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Joel L. HeilprinHarvard Business School © 59 th Street Partners LLC Mercury Athletic Footwear Discussion Materials For Additional Coverage of the Topics Please See Your Professor Or me at
© 59 th Street Partners LLC Harvard 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
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Overview 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 age range (i.e. Yuppies) Brands are associated with upwardly mobile lifestyle Distribution: Department & specialty stores – no big box retailers Joel L. Heilprin
© 59 th Street Partners LLC Harvard 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
© 59 th Street Partners LLC Harvard 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, Mercurys performance was mixed WCF was able to expand sales of footwear, but was never able to establish the hoped for apparel line Joel L. Heilprin
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Overview of Mercury Athletic: 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 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 retailers Joel L. Heilprin
© 59 th Street Partners LLC Harvard 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 Womens casual footwear was a disaster Joel L. Heilprin
© 59 th Street Partners LLC Harvard 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
© 59 th Street Partners LLC Harvard 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 womens casual lines Joel L. Heilprin
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Strategic Considerations: Counter arguments to value creation: Poor strategic fit – Mercurys 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 make Mercurys business vulnerable to the large athletic shoe companies Joel L. Heilprin
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Firm Value & Cash Flows: As a starting point, lets 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 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
© 59 th Street Partners LLC Harvard 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 its financed In turn, this means we are interested in the un-levered FCF Un-Levered FCF = EBIT(1-t) + Depr - WC – Cap-x Joel L. Heilprin Net reinvestmentNOPAT
© 59 th Street Partners LLC Harvard 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 APV Joel L. Heilprin Consolidated Segment Revenue Less: Segment Operating Expenses Less: Corporate Overhead Operating Income = EBIT
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Firm 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 not included in Liedtkes projection To move from NOPAT to FCF we will simply subtract all of the net reinvestment in the firms operations ־This is the same as subtracting the ΔNOA; or in our case, (Cap-x + Depr – ΔWC) Joel L. Heilprin
© 59 th Street Partners LLC Harvard 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
© 59 th Street Partners LLC Harvard 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 depreciation Joel L. Heilprin
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Liedtkes Projections: Using the information contained in Exhibit 6, the following 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
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Liedtkes Projections: To begin with, the EBIT margins are highly simplified – though not unreasonable There is a tapering off of growth in athletic shoes Mens casual is assumed to grow at what might be the long-term rate of the industry Womens casual is to be discontinued Joel L. Heilprin The relatively high growth rates in athletic shoes for the early years are presumably a result of continued expansion into large discount retailers
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Liedtkes 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 Liedtke has based his WC projections on historical cash cycle ratios ־The volatility is the result of discontinuing the womens casual line along with a lagging effect from changes in revenue growth Joel L. Heilprin
© 59 th Street Partners LLC Harvard 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 firms asset beta can be obtained using one of the following β asset = (E/V)β equity or β asset = (E/(E + net Debt(1-t)))β equity Joel L. Heilprin Assumes a constant D/V ratio and a β debt of zero Assumes a changing capital structure with a β debt of zero
© 59 th Street Partners LLC Harvard 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 Liedtkes choice of a WACC based on a 20% D/V ratio Joel L. Heilprin If a changing capital structure had been assumed, the un-levered beta would have been 1.37
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Cost of Capital: With an average asset beta in hand, a new equity beta can be obtained based on Liedtkes assumed 20% D/V β equity = β assets (V/E) => 1.28(1/.8) = 1.6 Using CAPM, the required return on equity is r e = r f + β e (EMRP) => 4.93% + (1.6)(5%) = 12.92% The complete WACC is Joel L. Heilprin Assumes the Equity Market Risk Premium is 5% and the tax rate is 40% If the β d > 0
© 59 th Street Partners LLC Harvard 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 PV 2011 = (FCF 2011 )(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
© 59 th Street Partners LLC Harvard 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 bound Joel L. Heilprin
© 59 th Street Partners LLC Harvard 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, Liedtkes forecasted cash flows violate the above assumptions in the near-term; but, that does not mean the above equation doesnt hold after 2011 Joel L. Heilprin
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Terminal Value: Based on the 2011 projections, Mercurys long-term growth rate would be as follows: Joel L. Heilprin
© 59 th Street Partners LLC Harvard 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 Firm value is equal to the value of the operations plus the value of net non-operating assets (i.e excess cash)
© 59 th Street Partners LLC Harvard Business School Mercury Athletic Footwear Completed Valuation: The table below shows the sensitivity to growth rates and discount rates Joel L. Heilprin 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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