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Transcript of Joel L. HeilprinHarvard Business School © 59 th Street Partners LLC Mercury Athletic Footwear...
Joel L. HeilprinHarvard Business School © 59th Street Partners LLC
Mercury Athletic Footwear
Discussion MaterialsFor Additional Coverage of the Topics
Please See Your Professor
Or
E-mail me at [email protected]
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Overview of Active Gear: Active Gear is a relatively small athletic and casual
footwear company $470.3 million of revenue and $60.4 million of EBIT
compared to typical competitors that sold well over a $1.0 billion annually
Company executives felt its small size was becoming more of a disadvantage due to consolidation among Chinese contract manufacturers
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic FootwearOverview of Active Gear:
Products: Specialty athletic footwear that evolved from high
performance to athletic fashion wear with a “classic” appeal Casual/recreational footwear for walking, hiking, boating, etc.
Customers: Affluent urban & suburbanites in the 25-45 age range (i.e.
“Yuppies”) Brands are associated with upwardly mobile lifestyle
Distribution: Department & specialty stores – no big box retailers
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Overview of Active Gear: Company strengths:
By focusing on a portfolio of classic brands, Active Gear has been able to lengthen its product lifecycle
In turn, this has led to less operating volatility and better supply chain management as well as lower DSI
Company weaknesses: By avoiding the chase for the latest fashion trend and
avoiding big box retailers, the company has had very low growth
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Overview of Mercury Athletic: Mercury was a subsidiary of a large apparel company
As a result of a strategic realignment, the division was considered to be non-core
2006 revenue and EBITDA were $431.1 million and $51.8 million respectively
Under the egis of WCF, Mercury’s performance was mixed WCF was able to expand sales of footwear, but was never
able to establish the hoped for apparel lineJoel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Overview of Mercury Athletic: Products:
Men’s and women’s athletic and casual footwear Most products were priced in the mid-range More contemporary fashion orientation
Customers: Typical customers were in the 15-25 age range Primarily associated with X-games enthusiasts and youth culture
Distribution: Products were sold primarily through a wide range of retail,
department, and specialty stores – including discount retailersJoel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Overview of Mercury Athletic: Company strengths:
Established brand and identity within a well defined niche market that seems to be growing
Strong top-line growth resulting from inroads with major retailers Products were less complex; and therefore, cheaper to produce
Company weaknesses: Increased sales came as a result of pricing concessions to large retailers Proliferation of brands led to decreased operating efficiency and a
longer DSI Women’s casual footwear was a disaster
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Strategic Considerations: Central Question: What Are the Likely Rationales for
a Combination of Active Gear and Mercury? How do the acquirer and target fit together? What are the potential sources of value? How would any potential sources of value be realized?
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Strategic Considerations: Potential sources of value creation:
Operating synergies coming from economies of scale with respect to contract manufacturers
Perhaps some economies of scope with respect to distribution – extending the distribution network
Possible combination of the women’s casual lines
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Strategic Considerations: Counter arguments to value creation:
Poor strategic fit – Mercury’s focus is on a totally different market demographic
Likewise, Mercury’s niche maybe significantly more prone to fashion fads
Continued growth of extreme sports category may make Mercury’s business vulnerable to the large athletic shoe companies
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Firm Value & Cash Flows: As a starting point, let’s start with a basic valuation
paradigm
Note that the sole determinant of value is the generation of cash flow
Further the only relevant factors are the amounts, timing and risks of the cash flows־ FCF is assumed to be the mean of an a random distribution
Joel L. Heilprin
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒= 𝐸(𝐹𝐶𝐹1)(1+ 𝑟)1 + 𝐸(𝐹𝐶𝐹2)(1+ 𝑟)2 + ⋯+ 𝐸(𝐹𝐶𝐹𝑛)(1+ 𝑟)𝑛 + ൬ሺ𝐸(𝐹𝐶𝐹𝑛ሻ(1+ 𝑔)(𝑟− 𝑔) ൰(1+ 𝑟)𝑛
Annual Forecasts Terminal Value
Explicit forecast period is based on the analyst’s judgment TV is the going concern value at the end of the explicit forecast period
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Firm Value & Cash Flows: Determination of FCF
To begin, the preceding equation led to a value of the entire enterprise, meaning V = D + E
Thus, we are interested in what the total business is worth irrespective of who gets the cash or how it’s financed
In turn, this means we are interested in the un-levered FCFUn-Levered FCF = EBIT(1-t) + Depr’ - ∆WC – Cap-x
Joel L. Heilprin
Net reinvestmentNOPAT
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Firm Value & Cash Flows: Determination of FCF
In case Exhibit 6, Liedtke provides a set of projections for each of the operating segments – Thus,
Multiplying EBIT by (1-t) yields
the first term in the FCF equation Question: Are taxes being overstated?
