In this post module work, a detailed analysis of Henry Boot PLC for the financial year 2008 is presented by examining their annual report in detail. The work mainly consists of:
The press releases and press commentaries on results have been referred to wherever appropriate.
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Henry Boot Group is a Sheffield-based organisation which is one of UK’s leading players in property and construction (Annual Report, page 2). The company was founded in 1886 by Henry Boot whose direct descendant, Jamie Boot, is the current Managing Director. The Boot family owns about 20% of the company’s shares, either directly or in trust (https://business.timesonline.co.uk/tol/business/specials/rich_list/article3815317.ece, Sunday Times, Dt.12th Feb 2010). The company transformed from a pure play construction company to a firm with interests in property development, land management, construction and plant hire in the 1990s (https://www.henryboot.co.uk/corporate/history.aspx?s=corporate&p=history, Henry Boot PLC, Dt.12th Feb 2010). The group today consists of the following four trading subsidiary companies: The first two companies listed have endured a rough market in 2008 because of falling property rates and decrease in demand. These two companies have had to significantly downgrade the values of their inventory and book losses due to the economic downturn. Construction hasn’t suffered as much because of its reliance on centrally funded contracts under initiatives like Decent Homes and Prison Alliance. Plant Hire has seen a drop in demand but is still in the green (Annual Report, page 8).
Before looking at the financial performance of Henry Boot for the year 2008, it is useful to have a look at its performance over the past five years to provide a background for comparison and analysis. Since the annual report for 2008, didn’t have a five year review, the annual reports of the past 5 years have been used to get the financial numbers in this section.
As can be seen from the graph and table above, the revenue and cost of sales for Henry Boot have seen an upward trend in the past five years except for the year 2007 when both parameters fell. It is interesting to note that the property market in which Henry Boot operates has been seeing problems since 2007. In discussion later in this work, it can be seen that the rise in revenues for 2008 was more on account of profit booking by selling off inventory at the price available than a sign of a genuine sustainable trend. Cost of sales for a property developer and real estate player like Henry Boot consists of the initial cost paid to acquire the property, the money spent to develop it and in constructing structures. Cost of sales for Henry Boot isn’t as reliable a measure as it is for say a manufacturing firm, but is still quite indicative of the market conditions. Revenues generated from a property, through sale or rent, reflects two aspects – first the inherent quality of the property (which is more or less captured by cost of sales) and second the bullishness in the market. The years 2005 and 2006 were the boom years for the real estate market (https://www.lloydsbankinggroup.com/media/pdfs/research/2010/270110HousePricesin2000s.pdf, Lloyds Banking Group, Dt.12th Feb2010) and so rise in revenues outpaced rise in cost of sales. As normalcy returned in 2008, the cost of sales started to catch up with revenues once again.
The Capital employed by a firm is the amount of earning assets that a firm has or the total assets of the firm minus the current liabilities. Operating Profit is the Profit before Interests and taxes i.e. PBIT and is a measure of the operational well being of a firm. As can be seen from the figure, from 2004 to 2007, the operating profits increased as the capital employed increased. But in 2008, even though the capital employed has increased, the operating profit has taken a sharp turn for the worse. The reasons behind this fall in profit will be examined later in this work in detail.
The total shareholder return includes the gain in share price over the period plus the dividends granted by the company. As can be seen from the chart, the TSR of Henry Boot was much higher than FTSE Small Cap Index during the boom period of 2006-07 but has since fallen and in Dec 2008, the TSR was actually negative.
For gaining an in-depth understanding of the operating and financial performance of Henry Boot Group in the past two years, their Annual Report for the year 2008 was examined. The profitability, operational efficiency, cash management and capital structure for Henry Boot Group have been examined. The prospects of the group from a shareholder’s point of view have also been analyzed. Apart from the annual report, press releases and commentaries have also been used and are duly referenced.
