SUMMARY AND EVALUATION.
The industry of Blower and fans, SIC 3564, consists of establishments primarily engaged in manufacturing, distributing and servicing (See Appendix A):
1: industrial and commercial blowers,
2: industrial and commercial exhaust and ventilating fans,
3: attic fans,
4: dust collection and other air-purification equipment for heating, ventilating and air-conditioning systems or for industrial gas cleaning systems.
Blowers and fans are a growing and prosperous industry. The industry is differentiated into three segments:
1. Equipment manufacturers.
2. Distributors.
3. Service companies.
1) Equipment manufacturers
The industry has few big manufacturers (no more than seven or eighth nationwide), each one having a reasonable market share specialized in different segment of the market. Normal profit's margins for selling equipment range from 4 to 5%. However, when a market niche exists, the profit margin may be reaching 25-30%. Manufacturers generally have two kinds of customers:
a) End users of blowers and fans,
b) Original Equipment Manufacturers (OEM)
OEMs use blowers and fans as by-products, to move the air through their final products. For example, for one of the biggest manufacturers in the US, Chicago Blowers, OEM customers represent 50% of their sales .
Blowers and Fans can be divided into the following three categories:
1: Commercial (Appendix B)
2: Industrial, heavy (Appendix C)
3: Customized industry (such as for air planes, nuclear power plants, tunnel ventilation, and other applications)
2) Distributors
Most of the manufacturers have their own distribution system consisting of a line of representative as well as independent agents. An independent distribution company can represent many different manufacturers. Their sales primarily consist of 70 to 80% of mass produced standardized products, leaving 20-30% for customized products. Brand recognition is important for the distributors in terms of the product they sell and their own name recognition. Generally the customers are brand loyal.
The customers in the distribution segment include mechanical contractors, end-users and industrial accounts with an engineering department. Between the customer and the distributor, independent consultant engineers can be found providing advice to clients about redesigning already existing systems or assisting in developing a custom-made one from scratch. Normally distributors provide some engineering modifications, however not as a full service. Typically, the manufacturers work with OEMs, but in case of emergency situations they will deal directly with the distributors.
Distributors compete through the quality of consulting, the products quality and performance, and through technical expertise. Due to the heavy competition among distributors, the market doesn't allow to charge a significant premium for basic services.
The basic competitive tools of the distributors are 1º) delivery and 2º), price. In many situations, when urgent problems occur in plants or buildings, rapid delivery is essential making the price a less important issue.
Inside engineers in the distribution companies are more application based than design based. They can customize existing product, but mainly they are looking for different applications of standards blowers and fans. The standard products produced by the manufacturers have certain standardized characteristics and applications. After analyzing their customers' needs and current installations, the engineers can advise on the most suitable combination of the various products. A sale representative clientele includes generally 4 or 5 consultant engineer companies, 4 or 5 mechanical contractors, and 1 or 2 industrial type accounts which whom he normally interacts.
The most common application by industry can help prospective users of blowers and fans to identify both identical and similar applications in their industrial operations, allowing customer's benchmark other systems.
Current applications by industry, among others: (Appendix D)
Aquaculture Medical equipment
Bottling plants. Nasty gas.
Commercial Spa. Packaging equipment
Computer equipment. Paper processing machinery
Deicing. Plastic machinery
Electroplating. Pneumatic tube systems
Foundry. Pollution control
Industrial plants. Textile
Material handling
Five major application areas (Appendix D).
Solution and media agitation.
Pneumatic conveying.
Vacuum hold-down and pick up.
Air blow-off.
Process gases.
Distributors may use, apart from the normal catalogs, computer programs and simulation to select the most suitable fans for their clients. The computer program allows some customization of the product by selecting different parameters like in a "what-if" analysis. These programs are made by the manufacturers. Manufacturers also take care of training the distributors' sales representatives offering special courses. (Appendix E). In addition, it is important for the distributor to receive a cooperative attitude, a fast delivery from the manufacturer, and adaptability of the product. When a customer needs a specific customized product it can be difficult for the distribution firm to supply a brand recognized product. Other obstacles such as the sizes of the clients existing systems can create problems, both for the distributors and for OEM's. They can produce a high switching cost for the customer to change the current system if the type and size of the provided products do not match the old installations.
A well-managed distribution company is a company that has its managers close to the rest of the personnel, solving employee problems and motivating them. The later can be in terms of flexible working hours and other employee benefits. A good relationship between the company and its salespersons is essential to maintain the profitability of its operation.
3) Service companies
Services companies can be subsidiaries of blowers and fans manufacturing companies or independent companies. An example of the former is McQuay Services subsidiary of McQuay International. Examples of the latter are Frwmaye Services, Intech Co., and Natkan Co. They can offer many different services such as showed in Appendix F.
McQuay Service, for example, sustains products of many different manufacturers. They come after the sale. The manufacturer sells the equipment, and they follow this equipment with their service. They give instructions how to operate the equipment to the building engineers. After the first year warranty, they go and sell a comprehensive maintenance contract that is renewed on a year basis. Thus, they maintain a long term relationship with the customers. Service is a main point in the industry, and normally service companies are not involved in sales.
Service companies provide mainly service of blowers and fans for air conditioning equipment, and heating business for large buildings, factories, tunnels, and others. (Appendix G). McQuay Service has a permanent staff of 17 Service Technicians who takes care of the maintenance of air conditioning equipment in large buildings in downtown Dallas. The company is in touch with their customers on a daily basis. The service is crucial to maintain the product.
The service companies' customers are the air conditioning process plants (OEM), while their heavy commercial work includes plants and commercial industries. In addition, they work with property management companies that manage the large buildings, hospitals, colleges, and other big facilities, establishing with them comprehensive contracts on an annual basis to maintain the buildings.
It is very important for the service companies to have a highly qualified staff of technicians. Their sales engineers have been in the business for many years, giving them a thorough knowledge and experience in the field of air conditioning service.
The service companies frequently recruit their technicians from Tech Schools in trying to hire new apprentices they can train themselves. They establish education and training programs which take from 6 to 12 months to finish.
The industry has, on average, a low staff turnover ranging from 5 to 6%. Blowers and fans are a very specialized field with few educated and experienced technicians. The companies must compensate them well in order to motivate them to stay. The low turnover does reflect a satisfactory compensation level. Furthermore, the air conditioning industry is a non-dissolving market leaving the technicians and engineers with high job security. Supply and demand determine the compensation level.
A well-managed service company is one with an efficient communication between technicians and engineers, and manufacturers and managers, having their people "on the ground" motivated through weekly contacts, if not daily.
Legal issues/environment
The Air Moving and Conditioning Association (AMCA) establishes standards of performance (Appendix H). Most manufacturers are members of the organization that makes them fans certified. The most important function the association provides is the AMCA Certified Ratings Program. This program certifies that the published ratings of a manufacturer are based on tests conforming to the appropriate AMCA test standard. All the catalogs containing certified ratings are submitted to the AMCA technical staff for approval before publication. Licensed products are open to challenge tests initiated by competing manufacturers. Each licensed product line is subject to continuing check tests in the AMCA laboratory. On the other hand, AMCA maintains and circulates a Directory of Licensed Products. (See Appendix I) This program provides the buyer the best assurance available that the product will perform as stipulated by the manufacturer.
