Mueller Industries Inc.

Transcription

1 Mueller Industries Inc. Amanda Miller Park Hunter Shyla Walton Austin Head Josh Jacobsen

2 Table of Contents Executive Overview.6 Company Overview..13 Business & Industry Analysis Five Forces Model.16 Rivalry Among Existing Firms..16 Industry Growth...17 Concentration. 19 Differentiation...21 Switching Costs.22 Economies of Scale Learning Economies...23 Fixed to Variable Costs Excess Capacity Exit Barriers. 26 Conclusion...26 Threat of New Entrants..27 Economies of Scale. 27 First Mover Advantages...28 Channels of Distribution & Relationships...29 Legal Barriers. 29 Conclusion...30 Threat of Substitute Products..31 Relative Price and Performance 31 Buyers Willingness to Switch.32 Conclusion 32 Bargaining Power of Customers..33 Price Sensitivity.33 Relative Bargaining Power..34 Conclusion 35 Bargaining Power of Suppliers.36 Conclusion 37 Five Forces Conclusion 37 Key Success Factors of the Industry 38 Economies of Scale Economies of Scope Efficient Methods and Cost Control.. 41 Input & Distribution Costs Research, Development & Advertising...43 Summary Competitive Advantage Analysis...45 Large Scale Production

3 Production Efficiency. 46 Other Advantages..48 Summary.48 Accounting Analysis.49 Key Accounting Policies Goodwill...50 Pension Plan & Retirement Compensation...52 Hedging Activities..53 Management of Fixed Costs.. 54 Capital & Operating Leases...55 Degree of Potential Flexibility. 56 Goodwill...56 Pension Plan & Retirement Compensation...57 Hedging Activities..58 Management of Fixed Costs. 59 Capital & Operating Leases 59 Actual Accounting Strategy. 60 Goodwill 60 Pension Plan & Retirement Compensation...62 Hedging Activities 63 Management of Fixed Costs.. 64 Capital & Operating Leases 64 Evaluate Quality of Disclosure 66 Qualitative Analysis.. 66 Goodwill...66 Pension Plan & Retirement Compensation 67 Hedging Activities 69 Management of Fixed Costs.. 70 Capital & Operating Leases 71 Quantitative Analysis 72 Expense Manipulation Diagnostics. 72 Asset Turnover.. 72 CFFO/OI. 74 CFFO/Net Operating Assets 75 Total Accruals/Sales 76 Pension Expense/ SG&A 77 Other Employment Expense/ SG&A...78 Conclusion 79 Revenue Manipulation Diagnostics 80 Net Sales/ Cash from Sales. 80 Net Sales/ Net Accounts Receivable.. 81 Net Sales/ Inventory.. 83 Conclusion 84 Potential Red Flags

4 Undo Accounting Distortions..85 Financial Analysis, Forecasting & Cost of Capital Estimation. 88 Liquidity Ratio Analysis Current Ratio.. 89 Quick Asset Ratio.90 Accounts Receivable Turnover. 91 Days in Accounts Receivable.92 Inventory Turnover.93 Days Supply of Inventory 94 Working Capital Turnover 95 Cash to Cash Cycle.96 Conclusion..97 Capital Structure Ratios..98 Debt to Equity...98 Times Interest Earned.100 Debt Service Margin Credit Risk. 102 Conclusion. 103 Profitability Ratio Analysis 104 Gross Profit Margin 104 Operating Expense Ratio 105 Operating Profit Margin..106 Net Profit Margin Asset Turnover 108 Return on Assets Return on Equity 110 Internal Growth Rate Sustainable Growth Rate 112 Conclusion. 113 Financial Statement Forecasting. 114 Income Statement..114 Balance Sheet Statement of Cash Flows. 127 Cost of Capital Estimation Cost of Equity. 132 Backdoor Cost of Equity 135 Cost of Debt 136 Weighted Average Cost of Capital..138 Valuation Methods..140 Method of Comparables..141 Price to Earnings Trailing Price to Earnings Forward..143 Price to Book Dividends to Price

5 Price Earnings Growth P/EBITDA P/FCF EV/EBITDA 146 Conclusion Intrinsic Valuation Models Discounted Dividends Model..149 Discounted Free Cash Flows..152 Residual Income 156 Long Run Residual Income.159 Abnormal Earnings Growth. 163 Conclusion Appendix.166 Sales Manipulation Diagnostics Expense Manipulation Diagnostics Effects on Restatement of Goodwill..169 Liquidity Ratios..173 Profitability Ratios Capital Structure Ratios Altman s Z-score..178 Cost of Capital Regression Outputs Cost of Equity, Debt & WACC Method of Comparables Tables Intrinsic Valuations..197 References 205 5

