Case Study 5–3.

The Anatomy of a Transaction: K2 Incorporated Acquires

Fotoball USA
On January 26, 2004, K2 Inc. completed the purchase of Fotoball USA in an all-stock
transaction. What follows is an attempt to reconstruct the preclosing events to illustrate
how the acquisition process discussed in Chapters 4 and 5 may have been applied in this
transaction. Note that this is a highly condensed version of an actual business and acquisition
plan.
Industry-Market Definition
K2 is a sporting goods equipment manufacturer. K2’s portfolio of brands includes
Rawlings, Worth, Shakespeare, Pflueger, Stearns, K2, Ride, Olin, Morrow, Tubbs, and
Atlas. The company’s diversified mix of products is used primarily in team and individual
sports activities, such as baseball, softball, fishing, water sports activities, alpine skiing,
snowboarding, snowshoeing, in-line skating, and mountain biking.
External Analysis
The firm’s current top competitors include Adidas-Salomon; Rollerblade, Inc.; and Skis
Rossignol S.A. While other sporting goods suppliers, such as Amer Group PLC, Head
N.V., Nike, Inc., Fila USA, and Reebok International Ltd, do not currently compete in
K2’s served markets, they could easily enter them, due to their substantial brand recognition
and financial resources. Not only must K2 be concerned about existing and potential
competitors, a variety of substitute popular sports, such as horseback riding, ice hockey,
sky diving, surfing, and cross country skiing, could erode growth in their targeted markets.
The firm’s primary customers are sporting goods retailers. Many of K2’s smaller
retailers and some larger retailers are not strongly capitalized. Adverse conditions in
the sporting goods retail industry can adversely affect the ability of retailers to purchase
K2 products. Secondary customers include individuals, both hobbyists and professionals.
K2’s success depends on its ability to keep abreast of changes in taste and style and its
ability to provide high-quality products at competitive prices.
The majority of K2 products are manufactured in China, which helps to ensure cost
competitiveness. However, disruptions in international trade or shipping could adversely
affect the availability or cost of K2 products. K2’s revenue from international operations
was approximately 32 percent of total revenue for fiscal 2002, and approximately
26 percent of K2’s sales are denominated in foreign currencies. K2’s international operations
are subject to a variety of risks, including recessions in foreign economies, currency
conversion risks and fluctuations, limitations on repatriation of earnings, and reduced
protection of intellectual property rights in some countries. Other factors include social,
political, and economic instability; the adoption and expansion of government trade
restrictions; unfavorable political developments affecting international trade; and unexpected
changes in regulatory requirements.
K2 believes that the most successful sporting goods suppliers will be those with the
greatest resources. In addition to financial capabilities, such resources include the ability
to produce or source high-quality, low-cost products and deliver these products on a
timely basis and the ability to access distribution channels with a broad array of products
and brands. As the influence of large sporting goods retailers grows, management
believes these retailers will prefer to rely on fewer and larger sporting goods suppliers
to help them manage the supply of products and the allocation of shelf space.
Internal Analysis
K2 has a number of leading brands in major sporting goods markets. K2 is also involved
in the sports apparel business and faces stiff competition in this industry from Nike and
Reebok. Wal-Mart accounted for over 10 percent and 5 percent of K2’s consolidated
annual net sales and operating income, respectively, in 2003. No one customer of K2
accounted for 10 percent or more of its consolidated annual net sales or 5 percent of
its operating income in 2002.
Despite its strong brand names, K2 is susceptible to imitation. The sporting goods
markets and recreational products markets are generally highly competitive, with competition
centered on product innovation, performance and styling, price, marketing, and
delivery. Competition in these products consists of a relatively small number of large producers,
some of whom have substantially greater financial resources than K2. K2’s relationships
with collegiate and professional leagues and teams cannot be easily usurped
by smaller competitors that may want to enter into these markets. It takes time for the
necessary trust to build up in these relationships. Larger competitors may have the capacity
to take away some of these relationships, but K2 has so many that the loss of one or
two would not seriously hinder its overall revenue growth.
