Estimation of CF, Growth and
Terminal Value
Case: Mercury Athletic Footwear:
Valuing the Opportunity
West Coast Fashions, Inc. (WCF)
Active Gear, Inc.
Mercury Athletic
Strategic Reorganization
• In March 2007, John Liedtke, the
• Liedtke knew that acquiring
head of business development for
Mercury would roughly double
Active Gear, Inc., a privately held
Active Gear’s revenue, increase its
footwear company, was
leverage with contract
contemplating an acquisition
manufacturers, and expand its
opportunity
presence with key retailers and
distributors
• West Coast Fashions, Inc. (WCF), a
large designer and marketer of
• He also expected that Active
men’s and women’s branded
Gear’s bankers would quickly
apparel had recently announced
approach the company about a
plans for a strategic reorganization
possible bid for Mercury;
consequently, he wanted to
• The plan called for a divestiture of
complete his own rough
certain non-core assets and a
evaluation of the opportunity
renewed focus on WCF’s higherbefore hearing the bankers’ pitch
end business, business-casual, and
formal-wear apparel businesses
• One of the divisions WCF intended
to shed was Mercury Athletic, its
footwear division
Athletic and Casual Footwear Industry
• Footwear was a mature, highly
competitive industry marked by
low growth, but fairly stable profit
margins
• Despite the industry’s overall
stability, the performance of
individual firms could be quite
volatile as they vied with one
another to anticipate and exploit
fashion trends
• The market for athletic and casual
shoes remained fragmented,
despite the presence of a small
number of global footwear brands
• In the casual segment, companies
competed on the basis of style,
price, and general quality
• In the athletic segment,
competition revolved around
• Within the fashion-sensitive part
of the industry, product lifecycles
tended to be short, sometimes
lasting only a season
• Consequently, active management
of inventory and production lead
times were critical success factors
• Although a few firms sold their
products in company-owned retail
stores, the large majority of
athletic and casual footwear was
sold through department stores,
independent specialty retailers,
sporting goods stores, boutiques,
and wholesalers
• In 2007, many
Active Gear, Inc.
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Active Gear (AGI) was founded in 1965 to
produce and market high-quality specialty shoes
for golf and tennis players
The company’s products were among the first to
incorporate sculpted cushioned insoles and a
selection of high-performance tread patterns
designed for specific surfaces and/or playing
conditions
AGI began selling its shoes primarily in golf and
tennis pro shops and a few specialty sporting
goods stores
As its products became more established, AGI
moved into larger department and retail stores
The company also exported its shoes to Europe
and, to a lesser extent, Japan
Sales outside the United States were made
through a network of wholesalers, which the
company still employed in 2007
Beginning in the 1970s, Active Gear moved into
casual and recreational footwear aimed at what
had become its core customer demographic:
affluent urban and suburban family members
aged 25 to 45
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AGI was among the first companies to offer
fashionable walking, hiking, and boating footwear
By the early 1980s, the Active Gear brand and
logo were associated with a lifestyle that was
prosperous, active, and fashion-conscious
After years of steady if unspectacular growth,
AGI’s 2006 revenue and operating income were
$470.3 million and $60.4 million, respectively,
with 42% of revenue from athletic shoes and the
balance from casual footwear
Historical income statements and balance sheets
for AGI are presented in Exhibits 1 and 2
The firm’s athletic shoes had evolved from highperformance footwear to athletic fashion wear
with a classic image. The company’s traditional
casual shoes also offered classic styling, but were
aimed at a broader, more mainstream market
AGI’s casual footwear was sold by more than
5,700 North American department, specialty, and
general retail stores via a network of wholesalers
and independent distributors
Active Gear, Inc.
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Sales of athletic footwear were made through
independent sales representatives to a limited
number of sporting goods stores, pro shops, and
specialty athletic footwear retailers
A small percentage of both casual and athletic
shoes were sold through Active Gear’s website
By focusing on a smaller portfolio of classic
products with longer lifecycles, Active Gear was
able to maintain relatively simple production and
supply chains
This in turn allowed the firm to avoid the worst of
the industry’s cycles of inventory write-downs
and missed profit opportunities
AGI’s simplified approach to brand and inventory
management also contributed to its strong
operating margins
Table 1 shows AGI’s Days Sales in Inventory
compared to Mercury and other selected
footwear producers
U.S. import taxes ranged from 8.5% to 10.0% for
leather footwear, and 6.0% to 20.0% for synthetic
footwear
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Duties in the EU averaged 7.0% to 8.0% for
leather and 16.5% for synthetic footwear
Like most footwear makers, AGI outsourced
production to a network of contract
manufacturers located in China
To ensure quality and on-time delivery, AGI
conducted a rigorous screening and certification
program for all of its manufacturers
The company also maintained a staff of 85 fulltime professionals who monitored contract
manufacturing on-site from the initial sourcing of
materials all the way through final inspection
Financial Policy & Performance of AGI
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Active Gear was among the most profitable firms
in the footwear industry (Exhibit 3 presents
recent data for selected publicly traded footwear
producers)
However, the company was much smaller than
many competitors, and AGI’s executives felt its
small size was becoming a competitive
disadvantage
A recent wave of consolidation among Chinese
contract manufacturers created pressure to boost
capacity utilization; this was expected to favor
larger firms who could offer the manufacturers
longer production runs
