I recently completed a Master’s degree in Accounting and Finance at the University of Bath. I found this to be a challenging course taught by highly demanding professors. However, it was worth the time and effort. One of my favourite subjects is Financial Statement Analysis which is about delving into numbers and seeking the story behind them. Currently, I am working on a proposal on asset valuation as part of an application for a PhD.
A Financial Evaluation of Thornton’s Plc
Financial statement analysis coursework
‘A Valuation of Thornton’s Plc’
Thornton’s Plc is a company incorporated- and operating in the UK. Its shares are listed on the London Stock Exchange with a current market value of about ₤53.16 million. It is a manufacturer, retailer and distributor of high-quality chocolate confectionery and other sweet foods. The company started its business 100 years ago and now has 4000 employees, 377 shops and cafes and 222 franchises. It has two business lines: Retail and Sales and Operations. Retail is divided into three sub-segments: own stores, franchises, and Thornton’s Direct; the Sales and Operations section consists of commercial sales, purchasing, manufacturing and distribution.
On average, the confectionery industry has enjoyed very fast growth over the five years from 2006 to 2010, though it also suffered from the wide effects of the financial crisis: sales of chocolate confectionery has grown by 17%, to around ₤5 billion (Key Note Market Report Plus). However, the industry is highly competitive. The market is mixed, with the majority being small and medium sized players and the rest, the market leaders. Cadbury, Nestlé’s, Mars and Kraft Foods are the dominant competitors, with a turnover in 2009 of ₤5.98 billion, ₤1.45 billion, ₤729.6 million and ₤564.4 million, respectively. Thornton’s is among the top ten competitors and recorded revenue of ₤214.8 million in the same year. It is worth noting that recently there has been a trend of merges and acquisitions by market leaders to expand their market share and power.
It can be assumed that in next few years Thornton’s will find it very difficult to compete with these big players and maintain its current market share of 7% and capitalise fast growth rate of industry’s sales. A characteristic of this industry is the low threat of new entrants. Due to the presence of well-known brands and limited access to distribution channels, it is difficult for new producers to enter this mature market. Nonetheless, the availability and diversity of chocolate products and other products such as desserts, sweets and biscuits give customers strong bargaining power. Moreover, because there is almost no switching cost for chocolate products, given a substantial difference in price level, customers can easily switch from expensive products to the cheaper ones. The main suppliers for this industry are ingredients producers and distributors, who have average bargaining power.
Within the industry structure as such, Thornton’s has positioned itself as a differentiator. This is evidenced by the fact that the company produces high-quality chocolates and innovation continues to be a key element of the company’s strategy. During the year, two new product lines were launched and the existing lines were extended. As well as chocolate products, Thornton’s has launched new biscuit and chilled dessert ranges. Accordingly, the company has, to some extent, made a commitment to acquiring the core competencies needed for its differentiation strategy. However, in my opinion, this is not enough to sustain its competitive advantage. It is the nature of the industry that product innovation is a popular strategy as customers’ tastes change frequently. Moreover, it is a seasonal business. At Christmas, Valentine’s Day and on other special occasions, a wide range of new products is introduced to customers by chocolate producers to boost sales. Therefore, to raise customers’ awareness of Thornton’s as a luxurious chocolate producer, it should aggressively incorporate other strategies: investing more in brand image and research and development as well as delivering superior customer service. Besides, there are other key points in the company’s strategy. The company is trying to expand its business by improving retail performance in three channels (own stores, franchise, and Thornton’s direct) and on expanding commercial sales. Specifically, it is seeking opportunities in overseas markets which, up until now, have been dominated by the market leaders.
Further on, in the financial analysis section, we will see how well the company has realised its business strategy. In the 2010 annual report it was mentioned that during the last financial year, Thornton’s had succeeded in minimising the adverse impact of the financial crisis. On the other hand, some major risk factors are facing the industry and the company. First, the company generates revenue from retail sales and credit sales. While retail sales account for a large proportion of the Group’s sales and are mainly cash sales, credit sales expose the firms to significant credit risk. In addition, the rapid increase in the price of raw materials is a challenge for the confectionery industry as a whole and is reducing its profit margin. As reported in the 2010 annual report, in the last year the price of cocoa has risen by 25% and butter has increased by 66%.
After considering the industry structure and Thornton’s business strategy, we now take a closer look at the company’s financial statements to examine whether they fairly reflect the firm’s underlying business reality. The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS). Consequently, estimates, assumptions and judgements that affect the reported amount of assets, liabilities, revenues and expenses are used.
