Bellingham plc
Arthur Scroggs was a farmer. His family has owned and farmed 500 acres of prime land in the Vale of Aylesbury for four generations. In the mid 1980's small farms were finding the financial climate difficult with falling farm incomes and much talk of putting farm land to "alternative use". By 1985 Arthur had already sold his dairy herd to focus on cereal production when a fortuitous meeting with Lucy Bellingham at a business conference led him to reconsider the future of the family farm. Bellingham is a designer of bespoke fitted kitchens who had a business plan but little capital. The plan was to manufacture top quality fitted kitchen furniture and establish design studios/showrooms in high income areas. Having recently sold his dairy herd, Arthur had enough capital to fund the new business and also a number of large barns and outbuildings suitable for manufacturing the kitchen units subject to refitting and planning consent being obtained. Lucy's business plan was so convincing that Arthur decided to get out of farming altogether (by leasing his arable land to a local co-operative) and focus on developing the new business. From this small beginning grew the now publicly quoted company of Bellingham plc.
Initially, showrooms were established in Beaconsfield and then Kensington. Demand for their kitchens was brisk and “Bellingham Bespoke Kitchens” expanded rapidly but remained a partnership. The firm’s clients are mainly celebrities from the entertainment world and the cost of a Bellingham Bespoke Kitchen is now £40,000 - £150,000 or more. The firm was restructured as a limited company in 1990 and subsequently experienced rapid growth until 1999.
In that year the then directors decided that the business had reached the limit of development in its present form. Future development required large-scale expansion of production facilities in order to provide the range of materials, furniture, quality and prompt delivery required by their discerning clients. This in turn needed an injection of capital that the directors were unable to generate themselves. The conviction that there was much money to be made from “quality fitted kitchens" ” had been vindicated.
They investigated a number of possibilities deciding eventually to expand production facilities by purchasing a modern production unit on an industrial estate in Aylesbury. The expansion was funded by a stock market floatation and raising the necessary capital in the name of Bellingham plc.
As the market grew and to keep abreast of new production technology, the directors agreed to reverse the maxim so dear to the heart of the founders, Arthur and Lucy; “neither a (long-term) borrower nor lender be.” They financed updating of equipment and premises by means of issuing debentures.
It is now October 2012 and the present directors of Bellingham plc believe that the long-term success of the company lies in future international diversification and expansion. They consider that the most beneficial action they could take is to investigate the acquisition of a subsidiary in the USA.
The newly-appointed finance director, Bill Moneypenny, agrees with this opinion but insists that the company must first appraise its own current position and if necessary, make changes to strengthen its existing financial situation before embarking on new plans. He is particularly concerned that the company should preserve adequate liquidity and finance its assets in a beneficial manner. He is also concerned that too much emphasis has been placed on "pandering to the whims of the rich and famous" and not enough on running an efficient business operation. Lucy and Arthur still retain 30% of Bellingham's equity and other long-standing directors own a further 20%; a change of control is unlikely to be welcome.
During the last two years, the company has updated its design, production and showroom assets and, in what has been a difficult year, has been able to maintain sales and profit growth (see Bellingham's accounts in appendix 1). There has been a great deal of uncertainty about world economic growth and stock markets have been extremely volatile resulting low returns. However the firm’s ordinary shares have made good progress during the year. Ordinary share dividends have achieved substantial growth over the last two years although this rate of increase is not expected to continue. Ordinary dividends have grown at an average rate of 14% per annum over the past 10 years and this rate is a more realistic growth rate for future dividends.
The present market prices for Bellingham’s shares and debentures are:
£1 Ordinary shares £7.02 ex div
£0.50p, 6% Pref shares £0.55 ex div
7% Debentures 2016 £100.51 ex interest
Any new venture would be expected to achieve a return on capital employed in line with that experienced recently by Bellingham plc. The finance director favors a payback period of 5 years. Bellingham would therefore need to agree a realistic acquisition price for such a new venture and its future cash flows in order to determine whether these criteria could be met.
Although a number of investment projects are being considered, the main proposal currently being investigated offers an expansion into the US prime-property market which is forecast to grow faster than the UK market. Bellingham's finance director has already calculated the trends in the financial ratios of American Creations, an unquoted US company, from its unaudited annual accounts and has concluded that the proposal is now worthy of further investigation.