Manufacturing companies are subject to various environmental laws concerning emissions to the air. It is difficult to predict accurately companies' future expenditures for environmental matters. Concern for the environment has led to increased government regulations of the industry in many countries. Compliance with environmental laws and regulations is an immediate challenge to the industry. With no doubts, environmental legislation, mainly the Clean Air Act Amendment of 1990 (CAAA), will have an important impact on the industry in the near future, because of the increased demand of blowers and fans to accomplish what regulation require. The environmental equipment industry includes industrial air pollution control equipment. Air quality control equipment removes pollutants from a gaseous stream or converts pollutants to a non- or less-polluting form before discharge into the atmosphere. All those kinds of devices require the use of blowers and fans.
Surveys by the Department of Commerce, Bureau of the Census, based on Census 1992, showed that user industries spent more than $7.4 billion on pollution abatement equipment in 1991, up 23% from the previous year. Of this total, $3.7 billion was for air pollution control, up 45% from 1990 (largely due to new requirements imposed by the Clean Air Act Amendments). It showed also that the United States Pollution Abatement Operating Costs increased by 6%. The Journal of the Air & Waste Management Association estimated that US industries would spend more than $4 billion on air pollution control equipment and services in 1993. Small commitment compared to the 1995-1997 investments' requirements outlined in the CAAA. The same legislation is expected to increase average annual revenues for stationary source air pollution control equipment makers by about $2.3 billion a year among 1992 and 1995, and by $4.2 to $5.8 billion a year between 1992 and 2000. An Environmental Protection Agency (EPA) study also noted those market opportunities for air instrumental equipment will increase from about $120 million in 1989 to $300 million in 1994.
Despite alternate energy sources such as wind, solar, and biomass, the largest segment of new electricity generation in the world is projected to come from coal firing in the next several decades. It will bring related air pollution problems along with it. Environmental technology experts forecast that utilities worldwide will spend more than $800 billion in the next 10 years for fossil-fuel fired power generation equipment and related air pollution control systems. Asia will be the largest purchaser of the equipment, followed by the Americas, and Western Europe.
Future trends
Shipments of environmental equipment are expected to increase about 4% in 1994 and continue to expand in future years as the US and other countries aggressively enforce anti-pollution laws intensifying their efforts to clean the environment.
One of the newest application is in the hospitality industry. Restaurants are increasingly being pressured by regulatory authorities to control air emissions and to minimize the amount of smoke, grease and odors that are released into the air. This represents a large potential market for the blower and fan industry.
Manufacturing operations in the US are consolidating. Overhead costs are reducing, marginal product lines are narrowing, business systems are upgrading, and project management is improving. In reaching all those, new computer systems are being installed. Companies are focusing on their core products that provide solid growth and profitability prospects. Programs are underway to re-engineer products to improve their attractiveness to customers and their margins.
The blowers and fans' industry is involved in very expensive changes the customers must go through. This change is called the "CFC issue" which is an Environmental Protection Agency regulation regarding Cloral, Flour, and Carbon contamination. Those changes consist of an expensive redesign of refrigeration systems eliminating the refrigerant that harms the ozone in case of a leak, replacing it by a CFC "friendly" one. To eliminate the system systems which are ozone harmful from the market the government has forced an added taxation on the system to increase the prices making it less attractive to purchase. Manufacturers will have to spend significantly on updating their systems, "retrofitting" the old machines to modernized standards through internal changes. This forced law gives the Blowers and Fans industry a great opportunity for extra profit margins and increased demand when servicing the clients in their adaptation to the new regulations. By November 1995, by law, everybody has to change their refrigeration systems and their equipment. The Blowers and Fans companies will visit the customers, analyze their installations, and propose new installations including the price levels and implementation process.
"The industry (air conditioning, refrigeration, heating, air movement business) which requires blowers and fans as a basic product, is a very good business because there always going to be people who need to be kept cool and they always have to have the refrigeration for food and products."
Foreign issue
Imports do not have any particular importance in the US as the fans are big and transportation is very costly. However; in the past three to four years the imports have increased mainly due to the fall of the dollar. The industry does not expect this situation to continue for a long time. A lot of foreign companies (especially from Japan) have tried to enter the US market, but they did not succeed, either in Canada or in the US. The industry requires very fast delivery and product adaptability. Standard products have to be adapted often and that means active participation of the manufacturers. With long lead periods, and uncertainty because of potential custom delays or adaptability problems to local regulations, even with good quality and relatively lower prices, those products are not longer competitive in the US market.
On the other hand, a July 1993 EPA report on international trade in environmental protection equipment showed that the United States is a major exporter of environmental pollution equipment in general and air pollution control equipment in particular. Only 21% of the air pollution control equipment sold in the United States is supplied by imports.
Important issue: Market value and EVA
An interesting point regarding the industry is the current market value of some of them. Looking for a benchmark, we compared the Economic Value Added computation of one of the players in the industry, and its actual market value. The result speaks for itself since the market is willing to pay for the company more than three times our EVA computation value ($591 million against $184 million). In the latter calculation, and for the purpose of analyzing the market's perceived perspective for the industry, we figured out a Time horizon equals to zero (Appendix J).
As an overall conclusion, the SIC 3654 industry does not fit some of the basic acquisition criteria given. The industry seems to be generally well managed and many things are happening regarding regulations and technology within the industry, changing it at a fast pace. The companies have a strong market position, and have consistent earning power (for the distribution and service sectors). The capital expenditures are low while they have diversified customers and a geographically diversified revenue base. The industry follows the state of the economy and the industrial real estate cycle. It has a low exposure to technological obsolescence and its environmental risk is an opportunity for the industry. In the distribution and service sector where the profit margin is the highest, there are no labor intensive requirements, nor are unions present. The industry analyzed may be an industry to watch in the future. This industry is appropriate for the client only if they decide to change some of the acquisition criteria given in order to take advantage of the positive outlook of the Blowers and Fans industry in the short and medium range.
GENERAL CONSIDERATIONS
Environmental Issue
Only the companies that have chosen to be in the business of pollution control need to comply to the Clean Air Act. The request for a cleaner environment is established and growing worldwide, in developed and developing economies. However, business opportunities arise only when this concern is translated into broad government policy, and then translated into specific regulations. The Clean Air Act Amendments of 1990 will continue to play a key role in near-term business opportunities as major US industries invest in air pollution reduction and monitoring equipment required by the law. The CAAA requires US industries to make major investments in air pollution abatement equipment among 1995 and 1997. Utilities are expected to be the largest purchasers of pollution abatement equipment, followed by the chemical industry, the pulp and paper industry, and petroleum refining.
Phase I of the 1990 Clean Air Act Amendments in the US restricts the amount of sulfur dioxide from certain US utility plants commencing January 1, 1995. Alternative available to those plants includes the purchase of emissions credits, closing facilities with unacceptable emission levels, switching to lower-sulfur coal, switching from coal to natural gas, or removing sulfur dioxide from smokestack exhaust gases by scrubbing.
Phase II of the Act contains tougher standards to be met by January 1, 2000, that affect a broader range of utilities and industrial companies. Because switching to or blending in lower-sulfur coal is not expected to be sufficient to meet Phase II standards, greater use of scrubbing is expected for Phase II.
Distributors of many manufacturers think that regarding the Clean Air Act we will see factories and buildings with inadequate ventilation that need to install new air control system. Labor research shows that smoke free areas will need more exhaust fans. The Clean Air Act can generate 5 to 10% additional sales or more.
Customers' concerns are shifting to matters such as sounds level, vibration, power consumption, and wants of a "clean product" (small size, new product, without noses, nice looking, stainless steel, no isolation in the air stream). This creates new opportunities to differentiate products.
For McQuay Service company, the Clean Air Act is going to dictate to companies what they have to do to keep between standards the air quality in their businesses. It will increase the demand in the industry because of the regulation. The management is more aware of the standards of the air quality they have to maintain in the work place, in the office buildings, and in the factories.
