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Iin V8
Iin V8
MGSM835
Financial Management
Group Assignment
North Ryde Wednesday Class Term 2, 2015
Lecturer: Dr Vito Mollica
Valuation of iiNet
Due date:
Student Name
Gurbaksh SINGH
Withanage Asantha
PERERA
Alfred PAUL
Neil FERNANDES
Brian SANKEY
Student Number
43800963
43872956
41935098
41692446
41507495
Table of Contents
Executive Summary.................................................................................................. 4
Company Overview.................................................................................................. 6
SWOT Analysis.......................................................................................................... 7
Market Overview...................................................................................................... 8
Major Competitors.................................................................................................... 9
Australian Economic Status...................................................................................... 9
Company Strategies............................................................................................... 10
Customer Service Strategy..................................................................................11
Marketing strategy.............................................................................................. 11
Innovative Strategy............................................................................................. 11
Porters five forces.................................................................................................. 12
Buyer Power........................................................................................................ 12
Supplier Power.................................................................................................... 12
New entrants....................................................................................................... 12
Threats of Substitute........................................................................................... 12
Competitive Rivalry............................................................................................. 13
Ratios and Key Drivers for iiNet..............................................................................14
Asset Utilization:.................................................................................................. 14
Cost Margin:........................................................................................................ 14
Depreciation Rate:............................................................................................... 15
Dividend Payout Ratio:........................................................................................ 15
Gross Non-Current Assets / Revenue:..................................................................15
Interest Rate:....................................................................................................... 15
Movements in current Assets:.............................................................................15
Movement in Current Liabilities:..........................................................................15
Tax rate:.............................................................................................................. 15
Growth in Revenue.............................................................................................. 15
DUPONT.................................................................................................................. 16
Profit Margins...................................................................................................... 16
Asset Turnover..................................................................................................... 16
Leverage............................................................................................................. 16
Return on Assets (ROA)....................................................................................... 16
Return on Equity (ROE)........................................................................................ 17
Valuation of iiNet on forecast model.......................................................................20
Capital Asset Pricing Model (CAPM):....................................................................20
2
Executive Summary
This report provides a financial value of iiNet (ASX: IIN) as at May 2015. This
valuation commences with contextualising the company and market so as to
provide a foundation upon which assumptions and forecasting drivers can be
made. The valuation has been achieved through reviewing free cash flow to equity
(FCFE), over the past five years, applying key forecasting drivers, developing risk
profiles and discounting future cash flows to current value.
iiNet is a public company listed on the Australian Stock Exchange, the core
business data telecommunications and internet service provider with its primary
focus (and majority revenue), being the Australian Market in residential and
commercial sectors. However, iiNet has operations in Australia, New Zealand and
South Africa. The company employs around 2500 staff, with a revenue for 2014
reported as AU$1,008,259,000. With its strong position in the Australian market
and the growth through domestic acquisitions, the key growth drivers are from the
performance of its Australian operations.
The key forecasting drivers of iiNet include, revenue growth, market share,
technological changes and cost of capital. As iiNet is currently an acquisition
target, and as such, the share price has had a volatility range of 60.13%, with a
closing price on Tuesday 2nd June of $9.750.
This report proposes that iiNet is Overvalued. The Growth will continue to
increase moderately underpin purely on leverage.
Whilst the business value identified is based on one primary scenario, i.e. business
as usual (BAU), this is braced between two alternative scenarios; one being a
negative (worst case), scenario and the other being a positive (best case),
scenario. For all three positions, the financial positions were forecasted to
determine the Free Cash Flows to Equity (FCFE) holders, followed by applying a
Discounted Cash Flow (DCF) model to these cash flows, with the cost of equity
being calculated using the FCFE model to provide an estimate of the market value.
Figure 2. iiNet 2009 2014 stock performance comparison with sector and ASX All
Ords.
