Analysis of Capital Structure and Dividend Policy

ICI Pakistan Limited Assignment # 2

DATE: 17/05/1012 SUBMITTED TO: MS. SANA TAUSEEF SUBMITTED BY: ABDULLAH ABBASI MARIA AYUB SILAT SEHRISH FAWAD KHAN

INTRODUCTION
ICI Pakistan Limited is a public listed company. Its shares are traded on the Karachi, Lahore and Islamabad Stock Exchanges. The five businesses presently carried on by ICI Pakistan Limited are: Polyester Fiber: The business manufactures polyester staple fiber for sale into local textile industry. This polyester is not done anywhere else in Pakistan nor in the entire Akzo Nobel group other than here. It generates the highest amount of sales revenue of all ICI businesses. Soda Ash: ICI Pakistan is the largest supplier of Soda Ash in Pakistan and sells in international markets. Life Sciences: The business imports, markets and uses local contract manufacturing facilities for a wide range of pharmaceuticals and animal health products. General Chemicals: This business imports and also manufactures in Karachi a diversified portfolio of general and specialty chemicals. The bulk of this is generic chemicals. Paints: The Paints business develops, manufactures, markets, sells and distributes paints and coatings in Pakistan.

CURRENT SHARE CAPITAL

The authorized share capital of the company is Rs. 15,000,000,000 divided into 1,500,000,000 ordinary shares of Rs. 10 each of which 138,802,300 ordinary shares of the aggregate nominal value of Rs. 1,388,023,000 are issued and fully paid and the remainder are unissued. 75.81% of the issued shares are held by ICI Chemicals Omicron B.V., a company incorporated in the Netherlands, which is a wholly owned subsidiary of Akzo Nobel N.V., a company incorporated in the Netherlands.

CAPITAL RESTRUCTURING: ACQUISITION BY AKZO NOBEL AND 2011 ANNOUNCEMENT OF DEMERGER:

On 2nd January 2008 the acquisition of ICI Plc by Akzo Nobel was officially completed. The combination of Akzo Nobel and ICI Plc creates a leading industrial company in coatings and chemicals. The offer price valued the entire existing issued ordinary share capital of ICI at approximately EUR 11.5 billion (GBP 8.1 billion). The transaction, which was approved by Akzo Nobel and ICI shareholders in November 2007, consolidated Akzo Nobels position as the

worlds largest maker of paints and coatings, as well as generating estimated pre-tax cost synergies of EUR 280 millions. All businesses of ICI Pakistan have worked since then as part of Akzo Nobels continuing portfolios. In April 2011, the Board of ICI Pakistan announced its intention to split the Companys Paint business into a separate legal entity through a process of demerger. Once the scheme has been approved by the High Court of Sindh, all the assets and liabilities of the Paints business would be transferred to and vested in Akzo Nobel Pakistan Limited. Post demerger Akzo Nobel Pakistan Limited will be listed on the three stock exchanges of the country. Akzo Nobel will subsequently divest its shareholding in ICI Pakistan Limited The share capital, capital reserves, revenue reserves and un-appropriated profits and losses are going to be split into the ratio of the net assets of the Paints and Non-Paints businesses (33.46:66.54). For every shareholder holding 100 shares in ICI Pakistan will qualify for 66.54 shares in ICI Pakistan Limited and 33.46% in Akzo Nobel Pakistan.

RATIONALE FOR DEMERGER AND RESTRUCTURING

The Paints business of ICI Pakistan Limited is primarily engaged in the Decorative segment of the Paints and Coatings Industry, with products that serve millions of households across Pakistan. Being mainly a consumer business requiring aggressive investment in marketing and brand building programs, it operates on an entirely different business model compared to the other ICI Pakistan businesses. The others are largely industrial businesses which are more capital intensive in nature and require substantial capital investments for their future growth. In order to let those businesses flourish more successfully, the demerger process has been proposed.

