Section A – This ONE question is compulsory and MUST be attempted
Introduction
Man Lal relaxed in business class as the aircraft skimmed across the Uril Mountains. Generally he considered himself a contented man. He had successfully built his company, Ling, to be the largest light bulb manufacturing company in the world, with global revenues of $750m. From its factories in Lindisztan it supplied a worldwide market for LED (light emitting diodes) light bulbs. Lal congratulated himself on the fact that he had quickly spotted the potential of LED light bulbs and had entered large-scale production whilst his rivals were still focusing their production on candescent and halogen bulbs. The world now realised that LED light bulbs provided a cheaper, more energy efficient, greener solution than all of its alternatives. To that end, many countries had passed legislation requiring domestic and business consumers to replace candescent light bulbs with greener equivalents. In fact, he was on his way right now to Skod, a country which had passed efficient lighting legislation which, from 2017, banned the use of candescent bulbs in commercial premises and outlawed their production and importation after that date. Domestic consumers were expected to replace their candescent bulbs with newer technology as their bulbs failed. Man Lal confidently expected that LED would be, for many, the newer technology of choice.
The visit to Skod was of great significance to Man Lal because it was here that he did his business studies degree at Skodmore University. Indeed, he was due to give a lecture to the staff and students of the university the following day and he felt great personal pride in returning to describe the extent of his success and the fulfilment of his personal ambitions. He was also planning to visit a company called Flick which Ling was considering acquiring. This would be a new growth method for Ling. Up to now its worldwide expansion had been achieved by establishing wholly owned distribution companies in each targeted country. All production had remained in Lindisztan. However, for various reasons, Ling was now considering entering the Skod market by acquiring one of its light bulb producers, Flick.
In fact, remembering this brought a slight frown across Man Lal’s face. To help fund his global expansion, he had sold 49% of Ling to institutional investors. These institutional investors required growth and high dividends and he was having difficulty meeting their demands. There was now very little growth in the domestic Lindisztan market and the distribution approach used to expand into foreign countries was taking a long time to mature. The investors were demanding quicker growth and acquisitions appeared to promise this. Despite paying high dividends over the last few years, the company still had significant retained profits and this was another issue for the institutional shareholders. They felt that this money should be used to promote growth and have agreed to a $400m acquisition fund. So, thought Man Lal, what better place to start those acquisitions than Skod, the place where I studied as a poor overseas student so many years ago. However, he had to admit to himself, he was still much happier with organic growth through setting up his own distribution companies. Ling had made a few acquisitions in Lindisztan, but had never bought a foreign company and he was worried about the risk of failure.
Turbulence buffeted the aircraft as it made its final descent into the capital of Skod. To distract himself, Man Lal picked up the latest copy of Lighting Tomorrow, the research magazine of the light bulb industry. He skim read an article on tubular daylight lighting which promised to reduce the need for electric lighting by introducing more daylight into a building. Effective daylighting (it said) is achieved through the strategic placement of skylights and windows, as well as lighting controls which monitor available daylight and respond as needed to decrease or increase electric lighting. Perhaps I need to look into this, thought Man Lal.
At the airport, Man Lal took a taxi to his hotel. He could not help but notice that Skod was not as neat and tidy as it used to be. A lot of shops and buildings had been closed down and there was graffiti across many buildings and bridges. ‘Skod for Skodders’, said one, ‘Skod jobs for Skod people’, said another. Man Lal remembered now that the Skod nationalist movement had become increasingly popular. He mentioned this to the taxi driver. ‘Yes’, he said, ‘Most people are fed up with Skod being pushed around by the International Financing Consortium (IFC), we want prosperity and jobs for people who grew up here.’
Slightly unnerved, Man Lal, checked in at the hotel. He switched on the television. He watched with interest as Niklas Perch, the newly elected nationalist leader of the Skod government, outlined his plans for the future.
‘We are committed to a return to prosperity’, he said. ‘To achieve this we have to make some short-term adjustments which may be unpopular with our trading partners. We are currently considering the imposition of import taxes as a way of protecting our home industry. We wish to create a protected commercial environment here in Skod in which our companies can prosper.
