ABC Hides Company is a Ugandan trader of skins and hides that is considering investment possibilities in COMESA to add value to its exported products. Starting as a simple trader of raw hides and skins between producers and exporters, they have integrated the trading relations from production to port, and provide a regular though modest supply of raw skins and hides to the international market. Much of their catchment area is close to the Kenyan border and they believe that they can also add Rwandan and Kenyan operations, taking advantage of falling transport costs along the Mombassa-Kampala corridor. Investment to date is in two small collection warehouses, a larger warehouse near the port, and some small trucks. They currently provide no value added, only consolidation and shipping, but recognize that even small investments in upgrading their products can move them up the value chain to capture higher value on the export market. Long-term, they are considering the possibility of manufacturing leather goods for the regional COMESA market.
2. Opportunities in the Industry
ABC knows that the export market is willing to pay significantly higher prices for sorted and graded hides and skins, and even better prices if the pulling quality can be improved. The market is far from saturated, and recent destruction of European cattle and limitations on growth due to Mad Cow and Hoof and Mouth diseases actually increases demand, at least in the short-term. Adding value will require downstream training in production, grading, sorting, and quality control issues. Regionally, there is also increasing demand among Kenyan companies for local hides, both for re-export to Europe and Asia and for value added processing, including tanning and leather goods production. Ugandan tanneries are operating well below capacity and there appears to be no realistic local growth potential in the leather products industry due to low buying power locally and low quality for the export market. ABC believes that their best opportunities for upstream expansion, aside from moving from raw to wet blue hides, is to partner with a firm based in Kenya.
3. Investment Process
As an established trader, ABC already understands the trading system from slaughterhouse to port, and has established relationships with Ugandan suppliers and a few low-end European and Asian buyers. The company is familiar with processing, but does not understand it, and will need to obtain training as well as providing it to the suppliers. They believe that they can also invest in warehousing and processing facilities in Kenya along the trade routes to add value to Kenyan raw hides and skins. Several competitors further east in Kenya have the processing skills, but they but do not want to provide them to ABC based on a misconception that ABC will then compete directly with them. As a result, ABC has decided to approach the East and Southern African Leather Industry Association (ESALIA) to see if trainers are available through that organization, as well as contacting their foreign buyers for possible training. Due to costs and difficulties in bringing in foreign trainers, they decide to send several individuals for training in Kenya. They assume that there will be immediate pay-off as they improve the quality of hides and skins, and as they grade and sort the skins and begin to look into the purchase of additional land and facilities for processing and warehousing in Kenya and Rwanda. ,
They believe that they can finance their initial investments from existing cash flow and the immediate increase in revenues expected from value added, especially by moving into the very lucrative Italian market. They have decided that any additional upstream investment into actual tanning and leather production will need to wait due to high costs of equipment, chemicals, and effluent treatment facilities and the excess capacity of existing tanners. Even then, they expect to partner with Kenyan tanner, and have decided to build relationships by entering supply contracts now with several Kenyan tanners for wet blue hides.
Cost of Investment: For quality improvement, the upfront costs are relatively low, consisting of training and purchasing of improved skin pulling equipment. ABC feels that this can be funded from their current cash flow, with no need to borrow. They can train some of their traders who have a background in hide production to train Rwandan, Ugandan, and Kenyan pullers in higher quality skin production.
Each step up the value chain will require substantially more investment. Processing will increase the need for warehouse and processing space, additional staff training and hiring, plus some equipment and inventory of inputs. They are vaguely aware that there may be environmental laws about processing, but assume that the laws can be ignored or that the officials can be paid off. Land is available in rural areas – close to the producers – at low cost, but may take time to obtain. ABC believes they can navigate the bureaucracy sufficiently through contacts, relatives, and payments to speed up the process, and to obtain licenses they will need.
For tanning, the initial costs are prohibitive without significant financing, especially if they must comply with effluent treatment laws. If they can share effluent treatment facilities with other producers, then they can lower the cost. This is one reason they have decided to work with a partner, initially through a supply contract, and put off larger investment until later.
Revenues: For the export market, ABCs revenues from improved quality, graded and sorted hides will come from the established international market for hides and skins. They feel that they can immediately improve their revenues with existing buyers, and can find other buyers who are in the market for wet blue hides instead of raw. Thus the market is much larger and has pays more for improved products than is true for their current line.
ABC believes that it can also obtain acceptable returns exporting to Kenya under a supply contract, especially because Kenyan exporters receive a 20% rebate on exported products, giving them more money to purchase downstream products. Examination of the finished products market, however, is very different. The buying power in the region is very low, products must compete with imports of second-hand shoes, which are very inexpensive, and the leather products simply do not compete well on the international market due to quality. They decide that they will not enter the production line at all, but may look into it again in five or ten years.
Cost of Doing Business: The major costs for ABC will be in transport, tariffs and duties. Transport cost is already something they know well as traders and exporters, so that ABC sees no additional problems there. For tariffs and duties, they already handle Kenyan and Ugandan taxes. If they incorporate a subsidiary in Kenya, however, as a Kenyan company, they can also capture the 20% Kenyan rebate for exports of value added skins and hides. They will also need to learn the import side of the equation in order to bring in the chemicals and equipment they need. If they can develop themselves as a supplier of these items in the region, they can also defray the costs of sending their trucks home empty from the port.
