4. If you were in the position of George Smith, what decision you would have taken for Top Gear?

In the spring of 2013, George Smith had just come back from a trip to Scotland with a signed contract for collaboration with one of his biggest European customers, McTaggart Supplies Ltd. As he pondered about the implications of this deal, he started reminiscing about the path that had brought him to this point. George's first years in business were unusually harsh and turbulent. He graduated from a leading Michigan business school in 2010 when the American economy was just recovering from the Great Recession (2007-2009) caused by the subprime mortgage crisis and the collapse of the U.S. housing bubble. It was not that George had difficulty finding a job, however; it was that he took over the reins of the family business. His father timed his retirement to coincide with George's graduation and left him with the unenviable task of cutting back the workforce to match the severe sales declines the company was experiencing. HISTORY Top Gear Auto Parts was founded in 1975 by George's father to seize opportunities created by the earlier signing of the Auto Pact between Canada and the United States. The Auto Pact permitted the Big Three automotive manufacturers to ship cars, trucks, and original equipment (OEM) parts between Canada and the United States tariff-free, as long as they maintained auto assembly facilities on both sides of the border. The Pact had been very successful with the result that a lot of auto parts firms sprang up in Canada to supply the Big Three. In 2001, the Auto Pact was abolished, superseded by the North American Free Trade Agreement, which continued to create favourable conditions for trade between the United States and Canada. Top Gear Auto Parts prospered in this environment until, by 2008, sales had reached $60 million 1 with profits of $1.75 million. The product focus was largely on small engine parts and auto accessories such as oil and air filters, fan belts and wiper blades, all sold as original equipment. When George took over in 2010, the company's financial position was precarious. Sales in 2009 had dropped to $48 million and for the first six months of 2010 to $18 million. Not only were car sales declining in North America, but the Japanese were taking an increasing share of the market. As a result, the major North American auto producers were frantically trying to advance their technology and to lower their prices at the same time. It was not a good year to be one of their suppliers. In 2009, Top Gear Auto Parts lost $2.5 million, and had lost the same amount again in the first six months of 2010. Pressure for modernization and cost reduction had required close to $4 million in new investment in equipment and computer-assisted design and manufacturing systems. As a result, the company had taken up more than $10 million of its $12 million line of bank credit at an interest rate which stood at 3.25 per cent (U.S. prime rate charged by banks) in 2010. George's first six months in the business were spent in what he later referred to as \"operation survival.\" There was not much he could do about working capital management as both inventory and receivables were kept relatively low via contract arrangements with the Big Three. Marketing costs were negligible. Where costs had to be cut were in production and, specifically, in people, many of whom had been with the company for more than 15 years and were personal friends of George's father. Nevertheless, by the end of 2010, the workforce had been cut from 720 to 470, the losses had been stemmed, and the company had been saved from almost certain bankruptcy. Having to be the hatchet man, however, left an indelible impression on George. As things began to pick up during 2011 and 2012, he added as few permanent workers as possible, relying instead on overtime, part-timers, or sub-contracting. RECOVERY AND DIVERSIFICATION For Top Gear Auto Parts, the year 2010 ended with sales of $38 million and losses of $3.5 million (see Exhibit 1). Sales began to pick up in 2011, reaching $45 million by year-end with a small profit. By mid- 2012, it was clear that the recovery was well underway. George, however, while welcoming the turnaround, was suspicious of the basis for it. Top Gear's own sales hit $27 million in the first six months of 2012 and company profits were over $2 million. Top Gear was faced with increasingly aggressive competition from Canadian and offshore parts manufacturers. The short-term future for Top Gear, however, seemed distinctly positive, but the popularity of Japanese cars left George feeling vulnerable to continued total dependence on the volatile automotive industry. Diversification was on his mind as early as 2010. He had an ambition to take the company public by 2016 and diversification was an important part of that