6 Executive Summary Investment Recommendation: Overvalued Sell as of November 1 st, 2008 MLI - NYSE (Nov 1, 2008) $23.31 Altman's Z-Scores 52 Week Range: $ $ Revenue: $2.74 B As Stated Market Capitalization: $ M Restated Shares Outstanding: $37.14 M Percent Institutional Ownership: 96.10% Current Market Share Price (Nov 1, 2008) $23.31 As Stated Restated Financial Based Valuations Book Value Per Share: $19.13 $15.77 As Stated Restated ROE: 19.61% 23.58% Trailing P/E: $12.23 $10.39 ROA: 9.10% 9.94% Forward P/E: $41.86 N/A P/B: $10.62 $8.75 Cost of Capital Estimate (Including 2.3% Size Premium) D/P: $6.65 N/A R^2 Beta Ke P.E.G: - N/A 3 Month 36.03% % P/EBITDA: $19.54 $ Year 36.05% % P/FCF: $20.02 N/A 5 Year 35.89% % EV/EBITDA: $12.38 $ Year 35.81% % 10 Year 35.72% % Intrinsic Valuations As Stated Restated Upper and Lower Ke: 11.64% % Discounted Dividends: $10.12 N/A Published Beta: 0.88 Discounted FCF: $35.28 $39.57 Back Door Ke: 14.52% Residual Income: $10.35 $10.09 Cost of Debt: 5.99% Long Run Redisual Income: $14.33 $11.82 WACC (BT) 12.02% A.E.G.: $7.16 N/A Upper and Lower WACC (BT) 8.76% % 6

7 Industry Analysis Overview Mueller competes in the metal fabrication industry and makes all types of pipes, tubes, and fittings that are sold to a variety of customers across various industries. Our analysis of the industry consists of Mueller and its three closest publicly traded competitors: Alcoa, Madeco and Wolverine Tube Inc. Together these companies supply firms from automotive and housing all of the way to aerospace and electrical industries. As companies in the metal fabrication industry tend to make relatively simple and generic products, cost becomes the main source of competition. Cost control and operation management are imperative to being successful in this industry. The five forces model allows us to identify threats that are present throughout the industry as a whole and discuss the methods that are necessary for success. The following is a brief summary of the model and its conclusions. Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Customers Bargaining Power of Supplies Results of the Five Forces Model High Low High High Medium It is important to become familiar with the environment of a company s competition if one wishes to fairly evaluate it. Our discussion of the metal fabrication industry illustrates the external matters a company will face. The model describes the high concern of substitute products as each company makes more or less the same products. It also suggests the unlikely occurrence of new entrants as the industry requires a large amount of assets in order to be competitive. These and other concerns are addressed in the industry analysis section. 7

8 Accounting Analysis Overview The numbers that are published in the quarterly and annual reports are supposed to accurately reflect the businesses activities of each company. There are many regulations imposed by the SEC and GAAP as to how a company can account for their processes. In an accounting analysis, the first step is to identify the key accounting policies that can be examined to evaluate a company s transparency. These policies should be looked at closely as they provide potential for distortion and manipulation that can shine a company in a false light. We used revenue manipulation diagnostics ratios to demonstrate how current assets and current liabilities relate to net sales. These ratios also help us determine if there is anything out of the industry norm that could potentially be a red flag in the financial statements. Most of the revenue manipulation diagnostics looked within the industry norm. The only ratios that had stood out were the net sales divided by net accounts receivables and net sales divided by inventory. However, we concluded that both of these slight differences were due to fluctuating copper prices in the market and did not qualify as a red flag. We did identify one major red flag when examining Mueller s accounting practices, this being how the company accounts for goodwill. Over the past five years Mueller has been involved in a number of mergers and acquisitions, thus adding to their goodwill. However, they only impaired a small fraction of it. Goodwill does not last a lifetime; in fact, it should really have a useful life of about five years. Since Mueller keeps goodwill on their books for much longer than five years, we believe this significantly distorts the true value of the firm. We undid this distortion by taking the goodwill balance in 2003 and writing it off for the next five years, adjusting for new mergers and acquisitions along the way. We restated Muller s income statement and balance sheet to reflect these changes. This helps give investors a better picture of the true value of the firm. 8

9 On the other hand, analysis of other policies allows us to verify Mueller s as stated version. For instance, operating leases only account for 5.79% of total long term liabilities and thus suggests that the company gives a fair view of its lease liabilities. Likewise, the disclosure of hedging activities appears fair and reliable. The accounting analysis section compares these and other accounting policies that will have an impact on our valuation. 9