Technological or Obsolescence Risk
Obsolescence risk exists since the products need some technological design on standard products, and special design on blowers and fans to adapt the products to the customers' needs, but there it is a limited risk. There are many potentials uses for standard blowers and fans that reduce the risk of obsolescence. For tailor-made blowers or fans the technological risk can be higher.
In production, the technology has not changed significantly in the past 25-30 years. Engineering knowledge is moving very slowly and factories are cautious due to the expense of retooling the shop. Big manufacturers such as Chicago Blowers are continuing developing new product lines, a new series or type every 5-10 year. Normally after 20 years, the fans are obsolete due to more efficient fans. Indeed, new projects are coming that upgrade the equipment, incorporating the requirements of the Clean Air Act.
The technology in this industry is important. The fundamentals of blowers and fans are there, but the design remains important. Any advancement that improves reliability is incorporated to the manufacturer process. There exists a regular interest in introducing new materials such as fibber glass to the production of fans. Slack Buckner Systems corporation states that technology will not drive the industry in one particular direction, leaving regulations to do it. For Texas Air Handlers representatives, the permanent and increasing consolidation of companies in the industry leads to less and less research. Each time more companies copy what is already in the market. In the case of the Chicago Blowers manufacturing company they spend from 3.5 to 4% of sales in Research and Development.
On the other hand, McQuay Services explains that because of the technological risk of the products they keep their technicians up-to-dated with the latest technology that comes out. Technological changes exist in the blowers and fans' industry, in the way they are manufactured. Every year something comes out, such as more efficient variable speed drives for the fans, more energy efficient motors, vibration analysis, and new applications technological changes. Customers can call MicroTech control systems, a computerized control system, in order to control entire buildings, its blowers, fans, and the heat (Appendix K).
Litigation Risk
For distribution companies such as Slack Buckner Systems, litigation issues are not a major problem. In spite of that, they still have exceptions. If they are suited, the end of the chain will be the manufacturer that has always an insurance policy to cover these problems. Manufacturers usually keep track during 10 years of the model to know who designed it in order to take required actions regarding any possibility of litigation from end users. Distributors may sue the manufacturers in case of some trouble. Texas Air Handlers, for example, never had any trouble in 25 years of operations. They think that the risk is always there, and that manufacturers need to be careful always being covered by liability insurance.
Regulation Risk
There is no real regulation associated with this industry but there are some associated regulations that the company needs to fulfill in order to keep or increase its market share. The current general regulation is not an obstacle as it follows the normal standard for manufacturing industries. However, when competing in the pollution control market, the company will need to comply with the Clean Air Act mentioned earlier.
As mentioned at the beginning, most of the blowers and fan's manufacturers belong to the AMCA that keeps some production standards. The only kind of regulation in the industry is regarding the noise and the horse power effect but those constraints are not difficult to reach. There are no mandates about how a fan nor a blower should look like, or what size they should have. Some distributors explain that there can be changes in the regulations about every 4 or 5 year.
Unionization and Labor Relations
Technological advances have led to improvements in labor productivity and have contributed to an important decline in industry employment over the years. Now the process requires fewer and more skilled workers due to the introduction of robotics.
Interest data follow:
1991: 26,600 employees; payroll $700,200,000.
1990: 27,700 employees; payroll $724,800,000.
1987: 24,100 employees; payroll $548,600,000.
The numbers of employees in companies range from 50 to 400. The majority of manufacturer companies are highly unionized (100%) but some companies are unionized at 60% or less. Generally the labor relations are good in this industry despite some a few observed strikes. The strikes were mainly caused by the automation of the industry as it occurred last year at Chicago Blowers, not because of compensation problems.
In distribution companies, the personnel have the option to work flexible hours.
For the Texas Air company, labor relations have been changed. After some consolidations, unions became less cooperative. That provoked the shut-down of at least three plants causing the manufacturing to make a choice of moving to Canada, Mexico, or to an existing plant in the US to avoid the union. The processes continue to become more automated but the labor unions are creating some barriers for its implementation.
Level of Technology needed in Operations:
For this industry, it appears that the need of technology is not a major concern does not to seem a great concern. Nevertheless, we need to revise this judgment for niche markets. Since the niche market represents a more customer design product, it usually involves more technological skills. Generally, the customers agree to replace their blowers and fans with new and upgraded products as new technology is introduced. However, that decision depends on what degree the system needs changes. Significant changes are naturally very costly and a longer decision process will be needed.
Degree of Need to Continuously Reinvest more than small amounts of capitals:
The following figures for the industry are based on the 1992 Census data:
New Capital Expenditures:
1991: $46,000,000
1990: $56,900,000
1987: $46,100,000
Used Capital Expenditures:
1991: $ 2,000,000
1990: $ 8,800,000
1987: $ 4,100,000
Value of Manufacturers' Inventories:
1991: $427,900,000
1990: $449,000,000
Manufacturers have high capital expenditure caused by the use specialized machines. The 1992 census shows that in 1991, $46,000,000 was spent on capital expenditure. It is difficult to convert the expertise of the blowers and fans' industry to other applications. Manufacturers are very rigid. They commit a large investment in new lines and segments. Only new large orders will persuade the manufacturers to develop new lines or products. Nevertheless, there are exceptions. The agricultural fans require a low capital expenditure due to the low level of technology involved.
The Texas Air Handlers distribution corporation keeps a minimum level of inventory for resale with the basic standard types of blowers and fans. They mainly act as manufacturer representatives. When they receive the order from the customer they contact Chicago Blowers and Fans which then ships the goods directly to the end-user.
For services companies the capital expenditures are high since they have a great number of technicians working "on the ground" -17 service technicians in their case- each one driving a $22,000 vans, plus tools (around $15,000 in each vehicle) to provide services to the customers, making a total of $37,000 for each technician. This means a total expenditure of not less than $629,000 for a five year period. The McQuay Service company has established a program to change the used for new brand vans each 4 or 5 years depending on mileage -normally 80,000 to 90,000 miles-. It is important for the company to maintain a good image. Through new and clean vans and uniforms the company gives a good impression to their customers They are constantly cautious about traveling with unreliable vehicles to reduce the possibility of any potential problem.
Service companies have a big investment in inventory for repair parts to maintain the level of supply in order to service their customers to their satisfaction. The inventory levels for repair parts can on average be estimated to $200,000. The repair parts and equipment are shipped from their headquarters. The inventory is an essential part for the service companies to do business and they would not be able to survive without sufficient supply. The large supply gives them flexibility to provide competitive prices and fast delivery to their customers.
Industry Profitability on Sales and Assets, especially Operating Profits, and trends in these.
Manufacturers' profitability is relatively low, ranging from 4 to 5%. That profit margin is found on the sales of equipment and products. Customized industry can be very profitable, ranging from 30 to 40% profit margin on customized products versus 15 to 20 % for standard ones. Distribution companies have higher profit margin than manufacturers ranging from 25 to 35%. On the other hand, service companies may have the highest profit margins of the industry sometimes reaching more than 50%.
The service company McQuay Service made $12 million in sales last year and profit margins above 40%, much higher than the industry average. In order to service the equipment, they sell repair parts where they earn most of their high gross margins. Furthermore, gross margin is earned on labor rates, and on comprehensive contracts.