Property, Plant and Equipment
To determine the decrease in economic value of property, plant and equipment (PPE), the firm uses a straight-line depreciation method for these non-current assets. Land and assets being constructed are excluded from the assessment. Hence, it is assumed that the value of PPE decreases by the same amount every reporting period. Though this way of accounting for PPE is totally in compliant with IAS 16 Property, Plant and Equipment, the justification for the use of this method is solely due to its simplicity. The chocolate manufacturing industry relies heavily on plant machinery and the machinery is likely to reduce in value more rapidly during the early years of its useful economic life. Therefore, the reducing balance method seems to be a more appropriate way to reflect the firm’s economic position.
IAS 19 Employee Benefit prescribes its accounting treatment in the disclosure of employees’ benefits.
The calculation of post retirement benefits involves many assumptions and estimations that are subject to change over time: discount rates, mortality rates, investment returns, salary inflation and the rate of pension increases. The firm has two types of pension schemes: defined contribution scheme and defined benefit scheme. In general, Thornton’s PLC follows all the requirements of IAS 19. In the note, we can see the actual returns earned by the assets, funding status, the pension expense for the period and the present value of obligation and plant assets at the end of the period. Because an independent, professionally qualified actuary valued the Thornton’s Pension Scheme as at 26 June 2010, it is believed that this report reflects the firm’s true financial position in terms of pension benefits.
Trade and other receivables
As noted before, credit is a primary source of risk for the company’s commercial segment. At the end of 2010, the commercial segment accounted for 65% exposure to credit risk of the total trade receivables. In the annual report, it is reported that ‘a significant proportion of the receivables less than 60 days past due relate to large corporate customers for which there is no objective evidence that the Group will not be able to recover the amount owing and therefore no impairment has been made.’ There is some concern about what the so-called ‘objective evidence’ refers to. Therefore, the firm’s managers have some flexibility when estimating the provision for bad debt.
While accounting rules require a certain amount of minimum disclosure, managers have considerable choice in this matter. In Thornton’s annual reports, no note is provided to explain the breakdown of cost of sales. As the result, financial analysis and forecasting is more difficult because there is no way to identify what the components of cost of sales are and the percentage of each component. For example, it is impossible to estimate the effect of an increase in the prices in raw materials on the cost of sales for the next year without such disclosure.
Despite such concerns with respect to the firm’s accounting policies, judgements and assumptions, it can be concluded that the financial statements fairly reflect the company’s real economic position. Besides, if the firm had added more notes to the financial statements, anyone reading the annual report would have had a clearer understanding of the firm’s business activity and performance.
In the next step, I will use the ratio analysis to assess Thornton’s’ performance in 2010. To examine the drivers of a firm’s profitability and growth, we have to peruse product market strategies and financial market policy. The product market strategies include: operating management, which is about revenue and expense management and investment management that concentrates on managing working capital and fixed assets. Meanwhile, in terms of financial market policy, there are two important decisions to be made: the first one is a financial decision that presents the firm’s liability and equity management; the other is the dividend policy that concentrates on dividend distribution. In this coursework, I will focus on the operating activity of the company. In addition, the dividend policy is also analysed to give a full picture of the firm’s potential profitability and future growth.
One of the most important ratios in financial analysis is ROE. ROE gives some insight into the firm’s ability to earn income by using the source of funds provided by equity holders. Table 1 gives Thornton’s ROE over a five year period from 2006 to 2010.
Table 1: Traditional ROE
|ROE = Net Profit / Equity||16.77%||12.79%||17.32%||15.18%||11.42%|
From the table, it can be seen that Thornton’s ROE increased rapidly during the three years: 2006 to 2008. However, in 2009, it suddenly decreased, and then went up again to 16.77% in 2010. To determine the key drivers of the firm’s ROE, I broke it down into three components as follows:
ROE= Operating ROA + Spread x Net financial leverage
Here, operating ROA is a measure of how profitable a company is by deploying its operating assets to generate operating profit for both equity holders and bondholders. Spread is the incremental economic generated by using the debt with costs lower than firm’s rate of return. This incremental economic is magnified by financial leverage.
