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25765 | Corporate Finance AUT | 2014

UTS: FINANCE Discipline group

CASE STUDY COVER SHEET

|Surname |Initials |Student number |Signature * |
|Ng |J.W.C |88340722 | |
|Yeung |L |00049344 | |
|To |R.E |10576142 | |
|Afsahi |E |11364015 | |
|Wei |B |11924368 | |

* By signing your name, you agree that you have read, understood and followed the advice in the subject guide concerning cheating and plagiarism.

Case Company: Super Retail Group (ASX: SUL)

Lecturer: Dr Gerhard Hambusch

Lecture day & time: Monday 3:00 PM

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Table of Contents

1. EXECUTIVE SUMMARY 2
2. COMPANY AND INDUSTRY OVERVIEW 3 3.1 Historical Company Leverage Financing & Peer Industry Leverage Analysis 5 3.1.1 Interest Coverage Ratio 6

3.1.2 Managerial Inertia Theory 7

3.1.3 Security Mispricing Theory 7

3.1.4 Pecking Order Theory 8

3.2 Optimal Leverage Analysis 8 3.2.1 Trade -Off Theory 8

3.2.2 The Dividend Imputation System in Australia 10

3.2.3 Agency Theory 11

3.2.4 Stakeholder Theory 12

3.2.5 Predation / Product Market Completion Theory 14

Recommendation 14
4. REFERENCES 16
APPENDICES 18 APPENDIX A.1 - Super Retail Group: Key Financial Ratio Analysis: 2008 – 2013 18 APPENDIX A.2 - RCG Corporation Limited: Key Financial Ratio Analysis: 2008 – 2013 18 APPENDIX A.3 - Kathmandu Holdings Limited: Key Financial Ratio Analysis: 2010 – 2013 19 APPENDIX A.4 19 APPENDIX A.5 - Issued Share Capital 20 APPENDIX B - Comparative Analysis of D/E Ratios: Super Retail Group, Kathmandu, RCG Corp & Industry level 20

1. EXECUTIVE SUMMARY

Super Retail Group (the “Group” herein or known as “SUL”) is one of Australia’s top ten ASX listed company, specialising in the provision of specialty retail, supply chain and marketing services throughout Australasia and the Asia Pacific region.

Super Retail Group’s capital structure is analysed as requested by Super Retail Group’s Board of Directors to assist them in providing advice on whether the Group’s current capital structure is optimal.

This report compares Super Retail Group’s financial year-end results against two other comparable firms within the same industry: Kathmandu Holdings Limited (KMD) and RCG Corporation Limited (RCG). A detailed financial analysis was performed to determine whether an optimal capital structure is present within the Group. Further analysis has determined whether the Group had followed a number of contending theories notably: the Pecking Order, Trade-off, Agency, Stakeholder and Predation/Product Market Completion theories.

2. COMPANY AND INDUSTRY OVERVIEW

The Super Retail Group (ASX: SUL) is an Australian based conglomerate, operating for over 40 years with operations across Australiasia, Asia and India. The Group comprises of eight brands: Super Cheap Auto, BCF, Goldcross Cycles, Ray’s Outdoors, FCO, Rebel Sports, Amart Sports and Workout World spread across 3 core businesses Automotive Spare Parts, Leisure & Outdoors, and Sporting & Equipment Retailing.

Super Retail Group started as a small automotive accessories mail order business in Australia, back in 1972 by Reginald and Hazel Rowe. Within two years, the business established itself as a retailing operation and within ten years the Super Cheap Auto brand was born. In 2004, the Group was listed on the Australian Securities Exchange as Super Cheap Auto Group Limited. The following year the Group acquired CampMart and diversified the business into Leisure & Outdoors. After the purchase of Gold Cross Cycles in 2008 and Rays Outdoors in 2010, Super Cheap Auto Group commenced operating under the new name Super Retail Group in 2010. Subsequently, the Group ventured into the retail sporting industry when it secured the ownership of the Rebel Group, which includes Rebel Sport and Amart All Sports from Archer Capital in 2010. Workout World is the latest addition to the Super Retail Group’s retail empire in 2013. The acquisition of such a diverse group of brands has made the Super Retail Group develop into one of the leading specialty retailers in Australia with more than 600 stores, 12,000 employees across the Asia Pacific region.

