The problem of capital structure that affecting profit margin the case of hung vuong corporation

The percentage of debt in HVG’s capital structure was at the high rate and much higher than the rivals’ and the average of the industry.. The study also prefers to the possible solutions

UNIVERSITY OF ECONOMICS HOCHIMINH CITY

INTERNATIONAL SHOOL OF BUSINESS

THE PROBLEM OF CAPITAL STRUCTURE THAT

AFFECTING PROFIT MARGIN: THE CASE OF

HUNG VUONG CORPORATION

Instructor: Dr Pham Phu Quoc Student: Nguyen Thanh Quyen

MBA Class 5.2

Ho Chi Minh City – Year 2017

List of Tables

Table 1: Income Statement of HVG 2014 – 2015 11

Table 2: Capital structure of HVG over the period 2014 – 2015 12

Table 3: Performance of 4 biggest corporate in the fishery industry in 2015 15

Table 4: ROA and ROE of the 4 biggest companies in the fishery industry 16

Table 5: HVG Dupont Analysis 2012 – 2015 17

Table 6: HVG’s debt and BEP ratio 2013 - 2015 20

Table 7: Capital structure of 4 biggest corporates in the fishery industry in 2015 21

List of Figures

Pig 1: HVG’s stock price performance over the period 2013 - 2016 13

Pig 2 Revenue of the 4 biggest companies in the fishery industry 15

Pig 3 Profit margin of the 4 biggest companies in the fishery industry 15

Pig 4: Potential causes and effect tree of the problem 23

Pig 5 Methods of raising capital 32

Table of Contents

Executive Summary 5

Chapter 1: The Problem Context 6

The Framework of Thesis 8

Chapter 2: Problem Identification 10

2.1 Company’s Symptoms 10

2.1.1 The higher increasing in the revenue, the greater rising in cost and expenses 10

2.1.2 The decline of HVG’s profitability and profit margin over the time 11

2.1.3 The fluctuation and reduction of HVG’s stock price 12

2.2 Problem identification 13

2.4 Possible reasons of problem 16

2.4.1 Recognition of Possible reasons 16

2.4.2 In-deep on-the-field interview for more understanding the causes 22

Chapter 3: Design Solutions and Suggestions 25

Chapter 4: Action Plan 33

References 35

Appendix 38

The main causes lead to the problem of low profitability could be poor management of expenses, specialized in financial expenses According to the data collecting from HVG’s annual financial report and its competitors, HVG uses a very high financial leverage The percentage of debt in HVG’s capital structure was at the high rate and much higher than the rivals’ and the average of the industry An analysis Dupont model had been conducted based on financial data and also a survey of deep interview HVG’s staffs had been conducted to confirm the main causes which consistent with the findings of Hamid MA et al (1) that debt ratio is negatively and

significantly related to profitability and profitable firms depend more on equity as their main financing option The results also confirmed that an increase in leverage position is associated with a decrease in profitability

The study also prefers to the possible solutions for building an effective capital structure, improving operational efficiency by maintaining the debt percentage in the capital structure as the level of average of the industry and restructuring the HVG’s capital structure by raising capital instead of raising borrowing capital HVG should prioritize using endogenous sources (such as retained earnings) to response the demand of capital for operation, then debts and finally equities issued which used to be mentioned the research of Quang and Wu (2) Among numbers

of methods of raising equity, undistributed earnings may be best alternative internal capital for

borrowing capital from outside Finally, the action plan is also suggested in the study

Chapter 1: The Problem Context

Hung Vuong Corporation was initially established under the name of Hung Vuong Limited Company in September, 2003 with its major function as a processing plant of Pangasius for export Later the company enlarged its scope and officially changed its name into Hung Vuong Corporation in 2007 At the moment, Hung Vuong Corporation runs a closed system of

producing breed, aquaculture, processing, cold storage, and exporting Thus, the company is able

to self - supply raw materials, helping the company to strictly control the quality and cost of operation In 2015, Hung Vuong’s charter capital is VND 1,892 billion with the total of

employee is over 17,000 The head office of the company is placed in Block 44, My Tho

