Case Study Behr South Africa produces automotive radiators and air conditioners and was acquired by the Stuttgart based Behr Group in 1999. Foreign Investment in the South African Automotive Components Industry Prior to the 1980s, a rapidly growing domestic vehicle market together with high protection had acted as a magnet to foreign firms, which invested extensively in the South African automotive industry. Most of the main vehicle makes were assembled in South Africa although some of these operations operated under license. Local content requirements, which were introduced from 1960 and gradually extended, ensured that firms sourced a certain portion of components locally. Exports of both vehicles and components were negligible. In spite of the rapid influx of foreign investment in previous decades, by the late 1980s levels of foreign ownership were relatively low both among vehicle manufacturers and component producers. At this stage, only three of the seven vehicle manufacturers in SA had majority foreign shares. Many of the largest component groups were also locally owned and listed on the Johannesburg Stock Exchange. The relatively low share of foreign ownership was a function of a number of factors. The 1980s had been a period of economic stagnation and political turmoil unattractive for foreign investment. Japanese firms had for many years been prohibited by their government from making direct investments in apartheid South Africa although many had license arrangements and there was large scale two-way trade. In addition, in the 1980s an active international campaign encouraged disinvestment from South Africa, which was particularly effective against American firms: both Ford and General Motors transferred ownership to local interests during this time. In any event, the industry was highly inward oriented so that access to export markets was not a critical consideration for South African firms. The Impact of Government Policy The South African automotive industry has been through wrenching changes over the past 15 years as it has opened up to international competition (Black 2001). Liberalization began in the late 1980s and accelerated in the 1990s partly as a result of major changes sweeping the global automotive industry over this period but also reflecting the opening up of the South African economy with the demise of apartheid and important changes to government trade policy relating to the automotive industry. The first major change to the protectionist trade policy in the automotive industry was in 1989 when the introduction of Phase VI of the local content program signaled a partial shift from protection to export orientation. The Motor Industry Development Program (MIDP) introduced in 1995 continued the direction taken by Phase VI and entrenched the principle of import-export complementation by which exports could earn import rebate credits. It also introduced a tariff phase down at a steeper rate than required in terms of South Africa's WTO obligations. Import-export complementation enables automotive firms to use import credits to source components and vehicles at close to international prices. There is, therefore, considerable pressure on assemblers and distributors to gain access to import credits via exporting. Assemblers can, of course, achieve this through exporting vehicles and vehicle exports have increased from an average of less than 15,000 units per annum for the years 1992 to 1994 to approximately 110,000 units in 2002. But vehicle producers have also played a major role in expanding component exports either directly through subsidiary companies or through facilitating major contracts into their parent company global networks. This has encouraged large investments in certain components, the most important of which has been catalytic converters35, the industry in which one of the case firms operates. The change in trade policy and resulting internationalization of the industry manifested in growing exports and imports has had major implications for ownership. With the domestic market under pressure from imports and the introduction of an import-export complementation system, which effectively supported exports, it has become increasingly important for local firms to have links to international markets. This could most easily be achieved by establishing relationships with foreign firms. Thus, a key potential asset brought in by a prospective foreign shareholder or owner is the access to markets, which they could provide. Recent foreign investment has, therefore, frequently been linked directly or indirectly to export production. The access to international networks, which foreign owned firms could provide, is complemented by their control over the technology necessary to supply export markets and to meet the increasingly demanding requirements of domestic vehicle assemblers. In South Africa, before the recent influx of foreign investment in the automotive industry, the technology used and products produced by local firms were, however, generally licensed from major European, American or Japanese suppliers. While the South African plants may have had many features in common with that of the foreign licensor there were also significant differences. These differences were typical of manufacturing firms developing under import substitution policies. Firms in protected developing country markets tended to operate at much lower scale, were highly flexible and oriented to the domestic market (Katz 1987, Black 1996). The pressures on SA firms to break into export markets and therefore to secure a foreign partner, have been complemented by the rapid internationalization that has taken place in the world automotive component industry. Trends towards 'global sourcing' and 'follower sourcing' have had major implications in emerging markets where the trend is towards fewer first tier suppliers. In South Africa, and indeed in other emerging markets36, assemblers increasingly prefer to source components from joint ventures and wholly owned subsidiaries rather than from domestically owned firms. This is not only to achieve economies of scale but also to achieve quality levels in accordance with that achieved in the home plant. As indicated in the following case studies, the particular dynamics of the industry have had important implications for the form that FDI has taken and for the outcomes that have resulted. Behr South Africa The Behr Group is a large German multinational firm with global sales of 2.31 billion and 13,400 