Active Gear had recently increased its supplier
concentration—reducing the number of its
contract manufacturers—in an effort to improve
its negotiating position
Until recently, AGI’s largest supplier accounted for
no more than 12% of its volume; by 2006 this
figure was approximately 20%, and the two nextlargest firms together accounted for 22%
On the customer side, the rise of “big box”
retailers threatened AGI’s growth
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To protect the company’s brand image, Active
Gear did not sell through discount retailers
While this policy helped preserve operating
margins, it was believed to have hurt sales
growth
During 2000–2006 AGI grew its revenue at a
compound average rate of only 6% per year
compared with nearly 10% for the group shown
in Exhibit 3
During the past three years AGI grew even more
slowly—at an average annual rate of only 2.2%
Continuing pressure from suppliers and
competitors caused some deterioration of basic
performance metrics, such as return on net
operating assets, return on equity, and asset
turnover, during 2004–2006 (see Exhibit 1)
Mercury Athletic Footwear
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Mercury Athletic Footwear designed and distributed
branded athletic and casual footwear, principally to
the youth market
Its 2006 revenue and EBITDA were $431.1 million and
$51.8 million, respectively
Exhibit 4 presents recent income statements and
balance sheets for Mercury
West Coast Fashions had purchased Mercury from its
founder, Daniel Fiore, in late 2003
Fiore had started Mercury 35 years earlier, but
developed health problems that forced him to sell
the business
At the time of the transaction, WCF was in a period of
rapid expansion, driven by an aggressive acquisition
strategy; it planned to extend the Mercury brand by
creating a complementary line of apparel
WCF executives also believed that its larger, more
established network of distributors would
substantially widen Mercury’s distribution with
department stores and large discount retailers and
boost sales for both shoes and apparel
Mercury’s performance since the acquisition was
mixed, but disappointing on the whole
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WCF did exploit its own distribution network to
expand Mercury’s sales
However, the new Mercury Athletic line of branded
apparel never gained much traction with consumers
The most loyal purchasers of Mercury’s footwear
were 15 to 25 years old, with an active interest in
extreme sports
These customers were either uninterested in branded
apparel, or the specific apparel offered by Mercury
simply did not appeal to their tastes
Further, WCF’s efforts to establish the apparel line
included price cuts and promotions that hurt
operating margins
In late 2006, WCF’s board concluded that Mercury’s
size, customers, and brand image did not fit with
WCF’s and had determined to sell the business in the
context of a broader reorganization
Mercury’s managers were eager to abandon the
apparel line and return to an exclusive focus on
footwear
Mercury Products
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Mercury competed in four main
segments: men’s and women’s athletic
and casual footwear
During the 1990s, Mercury’s athletic
shoes became popular among extreme
sports enthusiasts and within the
associated X-Games subculture
As a result, the company’s brand
acquired an iconoclastic nonconformist
image that the company tried to
exploit by adding a line of active casual
footwear targeted at the same
demographic
Traditionally the company had
promoted the Mercury brand without
emphasizing individual products
In support of this strategy, Mercury
closely monitored styles and images
that evolved from a global youth
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The company also sponsored, or cosponsored, certain athletic and cultural
events with demonstrated appeal to its
target demographic
Such events included skateboarding,
snowboarding, and BMX competitions,
as well as alternative music festivals
and concerts.
Mercury’s price points were
predominantly mid-range, but the
company also had a few brands in
higher and lower price ranges
Mercury’s shoes were sold throughout
North America in a wide range of retail,
athletic, department, and specialty
stores, and via catalogs and the
Internet
No single geographic region accounted
for more than 10% of sales
Production & Operations
• Mercury sourced substantially all • It maintained its own financial
of its production from
statements, databases, resource
independent contractors in Asia
management systems, and
distribution facilities
• The company had developed an
operational infrastructure
• As of December 31, 2006, the
intended to help it adapt quickly
company had 1,123 full- and partto changes in customer tastes and
time employees
corresponding product
specifications
• The company had relatively little
capital spending and focused its
resources instead on market
research and product design
• It sourced the majority of its raw
materials from foreign suppliers,
and had 73 professional and
technical personnel in China alone
to oversee the quality, production,
packaging, and shipping of all its
Financial Performance
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Following the acquisition by WCF, Mercury’s
financial performance had been
disappointing
The growing popularity of extreme sports,
along with WCF’s large distribution network,
supported top line growth of 20% during
2006 and at a compounded annual rate of
10.5% from the date of the acquisition
However, when Fiore sold the company to
WCF, Mercury’s EBITDA margin had been
steady for years between 14.0–14.5%
In contrast, during 2004–2006 Mercury’s
EBITDA margin averaged 11.6%
Several factors contributed to the diminished
profitability
First, some of Mercury’s sales growth
resulted from lower prices
In particular, Mercury had discounted part of
its line to get product on the shelves of large
discount retailers
These pricing concessions explained part of
the financial performance displayed in Table
2
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However, a related problem, discussed
further below, was Mercury’s unsuccessful
entry into women’s casual footwear
Finally, the firm’s rapid sales increase,
proliferation of brands, and underperforming
women’s lines strained its infrastructure and
