Microsoft Word - BHP Case.docx

Diesel Price Risk at Bennett Hughes Productions

In early 2007, at 65 years old, Bennett Hughes was ready to retire. To do so, he would have to sell the Nashville, Tennessee-based live event and concert production company, Bennett Hughes Productions, LLC (henceforth BHP), that he had founded and grown over the previous three decades. Bennett Hughes had used the connections he had made during his employment in the 1970s as The Leonard Skinner Band's tour manager to start BHP in the early 1980s. Over the course of nearly 3 decades, BHP had done thousands of concerts and events in Nashville and the surrounding area.

As a full-service live event production company, BHP's business was quite simple; BHP provided all necessary equipment and personnel to set up and run a concert or live event. On a typical gig,1 BHP employees would drive trucks full of staging, lighting, and sound equipment from BHP's warehouse to the event site, unload the trucks, build the stage, set up the lights and sound equipment, and run the event. After the event was over, BHP tore down the stage, lights, and sound equipment, loaded up the trucks, and drove them back to the BHP warehouse. BHP bid for gigs on average one year in advance of the date of the gig, and contracts are signed within one month of submitting the bid to the client. When determining what they will bid for a gig, BHP's policy has been to estimate what it will cost them to produce the event and double it. This has resulted in generally stable gross profit margins of 50%. When estimating fuel costs, BHP uses the seasonally adjusted spot price of diesel and adds 3% to account for inflation. Because the location of the gig and the number of trucks required to transport equipment to the gig site are known to BHP, BHP can estimate the number of truck miles traveled quite precisely. BHP, however, does not have the expertise to forecast future diesel spot prices.

For the last ten years, Alan Michaels had been employed as BHP's manager and head engineer. Throughout his employment, Alan had tried to convince Bennett that BHP's profits and revenues could be grown more aggressively if the company were to pursue gigs outside of the 200-mile radius that BHP had been serving throughout its existence. Alan argued that the large number of competitors in Nashville forced BHP to accept low profit margin local gigs. If BHP would expand its range of operations, Alan believed it could charge higher prices and achieve higher profit margins. Furthermore, there were a limited number of gigs within 200 miles of Nashville, so expanding its range of operations would enable BHP to do more gigs, further increasing revenue. Bennett, however, did not share Alan's vision. Bennett believed that expanding BHP's range of operations would pose more difficulties than Alan imagined. By staying within 200 miles of Nashville, BHP was frequently able, for example, to use any one of its eight trucks to deliver equipment to multiple gigs in one day. Nonetheless, Bennett was ready to sell, and Alan saw an opportunity to grow BHP as he had been hoping to do for the past ten years.

After several months of negotiations and lining up financing, Bennett and Alan had agreed that $1.60 per $1 of revenue was a fair value for the company, resulting in a purchase price of $16,000,000. To facilitate his growth plans, Alan sought to borrow an additional $4,000,000 to expand BHP's fleet of trucks and purchase additional sound, light, and staging equipment, including a Stageline SL320 mobile stage. Alan had $1,500,000 in savings and was able to take out a second mortgage of $500,000 against the $750,000 house that he and his wife owned outright. The remaining $18,000,000 was financed through a 20-year 10% amortized syndicated loan from a group of lenders led by The Bank of Commerce of Tennessee. The terms of the loan required that BPH make annual payments of principal and interest of $2,114,000 in each December in each of the next 20 years. Alan was confident that BHP could make these payments, since BHP's annual cash flow had exceeded this amount in each of the previous 3 years.2 Furthermore, Alan's plans to grow the company would further help meet these obligations. Alan signed the purchase contract and loan documents in August 2006, and he would take over ownership in January 2007.

At the end of December 2007, Alan was reviewing BHP's year-end finances. In the first year of operations under his ownership, BHP had produced 250 more events than it had in 2006, reflecting a 12.5% increase year-over-year. More importantly, revenue had grown by $2.5 million, reflecting a 25% year-over-year increase. However, Alan noticed that gross profit margin had fallen from 47.9% to 43.9%. This concerned him. In digging deeper, Alan noticed that many of the gigs that BHP had produced in the last quarter of the year (October through December) had generated much less profit than he had forecast. To get a sense of how profit had missed his forecasts, Alan reviewed a gig in Oklahoma City that had generated especially low profit relative to his forecast. Alan had forecast that the $13,000 revenue gig in Oklahoma City would generate over $6,400 in profit; however, BHP had earned less than $5,700 in profit on that gig. His cost and revenue projections for this gig are presented in Exhibit 2.

A quick glance revealed that, even though costs for the crew had been lower than forecast, fuel costs were 31.2% higher. Looking at other 4th quarter gigs, Alan realized that fuel costs had eaten up much of the forecast profits. Upon this realization, Alan became worried that he had failed to consider how his plans to grow BHP's revenue and profits had drastically increased BHP's exposure to fuel price risk. Curious about fuel prices, Alan did a quick Goggle search for "historical diesel prices" and found the data and graph presented in Exhibit 3. Alan noticed that, in the past, diesel prices exhibited substantial seasonality-they tended to increase in the summer and decrease in the winter. 2007, however, was an exception. The price of diesel in December was higher than it had been in August. In fact, prices had increased in each of the last 4 months. Alan was worried.

BHP had contracts in place for 2008 that involved almost 3.4 million truck miles (a monthly breakdown of truck miles is presented in Exhibit 4). If the recent trend in diesel prices continued, Alan realized that he might not be able to meet the requirements of the loan he had taken to purchase BHP. If this happened, the lenders might seize the assets of the business, in which case he might be unable to make payments on his mortgage, and his family might lose their house.

To get a sense of what courses of action he can take, Alan has hired you and your team of consultants to assess his situation and determine how he can best reduce BHP's exposure to fuel price risk. Data on diesel options and diesel futures have been provided in Exhibits 5 and 6 to assist you in your analysis. BHP has cash and liquid assets on hand of $120,000, all of which Alan is prepared to spend (if necessary) on the hedging policy your team recommends.

Questions to address in your recommendation:

1. What positions in which securities can BHP take to hedge its fuel price risk? Be specific.3
2. Given that BHP's fleet averages 6 miles per gallon of diesel, calculate how much exposure BHP has to diesel price risk given the estimates of truck miles presented in Exhibit 4.
3. Now that you have determined how much diesel price exposure BHP has, devise the hedging strategy that you believe is best suited for BHP's needs. A complete answer will explain the costs and benefits of your strategy compared to other potential strategies. Furthermore, you should consider what BHP's income and cash flow will be at various future spot prices of diesel.

Format of your recommendation. Treat this assignment as if you were actually working for a consulting firm and creating a proposal to deliver to BHP. STYLE MATTERS. Support your written recommendation with whatever charts or tables you deem fit.