Interco Case

Executive Summary

As a major manufacturer and retailer of variety of consumer product and services, Interco
consisted with four major operating divisions: Apparel manufacturer, General Retail
Merchandising, Footwear Manufacturing and Retailing and Furniture and Home Furnishings.
In 1980s, Interco increased its long-term sales and return on shareholders’ equity through
improving the profitability of existing operations (furniture and footwear groups), and
divesting underperforming assets (apparel and general retailing groups). The poor
performance of apparel division weakened the overall operation of Interco and the equity
markets undervalued Interco’s common stock.

Given that, City Capital viewed Interco as a potential takeover target. On July 1988, City
Capital accumulated 8.7% of Interco’s common stock and proposed a merger with Interco. In
the proposal, City Capital offered 70 per share on the morning of August 8, 1988. After
consulted with its financial advisor and assessed the value of Interco, board of directors voted
to reject the 70 per share bid the same day. The data provided by Wasserstein, Perella & Co.
seems to support Interco’s decision to reject the offer from City Capital; however upon
further examination all of the data provided is unconvincing. Based on our analysis and our
calculation of a weighted average cost of capital for use as a discount rate, the discounted
cash flow share price calculations come out to a range of $57-$65. We suggested Interco
board to consider the offer.

1. Assess Interco’s financial performance. Why is the company a target of a hostile

takeover attempt?

Top indicators of financial health

Indicator Data from 1988 Indicator Data from 1988

Current Ratio 3.6:1 ROA (ROI) -Apparel 4.8%

Quick Ratio 1.39:1 ROA (ROI) -General 15.5%

Debt-to capitalization ratio 19.3% ROA (ROI) -Footwear 15.5%

ROE 11.7% ROA (ROI) -Furniture 21.7%

Considering quite high current ratio of 3.6 to 1 and debt to capitalization ratio of 19%,
Interco is very liquid and over capitalized company with ample financial flexibility. In
addition, we calculated quick ratio which only includes cash, marketable securities, and
receivables. Using this more conservative measure, we get the quick ratio of 1.39:1. This also
shows higher financial flexibility, but indicates high current assets are dependent on
inventory. (In balance sheet, inventory portion is about 60% of total current asset)

Not only the financial strength based on balance sheet, recent financial performance based on
income statement is also positive. Due to its strategic repositioning program focusing on
footwear and furniture group, sales and net income in 1988 was increased by 13.4% and

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 15.4% respectively. Especially, net sales and operating income for footwear group was
increased 34% and 72%. Growth in earnings made Interco further toward its goal of a 14-
15% ROE. 1998’s ROE was 11.7%. Moreover, based on Exhibit 5, we calculated ROA (ROI)
for each business segment using operating earnings data. Furniture group has the highest
ROA which means that they generate higher earnings from invested assets. Although ROA
for general retail division is 15%, it was due to low income and less invested asset. The
apparel and general retail divisions remained ongoing problems due largely to a change in the
nature of these businesses.

Although overall financial performance of Intero is improving, ongoing concern regarding

struggling business may cause Interco’s shares undervalued because apparel and general
retail division still accounts for 40% of Interco. It makes the company a target of a hostile
takeover by the company who see a profit opportunity in Interco. City Capital had already
accumulated 8.7% of Interco’s shares for takeover. After acquiring undervalued firm, they
plan to sell apparel businesses and to consider selling parts of the footwear and general
retailing businesses.

2. As a member of Interco’s board are you persuaded by the premiums paid analysis of
Exhibit 10 and the comparable transactions analysis of Exhibit 11? Why or why not?

As a member of Interco’s board, we are not persuaded by the offer from City Capital because
their premium percentage are below 1988 data. Especially, premium paid over 4 weeks stock
price and 52 week low price were 80.9% and 171% each, but Rales used 59.1% and 137.3%.

In addition, we cannot hardly persuaded by Exhibit 11 of purchase price multiples by

business segment data. To calculate average multiples per each segment, we excluded the
highest and lowest multiple to remove outliers and averaged remaining values. We realized
that apparel and central hardware division multiples were quite matched with the market, but
multiples of furniture and footwear division, the most promising divisions in the
organization, were highly undervalued compared to competitors. Lastly, value ranges by
business segment from Exhibit 11 shows the range of $1974.4 - $6420.9. The offer value of
firm by City Capital is $2941.3 and it is much lower than the second lowest value of $3138.4.
Therefore, we cannot accept the offer.

Avg Multiple NI Book Value Sales Op.Income Op.cashflow

Furniture 20.6 2.4 1.3 11.9 9.8

Rales 18.1 2.2 0.9 11.4 9.2

Footwear 34.7 1.8 1.4 21.1 17.9

Rales 18.1 2.2 0.9 11.4 9.2

Apparel 20.3 1.6 0.7 10.6 9.2

Rales 18.1 2.2 0.9 11.4 9.2

Central Hardware 22.0 2.3 0.6 13.1 9.2

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 Rales 18.1 2.2 0.9 11.4 9.2
3. Wasserstein, Perella & Co. established a valuation range of $68-$80 per common share
for Interco. Show that this valuation range can follow from the assumptions described
in the discounted cash flow analysis section of Exhibit 12. As a member of Interco’s
board, which assumptions would you have questioned? Why?

