Case Study

MCS November 2016 Financial Analysis

A financial analysis of Portafone for the MCS November 2016 CIMA exam.

Portafone's Statement of Profit or Loss

Starting with that top line and we quickly notice that Portafone has registered impressive revenue growth of almost 14% in 2015 in spite of weak global growth of around 0.7% for the industry as a whole. However, that strong growth is nullified by an identical increase in cost of sales so that the gross profit margin (gross profit/revenues) is flat at 42.5%. At least those costs are not spiralling out of control which could be a worry given the high cost of components and power of huge suppliers such as Samsung, so it's not all that bad (you can find much more on Samsung and other major industry players here).

When we look at operating profit margins (operating profit/revenues) though we see a big favourable movement from 9.2% to 12.8% - that's a 39% increase in that margin year on year. So, Portafone has held down those operating costs in a rather aggressive manner. In fact, one needs to ask whether the focus on growing that operating profit margin is short-sighted given the fact that Portafone has barely increased its R&D expenditure in such a fast-moving industry. Is a 1.2% increase in the R&D budget for the year enough and do they risk falling behind more innovative rivals?

In such a competitive and saturated market, maintaining the level of sales growth that Portafone has enjoyed in 2015 will be hugely challenging. If they want to grow revenues at a similar rate they would probably need to invest in new products and/or enter new markets. Of course, that kind of diversification requires thorough investigation so I would tend to encourage Portafone to invest more aggressively in R&D in 2016 and look to make savings instead in cost of sales which is by far the biggest expense. They could do so by looking to produce components themselves, for example.

Portafone's Statement of Financial Position

It's a little surprising to note that the goodwill and intangible assets of the company seem quite low. A highly valued brand like Apple on the other hand, had about $8.7 billion in combined goodwill and intangible assets at the end of 2014 indicating a much higher level of intellectual property (IP), patents etc. Portafone may be suffering here due to its reluctance to ramp up R&D and the balance sheet suggests to me that the company is not overly-focused on positioning itself as a market leader at the cutting edge of innovation.

Turning to current assets and we see that cash pile has grown by a whopping 41% over the year to just over F$10.4 billion. Given the fact that the current ratio (current assets:current liabilities) stands at 3.9 in 2015, it's clear that there are absolutely no liquidity issues at Portafone. Inventory days (inventories/cost of sales x 365) has come down slightly from 104 days in 2014 to 100 days in 2015 but is still a little too high for my liking considering that stock in this industry quickly goes out of date. Portafone should not want inventory sitting idle for too long as they may get stuck with high cost inventory that the market no longer values due to recent technical and/or design innovations. Finally, receivable days (receivables/revenues x 365) has stayed flat at 85 days.  

It's notable that there is no retained earnings line in the balance sheet. This could mean one of two things: 1). the retained earnings is included in Equity Attributable to Owners or 2). there are no retained earnings because Portafone is paying out some very generous dividends! No doubt their shareholders would be thrilled in the second scenario (for the moment at least), but there is a trade-off between dividend payments and re-investment in the company. Is Portafone sacrificing future growth to keep its shareholders happy in the short-term? It's important to point out that the equity section is unclear and open to interpretation, so please beware of that going into the exam. If Portafone truly has used all its net income to pay dividends, then it seems from the equity section that Portafone has issued shares in 2015. Given the fact that the company has also taken on debt in spite of having such a healthy cash position and it has kept R&D spending low in 2015, one may reasonably draw the conclusion that the company is building up its finances. For what we do not know, but I would not be surprised to see something appear on exam day on potential acquisitions or investments that the company could consider.

As I mentioned, Portafone has increased its debt and we have speculated a little as to why that may be. Still, the company is not heavily indebted as gearing (long-term debt/equity) stands at just 12.6% now (up from 10% in 2014). Payable days (payables/cost of sales x 365) stands at 98 days and like receivable days is at the same level as the previous year. Following on from that, we notice that the cash conversion cycle (inventories + trade receivables - payables) has come down slightly from 91 days in 2014 to 87 days in 2015. This means that Portafone's ability to turn current assets into cash has improved slightly over the course of the last year.

All in all, Portafone looks to be a very liquid and very solvent business. While debt has increased over the year the entity is more than capable of covering its finance costs with interest cover (operating profit/interest expense) standing at 12.7. The only worries would be those high inventories potentially becoming obsolete and I wonder whether that large cash pile could not be put to more productive use rather than sitting in an account that is not likely to be generating much in the way of interest for Portafone?

Note 1 - Segmental Information

When we analyse the revenues per region, it's interesting to note the minimal sales growth of just 1.2% registered in Asia in 2015. Considering the fact that it is the second most important market for Portafone behind Europe it is sure to raise concerns. Despite being the smallest market, the Middle East is undoubtedly the star performer in 2015. It has come on in stellar fashion given the fact that revenue growth there is 56.5% over the year.

