1. Introduction

The project assigned is an approach of some corporate finance aspects that we have been learning during this module. The company chosen for this assignment is Burberry that has a reasonable size to analyse. The analysis goes through the risk profile of the company, analyse the company’s capital structure, company dividend policy, and the value of the company in terms of market capitalisation.

Therefore, to get more reliable and accurate information, the analysis is based on Bloomberg, Burberry’s latest annual reports, some articles from Financial Times, and the lectures.

2. Company Overview

Burberry is a global luxury brand established in 1856. Is a British holding company that operates in the luxury goods manufacture, retailer and wholesales. The company operates in Europe, Asia Pacific, Americas and the Rest of the World. The company provides non-apparel accessories and clothing for men, women and children.

Is ranked in the FTSE100 in the Consumer Durables & Apparel Sector. The analysis compares Burberry and the other 8 securities, Hermes, LVMH, CIE, TOD’S, Christian Dior, Ralph Lauren, Coach and Hugo Boss, that belong to the same sector.

3. Corporate Governance Analysis

Corporate Governance concerns the relationship between management of a company, its shareholders, its board and other stakeholders. The corporate governance ensures an alignment between the management of an organization and the decisions taken by its members.

The Board is responsible for the success of the company. The Business strategy, trading performance, risk management and all major decisions are settled by the board of Burberry. This is composed of 8 members: Chairman, John Peace, CEO, Angela Andrehns Executive President, Stacey Cartwright, CFO, Andy Janowshki, and five non-executive directors. To assure a well-structured board is realized six scheduled meetings so that every member could be engaged and all “matters” should be solved. Also, the Chairman is responsible of leading the Board and arranges commitments with the other non-executive directors.

As referred in the annual report, the non-executive directors are independent of management and free from any business. However, they have shown an effective contribution to the company. The independence is seemed like a constructive challenge and also a responsibility to the Board’s decision-making process.

The importance of maintaining a good relationship between the shareholders is very important. Burberry communicates with is institutional investors frequently. Between the institutional shareholders are the top holders that represent almost 45% of the total shares of the company. Appendix 1.

4. Macro analysis of your company’s market

Macro-analysis of the Burberry Group can be best illustrated by considering their strengths, weaknesses, opportunities, and threats.

Strength:

First of all Burberry benefits from the company’s wide geographical presence. Currently Burberry operates in four regions as of 2011/2012. America represented 25% of retail/wholesale revenue, Europe counts for 32%, the rest of the world is 6% and the Asia Pacific counts as 37%.

Moreover, Burberry has a diversified network. The company distributes its products through retail, wholesale, e-commerce, and licensing.

Revenue increased 23% underlying to £1,857m. A 14% comparable-store sales gain combined with 11% space expansion and a 6% contribution from the China acquisition to produce 31% underlying retail revenue growth to £1,270m. Wholesale revenue increased 8% underlying (14% excluding the China transition) to £478m. Licensing revenue increased 5% underlying driven by strong performances in fragrance, timepieces and eyewear. The business achieved double-digit gains across all product divisions and regions with help of diversified distribution channels.

Furthermore, Burberry has positioned itself as a very strong brand. Company’s worldwide recognition and its record sales is further testament to its strong branding.

Weaknesses:

Burberry is experiencing weak efficiency as company’s turnover ratio is much lower than the industry average. And for the fashion brand, it is very important to have high turnover in order to be able to turn over fashion styles in order to meet constantly changing trends. Moreover, low turnover causes low efficiency.

Another weakness can be seen in low resonance in certain countries like Spain.

In 2012, the company had to discontinue its presence and operation in Spain causing the £2.5m operating profit loss. Total restructuring cash spend was £8.6m.

Opportunities:

First of all, Burberry can be benefiting from growth in emerging markets.

Also, rise in the popularity of e-retailing is growing. Rising internet penetration and increasing familiarity with online shopping is the trend of this current age. Burberry, having very strong brand equity established a strong presence in online retail already and can take further advantage and benefits.

