MAC1501 Introduction to Management Accounting

Turnaround Strategy and Shareholder Wealth Creation 

Comair Limited is a public listed entity and is a South Africa based entity. The company is engaged in the business of airline and is a British Airways Franchisee. The company operates a low cost airline under its own website known as Kulkula.com. The main base of operation of the aviation company is Johannesburg, South Africa and operates domestically with main focus city being Cape Town. The company has fleet size of 20 and operates on 11 destination domestically. As of 2019 the company had a revenue of 1.3 Billion ZAR and the company was profitable. The company has its origin in 1943 as commercial Air Service. The company is listed on Berlin Stock Exchange and the share value of the company is 0.502 Euro and has market capitalisation outstanding of Euro 27.23 Million.

The recent lockdown and ban on travel has cause huge problems for the company and has caused deep hole in the pocket of the company and the company has been suffering from acute financial crisis. An appropriate strategy at the moment to create a turnaround shall be a welcome move for the company. The memo seeks to outline possible turnaround strategies while listing out the cost of capital of the company and how the same can be reduced for the benefit of the shareholder. The memo also outline the financial performance of the company over the years.

Turnaround strategies

As the year 2020 marked the downfall of the company with closure of airport and ban on travels, a huge hole has been casted in the pocket of the company. As of 2019 the company had debt level of ZAR 2338.6 Million and the cash in the books stood at 536.2 Million. The onset of pandemic created pressure on the financials of the company causing the solvency of the company into question.

The issues started in mid of 2019 when many fleet of Boeing 737 Max was grounded and on account of which company posted the loss for the first time in December of 2019  and informed the Johannesburg Exchange that the profit of the company shall decline by 170% as compared to 2018. Further, post that the company operations were shut down with advent of pandemic and caused a huge debt loan on the company. In addition, South African Airways had default on the promise of the company to pay $ 67.4 Million to South African Company as part of travel agency incentive scheme while they did not pay the same in December 2019. (flightglobal.com, 2021)

Against the above background the following turnaround strategies the company is pursuing right now:

Option 1: Procurement of Fund

The company needs to borrow additional debt from the market and reduce its size of operation as the impact of pandemic is going to last till 2021 and the full recovery shall be expected in 2023. Thus, company should use debt wisely and direct the resources to higher profitable and footfall zones only. Further, company has to reduce and restrict the work force and enter into negotiation with vendors of the company. The fund procured shall be a mix of debt and equity. As company cannot go into FPO at this negative moment, it will be righteous for the company to make right issue for funding of the company. The company shall require to procure atleast 1 Billion ZAR from the market and that funding shall be channelized properly to cut existing debt and interest along with meeting the operating expenses of the company. Further, as the foot fall of passengers shall be low company shall be required to offer future flight tickets at discounted rates to entice consumers to buy ticket with an option to reschedule the same without any additional cost. Thus company need to regear the operating parameter and change capital structure accordingly. As a part of turnaround, company should hire turnaround specialists in Airline industry in this troubled times. Thus, first turn around strategy shall encompass the following:

• Procurement of fund from foreign and domestic institutional investors;
• Usage of such debt to pay off existing debt and maintain working capital of the company;
• Negotiating contract with Boeing for leasing of aircrafts and deferment of lease payment;
• Settling all legal dispute and coming out of insolvency;
• Focussing on profitable segments of the business;
• Flying airlines on routes which have higher booking and reducing operation;
• Enticing customer thorough discount and rescheduling options to ensure cash flow and maintain liquidity;
• Reducing operating workforce;
• Renegotiation of covenants of loan.
• Hiring a turnaround specialist

 

Option 2: Merger of the company

The second step or alternative is the merger of the company with big Airlines like Ethiad Airways as these airlines are cash rich and run under the control of the King of Middle East. The merger of the company with such big airlines shall provide abundant cash flow which is the main requirement of the company. Also, such merger shall help the company to restart its operations on a much larger scale. Further, under such a big brand name procurement of fund shall be easy for the company. After procurement of funds the turnaround strategy should focus on the following facts:

• Usage of such debt to pay off existing debt and maintain working capital of the company;
• Negotiating contract with Boeing for leasing of aircrafts and deferment of lease payment;
• Settling all legal dispute and coming out of insolvency;
• Focussing on profitable segments of the business;
• Flying airlines on routes which have higher booking and reducing operation;
• Enticing customer thorough discount and rescheduling options to ensure cash flow and maintain liquidity;
• Reducing operating workforce;
• Renegotiation of covenants of loan.
• Hiring a turnaround specialist

Cost of Capital

The capital structure of a company comprises of debt and equity. Debt carries fix rate of interest but no ownership right while equity enjoys ownership right but no obligation to pay dividend. The Comair 2020 annual report has been published on account of insolvency proceeding against the company.

The computation of cost of equity of the company has been made by computing the Beta of the stock and then Capital Asset Pricing Model has been applied to compute the cost. The formula is as under

 

The computed cost of capital stands at 8.84% and a premium of 10% has been added as the company has been fighting an insolvency battle. Also, the computed cost involves data of past and the current position of the company is much worse and thus procuring funds shall be very costly for the company and if one debt has been procured than it will be cheaper than equity.

