Mercury Athletic Slides

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Joel L. HeilprinHarvard Business School 59thStreet Partners LLC

Mercury Athletic Footwear

Discussion MaterialsFor Additional Coverage of the Topics

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mailto:[email protected]:[email protected]


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Street Partners LLCHarvard Business School


Overview of Active Gear:

Active Gear is a relatively small athletic and casualfootwear company

$470.3 million of revenue and $60.4 million of EBITcompared 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 amongChinese contract manufacturers

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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 storesno big box retailers

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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 andavoiding big box retailers, the company has had very lowgrowth

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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, Mercurys performance wasmixed

WCF was able to expand sales of footwear, but was neverable to establish the hoped for apparel line

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Products:

Mens and womens 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 storesincluding discount retailersJoel L. Heilprin


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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

Womens casual footwear was a disaster

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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?

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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

distributionextending the distribution network

Possible combination of the womens casual lines

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Counter arguments to value creation:

Poor strategic fitMercurys focus is on a totally different

market demographic

Likewise, Mercurys niche maybe significantly more prone

to fashion fads

Continued growth of extreme sports category may makeMercurys business vulnerable to the large athletic shoe

companies

Joel L. Heilprin


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Firm Value & Cash Flows:

As a starting point, lets start with a basic valuationparadigm

Note that the sole determinant of value is the generation ofcash flow

Further the only relevant factors are the amounts, timing andrisks of the cash flows

FCF is assumed to be the mean of an a random distribution

Joel L. Heilprin

= (

1)

(1 + )1 + (

2)

(1 + )2 ++ (

)

(1 + ) +((1 + )

(

)

(1 + )

Annual Forecasts Terminal Value

Explicit forecast period is based on the analysts judgment TV is the going concern value at the end of

the explicit forecast period


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Determination of FCF

To begin, the preceding equation led to a value of the entireenterprise, meaning V = D + E

Thus, we are interested in what the total business is worth

irrespective of who gets the cash or how its 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


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Determination of FCF

In case Exhibit 6, Liedtke provides a set of projections for

each of the operating segmentsThus,

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 APV

Joel L. Heilprin

Consolidated Segment Revenue

Less: Segment Operating Expenses

Less: Corporate Overhead

Operating Income = EBIT


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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 youll note that its notincluded in Liedtkes projection

To move from NOPAT to FCF we will simply subtract all of the net reinvestmentin the firms operations

This is the same as subtracting the NOA; or in our case, (Cap-x + Depr WC)

Joel L. Heilprin

Operating Results: 2007 2008 2009 2010 2011

Revenue 479,329 489,028 532,137 570,319 597,717

Less: Divisional Operating Expenses 423,837 427,333 465,110 498,535 522,522

Less: Corporate Overhead 8,487 8,659 9,422 10,098 10,583

EBIT 47,005 53,036 57,605 61,686 64,612

Less: Taxes 18,802 21,214 23,042 24,675 25,845

NOPAT 28,203 31,822 34,563 37,012 38,767


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Determining FCF - WC By reorganizing the balance sheet as shown,

the net operating assets and liabilities can bequickly segregated

Based on Exhibit 7, the working capital assets arecash, accounts receivable, inventory, prepaidexpenses

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-xDepreciation)

Joel L. Heilprin

Net Fixed Assets

Note that cash for larger firms with

access to capital markets may not

be part of working capital


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Firm Valuation & Cash Flows:

Determining FCFfinal thoughts

Based on the preceding exercise involving the reorganized

balance sheet, we can see that the DCF methodology isaimed 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/Sbuckets, we ensure that ALL of the changes in operatingassets & liabilities are reflected in FCF

Not just those included in working capital, cap-x or depreciation

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Liedtkes Projections:

Using the information contained in Exhibit 6, thefollowing set of FCF projections can be developed:

Are Liedtkes 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 2011

Revenue 479,329 489,028 532,137 570,319 597,717

Less: Divisional Operat ing Expenses 423,837 427,333 465,110 498,535 522,522

Less: Corporate Overhead 8,487 8,659 9,422 10,098 10,583

EBIT 47,005 53,036 57,605 61,686 64,612

Less: Taxes 18,802 21,214 23,042 24,675 25,845

NO PAT 28,203 31,822 34,563 37,012 38,767

Plus: Depreciation 9,587 9,781 10,643 11,406 11,954

Less: Changes in Working Capital 4,567 2,649 9,805 8,687 6,233

Less: Capital Expenditures 11,983 12,226 13,303 14,258 14,943Unl eve re d Fre e C as h Fl ow (FC F) 21,240 26,727 22,097 25,473 29,545


