du

Telecom

Financial Analysis Report Subject: TBS 901

(Accounting for Managers)
Prepared by: Lokesh Thadhani Student Id: 4031325 Subject Professor: Prof. David Goodwin

Contents: Scope & Objective Company Background Key Operating Areas Critical Accounting Estimates/Judgments du Ratio Analysis Industry Peers du Performance Highlights Internal Factors Impacting du's Performance External Factors Impacting du's Performance Analysis for Shareholders References

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Scope & Objective:

Objective of this report is to review and analyze financial reports of du and extract relevant information which may be useful to interpret key areas of accounting judgments and their impact on financial performance of company. It also includes applying ratio analysis and various factors affecting company's performance, finally concluding with a recommendation for shareholders. At the time of preparing this report, du had not yet released the annual report of 2010. Hence 3 years financial statements of du i.e. from 2007 till 2009 have been used in this report.

Company Background:
UAE had been a monopoly Telecom market for almost 3 decades with only one company Etisalat, operating throughout the country. As the population grew at fast pace, government realized the need for opening up the market to allow competition so that customers can get better value & services in a competitive environment. du ( Emirates Integrated Telecommunications Company) was established on 28-12-2005 with a share capital of AED 4 billion ( Par Value Per Share AED 1.00) and was listed on Dubai Financial Market. Du started to put basic infrastructure in place and launched its services in February 2007. Following are the major shareholders of du: Major Shareholders UAE Ministry of Finance & Industry Mubadala Development Co Emirates Telecommunication & Technology Co Public % of shares 39.50% 19.75% 19.50% 21.25%

Key Operating Areas:

du provides services to both residential and business customers. Their services include providing voice, data, video and content services. Above services are provided over both mobile and fixed networks. du's operating areas can be broadly divided in 3 segments as below: Operating Segment Consumers Target Clients Individuals Households Services Mobile & fixed voice calling Internet Data Services Television Fixed & Mobile solutions Professional Services Carrier and International Data Networks Wholesale Services

Business

Corporations Government Agencies International Operators MNCs and Telecom Carriers

Carriers

Critical Accounting Estimates/Judgments:

While preparing Financial Reports, managements use assumptions and estimates of future activity on the basis of present data available. However, future events may dictate change/adjustments of these estimates. The important judgments estimates which may affect future Financial Performance of du include following: 1. Royalty: du has kept a provision for potential royalty charge at 50% of the annual net profit to be paid to Federal Government, which is based on the current royalty being paid by its competitor Etisalat. As at 31st December 2009, government had not advised final structure of the Royalty Fee.

There had been talks that government may substantially reduce the Royalty Fee for du. If that happens, it will increase du's profits remarkably and company may declare dividends. 2. Doubtful Debts: du has kept a provision for doubtful debts in Account Receivables and some amounts have been written-off on the basis of actual account history. There is no basis given for the calculation of doubtful debts. Actual recovery of payments in future and further write-offs may significantly affect du's operating margins. 3. Statement of Cash Flows: Finance Income and Expense have been kept under the heading "Cash Flows used in Investing Activities". In fact, Finance Income and Expense should be recorded under "Cash Flows from Financing Activities" so that financial report provides an accurate classification of Cash Flows.

du Ratio Analysis:
1. Profitability RATIOS PROFITABILITY ROI (Return on Shareholders' Investment) ROCE (Return on Capital Employed) Operating Margin Gross Margin Overheads/Sales Sales Growth YEAR 2007 (22%) (22%) (57%) 56% 116% N.A. YEAR 2008 0.1% 0.25% 0.43% 64% 63% 157% YEAR 2009 6.6% 7.72% 10.13% 66% 56% 35%

du started its commercial services in year 2007. As is evident from above table highlighting profitability ratios for 3 years, 2007 produced a net loss. du had only started services and initial overheads/general expenses were obviously much higher during this year as du was busy in launching its services and expanding the infrastructure through-out the breadth & depth of the country.

As per the Government's telecom policy, du is also charged a telecommunication license fee payable to TRA (Telecom Regulatory Authority) in order to operate as a service provider. Other expenses, which are typical to Telecom industry is Indefeasible right of use, which is paid by du to operators of fibre-optic cable system. This resulted in accumulated losses for first year. In 2008, business picked-up the pace and sales grew by 157%. Overheads to sales ratio came down sharply. It was a remarkable year of du as they had broken-even within the second year of operation. In 2009, all major indicators of profitability were in positive range. Operating margin shot-up as overheads were contained. du ended 2009 with a decent profit of AED 264 million.

2. Liquidity: RATIOS LIQUIDITY Working Capital Acid Test (Quick Ratio) YEAR 2007 45% 42% YEAR 2008 94% 92% YEAR 2009 60% 60%

Liquidity ratios are a benchmark for working capital available and that whether company will be able to honor debt-payment commitments. Ratios above highlight a negative working capital. As du started expanding business at fast pace over 3 years, current liabilities have increased accordingly due to jump in Accounts Payable. However, let's not forget the fact that du is a service industry and in its initial years of launch, where it needs to invest in infrastructure hence the need for more working capital. In spite of negative liquidity, it is assumed that du has been able to negotiate with its sundry creditors to extend credit periods so that it can manage cash required for day-to-day operations.

