Mercury Athletic Footwear

Discussion Materials
For Additional Coverage of the Topics Please See Your Professor Or E-mail me at jheilprin@hbs.edu
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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 stores no big box retailers
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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 stores including discount retailers
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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?

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

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

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

Explicit forecast period is based on the analysts judgment

Mercury Athletic Footwear

TV is the going concern value at the end of the explicit forecast period

Firm Value & Cash Flows: As a starting point, lets start with a basic valuation ( (1 + ) paradigm ( ) ( ) ( ) ( )

(1 +

1 )1

(1 +

2 )2

++

(1 +

(1 + )

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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

Annual Forecasts

Terminal Value

NOPAT

Net reinvestment

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

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

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, Consolidated Segment Revenue Multiplying EBIT by (1-t) yields Less: Segment Operating Expenses Corporate Overhead the first term in the FCF equation Less: Operating Income = EBIT 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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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
Operating Results: Revenue Less: Divisional Operating Expenses Less: Corporate Overhead EBIT Less: T axes NO PAT 2007 479,329 423,837 8,487 47,005 18,802 28,203 2008 489,028 427,333 8,659 53,036 21,214 31,822 2009 532,137 465,110 9,422 57,605 23,042 34,563 2010 570,319 498,535 10,098 61,686 24,675 37,012 2011 597,717 522,522 10,583 64,612 25,845 38,767

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 NOA; or in our case, (Cap-x + Depr WC)
Joel L. Heilprin 59th Street Partners LLC

Harvard Business School

Note that cash for larger firms with access to capital markets may not be part of working capital

Net Fixed Assets

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)
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

Mercury Athletic Footwear

Liedtkes Projections: Using the information contained in Exhibit 6, the following set of FCF projections can be developed:
Operating Results: Revenue Less: Divisional Operating Expenses Less: Corporate Overhead EBIT Less: T axes NO PAT Plus: Depreciation Less: Changes in Working Capital Less: Capital Expenditures Unlevered Free Cash Flow (FCF) 2007 479,329 423,837 8,487 47,005 18,802 28,203 9,587 4,567 11,983 21,240 2008 489,028 427,333 8,659 53,036 21,214 31,822 9,781 2,649 12,226 26,727 2009 532,137 465,110 9,422 57,605 23,042 34,563 10,643 9,805 13,303 22,097 2010 570,319 498,535 10,098 61,686 24,675 37,012 11,406 8,687 14,258 25,473 2011 597,717 522,522 10,583 64,612 25,845 38,767 11,954 6,233 14,943 29,545

Are Liedtkes projections reasonable?

Consider the revenue growth rates & operating margins What about the changes in working capital?
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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
Harvard Business School
Growth Rates: Men's Athletic Men's Casual Women's Athletic Women's Casual EBIT Margins: Men's Athletic Men's Casual Women's Athletic Women's Casual Corp Overhead/Revenue 2007 15.0% 1.0% 12.0% 0.0% 2008 12.0% 2.0% 11.0% 0.0% 2009 10.0% 2.0% 9.0% 0.0% 2010 8.0% 3.0% 7.0% 0.0% 2011 5.0% 3.0% 5.0% 0.0%

13.3% 16.0% 10.2% -1.3% 1.8%

13.3% 16.0% 10.2% 0.0% 1.8%

13.3% 16.0% 10.2% 0.0% 1.8%

13.3% 16.0% 10.2% 0.0% 1.8%

13.3% 16.0% 10.2% 0.0% 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

Joel L. Heilprin

59th Street Partners LLC

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 2010-2011 Liedtke has based his WC projections on historical cash cycle ratios Working Capital Ratios:
Days Sales Outstanding Days Sales Inventory Outstanding Days Prepaid Outstanding Days Payable Outstanding Days Accrued Outstanding 36.0x 62.9x 10.9x 16.0x 19.4x 36.0x 62.9x 10.9x 16.0x 19.4x 36.0x 62.9x 10.9x 16.0x 19.4x 36.0x 62.9x 10.9x 16.0x 19.4x 36.0x 62.9x 10.9x 16.0x 19.4x
Changes in Working Capital 2007 4,567 2008 2,649 2009 9,805 2010 8,687 2011 6,233