Threats:

The main threat would be a global economic slowdown, which might cause consumers to save more, rather than spend.

Another threat can be illustrated in changing consumer preferences. The fashion industry is very competitive and trends are constantly changing. Consumers have no switching costs and can easily choose another new entering brand or even counterfeit.

According to Bloomberg, the “10-Year UK Government Bond is estimated to be around 1.53% for a coupon bond of 4.00 and a maturity date to 3rd of July 2022” (Bloomberg, s.d.). We will use this value as our risk-free rate that would be assumed for the macro analysis of the Burberry luxury goods market.

As one may be aware 1.53% is a very good risk-free rate for a 10-year Governmental Bond and this is due to the fact that UK country riskiness is ranked triple-A. This means that UK is classified as a safe country to invest in compare to other countries.

UK is classified as a riskiness country, ranked as triple-A country, and its low risk-free rate is the result of the country’s rating and therefore, a much likely attractive to the investors comparing to the other countries in the analysis. For instance, the Italian brand, Todd’s, operates in a A3 country, according to Moody’s latest ranking, and its risk-free rate is about 4.95%, which is relatively high. Also, the French brand such as Hermes, LVMH and Christian Dior have a risk-free rate of 2,3%, which is not so good as UK but not so bad as Italy.

The equity risk premium is the average additional return required by an investor as compensation for investing in equities rather than a risk-free interest. Normally, the countries that have a risk-free rate high have an equity risk premium low.

The equity risk premium would be 13.956% (Bloomberg Terminal seen 03.06.2012). This is quite a big percentage of “excess return that [Burberry] provides over a risk-free rate.” (Investopedia, s.d.).

If the stocks are correctly priced in the aggregate and we can estimate the expected cash flows from buying stock, it is possible to get the expected rate of return through the IRR. Subtracting out the Risk-free rate should yield an implied equity risk premium. This implied equity premium is a forward-looking number.

5. Analysis of Company Beta

Table created from the Bloomberg Terminal 12 month period

Burberry plc. R Squared = 0.69

R Squared values range from 0 – 100. The higher the figure the stronger the relationship is between the firm and the index. A low figure suggests that there is no significant or meaningful relationship between the firm and the index. A high R squared is usually in between 75-100 and a low R squared would be in between 70 and less.

From our explanation, we can see that Burberry plc and some of the other comparable companies in this industry have a low R squared and therefore they are not significantly related to the movements in each of their individual indexes.

We can from the information we have evaluate Jensen’s alpha. It is “a risk-adjusted performance measure that represents the average return on a portfolio [compared with the] predicted capital asset pricing model (CAPM).” (Investopedia, s.d.)

As we know that

We should calculate the CAPM to understand better our Jensen’s measure.

We can see that the returns of Burberry are on the average way lower (around 75%) than the expected return of CAPM prediction.

On the Bloomberg Terminal, we have encountered two types of Beta, the raw Beta, and the adjusted Beta. The raw beta is the leveraged beta and the adjusted beta is a predicted future beta that tends to get closer to 1 (the return of the market).

For a company that has many lines of business or which operates in various products like Samsung which produce phones, tv but also fridges; it is not uncommon to encounter various betas for each product line or sector line. However, Burberry has a unique line of products so there will be no need to evaluate an average beta for each sector of production.

Besides Burberry operates in 3 different channels: retail, licensing and, Burberry is classified in only one sector, consumer durables & apparel. Therefore, there is only one beta to calculate as Burberry has a unique line of products.

6. Estimated Company’s Betas per Business Line

7. Estimated company cost of debt

Burberry plc. Is a publicly traded company in the personal goods sector of the LSE trading on the following indices, FTSE 100, FTSE 350, and FTSE All-Shares. For our analysis, we have decided to compare Burberry to FTSE100 with an expected market return of 12.30%. The cost of debt can be calculated below:
the formula for security i:

The corporation does not have traded bonds and therefore we will have to use other means of evaluation for this company-estimated cost of debt. If it had traded bonds the yield to maturity on those bonds would have been the market-required rate on the firm’s debt.

