After reading the case on Peng Plasma Solutions and reviewing the financials we have identified 3 major problems that have occurred due to a number of factors. The first issue that Peng Plasma Solutions is facing had to do with its increasing cost of sales from 2008 to 2010 of nearly 8% while the profit margin decreased from 32.6% to 24.9%. In the region that Peng Plasma operates there was an increasing rate of turnover in labor. Many employees in the industry would leave one company for another for slightly higher wages. Charlie countered this by offering better wages than the market, but this approach cut into his gross profit margin. In addition, the cost of the raw materials that were needed to produce his products was undergoing consistent price increases.
The second problem that Peng Plasma is facing is the unsustainable growth through debt financing that the company is experiencing. Peng experienced growth in 2010 but it would be considered unhealthy due to the current RMB 242.7MM short-term debt with a 14.8% interest rate that was incurred in order to cover the financing activities. Charlie was leveraging debt without any returns, which is shown through the Debt to Invested Capital ratio of 0.72 and Debt to Equity ratio of 1.36. If Charlie had referred to “Jerry Peng’s Rules,” he would have realized that he was not following several of them, specifically #6, which states,“Growth is overrated. What counts is sustaining the family.”
The final problem of Peng Plasma Solutions was that in order to become viable in this industry there was a need to innovate and launch new products. Up to this point Charlie had not introduced a new product that had a major effect in four years. He estimated that it would take Rmb 200MM in order to do so. This investment would have to be partly subsidized by operating activities. But currently the cash flows from operating activities are declining even if the company ceased large investing activities (capital expenditures). Therefore, the company is not able to fund any capital expenditures without outside funding.
Our recommendation would be for Charlie to search out a larger firm that could potentially acquire Peng Plasma Solutions. This will give Charlie a large amount of capital that can be used for the innovation to stay competitive. But in order to become attractive for acquisition, Peng will need to collect the outstanding receivables on more timely basis, secondly cut costs where possible to increase margins (i.e labor costs), thirdly focus cash outflows towards liabilities and less on equity(i.e. pay short-term debt instead of dividends). We believe with these recommendations Peng Plasma would be able to reach the 20% ROIC mark and become an attractive candidate for outside investors.