In order to make a better recommended strategy for the Pennon Group, an analysis of the current situation of the group has been made. We found that though the group performed well in the profitability, the liabilities of the corporation is increasing quickly too, which, as a result, influence the cash flow of the group. Take other important factors into account, we suggest the Pennon Group 1, try to reduce the liabilities; 2, cut down the total cost; 3, avoid penalties of breaking the environmental protection laws. We expect that by introduce these strategies, the group can cut the total cost by 2%, and the total revenue will increase 1% because of the improvement of goodwill. The Cash Flow Valuation Model is used to forecast the effects of the recommended strategy. The result is that there will be a huge improvement in the total revenue and net profit, which will then reflect in the share price as well. Clearly there is a positive impact not only to the group, but also to the management, shareholders and the environment. However, there are still some limitations about the methods used in the report which will be illustrated in the last part. Thus the financial forecast may not be the exact numbers but it still worth referencing.
1. Analysis of Current Situation
Pennon Group is a Devon based water utility and waste management group in the UK, the group's business is running by two main subsidiaries. According to annual report 2009 (2009, P.1), South West Water Limitied operates water and sewerage appointment for South West England, while the Viridor Limited is one of the market leaders in waste management and renewable energy business in the United Kingdom. Moreover, Viridor is one of the UK's largest landfill site operators. The group "has assets of around £3.5 billion and a workforce of over 4,000 people."
Before suggesting a strategy for Pennon Group, a SWOT analysis is applied to give some general ideas about the corporation. As Appendix 1 shows, for the strengths' part, as is one of the leaders of the landfill market, Viridor provides the Pennon Group a strong market position in that filed. The South West Water has a superior customer service. Besides, the financial performance of the group seems steady. And the weaknesses of the group are caused by geographic restriction and the probability of violate the environmental laws. The group is facing the opportunity of increasing population and demand for environmental service in the UK. In addition, the concept of environmental protection calls people think more about developing and using renewable energy. Finally, main threats come from external are domestic market regulation, market competition and climate change.
When consider the financial performance of the group itself, it can be concluded that despite the extremely difficult business environment, the group kept a steady growth in critical profit performance.
Table 1 presents key data for Pennon Group during 2004-2008.
It is clear that although experienced a tough time during the economic recession, the group has a positive signal of recovering from the bad time. The group's total sale keeps growing at the rate of 8.9%. At first glance, the group may seem performed not so good in profit growth in FY2009. However when look into the depth, we can find there is a huge income tax due to a £143m in "Tax relief no longer available on industrial buildings" which made the net profit decrease largely. If the income tax is about the same as FY2008, the net profit will be about £143m, which is 107% of that in FY2008.
Furthermore, from the interim financial data of the group (see Appendix 1), the Pennon Group has achieved a six months revenue of £535.5m from 31st Mar to 30th Sep, 2009, which reached 56.1% of last financial year's revenue. And the net profit of £68.7m, which is 75% of that in FY2009.
When consider other financial data, the group's liabilities and gearing ratio keeps growing, while the ROE and ROCE experienced a significant drop in the FY2009, which means the weaken of the ability of generates enough returns to pay for its cost of capital.
However, when compared with its main competitors in the industry (see Appendix 2), we can find that the whole industry has suffered an even larger fall in the ROE and ROCE ratio, and the average Gearing ratio has almost doubled in the FY2009. Moreover, the Pennon Group's ROCE ratio is even better than the leading companies Centrica PLC and Severn Trent PLC. Thus we can conclude that the firm was performing better than the industrial average.
We use the GPRV model (see Appendix 3 http://www.infinancials.com/Eurofin/control/company?nbrdm=22513&view=gprv&pgselected=Domestic Peers&company_id=95306EX&type=0&company_id2=&comp_name2=&zone=&icb=#) to conclude, it is clear that the Pennon Group has shown a great ability in growth, and the profitability and risk control of the group is acceptable as well, but the value of the corporation needs to be improved.
2. Strategy Recommendation
While operating in the feature of utilities industry, product differentiation is not suitable for the Pennon group. After analyse the Pennon's annual report and financial statement, consider the market position and business scope of the group, we believe that the best way to improve the performance especially financial performance of the corporation is to reduce cost. There are three aspects which the group should pay attention to.
1, Reduce the group's liabilities.
When we check the group's Balance sheet (see Appendix 4), there is a huge increase in the short-term borrowings from £57.7m to £262.9m, which lead to a 45.72% rise in the total current liabilities. While the total current assets of the group has not increased in the FY2009 (actually there is a slight decrease in the current assets), the current ratio of the group has fallen from 1.45 to 1.085. Thus the liquidity of the group was influenced. Besides, the risen liabilities caused a more £7.2m in the interest paid, consider that the net profit of the group is £68.8m in the last financial year, the group need to reduce the liabilities. We suggest that since the group has a "Cash and cash equivalents" of £322m at end of the year, it can use about £100m to pay the liabilities. Then the liabilities of the group, together with the interest that has to be paid, will be reduced, while the "Cash and cash equivalents" will be the same as the FY2008.
