Canadian Company Profits In China

Montreal-based Dorel Industries is posting record profits after buying Pacific Cycle LLC--a U.S bike company that manufactures its product in China.

By all accounts, the China International Bicycle and Motorcycle Fair in early May was filled with smiling faces. Shipments by China's red-hot bicycle industry hit a record high during 2004, and the fair generated impressive attendance and booth sales. The man with the biggest smile, however, was on the other side of the planet. Martin Schwartz, president and CEO of Montreal-based Dorel Industries Inc. (TSX: DII.SV), took a tremendous gamble last year, paying US$311 million to acquire Madison, Wisc.-based Pacific Cycle LLC, which holds a 44% share in the U.S. mass-merchant bicycle sector–a market supplied mostly with Chinese imports. The deal was a huge success, adding $49.4 million to Dorel's operating earnings, turning what would have been a sluggish 2004 into the consumer products merchandiser's best year ever. As a result, Dorel posted record revenues and profits, a performance echoed in its first-quarter results for 2005. The good news was reflected in the share price, which bounced back to the $43 range in recent weeks, a 26% increase from its 52-week low. (The wheels came off the stock, however, on July 12, after Dorel warned that market challenges will curb full-year profit in 2005.)

The Pacific Cycle coup is nothing new to Schwartz, who runs Dorel with his brothers, Alan and Jeffrey, and brother-in-law Jeff Segel. The Schwartzes are seasoned business veterans, who through a string of astute acquisitions turned the company that their father, Leo, founded, in 1963, into one of North America's most aggressive marketers. Today, Dorel is the world's largest children's products distributor and one of the two largest ready-to-assemble furniture manufacturers. Under Schwartz's leadership, the company has shown an uncanny ability to make money selling to notoriously stingy mass merchandisers such as Canadian Tire, Wal-Mart, Toys “R” Us and Kmart. Particularly impressive is Dorel's long-term track record. During the past 10 years, it has generated exceptional compound annual revenue (22%) and profit (33%) growth.

The Pacific Cycle acquisition, especially its China focus, plays into Dorel's strengths and provides a good window into how the company operates. “China is not the only story at Dorel, but it's tremendously important and is the key to our sourcing strategy,” says Schwartz, 57, who has been doing business in Asia for 30 years. In many ways Dorel is at the forefront of the massive changes in the world's economy, which have accelerated since China's entry into the World Trade Organization, in 2001. While Dorel is a major importer of hundreds of items, ranging from bikes to baby strollers, many of its 5,000 employees are also line workers that manufacture goods for the domestic market. As a result, Dorel's accountants are constantly making cost-benefit decisions about whether to keep production in-house or whether to outsource. “Our strength is design, brands and marketing,” Schwartz says. “We come up with the ideas first, and then we decide what is the best place in the world for us to make the product.”

China's importance in Dorel's overall strategy is reflected in small ways throughout the company. One indication is the amount of time Schwartz spends in Asia: He visits three or four times a year, in large part to maintain relationships with suppliers who like to feel they are dealing with the top guy. The huge video-conference screen in Dorel's boardroom is another clue, as is the recent appointment of Jenny Chang as vice-president of Far Eastern operations. Chang heads a staff of 25 who are responsible for sourcing, supplier relations, supply-chain management and quality control for juvenile products–a huge issue with Asian manufacturers.

At first, Pacific Cycle didn't look like the ideal fit for Dorel. The investment bankers negotiating the sale didn't even contact Schwartz until the first round of potential buyers had been exhausted. But the Schwartzes knew a good opportunity when they saw one. Like Pacific, most U.S. bicycle marketers, particularly at the low- to mid-range levels, had long since moved production overseas, first to Taiwan, then–as the island's labour costs mounted–over to the mainland, an area that Dorel knew well. “We sell to the same accounts as [Pacific did], we are familiar with doing business in China and we wanted to diversify,” Schwartz says. “There was a lot of common ground.”

One pleasant surprise that did not show up in Dorel's due diligence review of Pacific Cycle: employees' sketches for an updated version of the Schwinn Sting-Ray. Schwinn is America's best-known bicycle brand, acquired by Pacific in 2001, with an impressive 88% market recognition. The Sting-Ray, famous for its banana seat and raised handlebars, was wildly popular during the 1960s and 1970s. Pacific's marketing staff had expected to sell maybe 50,000 units of the relaunched model, which looks like a kid's version of a chopper-style motorcycle.

Sting-Ray turned out to be a huge success. Pacific could barely meet demand and ended up shipping well over 500,000 units, which retail in the US$180 range. Sting-Ray ended up topping the “best outdoor toy” category at the Annual International Toy Fair Awards in New York, and earlier this year the company added an electric version of the bike as well as a Schwinn motorized scooter. The Pacific Cycle deal also brought significant additional synergies. Sales personnel were able to open new distribution channels by cross-selling cycle products to existing Dorel clients, a strategy that also worked in the opposite direction. The combined company, which is now one of the world's 20-largest movers of container traffic, used its new-found clout to wrestle volume discounts from transportation firms. The new entity also repositioned overseas operations to generate better tax efficiency, a move that brought an additional 70¢US per share of earnings.

But it's Dorel's partnerships with more than 100 Chinese suppliers that are its increasingly crucial success driver. Like most western-Chinese partnerships, Dorel supplies the designs, brand development and marketing while China supplies production. It's a relationship that works well, says Louis Chan, executive vice-president of Ideal Group, a Taiwan-based firm that manufacturers bicycles at mainland China plants for several western companies, including Pacific Cycle. “We often get approached by retailers asking us to manufacture for them, or to market our own brand, but this is not our strength,” says Chan on a tour of Ideal's recently opened Dongguan facility, in southern China's Pearl River delta, which last year devoted 35% of its capacity to Pacific Cycle products. “We could never have come up with the designs for the Sting-Ray. We are much better at making bikes.”

None of China's reputation as a low-cost producer is evident at the massive Dongguan operation, which will turn out 1.5 million bikes annually over the next three years, enough to supply the entire Canadian market. Workers, recruited mostly from inland China and housed in massive barracks located behind the plant, walk around the 98,000-square-metre facility dressed in stylish company uniforms. The spacious company cafeteria, leisure facilities and immaculate landscaping are testament to one of China's lesser-known secrets: it's getting harder for companies to attract workers, especially in the red-hot southern and coastal areas.

For skilled help, the situation is even worse. It's not uncommon to find Chinese workers job-hopping for even small salary increases, something that would have been unimaginable 10 years ago. To keep up, companies like Ideal have to pay higher salaries and supply better working conditions. “With China's aging population and its one-child policy, there's going to be a squeeze,” says Schwartz. In fact, Dorel has already been forced to look increasingly northward in the Shanghai area for suppliers, in order to tap broader labour pools. And like many companies, Dorel is studying other Asian production alternatives such as Thailand and Vietnam to pick up the slack.

Despite Dorel's continuing success, analysts express concern on two points: its high debt (US$497 million) and the fact that two clients, Wal-Mart and Toys “R” Us, account for almost half of its sales. Dorel had planned to pay down about $100 million of that debt last year, a move delayed by the Pacific deal. But executives remain committed to renewing the paydown this year. Beyond that, Schwartz hesitates about making longer-term commitments. Both he, his brothers and Segel remain active in the company and because of their relatively young age, succession is not an issue. “We've always said that we'd continue doing this as long as we are having fun,” he says with a smile. “And right now we are having fun.