+1 862 207 3288 Please read Cameron Auto Parts Part (A) and answer those three guideline questions:
1. Should Cameron have licensed McTaggart or continued to export?
2. Was McTaggart a good choice for licensee?
3. Was the royalty rate reasonable? Did Cameron leave money on the table?
CAMERONAUTOPARTS(A)
Alex Cameron’s first years in business were unusually harsh and turbulent. He graduatedfrom aleadingMichiganbusinessschoolin2001whentheAmerican economy was just falling into a recession caused by the combination of the burstingofthetelecomanddot.combubbleandtheterroristattacksofSeptember
11. It was not that Alex had difficulty finding ajob, however; it was that he took overthereinsof thefamilybusiness.Hisfathertimedhisretirementtocoincide with Alex’s graduation and left him with the unenviable task of cutting back the workforcetomatchtheseveresalesdeclinesthecompanywas experiencing.
HISTORY
Cameron Auto Parts was founded in 1965 by Alex’s father to seize opportunities created by the signing of the Auto Pact between Canada and the United States. The Auto Pact permitted the Big Three automotive manufacturers to ship cars, trucks and original equipment (OEM) parts between Canada and the United States tariff free,aslongastheymaintainedautoassemblyfacilitiesonbothsidesofthe border.ThePacthadbeenverysuccessfulwiththeresultthat alotof autoparts firms sprangupinCanadatosupplytheBigThree.CameronAutoPartsprospered inthisenvironmentuntil,by1999,saleshadreached$60millionwithprofitsof
$1.75 million.The product focus was largely on small engine parts and auto accessoriessuchasoilandairfilters,fanbeltsandwiperblades,allsoldasoriginal equipmentundertheAutoPact
When Alex took over in 2001, the company’s financial position was precarious. Sales in 2000 dropped to $48 million and for the first six months of 2001 to $18 million. Not only were car sales declining in North America, but the Japanese were takinganincreasingshareof themarket.As aresult,themajorNorth American auto producers were frantically trying to advance their technology and to lower theirpricesatthesametime.Itwasnotagoodyeartobeoneoftheirsuppliers.In
2000, Cameron Auto Parts lost $2.5million, and had lost the same amount again in the first six months of 2001. Pressure formodernization and cost reduction had required close to $4million in new investment in equipment and computer-assisted designandmanufacturingsystems.Asaresult,thecompanyhadtakenupover
$10millionofits$12millionlineofbankcreditataninterestratewhichstoodat
7.0percentin2001.
Alex’s first six months in the business were spent in what he later referred to as “operationsurvival.” Therewasnotmuchhecoulddoaboutworkingcapital management as both inventory and receivables were kept relatively low via contract arrangements with the Big Three. Marketing costs were negligible. Where costs had to be cut were in production and,specifically,inpeople,manyofwhom had been with the company for over 15 years and were personal friends of Alex’s father.Nevertheless,bytheendof2001,theworkforcehadbeencutfrom720to
470,thelosseshadbeenstemmedandthecompanysavedfrom almostcertain bankruptcy.Havingtobethehatchetman,however,leftanindelibleimpression onAlex.Asthingsbegantopick upduring2002and2003,headdedasfew permanentworkersaspossible,relying insteadonovertime,part-timersorsub- contracting.
RECOVERY AND DIVERSIFICATION
ForCameronAutoParts,theyear2001endedwithsalesof $38millionandlosses of $3.5 million (see Exhibit 1). Sales began to pick up in 2002, reaching $45 million by year-end witha small profit. Bymid-2003, it was clear that the recovery was well underway. Alex, however, while welcoming the turnaround, was suspicious of the basis for it. Cameron’s own sales hit $27 million in the first six months of 2003 and company profits were over $2 million. The Canadian dollar haddroppedaslowas77centsinterms ofU.S.currencyandCameronwasfaced withmoreaggressivecompetitionfrom Canadianpartsmanufacturers.Theshort- termfuture for Cameron, however, seemeddistinctly positive,but the popularity of Japanese cars left Alex feeling vulnerable to continued total dependence on the volatileautomotiveindustry. Diversification was on his mind as early as 2001. He had an ambition to take the company public by 2007 and diversification was an importantpartofthatambition.
Unfortunately,workingasanOEMparts suppliertotheautomotiveindustrydid little to prepare Cameron to becomemoreinnovative. The auto industry tended to standardizeitspartsrequirementstothepointthatCameron’sproductsweremade
toprecise industry specificationsand consequently, did not find a ready market outside the industry. Without a major product innovation it appeared that Cameron’s dependenceontheBigThreewas likely to continue. Furthermore, the company haddeveloped no “in-house” design and engineering strength from which to launch an attempt at new product development. Because product specificationshadalwayscomedownindetailfrom theBigThree,Cameronhad never needed to design and develop its own products and had neverhired any designengineers.