ambition. Unfortunately, working as an OEM parts supplier to the automotive industry did little to prepare Top Gear to become more innovative. The auto industry tended to standardize its parts requirements to the point that Top Gear's products were made to precise industry specifications and consequently, did not find a ready market outside the industry. Without a major product innovation, Top Gear's dependence on the Big Three was likely to continue. Furthermore, the company had developed no \"in-house\" design and engineering strength from which to launch an attempt at new product development. Because product specifications had always come down in detail from the Big Three, Top Gear had never needed to design and develop its own products and had never hired any design engineers. In the midst of \"operation survival\" in 2010, George boldly decided to do something about diversification. He personally brought in a team of four design engineers and instructed them to concentrate on developing products related to the existing line but with a wider \"nonautomotive\" market appeal. Their first year together showed little positive progress, and the question of whether to fund the team for another year (estimated budget $425,000) came to the management group: George: Maybe we just expected too much in the first year. They did come up with the flexible coupling idea, but you didn't seem to encourage them, Andy (production manager). Andy That's right! They had no idea at all how to produce such a thing in our facilities. Just McIntyre a lot of ideas about how it could be used. When I told them a Canadian outfit was : already producing them, the team sort of lost interest. John Ellis We might as well face the fact that we made a mistake and cut it off before we sink any (Finance): more money into it. This is hardly the time for unnecessary risks. George: Why don't we shorten the whole process by getting a production license from the Canadian firm? We could start out that way and then build up our own technology over time. Andy: George: The team looked into that, but it turned out the Canadians already have a subsidiary operating in United States not too well from what I can gather and they are not anxious to license anyone to compete with it. Is the product patented? Andy: Yes, but apparently it doesn't have long to run. At this point a set of ideas began to form in George's mind, and in a matter of months he had lured away a key engineer from the Canadian firm with an $110,000 salary offer and put him in charge of the product development team. By mid-2012, the company had developed its own line of flexible couplings with an advanced design and an efficient production process using the latest in production equipment. Looking back, George commented: \"We were very fortunate in the speed with which we got things done. Even then the project as a whole had cost us close to $1 million in salaries and related costs.\" MARKETING THE NEW PRODUCT George continued: We then faced a very difficult set of problems, because of uncertainties in the market place. We knew there was a good market for the flexible type of coupling because of its wide application across so many different industries. But, we didn't know how big the market was nor how much of it we could secure. This meant we weren't sure what volume to tool up for, what kind or size of equipment to purchase, or how to go about the marketing job. We were tempted to start small and grow as our share of market grew, but this could be costly too and could allow too much time for competitive response. Our Canadian engineer was very helpful here. He had a lot of confidence in our product and had seen it marketed in both Canada and the United States. At his suggestion we tooled up for a sales estimate of $30 million which was pretty daring. In addition, we hired eight field sales representatives to back up the nation-wide distributor and soon afterwards hired several Canadian-based sales representatives to cover major markets. We found that our key Canadian competitor was pricing rather high and had not cultivated very friendly customer relations. We were surprised how quickly we were able to secure significant penetration into the Canadian market. It just wasn't being wellserviced. During 2012, the company actually spent a total of $2.5 million on equipment for flexible coupling production. In addition, a fixed commitment of $1.5 million a year in marketing expenditures on flexible couplings arose from the hiring of sales representatives. A small amount of trade advertising was included in this sum. The total commitment represented a significant part of the company's resources and threatened serious damage to the company's financial position if the sales failed to materialize. \"It was quite a gamble at the time,\" George added. \"By the end of 2012, it was clear that the gamble was going to pay off.