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Ferro Industrial Products (Pty) Ltd and Spectrum Ceramics CC (51/LM/May07) [2008] ZACT 9 (23 January 2008)
.RTF of original document
IN THE COMPETITION TRIBUNAL OF SOUTH AFRICA
CASE NO: 51/LM/May07
In the matter between:
FERRO INDUSTRIAL PRODUCTS (PTY) LTD
Acquiring firm
And
SPECTRUM CERAMICS CC
Target firm
______________________________________________________________________
Panel
: DH Lewis (Presiding Member), N Manoim (Tribunal Member), and
Y Carrim (Tribunal Member)
Heard on
: 2 October 2007
Order issued on
: 9 October 2007
Reasons issued on
: 23 January 2008
REASONS FOR DECISION
THE PARTIES TO THE TRANSACTION
[1]
The primary acquiring firm is Ferro Industrial Products (Pty) Ltd (“Ferro”). The shareholders
of Ferro consist of: Investec Bank Limited (“Investec Bank”) which is a subsidiary of Investec Limited (“Investec”),
and management composed of Ian Forbes, George Duncan, Tinus VD Merwe and Johan Herbst who are individual shareholders. The primary target firm is Spectrum Ceramics CC (“Spectrum”),
a close corporation solely owned by Mrs Albina Alegra.
THE TRANSACTION
[2]
In terms of the proposed transaction Ferro intends to acquire the business operations and assets
of Spectrum as a going concern, including Spectrum’s associated names and styles. Ferro’s stated rationale for the acquisition
is to optimize and expand synergies in the production of frit and glaze in the local market. As far as Spectrum is concerned, Mrs
Alegra wishes to retire and has decided to sell the business to Ferro.
[3]
The parties have agreed that post-merger, Spectrum will be maintained as a subsidiary of Ferro and
that Mrs Alegra will continue to manage it for an indefinite period of time.
BACKGROUND TO THE HEARING
[4]
The Competition Commission submitted its recommendation in relation to this transaction to the Tribunal
on 15 August 2007. During the course of the Commission’s investigation, a few customers of the merging parties expressed the
concern that the merger will have an adverse impact on the price and quality of glaze .
[5]
Despite these concerns the Commission concluded that the transaction was unlikely to substantially
lessen or prevent competition in the glaze market and recommended an unconditional approval of the transaction.
[6]
In the course of the Commission’s investigation, it also emerged that Ferro, the acquiring firm,
had previously been present in the manufacturing of glaze, had then exited the market and had subsequently re-entered the market.
[7]
Having regard to the above history, the Tribunal held a pre-hearing on 31 August 2007 and requested
further information from the merging parties. The Tribunal also requested the Commission to obtain comparative pricing data in the
glaze market in order to assess the impact of Ferro’s entry, exit and re-entry on prices in the glaze market. A hearing was
held on 2 October 2007 and the following witnesses testified before the Tribunal:
1) Mr Renato Gonzalves from Smalticeram;
2)Mrs Alegra Albina from Spectrum;
3) Mr Allan Kromm from Vaal Sanitaryware; and
4) Mr Ian David Forbes from Ferro.
[8]
After the hearing the Tribunal approved the merger conditionally. These are our reasons for the
decision.
BACKGROUND TO THE TRANSACTION
[9]
Frit is a smelted compound made of various raw materials such as silica, feldspar, limestone, zinc
oxide, zircon flour and borax. It is essentially water quenched molten glass which is used as the base for producing ceramic glaze.
Frit is the main input for ceramic glaze. At the time of notification of the transaction, Ferro was the only producer of frit in
South Africa, and was also active in the downstream glaze market. Frit can be substituted with crushed glass, and is regarded as a commodity by glaze producers which can be sourced easily internationally.
[10]
Glaze is a vitreous coating used on ceramic products such as tiles and sanitary ware. It is made out
of a mixture of frit and various other materials such as silica, clay, calcium carbonate and others. Glaze can be manufactured without having any frit in it but this depends on the method deployed by the manufacturer. A process of
manufacturing that utilizes very high temperatures would not require frit as a smelted compound but would use the individual components
of frit. In South Africa glaze is produced at relatively lower temperatures and the process requires frit as a smelted compound. Glaze is not regarded as a commodity and customers who are concerned with the quality of the glaze tend not to import glaze as a
completed product. There are no substitute products for glaze.
