, Case 43

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Valuing Corporate Acquisitions)

Print-to- Fit, Inc.

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Ever since Sears announced plans to shut down its $3.3 billion catalog business in 1992,
Theresa Dunsmore had been swallowing more and more Pepto Bismol. It's not that she liked
the taste of the pink stuff, but as senior vice president in charge of in-store merchandising at C.
J. Nickel's--the nation's fourth-largest department store retailer-Theresa developed stomach
problems when Sears retired the Big Book. At first glance, you'd think that Sears' abrupt exit
from mail-order retailing would cause celebration in the hallways at C. J. Nickel's. But
remember, Theresa was responsible for Nickel's in-store retail operations-not the mail order
business.
While Nickel's catalog sales rose by almost $200 million in 1993 as thousands offormer
Sears' customers started ordering from Nickel's, the in-store division of the giant retailer faced
some major troubles. During the 1980s, Theresa worked hard to differentiate Nickel's
merchandise ,l~ from those offered by Sears. She dumped hardware items, garden supplies,
and auto parts, in favor of trendier fashions and more upscaleapparel items. She expanded in-
store merchandise selection and incorporated pricier brand names into the product mix, and
targeted the stores' merchandise mix toward aftluent, sophisticated shoppers.
Then the 1989-91 recession hit, and consumer confidence plummeted. Conspicuous
consumption was replaced by value-conscious shopping, and Theresa was stuck with a huge
inventory of upscale, high-fashion junk. Nickel's managed to move its merchandise only
through a big end-of-season markdown sale, and in the process, the retailer's annual earnings
fell 36 percent from the previous year. If that wasn't bad enough, soon after the end of 1992 the
ca rting record-breaking sales increases as former Sears'
tal customers shifted their business to the Nickel's catalog.
og Needless to say, the transparent "glass ceiling" that blocked Theresa's move into top
di management at Nickel's was rapidly turning into very visible concrete. Unless she improved
vi the financial performance of the in-store retail division at the firm, her career in retailing would
si face an untimely and involuntary demise. Now, you might argue that Theresa was a victim of
on circumstance-in the wrong management job at the wrong time-but the handwriting she saw
at on the corporate wall was clear: Restore sales growth and profitability within Nickel's in-store
Ni division, or seek work elsewhere.
ck After twenty years in retail management, Theresa was tough enough and smart enough to
el' accept the challenge. She quickly revised her division's merchandising strategy to emphasize
s consumer value-focusing on a combination of lower retail prices and higher product
sta quality--to restore sales and profit growth. She moved product emphasis away from the stuff
rte covered with little alligators and started stocking moderately-priced, private-label brands to
d boost her stores' gross margins. Finally, she slashed in-store operating expenses to boost
re Nickel's net operating margin.
po
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.ase 43

An these changes suited Theresa's superiors fine and dandy, but like most bosses, they
pressured her to do more. Nickel's still faced intense competition from several national retailers,
and Theresa needed to gain market share from these firms to earn the respect of Nickel's top
brass. In order to gain market share, she knew Nickel's must broaden its merchandise mix and
become more flexible in offering new shoppers a wide assortment of product choices.
Unfortunately, expanded product selections meant an increased investment in floor
inventory, and more inventory meant higher operating expenses and dwindling profit margins.
After the dismal 1992 selling season, Theresa could scarcely risk the adverse financial
consequences associated with expanding Nickel's product line.
There hdd to be another way-and with a little creative thinking and a little luck, Theresa
thought she'd found it. Scanning an industry trade publication late one evening after work,

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Theresa noticed a brief article about a sm$1l, unknown firm in the retailing industry, Print-to-Fit,

