The use of internal Capital Markets based on the example of Next & New Look

Table of contents

Table of graphs

Table of figures

Table of formulas

List of abbreviations

1 Introduction

2 Financial analysis of New Look
2.1 Profitability ratios
2.2 Liquidity ratios
2.3 Efficiency ratios
2.4 Financial structure ratios
2.5 Segment level performance
2.6 Interim summary

3 Internal capital markets
3.1 Benefits of internal capital markets
3.2 Drawbacks of internal capital markets
3.3 New Look acquisition and internal capital markets value
3.4 Interim summary

4 Next’s corporate governance and ownership structure
4.1 UK corporate governance code
4.2 Board structure and directors of Next
4.3 Next’s ownership structure
4.4 Effect on Next’s internal capital market

5 Acquisition of New Look
5.1 The private equity firm Brait
5.2 Acquisition of New Look
5.3 Interim summary

6 Costs and benefits of New Look as a standalone company
6.1 Benefits of a standalone company
6.2 Costs of a standalone company
6.3 Interim summary

7 Recommendations
7.1 Maximising limited partners return
7.2 Best interest of New Look

8 Appendices

9 References

Table of graphs

Graph 1: Return on capital employed

Graph 2: Return on shareholders’ fund

Graph 3: Gross profit margin

Graph 4: Net profit margin

Graph 5: Current ratio

Graph 6: Quick ratio

Graph 7: Inventory turnover

Graph 8: Receivable days

Graph 9: Payable days

Graph 10: Cash conversion cycle

Graph 11: Gearing

Graph 12: Interest cover

Graph 13: Number of IPOs and sum of money raised

Table of figures

Figure 1: Segmental report revenue

Figure 2: Segmental report operating profit

Table of formulas

Formula 1: Return on capital employed

Formula 2: Return on shareholders’ fund

Formula 3: Gross profit margin

Formula 4: Net profit margin

Formula 5: Current ratio

Formula 6: Quick ratio

Formula 7: Inventory turnover

Formula 8: Receivable days

Formula 9: Payable days

Formula 10: Cash conversion cycle

Formula 11: Gearing

Formula 12: Interest cover

Formula 13: Discounted cash flow method

Formula 14: Discounted cash flow method perpetuity

List of abbreviations

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1 Introduction

New Look Retail Group Limited (New Look) is an international multichannel retail brand, offering value-fashion for women, men, and teenage girls. The company has more than 900 stores, which are mostly based in the United Kingdom (UK). Its e-commerce grew sustainably over the last years and serves customers in 120 countries worldwide. Since 2015, New Look is owned by Brait Societas Europaea (Brait), a private equity (PE) firm.

It is now rumoured that the UK based retailer Next Public Limited Company (Next) is preparing a takeover bid for New Look. This report tries to examine the firm’s decision for the new acquirement by analysing New Look’s performance in the last five years, internal capital markets (ICM), corporate governance and ownership structure, as well as advantages and disadvantages of acquiring a firm backed by a PE investor. Finally, the last element of the analysis is the evaluation of the benefits and costs of New Look as a standalone firm, if Brait would undertake successfully an initial public offering (IPO) process to exit from New Look. In the conclusion, we provide a recommendation for the exit strategy of Brait from New Look, if the objective is either to maximise the return to the Limited Partners (LPs) or Brait acts in the best interests of New Look.

2 Financial analysis of New Look

In this section, we attempt to provide a financial analysis of New Look over the period 2013 to 2017. The financial analysis is mainly focused on the profitability, liquidity, efficiency and capital structure of the company during this five-year period and the purpose of it is to observe New Looks’ performance. To analyse the performance of New Look better, we calculated a market average to compare the performance with the following four companies: Marks and Spencer Public Limited Company (M&S), Debenhams Retail Public Limited Company, ASOS Public Limited Company (Asos) and Laura Ashley Public Limited Company (Laura Ashley), which are representing, among New Look and Next, the six largest UK retailers.