2, Cut cost
We can see from the group's income statement that the total cost of the corporation is £838.1m. While the total revenue is growing at 8.9%, the growing rate of cost is even higher than that of the revenue.
First of all, we noticed that there is an item named "Other Operational Expenses, Total" in the income statement, which keeps rising by around £50m annually. These may include expense that may not have a specific account to be recorded such as "Travel Expense" and "Food Expense". However, while the total revenue of the firm only has risen 8.9%, a 14.86% increase in those other operational expenses seems not reasonable. Thus if the group can control this part of expense by increasing no more than 10% annually, it can save a lot for the corporation.
Secondly, we suggest an investment in the landfill business of the group. In 2008/09 landfill accounted for 45% and landfill gas power generation 25% of Viridor's profit contribution. Appendix 5 shows that landfill tax accounts more than half of the tax contribution of the whole company. Since the landfill tax will rise from £40 currently to £72 per tonne in 2013/14, it is necessary for the group figure out a way to relieve the impact of this trend. Our advice is that the group spends £10m more on the R&D of the landfill business, and we expect that it will help reduce 10% of the cost of landfill tax in return.
Last but least, other cost such as administration cost and production cost also need to be cut down by operating efficiently. We learnt that the group has acquired several waste management companies, thus there must be a lot of overlapped used resource between companies. If the group can management these resources properly, we believe the fix cost of production will be lower than before.
3, Avoid penalties from breaking environmental protection laws
We noticed that due to the feature of the group's business and the government's regulation, the group is often confronting the probability of infringing environmental protection laws. The group was convicted on eight occasions for environmental offences and fined a total of £36,100 in 2008, though there were fewer convictions in 2009, the fine of £28,000 is still a large number. Besides, the records of breaking laws will hurt the reputation of the firm, which may cause customers losing. So what we suggest is that the group pay more attention to try to avoid breaking laws, even if do so may cost money, it will help to win a better goodwill for the corporation and is an indirect way of attracting potential customers and improving sales.
In conclusion, the recommended suggestion has three aims, to reduce liabilities, cost and penalties. We expected that the first two suggestions will help the group reduce total cost by 1% separately, and the goodwill built by the last suggestion will lead to a 1% increase in the total sales. One thing worth mentioning is that this number is only used to demonstrate the possible trend, not the exact portion of the decline or increasing.
3. Financial Forecast
In this part, we will use the data from the group's balance sheet and income statement to calculate the impact of the recommended strategy by applying the cash flow valuation model. A five year cash flow forecast will be shown in the following.
3.1 Financial forecast based on current strategy
The data of total sales, profit before tax, tax, earnings, fixed asset and working capital are picked from the group's balance sheet and income statement. The cost of equity (ke) is calculated by using the CAPM model, which shows that ke= rf + beta [E(rm)-rf]. The beta is found on the Financial Times, which is 0.4553 [1] . Since we will calculate the financial forecast on the base of our recommendation, for the risk free rate (rf), we use the five-year UK government bond which is 2.69%. [2] According to the Financial Times, the historical risk premium in the UK market is 3.99% [3] . So the Ke here is 0.04507. Consider that the influence of the economic crisis is not as terrible as it is before, we believe that the Pennon Group can keep the growth rate (8.9%) in the next several years.
As Appendix 5 shows, based on the current strategy, the group can get the earnings of £140.14m on the fifth year. Figure 2 shows the likely trend of earnings growth in each year.
Now Year1 Year2 Year3 Year4 Year5
3.2 Financial forecast based on recommendation
Under the new strategy, some data need to be changed as the performance of the group will be improved. First of all, the penalties reduction strategy will help increase the total sale, so the revenue of the group is expected to increase by 1%, which is £962.43m instead. Secondly, together with by introducing the reduce cost and liabilities strategy, we assume that the total cost of the group will cut by 2%, which is £777.92m. Thus we can get the new PBIT which is 962.43-777.92=£184.51m. For the tax part, we continue to use the rate of the last year's which is about 42.4%. Then the new earnings for the corporation will be £106.11m. Lastly, as fixed asset and working capital vary along with sales, the items of fixed assets/sales and working capital/sales do not need to be adjusted.
Appendix 6 shows the financial forecast based on recommended strategy. Total sales, PBIT and earnings are generating in a higher speed, and free cash flow and value are much better than it is before. Figure 2 shows the new trend of earning in the next five years after adjusts.
Now Year1 Year2 Year3 Year4 Year5
While comparing the results of the two forecasts, it is clear that although the Pennon Group can make a sizable profit by keeping the current strategy, it can earn more by using the recommended strategy. Figure 3 illustrates the gap between them. We can see in the fifth year, the earnings under the new strategy are 16% more than the current path. What is more, the net present value for the current strategy is only £391.73m while for the recommended strategy, it is £858.70m. Assume that there is a positive relationship between earnings and share price, we can draw the possible share prices based on the two different strategies, and the result is shown in table 2.