American Creations is a family-owned venture requiring further capital to repair its balance sheet after making losses on a property development in Nevada from which it has now withdrawn. Profits have suffered in the last two years due to write-offs associated with this development. The existing owners feel that the firm’s future lies in establishing wider international links and the retirement of senior family members, leaving the younger members active in the management of the firm. They are therefore considering selling a controlling interest of 60% to a suitable company. The firm has been established for 23 years, and is well respected in business circles. The average age of its fixed tangible assets is 3 years. The directors have indicated that they may accept part payment in Bellingham shares subject to negotiation.
The firm’s nominal share capital is $2.5m, and the directors have indicated that they value the firm at five times the year 2010 net profit. They consider this to be the firm's "normal" level of profit excluding the "extraordinary" effects of the Nevada development. As the firm is at present family owned and run, there is no available price/earnings ratio. P/E ratios for the only two publicly-owned companies in the same business sector, Harvey Wilkinson Designs plc and Cucci Lifestyle plc, are currently 10 and 8 times respectively although both of these firms, unlike Bellingham, operate internationally. Wilkinson has grown at a similar rate to Bellingham. The dividend yields of these companies have been as follows:
Wilkinson Cucci
Year to 31 December 2011 8.1% 7.25%
2010 7.2% 6.9%
2009 5.3% 5.95%
American Creations has its own manufacturing facilities and operates throughout the USA and Caribbean with design offices in New York, Miami, Los Angeles and Colorado Springs. Their main business, which is thriving, involves complete home furnishing and interior design for wealthy clients. In addition, the firm has a real estate office in each location and is thus able to offer a complete property service. The value of properties handled by the real estate offices is typically $5m - $20m.
Bellingham is interested not only in extending its operations internationally but particularly in the possibility of diversifying into the real estate business. Whilst well aware of the existence of a number of competitors, the directors feel that there is a ready market in the US for their established name in terms of design flair, service and products.
After discussions with the directors of American Creations, Bill Moneypenny has produced the following forecast. Under average economic growth conditions, the American Creations operating forecasts (in $*1000) for the next five years are based on the following:
Income:
From Sales: $7500 in 2013, rising by 12% per annum for the foreseeable future.
From real estate sales commissions: $2850 in 2013 increasing by 15% per annum for the foreseeable future.
Manufacturing variable costs:
Labor: $1250 in 2013, expected to increase by 8% per annum.
Materials: $3800 in 2013, expected to increasing by 5% per annum.
Fixed costs excluding depreciation:
Manufacturing O/H: $2065 in 2013, increasing by 5% per annum.
General O/H: $1850 in 2013, increasing by 2% per annum.
Depreciation:
Factory, machinery & vehicles: $500 per year.
Office/Design Studio fixtures: $200 per year.
The beta of Bellingham plc is believed to be 1.65 , the risk-free rate of return is 5.5% and the return for the last year on the FT All-share index is 2%. UK corporation tax is currently 32% payable 9 months after the end of the accounting year in question (you may assume for the purpose of this case that accounting profit and taxable profit are identical.)
Bellingham's directors estimate that the after-tax profits of American Creations could be allocated as follows: 70% as retained earnings and 30% as dividends. This has been the pattern under the under the present ownership. There would be no restriction on the transfer of the appropriate share of these dividends to the UK. The US corporation tax rate applicable is 20% payable in the year in which the profit arises. There is no double taxation of profits of US origin in the UK. (For the purpose of this case, ignore the possibility of any withholding taxes and the effects of foreign exchange risk.)
It is considered possible that, as the US economy develops further, even higher wages than that forecast may be demanded by the workforce.
Required:
Evaluate the American Creations proposal on behalf of Bellingham plc, supporting your arguments with relevant theory and calculations and indicating any non-financial matters you feel should be taken into consideration.
Your report should consider the following areas:
Question 1: An analysis of Bellingham's current position using relevant financial ratios. You should show the calculation of the ratios and provide interpretation of the results.
Question 2: Calculation of Bellingham's cost of capital, using alternative methods and arriving at the most appropriate figure.
Question 3: An investment appraisal of the American Creations proposal assuming the valuation suggested in the case, using a variety of methods and evaluation of the results.
Question 4: A sensitivity analysis of the proposal and interpretation of the results.
Question 5: Calculation and discussion of alternative valuations for acquiring the share in American Creations and how these would impact on the investment appraisal.
Question 6: A discussion of the various available methods of financing the acquisition and consideration of which is the most appropriate.
Your calculations and arguments should be supported by relevant theory, with evidence of wide reading around the subject.
You should provide a complete bibliography with appropriate referencing in your report.
Submission requirements:
Your answer should take the form of a written report of approximately 2500 words excluding appendices and the reference list.
This is an individual assignment and the report submitted should be entirely your own work.