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LECTURER: DR.

VITO MOLLICA
STUDENTS:
LJILJIANA CELLIC 43594417
PAUL BAWEJA

41477871

ISRAEL HUACCHO 43909639


JOSEPH MASSIH 43740227
AGNIESZKA BAGINSKA 30296773

IINET

FINANCIAL VALUATION REPORT

MGSM835 Financial Management T2 2015

Table of Contents
Executive Summary....................................................................................................................................................................... 2
1. Company History and Performance.......................................................................................................................................... 3
1.1 Business Description........................................................................................................................................................... 3
1.2 Source of Revenue.............................................................................................................................................................. 3
1.3 Company Strategy............................................................................................................................................................... 5
2. Macroeconomic Environment.................................................................................................................................................... 6
2.1 Political Factors................................................................................................................................................................... 6
2.2 Social Factors...................................................................................................................................................................... 6
2.3 Economic Factors................................................................................................................................................................ 6
2.4 Technological Factors.......................................................................................................................................................... 7
3. Industry Analysis....................................................................................................................................................................... 8
3.1 The NBN, the potential game changer, if and when its built...........................................................................................8
3.2 Industry Outlook.................................................................................................................................................................. 9
3.3 Porters Five Forces.......................................................................................................................................................... 10
4. Historical Financial Performance............................................................................................................................................. 11
4.1 DuPont Analysis................................................................................................................................................................. 11
4.2 Liquidity............................................................................................................................................................................. 12
4.3 Debt to Equity.................................................................................................................................................................... 12
4.4 Dividend Payout Ratio....................................................................................................................................................... 13
4.5 P/E Ratio........................................................................................................................................................................... 13
4.6 Working Capital Management........................................................................................................................................... 14
5. Valuation Analyses.................................................................................................................................................................. 15
5.1 Valuation Scenarios........................................................................................................................................................... 15
5.2 Key Assumptions for Scenarios......................................................................................................................................... 17
5.3 Scenario 1 Steady growth without acquisitions..............................................................................................................19
5.4 Scenario 2 Growth with acquisition................................................................................................................................ 20
5.5 Scenario 3- Declining growth (acquisition by TPG)...........................................................................................................21
5.6 Scenarios Comparison...................................................................................................................................................... 22
5.6.1 Free cash flows to equity........................................................................................................................................... 22
5.6.2 Sustainable Growth Rate........................................................................................................................................... 23
5.6.3 Revenue Growth........................................................................................................................................................ 24
5.6.4 Debt to Equity............................................................................................................................................................ 25
6. Conclusion............................................................................................................................................................................... 25
Bibliography................................................................................................................................................................................. 26
Appendix A iiNET SWOT Analysis............................................................................................................................................ 29
Appendix B Scenario 1, Steady Growth................................................................................................................................... 30
Appendix C - Scenario 2, Accelerated Growth............................................................................................................................ 31
Appendix D - Scenario 3, Declining Growth................................................................................................................................ 32

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MGSM835 Financial Management T2 2015

Executive Summary

This report covers the valuation of iiNET, an Australian telecommunications company. iiNET is Australias second
largest Internet Services Provider. It also provides telephony services.
iiNET is listed on the Australian Stock Exchange (ASX Code IIN). Since its inception over 20 years ago, the
company has undergone above-average growth by industry standards. This growth stems mostly from an
acquisition of over 30 Internet Service Providers (ISP), and from the acquisition of new iiNET customers and
increased sales to existing customers. The latter was achieved through improved service and product innovation,
very high levels of customer service evidenced by an international award for customer service in 2014.
In 2014 iiNET revenues were AUD1,005 million, up from AUD 940 million in 2013. Revenue growth was 13.2% in
2013, and 7.0% in 2014, with reports of 10% for 2015.
The Australian telecommunications industry is highly concentrated with a few major players having the majority of
the market. The proposed merger of iiNET with TPG may affect the competition in the industry if the prices
become high relative to the level of innovation and customer service.
In our analysis we identified several drivers and took into account historical financial data to build a financial
valuation model for the next five years. We used the Discounted Cash Flow Model to calculate the share value
and the CAPM for calculation of cost of equity. The key drivers of iiNET value have been identified as Revenue
and Cost of Goods Sold (COGS) and debt. iiNET growth strategy of strategic acquisitions, geographical
expansion and bundling of innovative services such as television, XBOX gaming, and innovative mobile bundles
are all contributing to the revenue growth.
As a result of risk analysis, we concluded iiNET growth is expected to slow beyond 2015 due to market factors
such as the introduction of Broadband NBN and resulting lower capital intensity inviting increasing competition,
through the entry of more numerous resellers of services in the industry. This may reverse the current trend
towards increasing industry concentration and prevent near- oligopoly pricing being established. We have also
taken onto consideration a possibility of a merger resulting in the loss of iiNETs competitive advantage in
customer service and innovation, which until now has set it apart from its competitors.
We analysed three scenarios: high growth through continuing acquisitions, stable growth and low growth due to
lack of synergies post takeover by TPG.
The first scenario assumes iiNET operating as a provider of higher value, higher cost services and continuing with
their acquisition strategy for growth, with an acquisition of a new company in Year 3 and 5. The second scenario
assumes stabilising growth in light of greater price and product competition through the roll out of the NBN and
entry of multiple smaller ISP providers. The third scenario assumes low growth as a subsidiary of TPG due to
corporate cultural incompatibilities and dilution of iiNETs competitive advantage as a provider of high value
adding services. Our analysis has led us to make the recommendation for the sale of iiNET shares as a currently
overvalued equity under all three scenarios.
Scenario
High growth with acquisitions
Average growth
Low growth- takeover by TPG
Figure 1Scenario outcomes share price

