Executive Summary
The challenges in the economic environment require firms to have hints of financial flexibility. Most companies have been striving to balance their capital structure to ensure long-term growth. Moreover, firms review financing options to propagate expansions and growth. At present, the financial markets offer some alternatives to improve company finances. But these options are accompanied with risks that have to be assessed. It is important for firms to understand their current needs and the uncertainties in the capital markets.
Wesfarmers Limited is no exemption to growing list of firms requiring the financing vehicles. Although Wesfarmers is historically stable, the need for the firm to be financially certain is a priority. To pursue this goal, Wesfarmers has tapped Goldman Sachs to serve as financial advisor. The responsibility provided to Goldman requires holistic comprehension of Wesfarmers’ current position. In addition, Goldman Sachs has to suggest some financing activities that will satisfy the funding requirements for Wesfarmers initiatives.
Introduction
The need for Wesfarmers to increase its financial capabilities is motivated by several reasons. The most pressing justification relates to the competitive edge that Wesfarmers needs to sustain. Wesfarmers also targets other firms as enhancement to operations. The company has been actively pursuing to acquire some vital companies within their operational expertise. Wesfarmers also seeks to finance the core activities of the firm. The expansion of these segments is critical in the long-term development of the firm.
As an investment bank, Goldman Sachs is tasked to find financing options for the company. There are certain methods used to determine the exact way Wesfarmers need to follow. The process starts with the evaluation of Wesfarmers financial performance. This segment suggests the capacity of Wesfarmers to be profitable during the course of an operating period. The operational capacity of the business is also evaluated. Wesfarmers is regarded diverse firm operating is variety of businesses.
In suggesting for financing activities, Goldman needs to evaluate possible risks involved. There are various elements that act as hindrances to the success of these initiatives. Financing can come in different forms. Wesfarmers can issue stocks and use the proceeds for its operations. The company can also issue bonds and other debt instruments. It is also possible for Wesfarmers to use the retained earnings for expansion. All of the stated methods are viable but each has strengths and weaknesses that need to be assessed.
Company Overview
Wesfarmers Limited started as a farmers’ cooperative in 1914. The mainly operates within various business portfolio in Australia and New Zealand. The firms’ main activities include coal mining, gas production, home improvement products, building supplies, safety products distribution, chemical and fertilisers, and insurance. In addition, Wesfarmers is involved in private equity and other activities. The primary goal of Wesfarmers is to provide maximum return to the shareholders and other related entities. The main strategies involve operation excellence, secure opportunities, renew portfolio, and ensure sustainability.
As stated earlier, Wesfarmers operates under several business portfolios. The home improvement segment is bannered by Bunnings. The company is also involved in distributing building materials. Most of the customers catered by Bunnings are individual contractors and homeowners. In 2007, Bunnings has erected 13 more warehouse stores. Wesfarmers coal, meanwhile, includes the Curragh Mine, the Hunter Mine, and the Bengalla Mine. Among the three mines, Curragh has been the busiest securing mining contracts with foreign firms.
Wesfarmers’ insurance segment serves direct and intermediary channels. The performance of the insurance division was affected by influx of claims. The segment was boosted with the integration of Australian International Insurance Limited portfolio, Dual, and Nautilus. Industrial and Safety is engaged in the distribution of engineering products, industrial consumables, safety, packaging, materials handling, and lifting. The two leading Wesfarmers distributors operate under the name of Blackwood and Bullivants.
One of Wesfarmers’ businesses that have delivered success is CSBP. The segment is known as provider of chemicals and fertilisers. The business is mostly focused on Western Australia where agriculture is a staple economic activity. Wesfarmers energy covers the firm’s gas business, power generation, and support provision. The priority of the segment is to expand the operations to other geographic areas. Aside from these main segments, Wesfarmers have interests in other businesses. These portfolios have also provided revenues that can sustain future growth.
Financial Performance
Overall, Wesfarmers experienced a positive year in terms of revenues. Earnings have gone up to $9.8 billion from $8.9 billion last year. The profit, however, was down to $786.3 million. As a result, earnings per share declined to 210.5 cents. Operating cash flow also increased by 14.3% to $3.41 per share. On the other hand, total assets of the company almost doubled from $7.4 billion to $12.1 billion. The company has also completed some notable acquisitions during the year.