High margins in service are not so different to achieve and their profit margins can be substantially higher than 40%. As mentioned before, they charge a huge margin on the repair parts provided to their customers. Their mark-up multiplier is calculated based on this table or similar:
Cost of the product for McQuay: multiplied by ... to charge their customers:
$0 to $10 3 (200% profit margin)
$10 to $100 2.5 (150% profit margin)
$100 to $1,000 1.7 (70% profit margin)
$1,000 to $5,000 and more 1.5 (50% profit margin)
In some cases they even charge more.
The sale of repair parts with those overcharges to customers, represent around 30% of the McQuay's revenues. They can put those prices, they can charge them as much as they want, because through them, is the only way the customers can get the necessary repair parts.
Current Acquisition Activity:
American companies have had some acquisition activity across their borders, but mainly foreign companies acquiring in the US. Since it is very difficult for foreign companies to enter the US market most of the foreign manufacturers have decided to acquire domestic blowers and fans' manufacturers. Therefore there exists high degree of take-over from foreign companies. Foreign investors are increasing their holdings in the US through acquisitions, such as the Buffalo Blowers acquired by an English corporation, or McQuay International recently acquired by a Malaysian firm. The filter branch of McQuay International, American Air Filters International, was acquired by the same group too.
At the beginning of the this year, one of the biggest players in this industry, SnyderGeneral Corp., was renamed to AAF-McQuay Inc. and split into two companies, AAF International, the filter branch, and McQuay International. Both McQuay International and AAF International were recently acquired by a Malaysian group.
There has been a lot of consolidation in the last five years: large companies buying smaller ones, depending on the specialization of company, such as dust collection for example. They buy the technology, and the customer data bases. Normally they remain in the same industry, but acquire different type of blowers and fan's manufacturers. The result is fewer and fewer companies and the main players grow.
Risk/Considerations Unique to the Industry:
The Industry is affected by the economy. A slow economy can slow down heavy equipment projects for several years. Usually regarding blowers and fans, projects are planned with many years in advance, from 2 to 3 years. The industry is tied very closely to the real estate cycle as well as to the business cycle. For the real estate cycle the blowers and fans' industry depends on the number of constructions of commercial and industrial buildings, and to a lesser extend of the residential buildings. The demand of air conditioning systems decreases when the construction is low. The industry follows the business cycle and the general state of the economy: in a period of expansion the demand for blowers and fans tends to be high. On the contrary, when the economy is in recession the demand declines rapidly.
Predominant Values of the Industry:
Economical expansion drives the manufacturing part of the industry. This part of the industry is also driving by other industries' wealth, primarily the construction industry. The other driver of this industry is the replacement cycle. Companies need to change their blowers and fans to take advantage of the products' improvement as well as to fulfill Government regulations, or simply because the product became too old and needs to be replaced.
On the other hand, the driver of the industry for distribution and service companies is profitability. Normally distribution companies are very linked with existing manufacturers' customers, and with the launch of new or existing products, but for new applications. Service companies usually follow the products sold by manufacturers offering maintenance and reparations.
Timing:
We were not able to get any information on the current acquisition prices since most of the companies analyzed were acquired by private or foreign competitors that did not want to disclose any data. Nevertheless, we can consider that the acquisition process for this kind of industry required a short period of time.
INDUSTRY BACKGROUND AND STRUCTURE.
SWOT Analysis of the Industry SIC 3564:
STRENGTHS
General:
Many applications in different industries.
Niche markets produce good profitability.
Brand recognition.
Blowers and Fans can be a "supplementary" industry with higher profit margins using the products as part of services to offer to customers.
Manufacturers:
Low R&D investments required.
Possibility to reduce manufacturing costs by moving factories overseas.
Low risk of technological obsolescence.
Brand recognition.
Distributors:
Low inventory level required.
Generally not unionized.
Moderate profit margin.
Service companies:
Brand recognition.
High profit margin.
Possibility to build entry barriers.
Low foreign competition.
WEAKNESSES
Very low profit margins for manufacturers.
Mature industry for manufacturers and distributors.
Difficult to differentiate the products (only through services and distribution).
OPPORTUNITIES
Clean Air Act, because of the regulation imposed on factories and buildings. Future demand of air-pollution control devices will increase substantially to meet requirements of the two Phases of the Act.
EPA's Cloral, Flour, and Carbon regulation.
Increased services; customized products to customers' needs.
Foreign markets are growing at a good pace. Steady near-term profitability. Prospecting is being made in Eastern Europe.
Easy to reach foreign markets by manufacturers and distributors of non-heavy equipment.
Promising future; increasing demand in the next years in different areas.
THREATS
Many competitors with small market share.
Buyer's market.
Low entry barriers (except for manufacturers).
Low switching costs (not in heavy applications).
US market: low near-term profitability (not for service).
There is no specific market concentration in the Blowers and Fans industry since companies target a broad kind of industries, from factories to restaurants. Furthermore blowers and fans are used in factories to aeration and in many different applications in several dissimilar products such as nuclear power plants, in hospitals, for tunnel ventilation, etc. Some companies are looking for certain niches and meanwhile others are entering diverse market segments.
Many multinationals and well-established domestic companies make up the industry. Many players with low market shares make this industry a high competitive market mainly in the bidding for projects.
Players and market shares for this industry in the US, by sales 1993 are as followed:
First two companies: 36.62%
First three companies:49.36%
First five companies: 55.74%
Company: Sales 1993 (million $) %
1) Eagle Industries Inc.1,26722.45%
2) SnyderGeneral Corp. 80014.17%
3) Air and Water Technologies71912.74%
4) Ampco-Pittsburg Corp.190 3.37%
5) Venturedyne Ltd. 170 3.01%
6) National Safety Associates Inc. 150 2.66%
7) Cooper Industries Inc. 120 2.13%
9) Buffalo Forge Co. 82 1.45%
The representation of the major players in the industry as far as market share is concerned are as followed:
From the list Ranked by Sales of 1993 (Appendix A), there are 99 private companies out of 152 and among the first 25 companies, 12 are private.
% of USPer Establ.of Shipments
StateEstablishmentsTotal ($M) Shipments % of USCost as % of shipments
Ohio37230.90 10.206.2038.40
New York23216.90 9.509.4047.30
California57173.10 7.603.0049.00
Illinois 39159.20 7.004.1041.60
Pennsylvania 27145.30 6.405.4032.50
North Carolina 20145.20 6.407.3044.30
New Jersey 22 98.50 4.304.5050.40
Missouri 10 82.10 3.608.2042.10
Wisconsin 12 78.40 3.506.5040.20
Texas 35 65.70 2.901.9044.40
Florida 18 42.10 1.902.3053.40
Connecticut 9 31.00 1.403.4052.30
Alabama 11 29.50 1.302.7049.80
Georgia 7 21.30 0.903.0047.40
Iowa 4 21.30 0.905.3053.10
Concerning the geographic area of operation, companies are broadening the markets they serve. They are including geographical markets such as the Pacific Basin, where numerous retrofit opportunities are available and significant coal-fired electrical generating capacity is being added.
Over the past two years, market growth rate had been around 5.6% (Appendix L) The industry is not seasonal but is subject to the cyclical nature of the industries and market served.
The industry has two different kinds of profitability. The first is ranging among 3 to 5%, which is generally obtained by selling equipment. Manufacturers striving for volume reach lower profitability caused by the price wars. The second profitability range for the industry exists when the manufacturers detect a market niche. Manufacturers can find many different applications and uses for their products. Applications and uses such as aeration, material handling, instrumentation, to prevent pomp from freezing in the winter, to put around the locks of the different rivers around the country, and for switch treatments, for farms use in aeration of silos. Air Conditioning manufacturers (including brands such as Carrier, McQuay, York, or Japanese and Korean manufacturers among others) use those products mainly for the boiler business, for pollution control, and for many other possible uses.
