Security valuation of APN news and media ltd

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This report discusses the security valuation of a media and publishing company called APN News and Media ltd. The research follows the three step valuation process and top down approach which starts by analysis of the economy and moves further for analyzing the industry and filters down to the company analysis and valuation of the stock. The First part of the report presents an in depth analysis of financial ratios for APN News and Media ltd and its two competitors Fairfax Media ltd and West Australian Newspapers Holding ltd.

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The financial analysis includes internal liquidity ratios, operating performance ratios, and risk and growth analysis. The Second part of the report discusses the calculation of weighted average cost of Capital and assumptions made for risk premium and risk free rate. It also discusses the weight and cost of debt for APN and expected rate of return by investors of APN and the cost of capital. The Third part of the report discusses the first two steps in the valuation process; Economic and Industry analysis and economic influences on the company. The analysis is based on influence of economic indicators on the stock. The final part of the report discusses the valuation of APN by employing various methods like Dividend Discount model, Free cash flow to Equity and Free cash flow of the firm. : Part i

Internal Liquidity Analysis

Figure 1: Current Ratio The Figure 1 above shows the current ratios for the three firms APN, Fairfax and West Australian Newspapers. Current Ratio is best known liquidity measure which examines the relationship between current assets and liabilities. Current ratio of APN has almost followed a sinusoidal format maintaining an average of 1.5 and has lost the track during global recession in 2008 reaching its lowest of 0.91 and has also recovered by gaining the average of 1.5 in 2009. Current Ratio for Fairfax has also followed sinusoidal format with an average of 0.75 which grew significantly from 2006 but later dipped down due to recession and though it has still maintained the average after recession but it has not seen any movement further up from past three years. The ratios for West Australian newspapers has higher average compared to other two and also shows clear signs of recovery after the recession. Figure 2: Quick Ratio Quick ratio analyzes the liquidity of the company to better accuracy and is more reliable as it only uses Cash and recievables for calculation of ratios and neglects inventories and other current asset. The quick ratio for all three companies has followed exactly the same path as current ratio but with lower averages. Figure 3: Cash Ratio Cash ratio is the most conservative liquidity ratio which analyzes the relationshio between cash and marketable securities to Current liabilities. APN has been quiet successful in maintaing an average of just below 30% in last five years and had dipped below 20% mark during recession and is also showing positive signal after recession. The cash ratio for FXJ is quite hapazard as it is not following a pattern which makes it really uncertain while WAN follows a smooth curve with very good average. Figure 4: Average Receivables collection period Receivables turnover is the meaure of firm’s accounts receivable. The faster these accounts are paid, the sooner the firm gets funds to pay off its current liabilities. It is very useful to convert this ratio into collection period which gives the ratio in terms of days and is very easy for analysis. The graph shows that receivable turnover period for APN in 2000 was 120 days which is very high and is consistently reducing from then which is a good indicaion and has reached a steady state of about 65 days from 2004 onwards.While the collection period for FXJ and WAN has stayed steady and consistent and also lower compared to APN. This is a good indication for APN that it can reduce the collection period further down. Figure 5: Average inventory processing period Inventory turnover examines the liquidity of inventory by calculating the proceesing time required for goods and inventory processing period indicates the ratio in terms of days which clearly gives processing time. Processing period for APN shows a very good indication as the time taken for processing has reduced from 18 days in 2000 to 8 days in 2009. While processing period for FXJ increased from 2000 to 2002 and later moved down to 9 days in 2009. While processing period for WAN had decreasing trend initially but later increased again. Figure 6 : Payables payment period Payables turnover is the measure of firms ability to pay the bills in time and indicates the time taken by the firm to pay for the raw goods. The graph shows no trouble for APN and indicates that APN takes approximately 0 to 5 days more to pay its bills after receiving it. While FXJ and WAN have maintained a lower payment period indicatin that bills are paid quciker than APN as their collection period is lower.

Operating Performance Analysis:

