Matson, Inc. Equity Analysis and valuation. Analysis Team. Taylor Meyers Dan Leonard Camron Cunningham Bodie Franklin

Transcription

1 Matson, Inc. Equity Analysis and valuation Analysis Team Taylor Meyers Dan Leonard Camron Cunningham Bodie Franklin

2 Table of Contents Executive Summary... 6 Analyst Recommendation: Sell (overvalued)... 6 As of May 5, Accounting Analysis... 7 Operating Leases... 8 Defined Benefits and Pension Plans... 8 Financial Analysis, Forecasting Financials, and Cost Estimations... 9 Valuation Summary Business and Industry Analysis Industry Overview Five Forces Model Rivalry among Existing Firms Industry Growth Concentration of Competition Degree of Differentiation Switching Costs Economies of Scale Fixed-Variable Costs Excess Capacity Exit Barriers Conclusion Threat of New Entrants Economies of Scale First Mover Advantage Access to channels of distribution and relationships Legal barriers Threat of Substitute Product Relative Price and Performance

3 Customers Willingness to Switch Bargaining power of Customers Switching costs Differentiation Importance of product for costs and quality Number of Buyers Volume per buyer Bargaining Power of Suppliers Number and Volume of Suppliers, Switching Costs, and Differentiation Importance of Product Costs Cost Leadership Economies of Scale and Scope Efficient Production Lower Input Costs Research and development Differentiation Superior product quality Customer service Flexible Delivery Competitive advantage analysis Differentiation of ships Ownership of Terminals Accounting Analysis Key Accounting Policies Operating Leases: Defined Benefits and Pension: Other Post-Retirement Benefits Assess Degree of Potential Account Flexibility Evaluate Actual Accounting strategy and Qualitative Analysis

4 Pension & Benefits Plan Undo Accounting Distortions Financial Analysis Liquidity Analysis Current Ratio Quick Asset Turnover Inventory Turnover Ratio Accounts Receivable Turnover Days Supply Inventory Days Supply Outstanding Cash-To-Cash Cycle Profitability Ratios Gross Profit Margin Net Profit Margin Asset Turnover Return on Assets Return on Equity Firm Growth Rate Ratios Internal Growth Rate (IGR) Sustainable Growth Rate (SGR) Capital Structure Ratios Debt to Equity Ratio Debt Service Margin Times Interest Earned Altman s Z-Score Forecasted Financial Statements Sales Forecasting Balance Sheet Income statement

5 Statement of cash flows Common sized Balance sheet Income statement Cost of Capital Estimation Size Premium Weighted Average Cost of Capital Price to Earnings Forecast Price to Book Ratio Price/Earning Trailing Ratios Price to Earnings Growth Ratios Price/EBITDA Enterprise Value/EBITDA Price to Free Cash flows (P/FCP) Dividends/Price Intrinsic Valuation models Residual Income Valuation Long Run Residual Income Valuation Abnormal Earnings Growth Valuation Discounted Dividends Discounted Free Cash Flows Valuation Discounted Free Cash flows sensitivity analysis Analyst Recommendation Appendix: Financial Analysis Appendix: Regressions Appendix: Financial statements Sources Cited

6 Executive Summary Analyst Recommendation: Sell (overvalued) As of May 5, 2014 Industry Analysis Matson Inc. (MATX) operates between covered US ports, with some service to China from California. While the shipping industry is generally fragmented and price competitive, Matson is given a degree of protection through the Jones Act. Matson owns the largest fleet of any company operating in the Hawaii-California Jones Act market with 17 ships. Matson s main competitor, Horizon lines, owns 14 ships. Matson is able to differentiate itself from the competition through its larger fleet, its ownership of a Hawaiian shipping terminal, and the top speed of their ships (22 knots versus 21 for Horizon). These competitive advantages allow Matson to thrive despite their higher rates. Competitive forces Rivalry among Existing Firms Threat of Substitute Products Threat of New Entrants Bargaining Power of Buyers Bargaining Power of Suppliers Degree of Competition High Moderate Low Moderate High Given the high cost of new ships, the threat of new entrants is low. The threat of substitute products is moderate to low in the Jones Act market because Matson s most direct competitor, Horizon Lines, cannot afford to buy new ships. 6

7 Additionally, Matson owns roll on/roll off cargo ships. While these ships are more expensive they also allow Matson to transport wheeled cargo such as cars. This adds another dimension to their business. The rivalry among existing firms is high due to the low number of companies in the Jones Act shipping industry and their relatively large market share. While buyers do have choices in some cases, in order to ship wheeled cargo to Hawaii or Guam going to Matson is nearly a requirement. This is because of Matson s fairly advanced fleet in comparison to its competition. The only area that Matson is at a disadvantage is their bargaining power relative to their supplier. The amount of shipbuilders who specialize in cargo ships specifically roll on/roll off is few and far in between. In this way, Matson is dependent on their suppliers and has little leverage in potential price negotiations. Accounting Analysis Accounting analysis is extremely important and many times overlooked when performing equity valuations. Accounting analysis can drastically change the market price of the firm if the incorrect accounting policies are implemented instead of the ones that demonstrate the company s actual value. When choosing an accounting strategy for a firm, the keys success factors of that firm are what drive value so these are the factors that the accounting strategy needs to most harp on. The key success factors for the shipping industry are, Relating to cost leadership, economies of scale and scope, efficient production, and lower input costs. When regarding differentiation, superior product quality, customer service, and flexible delivery are also key success factors. Key success factors are prime targets for accounting distortion. Potential items of distortion, for Matson, are operating leases and defined benefit plans. 7

8 Operating Leases Matson s long term operating lease obligations are $68.6m compared to $302.7m in long term debt, a 22.77% ratio. This ratio is smaller than its direct competitor Horizon Lines with a ratio of 40%. This simply means that Matson owns more of its long term assets than Horizon. Despite this fact though, since the ratio is over 20% it needs to be restated. The restated numbers are found later in the analysis. Defined Benefits and Pension Plans These accounts are shown on the balance sheet at present value and can skew information because these plans are primarily created by the employees of the firm so there is a relatively high chance of human error. Matson and its main competitor, Horizon lines, both properly disclose pensions under FASB ASC topic 820. FASB ASC Topic 820 establishes a fair value hierarchy which requires the pension plans to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value (Fasb.org). MATX Discount Rate 4.2% 4.9% 5.8% Above are the discount rates Matson uses for their pension plans. They have slowly been increasing over the last couple of years because of the financial crisis in 2008 hit them hard. Asset Category Target 2012 Domestic Equity Securities 53% 56% International Equity Securities 15% 14% Debt Securities 22% 19% Real Estate 10% 5% 8

9 Other and Cash 0% 6% Total 100% 100% Since Matson has disclosed everything, it is actually possible to see the asset allocation of the pension plans and weights in each. The expected return of these funds was 8.3% the last 3 years in a row. Net pension liability as of 2012 is $60.9 million compared to long-term liabilities of $302.7m, accounting for 20.12%. While this figure is a significant portion of Matson s long-term liability, the growth of fund assets currently outpaces the growth in liabilities. Overall, their pension disclosure and methodology is appropriate. Financial Analysis, Forecasting Financials, and Cost Estimations In order to do a financial analysis of a company, the financial ratios must be calculated. The ratios that are calculated are ratios that measure a firm s liquidity, profitability and the capital structure of a firm. These ratios are necessary because they are use in comparison to the industry. The results of Matson s ratios suggest that they are a average firm in the shipping industry. Despite being overall average, Matson has the highest Operating profit margin. Matson is able to do this because they have a larger ship fleet that frequently services larger routes. But overall, they are average in the ROE, ROA, GPM. Lastly, they have the lowest Asset turnover ratio in the shipping industry. The significance of this is that they aren t generating enough sales per asset they own. The cost of capital estimation is a measure of the opportunity cost of an investment. Cost of capital is determined by the weight average cost of debt and equity (WACC). In essence, WACC is the average between the interest rate of 9

10 debt and the required rate of return that stockholders expected in return for purchasing stock. We were able to calculate the WACC by using the equation WACC= E/V X Re + D/V x Rd. This formula explained is the weight of equity against debt plus equity, times the cost of equity. Add this to the weight of debt against debt plus equity and multiply that by the cost of debt. In Matson s case, the weighted average cost of capital is 4.20%. The significance of this rate is that if a project doesn t have an expected return of 4.20% or above, they shouldn t undertake that project. In order to value the company, we had to forecast out the financial statements because the forecast values drive the models of intrinsic valuation. We were able to forecast out the balance sheets by deriving the forecasted growth rates of the firm. To forecast out the growth rates, we had to find a correlation between USA GDP growth and Matson s revenue. Once the correlation was found, we forecasted out sales revenue through a forecasting equation. We believe this to be a reliable method of forecasting because the correlation between USA GDP growth and Matson s revenue was 42%. Valuation Summary To properly value a company we must retrieve information about the company and their competitors in the industry. Oceanic shipping industry has factors to consider first we found the main competitors in the industry, which are Hub Group and Horizon Lines. With knowledge of the competitors we then performed an analysis of the Five Forces Model, which gave us an inside look at the oceanic shipping industry and how Matson compares against their competition. We forecasted out Matson financials ten years found in Matson s 10k, and ran ratio analyses. Lastly, we did intrinsic value models. Intrinsic models offer a more accurate valuation because the models operate under theory-based assumptions. Intrinsic models rely on accurate 10

11 financial forecasting because financial forecasting is critical component of each model. The significance of the sensitivity analyses on each model is that they round out the errors and create a more accurate prices ranges. Based on the outputs of the model in comparison to the observed share price of $23.80 on May , we believe that Matson is an overvalued company. 11

12 Business and Industry Analysis Company Overview Matson Inc. (MATX), founded in 1882, is the U.S. leading freight carrier in the Pacific (MATX 10-K). Matson is the primary carrier of dry containers of mixed commodities between Hawaii and the U.S. West Coast. These commodities include refrigerated and packaged food, building materials, automobiles, and household goods. Matson operates a fleet of 17 ships. Out of these ships, ten are container ships, three are combination container roll on/roll of ships, one roll-on/roll-off barge, two container barges equipped with cranes, and one container barge with cranes that is available for charter. Matson is one of the few companies to provide regular service to the islands of Hawaii, Micronesia, and Guam. Matson also operates a premium expedited service from China to Southern California (MATX 10-K). Matson also provides logistics services through the fully owned subsidiary Matson Logistics Inc. Matson logistics is headquartered in Concord, CA and has seven regional operating centers. The logistics services offered are: rail, highway, warehousing, and distribution services. Matson logistics also provides freight forwarding, consolidation, customs brokerage, purchase order management, and non-vessel operating common carrier services (MATX 10-K). The main competitor of Matson Logistics is C.H. Robinson Worldwide. In addition to shipping and logistics, Matson operates a terminal service through Matson Terminals, Inc., which is a wholly-owned subsidiary of Matson Navigation Company Inc. (MATX 10-K). They provide stevedoring, container equipment maintenance, and other terminal services at their 105 acre terminal in Honolulu (MATX 10-K). Matson operates seven cranes at the terminal and their lease with the State of Hawaii runs through

13 The headquarters of Matson Inc. is located in Honolulu, HI. Matson has 1,068 employees, 23% of which are union. In 2013, Matson acquired the primary assets (MATX 10-K) of ReefShipping Company in order to expand services to NZ, Fiji, and other South Pacific islands. This shows that Matson desires expansion and also seeks to continue its model of service to smaller islands. The Jones act allows Matson to operate with few competitors between U.S. ports. Their main competitors for U.S. routes are Horizon Lines Inc. and Hubgroup Inc. Matson relies on a strategy of specialized routes between US ports, China, and South Pacific Islands. Their emphasis on Pacific routes allows them to remain competitive. Industry Overview The shipping industry is fragmented and price competitive. Different shipping markets, however, have different levels of competition and additional legal or political factors that affect competition. Regarding American shipping companies, the most important piece of legislation is the Jones Act. The Marine Merchant Act of 1920 (the Jones Act) is requires that all goods transported by water between U.S. ports be carried on U.S.-flag ships, constructed in the United States, owned by U.S. citizens, and crewed by U.S. citizens and U.S. permanent residents. (law.cornell.edu). The Jones Act is a significant barrier to entry if a company desires to run routes between US covered ports. For many companies, the significant capital investment required to operate under the Jones Act is not worth the return. The lack of carriers with Jones Act qualified vessels leads companies that do have qualified vessels to differentiate their fleet. Instead of investing purely in container ships, Jones Act companies also purchase roll on/roll of ships to maximize the types of cargo that they can carry economies of scope while 13

14 carrying the most cargo possible economies of scale. Roll on/roll of (RORO) ships, as opposed to the typical container ship, allow for the transport of large wheeled cargo. This can range from cars to heavy construction equipment. RORO vessels are specialized and as a result are costly to acquire. Matson, Horizon, and Pasha Hawaii (privately traded) are the only major companies to service Hawaii with RORO ships. Horizon and Matson currently operate the largest Jones Act qualified fleets, owning 14 and 17 ships respectively. The differentiation of vessels is where firms find their competitive advantage, relative to each other. While global shipping is an (almost) purely price competitive business, the Jones Act has resulted in firms differentiating their product in order to gain an additional competitive advantage. Five Forces Model A company cannot be adequately valued without fully understanding the industry it operates in. The Five Forces Model is a tool that we use to understand the industry. The model will enable us to evaluate the industry structure and level of competition. The significant of the Five Forces model is that it allows us to analyze how profits value is generated in a given industry. Different industries are able to sustain different levels of profitability, depending on the level of competition. The first 3 forces in the model--rivalry among existing firms, the threat of new entrants, and the threat of substitute product analyze the degree of actual and potential competition within an industry. The other two forces in the model describe the bargaining power customers and supplier has over a firm. These are important because they describe the amount of control the company has over their inputs and outputs. If the forces are intense.almost no company earns 14