Regularly large corporations have a credit rate just like countries do from Moody’s or other rating agencies. Burberry even though it is a well-known firm and is present worldwide it is not rated by an external agency. If the firm would have been rated we could have estimated the cost of debt by adding the typical default spread on bonds with Burberry’s rating to the risk-free rate.

In their annual report, it is stated that the group has no significant volumes of credit risk. The group goes through a strict procedure to assure that wholesale sales will be made only to clients who have an acceptable and suitable credit history. Burberry states that a risk arising from other financial assets the company is holding such as cash, short-term deposits, and some derivative instruments comes from the default of the counterparty. Furthermore, the group has another policy that restricts the volume of credit exposure to financial service institutions and says that the company only deposits funds with independently rated financial institutions with a minimum rating of ‘A’.

Since we cannot use both examples mentioned above for the estimated cost of debt we will have to use a method that is used for non-rated firms. There are two ways of doing this.

1. Cost of recent long term bank borrowing
2. Estimated company rating and following the route of rated firms In our report, we will be using method number 2.

United Kingdom

The UK is a triple A-rated country and therefore the yield on the 10 year UK government bond is the risk-free rate for Burberry plc which is 1.43%. The corresponding default spread for AAA companies from January 2012 is 0.65%. Assuming on the information that we have and the ratios that we have calculated Burberry plc should be rated AAA Company.

To find out the companies cost of debt if it were to borrow money we need to add the risk-free rate of the country to the corresponding default spread.

Marginal Tax Rate

The corporate tax rate for corporations in the UK was at a rate of 26% for the year 2011. For the year 2012, the corporate tax rate has changed and has decreased to 24%.

8. Estimated Company Cost of Capital

9. Burberry’s debt:

Companies always have to decide whether to use debt or equity to finance projects within the firm such as expansion or an acquisition.
This is an important decision because whether Burberry decides to use debt or equity there will be different advantages of disadvantages. There are two main advantages of using debt for Burberry and those are tax advantages and “managerial discipline”.

The advantage that comes from using debt payments instead of equity payments is that debt payments are tax-deductible since they are “interest payments”.

Some corporations might benefit from tax benefits from government subsidies but this is not the case of Burberry plc. Companies that qualify for these sorts of subsidies are generally start-up businesses or businesses that operate in important industries that need assistance by governments due to “market failure” or declining industry. The other advantage that comes from using debt payments is management discipline. Managers are well aware of the consequences of using debt since debt is a contractual obligation and the firm will have to have a minimal amount of returns in order to pay the interest to its creditors.

All though there are some advantages from using debt instead of equity there are disadvantages when using debt as well.

One of the biggest disadvantages of using debt, and this goes for all types of companies including Burberry, is the probability or possibility of going bankrupt due to the use of debt, the risk of projects not turning out as expected, and the risk of defaulting on debt.

Bankruptcy might be appealing to some people since it is seen as an easy way out of contractual obligations. But there are negative sides to going bankrupt. When firms declare themselves bankrupts the costs associated with this are generally high and leave the shareholders of the business vulnerable. The costs associated with bankruptcy, in general, are corporate lawyer fees and court fees. Another big disadvantage concerning bankruptcy is the access to funds once you have gone bankrupt. Logically once the company has been lent money and has defaulted it might be harder for the firm borrows money in the near future.
Bankruptcy should be Burberry plc’s last resort and not an easy way out of debt.

We also mentioned how debt enhanced managerial discipline, this is somewhat contradictory because once a manager is in possession of debt (borrowed funds), his goal is to maximize share value and therefore the debt would feed his risk appetite as he would want to perform well in order to receive compensation for his performance. On the other hand, if he performs badly he/she does not have any contractual obligations to the debt, the shareholders do.