The operating profit section sheds more light on the regional situation. It's clear that Europe is also registering very strong growth in terms of profitability with almost double the profits of 2014. Obviously the bulk of the operating cost cuts that we spoke of earlier are taking place in Europe. Perhaps Portafone is strategically pulling back a little in the mature European market and is looking to channel some investment into the high-growth Middle Eastern market? Indeed, when we look at the Middle East we see that the operating profit margin (operating profit/revenue) is lower than all the other regions at 10.5%. The operating profit margins for Europe and Asia for example are 14.4% and 13.9% respectively. This indicates to me that operating expenses are not being held down in the Middle East. It's an emerging market for Portafone and requires investment, marketing to enhance brand recognition and R&D spending. As a result, profitability is not as high as the mature European and Asian markets where Portafone is reaping the benefits of having probably sunk investments into those regions at an earlier stage.

Note 2 - Intangibles

We commented briefly on the low level of intangibles on Portafone's balance sheet and on page 16 of the pre-seen we have more detail. The value of patents and trademarks held by Portafone has actually declined over the year implying a slow rate of innovation at a company whose industry rivals are likely prioritising intellectual property (IP) just to keep up with the technical evolutions that are part and parcel of the mobile phone industry.

Maltone's Statement of Profit or Loss

Interestingly we have a direct rival against which to compare financials. Maltone is a similar-sized competitor offering a similar range of products to Portafone.

On the Profit and Loss side we can see that Portafone and Maltone are very close in that they register revenues, costs and profits of a very similar size. Where the difference is though, is in the trends for those categories over the last year. Whereas for Portafone revenues are up, cost of sales are up but under control, operating costs are being held down aggressively and profitability is up, for Maltone revenues are down, cost of sales are growing at a dangerous rate and net profit is down. Portafone has overtaken its rival in terms of performance.

Maltone is likely losing market share to its rival and while its revenues fell in 2015 its cost of sales increased by 11%. It may well be that Portafone is a more astute purchaser of component parts than we initially thought. Maltone has also cut R&D so, like Portafone, we should be slightly concerned about their credentials as an innovator.

While net profit fell over the year for Maltone, they still have a better net profit margin (net profit/revenue) than Portafone. In 2015 Maltone has a net profit margin of 11% versus Portafone's margin of 10%. The key is the trend though, because that margin stood at 16% in 2014 for Maltone whereas Portafone's was 7%.

Maltone's Statement of Financial Position

Maltone has a lighter balance sheet than Portafone. Their PPE position is significantly less than Portafone's signalling that perhaps they outsource at least part of their production in much the way Apple does to Foxconn of China. With less of a manufacturing need it's obvious that Maltone would require less in the way of machinery etc than a company like Portafone that keeps manufacturing in-house. While there is less of a need for intensive capital expenditure in such a scenario, could it possibly explain the spiralling cost of sales Maltone encounters? After all, if they do outsource manufacturing the 3rd party charging for their services will need to add a mark-up to their costs to ensure the viability of their own business.

Like Portafone, Maltone's inventory figure is quite high and is on an upward trend with inventory days at 92 days compared to Portafone's 100. Like Portafone, Maltone is a very liquid company with a current ratio of 3.0. This is not quite as high as Portafone's so it indicates that they are not letting as much cash sit idle. With receivable days of 54 days and payable days of 87 days in 2015, Maltone's cash conversion cycle is a good deal lower than Portafone's (58 days for Maltone versus 87 days for Portafone).

Unlike Portafone, Maltone has deleveraged somewhat in 2015 by reducing it's long-term debt by around F$1 billion. It's probably just as well Maltone reduced its debt as its gearing stood at an uncomfortably high 44% in 2014 whereas it now stands at a reasonable 29%. So, rather than getting ready for new investments in the way I suspect Portafone may be doing, I believe Maltone's moves were motivated by a desire to get the company on a less risky financial footing.

In conclusion, it's telling that the examiners have decided to include financial information of a direct rival to Portafone and you need to ask yourself why they are doing so. Perhaps with Portafone's war chest of finances they are preparing themselves for a takeover of their rival, for example? Maltone is not growing and its shareholders may welcome a takeover bid if they were to receive a premium on their shares. In spite of the slight decline in revenues in 2015, Maltone has much going for it. It is a liquid and solvent company with a seemingly better ability to put its assets to good use and turn them into profits. Maltone's return on capital employed (operating profit/capital employed) for example is over two times higher than Portafone's in 2015 (45% versus 22%). Maltone may be lighter on assets than its rival but those assets are worked very hard indeed to generate equivalent revenues and profits to Portafone's indicating strong internal efficiencies within Maltone. This is clear when you see that the asset turnover ratio (revenues/capital employed) for Maltone in 2015 is 3.29 against Portafone's 1.70.

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