\" Sales by Market Sector ($ millions) OEM Parts 2008 2009 2010 2011 2012 60 48 38 45 58 Flexible Couplings Nil 60 Nil 48 Nil 38 Nil 45 10 (six Total After Sales Sales Sales Tax Profits 1.75 (2.50) (3.50) 0.25 68 5.80 months) Top Gear's approach to competition in flexible couplings was to stress product quality, service, and speed of delivery, but not price. Certain sizes of couplings were priced slightly below the competition but others were not. In the words of one Top Gear sales representative: Our job is really a technical function. Certainly, we help predispose the customer to buy and we'll even take orders, but we put them through our distributors. Flexible couplings can be used in almost all areas of secondary industry, by both large and small firms. This is why we need a large distributor with wide reach in the market. What we do is give our product the kind of emphasis a distributor can't give. We develop relationships with key buyers in most major industries, and we work with them to keep abreast of new potential uses for our product or of changes in size requirements or other performance characteristics. Then we feed this kind of information back to our design group. We meet with the design group quite often to find out what new types of couplings are being developed and what the intended uses are, etc. Sometimes they help us solve a customer's problem. Of course, these 'solutions' are usually built around the use of one of our products. FINANCING PLANT CAPACITY When George first set his diversification plans in motion in 2010, the company's plant in suburban Detroit was operating at 50 per cent capacity. However, by early 2013, sales of auto parts had recovered almost to pre-crisis levels (before 2007), and the flexible coupling line was squeezed for space. Andy McIntyre put the problem this way: I don't see how we can get sales of more than $85 million out of this plant without going to a permanent two-shift system, which George doesn't want to do. With two full shifts we could probably reach sales of $125 million. The problem is that both our product lines are growing very quickly. Auto parts could easily hit $80 million on their own this year, and flexible couplings! Well, who would have thought we'd sell $10 million in the first six months? Our salespeople are looking for $35 million to $40 million during 2013. It's wild! We just have to have more capacity. There are two problems pressing us to consider putting flexible couplings under a different roof. The first is internal: we are making more and more types and sizes, and sales are growing to such a point that we may be able to produce more efficiently in a separate facility. The second is external: The Big Three like to tour our plant regularly and tell us how to make auto parts cheaper. Having these flexible couplings all over the place seems to upset them because they have trouble determining how much of our costs belong to Auto Parts. If it were left to me, I'd just let them be upset, but George feels differently. He's afraid of losing orders. Sometimes I wonder if he's right. Maybe we should lose a few orders to the Big Three and fill up the plant with our own product instead of expanding. Flexible couplings were produced on a batch basis, and there were considerable savings involved as batches got larger. Thus as sales grew, and inventory requirements made large batches possible, unit production costs decreased, sometimes substantially. McIntyre estimated that unit production costs would decline by some 20 per cent as annual sales climbed from $20 million to $100 million and by a further 10 per cent at $250 million. Scale economies beyond sales of $250 million were not expected to be significant. John Ellis, the company's financial manager, expressed his own reservations about new plant expansion from a cash flow perspective: We really don't have the balance sheet (see Exhibit 2) ready for major plant expansion yet. I think we should grow more slowly and safely for two more years and pay off our debts. If we could hold sales at $75 million for 2013 and $85 million for 2014, we would be able to put ourselves in a much stronger financial position. The problem is that people only look at the profits. They don't realize that every dollar of flexible coupling sales requires an investment in inventory and receivables of about 30 cents. It's not like selling to the Big Three. You have to manufacture to inventory and then wait for payment from a variety of sources. As it is, George wants to invest $10 million in a new plant and equipment right away to allow flexible coupling sales to grow as fast as the market will allow. We have the space on our existing site to add a separate plant for flexible couplings. It's the money I worry about. FOREIGN MARKETS As the company's market position in North America began to improve, George began to wonder