eroded operating efficiency
In 2006 Mercury’s DSI was more than 10 days
longer than the industry average, and the
company’s return on net operating assets
was only 12.9%, compared with an industry
average of approximately 20%
DSI or days sales inventory is computed here
as end-of-year inventory / (revenue /360)
Return on net operating assets equals net
operating profit after tax / end-of-period net
operating assets
Asset turnover is computed as revenue
divided by end-of-period net operating assets
Performance data for each of Mercury’s
product segments are presented in Exhibit 5
Men’s Athletic Footwear
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Men’s athletic footwear was by far the
company’s largest segment and
constituted its core business
Revenue for this segment grew more
than 40% over the prior year, and at an
average compounded rate of 29%
between 2004 and 2006
Mercury’s managers attributed the
growth primarily to increased sales
through large discount retailers, which
began handling Mercury’s products
nationwide in the second quarter of
2005
In addition to robust sales growth,
men’s athletic footwear enjoyed
operating margins that were
consistently higher than rival firms’
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On the one hand, loyal customers
associated with extreme sports paid
medium to high prices for Mercury
footwear
On the other, Mercury’s shoes were
relatively inexpensive to produce:
simple designs in combination with
basic materials reduced complexity and
cost in manufacturing
Operating margins for men’s athletic
footwear had been approximately 14%
historically
A slight decline in 2005 was due to rollout costs associated with introducing
the line to discount retailers
Men’s Casual Footwear
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Sales of men’s casual footwear peaked in 2004, and
had declined since then at an average rate of 6.25%
per year
Mercury attributed much of the decline to a
combination of cannibalization and unfortunate
shipping problems
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The firm introduced a new fashion line for the 2005
holiday season that was received enthusiastically by
retailers, who placed strong orders
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When bad weather and strikes by dockworkers
delayed deliveries, Mercury’s holiday sales were
disappointing: stores had trimmed their orders for
Mercury’s existing men’s casual products to make
room for the new line, which showed up late
When sales failed to recover satisfactorily in 2006,
Mercury took steps to upgrade parts of the line and
boost support of the casual segment generally
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As a result, Mercury expected 2007 and following
years to show steady improvement
Despite its small size and recent sales declines, the
men’s casual segment consistently posted Mercury’s
highest profit margins
High profitability was attributed to a marketing and
distribution strategy in which casual products were
sold exclusively through specialty shops with proven
ability to reach the youth demographic
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In addition to supporting prices, the exclusivity
reinforced the brand’s image
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Finally, this set of retailers tended to be quite
fragmented, and most lacked a national footprint,
which allowed Mercury to obtain very favorable terms
Women’s Athletic Footwear
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In contrast to the relative strength of the
men’s lines, Mercury’s lines for women had
subpar performance
Women’s athletic footwear turned in solid
sales growth, averaging 13.5% per year
during 2004–2006
However, as with the men’s line, much of this
growth was due to the recent introduction of
Mercury’s shoes to large discount retailers
An equally important driver was the growing
participation of women in extreme sports
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Operating margins for women’s athletic
footwear averaged just over 10%, which was
below the industry mean of 11.9%
Mercury’s managers felt the primary reason
for lower margins was the high cost of
building brand image and awareness among
women
Prior to the acquisition by WCF, Mercury had
done almost no marketing specifically
targeted at female consumers
Since then, targeted advertising and
promotional programs had improved the
brand’s standing among women, and
Mercury’s managers anticipated better
margins in the immediate future
Women’s Casual Footwear
• Women’s casual footwear was • During 2004–2006 sales
Mercury’s worst-performing
dropped alarmingly, which led
line of shoes
to multiple rounds of
inventory write-downs
• WCF had expected that its
expertise in marketing upscale • These in turn further eroded
women’s apparel would
margins and led to operating
naturally boost the line of
losses
women’s casual footwear that • By the end of 2006, the line
Mercury introduced just after
was considered all but dead
the acquisition
and Mercury’s managers were
not eager to try the
• The new line was launched
with heavy promotion in 2004,
experiment again
but sales began to falter in
2005, as soon as promotional
support was reduced
Valuing Mercury Athletic
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To perform a preliminary valuation, Liedtke developed
a base case set of financial projections based on
forecasts of revenue and operating income for each of
Mercury’s four main segments as shown in Exhibit 6
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Liedtke’s base case assumed that women’s casual
footwear would be wound down within one year
following an acquisition, as he doubted that WCF
would be willing to sell Mercury without it
He further assumed that Mercury’s historical
corporate overhead-to-revenue ratio would conform
to historical averages
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To accompany the operating projections, Liedtke
prepared projections for certain balance sheet
accounts for Mercury, shown in Exhibit 7; these
corresponded to operating assets and liabilities that
Liedtke expected would be required to support his
operating projections
He did not prepare projections for debt or equity
accounts since Mercury likely would not have its own
balance sheet and capital structure following an
