03.06.13 mercury athletic slides

Mercury Athletic
Footwear
Discussion Materials
For Additional Coverage
of the Topics
Please See Your
Professor
Or

E-mail me at
jheilprin@hbs.edu
Mercury Athletic Footwear
Overview of Active Gear:
Ų Active Gear is a relatively small
athletic and casual footwear
company
Ų $470.3 million of revenue and
$60.4 million of EBIT compared
to typical competitors that sold
well over a $1.0 billion annually
Ų Company executives felt its
small size was becoming more
of a disadvantage due to
consolidation among Chinese
contract manufacturers

Ų Products:
Ų Specialty athletic footwear that
evolved from high performance to
athletic fashion wear with a
“classic” appeal
Ų Casual/recreational footwear for
walking, hiking, boating, etc.
Ų Customers:
Ų Affluent urban & suburbanites in
the 25-45 age range (i.e.
“Yuppies”)
Ų Brands are associated with
upwardly mobile lifestyle
Ų Distribution:

Ų Department & specialty stores –
no big box retailers
Ų Company strengths:
Ų By focusing on a portfolio of
classic brands, Active Gear has
been able to lengthen its product
lifecycle
Ų In turn, this has led to less
operating volatility and better
supply chain management as well
as lower DSI
Ų Company weaknesses:

Ų By avoiding the chase for the
latest fashion trend and avoiding
big box retailers, the company has
had very low growth
Overview of Mercury Athletic:
Ų Mercury was a subsidiary of a
large apparel company
Ų As a result of a strategic
realignment, the division was
considered to be non-core
Ų 2006 revenue and EBITDA were
$431.1 million and $51.8
million respectively
Ų Under the egis of WCF,
Mercury’s performance was
mixed

Ų WCF was able to expand sales of
footwear, but was never able to
establish the hoped for apparel
line
Ų Products:
Ų Men’s and women’s athletic and
casual footwear
Ų Most products were priced in the
mid-range
Ų More contemporary fashion
orientation
Ų Customers:
Ų Typical customers were in the 15-
25 age range

Ų Primarily associated with X-
games enthusiasts and youth
culture
Ų Distribution:
Ų Products were sold primarily
through a wide range of retail,
department, and specialty stores –
including discount retailers
Ų Company strengths:
Ų Established brand and identity
within a well defined niche
market that seems to be growing
Ų Strong top-line growth resulting
from inroads with major retailers

Ų Products were less complex; and
therefore, cheaper to produce
Ų Company weaknesses:
Ų Increased sales came as a result of
pricing concessions to large
retailers
Ų Proliferation of brands led to
decreased operating efficiency
and a longer DSI
Ų Women’s casual footwear was a
disaster
Strategic Considerations:
Ų Central Question: What Are
the Likely Rationales for a
Combination of Active Gear and
Mercury?

Ų How do the acquirer and target fit
together?
Ų What are the potential sources of
value?
Ų How would any potential sources
of value be realized?
Ų Potential sources of value
creation:
Ų Operating synergies coming from
economies of scale with respect to
contract manufacturers
Ų Perhaps some economies of scope
with respect to distribution –
extending the distribution network

Ų Possible combination of the
women’s casual lines
Ų Counter arguments to value
creation:
Ų Poor strategic fit – Mercury’s
focus is on a totally different
market demographic
Ų Likewise, Mercury’s niche maybe
significantly more prone to
fashion fads
Ų Continued growth of extreme
sports category may make
Mercury’s business vulnerable to
the large athletic shoe companies

Firm Value & Cash Flows:
Ų As a starting point, let’s start
with a basic valuation paradigm
Ų Note that the sole determinant of
value is the generation of cash
flow
Ų Further the only relevant factors
are the amounts, timing and risks
of the cash flows
Ų FCF is assumed to be the mean of
an a random distribution
Ų Determination of FCF

Ų To begin, the preceding equation
led to a value of the entire
enterprise, meaning V = D + E
Ų Thus, we are interested in what
the total business is worth
irrespective of who gets the cash
or how it’s financed
Ų In turn, this means we are
interested in the un-levered FCF
Un-Levered FCF = EBIT(1-t) + Depr’
- ∆WC – Cap-x

Ų In case Exhibit 6, Liedtke
provides a set of projections for
each of the operating segments –
Thus,
Ų Multiplying EBIT by (1-t) yields
the first term in the FCF equation
Ų Question: Are taxes being
overstated?
Ų It is true that interest expense
creates a tax shield
Ų However, the value of the tax
shield is acknowledged in the
WACC or in a separate calculation
when using APV