The Global Industry Classification Standard (GICS) has classified the Super Retail Group as part of the retail industry sector. However, with a variety of retail brands under the Group’s ownership, the Group is seen as a specialist retailer with majority of the sales revenue being generated by the auto, sports and leisure divisions.

The selection of two comparable companies operating within the sporting and leisure industry is supported by the fact that Super Retail Group earnings from their Leisure & Outdoors and Sporting divisions contributed majority of the total sales revenue.

A comparable company to the Super Retail Group is Kathmandu Holdings Limited. The company is incorporated and listed on the New Zealand Securities Exchange. In 2009 Kathmandu has its first official listing on the Australian Securities Exchange with the first reporting period in Australia in 2010. The company’s core businesses are outdoor, travel and adventure retailing. Another comparable company is RCG Corporation, which also owns and operates retailers within the sporting and outdoor industries. These include The Athlete’s Foot and Podium Sports which are in direct competition with the Super Retail Group’s Rebel Sports stores.

3. CAPITAL STRUCTURE ANALYSIS

3.1 Historical Company Leverage Financing & Peer Industry Leverage Analysis

In this report six years of quantitative data from DatAnalysis is analysed in conjunction with the qualitative information obtained from the company’s annual reports starting from 2008 to 2013 (UTS Library 2014). The financing and leverage history of Super Retail Group have remained strong over the six year period. From the FY2008 – FY2013 annual reports SUL’s management have set a target ratio within 40% to 50% for the firm each year. This target ratio is required to be maintained if the Group is to have an optimal capital structure in order to continue as a going concern, to mitigate balance sheet risk, provide returns back to shareholders, increase firm value and reduce the cost of financial distress (COFD) (Super Retail Group 2014, pp.66 - 70).

Appendix A.2 & A.3 shows that at the height of the Global Financial Crisis (GFC) when the comparable firms like Kathmandu (KMD) and RCG Corporation (RCG) were cutting back on debt, (SUL) Super Retail Group’s (Appendix A) financial leverage ratios have increased dramatically noticeably the debt-to-equity ratio peaking at 0.941 in FY2008 before declining back down to 0.841 in FY2009. At the same time, the Group’s gearing ratio peaked at 0.467 in FY2008 before decreasing to 0.423 in FY2009. By contrast the SUL’s financial leverage have also increased to the level of 2.84 (FY2008) and 2.80 (FY2009) respectively. The increase in the leverage ratios during FY2008 – FY2009 is the result of the Group borrowing large amounts of short and long term debt to fund for the acquisition of Melbourne based Goldcross Cycles in order to acquire 100% of the issued share capital of Goldcross at a cost of AUD$15 Million (ASX 2008).

SUL’s prerogative to issue debt is because management considered debt as a much cheaper source of financing and are able to obtain after tax interest savings on debt based on the 30% company tax rate in Australia comparative to issuing equities. Hence “net debt” rose from $95 Million (FY2007) to $119 Million (FY2008), and yet despite economic uncertainties Super Retail Group still managed to maintain its target ratio between 40% - 50% over FY2008 – FY2009. This clearly shows that SUL still maintains an optimal capital structure and meeting their debt and interest re-payments. Appendix A.1, A.2 & A.3, SUL and its competitors both the interest coverage ratio and cash ratios remains emphatically high over the six year period which suggests that SUL and its comparable firms are generating enough cash to meet interest payments and satisfy credit ratings which credit ratings are very important in capital structure decision making (Servaes & Tufano 2006).