Figure 7: Operating profit Margin The variability of operating profit margin over time is a prime indicator of the business risk of the firm. Operating profit margin is gross profit minus the general and administrative expenses. Profit Margin for APN was in between 20 % to 25 % from 2000 to 2008 but has dipped down to 18% in 2009 which is not a good sign and this has to be corrected by reducing the expenses or by increasing the sales. The profit margin for FXJ has stayed below or same as APN which shows that APN has a decent margin but WAN has very high profit margin which was above 35% from 2004. It is interesting to observe that all the companies have reduced its profit margin after 2008 which is due to recession. Figure 8: Total asset turnover The figure 8 above shows the total asset turnover for three companies. This ratio indicates the effectiveness of the firm’s use of its total asset base by comparing it with sales. The asset turnover has steadily increased from 30 % in 2000 to 45 % in 2009 which shows that APN is utilizing its assets to the maximum extent but there is a declining trend from past three years which is the factor that has to be taken care. It is a good sign to see that asset turnover for APN is moderate in industry which can be moved further above to the level like WAN which has above 80% turnover. Figure 9: Interest Expense Rate Interest expense rate shown in the figure 9 above shows the amount reported by company as an expense for borrowed money. Again APN is placed moderately in between FXJ and WAN and the interest expense increased significantly in 2000 and stayed moderate thereafter. It is observable from graph that WAN with higher interest expense has higher risk but it is also utilizing the capital in profitable way which is evident from graphs of operating profit margin and Asset turnover. Again there is a dip after 2008 due to financial crisis. Figure 10: Financial leverage multiplier The financial leverage calculated as Total Assets / Total Stockholders’ Equity examines how a company uses debt to finance its assets and it is also known as the financial leverage ratio. The leverage ratio for APN has been in between 1.5 and 2.3 in the period 2000 to 2010 which shows debts of little above 50% for APN while it is below 50% for FXJ but WAN is the risk lover with total assets of about 7 times of equity during 2005 to 2007. Figure 11: Tax Retention rate The above figure 11 shows the tax retention rate for three companies which is the proportion of the total net earnings before tax retention rate. The graph shows a very high retention rate for APN which ranges from 70% to 85% in the period 2000 to 2010 higher than its competitors whose retention ratio ranges from 65% to 75%. A higher retention rate means higher earnings available for dividends which is a positive aspect for investors. Figure 12: ROE The figure 12 above shows the Return on Equity for three companies which is an important indicator of performance as it indicates the return that management has earned on the capital provided by Stockholders. APN’s ROE ranges between 8 and 10.5% in the period 2000 to 10 which is just moderate return but still earns higher return than FXJ whose ROE declined from 11.8 to 4.8% in the same period. While WAN with higher debt and risk earned a return ranging from 40 to 100% in the same period with 140% as the peak ROE during 2006. Figure 13: Equity turnover The figure 13 above shows the equity turnover for three companies which examines the turnover of the capital component of the firm. Equity turnover for APN ranges from 0.5 to a 1.1 in the period 2000 to 10 which is a significant increase and also it means that it is generating sales worth its capital indicates a fair use of equity which has sunk in the case of FXJ from above 1.1 to 0.5 in the same period. While again WAN has taken the lead to generate sales worth twice the equity in the initial five years and about 4.5 times in next four years. Figure 14: ROIC The figure 14 above shows the ROIC for three companies which relates the firms earnings to all invested capital involved in the firm which includes interest bearing debt. ROIC for APN ranges from 11.4 to 8.6% which shows a decline in the return in period 00 to 10 and FXJ has a similar decline from 13 to 6% in the same period. While WAN has achieved a good growth from 25 to 30 % in the same period. APN’s ROE shows an increase while ROIC has declined in the same period which shows that debt is not utilised properly by APN to generate higher returns.

BUSINESS RISK

Business risk is the uncertainty of operating income caused by the firm’s industry. This uncertainty is due to Variability of sales over time caused by volatility of earnings. Firm’s capability to produce its products and the balance between variable and fixed costs The business risk, sales volatility and operating leverage for three companies are as shown below. Refer Appendix C for calculations. APN FXJ WAN Business Risk (operating earnings) 0.3113 0.4262 0.2638 Sales volatility 0.2632 0.3166 0.1564 Operating leverage 1.4953 3.4548 1.9569 The above table gives a high risk for FXJ with all the three factors of volatility higher than other two companies but APN has a moderate risk which is in between FXJ and WAN. WAN has the lowest risk with least volatility in its earnings and sales. The more volatile the operating earnings as compared to the volatility of sales, the greater the firm’s operating leverage. So operating leverage is least in case of APN when compared to other two competitors which place it in a fairly good position and moderate Business risk.

FINANCIAL RISK

Financial risk is additional uncertainty of returns to equity due to firm’s use of financial obligation securities. This risk adds up to the business risk and acceptable level of financial risk depends upon business risk of the firm. In turn if a firm has low business risk, investors are ready to take higher financial risk. In this analysis, the financial risk was analysed using few balance sheet ratio that indicate the proportion of capital derived from debt and few ratios that considers cash flows available to pay fixed financial charges. Please refer to Appendix C for calculations. The balance sheet ratios used are debt to equity ratio and long term debt to capital ratio; Debt to equity ratio for APN has increased from 45 to 75% in the period of ten years while it has reduced from 65 to 38% for FXJ and it has increased from 150 to 200% for WAN. APN has higher financial risk as 75% of total capital is debt and WAN has very high financial risk with debt about 1.5 times the equity but still has higher returns. The other ratio which can explain the financial risk is interest coverage ratio which is firm ability to earn at least the interest payable. The interest coverage ratio has decreased from 6 to 4 times for APN, 6 to 3 times for FXJ, 11 to times for WAN. The interest coverage ratio is currently 4 for APN which means the operating profit is 4 times the interest expense which is moderate and APN is in a position to pay back the interest and WAN is able to earn 11 times the interest which will balance the higher debt of the firm. The next important ratio which examines the financial risk is Cash flow coverage ratio which determines the cash flow when compared to interest expense. Cash flow coverage ratio provides similar results as interest coverage ratio and the risks for the firm remains the same as the above analysis with higher risk for WAN, moderate risk for APN and lower risk for FXJ.