‘We must also ask our citizens to continue with their energy saving measures. As you know, the government has agreed that all street lighting will be turned off from 2300 hours to 0500 hours. I have also decreed that all government offices must proactively embrace energy saving lighting and heating. In the same way, I expect our citizens to look at ways of saving money and energy.
‘The government also recognises that the country continues to be in a recession, and that disposable income is falling for all people. However, I cannot condone the recent demonstrations against, and boycott of, foreign goods and food products. We must rebuild our country peacefully and legally. I would ask all citizens to support me in this.’
Just then, the air conditioning failed and the television went off. Another energy failure in Skod. There were three further failures that night. The hotel manager apologised to Man Lal in the morning. ‘I am sorry’, he said ‘but despite higher energy prices, this is an increasing feature of life in Skod.’
Skod electric light bulb industry
All electric light bulbs are largely made out of glass and metal and this is likely to remain the same in the foreseeable future. In Skod, 90% of glass is produced by three companies. However, for all of these three companies, light bulb manufacturers are unimportant customers. Most glass manufacture goes to the construction industry, light bulb manufacturers take less than 0·5% of the country’s glass production. Metal manufacture in Skod is dominated by one company, OmniMetal. Most metal is sold to the automobile industry. Light bulb manufacturers take less than 0·1% of OmniMetal’s production. However, the quality of glass and metal required by the light bulb manufacturers is quite standard, so switching between suppliers is, in theory, relatively easy. Light bulb manufacture takes place in factories which require substantial initial investment and have no obvious alternative use.
In Skod, light bulbs are low cost commodity products which are replaced infrequently by domestic consumers. Commercial consumers change their light bulbs a little more often and some businesses have recently switched all their bulbs to LED to save energy, reduce costs in the long term and to reflect their aspirations as ‘green businesses’. There is very little brand awareness in the light bulb market and all the light bulbs have to fit the standard sockets used in the country.
Electric light bulb manufacture in Skod is dominated by the five companies listed in Table One. Two years ago a large American light bulb manufacturer, Krysal, attempted to enter the market. The five dominant companies in the industry reacted to this by cutting prices, running marketing campaigns which emphasised the benefits to the country of home-based production and lobbying supermarket groups to not stock products produced by the new entrant. Krysal withdrew from the market after six months. When not focused on fighting new entrants, the five main competitors are regularly involved in price cutting, disruption of competitors’ distribution channels and aggressive marketing.
The products produced by the Skod light bulb industry are largely sold through supermarket groups (50%), household product superstores (30%) and large electrical chains (10%). The rest of the production is sold through small shops, except for a tiny percentage of production (less than 1%) which is sold directly to large organisations, such as government departments. However, light bulbs do not constitute a large sales item for any of these distribution channels. In fact, in a recent report, light bulb sales were one of the products which contributed less than 0·1% of a major supermarket’s revenue.
The light bulb companies in Skod have largely focused on candescent (60% of production) and halogen (30% of production) technologies. Man Lal intends to fund the updating of the production facilities at Flick to allow the production of LED lights, alongside the continued production of candescent and halogen light bulbs. He wants to achieve this before domestic competitors in Skod gear up their own LED light bulb production. He believes that Ling’s competencies in LED manufacture will give Flick a head start. Initial discussions with Flick suggest that the company is open to acquisition and a bid price has been agreed which is acceptable to both parties. Financial information for Flick and the Skod light bulb industry as a whole is shown in Appendix One.
Appendix One: Financial information for Flick and the Skod light bulb industry
Extract from financial statements
All figures in $millions
Analyse the macro-environmental factors affecting the Skod light bulb industry using a PESTEL framework. Your analysis should reflect the fact that Ling might enter this industry directly by setting up a distribution company for its products or through the acquisition of Flick.
A PESTEL analysis identifies the main drivers in the external environment which are largely outside the control of the company. The relevance of these factors may depend upon whether Ling decides to enter the light bulb market directly or to enter it by acquiring a Skod-based company. In some instances the driver affects the industry wherever it is based.
