Competition Bikes: Expansion Into Canada
Competition Bikes (CB) is looking at expanding its operations in Canada. Currently, Canada absorbs about 10% of the company’s output. With market research showing that there is a market for CB’s products. The move would require CB to use its efficient operations and management strategy developed in the US but more importantly, would require CB to put up a brand new manufacturing facility abroad. After considerations regarding availability and cost of qualified labor, land cost, facility construction costs, taxation and tax incentives, transportation and other important aspects, CB’s Management has chosen Toronto as its favored area for setting up the manufacturing facility.
Recently, a competing manufacturer Canadian Bikes (CANBI) contacted CB to propose the following:
- Merger with CB
- Acquisition by CB at a 30% premium over its year end stock price of $1.40
- Use of its patented titanium frame technology for $200/frame or to supply it to CB at $450/frame. This could be introduced to the US markets in turn.
CANBI is a strategic partner because it already has a strong presence in Canada and produces at a lower unit cost compared to CB. This demonstrates expanding into foreign markets in a strategy that many companies develop to ensure growth and sustained profitability (Nagel, 2008).
The recommendations herein state the most logical, financially and operationally, direction for CB going forwards its expansion plans to Canada.
- Historical Performance of CB
- Income Statement
In the last three years, CB’s sales have been erratic. From year 6 to 7 sales were up by 33% but declined by 15% between years 7 and 8 (only a 13% increase from years 6 to 8). The decline in sales is in part due to the belt-tightening done by the company from year 7 to 8. The horizontal analysis shows that the company decreased its expenditures from year 7 to 8 resulting in the decrease in sales revenues. The graph shows the comparative change from year 6 to 7 and 7 to 8 below. It is not clear why the company did not endeavor to spend more for growth in the period year 7 to 8 based on the income statement. The proportions of the spending’s did not change as well. The cost breakdown of the company for the historical years 6 to 8 show the following breakdown of costs.
Figure 1 Horizontal Analysis
Sales projections going forward indicate a modest increase in sales revenues. Using year 8 as the base year, growth is projected to be around 11.76% by year 11. The annual (year-on-year) growth is estimated to be about 3% from year 8 to 9, year 9 to 10 and then 5% from year 10 to 11.
Figure 2 Trend Projection
- Balance Sheet
Accounts receivables have increased for CB from year 6 to year 8. In year 6, about 6.5% of the current assets of the company are receivables, by year 8 this number more than doubled to 14%. Account payables have also doubled. In year 6, about 1.6% of the current liabilities are account payables and by year 8, this has expanded to 6.1%. In year 7 and 8, the company bought back shares at a total of 200,000.
The horizontal analysis indicates that the company is saving up its cash. In period 6 to 7, more cash was used by the company. In the following period, this has swelled by about 348%. This means that the company is keeping its resources for a big investment. Receivables have decreased between the two periods indicating that even the volume of receivables have increased (due to volume sales increase), the cash is managed better because collections have improved. Again this is a sign of the company saving up for future investments.
The company is also paying off its short-term liabilities, with only an increase in liabilities of 28% in period year 7 to 8 compared to 122% in year 6 to7.
- Ratio Analysis
Profitability – CB profitability is down. Gross profit margin, operating profit margin and net profit margin have increased from year 7 to 8. Their profitability levels were similar to its competitor in year 7 but in year 8, the company suffered huge deductions in profitability.
Liquidity – CB is still at the same level of liquidity, with the current ratio and the acid-test ratio not changing significantly between the two years. However, its ability to cover interest payments has decreased in year 8. This is alarming considering the level of debt that CB has taken on has not changed.
Activity – CB’s collection (resource use) has not improved but its ROA and ROE have decreased significantly. This is because the revenues from the operations of CB have not risen in pace with the increase in asset base nor the increase in shareholder contribution.
Market – the earnings per share dropped significantly prompting an increase in the P/E ratio. Fortunately, the market has not reduced its valuation of CB’s stock despite its quizzical cash management strategy.
