Reference no: EM13489221

Palindrome Brands (Pty) Ltd ('Palindrome Brands') imports and distributes a range of internationally branded apparel to retail customers in South Africa. Palindrome Brands was established in 1995 by Ms Eve Tenet who remains involved in the business as Chief Executive Officer (CEO) and major shareholder. Ms Tenet is a South African citizen and resident. Ms Tenet was recently interviewed by South Africa's leading business newspaper and the following are extracts from the published article:

I started Palindrome Brands in my garage at home with limited capital. At the time, many global clothing brands were not available in South Africa, either because of the political stance taken by these global groups or because of ignorance regarding the potential of selling their brands on the African continent. I had a vision of securing the distribution rights for leading international apparel brands and bringing these to South Africa. I had previously been the chief buyer for the largest clothing retailer in the country and understood both the challenges and the potential of selling branded clothing ranges at retail outlets.

We were fortunate in securing the rights to import and distribute the world's leading brand of jeans in 1997. This placed Palindrome Brands on the local map. Over the past 12 years we have expanded our product range to 25 leading global clothing brands, targeting both male and female consumers.

We import branded jeans, casual trousers, sportswear, formal shirts, T-shirts, sweaters, jackets and underwear. There are five key aspects to our success:

· We supply high quality, price competitive merchandise. We target end consumers who are prepared to spend a bit extra on our branded
merchandise because they know that they will be able to wear these clothes for a couple of years and still look good in them;

· Palindrome Brands is not overly dependent on any single supplier in terms of how much it represents of Palindrome Brands's turnover;

· We import directly from our suppliers' accredited factories in China and other Asian countries. We used to order from our suppliers who in
turn sourced apparel from their manufacturers, but it is far cheaper to pay our suppliers a royalty on revenue than purchase directly from them. We thereby avoid their additional mark-up on clothing and reduce the time from placing an order to shipping;

· We support our brands locally by spending a fixed percentage of our revenue on advertising and promotions. We ensure advertising is consistent with our suppliers' global marketing messages but that the campaigns also have a local flavour; and

· Palindrome Brands continually invests in its staff by ensuring the working environment is a 'home away from home'. We have found that flexible hours do not work but that we should support employees where possible in saving time on domestic and personal chores. For example, Palindrome Brands employs drivers to collect and transport employees' children to and from school. Employees are not charged for these services, nor do we allocate any amount of their remuneration to these perks. All employees are shareholders of Palindrome Brands, which ensures a further alignment of interests.

2

Palindrome Brands supplies all the major clothing retail groups in South Africa and does not supply independent retailers. We treat our customers as partners in our business. If they make money from selling our clothing ranges, we will reap the benefits, too. Likewise, if our clothing does not sell in their stores, we all have a problem. We regularly meet with our customers to ensure consistency in retail pricing. It would be disastrous if retail prices of our branded clothing varied in the market. Ultimately this would erode our customers' margins and eventually place us under pressure to reduce our gross profits margins.


Potential acquisition opportunity: Zoosh Footwear (Pty) Ltd

The sole shareholder and CEO of Zoosh Footwear (Pty) Ltd ('Zoosh Footwear'), Mr Bob Toot, recently approached Ms Tenet regarding the potential acquisition of his business.

Zoosh Footwear is well established in the South African market, and imports and distributes branded footwear to major retail outlets. The company grew rapidly over the past five years and has struggled to fund this expansion. Zoosh Footwear mainly used a bank overdraft to fund this organic growth. Zoosh Footwear is currently experiencing cash flow difficulties which may be ascribed to various factors, including the slowdown in consumer spending. Mr Toot has proposed that Palindrome Brands acquires a controlling interest in the business of Zoosh Footwear and also provides funding support to enable the business to trade itself out of its current cash flow predicament.

Mr Toot has forwarded a formal written proposal to Palindrome Brands which included the following terms and conditions:

· Palindrome Brands is to acquire 75% of the issued shares of Zoosh Footwear for R15 543 900, payable in cash;
· Palindrome Brands is to advance a shareholder's loan of R7 500 000 to Zoosh Footwear. This will be repayable in five equal annual instalments commencing on 1 January 2011. The loan is to bear interest at the prime overdraft lending rate (currently 10,5%); and

· Palindrome Brands agrees to purchase Mr Toot's remaining 25% shareholding in Zoosh Footwear at fair value, to be determined by an independent investment bank, on 1 January 2016.

In his formal proposal Mr Toot stated that the financial results of Zoosh Footwear for the year ended 30 September 2009 were an aberration and not indicative of the sustainable earnings of the business. The suggested valuation of Zoosh Footwear was calculated as six times the audited profit for the year ended 30 September 2008. In Mr Toot's opinion, a price-earnings multiple of six is reasonable for a private company which has the stature that Zoosh Footwear does in South Africa.