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Forecast Share Price, AUD


8.62
7.07
8.06

MGSM835 Financial Management T2 2015

1. Company History and Performance


iiNET was founded in 1993 to provide internet services in Western Australia. iiNET is ranked number 410 out of
the top 2000 companies in Australia.
In 1998 iiNET acquired fourteen small companies which were mostly resellers of its products.
In 1999 the company listed on the Australian Stock Exchange and acquired a further eight telecommunication
companies in Western Australia. In 2000 it introduced broadband services and in 2001 it launched its own
telecommunication carrier and application hosting businesses. In 2003-2004 it acquired a further 11 companies
including one New Zealand based. In 2005 it became the first company in Australian to provide a high quality
VOIP service. It launched a South-African based call centre in 2008. Between 2006 and 2012 it acquired another
five businesses, continuing its expansion across various states of Australia and into New Zealand. Most recently it
acquired Adam Internet for AUD 60 million in 2013, and a 60% share in the Tech2 group.

1.1 Business Description


iiNET Limited offers a range of internet and telecommunications solutions for both residential and business
customers including:

Internet access - broadband, naked DSL, Wi-Fi hotspots, virtual private networks access
Phone - home phone service, business landlines, VOIP plans
Domain, web hosting & email hosting
Hardware & Software - modems, routers, handsets, software, cards & adapters
Fetchtv 2 - an IPTV service
Additional services - computer support, static IP, Cloud computing.

The companys competitive advantage comes from the provision of exceptional customer service by Australian
and international standards, as well as value- adding in the product and service offerings through enabling
entertainment content delivery in new and competitively priced ways, such as Xbox unlimited download plans and
Fetchy TV.

1.2 Source of Revenue


iiNET is a significant market player in the Internet services industry in Australia.
It currently holds a 14% market share, which places it second after Telstra. At this point it is still a minor player in
the wireless telephony market.

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MGSM835 Financial Management T2 2015

Figure 2 IBIS World Industry report

iiNET main source of revenue is from internet related services such as VoIP, XBOX, Netflix and business internet
connectivity.

Figure 3 IBISWorld Company Report-iiNET

The majority of the revenue for iiNET is generated by two categories of customers: residential and business.
Products- non-business:

NBN, ADSL and naked DSL internet connections


Mobile and data plans, mobile handsets
TV on demand

Products- business:

Reliable high speed internet products for business needs


Solutions for traditional and VOIP business phone needs, mobile fleet, bundles
Domains, Hosting , cloud computing, Histed Microsoft exchanges

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MGSM835 Financial Management T2 2015

1.3 Company Strategy


iiNET has established a firm position as the second largest ISP in Australia. They have recognized an unmet
demand of data usage within Australia which Telstra, alone, was unable to service. With an open market to
penetrate, iiNET commenced the aggressive acquisition of privately owned ISPs, initially within its home state of
WA, then the company strategically expanded across Australia and New Zealand with purchases such as
Netspace in 2010, and Internode in 2011 opening large market access to NSW, VIC and SA.
Acquisitions have been selected to coincide with the industry trend away from traditional profitable services like
phone calls and text messages to internet-based communications.

Acquired companies complement iiNET

residential customer base, where customer service is of international standard and key to their core business
success.
In 2008, iiNET changed their target market to business/corporate customers. This came with the acquisitions of
TransACt and Internode in 2011 and Adams Internet in 2013, which came with a significant business consumer
base. iiNET recognizes its business clientele as a profitable source of revenue, and has since expanded their
service offerings to account management, cloud storage and set up support/assistance for small, medium and
corporate sized businesses.
Second to high level customer service, iiNET is developing its reputation in innovation and entertainment.
Product extensions have included Fetch TV in 2010, gamers.net.au, unmetered content data for Xbox live, ABC
iView and streamed radio stations and most recently the launch of JIVA broadband offering unlimited downloads.
Driving the entertainment in iiNET, the marketing approach is now infiltrating the national sports arena, signing
up as a major sponsor for AFL club, Hawthorn and the Sydney Sixers in 2013. iiNET Chairman, Michael Smith,
explains the marketing platform has significantly increased brand awareness, which is assisting them in
expanding their market share prior to the introduction of the NBN.
The NBN threatens to place all ISPs on a level playing field. Hence iiNET is gearing up to expand its current
occupation of 25% of the NBN customer base, including the conversion of Telstra customers, as a prime strategy
to increase revenue. Acquisition based growth is not likely to continue given the minimal privately owned ISP
companies remaining as a result of the aggressive acquisitions by iiNET, M2 and other telecommunication
companies such as TPG. Thus consolidation and product extension and technological changes will lead iiNET
revenue production into their next three years.
The challenge for iiNET will be to explore other revenue sources upon the introduction of the NBN, or indeed
other technological advances in data access, such as the potential of Google net. Revenue prospects are moving
with the industry into online communications such as Google, Facebook and Whats App and away from traditional
telecommunications. Business clients will have a greater longevity in their reliance on traditional communications.
While iiNET has vouched a focus on this area, in addition to growing acquisitions such as Internode, Adam
Internet and TransACT, their marketing strategies and service extension lines are all geared toward retail
customers and are not consistent with corporate clientele.

