Assignment
Kootenai International, Inc.
Kootenai International, Inc., (NASDAQ symbol: KHALB) is a diversified furniture and electronics manufacturer that sells wood and metal office furniture, lodging furniture, and electronic assemblies (including computer keyboards and mouse pointing devices).* The Lodging Group (part of the "Furniture and Cabinets" segment) is experiencing dramatic growth in sales and income, increasing market share at the same time that the hospitality industry is con-tinuing its refurbishing cycle. The assistant treasurer is considering increasing the company's investment in this high-growth area. He believes if the company changes its credit standards and credit period, it will add profitable sales. Along with the rest of the top management staff and the board of directors, he is concerned about the slowly growing or declining sales and/or market share in some of Kootenai's segments [such as the original equipment manufacturers (OEM) Furniture and Cabinets unit]. Sales continued to grow at a moderate pace in the larger two of the company's three business segments-(Furniture and Cabinets, and Electronic Contract Assemblies), but sales in the company's smallest business segment- (Processed Wood Products and Other) declined from the prior year's first quarter. According to the company's 10-K annual report of its financial statements and operating results:
"Sales of Original Equipment Manufacturer (OEM) product lines, primarily television cabi-nets and stands, audio cabinets, and residential furniture, decreased in the 3-month period when compared with one year earlier. Lower sales vol-ume of cabinets were caused by a major cabinet customer experiencing lower market demand for their products. Although certain other cabinet customers increased their volumes, this product line experienced an overall decline in sales volume. Production flexibility is inherent in the OEM supplier market and may cause short-term fluctuations in any given quarter. Volumes of contract residential furniture increased from the prior year. Some OEM production capacity was used for production of hospitality furniture during the quarter. OEM operating income declined from the prior year's level as a result of the decrease in sales volume and, to a lesser extent, an unfavorable sales mix toward lower margin products."
The assistant treasurer believes that the company's future is linked to significant growth in a few areas such as the Lodging Group. He has asked for your advice as the senior credit analyst in the credit department.
At present, the company holds roughly 29 percent of its $597 million asset base in the form of cash and marketable securities. Its present average credit period for paying customers of the Lodging Group is 46 days. The company extends 30-day terms to its customers. The bad debt losses on the Group's sales are a respectable 2.2 percent. Sales in the Lodging Group are S105 million, about one-tenth of the company's S983 million sales. The variable costs for lodging furniture, excluding credit administration and collection costs, average 46 percent. The company's weighted average cost of capital is 14 percent. It presently has surplus funds invested at an average rate of 3.5 percent. Sales estimates under two independent proposals for changes in the credit policy are as follows:
Proposal A: Lengthen credit period to 60 days. Proposal B: Ease up on credit standards.
Proposal C: Implement both Proposals A and B.
Other relevant aspects of the company's financial position were also provided to the credit analyst from the management discussion in the 10-K report.
Consolidated selling, general and administrative expense, as a percent of sales, increased 1.3 per-centage points for the 3-month period (com-pared to the year earlier), primarily as a result of moderate additions to the Company's existing infrastructure supporting the higher sales volume, additions as the result of acquiring Farad Semiconductor in the latter half of the prior fiscal year, and certain other costs that are variable with earnings.
Operating income for the first quarter of 2017was $20,181,000, increasing 2.6 percentagepoints, as a percent of sales, when compared to the first quarter of 2016, primarily as a result of sales volume increases, the diminished effects of material price increases that were experienced in the prior year's first quarter, and manufacturing efficiency improvements, including benefits from quality and cost containment initiatives.
Investment income for the first quarter remained flat when compared to the same period in the previous year, as higher investment balances were offset by a lower effective yield. Other-net includes $3.6 million related to a loss on the sale of a foreign subsidiary in the current year, which is offset by a $3.6 million income tax benefit recorded in Taxes on Income. The remaining decrease in Other Income or Expense- Net is primarily due to larger gains realized on the sale of assets in the prior year.
Taxes on Income includes a $3.7 million tax benefit relating to the sale of a foreign subsidiary in the current year's first quarter. This tax benefit was the result of a higher U.S. tax basis in this subsidiary as a result of previously nondeductible losses on the investment in this U.K. subsidiary. Excluding this tax benefit, the effective income tax rate decreased 1.1 percentage points in the 3-month period when compared with the prior year partly as a result of reduced European operating losses that provide no immediate tax benefit.
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Credit Administration &
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Paying Customers'
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Lodging Group
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Bad Debt Expense Rate
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Collection Expense
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Collection
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Policy
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Sales
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{% of revenue)
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(% of revenue)
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Period
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Present
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S95 million
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2.1%
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2%
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56 days
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Proposal A
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S99 million
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2.0%
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2.3%
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68 days
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Proposal B
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$106 million
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2.4%
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3.2%
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61 days
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Proposal C
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$111 million
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2.19%
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2.25%
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72 days
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The company achieved net income of $15,531,000, or $0.66 per share, for the first quarter of the 2017 fiscal year, a 57.6% increase over the prior year's first quarter net income of $9,846,000, or $0.42 per share.
LIQUIDITY AND CAPITAL RESOURCES
Cash, Cash Equivalents and Short-Term In-vestments totaled $143 million at September 30, 2017, as compared with $111 million one year earlier. Liquidity remained strong with working capital and the current ratio at $233 million and 2.9 to 1, respectively, at September 30, 2017as compared with $201 million and 2.7 to 1, respectively, one year earlier.
Operating activities continued to generate positive cash flow, which amounted to $42 million for the three months ended September 30, 2017. Portions of the company's cash flow from operations were reinvested in the business to fund $10 million of capital investments for the future, primarily production equipment upgrades and improvements in the company's business information systems. Six million dollars was used for financing activities, primarily to pay dividends. Net cash flow, excluding purchases and maturities of short-term investments, amounted to a positive $28 million for the 3-month period ended September 30, 2017.
The company anticipates maintaining a strong liquidity position throughout the 2017 fiscal year with cash needs being met by cash flows provided by operations, available cash balances, and short-term investments on hand.
1. Which proposal, if any, should Kootenai adopt? Defend your position based on the value effect and the present financial position of the company. Indicate why you chose the discount rate used in the analysis.
2. How does the financial position of the company strengthen or weaken the recommendation you made in Q.1?
3. The assistant treasurer indicates to you that one of the Electronic Products senior managers thinks capital should be allocated to his unit instead of to the Lodging Group. How should the assistant treasurer respond to this concern? (You may use any business concept or approach to answer this, not limiting the answer to the credit policy pro-posals.)
4. What competitor reactions are likely if Kootenai unilaterally makes one or both credit policy changes? How might this be incorporated into the present analysis?