Now Year1 Year2 Year3 Year4 Year5
Table 2: Comparison of possibly share price
　
Share price based on current strategy
Share price based on recommended strategy
Year 1
584.22
677.56
Year 2
636.23
737.84
Year 3
692.87
803.51
Year 4
754.55
875.04
Year 5
821.68
952.90
4. Recommendations dealing with corporate governance
Corporate governance plays a very important role in the performance of a company. Shleifer and Vishny (1997) defined corporate governance as "deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment". Thus the managers of a company need to chase a balance between the development of the firm and the benefit of its financial suppliers.
As mentioned before, with the applying of the recommended strategies, the Pennon Group will expect not only an increase in the total revenue, but also a decrease in the total cost. The result is a greater growth both in the net profit and the goodwill of the group. The expected increase in the share price will satisfy the group's shareholders with higher annual bonus. The management team and employees will get higher income due to the improved earnings, which will encourage them to perform better. Besides, a better profitability and goodwill of the group, and the control liabilities strategy will make the debt-holders feel unworried about their debt. Furthermore, the development in the landfill business and fewer occasions for environmental offences are absolutely eco-friendly, which will be welcomed by government and citizens of the country.
However, when introducing these strategies, there must be some difficulties. Since items in the "Other Operational Expenses" need to be cut down, some employees' benefits must be reduced. Sometimes it is the staff or manager himself needs to make the decision of cut his own allowance for saving the cost for the group, they may feel not good by doing this, which will influence their performance as a consequence. So there must be some guide to those stuffs to let them understand the balance between short-term benefit and long-term benefit both for themselves and the group. Then we suggest that rewards should be given to encourage some big steps in the cost saving activities. The board need to pay attention to the process of cutting cost, and strict rules should be applied to assist the strategy.
The last problem related to the recommended strategy is about the research and development. We all know that the input and outcome of R&D is always hard to estimate, and if work in a wrong way, all the investment on R&D may lose. We learnt that all the members of the board of directors has many years of working experience in the utilities industry, and some of them are also experts in this particular operations, so we believe that they can help the group do the research and development job on the right direction.
5. Critique of the models used
Since we have used the Cash Flow Valuation Model in the report, some critical evaluations will be illustrated in this part, and reference will also be given.
Firstly, CAPM model was used for calculating the discount rate of return. On the one hand, "the CAPM is elegantly simple, and easy to use." (Bender & Ward 2009). The risk free rate (Rf) can be obtained from the government bonds' yield to redemption. The companies' betas can be calculated easily from the historical data. Because most investors have diversified portfolios, D'Arcy and Dyer (1997) note that the CAPM model only considers the systematic risk. And the theoretical relationship between risk and return generated by CAPM has been used in empirical research as well. When compared with other models, the CAPM can calculate the cost of equity better than the dividend growth model (DGM), and the CAPM can do a greater job in providing discount rates than WACC does in estimating investment.
On the other hand, however, there are some disadvantages in using the CAPM, mainly because of some of its assumptions. While we use the beta as a full measure of risk, there is a problem about how to choose the period of regression to calculate the beta (Bender & Ward 2009). The same things happen to the Rf data as well, we cannot easily choose the exact duration of the government bonds. Besides, the CAPM lead people pay more attention to the market risk and sometimes neglect the corporate risk, this may cause mistakes. Moreover, Vintilã (2007) suggest that hypothesis for CAPM ignores investors' dynamic behaviour.
The cash flow valuation model uses the data from the balance sheet and income statement to help the decision maker measure the strategy, and the model forecasts cash flow in next several years, which can suggest the way of investing. It also shows the changes in equity, value, growth and so on. But the drawbacks of the cash flow valuation model are obvious as well. For example the cash flow valuation model could be addressed by subjectively eliminating investments in growth from the measure of free cash flows. Besides, since some data may not available, misrepresentation would happen to accounting numbers. Nevertheless, since the model is easily applied, and the result is straightforward, it is still wildly used.
6. Conclusion
To sum up, we recommend the Pennon Group strategies from three aspects to help improve its performance. These strategies including reduce liabilities, cut cost and avoid penalties. By applying the cash flow valuation model, it is clear that the net profit and share price will increase more.
To implement those strategies, new rules need to be applied to help, and the corporate government plays an important role in leading the group in the right direction.
Shleifer, A., Vishny, R. W. and Harvard Institute of Economic, R. (1995) A survey of corporate governance, Discussion paper / Harvard Institute of Economic Research, Cambridge, Mass.: Harvard Institute of Economic Research.
Bender, R. and Ward, K. (2009) Corporate financial strategy, 3rd ed., Oxford: Elsevier Butterworth-Heinemann.
D'Arcy, S.P., and Dyer, M.A., "Ratemaking: A Financial Economics Approach." Proceedings of the Casualty Actuarial Society, Volume LXXXIV, pp. 301-390, 1997.
Vintila,N.,"Assessing Discount Rate for a Project Financed Entirely with Equity Capital" Theoretical and Applied Economics, pp. 11-20,2007