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MGSM835 Financial Management T2 2015

2. Macroeconomic Environment
2.1 Political Factors
The

major

political

factor

influencing

Australian

telecommunication sector is the government commitment to


provide internet and other technology based services to all
Australians through implementation of National Broadband
Network (NBN). The NBN is Australia's first national wholesaleonly, open access communications network that is being built to
bring high speed broadband and telephone services within the
reach of all Australian premises (NBN Co). The project will be
implemented by government established public-private company
NBN Co in joint co-operation with Telstra Corporation Limited.

2.2 Social Factors


Given the growth in Australias population as well as the nations small business sector, (Connolly, Norman &
West, 2012, it is not surprising that the demand for internet services has been increasing in both the residential
and business sectors of Australia. With its roll-out, the NBN will become the predominant infrastructure for
providing these services, and as a utilities-based network it will also provide its services to other sectors, such as
healthcare, education and business. With these sectors involved the Australians will see the industry develop
specific new business models around infrastructure, ICT and retail (BuddeComm, 2013).

2.3 Economic Factors


Historically, Australias economy has had a solid performance, (see Figure 4 and 5). According to the market
analyses, (BuddeComm, 2013), the telecommunications business is a double-edged sword. On one hand it is an
enormous growth industry because of its function as a key facilitator in the transformation of societies and
economies towards a future that is driven more and more by ICT (Information & Communication Technology
developments (BuddeComm, 2013). On the other hand many of the traditional telecommunications businesses
operating in this market are recording declining results not because the market has not been growing, but
because of the pressure on their margins. New technologies enable many of the traditional telecoms products
and services to now be produced and delivered by the so-called OTT (Over-The-Top) companies, often at a
fraction of the cost.
Prices are driven down further and faster than growth within that industry as a result of increased competition
from inside and outside the traditional industry.
It is expected that this trend of lower cost is to continue at a higher rate than the overall telecoms market is
growing.

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MGSM835 Financial Management T2 2015

Figure 4 GDP per Capita; source:


RBA

Figure 5
Australias
inflation rate;

Annual
source:

RBA

2.4 Technological Factors


Overall technology evolution had strong impact on Australian telecommunication industry and consumer
preferences. Sales figures are indicating a sharp decline in sales of personal computers by 20.2% followed by the
16.8% lower sales for laptops and notebooks. At the same time, sales of tablets doubled in 2014. According to
Telsytes survey, tablets will become the primary computing device in the coming years. Telsyte Managing
Director Foad Fadaghi states that This shift in preferences is creating new digital opportunities that span
consumer services, education and entertainment.
NBN roll-out is underpinning this development with its commitment to deliver a universal set of mobile services to
almost all Australians regardless of where they reside (AUS Telco Report, 2013).
In 2013 there were more than 5.5 billion mobile broadband subscribers and this number has grown since then.
The release of additional 4G network coverage and increases in capital expenditure by the mobile network
operators will see increased market penetration of the availability of these 4G/LTE networks (Long-Term
Evolution). According to the BuddeComm (BuddeComm, 2013) it is expected that the MNOs (Mobile Network
Operator) will be anticipating a greater return on their investments, but that uptake will slow down to an annual
growth rate of around 3% with average return per user continually falling as market pricing drives uptake.
From the aspect of iiNET, technological advancements in the telecommunication landscape is encouraging,
however it is also bringing in new challenges with regards to the point of differentiation with cost being the main
driver over the reliability and performance (Whirlpool, 2011).
Technological innovations, uptake of internet services by businesses and private users will transform lifestyles.
and the way business is conducted. Machine to Machine technology is the next big transformative force in
telecommunications. These technologies will allow an individual to connect and use multiple devices
simultaneously, unlike using a mobile phone. Data from these devices will provide actionable business
intelligence.

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MGSM835 Financial Management T2 2015

3. Industry Analysis

According to The Australian Bureau of Statistics (ABS),


12,408,000 Australian individuals had an active subscription to the
internet, increase of 30% since June 2010 (ABS, 2013). As
reflected in the Figure 6 the Australian Telco report 2012-2017
forecasted the strong growth in the broadband subscription over
the next five years as consumers and businesses looking to
increase their data usage partly driven by rich media content like
IPTV and cloud technology (BuddeComm, 2013).
With increasing coverage of LTE/4G network fuelled by high
adoption for mobility products, such as smart phones and tablets,

Figure 6 Industry Trends, Fixed Line 2029


2017;source: IBISWorld Report

and emergence of advancing technologies such as Naked DSL,


VoIP and the NBN, consumers and business alike recognise fixed line as non-essential and an added expense,
resulting in sharp decline since 2010.

