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Financial Analysis of Elbit Systems

Pages:82074

CHAPTER 1– BACKGROUND AND RESEARCH

Vietnam Economy

Vietnam is one of the fastest-growing of all Southeast Asia’s emerging economies. With an annual growth rate of 7.1 percent in 2018, the country is well on its way to becoming a formidable economic powerhouse. (https://www.worldbank.org/)

Vietnam’s development over the past 30 years has been remarkable. Economic and political reforms have spurred rapid economic growth, transforming what was once one of the world’s poorest nations into a lower-middle-income country. Between 2002 and 2018, more than 45 million people were lifted out of poverty. Poverty rates declined sharply from over 70% to below 6% (US$3.2/day PPP), and GDP per capita increased by 2.5 times, standing over US$2,500 in 2018. (https://www.worldbank.org/en/country/vietnam/overview)


Vietnam has continued to expand its economy, growing the fastest in Southeast Asia in 2019, in part due to the US-China trade war. Manufacturing, tourism, and private consumption contributed to Vietnam’s strong GDP growth of 7 percent.(https://www.vietnam-briefing.com/news/us-china-trade-war-inspires-vietnam-growth.html/)

Overview of the modernization of Vietnam People’s Army

Vietnam has devoted significant budget to achieving military modernization targets focused on:

  1. The designing and manufacturing of new types of weapons and equipment.
  2. revamping of training methods
  3. procurement and retrofitting of existing weapons

China’s increased naval presence and territorial claims in the disputed waters of the South China Sea are the major factors compelling the Vietnamese Government to increase its military capabilities. Over the last decade, there has been a significant increase in the expenditure of the Vietnamese Military. Vietnam’s total arms imports between 2011 -2019 represented a 699% increase from the 2006-2010 period. In 2019, the Vietnamese Government allocated close to US$5.5 billion towards military spending, of which 32.5% is earmarked for the procurement of defense equipment.

 

Exhibit 1: Vietnam Military Expenditure 2010 – 2018

 

The lack of technology and low domestic defense capability has forced the country to import weapon systems from foreign OEMs to fulfill its military requirements.

(https://www.businesswire.com/news/home/20190418005440/en/Future-Vietnamese-Defense-Industry-2024-Defense-Budget)

Looking to the future, the modernization of Vietnam People’s Army is likely to be accelerated in response to China’s intensifying civil and military activities in the disputed waters of the South China Sea. The SEA region is experiencing some destabilization due to the Chinese governments’ aggressive actions in the South China Sea. Beijing insists it has sovereign rights to nearly all of the South China Sea, a strategic waterway through which about a third of all the worlds traded oil passes. The disputed waters – also claimed in part or whole by Vietnam, Malaysia, the Philippines, Taiwan and Brunei – have also become the stage for a struggle for regional dominance between Beijing and Washington, the world’s two largest economic and military powers. Vietnam considers itself a leading nation in SEA and is currently allocating both diplomatic and military resources to remain a dominant force and maintain its national interests. In their effort to strengthen its dominance, Vietnam is continuously developing its defense capabilities intending to create a long-lasting “Balance of Power” in the region.

 

Exhibit 2:

 

The opportunity for Israeli companies

Traditionally the Russians remain the dominant ally of the Vietnamese Government. However, due to the current economic situation in Russia and the fact that Moscow has further solidified its relationship with Beijing, the leaders in Hanoi are looking for alternative sources for Defence capabilities. It is expected that the Military Expenditure in Vietnam will rise to  US$5.8 billionby the end of 2020 and trend around this value in the coming years.

Exhibit 3: Vietnam Military Expenditure 2010 – 2025

Given the circumstances, Israel has become an attractive and reliable source for Vietnams’ defense technologies due to several key factors:

  1. Leading state-of-the-art technology
  2. The embargo on China (Israeli defense technologies is not accessible in China as opposed to Russian technology)
  3. Flexibility to provide tailor-made solutions and transfer of know-how programs.

As a result of the enhanced cooperation between the two countries, In 2015, Israel has officially opened its IMOD (Israel Ministry Of Defense) office in Hanoi with a designated Defence Attaché.In the last five years, Russia remains the largest supplier of military hardware to Vietnam, with a share of over 77.9% of Vietnam’s military imports. However, Israel has managed to become the second-largest exporter of military equipment to Vietnam, with over 9.1% of the market share followed by much larger countries such as Belarus, South Korea, and Ukraine, with 4.1%, 2.8%, and 2% respectively (see exhibit 4). In 2018, the two countries conducted the first-ever defense policy dialogue in Hanoi at the headquarters of the Vietnamese defense ministry. The meeting was co-chaired by Vietnam’s deputy defense minister and the director-general of the Israeli defense ministry. The dialog between the leadership of the two countries will open new opportunities for the Israeli defense industries such as establishing JV in Vietnam and allow Israeli companies to invest in the local market.

(https://thediplomat.com/2018/10/whats-in-the-new-vietnam-israel-defense-dialogue/)

An excellent example is the “Z111” project. The Israel Weapon Industries (IWI) has established a production facility in collaboration with the Vietnamese Ministry of Defence for the manufacture of “Galil” rifles for the Vietnam People’s Army. The goal was to replace the Kalashnikov rifles with in a project estimated at more than 100mUS$ investment. (https://www.israeldefense.co.il/en/content/production-galil-rifles-vietnam-has-begun)

Exhibit 4: Vietnam military’s share of importer’s total import 2018[1]

 

CHAPTER 2 – THE INVESTMENT

In 2018, Israel Global defense export surpassed $7.5 billion, while Asia and the Pacific region lead the way with 46%.https://www.israelhayom.com/2019/05/21/israel-wraps-up-second-highest-defense-export-year-in-past-decade/

Only Three Israeli companies are ranked in the top 100 global defense exporters of 2019: https://people.defensenews.com/top-100/

  1. Elbit Systems Ltd-global ranking 28, US$3.6 billion in revenue
  2. Israel Aerospace Industries Ltd – global ranking 37, US$3.6 billion in revenue
  3. Rafael Advanced Defense Systems Ltd – global ranking 42, US$2.6 billion in revenue

Elbit Systems

Elbit Systems is an international high technology company engaged in a wide range of programs throughout the world. We develop and supply a broad portfolio of airborne, land and naval systems and products for defense, homeland security and commercial applications. Our systems and products are installed on new platforms, and we also perform comprehensive platform modernization programs. In addition, we provide a range of support services.

