UniSA

ADELAIDE

Study Period 3, 2008

Sample Group Project

Mr Bob GILLIVER

. International Graduate School of Business University of South Australia,

• (08) 8302 9292 Office

• (08) 8302 0709 Fax

• bob.gilliver@unisa,edu,au

CONTENTS

1. INTRODUCTION ...........................................................................................................•. 4

2. MARKET AND COMPANY REVIEW 5

2.1 INDUSTRY 5

2.2 MARKET AND CUSTOMERS 6

2.3 GROWTH AND ACQUISITION 6

3. ASSESSMENT OF MARKET PERCEPTION 7

3.1 ANALYSIS OF COLORPAK DIVIDEND PERFORMANCE 7

3.2 MARKET EVALUATION 8

4. ASSESSMENT OF PROFITABILITY 9

5. ASSESSMENT OF LIQUIDITY AND CASH FLOWS 10

5.1 LIQUIDITY 10

5.2 SOLVENCY 10

5.3 CASH FLOW ANAL YSIS 10

5.3.1 Cash flow from Operations (CFO) 11

5.3.2 Cash Flow from Investing (CFI) 11

5.3.3 Cash Flow From Financing (CFF) 11

5.4 DAYS DEBTORS AND DAYS INVENTORY 11

6. ADJUSTMENT FOR ONE·OFF EXPENSES 13

7. CONCLUSIONS AND RECOMMENDATIONS 15

7.1 CONCLUSIONS 15

7.2 RECOMMENDATION 16

REFERENCES 17

Appendix A: Relevant Interest Rates 18

Appendix B One-Off Expense Adjustments 20

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REFERENCES

LIST OF FIGURES

Figure 1: Australian folding carton market share ~ 5

Figure 2: Market Capitalisation vs Total Equity 8

Figure 3: Profitability Ratios for Colorpak Ltd 9

Figure 4: Days Debtors and Days Inventory 12

LIST OF TABLES

Table 1: Dividend Analysis 7

Table 2: Solvency Ratios 10

Table 3: Selected Statistics resulting from One-Off Expense Adjustments 14

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1. INTRODUCTION

This report details the analysis of the June 2006 Annual Report of the company Colorpak Ltd, which trades under the code CKL on the Australian Securities Exchange (ASX), and has been listed on the ASX since 15 April 2004.

The Group approached its analysis from the perspective of a prospective small investor assessing the company for share purchase, to provide a future income stream from dividends. This investor profile would typify an older, conservative investor looking at an income stream into retirement. Growth in share price is a secondary consideration. We assume such an investor might have an upper limit of AUD 50,000 to invest in Colorpak (approximately 100,000 shares).

The 2006 dividend payout is 2.75c per share, a yield of 5.85%. Dividends are fully franked so assuming an investor receives them at a marginal tax rate of 30%, they represent a pre-tax return of 7.9%. This compares favourably with the generally accepted risk free rate of return (ie as established by the Australian Treasury bond return of 5.5 to 6.0% (range in first half of 2006)1. This means that for 2006 Colorpak pre-tax return is in line or higher than the risk free rate plus a beta factor.

We are setting a 3-year goal of improvement of 0.25 cents per share in the dividend payout, ie from 2.75c to 3.00c. This rate of growth would need adjustment to account for cash rate rises. Our time horizon to review this investment is 3-5 years, during which the company's performance will be closely monitored.

In addition we will show that at $0.47 per share Colorpak is undervalued, hence our initial investment will generate a corresponding greater number of shares compared to a higher valuation, which in turn will lead to a greater per year dividend payout.

Our analysis will focus on the following areas:

• Broad market review where Colorpak competes;

• Dividend performance and share valuation at 30 June 2006;

• Profitability and cash flows, the source of dividend payments; and

• Management of liquidity and solvency that underlies long term stability, important for the dividend focused investor.

