Bertrand Caron sat in his office and contemplated his most recent communications with George Milne and Philip Brown of Vancouver Aluminum Company of Vancouver, Washington, USA. Caron was the marketing director of the Canadian Railway Car Corporation (CRCC) headquartered in Montreal. CRCC was a privately-held firm that manufactured various types of railway cars. However, Caron’s firm was now threatened by increasing competition from U.S. manufacturers now able to take advantage of lower tariffs on railway cars because of the North American Free Trade Agreement (NAFTA). Within five years these tariffs would be completely eliminated and the U.S. cars would be even more price competitive. Caron felt that increasing CRCC’s production volume by penetrating the U.S. railway car market with potential customers such as Vancouver Aluminum was essential to the company’s survival.
Protective tariffs had insulated firms on both sides of the border from foreign competition for many years. The advent of the U.S./Canada/Mexico free trade area had begun to eliminate such barriers. This was especially troubling to Canadian firms as the smaller Canadian volume prevented achieving the economies of scale realized by U.S. competitors. As tariffs became less of a factor in the market, the profit margins of Canadian firms were being severely squeezed. The two surviving Canadian firms felt that they would either have to increase their volume by becoming competitive in the U.S. market or face withdrawal from the railway car industry.
U.S. manufacturers had experienced boom and bust cycles. Twenty-three U.S. manufacturers had a total production of over 105,000 railway cars in 1979. However, a combination of factors would send these production figures spiraling to unheard of depths and result in industry consolidation. U.S. railway car production was only 6500 in 1983.
The first factor that created such swings was the deregulation of the railroad industry in 1979. Deregulation permitted the railroads to utilize their fleets of cars much more efficiently. Total tonnage hauled increased, sometimes at dramatic rates, in the next few years. However, the railroads did not add to their car fleets. Instead, they utilized sophisticated distribution strategies in combination with computer technology to accommodate this increased tonnage with existing fleets.
Railroads also continued to lose significant amounts of business to trucks after deregulation. Tonnage shipped by rail did increase as the volume of high-density cargoes such as coal and grain climbed. The change in cargo composition quickened the pace of the movement away from the use of boxcars and spelled the end for manufacturers specializing in boxcar production. Changes in U.S. tax laws also dampened enthusiasm for new equipment purchases.
The deepest U.S. economic downturn since the depression of the 1930’s began to take hold as the Reagan administration turned its attention to fighting inflation in 1981. Railway car production was slightly more than 7,000 in 1982 and less than 6,500 in 1983. Production had fallen 95 percent in just three years since the high volume of 105,000 cars in 1979. Only six railway car manufacturers remained in the U.S. and two in Canada by 1991.
The picture for surviving U.S. manufacturers of railway cars had improved since 1985. The production levels for CRCC and the other surviving Canadian manufacturer also recovered somewhat. However, both continued to produce at much lower levels (e.g. CRCC production in 1979 was 1,200 cars, falling to 150 in 1983 and recovering to 900 in 1990) than their U.S.-based competitors.
Vancouver Aluminum, a new entrant in the U.S. aluminum industry, went into production in 1989. The timing could not have been worse. Industry-wide profits plummeted 40 percent from 1989 to 1991. Profits in 1991 were 50 percent less than a year prior. Even though Vancouver Aluminum’s plant was one of the most efficient in the world, the timing of the current downturn had been very tough for the company.
A friend who worked for Vancouver Aluminum had alerted Bertrand Caron of a potential sales opportunity. The friend, Philip Brown, had met Caron in 1979 at a two-week executive training session at the Wharton School of Business in Philadelphia. Brown had been discussing how the company should react to the recently announced abandonment of the railroad spur that served their plant with other Vancouver executives. Both bauxite and alumina were delivered to the plant via rail and the rails were also utilized extensively for shipping a wide variety of finished aluminum products. The loss of such a vital part of their distribution system was viewed as a serious problem by Vancouver Aluminum management. One option discussed at this initial meeting was for Vancouver Aluminum to purchase and operate the 60-mile section of track that connected its plant to the main line. Vancouver officials felt confident that this main line would not be abandoned any time soon as it was a very high traffic line.