GROWTH ANALYSIS

Figure 15: Growth analysis The figure 15 above shows the growth of the three companies which was calculated using retention ratio and ROE. The growth of a business depends on amount of resources retained and reinvested and rate of return earned on reinvested funds. Please refer to Appendix D for calculations. So g = Retention ratio x ROE. The growth rate of APN starts with 2 % in 2000 and increases to 4% in 2005 and decreases back to 2% in 2007 and has a growth of 3 % for 2008 and 2009. The growth rate for FXJ and WAN are scattered but the trend line moves toward upward direction showing the growth in the media industry.

ALTMAN’S Z SCORE

Altman Z score used to examine the characteristics of a firm for bankruptcy. Five variables are used for prediction of corporate bankruptcy. They are: • X1 working capital/total assets • X2 retained earnings/total assets • X3 earnings before interest and taxes/total assets • X4 market value of preferred and common equity/book value of total liabilities • X5 Sales/total assets Figure 16: Z score The figure above shows a Z score analysis and in this model, a Z score of above 2.90 indicates non – failure, and a Z score below 1.23 indicated bankruptcy. According to Z score analysis APN and FXJ are very close to bankruptcy and WAN is very well placed. Please refer to Appendix E for calculations. : Part iI Calculation of weighted average cost of capital: Krf 4.9 Kmrp 5.5 ? 0.9505 Ks 10.1278 Wd 0.6595 Kd 6.8486 tax rate 0.1473 Wc 0.3405 WACC 7.2998 The 90 day Treasury bill yields in Australia was considered as the risk free rate of 4.9% (RBA, 2010) and risk premium was considered as 5.5 % which is the mean risk premium used in 2010 by analysts and companies in Australia (Fernandez and Campo, 2010). The beta for the firm was calculated by using regression analysis of return index of market and return index of the firm which was obtained as 0.9505. Please refer to calculation in Appendix F. So after calculation the expected rate of return is 10.1% and WACC is 7.3%. : Part iii

Effect of Economic indicators on firm’s share price

Figure 17: GDP, CPI on Share price The figure 17 above shows the effect of GDP and CPI on share price of the firm APN. On careful analysis it can be observed that there is no effect of GDP on share prices whereas CPI is inversely proportional to Share price which means for every positive change or increase in CPI leads to decline in the share prices and if CPI decreases, then there will be an increase in share price. So CPI has an adverse effect on share prices. CPI is a measure of average price of consumer goods and services purchased by households and also APN being in industry of Consumer discretionary; the effect can be explained by the increase in prices of goods and services in the industry affecting the profitability of goods of APN and so the decrease in share prices. Figure 18: Interest rate on Share prices. The above figure 18 shows the effect of interest rate on share prices and indicates that Interest rates does not affect the share prices of the firm APN.

Industry analysis:

APN which is a media and publishing company belongs to consumer discretionary industry. This industry relies on consumers to spend that part of their paycheck that is disposable or discretionary on things they do not absolutely need to survive. In many economies, this is the largest segment of the economy because it includes automobiles (the largest), all retail store, and fast food and media companies. It has a market capitalisation of $168b which is about 13% of the whole stock market. In the present situation Australian retail and consumer companies are lagging behind their international peers. This position is untenable in the medium term, so effort has to taken to match the international standards. The economy is expected to drive the competition and so it is up to firm’s strategies whether retail and consumer companies will drive the agenda, or simply respond to a market shift generated by government regulation and consumer demand. Internationally, many retailers have already seen a rapid change in consumer sentiment regarding the environment and felt a resulting impact on their brands. : PART iv Three valuation methods were employed to value the firm’s stock namely dividend discount model, Free cash flow to equity, Free cash flow to the firm. Please refer to Appendix H for calculations. The following assumptions were made based on the economic and industry analysis together with financial ratio analysis. APN’s growth rate was consistently increasing until it met with the global economic recession and now it has recovered from the recession. As per ANZ outlook 2009, Companies should be completely out of recession by 2011 and so it was assumed that APN would start growing again until it meets the constant growth period after three years. First valuation method employed for analysis is dividend discount model and this model can be used for valuation of APN as it issues dividends to its share holders regularly and the value of the stock obtained by using this method is as shown below. The second valuation technique employed by analysis is free cash flow to equity. This technique resembles a present value of earnings concept except that it considers the capital expenditure required to maintain and grow the firm and change in working capital required for a growing firm. It determines the free cash flow that is available to the stock holders after payments to all other capital suppliers and after providing for the continued growth of the firm. The value of the stock estimated by this technique was The third technique employed for valuation was free cash flow to the firm which determines the value of total firm and subtract the value of the firm’s debt obligations to arrive at a value for the firm’s equity. In this technique we discount the firm’s OFCF at the firms weighted average cost of capital rather than cost of equity. The value of the stock estimated by this technique was The impact of key economic indicators and industry on the firms valuation is discussed in detail in Part III. COnCLusion: The value of the firm’s stock obtained by different valuation techniques are as given below Price Dividend Discount Model $1.36 FCFE $3.6 FCFF $1.55 The value of the stock obtained by valuation methods are almost the current value of the stock.

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