Each of these assessments are described in the sections below, followed by Conclusions and Recommendations regarding whether or not shares should be purchased.

1 Reserve Bank of Australia data http://www.rba.gov.au/ChartPack/interest rates australia.pdf. Selected charts are reproduced in Appendix A.

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2. MARKET AND COMPANY REVIEW

2.1 INDUSTRY

The Australian paper and board packaging industry has a market size of $3.3b p.a. with the folding carton packaging segment having a market size of $610m p.a. (Merrill Lynch July 2006)

The folding carton segment can be divided into two parts:

• High quality more specialised (and hence higher margin) packaging for consumer products such as pharmaceuticals, cosmetics, natural medicines, multimedia and technology, wine and premium food products.

• High volume, less sophisticated (and hence lower margin) consumer goods such as beer, cereal, packaged teas, washing powders and other food products.

Chart 1: Australian folding cmon markclshare

Figure 1: Australian folding carton market share

The market is dominated by two producers, Amcor Cartons and Carter Holt Harvey (CHH), with similar market shares focusing on the high volume segment of the market leveraging off their upstream paperboard manufacturing facilities.

Colorpak's market share is estimated at 9%, placing the company as the fourth largest folding carton producer in Australia by sales revenue. The Australian carton board industry is both competitive and capital intensive.

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2.2 MARKET AND CUSTOMERS

In a price sensitive industry, print quality, design capabilities and the ability to meet customer needs is a strength and focus for Colorpak as shown by the rating 1 in SIS Shrapnel's annual survey of carton board customers (Merrill Lynch July 2006).

Colorpak's focus is on the premium product segment such as pharmaceutical and healthcare and comprises 60%+ of the company's revenues (Merrill Lynch July 2006). This is the faster growing and higher value segment.

Colorpak focuses on providing packaging solutions to specific end-use markets. They have 3 key accounts that represent 30% of total turnover (Colorpak Annual Report, pg 7), with long term supply contracts of 3 years recently resigned. This poses a number of issues:

• These long term contracts mitigate the risk that one or more of these key accounts may be won by the competition (which would significantly weaken Colorpak's market position).

• Whether very favourable credit terms had to be negotiated for the long term supply contract (see section 5.4 re Days Debtors).

• These key accounts may well depend on long standing relationships built up through the Commins family and other senior executives. This current strength could then become a weakness if such executives were to leave the company.

2.3 GROWTH AND ACQUISITION

Colorpak's solid history of revenue growth (17% compound growth over the past 10 years) has been generated by organic growth and acquisitions of four complementary businesses - Femara, Foilmasters, Hale Foldpack and Castle Graphics.

Further consolidation of the folding carton packaging industry is possible. One analyst (Merrill Lynch July 2006) has commented that Colorpak is undervalued and put a forward share price range at $0.75 to $0.78.

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3. ASSESSMENT OF MARKET PERCEPTION

Since listing on the ASX, Colorpak has had three opportunities (2003-04, 2004-05, and 2005- 06) to issue dividends.

3.1 ANALYSIS OF COLORPAK DIVIDEND PERFORMANCE

The majority shareholder in Colorpak is Carton Services Pty Ltd which at July 2006 own 31.7% of the shares. Carton Services is the trustee of the Commins Family Trust. Walter Commins and several partners bought Colorpak in 1985, and in 1992 the Commins family purchased the company outright. Walter Commins continued as Managing Director till 2000, at which time his 3 sons took over senior management roles.

Executive management team salaries/ are considered to be market level salaries. Hence dividend payouts provide income to the Commins family trust, and we conclude will continue to be given strong importance by the company.

There are two ratios that assist in this analysis.

• Dividend Yield

Dividends per share divided by Market price per share.

• Dividend Payout

Dividends divided by Net Income, which determines the proportions of earnings the company pays out in Dividends.

