CASE7 Baker Adhesives

Baker Adhesives Case Analysis I.

Introduction Baker Adhesives is a small manufacturing company of specialty adhesives in the US. It was owned by Doug Baker who recently entered the International market. In early June of 2006, Baker met with his sales manager, Alissa Moreno to discuss the results of the company’s recent penetration in the international market. NOVO, a Brazilian toy manufacturing company, was Baker’s first international sales and Baker Adhesives was very excited to make another deal. The original sale with NOVO had been 1,210 gallons and significantly boosted the company financially. The purpose of the meeting is to decide whether or not Baker Adhesives should go ahead and accept a new order proposal from Novo. The next NOVO order would be 50% larger than the original order and the adhesive will be used for the production of their new toy product line. The toys needed to be waterproof and the adhesives require very specific needs. Also, the payment from the first order had just been received and Baker was looking to pay down some of the balance of their line of credit, which currently stood at $180,000. However, Moreno told Baker that their sale of adhesives to NOVO was not going to be as profitable as they originally anticipated. The first order from Novo was denominated by Brazilian real (BRL) which would be converted into US dollars (US$). Since the time that Baker and Novo agreed to terms on the sale, the value of the deal had dropped significantly because of the exchange rates. Furthermore, because Baker and Novo had agreed on a per-gallon price, the exchange rate changes severely hurt the profit margin Baker Adhesives expected on receiving from the first deal. What made it more difficult was that Novo was unwilling to change the per gallon price for this new order. This would mean that the new order would not be as profitable as Baker Adhesives initially thought. On top of that, Baker’s costs of materials had also risen by 10% since the last order from Novo. Because of the newfound awareness of exchange-rate risk, Moreno had gathered information on exchange rate markets. Moreno discussed her concerns with the bank when she had arranged for conversion of the original NOVO payment. The bank had described two ways to minimize the exchange risk: To hedge in the forward market, or to hedge in the money markets. In the forward market, Baker agrees to an exchange rate at a specified time and at a specified rate. Baker essentially is locking in an exchange rate between Brazilian real and US dollars. In the money markets, Baker borrows money “today” in foreign currency against an expected inflow or making a deposit “today”. The amount to be borrowed depends on the interest rates of the foreign currency as Baker would not want to transfer more or less that it has to.The meeting left Baker disappointed however he learned some important key lessons. Also the international sales were one of the future key of the company into further success thus they focused their attention on the said new NOVO order.

II. Statement of the Problem Baker Adhesive is a small company that manufactures specialty adhesives. Recently, it entered an overseas transaction with Novo, a Brazilian toy manufacturer. The Novo order is denominated in Brazilian real and the payment has to be converted into US dollar. Currently, Novo wants to close another transaction by ordering 50% more of what they have ordered during the first transaction. Sudden exchange rate fluctuation affects the company negatively and Doug Baker would like to know how to minimize/handle this risks. In line with this, the company would like to answer the following questions: 1. What would be the net present value of the future cash flow from the additional order when:  There is no hedge?  The company hedges using forward contract?  The company hedges using money market? 2. How should the company manage or minimize the effect of foreign exchange rate fluctuation to their international transaction?

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3. Should the company accept the additional order from Novo? III. Industry Analysis SWOT Analysis

STRENGTHS One of Baker Adhesive’s strengths is that it has the ability to produce specialized adhesives. The company is able to manufacture their products based on the specifications given by their costumer which was shownin the case of NOVO which has very specific preferences in the adhesives that will be used in producing their waterproof toys. Since, it based its production on customer’s specification; they were able to have loyal customers and also steady sales during their operations yearly. Also, Baker Adhesive had done well financially for the past few years which resulted for the company’s margin to be higher compared to large companies’ margins. Moreover, Baker it has an excellent relationship with a local bank that had always provided sufficient funds to cover the company’s short term needs. WEAKNESSES Since the market of Baker Adhesive was focused on making specialized products, growth in their sales was slow. It was because their capacity to produce was limited to the customer’s order. Unlike the large scale adhesive companies which were able to have higher growth sales because they were producing general products for consumers. Another weak point of the company is their lack of overall knowledge in the course of business. As they were still a new company entering the International market scene they still lack the experience as well as the knowledge regarding the market routine. It was shown in their inability to anticipate future risks. OPPORTUNITIES Large Adhesive Companies focus on scale of economy thus market for the specialty adhesive was left open. Small firms like the Baker Adhesive took this opportunity to capture the market. The key drivers to the success for this scale was to be able to make specialized adhesives that would fit

