The Gemini Electronics case study

W11710

GEMINI ELECTRONICS

Dan Thompson wrote this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to protect confidentiality.

Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail [email protected].

Copyright © 2016, Richard Ivey School of Business Foundation Version: 2016-03-15

Sarah McIvor, CA, a junior partner with Price Waterhouse Coopers, had been selected to conduct a financial review of Gemini Electronics Ltd. Gemini was an up-start American electronics company that recently went public and now wanted to expand its business in order to rival major Korean and Japanese producers. Before the company finalized any expansion plans, Dr. Frank Wang, the founder, felt it was prudent to conduct an independent evaluation of Gemini’s financial condition.

Having managed a number of audits of leading companies in the industry, McIvor’s knowledge of consumer electronics was extensive. If the report was well-received by Gemini, this would mean a lot of additional auditing and consulting business for her firm and a promotion to senior partner. She decided to clear her desk of all other files and to focus on the Gemini account for the next two weeks.

COMPANY FORMATION

Gemini Electronics was a U.S.-based manufacturer of televisions (TVs). The company was founded in 2002 by Frank Wang, a second-generation American of Chinese descent. As part of his PhD studies in electrical engineering at the California Institute of Technology (CIT) in the early 1990s, Wang participated in a number of basic research projects relating to the development of liquid crystal displays (LCD). Despite being only a doctoral student, he made a number of significant contributions to these projects and came in contact with venture capitalists who were working with CIT to commercialize this important work. Coming from a family of entrepreneurs, Wang became very interested in the business side of research and development (R&D). His plan after graduation was not to pursue a career in teaching and research as most of his colleagues wanted to do but to build a major electronics firm to rival the likes of Samsung, Sony and LG. Not only would he bring honour and wealth to himself and his extended family, but he felt strongly that such an enterprise would allow the United States to re-establish itself as a major manufacturer of consumer electronic products. Since the 1980s the United States continued to make major contributions in the area of basic research, but most of the design and manufacturing was done by firms in countries such as Japan, Korea and Taiwan. Wang’s goal was to reverse this trend. ㈮洀Realizing that he needed to acquire practical design and production experience, in 1995 Wang made

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Realizing that he needed to acquire practical design and production experience, in 1995 Wang made the decision to return to his father’s home country of Taiwan and work for a number of electronics contract manufacturers there who did TV work for the Koreans and Japanese. Wang stayed in Taiwan for nearly six years before returning to the U.S. with his young family. Immediately upon his arrival, he went to work promoting his business plan for Gemini Electronics to venture capitalists in California.

Gemini was going to produce big-screen LCD and plasma TVs for the U.S. market. Wang hoped to capitalize on American patriotism and disappointment over the loss of so many U.S. brands such as RCA, Zenith, Quazar and Motorola to other countries. He planned to cater primarily to big box retailers such as Best Buy, Costco, Sam’s Club, Walmart and Target who wanted to shorten their supply chains by sourcing TVs in North America. Gemini would produce its TVs on a just-in-time basis and pass on most of the distribution savings (transportation and warehousing) to the consumer. This would allow Gemini to quickly build market share in the U.S., Canada and Mexico by offering prices that were considerably below the competition.

RAPID GROWTH

By 2005 this strategy had proven to be a great success. Gemini was the largest TV producer in the U.S. with a 35 per cent market share. Major retailers quickly agreed to carry the brand because of its reputation for excellent quality at an affordable price. Gemini was becoming a source of great concern for its major competitors Samsung, Sony and LG. Due to changing technology, Gemini decided to focus on just LCD TVs but had added a number of additional products such as DVD players (HD and Blue Ray), home theatre sound systems and cable sets. The venture capitalists had taken the company public in December 2004.

