QUESTION

You are required to submit an answer for

Section A: Equity Investment report AND

Section B:  A report to the CFO of Meesrog Ltd

Section A carries 75% of the marks for the assignment and Section B carries 25% of marks for the assignment.

There is a word limit of 2700 words (excluding appendices) for Section A and 800 words (excluding calculations) for Section B. Total word count 3500

Section A: Equity Investment Report

Holmes and Watson Investment Management Limited is a leading, independently owned, financial and professional services company. Holmes and Watson look after the financial affairs of individuals, families and firms.

You work as an investment analyst for Holmes and Watson. A colleague, Nicola, works in the wealth management department. She has two clients who have expressed interest in making an investment in the equity of a specific company, hereafter the target company and you have been asked to prepare an equity investment report on the target company.

Nicola’s two clients are:

• Caroline – a successful entrepreneur who has a young family. Caroline is a higher rate taxpayer, so although she has some income requirement is more interested in medium risk capital growth potential from her investments.
• Richard – a retired accountant who has agreed to finance the education of his grandchildren and therefore needs a steady income stream but also requires long-term financial stability and if possible capital growth.

Assessment Instructions

Your assessed task is to write an equity investment report on the target company to which you have been allocated. The conclusion of your report should consider the attractiveness of an equity investment in the target company for both Caroline and Richard.

You must base your main analysis on the 2018 Annual Report of the Company which will available on mywbs and from the relevant corporate website, this can also  normally be found under Investor relations sections as reports, you should access these websites as there is a wealth of additional material which will enrich your analysis.

You should include the below data and discussion of the following:

(Show all your workings in excel separately attached)

• Outline of operations and strategic and operating policies and critical appraisal of these policies and of the Company’s success in achieving its aims
• Discussion of economy, market or other contextual information
• Identify any accounting quality issues (such as key figures in the financial statements or key accounting policies or changes that the company mentions in the AR) which you believe deserve the attention of investors.
• Horizontal analysis of financial accounts
• Ratio analysis of financial accounts ( you should construct your own ratios and NOT simply use those published by the Company or any other on-line source)
• Trend and segmental analysis if relevant
• Use of the information provided in the notes to the accounts
• Comparison of the above with a suitable competitor company or industry wide data
• Use of the information provided in the notes to the accounts
• Critical analysis of the Company’s own narrative reporting on the financial performance and position
• Market analysis of the Company’s current share price and other investor ratios, you should compare the Company to other market performance as appropriate.
• A summary of your analysis together with a discussion of the investment from the perspectives of the two clients.

You should include any detailed calculations in the Appendices to the report so that they will not be part of the word count (see below)

You are encouraged to bring any other relevant information news items, company briefings, financial up dates, analysts’ comments) which you can find.  In particular, the London Stock Exchange website is an excellent starting point and you should use the Company’s own website.

Remember you are providing a report to a very busy (and wealthy) client who is paying for your services. You should not go into lengthy “text- book” explanations of HOW you arrive at your ratios unless you have adjusted the company’s own figures and think it is important for the client to understand the implications of this. If you have key calculations which involve manipulation or correcting accounting distortions these should be only briefly explained.

The client will expect critical, well-reasoned analysis and for you to concentrate on the important information.

Marks will be awarded based on your ability to provide Nicola with a report that she can share with her clients. You need to give clear recommendations backed up by evidence and the essential information needed to back up your recommendation.

Remember Holmes and Watson provide a professional advisory service to high-level clients who expect relevant and decision useful analysis and not general discussion.

End of Section A

Section B

Meesrog ltd is a technology company that designs products for what it calls “broadband improvement services”. It has spent $850,000 over the last 2 years designing a product which ensures broadband is distributed throughout larger properties such as offices and houses (such as those used by students or large families).  It is very pleased with the development so far and is now considering bringing it to market with the name “Homeband”.

Each Homeband unit will sell for a price of $250 per unit and demand is expected to be 5,000 units in the first year. In subsequent years Meesrog is planning to sell internationally so sales are expected to rise by 20% a year for the next 5 years.

