Richard Ivey School of Business The University of Western Ontario IVEY 906M15 CAMERON AUTO PARTS (A) - REVISED Professor Paul Beamish revised this case (originally prepared by Professor Harold Crookell) solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This material is not covered under authorization from CanCopy or any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, clo Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright @ 2006, Ivey Management Services Version: (A) 2006-01-10 Alex Cameron's first years in business were unusually harsh and turbulent. He graduated from a leading Michigan business school in 2001 when the American economy was just falling into a recession caused by the combination of the bursting of the telecom and dot.com bubble and the terrorist attacks of September 1 1. It was not that Alex 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 Alex'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 Cameron Auto Parts was founded in 1965 by Alex's father to seize opportunities created by the 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. Cameron Auto Parts prospered in this environment until, by 1999, sales had reached $60 million 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 under the Auto Pact.Page 2 9306M015 When Alex took over in 2001, the company's nancial position was precarious. Sales in 2000 dropped to $48 million and for the rst six months of 2001 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 antically 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 2000, Cameron Auto Parts lost $2.5 million, and had lost the same amount again in the rst six months of 2001. 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 over $10 million of its $12 million line of bank credit at an interest rate which stood at 7.0 per cent in 2001. Alex's rst 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, specically, in people, many of whom had been with the company for over 15 years and were personal 'iends of Alex's father. Nevertheless, by the end of 2001, the workforce had been cut from 720 to 470, the losses had been stemmed and the company saved from almost certain bankruptcy. Having to be the hatchet man, however, left an indelible impression on Alex. As things began to pick up during 2002 and 2003, he added as few permanent workers as possible, relying instead on overtime, part-timers or sub- contracting. RECOVERY AND DIVERSIFICATION For Cameron Auto Parts, the year 2001 ended with sales of $38 million and losses of $3.5 million (see Exhibit 1). Sales began to pick up in 2002, reaching $45 million by year~end with a small prot. By mid-2003, it was clear that the recovery was well underway. Alex, however, while welcoming the turnaround, was suspicious of the basis for it. Cameron's own sales hit $27 million in the rst six months of 2003 and company prots were over $2 million. The Canadian dollar had dropped as low as 77 cents in terms of US. currency and Cameron was faced with more aggressive competition from Canadian parts manufacturers. The short- term future for Cameron, however, seemed distinctly positive, but the popularity of Japanese cars left Alex feeling vulnerable to continued total dependence on the volatile automotive industry. Diversication was on his mind as early as 2001. He had an ambition to take the company public by 2007 and diversication was an important part of that ambition. Unfortunately, working as an OEM parts supplier to the automotive industry did little to prepare Cameron to become more innovative. The auto industry tended to standardize its parts requirements to the point that Cameron's products were made Page 3 QBDGMO15 to precise industry specications and consequently, did not nd a ready market outside the industry. Without a major product innovation it appeared that Cameron's dependence on the Big Three was likely to continue. Furthermore, the company had developed no \"inhouse\" design and engineering strength from which to launch an attempt at new product development. Because product specications had always come down in detail from the Big Three, Cameron had never needed to design and develop its own products and had never hired any design engineers. In the midst of \"operation survival\" in 2001, Alex boldly decided to do something about diversication. 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 \"non~automotive\" market appeal. Their rst 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: Alex: Maybe we just expected too much in the rst year. They did come up with the exible coupling idea, but you didn't seem to encourage them, Andy (production manager). Andy McIntyre: That's right! They had no idea at all how to produce such a thing in our facilities. Just a lot of ideas about how it could be used. When I told them a Canadian outt was already producing them, the team sort of lost interest. John Ellis (Finance): We might as well face the fact that we made a mistake, and cut it off before we sink any more money into it. This is hardly the time for unnecessary risks. Alex: Why don't we shorten the whole process by getting a production licence from the Canadian rm? We could start out that way and then build up our own technology over time. Andy: 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 licence anyone to compete with it. Alex: Is the product patented? Andy: Yes, but apparently it doesn't have long to run. Page 4 9B06M015 At this point a set of ideas began to form in Alex'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-2003, 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, in retrospect, Alex 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 Alex 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 well- serviced. During 2003, the company actually spent a total of $2.5 million on equipment for flexible coupling production. In addition, a fixed commitment of $1.5 million a year in marketing expenditures on flexible couplings arose from the hiring of sales representatives. A small amount of trade advertising was included in this sum. The total commitment represented a significant part of the company's resources and threatened serious damage to the company's financial position if the sales failed to materialize.Page 5 QBDGMO15 \"It was quite a gamble at the time,\" Alex added. \"By the end of 2003, it was clear that the gamble was going to pay off.