3.1 The NBN, the potential game changer, if and when its built
Several concerns were identified during the privatization of Telstra, the monopoly tier 1 provider in the Australian
Telecommunication industry:

Broadband quality was below the international

benchmark;
End-user and whole sale prices where above

the mark; and


No economically viable business for high-speed
broadband infrastructure for regional and rural
Australia.

The NBN was built with the intention of removing


Telstras Monopoly hold on broadband. Acting as a
single wholesaler for any Telco who wishes to purchase
its fiber and negotiates individual rates based on the
companies its does business with, leveling the playing
field and acting as artificial stimulant for competition.
Figure 7 Industry Trends, Mobile Sector 2010 2017;
source: IBISWorld report on telecommunications
industry

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MGSM835 Financial Management T2 2015

3.2 Industry Outlook


Tier 1 vendors, such as Telstra, Optus and Vodafone will most likely continue to hold on to their market
dominance by exploiting the type of bundled services offering with their fixed and mobile services. Optus margin
could improve by negotiating better wholesale rates from NBN than their current arrangement with Telstra.
Vodafone could also leverage the NBN infrastructure by bundle fixed and mobile services and shake off its
mobile only characterization in the Australian market.
Tier 2 vendors, such as M2 and iiNET are in a potentially more difficult position. They have historically established
attractive resale businesses around their consumer and business-grade broadband services, however they may
face increase challenges when new carriers enter the telecommunications market that may be backed by large
corporate groups access to substantial capital and stronger brand.
The Australian insurance industry went through a recent change with the entrance from Coles and Woolworths.
Similarly, the telecommunications market could expect a
range of new carriers to be established by larger enterprises
from other industries, such as the big 4 commercial banks.
The NBN offers new opportunities to enter the broadband
market with ease, and since the telecommunications market
is price sensitive, bundle deals, such as discount shopping
or fuel when bundle with internet services may bring new
challenges to the more established players within the
telecommunications market.
The telecommunications industry will change out of
recognition following the deployment of the NBN; however,
the winners and losers will depends on the strategies
adopted by individual players and the evolving regulatory
landscape over the next five years.

Figure 8 Industry Trends, Broadband, 2010 - 2017

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MGSM835 Financial Management T2 2015

3.3 Porters Five Forces


This market is characterized by increasing supplier power. This is driven by high switching costs as well as the
quality of supplied services.
In practice customers have tendency to change ISPs in order to get better value for money.
Overall the degree of rivalry is considered to be moderate due to strong growth of the Australian
telecommunication market in recent years.
The market has been growing at a variable rate over recent years. Also, established companies are committed in
building their reputation and consolidating their position by competing on price. This all leads to moderate risk of
new entrants.
Currently substitutes are not present.

BUYER POWER M

Tendency to switch
Unidentified product
Backwards integration
Buyer independence
Buyer size
Financial muscles
Low cost switching
Oligopoly threat
Price sensitivity
Product dispensability

SUPPLIER POWER H

NEW ENTRANTS M

Supplier accessible
Undifferentiated product
Week brands
Little regulation
Little IP involved
Low cost switching
Market growth
Scale unimportant

THREAT OF SUBSTITUTES - L

Low cost switching


Beneficial alternative
Cheap alternative

Figure 9 Industry Porters Five Forces-Summary

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Switching cost
Differential input
Forward integration
Importance of quality/cost
No substitute inputs
Player independence
Supplier size
Oligopoly threat
Player dispensability

DEGREE OF RIVALRY M

Undifferentiated product
Competitor size
Easy to expand
Lack of diversity
Low fixed cost
Low cost switching
Similarity of players

MGSM835 Financial Management T2 2015

4. Historical Financial Performance


4.1 DuPont Analysis
The DuPont Analysis below provides a snapshot of the financial position of iiNET breaking down ROE into three
ratios: Equity, Profit Margin and Asset Turnover. It is an integrated approach that provides an overview of key
drivers of iiNETs performance. It provides an indication of ROE is either being driven by returns generated by the
assets of the company or merely through leverage and further, if Return on Equity (ROE) is indeed driven by
ROA, whether this is driven by profit margins or asset utilisation.