Table 2: Alternative ROE
|Effective int. rate after tax||3.08%||4.59%||6.62%||5.26%||3.31%|
Table 2 shows three components of ROE: operating ROA, spread, and leverage. It is clear that all three components were better in 2010 and 2008 in comparison with 2009, leading to an improvement in ROE of 3.98%. It is likely that the financial crisis had a significantly negative impact on Thornton’s performance in 2009. However, in 2010, Operating ROA improved by 1.04%, spread rose by 2.55% and leverage increased by 0.09. Spread, more than the other factors, is the driving force pushing up ROE. In turn, the increase in spread is due to an increase in ROA of 1.04% and a drop in the effective interest rate after tax of 1.51%. It indicates that, so far, Thornton’s has almost recovered from the financial crisis, thanks to the fact that the board managers have successfully managed both operating and financing activities, and the favourable condition of low cost of debt. The low cost of debt may not continue in the next few years; in this case, to maintain the current ROE, Thornton’s would have to perform better in operating activities. Besides, we can see that Thornton’s financial structure is not constant over this five-year period.
Furthermore, operating ROA can be broken down into the NOPAT margin and operating asset turnover as follows:
Table 3: NOPAT margin and net profit margin
|Operating asset turnover||4.12||3.97||3.77||3.15||2.29|
|Net profit margin||2.03%||1.68%||2.92%||2.85%||2.07%|
Once again, it can be noted from this table that the company somehow succeeded in overcoming the credit crunch: the company’s net operating profit margin in 2010, though much lower than 2008, is higher than 2009. The pattern is the same for the net profit margin. In addition, the operating asset turnover has been increasing gradually over five years. It means that the company used its asset base more efficiently to generate sales.
In the annual report it was stated that ‘the focus in 2010 was on implementing sustainable cost-saving initiatives for both current and future years’. The firm reduced its headcount in Manufacturing and Head Office. Also, it cut costs in manufacturing by reducing capital investment on packaging and moulding lines. Table 4 shows a remarkable difference between the net profit margin and the gross profit margin over the relevant years. The high percentage of operating expenses in total sales might be because of the increased price in raw materials. More information would have been obtained about this difference if there had been a note dedicated to classify operating expenses. Due to the limited available data of operating expenses, I cannot analyse in more detail how well the company implemented its cost-saving initiatives.
Table 4: Gross profit margin and net profit margin
|Gross Profit Margin||49.66%||48.87%||50.50%||53.75%||52.01%|
|Net Profit Margin||2.03%||1.68%||2.92%||2.85%||2.07%|
Next, the dividend policy of the company is examined.
Table 5: Dividend payout ratio
|Cash Dividends Paid||4,553.00||4,040.00||4,550.00||4,512.00||4,443.00|
|Dividend Payout Ratio||1.05||1.12||0.75||0.85||1.22|
Based on the dividend payout ratio, Thornton’s consistently has a high payout ratio. In 2006, 2009 and 2010, it paid out more than it earned. It seems that this firm has no ambition for future growth because even though it has a relatively high ROE, it retained almost nothing to make the most use of its profitability for future growth.
After analysing the company’s main financial ratios, I looked at its forecasting. At the time this coursework started, Thornton’s had already published its interim report ended 8 January 2011. Hence, to make the forecast to reflect the latest information included in the interim report, I used both the interim report and the annual report to make the assumptions for forecasting. Firstly, according to the interim report, after taking into account two key occasions during the year: Easter and Mother’s Day, and being cautious for the sales in the second half of the year, Thornton’s sales are expected to be the same as the last year. Therefore, I estimated the annual sales for 2011 to be at ₤214,553,000. From Table 4, it can be noted that the gross profit margin has been quite stable over five years; around 50%. Hence I assume that the gross profit margin for 2011 is 50%. Consequently, the company’s estimated gross profit in 2011 is ₤107,276,500 and equals the cost of goods sold. To arrive at the figure for operating expenses, I used the percentage of operating expenses in the last year, which was 46.92%. This results in the same operating expense of ₤100,676,000 as last year. Other operating income consists of franchise fee income, licensing income and rent receivables. Licensing income is predicted to grow at 12.2% as stated in the interim report. In 2010, franchise income was affected by the closure of Birthday Limited. However, in 2011, it is expected to come back to the 2009 level of ₤197,000. Rent receivable is assumed to be the same as 2010, being ₤255,000. The total remaining operating income amounts to ₤1,543,710. Financial income and financial costs are predicted to be double the number in the 2011 interim report: ₤22,000 and ₤1,516,000 respectively. Tax rate remains constant in 2011 at 27%. The forecasted net income after tax for 2011 is ₤3,727,000, which is only 85.6% of the net income for 2010 and is the lowest level over five years. From my point of view, this figure is based on a conservative basis and is consistent with the business strategy analysis above. The lower net income reflects the risk of the increasing price of raw materials and the fierce competition in the market. Thornton’s competitive advantage is not strong enough to exploit the industry’s high growth rate.