Financial Snapshot

Profitability:

  • 5% profit margin in 2018
  • 7 profit margin in 2017
  • 6 profit margin in 2016

With a drastic increase in the cost of revenue, Profit declined for the year 2018. The cost of revenue should be controlled or decreased. The cost of revenue includes; the cost of production, distribution, and other services provided by the company.

 

 

Asset management ration

  • ROA 2018 (Net Income/ Total assets) = 3.2%
  • Total asset turnover (2019 revenue / average asset 2019) = 0.65

ROA 2017 and 2016 were 5.1% and 5.4%. During 2018, The total assets increased significantly. Includingproperty, plant, and equipment. Moreover, long term trade and unbilled receivables also increased during 2017 and 2018.

Total asset turnover, the ability of the company to use its assets for the generation of revenue, in 2018 was 0.57. An increase of 0.9 points in 2019 shows growth in sales/revenue.

Debt management

  • Long term debt / total assets:
    • 2018- 26.1%
    • 2017 – 19.2%

The increase in the Debt ratio puts the company at higher risk. Long term loans increased radically, in 2018. The company completed two acquisitions of the privately-owned U.S.company Universal Avionics Systems Corporation (Universal) and IMI Systems Ltd. (IMI)

 

The Investment: Establish a Factory in Vietnam

ELBIT Systems’future success depends on its ability to develop new offerings and technologies, to structure its businessthrough joint ventures, teaming agreements, and other forms of alliances, to reflect thecompetitive environment.Part of the company growth strategy includes its continued activity in mergers and acquisitions and jointventures with respect to businesses, assets and complementary technologies both in Israel and internationally – [ELBIT financial report 2018]

ELBIT Systemswill invest in Vietnam to take over market share and expand its sales potential in the SEA region. The company will establish a Factory to manufacture military-grade communication systems and electro-optic devices (2 out of the company 9 main activities). The factory will sell its products to Vietnam’s Ministry of defense with an option to expend to other countries in the Asian region.

Assumptions:

  1. Israel’s leading defense companies represent 70% of the market share in Vietnam divided equally at 23.3% per company (in the defense sector, the selling cycle is long, and the deals are not finalized annually. I have accumulated this estimation and spread the calculation on a period of 5 years
  2. Vietnam Military Expenditure 2020 – 2025 – US$5.8 billion (annually)
  3. Expenditure allocated for procurement of defense equipment: 32.5% = 1.9 US$5.8 billion
  4. Market share for Israeli defense exporting companies: 9.1% = US$171 Million
  5. Elbit potential market share in Vietnam –23.3% = US$39.9 Million
  6. Market share in Vietnam after establishing the factory (full operation): 35% = US$60 Million
  7. Israel defense export volume to Asia and the Pacific region 2018 – US$3.5 billion

ELBIT SYSTEMS – SWOT Analysis

Strength

·         Global leader in defense technology with strong reputation

·         As an Israeli company, enjoy the strong Bilateral relationship to export its technology to Vietnam

·         Strong financial capabilities

·         Competent workforce

 Weakness

·         Culture barrier

·         Strong competition from US and Russian manufacturers

·         Limited infrastructure in Vietnam

·         Risk of changes in government approval regarding export licenses.

·         Changes in Exchange rate, if production cost is not denominated in USD
Opportunity

·         Could gain market power in the south-east Asia region.

·         Transfer of applicable activities and facilities

·         Tax incentive and land rental waivers from the Vietnamese government

·         Low Labor wages and production cost

 Threats

·         Sanctions by theUSA

·         Rapid demographic and Social changes (World Bank report)

·         Costs to moving containers from factories to seaports are higher in Vietnam (World Bank Doing Business report)

·         Deterioration of diplomatic relations

 

 

 

The competition – current and future

  • Russia

    • Russia is the leading provider for Vietnam ministry of Defence with around 80% market share
    • Vietnam is the biggest customer of Russia in the ASEAN
    • Some of the Main programs in recent years included: 3 strategic submarines, the SU- 30 new fleets, missile systems and; battleships
    • Leading Russian exporting agency – ROSOBORONEXPORT

  • INDIA

    • The first Indian PM to visit Vietnam in 15 years in September 2nd 2016, with the arms to strengthening links with Southeast Asian countries through his “Act East Policy.”
    • A new $500 million line of credit for Vietnam from India to facilitate deeper Defense cooperation (including 2 missile programs)
    • Leading Indian exporting company – BHARAT-RAKSHAK

  • USA

    • The milestone visit by US President Barrack Obama to Vietnam on 22-25 May 2016 gave immediate and essentialresults as the US fully lifts its long-standing lethal arms embargo on Vietnam.
    • The lift of the defense embargo enables the penetration of the largest defense companies in the world to enter the Vietnamese market for the first time.
    • Leading Indian exporting company – Lockheed Martin, Boeing, Raytheon

 

 The Investment:

  • Investments >100M USD
  • CAPEX
    • Factory establishing cost – $100 million
    • Land – free (will be provided by the Vietnamese Government)

FINANCIAL PROJECTION

Total Investment $100 million

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 year 8
Revenue growing 10% 15% 20% 10% 20% 10%
                 
Revenue 39 39 42.9 49.3 59.2 65.1 78.1 86.0
Cost of revenues 27.3 27.3 29.2 33.5 37.3 41.0 49.2 54.2
Gross profit 12 12 14 16 22 24 29 32
Operation Expenses 7.8 7.8 4.3 4.9 5.9 6.5 7.8 8.6
Operating Income 4 4 9 11 16 18 21 23
Financial expenses, net 0.47 0.47 0.51 0.59 0.71 0.78 0.94 1.03
Income before taxes 3 3 9 10 15 17 20 22
Tax Income 1 1 1 1 2 2 2 2
Net Income 2.7 2.7 8.0 9.2 13.7 15.1 18.1 20.0

 

