Company X
ANNUAL REPORT ANALYSIS
Eugene Bala
Note: This is a study case of corporate financial reporting where, for privacy reasons, the real company name was
changed to Company X.
1. Overall Assessment of Company X's Financial Reporting
Under the pressure of the new economy driven by the internet, Company X focus on becoming an end-toend telecommunication provider of bundled services - data, video, voice - by increasing bandwidth and market
coverage in order to capture a broader revenue base for matching huge costs as the business matures, achieve
synergies among different channels and generate profits. Increased fixed costs due to huge up-front investment in
infrastructure and shrinking margins are industry specific. In the short term the expenses may increase as a
percentage of total revenue after the company enters a new market because many of the fixed costs of providing
service in new markets are incurred before significant revenue can be expected from those markets.
In an attempt to better presenting the financial position of the company to investors and financial analysts
(among others) and fairly disclosing the economic reality of rapidly growing business of this size create several
problems for the accountants and managers. The management makes estimates and assumptions that affect the
reported amounts of assets and liabilities at the date of the financial statements and the amounts of revenue and
expenses disclosed in the notes. As there are no adjustment for impairment of long-lived assets that implies
management strong belief that expected future cash flows to exceed the current carrying value. As new technology
evolves and the fight for market reach is fierce among large incumbents, these estimated future cash flows should
be put into some perspective (what if Company X cannot increase the traffic through its fiber optic network?).
However, the POP are proprietary and represents a strong foothold in the broadband corporate data transmission
and internet communication area. The company's recent acquisition of Rogers Telecom Inc (RTI) by buying all its
common stock rises the issue of intercorporate investment and financial consolidation. Buying all RTI's common
shares with cash and issuing non-voting shares acquiring total control of the firm, Company X has been required to
consolidate its financial statement in conformity with GAAP and CICA Handbook. Furthermore, the company
issued $1.8b new debt (high-yield debentures) in order to implement its aggressive growth strategy. The
accountants decided to record the debt at its historical cost because it has generated a fixed liability. However, fixed
interest rates imply variable present value of the debenture and as such one might argue that it should be accounted
for on a present (fair) value basis, therefore highlighting even more its weight in company's cost of capital.
One of the most important financial highlights presented in Exhibit 1 is the EBITDA, commonly used in
the telecommunication industry. It allows the analysts to compare firms in the industry and make valuations and
measure the current debt capacity sustained by operations without taking into consideration company specific debt
burden and depreciation expense that particularly for growing companies requiring significant CAPEX and
aggressive financing may distort the analysis and may not be consistent from one company to another. Moreover, it
can be argued that although depreciation is needed in order to maintain earning power, in this high growth situation
a portion of the depreciation and amortization is not required to sustain operations. The reader of this financial
statements should be aware that EBITDA is not intended to represent a cash flow or results of operations in
accordance with Canadian or US GAAP.
The company disclosed its consolidated financial statements in accordance with Canadian GAAP, which, in
the case of Company X correspond in all material aspects with those in US except for stock-based compensation
expense, shares object to put agreements and foreign exchange. The For US GAAP purposes, the company has
chosen to account for stock based compensation using the intrinsic value method prescribed in APB no 25.
Accordingly the compensation expense for US GAAP purposes has been recognized at the date of share purchase
or option grants at the amount by which the quoted market price of the stock exceeds the amount an employee must
pay to acquire stock. In 1997 and 1996, the minimum value method was used for options granted prior to the date
of the initial IPO as there were no market for the company's common shares in which to monitor stock prices
volatility. The company utilized the Black-Scholes option pricing model to estimate the fair value at the date of
Eugene Bala
Company X's Annual Report
grant for options granted subsequent to the company's IPO (Exhibit 2). Had the company determined compensation
costs based on the fair value at the date of grant for stock options under SFAS No 123, the loss attributable to
common shareholders and basic loss per share would increased by $10m as indicated in Exhibit 3. The
management used the most favorable method to reconcile the Canadian GAAP and the US GAAP. The company
would have to take into consideration recent accounting pronouncement, SFAS no 133 regarding the "Accounting
for Derivatives and Hedging Activities" and did not assessed the impact on its financial position as it will be
required to implement it only for its fiscal year ended December 31, 2000.
2. Key Accounting Policies
Tangible Capital Assets
31% total assets
Property, plant and equipment increased eight fold from $116m to $870m in 1998, are recorded at cost and
provisions for depreciation are using the straight-line method over the estimated useful lives of the assets (Exhibit
4). Under the cost method, the investment is initially recorded at cost which remains the carrying value until the
investment is sold or a decline in value become evident. The acquisition of RTI has been accounted for using the
purchase method. Under the purchase method, Company X acquired the assets, equities, service potential and
obligations of RTI for $1.05b, $600m in cash and $450m in non-voting class B shares and the results of operations
have been included from the date of acquisition - Exhibit 4. The value of net assets acquired being $355m plus a
$32m non-compete agreement.
