Large UK Health and Beauty Retailing Company - Case Study Example

1a. Boots Group PLC is a large UK health and beauty retailing company with about 68,000 of employees, operating in 130 countries. To analyse the profitability of the company several profit ratios will be used, such as gross profit margin, and net profit margin. The group turnover in 2005 was 5,469.1 m, which is higher than 5,325 m of the year 2004 (Boots Group PLC Annual Report 2005, p. 53). Reasonably, the increase can be also found in the gross profit: compare 2,518.3 m in 2005 to 2,432.1 m in 2004 (Boots Group PLC Annual Report 2005, p. 53). Gross profit margin=gross profit/turnover The gross profit margin is 2518.3/5469.1=0.46, almost the same as previous year, but slightly higher (0.456 in 2004), which is a sign of stability during these two years. Net profit margin=net profit/turnover The net profit was 501.7 m in 2005 and 550.1 m in 2004 (Boots Group PLC Annual Report 2005, p. 46). The net profit margin has changed from 0.103 (2004) to 0.092 (2005). The following graph supports the information on the changes of group turnover, net profit, and net profit margin throughout the last 5 years. Graph 1: Five year change of turnover and net profit (Boots Group PLC Annual Report 2005, p. 2) Graph 2: Five year change of net profit margin It is important to notice that while the group turnover is increasing (more goods are sold), the net profit are decreasing (non-operating costs are rising), and the profitability of the company is falling. Nevertheless it is high enough in compare with the main competitors: Alliance UniChem had the same net profit margin of 0.022 over two years (Alliance UniChem Key Financial Data, 2005); and J Sainsbury has decreased its net profit margin from 0.031 in 2004 to 0.020 in 2005 (J Sainsbury Financials, 2005). More detailed comparison is available in Appendix 1. To measure the liquidity of the company one should evaluate the company's ability to meet its short-term obligations. Current ratio=current assets/current liabilities Current assets of Boots PLC in 2005 were 1575.8 m, while the current liabilities were 1074.1 m (Boots Group PLC Annual Report 2005, p. 47). Therefore current liquidity ratio for 2005 is 1.47, which means that a company can meet its short-term obligations without serious troubles. The current liquidity ratio for the year 2004 was 1.52, which means the ratio of current assets to current liabilities has decreased - definitely, not a good sign for the company. Looking at the cash flow statement of the Boots PLC one can see that cash inflow from operating activities has significantly decreased from 637.8 m in 2004 to 514.7 m in 2005 (Boots Group PLC Annual Report 2005, p. 48) due to lower operating profit and larger increase in working capital. Still the main cash inflow comes from operating, which is a sign of financial health of a company. Also the company has increased its debt significantly by 668 m (Boots Group PLC Annual Report 2005, p. 64) returning funds to shareholders to make the balance sheet more efficient. Therefore overall closing net debt in 2005 was 594.1 m comparatively to 148.5 m in 2004 (Boots Group PLC Annual Report 2005, p. 48). Long-term debt/equity ratio=long-term debt/shareholders' equity Long-term liabilities of Boots PLC are 588.7 m (Boots Group PLC Annual Report 2005, p. 47). Equity shareholder's funds are equal to 1,609.4 m (Boots Group PLC Annual Report 2005, p. 47). Therefore debt-to-equity ratio is 0.37, which is a low number indicating that a capital structure of a company can be shifted more towards using debt. The high liquidity ratio shows that it is possible to use debt furthermore. 1b. Currently the company's use of retained earnings for financing its operations is low in compare to its use of debt. Nevertheless, high liquidity allows further use debt for financing. The capital structure of Boots PLC is not optimal; the company should take the opportunity of increasing its debt for financing. The other ways of financing operations of Boots PLC can be achieved through the use common or premium stock. 2a. I. 'Dividends as residual' theory implies that a company pays dividends to shareholders only when it is impossible to reinvest the leftover revenues. That is, dividends are paid only when all the requirements on company's internal financing are met. On the one hand it means that a company pays lowest possible dividends to shareholders. On the other hand it means that a company invests all the needed funds into its operations without the excessive use of borrowings. Additionally taxes paid from dividends are higher than from capital gain. Therefore, when a company uses a residual dividend policy, it increases its value, and consequently brings more favour to shareholders. In a given case directors are committed to shareholder's wealth maximization. Applying 'dividends as residual theory' this means a company will increase its value in order to bring more profits and eventually increase the leftover funds for dividends. As can be seen from the increase of profits, dividends and a number of shares the company places its profits in front of dividends, however such policy leads to the increase of both. Quoting on the Alternative Investment Market means that a company is primarily concerned with own expansion and growth. Investing in AIM companies is advantageous because "for tax purposes they are treated as 'unquoted investments' (even though they are quoted)." (Finance Glossary, 2005). Therefore a company achieves maximization of shareholders' wealth through continuous expansion and gradual improvement with a constant or slightly increasing expenditures. II. The signaling theory focuses on the information the dividends bring from the company to shareholders. Dividend announcements contain the information about the future prospects of the company. Therefore, according to this theory, the company will only increase dividends only if it is confident about its future performance (Wikipedia, 2005). In other cases it will keep dividends constant, or even lower them. According to the signaling theory, directors are confident in the future of their company. Doubling the number of shares four years ago, further increase of ordinary shares by 30 per cent two years ago, along with constant increase of dividends and profits rising - all these indicators show a good financial health of the company, and present its shares as a good opportunity to buy. III. The theory of clientele preferences assumes that different types of stockholders choose companies applying dividend policies that are best suited for them. While one type of shareholder prefer high dividends, others are not interested in rapid income - non-paying policy is best suited for them. Therefore a company should apply a certain dividend policy considering the interests of its shareholders. Applying this theory to our case one can see that as the company is quoting on the AIM its shareholders are interested in gradual increasing and stable income from the dividends, allowing them to use the benefits of tax relief on any gains they receive after each year of owning shares. 