15 attractive returns on investment. (Michael Porter). The level of competition, and what drives it, tells the analyst whether or not an industry in profitable and worth of investment. Competitive forces Rivalry among Existing Firms Threat of Substitute Products Threat of New Entrants Bargaining Power of Buyers Bargaining Power of Suppliers Degree of Competition High Moderate Low Moderate High Rivalry among Existing Firms Rivalry among existing firms is defined as the competition that goes on between firms as they try to increase their market share (extension.org). In most industries, the average level of profitability is primarily influenced by the nature of the rivalry among existing firms in the industry (Healy and Palepu). A highly competitive industry with an intense rivalry among firms will lead to a high degree of price competition. An industry with a low level of rivalry among firms will seek to differentiate their products in order to gain a competitive edge. The components of the rivalry among existing firms are industry growth, concentration of firms, differentiation, switching costs, economies of scale, fixed to variable cost ratio, level of capacity, and exit barriers. These factors give an overall look at the level of competition in the industry. 15

16 Industry Growth The rate of growth in an industry is dependent upon several factors, such as demand, the state of the economy, and new entrants into the industry. Industry growth or decline can give an idea of the overall demand for an industry. Fast growing industries are typically in demand and growth does tend to mute rivalry, because an expanding pie offers opportunities for all competitors (Michael Porter). Typically in an industry that is on the decline, firms tend to compete more for market share. It is important to know whether an industry is growing or declining in order to formulate an appropriate business strategy. The best way to gauge growth is to look at an industry s sales. The graph below clearly depicts how the industry has grown post-recession. From , industry sales dropped close to 17%. Some of the main items this industry ships across the world are commodity goods. In recessions, the demand for these types of goods falls dramatically thus the dip in industry sales volume in Once the economy started to recover, the industry s sales volume began to increase as well. Current growth trends indicate companies will compete to gain additional market share, leading to the possibility of price competition. 16

17 Sales volume (Billions), Total assets (Billions), and Growth for past 5 years Year Sales Volume Growth/Decline % 17.02% 4.24% -9.30% Total Assets Growth/Decline % 5.04% 1.60% % Sales Volume Growth/Decline % 0.00% % 3.88% Total Assets Growth/Decline % -8.10% % -6.03% Sales Volume Growth/Decline % 21.19% 50.27% 13.45% Total Assets Growth/Decline % 9.78% 33.88% 9.16% Sales Volume Growth/Decline 34.78% % -9.41% -7.26% Total Assets Growth/Decline 14.41% 9.56% 22.32% -4.19% INDUSTRY Sales Volume Growth/Decline % 10.54% 16.89% 4.01% Total Assets Growth/Decline % 3.58% 5.13% %

18 All numbers referenced from Industry Sales Volume Sales Volume (Billions) Year The figure below depicts a job creation index in the United States following the financial crisis of When the job creation index is compared to the industry sales volume, one can easily conclude that the two are positively correlated. The shipping 18

19 industry thrives when the economy is in a boom and suffers when it s in a recession % 15.00% 10.00% 5.00% Industry Sales Growth/Decline Growth 0.00% -5.00% % % % Year Company Number of Ocean Vessels Matson 24 Horizon 24 Hub Group 0 Int. Shipholding 51 19

20 Concentration of Competition The concentration of competition in an industry is determined by the number of firms and their relative sizes (Healy and Palepu). This is important to the investor because the concentration of competition can tell the potential investor whether or not there will be a high level of price competition or cooperation among firms. If there is a high concentration of firms then there is likely a high level of price competition. In an industry with one dominant firm, it is the dominant firm that sets prices and leads the industry. An industry with several large firms can avoid destructive price competition and instead cooperate with each other (Healy and Palepu). Market Share International Shipholding Corporation Hub Group Inc. Horizon Lines Matson 4% 26% 18% 52% According to the graph above, Hub Group Inc. has more than half of the market share for the industry with Matson a far second with about a quarter of the market. This shows the shipping industry being a highly concentrated industry with a few large corporations. According to the Herfindahl-Hirschman Index, a measure of industry concentration on a scale of 1-10,000, the shipping industry rates at Anything 20

21 over 2500 is considered highly concentrated. The small number of firms and the presence of an industry leader results in a high level of price competition. Degree of Differentiation According to Business Analysis and Valuations by Healey and Palepu, the extent to which firms in an industry can avoid head-on competition depends on the extent to which they can differentiate their products and services. This is particularly important because firms that have similar products tend to compete on price. An industry with a high degree of differentiation will see firms competing on innovation. In the maritime shipping industry, firms can differentiate themselves through the goods they will carry, the type of specialized containers that are aboard their ships, and the ports they will service. Matson is one of two companies to with a fleet comprised of Jones Act qualified vessels, the other being Horizon lines. Both companies offer refrigerated and nonrefrigerated shipping, household goods, auto parts, and building materials (MATX 10- K/Horizon 10-K). Due to the similarity in the products offered and the ports that they service, Horizon and Matson compete on price. International Shipholding Inc. is more capable of operating routes to China and the US West Coast because of their large number of vessels and the larger size of those vessels. As such, they can offer lower prices on international shipping. However, they do not have Jones Act qualified container vessels. Their product is somewhat differentiated and they pose a low threat to Matson s Hawaii business. The logistics side of the shipping industry is also highly fragmented with similar products, leading to a high level of price competition. Overall, he shipping industry has a high level of price competition. 21

22 Switching Costs Switching Costs are the costs incurred by a firm if it decides to use its assets for other revenue producing opportunities. High switching costs means it is cost-prohibitive for a firm to switch the use of its production assets because its assets are used for a specific purpose. Low switching costs indicate it is easy for a firm to use its assets in a different industry. This is important because in the event an industry is no longer attractive, a company needs to look at all possible options. The shipping industry, and in particular the container shipping industry, is highly specialized. The boats are made to order and it is extremely expensive to convert a container ship to anything other than its intended use. Due to the high degree of switching costs, it s easy to conclude most firms in the shipping industry are committed only to shipping. Economies of Scale If there is a steep learning curve or there are other types of scale economies in an industry, size becomes an important factor for firms in the industry. (Healy and Palepu). In the container shipping industry, economies of scale refers to container capacity and the size of the fleet. It is imperative that a shipping company fills as many containers as possible in order for the voyage to bring an acceptable return. The learning curve is steep because ships are made to order, high-cost assets. The Jones Act in particular makes it cost prohibitive because of the stringent regulations enforced on Jones Act qualified vessels. The sheer amount of cost indicates a steep learning curve. In such situations, there are incentives to engage in aggressive competition for market share. (Healy and Palepu). An aggressive competition for market share leads to price competition, which is a common theme in the shipping industry. Total Assets (Millions) 22

23 Company Matson Horiozon Lines Hub Goup Inc Int. Shipholding Corp Total Fixed-Variable Costs According to Healy and Palepu, if the ratio of fixed to variable costs is high, firms have an incentive to reduce prices to utilize installed capacity. The shipping industry has high fixed costs, with the vast majority relating to buying vessels. The variable costs, most notably fuel and maintenance, are relatively insignificant compared with the massive costs of acquiring containers and ships. The variable costs also fluctuate wildly since they are so closely tied to fuel costs. In an industry with a high fixed to variable cost ratio, price competition is common (Healy and Palepu). Excess Capacity Excess capacity is the capacity an industry has above demand. In such a situation, firms will seek to cut prices in order to fill their capacity (Healy and Palepu).. Excess capacity is important because a reduction in prices can be problematic to a firm engaged in price competition while operating at the margins typically seen in the shipping industry. Currently, there is a global surplus of container vessel capacity in the shipping industry (MATX 10-K). The significant that surplus has on the overall shipping industry is that makes it difficult to be competitive in this service. Firms in the container shipping industry alleviate these costs through the practice of slow steaming. Slow steaming is when a ship filled with commodities is told by the customer to slow down or stop completely before they reach port until prices rise to an acceptable level. Excess capacity in the shipping industry is directly tied to the demand 23

24 for commodities and household goods. The global recession, and thus a large supply of excess capacity, has led to price competition in the shipping industry. Exit Barriers Exit barriers are the obstacles a firm faces when evaluating whether or not to leave an industry. When an industry requires highly specialized assets, exiting is costly and thus exit barriers are high (Healy and Palepu). The shipping industry requires specialized assets to operate. Ships are made to order and the only market for container ships are other container shipping companies. Container ships sell for a fraction of their new price, making a potential exit costly. Conclusion The rivalry among existing firms is a key indicator of the degree of competition in a particular industry. The aspects of this are industry growth, concentration, differentiation, switching costs, economies of scale, fixed to variable costs, excess capacity, and exit barriers. After reviewing these factors, it is clear the shipping industry is highly concentrated, has a low degree of differentiation, high switching costs, high fixed to variable costs, excess capacity (in a difficult economy), and high exit barriers. This combination of actual competition leads to the conclusion that the shipping industry has a high degree of competition among firms. Threat of New Entrants The shipping industry of the pacific is a very limited market with few competitors that is protected by American legislation (Jones Act). The industry is very appealing from a pure revenue standpoint, the top three companies bringing in over one billion dollars in revenue. Company MATX HRZL HUB 24

25 Revenue (2012) 1.62B 1.04B 3.29B Despite the appeal of the revenue, it would take a large amount of financing to enter the industry for many reasons. Economies of Scale A company entering the industry today would not be able to afford to purchase brand new ships. The price of a new ship varies and requires a significant amount of time to build. If a company was able to purchase a brand new ship, the time required to build it would be so significant by the time the ship was constructed; Industry leaders operations would be larger and more efficient that this new company would not be able to compete. The only viable option that a company entering the industry would have would be to purchase a used ship from a company already present in the industry. The problem that this would present to the new company is that they would be purchasing an old used up ship and giving an significant amount of capital to the seller. The seller could then use this new capital to finance the construction of a new ship. The seller would be able to bear the period of time that construction requires because they would already have a fleet of ships that are frequently carrying cargo. In addition to financing a fleet of ships, a new company would have to finance a crew to pilot the ships. On average it takes about 15 people to crew a cargo ship. Depending on how large of a fleet a new company would be able to produce, they would need to offer more than the industry average of $73,760 for a captain and the crewman averages $48,000 (bureau of labor). They would have to offer more than the average to lure them away from established companies because the labor force in this industry is scarce. In addition to competitive pay, this new company would have to offer more attractive benefits such as health insurance, dental insurance and retirement options. These addition benefits would require financing that would most likely by out of reach. 25

26 First Mover Advantage Any company that entered first into this unique shipping industry has many first mover advantages. The first advantage a company in the industry would have is that is it is an American company that is permitted by the Jones act to ship through the strict USA pacific routes. The second advantage that the top three companies of this industry share is that they are already doing business in an industry that has huge entering barriers. If new companies emerged into the industry, customers would most likely be unlikely to switch because the new companies would have to charge higher shipping rates to compensate the high start up cost. There are only two scenarios where customers would most likely switch to different companies other than the top three. If the Jones act were repealed then foreign shippers would undercut a significant amount of industry business. The second scenario would be if a foreign company was able to restructure their ownerships into American owned and the firm operated with American made ships. This newly formed American company would be able to compete for business and possibly undercut the top three. Access to channels of distribution and relationships If a new company decided to enter the industry, a barrier they would face would be the channels of distribution. Companies already established in the pacific shipping industry would have established strong relationships with customers through contracts and brand loyalty. A contract would not allow large commercial customers to switch to a new shipping company. In this instance, a new company would have to generate their sales from customers shipping personal items or small amount of cargo. Since the large majority of this industry is commercial, a new company would not be able to generate a significant amount of business. Legal barriers There are many legal barriers in this industry that prevent companies from entering. The most significant legal barrier that is present is the Jones Act of The 26

27 act prohibits ships that are not American-flagged ships to commence commerce in U.S ports and U.S waters. This legal barrier prevents foreign companies from entering the industry. In order for a foreign company to enter this industry, they would have to restructure the ownership of their company into American ownership. Secondly they would have to obtain American crafted ships that are crewed by strictly Americans. In essence a foreign company faces too many financing barriers from the Jones act to attempt. Lastly any company entering the industry will have to make sure their ships meet industry regulations that are enforced by the U.S government. For a new company to modify ships up to code could be very costly and thus making it very unlikely that a new company would enter the industry. Threat of Substitute Product A substitute product is a product another firm can get in the industry that offers the same benefit as they are currently receiving from their firm. A substitute product can affect competition within any industry. It is vital to analyze other companies to see if they are able to pose a threat by having a substitute product, or in the industry s case, a company being a substitute option. In the transportation industry buyers can choose from overseas, intermodal, highway, and airway services. Matson has to observe their shipping prices and alternative means of transportation compared to other companies, and also consider a rival s relative price and performance, as well as, the buyer s willingness to change. Relative Price and Performance When two different products perform the same function for the same price, it makes the customers focus more on the price then the product itself (OSG Analysis). To keep customers, companies must charge the right prices being that they provide the same function as their competitors. For the years 2010, 2011, and 2012 Matson, on average had a price per container of $479, $502, and $534 respectively. Whereas Horizon Lines for 2010, 2011, and 2012 charged $410, $437, and $457. As of January 27

