australia. DSLAM allowed a speed of over 1.5 Mbit/s with a maximum download of 24 Mbit/s. The potential risk with the product development strategy is the possibility of changes in product line and pricing owing to close competition from other major players such as the regulatory conflict with Telstra. Another medium term growth strategy is the inorganic route of acquisitions. In the early 2000s, IIN expanded nationwide by acquiring RuralNet Tas Access, Granite Internet and so on. In 2003, the biggest acquisition of ihug Ltd. followed. Residential ISP business and trademarks of rival OzEmail followed in 2005. After a hiatus, IIN recommenced its acquisition strategy to acquire Perth-based ISPs, Up’n’away and Westnet. Potential risks for acquisition include synergy and funding risks. When IIN acquired OzEmail, the business side remained with its US-parent, MCI but the retail business was neglected. OzEmail moved very late into ADSL and by 2006, IIN had abandoned the OzEmail brand. Fund-raising for acquisitions is a major concern. In 2006, IIN requested a share trading halt after its share value slid by 50%. There was uncertainty from IIN’s bankers as the company had capital raising issues and thus, unable to honour the bank’s covenants. As the third largest ISP, IIN has utilised its brand for strategic purposes. To increase its market share in metros and regional Australia, the company has invested in the “Hallelujah” and the “Humanology” brand campaigns. A new hi-tech wireless home gateway, ‘BoB’, is featured in its “Hallelujah” campaign. The increased brand investment has led to increased sales across its businesses. The company has launched its next phase in brand expansion. A potential risk to the brand strategy of IIN is the existing competition in the ISP segment. There are over 600 ISPs in Australia with Telstra leading the market with 43% market share. The second largest player, Optus holds 11% market share. IIN with its 8% share will need to increase its footprint in Australia to compete with the large players and aid its brand recall with customers. Question 2: Liquidity (136/150 words) (a) 2009 Current Ratio = Current Assets/Current Liabilities ($’000) = 46,939/81,763 = 0.6 2008 Current Ratio = 34,494/77,511 = 0.4 2009 Acid Test Ratio = Current Assets–Inventories-Prepayments/Current ($’000) Liabilities-Bank Overdraft = 46,939–1,078-13,981/81,763-501 = 0.4 2008 Acid Test Ratio = 34,494-1,073-8,922/77,511-2,846 = 0.3 (b) IIN’s availability of cash and other current assets to cover accounts payable, short-term debt and other liabilities stands at 0.6 in 2009. The current ratio has improved from 0.4 in 2008 to 0.6 There is an increase in the acid-test ratio from 0.3 in 2008 to 0.4 in 2009. The acid test ratio is a more stringent test, incorporating only those assets that can be converted to cash quickly. Current and quick (acid-test) ratios are in high correlation in both the years. The short-term liquidity risk of IIN appears to be moderate. Question 3: Working capital management efficiency (247/250 words) (a) 2009 Days Inventory = (Average Inventory/Cost of Sales) x days in year ($’000) = (1,076/328,565) x 365 = 1 day 2008 Days Inventory = (709/188,669) x 366 ($’000) = 1 day 2009 Days Debtors = (Average Trade Debtors/Sales) x days in year ($’000) = (17,547/417,760) x 365 = 15 days 2008 Days Debtors = (15,698/249,850) x 366 ($’000) = 23 days 2009 Days Creditors = (Average Trade Creditors/Cost of Sales) x day n year ($’000) = (39,770/328,565) x 365 = 44 days 2008 Days Creditors = (32,120/188,669) x 366 ($’000) = 62 days (b) Days Inventory ratio shows the inventory held by IIN in 2009 took on an average 1 day to sell. As a telecom service company, IIN’s inventory is very low and hence the low Days inventory. The Days Debtors ratio indicates the number of day’s worth of sales that are represented in trade debtors. Days Creditors highlights how efficiently management is making use of credit facilities. The collection period is 15 days in 2009 is an