In general, financial analysis contributes to a better understanding of a company’s performance as well as its financial position and structure. However, since no one can come to conclusions based only on absolute numbers, the analysis is being implemented with the help of various major ratios per category that is being examined and compared to the calculated industry average. We acknowledge the fact that we are comparing a privately held company with publicly listed ones and, as stated by Clor-Proell and Maines (2014), there are significant differences between their financial reports. Subsequently, the performance of all ratios is being measured over time in order to help to identify if New Look is profitable, has a good future prospect, is growing and how it is structured.

2.1 Profitability ratios

Profitability ratios show whether the company is generating a sufficient return for its owners, as manager’s incentive is to maximise shareholders’ value (McLaughlin and Henderson, 2017). We take a closer look at return on capital employed (ROCE), return on shareholders’ funds (ROSF), gross profit margin (GPM) and net profit margin (NPM).

2.1.1 Return on capital employed

There are a lot of ratios that contribute to businesses’ profitability measurement. ROCE is an important measure of business performance which expresses the relationship between the profit generated by the business and the long-term capital invested in it. Therefore, this ratio shows how efficiently a company employs capital, long-term borrowings and equity in order to make net profits before interest payment and taxes.

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Formula 1: Return on capital employed

As it is easily understandable, it is always desirable to be as high as possible.

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Graph 1: Return on capital employed

In the case of New Look, we observe that the company increased its ROCE from 2013 to 2015 to 14.99 percent. In the following two years it dropped to 7.52 in 2017. But during the five-year period New Look always performs under the industry average. Only from 2013 to 2015 it was possible to perform in the opposite direction than the industry average moved. The average dropped from year to year to its minimum of 19.61 percent in the year 2015, which is nevertheless 4.62 percent above ROCE from New Look. Unfortunately, New Look was not able to keep the increase of its ROCE until 2017. It followed the market trend and dropped. The industry average was falling therefore to its lowest level to 13.98 percent in 2017, while New Look was only able to reach a ROCE in the amount of 7.52 percent. The changes over the years of New Look only appear to the changes in the profit before interest and taxation. The equity and non-current liabilities stayed almost at the same level over the five-year period. However, ROCE of New Look was always below the industry average.

2.1.2 Return on shareholders’ funds

Similar to ROCE, ROSF shows the relationship between the invested equity capital and the profit generated by the business.

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Formula 2: Return on shareholders’ funds

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Graph 2: Return on shareholders’ funds

In the case of New Look, the trend seems to be more or less similar to the one of ROCE. In terms of this ratio, it is positive except the year 2013 and 2015 where it was -1.08 percent and -16.89 percent respectively. But in the case of New Look we have to be careful, because the net profit is Great British Pounds (GBP) -53.6 million in 2014, GBP -34.4 million in 2016 and GBP -20.2 million in 2017. It was only possible to generate a positive net profit in the years 2013 and 2015, which are GBP 3.4 million and GBP 52.9 million respectively. In addition, it appears that New Look had a negative equity over the whole five-year period. These circumstances are the reason for a negative ROSF in 2013 and 2015. Due to this fact, a comparison with the industry average, where all companies had positive net profit and equity, is difficult and not meaningful. However, we need to highlight that in years 2014, 2016 and 2017 we have a loss and in 2013 and 2015 a profit. Having said that, a negative equity entry over the years makes ROSF not comparable to the industry averages.

2.1.3 Gross profit margin

GPM measures the profitability of a company based on its revenue and cost of sales, disregarding all the other expenses. Therefore, it measures the profitability depending on the business model in buying, producing or selling goods before any other expenses are taken into account. Using it for comparison requires carefulness as gross profit margins vary significantly depending on the nature of business and production.

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Formula 3: Gross profit margin

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Graph 3: Gross profit margin

New Look has a better GPM than the industry average over the whole five-year period. It is very stable and every year over 50 percent with a maximum in year 2014 of 52.79 percent and a minimum in year 2017 of 51.34 percent. The industry average is constant as well over this period with a maximum of 35.7 percent in 2013 and a minimum of 33.53 percent in 2017. It is important to say that M&S is not included in the industry average because they did not publish a gross profit as well as cost of sales. New Look is therefore every year around 15 percent higher than the industry average. Reasons are significant lower cost of sales compared to the revenue of the industry average. But New Look had very high administrative expenses compared to the industry average. Given that, one of New Look’s biggest expenses is administrative expenses, Next might have the expertise and knowledge to reduce this cost significantly through synergies as we explain later in section five. It can be possible that they booked some expenses under administrative expenses instead of under cost of sales. Unfortunately, they do not provide information in the notes about this fact.