In addition to a deep recession in 2008 and 2009, in late 2009 a major threat emerged as Gemini’s Korean and Japanese competitors began lowering their prices to comparable levels. With the falling U.S. dollar, brought on by that country’s large trade deficit, and Gemini’s significant advantage in logistic costs, it was felt these lower prices were not sustainable. Of greater worry were a number of technological trends. First, Sony announced that it would introduce a 3-D TV by summer 2010, and other major producers were expected to quickly follow. Initially, prices for these new products would be high and 3-D recorded content would be in short supply, but it was expected that within a few years 3-D TVs would be the industry standard; when this actually occurs will depend on how quickly consumers replace their TVs again after just having upgraded to digital/HD units. A second trend was the need to add video phone capabilities to TVs. With the growing popularity of Internet phone services such as Skype, it was felt that a much higher percentage of phone calls would be made with video. TVs would have to accommodate the dialling of numbers and contain video recording and voice input capabilities. Finally, future TVs will likely have to incorporate hardware and software so users can “surf” the Web and read/send e-mail without a micro, laptop or notebook computer. Gemini felt it would be able to produce 3-D TVs within 18 months, likely in time to meet the expected growth in demand. Introducing video phones, Web browsing and e-mail capabilities is something it can do now as all needed technology is available; in fact, the company already has prototypes under development.

PRODUCT DIVERSIFICATION

In January 2010, Wang formed an ad hoc committee of senior managers at Gemini to study different growth options. One option was to continue to focus on TVs but to expand geographically into South

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America, Europe and Asia. Wang felt that geographic expansion was wise, but he also wished to develop Gemini’s product offering so he could compete with Samsung, Sony and LG in all market segments. Possibilities included smart phones, e-readers and tablets, MP3 players, game machines, advanced audio systems and notebook, laptop and micro computers. Gemini could design these new products internally or expand through acquisition. Motorola had expressed interest in selling its cell phone unit while Palm had clearly stated it was looking to be acquired by a firm with greater financial resources. Taiwan’s Acer was disappointed with its acquisition of Gateway in 2007 and was rumoured to want to sell. Bose had discussed merging its audio business with a larger company that had greater access to international markets.

FINANCIAL STATEMENTS

Exhibits 1, 2 and 3 contain financial statements provided by Gemini Electronics for the last five years since the initial public offering (IPO). Exhibit 4 contains industry averages.

OPERATIONS

Gemini had a number of advantages over its Asian competitors. As a young and relatively small company compared to others in the industry, it was more innovative and less prone to bureaucratic delays and in- fighting. The company was forced to greatly expand the number of administrative and sales personnel in 2006 and 2007, but rapid growth soon improved efficiency.

Southern California, despite inroads from other countries, was still the premiere location in the world for R&D in the electronics industry. Gemini had been trying to take advantage of this by purchasing a number of patents from U.S. universities and expanding its own R&D program. In 2009, Gemini opened a new research facility on the CIT campus.

LCD TVs were large items that were expensive to ship and prone to damage during their long journey from Asian factories. These costs necessitated higher selling prices as did the fact that retailers had to keep larger inventories on hand to guard against supply interruptions. Gemini’s just-in-time production and delivery of TVs from factories in the U.S. allowed them to sell units at greatly reduced prices despite having to pay much more for labour in the U.S. and in Mexico where many of their component parts were produced.

Gemini’s production facilities were state-of-the-art as they were only a few years old. Assembly lines were highly automated and could be quickly changed to produce different models, resulting in smaller inventories of work-in-progress and finished goods to meet retailer demand. Due to the limited amount of electronics manufacturing being done in the U.S., Gemini still had to source many of its parts from Asian contractors. This meant that larger parts inventories had to be maintained because of long delivery times. In recent years, the company had been successful in sourcing a much greater proportion of their parts in North America.

Being a new American TV brand in an industry that had long been dominated by Asian producers, Gemini had a hard sell trying to convince major retailers that their products were worth carrying. All appreciated the low costs and fast delivery time, but none were sure whether the customer could be convinced to buy this new brand. To compensate, many retailers demanded more generous credit terms than Net 30, which was standard in the industry. Interest was also not charged on overdue accounts.

