financial case question

UVA-F-1527 Rev. Jan. 28, 2016

This case was prepared by Associate Professor Marc Lipson. It was written as a basis for class discussion rather than

to illustrate effective or ineffective handling of an administrative situation. Copyright  2007 by the University of

Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to

[email protected]. No part of this publication may be reproduced, stored in a retrieval system,

used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,

recording, or otherwise—without the permission of the Darden School Foundation.

ALLIANCE CONCRETE

Alliance Concrete was a small ready-mix concrete producer in Michigan’s northern lower

peninsula. The company operated 14 mixing plants and owned a fleet of 240 mixing trucks. Its

customers were predominantly in the residential and commercial construction industry with

some additional sales related to road construction and repair. The company had been extremely

successful, with substantial revenue and income growth over the last few years driven by a

strong residential real estate market. Although Alliance was purchased a year earlier by National

Industrial Supplies, a Canadian construction conglomerate with assets in both the United States

and Canada, it continued to operate as a separate legal entity.

In late January 2006, Alliance CFO Martin Harris was putting together forecasts of the

firm’s operations for the coming year. Harris had been recently promoted to this position after

the departure of some of Alliance’s senior management when the acquisition was completed. In

addition to facing a relatively new task, Harris was understandably nervous for two reasons.

First, National’s head office had made it abundantly clear that the accuracy of financial

projections was a significant concern. In anticipation of an upcoming equity issue, National’s

current investors and numerous analysts were asking for guidance on National’s expected future

performance, and National was reluctant to provide such guidance unless it was quite sure of the

numbers. Second, early the next week, Harris would have his first meeting with Alliance’s bank

to discuss progress on reducing the company’s debt.1 While Harris was confident about

Alliance’s prospects and believed the principal repayment would be easily accommodated, it

would be his first meeting with the bank as CFO.

As Harris began to put the final touches on his projections, what had been a slight case of

nerves became something more akin to fear. Not only did he realize the full extent to which

Alliance’s operations might reasonably deviate from his projections, but it turned out that the

company was stuck between a rock and a hard place. Despite Alliance’s recent success and clear

signs of continued growth, necessary capital improvements would make it impossible for the

1 Previous owners of Alliance Concrete had borrowed an additional $20 million in 2003 to buy out one of the

firm’s original founders and had agreed to pay down principal of $4 million a year for each of the next five years.

This would return the company to a debt level below Alliance’s original $60 million borrowing limit.

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company to both meet its obligations to the bank and make an expected dividend payment to

National. Someone was bound to be disappointed.

Ready-Mix Industry

Concrete was a manufactured material in which a hardened paste held stone together. The

paste resulted from the chemical reaction between cement and water. In general, the stone and

cement were combined and then mixed with water to initiate the reaction. Concrete was mixed in

small batches at a job site. For large jobs such as foundations, driveways, or road beds, however,

mixing in small batches was neither feasible nor economical. A ready-mix operation mixed

concrete at its plant and transported the premixed and ready-to-use concrete to a job site. At the

site, the concrete was transferred to waiting forms where it started to harden. Ready mix was

typically ordered by the cubic yard.

At a ready-mix plant, dry ingredients were transferred, usually by conveyor belt, to a

central mixing drum. In addition to the cement and stone (called aggregate, and consisting of

sand, gravel, and/or coarse crushed stone), various admixtures were included that altered the

plasticity, strength, and time to set (initial hardening) of the concrete. Water was added to the

drum as it rotated to thoroughly mix the ingredients. When finished, the drum was tipped up and

the contents poured into trucks. The trucks, a common sight wherever building was going on,

kept the ready mix in motion until it was ready to be poured because concrete would harden as

soon as it was still. Each batch of ready mix could have unique properties that were determined

by the relative proportion of dry ingredients as well as the selection of admixtures and the

amount of water used in the mixture.

The chemical reaction between cement and water, which brought about the hardening of

concrete, was complicated and highly variable. This process, called hydration, included an initial

setting up and hardening phase, but also continued over time (even years) as moisture induced

further chemical changes and continued strengthening. In fact, concrete did not have to dry out to

harden—just the opposite. Because water was needed for hydration, concrete was often kept wet

for a few days while the most critical phases of the process were completed. Certain admixtures

could hasten this process, which could be desirable under conditions such as extreme cold.

Cement was created by baking limestone and clay together at high temperatures in a

rotating kiln. This baking created marble-sized chunks, called “clinker,” which were then ground

into a fine powder. The cost of concrete was a function of both the raw materials and the cost of

heating the kilns. Of course, cement was only about 20% to 30% of the volume of concrete, with

the rest being relatively cheap aggregate.

