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Slides for Mercury Athletic Footwear
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5/22/2018 03.06.13 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
Please See Your Professor
Or
E-mail me [email protected]
mailto:[email protected]:[email protected]5/22/2018 03.06.13 Mercury Athletic Slides
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Street Partners LLCHarvard Business School
Mercury Athletic Footwear
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
Joel L. Heilprin
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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 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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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 andavoiding big box retailers, the company has had very lowgrowth
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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 wasmixed
WCF was able to expand sales of footwear, but was neverable to establish the hoped for apparel line
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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 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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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
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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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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
distributionextending the distribution network
Possible combination of the womens casual lines
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Strategic Considerations:
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
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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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Firm Value & Cash Flows:
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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Firm Value & Cash Flows:
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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Firm Value & Cash Flows:
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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Mercury Athletic Footwear
Liedtkes Projections:
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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Liedtkes Projections:
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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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
equity= assets(V/E) => 1.28(1/.8) = 1.6
Using CAPM, the required return on equity is
re= rf+ e(EMRP) => 4.93% + (1.6)(5%) = 12.92%
The complete WACC is
Joel L. Heilprin
Debt/ Debt/ Asset Equity Cost of Cost of
Value Equity Beta Beta Equity Debt WACC
20.0% 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%
=
If the d> 0
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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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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 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%