Itek Engineering
In September of 1989, Mr Al Tanton, President of Itek Engineering, West Royalty, PEI, reflected on the events of the last twelve months. He had successfully secured a manufacturing license from Elge Heat Exchangers of Sweden and distribution rights from Naval valves of Finland and ISS Heat Meters of Denmark. Al was pleased with the joint venture relationship with each company and the quality of the products, but now he faced decisions about the future operations of his company.
Company Background
Itek Engineering was founded in 1988 to manufacture, distribute and service some of the key components of district heating systems. The founder, Mr Al Tanton, had been a consultant to contractors, engineers and other clients in the fields of metallurgy, welding and design of quality control systems for the manufacturing of pressure vessels. In recent years, he had been active consulting on district heating projects because the construction of a district heating system involved specialized welding and the use of pressure vessels.
This case was prepared by Professor Timothy Carroll of the University of Prince Edward Island for the Atlantic Entrepreneurial Institute as a basis for classroom discussion, and is not meant to illustrate either effective or ineffective management. Some elements of this case have been disguised.
Copyright 0 1991, the Atlantic Entrepreneurial Institute. Reproduction of this case is allowed without permission for educational purposes, but all such reproductions must acknowledge the copyright. This permission does not include publication.
This work led him to be in contact with a number of district heating component suppliers including Elge, Naval and ISS. The idea of becoming a distributor for each had been discussed, but never really progressed until Elge began to experience difficulties with its North American manufacturer.
The units that were being assembled by this manufacturer were not passing inspection by the PEI Department of Labour which administered the Boiler and Pressure Vessels Act. Elge hired Al as a consultant to go in and act as a troubleshooter on the failed inspections. Al supervised the welding and assembly of the heat exchangers on their behalf and his work was eventually completed.
Elge officials were impressed with Al's expertise and knowledge of district heating systems and welding. They also knew that Al's consulting activities provided a lot of contacts that could prove to be useful as they entered the North American market.
Elge calculated that it was less expensive to license sub-assembly in Canada than to establish their own operation. Mr Tanton informed Elge that he was interested in the opportunity, but did not have the financial resources to start up a manufacturing facility for heat exchangers. Consequently, Elge offered financial support in the form of collateral and payment terms. This, combined with local government assistance programs, led to the establishment of Itek Engineering.
Naval and ISS immediately initiated discussions with Itek regarding distributorship arrangements. Agreements with each company were finalized in the summer of 1989, for distribution of all products and the assembly of Elge heat exchangers.
The manufacturing operations of Itek were based on specialization. An illustration of this was the fact that Itek did not plan to hire local journeyman welders who were trained in the conventional way. According to Al, a journeyman welder was too independent and creative to follow the precise quality control requirements of an Elge heat exchanger. He planned to hire a technician who would operate a computerized welding machine.
District Heating Systems
In its simplest terms, district heating was the provision of heat from a central source and then distributed to a number of buildings. This was quite different from the conventional North American heating system where each building had its own heating unit. In Europe, district heating was available as a commercial service, much like a power utility, and anyone within the geographic limits (usually 3 Ian) could be connected to a central heating source.
District heating with steam had been used in North America in the past. In the European district heating system, water had been used as the heat distribution medium over the last 40 years. The use of water provided greater economy in overall fuel use and water was the only practical medium for transmitting heat over long distances.
The water was heated in a central boiler and distributed by underground insulated pipe to various heat consumers. The distribution was a dosed two-pipe system where hot water was pumped out to consumers and the cooled water was returned to the boiler plant for reheating.
There were three major elements in any hot water district heating system. They were:
1.Heat consumer's equipment which consisted of whatever heat distribution system they already had for the building such as radiators, convectors or forced air. The only change was the replacement of their existing boiler with a heat exchanger like the one produced by Elge.
2.Distribution system consisting of pumps, meters, valves and insulated pipework system.
3.A central heat system that could be fired from off or any other fuel. In PEI, wood chips were used as fuel.
The first installation in North America of a state-of-the-art district heating system using water was the installation at the University of Prince Edward Island (UPEI) in 1985. Some of the benefits for UPEI included the elimination of maintenance costs for several burners and boilers, reduced fire insurance premiums, alternative uses for space where burners were located and the elimination of liabilities regarding above or underground fuel storage tanks. In addition, air pollution was reduced because it is much easier to control emission from one central unit than a number of smaller units.