Industrial Zone, Tien Giang Province, Vietnam and two Representative offices in Ho Chi Minh City One is in 144 Chau Van Liem St, Ward 11, District 5, Ho Chi Minh City, Vietnam and the other one is in Level 7, Resco building, 94-96 Nguyen Du St, Ben Nghe Ward, District 1, Ho Chi Minh City, Vietnam

Hung Vuong Corporation is proud of itself after over 10 years in business Hung Vuong is the biggest processor and exporter of Pangasius in Vietnam At present, Hung Vuong’s products are available in 60 countries in the world (Appendix 1) EU and USA are the two main exported markets, these markets account for 60% in total Hung Vuong's Export Market Share by Country (Appendix 2) The export value of Hung Vuong Corporate has been increasing since 2004 until now In 2015, its total export value achieved USD 400 million in average (Appendix 3)

According to the result of operating during the period of 2012 - 2015, profit decreased significantly and did not achieved the annual plan while the revenue showed the up-ward trend HVG’s gross profit margin (GOS) and other financial ratios of efficiency such as return on asset

(ROA), return on equity (ROE), return on revenue (ROS)… also showed the down-ward trend

In 2015, HVG’s profit after tax was VND 120 billion, down 58.86% in comparison with 2014’s and equal 22% profit plan in 2015 The gross profit margin was 7.51%, down 0.29%, ROA and ROE decreased significantly from 3.22 and 12.3 to 0.383 and 3.61 in respectively Additionally, EPS was VND 750 per share which was much lower the EPS in 2014 (VND 2,200 per share) This study will make a deeply analysis in the operation of the company over the period 2013-

2015 in order to find the real problem causing the fallen in Hung Vuong Corporates operation in recent years

The Framework of Thesis Company's

control-such as financial structure, size, market share, and business strategy

Real problem: Low business efficiency related to high cost and expenses in operation

Main causes Recognizing possible reasons through theory information, Dupont model

analysis and In-deep interview, including:

- The asset was not utilized effectively; and;

- Poor management of cost and expenses lead to profit margin down;

 The asset was not utilized effectively;

 Poor management of cost and expenses lead to profit margin down: (i) COGS and especially (ii) Financial expense (Financial structure) Design

- Most of the firm prefers internal to external financing; ect…

Solution: reconstructing the capital structure

- Maintaining the debt percentage in the capital structure as the level of average of the industry;

- Raising equity instead of raising borrowing capital:

 Internal capital: Paid-in capital, Undistributed earnings; and

 External capital: Debt; Issuing new share

Action plan - Identifying capital needs for operating activities;

- Capital mobilization options to choose reasonable source of capital;

- Making a capital distribution and utilization plan effectively and efficiently

Chapter 2: Problem Identification 2.1 Company’s Symptoms

After investigating some of the financial ratios and interviewing all the responsible

members of the company, the symptoms of the problem had revealed as following:

- The growth rate of the HVG’s cost of goods sold and expenses is greater than this of its revenue;

- HVG’s profit margin and profitability have decreased steadily over the time;

- HVG’s stock price has fluctuated in a wide range and illustrated the down-ward trend

in the last few year

In detail, the symptoms have been proved as below:

2.1.1 The higher increasing in the revenue, the greater rising in cost and expenses

For the whole company, export value and operating revenue increase gradually over the period 2013-2015 In detail, the Company’s export value increased sharply in 2014 and got the highest value at USD 400 million in 2015 (Appendix 3) Operating revenue increased from VND 7,749 billion in 2012 to VND 11,179 billion and VND 15,042 billion in 2013 and 2014

respectively Although in 2015, its operating revenue could not maintain this amazing rate and decreased slightly 17%, in general, the company has a high growth rate over the period The average growth rate during the period 2012-2015 was 20.5% - quite high when comparing to the average rate at 10.6% of the fishing industry as published by the General Statistics Office of Vietnam