\" Sales by Market Sector ($ millions) OEM Parts Flexible Couplings Total After Tax Sales Sales Sales Prots 1999 60 Nil 60 1.75 2000 48 Nil 48 (2.50) 2001 38 Nil 38 (3.50) 2002 45 Nil 45 0.25 2003 58 10 (six months) 68 5.80 Cameron's approach to competition in exible 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 Cameron 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 rms. 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 nd 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 Alex rst set his diversication plans in motion in 2001, the company's plant in suburban Detroit was operating at 50 per cent capacity. However, by early 2004, sales of auto parts had recovered almost to 1999 levels and the exible 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 twoshi system, which Alex doesn't want to do. With two full shifts we could probably Page 6 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. Mr. 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 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 exible couplings! Well, who would have thought we'd sell $10 million in the rst six months? Our salespeople are looking for $35 million to $40 million during 2004. It's wild! We just have to have more capacity. There are two problems pressing us to consider putting exible couplings under a different roof. The rst 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 efciently 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 exible 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 Alex 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 ll up the plant with our own product instead of expanding. sales of $250 million were not expected to be signicant. John Ellis, the company's nancial manager, expressed his own reservations about new plant expansion from a cash ow perspective: We really don't have the balance sheet (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 2004 and $85 million for 2005, we would be able to put ourselves in a much stronger nancial position. The problem is that people only look at the prots. They don't realize that every dollar of exible 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, Alex wants to invest $10 million in new plant and equipment right away to allow exible coupling sales to grow as fast as the market will allow. We have the space on our existing site QBDGMO15 Page 7 QBDGMO15 to add a separate plant for exible couplings. It's the money I worry about. FOREIGN MARKETS As the company's market position in North America began to improve, Alex 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 oen a year or two in advance, and Cameron just supplied them. As Alex put it: It was different with the exible coupling. We had to nd our own way into the market. We did, however, start getting orders from Europe and South America, at rst from the subsidiaries of our US. customers and then om a few other rms as word got around. We got $40,000 in orders during 2003 and the same amount during the first four months of 2004. This was a time when we were frantically busy and hopelessly understaffed in the management area, so all we did was ll the orders on an FOB, Detroit basis. The customers had to pay import duties of approximately three per cent into most European countries, and a value added tax of about 20 per cent (20 to 50 per cent into South America), on top of the freight and insurance, and still orders came in. Seeing the potential in Europe, Alex promptly took a European Patent from the European Patent Ofce in the United Kingdom. The cost of the whole process was under $10,000. A LICENSING OPPORTUNITY In the spring of 2004, Alex 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. Cameron Auto Parts had received unsolicited orders om overseas amounting to $40,000 in the rst four months of 2004, and over 10 per cent of these had come from McTaggart. Alex was pleasantly surprised at the reception given to him by Sandy McTaggaIt, 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 exible 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! Alex: 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 . . . . Page 8 QBDGMO15 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 three per cent tariff coming in, eight 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 ()1 but I have to pay you in dollars. And on top of all that, I never know how long the goods will take to get here, especially with all the dock strikes we have to put up with. Listen, why don't you license us to produce exible couplings here? After a lengthy bargaining session, during which Alex secured the information shown in 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 UK market via McTaggart's sales force. McTaggart's production skills were not as up-to-date as Cameron's, but his plant showed evidence of a lot of original ideas to keep manufacturing costs down. Furthermore, the rm seemed committed enough to invest in some new equipment and to put a major effort into developing the UK. market. At this point the two executives began to discuss specic terms of the license arrangements: Alex: Sandy: Alex: Sandy: Alex: Let's talk about price. I think a gure around three per cent of your sales of exible couplings would be about right. That's a bit high for an industrial license of this kind. I think one and a half per cent is more normal. 