3. Gearing: RATIOS GEARING Gearing Ratio Interest Cover YEAR 2007 N.A. N.A. YEAR 2008 52% 0.9 times YEAR 2009 52% 41 times

Gearing ratios highlight the company's ability to repay long-term debts and interest. du realized in 2008 that it needs substantial amount of money to put-up infrastructure, etc in order to support its expansion drive. Hence they decided to get a long term loan facility of AED 3 billion, which is due to be paid in 3 years. While gearing ratio is still high at 52% but as evident from above, high profits in 2009 made sure that du has sufficient cover to fund the interest charges over long term. 4. Activity/Efficiency: RATIOS ACTIVITY/EFFICIENCY Asset Turnover Days' Sales Outstanding YEAR 2007 35% 93 Days YEAR 2008 51% 55 Days YEAR 2009 56% 62 Days

Asset Turnover ratio is a benchmark for company's ability to utilize assets to generate sales. Efficiency of a company to implement a high asset turnover results in generation of more revenue/cash. du has continuously improved Asset Turnover during last 3 years. While Outstanding Sales were higher in 2007 because of 1st year of operation, du has tried to manage receivables from its debtors during subsequent years

5. Shareholder Return: RATIOS SHAREHOLDER RETURN Dividend per Share EPS (Earnings per Share) YEAR 2007 N.A. (AED 0.22) YEAR 2008 N.A. AED 0.001 YEAR 2009 N.A. AED 0.066

As explained in Profitability Ratios, du made a net loss in 2007 and broke even in 2008. du made decent profit in 2009 but management decided to retain profits to compensate accumulated losses in previous years. Hence du did not pay any dividends in all these years. Earning per Share has steadily improved as du started to book profits in 2009.

Industry Peers:
It is important to compare financial results of du with other players in Industry. du has only one competitor in the UAE, Etisalat. Let us have a look at Ratio Analysis of Etisalat.

Etisalat Ratio Analysis: RATIOS PROFITABILITY ROI (Return on Shareholders' Investment) ROCE (Return on Capital Employed) Operating Margin Gross Margin Overheads/Sales Sales Growth LIQUIDITY Working Capital GEARING Gearing Ratio Interest Cover ACTIVITY/EFFICIENCY Asset Turnover Days' Sales Outstanding SHAREHOLDER RETURN Dividend per Share EPS (Earnings per Share) YEAR 2008 23% 39% 22% 64% 63% 37% 81% 7% 12 times 47% 68 Days 0.41 1.18 YEAR 2009 23% 40% 29% 66% 56% 5% 83% 7.8% 15 times 43% 90 Days 0.49 1.23

ROI and other profitability indicators are much higher for Etisalat than compared to du. Though Gross Margins are almost similar for both companies, the difference lies in high-overheads and operating expenses for du in initial years of launch of services, which has severely affected its net profits. Etisalat is more than 3 decades old company and past its initial growth years. Sales growth in 2009 has been a meager 5%, which suggests saturation in its ability to attract more clients because of stiff competition with du. Etisalat has a more favorable working capital ration compared with du It is interesting to note that while Etisalat has a low gearing ratio, which is due to the fact that long term borrowings are much lower compared to shareholders' funds, at the same time it is not generating enough profits to fund interest charges for a long term. Interest cover in year 2009 at 15 times is much lower than du's 41 times. Etisalat seems to have a problem with managing receivables as total sales outstanding in 2009 has jumped to 90 days. Unlike du, Etisalat has paid decent dividends though-out the years and has recorded a modest Earning per Share.

du Performance Highlights:
Since the launch in Feb 2007, du has continuously strived to grow by leaps & bounds and it has been successful in taking major share of business against the Telcom giant Etisalat. At the end of 2009, du had a 32% mobile market share with a customer base of 3.4 million in a population of around 5 million. It's worth mentioning that majority of new subscribers in the UAE came to du. Revenues in 2009 grew by 35% to reach 5.3 billion. During this year du launched innovative packages to mobile & broadband services to attract new customers. Du ended 2009 with a profit of AED 264 million.

Internal Factors Impacting du's Performance:

As du has been in growth years till now and trying to expand at breakneck speed, following internal factors may affect its future performance: du has invested heavily in Properties, Plant and Equipments in order to build infrastructure. These investments have been made through long term debts and promissory note. du is supposed to pay its long term debt of AED 3 billion by June 2011. In order to repay the debt, du will have to turn-around its business to generate sufficient cash during 2010. If du is unable to pay, it may have to re-finance this debt probably at higher interest charges. It poses a catch 22 situation for du as it may require further investments in 2010 to fuel its growth. du has already announced that it will be investing around AED 2.2 billion during 2010, in order to upgrade its telecom services. This situation is typical of service industries in high growth phase and all depends upon how well du manages its long terms debts versus cash being generated. Telecom industry is fast evolving with customer preferences changing at fast pace. To achieve success, companies need to have teams of Technocrats who are capable to keep abreast with latest trends/changes in different product profiles. du's ability to perform will depend upon how well it keeps a track of new products/services being offered worldwide and then preparing itself to provide those services in time to its target markets.