Magbitang, Redilyn B. | Papa, Richelle Angeline O.| Talucod, Regine Marie L. |Tañedo, Pauline D. 2

the customers’ specification, a good chemist and a flexible production system which Baker Adhesive has. Also it would be a great opportunity for the company to offer different product line as per different type of industry they were serving like for toy manufacturer, toiletries and many more industry. Furthermore, Baker may impose lower costsbecause the company didn’t need to invest a lot for large machinery since they were made to order. Unlike the large companies which were both capital and labor intensive that needs a lot of funding. THREAT Although Baker Adhesive was one of the companies that dominated the specialty adhesive markets, they were still threatened by large companies. Since their product is closed in doing specialty products, large company dominated the free market and provided vast bulk of adhesives in US and globally. Also, since their product is general, they can sell it to anyone who was looking for adhesives.

Rivalry Among Competitors 5

Threat of New Entrants

Threat of Substitutes 0

Bargaining Power of Suppliers

Bargaining Power of Buyers

PORTER’S

Five

Forces Analysis Bargaining Power of Supplier (LOW) There is a large amount of suppliers meant for Baker Adhesives internationally. Commonly, these are small suppliers gaining small market share which has no power to exert. Due to this, there are no controllable prices that each supplier can demand to the company. They are not able to exercise this power and in turn will not squeeze the profit of the industry. On the other hand, the company can easily switch to any supplier that can match the quality and the price they want. Overall, this industry has a LOW bargaining power of suppliers. Bargaining Power of Customers (SIGNIFICANT) This industry is provided by customers with different types whether they are sensitive to price or not. Usually, customers will buy on larger volume and lower price giving them the power. Although LEGEND

Magbitang, Redilyn B. | Papa, Richelle Angeline O.| Talucod, Regine Marie L. |Tañedo, Pauline D. 0 No threat to the business 3 1 Insignificant threat to the business

there are consumers who consider quality as a priority in choosing supplier which is an advantage for Baker Adhesives which is already well known for providing this type of products. For those who are looking for small scale companies, there are also these type which are newly entering the market and favors the consumers. This brings to a SIGNIFICANT bargaining power of consumers. Threat of New Entrants (MODERATE) Since the market of Baker Adhesives is dominated by few large firms that provide bulk of adhesives globally, there is a small chance that some companies will enter this industry. Given that the existing competition is fierce, these firms already owned a stable market share which new entrants would not be able to get since this will cost them a large investment. In this type of industry, efficient production system is highly required to be successful. These production systems must be flexible since they must be able to produce relatively small batches with distinct properties feasibly and economically. One key driver of success is also having good and brilliant chemists which will lead them to marketable products that can make them acknowledged by customers globally. Due to these factors, the duration of the newly entered companies in this market must be considered although they can attract small consumers. Out of this, it can be concluded that there is a MODERATE threat of new entrants. Threat of Substitutes (MODERATE) Substitutes for adhesives are sometimes done by consumers which find this lowly needed wherein they can be made at home with little efforts. These are consumers who are usually on rural areas or place wherein this market is not feasible. But since Baker Adhesives is a company of specialty adhesives with high quality; this cannot be easily substituted for consumers who buy this in bulk. Given that, adhesives are used in many aspects like automotive, construction and electronics, there are a great number of consumers who find this product highly needed. To sum up, there is a MODERATE threat of substitutes. Threats of Existing Rivalry (HIGH) Some of the existing competitors of Baker Adhesives in market share are BASF, Dow Chemicals, Henkel, Bayer, H. B. Fuller, Acucote Inc., Ashland, Inc., Beardow Adams (Adhesives) Ltd., Creative Materials Inc., and Franklin International Inc.which are all large firms that provide bulk of adhesives for consumers. Given that they are large firms, it can be concluded that this industry has a fierce competition. To become successful, these companies invested in efficient and flexible production system as well as good chemists which are all also possessed by Baker Adhesives. The competitive advantage of the others is they were able to dominate international market and sourcing capabilities while Baker Adhesives is experiencing issues in entering international market. This leads to HIGH threats of existing rivalry.