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To begin with, the EBITmargins are highlysimplifiedthough not

unreasonable There is a tapering off of

growth in athletic shoes

Mens casual is assumed togrow at what might be thelong-term rate of theindustry

Womens casual is to bediscontinued

Joel L. Heilprin

Growth Rates: 2007 2008 2009 2010 2011

Men'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 shoesfor the early years are presumably a result of

continued expansion into large discount retailers


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Changes in net working capital

Notice that the increase in 2008 is smaller than that of 2007, andthat the rate of increases again in 2009 and falls in 2010-2011

Liedtke has based his WC projections on historical cash cycleratios

The volatility is the result of discontinuing the womens casual linealong with a lagging effect from changes in revenue growth

Joel L. Heilprin

2007 2008 2009 2010 2011

Changes 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 36.0x

Days Sales Invent ory Out st anding 62.9x 62.9x 62.9x 62.9x 62.9x

Days Prepaid Outstanding 10.9x 10.9x 10.9x 10.9x 10.9x

Days Payable Outstanding 16.0x 16.0x 16.0x 16.0x 16.0x

Days Accrued Outstanding 19.4x 19.4x 19.4x 19.4x 19.4x


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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 firms asset beta

can be obtained using one of the following

asset= (E/V)equity or asset= (E/(E + net Debt(1-t)))equity

Joel L. Heilprin

Assumes a constant D/V ratio

and a debtof zeroAssumes a changing capital structure with a debt

of zero


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Cost of Capital:

Based on the preceding, the following average un-

levered beta can be obtained

A constant capital structure was used based on Liedtkes

choice of a WACC based on a 20% D/V ratio

Joel L. Heilprin

Equity Net Equity Asset

Casual & Athletic Shoe Companies: Market Value Debt D/E Beta Beta

D&B Shoe Company 420,098 125,442 29.9% 2.68 2.06

Marina Wilderness 1,205,795 (91,559) -7.6% 1.94 2.10

General Shoe Corp. 533,463 171,835 32.2% 1.92 1.45

Kinsley Coulter Products 165,560 82,236 49.7% 1.12 0.75

Victory Athletic 35,303,250 7,653,207 21.7% 0.97 0.80

Surfside Footwear 570,684 195,540 34.3% 2.13 1.59

Alpine Company 1,056,033 300,550 28.5% 1.27 0.99

Heartland Outdoor Footware 1,454,875 (97,018) -6.7% 1.01 1.08

Templeton Athletic 397,709 169,579 42.6% 0.98 0.69

Average 24.9% 1.56 1.28

If a changing capital

structure had been

assumed, the un-levered

beta would have been 1.37


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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)/(rg) Given that we have already developed estimates for FCF

and WACC, an estimate of the long-term growth rate needs

to be calculated

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Terminal Value:

Estimating the long term growth rate

As a starting point, no business can grow faster than the macro

economy on a continuous basisThus, an upper-bound equal to the long-run macro economic growthrate must exist

In terms of lower bounds, the long-term growth rate must bepositive 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 bound

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Terminal Value:

Estimating the long-term growth rate

Conceptually, the growth rate should be tied to estimates of

long-term profitability and reinvestmentSpecifically:(Return on Capital)(Net Reinvestment Rate) = EBIT growth

Obviously, Liedtkes forecasted cash flows violate the aboveassumptions in the near-term; but, that does not mean theabove equation doesnt hold after 2011

Joel L. Heilprin

= ( + ) =

( + )


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Terminal Value:

Based on the 2011 projections, Mercurys long-term

growth rate would be as follows:

Joel L. Heilprin

Long-Term Growth Rate: 2011

NOPAT 38,767

Invested Capital (1) 331,381

ROC 11.7%

Net Reinvestment 9,222

NOPAT 38,767Reinvestment Rate 23.8%

Est. Long-term Growth Rate 2.78%

(1) Based on 2011 net operating assets


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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 2011

NOPAT 28,203 31,822 34,563 37,012 38,767

Plus: Depreciation 9,587 9,781 10,643 11,406 11,954

Less: Changes in Working Capital 4,567 2,649 9,805 8,687 6,233

Less: Capital Expenditures 11,983 12,226 13,303 14,258 14,943

Unlevered Free Cash Flow 21,240 26,727 22,097 25,473 29,545

PV Factor 0.900 0.811 0.730 0.657 0.592

PV FCF 19,125 21,671 16,133 16,746 17,490

Sum, PV FCF 91,165 19,125 21,671 16,133 16,746 17,490

Terminal value 367,070

PV TV 217,292

Enterprise Value w/o cash 308,457

+ EOY 2006 cash 10,676

Enterprise 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)


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Completed Valuation:

The table below shows the sensitivity to growth rates

and discount rates

Joel L. Heilprin

Enterprise Value: Se nsi tivity Table

TV Growth rate

0% 2.78% 3% 4% 5% WACC

360,978 505,776 523,852 632,434 813,405 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%

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