Inc. Unknown in retailing becaust the small firm wasn't a retailer, Print-to-Fit was a
manufacturer of textile printers that modified Canon's color laser printing technology to print
on fabric, rather than paper. Using its patented, bubble-jet transfer method, Print-to-Fit was
able to squirt microfine droplets of yellow, cyan, magenta, and black ink on a variety of textile
surfaces, creating colorful designs and pattems on ordinary, ready-to-wear fabrics.
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While Print-to-Fit was a computer manufacturing company, Theresa immediately
recognized that the firm's future was in retailing-not manufacturing. Using Print-to-Fit's 4
printers connected to microcomputers in selected areas of Nickel's retail stores, customers could
literally design their own clothing, preview various designs on the computer's screen, and print
their favorite selections on blank apparel items stocked in Nickel's "inventory.
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Theresa envisioned almost unlimited potential for the new technology: customers in the
menswear department ,~
could design their own neckties; in womenswear, shoppers could
instantly change life color and pattem of mix-and-match separates; and even better, in the
children's department kids could dress up dull, white tee-shirts with full-color pictures of their
favorite cartoon characters and other images. 'From the shopper's viewpoint, this would be a
different and fun way to shop. From Theresa's perspective, it would be an efficient and
inexpensive way to move merchandise. Nickel's could offer, quite literally, an infinite array of
merchandise, yet the firm's inventory could be reduced to a small set of pattern masters waiting
to be printed.
After thinking quietly about the potential changes that Print-to-Fit might bring to Nickel's,
Theresa had a fiightening thought: If Nickel's could purchase textile printers from Print-to-Fit,
why couldn't other retailers do the very same thing? Theresa answered her question almost as
soon as it entered her mind-Print-to-Fit's technology was protected by patent, and if Nickel's
bought the entire firm, rather than just its printers, she'd own the patents. Finally, Theresa had
a new retail strategy, and the means to prevent her competitors from copying it.
Over the course of the next several weeks, Theresa negotiated with Print-to-Fit's managers
and Board of Directors for the purchase of the small film by Nickel's. As the income statement
shown in Table 1 reports, Print-to-Fit's 1993 sales volume was a modest $9 million, which was
dwarfed by Nickel's $17 billion in 1993 sales. Clearly, Nickel's could afford this small
acquisition.
After extensive negotiation between Print-to-Fit's Board and her own finance people,
Theresa was able to assemble the projected financial statements shown in Tables I and 2.
These data conservatively estimated how Print-to-Fit would perform as a division of C. J.
Nickel's over the 1994-97 period. While Theresa considered the projected statements
reasonable, she made sure that they reflected the dramatic sales potential that Print-to-Fit's
technology offered Nickel's retail stores.

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~ Case 43

• In addition, Theresa prepared the estimate of Print-to-Fit's optimal capital structure shown

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in Table 3. Using the financial information shown in these three tables, she was ready to ,-
estimate Print-to-Fit's acquisition value to her employer. In previous conversations with Print-
to-Fit's Board, she learned that the firm would probably be receptive to a stock-for-stock
exchange. In addition, she felt that Print-to-Fit's shareholders would be willing to accept around

• 250,000 shares ofC. J. Nickel's common stock, currently worth $81.32 per share, to tender their
Print-to-Fit common stock-lock, stock, and bubble-jets-to Nickel's.

, Now, it was up to Theresa to make a decision. Her intuition told her that Print-to-Fit was
a good strategic acquisition for Nickel's, but at what price? It was obvious to her that the small

• firm's Board knew she was anxious to deal, and looking at the projected financials, she began

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to wonder if perhaps she was too anxious. After all, she was accountable to the shareholders
at C. 1. Nickel's, and the last thing she wanted to do was squander the shareholders' money by

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approving an ill-advised and ovl!--pliced acquisition. Then again, Print-to-Fit represented an
excellent opportunity to offer Nickel's shoppers a novel retail experience, and Theresa needed
just such a novelty to build in-store sales and market share within her division.

TABLE 1

Print-to-Ftt, Inc.
Statement of Revenue and Expense
December 31. 1993 .
($OOOs)
"- Actual -------------------- P .'0 j ected--
i ,''1
r-
1993 1994 1995 1996
Net sales revenue $9,194.0 $13,892.0 $17,859.3 $18,220.9
Less: Cost of goods sold (5,184.2) (8,107.0) (11 ,145.8) (10,680.2)

Gross profit $4,009.8 $5,785.0 $6,713.5 $7,540.7

Less: Operating expenses ($1,400.4) ($2,670.9) ($4,100.9) ($4,539.1)

Depreciation expense (12.7) (858) (132.4) (178.3)

Net operating income $2,596.7 $3,028.3 $2,480.2 $2,823.3

Plus: Nonoperating income $44.7 $113.0 $52.8 $243.3

$2,641~4
Earnings before interest and taxes $3,141.3 $2,533.0 $3,066.6
.. -
Less: Interest expense ($29.8) ($80.0) ($2276) ($158.8)

Earnings before tax $2,611.6 $3,061.3 $2,305.4 $2,907.8

Less: Income tax expense:

Current income tax expense ($1,338.0) ($1,535.0) ($987.2) ($1,197.7)
Deferred income tax expense (47.8) (1257) (51.6) (39.9)
Total income tax expense ($\,385.8) ($1.6607) ($1,038.8) ($1,237.6)
Net income
$.12~'i 8 $l.4QM $.L2666 tl f..70 '2