The gross profit for this industry is high. The total for 1993 was $730,518,000. This gives a gross margin on cost of 32.30% on overall (Appendix M). The following table gives you the gross profit and the gross margin for the main players in this industry (Appendix N) for 1993.
As one can notice, the gross profit margin varies between 23 and 37% which is pretty high since the technology involved -as we already mentioned- is low for basic product.
The US market condition will continue to be difficult for the near term. While the long-term outlook is promising on several issues, near-term market conditions are mixed. As previously mentioned, US markets are expected to be weak over the next two to three years as customers defer capital spending on pollution control projects as long as possible before committing to new systems and retrofits required to meet the stricter Phase II standards in January 2000. Excess capacity is expected to continue to depress margins in the US until Phase II business begins to materialize in 1996 or 1997.
Foreign markets are more promising in the near-term, and hold significant long-term potential, as coal-fired electrical generating capacity is added to meet the growing demands of emerging economies. Longer growth potential may emerge in Mexico and South America as countries strive to balance the environmental impact of increasing industrialization. Countries such as Taiwan and Korea have existing and growing air pollution control needs, while countries such as Thailand, India, Mexico and China represent potential markets. All of them offer large populations and increasing industrial development. In many cases they have quite serious air quality problems.
The blowers and fans' industry exports worldwide, mainly to Japan, Australia, England, Thailand, South America, Middle East, and Eastern Europe in the future. In some cases manufacturing licenses are needed to access those markets so American companies are not exporting directly from the United States; they supply them through local manufacturing.
Mexico and the Caribbean are good export markets for the money involved. One problem can be the expected caution on imported products. Usually the clients are afraid of the delivery time if a trouble appears such as problems with custom's regulations or important delays. Thus, clients normally prefer local suppliers.
Some service companies such as McQuay Service has some international activity, sending qualified technicians abroad for specific tasks (ex. to South America). Furthermore, "This is an international company which has been acquired by a Malaysian group and they actually have business around the world."
COMPETITIVE ANALYSIS AND STRATEGY
For the manufacturers and distributors, competition is now based primarily on quality, price, performance, delivery, and service due to little product differentiation. Multinational and well-established competitors have a relatively low market share, and the industry is characterized by considerable competition for projects. The components of the marketing mix are product, price, and distribution. We will not focus our attention on promotional issues due to its in-consistency of spending used by the individual competitors. Strategy for manufacturers, distributors, and service companies usually consists of mass marketing and advertising in regional and national specialized magazines, and trade shows. Usually they are involved in a number of trade shows and fairs every year to tell them what kind of services the company can provide . Trades such as the Hospital trade show in Tulsa where all the hospital administrators and builder engineers go. They are also very active in direct mail programs. After mailing, they follow up through personal phone calls to that particular engineer. They contact them to arrange a personal interview.
The blower and fan products are not considered as a high tech product. Nonetheless, they require some basic technology in the production stage. The percentage of sales dedicated to the Research and Development range from 6 to 25% depending on the size of the company.
Product:
There is not a lot of difference between each product as if you compare Ford to Chevrolet, but some small features will differ, according to John Lambert from Chicago Blowers. For the product itself, the differentiation will appears in the internal design. The core product remains about the same, but some modifications are made to best suite the customer needs. Another product differentiation can be made in the use of the product. They do not have the same finishing since some of these products will be used as by-product by the Original Equipment Manufacturers (OEM). Other products will be used as finished product and be directly sold in the market. Some companies have decided that their products will be customer based. The engineers of the manufacturers and of the client will decide which features will be required, and which modification should be done to existing products. They can create new products for a particular industry or client if this one represents a good market. In addition, a differentiation does not only need to relate directly to the product itself, but can relate with the services that surrounds it.
All the manufacturers we were in contact with claims that their products have the highest quality, thus it was not a base of comparison. When we asked about the services they provide, we found that differences exist. Some companies do not attach any direct services when they sell a product. They let the distributor repair any default. Other manufacturers chose to provide powerful customer services, designed for the client. They do that contracting for any repairs and for basic maintenance.
Distribution companies can differentiate themselves by offering services and products unique from its customers. The employees knowledge level can have a substantial influence on potential sales. The marketing strategy depends on the selected market segments. The individual distributor must match his marketing strategies with the customers predetermined demands including product preferences, system responsibility and reliability, and prices. Differentiation can also be achieved by offering separate repair facility for the product line the distributor represents. Differentiation always requires a staff of full-time engineers with an in depth knowledge and capability to service the customer directly from the warehouse. The sales personnel can best describe the market needs because of their market experience being for long time in both, the areas of standard products or of custom made ones.
For the service companies the story is very different. The high customer loyalty proves that the companies do provide the level of services expected from their clients. The other reason for the customers' commitment is the favorable and attractive prices offered by the individual company. A competitive advantage can be reached mainly within the following areas:
1. Quality and performing products.
2. Unique products.
3. Fast delivery .
4. Professional and experienced staff.
5. Agreements representing quality manufacturer
Technicians have the daily contact with the clients. Manufacturers' sales representatives not only sell the product, but also the service that follows. However, the service companies represent and follow product of predetermined or contracted manufacturers. Brand recognition is very important for the service companies; it is a barrier of entry since a new player will have to spend a lot of many and resources in advertising.
Price:
The customers are price sensitive since the market provides a large range of supply of blowers and fans, making the substitution effect high. However, it s important to notice that the clients are willing to pay small premium for a custom designed product. Most manufacturers offer discounted prices or attractive terms of payment to attract new potential market segments or to maintain and service their existing customers.
The US manufacturers are striving for profitability and will not sink the market by offering low prices in order to eliminate the weaker competitors. Price wars will eventually make all parties worse off, except for the customer. However, they do succeed to maintain decent profit margins for the industry (ranging from 4 to 5%). On the contrary, the European blowers and fan's manufacturers use different price strategies. They try to gain as much market share as possible lowering their prices to enter the market or to increase their market share slowly forcing out the competition. This strategy is mostly seen in recession periods. The European labor market is highly unionized making it very difficult to terminate employees. For the companies to survive, high market shares are essential. When the economy is recovering large profits can be earned.
Distribution:
The distribution system used varies from company to company. There are three major types of distribution systems. The manufacturing company can choose to
1) use its own distribution channels.
2) resell to another distributor.
3) use independent agents.
The distributors have sales personnel out in the field seeking for next potential accounts, following up on leads, service the existing customers, and advertising for new products and applications.
Only few manufacturers have their own distribution channel due to the associated costs. The manufacturers try to locate a market niche but often they need a nationwide distribution system, if not worldwide. The main factor for the manufacturers is the time for delivery. If it takes eight weeks to deliver a product the customer will locate a competitor with a similar product that can deliver within a shorter time frame. The manufacturers can concentrate on producing a high marketable product by selling their products to distributors eliminating the manufacturers concern for these issues,
The choice of distributors is crucial for the manufacturers, because it will determine the cost of transportation from the plant to the distributors' facilities. In addition, the manufacturers need to know precisely where the distributors are located. Since there are a lot of possible distributors, the manufacturer can easily choose the one or several that correspond the best to its marketing strategy vis-à-vis its market expansion, or to reinforce a particular location. Close distributors mean better handle of rush orders for quicker delivery.
