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To make the most of the available growth opportunities in the region, the management of X Corporation is analyzing different options to access more capital.
X Corporation is a well-established IT firm in Norfolk that provides IT support and solutions such as Cloud computing, Disaster recovery, and Voice and Data networks to SME businesses. Being in operations for the last 30 years, X Corporation has demonstrated a history of tremendous growth, customers satisfaction, and solid financials.
Having been managed by an experienced and committed board, constant and stable cash flows from operations, and a low level of debts make X Corporation an enticing target for acquisition or a “Leveraged Buyout”.
Customer Composition and Concentration:
X Corporation has exhibited great customer retention capability over the years. Due to its experienced and knowledgeable team and high level of customer service provision, X Corporation enjoys a large array of loyal customers.
X Corporation serves customers ranging from small to mid-sized private businesses and non-profit organizations. The customer base is not limited to any particular industry; X Corporation has a much-diversified clientele that includes clients from a variety of industries such as engineering, construction, professional services, and motor retail.
With more than 51% of the total revenue coming from the clients who are not among the top 10, X Corporation enjoys a low concentration among its clients; hence lesser reliance on any of the clients.
Future Perspective:
Future brings several avenues of growth for X Corporation in existing and synergistic markets. Increasing dependency on IT systems and the opportunity of cross-selling of products and services in the future promise good expanding potential.
Financial Strength:
A strong balance sheet:
X Corporation possesses a very strong balance sheet with almost no long-term liability. Its asset base has been increasing steadily and is expected to continue the pace as much of the profit stays in the business because of the low capital requirements. The fixed assets of the company include a plant and vehicles which don’t require any capital expenditure in near future. The stocks held with the company only include computer hardware for clients which might be required on an urgent basis; otherwise, hardware is ordered as per the demand. Due to the increasing turnover, trade creditors and debtors have been on a rise since FY14. Debtor days have gone from 26 t o31 days while creditor days have gone from 40 to 59 days in the period of the last five years.
In order to support growing turnover, never staff members have been hired which has resulted in an increase in social security. X Corporation partially financed its purchases of vehicles through “Hire purchase contracts” for which there is no longer a liability as all the payments have been paid and the vehicles are now completely owned by the company.
Growing turnover and stable gross profit margins:
Due to the satisfactory customer services and the increasing reliance of companies on IT products, X Corporation has succeeded in growing its turnover by an impressive CAGR of 10.4% from the fiscal year of 2014 to 2018. During the tenure of the last five years, X Corporation has maintained its cost of goods sold and demonstrated a healthy gross profit margin, averaging at 45.8%. However, because of the pension contributions to Mr. Robert Taylor, an employee in the operations department, gross profit margin declined slightly to 45.74% in 2017 and 44.54% in 2018.
Constant operating profit margins
The company has done well in managing its administrative expenses and kept the operating profit margins slightly above 30% during the last five years. Operating profit margin suppressed little in 2017 and 2018 due to the Director’s pension contributions which is a nonrecurring expense. Even with the increasing turnover, X Corporation has successfully maintained its administrative cost base.
X Corporation as an acquisition target:
Private equity firms lookout for companies that promise stable growth rates in the future with minimum risk. X corporation is operating in the IT industry which is poised to grow at a phenomenal rate in the future due to the growing influence of tech on businesses. Furthermore, X Corporation also has a very experienced and knowledgeable management leadership which has been leading this company for 30 years now and is willing to be a part of this company after the transaction to ensure a smooth transition to an incoming purchaser.
X Corporation also enjoys a strong competitive advantage over its competitor as it has been in business for so long and has built a strong brand name due to its satisfactory customers’ services.
Moreover, X Corporation requires a very low capital expenditure in the future and very little working capital in order to operate effectively.
All of these factors plus the strong financial past record which is mentioned above, makes X Corporation a very lucrative target for an acquisition.
Projected Financials:
X Corporation has grown its turnover by an annual average of 10.9%; keeping in mind the sound growth prospects in future for the company, we have taken the assumption that X Corporation will continue its growth momentum and will increase its yearly turnover by 10.9% annually. Gross Profit Margin will also remain constant and will follow the past average annual rate of 46%. Administration expenses will remain constant and won’t be including director’s pension contributions as in recent years directors have been paying themselves exceptional pension contributions which will not continue going forward after this transaction has been taken place.
According to our forecast, X Corporation will post a healthy net income of £386,000, £434000, and £510,000 in the following three years FY19, FY20, and FY21, respectively.
Discount rate:
In order to value any company, analysts are required to calculate a discount rate through which they can bring the future cash flows of the company at a present value. Usually, two kinds of discount rates are used for discounting purposes, WACC and Cost of Equity. As X Corporation doesn’t have any debt, we have preferred to use Cost of Equity as a discount rate. The cost of Equity can be calculated through a formula of CAPM which requires a risk-free rate, company’s beta, and market risk premium. As X Corporation is not a listed entity, we can’t find its trading Beta, that is why we are using an average of Cost of Equity rates of similar companies like X Corporation which are publically listed and regularly traded on the stock market. For the valuation of X Corporation, we will be using 9% as a relevant Cost of Equity.
Terminal Value:
While evaluating a company, analysts can only forecast cash flows to some foreseeable future. However, to know the overall value of any company, analysts also need to take into account the cash flows and value generated by the company after the forecasted future and for this purpose, analysts use the concept of “Terminal Value”. Terminal Value tends to tell the value of a company considering that the company will generate cash flows even after the projected period. To calculate the terminal value of X Corporation, we have used the FCFE of FY20 and divided it by the required rate of return, which is the cost of equity in this case, after subtracting the sustainable growth rate of 2%.
Valuation:
To value X Corporation, we have preferred Discounted Cash Flow methodology and have used “Free Cash Flow to Equity” as the company doesn’t have any debt. FCFE has been calculated by using Net income and then adding to it all the non-cash charges like depreciation and amortization. After that, we subtracted all the essential and necessary expenses like investments in working capital and capital expenditure.
After deriving the free cash flow for FY19, FY20, and FY21, we calculated the terminal value by using a sustainable growth rate of 2% and a required rate of return of 9%.
Conclusion:
X Corporation presents a very lucrative opportunity for acquirers. X Corporation’s senior and committed management, low capital and working capital reinvestment requirements, negligible amount of debt on the balance sheet, and established and loyal customers make X Corporation an enticing target for a leveraged buyout.
The total value of X Corporation is £5,728,000.