Table 1: Dividend Analysis

EPS Dividends
Share Dividend Dividend Payout
(cents per Price ($) (cents per Yield Ratio
share) share)
2004 1.98 0.46 03 0% 0%
2005 6.84 0.65 2.50 3.85% 15.1%
2006 5.59 0.47 2.75 5.85% 44.7% 2005 and 2006 indicate a strong upward trend in dividend payments. The dividend yield has improved from 3.85 to 5.85%, reflecting an increasing dividend and a decrease in share price.

The Dividend Payout ratio has increased significantly between due to the increase in dividends occurring in the same year as a decrease in profits. This is favourable to the shareholder in the short term, but the funding base for future growth could be compromised, and needs to be watched.

2 Annual Report 2006, page 28

32004 is the year that Colorpak was listed, and no dividend was paid.

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3.2 MARKET EVALUATION

The share market's perception of the company can be determined by comparing the Market Capitalisation of Colorpak", with the Total Equity.

Market Capitalisation vs Total Equity

.

:

--

_MarI<etCaj:jt>ll,atI(]1 _Tl:tlIEcaJlV

Year (;HI ~t 30 Jl,lnlll)

Figure 2: Market Capitalisation vs Total Equity

In 2004, there was high confidence with Market Cap exceeding Equity. By 2005, the Market Capitalisation had fallen below Equity. By 2006 this shortfall between Market Cap and Equity has increased to over $5m.

This means the company is generally undervalued by the share market (this is reinforced by a relatively low PIE of 8.4 in 2006). The company's non current assets are dominated by goodwill ($46m). The market may be undervaluing this asset component, pending further increased revenues and efficiency savings resulting from the recent series of acquisitions that Colorpak has made.

This undervaluation is positive for our prospective investor, as a greater number of shares is obtained for a given investment sum.

4 http://www.ibisworld.com.au/enterprisefuIIJdefault.aspx?entid=1 0394 Market Capitalisation Figures

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4. ASSESSMENT OF PROFITABILITY

Our prospective shareholder is seeking a steady and ongoing generation of profit to fund dividend payments.

Key indicators that form part of this assessment include:

• Net Profit at 2006 of $4.5m, decreasing 15% compared to 2005 (down from $5.3m)

• Return on Equity (Net Profit! Total Equity) from 11.7% to 9.4%, 2005 to 2006

• Profit Margin from 9.1% to 6.6%, with a cost of sales increasing by $10.3m (18% increase), and the Net profit decreasing by 15% (as shown above), 2005 to 2006.

Figure 3 illustrates these trends.

-+- Net Profit

- Return on Equity

EBIT

~ Profit Margin ~ Return on Assets

g 90% +-----------~~~~--------~

....

'5

IV

gj

m 80% +---------------~~~~----~

70%+-------------,-------------~

2005

2006

year

Figure 3: Profitability Ratios for Colorpak ltd

While these declining ratios are of concern, we note that there has been a significant increase in capital investment in 20065, which is of a cyclical nature, and we would expect higher levels of profitability to result in the next 3 years.

5 e.g. $5.5m investment in Property, Plant and Equipment on Cash Flow Statement

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5. ASSESSMENT OF LIQUIDITY AND CASH FLOWS

5.1 LIQUIDITY

Current Ratio (Current Assets/Current Liabilities) is one of the most common measures of liquidity, the ability of a company to meet its current obligations. Colorpak's Current ratio has increased slightly from 1.3 to 1.4 (in 2005-06). We would be looking for this to move into the 1.5-2.5 range in the next 2 years.

Working Capital, also relating Current Assets and Current Liabilities, has increased from $3.5m to $6.3m from 2005 to 2006, with accounts receivable and inventory increasing faster than accounts payable. This is an encouraging sign of future profitability due to management discipline.

The Quick Ratio ((Current Assets-Inventory)/Current Liabilities) is steady during 2005-06 at 0.9. We would be expecting this to move above 1.0 in the next 2 years.