CAPITAL STRUCTURE
Since the last five years there have been no changes in ICIs capital structure. The structur e is of 100% equity that is no debt at all. The following table explains the capital structure. Issued, Subscribed and Paid-up Capital Number 125,840,190 318,492 25,227 12,618,391 138,802,300 Amount in 000 Ordinary Shares of Rs. 10 each fully paid in cash 1,258,402 Ordinary Shares of Rs.10 each issued as fully paid 3,185 for consideration other than the cash Ordinary Shares of Rs. 10 each issued as fully paid 252 bonus shares Ordinary Shares issued pursuant to the scheme of 126,184 the demerger of PTA Business of the company. 1,388,023 Rs

Akzo Nobel owned 75.81% (105,229,125) ordinary shares. Institutions hold 19.08 and individuals and others held the balance 5.11%. As said earlier, ICI follows a zero debt structure. This is reflected in its debt to equity ratio and total debt to capital ratio over the ten years time. Debt equity (%) Total Debt to Total Capital (ratio) 2002 to 7.44 2003 2004 1.39 2005 2006 0.04 2007 2008 2009 2010 2011 -

33:67 40:60 1:99

0:100 0:100 0:100 0:100 0:100 0:100 0:100

OPTIMALITY OF THE CURRENT CAPITAL STRUCTURE

The logic behind this capital structure is that ICI generates sufficient cash to support its CAPEX expansions. Their Soda Ash plant is a very mature business in Pakistan and ICI is the market leaders in it. Polyester generates the highest amount of sales revenue of all their businesses. There has never been need for debt financing. The companys cash generating ability can be analysed by looking at the trend of cash generated from operations over the period of five years and various liquidity ratios.

CASH FLOW TREND

6,000,000 CASH GENERATED FROM OPERATING ACTIVITIES 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 2007 2008 2009 2010 2011 1,188,392 4,312,406 3,716,187 4,938,310 4,038,998

As the above graph shows, ICI regards its cash flows stable since other than the drastic fall in 2008 it has maintained cash flows above 3 billion. For instance in 2011, cash flows from operations increased from Rs. 3.7 Billion to Rs. 4.04 Billion. The drastic fall of 2008 is attributed to the challenges faced as a result of global recession. These problems affected not just ICI but the entire industry. Security concerns, extended energy outrages, high inflation, hike in interest rates and depreciation of Pak Rupee coupled with recession in the developed world put the economy under pressure and affected the demand and supply dynamics. The biggest impact of recession has been on Polyester, which is their biggest business in Pakistan in terms of sales volume. Polyesters primary use is in textiles. The textile value chain ends up in Europe and the US. When the US and Europe are in a crisis, Pakistan exports suffer and the textile value chain suffers overall. Paints brands sales volume has been on the lower side since 2008. This is because their premium brands (Deluxe) prices have gone up. The paint cycle (the average number of days in which the average customer repaints his house) was 3 year but it has now gone up to 5 years as people simply do not have the disposable income to buy expensive paints. Life Sciences took a hit after the floods as the ability of the farmers to purchase agro-based products went down. As the economy got on the road of recovery, the cash generation of the individual businesses has gone up too. The table below shows the liquidity ratios which further assess the sustainability of the cash generation enough to meet current liabilities. Current Ratio Quick 0.97:1 Ratio Cash Ratio 0.58:1 2007 1.44:1 2008 1.81:1 1.02:1 0.44:1 2009 1.92:1 1.27:1 0.77:1 2010 2.17:1 1.39:1 0.85:1 2011 2.10:1 1.26:1 0.79:1

In 2011, the current assets were more than twice sufficient to meet all current obligations/liabilities, the most liquid current assets (excluding inventory) was 1.26 times sufficient and only cash (and cash equivalents) were enough to meet 79% of all current liabilities. Both the current and quick ratios have increased consistently with cash ratio showing little fluctuation but maintaining a reasonably stable value over 0.75 in the last three years.

As long as company is able to generate enough cash it will pursue the current capital structure. However, it might consider debt financing if there is a need in future according to Treasury Manager of ICI Karachi.