One final disadvantage from using debt to finance projects is that if Burberry defaults on some of its debt obligations then this will reduce the financial flexibility of the firm, as it will be harder for Burberry to seek debt financing.

The estimated debt ratio should be:

We do believe that this ratio being relatively low is to the advantage of Burberry, as it shows no possible growth it could be explained by their strategy. We believe that they have a lower ratio because of the way they manage their product distribution line. It might also be because of the way they manage their business whereas most of the supply chain reduces rental cost by exploiting wholesales and licensing. It might also reduce the possibility of bankruptcy risk.

10. Burberry’s optimal capital structure:

From our analysis to reduce the cost of capital or the weighted average cost of capital (WACC), one could increase the use of debt financing. As we can see from our table below as the debt used to increase the WACC has a tendency to decrease:

11. Looking at the history of performance, cash flow and balance sheet realities, decide whether changes are necessary to a firm’s capital structure?

Looking at the Cash flow statement, the Income Statement, and the balance sheet, for the last 5 years (appendix), we can see that the company has managed to grow despite the difficulties they have encountered in their investment in Spain in 2009. However, they would definitively need to decrease their WACC to fit in with their competitors, rendering them slightly more competitive.

12. Are change in leverage required:

A slight change in leverage would be necessary and would eventually surface with the change in the capital structure. The change is quite consequent and might scare off the investors or current shareholders thus, a gradual transition might be more attractive and should lower the risk of failing this needed transition.

13. What is your recommended pathway for altering Burberry’s capital structure?

Burberry does not have to worry too much about its debt position, for the moment. They should however increase their usage of debt by issuing debt to finance future projects.

Their position in equity is very important and they should strongly think of buying back stock using the money collected from issuing debt to stabilize their position and their capital structure. The current situation is to our understanding to risky and relies too much on equity which exposes the company to a large variety of risks regarding the market situation.

Finally, it is more than clear to use that Burberry must withdraw its position in equity and invest in any future project using debt.

14. Review the business/ typical investment projects of Burberry and list the features you’d expect in their financing instruments:

Burberry is mainly positioned in pounds, they do operate around the world, however, and they always convert all expenditure in pounds. Their main financial operations are towards issuing and paying shares and dividends.

We have found in Burberry’s Annual Report of 2011 that they were exposed to floating interest rates and they decided to change to a fixed interest rate.

15. Compare the FCFE that Burberry generates to the cash payouts it makes (dividends and share buybacks.)

We can see that the numbers are better in 2010 than in 2011 this might be due to the fact that we have not taken into account the impact of the failed penetration of Burberry’s in Spain.

We believe that Burberry is trying to compensate for their losses in Spain and that in the long-term they are going to increase their repurchases of shares pattern.

Their returns are slightly higher than the cost of capital which is reassuring. If the company was only managing their returns lower than the cost of capital then we should be a concerned for the well-being of the company, or it would show that Burberry is a new company; which in our case is really not the position of Burberry. Burberry is now a mature mid-size company.

16. Perform a DCF valuation of Burberry

Bibliography

Bloomberg, n.d. U.K. Government Bonds. [Online] Available at: http://www.bloomberg.com/markets/rates-bonds/government-bonds/uk/ [Accessed 3 June 2012].

Burberry, 2011. Annual Report, s.l.: s.n.

Investopedia, n.d. Definition of ‘Jensen’s Measure’. [Online] Available at: http://www.investopedia.com/terms/j/jensensmeasure.asp [Accessed 6 6 2012].

Investopedia, n.d. Equity Risk Premium. [Online] Available at: http://www.investopedia.com/terms/e/equityriskpremium.asp#axzz1wxz0JTe3 [Accessed 06 06 2012].

Appendix I: Balance Sheets

Appendix II: Cash Flows

2010 re-presented to exclude discontinued Spanish operations

Appendix III: Income Statement