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Market research indicated that most Americans did not realize that Gemini TVs were made in the United States, so in early 2009 the company felt it was in a financial position to begin advertising this point heavily in TV spots. Previously, its advertising was limited to funding product ads in store flyers.

Wang knew from experience that consumer electronics was a very competitive industry and that Asian competitors were long-term thinkers who were willing to sacrifice profits in the short term to build market share. Company policy was to maintain large cash balances to guard against this uncertainty.

Venture capitalists funded Gemini’s start-up with a number of rounds of financing beginning in fall 2002, and by late 2004 they had accumulated a 45 per cent equity stake. After just three years, the decision was made by the venture capitalists to take the company public in an IPO. Wang owned the remaining 55 per cent of the company and was very concerned about losing control. Subsequent to the IPO, the company adopted a policy of paying no dividends and financing all growth with debt; no new common shares would be issued.

Gemini had a $500,000,000 line of credit with Wells Fargo Bank to finance seasonal variations in net working capital — the loan had to be 200 per cent secured by inventory and accounts receivable. All land, plant, equipment and some patents were financed with term loans. These loans were negotiated with a number of banks so Gemini could diversify its funding sources. To comply with the line of credit and term loans, the current ratio had to be kept above 1.5.

All inventory purchases were on terms 2/10, Net 60, and most suppliers charged interest at 12 per cent per annum on any overdue amounts.