FINANCING DECISIONS
For long term funding through loans, both the Regional Treasury in Singapore and Global Treasury in Amsterdam are consulted. Management seeks advice from the regional heads especially if the funding is required for a project being undertaken outside Pakistan. For local projects, only local boards need to be consulted. The amount of deliberation depends on the size of the investment. The bigger the investment, the higher up the chain of authority manager need to go for approval. Comparison of Capital Structure Policy with Competitors: To render a useful comparison, we have selected only the biggest competitors of the company. The table below gives a comprehensive comparison.1 Debt to Equity Ratio 2010 2011 Ibrahim Fibres Limited 0.4 0.2 Clairant Pakistan Limited 0.435 0.277 Berger Paints Limited 2.83 3.23

The three competitors are away from a 100% equity capital structure. Though, Ibrahim Fibres and Clairant have decreased the debt financing whereas Berger maintains a high leverage with more than 76% of its total capital being financed with debt. There can be no comparison made across these companies since there are in different industries altogether. The only comment that can be made is the capital structure differs with ICI and a possible reason can be the diverse businesses that ICI houses which strengthens its cash generation greatly.

http://www.berger.com.pk/aboutcompany/annualreport/2011/annualreport2011.pdf http://igcpk.com/wp-content/uploads/2011/10/IFL-AR-2011-Complete.pdf http://www.clariant.com.pk/C12576710018E579/vwWebPagesByID/10D747792B13106BC1257737002E9 7EF

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DIVIDEND POLICY ANALYSIS AND THE RATIONALE

The company already has a very high dividend payout ratio. In 2007, its DPO was 46.66% whereas by the end of 2011, its DPO had risen to 64.52%, an increase of approximately 40% over the last 5 years. Similarly, in 2007 dividend per share was Rs. 6 whereas in 2011 it had increased to Rs 9. On the other hand market value per share of the stock dropped from Rs 196.65 to Rs 120.27. This explains for the increase in dividend yield of the company over the years; from 2007 it was 3.05% whereas it rose to 7.48% by the end of 2011. Why did the market value or stock price of the share fell? Whenever you analyze a stock, it has to be in reference to the stock market. At the end of 2007, stock market was at 14000. In October 2007, the stock market crashed and trading froze. The market reopened at 6000 and fell down further to 3000. When the overall stock market crashed, our stock price fell. The fall in stock price in 2008 can be attributed to this. The biggest impact of recession would have to be on Polyester, which is our biggest business in Pakistan in terms of sales volume. Polyesters primary use is in textiles. The textile value chain ends up in Europe and the US. When the US and Europe are in a crisis, Pakistan exports suffer and the textile value chain suffers overall. Also, our paints brands sales volume has been on the lower side since 2008. This is because our brands are premium brands (Deluxe) whose prices have gone up. We calculated our paint cycle (the average number of days in which the average customer repaints his house) at 3 years. That has gone up to 5 years as people simply do not have the disposable income to buy expensive paints. Moreover, Life Sciences took a hit after the floods as the ability of the farmers to purchase our products went down. Moving on to the dividend policy, the dividend cover which is a ratio of a companys earnings per share divided by the dividend per share is falling. From 2.14 times in 2007, it fell to 1.55 times in 2011. The reason being because although earnings per share had increased during the five year period, the increase in dividend per share over the last 5 years was much greater than earnings per share which resulted in a fall in dividend cover. The reason for such an appealing dividend policy can be easily backed by the significant amount of cash balances that the company has in the company reflected in the balance sheet and cash flow statements. The company had approximately Rs 3.615 billion in 2007 and this large amount even rose further to approximately 4.86 billion by the end of 2011. Because the company has been generating such large cash reserves, it has been actively paying out this as dividends which explain for the high dividend payout ratio and high dividend per share.

Moreover, sales and net profit after taxation have greatly increased during the five year period. Turnover has risen by approximately 73% whereas net profit has increased by approximately 9%. Thus the company is realizing enough profits and growth that it is confident enough to pay higher dividends.

FACTORS CONTRIBUTING TO THE DIVIDEND PAYOUT.

There are two major factors that determine the level of dividends paid out from the company: The cash at our disposal; the company has been a cash rich company. The CAPEX requirements determine our payout ratio. If they do not have any major CAPEX requirements, it would be redundant to keep the cash tied up therefore their dividend payout ratio would be high. As of now, there is only one CAPEX project that the company has announced. It is the Rs 2 billion coal fired boiler project that they have undertaken for their Soda Ash Plant.

Note that the company had a 100% dividend payout ratio in the year 2010. In the same year it had a relatively higher dividend per share and dividend yield; Rs 17.50 and 12.13% respectively. This is an interesting case in point because during this year the net profit as compared to the five years was the highest (Rs 2.428 bn) and cash was in huge sums amounting to Rs. 4.66 bn (second highest to the year 2011).