10 Financial Analysis, Forecasting and Cost of Capital Estimation We begin the financial analysis by looking at a number of liquidity, profitability and capital structure ratios. These ratios give us an idea of Mueller s financial position and allow us to put them up against their competitors. In doing so, we are able to see what aspects the company excels at and in what aspects they are lacking. The day s supply of inventory is one that Mueller has to its advantage as it is able to turn inventory into sales relatively quicker than its competitors. Profitability ratios measure how well a firm s revenues cover its expenses. The ratios show a percentage of sales, where sales equal 100%. Overall, Mueller was efficient in covering its expenses compared to the metal fabrications industry. Mueller was average using operating profit margin and net profit margin. Mueller outperformed the industry average in gross profit margin, operating expense ratio, asset turnover, return on assets, and return on equity. After analyzing these profitability ratios, we concluded that Mueller has kept a strong competitive strategy over the past 5 years by continually being either average or above average in the industry. Liquidity ratios determine the ability at which a firm is able to handle its short term assets, these assets include: cash, accounts receivables, and inventory. Knowing how well a firm is able handle its short term assets also explains to analysts how well a firm is able to pay of its short-term debt. In the case of Mueller, its liquidity ratios seemed to be average in comparison to competitors within the metal fabrication industry. The table below states how each of Mueller s liquidity ratios did in comparison to the industry average (above, equal, and below). Results of Liquidity Ratios Current Quick A/R Days in Inventory Days in Working Cash to Asset Turnover A/R Turnover Inventory Capital Turnover Cash Cycle Above Above Below Below Above Above Below Equal Forecasting financial statements are important as it allows us to get a view of the company into the near future. Forecasting will never end up exactly as planned, but the 10

11 analysis of financial ratios helps us improve our accuracy. There are a number of estimates that go into forecasting, such as growth rates, discount rates and prediction of the economy in general. Forecasting financial statements involves looking at a company s current and past financial data to predict how the company will perform in the future. The most crucial forecast was had to make was sales growth. We could not simply look at Mueller s sales growth over the past few years to predict the future, mainly because the country is headed into a recession which is sure to affect Mueller s revenues. Therefore, we looked back at Mueller s sales growth during the last major recession to see how the company was affected. We mirrored our sales growth based off of these numbers, but assumed Mueller would be hit slightly harder by this recession. Also, a lot of our forecasts were based upon our previously calculated financial ratios. For example, we used the asset turnover ratio to link the income statement and balance sheet. Lastly, we forecasted the statement of cash flows, where we forecasted out cash flow from operations, cash flow from investing activities, and dividends. It is also important to note we forecasted out Mueller s restated financial statements as well since the changes we made to goodwill significantly altered Mueller s financial statements. The final subject discussed in this section is the cost of capital for Mueller. This is the return that investors expect to receive for investing in Mueller s stock. We calculated this return by running a regression of U.S. Treasury rates and S&P 500 returns over the last seven years. Using multiple periods and their treasury rates, we are able to estimate the beta, or risk for investing with Mueller specifically. With these pieces in place, we were given an estimated cost of capital for Mueller Industries of 18.28%. This rate serves as our discount rate in the following section of valuation analysis. Full discussion of financial ratios, forecasting and cost of capital is disclosed in the corresponding section. 11

12 Valuation Analysis Our method of valuation for Mueller Industries can be divided into two parts. First, the method of comparables allows us to derive a share price for Mueller based on the performance of its competitors. Ratios such as the price to earnings ratio and price to book ratio are calculated for each competitor, and by setting Mueller equal to the industry average, we can solve for the share price of each equation and thus estimate Mueller s value. This method does have significant flaws in that it prices the company solely on the performance of its competitors. This means that any competitive advantage that Mueller may have can be overlooked if it is not involved in the ratio. With this is mind, we found the method of comparables to be less useful than the intrinsic valuation models. The intrinsic valuation models hold more weight in our determination of the value of Mueller as they are based on the actual operations of the company instead of comparisons to competitors. Our forecasts played a huge part in these valuations as the share price was based on the present value of future financial estimations. Because these forecasts are based on multiple estimates, we used five different models before concluding on Mueller as being an overvalued company. Out of the five models, the discounted free cash flow model was the only one that did not give Mueller and overvalued rating. Models such as the discounted dividend model and residual income model use the cost of equity as the discount rate to turn future estimates into present value. In models that use net income as a starting point (an after tax figure), our weighted average cost of capital before tax is used as the discount rate. In turning to our valuation section, one can see that Mueller appears to be overvalued and individuals holding shares would be advised to sell them. 12

13 Company Overview Mueller Industries began back in 1917 under the name Mueller Metals. Since then, the company has been a leading manufacturer of copper, brass, aluminum, and plastic products. The company s headquarters are located in Memphis, Tennessee, but it does business throughout the United States, Canada, Mexico, Great Britain, and China (muellerindustries.com). Today, Mueller Industries employs over 4,800 people and has a market cap of 1.5 Billion dollars (yahoo finance). Mueller is a growing company as you can see by the following chart of its total asset value over the past five years. Mueller s Total Assets (In thousands) $1,055,184 $963,731 $1,116,928 $1,268,907 $1,449,204 Mueller Industries operates in two segments, plumbing and refrigeration, and original equipment manufacturers (OEM). The plumbing and refrigeration segment manufactures products for the plumbing and refrigeration industries. It makes many varieties of copper tubing for refrigeration and water tubes for plumbing. Additionally, this segment creates copper and plastic fittings used in both the residential and commercial construction markets (Mueller 10-K 2007). The OEM segment manufactures brass rod, nonferrous forgings, and impact extrusions for OEMs in the plumbing, refrigeration, fluid power, and automotive industries, as well as for other manufacturers and distributors ( To manufacture its copper products, Muller begins by obtaining its raw materials. Muller does not mine its own metals, but it does own portions of mining companies throughout the world. They also enter into futures contracts with other copper suppliers. After Muller has its copper and other metals, the manufacturing process 13

