The case presents the reader with a scenario involving Bill Watson, president of Science Technology Company (STC), analyzing a financing plan prepared by Harry Finson, chief financial officer. The central problem facing Watson is whether or not the financing plan accurately reflects STC’s position, and whether or not it makes the wisest prescriptions for the company’s success.
To determine the financing plan’s validity, I will be taking a three-pronged approach. First, we will see if the 5-year forecasts are actually useful by comparing the overall industry’s performance to STC’s performance. Then I will examine the potential impacts of inflation on STC’s bottom line through examining which aspects of the business would be hardest hit by inflation. Finally, we are going to look at how feasible it is for STC to continue raising the necessary capital to finance their growth rates. I will then conclude by offering potential measures for offsetting any problems the 5-year plan might have neglected to account for through the three-pronged structure.
Problem 1: Usefulness of Forecasts
The first problem we face is “In view of the uneven growth in sales, inventories and receivables and earnings in the past were Mr. Finson’s 5 year forecast useful?” To answer this, let’s look at the electronics market as well as STC’s performance. Computer related technology products are exploding in growth – as can be seen in Table A, the broader electronics market has enjoyed growth of 28%. Knowing this, I view Mr. Finson’s 5-year forecast as being somewhat useful. A 30% annual increase in projected sales for STC is certainly achievable, since the market for their the ATE and VLSI products is rapidly expanding. From 1978 to 1984 we observe a sales increase of $359 million to $1.6 billion from the ATE market alone. And STC has been enjoying steady sales growth as a result.
But this is where the usefulness of the forecast starts coming into question. Although overall market trends are positive, STC’s whipsawing profit margins hamper the ability to accurately forecast sales for the next five years, as can be seen in Exhibit 1. Trying to calculate a meaningful forecast from these numbers would likely result in an overly optimistic picture for the company.
Problem 2: Inflation
The second problem is “What impact would a resurgence of inflation, fueled by massive budget deficits, have on STC?” In high inflation markets, credit markets break up. Lending money only would hurt a lender, so no one lends. A side effect of inflation is higher prices as well, which translates to lower purchasing power.
A key issue with Mr. Finson’s forecast is that it does not appear to account for inflation in his 5-year forecast. That would obviously have a big impact on its financial statements. A lot of fixed expenses are put into product cost and when inflation hits, that will costs substantially and therefore cut into profitability.
Problem 3: Growth Financing
The last problem to consider is whether or not the company is well positioned to finance the rapid sales growth that was anticipated. The answer at first glance appears to be “yes, and no” at the same time. STC has the best current ratio compared to its peers at 3.8, which shows it has a lot of cash to pay back obligations and debts. The company also was able to raise capital through a 3.45 million share offering sold in 1982 and 1983, further bolstering its cash positions.
Despite these positives, however, STC might have issues meeting their goal of decreasing the cost of goods sold by 41%, since the current plan is dependent on ever-fickle sales numbers. When compared to key competitors, STC is struggling to keep up on a number of financial metrics, including return on equity, earnings per share, and net income (See Exhibit 2). STC stock is trading at 40 times earnings multiple, compared to competitors which trade at 16, 11, and 21 times respectively. This shows STC has a much higher valuation on a times earnings basis when the numbers behind that show that high price isn’t justified.
With this information in mind, what sort of measures should STC take to reverse course? For the first problem, I would propose two solutions together: contact sales to obtain more accurate sales data and shift to just-in-time inventory. The sales forecasts are not specific enough, especially for a fast-moving industry like the semiconductor market. Mr. Finson should request seasonal/quarterly sales figures as opposed to only looking at annual numbers to better track performance.
Since the sales projections’ accuracy is questionable, this leads to a high risk of miscalculating inventory needs, thus leading to higher costs. Even though inventories were lowered in the projected 5-year forecast, perhaps a better plan would be to convert to just-in-time, which would boost predictability and decrease overhead costs.
For the second and thirds problem, I would propose three measures that would help reduce both issues: include the rate of inflation in cost calculations (self-explanatory), consolidate operations by closing the Colorado and Arizona plants and selling associated fixed assets, and winding down unprofitable overseas operations.
Two separate facilities on both coasts is adding unnecessary expense and excess manufacturing capacity for STC, leading to reduced efficiency and thus reduced return on assets. Therefore, it would be best to consolidate operations on the east coast, and sell the Colorado and Arizona plants. Should the need arise for additional capacity, it’d be comparatively cheaper to outsource manufacturing during peak times as opposed to always having to pay more overhead for two more headquarters.
On that same vein of thought, it would be better for STC to work through resellers and strategic partnerships in worldwide markets rather than maintaining physical presence in over a dozen international locations. The sell-off and consolidation would bring the company much needed cash and reduce the cost of goods sold, increase return on assets, and therefore increase EPS. Outsourcing would reduce costs while maintaining strong production.
Appendix: Charts and Exhibits