2.1.4 Net profit margin

NPM is indicating what percentage of revenues remains after all costs, expenses, interest and taxes are paid.

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Formula 4: Net profit margin

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Graph 4: Net profit margin

In the case of New Look, NPM was only positive in the two years 2013 and 2015, where they had a net profit. This concludes in a positive NPM of 0.23 percent and 3.74 percent respectively. In the years 2014, 2016 and 2017 they realized a loss which results in a negative NPM of -3.92 percent, -2.31 percent and -1.39 percent. In contrast to New Look the industry average was every year positive but with a negative trend over the five-year period. The company performed every year significantly under the industry average except from 2015 where the average was 4.48 percent and New Look only had a difference of 0.74 percent.

2.2 Liquidity ratios

Liquidity is company’s ability to turn assets into cash in order to pay liabilities and other obligations. We take a closer look at current ratio and quick ratio or also known as Acid test.

2.2.1 Current ratio

Current ratio is the best way to measure the company’s liquidity based on current assets with current liabilities of the company.

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Formula 5: Current ratio

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Graph 5: Current ratio

New Look’s liquidity was measured by current ratio better in every year over the five-year period from 2013 to 2017. It is every year over 1.0, which means that current assets are greater than current liabilities. The highest current ratio was in 2015 which was 1.43. The lowest current ratio was in 2013 and was 1.04. Compared to the industry average the liquidity of New Look is better each year. The industry average remains almost stable around 1.0. The current ratio of New Look indicates that the company has a better liquidity management than its competitors and can pay in theory every short-term liability because of the ratio greater than 1.0, as an interpretation of the formula.

2.2.2 Quick Ratio (Acid test)

Quick ratio is similar to the current ratio with the difference that inventory is being deducted from current ratio. As it is more difficult to turn assets into cash, this ratio provides a more realistic image of company’s liquidity.

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Formula 6: Quick ratio

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Graph 6: Quick ratio

Quick ratio of New Look moved the same way as current ratio, because the inventories, which are deducted from current assets, are almost the same over the five-year period. The minimum of quick ratio is in the year 2013 of 0.62. The maximum is 2016 with a quick ratio of 0.89. However, quick ratio is every year significantly above the industry average which speaks for a good liquidity management of New Look.

2.3 Efficiency ratios

McLaughlin and Henderson (2017) argue that efficiency ratios provide an understanding of the company’s management with the working capital. We take a closer look at inventory turnover, receivables days, payables days and cash conversion cycle.

2.3.1 Inventory turnover

Inventory turnover is a ratio that measures the average period in days for which stocks are being held. It is also a measure of value and liquidity, which makes it important for investors and creditors, as they always want to know how valuable a company’s inventory is and how fast a firm can convert its inventory into cash.

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Formula 7: Inventory turnover

As expected, it is desirable for this period to be as short as possible as it reflects how quickly cost of sales can be converted into cash.

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Graph 7: Inventory turnover

As observed by current ratio and quick ratio New Look has a good liquidity management. Inventory turnover proves this statement. The company has a shorter time period regarding how long inventory was spending on the shelf before it was sold. Due to the seasonal business of a fashion retailer a shorter inventory turnover is beneficial. The inventory turnover of New Look was very stable over the five-year period with an average of 78 days. New Look was able to have a shorter inventory turnover period than the industry averages each year. M&S is not included in the calculation of the industry average because they did not publish the cost of sales, which makes it impossible to calculate inventory turnover for them.

2.3.2 Receivable days

This ratio calculates in days how long, on average, credit customers take to pay the amounts that they owe to the business and how quickly companies collect these payments.