Political
The government is considering the imposition of import taxes. This would be a threat if Ling decides to enter the market place using the distribution company approach and keep manufacturing in Lindisztan. However, it presents an opportunity if Ling decides to acquire Flick and continue to run it as a Skod-based company.
Economic
Although the country of Skod is in recession and consumer disposable income is falling, it seems unlikely that such a low cost commodity product will be greatly affected. This is an industry which is unlikely to be touched by changes in economic prosperity. The only minor issue may be the effect of switching off street lights. This may lengthen the life span of the bulb. However, overall, this is likely to have very little effect on total light bulb demand.
Sociocultural
There is a growing nationalist movement in Skod who are keen to keep jobs within the country. There have been instances, in other industries, where imported goods have been boycotted. It seems unlikely that a backlash against foreign goods would affect such an unglamorous product as a light bulb. However, it is possible, and any potential consumer backlash can be avoided by buying a Skod-based company and manufacturing light bulbs in the country.
Technical
Ling has so far benefitted from technological innovations which has put it ahead of competitors who have focused on candescent and halogen bulbs. However, other lighting initiatives, such as the tubular daylighting devices discussed in the Lighting Tomorrow article need to be continually monitored. This monitoring is required whether Ling enters the Skod market directly, or acquires a company such as Flick.
Legal
The ‘efficient lighting’ legislation due to become law in Skod in 2017 is an opportunity for Ling to enter the market with its innovative LED products. This is an opportunity whether the company enters the market directly or buys a home-based company such as Flick.
Environmental
Businesses and consumers in Skod are increasingly aware of energy issues. This is partly due to increasing energy prices as well as more frequent breaks in the electricity supply (such as the power cuts which affected Lal’s hotel). The LED bulbs offered by Ling are greener and more efficient than candescent and halogen bulbs, which are still widely made in the home industry. In the case of businesses, many are quickly moving to LED light bulbs to reduce running costs and boost their environmental credentials. The environmental attractions of its products is important to Ling but again this is independent of whether they are made by a home-based company or one based abroad.
Assess the attractiveness of the Skod light bulb industry using Porter’s Five Forces framework.
Bargaining power of buyers
In this scenario, the buyers of the industry’s products are large supermarket groups, household product superstores and large electrical chains. These buyers, particularly the supermarket groups, purchase a large volume of the industry’s products (90%) and so, on the face of it, they can demand favourable prices. However, the products the buyer purchases from the industry represents a relatively insignificant fraction of the buyer’s costs or purchases. A recent report suggested that light bulb sales contributed less than 0·1% of a supermarket’s revenue. Light bulbs are much less important to supermarket groups than food and drink. When the product sold by the industry is a small fraction of the buyers’ total costs, then buyers are less price sensitive. They are more likely to bargain with food suppliers than light bulb suppliers.
Buyers’ bargaining power in the light bulb industry is strengthened by the product being undifferentiated, with low customer switching costs. However, the buyers are extremely unlikely to move backwards in the supply chain to manufacture their own light bulbs and so this potentially limits their bargaining power. Again, their focus is likely to be elsewhere.
Some of the factors which concern the buyer also relate to the consumer (end customer) as well. To the end customer, light bulbs are undifferentiated and there are no switching costs. Light bulbs are an insignificant fraction of their total spend and so they are unlikely to shop around to get the lowest price.
Bargaining power of suppliers
A supplier group is more powerful if it is dominated by a few companies and is more concentrated than the industry it sells to. This appears to be the case in Skod, where 90% of glass production is accounted for by three companies and metal production is largely concentrated in the hands of one very large company, OmniMetal. The customers (such as Flick) are large but they are more fragmented than the suppliers. Furthermore, the supplier group is, by and large, not obliged to contend with other substitute products for sale to the industry. Light bulbs are largely made of glass and metal and it seems unlikely that this will change in the near future. This lack of substitutes increases the power of the supplier.
