Formerly a footwear manufacturing company, Interco developed into a diversified company that comprised subsidiary corporations in four major business areas: apparel manufacturing, general retail merchandising, footwear manufacturing and retailing, and furniture and home furnishings. Due to the fact that Interco’s subsidiaries operated as autonomous units and lacked integration between its operating divisions, the company is particularly vulnerable to a highly leveraged takeover, as far as the management concerned. The strategic repositioning program starting in 1984 resulted in a reversal of the sales mix of Interco, with sum of footwear and furniture groups’ sales surpassing that of apparel and general retailing divisions in 1988. The financial performance of Interco in FY 1988 was solid as a whole. Both the outstanding performance of furniture & home furnishings and footwear groups as well as a reduction of the company’s effective tax rate made great contributions to it.
Besides, Interco’s relatively high current ratio and low debt level show that the company is flexible, which also indicates healthy financial performance. However, ongoing problems remained in the apparel manufacturing and general retailing divisions as a result of the change in their business nature. As a matter of fact, it was believed that the apparel group’s performance would lead to continuous weakening of Interco’s overall operations and an undervaluation of the company’s common stock by the market. Given Interco’s organizing structure and financial performance at that time, it was unsurprising that the company was offered a merger proposition in July, 1988 by City Capital, a company that acquired undervalued targets with strong market niches. When evaluating the takeover bid offered by City Capital Associates, the board of Interco was advised by Wasserstein Perella and Co. (WPC).
This comparable analysis shows that share price of Interco should be much higher than $70 although the minimum price suggested by sales comparable is low. Therefore, in general the bid price offered by City Capital can be considered too low to be reasonable according to Wasserstein’s analysis. Board members may be persuaded by this result and then reject the bid offer. However, some may argue that the result is doubtful because the comparable transactions selected by Wasserstein may not closely resemble the situation of Interco. In addition to the comparable transaction analysis, premium paid analysis was also offered by Wasserstein Perella. This analysis also showed that City Capital’s offer was not acceptable because the premium offered was much lower than the one day, four week high, and 52-week low averages. Similar to comparable analysis, it was still questionable that the selected deals may not match Interco’s deal in terms of approach (hostile/friendly), size, industry, and transaction type and status. Hence, board should be prudent when make decisions according to this analysis.
Another valuation method used by WPC is discounted cash flow (DCF) method. Given assumptions in Case’s exhibit 12, we conducted a DCF analysis to verify the suggested share price reported by Interco’s consulting company WPC. First of all, a few process methodologies used in the DCF model should be addressed. 1. The calculation of cost of capital. With limited information, a 6% market risk premium was assumed by convention. Choosing 30-year treasury yield as the risk free rate, Interco’s cost of equity (15.1%) can be calculated under CAPM with a given equity beta of 1. Considering Interco’s cost of debt, the 10-year level A corporate bond yield (9.8%) among all listed yields would be more appropriate, with regard to the whole risk profile and industry status of the company. Thus the cost of capital can be easily calculated using the weighted average cost of capital formula (13.69%).
2. The process of profit margin. Given the profit margin range of 9.2% to 10.1% between the following ten years from 1989 to 1998, it is acceptable to assume that the margin rate was uniformly continuous with a 0.1% increase from year to year. 3. Both sales growth rate and working investment percentage used in the analysis are the averaged values of Interco’s four business segments. Taking all other assumptions in Case’s exhibit 12, the DCF model shows that the reasonable share price range with a discount rate of 13.69% and the terminal value multiples changing from 14x to 16x should be $62~67(see table below). Relaxing the cost of capital value from 12% to 14%, the range of acceptable stock price then becomes $$61~77, which is close to Wasserstein, Perella& Co.’s suggestion.
The calculation mentioned above shows some assumptions of WPC when they valuate the stock range of Interco. However, some assumptions should be questioned:
(1) Segments VS Integrity
The WPC uses total sales in 1988, average growth rate and average increase in working investment of four departments to estimate the future free cash flow. Due to the different situations of different segments, it is more appropriate to calculate the free cash flow separately based on its own growth rate and increase in working investments. So, we predict the 10-year free cash flows of four segments separately and calculate the sum of these four cash flows (see exhibit 4). After the adjustment, the range of stock price is from 63 to 79 while the discount rates from 12% to 14% (see exhibit 5).
(2) Projected growth rates
The WPC predicts that the growth rates of apparel group and retail group are 7.1% and 7.6% in future 10 years. Based on current market conditions, we believe that the growth rates of these two departments are overestimated. Therefore, we make sensitive analysis of growth rates and stock prices in our following valuation (see exhibit 6). Based on our DCF analysis and sensitive analysis, we would advise the board to take the $70 offer provided by the Rales Brothers, because this bid is reasonable and appropriate to increase shareholder value. In a sum, from the perspective of Interco board on August 8, 1988, it is understandable that the board voted to reject the offer based on results suggested by WPC’s three valuation methods.
However, our DCF analysis and sensitivity analysis shows that the board should be more prudent at that time and accepting the offer of $70 per share might be the right choice. Additionally, agency problem may also be a factor that contributes to the decision of rejecting the bid offer. Interco board really did not seem like they were willing to consider any buyout offer and were convinced that they could improve shareholder value by restructuring the company. They were acting to protect their board positions with Interco.
On the other hand, WPC, as Interco’s financial advisor, seemed to have an incentive to convince the board not to accept City Capital’s offer because if the offer was accepted, WPC would lose millions of future restructuring fees, which may lead to the bias of WPC’s valuation. In contrast, Rales Brothers’s offer seemed to be more reasonable. They saw an opportunity to buy an undervalued firm and the bid price could be considered beneficial to both City Capital and Interco.