14 begins. This consists of casting, extruding, drawing, forming, joining and finishing. Through this process, the copper is transformed into finished products to meet the needs and demands of Muller s customers. Mueller Industries competes with various companies in the metal fabrication industry. Some of its competitors include Wolverine Tube Inc. (WLVT.OB), Madeco S.A. (MAD), and Alcoa Inc. (AA). Wolverine is Mueller s most direct competitor because both companies create copper, aluminum, and brass products for the housing and construction industries. While not direct competitors, Madeco and Alcoa also compete with Mueller across certain product lines. Madeco, located in Chile, manufactures and sells products created from copper, aluminum, and related metals, while Alcoa produces mainly aluminum products (Madeco and Alcoa 10-Ks 2007). While the industry is highly competitive, the sales growth among the firms is very inconsistent as shown in the graph below. All the companies show similar zigzag patterns of sales growth from 2004 to This means sales decreased, increased, and then decreased again across all firms. From this, it clear that there has been an inconsistency in the market over the past few years. There is nothing an individual company is doing to cause such fluctuations, but rather the conditions in the industry or economy are to blame. There is a large decrease in sales growth from , mainly because of the United State s declining economy. Since all the firms in this industry are very sensitive to changes in general economic conditions, including, in particular, conditions in the housing and commercial construction industry (Mueller s K 2008, Pg 11), they will all be affected by the recession. Sales will most likely continue to decline for the next few years. 14

15 Sales Growth Sales growth as percantage 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% % % Year Mueller Wolverine Alcoa Madeco Industry Business and Industry Analysis Mueller produces various pipes, tubes and accessories that are sold to wholesalers of industries with residential/commercial construction, refrigeration, heating and plumbing involvement. Like its competitors in the industry, a focus is held on cost leadership and large scale production as this is the best way to achieve stability in the market. Maintaining strong relationships with customers and suppliers is important as there are multiple choices for each to do business with. This is going to be very important now, since the United States is in a recession. Competition among firms in the industry is going to be extremely high and most everyone will see a decline is sales for the next few years. It will be harder for companies to focus on cost leadership and large scale production, especially when their costs for raw materials and such are going up as well. The industry as a whole is dependent on prices of raw materials and inputs that are used by all competitors. Further analysis of how the industry competes on these and other variables of concern are discussed below. 15

16 Five Forces Model When valuing a firm, it is important to understand the nature of the industry it competes in. The five forces model allows analysts to identify and examine five competitive forces that shape the industry. The model shows that when analyzing the degree of actual and potential competition, you need to be aware of the rivalry among existing firms, the threat of new entrants, and the threat of substitute products. It also takes into the account the bargaining power of customers and suppliers. With these five forces identified, an analyst can fully understand the competitive nature of the industry and the things that create value. The flowing table shows our analysis of the five forces impacting the metal fabrication industry, and the degree of competition produced by each one. Results of the Five Forces Model Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Customers Bargaining Power of Supplies High Low High High Medium Rivalry among Existing Firms When applying the Five Forces Model in the valuation of a corporation, one must contemplate the rivalry amongst existing firms in order to achieve a complete industry analysis. The rival among existing firms is measured by nine significant categories, these being: Industry growth, Concentration, Differentiation, Switching costs, Scale, Learning Economies, Fixed-Variable Costs, Excess Capacity, and Exit Barriers. In using these nine distinct categories we hope to express our corporation s industry as a whole, 16

17 whether that may be by the pricing of our products compared to those of our competitors, or by some other non-price related differentiation. Industry Growth The growth of an industry has a major role in determining how a corporation must function when it comes to competing with other firms. For example, existing firms entrenched in an industry booming with growth are less likely to have to strongly compete with each other in order grow themselves. The opposite of this situation being if an industry s growth is in the decline or remaining constant, then the firms within the industry will have to battle for their individual market share. The best way of measuring an industry s growth is by breaking down the total number of sales over the past five years from all the existing firms involved in the industry and comparing each firm s annual percentage change. Industry Sales Growth 25.00% Growth % 20.00% 15.00% 10.00% 5.00% 0.00% Year *Percentages computed by the revenues of: Mueller Industries, Wolverine Tube, Madeco S.A., & Alcoa. 17

