A brief evaluation of Hanson Private Label (HPL) will reveal signs of an excellent, growing, and well run company. There are no danger signs within the financials of HPL. The following have seen growth with every passing year: revenue, current assets, owner’s equity, net working capital, and sales (even groceries). The following categories have grown every year with the exception of 2005, where a higher than usual COGS caused a dip in gross margin – 15% versus a historically high teen’s percentage: Gross Profit, EBITDA, EBIT, and Net Income.
Utilization rates are high. During this same period, long term debt trended downward with decreases every year. Sales across HPL retail channels increased every year over year in the following categories: mass merchant, club, drug, dollar stores, convenience stores, and miscellaneous distributors. Groceries increased or held steady during this time, and never decreased. Market share increased in slight increments during 2005-2007. During the five year period 2003-2007, total assets rose over $40M, profits climbed steadily from $98M (2003) to 122. M (2007), net income has increased four of five years, and sales have outgrown the market. Additionally, long term debt has been cut nearly 50% over the last 5 years. The cumulative cash flows over the same period have been positive while the company has been able to pay dividends every year. It is a safe assumption to say that HPL is an excellent business and has shown maintainable, measured, and sustainable growth. The only potential downside is that the company, with high utilization rates, is reaching production capacity, and addition of more accounts will necessitate investment in expansion.
There are several strategic and economic considerations that influence the viability of this project for Hansson. First, analysis of the projected future cash flows provide indications as to if the project is economically desirable. The project’s future cash flows are depicted in the spreadsheet contained in the Appendix. For 2009, the future cash flows equate to a net loss of ($6,031,000) due to the first year’s initial increase in net working capital of $12. 865 million.
Cash flows are positive in the second year and continue to increase throughout the life of the investment. Using these projected cash flows, the NPV method gives the best overall indication of whether or not Hansson should accept the project. The project’s overall positive NPV of $6,121,380 means it would be a favorable investment. That number is calculated using all 10 years of projected cash flows from the assumptions, a discount rate of 9. 38%, and an initial investment amount of $45,000,000. The project has an IRR of 11. 47%.
Using this method, the project’s IRR is greater than the Discount Rate of 9. 38%, so Hansson should accept it. Using either method, analyzing the economic data indicates that the project should be accepted and would benefit the company. Strategically, this project would close off all other investment opportunities for the foreseeable future. It represents the first time Hansson had made a major investment without having a clear forecast of the future sales. If any of the assumptions or future projections were to change, it may lead to a different result.
For example, only the first three years of production estimates are contracted, so computing the cash flows using the figures from the first three years only results in an NPV of ($39,150,990) and an IRR of (40. 66%)! Despite the strategic risks, if Hansson wants to continue to grow and avoid falling into “harvest mode”, it has no choice but to accept the project. The two assumptions that have the greatest potential of impacting the NPV calculation are the Weighted Average Cost of Capital (WACC) and Capacity Utilization projections.
Dowling has provided a range of WACC values to be considered as a discount rate ranging from 9. 31% to 9. 67% and resulting in a 10 year NPV range of $6,121,380 to $5,214,000. The IRR of 11. 47% provides an upper bound for when NPV turns negative and should be kept in mind should lending costs begin to increase as the leverage of the company increases. In our opinion, the assumptions regarding Capacity Utilization for the new plant will have the largest impact on NPV and present the largest risk to the success of the project.
The biggest driver of this risk is the limited 3 year commitment of the customer. NPV at the 9. 38% discount rate for a 3 year period results in ($39,150,990). If Capacity Utilization for the new plant drops below 72. 5% for an extended period of time beginning in Year 4 of the project, the 10 year NPV will likely be negative. The most significant way to mitigate the risk associated with this project is to acquire a longer contractual agreement from the existing client, or, sign additional new clients to similar agreements that will span the length of the 10-year proposal.
This will ensure sustainable sales and revenue stream for the time period of the project. This project represents the largest expansion HPL has conducted in more than a decade. The company’s historical capital budgeting projects model may not accurately portray the amount of risk, and consequently, the appropriate discount rate to assign. HPL could hire an outside consulting firm that has experience with assessing appropriate discount rates that are relative to the magnitude of the expansion project.
Should Hansson decide to decline the expansion proposal, there are three potential alternatives he might consider for the future of HPL. First, he could embrace the idea of going into “harvest” mode. HPL would continue to grow at a conservative but steady rate, reduce debt, and remain in a position to evaluate opportunities to expand in the long term or during the next down cycle in the industry. The disadvantages of this option are the signal it sends to the ambitious managers, who want the growth opportunity provided by expansion and being subject to the passive growth generated by the market as a whole.
A second alternative to expansion is for Hansson to consider sale of the corporation. Hansson has removed the uncertainty and risk that plagued the company when he acquired it. Additionally, HPL has done well over the years, has a profitable business, and has a large customer that is looking to significantly grow the business. Because of the above, this might be the best time to sell the company to a more aggressive investor who is willing and more fiscally able to take the risk that worries Hansson.
After all, Tucker Hansson’s business model was to buy, fix, and sell. The final alternative would be to accept the offer but not expand. Capacity would be drawn from existing facilities at the expense of other existing clients. This would allow the company the opportunity to remove less desirable accounts. The downside to this strategy would be the risk associated with damaging business relationships that might be needed given the short 3 year commitment the expansion proposal includes.