Meesrog will buy in all the components and will then do the final assembly in house.  The cost for components is estimated to be $85 for each unit of Homeband.  Packing and distribution is estimated at $5 per unit.  Assembly will take the 4 hours per unit and labour will be hired locally at a rate of $18 per hour. As this is a technical product 5 employees on existing production lines will need to be transferred to the Homeband production line for the first year to carry out supervision and training. These 5 supervisors are currently paid an annual salary of $40,000 each which will continue. They will be replaced on the existing production lines by 10 current employees who will be paid an additional salary of $5,000 each during the first year for taking on the additional supervision responsibilities. Once production goes above 7,200 units pa an additional machine will be needed. This will be leased for $100,000 pa payable at the start of each year of the lease.

Meesrog will need to buy some new machinery if it goes ahead with this project and this will cost $1,200,000. This machinery will be sold at the end of the five years for an estimated $400,000. Meesrog uses straight-line depreciation for all its plant and equipment.

The production line will be located in an existing factory unit for which Meesrog currently pays $150,000 pa for the lease which has 7 years still to run. The unit is currently sublet to a storage company for $200,000 pa (payable at the start of each year) but once production expands to around 7200 units, the storage company will have to be evicted to make space for the additional level of activity. The only other costs are the power requirements for the plant of $120,000 pa per machine.

Meesrog estimates its cost of capital at 14%. Projects are usually evaluated over a 5 year life and are expected to earn a return in excess of 20%. (Normal operational cashflows can be assumed to occur at the year end unless specifically stated otherwise.)

Required

Prepare a brief report for the CFO to present to the Board on the viability or otherwise of the Homeband project.

End of Section B

___________________________________________________________________________

ANSWER

Part A

About

Redrow Plc is the largest housebuilder company of Britain. The main business of the company is to acquire land, develop a housing project on that piece of land and sale those houses to the customers. Founded in the year 1974 by Steve Morgan, the company is headquartered in Flintshire. It currently employs around 2300 workers and is listed on London Stock Exchange, being a constituent of FTSE 200 index.

Business Model

The company works on a very simple model of buy build and sell. But as simple as it sounds it is far more complicated. The very basic essence of a housing industry is the land on which the housing society or an individual house is built. Therefore, land is a very important factor and the company has a dedicated team to identify the piece of land on which they want to build a housing society and do the feasibility study of that particular area, whether such area can is liveable and in demand along with the financial feasibility study in which the cost of the land and the cost of construction is taken into consideration along with the sale of the housing project to the ultimate consumer to conclude whether or not the project is profitable or not. But the company did not become the largest homebuilder in Britain by just following this particular business model. The most unique feature of the company is their placemaking skills, which mainly involves setting of the house to an individuals liking as well as designing and developing the surrounding landscape in such a manner that the local communities can be easily connected to the new developing projects. Lastly, and the most important thing for a homebuilder company is to maintain its finances. Like a typical business, this business also requires huge investment upfront and has to wait to test the success of the business for a long time. For instance the time, the company decides to acquire a piece of land to the time the houses are ultimately sold to the end customer, is pretty long and the company has to make investment in the land at the starting of the project, further investment into the construction of the project and then the company will be able to generate funds by selling those properties to the home buyers. Over the years the company has good established relationship with the banks which helps to company to easily manage the finance in such a money driven business.

Operations

The business of the company is mainly developing homes. For that part of the business the company only operates in Britain. The company has divided the country into various geographical segments and these geographical segments are further divided into smaller segments. In total the compay recognizes 15 operating divisions which are evaluated on their individual performance. The company also has various investment in subsidiaries and joint ventures. The stand out of those investment is the investment by the company in the subsidiary named Harrow Estates which is a company’s arm that focuses on the entrepreneurial side of the property. That is Harrow Estates cater to the businesses and commercial property requirement of the clients. The company basically uses its vast experience of residential land acquisition and applies the same by developing and redeveloping the prospective lands for the purpose of resale.

