Joel L. HeilprinHarvard Business School © 59 th Street Partners LLC Mercury Athletic Footwear Discussion Materials For Additional Coverage of the Topics

Joel L. HeilprinHarvard Business School © 59th Street Partners LLC

Mercury Athletic Footwear

Discussion MaterialsFor Additional Coverage of the Topics

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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


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



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



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



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



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



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



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



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



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



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



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


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



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



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



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


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



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



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



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



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



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



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



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



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



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)



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%

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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