Inthemidstof“operationsurvival”in 2001,Alexboldlydecidedtodosomething about diversification. He personally brought in a teamof fourdesign engineers and instructedthem toconcentrateondevelopingproductsrelatedtotheexistingline but with awider “non-automotive”marketappeal. Their first year togethershowed littlepositiveprogress,andthequestionofwhethertofundtheteam foranother year(estimatedbudget$425,000)cametothemanagementgroup:
Alex: Maybewejustexpectedtoomuchinthefirstyear.Theydidcomeup withtheflexiblecouplingidea,butyoudidn’tseem toencouragethem, Andy(productionmanager).
AndyMcIntyre:
That’sright! Theyhadnoideaatallhowtoproducesuchathingin ourfacilities.Justa lot of ideas abouthow it could be used. WhenI told themaCanadianoutfitwasalreadyproducingthem,theteamsortof lostinterest.
JohnEllis(Finance):
Wemightaswellface thefactthat wemadeamistake,andcutitoff before we sink any more moneyintoit.This is hardlythetime for unnecessaryrisks.
Alex: Why don’t we shorten the whole process by getting a production licencefromtheCanadianfirm? We couldstartoutthatwayandthen buildupourowntechnologyovertime.
Andy: Theteamlookedintothat,butitturnedouttheCanadiansalreadyhave asubsidiaryoperatinginUnitedStates —nottoowellfrom whatIcan gather—andtheyarenotanxioustolicenceanyonetocompetewithit.
Alex: Istheproductpatented?
Andy: Yes,butapparentlyitdoesn’thavelongtorun.
At this pointa set of ideas began to formin Alex’s mind, and inamatter of months hehadluredawayakeyengineerfromtheCanadianfirm withan$110,000salary offerandputhim inchargeoftheproductdevelopmentteam.Bymid-2003,the company had developed its own line of flexible couplings with an advanced design and an efficient production process using the latest in production equipment. Lookingback,inretrospect,Alexcommented:
Wewereveryfortunateinthespeedwithwhichwegotthings done.Eventhentheprojectasa wholehadcostuscloseto$1 millioninsalariesandrelatedcosts.
MARKETING THE NEW PRODUCT
Alexcontinued:
We then faced a very difficultsetofproblems,becauseof uncertainties inthe market place. We knew there was a good marketfortheflexibletypeof couplingbecauseofitswide application across so many different industries. But, wedidn’t know how big the market was nor how much of it we could secure. Thismeantweweren’tsurewhatvolumetotoolupfor,whatkind or size of equipment to purchase, or how to go about the marketing job.Weweretemptedtostartsmallandgrowasourshareof market grew, but this could be costly too and could allow too much timeforcompetitiveresponse.OurCanadianengineerwas very helpful here. He hada lot ofconfidence in our product and had seen it marketed in both Canadaand the United States. At his suggestion wetooledupforasalesestimateof$30million—whichwas pretty daring. In addition, wehiredeight field sales representatives to back up the nation-wide distributor and soon afterwards hired several Canadian-based sales representatives to cover major markets.Wefoundthatourkey Canadiancompetitorwas pricing rather high and had not cultivated very friendly customer relations. We were surprised how quickly we were able to secure significant penetration into the Canadian market. It just wasn’t being well- serviced.
During 2003, the company actually spent a total of $2.5 million on equipment for flexiblecouplingproduction.Inaddition,afixedcommitmentof$1.5milliona yearinmarketingexpendituresonflexiblecouplingsarosefrom thehiringofsales representatives. A small amount of trade advertising was included in this sum. The total commitment represented a significant part of the company’s resources and threatenedseriousdamagetothecompany’sfinancialpositionif thesalesfailedto materialize.
“Itwasquiteagambleatthetime,”Alexadded.“Bytheendof2003,itwasclear thatthegamblewasgoingtopayoff.”