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Formula 8: Receivable days

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Graph 8: Receivable days

Again, it is desirable for this ratio to be as short as possible. The quicker the debtors pay the company, the better for the company’s cash flow. In the case of New Look, it is very easy to detect the effectiveness of the company over the five-year period. It was very stable with an average of 20 days. New Look was able to not follow the industry average upper trend from the year 2015 until 2017, which supports its cash management. Only 2013 and 2015 was the industry average slightly below New Looks receivable days.

2.3.3 Payable days

This ratio measures in days how long, on average, the company takes to pay out their trade creditors.

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Formula 9: Payable days

In contrast with receivable days, in this case, it is preferable for the company to delay the payments to its suppliers for some time to finance itself in the short-term. However, caution needs to be taken in the payable days level of the company, as too many days can signal that the firm is not in the position to meet its payments which is disadvantageous.

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Graph 9: Payables days

The payable days of New Look are constant over the observed period. It has a minimum of 129 days in 2013 and a maximum of 145 days in 2015. Roughly said, it followed almost the industry average over the time. M&S is not included in the industry average, like for inventory turnover, because they did not publish the cost of sales, which makes it impossible to calculate the payable days for them.

2.3.4 Cash conversion cycle

This ratio measures the average number of days that working capital is invested in operations. More specifically, it indicates the length of time cash spends tied up in current assets. It shows, therefore, the time difference between outlay of cash and cash recovery.

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Formula 10: Cash conversion cycle

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Graph 10: Cash conversion cycle

The cash conversion cycle of New Look is negative for each year of the observed period. This leads to the conclusion that the company can finance a part of its business itself only through the difference between the outlay of cash and cash recovery. The time between the outlay and the recovery is the same as a short-term loan without interest expenditures. New Look has the best cash conversion cycle in the year 2014 with a value of -49 days and the worse value of -33 days in 2017. Nevertheless, it had better figures each year than their competitors measured by the industry average. Excluded for the industry average for the cash conversion cycle is M&S because we were not able to calculate inventory turnover and payable days for it.

2.4 Financial structure ratios

McLaughlin and Henderson (2017) claim that this category of ratios indicates the way that the firm is financed. Two very important ratios for this purpose are gearing and interest cover.

2.4.1 Gearing

Gearing shows the composition in long-term financing of a company.

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Formula 11: Gearing

It is very important to mention that the higher the proportion of debt for a company’s structure, the higher the gearing and exposure to risk.

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Graph 11: Gearing

McLaughlin and Henderson (2017) consider that it is not so easy to have a general rule to indicate whether a specific level of gearing can be considered as acceptable or not. They explain that it depends on the firm’s ability to support its earnings with security and stability and also on the attitudes of lenders. It is useful to mention that in the UK, a company is regarded as highly geared if it has reached a gearing ratio of 40 percent (Department for Environment, Food & Rural Affairs, 2014). In our case, we can see New Look had a gearing over 100 percent over whole five-year period, which is due to the negative equity. The highest gearing was in the year 2014 with 142 percent. The lowest gearing was 2016 with 130 percent. However, the trend line of New Look’s gearing is stable over the observed period. Nevertheless, compared to the industry average New Look had a significant higher gearing than their competitors. Asos is not included in the calculation of the industry average because they are almost only financed by equity and short-term debt, which it is not very representative for the average in our opinion. However, the industry average is stable as well but with an average of 41 percent which is regarded as highly geared, according to the Department for Environment, Food & Rural Affairs (2014). The high gearing of New Look shows that the company’s risk is very high as lenders can demand higher finance payments due to the possibility of bankruptcy.

2.4.2 Interest cover

With the help of this ratio we have the ability to quantify the capacity of the company to meet interest payments out of operating profits.

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Formula 12: Interest cover

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Graph 12: Interest cover

The result of this ratio in this five-year period is another example of the high level of New Look’s debt. More particular, it is significantly below the industry average. New Look’s maximum interest cover was 1.29 in the year 2015 and its minimum 0.76 in the following year. The industry average, on the other hand, had a maximum of 7.55 in 2016 and a minimum of 5.24 in 2014, which is much more than New Look had. Excluded for the industry average for interest cover are Asos, because they did not publish interest expenses in 2016 and 2017, and Laura Ashley, because it had not very representative ratios for the industry, in our opinion.

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