[11]
The total South African Market for all glaze (excluding imported tiles) in 2006 was approximately R209.7
million, of which 6.5% was spent on glaze required for sanitary-ware products, 1.5% was spent on other applications such as dinnerware,
pottery and the remainder, approximately 92%, on tiles. The largest consumers of glaze in South Africa are tile manufacturers, the
largest of these being Ceramic Industries Limited (“CIL”). Tile manufacturers therefore possess a relatively high degree
of bargaining power in the glaze market.
[12]
In general, two types of glaze are used in tile manufacturing. Glaze 1 is the basic glaze which forms
the undercoat or base, and is known as engobes. Glaze 2 is the final top coat of glaze which is applied in either a gloss or matte
finish.
[13]
The manufacturing of glaze involves a highly specialized process requiring technical skills. However,
it is considered to be both a skill and an art form because the quality of glaze is inextricably linked to the design of the clay
product, especially so in the tile industry. In the tile manufacturing sector, glaze producers are very closely associated with their
clients’ production processes, at times being stationed at their customers’ plants. In some instances, the relationship
between glaze producers and tile manufacturers tends to be a technical partnership spanning a number of years.
Relationship between Ferro and Spectrum
[14]
Spectrum has been involved in the glaze market for more than 10 years. The business was started by Mrs
Alegra and continues to be run very much under her supervision and expertise. The relationship between Ferro and Spectrum pre-dates
this transaction. Ten years ago Ferro acquired Republic Enamels (“Republic”). Republic Enamels was a competitor of Ferro.
Mrs Alegra was an employee of Republic at the time of that merger. She decided to venture out on her own rather than stay with the
merged entity and established Spectrum.
[15]
Over time and under Mrs Alegra’s management Spectrum established a strong reputation in the market
due largely to the fact that Mrs Alegra and her team constantly strived to improve the quality of glaze, through research and development,
while keeping prices at a reasonable level. Unlike other glaze producers Spectrum was able to provide its customers with customized solutions and an integrated offering. Spectrum also offers a standard glaze product for certain uses such as enamelware. However its flexibility and responsiveness to
customers’ needs became the hallmark of Spectrum’s business.
[16]
Ferro on the other hand did not fare so well in the glaze market. Republic Enamels, trading under Ferro
SA after the merger, under -delivered in terms of service and quality standards. This led to a decision by Ferro to withdraw from
the downstream glaze market and concentrate its efforts on the manufacture and supply of frit. After Ferro’s withdrawal from
the glaze market, Spectrum became Ferro’s largest customer of frit.
[17]
Ferro subsequently underwent a change in management due to a sale of shares financed by Investec. In 2005 Ferro decided to re-enter the glaze market in competition with its largest customer, Spectrum. The decision by Ferro to re-enter
the glaze market was apparently motivated by its desire to improve margins and move away from a commodity product such as frit to
a value- added product such as glaze. When it decided to re-enter the glaze market, Ferro set itself to achieve 20% share of the
glaze market within a period of two years. However, this strategic objective turned out to be unrealistic and optimistic.
[18]
In response to Ferro’s re-entry into the glaze market, Spectrum stopped purchasing frit from Ferro
and sourced it from imports. While Ferro had, at the time when it decided to re-enter the glaze market, identified the loss of Spectrum’s
custom as one of the possible risks of entering the glaze market, it seems to have once again underestimated the impact of such loss
on its own business.
[19]
The glaze market soon proved to be much more difficult than predicted for Ferro. Ferro found it extremely
difficult to break into the glaze market in any meaningful way, having gained only about 7% of the market in two years. In addition
it was also incurring losses in its frit business as a result of the loss of Spectrum’s custom. No other glaze producer was
large enough to off-take sufficient quantities of frit from Ferro at profitable levels as Spectrum had been able to do. At the end
of two years Ferro was suffering heavy losses and was forced to revise its targets as well as its strategy in the frit and glaze
markets.
