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Group 17, Phelps Dodge case

The copper industry has been changing during the decades leading up to 1984. The
market had transformed from one in which demand drove prices and production to
one in which supply seemed insensitive to demand and price. A prolonged decline in
copper prices prompts Phelps Dodge, founded in 1885, one of the worlds leading
copper producer in North American to consider corporate strategy to fight out the
income loss. According to the industry information and corporate structures of
Phelps Dodges rivals, the core problem could be concluded as following:

Phelps Dodge dependence on its copper producing business makes


it vulnerable to the volatility of copper price.
Large decline of copper price shrinks the revenues of Phelps Dodge
and adds higher cost of goods sold which results in the negative Net
income.

External analysis
Copper price was declined due to bigger amount of suppliers and lower demand on
the market. In order to gain profits and get competitive advantage, five forces
analysis of environment will be used for external threat analysis.
1. Rivals
Rivals were the main threat of Phelps and their profit shrinking. There are
three types of rivals.
I.
40% of the world copper supply was controlled by governments.
Governments had more political and resource advantages to
achieve larger economies of scale than any other independent
firm. Due to that they have a competitive advantage in the
market with a lower cost of production. State-owned Codelco
(Chile) could lower their cost to 45 cent per pound while Phelps
Dodges lowest cost was 70 cents a pound. Phelps had limited chance
to win the competition with governments.
II.
35% of world copper supply was controlled by non-copper companies.
Most of those non-copper companies were oil companies and able to
financially support copper companies to continue producing even while
prices were temporarily below the cost. As an experienced leading
copper company, Phelps has future opportunities to gain more market
share in the copper industry with acquiring other struggling
competitors.
III.
Other independent copper rivals like Asarco and Newmont used
diversification strategy to compensate the loss in copper business.
2. Suppliers
The threat from suppliers is relatively low for Phelps Dodge. As a leading
copper producer in North America, the bargain power of Phelps Dodge is
strong. According to Phelpss financial statements analysis, days payable
outstanding are 74 days while days sales outstanding count as 54 days. This
is an advantage for Phelps to pursuit its competitive advantage. The loss of
income did not come from the pressure of suppliers, but was the result of the
market price pressure.
3. Bargaining power of buyers
The buyers always choose the best combination of price and quantity for
their product. One way to keep some customers detached to your company is

Yao Zhang, Ivan Jajic, Xuan Zhang

Group 17, Phelps Dodge case


by loyalty programs or discounts when the customer is buying big amounts of
goods. Phelps company is trying to achieve selling fixed amount of goods to
the number of buyers at a fix price somewhere in the future (1984-1986).
4. Threat of new entrants
The threat from new entries and substitute products were limited or short of
information in the case, thus, would be exclude from the analysis.
Furthermore, this market has high barriers of entry and therefore there is a
small chance some new companies are going to enter the market. The only
possibility is through acquisition of the already operating companies in the
market.

Internal analysis
Because of the decline of copper price, Phelps had negative Net income in both
1982 and 1983, which indicates that the operational costs are higher than the
actual sales (1.044.789.000>977.383.000). It was urgent that Phelps needed to
reduce the cost of goods sold to compensate the decrease of the revenue.
Although with a negative Net income, Phelps still has a positive cash flow statement
with a cash conversion cycle of 19 days in 1983. It was improved by 15 days from
1983. Asset turnover of Phelps was 0.51, slightly lower than Asarco (0.67) and
higher than Newmont (0.34), which means Phelps was more efficient than Newmont
by the conversion of assets into revenue.

Risk analysis of Phelps

Generally, risk in the copper market could be classified as Hazard, Finance,


Treasury, Strategic and Operational risk. The matrix indicates the relationship,
impact and frequency of those risks. In the case of Phelps, many risks could be
determined. Although Hazard risk is limited, operational risk on the other hand is
present, because of low selling price, the cost of goods sold were high which need
to be neutralized. However operational risk is not the main risk. Negative net
income was not resulted from operation failure but from the decline of copper
market price. According to the external analysis, both treasury and strategic risk
were the main Phelpss risks on which the company should pay attention to,
because of their high impact on the company.