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Recent Trends

The most notable trend in the ready-mix market was the increase in cement costs. Cement

was a commodity used across the world and its use was closely tied to economic activity,

particularly construction of buildings and roads. The tremendous growth of China’s

infrastructure had added significantly to worldwide demand. In addition, rising energy prices had

increased the cost of manufacturing cement. Ocean shipping costs, rail disruptions, and port

congestion had caused widespread shortages even though there were numerous international

sources. Furthermore, domestic U.S. cement production had remained unchanged. In the face of

6% per year increases in consumption, the United States had become increasingly reliant upon

imports. Not surprisingly, the share of cement from imports rose from 22.7% at the end of 2004

to just over 25% by the end of 2005.

The net result of increased demand and increased costs was a remarkable and seemingly

relentless increase in cement prices. The U.S. Labor Department Producer Price Index showed

the costs of cement were 11% higher in April 2005 than a year earlier. In addition to its effect on

cement prices, increased energy costs also directly affected the ready-mix industry. One major

cost was the diesel fuel used to both mix ingredients and then to transport the ready mix to end-

users. Fortunately, there had been only modest increases in the cost of securing and cleaning

aggregate.

Alliance Concrete Operations

A central concern for Alliance and other firms in the ready-mix industry was how much

of the cement- and fuel-cost price increases could be passed along to customers without

materially affecting demand. While there were few, if any, alternatives to the use of concrete,

demand was still price sensitive, since many customers could delay or eliminate projects. For

example, demand for road projects was very sensitive to costs, since transportation divisions

operated with fixed budgets. As costs rose, those divisions simply scaled back their construction

plans.

Exhibit 1 presents the recent income statements and supporting schedules for Alliance

Concrete. Exhibit 2 presents the recent balance sheets along with critical financial ratios. In

preparation for his forecast, Harris had sought out the opinions of other top managers. Their

observations are summarized below.

 The sales manager expected unit sales to increase to 2.2 million cubic yards. This modest unit growth reflected a slight softening of the residential real estate market. But she

believed prices could be raised by 7% without a noticeable demand impact, although any

increase in prices above that would place Alliance at a competitive disadvantage relative

to the two other ready-mix companies in the area. She was quick to note that her

projection was just the most likely scenario. Realized revenues might differ substantially.

There was already concern that the real estate slowdown might become more pronounced

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due to rising interest rates. If there was such a slowdown, unit sales would remain

unchanged and Alliance (and its competitors) would be lucky to raise prices by 4%.

 The operations manager agreed with most forecasters and expected cement costs to rise by about 13% over the coming year. This would lead to a 9% increase in the average cost

per yard for Alliance’s operations. But cement prices were quite volatile and realized

prices could vary greatly from the forecast. On top of that, Alliance purchased much of

its cement internationally so exchange rate changes would also affect realized costs.

Given the high degree of uncertainty, the operations manager was submitting a budget

reflecting a 10% increase in his cost per yard. This would give him plenty of room to

handle unexpected price increases and still stay within budget.

 Alliance’s plant manager had been insisting for some time that Alliance needed to upgrade the motors and drive systems for some of its central mixing drums. He pointed

out that delays due to mixing stoppages had increased steadily, and he was worried that

this could prove to be a concern for customers. The customers were very sensitive to

delivery times, since they typically had large crews available to position the ready mix.

He also reminded Harris that in 2004 the sudden collapse of a mixing drum in the

company’s large Traverse City plant necessitated unexpected costs of $2.6 million and a

two-week shutdown.2 For this reason, he was planning capital expenditures of $16

million for the next year, well above expected depreciation of about $7.5 million.3

Unplanned repairs were certainly more disruptive and costly than those scheduled in

advance. “We might be able to postpone up to $4 million of these expenditures to the

start of next year. But it’s even odds we will have a major breakdown before that time

and have to do that same work at twice the cost.”

Incorporating these observations into his forecast would be relatively easy. For other accounts

Harris faced some complicated choices. Though it would be easiest for Harris to base much of

his forecast on recent Alliance performance, Alliance ratios were hardly stable from year to year.

Furthermore, Harris noted obvious trends in some accounts that he was reluctant to see

continued. For example, there was a lengthening in days receivable that was alarming given that

relationships with customers had always been excellent. An improvement in collections could

possibly improve the firm’s financial position.

Alliance Concrete Financing

Harris spent considerable time exploring previous correspondence with Alliance’s bank.