The industry is not an important customer of the supplier group. Most glass is sold to the construction industry. Most metal is sold to the automobile industry. The light bulb manufacturers use less than 0·5% of the country’s glass production and less than 0·1% of its metal production. This lack of importance increases the supplier group’s power, because suppliers’ fortunes are not closely tied to the industry and they will not need to protect it through reasonable pricing. Another factor increasing suppliers’ power is that the products (glass and metal) are a vital part of the buyers’ (customers) light bulb business. On the other hand, the supplier group’s products are largely undifferentiated and switching costs between suppliers appears to be reasonably low. Finally, it seems unlikely that the supplier group poses a credible threat of forward integration into light bulb manufacture and this will be a factor which reduces supplier bargaining power.
Threat of new entrants
Ling is considering entering this market and so the barriers to entry and the potential reaction of current suppliers is important to consider here. The main barriers to entry appear to be:
Economies of scale: The five large dominant companies in the industry should be enjoying economies of scale which force any potential new entrant to come into the market with large scale production, which carries with it a high risk of failure. This is not an issue for Ling who also currently enjoys economies of scale in its manufacture. However, it will deter many other entrants.
Capital requirements: The manufacture of light bulbs requires new entrants to invest large financial resources into production plants. Although capital may be available, the risk associated with large-scale entry may lead to high premiums on borrowed capital.
Access to distribution channels: This may be very significant, as the distribution channels are very specific (supermarket groups, large home products superstores and major electrical chains). The new entrant will have to persuade these channels to accept its products, perhaps through offering price discounts. It seems unlikely that the new entrant can create a completely new channel. Selling directly to the consumer seems unlikely in this industry where individual purchases are both infrequent and low value.
The reaction to new entrants of existing firms in the industry is likely to be relatively forceful as they have a history of vigorous retaliation to prospective entrants. The upsurge of nationalism in the country will also give them a powerful card to play in this retaliation.
Threat of substitute products
Substitute products are products which can perform the same function as the product of the industry under consideration. It is hard to envisage any potential substitute for light bulbs except for candles which, in the long term, are likely to be much more expensive. Another possible substitute is to do without. This is the approach taken by government policy on street lighting. It is turned off from 2300 hrs to 0500 hrs. However, it seems unlikely that many consumers will prefer to sit in the dark instead of using a relatively cheap lighting product. In the short term, the threat of substitute products seems very low. However, in the long term, the tubular daylight lighting initiative described in Lighting Tomorrow is a possible substitute product as it aims to reduce the need for electric lighting.
Competitive rivalry in the industry
Equally balanced competitors. When an industry is dominated by a few firms and these firms are relatively well balanced in terms of size, it creates potential instability because they may be prone to fight each other. This appears the case in Skod where five fairly similar sized firms produce 72% (2015) of the light bulbs sold in the country and wage short-term price cutting wars, disrupt competitors’ supply lines and react aggressively to potential new entrants.
Slow industry growth. Despite the switch to new technologies, there is little market growth. From 2010 to 2015 the market only grew by just over 2%. In such a situation, the only way a firm can increase market share is to take it from one of its competitors. Consequently, slow industry growth increases competitive rivalry.
Lack of differentiation or switching costs. Competitive rivalry is increased where the product is perceived as a commodity. In such circumstances the buyer’s decision is largely based on price and service and pressures for intense price and service competition result. Light bulbs are definitely a commodity product in Skod.
High exit barriers. Exit costs are high because of the investment required in plant and the fact that light bulb factories cannot easily be adapted for other uses. When exit costs are high, companies hang on in the industry often resorting to extreme tactics which weaken the profitability of the industry as a whole.
Ling is considering entering the Skod light bulb industry by acquiring Flick.
Evaluate the potential acquisition of Flick by Ling from the perspectives of suitability and acceptability.
One of the elements of suitability is a consideration of how well the strategy fits with future trends and changes in the environment. This environment has already been considered in the PESTEL and five forces analysis. Acquiring Flick is particularly appropriate in the context of the government’s threat to impose taxes on imported goods. The increasingly nationalistic Skod population can also be acknowledged if the acquisition is carefully handled. Ling can stress that it is investing in Flick to secure its future and to create jobs for the people of Skod. The impending efficient lighting legislation also provides an opportunity for Ling, but this is irrespective of whether the company enters the market directly or acquires Flick. However, it is better placed to quickly meet this demand through acquisition. Direct entry is generally a slower approach to growth, as Man Lal has acknowledged.