The ultimate objective of any enterprise is to earn profits and ensure that it keeps earning them year after year. To study financial and business performance it is essential to look at how profitable the firm is and what inferences can be drawn for future from the present profit numbers. From the published accounts of Henry Boot for 2008, the profitability of the firm is analyzed below:
Higher revenues are often the key to higher profits, so first a brief overview of revenues is being presented. Henry Boot witnessed an increase of 55% in the revenues from £ 124.8 million in 2007 to £ 193.7 million in 2008 (Annual Report, p58). The segment wise revenues are shown below: All major segments have shown an increase in revenue compared to 2007. Given the adverse economic scenario, Henry Boot has stayed away from making new acquisitions or investing in new developments unless the opportunity is very attractive according to the Operations Review (Annual Report, page8). The increased revenue has come because Henry Boot has completed several large land deals (Annual Report, page 4) which is also evident from the decreased inventories shown in Note 17 (Annual Report, page66).
With increased revenues, gross profit has also increased 38.5% from £ 42.4 million in 2007 to £ 58.7 million in 2008. However the increased gross profits don’t get reflected in operating profits which have fallen 56% from £ 50.4 million in 2007 to £ 22.1 million in 2008 (Annual Report, page 50). This fall has largely been on because of “property, impairments and revaluation” account which has gone from a surplus of £ 18.1 million in 2007 to a deficit of £ 22.4 million (Annual Report, page 50). As per chairman’s report, the deficit in 2008 has been on account of decrease in market value of a number of properties and land held by Henry Boot, most notably, their shopping centre at Ayr (Annual Report, page 4). The graph above shows the segment wise split of profits for Henry Boot. Increased sales in Land development segment have brought higher profits. The construction segment had a strong order book with centrally contracted work in initiatives like Decent Homes and Prison Alliance and so has seen a robust profit growth. Property investment and development has suffered on account of the revaluation deficit of £ 19.3 million. Group overheads and other report more losses on account of higher share based income and pension expenses.
Profit margin or PBIT expressed as a percentage of revenues is one of the most commonly used ratios to measure profitability. It measures the relationship between revenue and overall costs. The greater the ratio, the stronger is the ability to earn profits (Wendy, 2003). As can be seen from the table above, the profit margins have fallen from 40.38% in 2007 to just 11.41% in 2008. This fall again has been due to the revaluation adjustment made during the year 2008. Since revaluation is more of a one-time activity than a regular one, the profit margin is expected to improve as market conditions improve. However, the cost of sales going up from 66% in 2007 to 69.6% of revenues in 2008 can be an indication that the profit margins in near future will fall. Return on Total assets and Return on Capital Employed are ratios that measure how much profit can be earned by a unit investment in the firm. As Henry Boot is in a variety of businesses, it is difficult to compare its returns to those of its competitors. In 2008 both ROTA and ROCE have fallen significantly as seen from the table above. As explained earlier, the decrease in PBIT in 2008 is on account of revaluation of property and land and does not reflect any fundamental long term change in the business of Henry Boot. In a cyclic sector like real estate, there are bound to be years when there would be a huge revaluation surplus and other years when there is a huge revaluation deficit. The cyclicity of booms and busts is getting reflected in the ROCE and ROTA numbers. Overall, it can be concluded that the profitability of Henry Boot suffered a big blow in 2008 because of the revaluation and impairment deficit.
For any business to remain competitive over a long run, attention has to be paid to operational effectiveness. Operational effectiveness implies use of the given assets to generate the maximum possible revenues. A firm has two types of assets – fixed assets and current assets. How effectively Henry Boot used these assets in 2008 will be seen in the following section:
The table above shows that the Net Asset Turnover for Henry Boot Group has improved significantly to 0.841 in 2008 from 0.545 in the previous year. ROCE is a product of Net Asset Turnover and the Profit Margin. Since Net Asset Turnover has improved, it can be concluded that the fall in ROCE was only due to fall in Profit margin. The improvement in net asset turnover shows that Henry Boot was able to achieve higher sales per £ of capital employed. The improvement is a result of a strategy shift discussed in the Operations Review (Annual Report, page8) whereby Henry Boot is no longer interested in adding new properties to its portfolio and is keen to sell whenever it can get a fair price. This way revenues increase while the net assets employed remain constant. Fixed Asset Turnover also has increased significantly from 0.502 in 2007 to 0.765 in 2008. Property, Plant and Equipment (PPE) and Investments are the two biggest components of fixed assets (Annual Report, page 51). As most of the developments underway at the beginning of 2008 were completed during the year (Annual Report, page4), a significant amount of assets moved from PPE to Investments. Unlike a £ stuck in PPE, a £ in Investments can earn rent or is available for sale and so the revenues have increased because of higher share of investments compared to PPE in the fixed assets.