5.2 SOLVENCY

These ratios are concerned with long term financial stability of Colorpak, which is a prime concern for our prospective shareholder. Table 2 illustrates the key solvency ratios.

Debt ratios 2005 2006
Debt to equity ratio 55.4% 60.3%
Interest Cover 4.76 4.10
Leverage Ratio 45.7% 48.8% Table 2: Solvency Ratios

In general, these ratios recognise that debt and interest payments have increased during 2005-06, with recent capital investment. They are still comfortably within a healthy range, and are not cause for concern.

We would expect improvement in these ratios over the next 2 years as debt is repaid.

5.3 CASH FLOW ANAL YSIS

Colorpak has funded revenue growth and capital investment through long term borrowings. The key to managing growth properly is to ensure that positive cash flows are maintained during such phases to ensure short-term liquidity and longer-term solvency are sound.

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5.3.1 CASH FLOW FROM OPERATIONS (CFO)

Cash Flow from Operations (CFO) needs to remain positive in a sustained manner. CFO also needs to be greater than Net Profit to ensure there is surplus cash for Dividends and/or re-investment into the company and/or paying off debt.

CFO at $3.4m is less than Net Profit at $4.5m, which would be of concern if it were sustained over the following years. In 2005, the CFO of $7.9m comfortably exceeded the Net Profit of $5.3m.

Colorpak is generating positive cash, however, in 2006 it is less than Net Profit, and a resurgence of CFO exceeding Net Profit needs to occur within the next 2 years.

5.3.2 CASH FLOW FROM INVESTING (CFI)

Purchase of property, plant and equipment (PPE) at $6.1 m is greater than depreciation of $2.3m reported in the income statement. So the company is exceeding the book value of depreciation, and is thus increasing productive capacity.

The $6.1 m is greater than the net cash flow in CFO (by $2.7m), reflecting the increase in long term borrowings further emphasising the new investment in productive assets.

Colorpak's business is characterised by cyclical investment in new and updated productive machinery. Having made this recent investment the company will be looking to reduce debt levels over the next 2-3 years and thus improve the Current and Quick ratios.

5.3.3 CASH FLOW FROM FINANCING (CFF)

Borrowings have increased $5m, repayment of borrowings went up $0.9m and dividend pay out increased by $1.2m to $2.0m further supporting the notion of borrowing-led growth in 2005-06.

5.4 DA YS DEBTORS AND DA YS INVENTORY

Although Trade Receivables are on 30 or 60 day terms", Days Debtors has increased from 2005 and 2006, as shown in Figure 4. A possible explanation is that favourable and longer term credit conditions were negotiated for 3 long term supply contracts. Colorpak has too much cash tied up in Trade Receivable rather than cash, which could be used to reduce debt.

Days Inventory also increased. This could be reflective of higher level of demand and hence supply or poor inventory control.

Improvement in both of these ratios will increase profitability and underpin improved future dividends.

6 Note 9 p49 of 2006 Annual Report

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Days inventory

Days Debtors

o

20

40 Days

60

80

1112006 il2005

Figure 4: Days Debtors and Days Inventory

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6. ADJUSTMENT FOR ONE-OFF EXPENSES

In 2005-06, Colorpak had several expense items that can be considered one-off, and not part of typical operations. We have removed these one-off expenses and in doing so, the 'true' underlying performance of the company can be assessed.

The following adjustments were made to the financial statements of the company to reflect one-off expenses:

• An impairment cost of $509K for decommissioning equipment, and a cost of $827K7 for relocation expenses were removed from the Income Statement.

• A receipt of $1 ,818K as an insurance payment for fire darnaqe" was removed from the Balance Sheet.

• A new printing press worth $3,748K was installed in June 20069, with payment not due until after 30 June. This debt for a non-current asset was moved from Current to NonCurrent Liabilities on the Balance Sheet.

Spreadsheets detailing these adjustments and the resulting ratio values are located in Appendix B.