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Exhibit 1

INCOME STATEMENT

2005 2006 2007 2008 2009

Sales

Cost of Goods Sold

Gross Profit

Operating Costs

Selling and Distribution

R&D

Administration

Amortization

Operating Profit

Interest

Earnings Before Taxes

Taxes

Net Income

2,142,659,000

1,323,957,000

818,702,000

212,340,640

93,640,450

95,003,300

81,414,429

336,303,182

53,251,456

283,051,726

99,068,104

183,983,622

5,413,625,000

3,120,000,500

2,293,624,500

545,980,400

220,340,340

405,340,300

122,465,588

999,497,873

145,434,234

854,063,638

298,922,273

555,141,365

8,671,715,000

5,032,513,200

3,639,201,800

854,300,000

365,660,340

832,740,300

187,929,165

1,398,571,995

288,898,584

1,109,673,411

388,385,694

721,287,717

12,175,476,500

7,886,796,000

4,288,680,500

934,532,230

476,350,230

999,453,230

288,216,088

1,590,128,722

277,686,944

1,312,441,778

459,354,622

853,087,156

13,664,714,160

8,974,149,576

4,690,564,584

1,001,234,530

785,774,340

980,340,500

394,440,051

1,528,775,163

329,923,700

1,198,851,462

419,598,012

779,253,450

Exhibit 2

BALANCE SHEETS

Cash

A/R

Parts Inventory

WIP Inventory

Finished Goods Inventory

Total Current Assets

L,P,&E, Net

Intangibles

Total Assets

2005

310,630,300

316,972,950

253,578,360

26,789,180

359,340,630

1,267,311,420

710,727,625

103,416,660

2,081,455,705

2006

790,419,373

758,988,750

607,191,000

45,354,460

960,187,250

3,162,140,833

812,956,891

411,698,984

4,386,796,708

2007

1,437,227,573

1,201,094,250

960,875,400

66,650,675

1,451,230,215

5,117,078,113

1,317,388,220

561,903,428

6,996,369,761

2008

1,366,526,361

1,328,523,975

1,062,819,180

75,640,210

1,605,660,505

5,439,170,231

2,281,077,095

601,083,781

8,321,331,107

2009

1,413,474,400

1,503,560,340

1,201,345,530

89,575,400

1,805,340,520

6,013,296,190

3,363,891,508

580,509,006

9,957,696,704

A/P

Current Portion of LT Debt

Total Current Liabilities

Long-term Debt

Shareholders’ Equity

Total Liabilities and Equities

422,630,600

147,920,710

570,551,310

739,603,550

771,300,845

2,081,455,705

1,011,985,000

341,394,916

1,353,379,916

1,706,974,582

1,326,442,210

4,386,796,708

1,305,530,320

607,184,919

1,912,715,239

3,035,924,595

2,047,729,927

6,996,369,761

1,509,430,300

651,847,287

2,161,277,587

3,259,236,437

2,900,817,082

8,321,331,107

1,564,430,450

785,532,620

2,349,963,070

3,927,663,101

3,680,070,533

9,957,696,704

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Exhibit 3

SALES ANALYSIS

2005 2006 2007 2008 2009

TV-LCD Unit Price $ 1,640 $ 1,485 $ 1,425 $ 1,250 $ 1,070

Unit Cost $ 950 $ 835 $ 819 $ 810 $ 702

Quantity 250,000 2,620,000 4,889,600 8,560,300 11,230,388

TV-Plasma Unit Price $ 1,340 $ 1,100 $ 1,000 – –

Unit Cost $ 850 $ 700 $ 646 – –

Quantity 1,080,000 830,000 530,400 – –

DVD-HD Unit Price $ 250 $ 240 $ 225 $ 180 $ 140

Unit Cost $ 145 $ 134 $ 125 $ 120 $ 112

Quantity 240,000 1,400,000 2,010,000 1,400,000 350,000

DVD-Blue Ray Unit Price – – $ 275 $ 220 $ 185

Unit Cost – – $ 175 $ 161 $ 138

Quantity – – 330,000 1,580,000 2,890,000

Cable Sets Unit Price $ 105 $ 100 $ 100 $ 95 $ 95

Unit Cost $ 45 $ 45 $ 43 $ 40 $ 41

Quantity 245,600 399,400 854,300 1,298,700 1,654,200

Home Theatre Unit Price $ 570 $ 570 $ 570 $ 550 $ 520

Unit Cost $ 350 $ 355 $ 355 $ 350 $ 335

Quantity 350,300 410,500 956,500 1,367,500 1,745,000

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Exhibit 4

INDUSTRY AVERAGES

Key Financial Ratios Industry Averages

2009 Vertical Analysis (%)

Income Statement 2009 Vertical Analysis (%) Balance Sheet 2009

Current Ratio 2.84X Sales 100.00 Cash 4.54 Cash Ratio 0.05X Cost of Goods Sold 62.00 Accounts Receivable 8.34 Parts Inv Turnover in Days 32.26 days Gross Profit 38.00 Parts Inventory 5.48 WP Inv Turnover in Days FG Inv Turnover in Days

7.89 days 188.33 days

Operating Costs Selling and Distribution 10.89

WIP Inventory Finished Goods Inventory

1.34 31.99

A/R Turnover in Days 30.44 days R&D 7.01 Total Current Assets 51.69 A/P Turnover in Days Cash Conversion Cycle

11.11 days 192.81 days

Administration Depreciation

8.34 4.35

Land, Plant & Equipment, Net Other Assets

41.34 6.97

Fixed Assets Turnover 2.42X Operating Profit 7.41 Total Assets 100.00 Total Assets Turnover 1.00X Interest 2.31 Debt Ratio 0.50X Earnings Before Taxes 5.10 Accounts Payable 11.23 Times Interest Earned 3.21X Taxes 1.79 Current Portion of LT Debt 7.00 Gross Profit Margin Operating Profit Margin

38.00% 7.41%

Net Income 3.32 Total Current Liabilities Long-term Debt

18.23 31.50

Net Profit Margin Return on Assets

3.32% 3.32%

Shareholders’ Equity Total Liabilities and Equities

50.27 100.00

Return on Equity 6.60%

Source: Industry average information from a reliable third party source.

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