Its relatively small size in comparison to major competitors is the firm’s primary
weakness. Historically, the firm has been able to achieve profitable growth by introducing
new products into fast growing markets. The firm has historically applied its core
competencies of producing fiberglass and assembling structures for manufacturing skis
to new markets, such as snowboarding and in-line skating.
Mission Statement and Strategic Objectives
“K2 will accept nothing less than the best . . . We will create ever better products that
raise the bar of performance and celebrate the human spirit . . . We will build value by
growing and succeeding where others have failed.” The firm’s long-term objective is to
achieve the number 1 market share position in its served markets. Toward that end, K2
seeks to meet or exceed its corporate cost of capital of 15 percent. In addition, K2 intends
to achieve sustained double-digit revenue growth, gross profit margins above 35 percent,
and net profit margins in excess of 5 percent within the next five years. The firm also
seeks to reduce its debt-to-equity ratio to the industry average of 25 percent in the next
five years.
Business Strategy
K2 intends to achieve its mission and objectives by becoming the low-cost supplier in
each of its niche markets. The firm intends to achieve a low-cost position by using its
existing administrative and logistical infrastructure to support entry into new niche segments
within the sporting goods and recreational markets, new distribution channels,
and new product launches through existing distribution channels. Furthermore, the firm
intends to pursue continued aggressive cost cutting and to expand its global sourcing to
include other low-cost countries in addition to mainland China.
Implementation Strategy
In view of its great success in acquiring and integrating a series of small acquisitions in
recent years, K2 has decided to avoid product or market extension through partnering
because of the potential for loss of control and for creating competitors once such agreements
lapse. Consequently, K2 believes that it can accelerate its growth strategy by seeking
strategic acquisitions of other sporting goods companies with well-established brands
and with complementary distribution channels.
M&A-Related Functional Strategies
Functional strategies have been developed based on an acquisition-oriented implementation
strategy. A potential target for acquisition is a company that holds many licenses
with professional sports teams. Through their relationship with these sports teams, K2
can further promote its long line of sporting gear and equipment. All the different business
functions within K2 have roles to play in supporting the implementation strategy.
Research and Development
K2’s R&D activities are focused on developing only the highest-quality sports equipment
and apparel. The NBA, NFL, and the Major League Baseball are all potential licensing
partners. To support these critical activities, the research and development budget would
be increased by 10 percent annually during the next five years. High-quality and innovative
new products can be sold into the customer bases of firms acquired during this
period.
Marketing and Sales
The licensing agreements in existence between the target firm and its partners can be
enhanced to include the many products that K2 now offers. It must be determined
whether one sales force can sell both the products sold by K2 currently and those
obtained through an acquisition. If so, the two sales forces can be merged, resulting in
significant cost savings.
The human resources department is charged with the responsibility to determine
appropriate staffing requirements and how those can be best satisfied immediately following
a merger. Potential job overlaps are expected to contribute to significant cost
savings. The finance department is charged with quantifying the potential increase in revenue
from cross-selling K2 and the target’s products into each firm’s existing customer
bases and determining the feasibility of realizing anticipated cost synergies. Such information
would be used to determine the initial offer price for the target firm. The legal
department is responsible for determining the validity of customer and supplier contracts
and, in conjunction with the finance department, their overall profitability.
Finally, the tax department is responsible for assessing the tax impact an acquisition
would have on K2’s after-tax cash flow and shareholders.
Strategic Controls
Incentives Systems K2 has incentive systems in place to motivate employees to work
toward implementing its business strategy. Employees are awarded yearly bonuses based
on their performance throughout the year. At the end of the year, employees working in
sales are given up to 5 percent of the sales revenues for which they were personally
responsible. Management is given a bonus based on how well the manager’s department
has performed. Managers are given a bonus made up of 10 percent of the operating
income achieved by their department. This way they are motivated not only to increase
sales but to minimize costs.
Monitoring Systems Monitoring systems are in place to monitor the actual performance
of the firm against the business plan. Activity-based systems monitor variables that drive
financial performance. Such variables include customer retention, revenue per customer,
and revenue per dealer.
