China strategy has Dorel "Schwinning," in profits

Blurb: The Chinese-built Schwinn, Sting-Ray, Mongoose and other key brands in Dorel's newly acquired cycle division have fuelled much of the company's recent growth.

Shanghai ­By all accounts, the China International Bicycle and Motor Fair held here in early May was filled with smiling faces. Shipments by China's red-hot bicycle industry hit an all-time high during 2004 and the show generated impressive attendance and booth sales. But ironically, the man with the biggest smile was on the other side of the planet.

Last year Martin Schwartz, president of Montreal-based consumer products merchandiser Dorel Industries, (TSX: DII-SV) took a tremendous gamble, paying US $310 million to acquire Pacific Cycle, 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 its best year ever. As a result, Dorel finished the year with record revenues and profits, a performance echoed in its Q1 2005 results. The good news was reflected in Dorel's shares which bounced back to the $43.00 range in recent weeks, an almost 35 percent increase from their 52 week low.

The Pacific Cycle coup is nothing new to Schwartz, who runs Dorel with his brothers, Alan and Jeffrey and brother-in-law Jeff Segal. The Schwartzes are seasoned business veterans, who through a string of astute acquisitions turned the company that their father Leo founded into one of North America's most aggressive marketers.

It was an impressive accomplishment. Today Dorel is the world's largest children's products distributors and one of the two largest ready-to-assemble (RTA) 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 K-Mart. Particularly impressive is Dorel's long-term track record. During the past ten years the company has generated exceptional compounded revenue (22 percent) and profit (33 percent) growth.

The Pacific 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," said Schwartz, 57, who has been doing business in Asia since his mid-twenties. In many ways Dorel is in the razor's edge of the massive changes in the world's economy, which have been accelerating since China's entry into the WTO in 2001.

While Dorel is a major importer of hundreds of items, ranging from high chairs to booster seats, 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 out-source.

"Our strength is design, brands and marketing," Schwartz said, "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 there. (He visits three or four times a year, in large part to maintain relationships, --what the Chinese call "guanxi,"-- with suppliers who like to feel they are dealing with the top guy).

The huge videoconference screen in Dorel's boardroom is another clue, as is and 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, a huge issue with Asian manufacturers.

At first, Pacific 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 labor costs mounted,-- over to the mainland, an area which 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 said. "There was a lot of common ground."

One pleasant surprise that did not show up in the due diligence review the Schwartzes did on Pacific Cycle, were sketches employees had done for an updated version of the Schwinn Sting-Ray.

Schwinn is America's best known bicycle brand with an impressive 88 percent market recognition. The Schwinn Sting-Ray, famous for its "banana seat," was wildly popular during the 1960s and 1970s, but lay mostly dormant of late. Pacific's marketing staff had expected to sell maybe 50,000 units of the re-launched model, which looks like a kid's version of a Harley-Davidson 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 U.S. $180 range. Sting-Ray ended up winning the "best outdoor toy" award, at the International Toy Fair Awards and earlier this year the company added an electric version of the bike and 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, was able to use its newfound clout to wrestle volume discounts from transportation companies. And the new entity was also able to reposition overseas operations to generate better tax efficiency, a move that brought an additional $25 million of operating earnings.

But it's Dorel's partnerships with its 100 Chinese suppliers, which are its increasingly crucial success driver. Like most Western-Chinese partnerships, Dorel supplies the designs, brand development and the marketing and China supplies production.

It's a relationship that works well says Louis Chan, president of Ideal Group, a Taiwanese based company which manufacturers bicycles at mainland China plants for several Western firms, 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," said Chan on a tour of the company's recently opened DongGuan facility, which last year devoted almost half 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 when it's final phase is completed, will turn out 1.5 million bikes a year, enough to supply the entire Canadian market.

Workers, recruited mostly from inland China, and housed in massive barracks located behind the plant, scurry around the 700,000 square foot facility dressed in stylish company uniforms, that are worn by both managers and staff. The spacious company cafeteria, leisure facilities and immaculate landscaping are testament to one of China's lessor 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 ten 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," said Schwartz. In fact Dorel has already been forced to look increasingly northwards in the Shanghai area for suppliers, in order to tap broader labor 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 point to its high debt and to the fact that two clients (Wal-Mart and Toys "R"Us) account for almost half of the company's 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 pay-down during 2005.

Like many companies that trade on U.S. exchanges Dorel has also moved aggressively to address Sarbanes-Oxley compliance issues and recently expanded its board to increase the number of independent directors, which now hold six of the ten available slots. But Schwartz remains adamant about maintaining Dorel's dual class share structure, arguing that in the event of a takeover, all shareholders would be treated equally.

Beyond that, Schwartz hesitates about making longer-term commitments. Both he, his brothers and Segal remain active in the company and because of their relatively young age, succession is not an issue. Cashing in some chips also seems like an unlikely option.

"We've always said that we'd continue doing this as long as we are having fun," he said with a smile. "And right now we are having fun."

 

Photo caption: Louis Chan, president of Dorel sub-contractor Ideal Group, checks the production line at the company's massive DongGuan facility.

Sources:

o Company statistics from Dorel's annual report, quarterly statements, management proxy, and annual information form.
o Analyst reports: CIBC, RBC Securities, Oppenheimer
o Dorel's media contact: Rick Leckner, Maison Brison: 514-731-0000
o Martin Schwartz: 514-934-3034
o Ideal Group, Louis Chang, louischang@idealbike.com.tw,
86-0-769-895-1888
o Shanghai International Exhibition, Kevin Zhou,
021-627-92828-248, zhoucy@siec-ccpit.com

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