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ASSETS -
Current assets:
Cash and marketable securities
Accounts receivable (net)
Inventory
Prepaid expenses
Current assets - other
Total current assets
Long-term investments:
Plant and equipment (gross)
Less: Accumulated depreciation
Plant and equipment (net)
Other assets
Total long-term investments

Total assets

LIABILITIES AND EQU

Current liabilities:
Accounts payable
Income taxes payable

Accrued expenses

Current debt obligations

Total current liabilities
Long-term liabilities:
Nonconvertible debt
Capitalized leases
Deferred tax liability
Total long-term liabilities

Shareholders' equity:
Common stock - par value
Additional paid-in capital
Retained earnings
Total shareholders' equity
Total liabilities and
shareholders' equity
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Case 43
Print-to-lFit, inc.

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TABLE 3

Print-to-Fit, Inc.
Capitalization SummQJY r

December31, 1993
\

Short-Term Long-Term Common

Liabilities
. Debt Stock

Optimal capital structure 20% 10% 70%

Current capital cost (before-tax) 7% 10% 14%

Shares outstanding i- --------- ---- .•. _--- 50,000,000
Corporate tax rate I 37% 37%
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Case 43 lPrint-to-Fit, line.

1. Based.on the forecast book value of Print-to-Fit's total capitalization in 1997 (i.e., the total
quantity of debt and equity funds invested in the firm), what is the projected terminal value
of the firm in this year? Based on the perpetual value of Print- to- Fit's earnings stream
available to the firm's debt and equity providers in 1997, what is the projected terminal
value of the firm in that year?

2. Given your answers to Questions 5 and 6, what is the total acquisition value of Print- to-
Fit?

3. Given your estimate ofPrinrto-Fit's aggregate acquisition value in Question 7, what is

the value of this acquisition to the firm's stockholders?

Note: Short-tenn liabilities include accounts payable, Income taxes payable, accrued expenses, and current debt obligations. Only
50 percent of total short-term liabilities-representing current debt obligations-carry an explicit financing charge.
4. Based on (a) the total capitalization of Print-to-Fit, Inc., and (b) the total income that

QUESTIONS

1. In general telTI1S, how should C. 1. Nickels approach the problem of valuing Print-to-
Fit,
Inc.? How is this valuation problem similar to the way that analysts might value financial
assets such as corporate bonds and common stock?
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2. In eJ~luating corporate acquisitions, financial managers often use a variety of different
techniques to estimate the projected cash flows from a potential acquisition. These
techniques often include (a) projecting the total cash flows that the acquired firm will
provide to owners of its debt and equity securities, and (b) projecting the cash flows that
the acquired firm will provide to holders of its common stock. Briefly explain how each
of these cash flow streams would be calculated.

3. In valuing debt and/or equity securities, analysts typically use a single estimate offuture

cash flows to forecast what holders of these financial assets can expect to receive from
their investments in future years. In contrast, financial managers often use a variety of
different cash flow estimates to value corporate acquisitions. Why is a single estimate
of
future cash flows appropriate for valuing financial assets, while business acquisitions
normally require a number of different cash flow estimates?
4. What are Print-to-Fit's (a) weighted average cost of capital, and (b) required return on
equity capital?

providers of the firm's debt and equity capital will receive over the 1994-97 period, what
5. [Questions 5 through 9 deal with thereturn to total capital model of corporate
valuation).
What are the total annual net cash flows that Print-to-Fit's debt and equity holders will
receive from the film over the 1994-97 period?
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is the total return on capital offered by the firm over the 1994-97 period?
 5. [Questions 10 through 13 deal with the return to equity capital model of corporate
valuation]. What are the annual net cash flows that Print-to-Fit's common equity holders
will receive from their investment over the I 994-97 period?
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I 1. Based on the forecast book value of .shareholders' equity in 1997, what is the projected
terminal value of Print-to-Fit in-that year? Based on the perpetual value of the firm's
earnings stream available to common stockholders in 1997, what is the projected terminal
value of the film in that year?

6. Combining the cash flows developed in Questions 10 and 11, what is the total acquisition
value of Print- to-Fit?

7. Based on the shareholders' investment in Print-to-Fit and the annual income that these
investors will receive over the 1994-97 period, what is the return on equity capital that
the firm will provide over the 1994-97 period?

8. What is the total value that c.1. Nickel's plans to pay to acquire Print-to-Fit, Inc.? Given
the range of corporate valuation estimates that you developed in Questions 4 through 13,
should Nickel's proceed with this acquisition? Why or why not?

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