QUESTION

Savusa Limited ('Savusa') is a large media group listed on the JSE Securities Exchange. The Board of Directors of Savusa has decided to follow a strategy of diversifying and expanding through acquisitions. Numerous potential acquisition opportunities are being explored including acquiring a controlling interest in Oxus Proprietary Limited ('Oxus').

Oxus Savusa is considering the acquisition of a 60% shareholding interest in Oxus. The present shareholders in Oxus are Mr Depp (the Chief Executive Officer) and Ms Grape (the Chief Financial Officer), who jointly founded the business in 2000. Oxus publishes a range of magazines which are distributed free of charge to target markets. One of their best known titles is Health News, a 120- page A4 sized magazine distributed on a quarterly basis to doctors, specialists, healthcare professionals and hospital managers across the country. Health News contains articles about medical developments which may be of interest to anyone working in the healthcare industry.

Given the circulation of over 20 000 copies, the magazine attracts significant advertising spend from manufacturers and distributors of medicines, hospital supplies and products, and medical equipment and consumables.

Oxus owns and publishes 25 magazines which it distributes to the following industries:

· Healthcare (seven titles)
· Construction and engineering (three titles)
· Investment and asset management (four titles)
· Weddings (three titles)
· Automotive retail (two titles)
· Wine (two titles)
· Entertainment and arts (four titles).

Oxus has over the years developed various databases of individuals and businesses which may be interested in their magazines, including a database of over 25 000 engineering and construction professionals to whom their engineering titles are distributed.

Savusa approached Mr Depp and Ms Grape to find out whether they would be interested in selling shares in Oxus. During initial discussions the two partners were convinced of the merits of forming part of a larger media group and in realising some value for their efforts over the past 12 years.

Mr Depp and Ms Grape are equal shareholders in Oxus and are willing to sell 30% each to Savusa at fair market value (to be negotiated).

Ms Grape has performed a valuation of Oxus for purposes of the negotiations and has e-mailed this to the directors of Savusa.

Her valuation and explanatory notes are summarised below:

OXUS
YEAR END 31 DECEMBER
Notes 2010 2011 2012 2013 2014
R million R million R million R million R million
Advertising revenue 2 36,5 37,3 42,9 47,1 51,9
Cost of sales (17,1) (18,4) (20,6) (22,2) (24,1)
Printing costs 3 (9,1) (9,9) (11,1) (11,9) (12,9)
Sales commission 4 (3,6) (3,7) (4,3) (4,7) (5,2)
Mailing costs 3 (2,6) (2,7) (3,0) (3,3) (3,5)
Other costs of sales 3 (1,8) (2,1) (2,2) (2,3) (2,5)
Gross profit 19,4 18,9 22,3 24,9 27,8
Other income 5 0,2 0,2 0,2 0,3 0,3
Overheads
Employee costs 6 (10,9) (11,9) (9,5) (10,2) (11,1)
Freelance journalists 6 - - (2,5) (2,7) (2,9)
Premises rental costs (1,2) (1,3) (1,5) (1,6) (1,7)
Other overheads (1,1) (1,2) (1,3) (1,3) (1,4)
Earnings before interest,
tax, depreciation and
amortisation (EBITDA)
6,4
4,7
7,7
9,4
11,0
Depreciation (1,2) (1,5) (1,6) (1,7) (1,7)
EBIT 5,2 3,2 6,1 7,7 9,3
Interest income 0,1 0,1 0,3 0,8 1,3
Dividends received 5 0,1 0,1 0,1 0,1 0,1
Profit before taxation 5,4 3,4 6,5 8,6 10,7
Normal income tax (1,4) (0,9) (1,8) (2,3) (2,9)
Profit for the year 4,0 2,5 4,7 6,3 7,8
Ratios 7 % % % % %
Revenue growth 2,2 15,0 9,8 10,2
Gross profit margin 53,2 50,7 52,0 52,9 53,6
Annual change in overheads 9,1 2,8 6,8 8,2
EBITDA / revenue 17,5 12,6 18,0 20,0 21,2
Net profit margin 11,0 6,7 11,0 13,3 15,0
R million R million R million R million R million
Plant and equipment 8 4,6 5,5 5,2 4,8 4,3
Investments 5 2,5 2,7 3,0 3,2 3,5
Trade receivables 9 4,5 5,1 4,7 5,2 5,7
Cash and cash equivalents 1,6 2,6 8,7 15,1 22,9
Total assets 13,2 15,9 21,6 28,3 36,4
Share capital 0,1 0,1 0,1 0,1 0,1
Retained profits 10 10,8 13,3 18,0 24,3 32,1
Shareholders' funds 10,9 13,4 18,1 24,4 32,2
Trade payables 2,1 2,4 3,2 3,6 3,8
Taxation 0,2 0,1 0,3 0,3 0,4
Total equity and liabilities 13,2 15,9 21,6 28,3 36,4
3
OXUS (continued)
YEAR END 31 DECEMBER
Notes 2010 2011 2012 2013 2014
Ratios 7
Trade receivables days 45 50 40 40 40
Trade payable days 55 60 65 65 65
Return on equity 36,7% 18,7% 26,0% 25,8% 24,2%
Discount rate 11 17,5%
Discount factor 0,851 0,724 0,616
R million R million R million R million
Net movement in cash 6,1 6,4 7,8
Add back: Interest income
(after tax)
(0,2)
(0,6)
(0,9)
Free cash flow 5,9 5,8 6,9
Discounted free cash flow 13,5 5,0 4,2 4,3
Assumed growth into
perpetuity
4,0%
Discounted continuing value 12 27,9
Enterprise value 41,4
Investments 2,7
Cash on hand 2,6
Equity value (100%) 46,7