acquisition by AGI
To estimate a discount rate, Liedtke planned to
assume the same degree of leverage for Mercury that
AGI currently used, which he estimated to be 20%,
measured as debt divided by the market value of
AGI’s invested capital
Given current credit market conditions, he expected
this degree of leverage to imply a cost of debt of 6.0%
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After examining Mercury’s value using the base case
assumptions, Liedtke also wanted to consider the
value of possible synergies
Specifically, he believed that AGI’s inventory
management system could be adopted by Mercury at
little incremental cost and would reduce Mercury’s
DSI to the same level as AGI’s
In addition, he thought it was possible that Mercury’s
women’s casual footwear line could be folded into
Active Gear’s, rather than discontinued
In that case, he thought the combined businesses
could achieve an EBIT margin of 9% and revenue
growth of 3%
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The Mercury case requires students to •
formulate projections of debt-free
cash flows using pro forma financial
statements, to estimate a terminal
value and cost of capital for the
enterprise, and to consider whether
and how to incorporate the effects of
synergies
The primary goal is to generate DCF
values for the enterprise without
synergies
Time permitting, the treatment of
synergies may be addressed
qualitatively
Strategy
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Despite the fact that the Mercury case is intended to
teach valuation mechanics, not M&A, and certainly
not business strategy
This reminds that a valuable acquisition should have a
raison d’etre
There should be a story about why the deal makes
sense, how bidder and target fit together (or not),
what sources of potential value are present, how they
are to be realized, and so forth
The case itself does not provide a truly compelling
motivation for an acquisition, though speculate about
the deal’s potential for value creation: possible
operating synergies, or economies of scale in
(contract) manufacturing or of scope in distribution; a
possible combination of Mercury’s and AGI’s women’s
casual lines; a platform for further acquisitions, and so
forth session, once cash flow projections have been
formulated, to inquire whether the projections
actually reflect the strategic rationale or not
As noted below, the base case projections prepared
by AGI’s Liedtke and summarized in case Exhibits 6
and 7 are fairly rough, and reflect rather little in the
way of value creation
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Indeed, some will argue that significant value creation
is unlikely because the strategic fit is poor
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Mercury’s strengths lie in a market and demographic
that should be highly vulnerable to the athletic shoe
giants, should they decide to attack it, and which may
prove much more prone to fashion fads than AGI’s
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Certainly the “counter-culture” image of Mercury
does not obviously complement the upscale affluence
of AGI’s image, and each may even detract from the
other. WCF’s board has come to just such a conclusion
based on that company’s brief ownership of Mercury.
Finally, the rather modest projected improvement in
Mercury’s operations does not appear to result from
any unique advantage AGI has as a bidder
Consequently, one would expect Mercury to be fully
priced if WCF conducts an auction among qualified
buyers
Just as surely, one would expect AGI to prefer a
negotiated sale, conducted quickly and quietly,
without other participants, to increase the likelihood
of an attractive price
If AGI wins Mercury in an auction, there is an
excellent chance that it will have overpaid for a
questionable target
Firm Value and Cash Flows
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Modeling a business as a series of expected
cash flows which are then discounted at an
opportunity cost of funds, r, as shown below
All that matters are the amounts, timing, and
risk of the cash flow produced by the
business
Obvious examples are assets that provide
non-cash benefits (e.g., beautiful works of
art) and non-value-maximizing entities such
as some nonprofit organizations (the absence
of value- maximization makes the selection
of a discount rate more problematic, even if
cash flows can be estimated)
The length of the explicit annual forecast
period is up to the analyst’s judgment and
may depend on the position of the business
or the industry along some secular growth
curve or within a predictable life cycle; on the
timing of anticipated managerial actions,
such as a restructuring; and/or on the
availability of reliable data
Future cash flows are characterized here as
random variables, and the equation
incorporates the means of their respective
distributions, as opposed to, say, the medians
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In this equation, the terminal value is
modeled as a perpetuity with a constant
growth rate, g
This is a common way to model a going
concern, but depending on case-specific
facts, other methods might be considered as
well, such as liquidation value or an
estimated sale price
The expression above assumes cash flows are
received at the end of each period
Express a preference for the mid-period
convention, in which cash is assumed to be
received at a constant rate throughout the
period and so is modeled as if received at the
mid-point of the year, which in turn changes
the discounting period
Free Cash Flow Projections
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The equation above asks for three main
ingredients: free cash flow (FCFt) projections; a
discount rate; and a terminal value
We begin with FCF projections. A standard
“recipe” for a single period is
FCF = EBIT(1-t) + depreciation – ∆ net working
capital – capital expenditures
For example, where do we obtain EBIT(1-t)?
Usually it comes from projected income
statements
Basically, we are using the “top” part of projected
income statements, from the revenue line
through operating profit or EBIT
Why stop with EBIT? Because after EBIT, the
income statement adds and/or subtracts
nonoperating income and expenses, the prime
example being interest expense
Why exclude interest, which is, after all a cash
flow?
