Financial Analysis on Severn Trent PLC, being compared with United Utilities - Free Essay Example

Financial Analysis on Severn Trent PLC, being compared with United Utilities Trend Analysis The annual reports indicate that Severn Trent has experienced a steady rise in revenue over the period, with the exception of 2006 to 2007, when revenue fell by a third. This fall in revenue was due to the demerger of Biffa Plc, the waste collection and management company; as well as the sale of Severn Trent Property and US Laboratories. In addition, over the period from 2004 to 2007, the companys total equity fell by around 50% as a result of the demergers, as well as the decision to make a 575 million special dividend payout to shareholders in 2006. Over the period of the study, United Utilities has had much smoother performance, with revenue increasing steadily by up to 12% per year, with a small contraction from 2006 to 2007. United Utilities total equity has also risen by around 50%, to the point where it is now more than two and a half times that of Severn Trent, although United Utilities has only twice the post tax profit. This could imply that Severn Trents restructuring and demerging has made it more efficient when compared to its competitor. However, over the period of the study, the company has greatly expanded its balance sheet, taking on an additional 470 million of current assets and around 1.3 billion of long term debt. Most of the current assets were added from 2007 to 2008, as was most of the long term debt. This is due to the issue of new long term debt by Severn Trent to finance a major investment program to improve efficiency and meet its government KPIs. Severn Trents strategy of using long term debt for investment seems to be different from United Utilities, which has also increased its net assets by around 50%, but this has led to an 800 million increase in short term debt, with a 500 million reduction in long term debt over the course of the period. This could indicate that United Utilities current investments are more focused on short term gains and improvements, which Severn Trent is focusing on long term improvements to finance the long term debt. In terms of revenue and profits, Severn Trent has managed to raise its post tax profit by around 25 million, or around 14%, over the period, in spite of the loss in revenue due to the Biffa disposal. This represent significant financial efficiency gains, largely driven by the fact that operating costs have fallen by an even greater amount than the companys revenue. This indicates that the companys demergers and investments have been very effective at increasing the companys efficiency, even with the payout of a 575 million special dividend. In contrast, United Utilities has only seen a 15% rise in profit after tax in spite of seeing an increase in revenue of 11%, and not making any significant dividend payouts to investors. This indicates that, over the period of the study, Severn Trent has been more efficient than United Utilities in producing returns for its shareholders. Indeed, United Utilities has failed to even grow its revenues at the same rate as the overall UK water industry , which increased in size by a CAGR of 3.5% from 2002 to 2007 (Datamonitor, 2008a). Finally, Severn Trent has managed to reduce both its trade receivables and inventory over the period, indicating greater efficiency. However, it has only managed to reduce trade receivables by only 4%, in spite of a 23% fall in revenues. This implies that the company has not actually been effective at reducing receivables, particularly considering receivables fell by 100 million with the Biffa demerger. However, given that United Utilities saw a 37% increase in receivables over the same period, and a 22% increase in inventory, it seems that Severn Trent has performed better than its competitor. Ratio Analysis In this section; I will be analysing the ratios for Severn Trent Plc over the period 2004-2008 to determine the companys performance, and comparing them with United Utilities to gain an idea of the performance relative to industry peers. The main limitation to this analysis is that as Biffa, which was demerged in 2006, was a waste management company, it will have a different cost base to Severn Trent, and results from before this period may not be comparable to those after. In addition, the change in accounting standards from UK GAAP in 2004 and 2005 to IAS in 2006 (Severn Trent, 2009) may have caused inconsistencies in the ratio calculations. Unfortunately, without detailed management accounts, it will be impossible to determine the exact impact these changes will have. Liquidity Ratios Over the period from 2004 to 2005, Severn Trent maintained a very low current ratio of just 0.6, with an acid test ratio of around 0.55. This indicated that the company was in serious danger of liquidity problems should its creditors have decided to call in any loans. Indeed, in 2006 the current ratio fell to 0.44, and the acid test ratio to just 0.4. At this point, the company only had enough liquid assets to cover two fifths of its total short term liabilities, which could have been a cause for significant concern, particularly given that United Utilities maintained current and ratios of at least 1.15 over the same period. In 2007, both Severn Trents ratios rose slightly to 0.48 and 0.47; however this still placed the company in potential difficulties. However, from 2007 to 2008 the additional long term the company took on allowed Severn Trent to boost its cash reserves by around 500 million, boosting the current ratio to 1.15 and the quick ratio to 1.12. This action, which was pos sibly in response to concerns around the liquidity of short term credit during the credit crunch, brought both liquidity ratios up to a comparable level to United Utilities; which stood at 1.30 for the current ratio and 1.28 for the quick ratio respectively. Gearing / Solvency Ratio Over the period, Severn Trents debt ratio has increased from around 56% to 77%. This increase has generally been steady, but there was a significant jump