THE NEW CONTRACT
The new contract would dramatically increase the existing sales of Kilgore, and if all of the embedded options were exercised, the effect on Kilgore could be an additional increase in sales over the next five years of more than 100 percent. In terms of the potential for enhancing the valuation of Kilgore, and Steve's considering liquidating at least some of his sole ownership in the company in 5 to 10 years, the timing of the deal could not be better.
Exhibit 19.3 U.S. Monthly Auto Sales, Million of Units
Source: Bloomberg LLC.
While the technical specifications of the contract seemed highly complex and exacting, they basically laid out the design specifications for power window assemblies that Kilgore had extensive experience in producing. Some of the more complex parts of the contract dealt with unexpected, but potential, implications of significant design and production changes. In essence the contract had provisions that compensated Kilgore for any necessary modifications in the technical details of what would be produced. Thus, in terms of operational risk, it was felt that the contract was of low risk to Kilgore. While changes would have to be made to manufacturing processes and capacity, it was expected that these would proceed relatively smoothly given Rory's experience.
The more troubling aspects of the contract were financial, and more specifically the need to manage the financial risk. Under the terms of the contract, all proceeds to Kilgore were to be in U.S. dollars, even though virtually all of Kilgore's expenses were in Canadian dollars. The Japanese car manufacturer was setting up a plant to supply the U.S. market and in turn demanded that all supply contracts also be denominated in U.S. dollars. Part of the reason for doing so was to mitigate its own potential cyclical profitability due to exchange rate cycles. A second reason was the need for geographic diversity. The 2011 earthquake and tsunami in Japan had exposed a weakness of basing too much of a company's supply chain within a single region. While it wanted to diversify its supply chain across North America and utilize not only U.S. but also Mexican and Canadian suppliers, it did not want to incur currency risk.
Exhibit 19.4 USD/CAD Exchange Rate
Source: Bloomberg LLC.
Additionally, the contract had several built-in options whose exercise would benefit the Japanese manufacturer. For example, the contract could be extended by an additional three years. While there were provisions for payment of development expenses of retooling for any unforeseen model changes, the base profit margin in U.S. dollars was fixed. A second option embedded in the contract would allow the Japanese manufacturer to increase the number of units bought per year by up to 50 percent at the same fixed price. If the full range of options were exercised, this one supply contract would comprise almost 60 percent of Kilgore's total sales.
A major concern of Cathy Williams was the potential profitability of the contract, particularly when the embedded options were considered. With current U.S./Canadian dollar exchange rates, the contract was relatively profitable for Kilgore. Cathy calculated that there was approximately an 8 percent net profit margin built into the contract, which was only slightly below industry standards. The lower profit margin was considered to be a trade-off for the longer-term stability of the contract. However, a shift to a stronger Canadian dollar could quickly eliminate any profitability and potentially even lock Kilgore into a long-term loss. A chart of the history of the USD/CAD exchange rate is shown in Exhibit 19.4. Of particular concern was the potential for the Canadian dollar to creep above par as it had done periodically over the past five years.
A second concern was the potential for any inflation differentials between Canada and the United States. The contract had a built-in quarterly pricing adjustment based on the U.S. Producer Price Index (PPI). Kilgore's manufacturing costs, however, were more closely linked to the Canadian PPI, particularly as Kilgore's
Exhibit 19.5 U.S. and Canadian Producer Price Indexes
Source: Bloomberg LLC.
union contract was linked to Canadian PPI, as were the union contracts of most of its own suppliers. While the U.S. PPI and the Canadian PPI were closely linked, the relationship was not perfect. Political events on either side of the border could potentially change the economics of the deal for Kilgore. The respective PPIs for the United States and for Canada are shown in Exhibit 19.5.
If the full range of embedded options were exercised, and if exchange rates or inflation differentials moved adversely, the contract could potentially lock Kilgore into a long-term loss and essentially scuttle any plans to take the company public or to sell it as a going concern. Conversely, if the profitability of the contract could be maintained, it had the potential to significantly alter the profitability of Kilgore and give it the scope and economy of scale necessary to seek out other opportunities and to provide Steve MacLinden with a very attractive valuation for his company.