In the mean of time, the cost of goods sold increased dramatically from VND 10,058 billion in 2013 to VND 13,782 billion in 2014 This trend continued in 2015 with the cost of goods sold raised to VND 11,446 billion, accounted for 91.98% in the structure of the revenue

In addition, the financial expense showed an up-ward trend during the period, it rose from VND

298 billion in 2014 to VND 325 billion in 2015 The growth rate of financial expense in 2015 was 8.9% and this kept increasing highly up to 32.36% in just the first three quarters of year

2016, value VND 430 million On the contrary, other expenses from selling, administrating, etc.… illustrates the down-ward trend This leads to the result of net profit in 2015 which drops deeply 59% in comparison with its net profit in 2014 Details could be found on Table 1 below

Items Value (in billion VND) Position (%)

2013 2014 2015 2013 2014 2015

Revenue from sale of

goods and services 11,179 15,042 12,445 100.00% 100.00% 100.00%

Cost of goods sold 10,058 13,782 11,446 89.97% 91.62% 91.98%

2014 to VND 121 billion in 2015 and the net profit also decreased 58,9% in comparison with its result in 2014 Moreover, the position of net profit in the revenue decreased steeply from 2.22%

in 2013 to 0.96% in 2015

Additionally, Table 2 illustrates that most of the company’s financial ratios of efficiency showed the down-ward trend over the period In 2012, ROA and ROE was 4.08% and 11.97% respectively and these ratios decreased significantly to 0.83% and 3.61% respectively in 2015 The profit margin on revenue (GOS) also decreased from 3.39% to 0.97% in 2015, this problem leads to EPS going down gradually to 0.75 in 2015, this is the lowest rate of EPS in the last five years

Pig 1: HVG’s stock price performance over the period 2013 - 2016

Is there any relation between HVG’s performance and the capital structure? according to the result of Myers’ theory (3) that predicts a negative effect of leverage change on stock prices and a stronger effect for firms more likely to experience debt overhang Cai, Jie et al (4) also confirmed in their research that when a firm is more prone to debt overhang, an increase in the leverage ratio may affect future investment and expected future cash flow more severely and thereby effecting on the stock price

exercises control but owns only a small fraction of the firm’s cash flow (5) Shleifer and Vishny argued that as the control-ownership disparity increases, controlling shareholders appropriate more firm resource Thus, conflicts of interest among shareholders can lower firm performance Additionally, Joh and Sung Wook (5) argued that the other factors can affect the profitability includes industry, macro-economic and firm attributes such as financial structure, size, market share, and business strategy In term of capital structure, Joh and Sung Wook (5) emphasized that there are mixed effects of debt on firm profitability A rise in debt increases default risk, firms can reduce wasteful investment and increase firm performance to secure their survival On the other hand, debt can increase conflicts of interest over risk and return between creditors and equity holders Facing large debts, equity holders with limited liability may encourage the firm to undertake overly risky projects

In case of the HVG, with all the symptoms mentioned above, the problem may be related

to the factor of firm attributes in general and in expense management in detail For further

evidence to pursue that there is an existing problem in the company business Further

investigation on the competitor, market will be executed and made the comparison with the company The Pig 1 illustrates that HVG dominates the market share and its growth rate in revenue is always at the highest rate in the industry The value of revenue increased steadily over the period 2012 – 2015 and the gap between the company’s revenue and the other corporates’ is enormously huge On the contrary, HVG’s profit margin went down gradually over the time while its rivals showed the opposite trend during the period 2012-2014 and its profit margin got the lowest value among the four corporations in 2015 As gross profit margin is the quick

indicator of the ability of generate profit from the company main activity (6), it should be a positive number or at least show the positive improvement trend The negative trend in HVG’s

profit margin over the time signals that there must be a problem in the basic activity