  • Year 1-2 Revenues only from exporting of equipment from Israel – 23.3% of the total market share for Israeli companies in Vietnam
  • Year 3-4 The factory is operating and starting to generate revenues. The operation of a local factory decreasesthe operating costs. The saving in operation cost, logistics, and Tax Increase the Net income of the company over the years from 7% to 15%
  • Year 5-6 The factory producing in full capacity (domestically) and allows ELBIT to take over 35% of the market share (from Israeli companies)
  • From Year 7 Products from the factory are being exported to other countries in the ASEAN region increasing the revenue by additional 20%

 

Net Profit Margin

Net Profit Margin for year 1 = Net income / Total Revenue

= 0.069 or 6.92%

For year 2: NPM =  6.92%

For year 3: NPM = 18.64%

For year 4: NPM = 18.66%

For year 5: NPM = 23.14%

For year 6: NPM =23.19%

For year 7: NPM = 23.17%

Net Progit Margin for year 8 = 23.2%

Avergae Profit Margin for projected years = 17.11 %

Required rate of return

  • ROI – Estimating revenue growthof 5% from year 8 = ROI in year 11

The Weighted Average Cost of Capital (WACC) is

WACC = % of Debt * cost of debt * (1-tax) + % of Equity * cost of Equity

= 10.75% * 6.30% (1- 23%) + 89.25% *10.58%

= 10.00%

Note: Country Risk premium of Vietnam is 3.55% and the Average Unlevered beta is 1.10

CAPM = Rf + β (market premium) + Country Risk premium

= 0.549% + 1.10(5.89%) + 3.55%
= 10.58%

 

RECOMMENDATION

After looking at the financials of Elbit, I’ve a recommendation as whether Elbit should invest in Vietnam or not? I realized that Elbit has put great effort into put this feel forward and backing out on it could reflect badly, but my recommendation is that Elbit should invest in Vietnam. The reason is that Elbit is the only Israeli’s company to operate in Vietnam, they could gain market power in the south east Asia region. The company’s financials indicates a good return on investment, however to achieve ROI of 15%, cost of revenue shall be lessen.Profit margins shows a consecutive growth in the projected years.  Furthermore, the WACC being low indicates low level of risk, also as Vietnam’s Risk premium is higher. Vietnam’s positive economic outlook and the friendly diplomatic relations with Israel (and other major countries) adds a lot to the positive outcome of this investment.

 

 

Links:

Vietnam defense:

https://www.businesswire.com/news/home/20190418005440/en/Future-Vietnamese-Defense-Industry-2024-Defense-Budget

https://tradingeconomics.com/vietnam/military-expenditure

https://www.macrotrends.net/countries/VNM/vietnam/military-spending-defense-budget

Defence market in Southeast Asia

https://theaseanpost.com/article/defence-market-southeast-asia

https://www.jstor.org/stable/25798074?seq=1

 

ELBIT:

https://elbitsystems.com/products/communication-systems/software-defined-radios/

elbit investments in india:

https://www.business-standard.com/article/news-cm/bharat-electronics-receives-orders-worth-usd-33-mn-from-elop-israel-119022500337_1.html

 

Vietnam-Israel Defense Dialogue

https://thediplomat.com/2018/10/whats-in-the-new-vietnam-israel-defense-dialogue/

https://www.newmandala.org/vietnam-israels-closest-asean-partner/

 

IWI FACTORY

https://www.israeldefense.co.il/en/content/production-galil-rifles-vietnam-has-begun

https://en.wikipedia.org/wiki/Z111_Factory

 

 

 

MINI-CASE STUDY: VALUATION OF AN IT SERVICE COMPANY

Pages:8

You have just been hired to assist the CFO of anIT Group (ITG), a family-owned IT service group which owns and manage 4 small branches scattered in the Kingdom. The ITG headquarter is in Jeddah. The company is owned by non-Saudi resident liable to income tax. ITG plans to sell 2 branches outside Jeddahto focus on its core business in Jeddah.ITG employs 66 full-time employees.

To accelerate its development in Jeddah, ITG plans to buy another family-owned IT company (called MH) with2 offices based in Jeddah.

For this purpose, the ITGboard asks you to briefly diagnose the MH company performance and assess its value.

All questions can be handled independently with the information provided in the appendices.

1.1 MH company performance (Appendix 1)

From the consolidated financial statements, you will determine the return on capital employed (ROCE)and the return on equity (ROE) for theMH Company. You will also computethe operating margin rate for the last three years. A 20% corporate tax rate willbe used.You will justify, explain and interpret each calculation.

 

To calculate the ROCE, we will divide the EBIT of the company by the total capital invested. In order to get the total capital invested we will substrate total current debt from the total assets.

 

For ROE, we will divide the net income by the total provided equity. And for operating margin, we will divide the EBIT by the total turnover.

 

N N-1 N-2
ROCE 10.64% 8.10% 11.18%
ROE 14.41% 13.34% 14.30%
Operating Margin 7.93% 7.32% 7.58%

 

 

1.2 The MH Company weighted average cost of the capital(Appendix 2)

Since the MH company is not listed on a stock market, it is not possible to easily compute its cost of capital. Using data provided in appendix 2, you will estimate the weighted average cost of capital (WACC) of the MH Company based on data from comparable listed companies.

 

For the calculation of WACC, we first need to determine the weightage of debt and equity in the respective capital structure. For the weightage, divide the amount of debt and equity by the total sum of debt and equity.

 

After getting the portions of debt and equity, we will use the following equation to calculate the WACC.

 

WACC = (Cost of Debt * Portion of debt) * (1- Tax %) + (Cost of Equity * Portion of Equity)

 

Cost of equity 16
Cost of Debt 8
Tax 20.00%
Rounded off debt 50% 60% 50%
Rounded off Equity 50% 40% 50%
WACC N N-1 N-2
11.20 10.24 11.20

 

 

 

1.3 The MH company business Plan (Appendix 3)

Based on the financial data projections, you will estimate the free cash flow to the firm (FCFF) over the next five years.