3
Extracts from the audited financial statements of Zoosh Footwear are set out below:
ZOOSH FOOTWEAR (PTY) LTD
STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR ENDED 30 SEPTEMBER 2009
Notes 2009 2008
R R
Revenue 1 25 640 000 32 050 000
Cost of sales (19 230 000) (22 435 000)
Gross profit 6 410 000 9 615 000
Administrative and distribution expenses 2 (3 805 935) (4 006 250)
Other expenses 3 (415 000) 0
Finance costs 4 (945 000) (811 250)
Profit before tax 1 244 065 4 797 500
Income tax expense 5 (366 539) (1 343 300)
Profit for the year 877 526 3 454 200
Notes
1 Zoosh Footwear sells footwear imported from suppliers based in Europe and North America. The range of male and female footwear imported from Rosselini Inc. (Italy) has proved very popular and represents approximately 40% of the revenue generated by Zoosh Footwear.

2 The company managed to reduce overheads in the 2009 financial year by retrenching staff and cutting back on advertising expenditure.

3 Other expenses represent penalties and interest of R65 000 paid to the South African Revenue Service (SARS) in respect of late payment of value added tax (VAT) and a bad debt of R350 000. Zoosh Footwear was experiencing cash flow difficulties during 2009 and decided rather to incur penalties and interest than to pay over various VAT amounts when due.

The bad debt was incurred when an independent retail store to which Zoosh Footwear occasionally supplied was liquidated during the year. After this write-off, Zoosh Footwear took a policy decision only to supply larger retail customers.

4 Zoosh Footwear pays interest at a rate of 2% above the quoted prime overdraft lending rate.

5 The penalties and interest paid to SARS of R65 000 were not deductible for income tax purposes in the 2009 financial year. The only temporary differences relate to rental expenditure on premises (SARS permits a deduction of rental actually paid whereas the rental payable over the rental period is averaged for accounting purposes).

4
ZOOSH FOOTWEAR (PTY) LTD
STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 2009
Notes 2009 2008
R R
ASSETS
Non-current assets 981 617 899 508
Plant and equipment 6 905 000 850 000
Deferred tax 5 76 617 49 508
Current assets 10 097 945 11 327 260
Inventories 6 585 616 7 375 890
Trade and other receivables 3 512 329 3 951 370
Total assets 11 079 562 12 226 768
EQUITY AND LIABILITIES
Share capital 10 000 10 000
Retained earnings 5 639 500 4 761 974
Total equity 5 649 500 4 771 974
Current liabilities 5 430 062 7 454 794
Trade and other payables 7 1 328 700 1 051 986
Short-term borrowings 8 3 899 539 4 990 000
Current tax payable 201 823 1 412 808
Total equity and liabilities 11 079 562 12 226 768
Notes
6 The company acquired plant and equipment totalling R230 000 during the 2009 financial year. There were no disposals of plant and equipment during the year.

7 Included in trade and other payables was VAT due to SARS of R275 000 (2008: R130 000).
8 Short-term borrowings represent the bank overdraft Zoosh Footwear has with ABZ Bank. During 2009 ABZ Bank reduced the overdraft facility limit from R5 500 000 to R4 000 000 as the bank was concerned about Zoosh Footwear's cash flow difficulties and the company's lower profitability in 2009.

5
The initial response of the board of directors of Palindrome Brands to the Zoosh Footwear acquisition opportunity

The board of directors of Palindrome Brands met during October 2009 to consider the formal proposal of Mr Toot and to discuss the potential acquisition of Zoosh Footwear.

The following issues and matters were raised during the board meeting:
· Palindrome Brands had previously considered importing and distributing footwear, but had decided against this on numerous occasions. The reasoning was that distributing footwear required a significant investment in inventories. Research had indicated that an investment in footwear inventories would be higher than in their clothing ranges because -
o there is a wider range of footwear sizes compared to clothing sizes. For example, the men's range in a particular style would be from size 6 to 11 and ½ sizes would also have to be included; and
o retail customers will probably order lower volumes of footwear as these are slower moving items than apparel. Unfortunately, minimum order volumes from foreign suppliers would translate into a sizeable investment in footwear inventories.

· The directors were concerned about how Palindrome Brands would finance any acquisition. The company had cash resources of about R10 million at 30 September 2009 and had no interest-bearing borrowings. However, to fund a sizeable acquisition Palindrome Brands would need to obtain a medium-term loan from a commercial bank. The company has unencumbered property with a market value of R25 million which could be used as collateral. The Chief Financial Officer (CFO) of Palindrome Brands suggested that the company enter into a ten-year sale and leaseback arrangement with regard to the property to finance any acquisition. According to the CFO, Palindrome Brands would pay interest at the prime overdraft rate (currently 10,5%) on a five-year term loan from a bank whereas the effective yield on a property sale and leaseback transaction is currently 9%.

