Mercury Athletic Footwear

Discussion Materials
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Please See Your Professor
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E-mail me at jheilprin@hbs.edu
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Overview of Active Gear:
Active Gear is a relatively small athletic and casual
footwear company
$470.3 million of revenue and $60.4 million of EBIT
compared to typical competitors that sold well over a $1.0
billion annually

Company executives felt its small size was becoming

more of a disadvantage due to consolidation among
Chinese contract manufacturers
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Overview of Active Gear:
Products:
Specialty athletic footwear that evolved from high performance
to athletic fashion wear with a classic appeal
Casual/recreational footwear for walking, hiking, boating, etc.

Customers:
Affluent urban & suburbanites in the 25-45 age range (i.e.
Yuppies)
Brands are associated with upwardly mobile lifestyle

Distribution:
Department & specialty stores no big box retailers
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Overview of Active Gear:
Company strengths:
By focusing on a portfolio of classic brands, Active Gear has
been able to lengthen its product lifecycle
In turn, this has led to less operating volatility and better
supply chain management as well as lower DSI

Company weaknesses:
By avoiding the chase for the latest fashion trend and
avoiding big box retailers, the company has had very low
growth
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Overview of Mercury Athletic:
Mercury was a subsidiary of a large apparel company
As a result of a strategic realignment, the division was
considered to be non-core

2006 revenue and EBITDA were $431.1 million and

$51.8 million respectively
Under the egis of WCF, Mercurys performance was
mixed
WCF was able to expand sales of footwear, but was never able
to establish the hoped for apparel line
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Overview of Mercury Athletic:
Products:
Mens and womens athletic and casual footwear
Most products were priced in the mid-range
More contemporary fashion orientation

Customers:
Typical customers were in the 15-25 age range
Primarily associated with X-games enthusiasts and youth culture

Distribution:
Products were sold primarily through a wide range of retail,
department, and specialty stores including discount retailers
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Overview of Mercury Athletic:
Company strengths:
Established brand and identity within a well defined niche market that
seems to be growing
Strong top-line growth resulting from inroads with major retailers
Products were less complex; and therefore, cheaper to produce

Company weaknesses:
Increased sales came as a result of pricing concessions to large retailers
Proliferation of brands led to decreased operating efficiency and a
longer DSI
Womens casual footwear was a disaster
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Strategic Considerations:
Central Question: What Are the Likely Rationales for
a Combination of Active Gear and Mercury?
How do the acquirer and target fit together?
What are the potential sources of value?
How would any potential sources of value be realized?

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Strategic Considerations:
Potential sources of value creation:
Operating synergies coming from economies of scale with
respect to contract manufacturers
Perhaps some economies of scope with respect to
distribution extending the distribution network
Possible combination of the womens casual lines

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Strategic Considerations:
Counter arguments to value creation:
Poor strategic fit Mercurys focus is on a totally different
market demographic
Likewise, Mercurys niche maybe significantly more prone
to fashion fads
Continued growth of extreme sports category may make
Mercurys business vulnerable to the large athletic shoe
companies
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Explicit forecast period is based on the analysts judgment

TV is the going concern value at the end of

the explicit forecast period

Mercury Athletic Footwear

Firm Value & Cash Flows:

As a starting point, lets start with a basic valuation
paradigm
Annual Forecasts

Terminal Value

Note that the sole determinant of value is the generation of cash

flow
Further the only relevant factors are the amounts, timing and
risks of the cash flows

FCF is assumed to be the mean of an a random distribution

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

NOPAT

Net reinvestment

Mercury Athletic Footwear

Firm Value & Cash Flows:
Determination of FCF
To begin, the preceding equation led to a value of the entire
enterprise, meaning V = D + E
Thus, we are interested in what the total business is worth
irrespective of who gets the cash or how its financed
In turn, this means we are interested in the un-levered FCF
Un-Levered FCF = EBIT(1-t) + Depr - WC Cap-x

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Firm Value & Cash Flows:
Determination of FCF
In case Exhibit 6, Liedtke provides a set of projections for
each of the operating segments Thus,
Segment Revenue
Multiplying EBIT by (1-t) yields Consolidated
Less: Segment Operating Expenses
Corporate Overhead
the first term in the FCF equation Less:
Operating Income = EBIT
Question: Are taxes being overstated?
It is true that interest expense creates a tax shield
However, the value of the tax shield is acknowledged in the
WACC or in a separate calculation when using APV
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Firm Value & Cash Flows:
Determination of FCF
Having calculated NOPAT, we should have the following results, and are now in a position to proceed to
the next step in FCF determination

Note that the administrative charge has not been included in operating expenses
This is because the new owner would not incur the cost, and youll note that its not included in Liedtkes projection

To move from NOPAT to FCF we will simply subtract all of the net reinvestment in the firms operations

This is the same as subtracting the NOA; or in our case, (Cap-x + Depr WC)