As the discussion evolved over the next couple of months, it became apparent that Vancouver Aluminum was going to purchase the section of track and might well operate a train unit dedicated to servicing its plant. Attention was then turned to the possible acquisition of needed equipment. It was at this point that Brown advised Caron at CRCC of a potential sales opportunity. Brown indicated that the appropriate contact at Vancouver would be George Milne, vice president for purchasing.
Milne indicated to Caron that the decision had been made to purchase the section of track since the railroad had offered an acceptable price and very favorable terms. However, Vancouver was still wrestling with three options on the operation of the line. One was to contract out the railway operation to the owner/operator of another small line headquartered about 50 miles from Vancouver. Some members of management had expressed apprehension about the financial stability of this company, but several executives favored this option. It would prevent Vancouver from having to develop the expertise needed to operate a railroad and avoid the necessity of a capital commitment to such an undertaking. The owner of the line was seeking a ten-year contract commitment from Vancouver Aluminum. A second option was to lease all equipment (locomotives, cars, etc.) and operate the line internally. The final option was to make the necessary capital investment in equipment and internally operate the line.
Bertrand Caron wanted to sell railway cars to Vancouver Aluminum to get CRCC’s foot in the door of the U.S. market. He knew that Vancouver Aluminum’s choice of the contract operation option would likely foreclose this opportunity and wanted Vancouver Aluminum to pursue one of the other two options. He felt that the Canadian government might possibly finance the leasing option. However, he knew that the responsible government agency would require a minimum of 20 percent of the sales price be set aside as a reserve against possible losses. He also was fearful that they would require a substantial deposit of at least 10 percent from Vancouver Aluminum and that the government would practically live with CRCC until it felt secure in its position. He did not know Vancouver’s complete financial situation. However, he knew from visits with Milne and Brown that they were cash poor for now.
Caron wanted to figure out some way to negotiate a direct sale to Vancouver Aluminum. Milne and Caron had calculated that to adequately meet the needs of Vancouver Aluminum for hauling bulk material, a minimum of 50 cars would be needed. Caron indicated to Milne that he felt that either gondola or open-top hopper cars would be appropriate for bulk materials such as bauxite and alumina and that the prices of the cars were basically identical. He also indicated that the abrasive nature of some of the materials to be transported dictated that the cars be fabricated from high carbon steel. Regular steel cars, or CRCC’s new line of aluminum cars, would not hold up to such materials.
Milne indicated that if Vancouver decided to operate the rail line they would also want to work toward the shipment of finished products via rail. This would involve the use of flat-and boxcars. However, they would want to first see how well the shipment of bulk materials went before committing to the shipment of finished products. Trucks would be used exclusively in the shipment of these finished products during the trial period.
Caron had provided Vancouver Aluminum with the following price proposal based on an order of 50 cars. (At the time of this proposal, the exchange rate was US$1 = C$1.25.) He indicated that to qualify for these prices, Vancouver Aluminum must order a minimum of 15 of a given type (e.g. they could order 15 of one type and 35 of the other but not 10 of one type and 40 of the other). The proposed prices for hard carbon steel cars were:
Gondola – C$50,000.00 per car
Open-Top Hopper – C$51,000.00 per car
It was obvious to Caron that, with the total sales volume equaling or exceeding C$2,500,000, CRCC would have to be creative in dealing with cash-strapped Vancouver Aluminum. Caron had reviewed the following data in preparing for negotiations with Vancouver:
Variable costs of Gondola – C$26,500.00 per car
Variable costs of Hopper – C$27,250.00 per car
Freight to Vancouver Aluminum – C$500.00 per car
U.S. Tariff – U.S.$1,500.00 per car
After several months of face-to-face meetings and telephone conversations with Milne and other executives at Vancouver Aluminum, Caron felt he was no closer in January, 1992 to making a sale of railway cars than he had been in August, 1991. Philip Brown had called saying that a final decision on which operating option to pursue would be made within the next month. Brown reported that aluminum prices had not improved in recent months. The result was that Vancouver Aluminum’s cash position was worse than it had ever been.