Because we are interested in how much the
business is worth, based on how much cash it
generates, not in how it is financed, which
determines who gets the cash
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In the Mercury case, we have Liedtke’s
projections of revenue and operating costs by
segment (case Exhibit 6)
By adding them up and subtracting corporate
overhead, we get EBIT—the projected operating
profit for Mercury
Consolidated Segment Revenue Less: Segment
Operating Expenses Less: Corporate Overhead
Operating Income = EBIT
Next we tax EBIT, which gives us EBIT(1-t), the
first term in the FCF recipe
This called “EBIAT” or “net operating profit after
tax” (or “NOPAT”)
It also is sometimes called “debt-free net
income”
Must decide whether to take up the topic of
interest tax shields or defer it
It will come up here if a student points out that
the tax bill implicit in EBIT(1-t) is overstated
because no deduction was taken for interest
expense before taxes were paid
Free Cash Flow Projections
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“So we’re missing the value of interest tax
shields. Where do we pick them up?” T
he answer depends on whether WACC is to
be used as a discount rate or whether a
separate calculation is made for the value of
interest tax shields, as in APV
Next we add back depreciation
The common response is that depreciation is
a non-cash charge that is nevertheless taxdeductible. This is true, but the arithmetic is
only correct if depreciation has already been
subtracted from EBIT
Has it been? Yes – case Exhibit 6 states that
depreciation is included in each segment’s
operating expenses
What if it had not been included? Then we
would not add back depreciation, but rather
add the depreciation tax shield, equal to
depreciation times the tax rate
Before proceeding to the changes in working
capital, may want to take a moment to
discuss the administrative charge imposed at
the parent company level under current
ownership (see Exhibit 4)
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Historically, the administrative charge levied
by WCF has been small and has not been
included in operating expenses
Should it be? The key point for students to
recognize is that if a new owner would not
pay it (or something very like it) in cash, then
it is not incremental and should not be
included in the cash flow calculations
In fact, it is not included in the Exhibit 6
projections
Developing the Schedule of Changes
in Working Capital
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Begin by examining Mercury’s balance sheet
at t=0 (we’ll use the 12/31/2006 balance
sheet shown in Exhibit 4)
A helpful goal is to reorganize Mercury’s
balance sheet so as to assign every account
to one of the four “buckets” shown in Figure
1: net working capital (NWC); net fixed assets
(NFA); debt (D); and equity (E)
This exercise forces to consider which items
on the balance sheet are most closely
associated with operations (put these on the
“real” or “asset” side, i.e., the left) and which
with financing (put these on the “financial”
or “capital” side)
Net working capital is a category that will
likely contain both the traditional current
asset accounts as well as the trade- and
operations-related current liabilities
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On Mercury’s 12/31/06 balance sheet, the
net working capital accounts are cash,
accounts receivable, inventory, prepaid
expenses, accounts payable, and accrued
expenses
The last two are subtracted from the first
four
Developing the Schedule of Changes
in Working Capital
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Once reorganize the balance sheet in this fashion,
it becomes obvious to them how to compute
ΔNWC for the FCF recipe: it is simply the yearly
change in this NWC bucket using Liedtke’s
projections for the corresponding accounts in
Exhibit 7
It also reinforces their understanding of the
financial logic behind the FCF recipe
The DCF exercise as described here is aimed at
valuing the operations represented on the left
side of the reorganized balance sheet and
summarized in the NWC and NFA accounts
The FCF recipe is simply the cash produced by
operations minus the investment required by
operations
Put another way, it is EBIT(1-t) minus the increase
in these two aggregated accounts:
FCF = EBIT(1-t) - ∆NWC – ΔNFA
This expression is equivalent to the previous
version of the recipe when the that ΔNFA =
capital expenditures – depreciation
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Obviously, ΔNFA also includes acquisitions,
liquidations, and divestitures of fixed assets,
which are not present in the simple Mercury
projections
The same reorganized balance sheet comes in
handy again when students compute leverage
ratios for a cost of capital calculation (see below)
While they cannot use book values of D and E for
this purpose, reorganizing the balance sheet
forces them to identify which capital accounts are
debt and which equity
Unfortunately, real companies do not always lend
themselves to this degree of simplification
Figure 2 shows a more complex version of the
reorganized balance sheet
This one separates excess cash from the rest of
the assets and allows for a category of “other”
assets that may be neither NWC nor NFA
The right side allows for an “other” capital
account as well, and for the possibility of hybrid
securities such as convertible debt and some
types of preferred stock
Developing the Schedule of Changes
in Working Capital
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Excess cash is treated outside the DCF analysis for
several reasons: it is a nonoperating asset; it may
be best valued merely by “counting” it; and in
many calculations of leverage, excess cash is
essentially “negative” debt
Liedtke is treating Mercury’s cash as an operating
asset—specifically, as part of NWC—so excess
cash is zero
And he is projecting (see Exhibit 7) an initial
decrease in the amount of cash necessary to run
the business, followed by increases that reflect
the growth of Mercury’s operations
Besides suggesting that we treat excess cash
outside the DCF analysis, Figure 2 also reminds us
to address “Other” assets (which might in fact
result from the netting of “other assets” and
“other liabilities”)
An example in the Mercury case of an account
that might be characterized as “other” capital is
the company’s pension obligation
To the extent that this represents a financial
obligation to employees, to be paid at a future
date much as lenders are to be paid, the account
is reasonably treated as capital
On the other hand, it may be characterized as an
operating liability arising from employees’
productive services
In that case, it is a “real” account that should be
•
•
•
•
•
It still is the case that, because the account does
not change over time, it has zero effect on
Mercury’s projected FCF
Just like NWC and NFA, if Other Assets change
over time, the change must be subtracted from
FCF unless it is non-cash:
FCF = EBIT(1-t) - ∆NWC - ΔNFA – Δother.