28 4 th, 2014 the company increased their rates by $175 for freight westbound and $85 eastbound. With those prices, there has to be a factor setting them apart. Matson has to be outperforming the competition and showing they are better. The performance of a company can alter customer s perception. Although the rates are high, Matson continues to provide and satisfy their customers. Their performance allows them to charge a higher rate than their competition and keep buyer s business even as the prices increase. Customers Willingness to Switch The ocean transportation industry can be difficult to show differentiation. Customers will be drawn to lower prices and additional value in a company s service. In this industry customer s switching costs are low. A buyer can easily stop using any firm in the industry and switch to another firm that is offering lower prices. Despite low switching cost, the possibility of the customers willingness to switch is low. Customers are likely to view slightly lower prices as not much incentive to switch because of the inconvenience of switching. In order to combat the inconvenience, a firm must create additional value in their services that isn t being offered in the industry. Conclusion A company has to exhibit that they have the desirable service for buyers. Matson shows clearly how price is not a factor when a company does the job well and keeps the buyer coming back. It is evident that customer loyalty and performance drives this industry. The ease of being able to switch to a substitute product is a threat for companies, but if there is differentiation from the competition, prices will not matter and the customers will return. 28

29 Bargaining power of Customers Switching costs In the shipping industry of the pacific, customers need reliable shipping transportation. Since there are few firms in this industry, customers do not have many firms that they can switch to. Despite the limited choices in firms, the switching costs are low in this industry. For instances the switching cost of a non-contract customer would be zero. The cost for a customer that is under contract would be low because the cancellation fees structured into the contract are low and generally the contract are a year or less. Differentiation In industries with little price variation, companies set themselves apart through differentiation of their services. Differentiation appeals to customers because differentiation is a specialization that adds value to the service being offered to the customer. For instances companies could differentiate themselves from other companies by having a younger and more efficient fleet, roll on/roll off shipping and larger cargo capacity. As long as a company can add value to their service through differentiation, they will be able to attract more customers. Importance of product for costs and quality The price for shipping in this industry is very significant because there isn t much price variety and company variety. If a company began to charge higher shipping rates without offering any form of differentiation than that business will lose customers. Customers will began to switch to companies that charge lower rates because there isn t addition value being for offered for a higher price. Customers shipping low volumes may not switch to a lower costing company because of lack of familiarity. For instances customers measure quality in the speed of the shipping, the reliability of the shipping company and the services that the firm offers. A service that customers look for is the 29

30 option of roll on/ roll off cargo. Customers look for this service because it speeds up shipping and it reduces damage to their cargo. Number of Buyers The customer make up of pacific shipping industry from Hawaii to the west coast is very homogenous. The majority of the cargo being shipped is commercial items by large companies. A small percentage of the customer make up is individuals shipping personal belongs and small business shipping orders to Hawaii and the west coast. The numbers of buyers in this industry are very large. Despite the large presence, buyers don t control the barging power of the industry since ocean transport is the most efficient way to transport large volumes of cargo from Hawaii to the West coast. Volume per buyer Each customer s needs in any industry are unique; the amount of volume that a customer needs to ship will depend on their individual/companies needs. If rates were to rise, customers would begin to ship less. In addition since this industry provides high frequent routes between the west coast and Hawaii, the frequency of the routes would be reduce significantly. The industry would adapt to decrease in frequency by servicing their lower cargo capacity ships to accommodate their customers shipping needs. Bargaining Power of Suppliers Suppliers can hold a power over a company it is in business with. The way a company s profit goes will affect how the suppliers profit goes. If a company has an economic boom the suppliers will want that increase to reflect in their margins also. We will need to understand who provides the inputs in which value is added to a company (OSG Project). Ocean shipping transportation has limited suppliers in the industry. Companies are supplied with ships from shipbuilders and fuel. Matson s last ship was built in 2006, so there is no burden to worry about building costs. The most significant supplier with 30

31 this company is the fuel supplier because they are responsible for a large portion of incurred costs. Fuel-related surcharges move direct with fuel costs affecting the company s profit. Number and Volume of Suppliers, Switching Costs, and Differentiation The amount of fuel suppliers in an industry plays a role in available substitutes for a company to use. If there are many options it can be easy to switch, whereas if there are a limited number of suppliers, companies are restrained. The Ocean Transportation industry has about 68 fuel suppliers. With so many fuel companies it can be easy to switch if a contract or relationship becomes faulty. Companies might charge higher prices than others causing them to switch or they might not have enough fuel to supply the industry. They could also offer incentive contracts building customer loyalty. Switching costs are low in this industry just due to presence of substitutes. It can also be a challenge for fuel companies to differentiate themselves amongst each other. Trying to show differences in fuel is quite the challenge, so they must have the correct amount of fuel available to supply buyers and charge the best prices to attract them. Importance of Product Costs Competition with fuel companies will happen make bargaining power go away, but if there are no substitutes, the bargaining power is immense. If a supplier makes a decision to charge higher prices for fuel, it can be difficult to switch to another fuel supplier depending on the amount of available companies that supply fuel. More money given towards fuel costs means either less revenue made or raising fuel-related surcharges to recover from increases on fuel prices. Rising fuel-related costs caused Matson to raise its fuel-related surcharge from 40.5 percent to 45.5 percent in its Hawaii service effective February 26, Because of increasing container volume related to the recent exit of a key competitor, Matson did not increase its fuel-related surcharge for its Guam Service at that time, keeping it at 42.0 percent. Declines in fuel costs caused Matson to reduce its fuel-related 31

32 surcharge to 42.0 percent in its Hawaii service and 38.5 percent in its Guam service, effective June 17, Declines in fuel costs continued, and Matson further reduced its fuel-related surcharge to 39.0 percent in its Hawaii service and to 35.5 percent in its Guam service, effective July 15, After that, fuel prices and fuel-related costs began rising substantially, and Matson raised its fuel-related surcharge to 43.5 percent in its Hawaii service and 40.0 percent in its Guam service, effective October 7, 2012 (Matson 10-k). Again, fuel surcharges move relative to fuel prices. If a fuel company raises fuel prices it is practically unavoidable to not raise a cost to offset that fuel-price increase. The industry is dependent on fuel. For instances, fuel is Matson s largest expense. In 2012, Matson used approximately 1.9 million barrels of residual fuel oil for its vessels, compared with 2.5 million barrels in 2011 (Matson 10-k). The average price for fuel that each firm is paying is $109 (Matson 10-K). With a fuel company being a key supplier, they have a lot of bargaining power within this industry making price a key factor to observe. Conclusion Bargaining power of the supplier is important because it controls an industry to a certain extent. In the shipping industry, the power of fuel-prices gives the suppliers an advantage. Fuel is an important expense for ocean transportation. Companies do not know what the prices will be and if the supply of fuel will be there when it is needed. Increases in fuel prices will affect a companies competitive conditions because fuel-cost move relative to fuel-price. This could also require other expenses to go up for compensation. In this industry the bargain power of the supplier is high, for they can manipulate how a company s profit goes. Cost Leadership There are two ways to create a competitive advantage: differentiation and cost leadership. Cost leadership enables a firm to supply the same product or service 32

33 offered by its competitors at a lower cost (Healy and Palepu). Differentiation involves providing a product or service that is distinct in some important respect valued by the customer (Healy and Palepu). The competitive advantage of a firm is how a firm creates value. Knowing how a firm creates their competitive advantage is vital to making an informed investment decision. In the shipping industry, firms deliver a similar product and typically compete on a cost-leadership basis. The firms with lower costs have a clear competitive advantage. Cost leadership in container shipping entails out performing competitors through economies of scale and scope, efficient production, lower input costs, and little research and development. Economies of Scale and Scope Economies of scale and Scope are two important concepts relating to the shipping industry. An economy of scale is the cost advantage that arises with increased output of a product (investopedia). Economies of scope is an economic theory stating that the average total cost of production decreases as a result of increasing the number of different goods produced (investopedia). The efficient utilization of assets and the diversification of those assets is an important to the shipping industry. How a company utilizes its space, and the different types of vessels it has, dictates the type of customers it can draw. The high fixed-costs in shipping are offset by carrying large amounts of cargo. The more cargo a ship can carry, the lower its per-unit fixed costs. Firms in the container shipping industry compete on cargo space and the different types of cargo they can carry. The typical container ship servicing the Jones Act market has around 2,300 TEUs (twenty-foot equivalent unit) of space (Horizon and MATX 10-K). These ships require a substantial investment, making the utilization of container space vital. Firms in container shipping can compete on economies of scope through diversification of their ships. The Jones Act shipping markets is serviced by containerships and RORO (roll on/roll off) container ships. A RORO ship is different from a normal containership in two ways: it can ship wheeled cargo like cars, trucks, boats, 33

34 buses, motorhomes and other high & heavy equipment and it is considered the simplest and cheapest method of shipping vehicles (universalcargo.com). Manufacturers of large equipment prefer RORO ships because they are more cost less and are more efficient for shipping large wheeled-cargo (universalcargo.com). Even an in industry with similar services, shipping companies can differentiate in order to compete on price. Efficient Production Firms that compete on price can do so, in part, because they efficiently use their assets. Efficient production entails using your assets to produce as many goods and services as possible. This is important to the potential investor because a firm that produces efficiently is obtaining the most value out of their productive assets. In the shipping industry, companies compete on efficient production through how they use cargo space. Companies that can fill their space with the most valuable product tend to outpace their rivals in the shipping industry. Goods range from commodities, such as refrigerated and non-refrigerated goods, to automobiles and construction materials. Firms that operate with the right amount of cargo room not too little or too much are performing the best in today s economy. In , the global container vessel fleet expanded disproportionately to trade value growth by as much as 144% (atkearney.com). What does this mean? Simply put, there is too much available cargo space for current demand. Firms that efficiently utilize container space with the most valuable product are the firms that post the best results. Lower Input Costs Input costs are defined as the overhead costs, such as labor and material, in the production of goods and services (accountingdictionary.org). Lower input costs allow a firm to make a profit more easily than a competitor with high input costs. The largest input costs for container shipping firms, by a wide margin, are their vessels. Firms that purchase larger vessels receive the best per-unit return on their investment. In fact, 34

35 slot costs (the cost per slot of container space) decrease by as much as 50% from a 2,500 TEU vessel to a 10,000 TEU vessel. (atkearney.com). The acquisition of larger vessels allows a firm to reduce their per-unit input costs and thus turn a profit in a shorter amount of time. Research and development Research and development (R&D) is one of the mean by which business can experience future growth by developing new products or processes to improve and expand their operations. (investopedia). Container shipping companies do not typically have an R&D department because they do not produce a product. Because shipping companies provide a service, they do not typically expend resources on R&D. The users of R&D in the shipping industry are the shipbuilding companies themselves due to the massive sunk costs associated with building ships. Refining their process to lower cost is desirable in shipbuilding. However, container-shipping companies do not build their own ships, so the burden of R&D is on shipbuilders. Conclusion In the shipping industry, firms compete on cost in order to deliver a lower price to customers. Cost leadership refers to the competitive advantage a firm can achieve by having the lowest costs in a particular industry. Firms in the shipping industry lower costs through economies of scale and scope, efficient production, lower input costs, and little research and development. A company with lower costs is able to establish a competitive advantage, as it takes less time to turn a profit when costs are lower. Firms that successfully utilize these strategies have the lowest costs, and thus the best results in the container shipping industry. Differentiation Differentiation, as explained earlier, is when firms compete by having a product or service that differs from their competitors. Unlike firms that use cost leadership 35

36 strategy who focus on lowering expense to compete more effectively on price, firms that create a competitive advantage using differentiation focus on having a superior innovative product. Firms in the shipping industry tend to use more cost leadership strategy than differentiation. The shipping industry uses more of the cost leadership strategy because of the simplicity of the service. That said though, there are items that firms in the shipping industry can focus on to differentiate themselves from competitors such as superior product quality, customer service, and more flexible delivery. Superior product quality Superior product quality in the shipping industry relates to the new innovative vessel designs. Some of the firms have the ability to transport items that need to be chilled because they have the ability to use refrigerated containers. This is a huge factor companies will look at when deciding on what shipping company they want to choose. Roll on roll off (RO-RO) cargo vessel is another factor that can set these companies apart. A RO-RO is a ship specifically designed to allow cargo to be driven or towed directly on and off the ship by using the ship s or shore-based ramps (osha.gov). This is a key aspect because it allows the shipping company to transport cars safely and easily. If a firm in the shipping industry wants to compete for market share, these are some of the product quality aspects needed. Customer service Obviously customer service is everything in the service industry. Customer service is the firm s ability to come through on all of the customer s wants and needs. The customer service in the shipping industry is about providing customers with, information, options, and the expertise to help you make the right transportation decisions. It's about helping you understand trends and dynamics in the markets that can impact your business. It's about working with you to deliver the best possible value for your transportation dollar (matson.com). If a firm in this industry provides better 36

37 than average customer service taking all these things into account, they have effectively differentiated themselves among the industry competitors. Flexible Delivery Flexible delivery is best defined as the possibility to respond to short term changes in demand or supply situations of other external disruptions together with the adjustment to strategic and structural shifts in the environment of the supply chain (impgroup.org). The world economy is constantly changing; changes in supply and demand are just the start. The shipping industry has to be flexible related to supply and demand of goods they transport as well as changing items being transported. If a firm can keep up with these changes and change their business model in an effective and timley way, then they will create a competitive advantage. Conclusion Firms in the shipping industry, for the most part, use a cost leadership strategy to maintain a competitive advantage. Despite this fact, there are some instances where these firms can differentiate themselves through superior product quality, customer service, and flexible delivery. The firm in the industry that successfully completes these three things can add a competitive edge on the competition. Competitive advantage analysis In a industry unique as the pacific shipping from the west coast to Hawaii, competitive advantages are vital in order to draw customers and succeed in business. Since shipping rates are generally the same, companies are able to gain competitive advantages by adding value to their services by differentiating themselves from the industry. Matson, Inc. is able to separate itself from its main competitor Horizon lines and the industry itself through differentiation of ships and services. 37