Source: Morning Star iiNet Report
Company Overview
iiNet is an Australian company founded in 1993 by Michael Malone and Michael
O'Reilly, who initiated the business in a residential garage in Perth (iiNet
5
SWOT Analysis
Strengths
Weaknesses
Opportunities
Threats
Market Overview
The Australian Communication and Media Authority (ACMA), propose that the total
ISP market for Australia has an estimated value of approximately $5B. The growth
of Australias broadband internet market has slowed since around 2005 due to the
market saturation and increased level of penetration among consumers. The
sector has experienced a year on year growth of 2-3%, due mainly to the rapid
growth of wireless mobile broadband subscribers.
The capital intensive technical infrastructure for ISPs (including wire and fibre), is
also paralleled by an increasing market for wireless internet connections,
(primarily due to the high level update of mobile devices). This is highlighted by
Telstra announcing plans (mid-2014), to invest more than $100 million to build a
network of approximately two million hotspots nationally within five years.
Information from the Australian Bureau of Statistics (2014), indicates that between
2010 and December 2014, the number of ISPs in the Australian market (with more
than 1,000 subscribers), reduced from 104 down to 68. This reduction of ISP
numbers is due primarily to the acquisition of smaller operations, those operating
inefficiently or available below market value. Many of the smaller providers have
been absorbed by the 12 leading ISPs operating in the Australian market (each
with a minimum of 100,000 subscribers), dominated by Telstra, iiNet, Optus and
TPG. This general industry trend of consolidation is an attempt to take advantage
of economies of scale as competition on price increases. Smaller ISP often
compete through higher service quality, however, a high price elasticity of demand
results in this being unsustainable, with many small ISP often failing.
Major Competitors
The competitive environment in which IiNet operates, can be categorised into two
tiers, the top tier (in which iiNet is placed as the second largest), includes Telstra,
M2 Group, Optus/ Singtel, and TPG. The second tier includes Netspace, iPrimus and
Dodo.
Company Strategies
iiNet is a fast growing company in the industry of internet service providers. It is
the second largest internet service provider in Australia. It focuses on offering
three main groups of products to customers. They are Residential, Business and
Personal. The strategy that the company uses is the expansion strategy. Over the
years, they had acquired over thirty ISPs which include, OzEmail and Westnet. In
the year 2008, after the acquisition of these two companies subscribers exceeded
over 450000, making iiNet at that time the third largest ISP. The main objective of
the company was gaining market size and market share. Currently, the major
market share is Telstra with 47.5%.
Companies
Market Share
Brand Names
Telstra Corporation
Limited
47.50%
Bigpond, Belong
iiNet Limited
14.20%
iiNet
11.60%
9.20%
Other Companies
17.50%
Optus
M2 telecommunications group Ltd, NBN
co. Ltd
10
Marketing strategy
iiNet have established themselves by investing and growing their organisation by
Acquiring and diversification.
They have invested heavily on their branding, customer service and innovations.
They promote themselves as brand leaders to increase consumer confidence.
Innovative Strategy
To deal with risk of competition iiNet aims at developing new product offering to its
customers, it depends its own capital investments on the DSLAM coverage
network.
Currently its growth has reached its maturity in the Broadband markets by
expanding its space into new areas such as Mobile Voice, NetPhone, Fetch TV and
other new innovative consumer products of the company. National Broadband
Network (NBN) has also improved the market with its attractive rates for iiNet.
To maintain its competitive advantage iiNet has to invest on development as this
can restrict their cash flow.
11
Supplier Power
Telstra is the largest internet service provider and has the largest network and
infrastructure in the Australia, having the largest market share and is considered
as a monopoly.
As ISPs look to increase and upgrade their services, iiNet has improved its
services in certain locations to have faster internet service upgrading to ADSL 2+.
However as most services are provided by Telstra, iiNet is required to pay for the
fee and conditions they have set.
In the Last few years NBN have been steadily increasing their coverage, hence
this can reduce Telstras power to supply to other ISPs in the near future, causing
supplier power to diminish.
Supplier Power is high
New entrants
Internet service providers are fast growing in nature and do not require much
physical infrastructure as existing infrastructure can be purchased easily, hence
can be very attractive for new entrants
Customer demands have increased for faster and increasing Bandwidth. This can
put pressure on new entrants on technological innovation with huge costs and new
updated infrastructures. Competition is much bigger with the big players in the
industry, hence constraining new entrants to be different to others in the industry.