PAYOUT OVER THE YEARS Dividend Payout Ratio

120 100.01 100 80 64.52 60 40 20 0 2007 2008 2009 2010 2011 46.66 48.43 54.31 DPO

The Dividend payout ratio for the company has been generally very high. It reached a sky rocket of about 100% during the year 2010. Two factors for a high dividend payout ratio (cash and CAPEX) were discussed above. Other strategic reason for the high dividend payout ratio is explained below The acquisition of ICI by Akzo Nobel was not done just in Pakistan. It was more of a global thing. Akzo Nobel acquired ICI globally in 2008. As part of that global deal, they also got ICI Pakistan. If you look at the dividend payout ratio, it touches 52% in 2004 and it remains around that percentage till about 2009. In 2010, it goes up significantly. ICI was acquired by Akzo Nobel primarily as an add on to their paints capability. They wanted to become the largest paints company in the world. And they werent going to call it just Paints. They were to call it Paints and Co Paints as there are numerous components in Paints. For example Tin Cans Coating, Coil Coating etc. When Akzo Nobel acquired ICI, the sharp rise in dividends was a sign that the bulk of its businesses in Pakistan are non strategic. They are not businesses that are a huge part of its global strategy. Therefore they prefer to take out the dividend instead of investing and expanding these non strategic businesses.

OPTIMALITY OF THE DIVIDEND POLICY

The dividend policy of the company is an optimal one due to the reasons explained below: The company has no debt as a means of financing its capital structure so no regular interest payments. Moreover, the companys cash flow generation is very high and hence the dividend payout ratio is also very high as they have a parent that does not want to invest in the non strategic businesses in Pakistan. Akzo Nobel recently invested 500million Euros in a Speciality Chemicals plant in China but it has no plans of undertaking such expansions in Pakistan where it intends on keeping its Paints Division and selling the remaining 4 businesses as they are not allowing sustainable CAPEX and will therefore deteriorate overtime. Therefore, dividend payout ratio will remain high for ICI Pakistan.

COMPARISION OF DIVIDEND POLICY WITH OTHER FIRMS

ICI Pakistan is a very diversified and a well known company with many business units involved in different types of product line. To make the comparison more accurate and plausible, it is best to compare it with companies of the same level of proficiency. Thus if we compare

Dividend Ibrahim Payout Fibres Ratio Limited

A look at the dividend payout ratios of two other very strong competitors, Ibrahim Fibers Ltd and 2010 20% 0% 100.01% Berger Paints Ltd, clearly shows that it is incomparable to the DPO of ICI Pakistan. Ibrahim 2011 30% 0% 64.52% Fibers Ltd has a considerably good DPO but not as strong as that of ICI Pakistans. Berger Ltd does not even stand close to any competitor, with a DPO of 0%. Thus, ICI Pakistan is doing way better than two of its strong competitors.

Berger Paints Limited

ICI Pakistan

RECOMMENDATIONS:
ICI has a capital structure which is unique to it, considering the industry it operates in. At the moment this structure is optimal to the company because it saves it from the risk that pertains to leveraged companies and the cash burden of interest payments. However, the company might have the need to acquire debt financing after the demerger since the Paints business is a high cash generating business even though not the largest. Since ICI has well-managed the pure equity structure, we do not feel there is a need to shift to debt financing as long as it is able to maintain its cash flows. The focus should thus be on increasing Capex in businesses that have been neglected by Akzo Nobel till now and boost cash flows further. ICI Pakistans dividend policy has been very favorable for the owners of the business. Moreover it has also been consistent and rising at high levels. Be it the dividend per share, dividend payout ratio and dividend yield, everything has been very appealing. Currently, the company feels that the dividend policy is optimal due to its low CAPEX requirements, high cash generation and high revenue generation. However, as the company announced in April 2011 that it is strategically planning to demerge and split the Paints business into a separate legal entity can harm the dividend payout. This is because the Paints business is one of the most cash generating unit of the company, and after its split it will affect the cash flows and hence the level of dividends paid out. Dividend payout has the chances of falling significantly as a result of this decision, hampering the confidence of the owners. Hence the company should try to instill positivity in the owners regarding the affect on dividend payout (if there is) and give a realistic dividend paid with more focus on trying to convince them about the long term positivity that may result out of this de-merger and increase dividends in the long run.