An insolvency premium of 10% is fair as it is greater than cost of capital and company had a strong performance before the onset of pandemic and thus 10% compensation shall entice investment.

Weighted Average cost of capital is a mixture of debt and equity, the more the debt is added in the capital structure, the equity is better off in terms of MM II model. However, the above relation shall continue upto optimum point beyond which the said relation shall fail and any addition of debt in the capital structure shall increase the cost of capital. Thus, the method to alter WACC to shareholder benefit is addition of debt as the same carries lower cost and provides tax shield to the company. Further debt does not carry any ownership rights and thus helps the holder of equity with higher pay off and benefit of trading on equity is realised.

Valuation of the company

The two common models to value the company are discounted cash flow technique model and market multiple method. Under discounted cash flow technique the valuation of the company is carried out by projecting the future cash flow of the company and computing the terminal value. Post computation of cash flow the same is discounted to present value using appropriate rate of discount to compute the present value of equity of the company. This method involves lot of acumen and skills and has the following advantage and disadvantage:

Advantages of the model

The model is extremely detailed and considers all the factors which might influence the value of the future cash flow and consequent valuation of the company. It includes all the major assumption which revolve around the business. This method helps to determine the intrinsic value of business and take time value of money into consideration. The model also permit sensitivity analysis and scenario analysis. Hence the model is fit

Disadvantage of Model

The model involves a lot of assumption and is prone to error as the result are as good as the assumptions under the model. The model has been prone to make computation over complex and is very sensitive to change in underlying assumptions. It does not take competitor valuation under consideration and carries out standalone valuation of the company. Further, estimation of terminal value is complex and is most prone to error. Thus the valuation under the said model can be very sensitive to growth rate and WACC.

Market Multiple Method

This method is popular as it consider the industry valuation and takes market scenario into consideration for valuing the company. Under the said method valuation of comparable companies based on parameter like Price to Earning, EV to EBITDA , EV to revenue etc is drawn and then appropriate average of the industry is considered to determine the valuation of the company. The advantage and disadvantage of the said valuation method has been highlighted as under:

Advantages

The method is simple and easy to perform. Data about comparable companies if listed are easy to obtain.  Further, it is in touch with reality and considers the current market position of comparable companies and determine the valuation.

Disadvantage

The disadvantage of the model is that it does not consider time value of money. Also, the model simplifies the complex information into single value which is not appropriate. Besides, it disregard company’s internal factor like growth, intrinsic value etc. The model is static and disregard future potential of the company.

Based on above, it may be inferred that both models have their own advantage and disadvantage and company may apply any method to make an appropriate valuation. Further DCF valuation shall be preferred over Market Multiple Method in the current case as it shall consider the brand valuation of the company while forecasting cashflow. Thus, the focus shall be more internal than external.

The most relevant factor which define the valuation of the company are the profits and revenue of the company. Also the cash flow of the company and its market image along with future prospect of the company are a vital factor in determining the valuation of the company. If the company has strong market share with a good profit the valuation of the company tends to be high. Thus, the valuation of the company is based on cash flow, market capture and growth potential.

Based on above computation, it may be inferred that performance of the company was good uptill 2019 and the only issue in the financial was absence of liquidity in the company which has been clearly reflected in the liquidity ratios of the company. Besides above, the efficiency ratio of the company was good which reflected on the profits as the profit of the company. Thus, one may see that company has performed excellent and its margin was upward sloping. The debt of the company has reduced and the efficiency of the company was improving. The only negative factor was liquidity and the ground of planes and onset of pandemic and has caused this concern to aggravate and ultimately challenged the financial solvency of the company. Accordingly, one may conclude that company has strong financial performance and reviving the same shall be a good option.

Question 2

The process which an prevent the total shut down of the company is the infusion of funds in the company. The company needs at least ZAR 1 Billion cash infusion to protect it form insolvency. The steps required to prevent the total shut down are as under:

• Procurement of fund from foreign and domestic institutional investors;
• Usage of such debt to pay off existing debt and maintain working capital of the company;
• Negotiating contract with Boeing for leasing of aircrafts and deferment of lease payment;
• Settling all legal dispute and coming out of insolvency;
• Focussing on profitable segments of the business;
• Flying airlines on routes which have higher booking and reducing operation;
• Enticing customer thorough discount and rescheduling options to ensure cash flow and maintain liquidity;
• Reducing operating workforce;
• Renegotiation of covenants of loan.
• Hiring a turnaround specialist

 

If the company receives fund lower than the required threshold it may start its operation by negotiation but it will soon feel the pressure of insolvency as the fund shortage shall kick in. Also, the company shall be required to pay higher return to the shareholders and the same shall required high funds wider operations and a good economic environment which is not expected to happen in next two years.

References

comair.co.za. (2021, May 13). Comair Limited. Retrieved from www.comair.co.za: https://www.comair.co.za/investor-relations/sens-report

flightglobal.com. (2021, May 13). Comair blames Max delay and SAA debt for expected first-half loss. Retrieved from www.flightglobal.com: https://www.flightglobal.com/strategy/comair-blames-max-delay-and-saa-debt-for-expected-first-half-loss/136736.article

Loh, C. (2020, September 4). South Africa’s Comair Hopes To Be Flying Again In December. Retrieved from simpleflying.com: https://simpleflying.com/comair-flight-resumpti

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