Selected statistics from this adjustment are shown in Table 3.

• Net Profit and EPS indicate a steady underlying increase rather than a decrease

• Returns on Assets and Equity are stable or slightly increasing at a premium above the

comparison rates (Appendix A) rather than declining

• Dividend Payout is 35% of earnings, a more sustainable level than 45%

• Current Ratio increases to a more comfortable 1.7, rather than 1.4

• Debt/Equity indicates a higher underlying proportion of gearing, which is still within a comfortable range.

• Days Debtors is reducing rather than increasing, which is more desirable indicating more efficient use of working capital

Overall, these figures suggest underlying performance is more favourable than immediately apparent in the 2006 Annual report.

7 Annual Report 2006 Note 4 8 Annual Report 2006 Note 9

9 Annual Report 2006 Note 14

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Table 3: Selected Statistics resulting from One-Off Expense Adjustments

_Statistic 20_05 200_6 (original) _ 200_6 (adjusted)
Net profit $5,318K $4,501K $5,837K
EPS 6.7 c/share 5.6 c/share 7.3 c/share
Return on Assets 6.4% 4.8% 6.4%
Return on Equity 11.7% 9.4% 11.9%
Dividend Payout 15.1% 44.7% 34.5%
Current Ratio 1.3 1.4 1.7
Debt/Equity 55.1% 60.3% 66.3%
Profit Margin 9.1% 6.6% 8.5%
Days Debtors 68.3 days 72.3 days 63.6 days Errorl No text of specified style in document.

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7. CONCLUSIONS AND RECOMMENDATIONS

7.1 CONCLUSIONS

The company history since it was listed'? is one of growth through acquisition and organic growth. The share price of Colorpak and the resulting Market Capitalisation does not reflect this growth and we have concluded that the company is currently undervalued, and thus a value for money share purchase proposition.

Colorpak has delivered in 2006 an increased dividend per share even though net profit decreased compared to 2005.

We believe the profitability outlook over the next 2-3 years is positive, due to:

• Increased top line revenue due to acquisition of Castle Graphics

• Increased revenue through recent capital investment

• Lower capital expenditure requirements

• Reduction of Debt of those capital investments leading to decreased interest

expenses.

This should create the conditions for Colorpak to lift dividend per share payout from 2.75 cents to 3.00 cents or higher in the next 2-3 years.

Wealth is returned to the Commins family trust (the majority share holder) via dividends, so we reasonably expect Colorpak to focus on attractive dividend returns into the foreseeable future.

Colorpak pays fully franked dividends, which provides a tax effective return for the small shareholder.

There were some concerns with some ratios analysed, particularly regarding Profitability. However, adjusting for one-off expenses indicates that the underlying performance of the company is strong and poised for further long-term growth and improved profitability.

The trend of CFO and Net Profit from 2005 to 2006 needs monitoring with the objective to see CFO greater than Net Profit in the next couple of years, otherwise this may impact adversely on dividend payouts.

10 http://www.ibisworld.com.au/enterprisefull/default.aspx?entid=1 0394 Company Background and History from 2004 to 2006

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7.2 RECOMMENDA_TION.

We recommend Colorpak to our prospective small shareholder, focussed on dividends. Our analysis shows that the investor should pay close attention to:

• Profit Growth

• CFO greater than Net Profit

• Debt/Equity and Leverage Ratios decreasing

over the next 2-3 years as a result of recent capital investments.

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REFERENCES

Colorpak Annual Reports 2004, 2005 and 2006.

Ibis World Financial Report of Colorpak http://www.ibisworld.com.au/enterprisefuIIJdefault.aspx?entid =10394

Merrill Lynch Market report of Colorpak, http://www.colorpak.com.au/investors reports.aspx July 2006

Reserve Bank of Australia Interest Rate Charts http://www.rba.gov.au/ChartPack/interest rates australia.pdf

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