The cupboard is bare.

Richards, Curtis A. ; Byrd, John T. ; Collins, David 等

MHC CABINET COMPANY

MHC Cabinet Company was founded in 1990 by Michael Carlisle. Michael had spent 20 years designing and building products for a national company that supplied "stock" kitchen cabinets to the big- box DYI stores. Michael tired of the restraints imposed on him and desired to design and build high-end and custom cabinets for discriminating customers.

MHC had two primary product lines. The first, which provided less than one-third of company sales, were truly custom-built cabinets for a variety of residential and commercial installations (kitchens, closets, offices, sales displays, etc.). Although not a large part of total sales, MHC's marketing efforts focused on this business segment since it was the most visible to potential customers and the most profitable for the company.

The second product line provided high-end builders with several choices of "custom" cabinets that can be offered to customers as upgrades in their homes. Because of Michael's design expertise, this product line competed well with similar offerings from other cabinet companies; including the national suppliers. With growth coming mostly from this area, MHC had grown to a mid-size company with annual sales above $4 million. By the middle of 2002, Michael was confident that the relationships he had developed with area builders would push sales over $5 million within two years.

Late in 2002 disaster struck; at least for Michael. He was involved in an automobile accident that prevented him from continuing in the business he had started and nurtured to success. To properly address his personal health issues, Michael needed to sell MHC Cabinet and he needed to sell it quickly. That is when Michael's lawyer introduced him to Jim JT Thomas.

JT was a successful entrepreneur who had started and sold several successful businesses and was currently looking for his next investment opportunity. JT specialized in taking equity positions in companies that had achieved a good level of success but needed his financial expertise to take them to the next level. Once there, JT's exit strategy was to sell his stake, either to the original owner or, if that owner also wanted an exit, to sell the company to a larger firm.

JT met with Michael and carefully reviewed the operating and financial history of MHC Cabinets. He was very impressed with the work that Michael had done and with the competitive position that MHC Cabinet was in. Had Michael been able to stay with the company (and remained in charge of operations) this would have been a no-brainer for JT. It was exactly the type of investment opportunity that he reveled in and one that he could have brought to a profitable exit within three to five years.

But, Michael could not remain with the company. This meant that JT would need to meet the company's operational needs, in addition to its financial needs--his more familiar territory. Still, his analysis had shown him (and Michael had assured him) that current customer orders would carry the company's operations through at least the next two years. This would give JT time to find someone with the necessary operating expertise to help him out.

CHIP'S INVOLVEMENT WITH MHC

Chip was a seasoned business entrepreneur who had created a very profitable custom cabinet company and had recently sold it to one of the national companies for enough money to retire. But at 46, he decided it was too early to retire, and his entrepreneurial instincts led him to look for new investment opportunities. It was about this time he met JT Thomas, who had recently purchased MH Cabinet Company and who was looking for a business partner.

Chip met JT on the golf course via a mutual friend. Chip liked that JT also was a successful business entrepreneur who had owned and sold several businesses and they enjoyed discussing business opportunities with each other. During those discussions it was natural for JT to discuss his situation at MHC. Because of his own operational background, the possibility of joining JT at MHC Cabinet intrigued Chip.

Chip asked if he might visit MHC and JT agreed. During that initial visit JT asked Chip if he would review MHC's operations and provide an analysis of the company's needs. Chip agreed to do so and JT promised an appropriate consulting fee. Chip was excited about returning to the operating floor of a successful woodworking plant; he could almost smell the wood chips as he thought about this consulting gig.

Chip spent about four weeks working with the plant manager and was able to make a number of recommendations for tracking job production and customer installations. Chip felt at home in the business, liked the people he met, and was interested in continuing with MHC in some capacity. For his part, JT was impressed by Chip's knowledge of manufacturing operations and his ability to get along with the employees and engage them in the improvement process.

Both men recognized that Chip's operational experience blended well with JT's financial expertise. Desiring to continue their business relationship they began to seriously discuss an equity opportunity for Chip. It seemed like a good match and Chip was excited to take a closer look at the company's financial condition. Although Chip's personal area of experience was operational, he understood financial statements. After all, he had experience managing and selling a successful company. He also had an MBA from a respected private university.

Chip reviewed the financials for the previous two years; the years that JT owned the company:

He was quite impressed by MHC's apparent financial condition and prospects for the future. One concern was that the financial results for the first two months of the current year were not available. JT assured him that MHC regularly prepared quarterly results and that they would be ready for review at the end of the 1st quarter. This seemed reasonable to Chip. He knew that smaller businesses did not complete financials as timely as larger companies did and that the early months of the first quarter were especially difficult as most small businesses were still trying to close the previous year.

A second concern was that JT did not want Chip talking to any of MHC's customers before his equity investment was complete. JT explained that, since he had purchased the company only two year prior, he did not want to alarm existing customers with another change in ownership and management until the deal was done. Chip, a stickler for due diligence, recognized that not contacting current customers was a problem. Still, this was not an unusual request for small business owners and one that he himself had made in his prior businesses.

Pushing his feelings of caution aside and feeling quite sure of himself--and his "investor savvy"--Chip purchased a 50% equity interest in MHC and JT enthusiastically welcomed Chip into the business.

CHIP'S INVESTMENT IN MHC SOURS

Using standard discounted cash flow analysis Chip had determined that the market value of MHC's equity was approximately $2.4 million at the end of 2004. This was only marginally higher than MHC's $2.3 million book value, but Chip had expected that. JT's very recent purchase of the company certainly suggested that reported book value would be very close to estimated market value. However, to reduce his downside risk, Chip negotiated a 50% equity interest for only $1 million. While Chip was pleased with himself for being such a skilled negotiator, but events would very quickly turn the taste of pleasure sour.

