Etna Confectionary Case

Etna Confectionary Case Current Situation The management of Etna Confectionary is dealing with a crisis situation. A year ago, the European Fresh and Frozen Food Commission changed its reporting requirements effective in 26 months. Etna s largest customers have been discussing methods of compliance. It is now clear that many of the European Union customers are going to require two changes in operations as follows: Grouping of Shipments and Packaging. Single electronically labeled and coded shipments will be required once the new regulations take effect. This means that the customer will accept from Etna only consolidated shipments that include chocolate and sugar candies and gift items. Separate truckloads or partial truckloads from each factory will no longer be acceptable. Electronic Internet Identification and Processing. Each consolidated shipment will carry an electronic labeling sticker that matches an electronic labeling transmitted in advance using the Internet. If the technology is not employed, the customer will not accept a shipment. Computer Upgrade It will be no problem to upgrade the company s computer systems to comply with the new labeling and Internet notification. It is simply a matter of purchasing new equipment with installed software sold by an Austrian company. Jumbo Warehouse Options During the past year, Etna has been exploring ways to consolidate its packaging into a single large warehouse. The three divisions would ship product to the new facility where goods would be grouped by customer in single shipments of all three product lines. Three alternatives have been evaluated: Santa Maria. A level area can be purchased near the Santa Maria operation. Local officials have agreed that a warehouse could be built on the site. With the help of the governor of the province, the company has obtained all approvals needed to start construction. Fruit Grove. The sugar candy operation is located in part of a fruit grove owned by Etna Confectionary. The area is suitable for the new warehouse. The company has been pursuing the necessary approvals to start construction but they have not yet been successful in obtaining them. Messina. The city of Messina is less than a two-hour drive from the company s factories. To encourage economic development, the city has offered land in its port area where a warehouse could be constructed. The city has also agreed to fast-track the process of obtaining approval to start construction. 1

Financial Analysis The company has cost estimates for building each facility. Warehouse Consolidation S. Maria Fruit Gr. Messina Cost of the Land 1800 0 3240 Cost of Construction 2880 3168 6336 Warehouse Equipment 1450 1450 1570 Computer Systems 396 396 396 Total Cost 6526 5014 11542 To finance the project, the company plans to borrow money from either a commercial bank or regional development authority. Discussions are well underway with three different possible sources of financing. Forecasts have been made with and without the project. Historical Data An appendix contains historical data on the company. Required The Board of Directors wants a recommendation as to what should be done. Provide it in the form of a formal presentation. 2

Balance Sheet After Project. No Change S. Maria Fruit Gr. Messina Cash and cash equivalents 2,866 2,866 2,866 2,866 Accounts receivable 5,861 5,861 5,861 5,861 Inventories 4,307 4,307 4,307 4,307 Other current assets 1,398 1,398 1,398 1,398 New Assets 0 6,526 5,014 11,542 Other Fixed assets 45,990 45,990 45,990 45,990 Total Assets 60,421 66,947 65,435 71,963 Accounts payable 5,685 5,685 5,685 5,685 Accrued liabilities 5,685 5,685 5,685 5,685 Long-term debt 34,572 41,098 39,586 46,114 Pension obligations 4,589 4,589 4,589 4,589 Total Debt 50,531 57,057 55,545 62,073 Common stock 3,115 3,115 3,115 3,115 Retained earnings 6,775 6,775 6,775 6,775 Total Equity 9,890 9,890 9,890 9,890 Total 60,421 66,947 65,435 71,963 Balance Sheet in Three Years. No Change S. Maria Fruit Gr. Messina Cash and cash equivalents 1,969 3,243 3,243 3,243 Accounts receivable 3,986 6,565 6,565 6,565 Inventories 2,929 4,825 4,825 4,825 Other current assets 960 1,582 1,582 1,582 New Assets 0 5,482 4,212 9,695 Other Fixed assets 40,301 40,301 40,301 40,301 Total Assets 50,146 55,627 55,627 55,627 Accounts payable 4,209 6,932 6,932 6,932 Accrued liabilities 3,093 5,094 5,094 5,094 Long-term debt 28,031 27,871 27,481 27,315 Pension obligations 3,431 3,842 3,842 3,842 Total Debt 38,765 43,740 43,350 43,184 Common stock 3,179 3,179 3,179 3,179 Retained earnings 8,202 8,708 9,098 9,264 Total Equity 11,381 11,887 12,277 12,443 Total 50,146 55,627 55,627 55,627 3