Figure 10 DuPont Definition

Figure 11 Dupont analysis

The above data confirms that the ROE is primarily driven by the aggressive acquisition strategy. Through the
utilisation of leverage and the purchasing smaller companies for low multiples the company managed to continue
to drive ROE growth. This increase in leverage from 2012 onwards indicates iiNETs increased reliance on debt
financing. Non-current liabilities increased two-fold mainly due to increase in non-current borrowings. These noncurrent borrowings have tripled over the same period of time as they have been used to finance iiNET aggressive
acquisition program.
Also the Return on Assets (ROA) movements do not correspond to changes in total equity increase over the past
five years. This indicates that increase in equity is a result of increased retained earnings which iiNET is using to
support their growth plans and opportunities.
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MGSM835 Financial Management T2 2015

4.2 Liquidity
The Acid test ratio does not include inventory on hand and prepayments as these cannot be converted to cash
quickly. It determines whether a firm has sufficient short-term assets to cover its immediate liabilities without
selling inventory.
iiNET has a liquidity level that has been quite stable over the last 7 years and it averages around 0.5. Such
liquidity indicates that company is over-leveraged and it would find having difficulties in meeting current
obligations using liquid assets. This lines up with their cash flow position.

Quick (Acid Test) Ratio


1.2
1
0.8
0.6
0.4
0.2
0
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Figure 12 Acid Test Ratio2005-2014

4.3 Debt to Equity


Reviewing the historical data of iiNET debt to equity ratio it is obvious that this ratio had increased significantly
since 2011. This two-fold increase indicates that iiNET has been aggressive in financing its growth with debt to
support its acquisition strategy of privately owned ISPs.

Debt/Equity Ratio
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
2005

2006

2007

2008

Figure 13 iiNET debt to equity ratio2005-2014

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2009

2010

2011

2012

2013

2014

MGSM835 Financial Management T2 2015

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MGSM835 Financial Management T2 2015

4.4 Dividend Payout Ratio


From the dividend payout perspective, over the past ten years iiNET has been consistently increasing its
dividend payments. Higher payments over the last three years coincide with iiNET increase in debt. iiNET has
been generating more earnings than it would have without external debt financing and is using part of these
earnings to fund dividend payouts.

Payout Ratio (%)


200
150
Axis Title

100
50
0
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Figure 14 iiNET dividend payout ratio 2005-2014

4.5 P/E Ratio


The Price to Earnings (P/E) ratio indicates the expected price of a share based on its earnings. iiNET price to
earnings ratio have been steadily increasing over the last ten years, particularly over the last three years which
coincides with their latest acquisitions. This increase indicates positive future performance for the business and
investors willingness to pay a premium for iiNET shares.
iiNET P/E ratio range indicates that their stock is fairly fair valued compared to the industry average and in in
comparison to major competitors such as Telstra and TPG.

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MGSM835 Financial Management T2 2015

P/E Ratio
80
70
60
50
40
30
20
10
0
2005
-10

2006

2007

2008

2009

2010

2011

2012

2013

2014

Figure 15 iiNET P/E Ratio 2005-2014

4.6 Working Capital Management


Working capital is a common measure of a company's liquidity, efficiency, and overall short- term financial
management.
Negative working capital generally indicates a company is unable to pay off its short-term liabilities as a result of
becoming overleveraged. iiNET working capital is consistently decreasing which confirms that company is
investing heavily in growth.

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MGSM835 Financial Management T2 2015

Figure 16 iiNET working capital 2005-2014

Working Capital
20
0
2005
-20

2006

2007

2008

2009

2010

2011

2012

2013

2014

-40
-60
-80
-100

Figure 17 iiNET working capital graph 2005- 2014

Looking at iiNET the cash conversion cycle is important for two reasons. First, it's an indicator of iiNETs efficiency
in managing its important working capital assets and second, it provides a clear view of a company's ability to pay
off its current liabilities.
iiNET Cash Conversion Cycle (CCC) historically has been low which is indicating that they have been using their
cash reserves to streamline operational activities and finance further acquisitions by being reliant on this indirect
source of financing from their creditors to offset the need for short term loans. From 2011 onwards their CCC is
sharply moving upwards and although is still negative it indicates that increase in their current liabilities is driven
by aggressive growth initiatives.

5. Valuation Analyses
5.1 Valuation Scenarios
We have chosen to perform an analysis of three possible future scenarios. The first scenario is for stable growth.
In this scenario iiNET pursues average growth through increases in sales. It does not undertake any acquisitions
or divestments.
The second scenario assumes iiNET continues its growth trajectory, through an acquisition strategy in two out of
the five years of forecast cash flows.
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The last scenario assumes that TPG acquires iiNET and therefore a number of new factors come into play. Such
as: a decrease in sales, increase in depreciation and decrease in cost of goods sold.
To perform our forecasts we analysed the 2014 iiNET drivers and performed adjustments of these values in
different scenarios.
An explanation of the key drivers used in our financial valuation model for iiNET is presented below:

DRIVERS

2014
VALU
E

EXPLANATION

REFERENCE

Sales Growth

4.80%

This is based on our industry analysis


as well as considering future growth
opportunities available to iiNET.

BuddeComm - global
independent
telecommunications
research company.
Australia Telecoms
Industry: Statistics and
Forecasts.