The total capital cost in 1985 of the UPEI system was approximately $1,500,000. Half of this cost was for the installation of a wood chip fired boiler unit and the other half included the components and installation of the district heating system. Approximately half of the district heating capital costs were devoted to the specialized insulated pipe and its installation. This pipe was purchased from I.C. Moore of Denmark. The remaining $375,000 (approximately) was paid to cover the cost of the items to be sold by Itek Engineering including heat exchangers, control valves and heat and flow meters.
According to one analysis done by the PEI Energy Corporation, the energy savings to UPEI as a result of the district heating system, were approximately $110,000 per year since 1985. The savings came from the increased efficiency of distributing heat with water and the lower cost fuel. As the price of oil increased, the savings from the system increased.
The Market
The energy crisis of the mid-seventies marked the beginning of sustained interest in North America in alternative energy sources and systems. District heating with steam was designed in North America when energy was considered to be limitless, therefore, little consideration was given to thermal efficiency. The European concept of using water and heating a number of buildings from the same source had continued to attract interest because of its economic and environmental advantages.
The typical prospects for district heating systems in North America included both public and private sector institutions, although public institutions seemed to be leading the way The typical prospect usually invested in district heating when new construction was involved or when existing systems had become unworkable. Consulting engineers were usually involved in recommending district heating. A good example were the Canadian prison facilities which were outdated and in need of repair, therefore Public Works Canada was considering the district heating system alternative.
Al Tanton had worked on the UPEI system as well as other Island systems that had been installed for buildings in the Charlottetown area. He knew there was a growing interest in district heating in North America because of the number of orders and inquiries he was receiving from consulting engineers.
When Itek first started operations in 1989, it had firm orders for fifty-seven Elge heat exchangers at a value of $230,000. In addition, $90,000 worth of heat meters and Naval valves were being ordered. This was to fill one order from Public Works Canada for installation at the Springhill Minimum Security Prison in Springhill, Nova Scotia. Public Works Canada indicated that the Springhill project was a pilot project. If district heating proved successful there, they planned to begin converting all prison facilities across Canada to district heating over the next five to ten years.
The City of Minneapolis, Minnesota had already started a major district heating retrofit. They indicated that they had installed plate type heat exchangers and they were now leaking. They had seen Elge heat exchangers in Sweden which did not leak. They indicated they would place orders with Itek as soon as Itek received their ASME-U1 certification.
In addition, Itek had received inquiries from a number of U.S. based consulting engineering firms who were involved in heating projects in Chicago, Detroit, Newark, Boston, Oregon and Minnesota.
Officials from the PEI Energy Corporation who were spearheading district heating in PEI indicated they needed seventeen additional heat exchangers along with necessary valves and heat meters for upcoming projects in 1990.
District heating was-Itek's primary market, but Mr Tanton knew from his experience with the pulp and paper and mining industries that the valves and heat meters might have applications in those industries also. This was confirmed by Naval and ISS marketing personnel. However, he was not anxious to pursue those markets right away because he had all he could handle in the district heating market.
1ASME-U Specifications for pressure vessels in Canada were administered by provincial government departments under legislation similar to the P.E.I. Boiler and Pressure Vessels Act. In the U.S.A., regulation of pressure vessels is conducted by the American Society of Mechanical Engineers (ASME). No pressure vessel can be sold by a company anywhere in the USA unless their plant and quality control procedures were inspected and approved. This was signified by an ASME-U stamp. Al was familiar with their regime and, in fact, he had just completed a consulting project in Nova Scotia for a firm that was awarded ASME artification. Al estimated the process would take 6-12 months and cost Itek approximately $100,000.
Elge Heat Exchangers
Elge was a relatively small company located in Linkoping, Sweden and employed about 110 people. It was bought by the giant conglomerate ASEA-Brown-Bavaria in 1985, and later sold to the management of the company in 1988.
The Elge heat exchangers soon became the leader in the district heating market in Europe by virtue of a technological breakthrough developed in 1980. Prior to 1980, heat exchangers were either plate type or tubular bundle type. The plate type consisted of layer upon layer of copper plates that were separated by seals. The tubular bundle type consisted of a circular bundle of copper tubes.
