1. Is Mercury an appropriate target for AGI? Why or why not?
Yes, we do think so.
In the case, we could find some characteristics of footwear industry: (1) It is a mature, highly competitive industry marked by low growth, but stable profit margin. (2) Performance of individual firms could be quite volatile for they need to anticipate and exploit fashion trend. (3) Except some global footwear brands, athletic and casual shoes market is still fragmented, which means each company could has its own market because of its characteristic. (4) In this market, it is important for the brand image, specialized engineering for performance and price. (5)
Life cycle is short.
(6) Inventory management and production lead times are critical for the success. (7) Main sale channels are department stores, independent specialty retailers, sporting goods stores, boutiques and wholesalers. (8) Most of the firms outsource the manufactures in China.
Below are some characteristics for Mercury and AGI we need to focus on during the analysis:
Target customers are urban and suburban family members aged 25 to 45. Youth market, mainly 15 to 25.
Among the first companies to offer fashionable walking, hiking and boating footwear. Its mother company decided to extend the brand by creating complementary line of apparel. Because of the poor performance, it was decided to sold.
Logo is marked with prosperous, active and fashion-conscious lifestyle. Its main customers are not interest in its apparel.
Among the most profitable firms.
Had poor performance after acquisition by WCF.
42% of revenue from athletic shoes and balance from casual footwear. Revenue and operating income were 470.3 million and 60.4 million in 2006. Revenue and EBITDA were 431.1 million and 51.8 million..
Athletic shoes developed from high-performance footwear to athletic fashion wear. Four main segments: men’s and women’s athletic and casual footwear.
Casual shoes focus on mainstream market.
In order to emphasizing individual products, it began to monitor styles and images from global culture
Focus on smaller portfolio of classic products with longer lifecycles and could maintain simple production and supply chains.
Mainly sold in department stores, specialty retailers, wholesalers and independent distributors. Small percentage is sold through website. Department stores, specialty stores, catalogs, discount retailers and internet.
Good at inventory management in the industry.
Inventory management performance is worse than the average level.
Outsource manufacture in China.
Outsource main materials in foreign suppliers.
It takes small size as its competitive disadvantages. And it faced with some problems in the consolidation of manufacturers. Price cuts and promotion in apparel line hurts operating margins but helped to the growth in sales.
Sales growth is lower than the average because of there is little discount in price.
We could learn that managers of AGI want to enlarge the scale of its company and gain larger market share because of the stable profit margin. And since the revenue is almost the same, it is a good choice to merge with Mercury, which means that revenue would be doubled after acquisition.
And these two companies have some similar factors, such as : (1) They could use the same sale channels after acquisition, and internet channel could be enlarged. (2) They could combine manufacturers to get a powerful bargain in suppliers. (3) The product segments are almost the same, which means that there should be little work to do after acquisition in product adjustment. (4) Thanks to the profitable ability of AGI, it is much easier to make a better financial performance of Mercury. (5)
It is good for them to increase the performance of inventory management if they merge together. (6) Although their target customers are different, especially in ages, which means that style and brand are different in the very beginning, this factor could turn into an advantage for the new company could have a fully segment of customers with a wider age ranges.
Therefore, take into above factors into account; we think that Mercury should be an appropriate target for AGI.
2. Review the projections formulated by Liedtke. Are they appropriate? How would you recommend modifying them?
In the case, we could find that Liedtke used historical averages to assume the overhead-to-revenue ratio. However, historical data is usually useless for future. Some studies found there is little evidence that firms grew fast continued to grow fast in the next period. And sometimes there are even negative correlations between growth rates in the two periods.
Besides, smaller firms tend to be more volatile than others, which we could find the same characteristics in these two firms we are talking about. And just as we mentioned in the question 1, revenue may be doubled after acquisition, it just fits the theory that it is difficult to maintain historical growth rates as firms double or triple in size. Therefore, based on the above analysis, we think that it is not reasonable to use historical data for future projections. And sometimes, analyst should be better than the historical growth.
Considering that there are five main channels for analyst forecasts: firm-specific information, macroeconomic information, information revealed by competitors on future prospects, private information about the firm and public information other than earnings, we think Liedtke could find more information from above channles to get more accurate assumption.
And since performance of Mercury is poorer than the average of the industry, it is better to use industry average level for the benchmarking of Mercury when predicting, instead of a discount rate of AGI for example.