־ It is true that interest expense creates a tax shield־ However, the value of the tax shield is acknowledged in the
WACC or in a separate calculation when using APVJoel L. Heilprin
Consolidated Segment RevenueLess: Segment Operating ExpensesLess: Corporate OverheadOperating Income = EBIT
© 59th Street Partners LLCHarvard Business School
Mercury Athletic FootwearFirm Value & Cash Flows:
Determination of FCF Having calculated NOPAT, we should have the following results, and are now in a
position to proceed to the next step in FCF determination
־ Note that the administrative charge has not been included in operating expenses־ This is because the new owner would not incur the cost, and you’ll note that its not included in
Liedtke’s projection To move from NOPAT to FCF we will simply subtract all of the net reinvestment in the
firm’s operations־ This is the same as subtracting the ΔNOA; or in our case, (Cap-x + Depr’ – ΔWC)
Joel L. Heilprin
Operating Results: 2007 2008 2009 2010 2011Revenue 479,329 489,028 532,137 570,319 597,717Less: Divisional Operating Expenses 423,837 427,333 465,110 498,535 522,522Less: Corporate Overhead 8,487 8,659 9,422 10,098 10,583EBIT 47,005 53,036 57,605 61,686 64,612Less: Taxes 18,802 21,214 23,042 24,675 25,845NO PAT 28,203 31,822 34,563 37,012 38,767
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Firm Value & Cash Flows: Determining FCF - ∆WC
By reorganizing the balance sheet as shown, the net operating assets and liabilities can be quickly segregated־ Based on Exhibit 7, the working capital assets are
cash, accounts receivable, inventory, prepaid expenses
־ The WC liabilities are accounts payable and accrued expenses
Of course, the same excise can be used to determine the net investment in fixed assets (cap-x – Depreciation)
Joel L. Heilprin
Net Fixed Assets
Note that cash for larger firms with access to capital markets may not be part of working capital
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Firm Valuation & Cash Flows: Determining FCF – final thoughts
Based on the preceding exercise involving the reorganized balance sheet, we can see that the DCF methodology is aimed at valuing the operations of the firm (left side of B/S)
Further, we can see
FCF = EBIT(1-t) - ∆WC - ∆Net Fixed Assets By forcing every line item to be placed in one of the B/S
“buckets”, we ensure that ALL of the changes in operating assets & liabilities are reflected in FCF־ Not just those included in working capital, cap-x or depreciationJoel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Liedtke’s Projections: Using the information contained in Exhibit 6, the
following set of FCF projections can be developed:
Are Liedtke’s projections reasonable?־ Consider the revenue growth rates & operating margins־ What about the changes in working capital?