The debtor days has improved significantly from 84.27 to 51.31 which imply that Henry Boot has started collecting payments from its buyers more than a month earlier than it did last year. However there is no mention of any special effort put towards this end in the Annual Report and so finding out the reasons would require a more careful analysis. Firstly, receivables of £ 5.344 million which are due after more than a year have been shifted to non-current assets in 2008 (Annual Report, page 64). Secondly in large land deals, like those completed in 2008, payments are generally made upfront. These two factors have resulted in higher revenues with receivables being same and have brought down the debtor days number.
Creditor days for Henry Boot has come down from 244.72 to 140.29 implying that the suppliers are less willing to extend credit to Henry Boot. There has been a transfer of £ 7.233 million to non-current liabilities. Secondly increased sales in 2008 have been accompanied by decrease in inventory and not by fresh investment in stock. So the payables have remained constant with cost of sales increasing significantly.
The Days Inventory number has also come down from 369.36 in 2007 to less than half i.e. 159.56 in 2008. The reasons for this are two fold – sales have happened in 2008 without fresh addition to stock thereby depleting inventory and secondly cost of sales has increased in keeping with revenues. With the numerator falling and denominator rising, a fall in days inventory number is understandable. Overall, it can be concluded that Henry Boot’s operational efficiency is improving on most parameters and if it can be maintained, it will be very helpful for the group in the hard economic conditions expected in near future.
The assets that a firm has have to be financed in one way or the other – either through equity or by borrowings. The exact mix of equity and borrowings defines the capital structure in use. Let us have a look at how Henry Boot’s capital structure has changed in the past two years and how robust is its balance sheet to meet its payment obligations:
As on 31st December 2008, Henry Boot had £45.463 million of loans due within a year compared to £55.702 million due within a year on 31st December 2007. The loans due after more than a year have fallen drastically from £ 17.556 million in 2007 to £ 6.394 million in 2008 (Annual Report, page 67). Majority of the loans taken are floating rate loans and expose the firm to flow interest rate risk.
The gearing or leverage is defined as the amount of borrowings or high risk finance the firm has for every £ of equity or low risk finance (WMG Notes, 2010). Borrowings are high risk finance because of interest rates risk as well as the fact that interest has to be paid even when firm is making losses. Shareholders who provide equity need not be paid any dividends if the firm is short of money. As seen from the table, the Gearing has been brought down to 26.16% in 2008 from 39.28% in 2007. The reduction in gearing indicates a decision to reduce the financial risk involved by getting rid of high risk sources of finance i.e. loans. In the prevailing economic climate, the business risk for Henry Boot Group is pretty high in itself with property values reducing by as much as 15% in a single quarter (Annual Report, page 8). Adding financial risk on top of the business risk will further aggravate the situation. So, Henry Boot Group has wisely chosen to reduce its dependence of loans.
Since 2007, the interest rate to be paid on floating rate bank loans or for bank overdrafts has fallen by close to 1%. A 1% change in interest rate would impact PBT by £ 346,000 (Annual Report, page 67). The interest paid during the year 2008 was £3.427 million compared to £4.195 million in 2007. The reduction in interest rates occurred because the total borrowings have gone down from £73.258 million in 2007 to £51.857 million in 2008 (Table 9). The reduction in interest costs is essential for the time being because the current economic situation is believed to prevail for quite some time. In such a situation, Henry Boot has to depend on rental incomes from investments and construction incomes which are not a match for the “deal driven” profits being made earlier (Annual Report, page 4). Accordingly it is wise to cut the expenses also as much as possible and starting with interest costs isn’t a bad idea at all.
To examine whether any firm would be able to honour its payment obligations, it is important to check its interest cover figure. As can be seen from the table the interest cover for Henry Boot has fallen from 12.01 in 2007 to 5.63 in 2008. Though such a steep fall is worrisome, Henry Boot has been reducing its borrowings and the profits for 2008 were especially low because of the revaluation deficit and can be expected to pick up in future. Current Ratio and Acid Test Ratio check the ability of a company to pay its short term obligations from its short term assets. With a current ratio of 0.795 in 2008, Henry Boot will only be able to pay for about 80% of its short term obligations from its short term assets. Overall, it can be concluded that Henry Boot has manageable financial risk (30-40% gearing is normal for firms in UK as per WMG Notes, 2010). The efforts to reduce gearing even further will only help in reducing risk even more. And despite taking a hit in 2008, the group also has enough liquidity to meet its payment obligations as reflected by an interest cover of 5.63.