Notes

1 The 2010 financial information has been audited. The 2011 financial information is based on the latest management accounts. The forecasts for the financial years ending 31 December 2012 to 2014 have been reviewed by the directors of Oxus, who have approved these for release to Savusa.

2 Revenue growth in the 2010 and 2011 financial years ('FY2010' and 'FY2011') was affected by the poor economic conditions. Oxus has entered into an agreement with Savusa to publish a 100-page glossy magazine to celebrate Savusa's 50th anniversary in 2012. Oxus expects to earn revenue of R2 500 000 from this once-off publication at a gross profit margin of 40%.

3 Print costs are determined based on the quality and number of pages in the magazines. Mailing costs vary according to the number of copies of the magazines distributed. Other cost of sales items are largely fixed in nature.

4 Sales persons earn a commission of 10% of advertising sold. Oxus is considering changing the commission basis to 20% of gross profit earned on particular magazines. However, it still needs to engage with relevant employees before making this change. The forecasts are based on the assumption that the current policy will remain in place throughout the forecast period.

5 Investments represent a portfolio of listed shares that Oxus acquired in FY2008. The company earns dividend income from the share portfolio. In addition, the annual increase in the fair value of the share portfolio is recognised as 'other income'.

6 Oxus employs journalists to write articles for its numerous publications. As from FY2012, Oxus will encourage its journalists to resign and enter into freelance contracts with the company, thus only writing articles as and when required. The management of Oxus believes that this will benefit both parties. Journalists will be free to work for other publications and generate significantly more revenue than they currently earn at Oxus. The company will in turn convert a fixed expense into a variable cost, and also reduce its operating costs.

7 You may assume that the ratios listed have been correctly calculated.

8 R2 500 000 was spent on upgrading the information technology infrastructure in FY2011 to cater for growth over the next 5-7 years. Normal capital expenditure is in the region of R1 000 000 to R1 200 000 per annum.

9 Oxus's policy is that clients should pay for advertising prior to publication of magazines, but the company rarely enforces this policy and allows clients to pay amounts owed for advertising within a reasonable period. However, from FY2012 Oxus plans to focus on collections to improve cash flows and encourage clients to pay amounts when due.

10 Oxus normally declares a dividend equivalent to 50% of after tax profits. However, in FY2011 no dividend was declared or paid due to higher than normal capital expenditure.

11 The discount rate of 17,5% was derived from Savusa's weighted average cost of capital of 12,5% (as disclosed by Savusa to Oxus) plus a 5% premium for the fact that Oxus is an unlisted, smaller company. Savusa's cost of equity is 16,0%, its after-tax cost of debt is 7,25% and the debt : equity ratio per its most recent audited statement of financial position was 40,0%.

12 Continuing value (discounted cash flows from FY2015 onwards) was estimated using the Gordon Growth Model [(cash flow FY2014 x 1,04)/(17,5% - 4%) x 0,524 (discount factor for 2015)].