Joel L. Heilprin
Operating Results: 2007 2008 2009 2010 2011Revenue 479,329 489,028 532,137 570,319 597,717Less: Divisional Operating Expenses 423,837 427,333 465,110 498,535 522,522Less: Corporate Overhead 8,487 8,659 9,422 10,098 10,583EBIT 47,005 53,036 57,605 61,686 64,612Less: Taxes 18,802 21,214 23,042 24,675 25,845NO PAT 28,203 31,822 34,563 37,012 38,767Plus: Depreciation 9,587 9,781 10,643 11,406 11,954Less: Changes in Working Capital 4,567 2,649 9,805 8,687 6,233Less: Capital Expenditures 11,983 12,226 13,303 14,258 14,943Unlevered Free Cash Flow (FCF) 21,240 26,727 22,097 25,473 29,545
© 59th Street Partners LLCHarvard Business School
Mercury Athletic FootwearLiedtke’s Projections:
To begin with, the EBIT margins are highly simplified – though not unreasonable
There is a tapering off of growth in athletic shoes
Men’s casual is assumed to grow at what might be the long-term rate of the industry
Women’s casual is to be discontinued
Joel L. Heilprin
Growth Rates: 2007 2008 2009 2010 2011Men's Athletic 15.0% 12.0% 10.0% 8.0% 5.0%Men's Casual 1.0% 2.0% 2.0% 3.0% 3.0%Women's Athletic 12.0% 11.0% 9.0% 7.0% 5.0%Women's Casual 0.0% 0.0% 0.0% 0.0% 0.0%
EBIT Margins:Men's Athletic 13.3% 13.3% 13.3% 13.3% 13.3%Men's Casual 16.0% 16.0% 16.0% 16.0% 16.0%Women's Athletic 10.2% 10.2% 10.2% 10.2% 10.2%Women's Casual -1.3% 0.0% 0.0% 0.0% 0.0%
Corp Overhead/Revenue 1.8% 1.8% 1.8% 1.8% 1.8%
The relatively high growth rates in athletic shoes for the early years are presumably a result of continued expansion into large discount retailers
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Liedtke’s Projections: Changes in net working capital
Notice that the increase in 2008 is smaller than that of 2007, and that the rate of ∆ increases again in 2009 and falls in 2010-2011
Liedtke has based his WC projections on historical cash cycle ratios
־ The volatility is the result of discontinuing the women’s casual line along with a lagging effect from changes in revenue growth
Joel L. Heilprin
2007 2008 2009 2010 2011Changes in Working Capital 4,567 2,649 9,805 8,687 6,233
Working Capital Ratios:Days Sales Outstanding 36.0x 36.0x 36.0x 36.0x 36.0xDays Sales Inventory Outstanding 62.9x 62.9x 62.9x 62.9x 62.9xDays Prepaid Outstanding 10.9x 10.9x 10.9x 10.9x 10.9xDays Payable Outstanding 16.0x 16.0x 16.0x 16.0x 16.0xDays Accrued Outstanding 19.4x 19.4x 19.4x 19.4x 19.4x
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Cost of Capital: Exhibit 3, provides some comparable company
information that includes observed equity betas along with the market values for debt and equity Using that information each comparable firm’s asset beta
can be obtained using one of the followingβasset = (E/V)βequity or βasset = (E/(E + net Debt(1-t)))βequity
Joel L. Heilprin
Assumes a constant D/V ratio and a βdebt of zero Assumes a changing capital structure with a βdebt
of zero
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Cost of Capital: Based on the preceding, the following average un-
levered beta can be obtained
A constant capital structure was used based on Liedtke’s choice of a WACC based on a 20% D/V ratio
Joel L. Heilprin
Equity Net Equity AssetCasual & Athletic Shoe Companies: Market Value Debt D/E Beta BetaD&B Shoe Company 420,098 125,442 29.9% 2.68 2.06Marina Wilderness 1,205,795 (91,559) -7.6% 1.94 2.10General Shoe Corp. 533,463 171,835 32.2% 1.92 1.45Kinsley Coulter Products 165,560 82,236 49.7% 1.12 0.75Victory Athletic 35,303,250 7,653,207 21.7% 0.97 0.80Surfside Footwear 570,684 195,540 34.3% 2.13 1.59Alpine Company 1,056,033 300,550 28.5% 1.27 0.99Heartland Outdoor Footware 1,454,875 (97,018) -6.7% 1.01 1.08Templeton Athletic 397,709 169,579 42.6% 0.98 0.69Average 24.9% 1.56 1.28
If a changing capital structure had been assumed, the un-levered beta would have been 1.37
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Cost of Capital: With an average asset beta in hand, a new equity beta
