UVA-F-1650 Rev. Sept. 21, 2016 This case was prepared by Marc L. Lipson, Robert F. Vandell Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2011 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. Geo Tech Thomas Boyatt did not set out to be a player in the sustainable-development arena. When he founded Geosystems Technology Group (Geo Tech) in 2006 to develop and sell a geographic information system (GIS), his goal was for timberland owners to use the technology to monitor harvesting activities under sales contracts. But rising concerns about the sustainability of natural resources had greatly expanded the technologys possible applications, so the company had responded by developing a portfolio of products that enabled companies to access and explore data on their timber holdings, optimize development, and maximize long-term value. By the end of 2014, after a few early setbacks, Geo Tech was growing, and Boyatt was very pleased with the systems he was sellingvaluable tools at a reasonable price. He was acutely aware, however, that even though Geo Techs offering was still the only system of its kind with appreciable traction in the United States, a number of competing products were selling well internationally. To preempt the establishment of a competitor in Canada, where systems of this type were not yet regularly employed, Boyatt was considering the establishment of a Geo Tech facility in Alberta, Canada. Geo Tech Products As with most geographic information systems, Geo Techs products presented geographic information digitally along spatial and temporal dimensions, allowing vast amounts of data to be manipulated intuitively for a wide variety of analytic purposes. Applications might include assessing the environmental impact of development, calculating the best delivery route for resources during natural disasters, or documenting the environmental impact of public works projects. Geo Tech leveraged these capabilities with the timber industry in mind. Within a digital model of a given clients sitederived from topographic maps and detailed ecological surveys and updated with weather data in real timeGeo Techs sophisticated suite of products projected ecological system data dynamically, enabling the client to simulate and forecast outcomes for a variety of management strategies. A timberland owner could consider the long-term implications of various harvesting procedures, replanting choices, and development projects such as road and dam building. Information on the sites was regularly updated with spot visits. One advantage of Geo Techs system was its ability to store and track timber contracts, which could be quite complex (specifying, for example, which types of trees could be harvested when, what kinds of access disturbancessuch as road buildingwere allowed, how long the contract lasted, and how the area would be treated after harvesting). By monitoring both compliance with these contracts and the many legal constraints in particular locations, timber companies could write contracts with a level of complexity more conducive to the development of sustainable practices. In fact, this feature had driven most of the interest in Geo Tech products and placed it at the forefront of the sustainability movement. Page 2 UVA-F-1650 Product Licensing Geo Tech offered three levels of service. Baseline service, called Tracker, simply tracked usage of timber resources. The midlevel service, Foresight, included a broad suite of plug-in modules that provided most of the sophisticated modeling capabilities users desired, making it the most popular choice. The top-level service, Oasis, included a high degree of customized development that would automate tasks that were desired by particular users. Clients signed three-to-six-year contracts. The contracts stipulated annual licensing fees, which provided remote access to models of their site and toolkits stored on Geo Techmanaged servers. The constant upgrading, maintenance, and ongoing development of plug-ins, combined with the need to customize hardware to optimize software routines, made it impossible to host site models on client systems. The fee structure was relatively simple: Geo Tech charged an initial setup fee of USD18,0001 and annual licensing fees of USD3,000, USD8,000, and USD14,000 for Tracker, Foresight, and Oasis, respectively. Canadian Market Decision The motivation for creating a new site in Canada was rather subtle. Boyatt could conceivably expand the existing two sites in the United Statesone on each coastto accommodate any additional work, but Geo Tech programs required a great deal of company information, and quite a few Canadian companies had expressed concerns about storing such data in the United States. This perception may have been a reaction to the powers granted to the U.S. government under the Patriot Act and concerns that U.S. companies were more likely to be targets of cyber espionage. Regardless of the source of the concerns, Geo Tech did not have a single Canadian client. Boyatt believed any fears in the industry regarding data location would dissipate over time, and he was confident that any clients he might gain from a Canadian facility would eventually be willing to move to a U.S. site. The Canadian investment was, therefore, viewed as a temporary measure; Boyatt planned to liquidate the Canadian facility after five years and transfer clients to one of the U.S. sites. Boyatt was a careful businessman, and he believed, perhaps not surprisingly, in the ability of analysis to provide meaningful insight into a decision. As he contemplated an entry into the Canadian market, he wanted to be sure that it would turn out to be a sound business decision. He asked an associate at the company, Jessica Engle, who oversaw the companys economic timber models (one of the most popular analyses Geo Tech supported, it evaluated the economic merits of various proposed timber contracts and policies for clients) to generate an analysis. After some discussion, the two agreed on the following assumptions for the analysis: The investment would last five years. All contracts would be at the Foresight level, for three years, and would be priced in Canadian dollars. Given Geo Techs U.S. prices, the exchange rate at the time of USD0.860 per CAD2 and rounding to the nearest thousand, the fees would be priced at CAD21,000, and the annual licensing fee would be priced at CAD9,000. These contract prices were not expected to change over the coming five years. The company would generate 20, 30, and 20 new contracts over the first three years, respectively, and 10 contracts in each of the last two years. The decline in contracts written for the Canadian facility reflected the expectation that in a few years customers would become less concerned about data location and would be willing to sign on for services at the U.S. facility. 