Revenue per segment provided the following figures: home improvement, 39%; coal, 25%; insurance, 9%; industrial and safety, 8%; chemical and fertiliser, 7%; others, 7%; and energy, 5%. Home improvement recorded the highest revenue among segments totalling to $4.94 billion. The insurance segment also fared well contributing $1.41 billion to the company earnings. The industrial and safety division managed to record sales growth from 1.16 billion in 2006 to 1.21 billion in 2007. Chemicals and fertilisers, however, decreased revenues from 595 million in 2006 to 592 million in 2007.
The energy department has provided significant increase in earnings. The total revenue of the segment in 2007 is 463 million. The goal of Wesfarmers is to sustain the increase in revenues posted in 2007. Focus of expansion will be a major initiative for the company. Wesfarmers is also considering reviewing the processes to reduce cost. Moreover, Wesfarmers is targeting several firms to become part of their operations. The environment will indeed be challenging but Wesfarmers appears to be poised to enjoy sustained success.
Capital Structure
The most common practice for firms is to combine debts, equities, and hybrid securities. As of 2007, the company boosts a debt to equity ratio of 143.6%. Without the $2.1 billion debt financing used for Coles, the debt to equity ratio is 83.5%. This means that majority of the firm’s financing is taken from borrowings. Current standards suggest that debt needs to be 80% and equity has to be 20% of the total capital.
Based on Wesfarmers 2007 reported balance sheet, liabilities of the firm reached $8.57 billion. Of these debts, $1.39 billion are long-term. On the equity side, the total is valued at $3.50 billion. Of this amount, $2.26 billion are part of the contributed equity and $1.31 billion cover retained earnings. The cash flow suggests that Wesfarmers spent $4.19 billion for investing activities.
Dividend Policy
Wesfarmers have declared 225 cents dividend per share in 2007. This means that for every common stock earned by a stockholder, 225 cents is provided as compensation. The equity dividends paid by Wesfarmers amounted to $764 million. This amount was taken from the $1.31 billion retained earnings generated during the year. The consistent dividend payout provided by the firm is important. Some investors base their decisions on the ability of companies to provide dividends.
Risk Management
Financial risk management allows firms to use financial vehicles to lessen the impact of risks (Dorfman, 1997). The most common risks affecting firms include credit and market risks. Other risks that are also assessed include volatility, exchange rate, liquidity, and inflation. In this process, the term hedging is usually used. The most common notion in financial risk management is that firms have to evaluate these risks. This method will allow companies to create value in their investments and entice more investors to participate.
Credit Risk
The credit risk involves the non-capacity of Wesfarmers to pay for debts obtained during the course of operations. The balance shows that the liabilities of the company have increased from $4.26 billion in 2006 to $8.57 billion in 2007. In normal assessment, the rise in debt is never a good indication. But further investigation reveals that Wesfarmers has been faring well in managing debt. Despite the doubling of debt, Wesfarmers have managed to reduce long-term interest bearing loans from $1.07 billion in 2006 to $686 billion in 2007.
Another positive note that needs to be taken into consideration is the proceeds gained from. This illustrates the credit worthiness of Wesfarmers. But there are still concerns that have to be assessed. Interest rates have been volatile in the current financial markets. In addition, long-term success has become an unpredictable aspect. Overall, the risks to credit mostly involve the interest rates and future paying capacity. The current situation for Wesfarmers appears to be favourable.
Liquidity Risks
Liquidity is an important element that most firms seek to attain. There are several interpretations to liquidity. The most common notion is the availability of cash and current assets. The cash flow shows that ending cash balance for the firm amounted to $215 million. This is high considering that Wesfarmers spent nearly $5 billion in investing and paid dividends to stockholders. In addition, the current assets of Wesfarmers amounted to $4.02 billion. The current assets cover half of the total assets carried by the company.
The significance of liquidity in any operations is established. Having the liquidity allows firms to hedge short-term risks. In addition, a liquid company is capable of making immediate financing activities. Since the environment where Wesfarmers operates provide unlimited opportunities, this capability is highly important. The risks to this liquidity are also a cause of concern. Firms that have excess current assets are prone to lose in the long run. In addition, these assets are more important when used immediately. When these assets are kept, the process of growth in also stalled.
Market Risks
Market risks are mostly determined by equity, interest rate, currency, and commodity (Lam, 2003). Equity risk shows the vulnerability of Wesfarmers’ stock price to drop significantly. When this happens, panic selling occurs and there is possibility of the Enron-like scenario happening. At present, Wesfarmers’ stock price has been solid. Although the price is lower than last year, the decrease is tolerable. In terms of interest rates, the prevailing figures in Australia have been favourable to firms as shown in the increased borrowing of Wesfarmers.