can be obtained based on Liedtke’s assumed 20% D/Vβequity = βassets(V/E) => 1.28(1/.8) = 1.6
Using CAPM, the required return on equity isre = rf + βe(EMRP) => 4.93% + (1.6)(5%) = 12.92%
The complete WACC is
Joel L. Heilprin
Debt/ Debt/ Asset Equity Cost of Cost ofValue Equity Beta Beta Equity Debt WACC20.0% 25.0% 1.28 1.60 12.92% 6.00% 11.06%
Assumes the Equity Market Risk Premium is 5% and the tax rate is 40%
𝛽𝑒 = 𝛽𝑎൬𝑉𝐸൰− 𝛽𝑑൬𝐷𝐸൰
If the βd > 0
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Terminal Value: If Mercury has indeed reached a steady state by 2011,
then we can envision the firm as providing a stream of cash flows that grows at a constant rate forever This would imply that the going concern could be valued as
a growth perpetuity
PV2011 = (FCF2011)(1+g)/(r – g)
Given that we have already developed estimates for FCF and WACC, an estimate of the long-term growth rate needs to be calculated
Joel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Terminal Value: Estimating the long term growth rate
As a starting point, no business can grow faster than the macro economy on a continuous basis־ Thus, an upper-bound equal to the long-run macro economic growth
rate must exist In terms of lower bounds, the long-term growth rate must be
positive or else the firm would not be a going concern (i.e. it would have a finite life)
A growth rate equal to the long-run rate of inflation would suggest a zero real growth rate־ In the case of Mercury, this would seem to be the lower boundJoel L. Heilprin
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Terminal Value: Estimating the long-term growth rate
Conceptually, the growth rate should be tied to estimates of long-term profitability and reinvestment – Specifically:
(Return on Capital)(Net Reinvestment Rate) = EBIT growth
Obviously, Liedtke’s forecasted cash flows violate the above assumptions in the near-term; but, that does not mean the above equation doesn’t hold after 2011
Joel L. Heilprin
𝑅𝑂𝐶= 𝑁𝑂𝑃𝐴𝑇(𝐸+ 𝐷) 𝑎𝑛𝑑 𝑁𝑒𝑡 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = (∆𝑊𝐶+ ∆𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠)𝑁𝑂𝑃𝐴𝑇
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Terminal Value: Based on the 2011 projections, Mercury’s long-term
growth rate would be as follows:
Joel L. Heilprin
Long-Term Growth Rate: 2011NOPAT 38,767Invested Capital (1) 331,381RO C 11.7%
Net Reinvestment 9,222NOPAT 38,767Reinvestment Rate 23.8%
Est. Long-term Growth Rate 2.78%
(1) Based on 2011 net operating assets
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Completed Valuation: Below is a completed valuation of Mercury based on a
WACC of 11.06% and a long run growth rate of 2.78%
Joel L. Heilprin
Unlevered Free Cash Flow: 2006 (t=0) 2007 2008 2009 2010 2011NO PAT 28,203 31,822 34,563 37,012 38,767Plus: Depreciation 9,587 9,781 10,643 11,406 11,954Less: Changes in Working Capital 4,567 2,649 9,805 8,687 6,233Less: Capital Expenditures 11,983 12,226 13,303 14,258 14,943Unlevered Free Cash Flow 21,240 26,727 22,097 25,473 29,545PV Factor 0.900 0.811 0.730 0.657 0.592PV FCF 19,125 21,671 16,133 16,746 17,490Sum, PV FCF 91,165 19,125 21,671 16,133 16,746 17,490
Terminal value 367,070PV TV 217,292Enterprise Value w/o cash 308,457+ EOY 2006 cash 10,676Enterprise Value 319,133
Firm value is equal to the value of the operations plus the value of net non-operating assets (i.e. 2006 excess cash)
© 59th Street Partners LLCHarvard Business School
Mercury Athletic Footwear
Completed Valuation: The table below shows the sensitivity to growth rates
and discount rates
Joel L. Heilprin
Enterprise Value: Sensitivity TableTV Growth rate
0% 2.78% 3% 4% 5% WACC360,978 505,776 523,852 632,434 813,405 8.00%287,871 365,682 374,355 422,402 489,667 10.00%260,035 319,133 325,461 359,633 405,091 11.06%239,334 286,576 291,491 317,569 351,098 12.00%204,821 235,820 238,898 254,801 274,237 14.00%
Note the extreme variance of results even if the range is tightened to a growth rate of 2.78% - 4% and a discount rate from 10% - 12%