ISPs generally find it challenging to attain economies of scale as they are very
capital intensive and have fixed cost making it unattractive for new entrants,
The threat to new entrants is weakened.
The threat for new entrants for entering into the market is moderate to
weak
12
Threats of Substitute
Since the increase usage and development of the internet for both for business
and household, Internet service providers have had a substantial impact on
traditional methods such as Newspapers, shopping, media and general research.
In the last few years with technological advancement ISPs now are facing threats
by Mobile telecoms which have now developed the latest of 4G improving data
speeds.
iiNet relies on WiMAX technology which is now competing with 4G mobiles
internet. This is now a threat even for other ISPs.
Threats of Substitute is currently moderate
Competitive Rivalry
Competition in the ISP industry is very high with 433 ISPs in the Market. The
Market is currently dominated by Telstra. Competition is based by pricing, two
things that are taken into account for pricing are download speeds and
downloading activity.
Providing faster internet speed, better service all included with better value for
money drives a companys success in the industry. For iiNet to be at top of their
game have to keep innovating and delivering an exceptional service to stay at the
top of their market.
In this highly competitive market it is important for iiNet to keep innovating and
developing their services in order to stay in the market.
Competitive Rivalry is high
13
As of 2014
Asset Utilisation
Cost Margin
Debt/Revenue
Depreciation Rate
Dividend Payout Ratio
Interest Rate
Movement in Current Assets
Movement in Current Liabilities
Movement in New Equity
Non-Current Assets/Revenue
Revenue Growth
Tax Rate
Total Current Liabilities/Revenue
34.19%
93.74%
20.29%
13.71%
21.99%
9.86%
-1.53%
5.90%
9.80%
74.36%
7.00%
30.00%
20.36%
Asset Utilization:
Asset Utilization reflects the way in which a company uses its assets to obtain
revenue and profit. The higher the ratio, the more efficiently the business manages
its assets. In the case of iiNet AU sits at 34.19%., which suggests that iiNet utilised
its resources almost AUD0.3419 for each dollar of resources held by the company.
Their utilization is very low. iiNet sources its finances through debt.
Cost Margin:
This measurement distinguishes the efficiency of management. This ratio can also
be analysed using operating expenses ratio. Using data from the income
statement, this ratio illustrates the change in operating expense to revenue (net
sales). For the fiscal year 2014 the cost margin for iiNet was 93.74 per cent, which
indicates that its efficiency is very high when compared to utilization of fixed
assets against its variable costs.
14
Depreciation Rate:
iiNet uses a straight line depreciation method for property, plant, and equipment
(PP&E) as mandated. Depreciation calculates the cost of its tangible assets over
the expected useful life of the capital good. The deprecation rate for iiNet during
the fiscal year 2014 was 13.71 per cent.
Interest Rate:
The interest rate applied to iiNets liabilities for the fiscal year 2014 was 9.86 per
cent. According to the 2014 Financial Report. Interest Rate currently being paid by
iiNet in terms of its short and long term borrowings
Tax rate:
Tax Rate specified for iiNet for FY 2014 was 30% according to the 2014 Financial
Report.
Growth in Revenue
This analysis is the comparison of increase of sales to the previous year. The
revenue growth rates gives investors an indication of the forecasted sales increase
throughout the year. iiNet had revenues for the full year 2014 of $1.01bn. This was
6.97% above prior years results. iiNet having successfully acquiring and
integrating a number of business over the past 5 years were able be a leading
challenger increasing revenue.
15
Figure 6.
Source: Morning Star iiNet report
DUPONT
Profit Margins
Profit Margin for iiNet for the last 5 years have been anywhere between 4-7%. IiNet
has always been a business offering consumers highly competitive internet
products. Pricing has been quite stable and this has been reflected via their Profit
Margins to date over the last 5 years. This not only shows you an insight into
Pricing strategies but also costs control for iiNet over the last 5 years.
Asset Turnover
Asset Turnover for iiNet over the last 5 years have been anywhere between 1.1 to
1.5 and averages at 1.2. Companies with low profit margins tend to have high
asset turnover, while those with high profit margins have low asset turnover.