Income Statement in Three Years. No S. Maria Fruit Gr. Messina Change Chocolate Division 26,455 41,731 41,731 41,731 Sugar Candy Division 9,066 15,622 15,622 15,622 Gift Products Division 12,317 21,555 21,555 21,555 Other Income 186 186 186 186 Revenues 48,024 79,095 79,095 79,095 Cost of Chocolate Products 14,021 22,118 22,118 22,952 Depreciation, Chocolate 2,889 3,542 3,390 4,043 Cost of Sugar Candy 3,844 6,624 6,624 6,936 Depreciation, Sugar Candy 1,959 2,612 2,460 3,113 Cost of Gift Products 5,050 8,838 8,838 9,269 Depreciation, Gift Products 1,346 1,999 1,848 2,500 Cost of Goods Sold 29,109 45,731 45,277 48,814 Gross Margin 18,915 33,364 33,817 30,281 Selling and administrative 15,637 15,637 15,637 17,513 Other Depreciation 665 730 715 780 Operating Income 2,614 16,997 17,466 11,988 Interest 2,046 2,108 2,171 2,236 Pre-tax Income 568 14,890 15,295 9,752 Income taxes (Tax Credit) 85 2,233 2,294 1,463 Net Income 482 12,656 13,001 8,289 Earnings Per Share 0.06 1.69 1.73 1.11 Cash Dividends 362 12,150 12,611 8,123 Dividends per Share $0.05 $1.62 $1.68 $1.08 Change, Retained Earnings 121 506 390 166 4

Appendix. Historical Data. Lines of Business In 1912, two brothers founded a candy company in a small village near the city of Catania. The business survived trials and tribulations, including the Second World War and regular eruptions of Mount Etna, and grew dramatically during the 1970s. Today, the company has three primary operating divisions: Chocolate Products. This division manufactures 140 chocolate candy products under 16 brand names. The products are sold to department stores and retail outlets located throughout Europe. Its products are known for their excellent quality and taste. Since its formation in 1991, the division has experienced steady growth and has maintained long-term relationships with many of its customers. The unit pursues a high-quality sourcing strategy and is generally viewed as a premium producer. Etna Sugar Candy. This division manufactures 78 citrus and sugar candy products under 14 brand names. Like the chocolate division, it competes directly with other candy providers in department stores and retail outlets in the European Union and neighboring countries. The line of candy enjoys an excellent reputation in the industry. Etna Gift Products. This division packages chocolate and sugar candy with fresh oranges, other fruit products, cheese, and Italian gourmet foods and spices. It creates gift boxes and baskets that are sold to individuals and companies. In recent years, the division has signed up cruise ships, trade association conferences, and sporting event organizers as new customers. Like its sister divisions, Etna Gift Products enjoys an excellent reputation for quality and service. Mission Etna Confectionary Company provides the finest quality chocolate and sugar candy, holiday confection, and sweet citrus and gift products for European Union and neighboring customers. The company pursues happy and satisfied customers, respects its employees, seeks to be a respected citizen of Sicily and the province of Catania, and protects the image of their brands and products. Operating Facilities Etna s headquarters is in Zafferana Etnea, a town of 8,000 people high on Mt. Etna 24 km from Catania. The 575,000 square kilometer mountain has been enriched by volcanic ash for thousands of years. Historians have documented 140 major eruptions since 400 B.C. Catania, the provincial capital with a population of 700,000, was destroyed in 122 B.C. and 1669 A.D. It was not affected by major eruptions in 1971, 1981, 1983, 1986, 1989, 1993, and 1998. Three offices, factories and warehouses surround the dominating volcano. 5

