Question 1 Happy Lappy Son Bhd (HLSB) is a listed company which manufactures tyres for motor vehicles. It is based in Malaysia, a prosperous, industrialised country. Industry background The manufacturing of tyres is an international industry which is dominated by three companies (the 'big three") which are located outside Malaysia, although there are other large manufacturers throughout the world. There has, however, been increased capacity in the industry in recent years with new manufacturing facilities being set up in low-cost countries. The additional capacity has come from both start-up companies and from existing companies setting up additional manufacturing capacity. This has resulted in increased competition and downward pressure on wholesale prices. Some of the new manufacturing capacity in low cost countries are not additional capacity, but arises from international tyre manufacturing companies relocating there from existing factories in high cost countries. Malaysia is not a major tyre producer in the context of the global industry, but the "big three" producers have factories there and there are some Malaysian manufacturers, including HLSB. As a consequence, Malaysia is a net importer of tyres, Raw materials for manufacturing include: rubber, oil, synthetic rubber, steel, and carbon, There have been significant increases in the prices of these commodities in recent years, which has put pressure on industry profits. There is little control exercised over such input prices, even by the "big three' manufacturers, as these commodities are priced on world markets, mainly by major rubber, oil and steel producers, but also by financial traders of these commodities. As a result, there is limited scope for obtaining reductions on these commodity prices, even for major tyre manufacturers. Malaysian tyre market The market for rubber tyres for motor vehicles is about RM1.350 million at manufacturers' selling prices (Table 1). Typically, retailers of tyres would sell at a mark-up of 50% on manufacturers' prices. The main tyre product sectors are passenger vehicles (which accountfor 70% of the market), commercial vehicles (eg trucks and lorries), motor cycles, specialist agricultural or engineering vehicles and other vehicles. The market consists of two main sectors: new vehicles, where tyres are sold to motor vehicle manufacturers; and replacement tyres, which are sold to tyre retailers, who supply to motor vehicle owners when the previous tyres have worn out. The replacement tyre market has two sub-sectors: new tyres and retreads. Retreads are where an old tyre is not replaced but is repaired by fitting a new tread (the part in contact with the road). This market is only about 2% of the passenger vehicle tyre sales, but can be as much as 70% of commercial vehicle tyre sales. Company background While HLSB is one of the largest of the Arcadian producers, it is only small by comparison to the "big three'. HLSB's tyres are above average quality for the industry, and are marketed and priced as a premium product. HLSB only makes tyres for passenger vehicles. HLSB operates from one factory in Malaysia, currently manufacturing about 3.6 million tyres per year, Its customers in terms of sales volumes are as follows: Exports 30 Foyotaul 50 Tyre retailers and wholesalers 20 Competition in the export market is significant and this market has been decreasing for HLSB in recent years. Foyotaul is a major car manufacturer, located in Malaysia, which has several tyre suppliers, one of which is HLSB. Foyotaul's supply contracts are renewed annually. HLSB delivers directly to the central depots of major chains of tyre retailers. In respect of smaller tyre retailers, HLSB does not have the distribution network to make individual deliveries and therefore it delivers to wholesalers who then make distributions. Overall company sales have been falling and HLSB currently has 25% spare capacity at its factory. The acquisition of Impak Maksima Ltd Due to the poor performance of HLSB and the increasing competitiveness of tyre manufacturing, the HLSB board decided in 2015 that it needed to diversify while staying close to its core competences. After some consideration, it was decided to acquire a tyre retailing chain. Unfortunately, for some time after the decision was made, there were no suitable businesses available for acquisition. However, in May 2016 a small chain, ImpakMaksima Lid (IML), became available. IML's business model was to sell low-quality, passenger-vehicle tyres for the lowest price in the area around each outlet. Its outlets are in low cost, out-of-town locations and all tyres are acquired at the lowest price available. It does not supply retreads. A board meeting of HLSB was called in June 2016 to discuss the proposal. The board meeting - June 2016 The marketing director was the first to speak: This acquisition is not ideal for us. We are seeking to establish a quality, up-market retail chain and IML is low-cost and downmarket. This sector of the market is too crowded. We cannot supply our own tyres in this downmarket sector. If we make this acquisition of IML we will have the immediate problem of changing market positioning and consumer perceptions, and that is not easy in the tyre market where they cannot see the quality of the product very easily." The finance director tended to agree: "We really want a much larger initial market presence. I ML only has 20 outlets, all of which are in the same region. We will need to open up additional new outlets ourselves to make the venture worthwhile in terms of size.' The chief executive was more positive: 'At least this acquisition gives us a foothold in the retail tyre market and, because IML's profits have declined in recent years to a minimal level, we are only paying a small premium above asset values, We have looked and looked for more suitable acquisitions and they are just not there at the moment. We could wait forever to enter this market if we searched for the perfect company, and even then we would have to pay a big premium for it. The only alternative to acquiring IML would be to set up outlets ourselves, one-by-one. That would be a long process'. The production director agreed: The key thing is that HLSB will have a new customer in IML for our tyres, and this will use up much of our spare manufacturing capacity. I am not saying we force HLSB tyres on all IML customers but, where no preference is expressed, then we should tell I ML managers to sell HLSB tyres. After all, we would be part of the same company. Also, I see no reason for the transfer price of tyres from HISB to IML to be below the market price. However, I do not see why we should carry on supplying rivals to IML who were previously HLSB 's retail customers. That would just help IML's competitors. IML should be the only retailer of HLSB tyres in Malaysia." Two years later - June 2018HLSB went ahead and made the acquisition of IML in July 20X6. Two years later, HLSB had expanded the IML network, but made operating losses (Table 2). The strategy of taking the company upmarket was implemented using a large budget for 'quality development expenditure', which is short-term investment expenditure to enable a transition to take place in IML's market positioning. It consisted of: providing comfortable surroundings and drinks for customers while they wait; marketing expenditure; staff training for customer service; and setting up a 'collect your car from home' service. Surveys showed that these features were well received by customers and a strong loyalty was being developed. Initially the IML brand was retained, but consideration is now being given to rebranding the outlets with the HLSB name. The other directors disagreed with the production director's suggestion for HLSB to cease supplying rival retailers to IML. These sales therefore continued. Table 1 - Malaysian tyre industry and tyre market Years to 30 June 2018 (estimate) 2017 2016 RM million RM million RM million Total Malaysia tyre sales at msp* (all 1,350 1,350 1,310 vehicles) Total Malaysia-based tyre production at 670 680 700 msp* (all vehicles) manufacturers' selling prices Table 2 - Impak Maksima Ltd Summary of income statement Years to 30 June 2018 (estimate) 2017 2016 RM '000 RM '000 RM '000 Revenue 21,600 18,563 15,000 Cost of tyres (13,500) (11,600) (10,000) Other operating costs (6,500) (5,600) (4,800) Quality development expenditure (2,500) (2,000) Profit /(loss) (900) (637) 200 Other performance data Years to 30 June 2018 (estimate) 2017 2016 Average number of outlets 30 25 20 Tyres sold 360,000 337,500 300,000