Intangible Capital Assets
26% total assets
The value of net assets acquired being $355m plus a $32m non-compete agreement the difference from the
price has been accounted for and recorded as $666m goodwill - Exhibit 5. The goodwill should reflect the PV of
future profits resulting above those that might normally be expected from investment in the tangible assets of the
business. Through the acquisition of RCI the company substantially increased capacity and market share without
incurring the normal start up and developmental costs. The goodwill is amortized on a straight-line basis over its
estimated useful life of 25 years, in conformity with GAAP. However, it is questionable weather the above the
normal benefits from acquisition will occur over such a long period of time. If amortized at a higher rate, the huge
amount of goodwill would negatively impact the earnings per share (making the losses look even worse). The noncompete agreement has been recorded at its fair value determined by an independent valuator (although its name is
not disclosed) and not by the management team, and is amortized -reasonably- on a straight-line basis over its
estimated useful life of only 4 years.
Cash and Short-term Deposits
32% total assets
In conformity with GAAP the company regroups and discloses under this category its short-term
investments in liquid lower risk securities. They have been recorded at cost approximating the fair market value.
Under this method, based on the historical cost and the revenue realisation principal according to CICA handbook,
any gain and losses on the investment is postponed until the security is sold. Because of their size huge losses may
occur in an adverse market. However, the real use of cash is for capital assets investment - in alignment with the
overall strategy - and for hedging purposes against interest rate and foreign exchange rate exposure.
Long-term debt
70% total liabilities
Company X took advantage of the red-hot capital markets in the high growth telecommunication sector,
and successfully secured the financing required by its internal and external growth. It has issued and sold notes in
four offerings during 1997 and 1998 with stated amounts of $1.8b. As the notes are not convertible there is no
equity component attached to them and as such only the notional amount of proceeds has been recorded and
amortized over the period to November 2002, respectively June and December 2003 - Exhibit 6.
3
3. Assessment of Company X's Financial Position and Performance
Leveraged by huge amount of debt and without generating profits, the ROE rocket up to 111% in C$ and
93% in US$ compared to 24% TSE Telephone Utilities Index respectively 47% S7P Telephone Index. This figures
make Company X a rare jewel and a strong buy. The Exhibit 7 shows some of the key financial highlights of
incumbents in the buoyant telecommunication industry and puts some perspective in the last assessment.
The company will probably continue its aggressive financial strategy - 75% debt and 25% equity - in order
to take advantage of the favorable capital markets. However, the most profitable segment of the market is the transborder corridor between Canada and US. Therefore, a strategic US based investors is critical for sustaining
furthermore a high growth rate and achieve its objective. Under this scenario the company might have to dilute its
Corporate Financial Reporting
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Eugene Bala
Company X's Annual Report
ownership and issue more equity, a move that has been somehow restricted in the past : the company issued only
.04% of its equity base in class A voting and 99% class B and C non-voting and warrants on the top. A strategic
investor would require a significant portion of the voting common equity (although restricted to 33% foreign
investment by the Telecommunication Act).
High total shareholder return - as presented in the annual report - is due to an implied high P/E ratio is
comparable with that of internet companies - with the difference that Company X is an infrastructure company that
own huge assets -huge fiber optic network and related equipment - and generates revenues. The lower risk related
to its capacity to deliver is counterbalanced, however, by the bankruptcy risk related to the current portion of LT
debt is high - the interest coverage is negative as the EBIT is negative.
Corporate Financial Reporting
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Eugene Bala
Company X's Annual Report
Exhibit 1
Underlying stock fair value (weighted-average)
Risk free rate of return
Volatility factor
Estimated options life
Vesting period
Dividends
Exhibit 2
14.50
0.06
0.35
5.00
3.00
-
Income Statement
Revenue
Expenses
Loss before the undernoted
Other income
Loss before income taxes
Income taxes
Loss for the year
Canadian GAAP
US GAAP
pro-forma
Deficit, beginning of the year
Deficit, end of the year
Loss/common share Canadian GAAP
US GAAP
pro forma
1998
76,238,000
190,092,000
(113,854,000)
91,322,000
(205,176,000)
7,625,000
(212,801,000)
(213,398,000)
(223,798,000)
(39,410,000)
(252,211,000)
(6.04)
(6.05)
(6.35)
Note:
Pro forma values correspond to values obained from the Black-Scholes valuation
Exhibit 3
Corporate Financial Reporting
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Eugene Bala
Company X's Annual Report
Life span
Book Value
20 years
157,000,000
7 years
608,000,000
3-5 years
43,000,000
5-7 years
10,091,000
20 years
4,332,000
7 years
37,503,000
term of lease
9,058,000
Telecommunication networks
Electronics and related equipment
Computer hardware and software
Furniture and office equipment
Buinding
Power equipment
Leasehold improvement
Exibit 4
Exhibit 5
12% senior notes (US $ 247.9 million)
10.75% senior discount notes (US $ 113.8million)
9.95% senior discount notes (US $630 million)
10.625% senior notes (US $225 million)
$ 379m
$ 174m
$ 964m
$ 344m
Exhibit 6
Company
Bell Canada
MCI WorldCom
Rogers Communications
Metronet
Corporate Financial Reporting
EBITDA
in millions D/E
4,714
7,445
210
(59)
Exhibit 7
03/08/16
x
1.08
0.46
(0.80)
2.80
Interest
coverage
EBITDA base CAPEX
8.46
1,947
11.68
5,418
0.40
658
-0.46
400
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