Some manufacturers choose to deal with independent agents whom they personally train. For the Chicago Blowers corporation the recruiting system of sales personnel consists basically in two training programs. The first one it is a program of one year and a half in the sales department. The second program consists of three months in the manufacturing plant in order to get a good knowledge about the product and its applications. The participants are compensated during this training. Eventually they become independent agents paid only on a commission basis. In this way, even if the cost of training is high, the company is able to develop a vast network, and still satisfy the market demands.
Chicago Blowers has formed a representative counsel that brings forward the customer's ideas about new products to the manufacturing plant. The production manager will then analyze together with the engineers the possibility of manufacture this new product within a given price and still produce the expected profit. They are very customer oriented. Their customers decide which products and new products will be manufactured. When the new or modified product is made, Chicago Blowers creates a test market giving three or four blowers or fans to different potential customers. This customer will test the products and some ideas to how to improve them. Thanks to the close relationships between the manufacturers and their customers, Chicago Blowers can offer a customized product. Nevertheless, this strategy is time consuming and expensive.
One distributor, Texas Air Handlers, differentiates their business by the size of the blowers and fans, heavy versus light equipment. Theirs expected delivery time can be as short as two weeks or longer depending on the individual order and its specialization. The company works closely with OEM and consulting engineers in their target market areas. Texas Air Handlers has an established contact list and targets their marketing strategies separately to the various segments.
The five forces model discuss the entry barriers, the substitution threat, the suppliers' power, the buyer power and the level of rivalry among competitors.
Barriers of entry:
Manufacturers:
High investment in machinery and technology required.
Low profit margins.
Brand recognition.
Distributors:
Dealer of recognized products (agreement with main manufacturers).
Customer data base.
Distribution network.
Trained people with high product knowledge for qualified consulting.
Service companies:
Qualified and well-trained technicians.
Brand recognition.
Rapid and easy access to repair parts.
Inventory investment.
Manufacturers' involvement in the products.
As we previously mentioned, Blowers and Fans is a highly competitive industry but there are only few barriers to entry. The first one is the required level of capital investment for the manufacturers. Precision manufacturing tools and a good engineering department is needed since the products can require high technology depending on the focused market.
A second barrier to entry is the distribution network. One of the most critical issues is to be able to distribute the product nationwide, or even worldwide. The cost and time to implement an effective network should not be neglected. To start a distribution company the initial step is to have a complete and diversified customer data base. Basic information of the customers can be retrieved from the following sources: manufacturer data bases; Chamber of Commerce; Yellow Pages; and the local Directory of Manufacturers, among other possibilities. Once a client's account is established a continuous contact must be maintained to serve the client to the complete satisfaction. It is required for the sales representatives to have an extensive product knowledge. Therefore, it is important for the company to provide thorough training in sales and in their products. The salespersons (engineers) in the distribution companies have a tendency to switch between different blowers and fan's companies creating a relatively high turnover rate.
The third barrier is the service. New entrants will need to measure the importance of the service in the relation with their customers. The industry relies on efficient communication between the customers and the manufacturer's engineering departments. If the after sale service does not follow, the manufacturer may lose the client, or worse, part of its market share.
The fourth barrier is the learning curve and the economies of scale regarding manufacturing. Therefore, it will take time before a new entrant reaches the peak of the learning curve enjoying the economy of scale. On the other hand, for service companies looking for the product differentiation, knowledge is a crucial component.
Other force of the model is the substitution threat. As previously discussed, there does not real production differentiation for the core product. Customers can easily substitute one product from another if they do ask for special requirements. However, there is no substitution for customer designed products.
The next determinant is the suppliers' power. The main materials needed are steel, aluminum, copper, castings, electric motors and generators, and plastic. There are a large number of suppliers, which do not have much power of the blowers and fans' manufacturers. The only threat can come from a forward integration, but it is not likely to happen due to the capital requirement.
The next force of the model is the buyers' power. The relationship between the manufacturers and its customer is very important since it determines most of the products prices and the type of products the manufacturer will produce. In addition, one must not forget the substitution threat mentioned earlier. The buyers have power whether it is over a business, a distributor, or an OEM. The buyers are price sensitive in their demand for a core product. In a case of a custom designed product, the power between the manufacturer and its client is more balanced. Currently, there is no backward integration threat. However, an OEM can evaluate the benefits of buying its own blowers and fans' production facility if a very specific and customized type is demanded, assuming large volumes and continuous production.
The last force in the model is the rivalry among competitors. Companies prefer to acquire competitors rather to start a price war that can destroy the market, as describe in the Industry Background and Structure. Other important determinants are the barriers to exit and the switching costs. In spite of the high investment in machinery and technology required for the manufacturers, the barriers of exit can be less complicated when the machinery was developed for standardized products. However, conversion of highly technical plants can be very expensive and time consuming, unless a competitor is willing to acquire this particular equipment. Labor issues can be another obstacle to exit the industry. The highly unionized plants must negotiate with the unions regarding the individual labor contracts handling issues like lay-off compensation costs, relocation of personnel, and retraining. The switching costs of the manufacturers can be low for the core product, but it may not apply for the special products. For the distributors, the exit barriers can be also less complicated using its customer data base and distribution network to carry different products in related industries.
The best way to enter the industry is through acquisition to minimize the barriers of entry. For a distributor, one method to enter the market is by having inside connections in a plant facility. The maintenance employee has often more informal power and product knowledge than the engineers. On the other hand, in commercial sales the consulting engineers will approve or disapprove of the products. Secondly, the distributor can enter a market niche by discovering new applications or methods. An example is fiber glass fans, however, newly issued laws will make these products disappear in the near future considering the chemical content. Before entering a market, the distributor must carefully analyze the current and future needs of the end user. Only after that they combine it with the external stakeholders to measure the actual the actual probability of producing and selling the product conforming to the expected performance. The distribution company will have a competitive advantage entering the market with new products only if it has an already established market and channels. The current customers have the reliance from previous deliveries, services and from many years of personal contacts.
To approach this industry, service is very important. Qualified personnel are scarce and to attract them companies should pay above actual salaries. Furthermore, companies should be looking for them for a long time in order to find qualified technicians with many years of experience in the business. For service companies, it is essential to have a good staff of technicians with good equipment.
REFERENCES:
Clean Air Act Amendments, Public Law 101-549, November 15, 1990.
Preliminary Report Industry Series, issued October 1994 based on the 1992 Census of Manufacturers, by the US Department of Commerce, Economic and Statistics Administration, Bureau of the Census.
Statistics for Industry Groups and Industries. 1991 Annual Survey of Manufactures. Department of Commerce. Bureau of the Census.
Environmental Protection Agency. 40 CFR Ch. I (7-1-93 Edition).
Census of Manufacturers, 1987.
Census of Manufacturers, 1992.
Preliminary Report Industry Series, based on the 1992 Census of Manufacturers, issued in October 1994 by the US Department of Commerce, Economic and Statistics Administration, Bureau of the Census
Slack Buckner Systems, distributors, interview with Steven Wheeler, Engineer, Nov. 3, 1994.
Applied Energy Company Inc., distributors, interview with Shabbir A. Sajanlal, Engineer, Nov. 3, 1994.
Texas Air Handlers; manufacturers' representatives, interview with Collin Prewitt and David L. Corder, Nov. 3, 1994.
McQuay Service; private company, subsidiary of McQuay international, interview with Ronald E. Keith, District Manager, Nov. 4, 1994. + Interview with a Technician (Kevin) of McQuay Services.
Ward's Business Directory of US Private and Public companies - 1994.
AMCA, phone interview with Mr. Saxon, Chief Engineering Standards, November 8, 1994.
I- Value of the firm
We choose to determine the value of Donaldson Company, Inc. which belongs to the Blowers and Fans industry (SIC:3564).