Business Plan Financials and Valuation
K2’s net revenue was projected to grow from $790 million in 2004 to $988 million in
2008 on a stand-alone basis. After-tax income is expected to increase from $17.6 million
to $41.2 million during the same period. Reflecting a sharp improvement in free cash
flow from ($7.6) million in 2004 to $46 million in 2008, K2’s current valuation based
on discounted cash flow (with no new acquisitions) is $812 million or $23.79 per share.
Acquisition Plan
K2’s overarching financial objective for any acquisition is to at least earn its cost of capital,
and its primary nonfinancial objective is to acquire a firm with well-established
brands and complementary distribution channels. More specifically, K2 is seeking a firm
with a successful franchise in the marketing and manufacturing of souvenir and promotional
products that could be easily integrated into K2’s current operations.
Timetable
February 28, 2003 Acquisition plan completed.
March 30, 2003 Search for potential target companies completed.
May 30, 2003 Screening for potential target companies completed.
June 30, 2003 First contact completed.
October 30, 2003 Negotiations completed.
November 30, 2003 Integration plan developed.
December 30, 2003 Closing completed.
June 30, 2004 Integration completed.
September 30, 2004 Acquisition process evaluation completed.
Resource-Capability Evaluation
Operating risk. After completion of a merger, K2 must successfully integrate the
target’s sourcing and manufacturing capabilities into K2’s sourcing and
manufacturing operations. The firm must sell K2’s portfolio of products and
brands through the target’s distribution channels, increase the target’s sales to
team sports and sporting goods retailers, and develop a licensing and cobranding
program. K2 would need to retain the management, key employees, customers,
distributors, vendors, and other business partners of both companies. It is possible
that these integration efforts would not be completed as planned, which could
have an adverse impact on the operations of the combined company. K2 believes
that, given its successful track record in acquiring and integrating businesses, its
management team can deal with these challenges.
Financial risk. Borrowing under K2’s existing $205 million revolving credit
facility and under its $20 million term loan, as well as potential future
financings, may substantially increase K2’s current leverage. Among other things,
such increased indebtedness could adversely affect K2’s ability to expand its
business, market its products, make needed infrastructure investments, and the
cost and availability of funds from commercial lenders.
Overpayment risk. If new shares of K2 stock are issued to pay for the target firm,
K2’s earnings per share may be diluted if anticipated synergies are not realized in
a timely fashion. Moreover, overpaying for any firm could result in K2 failing to
earn its cost of capital.
Management Preferences
The target should be smaller than $100 million in market capitalization and have
positive cash flows. Also, it should be focused on the sports or outdoor activities
market.
The search should be conducted initially by analyzing current competitors.
The company has an experienced acquisition team in place, which would be
utilized to complete this acquisition.
The form of payment would be new K2 nonvoting common stock.
The form of acquisition would be a purchase of stock.
K2 will not consider takeovers involving less than 100 percent of the target’s
stock.
Only friendly takeovers will be considered.
The target firm’s current year P/E should not exceed 20.
Search Plan
After an exhaustive search, K2 identified Fotoball USA as its most attractive target due to its
size, predictable cash flows, complementary product offering, and many licenses with most
of the major sports leagues and college teams. Fotoball USA represented a premier platform
for expansion of K2’s marketing capabilities because of its expertise in the industry and
place as an industry leader in many sports and entertainment souvenir and promotional
product categories. The fit with the Rawlings division would make both companies stronger
in the marketplace. Fotoball also had proven expertise in licensing programs, which
would assist K2 in developing additional revenue sources for its portfolio of brands.
Negotiation Strategy
K2 has positioned itself as a holding company and does not take an active management
role in the businesses it acquires. The firm generally allows acquired companies to function
independently. In 2003, Fotoball lost $3.2 million so it was anticipated that the firm
would be receptive to an acquisition proposal. A stock-for-stock exchange offer would be
very attractive to the shareholders of Fotoball due to the combined firms’ anticipated
high-earnings growth rate. The transaction was expected to qualify as a “tax-free” reorganization
for federal income tax purposes. Additionally, management and most employees
would be retained.
