PreFab (Pty) Ltd ('PreFab') manufactures, sells and rents out prefabricated units, and is the leading manufacturer of these products in South Africa. Units are manufactured at its factory situated in Centurion, Gauteng. PreFab's individual units vary from 12 m2 to 612 m2, and because of the modular format of units, can be sized according to customer requirements.
PreFab supplies significant volumes to various South African government departments, which accounted for 22% of the company's revenue in the 2007 financial year. The government uses PreFab's units for new schools and in low cost housing developments. Various government departments have also embarked on an extensive infrastructural development programme and PreFab is confident that it will benefit from increasing expenditure from them.
The rest of PreFab's customer base is diversified and no single customer accounts for more than 10% of the company's total revenue. Some of these customers, for example South African and African mining groups involved in exploration projects and new mining projects, use prefabricated units to provide temporary accommodation for staff. Others use the units for office accommodation on a temporary or permanent basis. The construction industry is undergoing a major growth phase and many of the major construction groups use PreFab's units as temporary offices and residential accommodation on construction sites.
PreFab also rents out units to customers, and the demand for rental units is increasing. The minimum rental period is three months, and monthly rentals of units are determined as the historical cost of the unit divided by 24. In order to keep up with customer demand for rental units, PreFab has utilised most of its historical cash flows and raised term loans from banks to fund the acquisition of units by the Rental division. The Rental division was started in January 2006.
Steven Hamilton founded PreFab in 1996 and is still the Chief Executive Officer (CEO) of the company. Mr Hamilton's family trust, The Hamilton Family Trust, owned 100% of the shares in issue until July 2007. The Hamilton Family Trust advanced a R35 million loan to PreFab in 2000 which loan bears interest at 13% per annum, payable annually in arrears, and has no fixed date of repayment.
Effective from 1 July 2007 BBZ Holdings, a broad-based black economic empowerment (BEE) investment group, acquired a 30% interest in the company and advanced an interest-bearing shareholder's loan of R15 million to PreFab on the same date. The terms and conditions of the loan are the same as those applicable to The Hamilton Family Trust loan.
The PreFab shareholders' agreement contains a clause that provides that if any shareholder disposes of its equity to a third party, the purchase consideration would first be allocated to shareholder loan accounts and thereafter to the shares.
Xtatic Ltd ('Xtatic'), a company listed on the JSE Ltd, has recently approached the shareholders of PreFab with an offer for the acquisition of a 100% shareholding in the company. Xtatic is in the process of formulating an offer price for PreFab shares and has indicated that a key condition of the acquisition would be that Steven Hamilton remains as CEO of PreFab for three years after the acquisition. Xtatic has indicated that it will pay cash for the shareholding in PreFab. Xtatic is a major manufacturer and supplier of mining and construction capital equipment, and is aggressively growing through acquisitions.
Abridged historical and forecast income statements of PreFab
PREFAB (PTY) LTD
INCOME STATEMENTS FOR THE YEARS ENDED/ENDING 31 DECEMBER
Actual
Forecast
Notes
2006
Rmillion
2007
Rmillion
2008
Rmillion
Revenue
94,1
147,0
197,4
Manufacturing division
84,1
122,0
152,4
Rental division
1
10,0
25,0
45,0
Cost of sales
(56,9)
(86,8)
(113,4)
Manufacturing division
(53,4)
(78,0)
(97,6)
Rental division
2
(3,5)
(8,8)
(15,8)
Gross profit
37,2
60,2
84,0
Operating costs
(20,9)
(24,7)
(27,7)
BEE transaction costs
3
-
(12,4)
-
Unusual entertainment costs
4
-
(2,4)
-
Contract penalties
5
-
(1,8)
-
Depreciation
(1,8)
(2,2)
(2,3)
Profit before interest and tax
14,5
16,7
54,0
Finance charges
(0,5)
(2,1)
(3,8)
Interest on shareholders' loans
(4,6)
(5,5)
(7,0)
Interest income
0,3
1,0
1,9
Profit before tax
9,7
10,1
45,1
Tax
6
(2,8)
(6,5)
(13,1)
Profit after tax
6,9
3,6
32,0
9
Notes
1 The periods of rental agreements vary from three months to 12 months with the option to renew. PreFab has a long waiting list for rental units and accordingly plans to acquire further units to rent over the next three years.
2 Cost of sales for the Rental division comprises mainly depreciation, maintenance and servicing costs of units. Rental assets are depreciated on a straight-line basis over ten years. Depreciation amounted to R2 million in the 2006 financial year. The Rental division purchases prefabricated units from the Manufacturing division at the same prices at which units are sold to external customers, which in total amounted to R30 million in 2007 (2006: R20 million). It is forecasting acquisitions of R40 million in the 2008 financial year. The Manufacturing division revenue shown in the income statements includes sales at market value to the Rental division.