Entering the market through acquisition also means that it can use the effective distribution channels which are already in place. There is no guarantee that the established distribution channels would welcome a new entrant into the market and indeed they may demand price reductions in exchange for distribution access. Acquisition also means that no new capacity is brought to the market. Ling can then focus on increasing market share in a competitive, relatively slow-growing market. Entering directly is likely to prompt a hostile reaction from competitors currently in the market. Acquiring Flick might also invoke a hostile reaction, but it is likely to be more muted because it does not immediately alter the balance of power in the market.
However, in the longer term, the worldwide size of Ling may affect the bargaining power of suppliers and buyers in the Skod market. As a group, it has revenues which exceed the Skod market total, so there may be possibilities for negotiating reductions in raw material costs and the profit margins of suppliers. If these savings are not passed on to the end consumer, then Ling’s profitability will inevitably improve. If these savings are passed on, then Ling will begin to dominate a commodity market place.
A further element of suitability is whether the acquisition provides an opportunity to exploit the strategic capability of Ling. In one sense it does, as it provides an opportunity for it to exploit its technical capability in LED lighting, before the domestic industry can gear up its production levels. However, in another sense the strategy is not suitable because Ling does not have strategic capability in acquiring foreign companies. All of its growth has been achieved through setting up wholly owned distribution subsidiaries. Its only production factories are in Lindisztan.
Acquisition also has to meet the expectations of the stakeholders. In terms of the institutional stakeholders who hold 49% of Ling’s shares, the acquisition promises the rapid growth which they are lobbying for. They have been critical of Ling’s slow, cautious foreign growth and the maturity of the Lindisztan market means that there is little opportunity for growth there. The institutional shareholders have also been critical of the high levels of retained earnings and they wish to see a significant portion of it invested back into the company to fuel growth. The size of the retained earnings makes the acquisition financially feasible, although of course there is always the possibility that such funds could be better invested elsewhere.
The acquisition of Flick is also of personal significance to Lal himself. It provides him with an opportunity to show the country where he received his business education that he has succeeded. This tangible proof of his success and ambition is important to him. Acquisition is a speedy approach to growth, but it can raise issues of culture clash. This needs further investigation and will be one of the challenges which Ling faces, because it does not have any previous experience of this method of growth. It seems unlikely that the business culture of Skod and Lindisztan is exactly the same and so cultural issues can be expected. Perhaps this is contributing to Man Lal’s unease about the acquisition policy.
The acceptability of the acquisition can also be considered in the light of Flick’s financial performance in its market sector.
The profitability of Flick is currently below average for the industry sector. Gross profit margin in 2015 was 21·43% (industry average 30%), net profit margin 15·71% (industry average 24%) and ROCE 4·07% (industry average 5·74%). This may suggest to Ling’s shareholders that there are short-term profits to be gained by reducing the cost of sales and overheads to a point where the company at least achieves the average performance of its sector.
In contrast, liquidity is higher than the industry averages. The current ratio is 3·33 (compared with 2·69 for the industry as a whole) and the acid test ratio is 1·83 (1·74 for the industry as a whole). It is possible that the high current ratio reflects a lack of investment in plant and equipment. At Flick, property, plant and equipment accounts for 63·33% of its assets, compared with an industry average of 71·09%. Inventory holding appears unnecessarily high and perhaps shows a lack of good inventory management practice. 15% of the total assets are held in inventory, compared with an industry average of 8·7%. Flick’s liquidity is boosted by the amount of money it holds in cash or cash equivalents. This accounts for 11·87% of the asset base, more than double the industry equivalent.
Gearing is relatively low. The gearing ratio is 25·9% (compared with an industry average of 35·9%) and the interest cover ratio is 4·4 (compared to an industry average of 2·4). This points towards a cautious approach to investment and borrowing. It may again suggest that Flick has been reluctant to borrow money to invest in production machines and processes which, in the long term, contribute to more profitable products. It has preferred a lower risk strategy which leads, in turn, to the company making lower profits.