- Expanding into Canada: Owning the Facility
- NPV of Expansion
There are two revenue projections for CB, a low demand projection and a medium demand projection. At the low demand projection, the NPV of the expansion is -$39,281 while at the medium demand projections, the NPV is $8,447. The upside is significantly lower than the potential loss, if the market does not respond well to CB’s products in Canada.
The NPV analysis thus indicates a decision point for the company. Will it bet on its demand projections being low or moderate? What does it lose if it does not expand? What does it lose if it expands? If it does expand, it will lose at most US$ 39,281 but if it does not expand it loses its growth potential. Stagnation would be a more serious, irresolvable problem compared to a first year loss.
- IRR of Expansion
The Internal Rate of Return (IRR) simply states the interest rate for which the NPV would be equal to zero. It is the hurdle rate wherein the cash flows would leave the company no better off than it were before taking on the project.
The IRR of the expansion at low demand projections is 8.4%, clearly below the hurdle rate of company and would merit an automatic rejection of the planned expansion since the company hurdle rate is 10%. The IRR of the expansion at medium demand projections is 10.4%, above the hurdle rate of 10% but only by a small margin.
This means that the expansion is a precarious position for the company with only a 0.4% spread. However, similar to the NPV, a 0.4% spread is better than a 0.0% growth.
- Capital Structure
Fortunately for it can fund its expansion without acquiring bank financing. Its options include the mix of bonds, preferred shares (PS) and new common shares (CS) issue. The net income based on the different options available given the EBIT projections of CS for years 9 to 13 are summarized below. The highest total income available for shareholders is the option 20% bonds at a 9% interest rate and 80% common stock. However, the market will not take this favorably because this does not provide the highest earnings per share. The highest earning per share is projected to be acquired when CB finances its expansion through 50% PS and 50% common shares.
The advantage of using PS over issuing bonds is that PS behaves like CS in that they have less risks compared to a debt instrument such as bonds. Adkins (2012) says that there are many advantages of using PS such as the improvement of the balance sheet of the company without the dilution of voting power of CS holders and because of the growth potential of the company, will be more attractive to potential investors, hence easier to “sell” to the public for the purpose of raising funds.
Figure 3 Total Income Available at Different Financing Options Available for CB
Figure 4 Earnings Per Share at Different Financing Options Available for CB
- Leasing or Buy-Back
A facility was found in Canada that can be used by CB either through a lease or through a buy-back option, which meant that the facility could be built by the company but bought back by the previous owner of the land for a certain residual value. The cash flows for both facilities are examined and the NPV of the outflows were determined. The outflows in the case are the expenditures of the company for either leasing the property or from building-and-selling the facility after the projected period. The NPV’s for both options are shown below:
- Lease – NPV outflow of 321,660
- Buy-back - NPV outflow of 333,999
The lease option is more expensive on a yearly basis (67,500 per year) while the buy-back has a lower annual cost (lower cash out compared to the annual cash out of the lease). The total present value of the buy-back however, is more expensive than the lease option, as shown above. What is important for a company that is expanding overseas is to manage its cash capital while it is still establishing its presence in that country. If CB wishes to use its capital wisely, it make decisions that would conserve cash, given its state of unfamiliarity of the market. The buy-back option has notably higher net present value but what is important is that the annual expenditures shelled out by the company is kept very low especially during the “entry” phase of the company into Canada. Because of the uncertainty in market reception of CB’s products, it is recommended that CB to manage its working capital by minimizing its annual expenditures to enable the company to concentrate on market penetration through sales and marketing. This would be achieved by opting to go for lower annual payments so the buy-back option must be pursued.