Though a firm might be making profits, it can still go out of business if it doesn’t pay attention to its cash situation. After all, a firm can make losses a number of times but can only run out of cash once (WMG Notes, 2010). The cash management abilities of Henry Boot are being analyzed in this section by examining its Cash Flow Statements:
The Cash Flow from operating activities for years 2008 and 2007 throw up interesting and contrasting pictures. In 2007, the operating profit was high at £ 50.381 million but the net cash from operations was only £ 4.005 million. On the other hand, for 2008 the operating profit was much lower at £ 22.115 million but the net cash from operations was £ 57.234 million (Annual Report, page 53). This is because in 2007, there was a revaluation surplus which increases profit without increasing cash flow. Also in 2007, the inventories increased which means that additional cash was tied up but profits remained the same. In complete contrast to this, in 2008, there was a revaluation deficit which decreases profits but has no effect on cash. Also the inventories fell in 2008 which means that cash was freed up.
The cash out flow from investing activities is much lower at £27.614 million in 2008 than the outflow of £51.800 million in 2007. This decrease in investing outflow is primarily because the purchase of property, plant and equipment has gone down from £58.275 million in 2007 to £38.687 million in 2008. Apart from this the cash inflow from disposal of investment properties is £5.729 million in 2008 compared to just £0.739 million in 2007.
The cash outflow due to financing activities in 2008 is almost the same as that in 2007. Overall, the cash and cash equivalents witnessed an increase of £21.654 million in 2008 compared to a decrease of £55.034 million in 2007. This is because in 2007, a lot of property and land blocks seemed attractive for investment and Henry Boot built up inventories anticipating gains in future. But the economic climate in 2008 has forced Henry Boot to adopt a defensive strategy whereby they are trying to dispose off inventory if offered a reasonable price and are not too keen on adding more to their stock (Annual Report, page 5).
Henry Boot PLC saw its Earnings per share decline from 24.5p per share in 2007 to 10.8p per share in 2008. Aside from the information available in the table, Henry Boot PLC has underperformed every comparative index by giving a Total Shareholder Return of – 62% in 2008 compared to -42% on FTSE Construction Sector, -47% on FTSE Real Estate and -44% on the FTSE Small Cap index (Annual Report, page 5). As can be seen from the table, the return to shareholders also has fallen from 17.40% to 7.35%. Dividends though, have been maintained at 5.0p a share. Overall, Henry Boot in 2008 doesn’t sound too attractive for the shareholder in the short run. But one must also understand that Henry Boot has a strong order book in Construction, the road link A69 will keep bringing in recurring income and also the defensive strategy with respect to property development and land development will give its benefits sooner rather than later (Annual Report, page 5). According to IPD, the annual decline in commercial property has been 26.3% but Henry Boot has only taken a 12.6% revaluation deficit (Annual Report, page8). Another important factor in favour of Henry Boot is that despite taking a big hit in 2008, its NAV per share has increased by 5% to 146p. Recurring income from property rentals, A69 and construction sector coupled with a rise in NAV, makes me believe that Henry Boot still has something to offer to a shareholder in the long run.
Henry Boot PLC had a rough year like everyone else in 2008. Though the group is focussed mainly on the real estate sector which is going to be under strain in the foreseeable future, Henry Group also has alternate businesses that can keep bringing in income even when the market is bad. Rental income from property investments, centrally contracts for construction segments and PFI will keep the cash registers ringing till the situation improves and real estate market starts picking up again. The real challenge for Henry Boot will come if the crisis continues longer and it has to take tough decisions about reorganizing its business around construction once again, the way it had started way back in 1886.