employees in 2000. Its major products are vehicle air conditioning and engine cooling systems which together account for over 85 per cent of turnover. Twenty per cent of the vehicles built in Europe use Behr cooling equipment but in common with many other German suppliers, the share of production outside of high cost Germany is growing. Production (as opposed to sales) outside of Germany accounted for 49 per cent of total sales in 2000, up from 37 per cent in 1996. In emerging markets Behr has plants in Brazil, India, the Czech Republic and South Africa. The Behr Group is growing rapidly with total sales having increased by 82 per cent between 1996 and 2000. Reasons for the Acquisition The Behr Group acquired its South African operation from the US firm, Federal Mogul, in May 1999. Federal Mogul had itself purchased the firm as part of a worldwide deal when it took over T&N plc, the UK based component supplier, a year earlier. T&N plc held a 51 per cent stake in T&N Holdings, a company listed on the Johannesburg Stock Exchange. The latter firm's divisions were friction materials; pistons, bearings, gaskets and heat transfer equipment. The T&N Heat Transfer division did not fit into the Federal Mogul structure as the latter company was not involved in this sector and this relatively small acquisition would not have given it critical mass in the sector. As the South African automotive industry has become more internationally integrated, foreign owned vehicle manufacturers have become drawn more closely into the networks of the parent company. This increasingly meant that they wanted selected suppliers to be located in South Africa. The Behr Group faced these pressures from key customers (BMW, Daimler Chrysler and VW) who were looking to expand vehicle production in South Africa. In particular, the Mercedes C Class export project offered the prospect of large contracts in the form of the air conditioner, radiator and condenser for this vehicle, which was to be built in volumes of 50,000 per annum in South Africa. According to the managing director of Behr (SA), the German group was faced with three alternatives. The first option was to invest in a greenfield facility. A second alternative was to purchase an existing firm and the third possibility was to simply continue their license arrangements with existing firms operating in South Africa. Essentially the decision on mode of entry revolved around risks and resources. The greenfield route was considered to be very demanding in terms of resources and also involved fairly high levels of risk. Maintaining a licensing arrangement was seen as risky because it involved losing control of core technology. T&N (and then Federal Mogul) had already been supplying the BMW 3 Series under license but this was on an assembly basis and Behr was reluctant to license its core technology. A license arrangement which involved assembly would allow only low value added in South Africa. Investing in emerging markets fitted with Behr's expansion strategy. While it was a multinational firm, it was very much German based and "there was a perceived need to have a global footprint" (Interviews). For this reason, Behr had invested in Brazil in 1992. It also has an operation in India and is looking to integrate this more closely into the Behr network. From the side of the South African operation, it was important to have a global partner. In the words of local management, "the MIDP was starting to bite" and without a foreign investor the company "could have stagnated into the aftermarket or even died". The Behr Group proved to be an ideal candidate. Not only was Behr actively looking for an investment in SA as a result of pressure from its customers but it already had a well-developed relationship with the South African company because of technology developed by the latter, which had been licensed to Behr. The Behr Group purchased 100 per cent of Federal Mogul Heat Transfer in May 1999 for an amount of 25 million, roughly equivalent to net asset value. Performance of the Subsidiary Behr (SA) produces radiators, automotive air conditioners and condensers. Half of sales are original equipment and the remaining half are to the aftermarket. Direct exports account for a third of sales and are nearly all to the aftermarket. While the company does not export significant volumes of original equipment components, it supplies domestically assembled vehicles, many of which are exported. The basic strategy of the South African subsidiary has been to focus its activities in selected core areas. Turnover doubled between 1998 and 2001 to approximately ZAR 620 million. Rapid growth is expected over the next few years and the SA firm is highly profitable. It is clear that this investment has been advantageous for the local operation, which faced the prospect of cutting production and increasingly competing on price in the aftermarket. Local management expect that employment would have fallen and the company would have struggled to maintain its technological edge. Since the acquisition, in each business division there have been productivity and efficiency improvements. By 2001, Behr (SA) had 1,100 employees in four sites, up from 1,000 three years previously. Prior to this, the firm had been experiencing "jobless growth" as it restructured in the face of tariff reductions and growing export opportunities. As has been typical in the component sector, perhaps the most important contribution of the investor has been to facilitate access to key automotive customers. The Behr Group is one of the largest worldwide suppliers to the three major German automakers (VW, Daimler Chrysler and BMW) all of which have plants in South Africa, which increasingly act as a base for export. The export drive has necessitated the introduction of new technology on a large scale and the car firms have actively promoted investment and joint ventures by German component suppliers. In the Port Elizabeth air conditioner plant, production has been greatly increased through obtaining the contract to supply the C Class Mercedes. The Durban plant produces the radiator for the C Class but has also seen an expansion of exports into the aftermarket. The copper-based radiator plant at Silverton, Pretoria, which was looking at reducing production because of the transfer of technology to aluminum-based radiators, has attracted additional business. Production from a recently closed copper-based plant in Spain has been transferred to Behr (SA) and the same was expected to