Business Operations of Sainsbury Plc - Research Paper Example

? Valuation of Sainsbury and writing the report Table of Contents Table of Contents 2 Motives 3 Future of retail- 4 Valuation of Sainsbury 5 Financing 12 Recommendation 14 Bibliography 18 Motives CF Inc is a large sized retail company with worldwide operations. However, the company is facing issues like falling profitability and rising competition in the key markets. Despite the financial soundness of the company it has failed to get the attention of the market participants. The waning confidence of the investors has resulted in depressed valuation of the company. The low valuation of the company exposes it to dangers of potential takeover target. To enhance the value of the company the board is thinking of measures to improve the company valuation. There is an increased perception that the company will be able to benefit from geographical diversification and to improve its image in the market. The company management has come up with the idea of acquiring the UK based J Sainsbury Plc in a bid to improve the valuation of the company. The companies listed on the London Stock Exchange exhibit high level of compliance to corporate governance and corporate social responsibility practices. The domestic companies are mandated to adhere to the corporate codes and ethics. If a company fails to comply with any particular code then it has to explain the reason for the non-compliance. This ensures transparency in financial reporting and makes the financial reports of the company more credible. The retailers in the European region have a strong brand image and are highly responsive to the requirements of the customers. The major retail chains in UK like Tesco, Sainsbury are mature and are continually expanding internationally as well as in terms of wider range of products and services. The retailers in the country are diversified in the true sense with some of them even engaged in financial services. Even Sainsbury is involved in banking services. The movement of the retail chain into financial services is a type of horizontal diversification (Welch & Worthington, 2008). Sainsbury is a UK based company with a diversified range of products and services. By the acquisition of Sainsbury, CF Inc will be able to make a foray in the European market. The primary activities of Sainsbury are retailing in groceries and other related items. The company also has an alliance with the Lloyds Banking Group in financial services (Reuters-b, 2011). In the recent financial crisis the retailers across the world witnessed a fall in the net income owing to the reduced consumer spending. With the rebound in the economy the performance of the retail industry is expected to improve. The economies across the world are slowly on the way to recovery. With a rise in the level of economic activity it is anticipated that there will also be arise in the disposable income of the consumers. This is likely to have a positive impact on the retail businesses as well. The consumer demand is expected to rise with the increase in the income level. It is expected that the consumers will increase their retail spending which will also boost the earnings of the retail businesses. Future of retail- Advancement in technology like internet facilities has made retailing an exciting and challenging field. The recent fundamental changes have altered the ways and mechanism of retailing. Despite this retailing is necessary in some form or the other. For instance though the manufacturers are now able to sell directly to the consumers through online system but still it is difficult for the consumers to make all the purchases online. The traditional retailers operating through physical stores would still be necessary. This is because for some products the consumers are convinced only after a thorough examination of the product before purchasing it. In some cases the experience of going to the retail store is as important as making the purchase (Harris, 2000). Valuation of Sainsbury The fundamental analysis involves valuing a company based on important financial parameters. If the intrinsic value of a company is more than the market value then the company is said to be undervalued. An investor can benefit by taking a long position in the shares of the company (Dash, 2009, p.158). On the other hand if the intrinsic value of the company is less than the market value then the company is said to be ‘overvalued’ (Mosquera, 2010; Keown, 1998, p.179). . To make a gain out of this mispricing an investor can initiate a short position in the stocks of the company. The methods of valuation of a company include- dividend discount model, free cash flow equity approach, free cash for flow firm approach and relative valuation. Sainsbury has been valued using the free cash flow for equity (FCFE) approach and relative valuation method. Under the FCFE approach the forecasted free cash flow is obtained by deducting the forecasted capital expenditure and depreciation and any change in working capital from the net income available to the equity investors (Correia, et al., 2007, p.23). Here the growth rate used can be based on the past growth rate in sales or net income. For the valuation of Sainsbury the growth rate has been taken as 5.32%. This is the average growth rate in the revenues of the company over the last four years. Estimation of sales growth rate- 2011 2010   2009 2008   2007 Sales 21102       17151 CAGR 5.32%         The average growth rate in net income over the five years is calculated as 18%. This rate is higher than the estimated cost of equity. For this reason this figure has been ignored. The risk free rate is taken as 3.65%. The beta of the company available from the financial website ‘Reuters’ is taken as 0.71. The beta of the company is less than one indicating that it is a defensive investment (Bodie, et al., 2009, p.312). In other words the share price of the company increased or decrease less than in proportion to the market movements (Business Valuation Resources, LLC, 2007, p.171). The market risk premium is taken as 5% and the rate of tax is taken as 30%. Here the market risk premium is the excess return offered by the market over and above the risk free rate of return. When this figure is adjusted with the market beta it