Industry

The company exist in a country which is going through the most turbulent economic time of this era. Britain as well all know is going through the period of Brexit, but what no one knows is what the terms of Brexit would be. And like every company that operates in European market, Redrow is not confident about whether the terms would be favourable or unfavourable for the company. It is predicted by most of the financial pundits that the Brexit would lead to a downturn for the Britain’s economy and if that is the case the housing industry will be on the downside. The simple reason for this is, if the economy is on the downside the purchasing power of an individual decreases and thus the demand for the houses decreases. Therefore, this would lead in a sharp fall in the price of the house. Redrow, which would have purchased the land at higher rates would be demanding the higher prices for its premium property which the consumers wont be able to pay and thus the company would be left with only two options either to decrease the prices of the house or hold the inventory to sell once the market revives. Both the options are not looking good for the company. But this is short term jerk, as the company operates in an industry which is highly correlated with the business cycles. Once the British economy recovers from the jerk of Brexit, the company is expected to perform better.

The annual report of the company confirms the downturn in the housing industry of Britain. It states that even though a new proposal of National Planning Policy Framework was approved by the government, the approval rate of the applications for the house was down by 2% which clearly is against the policy decided by the government to be able to speed up the delivery of houses across the country. The annual report further goes on to say that the mortgage approval remains the key indicator to measure how the housing industry is performing in a country. As we can see from the given data in the annual report because of the increase in the interest rate across the country the mortgage approvals have fallen and is lowest among the last three years. Similar is the case with the housing supply and residential transaction which have fallen year on year basis.

One thing that can be said about Redrow is that the company operates in an industry in which the profit is highly dependent on the external factors. Whatever a company will do they just wont be able to create demand for the houses by themselves. Also, this industry is highly regulated industry with a huge interference by the government. Having said that the company has been able to outperform the industry in past two years.  The company’s year on year growth rate of earnings has been on the positive note for the past five years with a CAGR of 34.6% which is way ahead against the industry average of 23.6%. The return on equity of the company as per the recent financials is round about 21.1% which is quite higher than the industry average of 16.3%. Even though the company has been able to outperform its peers does not necessarily means that the company will be able to repeat the same in the coming years. The Brexit being the biggest issue for the British companies right now, the investors are still vary of the impact of the Brexit on housing industry which is very hard to predict given the recent development on the Brexit.

Management

The management of the company went through a major change recently. The founder and the executive chairperson of the company, Mr. Steve Morgan decided to step down from his responsibilities after 10 years of returning to the board of the company. Mr. Morgan originally stepped down in the year 2000 from the board of the company but in the year 2009 when the company was facing financial trouble and the shares of the company went below 100p, he was asked to re-join the board. Getting him back on the board worked for the company as he was able to turn a GBP 140 million loss into GBP 43 million profit within few years. His stepping down at a crucial juncture would be a great detrimental factor for the investors. His position is fulfilled by John Tutte who joined the board of the company in the year 2002 and has been the group chief executive since 2014. It would be interesting to see what policies the new management would follow, whether they would follow the principle laid by Mr. Morgan or try to bring changes into the working of the company.

Accounting Quality

It is hard to comment on the accounting quality by just looking at the annual report as they do not contain any detailed accounting information. As per the overview of the financial statements the company is following IFRS with utmost care. Moreover, the auditors of the company are Price Waterhouse Coopers a leading audit firm of the world.

The only aspect in which raises some serious questions is relating to the valuation of inventory. So the inventory for the company is land and as per the company they use various multiples to arrive at the price of that land at the end of the year. The auditors comment on the same are not that clear and this is a grey area in which there could be a possibility of fraud. The company can over estimate the value of land thus increasing the profit of the company for that particular fiscal year. Therefore, any investor before investing should look into the manner in which the land has been valued by the company.