Strategies suggestion

Basically, in order to thrive from current financial and operation difficulty, Phelps
should either like state-owned firms operate with lower costs, meaning that their
surplus is higher, or like Asarco and Newmont introduce diversification strategy.
Another way is to use the model of non-copper firms that use extra cash flow to

Yao Zhang, Ivan Jajic, Xuan Zhang

Group 17, Phelps Dodge case


support the loss. Strategies could be carried out for short term and long term run.
Cutting the costs and generating positive net income should be the main short-term
goal of the company.
For long term run, the target is to achieve competitive advantage. The strategies
could be cost leadership or product differentiation on the business level. On the
corporate level, the strategies could be diversification or strategic alliance. In the
long run, Phelps needs to reduce its dependence on the copper price in order to be
competitive. Both cost leadership or diversification strategy could increase the
flexibility of Phelps to handle the volatility of the copper price.
However, cutting costs or cost leadership strategy will provide competitive
advantage for Phelps over non-copper companies. However, state-owned copper
firms will be the most cost productive in the market and therefore will suppress the
price of copper due to their lower cost of production. Therefore diversification or
product differentiation are essential for Phelps in the long run in order to improve
the flexibility of the company to the volatility of the copper price.
Almost 68% of Phelps business was related to the copper business. Asarco depends
29% and Newmont 37% on the copper market. Both Asarco and Newmont had
positive net income due to their diversified portfolio, which indicates a good proof
for diversification.

Restructuring plan and adjustments suggestion


The restructuring plan is based on the forecasted average copper price of 65 cents
per pound for the following 3 years. Basically, the restructuring plan is mainly
focused on the cost reduction and sale of asset to achieve sufficient cash flows and
increase production efficiency. Restructuring plan is forecasted to provide net profit
of 2.6 million in 1985, 10 million in 1986 and 8.9 million in 1987.
By operating restructuring plan, the operational risk could be minimized.
Restructuring plan could be treated as risk management on operational risk and
partly on the treasury risk. In copper industry, reducing cost may not be enough to
neutralize all treasure risk that could arise in the long run. This is the case because
of the existence of state-owned firms and their cost advantage, which could
decrease the price of copper per pound even lower than 65 cents.
By selling non-copper related businesses to increase cash flow flexibility, Phelps
could reduce finance risk of the company. However, this action increases the
dependence of company to copper market so that the strategic risk and treasure
risk will still increase.
The key issue of restructuring plan is based on the forecasted average price of 65
cents. The average copper price from 1975 to 1984 was 72.26 cents with volatility
of 15.81 cents per pound. The price interval will be (88.96, 56.45). There is still a
chance that the price will go way below 65 cents per pound and therefore fail the
restructuring plan.

Hedging

There are two ways of hedging. One is hedging with future. Another is hedging risks
by using diversified portfolio. Treasure risk could be hedged by using financial
instruments such as forward or future contract. Future contract for 1984 is to sell at
Yao Zhang, Ivan Jajic, Xuan Zhang

Group 17, Phelps Dodge case


59.45 and 59.95 cents per pound and the price is continuing to increase for the
following years. Using future contracts could help Phelps further manage its
inventory level thus reducing operational risk. Furthermore, futures could highly
ensure the success of restructuring plan and generate positive cash flow in the
following years. Hedging reduces exposure of Phelps on copper price volatility and
combines this with positive free cash flow. In that way Phelps will be able to achieve
more debt capital. (Tax shield benefit).
Eggs should not be put in one basket. Future contracts could not totally solve the
problem of Phelps dependence on copper price, because future price is also
affected by market price and volume of supplies. Thus, restructuring plan could not
help Phelps for long-term run. A diversified business structure hedging is needed for
Phelpss long-term run.

Conclusion
Restructuring plan is a sufficient risk management method for Phelps which creates
values due to volatility reduction and positive future cash flow if hedged by future
contract. However, diversification strategy is necessary for Phelps long term run in
order to minimize its weakness to treasure risk and strategic risk.

Figure 1 - FINANCIAL STATEMENT ANALYSIS

Figure 2 - COPPER BASED BUSINESS ANALYSIS

Yao Zhang, Ivan Jajic, Xuan Zhang


Figure 3 - WORLD COPPER SUPLIES

Group 17, Phelps Dodge case

Figure 4 - COPPER SPOT PRICE (COMEX)

Yao Zhang, Ivan Jajic, Xuan Zhang