The need for Working Capital Management arises because of mismatch in the timings of sales receipts and the expenditure incurred to earn it. Working capital forms the lifeblood of any firm as it is used to pay for day to day expenses and bills. If a firm can extract a significant portion of its receipts earlier than it has to make payments, it will end up having a cash surplus. A firm with cash surplus has to invest surplus wisely balancing the return it wants to earn with the risk it is willing to take. If a firm has to pay up earlier than it starts receiving, it will run a cash deficit. A firm with a cash deficit has to raise money to stay afloat. Money can be raised by borrowing from banks, selling property or raising fresh equity. Effective working capital management involves choosing the best way to address cash deficit situation. After all, a firm can make losses many times but it can run out of cash only once. (WMG Notes, 2010) As commercial manager in my group, I had to keep in mind my responsibility towards working capital management whenever I made any decision about spending on Engineering and Quality or bidding for contracts. I had to make sure that even though my job required me to bid aggressively to get more orders, I wasn’t overstretching the finances of the firm while doing so. The payments from sales contract will only come once the delivery was made 6 quarters later but the expenses on production and those on engineering and quality had to happen before hand. Though financing this deficit is the finance manager’s job, I also had to make sure that the consequences of my decisions are not only profitable in the long run but also that the team can survive in the short run. For example, in Year 1, I got an order for 8 units of Terrier for the American market which required production cost of £ 16 million. To finance this, the firm took a loan of £ 10 million in Year 1. Similarly in year 2 and year 3, team took loans of £ 10 million and £ 60 million respectively. My decisions to spend on developing market for Tigers resulted in the team getting orders for the same and so it had to take loans to buy special machinery. Since loans were available at an interest of 10% whereas contribution was nearly 60% of sales value, it wasn’t much difficult for the team to manage the short term cash deficits. In a real world situation, the commercial manager has to deal with such issues in much more depth. For example, he has to negotiate the exact terms of payment to be received from buyers, offer discounts to those who pay early and make provisions for payments received in different currencies. Also in real world, there are various types of loans available – short term, medium term, long term, at different interest rates. Knowing exact requirements can lead to more efficient usage of loans. So, a commercial manager would also have to draw up sales plans, expected schedule of cash receipts and other projections for the coming periods so that finance manager can plan the raising of funds more effectively.
Absorption costing is a technique used to trace the overhead cost to the product being produced. The material and labour costs are directly attributed to the product but it is more difficult to determine how much of the overhead costs should be absorbed by a particular product when there are multiple products being produced. The aim of absorption costing is to find out the complete product cost which will help decide the firm which of the products is the most profitable to produce and what price should it offer to its customers. In the context of Winning Margin, it is possible to allocate some of the overhead costs directly to the product. This is because one machine was producing only one product. So the depreciation costs, the annual maintenance cost and the set up costs can be directly attributed to the product. Such a costing technique gives a much clearer picture about the profitability of a product than that given by contribution margin. For example, in Winning Margin, my team bought a Mark III machine for producing Tigers. A Mark III machine produces a unit of Tiger in one period. The depreciation cost for a Mark III machine is $0.5 million per period [$12-$4 i.e. $8 million to be depreciated over 4 years or $2 million each year or $0.5 million each period]. The maintenance cost for Mark III machine is $0.75 million per period since the annual maintenance cost is $3 million. So, this additional cost of $1.25 million (i.e. 0.5+0.75) should be absorbed by a unit of Tiger because it was the only product the machine was used for. Absorption costing cannot give the complete cost picture because it doesn’t deal with absorption of non-production overheads like expenditure on market development or research and development costs.
In today’s competitive and fast changing environment, a business continuously needs to change in order to survive. This change often entails investment in a new research, technology, machines or marketing campaign. Investment appraisal is the decision making process where any investment proposal is evaluated based on the potential costs involved and the potential benefits it might bring in future. Understanding the expected cash flow pattern, evaluating the return against the company’s required rate of return and understanding uncertainties involved are the steps involved in investment appraisal (WMG Notes, 2010). In Winning Margin game, the investment appraisal process was used to evaluate the decision of buying a Mark III machine. Since the demand for Tigers was increasing, the team had decided to concentrate on the market for tigers. First step of investment appraisal was to check whether the Mark III machine being bought fitted into this strategy of the team. Next, we had to understand the risk and return involved. A Mark III machine was capable of faster production but it would only be helpful if there were sufficient orders. Now the risk was that if the team failed to get enough orders, the investment as well as the annual fixed costs for the Mark III would be wasted. After that we had to calculate how long the payback period would be, will the machine be able to pay for itself in 2 years or 3 or 4. The team was confident of getting enough orders and also needed to produce fast, so investing in Mark III seemed the right choice.
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