 

 

In this question, we have used the following formula to calculate the FCFF

 

FCFF = EBIT (1-Tax %) + Depreciation Expense – CAPEX – Working Capital Expense

 

N+1 N+2 N+3 N+4 N+5
Turnover 4400000 5060000 5566000 5844300 5961186
Operating Income 176000 253000 333960 350658 357671
Tax Expense 35200 50600 66792 70131.6 71534.23
EBIT After Tax 140800 202400 267168 280526.4 286136.9
Add: Depreciation 176000 202400 222640 233772 238447.4
Minus: CAPEX 176000 202400 222640 233772 238447.4
Working Capital 440000 506000 556600 584430 596118.6
Minus: ChangeWorking Capital 24000 66000 50600 27830 11688.6
FCFF 116800 136400 216568 252696 274448

 

1.4 The MH company valuation with the DCF method(Appendix 4)

Following multiple meetings and exchanges, MH’s weighted average cost of capital and its business plan are reviewed. Using Appendix 4 assumptions, you are asked to assess the MHequity value using the discounted cash-flowsmethod (calculations in thousands of SAR).

 

The first step for the DCF Valution, we need to discount back the projected FCFF by the provided WACC. After getting the discounted values, we need to project the Terminal value of the company as we assume that the company will grow till eternity. For terminal value, we used the following formula:

 

TV = FCFF(last Year) *(1+Growth rate%) / (WACC – Growth Rate)

 

After calculating TV, discount it back. After discounting all the cash flows, add all the values and subtract the net value of debt.

 

WACC 12 %
Growth Rate 2 %
Net Debt 1380000
N+1 N+2 N+3 N+4 N+5
FCFF            150,000        170,000        200,000        240,000            280,000
Discounted FCFF            133,929        135,523        142,356        152,524            158,880
Terminal Value        2,856,000
Discounted TV        1,620,571
Total value of the firm        2,343,783
Total value of the equity            963,783

 

 

 

 

1.5 The MH company valuation with multiples (Appendix 5)

You are also asked to assess the equity value of the MH Companywith the multiples of its operating income and net income using Appendix 5.

 

Multiple method is based on the assumption that the peer companies tend to perform similarly; hence we use the average multiple of industry to predict the value of equity of our company.

 

A B C Average MH MH
Operating income 60 70 80 350
Net income 50 64 45 230
Value of Debt (M SAR) 200 300 400 1380 1380
Value of Equity (M SAR) 400 500 400 2194 1894
Enterprise Value 600 800 800 3667 3241
EV/Operating income 10.00 11.43 10.00 10.48
EV/ Net income 12.00 12.50 17.78 14.09
Ve/Operating Income 6.67 7.14 5.00 6.27
Ve/Net Income 8.00 7.81 8.89 8.23

 

 

 

 

1.6 Conclude on the opportunity for the Group ITG to acquire the MH company. Write a brief note for the members of the Board of Directors in the form of a summary note to explain if ITG Group should buy or not the MH company (1-page max).

 

Based on the analysis performed, in my opinion, buying MH Company is a good opportunity.

 

As per the data provided, the company’s turnover is expected to grow by good percentages in next five years and also the free cash flow to the firms are positive numbers for the next five years. Moreover, the equity value we have calculated from three methods are very good and we expect that the company will do great in future. So ITG should acquire MH Company.

 

Furthermore, the decision to sell other branches of company which were outside Jeddah is a good and recommended step. Acquiring of MH Company will not only prove viable financially but also it will help ITG in its operations in terms of probable synergies.

 

Also, if we discuss the industry with regard to its multiples, it seems to be a very attractive industry. EV multiples are high which shows the further growth potential.

 

 

 

 

 

Appendix 1

 

Financial statements–MH company(in KSAR)

 

 

 

Note: Provisions for pensions can be considered as a Financial Debt to compute the Net Debt.

 

 

 

 

 

 

 

Appendix 2

 

Estimated Weighted Average Cost of Capital for the MH company

 

To estimate the weighted average cost of capital of the MH company, a cost of equity of approximately 12% plus a 4% illiquidity premium will be usedsince the company is not listed.Given its financial situation, the MH company management estimates that it can borrow at an interest rate of 8% before tax.The financial structure will be rounded to the nearest (for example, we will retain 40% instead of 38%).The corporate tax rate is 20%.

 

Appendix 3

 

Assumptions for the MH company Business Plan

 

The forecasted turnover for the year N+1 is estimated at 4.4 million SAR. You anticipate an increase in turnover in N+2 of +15%, +10% in N+3, +5% in N+4, then a stabilization of growth at 2% per year. The projected operating margin rate is +4% for N+1, +5% for N+2 and +6% for subsequent years. Depreciation expense is estimated at 4% of revenues, as well as CAPEX. The working capital requirement is assumed to equal 10% of the current yearly revenues.

 

Appendix 4

 

Business valuation using the discounted free-cash-flows method

 

After a complete analysis, it was decided to use a 12% weighted average cost of capital and the following free-cash-flows projections:

 

Beyond the year N+5 (and over an infinite horizon), it will be retained a constant growth rate of 2% per year for the FCFF. The net debt value will be equal to the accounting (balance sheet) value.

 

Appendix 5

 

Business Valuation using multiples

 

Asample of three comparable companies (A, B and C) has been selected to evaluate theMH company.

The value drivers (or multiples) used for comparison are following:

  • the forecasted(N+1) operating income,
  • the forecasted (N+1) net income.

 

 

 

Concerning the MH company, the forecasted operating income is estimated to be 350 kSARand the net income part of the group is estimated at 230 kSAR.

ANALYSIS OF GOOD ENERGY

Pages:15

Glossary:

 

OFGEM Office of Gas and Electricity Markets
CAGR Cumulative Average Growth Rate
ROE Return on equity
ROA Return on assets
EBIT

 

 Earnings before interest and taxes
CR Current ratio
GPM

 

 Gross profit margin
OPM Operating profit margin
NPM Net profit margin

 

1.    Introduction – Good Energy

Good energy is a vertically integrated power generation and supply company which is listed on London Stock Exchange. Good Energy started its operations in 1999 and after 20 years of successful journey, it has more than 1400 independent power generators, producing a total of 54.5MWs of electricity, which use only renewable sources likewind, solar, hydro and bio-generation technology to generate 100% renewable electricity. Currently the fuel mix of Good Energy constitutes of 57% from wind, 20% from bio-generation, 18% from solar, and 5% from hydro. (Good Energy Group PLC, 2018)

Core Values:

With technology, people and partnerships as its core values, Good Energy aims to excel in the field of clean energy.