Table 6: 2011 Net income forecast
|Costs of Goods Sold||(107,276.50)||(108,009.00)||(109,836.00)||(103,017.00)||(86,022.00)|
|Other operating income||1,543.71||1,386.00||1,410.00||1,139.00||808.00|
|Profit before tax||5,106.50||6,137.00||6,288.00||8,470.00||7,081.00|
The final step is to evaluate the firm’s share value. There are various valuation techniques: discounted dividends, discounted abnormal earnings, discounted abnormal earning growth, and valuation based on price multiples. Each technique has both pros and cons. In practice, analysts often use them all to examine whether they are consistent in determining a firm’s value. I use the discounted abnormal earnings valuation model with a forecasting horizon of five years from 2011 to 2015. Abnormal earnings are the net profit adjusted for a capital charge. The firm’s equity value is equal to the opening book value plus the sum of discounted abnormal earnings. To use this model, cost of equity, net income and opening book value for five years are needed.
First, the cost of equity or discount rate is obtained from CAPM, which is of the following form:
Re = Rf + b*(Rm – Rf )
Thornton’s’ Beta value, which is taken from Thomson One, is 0.85. According to Lungu and Minford (2005), the average risk premium return from 1929 to 2000 is 7%. The annualised rate of a five-year UK Treasury bond is used as a risk-free rate because the forecast horizon is five years. The rate of 2.26% was obtained from the Financial Times website. Therefore, the cost of equity is:
Re = 2.26% + 0.85*7%= 8.21%
The net income for 2011 has been estimated in the section about forecasting. As recorded in the ratio analysis section, during the five years from 2006 to 2010, the dividend payout ratio is around 1 (see Table 5), and the company did not retain its earning for future investment projects. Moreover, in the annual and interim report, there is no indication of significant foreseeable investments. Hence, it is appropriate to assume that the retention rate is equal to 0, and the book value of equity remains constant during the forecasting period. I also assume that net income and the number of outstanding shares stays constant for the five year period. Consequently, forecasted EPSs also do not change. Then I calculated the terminal value for the firm. The terminal value is the value of the firm beyond the forecasting period. It is reasonable to assume that the long-term growth rate of abnormal earning equals 0 because of zero-retention rate and the cost of equity remains unchanged. Then, the discounted terminal value beyond 2015, is equal to
TV2015 = (1+g)*AE2015 / [(re –g)*(1+re )5] = (1+0)*0.024/[(0.082-0)*(1+0.082)5 = 0.196.
Table 7: Intrinsic value
|Beg. Of BV per share||0.388||0.388||0.388||0.388||0.388|
|Abnormal ROE = (ROE-r)||0.061||0.061||0.061||0.061||0.061|
|Long term growth rate = (1-k)*ROE(t-1)||0.000||0.000||0.000||0.000||0.000|
|Cost of equity||0.082||0.082||0.082||0.082||0.082|
|Discounted abnormal return||0.022||0.020||0.019||0.017||0.016|
|Intrinsic value per share||0.678|
From the calculation, the intrinsic value of Thornton’s share is 67.8p. Below is its return from May 2010 until the present. The current market price is 80.85p which is 19% higher than my estimation of intrinsic value. It means that the share is over-valued in comparison with my estimation.
The following chart shows the performance of Thornton’s share against FTAS Index over the last ten months.
From the graph, Thornton’s shares have performed very poorly. Its returns have been negative during the whole period, hitting a trough at -35% and only reaching 0% for a very short time in November 2010. The poor performance of Thornton’s shares can be explained by the poor performance of the whole market. However, even when FTAS showed signs of gradual recovery from November 2010, Thornton’s share price still plummeted until recently. In summary, business and ratio analysis reveals that Thornton’s is a company that lacks ambition for growth and has not yet succeeded in realising its business strategies. In addition, forecast and valuation indicates the poor performance of its shares. Therefore, I would not recommend that equity investors buy shares in this firm at the moment.
- Thornton’s Plc’ annual reports 2007, 2008, 2009, 2010 and interim report 2011. Available from company’s website: http://investors.thorntons.co.uk/.
- Lungu, L., Minford, p., 2006, explaining the equity risk premium. The Manchester school, 74(6) 670-700
- Key Note, 2011, Market report Plus 2011, Richmond Upon Thames, Key Note Ltd.
- Palepu, K.G., Healy, P.M., Bernarnd, V.L., and Peek, E., 2007. Business analysis and valuation. IFRS Ed. United Kingdom: Cengage Learning EMEA.
- Collony, C., 2008. International Financial Accounting and Reporting. Dublin: The Institute of Chartered Accountants in Ireland.