By the end of March, 2005, Chip had settled in at the factory. JT had retained the CEO title, but Chip had taken on the role of COO and the factory was all his. JT was looking to Chip's operational expertise to keep the factory running well. Chip was very comfortable in that role and left running the rest of the company to JT.

Based on Chip's earlier analysis--and JT's continued assurances--that sales growth was expected, Chip began to modernize the plant and increase productive capacity. This increased fixed operating expenses, but both Chip and JT agreed that it was a necessary step to prepare for the expected sales growth. But while, over the next six months, sales did remain good (in the $5 million per year range) they did not grow to the levels necessary to support the larger plant and its higher operating expenses.

To make matter worse, during the same six months, Chip discovered that MHC's cash flows were slower than he had expected and that JT was beginning to have difficulty meeting the company's financial needs. This caught Chip by surprise and by the end of his first six months with the company, the lack of expected sales growth and the cash flow difficulties soured Chip on his investment and he sold is equity back to JT for $500,000--a 50% loss to Chip.

Now, he is searching for what made him blind to the fact that "the cupboard was bare." What did he miss during his initial evaluation of the company? Chip decided to hire an accountant to help him determine--even without the information he did not have access to--what he missed that would have influenced his decision to invest in MHC.

REFERENCES

Beyer, J.M. Chattopadkyay, E. George, Glick, W.H., Ogilive, D.T., and Pugliese, D., The Selective Perception of Managers Revisited, Academy of Management Journal, June, 1997, pp. 716-37.

Eden, D. Leadership and Expectations: Pygmalion Effects and Other Self-Fulfilling Prophecies, Leadership Quarterly, Winter, 1992, pp. 271-305.

McYatt, D.B. and Judge, T.A., Boundary Conditions of the Galatea Effect: A Field Experiment and Constructive Replication, Academy of Management Journal, August, 2004, pp. 550-65.

Walsh, J. Selectivity and Selective Perception: An Investigation of Managers' Belief Structures and Information Processing, Academy of Management Journal, December, 1988, pp. 873-96.

Waller, M.J., Huber, G., and Glick, W.H., Functional Background as a Determinant of Executives' Selective Perception, Academy of Management Journal, August, 1995, pp. 943-74.

STUDY QUESTIONS

1. During Chip's initial review of MHC's operations he performed what he considered necessary financial analysis and sufficient due diligence. First, he selected industry data to compare MHC's financial results (Exhibit 2). Chip reasoned that if MHC could compare favorably to the industry, then it likely was a sound investment.

2. Based on the industry data in Exhibit 2, develop similar values for MHC Cabinet Company using the financial data in Exhibit 1. (Because he only had two years of data to work with, except for the percent change in sales, Chip used the two year average for the other data measures.)

3. Based on this analysis, why did Chip consider MHC to be a good investment?

4. Based on this analysis, would you consider MHC to be a good investment?

5. During his post-mortem review of what went wrong, Chip wondered what other red flags he had missed. Since his initial review mostly took an Income Statement approach--concentrating on operating results, which had convinced him that MHC was enjoying strong success--Chip's accountant convinced him to turn to the Balance Sheet for his answers. Hindsight reminded Chip that good operating results might not be sufficient if a firm is built on a shaky foundation.

6. Based on the industry data in Exhibit 3, develop similar values for MHC Cabinet Company using the financial data in Exhibit 1. (Because he only had two years of data to work with, Chip used the two year average for the data measures.)

7. What impact might this analysis have had on Chip's original investment decision?

8. What did Chip learn from this experience?

Curtis A. Richards, Bellarmine University

John T. Byrd, Bellarmine University

David Collins, Bellarmine University

Exhibit 1: MHC Cabinet Company Financial Statements

Balance Sheet (in 000s)                    2003   2004

Cash                                        314    182
Accounts Receivable                         423    831
Inventory                                   767   1178
Prepaid Expenses                            77     10
Current Assets                             1581   2201
Property, Plant, Equipment                 5411   5411
Accumulated Depreciation                    225    450
Net PPE                                    5186   4961
Total Assets                               6767   7162
Accounts Payable                            61     34
Short-Term Loans Payable                    211    255
Current Liabilities                         272    289
Long-Term Debt                             4581   4544
Total Liabilities                          4853   4833
Stockholders' Equity                       1914   2329
Total Liabilities 7 Stockholders' Equity   6767   7162

Income Statement (in 000s)                 2003   2004

Sales                                      4350   5110
Cost of Goods Sold                         2569   2614
Gross Profit                               1781   2496
Operating Expenses                         1401   1629
Operating Profit                            380    867
Income Taxes                                76     260
Net Income                                  304    607

Exhibit 2: Selected Industry Values for 2004

Percent Change in Sales (2003 vs. 2004)    8%
Working Capital (% of Total Assets)        7%
Cost of Goods Sold (% of Sales)            72%
Operating Expenses (% of Sales)            20%
Gross Profit (% of Sales)                  28%
Operating Profit (% of Sales)              8%
Net Income (% of Sales)                    5%
Debt to Asset Ratio                        30%
Return on Assets                           9%
Return on Equity                           11%

Exhibit 3: Selected Industry Values for 2004

Cash (% of Total Assets)                    10%
Accounts Receivable (% of Total Assets)     15%
Inventory (% of Total Assets)               8%
Accounts Payable (% of Total Assets)        18%
Current Ratio                              1.50
# of Days in Accounts Receivable            40
# of Days in Inventory                      28
# of Days in Accounts Payable               48
# of Days in Cash Cycle                     20