The volatility is the result of discontinuing the womens casual line along with a lagging effect from changes in revenue growth
Joel L. Heilprin 59th 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
asset = (E/V)equity
Assumes a constant D/V ratio and a debt of zero
Harvard Business School

or

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

Assumes a changing capital structure with a debt of zero

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Cost of Capital: Based on the preceding, the following average unlevered beta can be obtained
Casual & Athletic Shoe Companies: D&B Shoe Company Marina Wilderness General Shoe Corp. Kinsley Coulter Products Victory Athletic Surfside Footwear Alpine Company Heartland Outdoor Footware T empleton Athletic Average Equity Net Market Value Debt 420,098 125,442 1,205,795 (91,559) 533,463 171,835 165,560 82,236 35,303,250 7,653,207 570,684 195,540 1,056,033 300,550 1,454,875 (97,018) 397,709 169,579 D/E 29.9% -7.6% 32.2% 49.7% 21.7% 34.3% 28.5% -6.7% 42.6% 24.9% Equity Beta 2.68 1.94 1.92 1.12 0.97 2.13 1.27 1.01 0.98 1.56 Asset Beta 2.06 2.10 1.45 0.75 0.80 1.59 0.99 1.08 0.69 1.28

If a changing capital structure had been assumed, the un-levered beta would have been 1.37

A constant capital structure was used based on Liedtkes choice of a WACC based on a 20% D/V ratio
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

If the d > 0
=

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

Debt/ Value 20.0% Debt/ Equity 25.0% Asset Beta 1.28 Equity Beta 1.60 Cost of Equity 12.92% Cost of Debt 6.00% WACC 11.06%

Assumes the Equity Market Risk Premium is 5% and the tax rate is 40%
59th Street Partners LLC

Harvard Business School

Joel L. Heilprin

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 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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

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 59th 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
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

Mercury Athletic Footwear

Terminal Value: Based on the 2011 projections, Mercurys long-term growth rate would be as follows:
Long-Term Growth Rate: NOPAT Invested Capital (1) RO C Net Reinvestment NOPAT Re inve stme nt Rate Est. Long-te rm Growth Rate (1) Based on 2011 net operating assets
Harvard Business School Joel L. Heilprin 59th Street Partners LLC

2011 38,767 331,381 11.7% 9,222 38,767 23.8% 2.78%

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%
Unlevered Free Cash Flow: 2006 (t=0) NO PAT Plus: Depreciation Less: Changes in Working Capital Less: Capital Expenditures Unlevered Free Cash Flow PV Factor PV FCF Sum, PV FCF 91,165 T erminal value PV T V Enterprise Value w/o cash + EOY 2006 cash Enterprise Value 2007 28,203 9,587 4,567 11,983 21,240 0.900 19,125 19,125 2008 31,822 9,781 2,649 12,226 26,727 0.811 21,671 21,671 2009 34,563 10,643 9,805 13,303 22,097 0.730 16,133 16,133 2010 37,012 11,406 8,687 14,258 25,473 0.657 16,746 16,746 2011 38,767 11,954 6,233 14,943 29,545 0.592 17,490 17,490 367,070 217,292 308,457 10,676 319,133

Firm value is equal to the value of the operations plus the value of net non-operating assets (i.e. 2006 excess cash)
Joel L. Heilprin 59th Street Partners LLC

Harvard Business School

Mercury Athletic Footwear

Completed Valuation: The table below shows the sensitivity to growth rates and discount rates
Enterprise Value: Sensitivity Table TV Growth rate 0% 2.78% 3% 360,978 505,776 523,852 287,871 365,682 374,355 260,035 319,133 325,461 239,334 286,576 291,491 204,821 235,820 238,898 4% 632,434 422,402 359,633 317,569 254,801 5% 813,405 489,667 405,091 351,098 274,237 WACC 8.00% 10.00% 11.06% 12.00% 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%
Harvard Business School Joel L. Heilprin 59th Street Partners LLC