gives the risk premium of the stock (Hunt, 2009, p.44). The cost of equity is estimated using the following formula- Re = Rf + (Rm-Rf)*? Cost of equity (Rf) = 3.65%+5%*0.71 = 7.20% It is assumed that the capital expenditure and depreciation increase in the same proportion as sales. This assumption is based on the logic that any rise in sales is accompanied by a corresponding increase in capital expenditure and depreciation. It is because to enhance the level of production the company will have to invest in fixed assets. If the investment in the fixed assets increases there will also be a matching rise in the level of depreciation. The forecasted current assets and current liabilities are also assumed to maintain their proportion to sales. As the sales grow by 5.32% even the working capital of the company is expected to rise by the same proportion. The capital expenditure and depreciation for the year 2010 and the forecasted depreciation are given below-   2010 2009 Capital expenditure 1036 966 Depreciation 466 453 The forecasted level of current assets and current liabilities of the company are shown below-   2010 2009 Forecasted Current Assets 1,797 1570 1892.5903 Current Liabilities 2,793 2919 2941.572 Working capital -996 -1,349 -1,049 The forecasted net income of the company is calculated as ?674 million. The forecasted capital expenditure and forecasted depreciation is taken as ?1091 million and ?490 million respectively. The working capital is forecasted as (-) ?1049, implying that the company actually indulges in very fast cash flows which leaves it with a negative working capital. Although a positive working capital is likely to invoke perceptions about the company’s robustness, it might not entirely mean that the company is at a loss when it submits a negative working capital in all. The change in working capital is calculated to be ?53 million. After adjusting these figures with the forecasted net income figure we get the free cash flow for the equity holders. Only the equity portion of the forecasted capital expenditure, depreciation and change in working capital is deducted from the forecasted net income. This is because the expenses of the company are financed by a mix of equity and debt. The market value of equity is given as ?6924.5 million and the market value of debt is ?2416 million. From these figures the weight of equity and debt has been calculated as 0.74 and 0.26 respectively. Weight of equity 0.74 Weight of debt 0.26 The amount adjusted form the forecasted net income is calculated as- (Expected Capital expenditure – Depreciation + Change in working capital)*(1- weight of debt) (DePamphilis, 2003, p.338). = (?1091m - ?490m +-?53m)*.74 = ?405 million This amount is adjusted against the forecasted net income to estimate the free cash flow for the equity. The free cash flow for equity is then discounted using the cost of equity to obtain the intrinsic value of the equity. The value of the equity is then divided by the number of outstanding shares of the company to estimate the intrinsic value of each share of the company. The total number of outstanding shares of the company is obtained from Reuters as 1871.46 million (Reuters-a, 2011). The expected FCFE of the company is calculated as ?268 million. This is then discounted using the following formula- Value of equity= FCFE/ (Re-g) = 268/(7.20%-5.32%) = ?14265 million The total value of equity of Sainsbury is thus estimated as ?14625 million. This is divided by the outstanding shares of 1871.46 million to obtain the per share price. = ?14265/1871.46 = ?7.62 = 762 p. Expected PAT   674.0444 Forecasted Capital expenditures   1091.109 Forecasted depreciation   490.7886 Change in working capital   -53 Expected FCFE   268.2792 Value of equity   14265.92 Shares outstanding   1,871.46 Value of equity (in pound)   7.62 Value of equity (in pence)   762 The intrinsic value of the shares of Sainsbury is 762p. This is higher than the prevailing market price of 343p (London Stock Exchange plc-a, 2011). This shows that the share of the company is not correctly priced by the market participants. As per the FCFE approach the shares of the company are undervalued. To make a gain out of this temporary mispricing the investor can take a long position in the stock of the company. The FCFE approach is a reliable method of equity valuation. However the forecasts are entirely based on estimated growth rate of sales. In the event of a fluctuation in the level of sales in the future due to changes in market conditions the valuation of the company will also get affected. This is said to be one of the major limitations of the FCFE approach. To overcome this limitation the relative valuation approach has been used. The fundamental valuation relates to discounting the forecasted figures like the cash flows, dividend etc whereas the relative valuation approach specifies the firm value as based on the average fundamentals of similar companies (Nissim, 2011). Here the Earnings per share of the company is adjusted with the average EPS of the industry to estimate the actual value of the shares of the company (Tang, 2002, p.100). Here the PE ratio of the market has been taken as 10.41. The EPS of the company for the year 2011 is 34.40p. This is multiplied with the average PE ratio of the market to obtain the value of share. This is estimated as 358p. Relative valuation- PE ratio of industry   10.41 EPS of Sainsbury   34.4 Estimated Price   358.104 (London Stock Exchange plc-b, 2011). As per the relative valuation approach the real value of the company’s share is higher than the prevailing market price. In other words the shares of the company are underpriced as per this approach as well. However the extent of undervaluation under this approach is less than the FCFE approach. This method considers average figure of the industry. The advocates of this method are of the view that the use of industry average makes the valuation more representative and reliable. As the industry average is computed by taking account of the figures reported by all the major companies in the industry. However even this method suffers from various problems. It is argued that the average figure of the industry may be depressed or exaggerated due to market conditions. Therefore the use of industry average may not yield