Borrowing limits in this industry were typically expressed as multiples of EBITDA. The bank

had stated a number of times that it was unwilling to lend more than three times the prior year’s

EBITDA. It was clear that it had agreed to the additional lending only after protracted

2 This unanticipated outflow was included in general and administrative expenses for reporting purposes. 3 The $7.5 million expected depreciation assumes depreciation of $1.15 million from the additional $16 million

planned capital expenditure. While any deviation from this planned expenditure would impact depreciation, the

effect would be quite small and, to simplify the planning process, Harris chose to ignore this link.

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negotiations and Alliance’s agreement to repay the additional borrowings as scheduled.

Furthermore, the renegotiated loan covenants stipulated that the firm could not make major

capital expenditures without written approval. He realized that the planned capital expenditures

would certainly need approval along with any change in the scheduled repayment. Most

troubling of all, he knew the bank would ask about the effects of the recent real estate slowdown

and how that might affect Alliance. Currently, Alliance was paying 8.5% on its bank loan.

The equity structure of Alliance had been simplified by its sale to National. Rather than a

small group of owners, there was just one owner to work with. National was clearly enthusiastic

about Alliance. In just about every integration meeting after the acquisition, National

representatives observed that Alliance would be a financial benefit to National’s portfolio of

holdings. In fact, not long after integration was completed, a memo was received from National

instructing Alliance to increase its dividend payment to $3 million starting in 2006. At that time,

this seemed like a reasonable request. Harris was no longer so certain.

With his analysis finally completed and a variety of projections scattered across his desk,

Harris leaned back in his chair and began to think about exactly what he was going to say to the

bank, to National, and to the rest of Alliance management. It was clear Alliance was going to

have to ask somebody, maybe even everybody, for something. It was not news that he was

looking forward to sharing.

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Exhibit 1

ALLIANCE CONCRETE

Income Statements

2002 2003 2004 2005

Income Statement (dollars in thousands) Revenue $128,978 $143,560 $161,863 $185,815

Cost of goods sold1 100,857 111,203 125,756 144,594

Gross margin 28,121 32,357 36,107 41,221

General and administrative 12,482 13,685 18,131 17,327

Earnings before interest and taxes 15,639 18,672 17,976 23,894

Interest 4,537 6,150 5,964 5,695

11,102 12,522 12,012 18,199

Tax 3,882 4,288 4,312 6,210

Net Income $7,220 $8,234 $7,700 $11,989

Additional Data

Yards sold (in thousands) 1,751 1,850 1,957 2,085

Average price per yard (in dollars) 73.66 77.60 82.71 89.12

Average cost per yard (in dollars) 57.60 60.11 64.26 69.35

Depreciation (dollars in thousands) 5,436 5,762 5,983 6,439

Source: Created by case writer.

1 Depreciation expense is included in cost of goods sold.

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Exhibit 2

ALLIANCE CONCRETE

Balance Sheets

2002 2003 2004 2005 Balance Sheet (dollars in thousands) Cash $2,837 $3,330 $3,043 $4,180

Accounts receivable 18,092 19,823 23,104 28,203

Inventory 3,549 4,238 4,233 4,615

Current assets 24,478 27,391 30,380 36,998

Plant and equipment 87,534 91,392 93,569 97,476

112,012 118,783 123,949 134,474

Accounts payable 8,891 9,609 11,067 13,534

Other accrued expenses 5,313 5,713 6,490 7,897

Current liabilities 14,204 15,322 17,557 21,431

Long-term debt 55,000 75,000 71,000 67,000

Owners’ equity 42,808 28,461 35,392 46,043

$112,012 $118,783 $123,949 $134,474

Financial Statement Relations Margins and returns

Gross margin 21.80% 22.54% 22.31% 22.18%

Net margin 5.60% 5.74% 4.76% 6.45%

Return on book assets 6.45% 6.93% 6.21% 8.92%

Return on book equity 16.87% 28.93% 21.76% 26.04%

Asset ratios

Days receivable 51.20 50.40 52.10 55.40

Days inventory 12.84 13.91 12.29 11.65

Days payables 32.18 31.54 32.12 34.16

Total asset turnover 1.15 1.21 1.31 1.38

Fixed asset turnover 1.47 1.57 1.73 1.91

Leverage ratios

Debt to prior year EBITDA 2.98 3.56 2.91 2.80

Debt to total value (book) 49.10% 63.14% 57.28% 49.82%

Interest coverage 3.45 3.04 3.01 4.20

Source: Created by case writer.

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