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Note that cash for larger firms with

access to capital markets may not
be part of working capital

Net Fixed Assets

Mercury Athletic Footwear

Firm Value & Cash Flows:
Determining FCF - WC
By reorganizing the balance sheet as shown, the
net operating assets and liabilities can be
quickly segregated

Based on Exhibit 7, the working capital assets are

cash, accounts receivable, inventory, prepaid
expenses
The WC liabilities are accounts payable and accrued
expenses

Of course, the same excise can be used to

determine the net investment in fixed assets
(cap-x Depreciation)
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Firm Valuation & Cash Flows:
Determining FCF final thoughts
Based on the preceding exercise involving the reorganized
balance sheet, we can see that the DCF methodology is aimed at
valuing the operations of the firm (left side of B/S)
Further, we can see
FCF = EBIT(1-t) - WC - Net Fixed Assets
By forcing every line item to be placed in one of the B/S
buckets, we ensure that ALL of the changes in operating assets
& liabilities are reflected in FCF

Not just those included in working capital, cap-x or depreciation

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Liedtkes Projections:
Using the information contained in Exhibit 6, the following
set of FCF projections can be developed:

Are Liedtkes projections reasonable?

Consider the revenue growth rates & operating margins

What about the changes in working capital?

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Liedtkes Projections:
To begin with, the EBIT
margins are highly simplified
though not unreasonable
There is a tapering off of
growth in athletic shoes
Mens casual is assumed to
grow at what might be the
The relatively high growth rates in athletic shoes
long-term rate of the industry for the early years are presumably a result of
continued expansion into large discount retailers
Womens casual is to be
discontinued
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Liedtkes Projections:
Changes in net working capital
Notice that the increase in 2008 is smaller than that of 2007, and that the
rate of increases again in 2009 and falls in 2010-2011
Liedtke has based his WC projections on historical cash cycle ratios

The volatility is the result of discontinuing the womens casual line along with a
lagging effect from changes in revenue growth
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Cost of Capital:
Exhibit 3, provides some comparable company
information that includes observed equity betas along
with the market values for debt and equity
Using that information each comparable firms asset beta
can be obtained using one of the following
asset = (E/V)equity or asset = (E/(E + net Debt(1-t)))equity
Assumes a constant D/V ratio
and a debt of zero
Harvard Business School

Assumes a changing capital structure with a debt

of zero
Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Cost of Capital:
Based on the preceding, the following average unlevered beta can be obtained
If a changing capital
structure had been
assumed, the un-levered
beta would have been 1.37

A constant capital structure was used based on Liedtkes

choice of a WACC based on a 20% D/V ratio
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

If the d > 0

Mercury Athletic Footwear

Cost of Capital:
With an average asset beta in hand, a new equity beta
can be obtained based on Liedtkes assumed 20% D/V
equity = assets(V/E) => 1.28(1/.8) = 1.6

Using CAPM, the required return on equity is

re = rf + e(EMRP) => 4.93% + (1.6)(5%) = 12.92%

The complete WACC is

Harvard Business School

Joel L. Heilprin

Assumes the Equity Market

Risk Premium is 5% and the
tax rate is 40%
59th Street Partners LLC

Mercury Athletic Footwear

Terminal Value:
If Mercury has indeed reached a steady state by 2011,
then we can envision the firm as providing a stream of
cash flows that grows at a constant rate forever
This would imply that the going concern could be valued as
a growth perpetuity
PV2011 = (FCF2011)(1+g)/(r g)
Given that we have already developed estimates for FCF
and WACC, an estimate of the long-term growth rate needs
to be calculated
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Terminal Value:
Estimating the long term growth rate
As a starting point, no business can grow faster than the macro
economy on a continuous basis

Thus, an upper-bound equal to the long-run macro economic growth rate

must exist

In terms of lower bounds, the long-term growth rate must be positive

or else the firm would not be a going concern (i.e. it would have a
finite life)
A growth rate equal to the long-run rate of inflation would suggest a
zero real growth rate

In the case of Mercury, this would seem to be the lower bound

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Terminal Value:
Estimating the long-term growth rate
Conceptually, the growth rate should be tied to estimates of
long-term profitability and reinvestment Specifically:
(Return on Capital)(Net Reinvestment Rate) = EBIT growth

Obviously, Liedtkes forecasted cash flows violate the above

assumptions in the near-term; but, that does not mean the
above equation doesnt hold after 2011
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Terminal Value:
Based on the 2011 projections, Mercurys long-term
growth rate would be as follows:

Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Completed Valuation:
Below is a completed valuation of Mercury based on a
WACC of 11.06% and a long run growth rate of 2.78%

Firm value is equal to the value of the operations plus the

value of net non-operating assets (i.e. 2006 excess cash)
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC

Mercury Athletic Footwear

Completed Valuation:
The table below shows the sensitivity to growth rates
and discount rates

Note the extreme variance of results even if the range is tightened to a

growth rate of 2.78% - 4% and a discount rate from 10% - 12%
Harvard Business School

Joel L. Heilprin

59th Street Partners LLC