Good Energy believes that the usage of technological sources to generate clean and renewable energy is the future of global power industry. GE considers its leadership and the people as the core element of its success and aims to continue investing in its human resource. GE’s final core value encompasses the arena of partnerships as GE believes that the future of power industry relies on the effectiveness of partnerships among the stake holders of generators, suppliers and the technological enterprises. (Good Energy Group PLC, 2018)

 

Business Model:

Good Energy is a vertically integrated power generation company. From generation of electricity to its supply and applicable services, GE has a well control over its value chain. Good Energy’s integrated value chain also allows it to interact, connect and engage with its customers and clients directly. (Good Energy Group PLC, 2018)

Strategic Overview – Electricity Sector:

2018 was a very important and crucial year for electricity sector. The industry became more competitive with shifting dynamics, introduction of new regulations, continued development, and inception of latest technological advances. All of these factors impacted the industry where Good Energy operates.
The local market witnessed one of the most important and prominent regulatory changes in 2018. From January 2019, prices for consumer gas and electricity, supplied through various tariffs, have been regulated and capped at a price set by the energy regulator, OFGEM. The period of first capped prices would be from 1st January 2019 to 31st March 2019. A further price hike of 10% has been already implemented by OFGEM, effective by 1st April 2019. The regulator, OFGEM, will review and revise the price cap at every six month intervals. (Good Energy Group PLC, 2018)

Table 1

Profit and Loss Statement
2013 2014 2015 2016 2017 2018
Revenues 40407 57618 64281 90437 104509 116915
Cost of Goods Sold -26822 -38782 -42982 -62905 -75178 -83466
Gross Profit 13585 18836 21299 27532 29331 33449
Administration Expenses -9727 -15045 -17065 -21582 -23739 -26800
EBIT 3858 3791 4234 5950 5592 6649
Interest Income 116 87 23 18 2 16
Interest Expense -719 -2590 -4129 -4534 -4860 -4361
EBT 3255 1288 128 1434 734 2304
Tax -586 520 -323 -51 566 -660
Net Income 2669 1808 -195 1383 1300 1644

 

Table 2

Balance Sheet
  2013 2014 2015 2016 2017 2018
Current assets 32055 30559 25957 37554 61852 60687
Non-current assets 23918 48759 67604 65379 60237 58103
Total assets 55973 79318 93561 102933 122089 118790
             
Current liabilities 14104 21684 20140 40927 46565 43127
Non-current liabilities 25405 39691 56478 40961 57437 56837
Total liabilities 39509 61375 76618 81888 104002 99964
Equity 16464 17943 16943 21045 18085 18827
             
Total Liabilities & Equity 55973 79318 93561 102933 122087 118791

 

Table 3

Key Ratios
2013 2014 2015 2016 2017 2018
Gross Profit Margin 34% 33% 33% 30% 28% 29%
Operating Profit Margin 10% 7% 7% 7% 5% 6%
Net Profit Margin 7% 3% 0% 2% 1% 1%
Coverage Ratio 5.37 1.46 1.03 1.31 1.15 1.52
Current Ratio 2.27 1.41 1.29 0.92 1.33 1.41
Debt to Equity 2.40 3.42 4.52 3.89 5.75 5.31

 

Financial Highlights – Good Energy:

Figure 1

 

Good Energy has performed well in increasing its revenue in last six years. The total revenue of GE has grown at a CAGR of 23.68% during the tenure from 2013 to 2018. However, GE has significantly struggled in controlling its cost of sales and maintaining its net income. Cost of sales since 2013 to 2018, grew at a much higher CAGR than that of revenue; that is at a CAGR of 25.49% which shows that the business has been facing tough challenges on cost side. Moreover, the GE has not been able to transfer the increment in the revenue over the period to the net income. The net income during the tenure faced a decline at CAGR of -21.37%.(Good Energy Group PLC, 2018)

Figure 2

Good Energy has shown a keen approach towards constantly increasing its asset base. Since 2013, Good Energy has grown its assets by average yearly rate of 17%. This trend shows the positive intend of the company. However, in order to fund this growth, Good Energy has relied on raising new debts, on a yearly basis, Good Energy’s long term debt has increased by an average rate of 22% since 2013 till 2018. Constant increment in debt has played its negative role in shrinking the overall net income as with increasing debt comes higher finance costs.

Good Energy’s non-current assets mainly include lease hold lands, electricity generation assets and other equipment. (Good Energy Group PLC, 2018)

 

 Critical Analysis:

Figure 3

 

 Being an electricity generating and supplying company, it is really crucial that you keep updating and expanding your electricity generating assets in order to keep yourself in the competition. Good Energy has not only been successful in maintaining its electricity generating assets base but also it has reinvested and expanded its asset base. Last considerable investment in electricity generation assets has been witnessed in 2015, where Good Energy increased the electricity generating assets from £35 million to £65 million. During the period from 2013 to 2015, Good Energy increased its electricity generating assets at CAGR of 135.82%. (Good Energy Group PLC, 2018)

 

 

Figure 4

 With time, the trade and bill receivables of Good Energy has increased at a drastic rate, which can be quiet devastating for the effective management of liquidity of the company. Moreover, further intensifying the situation, the provisions against the trade and bill receivables, haven’t kept the pace with the rapidly increasing receivables.(Good Energy Group PLC, 2018)

Figure 5

Receivables as a percent of total revenue also has increased from being 13% in 2013 to 27% in 2018 which represents the problem that Good Energy has either supplying more electricity on receivable basis or is not effectively collecting its receivables. In any scenario, this might presents issues to Good Company like liquidity crunches which is quiet important to manage well in electricity generating and supplying businesses. (Good Energy Group PLC, 2018)

Figure 6

On the other hand, the company’s management has been reluctant in increasing the provisions against the increasing trade and bill receivables.