3 The auditors of PreFab recommended that a once-off cost associated with the BEE deal in July 2007 be recognised in the company's annual financial statements. The auditors are of the opinion that the difference between the fair value of shares acquired by BBZ Holdings and the actual cost of their share subscription (which was a nominal amount) should be accounted for based on their interpretation of IFRS 2, Share-based payment, and AC 503, Accounting for black economic empowerment (BEE). The following journal entry, which can be assumed to be correct, was processed at year end:
Rmillion
Rmillion
BEE transaction costs
12,4
Share premium
12,4
4 PreFab invited various client representatives to accompany them to the Rugby World Cup held in France in October 2007. The company deemed this to be a non-recurring expenditure and hence disclosed it separately in the income statement.
5 PreFab incurred a penalty due to the late supply of prefabricated units to Galaxy Mining. Such a penalty has never previously been incurred, because PreFab generally refuses to include a late supply clause in supply contracts. The late supply occurred as a result of disruptions caused by a ten-day strike by PreFab manufacturing employees over proposed wage increases. The strike took the executive directors of PreFab by surprise, as no such incident had occurred in the preceding three years.
6 The company's effective normal tax rate has historically been 29%. In the 2007 financial year the effective tax rate increased due to the non-deductibility of the BEE transaction costs.
7 PreFab's budgeting for and forecast of earnings have generally been highly accurate. Steven Hamilton is confident that forecast profit after tax of R32 million will be achieved in the year ending 31 December 2008, particularly given that the 12-month forward order book at the end of February 2008 exceeded R100 million.
Abridged historical and forecast cash flow statements
PREFAB (PTY) LTD
CASH FLOW STATEMENTS FOR YEAR ENDED/ENDING 31 DECEMBER
Actual
Forecast
2007
Rmillion
2008
Rmillion
2009
Rmillion
2010
Rmillion
Profit before interest and tax
16,7
54,0
78,7
105,1
Depreciation
Property, plant and equipment
2,2
2,3
2,2
2,2
Rental fleet
5,0
9,0
14,0
19,0
BEE transaction costs
12,4
-
-
-
Net interest
(6,6)
(8,9)
(8,7)
(6,6)
Tax
(5,6)
(11,5)
(18,5)
(26,5)
Working capital
Inventories
(4,7)
(4,3)
(4,3)
(5,1)
Accounts receivable
(6,7)
(6,1)
(7,6)
(8,4)
Trade and other payables
4,4
2,9
2,9
3,5
Capital expenditure
Property, plant and equipment
(2,5)
(2,0)
(2,1)
(2,2)
Rental units
(30,0)
(40,0)
(50,0)
(50,0)
(15,4)
(4,6)
6,6
31,0
Interest-bearing debt (net movement)
16,6
4,9
(10,1)
(3,6)
Shareholders' loans
15,0
-
-
-
Net cash movement for the year
16,2
0,3
(3,5)
27,4
The above cash flow forecasts have been reviewed and approved by the board of directors of PreFab.
Additional information
1 The total interest-bearing liabilities and cash balances were as follows at 31 December 2007:
Rmillion
Long-term interest-bearing borrowings
20,4
Shareholders' loans
50,0
Short-term borrowings
4,0
Cash and cash equivalents
20,4
2 The following information is available regarding companies listed on the JSE Ltd which operate in the same industry as PreFab:
• Their average increase in headline earnings per share in the 2007 calendar year was 25%, and they are expecting similar increases in 2008;
• Their average price earnings multiple, based on 2007 reported profits, is currently 12,0;
• Their average total revenue in the 2007 calendar year was R175 million; and
• They all have BEE shareholders.
REQUIRED
(a) Assuming that you were tasked to perform an earnings based valuation of Prefab (Pty) Ltd based on the profits achieved in the 2007 financial year -
(i) state, with reasons, what adjustments, if any, you would make to the reported profit after tax for the effects of the transfer pricing arrangement between the Manufacturing and Rental divisions;
(ii) state, with reasons, what other adjustments you make to the reported 2007 profit after tax in order to derive a sustainable earnings figure for the purposes of your valuation; and
(iii) indicate, with reasons, what price earnings multiple you would use to value PreFab (Pty) Ltd.
(b) Perform a free cash flow valuation of PreFab (Pty) Ltd in order to value 100% of the shares in issue of the company and the shareholder loan accounts. For the purposes of your valuation -
• assume that PreFab (Pty) Ltd's weighted average cost of capital is 17,5%;
• base the valuation on information from 1 January 2008; and
• assume that the company's annual growth in free cash flows will be 2% from the 2011 financial year onwards. State any additional assumptions that you have made.
Identify and describe five key business risks faced by PreFab (Pty) Ltd.
(d) Critically discuss whether or not it is in the best interests of PreFab (Pty) Ltd to have a transfer pricing arrangement whereby the Rental division acquires prefabricated units from the Manufacturing division at the same price that units are sold to external customers.