38 Differentiation of ships Through side-by-side comparison, one can see that Matson, Inc. has a larger fleet with ships that are newer with high cargo capacity than Horizon Lines. All of Horizon lines ships (that service the Hawaii to the west coast) were built in the 1980s.This makes Horizon lines Hawaiian fleet nearly 34 years old. Out of Matson, Inc. s fleet of 17, only 5 were made in 1980 or prior. Nearly 70% of Matson, Inc. s fleet is newer than Horizon lines. The significance of having a newer fleet is that enables Matson, Inc. to ship cargo more frequently because their ships have less maintenance cost than Horizon lines bears. Another reason Matson, Inc. is able to ship more routes frequently is because Matson, Inc. s fleet is larger than Horizon lines. The most important differentiation that Matson, Inc has created for their services is the option of roll on/roll off cargo. Roll on/ Roll off cargo is significant because it is a specialization of shipping that is designed for automobiles. Through Roll on/ Roll off automobiles are less damaged and easier to ship than the traditional method. Matson, Inc. is the only company in this industry to offer this service. Through faster ships, larger and newer fleet that has differentiation Matson is able to charge a slightly higher rate than Horizon lines. Ownership of Terminals In an industry with similar rates, a firm can remain competitive by cutting cost. A company can cut cost a number of ways, but Matson utilizes cutting cost by owning their own terminals. Matson owns and operates six terminals in contrast to Horizon that rents their terminals. The addition advantage that Matson enjoys from ownership is that they eliminate the middleman. Matson, Inc. doesn t have to deal with a terminal company that could possibly load the wrong cargo onto the ship, or create miscommunication that could cause a delayed shipment. Finally this is most advantageous because the ownership makes it easier for the customers. The customers only have to deal with Matson, Inc and not a middleman to arrange the loading of their cargo. 38

39 Conclusion Through the usage of cost leadership and differentiation of products and services, Matson Inc. is able to charge a higher rate for their services and able to stand out in comparison to other shipping companies. The differentiation that Matson Inc. is able to create adds value to their customers and lures them away from competitors because the services that they offer are inferior. By Matson, Inc. using cost leadership strategies and owning their own terminals, they are able to cut cost so that their returns are much higher than the industry average. Accounting Analysis The purpose of accounting analysis is to evaluate the degree to which a firm s accounting captures its underlying business reality. (Healy and Palepu). Accounting numbers are subjective and depend on the methods used. The methods that are used give mangers the ability to intentionally misrepresent their financials statements. The implication of misrepresented financials is that the firm could be portrayed to be in better financial health. In addition misrepresented makes it impossible to value a firm accurately.to perform a proper financial evaluation of a firm, it is imperative to confirm the use of appropriate accounting techniques. The steps of accounting analysis are as follows: 1. Identify Key Accounting policies: a. one of the goals of financial statement analysis is to evaluate how well these success factors and risks are being managed by the firm (Healy and Palepu). Analysis of key success factors and reconciling them with accounting policy is an integral part of valuing a firm. This gives us a benchmark in to measure the critical components of the firm and the risk associated with those components. 2. Assess Accounting Flexibility: 39

40 a. Some managers have substantial to no flexibility. This is problematic because it makes the accounting data less accurate in regards to understanding the firm s economics. The correct amount flexibility can lead to informative accounting numbers. It vital to asses because 3. Evaluate Accounting Strategy: a. The examination of a firm s accounting strategy involves examining how manager s exercise their accounting flexibility. (Healy and Palepu). This can include comparing a firm s accounting policy to industry standards, the changing of a firm s policy or estimates, and how a firm structures its business transactions. 4. Evaluate the Quality of Disclosure: a. Manager s can make it more or less easy for an analyst to assess a firm s accounting quality and use its financial statements to understand business reality. (Healy and Palepu). This step can help analysts determine the reasons for a firm s yearly fluctuation in performance. 5. Identify Potential Red Flags a. Red flags can include unexplained changes in: accounting, transactions, inventory, or other activities that affect net income. In other words Red Flags are items that worry us as analysts because the items challenge the integrity of the financials. Once these items are identified as red flags, we must obtain more information on these items. 6. Undo Accounting Distortions a. This is the process of restating the financials with accurate disclosures of operating leases, goodwill, R&D, or defined benefit plans. Restating the financials with more accurate numbers leads to less distortion in the financials. In essence, undo accounting distortions leads to a more accurate picture of the company. 40

41 Key Accounting Policies A firm s key success factors are what drive value for that firm and for its industry in general. One of the goals of financial statement analysis is to evaluate how well these success factors and risks are being managed by the firm. (Healy and Palepu). In the shipping industry, key success factors revolve around economies of scale and scope, efficient production, and lower input costs. We define type 1 key success factors for Matson as the success factors that drive value in shipping. Successful shipping firms compete on all three-type 1-success factors. The type 2 key accounting policies are cost leadership and differentiation. Relating to cost leadership, Matson competes on economies of scale and scope, efficient production, and lower input costs. Regarding differentiation, Matson competes on superior product quality, customer service, and flexible delivery. Key success factors are prime targets for accounting distortion. Since these factors drive the success and value of a firm, managers are more likely to distort numbers in their favor. Proper analysis of account strategy and it s relation to key success factors allow the analyst to determine a more accurate valuation of a firm. Potential items of distortion, for Matson, are operating leases and defined benefit plans. Operating Leases: An operating lease is a contract that allows for the use of an asset, but does not convey rights of ownership of the asset. Operating leases are often structured in a way that understands their true impact on the financials. The lease commitment is typically less than the life of the asset. (KPMG). Operating leases are a common area of distortion in industries with a need for fixed assets, such as shipping. Operating lease obligations include principally land, office, and terminal facilities, containers and equipment under non-cancelable, long-term lease arrangements that do not transfer the rights and risks of ownership to the company. (MATX 10k). Essentially, an operating lease is the rental of an asset over a period of years. 41

42 The most expensive fixed assets related to Matson s business and the container shipping industry are ships. Matson owns all of their ships, and as a result avoid significant lease liability. If Matson had an operating lease, the lease would be valued at around the total value of their fleet. Since Matson owns their ships, there are no operating leases that need restating. Defined Benefits and Pension: In a defined pension plan, an employer commits to paying its employees specific benefits for life beginning at his/her retirement. The amount of the benefit is known in advance and usually based on factors such as age, earnings, and years of service. (Newyorklife.com) Defined pensions are a significant liability for companies as they are long-term obligations a firm is required to fulfill. Defined benefit plans are typically a large portion of long-term liability and any distortion can lead to understated liabilities and prevent a correct valuation of a firm. Pension funds are listed at present value and their discount rates are determined by the amount of assets in the fund. To value the fund, the company relies on various assumptions, including the following factors: discount rates, expected long-term rate of return on pension plan assets, salary growth, health care cost trend rates, inflation, retirement rates, mortality rates, and expected contributions. (MATX 10k). Ultimately, it is the responsibility of management to determine the relative weights of each factor. If the discount rate is too high, a firm will understate its pension liabilities. Similarly, any improper distortion of the above mentioned rates has a significant adverse effect on the accuracy of a firm s financials. Matson and it s main competitor, Horizon lines, both properly disclose pensions under FASB ASC topic 820. FASB ASC Topic 820 establishes a fair value hierarchy which requires the pension plans to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value (Fasb.org). The hierarchy is as follows: 42

43 Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2: Significant other observable inputs other than level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data. Level 3: Significant unobservable inputs that reflect the pension plans own assumptions about the assumptions that market participants would use in pricing an asset or liability If the technique used to measure fair values includes inputs from multiple levels of the fair value hierarchy, the lowest level of significant input determines the placement of the entire fair value measurement of the hierarchy (fasb.org). Matson s similarity to competitor s determinations of fair value leads one to believe they are properly disclosing their defined pension plans. Matson has defined pension plans for all pre-2008 employees and post-2008 union employees. The financial crisis had a large effect on the size of pensions. Rates United States (inflation) Matson ( discount) Matson (other postretirement discount) 1.6% 3.2% 2.8% 4.2% 4.8% 5.8% 4.3% 4.9% 5.8% 43

44 The average inflation rates for were 1.6%, 3.2%, and 2.8%, respectively. Matson s discount rates outpaced rising inflation, generating a positive return in an economic downturn. Matson discounts their pensions at a higher rate so that it outpaces inflation and generates a return in excess of the risk-free rate of return. Other Post-Retirement Benefits Matson s other post-retirement benefits also outpaced inflation at a similar rate used on pension benefits. These rates are reasonable because they move the same way as inflation, yet still outpace it to provide adequate return. Pensions and defined benefit plans are largely funded through returns generated by Assets. Each company develops a formula to grow their assets. Matson follows FASB ASC Topic 820 to value assets. The first--and most import measure used to determine asset value are quoted prices for identical assets and liabilities in active markets. Asset allocation is also a prime determinant of portfolio return and risk. Matson has the following portfolio allocation and return: 44

45 Asset Category Target 2012 Domestic Equity Securities 53% 56% International Equity Securities 15% 14% Debt Securities 22% 19% Real Estate 10% 5% Other and Cash 0% 6% Total 100% 100% MATX Expected Return 8.3% 8.3% 8.3% Matson opted to invest a majority of their pension-funding assets in equity securities, with a particular concentration on large cap and mid cap companies. These companies have a lower default risk than your normal company but also generate a substantial return. Matson mitigates risk by allocating the rest of their assets in debt securities, real estate, and international equity securities. Matson s returns outpace inflation and are adequate to fund future pension liability. Net pension liability as of 2012 is $60.9 million compared to long-term liabilities of $302.7m, accounting for 20.12%. While this figure is a significant portion of Matson s long-term liability, the growth of fund assets currently outpaces the growth in liabilities. Overall, their pension disclosure and methodology is appropriate. Assess Degree of Potential Account Flexibility The accounting standards will vary from industry to industry due to the government regulation required. In addition some business activities require more regulation, meaning that the activities may be mandated by regulation to be record as an expense, while other activities 45

46 are left up to manager s discretion. This gives the power for the managers to potentially tell an informative story of the company in way that is helpful and clear for potential investors to understand. But the flexibility given to mangers should be closely monitored because mangers could as easily use the flexibility to tell a different story of the company, a story where probability it much higher. As stated before, we have concluded that firms create value in this industry by keeping cost low and differentiating themselves from other firms. Matson is able to do this through cost leadership and differentiation. We will explore the impact of operating leases, economics of scale; pension plans have on the financial statements. In addition we will examine how the disclosure of these information in compared to industry standards of disclosure. Evaluate Actual Accounting strategy and Qualitative Analysis In order to determine how much the financial statements reveal about a company s financial standing, the accounting strategies used by a company must be evaluated. It is crucial to determine the severity of the strategies used and the possible implications of the strategies. The final component that must be evaluated is how does a company s account strategies compare to other firms in the industry. We would describe the accounting strategies used for operating leases to be somewhat aggressive because the leasing obligation has a significantly smaller leasing life compared to the operating life of the vessel. The effect this has on Matson s financial statements is that their liabilities are low, while their asset value is understated. Even thought Matson is leasing their assets, they still have right to those assets and those rights aren t being correctly reported. Matson s financial statements make it unclear as to why Matson chooses to lease instead of purchasing the assets that are leased. Due to the lack of transparency, we can only conclude that Matson s choose to lease because the life of the leases is five years. The life of the leases is relatively shorter than the lives of their transport ships. Another potential issue with their accounting strategy is that Matson doesn t disclose the weights of the leases to their respective categories. This is significant because it is unclear what asset or assets make up the leasing obligation. Finally Matson doesn t disclose the discount rate used for operating leases. The discount rate would be useful in converting an operating lease into a capital lease. A capital lease is significant because it would be used to restate the financial statements and possibly 46

47 give us a different view of the company. In conclusion, Matson meets the industry standard for disclose concerning operating leases because the industry s transparency is low. Pension & Benefits Plan Matson and Horizon Lines are the only companies in the industry that disclose information about pension and post retirement plans. The availability of this info makes a company more transparent and gives a higher value over their competition. Matson provides information related to benefit plan costs and weighted average assumptions, which gives a high level of disclosure that allows investors to make an assumption on the financial information that Matson reports. Since Matson discloses quite a bit of information about the pension plans, we can conclude that they use a conservative accounting approach to gather this information. The 10-K reveals that there has been a decline in weighted averages used to determine benefit information. The footnotes state that unrecognized gains and losses of the post-retirement benefit plans are amortized over five years. This allows for Matson to increase income and defer the pension plans into the future. There has been a steady drop in the discount rate for pension plans making the pension benefit obligation increase without making costs increase because the expected return rate stayed high and above the discount rate. This information aids to prove that Matson uses a conservative accounting approach because the discount rate is low, expected return is higher, and there is information about the allocation of its pension. In order to be success in any industry, a firm must implement strategies that differentiation themselves from the industry. Matson is able to do this by keeping a larger, younger and higher volume ship fleet. The overall industry standard of the shipping industry in regards to details concerning ship fleets, the information is very transparent. Matson follows this industry standard by disclosing very detailed specifics of their fleet such as the age, size of their fleet and the volume that each ship is able to carry. Matson is able to further separate themselves from other firms in this industry by disclosing the potential implications if their competitive advantages are some how dissolved. For instances, Matson explains how they believe their firm would suffer if the Jones act was repealed or modified. The firm believes that their competitive advantage would be diminished because Jones act only allows American 47