Financial Statement Analysis

Starting with the income statement of the company, the sales have increased year on year by 15.67%. But looking at the income statement vertically things have not changed that much. The cost of goods sold have remained at 75.6% of the sales. This shows that the company has not been able to enjoy the economies of scale. Generally, as the sale of the company increases the gross profit margin increases but in this particular case the sales of the company have increased by 15.67% year on year but the same has not resulted any increase in the gross profit. On the upside, the selling and general administration expenses have decreased by 0.5% of the sales, this comes on the backdrop of 15% increment in sales is a good positive for the company. Other good thing for the company is the decrease in the interest expense in terms of sales. It has been already established above the reliance of company on proper ways of financing its projects. Interest being a fixed type of expense can put burden on the financials of the company. But over the course of one year the interest expense has decreased in absolute terms as well as in relative terms to sales. On and all nothing much has changed in the income statement other than increase in the revenue and simultaneous increase in all other items as per the revenue.

Looking at the balance sheet one would look at a very peculiar thing in the assets side of the balance sheet. That is the percentage of inventory in terms of total assets. In both the years under consideration the percentage of inventory in terms of total assets is around 92% which is pretty high but given the nature of the business that the company is involved it is justified. The inventory of the company is comprised of land which is valued by the company at the end of every financial year as per the assumption made by them and going market trends. As stated earlier investor must be aware of the valuation technique used by the company as there is a high probability of fraud in this particular domain. There is nothing much on the asset side of the balance sheet.

Coming to the liability side the strongest ability of the company is visible here. The company has almost become a debt free company in the year 2018 which is a great thing given the economic scenario that is about to be followed post the Brexit terms are decided. The company is mostly financed by the retained earnings. Moreover, lack of debt in the balance sheet gives the company ability to undertake new projects with the help of debt.

Ratio Analysis

The overall ratio analysis of the company gives the same picture as given by the above analysis of the financial statements, that the position of the company has not changed much the previous 2 years.

Liquidity Ratios

The current ratio of the company is around 3.2 which according to me is pretty high, the company can undertake more of short-term debt to woo the customer, such as giving credit to the customers when they purchase the house. But on the contrary side the quick ratio is pretty low, if the all the short-term liabilities come up, the company will have a hard time paying all those liabilities. Management of current asset is a very important for the company specially when 93% of the assets is made up of current assets. Therefore, the company should look into the current asset management to increase the profitability.

Turnover Ratio

Given the high inventory cost of the company, the company has a decent inventory turnover ratio. But one could argue there is still a probability of improvement in this particular ratio which depends on how one assesses the given situation.

Coming to asset turnover ratio, the company has low asset turnover ratio and can generate more sales on the same amount of assets.

Receivable turnover ratio tells a different story as compared to the other two turnover ratios, it is pretty high and that means the company is not selling much on credit.

Leverage Ratio

The company in the year 2018 has been able to drastically reduce the leverage, the results of which is clearly seen in all the three-leverage ratios. One could argue that taking on debt could increase the Earnings per Share to a shareholder but given the current it would be good for the company to go debt free.

Profitability Ratio

From the above analysis of the financial statements we were able to conclude that even though the revenue has increased in absolute terms the profitability of the company in terms of revenue have remained the same. The profitability ratio reiterates the fact that during the two years there was an absolute change but not a relative change. A relative change can be seen in the return on equity of the company as from 2018 onwards the company has started using more of equity and reduced the use of debt thus the return on equity has fallen over the two years.

Share Performance

The share of Redrow is up by 109% in the last 5 years. As compared to FTSE 250 (of which the share is constituent) the share has given far better returns. During five years of share price growth, Redrow achieved compound earnings per share growth of 34% per year. The EPS growth is more impressive than the yearly share price gain of 16% over the same period. Therefore, it seems the market has become relatively pessimistic about the company. But if we take dividend into the picture the share has outperformed every major share. Taking dividends into account the total return from the share in last 5 years is 154%.

