The footwear industry is a mature, very competitive with low growth and stable profit margins. Active Gear, Inc. is a privately held footwear company which is a profitable firm in the industry with $470.3 million revenue in 2006. West Coast Fashions, Inc is a large business of men’s and women’s apparel decided to dispose of one of their divisions: Mercury Athletic with $431.1 million revenue in 2006. AGI is very profitable but it is smaller than other competitors, which is becoming a competitive disadvantage, so that AGI saw it has a possible opportunity for growth via acquire Mercury Athletic which represents a similar market share in the mature, highly competitive industry.
There are several reasons why Mercury Athletic is an appropriate target for AGI since an acquisition. Firstly, AGI and Mercury are dealing in the similar footwear industries. And the main products of Mercury are athletic and casual footwear which are a strategic fit for the AGI. Both of the companies’ manufactures placed in China, it will help AGI overcome the competitive disadvantages. They can share the resources and infrastructure with each other through the geographical advantage. Secondly, Acquiring Mercury would build synergies by two companies merging those could improve both companies’ finances, like roughly double AGI’s revenue, increase its leverage with contract manufacturers, and expanding its presence with key retailers and distributors.
They are more successful when they work together than when they work separately. Finally, the acquisition would present some possible marketing advantages. Mercury Athletic has 4 major product lines: men’s and women’s athletic and casual footwear. Men’s athletic footwear is the leading product for Mercury Athletic. Women’s casual footwear is Mercury’s worst performing product that is may help AGI to achieve a lower acquisition price. Since despite the unsuccessfulness of Mercury’s women’s line, it may be able to be turned around by folding it into AGI’s women’s line, the rest of the three segments of Mercury show prosperous future prediction in margins and growth. Also, AGI would expand its current demographical target between family members and Mercury’s youth market. Meanwhile, acquire Mercury would cover the price level from low to high that can meet more customers’ needs and wants better than other competitors do.
Estimated Enterprise value of Mercury Athletic footwear
In this part, we analyse the information given and use some assumptions to estimate the value of Mercury Athletic Footwear by using Discounted Cash Flow (DCF) approach. In order to get the value of the enterprise, we should calculate the forecasted Free Cash Flows (FCFs), cost of capital, present value of FCFS and present value of terminal value of the targeted company. Mercury Athletic Footwear designed and distributed branded athletic and casual footwear, principally to the youth market. Its revenue on 2006 is $431.1 million and total asset is $270.6 million on 2006, Operating income (EBIT) is $42.3 million and net income is $25.9 million.
Forecast the Future FCFs
Base on the data given in the projection prepared by Liedtke, we can calculate the future FCFs of Mercury for 2007 to 2011 (Exhibit 4). The Free Cash Flow Method is used, which, : FCF = Net income + Depreciation – △ NWC – Estimated Capital Expenditure The net income or Earning Before Interest after Tax (EBIAT) cash flow of Mercury’s operations are determined using the estimated EBIT less the assumed corporate tax rate of 40%. We calculate the working capital assumptions through historical and projection data of Mercury. Thus we can get the changes in net working capital (Exhibit 4).
Estimate the Cost of Capital
In this case, we regard the Weighted Average Cost of Capital (WACC) as the discount rate to calculate the Net Present Value (NPV) of the targeted company. The cost of debt has been assumed by Liedtke, as 6%. We use CAPM method to calculate the cost of equity. In 2006, it was economy booming in US, 10-year long run risk-free interest rate is 4.73%. In 2013 the US fall into low interest rates for a long time, the 10-year rate has been changed to 2.60%. So we choose 10-year treasury obligation as a risk-free rate for this estimation which is 4.73%, although the project cash flows are not explicitly forecasted beyond 5 years period.
We also calculate Beta is 1.558, this number is based on the average beta of a combination of several similar enterprisers (Exhibit 3) since the average D/E of these company is similar to the D/E of Mercury (20%/80%=25%). Base on Market Risk Premium Used in 56 Countries in 2011: A Survey with 6,014 Answers1, we assume risk premium is 5.5%. Therefore, the cost of equity is 13.3% (Exhibit 4), and we calculate WACC is 11.36% (used for this discount rate).