happen with a copper-based plant in the US. A few years prior to being acquired by Behr, the South African heat transfer division was spending 4 to 5 per cent of turnover on R&D. This was significantly higher than most component producers in South Africa and the firm was doing fundamental research and development. The South African operation had even developed innovative production technology, which had been licensed to the Behr Group. This process involved a new method of braising aluminum radiators using a specially developed powder. But this innovative capability was not a significant factor in the decision to make the acquisition and the situation has now changed radically. After the acquisition took place, all R&D activity in South Africa was transferred to Germany or shut down. The South African subsidiary now only does development work although its capability for this is expanding partly due to the high cost of assistance from the parent company. South African management sees this development as positive for two reasons. Firstly, the South African subsidiary is now able to focus to a greater extent on its core activities. Secondly, they now have access to cutting edge R&D. A recent example of access to this know-how was a huge saving achieved in the course of a short visit from the parent company by a specialist in furnace technology. The Durban plant was set to invest ZAR 13 million in a new furnace to increase capacity but by reorganizing the spacing of parts and the adjustment of heating elements they were able to increase the capacity of the existing furnace with no additional investment. Since the acquisition the management team is virtually unchanged and there have been no expatriate staff introduced with the exception of technical staff seconded for relatively brief periods. Some of the plants have not changed very much since the acquisition. The biggest change has been at the Port Elizabeth air conditioner plant, which put in a new more automated line to supply components for the Mercedes W203 vehicles. Other changes have been in purchasing where the company is now able to source sub-components much more effectively and at world prices. Significant savings have, for instance, been made on aluminum tubes. Savings on sourcing components are particularly important in the air conditioner plant where imported content is as high as 65 per cent. The South African location offers a competitive source of supply into the Behr global network. Labor, tooling costs and some overheads such as buildings are very cheap in South Africa. An area where Behr (SA) is particularly competitive is in small batch production for the aftermarket. This is because levels of automation are relatively low and the South African subsidiary has considerable expertise in rapid changeovers and low volume production. This cost advantage has become increasingly realized by the parent company and the South African subsidiary is "playing an important role in the development of the worldwide spare parts business, as a supplier of heat exchangers" (Behr 2001). Conclusion With the liberalization of the South African automotive industry, there has been a shift in the rationale for FDI. Previously a sheltered but growing domestic market provided attractive opportunities for foreign firms. The orientation was mainly towards the domestic market and there was some scope for domestic adaptations. Local companies also invested in this sector and were able to operate on the basis of licensed technology. The basis of expansion has now become much more export oriented and it is increasingly important for component firms to have either direct or indirect access to export markets. The major asset contributed by foreign vehicle producers and component suppliers has undoubtedly been access to international networks. Carmakers have actively sought out component suppliers who are able to export and to supply components which meet the increasingly exacting standards of their own increasingly export oriented assembly operations. Foreign firms have played a major role as conduits between domestic firms and the international market in four main ways. Firstly, they have arranged large export contracts for component suppliers by facilitating access to their global networks. Secondly, they have brokered new investment by encouraging foreign suppliers to establish joint ventures with foreign firms or to set up new plants. Thirdly, they have brought in new technology and, fourthly, they have frequently accelerated the transfer of industry best practices in production organization to their suppliers. One of the main factors leading to the perceived success of the MIDP therefore, is that it has facilitated the increased internationalization, which has underpinned growing exports and investment in the industry. Thus, the spillovers resulting from foreign investment in the vehicle industry have mainly been of a vertical nature accruing to those suppliers who have had greater access to markets and technology as a result of being drawn into the international networks of multinational car companies (Saggi 2002). The mode of entry (acquisition or greenfield) has tended to be a function of conditions in the particular sub-sector concerned. Where local firms operating in the sector have been available, a joint venture or outright acquisition has been favored on the grounds that this was a cheaper and faster way into the market and also brought in local expertise and know how. In some instances, this would involve a South African firm, which was already using licensed technology from the prospective investor. The latter case clearly reduces transaction costs for the prospective investor, as there would already be an existing relationship and possibly some commonality in the equipment and processes used. This clearly enhances the benefits of an acquisition relative to a greenfield investment. In the case of acquired firms the result has been a reorientation of production and incremental additional investment rather than wholesale changes to the plant and organization, as would be the case in the extreme brownfield example. Greenfield investments have been pursued primarily in sub sectors where there has been no domestic capacity.

Question - 20 Marks

Advise the management of Behr on their Financing Strategy with regards to the expansion plans. Your advice must include direction on the options between debt and equity, elaborate on the considerations and implications of using either debt or equity.