Financial Management WAC
Thornton Corporation

3/5/2011

Personal Care industry
The personal care industry is a major industry in the US, with 2007 sales exceeding US$21bn. The industry has seen growth of less than 1% during the past four years, with an average growth in prices of 1.7% per annum. The major players in the industry include Procter & Gamble, Kimberly-Clark etc. Personal care products are available throughout the US via five main categories of retailers including mass merchants, club stores, supermarkets, drug stores and dollar stores. It is worth mentioning here that retailers exhibit a lot of muscle when it comes to sales of the personal care products, thus manufacturers of personal care products depend heavily on the retailers.
A unique attribute of the personal care industry is the substantial presence of private labels. These private labels have been introduced by these very retailers, who control the production, packaging and promotion of the products. Some retailers have vertically integrated and own the manufacturing of the products, while some retailers purchase their goods from third-party manufacturers (e.g T Corp) and re-sell under their own brand names.
The primary reason why private labels operate in the presence of heavyweight branded labels is to offer consumers with lower-priced alternatives to the more expensive branded goods. Acceptance levels of the private labels has been on the rise due to good quality of products, and in 2007 private label product categories had total sales exceeding US$70bn.
Retailers have the unique advantage of having a lower cost of goods sold, in case they purchase the goods from a third party manufacturer. Thus, the retailers can charge a much lower price than the consumer goods companies, doubling their profits despite the low prices. Exhibit – 1 shows the sales of various categories of personal care products during the years 2003-2007. According to statistics, private label products have a huge potential particularly due to the low prices they charge. Currently, private labels constitute only 5% of sales in many product categories with sales amounting to US$4bn out of the US$21.6bn for the entire personal care category.

T-Corp in the industry
In the private label category, T-Corp has a 28% market share with sales totaling US$1.12bn at the retail level. As shown in Exhibit – 5, the sales of T-Corp’s products depict a very interesting situation. Lets consider each of the five retail categories in detail.
Mass Merchants:
Being the biggest market for T-Corp, mass merchants have displayed a fine performance over the period 2003-2007 with an average growth of 12%. There has been a constant increase in the sales to mass merchants, with 13.5% growth seen in 2004, 14% in 2005, 12.3% in 2006 and 8.5% in 2007, as shown in Exhibit – 5.
Grocery Stores:
Grocery stores have remained a more or less stable market for T-Corp. The average growth over 4 years during the period 2003-2007 is 1.1%, with 2.2% growth occurring in 2004, no increase in growth in 2005 and 2006, and growth slightly picking up in 2007 to 2%, as shown in Exhibit – 5.
Club:
Club stores displayed an average growth of 5.3% during 2003-2007. The growth rate in 2004 was 3.7%, 5.7% in 2005, racing to 6.7% in 2006 and decreasing to 5% in 2007, as shown in Exhibit – 5.
Drug:
Drug stores have displayed an impressive performance over the 4 years, with average growth rate arriving at 9.8%. Exhibit – 5 shows the trend of growth rates, with being 9% in 2004, increasing to 10% in 2005, rising further to 10.6% in 2006 and falling to 9.6% in 2007.
Dollar:
Another star market for T-Corp, dollar stores depicted an impressive average growth rate of 10% over 2003-2007. Growth rate for 2004 remained at 9%, falling to 8.3% in 2005, rocketing up to 11.5% in 2006 and easing to 10.3% in 2007, as displayed in Exhibit – 5.
Other:
Other stores include convenience stores and sales to miscellaneous distributors. The sales to these ‘others’ categories showed a growth of 6.5% in 2004, a dismal 3% in 2005, an impressive 8.8% in 2006 and a slight easing to 8.1% in 2007, as shown in Exhibit – 5.
The overall growth in sales for T-Corp remained at an average of 7.8% during 2003-2007, with sales increasing by 7.7% in 2004, rising up further to 8.1% in 2005, increasing further still by 8.5% in 2006 and easing down to 6.9% in 2007.
Issues and suggestions in forecasting
One of the changes I would incorporate in John Flower’s projections would be the ratio of selling, general and administration expenses and revenue. According to Flower’s estimations, the selling, general and administration expenses are 7.8% of revenues. This ratio cannot be fixed as a percentage of revenues. We propose that this ratio be increased each year primarily because even slight variations in SG&A could change the NPV.
Exhibit 6 shows that variations in SG&A have the highest impact on NPV. This puts the company at a huge risk since even minute changes in SG&A would end up having significant effect of NPV and consequently the profitability of the company. Additionally this would put the company at the mercy of governmental regulation, labor laws and union. Also should any regulation raise the SG&A cost from 7.8% to 10%, this would decrease the NPV into the red zone, making the project unattractive.
Furthermore, Flower has made a financial model assuming that the project will run for ten years. We have been specifically told that the contract is only for three years, and there is no guarantee that the contract will be renewed.
We have assumed that T-Corp is raising US$50million for the new project entirely through debt. Yet Flower has not taken this fact into account. He has not included the interest expense while making his assumptions. We believe that interest expense and principal payments should be included in this forecast, and impact of both should be taken into account.

