This project is to identify and analyze HPL (Hansson Private Label ) company’s new investment decisions based on a series of calculations include: Operating Cash Flows (OCF), Net Present Value (NPV), Internal Rate of Return (IRR), and Sensitivity Analysis. The analysis suggests that Hansson should be very cautious regarding the investment proposal that is developed by his manufacturing team. Although the projections and analysis of the project for the next 10 years proposed by Robert Gates seems reasonable and will generate positive NPV and an IRR greater than the discount rate, NPV is very sensitive with regard to unit volume and unit selling price changes. A decrease in the projected unit volume and selling price might produce a negative NPV. Company Background and Performance Analysis
The Hansson Private Label (HPL), started in 1992 when Tucker Hansson bought over Simon Health and Beauty Products with 42 million (17 million with debt), is a company that manufactures personal hygiene products including soap, shampoo, sunscreen, mouthwash, and shaving cream (Stafford, Heilprin, and Devolder, 2010). Over the years, HPL has grown steadily under Hansson’s conservative expansion strategy, which is to expand only when Hansson makes sure that the capacity with any new facility should be at least 60% (Stafford, Heilprin, and Devolder, 2010). Right now, the four plants of HPL are all operating at 90% capacity, and the business generated 681 million in revenue in 2007. The market for personal care industry is mainly driven by the unit selling price, which has increased by an average of 1.7% each year in the past four years. Unit volume has increased less than 1% annually. Taking down to the company level, we can see that HPL has been growing steadily with revenue increases by about 35% in 2007 compared to 2003. The company has maintained an average growth of 8% in revenue throughout the five years. The net income has also grown by 33% from 2003 to 2007. Net income margin has averaged 5.3% each year in the last five years. HPL’s balance sheet for the past five years was looking better with total assets increased by 13% from 337.8 million in 2003 to 380.8 million in 2007, and long-term debt decreased by 40% from 91.6 in 2003 to 54.8 in 2007.
Cash flows from operations have averaged 32 million throughout the years, which means the company has well controlled its operating cash flows. It is not difficult to conclude that Hasnsson’s conservative expansion strategy has worked out well for HPL and the market share has reach a little over than 28% of the private label industry. Currently, Hansson is facing a new investment opportunity initiated by its largest retail customers that could take the business into the next level and significantly increase its competitive force in the private label industry. Since HPL is already operating near full capacity, the project requires Hansson to invest in new facility which costs $45,000 to accommodate for the additional production capacity (Stafford, Heilprin, and Devolder, 2010). However, this investment is not without significant risks. First and for most, Hansson would need additional debt to finance the new projects.
This will double HPL’s debt to value ratio and creates financial distress for the company and Tucker Hansson since most of his personal wealth is tied up with the company. Secondly, this important customer is only willing to commit to a three year contract with HPL. At the end of expiration date, it is uncertain whether the customer will continue to buy HPL’s products. In case it does not renew the contract, Hansson will have to find alternative customers in order to keep the production capacity going. Thirdly, because the risks associated with the new project increase the overall risks with HPL, the shareholders and creditor might require a higher rate of return. And since creditors claim the debt first in case of default, stockholders would have to live with the residue. If HPL cannot operate at the projected capacity, the value of the company will be largely decreasing, and put the company at danger. Investment Evaluation
-Cash Flow Forecasts-capital planning and recommendations for change The cash flows of each year during the lifetime of the project are derived by net operating income plus depreciation and minus the change in net working capital. Depreciation is included in the net income because it is tax deductible, and then it is added back because depreciation is a non-cash expense and should be added back to the cash flow statements. The change in net working capital is also taken into account in OCF since it is the change in cash flows. The calculation of OCFs is based on the projections developed and proposed by Robert Gates, the leader of the manufacture team. The production capacity starts at 60% in the first year of the project’s lifetime, and thereon steadily increases up to 85% at the end of the project. As mentioned earlier, the largest retailer is only willing to sign a contract of 3 years. The projection for capacity of 60%, 65%, and 70% in the first three years are reasonable because there is enough demand from this customer. However, assume the customer decides not to buy products from HPL after the expiration; there is not enough demand for such high capacity in the next 7 years unless it finds other customers who are willing to buy their private label products.
The project would become over optimistic for HPL. The unit selling price is another important contributor to the overall OCFs. Gates forecasts that the selling price will increase at 2% each year throughout the 10 years with a start at $1.77. Given that the market for private label products is growing considerably fast in recent years with consumers’ increased acceptance level, the projections for unit selling prices seem reasonable. However, a little fluctuation in unit selling price has a big impact on the cash flows and net present value. The sensitiveness of NPV in regards to the selling price will be discussed in detail in the sensitivity analysis session. One more factor that we are concerned about is the raw material costs for production. Right now the cost for raw material sits at $0.94 per unit in 2009 and steadily increases by 1% each year during the lifetime of the project. What if the costs growth is set too low? If the costs of raw material are happen to be higher than the projected figure, NPV again might be negative. Therefore, Hansson needs to take all these factors that might impact the project’s NPV into account and do a separate analysis for each one of them. And then make final decisions by combining the effects of each factor. -Sensitivity Analysis-NPV and IRR
Using Gates’ projection and assume everything goes well as planned; the investment has an NPV of $5249. NPV is calculated using present value of future cash flows and the initial investment. Working capital of the last year of the project is returned to the cash flow, and is taken into account in the calculation of NPV. IRR of the project is 10.22%, greater than the discount rate of the investment. Both NPV and IRR suggest that Hansson should invest in the project. Sensitivity analysis of NPV and IRR is conducted to determine the sensitiveness of NPV and IRR in response to changes in the parameters. First, a unit price increase about 7% from $1.77 to $1.90 is used to calculate the effect. With starting price at $1.90 and other things remain unchanged; the project has a positive NPV of $33,547 and IRR of 19.25%. Similarly, when the starting price increases to $2.00, the correspondence NPV and IRR is $55,314 and 25.31% respectively. On the other than, if the price decreased by 10% of the original price projection; the project has an NPV of -$3458 and IRR of 7.02. And in this case, the project needs to be rejected.