Figure 7

On a positive side, Good Energy is a good stock to keep for investors who wants constant and stable dividends. Good Energy has been paying a constant amount of dividends every year since 2013 irrespective of its profitability as in 2015, even when GE didn’t make any profit, it still paid dividends quiet similar to that of previous years. In 2013, the dividend payout ratio of Good Energy was 14%, however in 2018, this metric was 28%, almost doubled.

Ratio Analysis – Peer Group:

To analyze the performance of Good Energy over the period from 2013 to 2018, we will dig deep into its financials and compare its ratios with those of its comparable peers.

Profitability Ratios:

  • Gross Profit Margin Ratio:
Figure 8

While industry average of Gross Profit Margin has witnessed ups and downs since 2013, Good Energy’s GPM ratio has been more or less constant which shows that GE has somewhat control of its input costs. In 2013, the industrial average of GPM was above that of GE, however, with passing years, GE maintained its margin quiet effectively whereas the margin of industry deteriorated with increasing fluctuations in raw material costs. Fluctuations in the gross profit margin in attributed to variations in commodity prices. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

 

  • Operating Profit Margin:
Figure 9

 Operating Profit Margin shows how effectively the company has managed its operating expenses with respect to its operating profits. Higher the margin, higher the effectiveness. Whereas, the industrial average witnessed a massive decline in the OPM, Good Energy has very effectively managed and maintained its OPM which shows that GE has kept costs like administrative expenses in control. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

  • Net Profit Margin:

 

Figure 10

 

The Net Profit Margin comparison has also followed the same trend as of GPM and OPM. Industrial average deteriorated with time but GE has at least been successful in maintaining its profit margins. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

Liquidity Ratios:

  • Current Ratio:
Figure 11

 Current Ratio tells us about how effectively a company manages its current assets and current liabilities. A company should have enough current assets to cover up its current liabilities at any given time of the year. Usually, anything below than 1 in CR is not acceptable. Current ratio of Good Energy has been on a decline since 2013 with going below than 1 in 2016. However, it recovered slightly from being 0.9 in 2016 to 1.40 in 2018. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

 

  • Debt to Equity Ratio:
Figure 12

 Good Energy’s balance sheet has more debt than the industry average. The debt level of GE has significantly increased since 2013, the debt to equity ratio increased from 2.3 in 2013 to 5.3 in 2018. Higher debt level has contributed to increase the financial cost which has shrunk the net profit. The finance cost of Good Energy has increased at CAGR of 43.41% during the tenure from 2013 to 2018.(Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

  • Interest Coverage Ratio:
Figure 13

 

Interest coverage ratio tells us about the company’s ability to cover and fulfill its interest payment liabilities. Anything below 1 is a sign of severe distress; however, ideally the number should be above 5. Interest coverage ratio of Good Energy also has declined since 2013, showing that the either the EBIT has declined drastically or the finance cost has increased. Good Energy has invested heavily in its electricity generating assets in 2013 and 2014 after taking new debts which resulted in higher D/E ratio and lower interest coverage metric. We expect that this ratio will improve in coming years as expansionary projects will start generating electricity which will help increasing the EBIT and with time, the finance cost will also decrease. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

Other Important Ratios:

Table 4

  Green Energy (As per 2019) Industry Average
P/E Ratio TTM 14.08 19.81
Price to Sales TTM 0.29 1.8
Price to Cash Flow MRQ 2.61 89
Price to Free Cash Flow TTM 2.05 89.04
Price to Book MRQ 1.69 2.68
Price to Tangible Book MRQ 2.14 4.37
Return on Equity TTM 12% 15.98%
Return on Equity 5YA 7.12% 16.31%
Return on Assets TTM 1.94% 3.76%
Return on Assets 5YA 1.34% 3.72%
Return on Investment TTM 2.96% 4.63%
Return on Investment 5YA 1.99% 4.6%

(Anon., 2019)

 

Non-Financial Ratios:

 

Table 5

  2017 2018
Customer Meter Growth 4.3% 0.2%
Business Customer Volume Growth 46% 23.2%
NPS 46< 46<

 

Good energy has continued the good work of enlarging its customer base of both, domestic and business customers. However, the growth has slowed down in 2018 as compared to that in 2017. Customer meter growth shows the growth in meters supplied to domestic customers whereas business customer volume growth presents the number for meters sold to business customers. NPS is a measurement of how likely is that a customer of Good energy would recommend the services to someone else. (Good Energy Group PLC, 2018)

Corporate Governance:

Corporate governance means keeping in mind the interests of all stakeholders while making crucial decisions. A corporation has several stakeholders and their interests may vary from one another; the goal of a corporation is to effectively manage the relationships among all the stakeholders and make the best possible choices for the long term betterment of each stakeholder.

Good Energy has taken several steps which portrays its effective management of “Corporate Governance”

GE sources all of its electricity from certified and proved renewables sources of energy like solar power, wind power, hydroelectric power and biofuels. All of the Good Energy’s suppliers are based in United Kingdom and Green Energy pledges that it will always deal with UK suppliers only. Gas used by GE is carbon neutral where 6% of the total gas comes from bio-methane and the rest through the Green Gas Certification program. The projects of GE delivers wider benefits to the local communities, including helping out local poverty and empowering local women.

Furthermore, GE shares all the important information to its shareholders in a timely manner. GE’s board of directors include professionals who look after key decision makings and manage enterprise risk.  (Good Energy Group PLC, 2018)

Aligning to the goals of effective corporate governance has become so essential in this era of social media where any mishap can damage the reputation of the organization in the longer run.

Strategies to become a FTSE 100 Company:

 

Following are few strategies, the management of Good Energy can adapt to become a FTSE 100 company.

  • Invest in research and development. The energy sector is very rapidly evolving and to become competitive and remain relevant, GE should increase its investments in R&D to find better, cheaper, and cleaner ways of generating electricity.
  • Envisage future. Good Energy should start planning for future beforehand. In future data will empower homesand businesses to control and store electricity, GE should prepare itself for future to take a competitive edge.
  • Invest in human resource. Great companies are made and run by great people. In order to be a FTSE 100 Company, GE should bring industry best practitioners and experts in to its top management team.
  • Build better and sustainable partnerships. In an era full of uncertainties and variations, to grow and thrive, GE should build better relationships with its suppliers and distributors.
  • Good energy should be well prepared to any changes in regulations and compliance of government or regulatory organizations. As the electricity and power sector is very exposed and vulnerable to such changes, any drastic change in the policies can harm the operations and profits of Good Energy. Hence the management should be well prepared for such changes.

