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5 Budgeting & Forecasting
This part of the thesis will contain the budgeting and forecasting in order to conduct a valuation of Lego based on a present value approach.
The forecasting system is based on a sales-driven forecasting approach as recommended by Petersen et al. (2017).
The budgeting and forecasting are based on the findings in the strategic and financial analysis as the historical period is used as a foundation for the forecasts and provides insights about the trends and levels of the financial value drivers to be estimated.
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company’s most significant regions, Western Europe and North America experiencing a decline in revenue growth of 9.69 % and 12.95 %, respectively, and due to inventory clean ups. Asia Pacific has been the region with the most tremendous growth potential with China generating double-digit growth.
The company’s sustainable competitive advantages, its investments in growth markets and industry expectations are the key contentions for the forecasts.
Lego operates in the industry of traditional toy and games why the industry expectations mentioned in the strategic analysis are relevant to consider when determining the sales growth. The expectation for the sales growth in Lego’s geographical regions is determined based on historical figures and the strategic analysis hereunder industry expectations.
The Chinese market has provided Lego with double-digit growth due to more extensive investments in new stores, e-commerce, and economic growth in the market. The branded Lego stores are assessed to be valuable for the company as they can differentiate themselves from their competitors and as they ease fears of counterfeit products. It is expected that the Chinese market will continue to be an important market for Lego to invest in due to its growth prospects and changes in legislation which ensures improved terms for businesses including increased focus on fighting manufacturing and sales of counterfeit goods. Based on these observations the sales growth in the Chinese market is expected to continue at a high level which will drive the sales growth in the Asian Pacific region.
As concluded in the external analysis the most extensive distribution of the young population will continue to be Asia Pacific, Middle East and Africa and Latin America. This provides opportunities for Lego though it is essential to consider that in some regions, the GDP per capita is low, why expectations to these markets are not all high.
In addition, the external analysis concluded stagnation of Lego’s most generating geographical regions, Western Europe and North America while these markets are also expected to have a low future growth in the industry of traditional toys and games. This is also impacted by the increasing uncertainty with Lego’s fourth largest market, the UK, due to a possibility of a no-deal Brexit. Although the future expectation to these markets are low, they are still expected to be some of the most generating regions for Lego in the future.
Expectations for the future sales growth are additionally based on findings in VRIO analysis. The brand value of Lego, in comparison to its competitors, is at a considerably higher level. The Lego brand represents a clear history of quality and innovation. The company rely on its own resources regarding
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innovation as well as making use of collaborations and open innovation generating the company with new ideas. In order to maintain a strong competitor in the industry, innovation is vital key to survival due to the industry’s changeable nature. Innovation is assessed as a sustainable competitive advantage for Lego why it is thought that Lego will be able to meet the changing consumer needs and fickle industry. Today, Lego aims to offers a product portfolio which contains approx. 60 % new products each year demonstrating their ability of innovation. Lego’s ability to ensure innovation is thought to be a source of the future sales growth.
Lego is a market leader in the industry of construction toys and had 65.1% of the market shares in 2019.
This sub-industry is expected to grow at a CARG of 5.53% from 2020-2024 and has been applied when projecting the revenue growth.
Table 5.1: Own creation
The sales growth is projected to increase and will reach a steady state at 3% which is based on the long-term economic growth rate (Euromonitor). The projected sales growth for Lego is split into geographical regions and can be found in Appendix 14.
5.2.2 Operating costs
It is recommended to generate the forecasted operating expenses based upon the revenues. Operating expenses include the cost of goods sold, research and development and selling, general, and administrative expenses (Koller et al., 2010: 30). The cost of Lego contains of production cost, sales and distribution expenses, administration and IT expenses and other operating expenses which have been forecasted for the years 2020 to 2029. It is expected that a steady state appears after the year 2029. In figure 5.4, the forecasted costs of Lego appear.
Table 5.2: Own creation
5.2.2.1 Production costs
The production costs for Lego are projected to be 25.5% over the forecast period as well as the terminal period. The 25.5% is relative to the sales and is determined as the historical average. Lego identifies its production costs as both direct and indirect costs. The direct costs are composed of raw materials,
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direct labor and consumable costs. The indirect costs are composed of other costs related to the production of goods and supply chain related costs (LEGOa: 22).
The production costs are forecasted to be consistent due to Lego’s organizational structure as they have in-house production which is considered to keep costs down. Lego has full control on minimizing their costs, and due to the economics of scale, it has been possible to produce at a large volume while keeping the costs at a lower level. Furthermore, Lego continuously invest in solutions to keep their production costs low e.g. automated warehousing why it is thought that the costs can be maintained at a stable level.
The reason for the ratio not being forecasted as a lower ratio is due to Lego’s continuous expansion of new production facilities e.g. the expansion of the factory in Hungary, launching facility in China as well as an on-going expansion of the factory in Mexico due to increasing demand for Lego products (LEGO.com, P & LEGO.com, Q).
Due to the conditions mentioned above, it is estimated that the average historical production costs relative to revenue are the most truthful to use.
5.2.2.2 Operating expenses
The operating expenses are a combination of sales and distribution, administration and IT and other operating expenses. The operating expenses are forecasted as a ratio relative to the revenue and it is forecasted based on historical figures and future expectations.
Operating expenses for 2020 to 2021 represents an expected increase in expenses due to expansion of facilities which is expected to require an increase in administrative costs.
The sales and distribution expenses are expected to increase due to increasing sales and marketing efforts in new and existing markets. Efforts in the Chinese markets are expected to increase operating costs as well as increased IT investments e.g. e-commerce platform. Operating expenses are assumed to decrease thereafter at a slow rate as it can be expected that the investments require fewer resources to implement.
5.2.3 Tax
Furthermore, the tax rate is to be forecasted as it is an important driver for the calculation of NOPAT.
The effective tax rate in 2013 was 25.73% decreasing to 22.75 % in 2019 as shown in appendix 7. This indicates a development against the current Danish corporate tax rate of 22 %. The forecasted effective tax rate has therefore been set to 22 % assuming that the tax rate will be constant through the time period.
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The depreciation can be forecasted using three different methods. It is possible to forecast through a percentage of revenue or by using a percentage of property, plant and equipment (PP&E). The third method requires access to the company and their equipment purchases and depreciation schedules (Koller et al., 2010: 231). The method used to determine the forecasted depreciation is to estimate a depreciation as a percentage of tangible assets (Petersen, et al., 2017: 257).
Table 5.3: Own creation
The depreciation is expected to stand at a constant level through the years due to Lego’s continuous aim to be innovative and ensure the demand in the market are met why continuous investments are expected. It is assumed that depreciation as a percentage of tangible assets remains at a level of 13.4
% in line with the historical average.
5.2.5 NOPAT
After forecasting the items in the income statement, the forecasted NOPAT can be computed.
Furthermore, it is possible to determine a profit margin to illustrate the expected development. Graph 5.1 illustrates the development for both NOPAT and the profit margin through the forecast period as well as the terminal period.
Graph 5.1 – Own creation
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It can be concluded that Lego is expected to have an increasing NOPAT which can be explained as a result of increasing revenue. The profit margin appears as slowly increasing and reaching a steady state as it is expected that Lego will be better at generating profit from its revenue.