Chocolate Candy Physical Facilities. Facility. At the headquarters complex in Zafferana Etnea. 22,000 square meter factory, warehouse, and general office complex 15 kilometers from main crater. Entirely surrounded by a stone wall three meters high. Two stories. Cement and brick construction. Constructed 1971 and renovated in 1992. Evaluation Well maintained. Partial air conditioning. Not sprinklered. Water purification and processing pumping station near large pond used as reservoir for production and emergency. Backup electrical generating capacity. Extensive machinery investment, including pressurized and pneumatic production and refrigeration facilities. Mechanized forklift and belt moving systems in storage and shipping warehouse. Parking facilities and loading docks for large trucks. History Rarely any problems. Continuous uninterrupted production since 1971. Occasional problems with supply as a result of narrow roads linking facility with port that imports cocoa beans from Africa and South America. Ran out of water for 31 and 45 days during drought in the summers during 1987 and 1996. Inventory spoilage in 1998 when electric grid collapsed and backup generator failed. Still not recovered from loss of customers in Germany and France as a result of failure to ship products as promised. Sugar Candy Physical Facilities. Facility. On the southwest side of Mount Etna 18 kilometers from the crater. 16,000 square meter production building, warehouse, and general office complex. Facility situated in fruit and citrus grove with low hedge separating it from the road. One story. Stone, cement and brick construction. Built in 1928. Evaluation Older facility slightly run down. No air conditioning or sprinklers. Pumping station brings water up from underground well. Small electrical generating unit. Moderate machinery and refrigeration investment. Conveyor belt assembly line. Forklifts in warehouse. Parking facilities and loading docks for medium-size vehicles. History Facility temporarily abandoned in 1937, 1958, 1986, 1993, and 1998 for periods ranging from three days to six weeks as a result of volcanic activity. Loss of inventory in 1986 from heat and smoke damage and cessation of refrigeration. Occasional problems with fresh fruit and citrus supply as a result of water shortages every 10 years or so. Facility brought water in by truck in summers of 1987 and 1996. Inventory spoilage in 1983 and 1998 when refrigeration unit failed. Facilities study indicates concern about reliability of production plant. 6

Gift Products Physical Facilities. Facility. On the northwest side of Mount Etna near the town of Santa Maria 18 kilometers from the crater. 26,000 square meter factory and packaging building and warehouse. Situated on plateau surrounded by former lava flows. Stone fence around entire complex. One story. Stone and cement construction. Built in 1956. Evaluation Older facility upgraded in 1984. No air conditioning or sprinklers. Local water supply from town of Santa Maria. No backup electrical generating unit. Laborintensive packaging operation with limited machinery. Large refrigerated storage area. Manual assembly line. Forklifts in factory and warehouse. Limited parking facilities. Adequate loading docks. History Facility temporarily abandoned in 1983, 1986, 1989, 1993, and 1998 for periods ranging from nine days to seven weeks as a result of volcanic activity. Loss of inventory in 1989 and 1998 from smoke damage. Occasional problems transporting raw materials on narrow roads. Occasionally runs out of sufficient fresh fruit and citrus to meet production schedules. Water brought in by truck in summers of 1987 and 1996. Inventory loss in 1987 from mishandling of fresh fruit and again in 1995 from improper storage. Facilities study indicates high costs of manual operation and concern about reliability of product supply. Production Each operating facility produces its own products as follows: Chocolate Production. The unit imports raw materials and produces dark and milk chocolate candies on a year-round basis. Materials are brought by truck from the port of Catania. Packaging and other supplies are purchased throughout Europe. The warehouse can store raw materials and finished products equal to 35 days of production. Sugar Candy Production. This unit obtains citrus and fruit products locally but purchases sugar and other ingredients from countries as far away as Cuba. Production is cyclical, reflecting seasonal availability of citrus and fruit fillings. The complex can store 15 days of production. Gift Products. This unit is essentially a packaging operation. It receives chocolate and sugar candy and packages them with fresh fruit and citrus purchased locally. The resulting gift boxes and baskets are stored for less than a week before they are shipped by truck. The perishable nature of the products makes express trucking the key to the operation. 7