18 Industry Sales (In Thousands) Sales 40,000,000 35,000,000 30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000, Year *Percentages computed by the revenues of: Mueller Industries, Wolverine Tube, Madeco S.A., & Alcoa. These graphs show that the industry is continuously growing year by year. They also show that there was a huge growth in the industry from This is due in large part to an increase in market demand. Then, from market demand drastically reduced, which would explain why growth in the industry was not as impressive as it was in past years. In this particular industry there happens to be a fairly abundant amount of privately held corporations in both America and worldwide, which makes the industry s actual growth a little more difficult to predict. Also, both Madeco S.A. and Alcoa produce extensive lines of products that go beyond what Mueller and Wolverine produce, which in turn would alter these numbers as well. However, it is still apparent that industry growth decreased from , and will continue to do so for the next few years due to the U.S. s declining economy. As mentioned earlier, since all the firms in this industry are very sensitive to changes in general economic conditions, including, in particular, conditions in the housing and commercial construction industry (Mueller s K 2008, Pg 11), they will all be affected by the recession. Even though Madeco is not located in the United States, it will still be indirectly affected by it mainly because their risk factors depend not only on the growth in South America, but the growth in the company s export markets (Madeco 18

19 Annual Report 2007). Since the United States is one of their export markets, their sales will probably decrease as well. Also, Alcoa s operations consume substantial amounts of energy, and profitability may decline if energy costs rise or if energy supplies are interrupted (Alcoa 10-k 2007). During 2007 energy costs such as oil were on the rise. This adversely affected Alcoa s sales during 2007, along with other firms in the metal fabrication industry that consume a lot of energy. Because of the very weak and volatile economic conditions the U.S. is facing, sales in the metal industry are likely to decrease over the next two or three years. Concentration The concentration and balance of firms in an industry is the determining factor which tells us which competitors have the power in the industry. The fewer competitors that exist in an industry, the higher the concentration will be and vice versa. The amount of concentration in an industry usually determines how a corporation is going to set their prices, and other business shifts, in comparison to their competitors. Wolverine stated in their most recent 10-k that in some of its product lines certain competitors have significantly larger market shares than us, and tend to be price leaders in the industry (Wolverine 10-k 2007). Since Wolverine has significantly lower market share, they are forced to set their prices based upon what the market leaders are charging for the same products. Of course, a monopoly would be the best case scenario for any corporation who wanted a high concentration, but with monopolies being regulated, companies just hope to take the biggest portion of market share they can get. 19

20 2003 Market Share 2004 Market Share 2005 Market Share Mueller Wolverine Madeco Mueller Wolverine Madeco Mueller Wolverine Madeco 2006 Market Share 2007 Market Share Mueller Wolverine Madeco Mueller Wolverine Madeco Some of the fortunate companies are able to maintain a high market share and concentration by becoming a dominant figure in their industry (i.e. Microsoft). However, most companies must deal with stringent competition, as such in the metal fabrication industry. In these competitive industries, companies must use an unspoken understanding of prices in order to avoid an extreme driving down of prices within the given industry. The graphs above show the break down of market share over the past five years in the metal industry. Alcoa was excluded because it is a much more expansive firm than the others, in that they do more than just manufacture metal/plastic fittings, tubes, rods, and bars. If it was included in the pie chart it would consume over 90% of the pie. Knowing this one can make the assumption that Alcoa is not a true direct competitor. Nevertheless, the graphs indicate that Mueller has the highest market share, followed by Madeco, then Wolverine. However, the three firms have been fighting over market share. Over the past five years, Wolverine went from having 28% market share to 24%, Madeco went from 21% to 25%, and Mueller has fluctuated right around 51%. There are not any dramatic changes, but it is still evident that competition over market share exists among firms in the industry. 20

21 Another important factor to consider in regards to concentration would be to find out if firms within the industry mine their own metals. After much research one could come to the conclusion that some firms in this industry do mine their own metals, and some of them do in fact own portions of mining companies throughout the world. Everyday worldwide Alcoa Mines 86,300 tons of bauxite, an aluminum ore (Alcoa 10-k 2007). Also, Mueller owns 49.5% of Jiangsu Mueller-Xingrong Mining Company, and 25% of Ruby Hill Mining Company (Mueller 10-k 2007). By mining their own metals and having ownership in mining companies, firms within the metal fabrication industry are able to cover their costs of buying raw materials by technically buying it from themselves. Differentiation Firms that are able to differentiate their products within the industry are better suited when it comes to combating with the competitors they are up against. For example, a firm that has a certain product that is superior to that of its competitors is going to have more leverage in the market, such as Apple s iphone in the cell phone market. Having a product, in the iphone, that stands out from the rest allows Apple to charge whatever they please for this product. Consumers are forced to purchase at Apple s price if they wish to have this product, because none of its competitors have anything like it. However, in an industry of little product differentiation, firms are regulated to compete solely on who has the lower price. This is due to the fact that consumers are not going to pay more for a product that is identical to every other product manufactured in the industry. This industry s products consist of different types of materials such as copper, brass, plastic, and aluminum. These materials are used to produce items that include tubing, non-iron forgings, impact extrusions, and brass rods. These products are used in the air-conditioning, refrigerating, and plumbing industries. One must also take into account that firms included in the measurement of this industry such as Alcoa produce a much more extensive line of products. 21