1 USD = U.S. dollars. 2 CAD = Canadian dollars. Page 3 UVA-F-1650 Geo Tech would initially have to invest CAD840,000 in equipment, which would be depreciated straight-line over three years with no assumed salvage value but could be sold for CAD100,000 at the end of five years. The operation would have the following cost structure. Every setup of a contract would cost CAD14,000. Other cash operating costs would be CAD240,000 a year if there were less than 55 ongoing contracts and CAD360,000 otherwise. The tax rate on all earnings would be 35%. The majority of the conversation concerned the number of new contracts sold. As noted, Boyatt considered the Canadian investment to be a temporary strategic move largely to beat potential entrants into the Canadian market at a time when locating sensitive data in the United States was a deal killer. He did not want to include in his analysis of the Canadian site any clients that would have become Geo Tech clients even if no Canadian site were developed. Thus, since he believed he would have obtained all possible clients after the five-year mark, he only considered contracts sold in the first five years of the project. Similarly, because he believed he would have obtained those customers after the fifth year any way, Boyatt did not include annual licensing fees beyond the fifth year of the project. Finally, Boyatt knew there was little reason to keep the operation running if there were less than 30 ongoing contracts, and his forecast after the fifth year fell below that mark. Boyatt and Engle also discussed appropriate assumptions regarding the timing of revenues and costs. The setup fee was paid at the contract signing, the first licensing fee once the client model was running (about two months after the contract signing), and the subsequent annual licensing fees on the anniversary of the first licensing fee payment. They agreed that there was no reason to make the model overly complicated and were comfortable with annual cash flow estimates with the setup and first annual payment occurring in the same year, and all cash flows other than the investment beginning in one year. Recognizing that the contracts would be priced in Canadian dollars and that most costs would be incurred in Canadian dollars, Boyatt and Engle knew they would have to make adjustments for exchange rates. Engle was aware that the typical approach was to convert foreign currency cash flow estimates to domestic currency equivalents at the anticipated future exchange rates and then discount those at the usual (domestic) discount rate. She had therefore obtained a forecast of the Canadian dollar/U.S. dollar exchange rate, which is presented in Exhibit 1. The provider of the forecast noted that the assumed continued devaluation of the Canadian dollar was predicated on further collapse of commodity prices for commodities exported by Canada. Boyatt and Engle also agreed that the risks of the projects cash flows were comparable to those of their U.S. contracts. The Geo Tech discount rate for project valuation was 9.65% (the weighted average cost of capital for the company). Finally, Boyatt and Engle had debated the effects of inflation on the analysis and the magnitude of any home office costs (in U.S. dollars). As for inflation, market pressures had largely limited Boyatts ability to raise prices, and he had even lowered his fees twice in the past. Operating costs, on the other hand, were increasing with inflation. The squeeze on margins had been more than offset by volume growth, and the firms profitability was largely determined by Geo Techs ability to leverage its fixed operating costs and past research investments. Inflation in the United States was quite low and expected to average about 1.50% over the next five years. Inflation in Canada was expected to be slightly higher at 1.75%. As for costs in U.S. dollars, Boyatt believed there would certainly be some initial costs and modest ongoing costs, but he determined these would be small relative to costs in Canadian dollars and could be ignored. Boyatt was curious to see what the analysis would suggest and how sensitive the results would be to the assumptions he and Engle had made. Two things worried him. He was aware that the Canadian dollar had Page 4 UVA-F-1650 depreciated by about 12% over the previous three years and was therefore somewhat concerned about how currency value changes might affect any investment (Exhibit 2). He knew a further decline in the value of the Canadian dollar would hurt his investment. Second, he knew that the profitability of this investment would depend greatly on the number of contracts signed. Boyatt was quite sure Geo Tech could hit 80% of the forecast volumes given his knowledge of companies in Canada and his existing connections. Exceeding the forecast by 50% was also certainly possible given the size of the market. Page 5 UVA-F-1650 Exhibit 1 Geo Tech Year-End Exchange-Rate Forecast, Canadian Dollar in U.S. Dollars 2014 (Spot Rate) 0.860 2015 0.825 2016 0.805 2017 0.790 2018 0.780 2019 0.775 Data sources: U.S. Federal Reserve and case writer estimates. Page 6 UVA-F-1650 Exhibit 2 Geo Tech Exchange Rate of Canadian Dollar in U.S. Dollars, January 2000 to December 2014 Data source: U.S. Federal Reserve. USD 0.500 USD 0.600 USD 0.700 USD 0.800 USD 0.900 USD 1.000 USD 1.100 Jan-00 Aug-00 Mar-01 Oct-01 May-02 Dec-02 Jul-03 Feb-04 Sep-04 Apr-05 Nov-05 Jun-06 Jan-07 Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10 Feb-11 Sep-11 Apr-12 Nov-12 Jun-13 Jan-14 Aug-14