Safety First Airbags
SafetyFirst (SF) are a US company producing airbags for a variety of automobile manufacturers. The CEO of SF has received a phone call from his friend, the CEO of a textile manufacturing company called Rainbow Textiles (RT).
RT produce mainly wool and cotton for the clothing industry, but the company has obtained a large government contract to produce nylon for use by the military in manufacturing parachutes.
As such, RT is looking to secure an investment in a new production line to make nylon in its Chinese factory. By making this investment, SF will be purchasing equity in RT as a function of the post-investment value of that company.
Since he has the available funds, the CEO of SF is considering investing in his friend’s company, but he is looking for a ROI of 30% in the first year. He has hired us to assess the situation and deliver a recommendation on whether he should go ahead with the investment or not.
Identify the problem
The main issue here is whether investing in RT would generate the required 30% ROI. Therefore, the candidate should structure their approach and ask specific questions to acquire more information about:
- The context: what RT is looking for and the existing market
- The company
- Potential synergies
Context
RT is currently valued at $500m and is looking for $200m to cover the expenses, including personnel and equipment, required to expand into nylon production. With the new production line installed, the factory would be able to produce 10m bolts of nylon per year at full capacity.
The cotton market is predicted to grow at 10% per annum, driven by demand from clothing companies.
Demand for wool has been decreasing over the past 5 years and is expected to decrease by a further 5% in the next year.
The nylon market should remain roughly static.
The textile market is highly competitive and is dominated by Asian players, especially Chinese companies, but there is no monopoly player.
The key takeaways here would be that:
- Investing $200m would get SF an equity share of roughly 29%. That is, 200m/700m = approximately 29%
- The market for cotton will grow, the market for nylon will remain the same and the market for wool will shrink.
- The market is competitive but not consolidated.
At this point, the candidate should inquire into Rainbow Textiles itself to determine whether it is operating at a profit and where this data fits in generally.
Company: Rainbow Textiles
The candidate should aim to find out about production as well as the company's revenues and costs.
The company currently has four factories; three in Asia (China, Bangladesh, India) and one in Europe (Poland). The Asian factories are all profitable, with the European factory breaking even.
Production capacities are as follows:
China – 15m bolts of cotton, 10m bolts of wool
Bangladesh – 8m bolts of cotton, 4m bolts of wool
India – can only produce cotton; produces 5m bolts per year
Poland – only produces wool; produces 2m bolts per year
The Asian factories operate at full capacity to accommodate demand. However, the Polish factory is only operating at 20% capacity.
The candidate should then calculate the profit margin per bolt, also asking about the potential profits from the sale of nylon. The interviewer can provide the following information:
Key takeaways:
- All factories are profitable, except the Polish factory
- Nylon will be by far the most profitable textile the company will produce
- An observant candidate can inquire about the Polish factory since costs are significantly higher than in other factories
However, the Polish factory cannot be closed, as it is a prerequisite for maintaining an important relationship with clients in Europe. Those clients require short-notice shipments of wool, but also order large quantities of cotton from the other factories
Synergies
A good candidate can conclude that, if it chooses to invest, SF can order nylon from RT and potentially increase its own profits in the process.
Complication
However, RT’s CEO has agreed to retrofit the Polish factory to operate at full capacity and accommodate SF’s demand, at a break-even price of $30/bolt for an additional investment of $100m.
Currently, SF purchases 20m bolts of nylon at $25/bolt.
Candidates can conclude that a $300m investment would mean SF would own 300 / 800 = 38% of the company
Lead the analysis
The candidate can then calculate profits if all these investments are made:
China: 15m x 14 (cotton) + 10m x7 (wool) +10m x 19 (nylon)= $470m
Bangladesh: 8m x 11 (cotton) + 4m x 3 (wool) = $100m
India: 5m x 13 = $65m
Poland = 0
Total profit = 470m + 100m + 65m = $634m
Again, candidates have to realize that SF has two options here, depending on how much SF chooses to invest.
Without the additional investment in the Polish factory ROI would be:
Share of profits / Investment Amount
SF’s share of profits would be 29% x 635 = 184.15m ≈ $184
ROI = 184/200 = 92%
With the investment in the Polish factory share of profits would be:
38% x 635 = $241.30m ≈ $241
However, a good candidate will note that this would incur an additional cost of purchasing the slightly more expensive bolts of nylon from RT:
20m x 30 – 20m x 25 = 100m
This would be deducted from the profit since the extra nylon produced would not bring any profit to RT. So:
ROI = 141/300 = 47%
At this point, the candidate should ask whether purchasing nylon directly from RT would confer any benefit versus purchasing from current suppliers (cheaper transportation costs, less uncertainty of supply etc.), since this nylon would not bring RT any revenue and the extra investment would cut ROI in half.
Deliver the recommendation
The candidate should then proceed to make their recommendation. A good example would be:
I recommend that SF should invest $200m in RT, rather than $300m.
Despite the fact there is synergy with RT, it cannot accommodate SF’s demand and further investment would reduce ROI by a third. However, the government contract ensures a stable source of revenue from the production of nylon, which would be the most profitable material the company would sell.
The investment is more than three times the intended ROI of SF.
The company produces mostly cotton, for which the market is expected to grow.
Risks associated with the purchase are mainly that the wool market is declining, meaning the risk of higher fixed costs due to lowering production, especially in the Polish factory.