Current assets/ sales

12.00%

Illustrates the value of short-term


assets held to generate sales revenue
for iiNET. This is a low number, as the
telecommunications industry needs
capital-intensive infrastructure (longterm assets) to generate sales
(returns).

iiNET 2014 - Financial


statements and notes

Current liabilities/
sales

20.40%

iiNET has significant current liabilities


to sales due to material short-term
borrowings and a significantly high
working capital base.

iiNET 2014 - Financial


statements and notes

Net fixed assets/ sales

74.50%

i iiNET being in the


telecommunications industry requires
substantial investment in fibre-optic
networks and communications
infrastructure in order to generate
sales. These assets present costly
and long-term investments.

iiNET 2014 - Financial


statements and notes

Cost of goods sold/


sales

78.00%

The main costs of providing services


are: network and carrier costs,
employee expenses and corporate
expenses. This shows that iiNET is in
an industry with thin margins and it is
essential to grow the customer base
to improve profitability.

iiNET 2014 - Financial


statements and notes

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Depreciation rate

4.30%

iiNET s assets have a long useful life


and are expected to generate
economic benefit over a 5 - 15 year
time horizon. Hence, the depreciation
rate is low. However, in line with
competitors I.e. Optus and Telstra.

iiNET 2014 - Financial


statements and notes

Amortization

10.03%

This primarily incorporates the


reduction in value of: software,
licences and intellectual agreements,
IRU assets (finance leases) and
subscriber bases.

iiNET 2014 - Financial


statements and notes

Interest rate on debt

10.00%

iiNET 2014 - Financial


statements and notes

Interest paid on cash


and marketable
securities

2.80%

Tax rate

30.00%

This is the current cost of debt for


iiNET iiNET has taken on
considerable debt in terms of
financing acquisitions (e.g. with
AAPT). The higher leverage is
increasing the cost of debt capital for
the company.
This represents the standard rate of
return on cash/ cash equivalents.
Which is in line with the RBA market
cash rate.
This is based on the Australian
company tax rate.

Dividend payout ratio

50.00%

iiNET 2014 - Financial


statements and notes

Debt / Sales

20.00%

iiNET has had a consistent policy of


increasing dividend payments over the
past four years. Due to limited RE's
and consistently searching for new
acquisitions, iiNET has used debt
financing to maintain a high payout
ratio.
This measure has increases
significantly over the past four years
as iiNET has funded acquisitions via
debt. Higher debt levels increase the
risk profile of the company, raising the
cost of debt capital and the return on
equity.

Figure 18 Drivers iiNET 2014

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iiNET 2014 - Financial


statements and notes
Australian Taxation Office Company Tax - Tax rates
2014-2015 income year.

iiNET 2014 - Financial


statements and notes

MGSM835 Financial Management T2 2015

Figure 12 assumptions for analysis

5.2 Key Assumptions for Scenarios

5.2.1 Forecast Assumptions


iiNET forecast assumptions are based on the historical growth rates for the ISP telecommunication segment.
These are 6.6% for the years 2010- 2015. The IBISworld report forecasts growth for iiNET of 5.8% for the period
2015- 2020.
Financial analyses in this report will address three scenarios with different growth rates assumptions. Growth
beyond five year period will be defined in the terminal value section of this report.

These assumptions rest on iiNET continuing to be a significant player in the Internet Service Provider (ISP)
segment (currently with a 14.20% market share) and maintaining its number two position in the market as well as
maintaining its competitive advantage in customer service.
Further it was assumed that any technological advances will be taken up equally by all ISP providers and will not
advantage iiNET more or less than any other market player.
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Also it was assumed that iiNET will not become involved in:

The copper and other wired telecommunications network,

Wired telecommunication network operation,

Resale of telecommunications,

Wireless telecommunication carrier,

Data processing and web hosting services.

5.2.2 Cost of Equity


Capital pricing model (CAPM) was used to calculate iiNET cost of equity. The CAPM is defined as:

Where

rf

is the risk-free rate,

is iiNets beta relative to the broader market, and

rm

is the expected

market return. For the purposes of this report, the broader market was defined as the telecommunications market
and the risk-free rate as the Australian Government 10-year bond yield. As at 28 May 2015, the Australian 10year bond yield is 2.92 %(Bloomberg, 2015 & RBA, 2015) with long term average between 3% - 4%.For this
report the risk premium rate was considered to be 4.0% With calculated re-levered beta and an equity risk
premium of 7.9% we calculated cost of equity for each scenario. Explanation follows below.

5.2.3 Beta
The Morningstar database provides the levered beta for iiNET of 0.5 which is higher than industry beta of 0.37.
This indicates slightly higher level of risk (according to the market) associated to iiNET, compared to similar
market players. Unlevered beta was calculated based on average debt to equity in the period 20052014 and an
average tax rate of 30%. This unlevered beta was then re-levered based on forecasted debt to equity ratio for
2015 2020 and forecasted tax rate of 30%. The re-levered beta is 0.508 for scenario 1 (steady growth), 0.529
for scenario 2 (growth with acquisition) and 0.502 for scenario 3 (acquisition of iiNET by TPG).

5.2.4 Equity Risk Premium


Equity risk premium assumptions are based on average value over 1958 2005 (Hundley, 2006) being 7.9% 6.5%.