Caveats and Methodology:

  • In order to make the numbers comparable, financial results of 2018 of all companies have been used in the analysis presented in this report as complete results of 2019 have been not published for few of the peer companies.
  • Peer group includes OPG Power Ventures, Aggregated Micro Power Holdings PLC, YU Group PLC, and GREEN & SMART HOLDINGS plc
  • In order to normalize the results from all peers, certain elements have been neglected like impairment provisions, other income, non-recurring items, gain on sale of assets Etc.
  • Few of the peer companies were in losses in few years.
  • Peers companies might vary slightly with the subject company in terms of operational size, geography and operations.

Annexes:

Table 6

  Net Asset
2013 11733
2014 35239
2015 65247
2016 64732
2017 62051
2018 62081

 

Table 7

Interest Coverage Ratio
Good Energy
2013 5.366
2014 1.464
2015 1.025
2016 1.312
2017 1.151
2018 1.525

 

Table 8

D/E Ratio
Good Energy Peer Group Average
2013 2.400 0.699
2014 3.421 1.170
2015 4.522 2.007
2016 3.891 2.496
2017 5.751 1.714
2018 5.310 1.481

Table 9

Current Ratio
Good Energy Peer Group Average
2013 2.27 2.06
2014 1.41 4.52
2015 1.29 1.69
2016 0.92 1.62
2017 1.33 1.47
2018 1.41 1.14

 

Table 10

NPM
  Good Energy Peer Group Average
2013 6.61% 14%
2014 3.14% 14%
2015 -0.30% 5%
2016 1.53% 7%
2017 1.24% 4%
2018 1.41% -4%

 

Table 11

OPM
  Good Energy Peer Group Average
2013 10% 24.69%
2014 7% 26.82%
2015 7% 7.79%
2016 7% 13.20%
2017 5% 7.22%
2018 6% -1.52%

 

 

 

Table 12

GPM
  Good Energy Peer Group Average
2013 34% 38%
2014 33% 46%
2015 33% 27%
2016 30% 38%
2017 28% 30%
2018 29% 19%

 

Table 13

Dividends Paid
2013 377
2014 472
2015 451
2016 491
2017 459
2018 462

 

Table 14

Total Receivables to Net Revenue
2013 15%
2014 18%
2015 18%
2016 19%
2017 32%
2018 27%

 

Table 15

Dividends Paid
2013 14%
2014 26%
2016 36%
2017 35%
2018 28%

 

Bibliography

AMP PLC, 2018. Annual Report, s.l.: s.n.

Anon., 2019. Investing.com. [Online]
Available at: https://www.investing.com/equities/good-energy-group
[Accessed 31 december 2019].

Good Energy Group PLC, 2018. Annual Report, s.l.: s.n.

Green and Smart Energy, 2018. Annual Report, s.l.: s.n.

OPG , 2018. Annual Report, s.l.: s.n.

YU Group PLC, 2018. Annual Report, s.l.: s.n.

 

 

 

 

 

 

ONE SMART EDUCATION INTERNATIONAL – Equity Analysis

Pages:11

Summary:

  • Growing urban middle class, increasing trend of after-school education, and improving overall economics of Chinese people will lead the local education sector to further growth.
  • One Smart Education is an attractive buy at current level with a target price of $21.
  • In recent quarters, profits margins have shrunk because of increasing marketing, selling, and administrative expense as One Smart is currently focusing on expansion. We believe margins will improve over time which will result in positive upside in net income.

Introduction:

With 430 learning centers across 43 cities in China, One Smart International Education Group Ltd is an innovative and leading educational company which provides K-12 after-school education. One Smart Education caters kindergarten and primary, middle, and high schools (K12) segments of education industry and offers them tutoring services. By revenue of 2016 and 2017, One Smart Education is the largest K-12 after-school education service provider in China.

One Smart Education’s vision is to become the best and most trusted “Third Class” outside home and school by utilizing motivation, capability and perseverance of each and every student and bring the best learning power out of him. With customer focus, execution, innovation, and teamwork as their core values, One Smart Education aims to thrive further in the competitive environment of China and take the full benefit of opportunities provided by growing industry of education.

One Smart Education (One) raised $179 million by issuing 16.3 million shares on New York Stock Exchange on 27th March, 2018.

 Management:

One Smart Education was founded by Xi Zhang in 2008 in Shanghai, China. Xi Zhang did his master in business administration from Harvard Business School and had an experience of working with big multi nationals like Johnson & Johnson and Wrigley. Zhang was also recognized as a “Top 10 Most Innovative Entrepreneurs in China in 2012” by Global Times.

Honggang (Greg) Zuo is the Chief Financial Officer of One Smart Education. He completed his MBA from MIT Sloan School of Management in 2004. He has a vast experience of working in both, China and USA. Previously, he was engaged with Asian Special Situations Group of Goldman Sachs, MasterCard, General Electric, and PricewaterhouseCoopers.

XiaoqiangMeng serves at the senior vice president of One Smart Education and looks after the sales division. He has an experience of working in sales department of PepsicoLimited, Philip Morris, and Colgate Palmolive.

On the research and development side, Muyuan Ma uses his technical expertise to keep bringing latest updates to software of One Smart Education. He has a master degree from Warwick Business School.

One Smart Education currently employs 9023 employees. All of the top executives and employees of One Smart Education are well educated, experienced, and professionals in their respective fields.

Market Dynamics:

Business Outlook:

China’s economy is improving; poverty is on the decline and the overall living standard is rising. People are spending more money than ever on their kids’ education. China’s education market is poised to touch a mark of RMB3.36 trillion by 2020, increasing from a market of RMB2.68 trillion in 2018. (Source: Deloitte) The main triggers for this vibrant growth in the education sector are changing dynamics of Chinese demographics, increase in the governmental spending on education, and availability of capital to education sector through IPOs and VCs.