48 Goodwill % Percentage R&D % Operating leases % owned and operated ships to service the pacific. This is considered high transparency since they are disclosing possible threats to their firm s success. Undo Accounting Distortions If the accounting analysis suggests that the firm s reported numbers are misleading, analysts should attempt to restate the reported numbers to reduce distortion (Palepu & Healy). As stated on the balance sheet there has been no change in Goodwill, the balance was 27 million. The net fixed assets total value as of 2012 was million dollars. Total assets are 1,174,300 million giving us a goodwill ratio of 2.3%, contrast to net fixed assets which gives us 69.4%. Given the criteria that goodwill must be greater than 30% of the assets we do not have to restate them. The second item to require restatement would be goodwill impairment. Being that Matson s doesn t have goodwill impairment, it is less than 30%, and does not require to be restated. The third item to be restated is R&D expenses. The requirement for R&D expenses to be restated is that R&D must reduce operating income by 20%. Matson does not have any R&D expense; therefore we do not need to restate them. Lastly, the final item that would require restatement would be Matson s leases. In order for an operating lease to require restatement it has to increase non-current liabilities by more than 20%. Matson reports it s operating leases to be 68.6 million and it s total noncurrent liabilities to be 701 million, this gives a ratio of 9.7%. Even if we discounted the leases at a rate of 4.2% (10-K discount rate) we generate a present value of leases to be million. This reduces the previous operating lease to non-current liabilities ratio from 9.7% to a ratio of 8.75%. Since the operating leases discounted back do not 48

49 increase non-current liabilities by more than 20%, nor does the given values, we are not required to restate them. Financial Analysis When comparing a company to its competitors in an industry, investors and analyst use financial ratios to help determine how that company is doing. Observing financial ratios will help investors understand financial results and trends. They will also help show the performance of the company, revealing its strengths and weaknesses. These ratios help evaluate a company to its competition and the whole industry. Financial ratios measure a company s liquidity, profitability, and capital structure of a firm. Analysts can use the calculated numbers to forecast and compare data over a span of time. Matson s financial analysis we compare its overall financial worth to its competitors and industry. Liquidity Analysis Liquidity is a company s ability to convert an asset into cash and meet short-term debt obligations. This is one of the first of the ratios investors look at when analyzing companies. They are a good measure to observe if a company will be able to be safe when short-term debts arise. Investors should look at a company s ratios compared to its competitors, so we will do the same for a liquidity valuation. Our liquidity analysis will consists of current ratio, quick asset turnover ratio, accounts receivable turnover ratio, inventory turnover ratio, days supply inventory ratio, days supply outstanding ratio, and the cash-to-cash cycle. Current Ratio Current Ratio measures a company s current assets to current liabilities and shows the company s ability to pay short-term debt with short-term assets. To get current ratio you have to divide the current assets by the current liabilities. Higher numbers are better, implying that the firm has a higher amount of current assets when compared to current liabilities and should easily be able to pay off its short-term debt. Generally, you want to 49

50 stay above 1, even if a company is below 1 it is still able to meet obligations, just not as quickly Current Ratio Matson Hub Group Horizon Lines Matson Hub Group Horizon Lines As shown above Matson is able to meet the short-term obligations. The industry is primarily able to keep a current ratio over 1, so we can conclude it has the ability to cover short-term debt. Even though Matson s current ratio took a dive in 2010, the past 3 years have been increasing. As of last year they were able to beat out the competitions current ratio. 50

51 Quick Asset Turnover The quick asset ratio uses the most liquid assets in the calculation. Similar to current ratio, it simply takes Cash & Equivalents + Short-Term Investments + Accounts Receivable and divides them by Current Liabilities. Inventory is left out because it can be hard to liquidate and could have a different value on the company s books. 2.5 Quick Asset Turnover Ratio Matson Hub Group Horizon Lines Matson Hub Group Horizon Lines

52 Matson is still able to meet it s short-term obligations but not as good as their competitors. From 2008 to 2011 Matson is barely able to keep a quick asset ratio above 1. Last year they were able to get at.571, which is a lot better than the previous years. Amongst investors the quick asset ratio is not attractive when compared to the industry. Inventory Turnover Ratio Inventory Turnover shows how many times a company can sell their inventory. It is calculated by sales/inventory. This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall. (Investopedia). Matson Hub Group Horizon Lines

53 Inventory Turnover Ratio Matson Hub Group Horizon Lines Hub Group s 10-k does not list any inventory, so we compared Matson to Horizon Lines. In 2011 Matson had a vast increase in turnover and has been able to keep it up, as compared to Horizon Lines, who has had a decrease in their ratio. Again, a high ratio implies strong sales. Accounts Receivable Turnover The accounts receivable turnover is a calculation that measures how efficiently a company is extending credit to its customers as well as collecting its customer s debts. If a company has a high account receivable turnover ratio it is able to collect it s receivable on time. If a company has a low ratio, it is waiting a long time to collect its receivables, making them stat in debt longer. To calculate this ratio you must divide the sales, by the accounts receivable. The industry stays pretty consistent among each other with quite a bit of fluctuation between the 3 companies. This implies that the industry is able to collect their customer s debt. 53

54 Matson has been 2 nd for the past 4 years. The ratio shows no major concern with the competition. 14 Accounts Receivable Turnover Ratio Matson Hub Group Horizon Lines Matson Hub Group Horizon Lines

55 Days Supply Inventory Days Supply Inventory tells us how fast a company can convert into sales. The higher the ratio the longer the company keeps inventory. The lower the DSI the better it is for a company. This means they do not keep inventory on hand as much, showing they can quickly convert it. Matson has been able to keep their DSI low as compared to the industry. Whereas, Horizon Lines has a high DSI. This means that are able to convert their inventory into sales faster than their competitors Days Supply Inventory Ratio Matson Hub Group Horizon Lines

56 Matson Hub Group Horizon Lines Days Supply Outstanding This ratio is an indicator of how fast a company can collect their receivables from the customers. The higher the ratio the longer it takes a company to collect its receivables. It is better to have a low DSO because you collect your receivables faster. This is calculated by dividing the number of days in a year by the company s accounts receivables turnover. We see again that the industry it staying pretty consistent with each other. Horizon Lines is in first place letting us know that they are able to convert their receivables faster. 56

57 Days Supply Outstanding Ratio Matson Hub Group Horizon Lines Matson Hub Group Horizon Lines Cash-To-Cash Cycle Cash-To-Cash Cycle the length of time, in days that it takes for a company to convert inventory and receivables into cash flows. It attempts to measure the amount of time each dollar is tied up in the production and sales process before it is converted into cash through sales to customers. This metric looks at the amount of time needed to sell inventory and the amount of time needed to collect receivables (Investopedia). Here we still see how the industry is staying consistent with each other. Matson overall has a better cash-to-cash cycle than the industry. This lets us 57

58 Matson Hub Group Horizon Lines know that they convert receivables and inventory in to cash better than the industry. 60 Cash-To-Cash Cycle Matson Hub Group Horizon Lines Conclusion In conclusion, Matson is a liquid company and based off the liquidity analysis, is a company investors would like. Their current ratio and quick asset ratio has been increasing over time. This lets us know that they have been improving. Matson is demolishing the industry with the high inventory turnover and days supple inventory (Hub Group has no inventory). This shows that they get rid of the inventory through sales, which makes them able to convert it into cash faster than the industry. The industry stays about the same with the accounts receivables turnover; days supply outstanding, and the cash-to-cash cycle. In these liquidity ratios, compared the industry Matson is performing well holding a 2 nd place spot out of the 3 in accounts receivables turnover and DSI. This gives them the top competitor in the cash-to-cash cycle. Matson is doing well amongst their competitors. 58

59 Profitability Ratios The profitability of a firm demonstrates how effective they are at utilizing their resources to generate benefit for the firm. Profitability ratios allow the investor the effectively analyze different aspects of profitability. The ratios most commonly used are gross profit margin, operating profit margin, net profit margin, asset turnover, return on equity, and return on assets. Comparing these ratios with other firms, and the industry average, gives insight into whether or not a company is utilizing its resources effectively. Gross Profit Margin The gross profit margin is found by taking current years gross profit (sales minus Cost of goods sold) and dividing it by Revenues from that same time period. Fixed costs are significant in the shipping industry. As a result, firms have significant selling costs. These costs are primarily comprised of fuel, container, and crew costs. 59

60 Matson 13.67% 16.48% 12.44% 14.23% 14.36% Horizon Lines 17.88% 18.00% 15.20% 13.13% 16.17% Hub Group 12.31% 11.61% 11.37% 11.40% 11.00% Industry Average 15.10% 14.81% 13.29% 12.26% 13.58% Firm s desire the highest level of gross profit possible. The charts indicate that all firms took a dip during the recession years of , with noticeable improvements across the industry in Horizon lines is the industry leader, and this can be attributed to their shorter routes ergo, lower fuel costs. Matson initially follows the industry average before demonstrating improvement in 2012 and 2013, relative to the industry. Overall, Matson has a desirable gross profit margin. Operating Profit Margin Operating Profit Margin is calculated by taking income before interest and taxes (operating income) in a defined period of time and dividing it by Revenues from that same period. Analysis of Operating Profit Margin indicates whether or not the company can cover its fixed costs, primarily interest expense on long-term debt. Firm s with high 60

61 operating profit margins are often operating efficiently and also achieving the desired level of profitability % Operating Profit Margin 10.00% 5.00% 0.00% -5.00% % % Matson 6.11% 6.22% 5.40% 9.12% 2.65% Horizon Lines 1.96% 0.50% -9.55% 0.37% 3.00% HubGroup 3.71% 3.82% 3.42% 3.59% 3.38% Industy Avg 2.83% 2.16% -3.07% 1.98% 3.19% The shipping industry s operating profit margin fluctuated during the last few years as a result of the global recession. The firm with the largest shift was horizon lines, which experienced a -9.55% operating profit margin (very poor). HubGroups operating profit margin declined, although not as significantly as Horizon s. Ultimately, the Operating Profit Margin s in the shipping industry converge at nearly 3% in The chart indicates Matson routinely has a higher Operating profit margin than it s competitors and the industry as a whole. When other firms experienced significant shortfalls in 2011, Matson remained above 5% operating profit margin. Although in 2013 Matson is slightly below the industry average, the firm has historically operated above the industry average. Recent trends indicate Matson is less able to pay its fixed obligations, like interest expense, than competing firms. 61

62 Net Profit Margin Net Profit Margin is calculated by taking net income in a given time period and dividing it by revenue over that same period. This is the percentage that the company nets at the end of the year after all the firm accounts for all costs. Firms desire the highest net profit margin possible. Net Profit Margin 10.00% 5.00% 0.00% -5.00% % % % % Matson 3.30% 2.95% 2.32% 6.71% 3.15% Horizon Lines -2.76% -5.80% % -8.85% -3.10% HubGroup 2.25% 2.34% 2.11% 2.18% 2.05% Industy Avg -0.25% -1.73% % -3.33% -0.53% The chart indicates poor industry performance during This can be attributed to the recession. HubGroup stays near 2% net profit during this time period, while Horizon experiences substantial losses culminating with a 22% loss in Matson and HubGroup are relatively stable during these years, however, Matson is the industry leader in net profit margin. Despite the recession, Matson s net profit decreased in one year. In that year, it was not necessarily a decrease but a regression towards their normal figure of 3% after a banner year of 6.71%. Matson s net profit margin should be encouraging to potential investors. 62

63 Asset Turnover Taking this year s sales and dividing it by the total assets from the previous year calculate asset turnover. This gives the investor insight into how effectively a company is using their assets (from the last period) to generate revenue. Firms with higher ratios are using their assets effectively to create future benefit for the firm. Asset Turnover Matson Horizon Lines HubGroup Industy Avg The shipping industry average hovers between 2 and 3, with Matson reporting significantly lower asset turnover. Generally, shipping companies generate high revenue on their fixed assets which depreciate over time--leading to high asset turnover. The chart above indicates Matson is far behind the industry average for asset turnover. There are two important explanations: 1) Matson operates in the Jones Act shipping market with little direct competition. It is a small market with relatively little revenue compared to global shipping. This makes comparison difficult. Matson s main direct competitor, Horizon, is larger and generates more revenue on assets old, steam powered ships that are worth less. 63

64 2) Matson has more assets than your typical shipping company, as they own their own terminal, a fleet of technologically advanced ships, and most of their containers. Matson s asset turnover still leaves something to be desired, and should be taken into account by potential investors. Return on Assets Return On Assets (ROA) is calculated by using the current year s net income and dividing it by the previous year s total assets. ROA indicates whether or not a firm is efficiently using their assets to generate revenue. Profitable firms typically have a high ROA % 10.00% 5.00% 0.00% -5.00% % % % % % % ROA Matson 1.87% 3.87% 1.36% 1.81% 4.60% Horizon Lines -3.49% -7.08% % % -5.32% HubGroup 6.39% 7.50% 9.22% 8.07% 7.50% Industy Avg 1.45% 0.21% -9.96% -3.39% 1.09% The chart indicates a downward and then upward trend in the shipping industry. The downward trend can be explained by the global recession. Matson s primary direct competitor, Horizon lines, experiences significant losses during this period and their ROA reflects that. HubGroup, the industry leader, has a healthy margin over their competitors. This demonstrates their efficiency at generating returns from their assets. Matson is ahead of their competitor and is above the industry average over this 5-year period. 64