22 In the metal fabrication industry, there is going to be very little differentiation amongst the competitors. Minimal product differentiation among competitors in the U.S. wholesale product categories creates a pricing structure that enables customers to select products almost exclusively on price (Wolverine 10-k 2007). It also does not help that two of the more important factors in making products dissimilar are almost non-existent in this industry, these two factors being: technology and innovation. Switching Costs Switching costs refers to a company s ability to switch to a producing a different product or service. These are the costs subjected to the company if it were to switch to a completely different industry. When switching costs are high, companies are more inclined to continue producing the same type of product due to the high cost of changing businesses. In the case of the metal fabrication industry, research and development spending for most firms involved is almost non-existent, leading to lower levels of switching costs. However, there is a lot of money invested in machinery, equipment, and plants which are meant to build the distinctive products designed by the corporation, thus leading to higher levels of switching costs. Conversely, one could make the argument that this equipment and machinery could be used to manufacture products in another industry. This assumption, of course, would be in accordance to what the equipment/machinery are actually capable of doing. The evidence presented would have to conclude that the metal fabrication industry would typically have moderate levels of switching costs. Economies of Scale The economies of scale in the metal fabrication industry are remotely large because the entire industry does not have much product differentiation along with the fact that there is very little spending on research and development. With little product differentiation and many different competitors, the biggest firm in the industry really 22

23 has an advantage over the smallest one, in terms of capital. This is because the little guy is offering the exact same product at the exact same price as the bigger firms in the industry, leading to the assumption that one must have large numbers of capital and production in order to maximize profits. These large numbers of capital help the larger firms produce mass quantities of products compared to that of smaller firms, and the more products you can produce at an efficient rate, the cheaper the price you are able to offer. This is tremendously important in an industry in which prices play the most vital role. The following chart shows the total assets of each firm in the industry. It is obvious that Alcoa has the most capital, but once again it is because it is a much larger firm that the rest, and therefore, it is not considered a direct competitor. When looking at the other companies, Mueller and Wolverine have continued to increase their capital, while Wolverine s capital has slightly decreased. This could help explain why Wolverine s market share has decreased over the past five years and Madeco s has increased. Firm s with greater capital have a distinct advantage in a cost competitive industry. Total Assets (In Thousands) Mueller 1,055, ,731 1,116,928 1,268,907 1,449,204 Madeco 622, , , , ,066 Wolverine 553, , , , ,673 Alcoa 31,711,000 32,609,000 33,696,000 37,183,000 38,803,000 Learning Economies Similar to the economies of scale, the lack of use of the research and development in the metal fabrication industry makes the learning curve in this particular industry very minuscule. There are not many new innovations or technological advances being discovered when it comes to making rods, bars, shapes, forgings, impact extrusions, pipes, valves, tubes, faucets, and fittings from different types of metals and plastics. 23

24 Ratio of Fixed to Variable Costs Determining whether an industry usually has more fixed or variable costs is important when valuing an individual firm within that industry. In the metal fabrication industry, firms are more likely to have an equal volume of fixed costs compared to variable costs. This is mostly due in part to the fact that the firms within the metal fabrication industry usually outsource their finished products to other companies such as the auto, refrigeration, and plumbing industries. Along with the outsourcing of finished products, much of the firms in the metal fabrication industry also categorize their ownership of giant factories, mills, buildings, machinery and equipment as fixed costs. The variable costs that exist in this industry are very prevalent as well. For example, escalating production costs and cooling commodity prices are dragging down once-mighty mining and metal companies (Wall Street Journal). In order for firms to manufacture their product, they must first purchase the metals needed from their suppliers. Firms must first pay the market price for metals such as copper and brass in order to manufacture their products. This would be considered a variable cost to the company because these prices are never the same from year to year, and sometimes even vary from day to day. Although one must take in to account that even though these metals are variable costs to a firm, every other firm within the same industry must pay the exact same price as other. This importance of each firm having to pay the same price for these materials is; if high raw material costs were to occur for one firm, the same outcome would arise for the other industry firms as well, thus creating no particular advantage for any firm in terms of these costs. Another important factor to take into account in regards to an industry s fixed to variable costs ratio, would be research and development costs. Research and development usually plays a vital role in the costs a firm incurs, but as aforementioned in previous sections, R&D is limited in the metal fabrication industry. 24

25 Excess Capacity Excess capacity is defined in our book as: If consumer demand is lower than the capacity of the industry, then the firms within that particular industry will have to most likely lower their prices in order to restore capacity. (Palepu & Healy P. 2-3) The opposite of this situation being if the consumers demand is greater than supply, then the competitors are not going to have to compete with each other when it comes to prices. In this industry however, consumer demand is not very high as of late, this is fact is stated in Mueller s 10-K, The majority of the Company s manufacturing facilities operated at moderate levels during 2005 and the first half of In the latter half of 2006, and in 2007, the Company s manufacturing facilities operated at low levels due to reduced market demand. (Mueller Industries 10-K Filed February 26 th, 2008, Pg. 4, Pg 6 on Adobe Reader). Wolverine also stated in its 10-k that because of the excess capacity in the copper tube manufacturing markets, they have had little success in selling their used equipment. Sales / Total Property, Plant & Equipment Mueller Madeco Wolverine Alcoa These numbers in the diagram above state each firm in the industry s total revenue divided by their total property, plant, and equipment. This is important because it shows how well a firm is able to convert assets into revenue. Most of the firms which deal directly with only the metal fabrication industry seem to have extremely successful efficiency in their management of excess capacity. 25