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External Factors Impacting du's Performance:

Since the launch, Federal Government had reserved some areas exclusively for du so that it can gain some ground before being able to compete with Etisalat. From 2010, these restrictions will be lifted and both du and Etisalat will be able to offer services in all areas. They will also formalize an infrastructure sharing agreement. du will have immense advantage as it will be able to expand smoothly. Instead investing in infrastructure, du will be able to operate by paying a nominal fee against sharing of Etisalat's infrastructure. As per new rules, government will allow portability of mobile numbers from 2010. Which means Etisalat customers will be able to shift to du, without having their mobile numbers changed and vice versa. In that scenario, quality & cost of services will dictate customers' preference for service provider. du has kept a provision for potential royalty charge at 50% of the annual net profit to be paid to Federal Government, which is based on the current royalty being paid by its competitor Etisalat. As at 31st December 2009, government had not advised final structure of the Royalty Fee. There had been talks that government may substantially reduce the Royalty Fee for du. If that happens, it will increase du's profits remarkably and company will be able to utilize excess cash to pay its long term debts and invest in further expansion While du is expanding rapidly in the UAE, it would be worth mentioning that there is limit for growth in the UAE due to small increase in population. Local market has already started showing signs of saturation. Etisalat has heavily expanded in Middle East, Africa and Sub-continent. In order to achieve respectable growth in coming years, du will have to start exploring business potential in overseas markets.

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Analysis for Shareholders:

Telecom is a growth industry with tremendous opportunities. Since launch of its services, du has grown with a steady pace. Having registered losses in first year, du bounced back by breaking-even within the second year, which itself is an outstanding achievement given the extent of investments required in telecom industry. And then, du made a decent profit of 264 million in third year i.e. 2009. Revenues too grew substantially as du expanded operations. It is true that du has not yet declared any dividends and earning per share has only started to grow now. But fact remains that du is past its major investment phase. Operating margins will be much higher in coming years as revenues grow exponentially due to rapid expansion plans of du. Recent decisions like Infrastructure Sharing Agreement will also help du to keep overheads in control. Icing on the cake is government's recent decision (dated 15th Feb 2011) to slash annual royalty fee for du. Government has decided that du does not have to pay royalties for 2008 & 2009. And for 2010 it will be 15% instead of 50% being paid by its competitor Etisalat. This decision is a major boost for du as it has kept provision for royalties totaling AED 268 million for the years 2007 till 2009. Waiver of Royalty Fee would add AED 268 million in du's profits for above 3 years and there will be significant increase in Earning per Share. Subsequently, du is most likely to announce dividends for its shareholders. Share prices rose to 15 months high on government's decision. Current price (AED 3.15) and P/E ratio (10.99) are attractive and most of the analysts have recommended buying shares with a target price reaching AED 3.9 per share. Looking at all above factors, it is strongly recommended that shareholders increase their investment in du.

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References:
du, Annual Report 2007. Retrieved March 01, 2011, from http://media.corporateir.net/media_files/irol/19/199506/reports/2007_q4_fs_en.pdf du, Annual Report 2009. Retrieved March 01, 2011, from http://media.corporateir.net/media_files/irol/19/199506/reports/2009_q4_fs_en.pdf Etisalat, Annual Report 2009. Retrieved March 01, 2011, from http://www.etisalat.ae/index.jsp?lang=en&type=finrep&currentid=19b3e f5dc1b42110VgnVCM1000000c24a8c0____&parentid=249def484523a01 0VgnVCM1000000a0a0a0a Gulfbase.com, 2011, du company profile. Retrieved March 13, 2011, from http://www.gulfbase.com/site/interface/CompanyProfile.aspx?c=604 Gulfbase.com, 2011, Etisalat company profile. Retrieved March 12, 2011, from http://www.gulfbase.com/site/interface/CompanyProfile.aspx?c=448 Naeem Brokerage, 2011, du, A bright spot-BUY. Retrieved March 11, 2011, from https://online.naeembrokerageuae.ae:4443/etrade/ar/data/files/home_ page_reports/Du%20%204Q10%20Results%20Review%20and%20Valuation%20Update%20%209%20March%202011.pdf Reuters.com, 2011, Update 1-UAE's du 2010 profits seen doubling on royalty change. Retrieved March 02, 2011, from http://www.reuters.com/article/2011/02/15/emirates-duidUSLDE71E0HQ20110215 Sharewadi.com, 2008, du 2008 FY Annual Report. Retrieved March 04, 2011, from http://www.sharewadi.com/result-details.php?result_ID=1765

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