In other words, changes in other assets may
affect FCF and must not be overlooked simply
because they did not arise from capital
expenditures or the working capital accounts
On Mercury’s balance sheets, there are indeed
other such accounts: Trademarks and Other
Intangibles, Goodwill, and Other Assets
Developing the Schedule of Changes
in Working Capital
•
•
In fact, however, the projected balance sheet
items in case Exhibit 7 show no changes in these
accounts, so their effect on FCF during 2007–
2011 is zero
One of the implications of the reorganization is
the disparity between “Net Assets” (as shown in
TN Exhibit 1) and Total Assets (as reported in
Exhibit 4)
•
•
The difference, of course, is the netting of
operating liabilities, both current and long-term,
against operating assets on the left side
Finally, TN Exhibit 1 also presents completed
calculations for NWC and ΔNWC during 2007–
2011, where each variable is defined as described
above and figures are computed based on Exhibit
7
Liedtke’s Projections
•
•
•
•
•
•
TN Exhibit 2 recaps the projections given as
Liedtke’s base case in Exhibit 6, and includes
a calculation of the implied growth rates and
EBIT margins by segment
The margin assumptions, in particular, are
highly simplified: they are constant over the
projection period, albeit not unreasonable in
light of the recent performance shown in
Exhibit 5
Liedtke has assumed top-line growth for
men’s and women’s athletic shoes will
remain strong in 2007, due presumably to
continuing effects of expansion into large
discount retailers, but then recede steadily
beginning in 2008
He assumes growth in men’s casual shoes will
be reestablished and rise to 3% per year, and
that the women’s casual line will be
discontinued
TN Exhibit 3 presents FCF projections for
Mercury during 2007–2011, based on
Exhibits 6 and 7 and formulated according to
•
•
•
•
Draw students’ attention to the pattern over
time of ΔNWC
More specifically, the rise in NWC is smaller
in 2008 than in 2007, but then large again in
2009, and smaller again in 2010–2011
Is this pattern reasonable? Liedtke has based
NWC projections primarily on historical
averages of cash cycle ratios. But he reduced
projected cash used in operations for 2007
compared with 2006
More important, the reduction in ΔNWC in
2008 is explained by Liedtke’s assumption
that the women’s casual line will be
discontinued
Dropping this line reduces Mercury’s NWC
commitment from what it otherwise would
be, but not until 2008
• Estimating a Cost of Capital
• Students can derive a cost of capital for Mercury based on case facts and using the CAPM in conjunction with data on publicly traded
footwear companies presented in Exhibit 3.3 Students may voice doubts about whether these companies are sufficiently comparable to
Mercury and offer their arguments pro and con. While this issue is an important one, there is not sufficient time or information in the
Mercury case to do it justice. Accordingly, it is best to note the potential problem and students’ ideas for addressing it, but keep moving
through the mechanics of extracting an asset beta from the data.
• Asset Beta
• TN Exhibit 4 provides a derivation of the average asset beta for the set of comparable footwear companies. The calculation was based on
the simple formula:
• βasset = (E/V)βequity
• where E is the market value of equity, V is the sum of E and net debt (net debt = debt – cash), and βequity is the observed equity beta for
a given firm. The average asset beta for this set of firms is 1.28.4 Note that the calculations in TN Exhibit 4 assume a capital structure
different from that implied by Mercury’s simplified balance sheet in TN Exhibit 1 because Liedtke has chosen to compute a WACC that
incorporates a debt-to-capital ratio of 20%.
• Instructors should also be aware that the comparable firms shown in Exhibit 3 include two— Marina and Heartland—that have negative
net debt. Students who have not already encountered negative net debt in cases on cost of capital or capital structure may stumble over
the figures in the exhibit. Some may have excluded these two firms as outliers, which will affect their estimates of the asset beta.
• Even inexperienced students will point out that the range of individual asset betas within the sample is quite wide, from a low of 0.69 for
Templeton to a high of 2.10 for Marina Wilderness. Cursory examination of the firms in Exhibit 3 will lead some students to suggest
refining the sample a bit further. For example, Victory Athletic is an order of magnitude larger than the others by almost any measure, and
certain of the firms have rather different margins and capital structures. Students will suggest various alternative uses of the sample, and
will likely differ in their concluded asset betas. Several important points should come from this discussion. First, it is important to remain
aware of differences across “comparable” firms and to note the intra-sample variation of asset betas. However, it is generally not good
practice to compose a set of comparable firms, compute their asset betas, and then decide which ones don’t fit. A firm’s lack of
comparability should be based on its business characteristics, not its asset beta. Having said that, sometimes even a “good” comparable
firm has an anomalous asset beta, and analysts will sometimes exclude it as an outlier based, presumably, on the statistical argument that
its equity beta was mis-measured or distorted by some anomalous phenomenon. Finally, the range of asset betas in the concluded sample
often provides sensible guidance about a range of discount rates to be examined in sensitivity analyses.
• 3 Less-experienced students may need to spend
two class sessions on Mercury. In that case, this is a
pedagogically convenient place to divide the two
sessions: work on cash flows the first day and cost
of capital and TVs the second.
• 4 The unlevering formula in the text assumes a
constant debt ratio. If one assumes instead a
constant amount of debt, the corresponding
unlevering formula is βasset = (E/(E+net debt(1t)))βequity and the resulting average asset beta is
1.37. Both formulas assume the beta of debt is zero.
• Weighted Average Cost of Capital
• With an asset beta in hand, instructors can walk through an estimate of the required return on equity by re-levering the beta for the new
capital structure and incorporating the result into the CAPM. Using the same formula given above, an asset beta of 1.28 and a target
debt-to-value ratio of 20%, we obtain a re-levered equity beta of 1.60. The case gives the current yield on 20-year U.S. Treasuries of
4.93%. Combining this with the beta and a market risk premium of 5.0% gives a cost of equity for Mercury of 12.92%.5
• Putting this cost of equity into the basic WACC formula along with a cost of debt of 6.0%, a tax rate of 40%, and target leverage of 20%
debt, we obtain:
• WACC = (D/V)rd(1-t) + (E/V)re = 0.2(6.00%*0.6) + 0.8(12.92%) = 11.06%.