China is witnessing massive growth in its middle class population. With a middle class population larger than the total population of USA, it is estimated that there will 120 million applications for pre-school admissions by 2022, taking the pre-school school education market to RMB800 billion by2020. Moreover, these stats are also supported by the fact that the people born is 80s and 90s are becoming parents and they are more cautious regarding their kids’ pre and after-school education, including tutoring, as compared to their earlier generations. (Source: Deloitte)

The Chinese government has shown keen intention towards improving the educational standards in the country and making it more inclusive. In the budget of 2018, the government allocated RMB171.122 billion towards to educational sector, up by RMB10.501 billion, increasing by a growth rate of 6.5% as compared to last year. Preschool and high schooleducation received the most attention among all the other segments of education, getting a funding from government of RMB803million (increased by 35.6% from 2017’s actual spending) and RMB2.064 billion (increased by 21.5% from 2017’s actual spending). (Source: Ministry of Finance, China)

The capital markets and financial strategists also see a huge potential in Chinese educational sector. Eight educational companies proceeded towards IPOs in 2018 and deals worth of USD2.57 billion took place in the education sector in just the first six months of 2018, surpassing the number of total deals happened in 2017. (Source: Deloitte)

Industry-related risks:

This industry has no barriers to entry and this has started to trouble older players. With new players entering the market like Gogokid who are backed by big tech firms like ByteDance, the problems for One Smart Education will increase and this might result in shrinkage of profit margins and market share.

Another risk associated with this industry is very high customer acquisition cost. The firms in this industry typically spend a lot of money in trial classes, commission to sales employees and referral bonuses to teachers and parents. Sometimes the costs spent on acquiring customers exceed the profits which results in shrinking profit margins.

Corporate Strategy:

Going forward One Smart Education will eye following key strategies in order to retain its number one spot in China’s after-school education market and thrive further to grow its revenues.

For the next phase of growth, management of One Smart Education has made following strategies:

Reach national coverage and then scale:

One smart education wants to increase their coverage, open more class rooms and cater more students. From having 117 study centers in 2015 to 430 study centers in 2019, One Smart Education has executed this strategy fairly well. However, in order to boast its coverage to national level, it might have to face shrinkage in its margins. One Smart Education believes that once it has attained national coverage, it will scale and improve its margins.

Particular focus on “Premium tutoring services”

Although being number one in after-school education in China, One Smart Education only have 2.4% share of the Premium tutoring services market. The segment “Premium tutoring services” includes 1-1 class sessions or classes of very small groups; hence, increased instructor’s attention and better learning environment result in personalized and highly effective outcomes, leading to outstanding study results.

This particular segment of after-school education in China is poised to grow at a CAGR of 16% from the period of 2017 to 2022, faster than the overall tutoring market (9%). The key strategy of One Smart Education is to focus more on this segment and capture a bigger chunk of total market size. The aim of One Smart Education is to grow its share from 2.4% to 25% in the total market of Premium tutoring series, worth RMB433 billion.

Particular focus on key regions:

One Smart Education has strategized to focus on key regions and scale up the operations in the top 20 cities in order to increase revenue and improve profit margins.

Strengthening operational Excellency:

Work on core competencies in order to excel further towards being the market leader, drive continued product and services innovation through new technologies and revamp the incentive system to increase productivity.

Financial Analysis:

One Smart Education generates the largest revenue as compared to its peers.

According to our analysis, the stock of One Smart Education is an attractive buy at the current level of $7.26, with an estimated target price of $21. The main reason behind this projected upside is the increase in the net revenue because of the increasing of study centers and consumed class units. As per our forecast, the revenue will increase by 11.58%, 10.91%, and 10.50% in up-coming three quarters.

In recent quarters, the profit margins has shrunk slightly because of the increasing marketing, and advertising expense; we expect that profit margins will further deteriorate as One Smart will focus on expending and launching new study centers nationwide.

The decreasing profit margin is because One Smart Education is currently focusing on growth instead sustainability and retention. In order to increase the number of enrollments and to cater growing number of students, One Smart Education is spending much of its sales revenue on marketing and commissions.

We believe that profit margins will improve with time which will result in healthy growth in net income in future.

Lower SG&A Expenses:

SG&A expense of One Smart has declined in last two quarters and is lower than other of its peers.

Liquidity Management:

So far, One Smart Education has not been able to maintain a current ratio of above 1 which may not be a sign of risk as much of current liability consists of “Prepayments from customers”. However, the average current ratio of One Smart Education, since its IPO, is below than the industry average Current Ratio. (MRQ)

On the risk side, One Smart Education is highly leveraged and its net income has struggled in recent quarters due to high interest payments. We expect the interest expense to increase further in coming quarters as One Smart is focusing on expanding its operations right now; hence, further distress on net income is anticipated.

Price to book ratio of One Smart Education is in line with the industry trend with the exception of Puxin, which is slightly over valued as per the P/B ratio.

Valuation Methodology:

For the purpose of valuating One Smart Education, the analyst has used the “Discounted Cash Flow” methodology. After discounting the estimated “Earning before Income and Taxes” of next 3 quarters by an appropriate discount rate, the analyst has arrived at the target price of $21.

Conclusion:

One Smart Education caters kindergarten and primary, middle, and high schools (K12) segments of education industry and offers them tutoring services. One Smart Education is currently trading at $7.26, below its IPO price of $11, as recently net income has declined because of increasing expenses on advertisement and administration. But with key dominating factors like rapidly growing Chinese middle class population with increasing focus on children after school education, hike in government’s spending on education, and increasing influx of capital in education sector of China, we believe the stock of One Smart Education has the potential of reaching the a price of $21 in coming quarters.

Moreover, One Smart Education has funding from strong financial players like GoldmanSachs and Black Rock which shows further credibility and strength of this stock.

Sources:

https://markets.ft.com/data/equities/tearsheet/profile?s=ONE:NYQ

http://www.onesmart.investorroom.com/index.php?s=120

https://www2.deloitte.com/cn/en/pages/international-business-support/articles/trends-in-the-chinese-education-industry.html

https://www2.deloitte.com/cn/en/pages/technology-media-and-telecommunications/articles/golden-age-of-the-chinese-education-market.html

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