Appendix A.4 shows that Super Retail Group had a large reduction in debt borrowings since the Group had made alternative sources of funding through raising new equity via purchase share options, dividend reinvestment plans, share placements, and other institutional equity raisings in order finance other projects and acquisitions such as Goldcross cycles in Melbourne and Ray’s Outdoors. To reduce the company’s net borrowing costs and bring the company’s debt-to-equity ratio back into line with the industry leverage average, SUL had to re-balance their capital structure.

Kathmandu Holdings did not specify a target ratio but based on the financial information obtained from their annual reports from 2010 to 2013 an estimate was determined to be between 10% - 30%. Looking at appendix A.3 Kathmandu’s D/E ratios from FY2010 to FY2013 is consistent with the industry leverage average.

RCG Corporation also did not specify a target ratio nor did the company have any debt borrowings since 2008. This is partly due to the fact that the company had negative retained earnings (accumulated losses) dating back since 2005. A negative retain earnings implies that the company is highly unprofitable with high market-to-book values which can only rely heavily on equity as their source of funding because of leverage constraints.

Appendix A.5 shows the amount of new equity raised increased to unprecedented levels from 106,630 Million shares (FY2009) to 127,532 Million shares (FY2010), an increase of 20% post-GFC period (Super Retail Group 2014 pp.66-67).

3.1.1 Interest Coverage Ratio

The interest coverage ratio is defined as earnings before interest and taxes divided by the interest expense and it is used to measure a firm’s operating performance. It indicates to the firm and relevant stakeholders as to whether SUL is meeting its contractual interest obligations on borrowed loans as they fall due.

Servaes & Tufano (2006, p.30) argues that the interest coverage ratio is a key determinant in the company’s capital structure, its credit risk management and credit rating. Generally, an interest coverage ratio greater than 1.0 indicates SUL is meeting its contractual interest obligations however, below 1 is considered risky and questionable which implies SUL may have liquidity risk problems. In Appendix A.1 and A.2 the interest coverage ratio for SUL and RCG decreased during the GFC period. The decrease in the ratio can be explained by an increase in the net interest expense over the FY2008 – FY2009 period however, for KMD was the reversal. In spite of this, all three companies are relatively strong and still able to meet contractual interest payments.

3.1.2 Managerial Inertia Theory

Grinblatt & Titman (2002, pp. 595-693) argues that trade-off theorists predict managers will quickly adjust their company’s capital structure in order to maintain an optimal target leverage ratio. So if the value of equity increases the expected value of debt will decrease in order to maintain a target ratio. However, according to Wanzenried (2003) firms do not always act to adjust the capital structure based on trade-off theories. He argued that firms are inert and managers follow an inertia strategy and the firm’s capital structure are driven by stock price returns. When firms follow an inertia strategy the debt-to-equity ratio will decrease.

In Appendix A.1 for FY2008 – FY2013, the information for SUL suggests that when the debt-to-equity ratios are high in FY2008 – FY2009, share prices are low; and when share prices increase, the D/E ratio decrease. Furthermore, management have set a target gearing ratio between 40% - 50% between FY2008 – FY2013. During the GFC period debt levels have increased and in order to reduce the D/E ratio and maintain the target leverage after the GFC, SUL have decreased debt and increased equity by reducing the net debt-to-capital ratio of 42.3% (FY2009) to 22.6% (FY2010). As shown in Appendix B, by comparison SUL D/E ratio is by far and wide exceeds its competitor KMD and RCG and the industry average between 20% - 50% on average.

3.1.3 Security Mispricing Theory

Hussain (2007) argues that managers will issue shares if they know that security prices are overvalued and repurchase them back if they perceived that security prices are undervalued. This undervaluation leads to firms opting for more debt issues rather than equity however Baker & Wurgler (2002) contends that altering the company’s capital structure through varying the levels of equity and debt is reflected in security mispricing, and share buybacks from undervalued equities are result of timing the market.

