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

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

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

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, 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

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
Joel L. Heilprin

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

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

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

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
TV is the going concern value at the end of

the explicit forecast period
Explicit forecast period is based on the analysts judgment
Firm Value & Cash Flows:

As a starting point, lets start with a basic valuation
( (1 + )
paradigm
( ) ( )
( )
( )
(1 +
1
)1
(1 +
2
)2
++
(1 +
Annual Forecasts
(1 + )
Terminal Value
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
NOPAT
Net reinvestment

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

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
Joel L. Heilprin

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
Note that cash for larger firms with

access to capital markets may not
be part of working capital
Net Fixed Assets

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

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

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
Are Liedtkes projections reasonable?
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
Consider the revenue growth rates & operating margins

What about the changes in working capital?
Joel L. Heilprin
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
Growth Rates:
Men's Athletic
Men's Casual
Women's Athletic
Women's Casual
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%
EBIT Margins:
Men's Athletic
Men's Casual
Women's Athletic
Women's Casual
13.3%
16.0%
10.2%
-1.3%
13.3%
16.0%
10.2%
0.0%
13.3%
16.0%
10.2%
0.0%
13.3%
16.0%
10.2%
0.0%
13.3%
16.0%
10.2%
0.0%
1.8%
1.8%
1.8%
1.8%
1.8%
Corp Overhead/Revenue
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

Changes in net working capital
Changes in Working Capital
2007
4,567
2008
2,649
2009
9,805
2010
8,687
2011
6,233
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
The volatility is the result of discontinuing the womens casual line

along with a lagging effect from changes in revenue growth
Joel L. Heilprin

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
asset = (E/(E + net Debt(1-t)))equity
or
Assumes a changing capital structure with a debt

of zero
Joel L. Heilprin

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
Joel L. Heilprin
If the d > 0
=

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%
Joel L. Heilprin
WACC
11.06%
Assumes the Equity Market

Risk Premium is 5% and the
tax rate is 40%

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 bound
Joel 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, 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

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
2011
38,767
331,381
11.7%
9,222
38,767
23.8%
Est. Long-te rm Growth Rate
2.78%
(1) Based on 2011 net operating assets

Joel L. Heilprin

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

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%
Joel L. Heilprin

03.06.13 Mercury Athletic Slides

Uploaded by

Copyright:

Available Formats

You might also like

03.06.13 Mercury Athletic Slides

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

03.06.13 Mercury Athletic Slides

Uploaded by

Copyright:

Available Formats

Mercury Athletic Footwear

59th Street Partners LLC

Mercury Athletic Footwear

Company executives felt its small size was becoming

59th Street Partners LLC

Mercury Athletic Footwear

59th Street Partners LLC

Mercury Athletic Footwear

59th Street Partners LLC

Mercury Athletic Footwear

2006 revenue and EBITDA were $431.1 million and

59th Street Partners LLC

Mercury Athletic Footwear

59th Street Partners LLC

Mercury Athletic Footwear

59th Street Partners LLC

Mercury Athletic Footwear

Harvard Business School

59th Street Partners LLC

Mercury Athletic Footwear

Harvard Business School

59th Street Partners LLC

Mercury Athletic Footwear

59th Street Partners LLC

TV is the going concern value at the end of

Explicit forecast period is based on the analysts judgment

Mercury Athletic Footwear

Firm Value & Cash Flows:

Note that the sole determinant of value is the generation of

59th Street Partners LLC

Mercury Athletic Footwear

Harvard Business School

59th Street Partners LLC

Mercury Athletic Footwear

59th Street Partners LLC

Mercury Athletic Footwear

Harvard Business School

59th Street Partners LLC

Note that cash for larger firms with

Net Fixed Assets

Mercury Athletic Footwear

Based on Exhibit 7, the working capital assets are

Of course, the same excise can be used to

59th Street Partners LLC

Mercury Athletic Footwear

59th Street Partners LLC

Mercury Athletic Footwear

Are Liedtkes projections reasonable?

Consider the revenue growth rates & operating margins

59th Street Partners LLC

Mercury Athletic Footwear

Harvard Business School

The relatively high growth rates in athletic shoes

59th Street Partners LLC

Mercury Athletic Footwear

The volatility is the result of discontinuing the womens casual line

Harvard Business School

59th Street Partners LLC

Mercury Athletic Footwear