And from the comparison of 2007 to 2006, we can find Liedtke’s forecast need great input from AGI to support the development of Mercury, whether he has taken this into consideration? And he estimate debt/equity ratio remains the same as AGI, that is also unreasonable, for it is not possible to change that in short period.
3. Estimate the value of Mercury using a discounted cash flow approach and Liedtke’s base case projections.
（1）first of all, to calculate the cash flows from 2007 to 2011, Net Income
– (Capital Expenditures – Depreciation)
– Changes in non-cash Working Capital
= Free Cash flow to Firm
We can get the result.
Free Cash flow
(2) then we need to calculate the terminal value.
a. Cost of Capital
For cost of capital, we know the debt ratio is 20%, and cost of debt is 6%, we need to find the cost of equity. We assume the cost of equity equal return on equity, we can calculate the historical return on equity from 2007- 2011 is as below, Return on equity
We take 14% as reference.
Based on the formula:
Cost of Capital =debt ratio *cost of debt +equity ratio * cost of equity, We can get the cost of Capital in 2012, 12.7%
b. growth rate in future
We can find during the period from 2007- 2011, the growth rate of net income is not stable, so we assume from 2012, Mercury enter into stable and slow development stage. And it is necessary to calculate the cash flow in 2012. From 2007- 2011, the growth rate ranged from 4.74%- 16.3%, we assume the growth in future will be not that high. We can find during the period from 2008- 2011, the reinvestment rate 15.57%- 37.1%, we just take a middle one 24.37%, by multi reinvestment rate and cost of capital (assume cost of capital =return on capital), to reach growth rate afterwards= 3.09%.
c. based on the growth rate is 3.09%, we can get EBIT in 2012 is 39,930.. We have assumed ROC=WACC
Terminal Value=EBIT n+1*(1-t)/cost of Capital, we can get Terminal Value in 2011 is 315,237.
(3)Present value of cash flows:
We have get the cash flows of 2007-2011 and terminal value in 2011, and the cost of capital is 12.7%, we can get the respective present value of them and reach the total present value 226,514, which is the estimate Firm value of Mercury.
(4) Alternative method to calculate cost of capital, then value of Mercury:
We have learnt from Exhibit 3 of peer companies information in this business, we can calculate cost of capital in alternative ways. Unlevered beta for business= Beta comparable firms/[1+(1-t)(D/E ratio comparable firms)] From information provided in Exhibit, we can get average Beta and D/E ratio, is 1.56, 24.9% respectively. Therefore Unlevered beta for business= 1.35 We know the D/E ratio and tax rate of Mercury, then get levered beta for Mercury =1.52
b. risk free rate and risk premium
we assume risk free rate is 5%, and risk premium as the historically one 4.3%. The cost of equity will be 11.5%. Then the cost of capital will be 10.6%.
c. expect g and terminal value in 2011
expect g and terminal value in 2011 will be 2.6% and 374,576 respectively.
d. total present value of Mercury
Total value of Mercury will be 247,479, which is the estimate Firm value of Mercury under the alternative method.
In my opinion, the value calculated via alternative method will be more reliable.
4. Do you regard the value you obtained as conservative or aggressive? Why?
I think my valuation is conservative, the reason is as follows: (1) Under the basic method, the expected g is much lower than the average g from 2007-2011, even lower the lowest one within this period and the reinvested rate is lower than the average one from 2007-2011 and also not a high one in general business, and we can also found the EBIT Margin is lower than the average one in that business. (2)
(3) Under alternative method, the expected g is much lower as 2.6%, the risk free rate is also a medium one, and the risk premium is a historical one, which is much higher than recent risk premium in USA.
5. How would you analyze possible synergies or other sources of value not reflected in Liedtke’s base case assumptions?
We have conduct some simulation in the spreadsheet, we can find the present value of Mercury is very sensitive to cost of capital, under basic model if the cost of capital reduce to 10%, the value will rise up to 304,882. As for debt ratio and expect g, it is not so sensitive, but has some influence. To my surprise, the reinvestment rate is not sensitive to the outcome, I have not figure out the reason. Under the alternative model, beta, risk free rate and risk premium are all sensitive to the outcome, but not significant as capital in basic model.
As for synergy, the management of inventory has not shown great synergic effect to the outcome, for from 2007 to 2011, inventory level has not reduced. I think if AGI can reduce the cost of capital, which will show the great synergic effect to the acquisition.