• At this point instructors need to decide whether to proceed with a single value for WACC, say 11%, and return later to sensitivity analyses,
or to discuss now the range of plausible values for WACC based on the set of comparable firms. If time is short, the former tactic will be
preferable.
• Terminal Value
• Growing Perpetuity
• If Mercury has plausibly reached a steady state by 2011, its going concern value may be estimated using the formula for a growing
perpetuity. Many students of business mathematics will be familiar with this formula, which gives the present value (PV) at t=0 of cash
flows (CFt) received in perpetuity beginning at t=1 and growing at a constant rate of g per period. The discount rate is again denoted by r:
• PV0 = CF1/(r-g),
• Using this formula to estimate a terminal value (TV) for Mercury requires us to envision the future company as a stream of cash that
begins in 2012 and continues forever, growing at a constant rate. What is a reasonable rate? The instructor should ask students what rate
they would use or, alternatively, ask for pertinent benchmarks—i.e., upper or lower bounds. Commonly offered ones include the long-run
nominal rate of inflation (an argument for zero real growth, and in this case a likely lower bound), the long-run rate of nominal
macroeconomic growth (because no business can grow faster than the economy forever, more likely an upper bound), and zero (to “be
conservative”). Students also will mention a 2%-3% growth rate based on the maturity of the industry, and the growth rates implied by
the projections during 2008-2011 (after the women’s casual line has been jettisoned) of approximately 3.4% for FCF.
• More formally, instructors may wish to show students how to relate a growth rate to assumptions about long-run profitability and
reinvestment rates, assuming these are constant and that growth in FCF equals growth in EBIT.6 This approach enforces a discipline in
which long-term growth rates are yoked to fundamental business characteristics—the rate at which a business generates profits and the
rate at which owners reinvest in it.
• 5 The case does not mention a specific value
for the equity market risk premium so that
instructors may guide students according to
their own views on this topic. Some instructors
may wish to stipulate a particular value for the
EMRP in the assignment questions.
• 6 Students may need to be reminded that
Liedtke’s projections for 2007–2011 clearly
violate this assumption, though it may well
hold after 2011.
• Students should recognize that while this approach links the terminal value’s perpetual growth
rate to fundamental financial and operating parameters—which makes it seem less arbitrary and
ensures a degree of internal consistency—it will not save an analyst from his or her own biases
or from poor data. It is, obviously, still possible to inflate or otherwise mis-estimate profitability
or reinvestment rates.
• Completed Valuation
• TN Exhibit 5 shows a completed DCF valuation of Mercury based on Liedtke’s projections, a
range of WACCs from 8.0% to 14.0%, and range of terminal value growth rates from 0% to 5%. At
a WACC of 11.06% and a perpetual growth rate of 2.78%, the value of the enterprise is
approximately $308 million. The same exhibit shows the enterprise value to be very sensitive to
the values used for WACC and g, the perpetual growth rate. Some students find this high degree
of sensitivity disconcerting. It is not, however, very surprising. It shows, on the one hand, that the
value of Mercury at the end of 2006 is highly sensitive to its expected value as a going concern in
2011. This should not be unintuitive. And it shows, on the other hand, that the estimation of
discount rates and terminal values are well worth students’ time and attention.
• Market Multiples
• Many students will be familiar with the use of market multiples, based on Revenue, EBIT, or
EBITDA, as an alternative means of estimating the terminal value. Given that a multiple often
yields a different result from the perpetuity, a common question is “which is right?” or “when
should I use which approach?” In reality, professional appraisers are likely to consult both
whenever possible.
• Each has its limitations. For example, the future path of many “going concerns” may not be well approximated by a perpetuity with constant
growth commencing at the end of the explicit forecast period. In such cases a perpetuity will not yield a reasonable value, unless an
“unreasonable” growth rate is used. Accordingly, experienced analysts will tend to give greater weight to a TV based on multiples. On the other
hand, there is not always a reliable sample of publicly traded firms or recent transactions on which to base multiples. And there is always the
problem that multiples change over time, and it may be dangerous to apply multiples drawn from today’s market to generate a TV estimate for 5
or 10 years hence. As previously noted, conclusions of value will be highly sensitive to judgments about the appropriate terminal value.
• The Mercury case includes data that allows students to estimate a terminal value (and indeed, even a present value) for Mercury based on market
multiples. However, class time will not permit a thorough treatment of this topic, so the instructor should be prepared to present an example, or
let a student do so, and then compare it, at a high level, to the perpetuity approach. [Other case studies lend themselves more readily than
Mercury to a thorough examination of multiples.]