5.2.5 Terminal Growth Rate


Beyond 2020, it was assumed that iiNET terminal growth rate would be 3%.
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Following factors were considered when deciding on terminal growth rate figure:
1. Terminal growth rate was achieved by taking the cost of equity and calculating the market implied growth
rate using Gordons growth model:

With a cost of equity of 8.92%, the implied growth rate was calculated by taking the cost of equity and
subtracting the expected dividend yield.
2. It is assumed that the iiNET share price is trading at a premium due to the speculation on the takeover
bid through the announced potential sell out and that the price will fall once the decision is made about
company future.
3. M2 Group in their Competing proposal for iiNET indicated median broker terminal growth rate of 3.0%
4. RBA forecast for the growth in GDP over the next decade at around 2.5% per year (a little slower than
over past decades), within the economy there will be a shift towards services and away from primary and
secondary industries (like agriculture and manufacturing).
Although calculated terminal growth rate of 4.8% is based on real numbers, it is considered unrealistic based on
the additional factors listed above. Even though the recommended terminal rate of 3% is higher than long term
average GDP growth, the decision was made based on assumption that, on average, the service sector will grow
more than other industries.

5.3 Scenario 1 Steady growth without acquisitions

In this scenario the primary drivers affecting the value of the firm are sales growth, cost of goods sold and the
debt to equity ratio. The underlying reason for the historical growth of iiNET has been two-fold: acquisitions of
smaller ISP providers occurring frequently almost yearly and oftentimes of more than one company in any given
year.
According to IBISWorld report on iiNET (IBISWorld, 2015) the companys revenue is forecast to grow by 16.9%
per annum over the next 5 years if it were to follow a similar growth scenario through continuing aggressive
acquisitions. We believe that acquisitions will become harder for iiNET as it is now one of the top 4 companies in
the telecommunications market. Competitive pressures from other companies in respect of pricing will lead to the
stabilization of revenue growth at more conservative levels which in turn will affect the profitability and free cash
of iiNET. In addition the ACCC will step in to prevent further market concentration in the industry in order to
mitigate oligopolistic tendencies from emerging.
Our estimate of the share price is AUD 7.76 which compared to the current market price of AUD 9.58. The stock
is overvalued and does not present a good investment opportunity at this time.
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Figure 13 Value projections for iiNET 2015-2019 : steady growth without acquisitions by iiNET

5.4 Scenario 2 Growth with acquisition

In our second scenario we have assumed that iiNET will continue its current strategy of growth through
acquisitions. Whilst the company will not be pursuing acquisitions as aggressively as in the past, we have
assumed that an acquisition will occur in 2016 and 2018. These acquisitions will lead to increases of sales growth
from 4.8% in 2016 to 7 % in 2017 and 9% in 2018-19. At the same time, the debt ratio will increase to from the
current value of 20% to 30% and further to 35% of the turnover. We assume ROE increases over18% evidenced
in 2014 and is maintained at this high level.
This will lead to a decrease in cash available to equity and lead to in a drop in the share price to AUD 8.45.

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Figure 21 Value projections for iiNET 2015-2019: iiNET makes acquisitions

5.5 Scenario 3- Declining growth (acquisition by TPG)


In the third scenario, our analysis has shown that the merger with TPG will support the iiNET share value more
than in the aggressive growth scenario where iiNET acquires companies to grow. Free cash flows are increasing
as reliance on debt to fund operations decreases. iiNET has more access to cash to fund its business activities
as a result of faster depreciation (resulting in higher tax shields) and smaller investment need due to no
acquisitions.
The benefit of increasing cash flows can be potentially offset by a number of acquisition related costs or issues.
For example, higher than expected integration costs or operational delays due to the takeover may lead to a
decrease in revenues and increasing costs, meaning management may not realise all the benefits or synergies
forecast. As iiNET decreases investment and has more access increasing depreciation rate will result in higher
tax shields. Our valuation puts the expected share price at AUD 7.31, which is higher than the share price of
iiNET if it continues a growth by acquisition strategy. We conclude that under this scenario iiNET is also
overvalued.

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Figure 22 Value projection for iiNET 2015-2019 if acquired by TPG

5.6 Scenarios Comparison


5.6.1 Free cash flows to equity

The projected free cash flow to equity as shown by Figure 23 indicates that the free cash flows to equity for
scenario one (steady growth) and scenario three (acquisition of iiNET by TPG) are very similar with the steady
growth scenario being slightly better than being acquired by TPG. The financial model also projects more
available free cash flows with scenario two (growth with acquisition). However, this decreases significantly one
year after each acquisition. This is due to the assumption of iiNET repaying some of its increased debts following
the acquisition to reduce the risk its carrying from a very high leverage (debt to equity ratio).

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Free Casflow to Equity


250000
200000
150000
100000
50000
0
2014

2015

2016

Steady Growth

2017

Growth With Acquisitions

2018

2019

Declining Growth

Figure 23 Free cash flows to equity- comparison of 3 scenarios for iiNET 2015-2019 valuation

5.6.2 Sustainable Growth Rate


The iiNET s historical actual vs sustainable growth is represented in the graph below. It indicates that iiNET had
growth over the years in which the growth was driven by the increase in leverage.