Decision: Invest or not?
Under our analysis, the project’s NPV is US$10,752,000 with an internal rate of return of 12.89% discounted at a weighted average cost of capital of 9.38%. As per our recommendations, we suggest that T-Corp should not go ahead with the US$50 million investment.
A sensitivity analysis performed on the growth in selling price shows that as the growth in price increases, the NPV also increases. Our current NPV is a result of 2% growth in price, and as the growth rate of price increases to 5%, the NPV rises to US$60 million as shown in Exhibit – 8. We believe that price will not be increased by that much in the future, as any increase in price would actually be suicidal for T-Corp. The reason for this is that an increase in T-Corp prices would effectively reduce the retailers’ margins and they would look for other manufacturers. On the other hand, should the influential retailers force T-Corp to decrease the growth rate in prices to less than 2%, it would be devastating for the company by pushing the NPV into negative zone. T-Corp can only afford to raise prices at a growth rate above 2%, but it cannot afford to sustain the project at a growth rate of less than 2%. Keeping the power of retailers in mind, due to fact that the project is being undertaken for our biggest and most powerful customer, it would be too risky to undertake this investment.
As per a Tornado sensitivity analysis, we see that NPV is most sensitive to percentage growth in selling price, as shown in Exhibit – 6. This further justifies the fact that we should not go ahead with the investment, as we would lose retailers in case we increase our prices during the course of the project.
The company’s decision regarding running any new project at 60% utilization at a minimum is a very rational move. We carried out a sensitivity analysis on the capacity utilization, and there is a direct relationship between capacity utilization and NPV. Flower has assumed that we will only achieve 75% capacity utilization by the time the project is over in three years. Flower achieves 85% capacity utilization only in the year 2014 and beyond, three years after the project contract expires. Exhibit – 9 shows the change in capacity utilization on the NPV of the project. As per the calculations, a capacity utilization growth less than 2% would result in a negative NPV, but any growth above 2% will result in a positive and growing NPV.
Interest rates proved to be a very tricky aspect of the project. It was a very important decision to take the discount rate at 9.38%. The importance of discount rate can be judged from the fact it has an indirect relationship with NPV. Exhibit – 7 shows that as the interest rate cross 12.5%, the NPV turns negative. Given the fact that our new project is a fairly risky project, due to the limited nature of the project and no guarantee of a renewal in contract, therefore the discount rate should be higher than 9.38%. Increasing the interest rate though will dramatically reduce the NPV and would turn it negative if the discount goes beyond 12.5%
Yet another reason why T-Corp should not go ahead with the investment is its inability to manage a positive NPV over the three year contractual period. Should the retailer back out of the contract before three years, it would result in a huge fixed cost for T-Corp. Additionally, the retailer is the largest customer for T-Corp, and should it back out of the contract, it would be very difficult for the other smaller retailers in our portfolio to help us cover the investment cost. Although the project looks fairly attractive when considering it on a ten year basis, there is no guarantee that whatever estimates Flower has made about the sales units will actually last for ten years.

EXHIBITS

Exhibit – 1: T-Corp share of target market ($ 000’000)

Exhibit – 2: Sales revenue of T-Corp

Exhibit – 3: Growth in both branded and private label products

Exhibit – 4: Historical and expected gross margins of T-Corp

Exhibit – 5: T-Corp sales by retail channels

Exhibit – 6: Tornado chart showing NPV sensitivity of variables

Exhibit – 7: NPV sensitivity with interest rates

Exhibit – 8: NPV sensitivity with growth in price

Exhibit – 9: NPV sensitivity with capacity utilization

Exhibit – 10: NPV sensitivity with S, G &A cost