· The directors identified numerous synergies and cost saving opportunities which would flow from the acquisition of a footwear distribution business such as Zoosh Footwear, including the following:

o Many of the company's existing international suppliers have footwear ranges which could be introduced into the South African market;

o Palindrome Brands and Zoosh Footwear have many customers in common. Supplying footwear would increase Palindrome Brands's product basket with customers;

o Palindrome Brands's infrastructure (procurement, logistics, warehousing, finance and administrative functions) could cope with increased product volumes and hence, the company/group could unlock significant cost savings. The directors estimated that by acquiring the business of Zoosh Footwear and integrating this into the operations of Palindrome Brands, the current administrative and distribution expenses of Zoosh Footwear could be reduced by R2 million per annum. However, achieving these cost reductions would require once-off costs of R2 500 000 to terminate the property rental agreement and to pay retrenchment costs; and

o Palindrome Brands's average payment terms with international suppliers are 30 days from date of delivery. Zoosh Footwear is not able to negotiate such terms due to its smaller size and shorter track record. Zoosh Footwear generally pays a 50% deposit on order of goods and the balance on delivery. The directors of Palindrome Brands have estimated that if they controlled the 6 company, the 'normal' level of trade payables of Zoosh Footwear would be R2 300 000 (based on the 2009 financial year).

· The directors of Palindrome Brands are concerned about the possibility of a protracted decline or stagnation in consumer spending as a result of the current economic conditions.

· Ms Tenet stated that the Palindrome Brands shareholders should not be required to fund any acquisition opportunity. Her shareholding in Palindrome Brands is held through an offshore trust in which she is the major beneficiary and she would be averse to remitting any capital from offshore to finance a transaction of this nature.

In addition, Ms Tenet is concerned that the Reserve Bank and SARS may be informed of her interest in an offshore trust if this entity subscribes for more shares in Palindrome Brands. Ms Tenet was also adamant that the dividend policy of Palindrome Brands should remain unchanged, as the employees rely on this income stream.

High level overview of Palindrome Brands's financial position and trading performance
The financial position and recent trading performance of Palindrome Brands is
summarised below:
At 30 September 2009 2008
R'000 R'000
Cash and cash equivalents 10 050 12 650
Total assets 164 640 145 600
Total equity 150 200 126 400
Year ended 30 September 2009 2008
R'000 R'000
Revenue 273 200 235 500
Gross profit 88 825 82 425
Interest income 850 780
Profit for the year 36 800 32 970
Dividends declared and paid to shareholders 13 000 13 000

REQUIRED

(a) Calculate the ratios required to analyse the financial position and financial performance of Zoosh Footwear (Pty) Ltd for the 2008 and 2009 financial years.

(b) Identify, with reasons, any adjustments which may need to be made to the 2009 reported profits of Zoosh Footwear (Pty) Ltd in deriving its sustainable earnings.

(c) Identify and describe differences between the business practices and strategies adopted by Palindrome Brands (Pty) Ltd and Zoosh Footwear (Pty) Ltd.

(d) Identify and explain five key business risks currently faced by Zoosh Footwear (Pty) Ltd.

(e) Reconcile the earnings before interest and tax of Zoosh Footwear (Pty) Ltd to the net movement in its cash and cash equivalents for the year ended 30 September 2009.

(f) Identify and describe the potential advantages and disadvantages of Palindrome Brands (Pty) Ltd entering into a property sale and leaseback transaction as a method for financing the acquisition of Zoosh Footwear (Pty) Ltd.

(g) Prepare a report to the board of directors of Palindrome Brands (Pty) Ltd in which you advise them on the potential acquisition of Zoosh Footwear (Pty) Ltd. Your report should cover the following:

(i) The approach and methodology that Palindrome Brands should follow in valuing Zoosh Footwear (Pty) Ltd; and

(ii) A critical assessment of the transaction structuring proposed by Mr Toot, whether this is in the best interests of Palindrome Brands (Pty)
Ltd and whether there are any changes to the structure you would recommend.

(h) Calculate and determine the pro forma effect of the acquisition of Zoosh Footwear (Pty) Ltd on the profits and return on equity of the Palindrome Brands (Pty) Ltd group, assuming that -
· the acquisition is structured on the terms proposed by Mr Toot;
· the acquisition was made effective from 1 October 2008; and
· Palindrome Brands (Pty) Ltd raised a medium-term loan to partially fund the acquisition.
In your answer you should explicitly state any other assumptions that you made.

(i) Identify and outline any potentially unethical behaviour by and any contraventions of laws and regulations by Palindrome Brands (Pty) Ltd, Zoosh Footwear (Pty) Ltd and/or any of their shareholders and directors.

(j) Discuss the advantages and disadvantages of using a bank overdraft as a primary source of business funding.

Presentation: Arrangement and layout, clarity of explanation, logical argument and language usage.