Operating Results Etna Confectionary has experienced mixed operating results during the past three years. The company was slow to respond to changes in retail fresh and frozen produce distribution in its primary markets. Large retailers have been purchasing smaller candy operations. The result has been a reduction in the number of wholesalers who distribute candy products. Large retailers purchasing directly from producers have replaced them. Nestle, Hershey, and other producers are contributing to a drop in sales for Etna. Etna Historical Balance Sheets Year -4 Year -3 Year -2 Year -1 Cash and cash equivalents 2,047 1,364 2,896 2,954 Accounts receivable 4,503 2,871 5,863 5,980 Inventories 3,217 2,081 4,309 4,395 Other current assets 819 610 1,413 1,441 Fixed assets 45,031 46,157 44,311 47,412 Total Assets 55,616 53,083 58,792 62,183 Accounts payable 4,746 3,032 6,203 6,339 Accrued liabilities 3,485 2,228 4,562 4,665 Long-term debt 32,090 30,508 36,119 36,337 Pension obligations 3,893 4,064 4,251 4,455 Total Debt 44,215 39,832 51,135 51,797 Common stock 2,503 2,710 2,935 3,179 Retained earnings 8,899 10,540 4,721 7,207 Total Equity 11,401 13,251 7,657 10,386 Total 55,616 53,083 58,792 62,183 8

Etna Historical Income Statements. Year -3 Year -2 Year -1 Chocolate Division 32,400 23,328 37,260 Sugar Candy Division 11,340 4,423 13,948 Gift Products Division 14,580 8,019 19,246 Other Income 162 117 186 Revenues 58,482 35,886 70,640 Cost of Chocolate Products 17,172 12,714 19,375 Depreciation, Chocolate Assets 2,943 3,139 2,889 Cost of Sugar Candy Products 4,967 2,003 6,109 Depreciation, Sugar Candy Products 1,721 1,961 1,959 Cost of Gift Products 6,007 3,184 7,929 Depreciation, Gift Products 1,390 1,232 1,346 Cost of Goods Sold 34,200 24,233 39,608 Gross Margin 24,282 11,654 31,032 Selling and administrative 13,451 12,509 15,637 Other Depreciation 675 692 665 Operating Income 10,155 (1,548) 14,731 Interest 2,439 2,410 2,962 Pre-tax Income 7,717-3,958 11,769 Income taxes (Tax Credit) 1,150-602 1,824 Net Income 6,567 ( 3,357) 9,945 Earnings Per Share 0.93 ( 0.46) 1.33 Cash Dividends 4,925 2,463 7,459 Dividends per Share $0.70 $0.34 $0.99 Change in Retained Earnings 1642-5819 2486 9

Etna Historical Statement of Cash Flows Year -3 Year -2 Year -1 Net Income 6,567 ( 3,357) 9,945 Change in Accounts 1,632-2,992-117 Receivables Change in Inventories 1,135-2,228-86 Change in Other Current Assets 209-803 -28 Change in Fixed Assets -1,126 1,846-3,102 Change in Accounts Payable -1,715 3,172 136 Change in Accrued Liabilities -1,258 2,334 103 Cash Flows from Operations 5,445 ( 2,028) 6,851 Change in Long-term Debt -1,582 5,611 218 Change in Pension Obligations 171 187 204 Change in Common Stock 208 225 244 Dividends -4,925-2,463-7,459 Cash Flows from Financing ( 6,128) 3,560 ( 6,793) Cash, start of year 2047 1364 2896 Cash, end of year 1,364 2,896 2,954 10

Etna Operating Results by Business Segments. Year -3 Year -2 Year -1 Revenues Chocolate Division 32,400 23,328 37,260 Sugar Candy Division 11,340 4,423 13,948 Gift Products Division 14,580 8,019 19,246 Total 58,320 35,770 70,454 Chocolate Division 55.6% 65.2% 52.9% Sugar Candy Division 19.4% 12.4% 19.8% Gift Products Division 25.0% 22.4% 27.3% Operating Profits Chocolate Division 12,285 7,476 14,996 Sugar Candy Division 4,652 458 5,880 Gift Products Division 7,183 3,604 9,970 Total 24,120 11,537 30,846 Chocolate Division 50.9% 64.8% 48.6% Sugar Candy Division 19.3% 4.0% 19.1% Gift Products Division 29.8% 31.2% 32.3% 11