improvement from 23 days in 2008. On the contrary, IIN pays its creditors in a 44-day credit cycle in 2009 that is lowered from a 62-day credit cycle in 2008. Overall the Capital Management Efficiency of IIN is strong. The Net working capital days figures are consistently low, which is a desirable sign in terms of reducing short-term liquidity risk, implicating that IIN either received cash soon after sales or aggressively used suppliers to finance its current assets. Question 4: Financial structure (374/400 words) (a) 2009 Net Debt/Equity = (Financial Debt – Cash)/Equity x 100 ($’000) = (112,094 – 9,787)/201,649 x 100 = 50% 2008 Net Debt/Equity = (115,086 – 9,249)/187,082 x 100 ($’000) = 57% 2009 LT Debt/Total Debt = (Non-current financial debt/Total financial ($’000) debt) x 100 = (30,331/112,094,848) x 100 = 30% 2008 LT Debt/Total Debt = (Non-current financial debt/Total financial ($’000) debt) x 100 = (37,575/115,086) x 100 = 30% (b) The Net Debt/Equity ratio indicates the relative mix of the company’s investor-supplied capital. The lower the ratio, the safer the company - though a very low ratio can indicate excessive caution. On the positive side, the use of debt is beneficial as it provides tax benefits to the firm and allows it to exploit business opportunities and grow. For the capital-intensive telecom industry where telecom companies have to procure substantial debt to finance capital expenditure, the leverage ratio of the industry is high. Costs of expanding networks and services that become obsolete overnight and replacements of transmission systems frequently are funded through debt. The financial challenges of keeping up with rapid technological changes and depreciation can be monumental. In 2008, IIN had a Net Debt/Equity ratio of 57%, this position got stronger through 2009 with the company holding a lower ratio of 50%. In 2008, IIN committed $5,288,000 towards DSLAM infrastructure and installation costs. In 2009, its capital expenditure is $3,121,000. The commitments relate to DSLAM builds, site establishment and installation costs. Debt raised for the capital expenditure was the primary driver for the ratio of 57% in 2008. The Long Term Debt/Total Debt ratio helps assess the structure of debt for IIN. Companies will usually have a blend of short term debt to finance ‘working capital’ and longer term borrowings to finance ‘capital expenditure’ programs. In 2008 and 2009, IIN maintained a 30% LT Debt/Total Debt ratio. The solvency risk seems moderate. With a near-bankruptcy state in 2006 when IIN’s earnings became negative, the following years including 2008 saw high leverage. In general, higher debt ratios suggest higher risk. But, in 2009, the leverage ratio reduced to 50%. The frequently cited rule of thumb for companies is to finance 50% of their capital through external debt. I will consider the leverage ratio to be moderate. Question 5: Debt protection (266/250 words) (a) EBIT ($’000) 2009 2008 Profit from ordinary activities before income tax: 35,971 27,728 Plus: Significant items from continuing operations: - 2,086 Plus: Total financial expenses 2,647 1,406 Less: Financial income (575) (1,330) EBIT 38,043 29,890 Net-Interest Expense Calculation 2009 ($’000) Total financial expenses 2,647 Less: Financial income (575) Plus: Capitalised interest - Net-Interest Expense 2,072 Net-Interest Expense Calculation 2008 ($’000) Total financial expenses 1,406 Less: Financial income (1,330) Plus: Capitalised interest 288 Net-Interest Expense 364 Net-Interest Cover = EBIT/Net-Interest Net-Interest Cover 2009 = 38,043/2,072 = 18.4 times Net-Interest Cover 2008 = 29,890/364 = 82.1 times NPAT using all operations ($’000) 2009 2008 Profit for the financial period 25,633 19,898 Loss on significant items 0 2,088 Tax on significant items - 0 Significant items net of tax 0 2,088 Adjusted NPAT 25,633 21,986 Debt to gross cash flow ($’000) 2009 2008 Financial debt 24,848 32,789 NPAT (from continuing operations) 25,633 21,986 Plus: Total depreciation and