Ų Having calculated NOPAT, we
should have the following results,
and are now in a position to
proceed to the next step in FCF
determination
Ų Note that the administrative charge
has not been included in operating
expenses
Ų This is because the new owner
would not incur the cost, and you’ll
note that its not included in Liedtke’s
projection

Ų To move from NOPAT to FCF we
will simply subtract all of the net
reinvestment in the firm’s
operations
Ų This is the same as subtracting the
ΔNOA; or in our case, (Cap-x +
Depr’ – ΔWC)
Ų Determining FCF - ∆WC
Ų By reorganizing the balance sheet as
shown, the net operating assets and
liabilities can be quickly segregated
Ų Based on Exhibit 7, the working capital
assets are cash, accounts receivable,
inventory, prepaid expenses
Ų The WC liabilities are accounts payable
and accrued expenses

Ų Of course, the same excise can be
used to determine the net investment
in fixed assets (cap-x – Depreciation)
Firm Valuation & Cash Flows:
Ų Determining FCF – final
thoughts
Ų 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)
Ų Further, we can see
FCF = EBIT(1-t) - ∆WC - ∆Net
Fixed Assets

Ų 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
Ų Not just those included in working
capital, cap-x or depreciation
Liedtke’s Projections:
Ų Using the information contained
in Exhibit 6, the following set of
FCF projections can be
developed:

Ų Are Liedtke’s projections
reasonable?
Ų Consider the revenue growth rates
& operating margins
Ų What about the changes in working
capital?
Ų To begin with, the EBIT margins
are highly simplified – though not
unreasonable
Ų There is a tapering off of growth in
athletic shoes
Ų Men’s casual is assumed to grow
at what might be the long-term
rate of the industry

Ų Women’s casual is to be
discontinued
Ų Changes in net working capital
Ų 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
Ų Liedtke has based his WC
projections on historical cash
cycle ratios

Ų The volatility is the result of
discontinuing the women’s casual
line along with a lagging effect
from changes in revenue growth
Cost of Capital:
Ų Exhibit 3, provides some
comparable company
information that includes
observed equity betas along with
the market values for debt and
equity

Ų Using that information each
comparable firm’s asset beta can
be obtained using one of the
following
βasset = (E/V)βequity or βasset = (E/(E +
net Debt(1-t)))βequity
Cost of Capital:
Ų Based on the preceding, the
following average un-levered
beta can be obtained

Ų A constant capital structure was
used based on Liedtke’s choice of
a WACC based on a 20% D/V
ratio
Cost of Capital:
Ų With an average asset beta in
hand, a new equity beta can be
obtained based on Liedtke’s
assumed 20% D/V
βequity = βassets(V/E) => 1.28(1/.8) = 1.6
Ų Using CAPM, the required
return on equity is
re = rf + βe(EMRP) => 4.93% + (1.6)
(5%) = 12.92%
Ų The complete WACC is

Terminal Value:
Ų 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
Ų This would imply that the going
concern could be valued as a
growth perpetuity
PV2011 = (FCF2011)(1+g)/(r – g)
Ų Given that we have already
developed estimates for FCF and
WACC, an estimate of the long-
term growth rate needs to be
calculated

Terminal Value:
Ų Estimating the long term growth
rate
Ų As a starting point, no business
can grow faster than the macro
economy on a continuous basis
Ų Thus, an upper-bound equal to the
long-run macro economic growth
rate must exist
Ų 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)
Ų A growth rate equal to the long-
run rate of inflation would suggest
a zero real growth rate

Ų In the case of Mercury, this would
seem to be the lower bound
Terminal Value:
Ų Estimating the long-term growth
rate
Ų Conceptually, the growth rate
should be tied to estimates of
long-term profitability and
reinvestment – Specifically:
(Return on Capital)(Net
Reinvestment Rate) = EBIT
growth

Ų 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
Terminal Value:
Ų Based on the 2011 projections,
Mercury’s long-term growth rate
would be as follows:
Completed Valuation:

Ų Below is a completed valuation
of Mercury based on a WACC
of 11.06% and a long run
growth rate of 2.78%
Completed Valuation:
Ų The table below shows the
sensitivity to growth rates and
discount rates

03.06.13 mercury athletic slides

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03.06.13 mercury athletic slides