The plate type had the disadvantage of leaking after long periods of sustained use at high pressure and high temperatures. The tubular bundles were limited because of the number of tubes that were required to achieve capacities of heat exchange necessary for district heating. Elge developed the idea of constructing the "battery"2 with copper tubing that was wound in concentric circles.
This relatively simple principle eliminated any leaking by eliminating the need for seals and greatly increased the capacity. One Elge heat exchanger that was approximately five feet high and two feet in diameter had the same capacity of ten tubular bundle type heat exchangers or of a boiler that occupied a thousand cubic feet of space. See Exhibit 1 for diagrams and promotional information.
The proposal to Itek included North American marketing rights and a license to perform sub-assembly manufacturing. The battery or tubing works were to be shipped to Itek and Itek was
2Battery is the term used to describe the internal system of insulation and copper tubing in a heat exchanger.
responsible for forming the casing around the battery and welding the top and bottom to complete the heat exchanger. Elge assisted in the financing of Itek by giving them all the equipment except for a computer assisted welding machine. They provided promotional materials in both English and French and offered to train both manufacturing and sales personnel that were hired by Itek
The projected gross profit for heat exchangers was 40% of sales. Elge had strict rules against price cutting. They said 'When we have to cut prices to make a sale, then it's time for us to go back to our shop and develop better technology"
Naval Valves
Naval OY was also a relatively small company with about 100 employees. It was located in Laitila, Finland and produced welded steel ball valves for district heating and other high pressure applications. See Exhibit 2 for illustrations.
Although ball valves are not a new idea, the unique design of the Naval ball valve gave it several advantages over other ball valves and the more commonly used "gate" valves.
The key advantage of the Naval ball valve was its relative cost. For example, a standard 3" ball valve was sold to customers at $340.00 which compared favourably to a standard gate valve which sold for $550.00. Exhibit 2 shows that the Naval valve does not have flanges like gate valves for connecting it to pipes. The Naval valve was designed to be welded directly to the pipes which it controlled. This unique design feature combined with the low price allowed the valve to be a throw away when it eventually became dysfunctional.
The most common malfunction of a valve was when it began to leak. Gate valves have to be removed and repaired thereby requiring users to stock a supply of replacement parts. The Naval system of simply replacing the valve lowered inventory costs and reduced downtime for replacement.
The unique stainless steel construction combined with the flexible joints that sealed the ball tightly in place, regardless of whether it was opened or dosed, were important features. These features extended the useful life of the valve and reduced problems of leakage and seizing under high pressures.
Naval signed an agreement giving Itek exclusive distribution rights for Canada at a price that would return Itek a margin on sales of approximately 40%. Distribution rights were limited in the United States because another company was servicing the oil industry there. Naval indicated that when Itek was up and running with heat exchangers, they were interested in a subassembly agreement with Itek.
Al indicated that this would probably involve putting the handle on and painting the valve. Naval OY agreed to advance inventory in the early stages of Itek with no fixed payment terms until the company was on a more solid financial footing.
ISS Heat Meters
ISS Electronics was a large company based in Denmark with facilities all over the world that produced and sold electronic products. It was one division of a multi-faceted company involved in ventures that ranged from management of large buildings in the United States to making parts for the European automobile industry
Itek had an agreement to market the ISS Combimeter exclusively in Atlantic Canada as well as territorial marketing rights in other parts of Canada and the United States. The gross margin on Combimeters could range from 20% to 40% depending upon the volume sold. ISS also paid an additional 5% margin over the volume margins for accurate sales forecasts. This was because they had installed a state-of-the-art "just in time" production system which, combined with accurate sales forecast, held the potential for significant cost savings.
The Combimeter was a meter which measured the flow of heat and fluids electronically Unlike conventional flow and heat meters, the Combimeter had no moving parts and was much more precise than the mechanical alternatives. See Exhibit 3 for illustration and details.
Mr Tanton felt that there were a number of significant selling points for the ISS meters that gave them a competitive advantage over other market offerings. It was one of the few types that allowed measurement of both heat and flow with the same meter.
The 'black box' electronic technology made the meter more accurate and less susceptible to leaking and wearing out. If a problem did occur, then the computer assisted servicing made repairs quick and efficient. All of these features, combined with a competitive edge, led Mr Tanton to conclude that this item held great sales potential not only in district heating systems, but also for use in the mining and forest industries.