amortisation 29,218 21,720 Gives: Gross cash flow 54,851 43,706 Cash flow statement 49,059 58,941 Calculation of Debt to Gross cash flow ratio using cash flow from IIN: 2009 ($’000): 24,848/54,851 = 0.5 years 2008 ($’000): 32,789/43,706 = 0.8 years Calculation of Debt to Gross cash flow ratio using net cash from operating activities from the IIN cash flow statement: 2009 ($’000): 24,848/49,059 = 0.5 years 2008 ($’000): 32,789/58,941 = 0.6 years (b) IIN comfortably exceeds the benchmark level of ‘4 times’ net-interest cover for 2008 and 2009. In addition the Debt to Gross Cash Flow ratios highlights how quickly the company would repay debt in 2008 (0.8 years) and 2009 (0.5 years). Question 6: Profitability (333/300 words) (a) Return on Equity = NPAT – MI (in NPAT) – QED / E – MI (in E) - QE x 100 ($’000) 2009 2008 NPAT from all operations 25,633 21,986 Minority interest (in NPAT) - - Quasi-equity distribution - - Adjusted NPAT 25,633 21,986 Equity 201,649 187,082 Minority interest (in Equity) - - Quasi-equity - - Adjusted Equity 201,649 187,082 Calculation of 2009 ROE = 25,633/201,649 x 100 = 12.7% Calculation of 2008 ROE = 21,986/187,082 x 100 = 11.8% Return on Assets = EBIT/Total assets – Cash and cash equivalents – Interest bearing investments x 100 ($’000) 2009 2008 EBIT 38,043 29,890 Total assets 313,743 302,168 Cash and cash equivalents 9,787 9,249 Interest bearing investments - - Adjusted total assets 303,956 292,919 Calculation of 2009 ROA = 38,043/303,956 x 100 = 12.5% Calculation of 2008 ROA = 29,890/292,919 x 100 = 10.2% EBIT Margin = EBIT/Sales x 100 Calculation of 2009 EBIT Margin = 38,043/417,760 x 100 = 9.1% Calculation of 2008 EBIT Margin = 29,890/249,850 x 100 = 12.0% Net Profit Margin = NPAT – Quasi equity distributions/Sales x 100 Calculation of 2009 margin = 25,633 – 0/417,760 x 100 = 6.1% Calculation of 2008 margin = 21,986 – 0/249,850 x 100 = 8.8% (b) Return on Equity increased from 11.8% to 12.7% in 2009 owing to the increase in adjusted NPAT from 2008 to 2009. NPAT in 2008 was $21,986,000 and $25,633,000 in 2009. ROA disregards the method of financing assets and therefore measures the performance of a company’s operational management as distinct from its financial management. IIN’s ROA increased from 10.2% to 12.5% meaning the company became more efficient in utilising it’s assets during the period. EBIT Margin measures the percentage of each dollar of sales revenue after expenses and before interest tax. IIN’s EBIT margin decreased from 12% to 9.1% in 2009 reflecting heavy infrastructure spending in 2009. NPAT margin takes into account all expenses including financing and tax and therefore measures total corporate performance. IIN’s margin decreased from 8.8% in 2008 to 6.1% in 2009. Question 7: Quality of earnings (413/400 words) (a) IIN FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 EBIT*($’millions) 8,900 13,080 (1,729) 19,850 29,890 38,043 *EBIT for FY 04, 05, 06 and 07 has been sourced from the assignment questionnaire. EBIT for FY 08 and 09 have been sourced from previous answers and rounded to the nearest million dollars. Trend in Earnings before Income Tax (EBIT) has grown steadily for IIN till 2006. There is a decline in earnings in 2006 to the tune of $1,729,000 owing to the impairment charges booked in the year. The impairment loss was recognised for the write-down of the assets to fair value less costs to sell. The carrying value of its plant and equipments exceeded its estimated recoverable amount. In 2007, EBIT improved due to the inclusion of material items of non-recurring nature that included $5 million recognised as post-tax profit on the disposal of New Zealand based ihug, $4.8 million representing the clawback of prior period overcharging by Telstra as a result of backdating of the ACCC determination on line sharing and $57.8 million being the post tax impact of impairment charges booked in 2006. In terms of the profitability of IIN, ROE was still strong even allowing for the reduction in FY2009. Return