from 2006 to 2007, from 62% to 74%, probably due to the disposal of the Biffa group and other assets. In terms of long term debt only, there was also a jump from 69% to 75% from 2007 to 2008, as a result of the additional long term debt taken on for restructuring and to raise cash. In contrast, over the same period United Utilities has steadily paid down its debts and reduced both debt ratios from both being around 68% in 2004 to the total ratio being 59% and the long term only being 54% in 2008. This could indicate greater prudence from United Utilities, or it could indicate that United Utilities is less efficient, and cannot find good places to invest its debts. Both companys debt to equity ratios have mirrored their debt ratios, with Severn Trents going from 129% in 2004 to 339% in 2008, whilst United Utilities has fallen from 213% in 2004 to 145% in 2008. In addition, Severn Trent has seen its interest cover fall from 9.6 in 2004 and 2005 to just 3.9 in 2008, whilst United Utilities has risen from 5.5 to 9.2 over the same period. This could indicate that, in spite of the greater efficiency discussed above, Severn Trents high debt levels could now be a cause for concern, and could cause the company to post losses if revenue falls or costs rise. Activity Ratios Severn Trents net asset turnover ratio and the non-current assets turnover ratio has remained fairly steady over the period 2004 to 2006, however it dropped quite sharply as the revenue generating assets of Biffa and the other demerged parts of the business were sold in 2006, going from 0.42 in 2006 to 0.29 in 2007. However, as of 2008, both ratios stand at around 0.25, which is very similar to United Utilities where they are 0.28 and 0.3 respectively. This indicates that Severn Trents demerging has brought its asset turnover ratios back to the standard level for the industry. Inventory turnover ratios for both companies are very high, however given that both companies primarily trade water, this is to be expected. Severn Trents inventory turnover has increased significantly since the Biffa demerger, and it now turns over its inventory around every six days. However, United Utilities turns its inventory over around every 3.5 days, indicating that it is either more efficient, or holds lower levels of inventory relative to its customer base. Both companies have high receivables days, which again could be expected given that the companies must work out flexible payment plans with their customers according to their charters. As such, any late payment generally needs to be treated more flexibly than in most businesses (Datamonitor, 2008b; Datamonitor, 2008c). However, Datamonitor (2008c) reports that Severn Trents asset and receivables turnover ratios are much lower than its peer companies, indicating a lack of operational efficiency. Profitability Ratios Severn Trents ROCE saw a quite significant increase from 7.7% in 2004 to 9.4% in 2006, with the ROCE on long term debt only going from 8.5% to 11.3%. However, following the Biffa demerger ROCE fell back to 7.57% and 8.29% respectively, which is likely due to the additional debt the company took on. This is mentioned in the 2008 accounts, where the Chief Executive discusses maintaining the debt ratio (Severn Trent, 2009). This is lower that Severn Trent, which has a ROCE of 8.4% and ROCE on short term debt of 9.5%. However, these figures have fallen from 11.6% and 11.7% respectively, which may indicate that United Utilities is moving towards where Severn Trent is. However, Severn Trents return on equity shows a significant and decisive move from 8.3% in 2004 to 17.5% in 2008. This is consistent with the companys strategic goal of increasing its return on equity to its shareholders, and indicates significant shareholder value creation. In contrast, over the same period United Utilities has fallen from 17.6% to 13% respectively, indicating that United Utilities is becoming more inefficient and creating less value for shareholders. Over the same period, Severn Trent has increased its gross profit margin from 19.4% to 25.8%, and net profit margin from 9.2% to 13.6%. This again indicates significant efficiency gains, mainly from the disposals which occurred in 2006, with gross margin going from 20.6% to 25.3% and net margin going from 9.9% to 16.8% from 2006 to 2007, before falling back in 2008. In contrast, United Utilities has witnessed more stagnant performance, with its gross profit margin falling from 35.3% to 28.1% and net profit margin rising slightly, but only from 17.1% to 17.6%. This implies that, as discussed above, United Utilities is performing poorly, and failing to create value through efficiency and gross profits. As such, it is forced to resort to paying down debt to maintain its net profit margins. Segmental Analysis Segmenting Severn Trents business is extremely simple: over 80% of the companys revenue comes from its core business of water and sewage, operated in the area from mid Wales to Rutland and from the Bristol Channel to the Humber (Severn Trent, 2009). Other important areas of business generally fall under water purification and operating services; pipeline rehabilitation; pipeline repair; and metering services. This is combined with a diversified portfolio of environmental services, giving Severn Trent a broad base to operate within water services. Prior to the demerger of the Biffa group and other business groups, Severn Trent had interests in other sectors including household waste management. However it has now concentrated its business in the water segment, with significant financial benefits. If this focus can allow its operating efficiency to reach that of its competitors, it may be able to improve yet further. References Datamonitor (2008a) Water Utilities Industry Profile: United Kingdom. Datamonitor Industry Profiles; September 2008. Datamonitor (2008b) United Utilities Plc. Datamonitor Company Profiles; April 2008. Datamonitor (2008b) Severn Trent Plc. Datamonitor Company Profiles; January 2008. Severn Trent (2009) Severn Trent PLC. https://www.severntrent.com/ Accessed 6th January 2009.