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. 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 benet. With a royalty of one and a half per cent I reckon we could reach sales of 500,000 in our rst year and 1 million in our second. 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. 1One pound was equivalent to US$1.83 in 2004. Page 9 QBDGMO15 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 rst million in sales and one and a half per cent after that. Now mind you, we're to become exclusive agents for the UK. market. We'll supply your present customers from our own plant. Alex: But just in the United Kingdom! Now two per cent is as low as I'm prepared to go. You make those gures three per cent and two per cent and you have a deal. But it has to include a free technology ow-back 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 ve if we are both happy? Alex: Sounds good. Let's do it. Alex 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. Alex: . . . 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. John: We can certainly use the cash right now. And there doesn't seem to be any risk (nance) involved. I like the idea, Alex. Andy (production): Well, I don't. And Chuck (head of the Cameron design team) won't either when (production) he hears about it. I think you've sold out the whole UK. market for a pittance. I thought you wanted to capture foreign markets directly. Alex: 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. Andy: 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 Page 10 9B06M015 McTaggart on a silver platter. I reckon we're going to sell over $20 million in flexible couplings in the United States alone during 2004.Page 11 QBDGMO15 Exhibit 1 INCOME STATEMENTS For Years Ended December 31, 2001, 2002, 2003 ($0005) 2001 2002 2003 Net Sales 35 38,150 $ 45,200 $ 67,875 Cost of goods sold: Direct materials 6,750 8,050 12,400 Direct iabor 12,900 10,550 12,875 Overheads (including depreciation) 16,450 19,650 27,600 Total 36,100 38,250 52,875 Gross Prot 2,050 6,950 15,000 Expenses: Selling and administration (includes design team) 3,150 3,800 6,200 Other (includes interest) 2,400 2,900 3,000 Total 5,500 6,700 9,200 Net Profit before Tax (3,500) 250 5,800 Income Tax (500) - 200 Net Profit after Tax $ (3,000) $ 250 $ 5,600 Note: Alex expected total sales to reach $85 million in 2004 with prots before tax of $10 million. Flexible couplings were expected to contribute sales of $30 million and prots of $5 million on assets of $12 million. Exhibit 2 BALANCE SHEETS For Years Ended December 31, 2001, 2002, 2003 ($0005) 2001 2002 2003 Assets Cash $ 615 $ 430 $ 400 Accounts Receivable 5,850 6,850 10,400 Inventories 4,995 4,920 7,500 Total Current Assets 11,460 12,200 18,300 Property, plant and equipment (net) 10,790 11,800 13,000 Total Assets 22,250 24,000 31,300 Liabilities Accounts Payabie 4,850 5,900 9,500 Bank loan 11,500 12,000 10,000 Accrued Items (inctuding taxes) 450 400 500 Total Current Liabilities 16,800 18,300 20,000 Common Stock (Held by Cameron family) 500 500 500 Retained Earnings 4,950 5,200 10,800 Total Equity 5,450 5,700 11,300 Total Liabilities $ 22,250 $ 24,000 $ 31,300 Page 12 QBDGMO15 2003 Sales Total Assets Net prot after tax Control Market coverage Average factory wage rate Exhibit 3 DATA ON MCTAGGART SUPPLIES LTD. 35 million (down from 44 million in 2001). 11 million: Equity 65 million i 15 million McTaggart Family 15 sales representatives in United Kingdom, two in Europe, one in Australia, one in New Zealand, one in India. 8.00 per hour (which is below the UK. mean of 12.00 due to the factory being located in a depressed area) (versus $18.00 in America). Factory Old and larger than necessary. Some very imaginative 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 200172002 as one of the company's staple products was badly hurt by a U.S. product of superior technology. Company lled out its line by distributing products obtained from other manufacturers. Currently about one- half of company sales are purchased from others. Company has capacity to increase production substantially. Pricing Index Cameron's price to McTaggart 100 (same as not price to distributor in America) + Import duty 3 + Freight and insurance Importer's Cost 113 + Distributor's (McTaggart's) Margin (30%) 34 + Value Added Tax (17.5% on cost plus margin) _2 = Price charged by McTaggart 173 vs. Price charged by American distributor in US. 120 Page 13 QBDGMO15 Exhibit 3 (continued) Note: Under the European Union agreement, all imports from non-EU countries were subject to common customs tariffs. In 2004, the common customs tariff for the exible coupling had an import duty of 2.7 per cent. In addition to the import duty, all imported items were subjected to the value added tax (VAT) which was applied on all manufactured goods both imported as well as locally made. The VAT was going through a harmonization process but was expected to take some years before a common VAT system was in place. As of 2004, the VAT for United Kingdom was 17.5 per cent, and France 19.6 per cent. Denmark, Hungary, and Sweden had the highest VAT at 25 per cent