QUESTION
Zomat (Pty) Ltd ("Zomat") is a black economic empowered (BEE) group that supplies products to customers in the building and construction industries. BLM Investments, a broad based BEE group, currently holds 26% of Zomat's shares and the executive directors hold 74%. Zomat has quarries in the provinces of the Free State and Limpopo and raw materials from these operations is used to make concrete blocks and bricks as well as ready-mix concrete.
The group extracts and crushes dolerite rock from its quarries. This material is processed into what is commonly known as aggregates, namely sand (fine particles of rock) and stone (larger particles of rock). These aggregates are sold to customers involved in road building and construction activities. Zomat also uses aggregates as a raw material in the manufacture of concrete blocks and bricks as well as ready-mix concrete.
Zomat has numerous factories in the Free State and Limpopo that manufacture concrete blocks and bricks. The factories are situated close to major customers to minimise transport costs.
Zomat has its own fleet of trucks that delivers ready-mix concrete to customers at construction and building sites. The construction industry is experiencing significant growth because of spending on infrastructure by government and parastatal organisations, and the continued boom in the non-residential building sector.
The shareholders of Zomat have been approached by Al Zenbah L.L.C. ("Al Zenbah"), a major building products group based in Dubai, United Arab Emirates. Al Zenbah has proposed the acquisition of 100% of the issued share capital of Zomat as it is eager to participate in the continued growth in the construction industry in South Africa over the next five years. Some of Al Zenbah's customers are also active in building new stadiums in South Africa in preparation for the Soccer World Cup in 2010.
Al Zenbah has submitted a formal purchase offer of R60 million for the total equity of Zomat to its shareholders. The Chief Executive Officer (CEO) of Zomat, Mr Roots, is of the opinion that the purchase price offered is far too low. His opinion is based on the price-earnings (PE) multiples of similar listed companies on the JSE Ltd, such as the following:
Nature of business
Most recent year end
Annual revenue
Current share price
Audited earnings
per share
R'000
c
c
Altan Ltd
Civil engineering and construction
June 2006
475 000
1 400
87,5
KMLO Ltd
Retailer of building products
June 2006
1 050 000
1 800
120,0
Gigan Ltd
Manufacturer and supplier of building products
June 2006
2 607 000
950
76,0
Mr Roots also noted that Al Zenbah recently acquired a major concrete brick manufacturer in France based on an historic PE multiple of 13. He told his fellow shareholders in Zomat that a slight discount to this multiple of 13 would be appropriate for Zomat given the weakness of the rand against major international currencies. Mr Roots has suggested a fair value of R160 million for Zomat based on forecast profit after tax of R13,3 million for the year ending 30 June 2007 and using a PE multiple of 12.
The income statements for the years ended 30 June 2005 and 2006 of Zomat are summarised below, together with the forecast for the year ending 30 June 2007:
ZOMAT (PTY) LTD
INCOME STATEMENTS FOR THE YEARS ENDED / ENDING 30 JUNE
Notes
2005
2006
2007
Audited
Audited
Forecast
R'000
R'000
R'000
Revenue
1
49 495
52 100
70 400
Cost of sales
(25 235)
(24 890)
(33 440)
Gross profit
24 260
27 210
36 960
Other income
675
740
1 050
Operating expenses
(13 545)
(15 170)
(17 445)
Operating profit
11 390
12 780
20 565
Investment income
250
280
350
Finance costs
2
(2 480)
(2 360)
(2 140)
Profit before tax
9 160
10 700
18 775
Tax
(2 656)
(3 104)
(5 445)
Profit for the year
6 504
7 596
13 330
Notes
1 Revenue for the half year ended 31 December 2006 amounted to R35 million (2005: R26 million). The executive directors of Zomat are confident that the company will achieve revenue of over R70 million during the 2007 financial year, based on the current order book.
2 Zomat's average borrowing cost is currently 11% per annum and it earns 7,5% per annum on call deposits with banks.
Working capital
The finance director of Zomat, Ms Tshabalala CA(SA), is concerned about the increasing level of accounts receivable. At 30 June 2006 the accounts receivable balance net of provisions for impairments was R6 850 000 (2005: R5 750 000). The forecast accounts receivable balance at 30 June 2007 is R10 680 000.
Ms Tshabalala has had informal discussions with major customers of Zomat to determine why they are delaying payment of amounts due. According to these customers their cash flows are under pressure because of high revenue growth and retention monies held by their customers, which generally amount to 10% of total construction contract values. As a result, they have been forced to delay payments to Zomat each month to improve their own cash flows.
The Zomat policy on credit terms is that customers are required to pay amounts due within 30 days of invoice. Ms Tshabalala is considering introducing a settlement discount (5% of invoice value if paid within 30 days of invoice date) to customers to improve the collection period. It is estimated that 75% of Zomat's customers would make use of such a settlement offer.
Other matters
Ms Tshabalala recently reviewed an expense claim by Mr Roots. The claim totalled R38 500, comprising air fares of R10 400, golf green fees of R6 600, accommodation costs of R14 400 and restaurant bills of R7 100. After further enquiries to the CEO's personal assistant and the marketing manager of Zomat, she discovered that Mr Roots had taken three of his friends (who are neither customers nor employed by customers of Zomat) on a golfing trip to KwaZulu-Natal.
Ms Tshabalala confronted Mr Roots about the expense claim and stated that she would not authorise its payment as the expense had not been incurred for official company business. Mr Roots reacted with indignation and instructed Ms Tshabalala to pay the amount into his bank account immediately. He said that if she failed to authorise and pay the claim, he would make her life at Zomat a misery and he would not recommend that she be offered shares in the company. Ms Tshabalala is not currently a shareholder in Zomat, but the minutes of a recent shareholders' meeting recorded their intention to offer her a 5% interest in Zomat if her performance appraisal in August 2007 was satisfactory. Mr Roots has a 28% shareholding in Zomat.
REQUIRED
(a)
Discuss
• whether the purchase price offered by Al Zenbah L.L.C. represents a fair value for the full issued share capital of Zomat (Pty) Ltd; and
• the fair value recommended by Mr Roots.
(b) Using ratio analysis, comment on the forecast profitability of Zomat (Pty) Ltd for the year ending 30 June 2007 versus the actual results achieved in the 2006 financial year.
(c) Calculate the debtors' days' ratios in 2005, 2006 and 2007 (forecast) and indicate what further enquiries Ms Tshabalala should make and what analyses she should perform to identify the key reasons for the deterioration in the collection periods. Use 365 days per annum for your calculation.
(d) Estimate and discuss the potential impact that the introduction of settlement discounts may have on the profitability and cash flows of Zomat (Pty) Ltd.
(e) Discuss the issues arising from the submission of the expense claim by Mr Roots and his threats to Ms Tshabalala if she were to refuse to authorise and pay the expense claim. Indicate what action, if any, Ms Tshabalala should take following this instruction and these threats.