From Appendix A.1 it is evident that share prices for SUL from FY2008 – FY2013 have been increasing each year. Each year the company has been raising equity financing via dividend reinvestment plan (DRP), share and right issues, placements to finance projects and acquisitions of Ray’s Outdoors in 2010 and the Rebel Group in 2011. Due to its enormous growth through acquisitions, the total value of equity for the group is overvalued. In Table 1 below as at FY2013, SUL market value of per equity is 3.22 times more than its original book value as at the closing price of $11.97 (FY2013) therefore its adjusted book value per share should be $1.33. By comparison KMD is 1.83 and RCG is 2.97 times of its original book value.

|As at 30 June 2013 |SUL |KMD |RCG |
|Total Equity (000's) |731,500 |259,999 |44,925 |
|Total No. of Equity (000's) |551,800 |170,307 |66,732 |
|BV per share |1.33 |1.53 |0.67 |
|Closing Share Price |$11.97 |$2.08 |0.55 |
|M/B Value per share |3.22 |1.83 |2.97 |

Table 1: Book-to-Market vs Market-to-Book Value of Equity

3.1.4 Pecking Order Theory

Pecking Order theorists contends that firms prefer to use internal funding over external funding in order to finance investments. In other words managers will use the following sources of financing in order until that cost of financing become becomes too high: 1) Retained Earnings, 2) Debt and, 3) Equity (Servaes & Tufano, 2006, p.2). Servaes & Tufano (2006) argument is that internally generated source of finance is justified on the grounds raising equity finance in the capital markets is expensive and firms should finance investments at the least cost. If internal sources of funds are not sufficient to meet investment needs then finance it using debt unless the interest cost is too high then obtain equity funding. SUL’s financing behaviour is not consistent with the Pecking Order theory as during FY2008 and FY2009 they have been financing their investments and acquisition needs through debt financing rather than using their retained profits. In Appendix A.1 retained profits have been increasing over the years and therefore this is in stark contrast to their competitors KMD and RCG where most of their funding sources consist of equities.

3.2 Optimal Leverage Analysis

3.2.1 Trade -Off Theory

The Trade-Off theory states that the company will choose a capital structure by trading off the benefits of the tax shield against the cost of financial distress and the agency cost of debt. The theory proposes that firms would increase their leverage until they reach the optimal level where the firm value and the net benefit of debt is maximised. At the optimal leverage, marginal benefits of interest tax shields that result from increasing leverage are perfectly offset by the marginal cost of financial distress. Therefore the value of the levered firm can be viewed as: VL = VU + PV (Interest Tax Shield) – PV (Financial Distress Costs) (Grinblatt & Titman 2002, p.599).

Modigliani – Miller proposes that a company that employs debt financing has many tax saving benefits as interest payments are tax deductible at the 30% corporate tax rate in Australia however, the trade-off is that the more debt the company employs to enjoy the available after tax savings from the interest tax shield the higher the financial distress costs (Rahman, 2014).

Capital markets in Australia are highly regulated and no one company in Australia whether it be Super Retail Group, Kathmandu Holdings or RCG Corporation can fully take on the existence of 100% debt optimisation for tax purposes because these firms know that obtaining a tax advantage under Australia’s imputation tax system is not fully effective so it is hard to achieve 100% optimal leverage. To afford investor and shareholder protection for these highly levered listed companies, these firms are required to report on the solvency of their capital structure. Some of the key measures and determinants of optimal leverages are summarised in Appendix A.1 to A.3 which helps to determine the costs of financial distress and the probabilities of bankruptcy: 1) Current Ratio, 2) Quick Ratio, 3) Tax Shield 4) Interest Coverage Ratio 5) Return on Assets, and 6) Industry Type.

Looking at the ratios in Appendix A.1 – A.3, the current ratio determines the availability of liquid assets to meet short term liabilities while the quick ratio excludes inventory from the current assets however, the quick ratio provides a more robust method in measuring liquidity. By comparing the ratios of RCG with Super Retail Group and Kathmandu between FY2008 – FY2013, at first appearance the current and quick ratios for SUL and KMD are relatively lower compare to RCG and it is questionable as to their abilities to meet debts and interest payments; however this is not the case as both the interest coverage ratios for both SUL and KMD are quite high between FY2008 – FY2013 and are increasing in each year indicating that there are no issues in meeting contractual debt obligations.