Final

For the purpose of investment this share is bit tricky to finally conclude whether to buy or not. The share has climbed 109% in the past five years, one could say the share has realized all its value and there is not upside potential. Also, given the Brexit deal is around the corner and everyone thinks that post Brexit, the British economy would go into depression the housing market would be the worst affected and thus another downside of buying this share.

But on the contrary the company has good balance sheet and has been able to become a debt free company, and now that the company is looking for various diversification strategy one could say that the share has strong upside in the long term.

My final words would be if someone wants to buy the share for short term than this is not the right share but if someone wants to buy for long term than according to me this is the perfect share.

For the above two clients, I would recommend the share to only Caroline. This is because Caroline has long term horizon and wants to invest in medium risk company. Richard on the other hand is a retired accountant and his horizon wont be as long as Caroline’s.

Part B

To,

CFO Meesrog Ltd.

Dear Sir,

I have made a report on the financial feasibility of our new product, called “Homeband”. As you are aware that we are planning to launch this product for the domestic customers next year and for the international customers in the year to follow.

Our company has invested around $ 850,000 on the development of this product for the past two years. Even though this is quite a significant amount of money, the amount is still no considered for the purpose of evaluation of the project. This is because this is a sunk cost and whether we choose to start the production of Homeband or not, we have already incurred this cost and our future decision are not related to this particular cost. Therefore, for the purpose of the evaluation of the product Homeband we have not considered the development cost.

As per our sales team analysis we are expected to sell around 5000 units of Homeband in the first year itself. These units are expected to sell at a price point of $250 per unit. The sales are going to increase at the rate of 20% for the next 5 years in terms of units. Please note that, as per our sales team estimates, the selling price will remain the same over the next five years.

The production team has given the quote regarding various cost that would be incurred to make a final unit of the Homeband. This would include the components that would be procured at the rate of $85 per piece and every unit of Homeband will have one unit of this component. Additionally, labour would be required to assemble the product in the factory and it would take around 4 hours to assemble this product. The labour is available at the rate of $18 per hour which would mean, to make a unit of Homeband $72 would be spent on the labour. Lastly, the product would be required to be packed and shipped to the customers location and that would cost around $5 per unit of Homeband.

This gives a total variable cost of $162 per unit of Homeband. With selling price at $250 per unit the contribution per unit comes out to be $88 per unit. Here the thing to note is that this will remain constant over the course of 5 years which is bit strange.

During the first year of production, 5 supervisors would be required to supervise and train the staff involved in the production of Homeband. These would be transferred from some other production line, where the supervision work would be transferred to 10 employees by paying them $5000 more. In and all, because of production of Homeband the company will incur only $50,000 more for the first year in terms of supervisors. The salary of the supervisor does not matter here.

A new machine would be leased at the start of the year 3 (or one could say at the end of year 2) and the lease of $100,000 would be paid at the start of the year 3, 4 and 5. There would be one machine that would be purchased for the purpose of production of this particular product. The machine would be purchased for $1,200,000 at the beginning and would be sold for $400,000 at the end of 5 years. The depreciation on the machine does not matter here as the tax rate has not been given. Had the tax rate been given we could have taken the advantage of tax-deductible nature of depreciation. Electricity charges would be paid on two machines differently, on the machine that was bought at the starting, electricity charges would be paid at end of all the 5 years at the rate of $120,000 per year. On the machine that is being leased, electricity charges would be paid for 3 years at the end of the year 3, 4 and 5.

The leased space would be used from year 3 onwards and thus the lease payments that we were getting at the beginning of the year would from year 3. Which means we wont be getting lease payment at the beginning of year3, 4 and 5. After the completion of the project the area would be sublet to another company.

As per my estimate we should not go ahead with proposed production of Homeband. This is because the NPV after taking all the above consideration comes around $-130,000 which means that at cost of capital of 14% we should straightaway reject the proposal. We can only accept this proposal if we are willing to reduce are cost of capital to around 10%.

Appendix 1

Appendix 2

Scenario Analysis