RELEVANT MARKET DEFINITION
[20]
As discussed above frit is the main input for glaze. After a lengthy investigation the Commission identified
two relevant markets namely the upstream market for the manufacture and supply of frit and a downstream market for manufacture and
supply of glaze. These relevant market definitions were common cause between the Commission and the merging parties.
Upstream frit market
[21]
Frit is regarded as a commodity by the industry and can be sourced relatively easily internationally.
Mrs Alegra testified that when Ferro decided to enter the glaze market again, she stopped purchasing frit from Ferro and was able
to source imported frit easily at market related prices. Other competitors in the market such as Bonet and Smalticeram source all their frit requirements from Spain and Brazil. Given the
ease with which market participants have been able to source imported frit, we are of the view that this transaction does not give
rise to any competition concerns in the upstream frit market.
Downstream Glaze Market
[22]
The Commission identified the relevant downstream market as the manufacture and supply of glaze. The
geographic market was defined as national. We agree with the Commission’s findings. Unlike frit, glaze is not regarded as a
commodity and is not traded as such internationally. The price and quality of glaze are inextricably linked to the price and quality
of clay products produced in domestic markets.
[23]
The Commission identified the following players in the glaze market and set out their estimated market
shares for the year 2006 as follows:
| COMPANY NAME |
ESTIMATED MARKET SHARE (%) |
Bonet (Spain)
Colorobia (Spain/Italy)
Smalticeram (Brazil)
Glazecor (South Africa) |
23% |
[24]
From the above table it is clear that Spectrum is the leading producer of glaze in the market, with a market
share of 50%. Spectrum’s next largest competitors; i.e. Bonet, Colorobia, Smalticeram and Glazecor have a combined market share
that is less than half of Spectrum’s share. Bonet’s estimated market shares, based on sales indicated that Spectrum has
65%, Ferro 5%, and Bonet 30%. Both estimates show that Spectrum is the leading player, and Ferro a very small player in the glaze market.
[25]
Ferro’s status in the glaze market was uncertain at the time that this matter was heard. At the
pre-hearing the Tribunal was advised that Ferro was planning to exit the glaze market irrespective of the outcome of this inquiry.
However, its presence in the glaze market continued during the course of the hearings.
[26]
Mr Kromm testified that he was unaware of Ferro’s exit from the glaze market and that he was under
the impression that they were still supplying glaze to the tile industry. Mr Ian Forbes on behalf of Ferro testified that Ferro was simply complying with its residual obligations to its existing customers
with whom it had concluded supply contracts. It was not seeking new customers and had already closed its plant in Babelegi. However,
as discussed below, Ferro’s absence or presence in the glaze market does not significantly affect our conclusion on the horizontal
effects of this transaction.
COMPETITION ANALYSIS
[27]
The Commission had recommended that the merger be approved on the basis that barriers to entry were low
in the glaze market and that new entry in the form of Smalticeram had already taken place. Accordingly it held that the horizontal
effects of the transaction would not lead to a substantial lessening or prevention of competition.
Horizontal analysis
[28]
Spectrum is already the leading glaze producer in the market, with a market share of approximately 50%
as estimated by the Commission and 65% according to Bonet. If we were to assume that Ferro is still active in the glaze market then
the merged entity will have 57% or 70% of the glaze market. In both cases the market share accretion will be small and range between
5-7%.
[29] In order to assess the impact of this transaction on prices in the glaze market, the Tribunal had requested that the Commission
look at the history of prices in the glaze market, given that there was a history of entry and exit by Ferro. The Commission obtained
price information from the three largest players in the glaze market, namely Spectrum, Bonet and Ferro. The Commission’s investigations
included comparison of pricing data sourced from suppliers and customers alike, as well as interviews with customers and competitors.