26 Exit Barriers Similar to switching costs, a company s barriers to exit depend on the on the number of specialized fixed assets they have. The greater number of specialized assets that exist in a given industry will in turn make the barriers of exit greater as well. This is because with specialized assets companies become limited to that certain industry, thus forcing them to stay in the industry they re in and continue to battle it out with their existing competitors. As mentioned earlier, Wolverine had trouble selling its used equipment because of excess capacity in the industry, but it was also because the equipment was very specialized. Many times the equipment we have tried to sell, while productive and essential to the operations for which they were originally purchased, has been modified or built for specialized processes and products (Wolverine 10-k 2007). Other companies in the industry are likely to have similar specialized machinery. In the metal fabrication industry, since machinery is highly specialized, it leads us to the conclusion that the industry has medium to high exit barriers. Conclusion In the Five Forces Model all five sections play a significant role in the defining of an industry. The Rivalry of Existing Firms may be only one of these sections but has to be the one of the more noteworthy. In this section we drew conclusions about the entire industry, some of its competitors, and how they all factor into the 9 distinct categories: industry growth, concentration, differentiation, switching-costs, economies of scale, learning economies, ratio of fixed vs. variable costs, excess capacity, and exit barriers. In the industry growth section we learned that growth in the industry is based greatly upon market demand. The concentration section taught us that this industry deals with low levels of concentration, in that most of the firms are roughly the same size with the exception of Alcoa. We also learned that firms within the metal fabrication industry deal with high levels of differentiation, moderate levels of switching-costs and 26

27 exit barriers, and low levels of economies of scale and learning economies. Through all this information we can conclude that the metal fabrication industry is highly competitive when it comes to the Rivalry of Existing Firms. Threat of New Entrants Aside from dealing with the competition and rivalry that exists between current firms in the market, a company must also be weary of potential new competitors entering into the market. In an industry of low concentration, like metal fabrication, a firm cannot afford to lose what market share it already has. With the earning of abnormal profits being low in this industry, the threat of new entrants is low as well. If the industry were less established and not as stable, the potential for profit would be much higher resulting in a higher threat of new companies entering the industry. The various aspects that will better determine the risk of new firms are discussed below. Economies of Scale Success in the metal fabrication industry can be achieved through a few means. The first being the ability to produce and move large amounts of product in the most cost-efficient manner. This involves being able to take advantage of the benefits of producing in large volume. In a highly competitive market, profits come by selling mass quantities at the competitive price that is set by the market as a whole. Companies unable to produce at the large scale will be forced to take a cut on profit due to their lack of quantity produced, thus forcing them to surrender market share to those companies who can produce at a large level. This implies that in order for a new company to be successful in this industry, they must be able to attain the capital and resources that will be large enough to meet this high quantity standard. The difficulty in doing so is one of the reasons the threat of new entrants is relatively low. A simple chart showing each firm s assets will illustrate the scale necessary to be successful in this industry. 27

28 Total Assets (In thousands of dollars) Mueller 1,055, ,731 1,116,928 1,268,907 1,449,204 Madeco 622, , , , ,066 Wolverine 553, , , , ,673 Alcoa 31,711,000 32,609,000 33,696,000 37,183,000 38,803,000 *All data obtained from 10-K of each company The magnitude of the numbers above proves quite a hurdle that any incoming company would have to clear. The magnitude of the business activities necessary to account for such assets is immense. It would be very difficult for a competitor to step in and obtain enough resources to be able to compete against these already established companies. The large scale of assets needed is only one of the difficulties new entrants will face in the metal fabrication industry. First Mover Advantages A second aspect involving threat of new companies has to do with the benefits gained by the early pioneers of the industry. In a setting where low production costs can be the difference between life and death, one can understand how being among the first companies of the industry will benefit from building the best relationships in each of the businesses activities. This leaves each company in succession less and less of a chance to find cost efficient alternatives that their other competitors have not already taken advantage of. Among these problems is the difficulty a newcomer might face in acquiring the copper, brass and other raw materials necessary to compete. These inputs are by no means infinite, and thus they can at times become scarce. A company s ability to lock down purchase agreements can prove challenging and the 28