65 Axis Title The chart above reveals Matson s effectiveness compared to their competitors and the industry as a whole. Their ROA is a positive sign to potential investors. Return on Equity Return on Equity (ROE) is a measure of how much profit a company generates relative to the amount invested by shareholders. Taking the current year s net income and dividing it by the shareholder s Equity of the previous year results in ROE. This metric is useful for assessing profitability by how well a company uses funds invested by owners to generate growth % % % 0.00% ROE % % % % % % % Matson 4.10% 8.48% 3.03% 4.10% 19.29% Horizon Lines % % % 57.23% % HubGroup 10.79% 12.15% 15.43% 15.49% 13.77% Industy Avg -8.24% % % 36.36% % Horizon line s financial difficulties skew the industry average significantly, making it difficult to provide meaningful comparisons in data. In this category, the industry will be HubGroup and Matson. HubGroup s ROE is fairly steady from , with a slight uptick in Matson s ROE fluctuates, but is relatively stable compared to the industry outside of Matson s increase in 2013 is explained by the sale of their logistics business and 65

66 the revenues it generated for shareholders. ROE is a metric best used to compare firms rather than analyzing profitability. Compared to the industry, Matson is stable. Any significant future movement could cause concern. Conclusion The shipping industry was affected in a significant way by the recession, as shown in the charts above. MATX, relative to the industry, outperforms on cost but underperforms in efficiency. MATX is in line with firms on their selling costs (gross profit) and outperforms the industry regarding additional costs (operating profit and net profit). MATX is average to underperforming an all ratios related to revenue generated from assets, as well as investment from owners. However, MATX is improving and their future outlook is bright, should the trends continue. Ratio Performance Trend Gross Profit Margin Average Improving Operating Profit Margin Outperforming Declining Net Profit Margin Outperforming Declining Asset Turnover Underperforming Improving ROA Average Improving ROE Average Improving Firm Growth Rate Ratios Deciphering firm growth rate ratios is imperative when conducting and equity valuation. When thinking about growth rate ratios, two ratios are most commonly used, internal growth rate (IGR) and Sustainable growth rate (SGR). The difference between these formulas is minute but IGR tells the company the maximum amount of growth a firm can have without using funds from outside parties while SGR is more based on a 66

67 percentage change in sales and the financial strategy the firm has already implemented. Simply put, a firm growth rate ratio is the rate at which a company can grow without having to increase its leverage by borrowing money. These ratios are important because they show how much a company can grow without going broke or deviating from the corporate strategy. Internal Growth Rate (IGR) As stated above, the internal growth rate is the rate that determines the maximum amount of growth a firm can have without borrowing money from outside parties. A high IGR is what companies are seeking because having a high IGR means that a firm can effectively fund all of its business endeavors using the funds that are retained through operations. IGR is calculated by multiplying the firm s return on assets by 1 minus the dividend payout ratio or ROA*(1- dividends/net income). Below is the IRG of Matson and some of its competitors. IGR MATX 4.20% 9.12% 7.68% 7.61% 28.76% HRZL -3.66% -5.89% -8.31% % -5.34% HUBG 5.98% 6.90% 6.90% 7.39% 6.58% ISHC 8.50% 2.81% 4.74% 3.44% 2.77% Indusrty 2.83% 1.55% 1.37% 0.73% 2.08% 67

68 The results from the table above show the IGR of Matson, its competitors, and the industry average. Over the past 5 years Matson has increased its IGR dramatically compared to other firms that have just been stagnant or decreasing even. Horizon Lines has skewed the analysis because they actually had a negative net income over the past 5 years that s why they have a negative number for most of the ratios. There are a couple things that can decrease a firm s IGR and two of the accounts include having a low net income and paying out a large number of dividends. Sustainable Growth Rate (SGR) As stated above, the sustainable growth rate is the percent increase in annual sales related to a firm s financial strategy. Simply put, SGR is how much new sales will cost you based on the amount of debt and equity a firm has. The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept forces managers to consider the financial consequences of sales increases and to set sales growth goals that are consistent with the operating and financial policies of the firm (inc.com). SGR is calculated by multiplying a firm s IGR by 1 plus their debt to equity ratio. 68

69 SGR MATX 9.21% 20.04% 17.42% 31.92% % HRZL % % 32.04% % 76.16% HUBG 6.29% 7.24% 8.19% 8.56% 6.58% ISHC 17.67% 6.55% 12.65% 8.37% 5.40% Indusrty -1.45% % 14.45% % 26.00% % % SGR % % % 0.00% % MATX HRZL HUBG ISHC Indusrty % The results from the table above show the SGR of Matson, its competitors, and the industry average. In 2009 Matson s SGR was only a little above 1%. We think this has everything to do with the financial crisis in 2008 which hit the shipping industry as hard as any other industry if not harder. Since then though, they have increased this number by over 10 times. Again, Horizon line s data is skewed because of a negative IGR and what makes it worse, they also had a negative D/E ratio in some years as well. Capital Structure Ratios Capital Structure is the strategy a firm uses to fund its operations and growth in the future. Debt and equity are the two different ways companies fund their operations. When companies fund with debt, it is usually in some form of a corporate bond. When companies 69

70 choose to fund with equity, this means they are using stock. Debt is typically less expensive than equity but both are needed to have the optimal amount of growth and leverage. The capital structure ratios analyzed for Matson are; Debt to equity, Debt service Margin, Times Interest Earned, and Altman s Z-score. These ratios are important to analyze because they make decision making, while considering the firm s capital structure, that much easier. Debt to Equity Ratio The debt to equity ratio is a simple one to formulate, but arguably one of the most important. This ratio shows how aggressive, or risky, a company has financed its operations and is found by dividing total debt by total equity. To remain competitive in any market a firm must find the optimal balance in debt and equity. When this ratio is high, that is indication that a firm might have higher revenues. This is true because of the leverage the firm gains from having more debt. One drawback to this is the credit rating will be worse because of the high amount of risk thus deterring banks from giving out loans. Matson needs good credit because they finance their assets and want to pay the lowest amount possible. Having this ratio to low is also substandard. Too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash (US Chamber of Commerce). D/E MATX HRZL HUBG ISHC Indusrty

71 As stated before, having a good credit score is imperative in the shipping industry because most companies finance their ships. The ships make up a large percent of the total assets so paying the lowest interest rate as possible is very important to keep income high. Having a debt to equity ratio around 2:1 is what firms want. As the table above shows, Matson has a D/E ratio relatively close to that number with only one real spike in 2012 that increased the ratio to The other companies like horizon, have a debt to equity ratio that is way to high compared to the industry norm. This is a very bad thing because in a recession, it will be almost impossible for Horizon Lines to pay off all of its debt. Overall, Matson and International Shipholding Corporation have the best debt to equity ratios of all the companies in comparison. Debt Service Margin The debt service margin ratio shows if a firm has enough cash flow from operating activities to cover the current payments of long term debt. To find this ratio, divide the current year cash flows from operations (CFFO) by the current installment of long term debt for the year before. This is known as a lag ratio because you have to sure the year 71

72 before to calculate the current year s debt service margin. This ratio is important because if the number is too low, the company won t be able to pay its bill and eventually go bankrupt. Therefore, having the highest debt service margin is what is sought after. DSM MATX HRZL HUBG ISHC Indusrty From the table above, Matson s debt service margin decreased from but than almost tripled in 2013 up to.65. This could be due to higher cash flow from operating activites or lower long term debt payable. We believe the latter to be true due to the fact that most of Matson s ships were paid off around this time. Hub group Inc. had no long term debt in so that explains the zeroes in those years. Times Interest Earned Interest rates in the shipping industry are actually very high relative to the rest of the market. That being said, the times interest earned ratio is the capital structure ratio that measures the ability of a firm s earnings to cover the interest expense a firm is subject 72

73 to. Times interest earned is calculated by dividing earnings before interest and taxes (EBIT) by the interest expense incurred that period. A high times interest earned ratio is what is sought after though having one that is too high indicates that a company has an undesirable lack of debt or is paying down too much debt with earnings that could be used for other projects (accountingcoach.com). TIE MATX HRZL HUBG ISHC Indusrty Since the information in this ratio was so skewed, a graph would have only been confusing that is why there is not one in this section. Matson, when compared to Horizon and International Ship holding Corp, is right in the middle. As stated earlier, the higher the number for the times interest earned ratio the better. That being said, Matson still has enough money to keep up with its interest payments. Matson s times interest earned seems to be very unpredictable and will shoot up and fall down year to year. This makes it hard to really analyze the business using this ratio. Hub Group has a very high TIE because the amount they have in interest expense is very low. This company is smaller in comparison to Matson so its easy to conclude they outright bought their assets. Altman s Z-Score Altman s Z-Score is a very interesting formula and rather complicated to derive. The formula basically shows the user if the company being analyzed is going to go bankrupt. It bases this number off of a number of other capital structure ratios. Those ratios include working capital total assets, retained earnings total assets, earnings before interest & taxes total assets, market value of equity total liabilities, sales total assets. 73

74 Below 1.8 indicates a firm is headed for bankruptcy; Above 3.0 indicates a firm is unlikely to enter bankruptcy; and Between 1.8 and 3.0 is a statistical gray area. It is concluded from the chart above showing Matson s Altman s Z-Score that they are in a statistical gray area. This means that it is unpredictable whether Matson is heading towards bankruptcy or not. Forecasted Financial Statements Financial statements are crucial in valuing a company. Financial statements tell the investor the score of the company in the language of accounting. Forecasting financial statement is critical to valuing a company in terms of determining if it is over valued, under- valued, or fair valued because stock prices are the present value of future dividends. In order to accurately value a company, one must forecast the financials in order to determine how much dividends they will be able to pay. 74

75 Sales Forecasting Forecasting future sales is difficult because there isn t an exact method to do so. The method that we used was to find a correlation between the last six years of USA GDP growth and the operating revenue of Matson. USA GDP % Matson OPER REV % % 13.33% % % % 17.82% % % % 6.66% % 4.95% Once we calculated the growth percentages of both variables, we graphed the variables in a scatter plotter in order to find the R-squared value % 15.00% 10.00% y = x R² = % 0.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% Series1-5.00% Linear (Series1) % % % % % We found the R-squared value to be The significance of this value is that it demonstrates that USA GDP growth and Matson Revenue are have a relation to each other. This is important because this relation is the basis for our sales forecasting model. 75

76 The next step in forecasting was to predict USA GDP growth over the next ten years. As a starting point, we examined GDP projections from FRED, but we felt that those projections were too conservative. FRED projected USA GDP to grow on average of a rate of 2% per year. In order to combat the conservatism, we average out the USA GDP growth in order to match the trend that was formed. The GDP growth rate per year was closer to 4%. We believe this is more consistent with the current trend of USA GDP.As a result; we were able to forecast operating revenue that better matched the structure of the financial statements. In other words, the sales growth that we forecasted was consistent with the previous sales growth that of the last five years. We believe that the capital structure of Matson also supports this sales forecast. The operating revenue growth rates that we calculated are the following: % 5.11% 5.06% 2.44% 5.13% 5.04% 4.79% 4.15% 4.50% 4.67% 4.55% We believe that since the USA economy is improving as citing the USA GDP growth rate as evidence, we believe that consumers will begin to ship even more in the next ten years. The implication of more shipping is that consumers will turn to Matson for their pacific shipping needs. In addition, we believe that Matson will experience these growth rates because Horizon has had negative net income the last five years. The implication of negative net income is that Horizon is facing financial trouble and may face bankruptcy. Customers will want to do business with a shipping company that is reliable and in good financial health. Since Matson meets both criteria, we believe that Horizon customers will begin to switch over to Matson. The limitations of our sales forecast is that we weren t able to find any other variable that had a higher correlation with operating revenue. The only exception that we could find was operating expenses. The correlation between expenses and revenue 76

77 was 99%. We decided to not use this correlation because we were unable to predict future expenses. We attempted to use an average of the expenses but the results were unrealistic revenue growth rates of nearly 20% every year. In addition the revenue growth rates were not supported by the capital structure of Matson. Balance Sheet We were able to forecast the balance sheet of Matson by collecting the balance sheets of the previous five years and converting them into one common sized balance sheet. Once we created the common sized balance, we began to calculate ratios such as current and using those to predict future assets. The limitations of this method it is depended on Matson s current ratio to be consistent. Matson s current ratio has been consistent for the last five years. Income statement The method used to forecast the income statement was to project sales by developing a sales growth rate for the next ten years. The limitations as stated earlier are that we weren t able to find a variable that had a higher correlation with revenue. Statement of cash flows In order to predict future cash flows, we utilize the ratios CFFO/ Net Income. The ratio tells us how much operating cash contributes to net income. We found the ratios calculated to be consistent with the structure of the company and we see them as a good indicator of financial health of Matson. 77

78 ASSETS Current Assets Actual Cash and cash equivalents $ 19 $ 16 $ 14 $ $ 115 Accounts receivable Inventories Deferred income taxes Prepaid expenses and other assets Total current assets Investments in Affiliates Property - net 1,590 1,536 1, Employee Benefit Plan Assets Other Assets , Forecasted Total Long-term Assets 2,066 2,073 2,231 2, Total $ 2,350 $ 2,380 $ 2,495 $ 2, $ 1,174 $ 1,

79 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Actual Notes payable and current portion of long-term debt $ 52 $ 65 $ 136 $ 18 $ $ 13 Accounts payable Payroll and vacation benefits Uninsured claims Deferred income taxes Accrued and other liabilities Forecasted Total current liabilities Long-term Liabilities Long-term debt Deferred income taxes Employee benefit plans Uninsured claims and other liabilities Total long-term liabilities 1, , ,008 1,039 1,032 1,065 1,097 1,126 1,144 1,168 1,195 1,220 1,152 Total Liabilties 1,278 1,295 1,359 1, ,226 1,269 1,268 1,313 1,357 1,398 1,427 1,464 1,505 1,544 1,476 79