correct results. Moreover it is possible that the average figure in the industry is computed using only some of the major companies thereby ignoring the figures reported by the other companies in the industry. The inclusion of only the leading companies may result in overstated figures which can again hamper the valuation of the company. As a result even this method cannot be considered to be full-proof in the estimation of the value of the company. Financing The acquisition bid can be financed by a mix of equity and debt (Sherman & Hart, 2006, p.142). The company can raise money from the public by issuing new shares in the market. It can opt for the rights issue route. In the case of a rights issue the company can issues hares to its existing shareholders (Ahuja, 2008). The success of this mode of financing depends on the relations build by the company with its investors over the years. If the company has regularly generated good returns for its investors then it is not likely to face any hurdles is the issues of rights shares. But it may not be possible for the company to finance the acquisition entirely by equity. In such situations the company can tap the banks and financial institutions for financial assistance. Since the company has been operating over a considerable length of time it must have build an image for itself in the market. It can capitalise on this image for the purpose of generating funds from the financial institutions. As the company is a listed entity it is not likely to face any hurdles in convincing the banks for raising funds. The financial reports of the company are prepared as per the prevailing accounting norms and practices. This makes their reports even more reliable as the banks and financial institutions look into this aspect at the time of granting funds to a company. The company has a wide geographical base and has been conducting business for quite some time. This will also work in the favour of the company and make it easier for the company to access funds for the acquisition bid (Broyles, 2003, p.208). The company wishes to use these funds for financing its takeover of Sainsbury. As per valuation techniques used for estimating the intrinsic value of Sainsbury the share of the company is underpriced by the market. Therefore, if the company acquires it now it can reap good returns in the future. The valuation of Sainsbury can be used for convincing the investors that the funds raised from them will be invested in a profitable avenue. This will make it easier for the company to approach the banks. The banks scan the prospective investment at the time of giving loans. Here the high valuation of the company can be used for convincing the financers. The company can also finance the acquisition by using the retained earnings of the business. The company does not distribute the entire earnings to its shareholders rather it keeps aside a significant portion of its earnings. The money that is ploughed back in the business can be used for financing the future business expansion of the company. Most of the companies use the internal sources for funding the growth opportunities. This mode of financing does not require the company management to depend on any external assistance. However, the company cannot rely entirely on the internal sources for financing overseas acquisition. This is the reason the companies generally deploy a mix of all these sources. The company can seek financial assistance from the domestic financial institutions. In some of the recent acquisitions of UK companies the banks and financial institutions based in the country funded the bidding company. Another method that is adopted by a company is disposing off its existing businesses. It has been seen that the company opts for divestitures or selling off its non-core or unprofitable business ventures for financing the business acquisitions An excessive reliance on debt should be avoided as this can burden the company in the later stages. It has often been seen that the acquiring company gets overburdened by the cost of acquisition making the entire acquisition process a ‘huge loss’. So it is important that the company uses all the sources of financing judiciously and weighs the pros and cons carefully. The company management should make a careful assessment of the costs associated with the various modes of financing at the time of procuring the finances. Recommendation The acquisition of UK based retail chain Sainsbury Plc appears to be a viable investment proposition. The use of the valuation techniques like FCFE approach and the relative valuation approach justify the acquisition bid. As per the valuation techniques the shares of the company are mispriced by the investors in the market. The intrinsic value of the share of the company is higher than the prevailing market price. In the case of FCFE approach the intrinsic value of the shares of the company is almost twice the prevailing market price. Even in the case of relative valuation approach the value of the shares of the company is more than the current market price. Therefore as per the valuation tools the acquisition of the UK based retail chain is a viable investment opportunity. Moreover, by this acquisition the company will be able to enhance its geographical coverage. Already the company has retail businesses in several countries across the globe. The acquisition of Sainsbury will further diversify the business of CF Inc to the European region. There is a good trend for the retail market in the European region. The consumers in this part of the globe are specific about the quality of the products and are said to be brand loyalists. If the company is able to build a name then it will enjoy the patronage of the British consumers. This will keep the revenues of the company flowing even in times of depressed market conditions. The company has sufficient resources in place to improve the business operations of Sainsbury Plc. By lowering the cost to sales ratio the management of the company will be able to generate higher value from the Sainsbury acquisition deal. The company can finance this acquisition by a combination of debt and equity. It can tap the banks in UK for funding some portion of the business acquisition. 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