2b. Required rate of return is 0.065+0.9*0.05=0.11. The expected profit before tax next year will be 12.8 m. Expected dividend per share will be 5.94. The growth rate in dividends is 0.1. Therefore expected share value will be 5.94/(0.11-0.1)=6.4/0.01=594p. Since the current share value is 190m/100m=1.9 it is a good buying opportunity for company's shares. 3a. To determine a historic price/earnings ratio we need to divide the closest known price by earnings of the last year. Therefore, the historic price/earnings ratio is 205/14=14.64. 3b. The estimated future growth rate of dividends if it continues into the future is 7.7%. The future growth rate of earnings will be 7.7%. 3c. The required rate of return is 0.065+1.2*0.05=0.125 3d. 0.125-0.077=0.048. Then the real share value is 7*1.077/0.048=157p. Therefore shares at 205p are overpriced. 3e. The main problem of using historic price/earnings ratio as an analytical tool lies within the fact that this ratio operates with historical data, that is something that has already happened without taking into account current or future trend. That makes hard to use the historic price/earnings ratio for future forecasts. 3f. Valuation of an unquoted share would require multiple of company's profits after tax, analysed in the light of historic, current, and forecasted performance of the company, competitive environment, economic cycle of business. One would still require a price/earnings ratio taken from the quoted sector and adjusted for control premiums and differences in size. 4. Hedging strategies are used to avoid risks related to changes in currency exchange rates. Hedging can be defined as offsetting a certain currency exposure by establishing an opposite currency position. Forward market hedging implies a forward contract, entered at the time the transaction exposure is created, that offsets payables denominated in a foreign currency by forward buying that currency on the initially agreed price. The drawback is that a company may be tied with disadvantageous rates when using forward market hedge strategy. Using the conditions given in the task to describe the forward market hedge, the company signs a contract with the Malaysian seller that after three-month term expiration a company will pay M$600,000 on the exchange rate of M$5.4165/1. In this case the company will have to pay M$600,000, which will be 600,000/5.4165=110,770.If the company had not used hedging it would experience a benefit of 110,770-600,000/5.425=170 in the case of the same exchange rate as projected. However if the exchange rate was, for instance, M$5.4105/1, the forward market hedge strategy would have brought 600,000/5.4105-110,770=130 of benefit. Thus a hedging strategy brings additional costs but protects from negative effects of exchange rates' fluctuations. Option hedges allow a company to take one-sided bets on currency movements. In the case of option hedges a company pays a part now - a premium price, and a part later at a strike price, if a strike price is higher than the future spot price. Thus a buyer in the case of option contract receives the privilege to buy currency at a fixed price. However he pays a premium price for this privilege. But unlike other hedging options, if the future spot price is better than the one provided by option contract, than the buyer benefits. For example, taking the option of M$ 600,000 by the strike price of M$5.425/1 with the premium price of M$ 15,000 the company has to return simultaneously 15,000 M$. After three-months term the Malaysian dollar inflates and your sum of 585,000 M$ is equal to foreign liability of 600,000 M$. Once the liability has been paid off it depends on the spot exchange rate if a company use a strike price of M$5.425/1. In other case, Malaysian currency is bought at spot price and a company exercise. However if an exchange rate is higher than the strike price than a company does not experience additional losses. For that privilege a premium price of M$ 15,000 was paid previously. Money market hedge is about simultaneous borrowing and lending activities in two different currencies to lock in the home currency value of a foreign currency cash flow. Money market hedge strategy is implemented when borrowing in home currency, performing currency transaction on the spot market and depositing a sum in foreign currency. When the term passes, the deposited sum should inflate and equal the foreign liability. The only liability left to be paid is the interest of the initial borrowing, which can be eventually perceived as the price of money market hedge. For instance, put in the context of the given conditions a company needs to pay 600,000M$ in three years when the interest rate is 3%. Therefore, today a company needs 600,000/1.03=582,500 M$. Borrowing today a sum of 107,500=582.500*1/5.4165 (spot rate) and exchanging into deposit of Malaysian dollars will match with payment of 600,000 M$. However, the company will need additional 0.03*107,500=3,225 to repay the loan taken in sterling. This is the cost of money market hedge. At the same time the company eliminates the risk of higher than expected inflation that would lead to the increase of Malaysian price. References Alliance UniChem Key Financial Data. (2005). Retrieved December 24, 2005 from http://investors.alliance-unichem.com/auc/fd/kfd/ Boots Group PLC Annual Report. (2005). Retrieved December 24, 2005 from http://www.boots-ir.com/boots/companyinfo/reports/ar05/ar05.pdf. Finance Glossary. (2005). Alternative Investment Market. Retrieved December 24, 2005 from http://www.finance-glossary.com/terms/Alternative-Investment-Market.htmginPtrCode=00000&id=45&PopupMode=false J Sainsbury Financials. (2005). Retrieved December 24, 2005 from http://www.j-sainsbury.co.uk/index.asppageid=206 Wikipedia. (2005). The Dividend Decision. Retrieved December 24, 2005 from http://en.wikipedia.org/wiki/The_Dividend_Decision Appendix 1: Main Financial Data on Boots PLC, Alliance UniChem, and J Sainsbury Boots Alliance UniChem* J Sainsbury Group Turnover, m 5,469 10,605.9 16,573 Operating Profit, m 501 234.9 321 Cash inflow from operating activities, m 232 310.1 936 Earnings per share, p 45.7 47.7 3.5 Dividend per share, p. 30.1 18.5 7.8 * Data for Alliance UniChem is available only for 2004. Read More