80 Commitments and Contingencies (Note 12) Shareholders' Equity Actual Capital stock - common stock without par value; Additional capital Accumulated other comprehensive loss (96) $ (81.00) (82) (92) (45.50) (23.50) Forecasted Retained earnings Cost of treasury stock (11) (11) (11) (11) - - Total shareholders' equity 1,072 1,085 1,136 1, Total $ 2,350 $ 2,380 $ 2,495 $ 2, $ 1, ,

81 Common sized Balance sheet Common Sized Balance sheet Period ending ASSETS Current Assets Actual Cash and cash equivalents 0.81% 0.67% 0.56% 0.39% 1.69% 9.17% Accounts receivable 6.94% 7.23% 6.61% 6.59% 14.88% 14.60% Inventories 1.19% 1.81% 1.40% 0.17% 0.37% - Deferred income taxes % 0.32% 0.05% 0.56% 0.73% Prepaid expenses and other assets 3.15% 2.94% 1.68% 0.99% 2.44% 3.44% Forecasted Total current assets 12.09% 12.90% 10.58% 10.81% 19.94% 27.95% 15.71% 15.71% 15.71% 15.71% 15.71% 15.71% 15.71% 15.71% 15.71% 15.71% 15.71% Investments in Affiliates 8.85% 10.17% 13.19% 2.22% 5.08% 4.61% Property - net 67.66% 64.54% 66.17% 31.46% 64.93% 58.91% Employee Benefit Plan Assets 0.13% 0.13% 0.12% Other Assets 11.28% 12.27% 9.94% 55.51% 10.06% 8.52% Total Long-term Assets 87.91% 87.10% 89.42% 89.19% 80.06% 72.05% 84.29% 84.29% 84.29% 84.29% 84.29% 84.29% 84.29% 84.29% 84.29% 84.29% 84.29% Total % % % % % % % % % % % % % % % % % 81

82 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Notes payable and current portion of long-term debt 4.07% 5.02% 10.01% 1.23% 1.83% 1.37% Accounts payable 8.22% 10.19% 10.08% 9.53% 14.07% 13.62% Payroll and vacation benefits 1.41% 1.39% 1.47% 1.13% 1.79% 1.86% Uninsured claims 0.78% 0.69% 0.74% 0.46% 1.24% 1.66% Deferred income taxes 0.08% 0.00% 0.00% 0.00% 0.00% 0.00% Accrued and other liabilities 4.07% 5.64% 3.68% 7.26% 2.68% 3.53% Total current liabilities 18.62% 22.93% 25.97% 19.60% 21.62% 22.04% Long-term Liabilities 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Long-term debt 35.37% 31.35% 28.40% 13.37% 33.84% 30.06% Deferred income taxes 32.39% 33.05% 31.71% 3.88% 28.16% 35.83% Employee benefit plans 9.55% 8.96% 9.93% 7.95% 12.08% 8.17% Uninsured claims and other liabilities 4.07% 3.71% 3.97% 41.84% 4.29% 3.89% Total long-term liabilities 81.38% 77.07% 74.03% 80.40% 78.38% 77.96% Total Liabilties % % % % % % Commitments and Contingencies (Note 12) Shareholders' Equity Capital stock - common stock without par value; 3.08% 3.04% 2.99% 3.03% 11.40% 9.73% Additional capital 19.03% 19.35% 19.63% 21.23% 90.28% 77.44% Accumulated other comprehensive loss -8.96% -7.47% -7.22% -8.19% % -6.95% Retained earnings 87.87% 86.08% 85.56% 84.90% 14.58% 20.02% Cost of treasury stock -1.03% -1.01% -0.97% -0.97% 0.00% 0.00% Total shareholders' equity % % % % % % Total % % % % % % 82

83 Income statement Operating Revenue: Actual Forecasted Ocean transportation $ 1,021 $ 887 $ 1,040 $ 1,076 1, , Logistics services Real estate leasing Real estate sales Agribusiness Total operating revenue 1,871 1,397 1,646 1,463 1,560 1, Sales Growth % 17.82% % 6.66% 4.95% Gross Profit

84 Operating Costs and Expenses: Actual Forecasted Cost of operation 1,564 1,206 1,379 1, , , Selling, general and administrative Total operating costs and expenses 1,727 1,360 1,537 1,384 1, , Operating Income Other Income and (Expense): Gain on insurance settlement and other Impairment loss on investment (2) (2) (1) Interest income EBIT Interest expense Income From Continuing Operations Before Income Taxes Income taxes (25.10) (33.00) (32.20) Income From Continuing Operations Income from discontinued operations, net of income taxes (Note 2) (11.60) (6.10) - Net Income $ 132 $ 44 $ 92 $ $ $

85 Actual Net cash provided by operations Sales/CFFO OINC/CFFO Cash Flows from Investing Activities: (4.60) (6.30) (40.00) Capital expenditures for property and developments Proceeds from disposal of income-producing (109) (31) (95) property, investments and other assets Proceeds from insurance settlement Deposits into Capital Construction Fund Withdrawals from Capital Construction Fund (7) (4) (4) Acquisition of businesses, net of cash acquired Payments for purchases of investments (27) 10 - Proceeds from investments (60) (48) (102) Net cash used in investing activities Cash Flows from Financing Activities: (149) (31) (150) (70.20) (74.50) (61.10) Forecasted 85

86 86

87 Cost of Capital Estimation The opportunity cost of capital is the expected rate of return forgone by bypassing of other potential investment. The cost of capital is composed of weighted average cost of capital and the cost of equity. We can get the weighted average from the firm s percentage of financed debt and equity. The cost of equity is the required rate of return that stockholder s require. It usually costs more to finance equity, so the cost of equity tends to be higher than the cost of debt. Capital Asset Pricing Model (CAPM) is used to calculate the cost of equity. CAPM= Risk Free rate + Beta(Expected Return of the Market-Risk Free Rate) To calculate Matson s cost of equity, we first had to derive its beta coefficient. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. We used regression analysis to calculate Matson s beta coefficient. In our regression analysis we used 5 points from the yield curve: 3 month, 1 year, 2 year, 5 year, and 10 year risk free rates. After gathering this information we did regressions using 72 months, 60 months, 48 months, 36 months, and 24 months to see how stable and consistent our beta was. R Squared is a statistical method that explains how much of the variability of a factor can be caused or explained by its relationship to another factor (beta). With an adjusted R squared of 33.70% we get a beta of 1.351, these results came from the 3 month regression. Matson s beta throughout the different points on the yield curve is not very stable. Their beta ranges from.541 to 1.404, with a published beta of However, our calculated betas for each point on the yield curve for 36 months, did in fact, stay consistent with Matson s published beta. 87

88 3 Month T-Bill Yield Slice Beta Adj R Squared Lower Beta 95% Upper Beta 95% MRP Risk Free Size Premium Est Ke Lower Ke Higher Ke % 2.71% 1.70% % 10.27% 15.90% % 2.71% 1.70% % 9.51% 17.32% % 2.71% 1.70% % 7.06% 16.39% % 2.71% 1.70% % 5.49% 19.23% % 2.71% 1.70% 7.070% -3.05% 20.60% 1 Year T-Bill Yield Slice Beta Adj R Squa Lower Beta Upper Beta 95% MRP Risk Free Size Premium Est Ke Lower Ke Higher Ke % 2.71% 1.70% 11.22% 10.13% 15.71% % 2.71% 1.70% 11.68% 9.46% 17.30% % 2.71% 1.70% 9.98% 7.02% 16.34% % 2.71% 1.70% 10.59% 5.44% 19.16% % 2.71% 1.70% 6.94% -2.83% 20.12% 2 Year T-Bill Yield Slice Beta Adj R Squared Lower Beta 95% Upper Beta 95% MRP Risk Free Size Premium Est Ke Lower Ke Higher Ke % 2.71% 1.70% 11.17% 10.06% 15.68% % 2.71% 1.70% 11.55% 9.31% 17.19% % 2.71% 1.70% 9.83% 6.85% 16.21% % 2.71% 1.70% 10.43% 5.24% 19.02% % 2.71% 1.70% 6.94% -3.18% 20.46% 88

89 5 Year T-Bill Yield Slice Beta Adj R Squa Lower Beta Upper Beta 95% MRP Risk Free Size Premium Est Ke Lower Ke Higher Ke % 2.71% 1.70% 11.01% 9.88% 15.55% % 2.71% 1.70% 11.20% 8.92% 16.86% % 2.71% 1.70% 9.40% 6.41% 15.79% % 2.71% 1.70% 9.88% 4.69% 18.47% % 2.71% 1.70% 6.47% -3.64% 19.99% 10 Year T-Bill Yield Slice Beta Adj R Squa Lower Beta Upper Beta 95% MRP Risk Free Size Premium Est Ke Lower Ke Higher Ke % 2.71% 1.70% 11.04% 9.89% 15.60% % 2.71% 1.70% 11.07% 8.80% 16.74% % 2.71% 1.70% 9.22% 6.23% 5.53% % 2.71% 1.70% 9.61% 4.45% 18.16% % 2.71% 1.70% 6.18% -4.00% 19.72% From the St. Louis Federal Reserve we got a risk free rate of 2.71% and an S&P 500 return of 9.131%, giving us a market risk premium of 6.421%. Using the CAPM formula, cost of equity comes out to be 8.547%. Matson s Upper cost of equity was 12.14%, with a beta of 1.789, we calculated 10.44%. Matson's lower cost of equity was 10.27%, with a beta of.912, we calculated 6.650%. This gives us a lower backdoor cost of equity of 11.97% and an upper backdoor cost of equity of 13.84%. Size Premium Capital Asset Pricing model is not all the way complete due to the size premium of a company. This size effect could be due to riskier returns than CAPM indicates or incorrect pricing at the measured point of market capitalization (Palepu & Healy). Smaller firms tend to have larger betas, thus making their returns higher than the larger companies. A method for estimating the cost of capital combines the CAPM and the size premium effect. The market cap for Matson is 1.02 Billion, putting it in a size premium category of 1.7%. The appropriate equation to adjust CAPM with the size premium is: Cost of Equity = risk free rate + Beta(MRP) + Size Premium 89

90 Matson has a size premium of 1.70% making its cost of equity %. This value is reasonable because it falls between the lower and upper costs of equity. This size premium accounts for the relative high risk of the firm since it is involved in shipping with variable rates. 90

91 Cost of Debt When calculating cost of debt for a firm, taking into account both, short term and long term liabilities is extremely important. For this analysis cost of debt is calculated by a weighted average of each interest bearing liability on Matson s balance sheet and multiplying that weight by an appropriate interest rate. One weakness of this method is allocating a correct interest rate to each liability. In this analysis, the interest rate used for the short term liabilities was 3.36% and that number is from the St. Louis AA nonfinancial commercial paper rate. We used this rate in the analysis because it is a short term rate with a maturity much like that of the short term liabilities within the cost of debt calculation. For the long term debt, we used 2.52% as the rate. This rate is the same rate as the 10 year treasury constant maturity rate. We chose to use this rate because it has a similar maturity to the long term liabilities in the cost of debt calculation. These rates are used because it is the return Matson would get without bearing any risk. The table below shows the cost of debt calculation for Matson. Short Term and Long Term Liabilities Accounts Payable Notes Payable and current portion of long term debt Other liabilities Long term debt Uninsured claims and other liabilities Employee benefit plans Amount of each liability (millions) Percent of total liabilities Interest Rates Weight * Rate $ % 3.36% 0.69% $ % 3.36% 0.09% $ % 3.36% 0.13% $ % 2.52% 1.24% $ % 2.52% 0.16% $ % 2.52% 0.44% Resource for interest rates St. Louis AA Nonfinancial commercial paper St. Louis AA Nonfinancial commercial paper St. Louis AA Nonfinancial commercial paper 10 Year Treasury constant maturity 10 Year Treasury constant maturity 10 Year Treasury constant maturity Total $ % 2.75% Cost Of Debt

92 When explaining the table, the first column shows the interest bearing liabilities long term and short term. The second column shows the amount of each liability on Matson s balance sheet. The big liabilities are long term debt, accounts payable, and employee benefit plan with $320.70, $125.80, and $ respectively. The third column is calculated by dividing the amount of each account by the total value of all the liabilities added together which gives a weighted average. The fourth column shows the rates used to find the cost of debt from the St. Louis treasury site. The fifth column is simply the weight of the liability/total liability times the interest rate chosen. The sum of all those numbers results in a cost of capital of 2.75%. Weighted Average Cost of Capital The weighted average cost of capital (WACC) of a company is the average cost a company will pay on all of its financing activities. This is essentially the discount rate for the firm used to calculate npv and be the deciding factor when undertaking new projects through financing. The WACC is one of the most important computations in a valuation because having a high WACC for a company can be devastating. The formula for before tax WACC is E/V Re + D/V Rd. This formula explained is the weight of equity against debt plus equity, times the cost of equity. Add this to the weight of debt against debt plus equity and multiply that by the cost of debt. In Matson s case, the weighted average cost of capital is 4.20%. That means that if a project doesn t have an expected return of 4.20% or above, they shouldn t undertake that project. Price to Earnings Forecast For the Price to Earnings forecast, we required next years forecasted earnings. In order to find this ratio, we took the price per share and divided it by earnings per share. Price to earnings can vary because forecasted earnings vary depending on the methodology used and the analyst providing 92