Pig 2 Revenue of the 4 biggest companies in the

fishery industry

Pig 3 Profit margin of the 4 biggest companies

in the fishery industry

In detail, in 2015, among the four biggest corporates in the fishery industry, HVG

achieved the highest revenue among the four corporates in the industry, with IDI, were the two companies having the highest growth rate in the industry, approximately increased 20.2%

comparing with year 2014 (Table 4) However, HVG’s net profit decreased 56.2%, this was

much lower than VHC’s IDI and FMC are the two companies which have the positive growth

rate of profit while their revenue are less approximately 6 times in comparison with HVG’s

revenue Net profit of IDI and FMC are positive and increase 16.3% and 51.3% respectively

Revenue Profit after

In term of the profitable ratios, the Table 4 has showed clearly the accurate number and undeniable comparison with its competitors, In 2012, HVG’s ROA and ROE were 4.08% and 3.32% in respectively and were much higher than IDI’s and FMC’s In 2015, these financial

ratios of HVG’s decreased steadily and were much lower than that of the others in industry, its ROA and ROE were 0.83% and 5.8% respectively and were much lower than this ratio of FMC and VHC This is the reason why the capability earning profit per share of HVG is lowest among the four corporates in the statistic

ROA

(%) 2012 2013 2014 2015

EPS (%) 2012 2013 2014 2015

Table 4: ROA and ROE of the 4 biggest companies in the fishery industry

From result of analysis the company’s annual financial report and comparing with the

competitors, it could be seen that for similar company in the industry, their gross profit margin increased during the period 2012-2014 or slightly decreased in 2015 in spite of their lower

revenue in both value and the growth rate than this of HVG Additionally, their profitable ratios showed the up-ward trend instead of going down as the company’s It is proven that the problem

of HVG is unlikely due to the market condition but the company itself

2.4 Possible reasons of problem

2.4.1 Recognition of Possible reasons

To find the possible reasons of low efficient in HVG’s operation, an analyzing process was executed in Dupont Analysis based on the data collected from annual financial report of HVG According to S Christina Sheela1 el at (7) the model was created by F Donaldson Brown in the

early 1900s and is valid to use for assessment of the profitability which is based on analysis of Return on Equity (ROE) & Return on Investment (ROI) The return on equity disaggregates performance into three components: Net Profit Margin, Total Asset Turnover, and the Equity Mu ltiplier, the formula can be defined clearly as:

Net Income/Total Equity = (Net Income/Net Sales) x (Net Sales/Total Asset) x (Total Asset/

Total Equity); or it can be rewritten as

Net Income/Total Equity = (Net Income/Net Sales) x (Net Sales/Total Asset) x (Total

Asset/Total debt) x (Total debt/ Total Equity)

According to calculation from HVG’s financial reports, Dupont Analysis for HVG case is shown

in table 5 below:

2012 2013 2014 2015

Dupont (ROE) = (1) x (2) x (3) x (4) 0,120 0,106 0,123 0,036 Net Income/Net Sales (1) 0,034 0,022 0,019 0,010 Net Sales/Total Asset (2) 1,213 1,119 1,667 0,861 Total Asset/Total debt (3) 1,680 1,472 1,462 1,297 Total debt/Total equity (4) 1,748 2,902 2,614 3,367

Table 5: HVG Dupont Analysis 2012 – 2015

Table 5 shows an obvious analysis of components impacts on ROE The Total debt/Total equity ratio is increasing from 1,748 to 3,367 in the period of 2012-2015 In contrast, the Net sale/Total Asset and Net Income/Net Sales ratio is decreasing, which causes Dupont – ROE in a downward trend Technically, It can be pointed out that there may be two reasons causing ROE declining over the period These are:

- The asset was not utilized effectively; and

- Poor management of cost and expenses leads to profit margin down; in detail

The asset was not utilized effectively that means the capability of making revenue per one

unit asset decreasing The ratio of net sale to total asset deceased dramatically from 1,67 in 2014

to 0,86 in 2015 According to the annual financial report of year 2015, HVG’s total asset

increased significantly from VND 9.025 billion in the end of year 2014 to VND 14.446 billion The large proportion increased in the short-term receivable from customers and inventories, which increased 49,1% and 62,9% respectively In contrast, the revenue in 2015 declined in comparison with last year, down 20,9% This leads to the ratio net sale to total asset drop

dramatically in 2015

Moreover, According to the fishery industry of Asean security report, the market of

industry faced many difficulties over the time 2013-2015 due to tariff barriers and dumping law

of main exported markets The statistic of General Deparment of Vietnam Custom shows that the total exporting revenue of fishery industry in 2015 is USD 6.57 billion, down 16% in

comparison with 2014 The report also forecasts that in 2016, the fishery industry continues to face many disficulties related to price, exchange rate, tariff barriers and international dumping regular Therefore, it can be confirmed that this reason may be the effects of external

environment and this is the common problem which every corporates in the industry have faced

Poor management of cost and expenses lead to profit margin down: these are cost of

goods sold and expenses related to the company’s operation, such as depreciation of machine, location fee, transportation, delivery… In his book, Hansen et al (8) stated that for pricing

decision, product decision and strategic profitability analysis, all traceable costs need to be assigning to the product This mean the cost is not just only the manufacturing cost but also the non-production cost that related to the products such as: Research and Development cost,

Administrative cost, selling cost, etc In case of HVG, its (i) COGS and especially (ii) Financial

expense increase steadily over the time, and the growth rate of financial expense is much higher than its revenue On the contrary, its other expenses from selling, administrating, etc.…

illustrated the down-ward trend

(i) In term of Cost of goods sold: As it can be seen in the Table 1, the percentage of COGS

in revenue increased slightly 91.62% in 2014 to 91.98% in 2015, while financial expense

increased steeply 8.92% over the period On the other hand, HVG is one of the biggest

corporations in the industry which has a closed system of producing breed, aquaculture,

processing, cold storage, and exporting Thus, the company is able to self - supply raw materials, helping the company do not reply much on the outside materials and strictly control the quality and cost of operation Therefore, this reveals the problem may not come from COGS, it may be specific from the expenses

(ii) In term of financial expense: As it can be seen in the Table 6 that the company uses a

very high capital structure, total debt increased from VND 3.804 billion in 2012 to VND 11.138 billion in 2015, the total debt was 1.75 times higher than total equity in 2012 and total debt kept increasing and was over 3 times higher than total equity in 2015 On the other hand, the capital structure ratios show that HVG increased the percentage of debt by borrowing money from financial institutes instead of raising its equity The percentage of short-term debt in total asset increased highly from 88.2% in 2014 to 93.0% in 2015 Although long-term debt to total asset ratio decreased in 2015, total debt over total asset and equity increased significantly from 68.4% and 216.3% in 2014 to 77.1% and 336.7% in 2015 respectively

(in Billion VND or %) 2012 2013 2014 2015

Total Equity 2,176 2,339 2,361 3,308

Short-term debt 3,769 6,771 5,443 10,354

Long-term debt 35 16 729 784

Table 6: HVG’s debt and BEP ratio 2013 - 2015

According to the fishery industry report in April 2016 by Asean Security, the typical character of the fishery industry is that material expense accounts highly in the revenue, most of the corporates in the industry use much short-term debt to sponsor the operating activities, the average short-term debt to total debt ratio is 79.1% and the average of capital structure is 0.61 In comparison to the industry, HVG has short-term debt to total debt ratio and capital structure much higher, valued 92.96% and 0.77 in 2015 respectively Additionally, HVG’s financial leverage is 5.74 while financial leverage of most corporate in industry is 3.65 in average This leads to the financial expense increasing rapidly during the time and then affecting on the profit

Shubita et al (9) argued that the higher the debt ratio, the greater the risk, and thus higher the interest rate will be At the same time, rising interest rates overwhelm the tax advantages of debt

Coricelli et al (10) also stated that net benefits to debt financing rise for companies with low debt but decrease as leverage becomes high, implying that net benefits are a non-monotonic function of leverage They also argued in their research that at low levels of leverage, higher leverage is likely to be associated with higher TFP growth as the benefits to leverage outweigh the costs and debt is used to finance productive investment As leverage increases, the costs of debt become larger and erode the net benefits to leverage