Calculate the Terminal Value, Discounted Cash flows, and Enterprise Value Typically we assume the business will continue on in perpetuity unless information relevant to future revenue projections and returns are available. Therefore, we use the Gordon Growth Model2 to calculate the terminal value and we use the average growth rate of FCFs, 2.42% as perpetual growth rate of cash flows after estimated periods. As a result, we get the terminal value of $338.7 million (Exhibit 4). Then we discount this terminal value to get the present value of $179.80 million. Using discounted rate of 11.36% to find out the present value of cash flow for the periods, which is $90.4 million (Exhibit 4). We estimate the enterprise value of Mercury by adding present value of terminal value ($179.80 million) and present value of the cash flows for the period ($90.4 million). Finally, we get the estimated enterprise value of $288.2 million (Exhibit 4).
After assuming and calculating we conduct a sensitivity analysis of our results to evaluate the uncertainty of our estimates and their potential changes. We assume that the terminal perpetuity growth rate and the discount rate (WACC) increase and decrease 1% so that we can see the change of terminal value, NPV and total enterprise value. We calculate the terminal value in order to see when terminal perpetuity growth rate and the discount rate (WACC) fluctuate, how the value of NPV will be affected. We can see from the Exhibit 4 (The sensitivity of NPV) that even on the condition of growth rate (1.42%) and WACC (12.36%), the acquisition would remain a positive NPV project for Active Gear. We assume that the WACC will not be greater than 12.36%, which based on AGI historical behavior and industry average.
What’s more, the value of the growth rate of 1.42% is unrealistically low, because it is under historical rate of inflation in US from 2006-20113. Then from the Exhibit 4 (the sensitivity of total enterprise value), we can expect the value of Mercury to be at least $241.18 million at a very low growth rate and a high WACC and maybe $362.06 million at a relatively high growth rate and a low WACC. At the opposite end, if the WACC we calculated was higher than it actually will be, then our value will increase based on the growth rate. If this is higher than anticipated, it will provide an even greater value.
The value we got can be considered a conservative estimate. First, our terminal value is based on the average growth rate of FCFs. This can be regarded as a conservative growth rate. Second, we used a higher risk free rate obtained from 10-yr treasury rates so that the equity market risk premium is a conservative estimate. Finally, we use EBITDA multiples of other companies in the same industry to check the reasonableness of our values. The comparables and their corresponding EBITDA multiples are present in the (Exhibit 4)(Corresponding EBITDA multiple). On average, the results are valued at 9 times their EBITDA. Considering Mercury’s EBITDA, the corresponding value would be $400.2 million (Exhibit 4).
This is much higher than our enterprise value we calculated of $288.2 million so; we can see that our cash flow model is conservative. There are some possible advantages we don’t consider into. For example, because AGI wants to increase its leverage with Chinese contract manufacturers in order to raise their product’s profit margins, through purchasing Mercury Athletic Footwear they will expand not only their negotiating position but also its presence with key retailers and distributors. What is more, it is much more possible that Active Gear’s bankers may give a bid for Mercury so that Active Gear would have more cash flow. At last Active Gear will be able to have all the resources that Mercury Athletic Footwear have such as their loyal purchasers, their management system and market strategy. These resources could not only lead to higher revenues, but lower costs. Overall, it can be found that the valuation was calculated on a conservative way.
From financial projections above, Liedtke has sufficient evidence to acquire Mercury Athletic. With the project has the enterprise value of $288.2 million and a positive NPV which is $152.82 million even with a relatively high WACC:11.36%. With the successful acquisition of Mercury Athletic, Active Gear could increase revenue and leverage with contract manufacturers, boost capacity utilization, and expand its presence with retailers and distributors. These positive effects result AGI has a higher competitive advantage in the footwear industry.