Valuation of Lewis Group Ltd Tutorial group 6.

.4 We have decided to undertake a discounted future free cash flow to determine the value of Lewis ordinary shares at 31 March 2012. We have decided to use this model as it would give us a fairer reflection of the value of the business than a dividend growth model. As the future is uncertain and making judgements about it is difficult, we have to take a conservative approach in deciding which inputs to use in our model. Considerations taken into account in determining key inputs into the model: The increase in expected sales is driven by the increase in available floor space at stores, the inflation rate and Lewis real growth rate in sales. Lewis plans to expand their store base by 100 stores in the medium, which are 20 stores per year. These stores are a smaller format, 250m2, than conventional stores, 400m2. This results in an increase of 2% on existing floor space for the year ahead. The expected inflation rate for most of the 2013 financial period is 6% and the expected inflation rate in the medium term is 5%, according to African Economic Outlook. A medium term inflation rate of 4% will be used to maintain prudence as it is unwise to be too optimistic about the future for valuation purposes. A compounded annual comparable stores growth rate in sales will be used to determine Lewis real growth rate in sales. This is used to strip out sales increases through sales at new stores which is taken into account already through the increase in available floor space. The growth rate in comparable stores sales has been 2% over the past 5 years. Therefore the sales growth rate during the explicit period: Increase in available floor space : (2%) 1 + inflation rate : (5%) x 1 + real growth in sales : (2%) x Terminal growth rate: Inflation and real growth rate in explicit period Estimates after explicit period: 1 + inflation rate 1 + real growth rate

1.02 1.05 1.02 1.09 1.07 1.04 1.02 1.06

9% 7%

: : :

6%

The current repo rate of 5.5% has helped aid the economic recovery of South Africa through increased consumer spending. This means our customers having more spending power which is good for Lewis as 71% of sales are on credit. However, no further cuts in the repo rate are expected as the inflation rate is currently outside the upper end of the reserve banks inflation target of 3 6%. An increase in the repo rate may be expected. This would decrease our customers spending and could harm Lewis future sales. Gross profit margin for 2012 was 38.9%, up from 36.3% in 2011. Lewis management are targeting a gross profit margin of between 36% and 38%. We expect gross profit to remain on the upper end of this range and even above it as we have seen in the 2012 year, due to the introduction of new product ranges twice a year and changes in sales. However, to remain prudent we will use a gross profit margin of 37%.

Depreciation is 17% of the opening balance of PPE. This is the average depreciation rate in 2012. Capital expenditure of R 94 million is expected for 2013. Beyond 2013 we will use the percentage of PPE to sales in 2013 to get PPE for 2013 and also to Capex beyond 2013. Assume constant deferred tax. WACC In determining the cost of equity, the risk-free rate we applied is based on the current return on the R157 government bond. Our research indicated that a beta of 1.81 applied to the furniture retail industry. As investors would expect a return on their investments in a share that is greater than inflation due to the increased risk when investing in shares than compared to investing in government bonds, we have decided to use 10% as the market required rate of return. Inflation targeting by the reserve would lead us to expect the inflation rate to remain between 3% and 6%. The cost of debt used by Lewis is mostly variable based on 3 month JIBAR rates. The latest 3 month JIBAR rate is 5.06%. The following is a table of our inputs used and summary of the results of our valuation.
RESULTS Inputs WACC 13% Enterprise value Tax rate 28% Value of equity Depreciation to closing non-current book value 17% No. of share in issue Plant and machinery to sales 13% Value per share Inventories to sales 12% Market price at 31 March 2012 Receivables to sales 172% Market price at 28 Spetember 2012 Cash Balances (operating cash) to sales 3% Trade and other payables to sales 25% Taxation payable to sales 1% Gross profit margin 37% Operating costs to sales 96% Other income to sales 105% Investment income to sales 4% Growth rate in sales in explicit period 9% The following is a table of our free cash flows. Terminal growth rate 6%
Free Cash Flow

9077 9318 89 105.25 76.20 71.51

EBIT Tax Depreciation Gross cash flows

2012 1230 -344 49 935

2013 1293 -362 58 989

2014 1409 -395 63 1078

2015 1536 -430 69 1175

2016 1674 -469 75 1280

2017 1825 -511 82 1396

Investment cash flows (PPE and NWC) Movement in working capital Capital expenditure Investment cashflows FREE CASH FLOWS PV factor (using WACC) PV of FCF PV of years 2012 - 2017 Terminal value VALUE OF OPERATIONS Less : interest-bearing borrowings Less : retirement benefits Add : insurance investments Value of equity Conclusion

-342 -94 -436 499 1.00 499 2787 6290 9077 -1074 -64 1379 9318

-344 -86 -429 559 0.88 492

-374 -94 -468 610 0.78 475

-408 -102 -510 664 0.69 457

-445 -111 -556 724 0.61 440

-485 -121 -606 789 0.54 424

Calculation of terminal value Terminal value (799+g)/(WACC-g) PV of terminal value

11714 6290

It is evident from the comparison of the valuation calculation and the market value of the share price that Lewis share price is undervalued (i.e. market value of R71.51 versus a valuation value of R105.25). A share is undervalued when its market value is lower than its intrinsic value. An undervalued share will generally have a low PE ratio, Lewis PE ratio, according to Sharenet, is 8.10, which is quite low. In addition to the PE ratio, other factors that result in the share price being undervalued (amongst others) are: The earnings history of Lewis group is fairly good and appears to be stable. Lewis Group Ltd does not trade in high-technology products that can become obsolete extremely easily. Lewis Group Ltd isnt involved in a financial scandal of any sort According to the five year review included in the annual financial reports, Lewis Group Ltd did not make a loss in any year during the last recession.

The average share price for the Retailers Hardlines sector (the category that Lewis falls under on the JSE listings) is R41.47. This calculated using the share prices of Italitile Ltd (R6.39), JD Group Ltd (R46.50) and Lewis Group Ltd (R71.51), which constitutes all the groups that fall into the abovementioned category. Lewis market share price, even though undervalued, is substantially higher than the sector average. Ultimately an undervalued share is a practical investment option for investors as these shares are in a position to rise to their full potential.