Sales byMarket Sector ($ millions)
OEMParts
Sales
FlexibleCouplings
Sales
Total
Sales
AfterTax
Profits
1999 60 Nil 60 1.75
2000 48 Nil 48 (2.50)
2001 38 Nil 38 (3.50)
200245 Nil 45 0.25
2003 58 10(sixmonths) 68 5.80
Cameron’sapproachtocompetitioninflexiblecouplings was to stress product quality,serviceandspeedofdelivery,butnotprice.Certainsizesofcouplings werepricedslightlybelowthecompetitionbutotherswerenot.Inthewordsof oneCameronsalesrepresentative:
Our job is really a technical function. Certainly, we help predispose the customer to buy and we’ll even take orders, but we put them throughourdistributors.Flexiblecouplingscanbeusedinalmost allareasofsecondaryindustry,bybothlargeandsmallfirms.This is whywe need a large distributorwith wide reach in the market. What we do is give our product the kind of emphasis a distributor can’tgive.Wedeveloprelationships withkeybuyersinmostmajor industries,andweworkwiththem tokeepabreastofnewpotential uses for ourproduct, orof changesin size requirementsor other performancecharacteristics.Thenwe feedthiskindof information backtoourdesigngroup.Wemeetwiththedesigngroupquite often to find out what new types of couplings are being developed and what the intended uses are, etc. Sometimes they help us solve a customer’sproblem.Of course,these‘solutions’areusuallybuilt aroundtheuseofoneofourproducts.
FINANCINGPLANT CAPACITY
WhenAlexfirstsethisdiversificationplansinmotionin2001,thecompany’s plantinsuburbanDetroitwasoperatingat50percentcapacity.However,byearly
2004,salesofautopartshadrecoveredalmostto1999levelsandtheflexible couplinglinewassqueezedforspace.AndyMcIntyreputtheproblemthisway:
Idon’tseehowwecangetsalesofmorethan$85millionoutof this plantwithout going to a permanenttwo-shiftsystem,which Alexdoesn’twanttodo.Withtwofullshiftswecouldprobably
reachsalesof$125million.Theproblem isthatbothourproduct lines are growing very quickly. Auto parts could easily hit $80 million on their own this year, and flexible couplings! Well, who would have thought we’d sell $10 million in the first six months? Oursalespeoplearelookingfor$35millionto$40millionduring
2004.It’swild!Wejusthavetohave morecapacity.
There are two problems pressing us to consider putting flexible couplings undera different roof. The first is internal: we are making moreandmoretypesandsizes,andsalesaregrowingtosucha point that we may be able to produce more efficiently in a separate facility. The second is external: The Big Three like to tour our plant regularly and tell us how to make auto parts cheaper. Having these flexible couplings all over the place seems to upset them, because theyhavetroubledetermininghowmuchofourcostsbelongto AutoParts.IfitwerelefttomeI’djustletthem beupset,butAlex feelsdifferently.He’safraidoflosingorders.SometimesIwonder if he’s right. Maybe we should lose a few orders to the Big Three andfilluptheplantwithourownproductinsteadofexpanding.
Flexible couplings were produced on a batch basis and there were considerable savings involved as batches got larger. Thus as sales grew, and inventory requirements made large batches possible, unit production costs decreased, sometimes substantially.Mr. McIntyreestimatedthatunitproductioncosts would decline by some 20 per cent as annual sales climbedfrom $20 millionto $100 million,andbyafurther10percentat$250million.Scaleeconomiesbeyond salesof$250millionwerenotexpectedtobesignificant.
JohnEllis,thecompany’sfinancialmanager, expressedhisownreservationsabout newplantexpansionfromacashflowperspective:
We really don’t have the balance sheet (Exhibit 2) ready for major plantexpansionyet.I thinkwe shouldgrowmoreslowlyandsafely fortwomoreyearsandpayoffourdebts.Ifwecouldholdsalesat
$75 million for 2004 and $85 million for 2005, we would be able to putourselvesinamuchstrongerfinancialposition.Theproblem is that people only look at the profits. They don’t realize that every dollar of flexible coupling sales requires an investment in inventory and receivables of about 30 cents. It’s not like selling to the Big Three. You have to manufacture to inventory and then wait for paymentfromavarietyofsources.
As it is, Alex wants to invest $10 million in new plant and equipmentrightawaytoallowflexiblecouplingsalestogrowas fast as themarketwillallow.We have the space on our existing site
toaddaseparateplantforflexiblecouplings.It’sthemoneyI
worryabout.
FOREIGN MARKETS
Asthecompany’smarketpositioninNorthAmericabegantoimprove,Alex begantowonderaboutforeignmarkets. The company had always been a major exportertoCanada,butithadneverhadtomarketthere.TheBigThreeplaced their orders often a yearor two in advance, and Cameron just supplied them. As Alexputit:
It was different with the flexible coupling. We had to find our own way into the market. We did, however, start getting orders from EuropeandSouthAmerica,atfirstfromthesubsidiariesofourU.S. customers and then from a few otherfirms as word gotaround. We got $40,000 in orders during 2003 and the same amount during the first fourmonths of 2004. This wasa time when we were frantically busy andhopelesslyunderstaffedin themanagementarea,so allwe did was fill the orders on an FOB, Detroit basis. The customers had topayimportdutiesofapproximatelythreepercentinto most European countries, and a value added tax of about 20 per cent (20 to50 per centintoSouth America),ontopofthefreightand insurance,andstillorderscamein.