[30]
The Tribunal’s request was also motivated by the concerns raised by Vaal Sanitaryware. Mr Kromm from
Vaal Sanitaryware who had expressed concerns about the merger during the Commission’s investigation, testified that in his
view the presence of Ferro or a third player in the glaze market would exercise some competitive constraint on the price of glaze
in the market. Mr Kromm was of the view that while glaze was essential for his products, he did not have the economies of scale,
as did the tile manufacturers, to negotiate a volume discount with any glaze supplier. He was especially concerned that Spectrum,
could post merger, raise its prices unilaterally and lower the quality of its product without regard to its competitor’s behavior.
[31]
The Commission’s investigation into prices of glaze was limited to data obtained for the period
2003-2007 and showed that Ferro’s exit from the market and subsequent re-entry had a minimal, if any, impact on the price of glaze in
the market. When Ferro re-entered the market recently, its prices were lower than that of Spectrum and Bonet. However, Spectrum and
Bonet did not respond with reductions and maintained their prices. Soon thereafter Ferro’s prices increased and industry prices
leveled out. Ferro’s entry in the glaze market clearly posed no price constraints on its competitors. Both Spectrum and Bonet
continued to behave independently, as far as price competition is concerned, of Ferro’s entry in the market.
[32]
At the hearing, Mr Forbes explained that Ferro was unable to sustain the initial lower prices and consequential
lower margins over a prolonged period of time because it had not been able to secure large customers in the tile manufacturing sector.
Despite its lower prices, tile manufacturers were not keen to try its products. Ferro was unable to match the designs, quality and
service levels provided by Spectrum. Spectrum on the other hand was able to offer customers good tile designs, good quality glaze
and excellent service levels. Spectrum was also able to improve or at best retain the quality of glaze in the face of rising input
costs due to Mrs Alegra’s skills and passion. Ferro also did not have skilled people, as Spectrum did, who could be deployed
to customer’s premises at any given time to attend to any problems that may arise in the glazing step of the manufacturing
process. In order to ward off the losses it was incurring, it raised its prices but was still unable to compete with Spectrum on
quality and service levels.
[33]
Mrs Alegra testified that while the price of glaze was important to customers, quality and service levels
were equally if not more important than price. Imported glaze exercised a very limited, if any, constraint on domestic glaze prices
since customers are concerned about the quality of the product. In instances where glaze is imported by tile manufacturers, the concern
with quality has led to a practice where the glaze is imported for their own consumption from a glaze manufacturer with whom they
have had a long standing relationship. In general transport costs, tariffs and quality requirements and language barriers do not make the importation of glaze a reasonable
and practical alternative for customers. In her view, supported by Mr Kromm, Ferro was an inefficient company, with poor tile designs and lacking in skills to produce a good
quality product.
[34]
Mrs Alegra testified further that it was the large customers, such as tile manufacturers, rather than
her competitors, who exercised some constraint on price increases. Because the price of glaze affected the ultimate price of the
ceramic product, large customers such as CIL, exercised countervailing power and would not easily tolerate a unilateral increase
in price since it would affect their ability to compete in the tile market. While price was important to them, the quality of glaze
was far more important since it affected the quality of the ultimate product. This is why they often established partnerships, as
Johnsons had done, with glaze producers who were intimately involved in their production processes. This view is supported to some
extent by Mr Kromm’s evidence in which he stated that Vaal Sanitaryware would only switch to imported glaze if there was a
price increase of more than 10 - 15% because of quality concerns, and further because it is difficult to import a good or appropriate
quality of glaze for the reason that the supplier needs to gain insights into their products over time. Language differences and
distance affects the ability of manufacturers and glaze suppliers to achieve this.
[35]
Hence we see that in the glaze market price competition is not as important as competition on the basis
of quality and service levels. As shown by the Commission’s pricing analysis, Ferro’s entry, exit and subsequent re-entry
had little if any impact on the prices of glaze. Ferro had exercised no price constraint on Spectrum or Bonet. Even after it had
raised its prices, Ferro was unable to effectively compete on the basis of quality or service levels and was suffering losses to
such an extent that it was forced to reconsider its strategy in the glaze market. In our view from a horizontal perspective, the
transaction is unlikely to increase the likelihood of co-ordination or unilateral price increases. Nor will the removal of Ferro
from the glaze market, as a result of this transaction lead to the removal of an effective competitor.