- Partnering with CANBI
- Merger or Acquisition
There are two options for CB to partner with CANBI, to merge or to acquire. It is proposed that the company merges with CANBI instead of acquiring CANBI for the following reasons:
- The effect of the merger is an increase in CB’s EPS to 0.053 from 0.032. If this is multiplied with the resulting shares after the merger (CANBI’s shares become diluted to 30% of its original volume), the earnings at the time of the merger is 55,208. This is higher compared to the option of acquiring the company at the same year which results in net earnings for CB of 53,244. The superior strategy between the two is to merge with CANBI. A merger will increase the Earnings per Share of the merged company and will be beneficial finally to both CB and to CANBI.
- Acquiring the company results in a loss for the company. The net present value of CANBI based on its cash flow is 211,193 while they are offering to be acquired at 286,000. The present value of the cashflows is less than the offer price. At best, CB should offer to acquire only at the discounted value of the company. This means that acquisition is an inferior option for CB.
- The cash flow implications of the merger will enable CB to manage its resources better. Merging with CANBI will save CB the marginal cost due to licensing at $200 per frame, or purchasing titanium frames at $450 per frame, securing a qualified labor force by itself, incurring extra expenses on establishing additional sales management and distribution channels, and defray the cost of establishing a separate facility overseas.
- In addition to the financial benefits of the merger, CB will have intangible benefits as well. The merger will be possible because the transaction is friendly and will transpire between companies that are almost equals. If the transaction were unfriendly (i.e. CB wants to purcchase CANBI forcefully to acquire market shares) then it is called an acquisition. But since the transaction is wanted by both companies, it will be a merger. The retention of the identity of CANBI which means that its present clients will not be wary of buying from a relative unknown and new player (CB) thus ensuring that the market share is protected. CB benefits with an instant increase in market share, helping the company reach economies of scale and reach the efficiencies they are enjoying in the United States. Having the ability to be efficient makes the company more competitive thus being able to address the needs of the market more and gain leadership position in the industry.
- The most important benefit of the merger however, is the retention of the employees of CANBI. With the retention of employees, CB saves on having to identify, train and ensure that a workforce is behind the company. The option to acquire may include retrenchment of employees but a merger would ensure that there is job security thus enabling CB to hit the ground running.
- Management Recommendations
Despite the possibility of lower demand for CB’s products in Canada, it is recommended that CB go through the expansion process. This is justified by the decreasing trend in market-based revenues of CB in the US. While this could be due to the fact that the company has tightened spending on sales-enhancing activities to save on cash, the fact that the company has done so indicates that the company believes that the US market may be near saturation hence a period where growth could be pursued in other countries.
A suitable facility was found by CB and could replace the option of constructing a manufacturing facility based on US standards. Of the two options available, it is recommended that CB choose the buy-back option to help manage its annual cash flows (this option has lower annual payment requirements) which is suitable for the highly uncertain reception of the Canadian market to CB’s products.
Finally, it is recommended that CB merge with CANBI instead of acquiring the company. The net effect on the company’s cash flow is higher than acquiring the company.
This set of recommendations address the fundamental risks associated with expanding into Canada and follows the lessons outlined by Andreasen, A. R., & Kotler, P. (2003) in their book “Stragegic Enterprise Integration” . Expansion improves the chance for CB to have sustained profitability thus addressing the company’s strategic risks of going into the expansion. In terms of financial risks, the expansion would be raised through a combination of preferred and common stock, thus improving the company’s liquidity and leverage ratios. If the company succeeds in applying its efficient manufacturing process from the US to Canada, then it would also be able to address activity ratio requirements and its operational risks. The market ratios, with the merger and the cost-savings measures undertaken by the company will improve significantly thus addressing the reputational risks of CB in expanding into Canada.
Adkins, W.D. (2012). Advantages of Preferred Shares. EHow. Retrieved from http://www.ehow.com/about_4760209_advantages-preferred-stock.html
Andreasen, A. R., & Kotler, P. (2003). Strategic Enterprise Intergration. Los Angeles: Prentice Hall.
Boehme, R. (2012). Chapter 7: NPV and Capital Budgeting. Corporate Finance. Retrieved from http://www.rdboehme.com/MBA_CF/Chap_7.pdf
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