29 room left for new entrants is slim. Take industry giant Alcoa for instance, who has already secured $9,067 billion dollars in raw material and service agreements for the next five years alone (Alcoa Annual Report 2007). This further highlights the troubles faced by prospective companies and why the first mover advantage is so crucial in this industry. Access to Channels of Distribution and Relationships With the industrial sector making goods that are relatively widely used, multiple channels of distribution is one thing that can be beneficial to new entrants. A lot of the goods here are generic and companies that use these products may be indifferent between which company supplies them. This puts further stress on the importance of relationships between a company in the metal fabrication industry and those they distribute to. Most of the companies in this industry supply to wholesalers who in turn sell to the company making the refrigerator, air conditioner, etc. Since these customers will go with the company selling at the lowest price, every step in the distribution process is crucial. Mueller notes that, a growing portion of our products are acquired from suppliers in lower cost regions and this effort early in the process keeps costs low which allows the company to sell to its customers without passing on the extra costs incurred in the distribution process (Mueller 10-K 2007). Maintaining positive and open relationships are vital to firms of this industry as the threat of substitution and losing market share is one that is very threatening. Legal Barriers The list of legal issues facing companies in the metal fabrication industry is not long, but that does not mean these companies don t face legal challenges. Perhaps the greatest legal issue in this industry is the environmental standard enforced by the government and its agencies. With the growing concern of humanity s effect on the planet, these standards are only going to get higher and the costs continue to fall on 29

30 the companies. Wolverine notes that their operating facilities are, subject to extreme environmental laws and regulations [and they are] currently involved in various proceedings relating to environmental matters. They continue to disclose that they are not involved in any other legal proceedings which suggests that environmental standards account for most of the legal barriers faced in this industry (Wolverine 10-K 2007). While this may be one of the only legal concerns facing a company, it is one that companies must meet in order to make their product. Each company has discussed various monitoring costs that are necessary to comply with the environmental standards they face. As one can expect, these costs will be incorporated into the price of their product, and is one more cost that new entrants will have to deal with in their effort to compete in a low cost industry. Conclusion Overall, the threat of new entrants is low in this industry. For the firms already in existence, this serves as motivation to push their limits and to be cautious of complacency. Due to the large scale of production and the advantages of already being established, it is not likely that a new company can intrude on a company s current success without suffering serious difficulty. The advantage of moving first is seen in customer relationships and agreements and has already been captured by the established firms. Environmental monitoring to meet legal standards is one more cost that new companies will have to deal with in their effort to keep costs as low as possible. All of these issues would prove challenging for any newcomer trying to compete. Should a new company enter and bring its production to the par of the industry, existing companies would want to ensure that their current practices are at maximum capacity; however the likelihood of this occurrence is slim. 30

31 Threat of Substitute Products The third measure of competition in the industry is the threat of substitute products. Substitute products have a major impact on the metal industry. While no two firms have the exact same product lines, many of their products do overlap. These products, such as copper tubes, steel pipes, copper fittings, and valves are all standardized products. They are created to standard specifications to serve mainly the housing and commercial construction industries ( Thus, these highly standardized products are easily substituted for one another, causing the firms to compete primarily on price. Relative Price and Performance In the metal fabrication industry, prices for the same products are extremely similar. This is because standards established by customers and governmental bodies extremely limit the industries ability to differentiate their products. A particular product will have to abide by a certain size, measurement, and function ( Thus, companies are creating almost identical products. This leads to high price competition across all product lines. The prices of the products are based upon the prices and availability of the raw materials used to manufacture them, like copper for example. All the firms in the industry who use copper to make a particular product will experience its price fluctuations. So, no firm will have a definite advantage over another firm when purchasing raw materials. However, a firm that can create an identical product by using a material that does not suffer from price fluctuations will have a distinct advantage. Certain products such as plumbing tube are competing with products made of alternative materials, such as polybutylene plastic (Wolverine 10-k 2007). Alcoa, who mainly produces aluminum products, also competes with products made out of glass. Products made of plastic and glass are becoming substitutes for products originally made of copper and other metals. While Mueller Industries manufactures both metal 31

32 and plastic products, most other firms in the industry need to be aware of the threat these substitute products pose. Buyer s Willingness to Switch Customers for metal fabrication products are primarily the housing and commercial construction type industries. These businesses demand particular products at competitive prices. They are very sensitive to price and product availability because these factors have a major influence on their financial performance (Mueller 10-K 2007). Because competitors in the industry provide the same products, customers willingness to switch is fairly high. Customer s have the ability to shop around for the products they need, so other factors such as customer service and product availability tend to influence who they do business with. Another important factor relating to buyer s willingness to switch is the existence of substitute products that are composed of different materials, such as polybutylene plastic. These materials can be used to create some of the same products sold in the industry. Many of the buyer s are willing to switch to these products because they can be created to the same design features as copper and other materials and they perform the same function at a lower price. As the price of copper and other metals rise, copper products will become less attractive and people will be willing to buy products made of plastic instead. The use of substitute products can have major negative effects on all businesses in the metal fabrication industry. Madeco s brass mills unit suffered and 91% drop in earnings due partly to the strong presence of substitute products (Madeco Annual Report 07). Conclusion Since firms in this industry tend to create similar, if not identical, products, it forces them to compete by creating perceived value through customer service, product availability, and price (Mueller 10-K 07). These are the only ways for firms in this 32