IV. Alternative Courses of Action Effect of Foreign Exchange Rate Fluctuation in the original order

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Given that the previous transaction with Novo was already affected by the sudden fluctuation in interest rate, we would like to establish the impact of this event to the company and for comparison purposes too for the computations that will follow. The table would show the change in the company’s profit and revenue due to the change in exchange rate.

The table shows that approximately, the profit declined by 72.23% and revenues by 5.78%. Net Present Value of the Future Cash Inflow from New Order of Novo As the company’s operation goes overseas, they will be facing exchange rate risks for these transactions. With that, managing the said risk would be very important for the company’s profitability. The case stated that, Ms. Moreno is trying to figure out the best way of mitigating the risk and she is considering hedging in the forward market and money market. In this event, the following tables would show the Net present value for the future cash inflow of the company given that it is: Unhedged, Hedged in the Forward Market, and Hedged in the Money market. This computation will help them decide on how to handle the risk that they are and will be facing.

Ways to Hedge

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The following table will show the comparison of the computed NPVs above to the Unhedged NPV.

Analysis of the New Order from Novo We know for a fact that Novo is trying to close a deal with Baker adhesive by ordering 50% more of what they have previously ordered. The problem with this is that Novo is not willing to pay more than what they have paid from the previous transaction. The analysis below would give an overview of how the transaction will affect the company’s profit. It will help Ms. Moreno to decide whether to accept or reject the offer. The table below shows the computation for the possible profit (loss) that the company will incur in accepting the new order from Novo. This computation charged overhead costs to the new order. The end figure implies that the company will incur loss when the offer is accepted.

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On the other hand, in the computation in the table below, we do not include additional cost in overheads because the company is currently operating below its capacity, thus, charging additional overhead cost might wrongfully undervalue the possible profit that the company might incur in accepting the offer.

V. Recommendation Currently, Novo is into another transaction with Baker regarding the prior’s order of 50% more of what they have ordered during their first transaction. Given the problems arose with the pending transaction; Baker would like to consider factors that might be of help. First is the NPV approach. In order to mitigate the exchange risk that the firm Baker Adhesives is currently experiencing in line with its overseas transaction with Novo, Alissa Moreno considered comparing the present values of the cashflows when it is hedged in the forward market or in the money market. As for the result of the computation, it can be proven that the firm should opt to hedge in the forward market than in the money market since the $64,766.33 present value of the cashflows when it was hedged in the forward market is higher than the $64,190.10 present value when it was hedged in the money market.

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Given the facts and computations above, Forward hedge is preferred over the money-market hedge. This two hedges will not be directly compared to each other. They will be compared to the NPV value when the company choose not to perform hedging because it has the largest cash inflow. The forward hedge has lower difference compared to the money-market hedge. Note that, this recommendation may not be applied to all the future overseas transaction but this could be a guide.

And last is the profitability of accepting the new order of Novo. It has been said in the case that the company is currently operating below capacity and charging of additional overhead costs will undervalue the company’s profit. Therefore, modifying the cost structure will present a profit of $7,186.95 to the firm. Therefore, the company should consider accepting the 50% additional order of Novo.

Magbitang, Redilyn B. | Papa, Richelle Angeline O.| Talucod, Regine Marie L. |Tañedo, Pauline D. 8