Etna Historical Asset Data by Business Segment. Year -3 Year -2 Year -1 Capital Expenditures Chocolate Division 3,824 1,163 4,559 Sugar Candy Division 3,094 1,689 3,404 Gift Products Division 150 1,818 5,764 Total 7,068 4,670 13,727 Chocolate Division 54.1% 24.9% 33.2% Sugar Candy Division 43.8% 36.2% 24.8% Gift Products Division 2.1% 38.9% 42.0% Identifiable Assets Chocolate Division 19,363 20,244 18,269 19,938 Sugar Candy Division 11,708 13,081 12,809 14,254 Gift Products Division 9,457 8,216 8,802 13,220 Total 40,528 41,541 39,880 47,412 Chocolate Division 47.8% 48.7% 45.8% 42.1% Sugar Candy Division 28.9% 31.5% 32.1% 30.1% Gift Products Division 23.3% 19.8% 22.1% 27.9% Depreciation and Amortization Chocolate Division 2,943 3,139 2,889 Sugar Candy Division 1,721 1,961 1,959 Gift Products Division 1,390 1,232 1,346 Total 6,054 6,332 6,194 12

Etna Historical Geographic Area Data. Year -4 Year -3 Year -2 Year -1 Revenues Italy 20,995 9,286 16,723 Germany 9,914 7,905 12,145 France 9,914 5,230 8,858 Other European Union 7,582 5,627 13,410 Other Europe 9,914 7,723 19,318 Total 58,320 35,770 70,454 Operating Profits Italy 9,165 3,341 7,322 Germany 3,136 2,088 6,551 France 3,136 2,148 2,644 Other European Union 4,100 1,353 7,105 Other Europe 4,583 2,606 7,224 Total 24,120 11,537 30,846 Identifiable Assets Italy 35,462 35,684 33,618 39,210 Germany 1,216 1,412 1,515 1,991 France 1,013 1,205 1,316 1,754 Other European Union 1,662 1,869 1,954 2,513 Other Europe 1,175 1,371 1,476 1,944 Total 40,528 41,541 39,880 47,412 13

Etna Historical Dividend Data. Year -3 Year -2 Year -1 Dividends Cash Dividends 4,925 2,463 7,459 Dividends per Share 0.70 0.34 0.99 Earnings per Share 0.93 ( 0.46) 1.33 Dividend Payout 75.0% -73.4% 75.0% Retention of Earnings for Growth Net Income 6,567 ( 3,357) 9,945 Minus Cash Dividends -4,925-2,463-7,459 Change in Retained Earnings 1,642-5,819 2,486 Percent Change, Retained Earnings 18.4% -55.2% 52.7% Percent Change in Assets -4.6% 10.8% 5.8% Percent Change, Long-term Debt -4.9% 18.4% 0.6% Table 8. Historical Cash Flow Data. Year -3 Year -2 Year -1 Revenues 58,320 35,770 70,454 Cost of Products/Services -28,146-17,901-33,414 Selling and administrative -13,451-12,509-15,637 Income taxes (Tax Credit) -1,150 602-1,824 Cash from Operations 15,574 5,961 19,579 Use of Cash Capital Expenditures -7,068-4,670-13,727 Cash Dividends -4,925-2,463-7,459 Reconcile Cash Flow from Operations to Net Income Cash Flow from Operations 15,574 5,961 19,579 Minus Depreciation -6,054-6,332-6,194 Minus Interest -2,439-2,410-2,962 Plus Other Revenues 162 117 186 Equals Net Income 7,242 ( 2,664) 10,610 14

Etna Historical Profit Ratios. Year -3 Year -2 Year -1 Operating Income 10,155-1,548 14,731 Revenues 58,482 35,886 70,640 Return on Sales 17.4% -4.3% 20.9% Revenues 58,482 35,886 70,640 Assets 55,616 53,083 58,792 Asset Turnover 105.2% 67.6% 120.2% Operating Income 10,155-1,548 14,731 Assets 55,616 53,083 58,792 Return on Investment 18.3% -2.9% 25.1% Net Income 6,567-3,357 9,945 Equity 11,401 13,251 7,657 Return on Equity 57.6% -25.3% 129.9% 15