Again referring to Appendix A.1 – A.3, all of the three firms between FY2008 – FY2013 are generating enough return on assets which is a measure the amount of profits generated compared to the assets available and are being utilised in earning income. The most profitable and with the highest ROA is RCG at 18.78% (FY2013) while SUL stands at 8.91% (FY2013) ROA, which suggest that RCG is able to maintain their debt leverage structure more effectively through the optimisation of their tax shields.

The values of assets held are also considered as a key determinant in the costs of financial distress. Super Retail Group (SUL) (its affiliates AMART Sports, Super Cheap Auto, Ray’s Outdoors, Rebel Sports, Workout World, BCF and FCO) and its comparable firms KMD and RCG Corporation (Athletes Foot, Podium Sports, Saucony, Merrell, CAT and Sperry Top-Sider) all operate in similar industries as specialty retailers across automotive spare parts, outdoor & leisure, sporting apparel and equipment. Interestingly from SUL’s financial reports FY2008 to FY2013, a majority of their assets comes from intangibles therefore it will have higher costs of financial distress if the firm went into bankruptcy (Rahman, 2014).

The cyclicality and volatility of the revenues of Super Retail Group and its comparable firms RCG Corporation and Kathmandu in the specialty retailing which their business operates may also increase the cost of financial distress. In the specialty retailing business, automotive spare parts, apparel retail and outdoor leisure and sporting equipment products are not considered as consumer staples, hence the volatility in earnings and revenues are subject to business cycles so therefore the cost of financial distress increases.

3.2.2 The Dividend Imputation System in Australia

Prior to 1987 Australia followed a classical system of double taxation of dividend income at both at company level and then at the personal shareholder level when dividends are paid.

After 1987 Australia moved to a dividend imputation system to promote an equitable and fairer tax system so that at the personal tax level shareholders are not subject to double taxation on the capital gains shareholders received from the distribution of dividend income. The aim is to tax dividend distributions paid out of earnings at the company level at an effective tax rate equal to the shareholders personal tax rate.

The income that is earned by the Super Retail Group (SUL), Kathmandu (KMD) and RCG Corporation (RCG) is subject to a corporate tax rate (TC) levelled at 30 per cent in Australia. When SUL, KMD and RCG payout income in the form of dividends they generate tax credits which is called imputation credits and the amount of imputation credit generated is in the form of a fully franked dividend paid out to the investors, given by the formula: Dividend x [TC/(1 – TC)]

Full franked means that the shareholder would not be required to pay tax on those dividends that have already been taxed at the corporate level.

(Lintner 1956) argues that managers who follow the Lintner model are only concerned about stable dividends and sustainability of company earnings whereas the imputation system says that franking credits are only available to shareholders when franked dividends are paid for at the corporate level. Does the Lintner model work? The answer lies within the imputation model which looks at sustainability of earnings per share and stable dividends. Currently the Lintner model has stood the test of time.

In Table 2 below RCG appears to follow the Lintner model as it presents a stable dividend policy between FY2010 – FY2012 for given increase levels in the EPS as shown in Table 3. However for SUL and KMD dividend payout ratio have been increasing each year suggesting that the dividend have been adjusted to take into consideration of the franking credits given to shareholders. In a survey of 384 CFO and Treasurers in the USA (Brav et al. 2005) found that firms avoid reducing dividend payouts when it comes to a trade-off of having a tax benefit of debt.

| |Total Dividends Per Share (Cents) |
|Company Name |2008 |2009 |2010 |2011 |2012 |2013 |
| | Earnings Per Share (Diluted only) |
|Company Name |2008 |
|Leverage |2008 |2009 |2010 |2011 |2012 |2013 |
|RCG Corporation |- |- |- |- |0.029 |0.046 |

Table 4: Firm Leverages: Debt-to-Equity Ratio (%)

Looking at Table 4 RCG Corporation has the lowest debt-to-equity leverage ratio compared to Super Retail Group and Kathmandu Holdings Limited and if there was an outbreak of a price war, SUL would be the first to subject to predation.