Fotoball was a very young company and many of its investors were looking to
make their profits through the growth of the stock. The stock-for-stock offer contains
a significant premium, which would be well received, considering that the company
had been in the red; and it would allow Fotoball shareholders to defer taxes until they
decided to sell their stocks and be taxed at the capital gains rate. Earn-outs would be
included in the deal to give management incentive to run the company effectively and
meet deadlines in a timely order.
The acquisition vehicle used in the deal would be a C-type corporation. Postclosing,
Fotoball would be run as a wholly owned subsidiary of K2. This form would work best,
because K2 is in the process of acquiring many companies, and it cannot actively manage
all of them. In addition, such an organizational structure would be most conducive to a
possible earn-out and the preservation of the unique culture at Fotoball.
Determining the Initial Offer Price
Valuations for both K2 Inc. and Fotoball were done using discounted cash-free flow
methods. The valuations reflect the following anticipated synergies due to economies of
scale and scope: a reduction in selling expenses of approximately $1 million per year, a
reduction in distribution expenses of approximately $500,000 per year, and an annual
reduction in general and administrative expenses of approximately $470,000. The
stand-alone value of K2 was $23.79 per share or $812 million. The stand-alone value
of Fotoball was $3.97 per share or $14.3 million. Including the effects of anticipated synergy,
the estimated combined market value of the two firms is $909 million. This represents
an increase in the shareholder value of the combined firms of $82.7 million over the
sum of the stand-alone values of the two firms.
Based on Fotoball’s outstanding common stock of 3.6 million shares and the current
stock price of $4.02 at that time, a minimum offer price was determined by multiplying
the current stock price by the number of shares outstanding. The minimum offer
price was $14.5 million. If K2 were to concede 100 percent of the value of synergy to
Fotoball, the value of the firm would be $97.2 million. However, sharing more than 45
percent of synergy with Fotoball would cause a serious dilution of earnings. To determine
the amount of synergy to share with Fotoball’s shareholders, K2 looked at what portion
of the combined firms’ revenues would be contributed by each player and applied that
proportion to the synergy. Since 96 percent of the projected combined firms’ revenues
in fiscal year 2004 were expected to come from K2, only 4 percent of the synergy value
was added to the minimum offer price to come up with an initial offer price of $17.8
million or $4.94 per share. This represented a premium of 23 percent over the then
current market value of Fotoball’s stock.
Financing Plan
Due to the synergies involved in this transaction, as well as the relatively small size of the
target (Fotoball) as compared to the acquirer (K2), it is unlikely that this merger would
endanger K2’s creditworthiness or near-term profitability. Although the contribution to
earnings would be relatively small, the addition of Fotoball would help diversify and
smooth K2’s revenue stream, which has been subject to seasonality in the past.
Integration Plan
Organizationally, the integration of Fotoball into K2 would be achieved by operating
Fotoball as a wholly owned subsidiary of K2, with current Fotoball management remaining
in place. All key employees would receive retention bonuses as a condition of closing.
Integration teams consisting of employees from both firms would move expeditiously
according to a schedule put in place prior to closing to implement the best practices of
both firms. Immediately following closing, senior K2 managers would communicate on
site, if possible, with Fotoball customers, suppliers, and employees to allay their immediate
concerns.
Source: This case study is adapted from a paper written by Curt Charles, Tuukka
Luolamo, Jeffrey Rathel, Ryan Komagome, and Julius Kumar, Loyola Marymount
University, April 28, 2004.
Discussion Questions
1. How did K2’s acquisition plan objectives support the realization of its corporate
mission and business plan objectives?
2. What alternatives to M&As could K2 have employed to pursue its growth
strategy? Why were the alternatives rejected?
3. What was the role of “strategic controls” in implementing the K2 business plan?
4. How did the K2 negotiating strategy seek to meet the primary needs of the
Fotoball shareholders and employees?