93 the forecast. Forecasting earnings is also very inexact because of all the outside factors that can change between the point of forecast and the actual earnings announcement. Calamitous events, namely an economic downturn, can have a large adverse affect on earnings. The industry average numbers were taken from yahoo finance, minus Hubgroups numbers due to their significant deviation from the other companies. To reach the final computed price, we multiplied the EPS forecast by the industry average to reach a price of $ Given the listed price of 23.80, the model shows Matson as significantly undervalued. Price to Book Ratio To compute the Price to book ratio, we found the current price per share and divided it by the book value of equity per share. The industry average was taken average was taken from yahoo finance, minus the numbers for Horizon lines given their significant deviation from the rest of the industry. For the model s price per share, we multiplied the industry average by the book value per share. This gives Matson a model price of Matson, as of 5/1/2014, trades at per share. According to the model, Matson is overvalued. While this differs from the previous model, the deviation from the price is not significant enough to change the total analysis. 93

94 Price/Earning Trailing Ratios P/E Trailing Company PPS EPS P/E Trailing Computed Price Matson Horizon 0.70 (4.15) (0.17) Overvalued Hub Group ISH Average The prices to earning trailing ratios are calculated by using the price of the stock of the firms on May1st, 2014 and the earnings of the previous year. Since we used previous year s earnings, this is considered a lag ratio. Once this is found for all the companies, make a industry average and multiply that number by the EPS of Matson. We found by using this method, Matson had a computed price of $ This price shows that Matson has an overpriced stock at assuming we are 10% analysts. Horizon is a bit of an outlier making this method of valuation not the most reliable. Price to Earnings Growth Ratios P.E.G. P.E.G. P/E Growth PEG Industry Avg. Maston PPS Matson % Hub Group % 1.77 undervalued The price to earnings growth models (PEG) uses the price to earnings ratio for each one of the companies in comparison and divides that number by the expected growth in earnings. None of the competitors of Matson had a PEG ratio on Yahoo finance besides Hub Group so that is the only other company in comparison in this method. To find Matson s PPS, multiply Hub Group s PEG by Matson s P/E and it yields a price of This number is more than 10% higher than the observed price of $23.80 on May 1 st, 2014 so according to this method of valuation, Matson is an undervalued company. 94

95 Price/EBITDA Market Cap EBITDA P/EBITA Industry AVG EBITDA/Share Matson PPS Matson Hubgroup Horizon In order to calculate the Price/EDITDA model, we took the market capitalization rate and divided it by EBITDA. The market capitalization rate is defined as the current market price of the stock times the number of shares outstanding. We were able to find all of the relevant information for Matson and their competitors on Yahoo Finance. The final step in calculating the stock price under this model is to take the industry average of the P/EBITDA ratios and times it by Matson s EBITDA/Share. Matson s EBITDA/Share ratio is defined as earnings before taxes, depreciation and amortization divided by the shares outstanding. The price that we calculated was $7.22. This model suggest that Matson is overvalued. Enterprise Value/EBITDA EV EDITA EV/EBITDA Industry AVG Matson PPS Matson Hubgroup Horizon In order to calculate the Enterprise Value/ EBITDA model, we took the enterprise value of the firm and divided it by EBITDA. Enterprise value is defined as the sum of the market capitalization and book value of liabilities minus cash and investments. The second step in this model was to calculate the industry average of EV/EBITDA. We were able to do this by finding all the relevant information of Matson s competitors on Yahoo Finance. The third step in this model was to take the industry average and multiplied it by Matson s EBITDA. The final step was to add back cash and subtract the book value of liabilities and dividing the sum by the number of shares outstanding. This model 95

96 calculated a stock price of $ In comparison to the observed share price of $23.80 on May 1 st 2014, this firm is overvalued. Price to Free Cash flows (P/FCP) Market CAP FCF P/FCP Industry Avg Matson Matson Hubgroup Horizon The price to free cash flows model is calculated by taking the market cap divided by the free cash flows. Free cash flows are defined as the cash flows from operations plus/minus the cash flows from investing activities. The second step in this model was to gather all relevant information from Yahoo Finance and the 10-Ks of each competitor. Once this was done, we calculated the P/FCP ratio for each firm. The P/FCP is simply the Market Cap divided by the free cash flows. After calculating the industry average, we multiplied the Matson s free cash flows with the industry average and divided the product by the number of shares outstanding. The model derived a stock price of $7.90. This derived stock price suggests that Matson is overvalued in comparison to the observed share price of $23.80 on May 1 st Dividends/Price PPS DPS D/P Industry AVG Matson PPS Matson HubGroup Horizon The Dividends/Price is calculated by dividing the dividends per share by the current market price per share. We were able to find the PPS for each company from Yahoo Finance. In order to calculate DPS, we divided total dividends by shares outstanding. The information that we used to calculate DPS was found in the 10-k s of each company. The second step in this model was to find the industry average. The final step was to divided DPS by the industry average. The model derived a 96

97 price of $71.40 This suggest that Matson is currently under valued in comparison to the observed share price of $23.80 on May 1 st Despite this derived price, we believe that this model is skewed because Matson is the only firm to pay dividends. Conclusion The valuations of the models used in this section are split. The implications of this split is that we can not put much weight into our decision to decide if Matson is undervalued, overvalued or fairly valued. In addition, these models aren t the most accurate way to value stock. These models are used as a benchmark in relation to the intrinsic valuation models. We will ultimately base our valuation on the results of the intrinsic valuation models. Intrinsic Valuation models The significant of the Intrinsic Valuation models is that they derive a more accurate valuation of a firm. These models are derived by theory-based assumptions. Since these models are derived by theory-based assumptions, it makes it easy to enter the inputs necessary to calculate the value of the stock. The intrinsic valuation models that we will used are the discounted free cash flow, the residual income model (RI), the dividend discount model, the abnormal earnings growth model (AEG) and the long run residual income model(lri). In addition to computing these models, we will run a sensitivity analysis to round out errors to give us a window of prices. The sensitivity analysis will used different inputs of cost of equity, changes in growth rate, and returns on equity. Residual Income Valuation The residual income valuation model is arguably the best model to use when valuing a company. It has 80%-90% explanatory power which proves that it is the most reliant model out of the 5 total. Residual income is basically the degree a company is either underperforming or outperforming their cost of capital. Some of the main advantages to using this type of model is that it is the least sensitive to growth rates. The reason for having a low sensitivity to growth rates is because unlike the other models, residual income doesn t use a terminal value when formulating a price. When analysts use terminal value to calculate what a firm should be worth, a growth rate is estimated and this provides added variability to the valuation. The first part of computing the residual income model approach is to calculate the forecasted net income and dividend figures. These are both located on the forecasted income statement and 97

98 statement of cash flows respectively. These financials are stated earlier in our analysis. Once these numbers are found, the next step is to find the current book value of equity given in the company s 10-K. After this is found, it needs to be forecasted out as well similarly to net income and dividends paid. The strategy when forecasting book value of equity is to take the previous year s book value of equity and adding the difference between the current year s net income and dividends. Now the annual normal income must be calculated. This is a benchmark number and is very important in the model calculation. To find the annual normal income, simply multiply book value of equity in year 0 by the cost of equity. Continue doing this for the full 10 years of forecast. This benchmark number is used to find the annual residual income value. To find the annual residual income value, simply subtract annual normal income from the company s net income for each year. Once this step is finished, the next part of the formulation is to calculate the present value for each year for all the computations. The present value factor formula is 1-((1+Ke)^n). After you find this number for each of the 10 forecasted years, it is now possible to calculate the present value of residual income. All you need to do to find this value is to multiply the annual residual income found earlier and multiply it by the present value factor for the corresponding year. After this step is done, finding the percentage change in the annual residual income for each year needs to be found to calculate the terminal value of the perpetuity. This is used to accurately calculate a reasonable growth rate to use. The formula for the terminal value perpetuity is ((annual RI in yr 10/(Ke-g))*pv factor in year 9. Add this number to the book value of equity in year 0 and the sum of all the year by year present value residual income values to get the market value of equity. Once the market value of equity has been found, divide that number by the number of shares outstanding to get a model price. Next multiply this model price value by ((1+Ke)^(4/12)) to find a time consistent price. As a 10% analyst starting with an observed share price of $23.80, on May 1, 2014, the company is considered undervalued at any price greater than $26.18 and overvalued at any price less than $ Similarily, the price is fair valued if it falls anywhere between these 2 numbers. 98

99 g -5.50% -5.88% -6.25% -6.63% -7.00% 4.1% % Ke 8.1% % % Above is the price sensitivity analysis for the Residual income method for Matson. From the analysis it is easy to see that the company is overvalued when using a cost of equity 6.1% or above. This is something shareholders would not want to see because it means they need to sell their shares before the market brings Matson back down to the correct price. At a cost of equity of 4.1% though, the company is undervalued if paired with growth rates of -5.5% to -5.88% and fair valued at the rest of the growth rates. Long Run Residual Income Valuation The long run residual income model uses many of the same factors found in the previous residual income model. Instead of focusing more on the company s dividends to calculate the market value of equity of the firm like in the residual income model approach, the long run residual income method focuses more on using a convergence value to calculate the model price. The first thing that needs to be done in this valuation is to calculate the firm s forecasted average return of equity. To find this number, divide net income for the current year by the previous year s book value of equity. We found this number for the last 10 years and it was converging towards 14% so that is the number we used. We used the same Ke, growth rate, and BE from the residual income model that was calculated earlier. To find the market value of equity the equation MVE=BE(1+(ROE-Ke)/(Ke-g)). To get this number on a per share basis, we divide the MVE value by the number of outstanding share. This is the model price. The last step in this model is to find the time consistent price by multiplying 99

100 the model price by (1+Ke)^(4/12). For this model we decided to use 3 sensitivity analyses because of the 3 variables in the analysis. ROE Growth constant at % 12% 14% 16% 18% 2.1% % Ke 6.1% % % ROE constant at 14% 4.1% 6.1% 8.1% 10.1% 12.1% -5.50% % g -6.25% % % ROE Ke constant at 8.1% 10% 12% 14% 16% 18% -5.50% % g -6.25% % % Above are the sensitivity analyses. When interpreting these tables, one thing that automatically sticks out is a lot more red then yellow or green. Every place red is shown means that the company is overvalued. All these values found in the long run residual income perpetuity are 100

101 consistent with the previous residual income model prices. Overall, when only taking into account the residual income and the long run residual income perpetuity models, Matson is moderately overvalued Abnormal Earnings Growth Valuation Abnormal earnings growth model is based on book value and earnings. The model says that investors should pay more than book value if earnings are higher than expected and less than book value if earnings are lower than expected. Abnormal earnings growth rate is equal to a company s net income+ dividend reinvestment program minus the benchmark net income of normal earnings. In order for normal earnings to be calculated you have to multiply the net income of the previous year by 1 plus the cost of equity. To calculate you dividend reinvestment program you take the dividends of the previous year and multiply it by the cost of equity. Once these have been calculated, AEG can be calculated. To make sure that AEG is computed correctly, we benchmark it to our computed residual income for each year. Once you have done this, the present value factor needs to be calculated for each forecasted year to get AEG in 2013 dollars. Add those numbers up to get your total present value of AEG. The next step to figuring out AEG is to find the present value of the terminal perpetuity. To get this value you multiply the AEG for 2024 by the present value factor of Lastly, to calculate the total average net income of the perpetuity, we added the core net income, total present value of AEG, and the present value of the terminal value of the perpetuity. The graph below will show a sensitivity analysis: 101

102 Growth -5.50% % -6.63% -7.00% Cost 4.1% of 6.1% Equity 8.1% % % We used a negative growth rate because we are able to get the earnings back to equilibrium and ensure that Matson will provide return based on capital in the future. The above analysis shows that Matson is highly over-valued from using the original cost of equity and upper level cost of equity. This information derived from our sensitivity analysis lets investors know that they should not purchase shares of Matson. Discounted Dividends Since shareholders receive cash payments in the form of dividends, the value of their equity is the present value of future dividends. (Healy and Palepu). The shareholders return, outside of a positive change in value, is typically from dividends. This makes the dividends received particularly important. The two factors in this model are forecasted dividends and the cost of equity. Matson s computed cost of equity is 8.547% and forecasted dividends of 22 million per year. Given an average shares outstanding of 43 million (as of 2013), Matson s dividends per share came to.626 in 2013 and.504 thereafter. The discounted dividends model is considered fairly weak and inconsistent compared to other valuation models due o the fluctuation of dividends, particularly because a company has no obligation to disperse dividends. Matson s dividends varied significantly from year to year, so the only reasonable forecast was to take an average of those past dividends dispersed as the yearly forecasted number. 102

103 In order to obtain a valuation, we first calculated the present value of our Forecasted Dividends. The present value of the year by year dividends came to and the total present value of the year by year perpetuity came to , giving us a model price of as of 12/31/2013. Since the stocked is valued as of April 1 st 2014, we used a 4 month PV factor. This gave us a time consistent price of at a 4% growth rate. We used a range of 6.55% to 10.55% for the cost of equity given the range from our previous valuations. Since there is no discernable trend in dividend disbursement, we used a range of 0-4% based on our cost of equity and the fact that we forecasted our dividends per year at a flat rate. It is difficult to use the discounted dividends model for any meaningful comparisons to other firms. However, the model does give a fairly accurate view of the value of dividends. The weakness of the model lies in its reliance on dividends as the sole means of valuing a stock. Although investors take dividends disbursed into consideration, they typically place more weight on the gain of value in a stock and the financial health of a company. In this model, the cost of equity and the growth rate used give us a conclusion of overvalued. Discounted Free Cash Flows Valuation Another method used to value a firm is the discounted free cash flows valuation. This model used the discounted cash flow perpetuity and the present value of each cash flow to determine a stock price. Once a stock price is calculated, it is compared to the observed stock price. If the 103