Companies in the Telecommunications industry tend to have a very high turnover
ratio due mainly to sharp and competitive pricing.
Leverage
iiNet is Leveraged quite well and over the last 5 years has varied anywhere
between 1.6 to 2.6. Sales Growth for iiNet has been the norm over the last 5 years
so the business is using its financing capabilities quite well to help generate
Revenue growth YOY. Also the majority of it's debt is held within Non Current
Liabilities which means no short term debt and decrease in risk.
initial investments will generally have lower return on assets. ROAs over 5% are
generally considered good.
Figure: 5
Source: 2014 iiNet Financial Report
17
Figure:7
Source: Morning Star iiNet report
18
Figure :8
Source: Source: 2014 iiNet Annual Report
19
Three different forms of valuation methodologies have been applied to value iiNet (IIN) the
three valuation methodologies are:
The FCFE valuation model and DCF valuation model forecasts a iiNet share price valuation
based on forecasted free cash flow earnings and dividends paid to shareholders from 2015 to
2024. From 2024 onwards, a Terminal Value forecast is applied which accounts for long term
growth rates and a CAPM rate of return.
Rf was obtained from Morning star data analysis on 2nd June 2015. This indicates
the yield of a 10 year Commonwealth Government Australia Bond rate. Its
presumed that yield on a 10 year bond is more appropriate to compute CAPM
which is used to discount free cash flows to equity over the next 10 years.
iiNet beta was obtained from Morning Star data analysis. Since its lower than 1, it
suggest that iiNets sensitivity to market volatility is 50%. IiNet is less volatile than
the market posing less risk and their rate of return is much lower than the Market.
The market risk premium is the expected return on the market portfolio calculated
by risky assets less return on the risk free assets. The risk premium reflects the
return that investors require to accept the uncertain outcomes associated with
investment, relative to the return provided by a risk free asset.
20
In addition, a scenario analysis (worst case and best case) has been applied to the
BAU Forecast model to evaluate the FCFE valuation and DCF valuation differences
for iiNet.
+ / - 3% revenue growth rate was applied to BAU model to calculate the two
extremes.
Please refer to the iiNet BAU Forecast model in the appendix for further details.
The P/E analysis is applied as a check measure to iiNet to be measured against its
industry competitors in the telecommunication market.
These companies include:
M2 Group(ASX:MTU)
Telstra (ASX:TLS)
TPG (ASX:TPM)
Worst
Forecast
Share value based FCFE Valuation
Model
Market price (02nd June 2015)
Variation in share price (%)
Book value
BAU
Forecast
Best
Forecast
2.31
2.62
2.97
9.75
76%
2.21
9.75
73%
2.21
9.75
70%
2.21
22.8
3.53
Market
16.63
1.42
Sector
18.9
1.52
Company vs
Sector
21%
57%
The Price to Earnings (P/E) multiple of iiNet in comparison to its sector peers
indicates that the company is currently overvalued on a P/E 21%
Furthermore the P/E growth of iiNet(3.53) vs Sector(1.52) raises question how it
would sustain the growth in the future.
21
Conclusion
Share value derived from FCFE model & DCF indicates, that the real value of share
is in the range of $2.31 to $2.97. In comparison to book value of $2.21, this value
range derived from the model seems realistic given the low growth ratios and the
leverage of iiNet.
In view of these findings, the current share price of $9.750 is a highly inflated
value. It is evident that the recent market activities(M&A) and market sentiment
has push the price up to an unrealistically high value.
Therefore this report rates iiNet share price at its current price with its present and
forecasted future earnings Overvalued.
The acquisition offer of 1.5B from TPG & M2 for iiNet(1.005B revenues: 2014) also
indicates that they too have valued the share in the mid $2.00 range.
22
Appendices
23
24
25
26
References:
Growth rate in Australia, Viewed 04/06/2015:The Australian Bureau of Statistics
http://www.abs.gov.au/ausstats/abs@.nsf/Lookup/8146.0Chapter32012-13
The internet service market and Australians in the online environment, Viewed
22/05/2015
http://www.acma.gov.au/webwr/_assets/main/lib310665/the_internet_service_mark
et_in_australia.pdf
28