on Assets increased over the period suggesting an increase in the performance of the company’s operational management. EBIT and NPAT margin grew strongly. From 2004 onwards, EBIT has grown steadily by over 60% year on year till 2009 excluding the year, 2006. By 2009, IIN had successfully completed the consolidation of Westnet after acquiring 30 acquisitions in the previous years. Due to acceleration in the growth of customers and the commencement of the migration of a portion of Westnet customers, business reinvestment with capital expenditure increasing to $28.2 million was deployed. Therefore I consider IIN’s quality of earnings to be highly satisfactory. (b) Effective Tax Rate = Income tax expense on operating profit/pre-tax profit x 100 ($’000) 2009 2008 Income tax expense 10,338 7,830 Pre-tax profit 35,971 27,728 Calculation of 2009 Effective Tax Rate = 10,338/35,971 x 100 = 29% Calculation of 2008 Effective Tax Rate = 7,830/27,728 x 100 = 28% IIN’s effective rate is less than 30% because of capital expenditure costs, utilisation of tax losses, and revaluation of deferred tax balances and different rates of corporate tax. (c) Financial gearing profitability ratio: = (financial debt x ROA) – (borrowing costs expense) Financial gearing profitability ratio 2009 ($’000): = (24,848 x 12.5%) – (2,647) = 463 Financial gearing profitability ratio 2008 ($’000): = (32,789 x 10.2%) – (1,406) = 1,940 The two years above show that IIN has earned greater profit from their borrowed funds than the cost of borrowing those funds. Therefore the use of borrowed funds has increased returns to IIN shareholders for the 2008 and 2009 financial years. Question 8: Earnings per share and price/earnings ratio (a) EPS = NPAT – Minority Interest – Quasi-equity distributions/WANO x 100 NPAT = 25,633 (note, this figure is different to the NPAT calculated in question 5, as for the purposes of this subject significant items are excluded when calculating EPS, see pp10.12 of the course notes). Minority Interest = n/a Quasi-equity distributions = n/a WANO/EFPOWA = Shares on issue Days on issue Days in year DF1 DF2 DF3 151,581,652 365 365 0.9999 0.9999 1.0000 29,400 301 365 1.0000 0.9999 1.0000 20,000 236 365 1.0000 1.0000 1.0000 -222,665 198 365 1.0000 1.0000 1.0000 -179,535 167 365 1.0000 1.0000 1.0000 -232,564 138 365 1.0000 1.0000 1.0000 30,000 107 365 1.0000 1.0000 1.0000 80,000 62 365 1.0000 1.0000 1.0000 DF4 DF5 DF6 DF7 Average Shares 1.0000 0.9999 0.9984 0.9986 152073533 1.0000 0.9999 0.9984 0.9986 24321 1.0000 0.9999 0.9984 0.9986 12971 1.0000 0.9999 0.9984 0.9986 121163 1.0000 0.9999 0.9984 0.9986 82394 1.0000 1.0000 0.9984 0.9986 88194 1.0000 1.0000 1.0000 0.9986 8807 1.0000 1.0000 1.0000 1.0000 13370 efpowa 152424753 Therefore EPS = NPAT/EFPOWA = 25,633,000/152,424,753 x 100 = 17.0 cents per share (b) Price/earnings ratio = Current market price per share/Earnings per share PE ratio = $1.73/17 = 173/17 = 10.3 times Question 9: Dividends (110/100 words) (a) Dividend per-share = Interim + Final dividend per-share 2009 = 3 + 5 = 8 cents per share Dividend Yield = Dividend per-share/Current market price x 100 2009 = 8/173 x 100 = 4.6% (b) After tax dividend yield = After-tax dividend per-share/Current market price x 100 Dividend received 0.08 Gross up imputation 0.08x.03/.07=0.03 Assessable income 0.11 Tax 15% 0.017 Less franking credit 0.017 – 0.03 = (0.02) Excess franking refundable (0.02) After tax dividend 0.08+0.02=0.10 After tax dividend yield = 10/173x100 = 5.8% (c) Dividend cover = Earnings per-share/dividend per-share = 17/8 = 2.1 times IIN has a more than adequate dividend cover exceeding rule of thumb of 1.7-2.0 times. Question 10: Net tangible assets and cash flow (202/200 words) (a) NTA per share = EA – MI – QE / Number of ordinary shares 2009 ($’000) = 18,015,900 / 151,106,288 = $1.2 2008 ($’000) = 161,102,000 / 151,581,652 = $1.1 (b) Although there was an increase in the NTA per share figure from 2008 to 2009 both results are well below the current market price of $1.73 for IIN. This means that the stock market is valuing IIN on anticipated future profit performance rather than the company’s underlying asset value. (c) Cash flow per share = Cash flow from operations/WANO x 100 2009 ($’000) = 49,059,000/152,424,753 x 100 = 32 cents per share 2008 ($’000) = 58,941,000/152,424,753 x 100 = 38 cents per share (d) IIN’s cash flow per share is 32 cents per share compared to its earnings per share which is 17 cents in 2009. The reason cash flow from operations is high is due to the depreciation factor of the huge infrastructure of IIN. In 2008, the cash flow per share was 38 cents. The decrease is attributed to capital expenditure in 2008-2009. Cash flow per share for both the years is very attractive. It is a critical variable in assessing a company. IIN has strong profits and stronger cash flow. Question 11: Conclusions and recommendation (512/500 words) I give IIN a HOLD recommendation, though potential for rerating is high through margin expansion and earnings growth through organic and inorganic means. The 2008/09 financial year reports highlights the sound fundamentals of the company and it position of strength going into the 2009/10 financial year. Key features of the group’s financial year results include (all numbers are $’000 unless otherwise noted): There appears moderate liquidity risk with IIN providing a current ratio of 0.6 (up from 0.4 in FY08) and acid test ratio of 0.4 (up from 0.3 in FY08). Days creditors and days debtors both improved during FY09, down 50% from FY08. IIN’s Net debt to equity ratio is moderate in both the years and there was a further improvement from 2008 to 2009. But, IIN’s Net interest cover (18.4 times) and Debt to gross cash flow (0.5 years) highlighting the ability of the company to carry additional debt comfortably solves the risky situation. Sales revenue was up 67% from $249,850,000 to $417,760,000. NPAT from all operations increased by 17% over the previous period to $25,633,000. EBIT of $38,043,000 was up 27% on the prior period. EPS was 17 cps up 17% on the previous year. Return on Equity increased from 11.8% to 12.7% in 2009 owing to the increase in adjusted NPAT from 2008 to 2009. IIN’s ROA increased from 10.2% to 12.5% meaning the company became more efficient in utilising it’s assets during the period. IIN is the third largest ISP in the telecom industry in Australia. The NPAT result was largely from the core strength of IIN leading on innovation and delivery of content that produced a 123% growth in its Naked DSL customers. Developing alliances with key content partners, IIN has launched new product features every month. The company’s strategy to consolidate by successfully integrating Westnet in FY09 after acquiring more than 30 companies in a mature market has positioned it uniquely to continue leading industry consolidation. Westnet represented the largest consolidation in IIN’s history. Churn rate, a measure unique to the telecom industry is the most sensitive financial lever of IIN. Customer churn, the rate at which customers choose to leave iiNET was down 25 basis points to 1.8% per month. IIN successfully financed its net working capital needed through payment from suppliers. The short-term liquidity and solvency risks are moderate. IIN’s price to earnings ratio of 10.3 is at a discount to the Industrials benchmark of 20.8 times. This is an attractive position for IIN as the profitable company comes priced much lower than the industry average. Looking forward, potential for rerating of IIN is high. In a mature Australian telecom market where the market leader holds 43% of the market share, the possibilities for growth of IIN can only be through product innovation and acquisitions including international alliances and acquisitions. Key risks for the future include the challenges of keeping up with rapid technological changes. The highly competitive market requires IIN to not only reduce its costs but also differentiate itself by high quality and speed. Read More