Historical Actual vs Sustainable Growth, %


35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
2010

2011

2012
SGR

2013

2014

Actual Growth

Figure 24 Actual vs sustainable growth rate: iiNET historical data

There are limitations to the usefulness of the sustainable growth analysis as it assumes that debt to equity ratio
remains stable. This is rarely the case in real life. In scenario with accelerated growth through acquisitions this
analysis is affected further as the debt to equity ratio fluctuates.
Future sustainable growth rates are similar for the decreasing and stable growth scenarios. The medium term
SGR for the scenario with accelerated growth is increasing, pointing to the ability of the firm to generate increased

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sales and cash flows. This indicator suggests that the future company performance will be strong and sustainable
despite increases in debt to fund growth.

Future Sustainable Growth Rate, %


14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
2010

2011

2012

Steady Growth

2013

2014

2015

Growth With Acquisitions

2016

2017

2018

2019

Declining Growth

Figure 25 SGR- comparison of 3 scenarios for iiNET 2015-2019 valuation

5.6.3 Revenue Growth


Revenue growth in all three scenarios is increasing. Revenue growth for the accelerated growth scenario is
growing more as the geographical reach and product and service mix is more varied and appeals to more
customer groups. As a result market share is bound to increase and the revenue will increase over the medium
term that is until the majority of the NBN roll out is achieved. This will in turn result in smaller players entering the
market. This will have two effects; more customers signing up for telecommunications services, greater number of
services on offer and increased price and non- price competition.
In the steady growth scenarios, and declining growth the revenues are increasing more moderately. In the case of
TPG taking over iiNET, through the potential sell-off lower-performing parts of the business, revenues will
increase at a decreasing rate.

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Revenue Growth
1600000
1400000
1200000
1000000
800000
600000
400000
200000
0
2014

2015
Steady Growth

2016

2017

Growth With Acquisitions

2018

2019

Declining Growth

Figure 26 Revenue growth- comparison of 3 scenarios for iiNET 2015-2019 valuation

5.6.4 Debt to Equity


The clear standout in this case is the scenario where iiNET grows through acquisitions. Not surprisingly, the 2
acquisitions made by iiNET require additional funding in the form of greater borrowing, thus increasing the debt to
equity ratio. The companys growth is being financed not by an expected internal positive cash flow, but by
creditors. If, in the medium term, company sales grow faster than its assets, lenders may become hesitant to
provide funding to iiNET, in which case iiNET would not receive enough cash to continue to grow and finance it s
long term debt.
The other two scenarios do not require as much debt to fund the companys assets The debt to equity ratio is
decreasing and trending towards 1.0 which is the more in line with industry average debt to equity ratio of 0.89.
(Statistics).

Debt to Equity
2.00
1.60
1.20
0.80
0.40
0.00
2014

2015

2016

2017

Figure 27 Debt to equity- comparison of 3 scenarios for iiNET 2015-2019 valuation

6. Conclusion
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2019

MGSM835 Financial Management T2 2015


iiNet is the number two provider of Internet services in Australia, and the fourth largest communications company
which differentiates itself through high-value adding, innovative services and products supported by a high level of
customer service. Hence it occupies a niche position, which shelters it from competitive pressures of other major
and minor market players. The telecommunications industry is highly concentrated which results in more supplier
power. However the industry is still attractive for small entrants who can compete on price in a selective market
segment, which demands low-cost services.
In our financial valuation of iiNet we have considered three possible scenarios for the companys future growth
trajectory. Scenario 1 the company continues on the path of steady growth, Scenario 2 iiNet expands its
acquisition strategy to fast-track growth and Scenario 3 economic and industry constraints result in declining
future growth.
In our opinion, based on our investigations and research into iiNet, its major competitors and the
telecommunications industry, Scenario 2 presents the most viable future proposition. This option maximises
shareholder wealth and results in iiNets present fundamental business value being $3,648,379.63. This equates
to a share price of $8.45, which, in comparison to the current market price of $9.58, indicates the company is
currently overvalued.

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Appendix A iiNET SWOT Analysis


STRENGTHS

Syndicate finance loans over long term

reduction of financial risk


Strategic and synergetic acquisitions
Steady growth
Well known household name
Niche household market
National coverage
Sustainable growth
Customer service

WEAKNESSES

Niche residential customer base, lower revenue

than corporate customers


Only invest in ISP nation wide
Minimal service differentiation or competitive
edge in preparation for NBN, relying on market

share volume
Limited revenue avenues that are reliant on data
contracts. Major revenue opportunity trending in
online communication enablers, such as Whats
App, Facebook, imessage

OPPORTUNITIES

Bundling options
Competition edge
Increase national coverage with Perth deal

THREATS

TPG acquisition
Expense of consolidation/back office integration
NB and associated political climate
Technological advance in data usage that may
threaten traditional ISP business model

Figure 28 iiNET SWOT Analysis

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Appendix B Scenario 1, Steady Growth

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Appendix C - Scenario 2, Accelerated Growth


Appendix D - Scenario 3, Declining Growth

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