• A straightforward example may be based on an EBITDA multiple drawn from the comparable company data in Exhibit 3. Excluding Victory Athletic
from the sample, due to its significantly larger size, gives an EBITDA multiple of 7.67x. Applying this to Mercury’s 2011 EBITDA of $76.57 million
gives a terminal value of $587.9 million. This in turn results in a concluded DCF Enterprise Value of $438.9 million. This value is about $130 million
higher than the figure obtained above using 11.06% for WACC and 2.78% as the TV growth rate. However, it is well within the range of values
shown in the sensitivity table in TN Exhibit 5. A final interesting point of comparison is the value obtained by applying the same 7.67x EBITDA
multiple directly to Mercury’s 2006 EBITDA of $51.8 million. This gives $397.3 million; call it $400 million. This lower value does not reflect the
improvements in earnings anticipated by Liedtke due to, among other factors, the elimination of Mercury’s Women’s Casual line.
• Synergies
• The last page of the case mentions at least two possible sources of value creation clearly not captured in Liedtke’s base case numbers: a significant
reduction in Mercury’s DSI, and a possible combination of Mercury’s and AGI’s women’s casual lines. A third possibility is mentioned earlier in the
case as a prime reason for AGI’s interest in Mercury: a hoped-for boost in negotiating clout vis-à- vis contract manufacturers, because the
combined firm will be twice as large as either the bidder or target alone. Students may offer other hypotheses as well.
• There will not be time in class for a quantitative treatment of any of these, but students should be asked how they would design an analysis to
quantify their value. The easiest one to consider is the reduction in DSI. Table 1 shows AGI’s DSI is about 70% of Mercury’s: 42.5 versus 61.1 days.
What would be the effect of reducing Mercury’s DSI to 42.5 days? There are likely many effects, but the first-order financial effects would be an
immediate reduction in Mercury’s inventory, accompanied by smaller subsequent investments in NWC. Mercury’s 2006 inventory is about $73
million. Cutting this figure by 30% represents an immediate cash flow benefit of $22 million, which is significant— about 7% of the enterprise
value computed above. Further savings are associated with avoided future investment. To compute these, students would need to re-compute the
ΔNWC schedule for 2007–2011, using the new DSI estimate, and recognize that the terminal value will likewise be affected. This may be assigned
as an exercise. Rather than discussing the details of it in class, it is probably more worthwhile to question the plausibility of a dramatic reduction in
inventory. As the case notes, AGI’s low inventory has much to do with the styles it offers and the demographics of it
• customers, both of which are quite different from Mercury’s. Reducing Mercury’s inventory might not be valuemaximizing even if it is logistically feasible.
• The other two sources of value can be discussed with even less quantitative detail. Both require more information
about AGI’s business than the case provides. Combining the two women’s casual lines may well be a good idea, but
to quantify its effects, we need to know how each will perform alone (we have no data on AGI’s) in addition to the
likely performance of the combination. We also would want to understand the supposed sources of the improved
performance—why should the combined lines perform better than each individually?
• The same is true for the anticipated benefit of larger size in negotiating terms with contract suppliers. This may be
the prime motivation for AGI’s interest in a substantial acquisition—it feels an acute need to be bigger—but is it also
probably the most difficult to quantify? A convincing analysis of it would have to include data on terms achieved by
other shoe companies as a function of their scale, or a schedule of proposed terms offered by one or more
manufacturers that shows how terms vary with volume. And it may be the case that one acquisition—of Mercury, let
us suppose—is necessary but not sufficient. In other words, AGI might have to get much larger to realize significant
savings. In that case, how should the first step in this direction be evaluated?
• Suggested Assignment Questions
• Is Mercury an appropriate target for AGI? Why or why not?
• Review the projections formulated by Liedtke. Are they appropriate? How would you recommend modifying them?
• Estimate the value of Mercury using a discounted cash flow approach and Liedtke’s base case projections. Be
prepared to defend additional assumptions you make. [The instructor may add more detailed or specific instructions
regarding assumptions he/she would like students to examine.]
• Do you regard the value you obtained as conservative or aggressive? Why?
• How would you analyze possible synergies or other sources of value not reflected in Liedtke’s base case assumptions?
• Suggested Teaching Plan
• 1. Is Mercury an appropriate target for AGI?
a. Strategic fit: brands, products, customers, distribution
b. Specific sources of value
c. AGI’s strengths/weaknesses compared with other
bidders’.
• 2. DCF basics: a business is a stream of cash flow
a. The format: yearly FCF projections + a terminal value
b. The recipe for FCF
• i. Why begin with EBIT?
ii. Why add back depreciation? iii. Why no interest
charge?
iv. Etc., as needed
• 3. Apply the FCF recipe to Mercury a. EBIT(1-t)
• b. Depreciation and Cap x c. ΔNWC
• i. How to compute it
ii. A detour, if necessary, through a reorganized balance sheet iii. Pulling ΔNWC, ΔNFA, ΔOther, etc.
• 4. Pause to analyze, criticize the FCF projections
a. Ratios and margins are reasonable?
b. Patterns over time reasonable?
c. Do the numbers tell the intended strategic/business story?
• 5. Cost of capital
a. asset beta and cost of equity
• b. WACC; point estimate and range
• 6. Terminal value
a. Growing perpetuity method
• i. Theory & formula
ii. Benchmarks and boundaries for g iii. Implied TV
• b. Market multiples (as time permits)
• 7. Completed valuation – putting it all together a. Mechanics of assembling the parts b. Point estimate of enterprise value
c. Sensitivity analyses
• i. TV
ii. WACC
iii. Other, e.g., margins (time permitting)
• d. Interpretation
• 8. Synergies - qualitatively a. What are they?
• b. Could you quantify them? How?
c. What important elements cannot be quantified?