As we can see from the attached spreadsheets, NPV and IRR are very sensitive to price changes. Even a small fluctuation in price could result in a negative NPV of the project and an IRR smaller than the discount rate. Using the same method, we also measure the sensitiveness of the NPV and IRR on unit volume changes. When the unite volume decreases by 10% of the original forecasts, the NPV of the project becomes a negative of $10,176, and a corresponding IRR of 4.32%. And if the unit volume is increased by 10% of the original, the NPV changes to a positive of $22,043 and a IRR of 15.64%. These figures deviate far from those in the otherwise normal scenario, which also suggests that NPV and IRR are quite sensitive to changes in the unit volume. In other words, if the unit selling price does not grow as forecasted and that the demand is not as optimistic; it is highly possible that the stockholders of the HPL will experience losses. Careful consideration should be given to the market price and demand, and what is the true drive force of the private label industry. Industry Analysis
In 2007, the personal care industry had total sales of 21.6 billion and the private label industry accounted for 4 billion of the total with 2.4 billion whole sales from manufactures (Stafford, Heilprin, and Devolder, 2010). HPL, as one of the leading manufactures, had over 28% market share of that total. Exhibit 2 of the private label share of U.S consumer packaged goods spending (Stafford, Heilprin, and Devolder, 2010) shows that the unit share and dollor share both grow at approximately 1% each year from 2005 to 2007. One thing I am curious about is that the growth is the true growth or as a result of the inflation? If it is due to the inflation, the projections of sales would be far off leading to a failure of the project. Hansson has to be especially careful with this assumption and weight the inflation effects accordingly. It is found that the retail giants and mass merchants have shown increasing interests in developing in-store brands (private labels) because of the attractive marginal benefits and low costs provided by the private label products. Another reason is to achieve a distinct shopping destination for customers and maintain customer loyalty (L.E.K, 2013). One implication for HPL, under such trends, is that the marketing team should pay more attention to packing. Packaging has become a crucial element for the retailors and the private label industry. Innovative packaging not only strengthens private label’s competing power with national brands but also impress consumes by presenting value adding features including user friendly, modern, and appealing green packaging (L.E.K, 2013). If HPL is able to incorporate the innovative packaging into its program, the company will be more competitive and take more market share even after the contract with its customer expires.
Recommendation and Discussion
The project has a positive NPV and an IRR greater than the discount rate (9.38%), which means that in theory, Hansson should take this investment opportunity. However, I wonder if the projections are a bit too optimistic. In this paper, we only test the sensitivity on price and volume changes. The management should look at the factors that will have essential impact on the project such as the limitation of the contract with this customer and the industry growth figures. It is better to break the investment lifetime into two portions, and calculate NPV and IRR separately. The first portion is the 3-year contract period, and we are pretty sure that the project will be profitable in this period. The second portion would be the remaining period after the contract expires. This is the part where uncertainty problem lies. As we discussed earlier, the customer might or might not continue to buy products with such volumes with HPL, and given the fact that this industry is largely controlled by retailers; HPL should make clear whether it is able to find a replacing customer of this scale. Another issue with this investment is that Robert Gates could intentionally push Hansson to take the project because they think the company has reached to a maturity stage and there would be no opportunity for further growth. This is the principal-agent problem we talked about at the start of the module.
If Hansson is confident enough in Gates’ projection, this project is worth taken. Using the data provided in the case, we also calculate the discount rate of the project and get a rate (9.44%) that is slightly higher than the rate (9.38%) provided. The required rate of return of equity is determined by the CAPM. The beta of HPL is the average beta of similar companies in the similar industry which is a beta of 1.4. Market risk premium, riskless rate, and the portion of debt and equity are also given in the case, and these are used to calculate the WACC. The higher discount rate suggests that the project is riskier than proposed and higher discount rate should be used. An alternative for Hansson could be finding an investor who’s willing to invest in the project and share the profits and risks with the company. However, the downside of this option is that the cost of equity is higher than the cost of debt. Cost of equity is 10.7% as calculated in the WACC spreadsheet, whereas the cost of debt that is with 25% D/V is only 7.75%. But this option allows Hansson to diversify away some of its risks, and that Hansson is less financially distressed. That all been said, Hansson should consider the suggestion of incorporate innovative packaging into its product line if Hansson were to take this project after careful evaluation of the financial and non-financial risks. The benefits of innovative packaging would allow HPL stands firmly in its competing position against the competitors.
Stafford, E., Heilprin, J., and Devolder, J., (2010) ‘Hansson Private Label, Inc.:Evaluating an Investment in Expansion’, Harvard Business School (Accessed: 06 April 2014). L.E.K Consulting (2013) ‘Generic No More: How Packaging Innovation Can Help Private Label Gain Market Share’, Executive Insights, XV(23), pp. 1-4. Available at:http://www.lek.com/sites/default/files/L.E.K._How%20Packaging%20Innovation%20Can%20Help%20Private%20Label%20Gain%20Market%20Share.pdf (Accessed: 9 April 2014).