Risk: ABC’s most significant risks are at the Kenyan border. Unstable practices in applying duties result in varying costs. Although ABC has the raw hide system down well, the wet blue market is new to them. In addition, there ability to develop Kenyan businesses may be negatively affected by selective subsidies to purely Kenyan companies who will be competing for the same raw skins, but at with a lower cost structure. Smuggling is an issue for supplying skins to Kenyan tanneries because smugglers can undercut their prices and reduce their market share. For export to Europe and Asia, however, it is not particularly relevant
The ABC Hides case study focuses primarily on the costs of investment. Although this Ugandan company understands the dynamics of its own country and the export market for one commodity, they do not fully understand the complexities of expansion.
Their first investment is in training. ESALIA, the Leather and Leather Products Institute, and a number of public and private sector initiatives to improve skills in the leather industry will enable ABC to obtain training at different levels and lower costs than were available until a few years ago. These organizations are beginning to respond effectively to demand in providing not only the needed training, but also market information and research. This will greatly enhance ABCs chances of success. On the other hand, ABC intends to keep the grading and quality control in-house to avoid expenses on contracting out. This is a mistake initially, because they do not have a reputation for the higher value goods, whereas grading by a recognized authority would ensure buyers that the goods are indeed higher value. As a result, ABC will find that they have made mistakes in sorting and grading, leading to lower returns and a damaged reputation.
To expand into processing, they will need additional land and facilities. Land is relatively inexpensive and available (except in Ethiopia, which ABC has not considered as an investment market due to this problem and the lack of any common cultural ties). However, ABC has underestimated how long and costly the process will be, and that they may encounter serious discrimination while buying as foreigners. These problems make it tempting to engage local counterparts to obtain facilities for them, but this raises the risks, especially if the local counterparts are unscrupulous. Courts may not enforce the contracts in their favor.
Failure to understand the need to establish a reputation for their value added product means that ABC will not enjoy the increased cash flow as quickly as expected, and will thus need to obtain financing for their various investments. In addition, they did not realize that their newly found Italian buyers will only take product on consignment, and that banks will not finance consignment shipments. Unfortunately, commercial lenders will also not permit them to use inventory, equipment or after-acquired property as collateral to lower the cost of financing and they may be subject to interest rates as high as 30-45% annually. This cost of capital will slow down their scheduled investment plan, requiring them to grow much more slowly as they try to build and pay off their financing while learning the new markets.
They have also underestimated the time and energy needed to obtain permits, licenses and approvals, especially when attempting to operate as a foreign company. They are likely to run into corruption among some officials, then find honest officials who will want to sanction them for attempted corrupt practices if ABCs gets in the habit of grease payments. When they run into problems in contracts with local counterparts, especially local labor, they will also find that the courts generally favor their opponents, increasing the risk of their investments.
Investment as a new comer into the tanning industry will simply not work in the current environment. There is already a very high level of excess production capacity outside of Kenya, and Kenya is only somewhat better. Initial costs of effluent treatment plants are very high, and can destroy the competitive capacity of the environmental laws are not applied to all producers. In other words, if some tanneries are not required to comply with effluent treatment laws, they will completely undercut their compliant rivals because of the high levels of expense. The local market for products has low buying power, so there is little opportunity for a newcomer to recapture investment and achieve an acceptable return on investment.
ABC will slowly be able to build its operations into basic processing, but will not get into processed leather or leather products such as shoes. However, they will eventually be able to make significant revenues from their improved quality, which will also result in higher value to the producers.
6. What COMESA Can Do
This case study provides good examples of both successes and gaps. On the success side, ESALIA and LLPI are excellent examples of the importance of strong industry organizations. These organizations reduce the cost of investment by bringing technology to the region and offering it to their members at much lower cost than would be incurred through bringing in foreign experts or sending local trainees abroad. Moreover, they provide critical market information, including price and quality data. As they develop further, they can also provide certification of quality, or assist other organizations provide such certification to ensure consistent prices. This lowers the risk for buyers and enables them to pay for guaranteed higher quality without fear of being tricked or cheated. COMESA’s support for these organizations in various sectors and products will have positive impacts for the entire region.
There are several obstacles to investment highlighted in this study. First, there are still high barriers to direct investment in the form of non-tariff barriers such as approvals and licenses. As noted in any of the many national Roadmaps, these discourage new foreign investors, but they also discourage regional investors who must put up with these problems in each new country. COMESA can continue to highlight these problems in the context of impact on regional investment and work toward regional standards based on international best practices.
Cost of funds for investment (or even for financing operations) was noted by many investors in all of the industries studied, not just leather. COMESA (in its previous incarnation as the PTA) has established and still supports a project and trade finance institution, PTA Bank, which is headquartered in Nairobi, Kenya. Other programs and institutions are needed , however, because demand for financial services is well beyond this institution and even existing commercial banks to meet. Even with increased financial services, however, the region suffers from a proper legal framework for secured financing based on registry and notice. Without this, growth will be drastically limited. COMESA should seriously consider a regional program to encourage adoption and implementation of secured financing laws and registries. In fact, this is exactly the type of change economist Hernando de Soto describes as indispensable for unleashing the value of billions of dollars of “dead capital” in the developing world.
Issues of corruption or “unlevel playing fields” have been emphasized several times in this study. It is worth noting that there is another side to this. Some investors are very good at using corruption to obtain unfair advantages and drive competitors out of business or limit market access. Thus they do not only have keep new investment out, they can create cartels and monopolies that raise the cost of goods and lower the number of jobs produced. COMESA is a natural clearinghouse for information on corruption and leading the initiatives to reduce it. The existing web site could serve as a point for confidential reporting with eventual public disclosure when accusations are found to have merit. (Claims of corruption should not be immediately made public without verification – corrupt investors are among the first to accuse their competitors of corruption when better products begin to cut into existing markets.)