The Australian dollar has been consistent versus the US dollar. Although a lower has some negative impact, high Australian dollar is more important. This is true because the markets were Wesfarmers operate are primarily located in New Zealand and Australia. Prices of commodity in Australia have also been stable. The country has yet to experience massive inflation rate increase. Most of the products provided by Wesfarmers are consumer goods. Hence the increase in commodity prices will decrease the demand for Wesfarmers’ products.
Operational Risks
Wesfarmers operate in different segments causing more operational risks to come out. One of the most risky businesses that Wesfarmers is involved with is mining. In 2007, the firm has experienced problems is expanding the coal plants. In the insurance business, the constant threat of nature has increased payouts to insurance holders. Chemicals and fertilisers were sold seasonally causing sales to decrease. In addition, Wesfarmers has been involved in the maintenance of plants and warehouses.
Financing Options
Opting to obtain American Depositary Receipts is one option that the company can use. The process involves trading Wesfarmers shares in the US financial market. ADRs are usually priced at par value of stocks in the local stock market. Adjustments such as currency rates are implemented. Firms deal with depositary banks, which also performs legal obligations to holders. The individual shares of foreign firms are often referred as the American Depositary Shares. ADR can be used to raise capital and introduce Wesfarmers to the US market. Moreover, Wesfarmers can diversify securities and financing options. The risks in this process involve currency rates and possible company takeover.
The most common for of ADR is the issuance of unsponsored shares. This is done over-the-counter and requires no reporting for the US SEC. In this option, Wesfarmers will have no formal arrangement with the custodian bank. At present, most foreign firms are trading at Level 1 ADR. A depositary institution is tasked to act as transfer agent. Level 1 ADR is only traded in the OTC market and US SEC demands minimal financial reporting. Level 2 ADR requires firms to make registration statement to SEC and abide by the agency’s rules. Firms have to submit form 20-F, which is the US version of 10-K. Level 3 ADR is similar to an IPO and allows firms to raise capital. Foreign companies are required to submit Form F-1, provide 20-F, and follow US GAAP rules.
There are several methods used to evaluate financing. These mechanisms are employed to determine rate of return and risk calculation (Beaney, 2005). Another method of financing that can be used involves asset securitisation. The process allows Wesfarmers to translate cash flow assets into securities. This is done to increase company funding and to transfer the risk of handling assets to future acquirers. There are disadvantages to securitasation that needs to be considered. Securitasation will potentially the firm’s portfolio quality. In addition, securitisation requires huge cost and limited in terms of size.
Debt Financing
There are advantages and disadvantages associated to debt. Debt insures that the current stakeholders of the company are maintained. In addition, there are several methods available to hedge the risks of debt. Instruments such as derivatives are important considerations. There are several barriers, however, that can affect this process. The creditworthiness of the company is dependent on rating agencies such as Moody’s, Fitch, and S&P. The risk of repayments also bodes problems since markets are highly uncertain.
Equity Financing
There is one important consideration that Wesfarmers have to consider. As the company deepens the penetration in foreign financial markets, the level of regulations also intensifies. After the Enron disaster, the U.S. has adapted the Sarbanes-Oxley accounting regulation. US SEC is strict in implementing the GAAP in making financial reports. Europe follows different accounting systems as well as other regions. Both the US SEC and European Commission are required comprehensive and meticulous financial reporting standards. Economic differences can also affect the value of securities. Downturns in major markets will impact even Wesfarmer’s local shares. For instance, several ADR listed firms have been affected by the current economic problems in the US.
Recommendation/Conclusion
Wesfarmers have to determine a financing mode to sustain growth. The company needs to ensure that the 80-20 rule on capital structure is maintained. Initially, the company can issue ADR that has some restrictions. Level 1 listing will allow Wesfarmers to prevent U.S. investors from taking over the firm. The firm can also provide European Depositary Receipts to further boost the capital of the company. In terms of asset securitization, the company has two vital asset groups to choose. The first comprise of insurance premiums from clients. The second part includes assets from the oil and energy segments.
References
Beaney, S., (2005), The Institute of Chartered Accountants, “Defining corporate finance in the UK”.
Dorfman, M.S., (1997), Introduction to Risk Management and Insurance, New York: Prentice Hall.
Lam, J., (2003), Enterprise Risk Management: From Incentives to Controls, New York: John Wiley.
Wesfarmers Limited, (2007), 2007 Annual Report, Web.