about foreign markets. The company had always been a major exporter to Canada, but it had never had to market there. The Big Three placed their orders often a year or two in advance, and Top Gear just supplied them. As George put it: It was different with the flexible coupling. We had to find our own way into the market. We did, however, start getting orders from Europe and South America, at first from the subsidiaries of our U.S. customers and then from a few other firms as word got around. We got $40,000 in orders during 2012 and the same amount during the first four months of 2013. This was a time when we were frantically busy and hopelessly understaffed in the management area, so all we did was fill the orders on a FOB (free-on-board), Detroit basis. The customers had to pay import duties of approximately 3 per cent into most European countries and a value added tax (VAT) ranging between 15 per cent (Luxembourg) and 27 per cent (Hungary), with an average of about 21.5 per cent, on top of the freight and insurance, and still orders came in. The VAT for the United Kingdom was 20 per cent and France 19.6 per cent. Seeing the growing potential in Europe, supported by clear signs of recovery from the financial crisis and the European debt crisis, George promptly took a European Patent from the European Patent Office in the United Kingdom. The cost of the whole process was under $10,000. A LICENSING OPPORTUNITY In the spring of 2013, George made a vacation trip to Scotland and decided while he was there to drop in on one of the company's new foreign customers, McTaggart Supplies Ltd. Top Gear Auto Parts had received unsolicited orders from overseas amounting to $40,000 in the first four months of 2013, and over 10 percent of these had come from McTaggart. George was pleasantly surprised at the reception given to him by Sandy McTaggart, the 60-year-old head of the company. Sandy: Come in! Talk of the devil. We were just saying what a shame it is you don't make those flexible couplings in this part of the world. There's a very good market for them. Why my men can even sell them to the English! George: Well, we're delighted to supply your needs. I think we've always shipped your orders promptly, and I don't see why we can't continue . . . Sandy: That's not the point! Those orders are already sold before we place them. The point is we can't really build the market here on the basis of shipments from America. There's a 3 per cent tariff coming in, freight and insurance cost us another 10 per cent on top of your price, then there's the matter of currency values. I get my orders in pounds ()2 but I have to pay you in dollars. And on top of all that, I can never be sure how long exactly the goods will take to get here, especially with the ever-looming risk of strikes. I still remember the 2009 postal strikes. Listen, why don't you license us to produce flexible couplings here? After a lengthy bargaining session, during which George secured the information (see Exhibit 3), he came round to the view that a license agreement with McTaggart might be a good way of achieving swift penetration of the U.K. market via McTaggart's sales force. McTaggart's production skills were not as up- to-date as Top Gear's, but his plant showed evidence of a lot of original ideas to keep manufacturing costs down. Furthermore, the firm seemed committed enough to invest in some new equipment and to put a major effort into developing the U.K. market. At this point the two executives began to discuss specific terms of the license arrangements: George: Let's talk about price. I think a figure around 3 per cent of your sales of flexible couplings would be about right. Sandy: That's a bit high for an industrial license of this kind. I think one and a half per cent is more normal. George: That may be, but we're going to be providing more than just blueprints. We'll have to help you choose equipment and train your operators as well. Sandy: Aye, so you will. But we'll pay you for that separately. It's going to cost us 500,000 in special equipment as it is, plus, let's say, a $100,000 fee to you to help set things up. Now you have to give us a chance to price competitively in the market, or neither of us will benefit. With a royalty of one and a half per cent, I reckon we could reach sales of 500,000 in our first year and 1 million in our second. George: The equipment will let you produce up to 4 million of annual output. Surely you can sell more than a million. We're getting unsolicited orders without even trying. Sandy: With the right kind of incentive, we might do a lot better. Why don't we agree to a royalty of two and a half per cent on the first million in sales and one and a half per cent after that. Now mind you, we're to become exclusive agents for the U.K. market. We'll supply your present customers from our own plant. George: But just in the United