As Caron settled into his chair at the end of a long day, he browsed through the most recent edition of Railroad Weekly and continued to think about the fading Vancouver Aluminum opportunity. Just then an article caught his eye. It seemed that electrical utilities in the Eastern and Midwestern states of the U.S. were increasingly using low-sulfur coals from Wyoming and Montana. The article reported that the low abrasiveness of these low sulfur varieties had led to the use of coal slurry pipelines (where coal is mixed with water) for the eastward movement of much of this coal. Caron thought to himself, “I’ll bet it would be cheaper to use aluminum railway cars.”
What would you do in Bertrand Caron’s situation?
- Do nothing, i.e., do not pursue the Vancouver Aluminum opportunity in any way.
- Structure a strategic alliance with one of the major U.S. railway car manufacturers to pursue the immediate sale opportunity with Vancouver Aluminum and ensure long-term competitiveness.
- Insist on a straight cash sale.
- Try to sell to the contract operator if Vancouver Aluminum should choose that option.
- Engage in some form of countertrade with Vancouver Aluminum.
- Sell the entire company to a U.S. manufacturer of railway cars or to one of the profitable U.S. railroads, etc.
What Happened in the Real Situation?
This case is based on a factual situation but the firms and characters have been disguised. The case is also set in a different industry, but many economic and regulatory aspects of the actual case have been maintained. In the real transaction, the cash-strapped firm was Canadian (it was in the Canadian version of Chapter 11 bankruptcy) and it needed to buy some industrial equipment in order to improve the efficiency of its manufacturing operations. The U.S. supplier of the equipment proposed a countertrade arrangement under which the Canadian firm would supply raw materials that the U.S. firm would use to produce the type of equipment the Canadian firm was interested in buying. The selling price of the raw materials was below market but above the Canadian firm’s variable costs. This “win-win” arrangement worked out so well that it has been ongoing for several years now.
In order to use countertrade in this case study, CRCC might supply high-carbon steel railway cars to Vancouver Aluminum in exchange for aluminum that it would use to manufacture cars for customers such as the electrical utilities that transport low-abrasive materials. The aluminum would likely be exchanged at a price below market but above Vancouver Aluminum’s variable costs.
What is Countertrade?
Countertrade is any trading practice that conditions the completion of a sales transaction on a separate purchase of goods or services by the original seller from the original buyer. This means that the buyer conditions its purchase of the product on a reciprocal purchase by the seller.
While there is some disagreement as to the forms that countertrade may take, there seem to be three basic types. The oldest and best known is barter, which is the exchange of goods for goods without money changing hands. An example of barter was the exchange of U.S.-grown wheat for Russian-built locomotives.
Counterpurchase is a transaction in which a seller agrees to purchase some product from the buyer. The amount of reciprocal purchase generally ranges from 20 percent to 100 percent of the original sale. An example of such a transaction was the sale by Caterpillar of tractors to Albania in which Caterpillar agreed to purchase Albanian wine worth 30 percent of the value of the tractors.
The third form of countertrade is referred to as buyback, or compensation. In such a transaction, a seller sells some product, oftentimes a turnkey manufacturing facility, and agrees to purchase a portion of the output of this product/facility over a period of years. The value of products bought back often exceeds the value of the original sale. An example of such an arrangement was the 1974 deal wherein Occidental Petroleum sold a fertilizer manufacturing facility to the Soviet Union and agreed to be paid with fertilizer produced by the plant over a 20-year period.