The equation to determine the value of a firm is:
V: Value
D: Total Debt
E: Total Equity
NOPAT: Net Operating Profit After Tax
ROE: Return on Equity
t: Tax Rate
I: Investment
IRR: Internal Rate of Return
WACC: Weighted Average Cost of Capital
T: Time Horizon
Note: All dollar amounts are in thousands except otherwise indicated
A - Current Operation:
Since we are dealing with current operation, we choose to use only the latest results.
1) Determination of the Net Operating Profit After Tax for Donaldson Company Inc.:
In 1993, NOPAT = $28,214
2) Determination of the Return on Equity:
In 1993, Equity = $174,008
ROE = NOPAT/Equity = 28,214 / 174, 008 = 16.21%
3) Determination of the Current Operation:
Current Operation = NOPAT / ROE = 28,214 / 16.21% = 174,053.05
The total amount of current operation is $174,053.
B- Tax Benefit of Debt:
Since we are dealing with current tax benefit of debt, we choose to use only the latest results.
1) Determination of the effective income tax rate
In 1993, t = 36.9%
2) Determination of Debt:
In 1993, Total Debt = $26,515
3) Determination of Tax Benefit of Debt:
Tax Benefit of Debt = tD = 36.9%(26,515) = 9,784.04
The total amount of tax benefit of debt is $9,784
C- Value of Forward Business Plan:
Since this part of the equation is based on forecast, we decided to take the average of the past five years whenever needed.
Forward Business Plan =
1) Determination of the Weighted Average Cost of Capital:
Where:
LTD: Long Term Debt
ROE: Return on Equity
Kd: Return of Debt
t: Marginal Tax Rate
a> Determination of Cost of Equity:
In 1993, LTD = $18,920
b> Determination of Cost of Debt:
Since the return on debt will be different from the risk free rate, we need first to compute Kd.
According to the derivative of the Capital Asset Pricing Model (CAPM), we have the following:
Where:
Ke: Return on Equity
Km: Return on the Market
Kd: Return on Debt
Krf: Risk Free Rate
Determination of Km
Since we only have the highest and the lowest market price for 1993, we assume that the average market price be the arithmetic average of 403/8 and 28, that is 34.1875
In 1993, the EPS was 2.03
PER = 34.1875 / 2.03 = 16.84
So,
Determination of Krf
We assumed that the risk free rate is equal to the interest rate on T-Bills. In 1993, the average rate of T-Bills was 2.66%
Determination of Kd
We have: Ke = Km + Kd - Krf
16.21% = 5.94% + Kd - 2.66% <=> Kd = 12.93%
Determination of the Cost of Debt:
Determination of the Weighted Average Cost of Capital
WACC = Cost of Equity + Cost of Debt = 14.62% + .8% = 15.42%
2) Determination of the Investment
For the investment, we assume that the full amount left from the average of the past five years of Net Operating Profit After Tax, Equity, and Long Term Debt will be reinvested into projects. We also assume that Donaldson will neither issue more capital nor debt to finance its investment(s).
Total investment = NOPAT + Equity + L-T Debt = 22,898 + 141,912 + 25,429
= $190, 239
3) Determination of the Internal Rate of Return
Since we do not have the stream of future cash flows, we will assume that the Internal Rate of Return for the company is equal to the average of the past five years of its Return On Investment (ROI).
The return on investment is 14.08%.
4) Determination of the Time Horizon
In this calculation, and for the purpose of analyzing the markets perceived perspective for the industry, we figured out a Time horizon equals to zero.
D Value of the company:
For the present time, the value of the company is:
so, V = 174,053 + 9,784 + 0
Value of the company is (in thousands): $183,837
Market Value of other players in the industry
Companies Market value (in million $) 09/30/94
Air and Water Technologies234.50
Ampco-Pittsburgh76.62
Cooper Industries4,640.00
Donaldson Company591.10
Environmental Elements26.48
Joy Technologies454.40
Trion Inc.35.17
Mid Term exam
I- Value of the firm
We choose to determine the value of Donaldson Company, Inc. which belongs to our Capstone project on Blowers and Exhaust Ventilation Fans (SIC:3564).
The equation to determine the value of a firm is:
V: Value
D: Total Debt
E: Total Equity
NOPAT: Net Operating Profit After Tax
ROE: Return on Equity
t: Tax Rate
I: Investment
IRR: Internal Rate of Return
WACC: Weighted Average Cost of Capital
T: Time Horizon
Note: All dollar amounts are in thousands except otherwise indicated
A - Current Operation:
Since we are dealing with current operation, we choose to use only the latest results.
1) Determination of the Net Operating Profit After Tax for Donaldson Company Inc.:
In 1993, NOPAT = $28,214
2) Determination of the Return on Equity:
In 1993, Equity = $174,008
3) Determination of the Current Operation:
The total amount of current operation is $174,053.
B- Tax Benefit of Debt:
Since we are dealing with current tax benefit of debt, we choose to use only the latest results.
1) Determination of the effective income tax rate
In 1993, t = 36.9%
2) Determination of Debt:
In 1993, Total Debt = $26,515
3) Determination of Tax Benefit of Debt:
Tax Benefit of Debt = tD = 36.9%(26,515) = 9,784.04
The total amount of tax benefit of debt is $9,784
C- Value of Forward Business Plan:
Since this part of the equation is based on forecast, we decided to take the average of the past five years whenever needed.
Forward Business Plan =
1) Determination of the Weighted Average Cost of Capital:
Where:
LTD: Long Term Debt
ROE: Return on Equity
Kd: Return of Debt
t: Marginal Tax Rate
a> Determination of Cost of Equity:
In 1993, LTD = $18,920
b> Determination of Cost of Debt:
Since the return on debt will be different from the risk free rate, we need first to compute Kd.
According to the derivative of the Capital Asset Pricing Model (CAPM), we have the following:
Where:
Ke: Return on Equity
Km: Return on the Market
Kd: Return on Debt
Krf: Risk Free Rate
Determination of Km
Since we only have the highest and the lowest market price for 1993, we assume that the average market price be the arithmetic average of 403/8 and 28, that is 34.1875
In 1993, the EPS was 2.03
So,
Determination of Krf
We assumed that the risk free rate is equal to the interest rate on T-Bills. In 1993, the average rate of T-Bills was 2.66%
Determination of Kd
We have: Ke = Km + Kd - Krf
16.21% = 5.94% + Kd - 2.66% <=> Kd = 12.93%
Determination of the Cost of Debt:
Determination of the Weighted Average Cost of Capital
WACC = Cost of Equity + Cost of Debt = 14.62% + .8% = 15.42%
2) Determination of the Investment
For the investment, we assume that the full amount left from the average of the past five years of Net Operating Profit After Tax, Equity, and Long Term Debt will be reinvested into projects. We also assume that Donaldson will neither issue more capital nor debt to finance its investment(s).
Total investment = NOPAT + Equity + L-T Debt = 22,898 + 141,912 + 25,429
= $190, 239
3) Determination of the Internal Rate of Return
Since we do not have the stream of future cash flows, we will assume that the Internal Rate of Return for the company is equal to the average of the past five years of its Return On Investment (ROI).
The return on investment is 14.08%.
4) Determination of the Time Horizon
Since this is a mature industry and that the company has no competitive advantage that would add value, we assume that the time horizon is zero.