Seeing the potential in Europe, Alex promptly took a European Patent from the European Patent Office in the United Kingdom. The cost of the whole process was under$10,000.
A LICENSING OPPORTUNITY
In the spring of 2004, Alexmadea vacation trip to Scotland and decided while he was there to drop in on one of the company’s new foreign customers, McTaggart SuppliesLtd.CameronAutoPartshadreceivedunsolicitedordersfrom overseas amountingto $40,000 in the first four monthsof2004,andover 10 per cent of these had come from McTaggart. Alex was pleasantly surprised at the reception giventohimbySandyMcTaggart,the60-year-oldheadofthecompany.
Sandy: Come in! Talk of the devil. We werejust saying what a shame it is you don’tmakethoseflexiblecouplingsin thispartoftheworld.There’sa verygoodmarketforthem.Whymymencanevensellthem tothe English!
Alex: Well,we’redelightedtosupplyyourneeds.Ithinkwe’vealwaysshipped yourorderspromptly,andIdon’tseewhywecan’tcontinue….
Sandy: That’snotthepoint! Thoseordersarealreadysoldbeforeweplace them. Thepointis we can’treallybuildthemarkethereon thebasis of shipmentsfrom America.There’sathreepercenttariffcomingin, freight and insurance cost us another 10 per cent on top of your price, thenthere’sthematterofcurrencyvalues.Igetmyordersinpounds (£)1butIhavetopayyouindollars.Andontopofallthat,Inever know how long the goods will take toget here, especially with all the dock strikes we have to put up with. Listen, why don’t you license us to produceflexiblecouplingshere?
After a lengthybargainingsession, during which Alex secured the information shown in Exhibit 3, hecame round to the view that a license agreement with McTaggartmightbeagoodwayofachieving swiftpenetrationoftheU.K.market viaMcTaggart’ssales force.McTaggart’sproductionskillswerenotasup-to-date asCameron’s,buthisplantshowedevidenceof alotof originalideastokeep manufacturingcostsdown.Furthermore,thefirm seemedcommittedenoughto investinsomenewequipmentandtoput amajoreffortintodevelopingtheU.K. market.Atthispointthetwoexecutives began to discuss specific terms of the licensearrangements:
Alex: Let’stalkaboutprice.Ithinkafigurearoundthreepercentofyour salesofflexiblecouplingswouldbeaboutright.
Sandy: That’sabithighforanindustriallicenseofthiskind.Ithinkoneanda halfpercent ismorenormal.
Alex: Thatmay be, butwe’regoingtobe providingmorethanjustblueprints.
We’ll have to help you choose equipment and train your operators as well.
Sandy: Aye,soyouwill.Butwe’llpayyouforthatseparately.It’sgoingto cost us £500,000 in special equipment as it is, plus, let’s say, a
$100,000 fee to you to help set things up.Now you have to give us a chance toprice competitively in the market, or neither of us will benefit. With a royalty of one and a half per cent I reckon we could reachsalesof£500,000inourfirstyearand£1millioninoursecond.
Alex: Theequipmentwillletyouproduceupto£4millionofannualoutput.
Surelyyoucansellmorethanamillion.We’regettingunsolicited orderswithouteventrying.
1One poundwas equivalent to US$1.83in 2004.
Sandy: Withtherightkindofincentive,wemightdoalotbetter.Whydon’t weagreetoaroyaltyof twoandahalf percentonthefirstmillionin sales and one and a half per cent after that.Now mind you, we’re to become exclusiveagents for the U.K. market. We’ll supplyyour presentcustomersfromourownplant.
Alex: ButjustintheUnitedKingdom! NowtwopercentisaslowasI’m prepared to go.You make those figures three per cent and two per cent andyouhaveadeal.Butithasto includeafreetechnologyflow-back clause in the event you make any improvements or adaptations to our manufacturing process.
Sandy: Youdriveahardbargain! Butit’syourproduct,andwedowantit.I’ll have our lawyers draw up a contract accordingly. What do you say to a five-yeardeal,renewableforanother fiveifwearebothhappy?
Alex: Soundsgood.Let’sdoit.