Vertical Analysis
[36]
We are satisfied that no competition concerns arise in the upstream frit market. Furthermore because frit can
be easily imported and is regarded as a commodity, glaze producers would easily be able to find alternative suppliers of frit in
the event that the merged entity attempted to engage in foreclosure strategies.
[37]
The main concern raised by Mr Kromm in relation to the vertical effects of this transaction was that
Spectrum would become integrated into the sluggish and inefficient culture of Ferro and that Ferro would require Spectrum to purchase
frit from it at non-market related prices which would be passed onto the customers. In his view this vertical integration would lead
to a lowering of quality, poorer service levels and higher prices.
[38]
While the larger consumers of glaze such as tile manufacturers enjoyed economies of scale and could exercise
countervailing power and constrain price increases, smaller consumers such as Vaal Sanitaryware did not enjoy such advantages. Mrs
Alegra confirmed that tile manufacturers such as CIL exercised countervailing power and usually enjoyed volume discounts in the form
of rebates which smaller players did not enjoy. These large customers also had the resources to facilitate new entry into the glaze market, as CIL was doing with Smaliticeram, in
order to meet their price and quality requirements.
[39]
As far as quality of glaze and service levels are concerned both Mrs Alegra and Mr Forbes assured the
Tribunal that Spectrum would be retained as a separate subsidiary managed by Mrs Alegra. They had no intention of reducing the quality
of glaze produced by Spectrum or service levels rendered to customers because this was the basis of Spectrum’s success. As
far as higher prices are concerned, both Ferro and Mrs Alegra assured the Tribunal that there was no intention to supply frit to
Spectrum at prices that were not market related.
[40]
However, in a letter addressed to Mrs Alegra on 16 February 2007, in which certain conditions of the
deal were discussed, Mr Forbes states: :
“Subject to acceptance of the Offer, Ferro will exit the tile market and supply raw materials to Spectrum on an import parity price
basis or at a 20% GP, whichever is higher…”
[41]
Furthermore, Clause 10.4 of the Sale of Shares Agreement concluded by the merging parties states that:
“For the duration of the Future Earnings Period, all raw materials supplied by the Purchaser or its subsidiaries to the Business shall
be supplied at a price which is the greater of an amount determined by the Purchaser supplying the raw materials to the Business
at a gross profit of 20% (twenty percent) or a price determined on an import parity pricing basis (delivered Jet Park). The Business
will endeavour to maximise the synergistic benefits for both the Purchaser and the Business, by at all times utilising the Purchaser’s
locally produced material in favour of imported or alternative suppliers of raw material. The Business shall be required to acquire
such raw materials from the Purchaser or its subsidiaries provided that the price, the quality of the raw materials supplied, availability
and delivery times accord with market standards. The Surety undertakes to procure that the stock of raw materials held by the Purchaser
as at the Closing Date will be used in the Business on the aforesaid basis.”
[42]
When these documents were put to Mrs Alegra, she testified that her understanding of the terms of the
sale was that Spectrum will continue as an independent subsidiary from Ferro and that she was free to purchase frit from whomever
she chose provided quality and price were market related. Mrs Alegra explained that Spectrum had become the leading producer of glaze
in South Africa because it produced the best quality glaze at reasonable prices. Its continued success in the glaze market depended
on it being able to continue doing so. She would not purchase frit at a premium from Ferro because this would increase her input
costs, a cost she would not easily be able to pass onto her customers, the large tile manufacturers, who faced intense competition
from international suppliers and who had countervailing power in relation to the price of glaze in the South African market. However, this did not address the concern raised by Mr Kromm that such price increases would be passed onto smaller customers, such
as Vaal Sanitaryware, who did not enjoy countervailing power.
[43]
Mr Forbes did not explain the intention behind clause 10.4 but testified that despite the existence of
clause 10.4 there was no intention to supply frit to Spectrum at inflated prices. However, Ferro’s correspondence with Spectrum prior to the conclusion of this deal, suggests that it intended to do just that.
[44]
Nevertheless, both the merging parties were willing to accept a condition that prevented Ferro from requiring
Spectrum to purchase frit from it at prices higher than market related prices. 