However, one area where Flick appears to excel is in its management of receivables. At an average of 104·3 days this is much lower than the industry norm. Its industry payables is broadly in line with the industry norm (192·5 days compared to 208·6 days).
Conclusion
The acquisition of Flick is, potentially, an excellent way of entering the Skod light bulb market. It appears to be a cautiously run company which has reported lower profitability, perhaps as a result of failing to invest in efficiency initiatives. The threat of import controls makes direct entry very risky and there is sufficient evidence to suggest that Ling’s input will improve Flick’s position in a very competitive market.
One reservation might be the lack of experience the company has in acquiring and managing foreign companies. Thus a comprehensive due diligence process to purchasing the company and a non-intervention approach to managing Flick when it is acquired is recommended, particularly while Ling gets to grip with the cultural differences which are bound to exist. Such an approach is also likely to partly appease any nationalist critics. Even in the short term, there appears to be improvements which can be made to Flick and profitability will improve by just bringing company performance into line with the national average. Although it is expected that Ling will supply most of the funding for expansion and equipping the factory to produce LED bulbs, liquidity and gearing data suggest that Flick itself has unlocked financing potential which could be used to help finance growth.
The finance director of Ling is concerned that Ling has no expertise in acquiring foreign companies and he is advocating a strategic partnership with Flick instead.
Discuss the appropriateness of such an approach to facilitating Ling’s proposed entry into the Skod light bulb market. (8 marks)
Professional marks are available in question 1 for the structure, coherence, style and clarity of your answer. (4 marks)
There are many documented cases where acquisitions have been unsuccessful and so the caution of Ling’s financial director is understandable. Strategic alliances appear to offer a less risky way of entering a market place.
A strategic partnership is where two or more organisations share resources and activities to pursue a strategy. The basis for an alliance between Ling and Flick would be co-specialisation, allowing each partner to focus on their core capabilities. Johnson, Scholes and Whittington suggest that ‘alliances are used to enter new geographical markets where an organisation needs local knowledge and expertise in distribution, marketing and customer support’. This is exactly the situation Ling finds itself in. In such an alliance it could exploit a new market, retain all production in its own country and save itself the costs of acquisition and due diligence. In return, Flick would gain new energy-efficient products for its home market which would allow it to fulfil the requirements of impending legislation. Crucially, however, the profit of the alliance would have to be split, on some agreed basis, between the two companies.
There are different types of strategic partnership. In a joint venture a new organisation is created which is jointly owned by the parents. The parent companies remain independent trading companies. This is unlikely to be attractive in the Ling/Flick situation. It seems more likely that Flick would wish to sell the product as its own and not confuse the market place with an offering from a related company. A joint venture is probably more appropriate where the participating companies are entering into a different market place. For example, Ling and Flick combining their expertise to enter the energy management consultancy business. At the other end of the spectrum, a network of firms might collaborate without too much formality. For example, Flick could agree to brand and distribute Ling’s products, paying a fraction of the sales price (or profit margin) back to Ling. This is in effect a licensing agreement, and this might eventually stretch to the company making the LED bulbs in Skod under licence, after testing the market first through branding and distributing them.
Different levels of formality of the alliance lead to different characteristics. For example, if speed to market is important, then an opportunistic alliance would be preferred to a joint venture. Indeed a joint venture might easily take longer to agree and legally establish than to complete an acquisition.
The form of the strategic alliance can be shaped to take into account the environmental factors which affect the industry and the different capabilities of the participants. It can also be made responsive to cultural differences. However, in the Ling/Flick situation, it is difficult to see how a strategic alliance will address the needs of the institutional stakeholders for growth and Lal’s personal desire for acknowledged success and prestige. Furthermore, there may be concerns about the long-term viability of any such alliance. Trust is probably the most important ingredient of any alliance and it seems likely that Ling will be reluctant to licence a product which could be easily imitated by the licensee. Furthermore, just as Ling has limited expertise in acquisitions, it also has no experience of strategic alliances at all. Success requires expertise in setting up and monitoring clear goals, governance, financial arrangements and other organisational issues. There is no evidence in the scenario that Ling has this expertise.