Alex signed the contract the same week and then headed back to America to break thenews.Hetravelledwithmixedfeelings, however.On theonehand,hefelthe had got the better of SandyMcTaggart in the bargaining, while on the other, he felt he had no objective yardstick against which to evaluate the royalty rate he had agreed on. This was pretty much the way he presented the situation to his executivegroupwhenhe gothome.
Alex: …soIthinkit’sagoodcontract,andIhaveachequeherefor
$100,000tocoverourcostsinhelpingMcTaggartgetsetup.
John: Wecancertainlyusethecashrightnow.Andtheredoesn’tseemtobe anyrisk(finance) involved.Iliketheidea,Alex.
Andy(production):
Well, I don’t. And Chuck (head of the Cameron design team) won’t either when (production) he hears about it. I think you’ve sold out the wholeU.K.marketforapittance. Ithoughtyouwantedtocapture foreignmarketsdirectly.
Alex: ButAndy,wejustdon’thavetheresourcestocaptureforeignmarkets ourselves. We might as well get what we can through licensing, now thatwe’vepatentedourprocess.
Andy: Well,maybe.ButIdon’tlikeit.It’sthethinedgeofthewedgeifyou ask me. Our know-how on theproduction of this product is pretty special,andit’sgettingbetterallthetime.Ihatetohanditovertoold
McTaggartonasilverplatter.Ireckonwe’regoingtosellover$20 millioninflexiblecouplingsintheUnitedStatesaloneduring2004.
Exhibit 1
INCOME STATEMENTS
For Years Ended December 31, 2001, 2002, 2003 ($000s)
2001 2002 2003
NetSales
Costof goodssold: Directmaterials
$38,150
6,750
$45,200
8,050
$67,875
12,400
Directlabor 12,900 10,550 12,875
Overheads(includingdepreciation) 16,450 19,650 27,600
Total 36,100 38,250 52,875
GrossProfit 2,050 6,950 15,000
Expenses:
Sellingandadministration(includesdesignteam)
3,150
3,800
6,200
Other(includesinterest) 2,400 2,900 3,000
Total 5,500 6,700 9,200
NetProfitbeforeTax (3,500) 250 5,800
IncomeTax (500) – 200
NetProfitafterTax $(3,000) $ 250 $ 5,600
Note:Alexexpectedtotalsalestoreach$85millionin2004withprofitsbeforetaxof$10million.Flexible couplingswereexpectedto contributesalesof$30millionandprofitsof$5milliononassetsof $12million.
Exhibit 2
BALANCE SHEETS
For Years Ended December 31, 2001, 2002, 2003 ($000s)
Assets
2001 2002 2003
Exhibit 3
DATA ON MCTAGGART SUPPLIES LTD.
2003Sales £35million (downfrom £44millionin2001).
TotalAssets £11million:Equity£6.5million
Netprofitaftertax ±£1.5million
Control McTaggartFamily
Marketcoverage 15salesrepresentativesinUnitedKingdom,twoinEurope,onein
Australia,oneinNewZealand,oneinIndia.
Averagefactorywagerate £8.00perhour(whichisbelowtheU.K.meanof£12.00duetothe factory being located in a depressed area) (versus $18.00 in America).
Factory Old and larger than necessary.Some very imaginative manufacturingknow-howinevidence.
Reputation Excellentcreditrecord,businessnow130yearsold,goodmarket contacts(highcalibresalesforce).
Other Companysalestookabeatingduring2001–2002asoneofthe company’s staple products was badly hurt by a U.S. product of superior technology. Company filled out its line by distributing productsobtainedfrom othermanufacturers.Currentlyaboutone- halfofcompanysalesarepurchasedfrom others.Companyhas capacitytoincreaseproductionsubstantially.
Pricing Index
Cameron’spricetoMcTaggart100 (same asnetpricetodistributorinAmerica)
+Importduty 3
+Freightandinsurance10
Importer’sCost 113
+Distributor’s(McTaggart’s)Margin(30%)34
+ValueAddedTax(17.5%oncostplusmargin) 26
= PricechargedbyMcTaggart173 vs. PricechargedbyAmericandistributorinU.S. 120
Exhibit 3 (continued)
Note: UndertheEuropeanUnionagreement,allimportsfrom non-EUcountriesweresubjectto common customs tariffs. In 2004, the common customs tariff for the flexible coupling had an import duty of 2.7 per cent. In addition to the import duty, all imported itemswere subjected to the value added tax (VAT) which was applied on all manufactured goods — both imported as well as locally made. The VAT was going through a harmonization process but was expected to take some years before a commonVAT system was in place. As of 2004, the VAT for United Kingdom was 17.5 per cent,and France 19.6 per cent. Denmark,Hungary,andSwedenhad thehighestVATat25percent.
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