Kingdom! Now 2 per cent is as low as I'm prepared to go. You make those figures 3 per cent and 2 per cent and you have a deal. But it has to include a free technology flowback clause in the event you make any improvements or adaptations to our manufacturing process. Sandy: You drive a hard bargain! But it's your product, and we do want it. I'll have our lawyers draw up a contract accordingly. What do you say to a five-year deal, renewable for another five if we are both happy? George: Sounds good. Let's do it. George signed the contract the same week and then headed back to America to break the news. He travelled with mixed feelings, however. On the one hand, he felt he had got the better of Sandy McTaggart in the bargaining, while on the other, he felt he had no objective yardstick against which to evaluate the royalty rate he had agreed on. This was pretty much the way he presented the situation to his executive group when he got home. George: John: Andy (production ): George: Andy: . . . so I think it's a good contract, and I have a cheque here for $100,000 to cover our costs in helping McTaggart get set up. We can certainly use the cash right now. And there doesn't seem to be any risk (finance) involved. I like the idea, George. Well, I don't. And Chuck (head of the Top Gear design team) won't either when (production) he hears about it. I think you've sold out the whole U.K. market for a pittance. I thought you wanted to capture foreign markets directly. But Andy, we just don't have the resources to capture foreign markets ourselves. We might as well get what we can through licensing, now that we've patented our process. Well, maybe. But I don't like it. It's the thin edge of the wedge if you ask me. Our know- how on the production of this product is pretty special, and it's getting better all the time. I hate to hand it over to old McTaggart on a silver platter. I reckon we're going to sell over $20 million in flexible couplings in the United States alone during 2013. As George walked back into his office after this conversation, he wondered whether signing the deal might have been premature. EXHIBIT 1: INCOME STATEMENTS (for years ended December 31 ($000s) 2010 Net Sales Cost of goods sold: Direct materials Direct labour Overheads (including depreciation) Total Gross Profit Expenses: Selling and administration (includes design team) Other (includes interest) Total Net Profit before Tax 2011 2012 $38,150 $45,200 $67,875 6,750 12,900 16,450 36,100 2,050 8,050 10,550 19,650 38,250 6,950 3,150 2,400 5,500 (3,500) 3,800 2,900 6,700 250 Income TaxNet Profit after Tax $ (3,000) (500) $ $ 5,600200 250- 12,400 12,875 27,600 52,875 15,000 6,200 3,000 9,200 5,800 Note: George expected total sales to reach $85 million in 2013 with profits before tax of $10 million. Flexible couplings were expected to contribute sales of $30 million and profits of $5 million on assets of $12 million. Source: Company files. EXHIBIT 2: BALANCE SHEETS (for years ended December 31 ($000s) 2010 Assets Cash Accounts Receivable $ 615 5,850 2011 $ 430 6,850 2012 $ 400 10,400 Inventories Total Current Assets Property, Plant and Equipment (net) Total Assets Liabilities Accounts Payable Bank Loan Accrued Items (including taxes) Total Current Liabilities Common Stock (Held by Smith family) Retained Earnings Total Equity 11,300 10,790 22,250 11,800 24,000 13,000 31,300 4,850 11,500 5,900 12,000 9,500 10,000 500 500 500 10,800 Total Liabilities $22,250 $24,000 $31,300 EXHIBIT 3: DATA ON MCTAGGART SUPPLIES LTD. 2012 Sales 35 million (down from 44 million in 2010). Total Assets 11 million: Equity 6.5 million Net profit after tax 1.5 million Control McTaggart Family Market coverage 15 sales representatives in United Kingdom, two in Europe, one in Australia, one in New Zealand, one in India. Average factory wage rate9.00 per hour (which is below the United Kingdom mean of 12.92 due to the factory being located in a depressed area) (versus $19.54 in America). Factory Old and larger than necessary. Some manufacturing know-how in evidence. Reputation Excellent credit record, business now 130 years old, good market contacts (high calibre sales force). Other Company sales took a beating during 2010-2011 as one of the company's staple products was badly hurt by a U.S. product of superior technology. Company filled out its line by distributing products obtained from other manufacturers. Currently about onehalf of company sales are purchased from others. Company has capacity to increase production substantially. Pricing Top Gear's price to McTaggart (same as net price to distributor in America) + import duty + freight and insurance 10 import's cost very Index 100 3 113 + distributor's (McTaggart's) margin (30%) 34 + VAT (20 % on cost plus margin) 29 = price charged by McTaggart 176 versus price charged by American distributor in the United States 120 imaginative