4. RECOMMENDATION

After comparing Super Retail Group’s capital structure from 2008 to 2013 against two comparable firms, Kathmandu Holdings and RCG Corporation, all three firms operates in the same specialty retail services industry and by taking into consideration other theories which are deemed pertinent in reaching a conclusion to the analysis. The Group’s management have set a targeted debt-to-equity ratio between 40% - 50% compared to the industry benchmark average for the period 2008 – 2013. From the analysis that has been undertaken, the Group’s capital structure is found to be highly levered and should be revised to approximate the industry average. This in turn will see an increase in the enterprise value of the firm and an increased in shareholder returns.

5. REFERENCES

Australian Securities Exchange 2014, Super Retail Group, Announcements 2008, viewed 27th April 2014,

Mitchell, S. 2014, ‘Super Retail's Peter Birtles staying on as group pushes growth strategy’, Sydney Morning Herald, 27 March, viewed 7th May 2014,

Super Retail Group 2014, Reports & Publications, Annual Reports 2008 – 2013, viewed 26th April 2014,

UTS Library 2014, Morningstar DatAnalysis Premium, Electronic Version, viewed 26th April 2014,

Grinblatt, M. & Titman, S. 2002, Financial Markets and Corporate Strategy, 2nd edn, The McGraw-Hill Companies, pp. 595-693

Rahman, N. 2014, Corporate Finance, 1st edn, McGraw-Hill Education, Australia

Baker, M. & Wurgler, J. 2002, ‘Market Timing and Capital Structure,’ Journal of Finance, vol. 57, pp 1-32

Brav, A., Graham, J., Harvey, C. & Michaely, R.2005, ‘Payout Policy in the 21st Century’, Journal of Financial Economics vol. 77, pp. 483-527

Lintner, J. 1956, ‘Distribution of Incomes of Coporations Amond Dividends, Retained Earnings, and Taxes’ The American Economic Review, Papers and Proceedings of the Sixty-eighth Annual Meeting of the American Economic Association, vol. 46, no. 2, pp. 97-113

Iqbal-Hussain, H. 2007, ‘Capital Structure and Market Timing in the UK: Deviation from Target Leverage and Security Issue Choice’, PhD Thesis, University of Hull, United Kingdom

Servaes, H. & Tufano, P. January 2006, ‘The Theory and Practice of Corporate Capital Structure’, Deutsche Bank: Corporate Capital Structure, pp. 1-34

Wanzenried, G. April 2003, ‘Capital Structure Inertia and CEO Compensation’, PhD Thesis, University of Bern, Switzerland

APPENDICES

APPENDIX A.1 - Super Retail Group: Key Financial Ratio Analysis: 2008 – 2013

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APPENDIX A.2 - RCG Corporation Limited: Key Financial Ratio Analysis: 2008 – 2013

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***RCG does not have a Company Target Ratio for FY2008 - FY2013 as the company did not use borrowings. All funding done through Retained Earnings

APPENDIX A.3 - Kathmandu Holdings Limited: Key Financial Ratio Analysis: 2010 – 2013

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APPENDIX A.4 - Total Debt-to-Equity Graph

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APPENDIX A.5 - Issued Share Capital

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APPENDIX B - Comparative Analysis of D/E Ratios: Super Retail Group, Kathmandu, RCG Corp & Industry level

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[1] **KMD do not have a specify company target ratio but based on long-run projection is estimated between 10% - 30%

[2] ***Kathmandu Holdings is a dually listed company incorporated in New Zealand. Official listing on ASX: 13 November 2009: First Financial Year End in Australia is 2010. All financial data obtained in DatAnalysis Morningstar are in Australian Dollars.

[3] *Kathmandu Ltd: FY2008 – FY2009, no financial data available as no debt was conceived

[4] **RCG Corp: FY2008 – FY 2011, no financial data available as no debt was conceived