Short-term debt (Billion VND) Short-term debt/Total debt (%)

2012 2013 2014 2015 2012 2013 2014 2015

HVG 3.769 6.771 5.443 10.354 HVG 99,1% 99,8% 88,2% 93,0%

IDI 839 1.201 1.216 1.916 IDI 80,2% 84,7% 81,9% 74,8%

Table 7: Capital structure of 4 biggest corporates in the fishery industry in 2015

In comparison with the competitors, HVG’s short –term debt increased gradually over the time with a much higher growth rate in comparison with the other corporates Highly short-term debt in the total debt seems a typical character of the industry, however, this ratio of HVG was higher the average of the industry (79.1%) In term of capital structure, HVG also showed the up-ward trend over the time and was the highest among the four corporates

Another evidence to pursue the reason related to the financial expense has been

conducted through an analysis based on the Basic Earning Power (BEP) ratio which indicates basic profitability of assets and is useful in comparing firms with

different degree of leverage The formula to calculate this ratio is

Earnings Before interest and tax (EBIT)/Total assets (TA) Robert B Burney et al (11)

demonstrates that in order for financial leverage to increase ROE, the interest rate must be lower than BEP ratio (r < EBIT/TA) As showed in the Table 6, HVG’s BEP ratio decreased

significantly from 9.47% in 2012 to 6.18% and even to still 3.3% in 2015 This is quite low in comparison with the interest cost that HVG has to pay to some financial institutes and even lower than the average interest rate of saving in the Vietnam’s market which is approximately

6.5% This means the more HVG uses debt for financing its operating activities the worst the

profit rate is This is in order with the finding of Shubita et al (9) that an increase in debt position

is associated with a decrease in profitability; thus, the higher the debt, the lower the profitability

of the firm

2.4.2 In-deep on-the-field interview for more understanding the causes

In order to identify the real of problem of HVG, a survey of deep interview HVG’s staff and a financial analysts of Saigon Securities Incorporation (SSI) have been conducted

Through interviews, the responders have specified the whole situation of the HVG over the period (2012 – 2015), this can be summarized:

Mr Tuan Vu, an experience accountant of HVG, stated that the most worrying point is the expansion of HVG too fast accompany the total short and long - term debt increased from 2,958 billion in 2012 to 8.355 billion in 2015 (accounting for 58 % of total assets) has created

considerable pressure on interest rates Interest expense is always at the high level, 2015

recorded 239 billion

In detail, Ngoc Thuy, a financial staff of HVG, illustrated that the reasons why HVG’s profit decreased over the period while it revenue showed the opposite trend, includes internal and external causes The external causes come from the unstable market over the a few last years, the pangasius market become very competitive, the price decreased steadily and the demand of main foreign market become narrow, such as USA, Asean, Mexico… and especially European market, the value exported to this market decreased deeply because of the dumping rule published by these countries The internal causes come from investing with a high growth rate and using high leverage The total of short-term and long-term debt increased sharply over the period This lead

to the financial expense always being at the high percentage in the revenue and increased

steadily

Moreover, according to Mr Tuan Vu, another problem which HVG facing is quite large accounts receivable increased from 1,854 billion in 2012 to 5,641 billion in 2015 makes

provision for bad debts of up to 347 billion in 2015 Additionally, HVG’s inventory also showed the up-ward trend over the period, accompany with investing with a high growth rate making fixed assets increased steadily over the year This lead to the total asset increased highly while the net profit decreased This means that the capability of making revenue per one unit asset decrease

After the meeting and in-depth interview with the company’s staff and base on symptom; data collected from competitors From that result, the concise cause-effect tree of this division problem is generated in Figure 1 below:

Pig 4: Potential causes and effect tree of the problem

In summary, it could be illustrated that during the period of 2012 - 2015, HVG’s

competitors could maintained the growth rate of profit higher than HVG’s profit growth rate

HVG’s performance efficiency decreasing

The decline of performance efficiency over the time

The fluctuation and decrease of HVG’s stock price