D> Value of the company:
For the present time, the value of the company is:
so, V = 174,053 + 9,784 + 0
Value of the company is (in thousands): $183,837
We think that the value of the company could be increased by modifying the capital structure. As a matter of fact, 90.2% of the capital structure is in stocks and only 9.8% is in long term debt. In order to add value, the company should retire some stocks whose weighted cost is 14.62% (ROE=16.21%) and replace them by issuing long term debt whose weighted cost is 0.8% (Borrowing cost=12.93%). Thus this will reduce the WACC, and then, the IRR can be greater than the WACC. With a different cost structure, the company will have a competitive advantage, and thus T (big "T") will be different from 0. To put into a nutshell, the forward business plan will be strictly positive, and therefore, adding value to the company.
II-
A- Is it possible to know the value of the firm at a particular point in time?
It is possible to know the value of the firm at a particular point in time, but the problem is its accuracy. The value of a company can be measured by adding the value of current operation and the value of the tax benefit of debt and the value of the forward business plan. The first two parts of the equation are easy to determine since they are based on past data. The only "difficulties" may come from the value of the forward business plan since you need several variables that are forecasted. For instance, you need to know what will the future stream of cash flows be for the company next years. Furthermore you need to predict the length of time your company will keep its competitive advantage ("big T"), and be able to choose group one projects.
B- What is the precondition for a positive NPV project?
The Net Present Value discounts all expected future cash flows to the present using minimum desired rate of return. The NPV is the Present Value of Inflows less the Present Value of Outflows. In order to have a positive NPV, that means that the PV of inflows is greater than the Investment. Thus, the precondition for a positive NPV is that the Internal Rate of Return (IRR) of the project be greater than the Weighted Average Cost of Capital (WACC).
Nevertheless, other conditions apply to the use of NPV. For instance, you cannot use NPV if your projects are mutually exclusive, if the project has negative future cash flows. The NPV is not reliable if the IRR is too high because you will have some reinvestment problems. In all these cases, the Residual Income computation is better.
C- Why would every person purchase an identical portfolio of stocks if they do not have identical preferences for risk-bearing?
In the process of diversification, investors may choose the same stock portfolio than others' in order to have an efficient portfolio. Assuming that the market is efficient, two different investors will have an identical portfolio of stock if both think it is the most efficient. However, since they may not have the same risk bearing, they may not have the rest of their portfolio identical. For instance, a more conservative person, risk averse, will add a larger portion of short term instruments or AAA bonds. A risk taking person can choose to take high return bonds (junk bonds). Nevertheless, in both cases, they will have the same portfolio of stock.
D- If the risk-free rate of return is 4% and the expected return on the market is 9%, would you buy a stock with a beta of .88 if that stock was priced to provide an expected return of 8.6%? Why?
According to the Capital Asset Pricing Model (CAPM), we have:
Ke = Krf + (Km-Krf)
with:
Ke: Rate of return
Krf: Risk Free Rate
Km: Return on the market
: Beta, measure of systematic risk
Ke = 4% + ( 9% - 4%).88
Ke = 11.60%
Since the expected return is 8.6%, and you get a stock having a rate of return of 11.6%, therefore, you are making an abnormal return of 3% since the stock is under-priced. Thus, we will definitely buy this stock cet par.
E- What is an efficient portfolio?
An efficient portfolio minimizes portfolio risk for a given expected return. That is to say that investors try to minimize the systematic risks through portfolio diversification. The diversification is made by gathering stocks that do not share the same unsystematic risk and are usually negatively correlated. A portfolio can be efficient as long as it is on the efficient frontier whatever its rate of risk be.
F- If a firm lowers its beta to reduce its risk to investors, it is not likely that those investors will appreciate the firm's efforts on their behalf. Why?
The company cannot directly lower its beta which measures its systematic risk (interest rate risk, purchasing power risk, market risk) but by reducing its unsystematic risk (through changes in capital structure for instance to reduce the financial risk or changes to reduce the business risk attached to the industry), the company will reduce its required rate of return for the investors. Nevertheless, investors may have chosen this company due to the fact that it bears some risk and get certain return for that. By reducing the risk, and thus reducing the return, investors may choose to sell the stock and buy a more profitable (higher rate of return) stock.
III-
A- How would you describe or characterize the US Bicycle Industry in 1974 (Case) in terms of the Five Forces Model, as presented by Porter and elaborated upon by Day?
The Five Forces Model is decomposed as follow:
1) Entry Barriers:
Economies of scale: Some economies of scale exist that may prevent new entrance. These are made in different sectors such as production, distribution, and advertising.
Product differentiation: Since most of the bicycles are basically the same, the product differentiation based on brand recognition is high.
Capital requirements: This depends if the company intends to set a production line or only assembles and/or distributes its products. The fact is that "the two most important criteria for the make-buy decision were (in 1974) the capital intensity of the component manufacturing process and the level of technological expertise required."
Cost disadvantage: some components (labor for instance) can be find at a cheaper price abroad.
Access to distribution channels: The nation wide distribution using wholesalers such as K-Mart, Sears, Winn-Dixie can be difficult to access, but regional, small retailers are more willing to distribute unknown brands for a low cost.
Government Policy: Different kinds of regulations exist. For instance the safety standards in July 1974 stipulate "minimum strength and performance requirements on brakes, steering systems, frames, and other bicycle components. The federal standards gave bicycle retailers, in addition to government officials, the authority to recall defective bicycles, at the manufacturers' expense."
2) Substitutes:
Cars in the beginning of the century as well as motorbikes in a lower proportion used to be a good substitute for bicycles. With the change in population's habits, bicycle manufacturers lead to a more focus marketing strategy which results in other kind of substitutions such as health activities, ecological movements, sports, and familial activities in general.
3) Powerful Suppliers:
"The bicycle parts supply industry was populated by a large number of relatively small, highly specialized firms serving the world market. Foreign-made parts represented about 30 percent of the parts on a typical US made bicycle in 1974 and made up approximately 35 percent of the dollar imports in the bicycle industry. Most foreign parts manufacturers specialized in one or two component areas and sold worldwide." Therefore, we can deduct that the supply industry is numerous and specialized, but yet, not very powerful. The threat of integration is very low, and the bicycle industry is not an important customer of the supplier group.
4) Powerful Buyers:
Big distribution channels (Sears, K-Mart, Winn-Dixie,...) which represent 70 percent of the sales in the US, buy bicycles in big volume, and sell them practically at cost using them as traffic builders. In addition, national department store, independent department stores, discounters, and regional department store chains are price sensitive. These wholesalers have got some power and must not be underestimated. As a matter of fact, there may be an integration threat for small bicycle companies.
On the contrary, bicycle dealers which represent 30 percent of sales, base their sales on brand loyalty and personal selling and price cutting is limited. Therefore, bicycle dealers do not seem to have much power.
5) Rivalry:
The rivals are diverse in strategies, origins and the way they compete.
Structure of competition: Competitors are numerous, but are not equal in size, power and origin
Industry growth was high from 1970 to 1973 with a total growth of 121.73%. In 1974, the growth is expected to be lower (around 2%).
Some manufacturers differentiate their products through quality, price, advertising, but the switching cost remains low.
Exit barriers are relatively low since there are no specialized assets, or hard to sell buildings.
B- Place each bicycle manufacturer discussed on pages 129 through 135 on a strategic group map and indicate the generic strategy of each company.
Generic Strategy classification:
(1) Cost Leadership
(2) Differentiation
(3A) Cost Focus
(3B) Differentiation Focus
There are 5 main clusters:
1) Schwinn, Raleigh, AMF
2) Murray, Huffman
3) France, Italy, United Kingdom, Japan
4) Steiber, MTD products, Austria, Germany, Korea, Taiwan
5) Chain Bike, O.F. Mossberg