To verify the valuation range, we analyzed the discounted cash flow of Interco in the following
steps:

a. Assume the operating margin. In Exhibit 12, the total operating margin ranges from 9.2%
to 10.1% in 1989 to 1998. We assumed it increased by 0.1% consecutively for 10 years;

b. Calculated the free cash flow (See Exhibit 1 for the detailed FCFF Analysis);
CF10= 338.849 million

c. Discounted the free cash flows. Cash flows from 1989 to 1998 were discounted based on the
discount rate of 10%, 11%, 12% and 13% respectively (See Exhibit 2-Discounted Cash Flow
Analysis for Interco Valuation);
VT-
14.0X 15.0X 16.0X
Terminal valve ($ 000s) 4,743,889 5,082,738 5,421,587
VT-
Discounted rate
10.0% $1,496,368 $1,496,368 $1,496,368
11.0% 1,427,905 1,427,905 1,427,905
12.0% 1,364,045 1,364,045 1,364,045
13.0% 1,304,410 1,304,410 1,304,410

d. Calculated firm value. And we also verified the implied stock price by using the firm value
divided by shares issued (41,356,847 shares issued according to Exhibit 6);

Firm Value = VT- + VT+ = VT- + TV/(1+r)10

Multiple of Cash Flow in Year 10

14.0X 15.0X 16.0X
Terminal valve ($ 000s) 4,743,889 5,082,738 5,421,587
Implied stock price
Discounted rate
10.0% $80.41 $83.56 $86.72
11.0% 74.92 77.81 80.70
12.0% 69.91 72.55 75.19
13.0% 65.33 67.75 70.16

e. According to Exhibit 9, we assumed the net debt was 318.5 million. We calculated the share
value.

Share Price = (Firm Value-Net Debt)/Shares Outstanding

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 Share Price of Interco
14.0X 15.0X 16.0X
Discounted rate
10.0% $80.18 $83.67 $87.15
11.0% 74.14 77.32 80.50
12.0% 68.61 71.52 74.43
13.0% 63.56 66.22 68.88

Other assumptions we made:

a. The corporate expense and other income stayed the same for the next 10 years;
b. No change in working capital from 1989 to 1993.

Given the data and these assumptions, the stock price calculations were confirmed, however the
following questions should have been raised:

1) Why there is no working capital change in the first five year, while starting 1994, there is a
11.6% as of the change in sales?
2) Where did the growth rate come from? Especially the apparel group and retail group showed
strong sales growth, even though these two groups have been struggling recently. Why the
total growth rate is the weighted average of growths of the four groups?
3) Where is the discount rates come from? Is the stock price overvalued by using these
discount rates? What is its actual discount rate (WACC)?
4) Why multiples of 14, 15 and 16 are chosen?

4. How would you advise the Interco board on the $70 per share offer?

First, we calculated the cost of capital of Interco.

WACC = rD*(1-t) (D/V) + rE (E/V)
Where rE = rf + β*(rM-rf)

Assumption:
t = 41%
rD = 9.80% (From Exhibit 14, 10-year A, as Interco had lower debt)
β = 0.9 (From Exhibit 14, approximately similar to S&P 500)
rf = 9.01% (From Exhibit 14, 10-year Treasury bonds)
rM-rf = 6.95% (Historical U.S. 1928-1987 Arithmetic Mean)
D/V = 318.5/2,941.3 = 0.1083
E/V = 2,622.8/2,941.3 = 0.8917

WACC = 9.8%*(1-41%)*0.1083+(9.01%+0.9*7%)*0.8917 = 14.3%

Based on the calculation above, the discount rate is 14.3%. Some of the assumptions made could
not be verified due to the lack of data. With the calculated discount rate, the new evaluation of the
stock price would be in the range of $57-$65 per share given the cash flow multiples of 14, 15
and 16. Thus, the offer made by City Capital of $70 per share is above the current DCF valuation,
and Interco should accept the offer (See Exhibit 4-Revised Discount Cash Flow Valuation of
Interco).

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 The reason that Interco did not accept the offer may be that Interco believed that its restructuring
plan would work to make it be profitable enough to surpass this share price.

Share Price of Interco

14.0X 15.0X 16.0X
Firm Value 2,479,086 2,568,117 2,657,149
Firm Value/Share Issued $59.94 $62.10 $64.25
Equity Value 2,160,586 2,249,617 2,338,649
Equity Value/Share Outstanding $57.62 $59.99 $62.36

5. How would you assess the actions of Interco’s board up to August 8, 1988? Wasserstein,
Perella & Co.’s? The Rales brothers’?

Based on the analysis in question 2, the offer provided by City Capital is not a good option for
Interco.
a. From exhibit 10, we can conclude that the percentage of premium paid by City Capital is
basically lower than that of Interco in 1988.
b. The offer value of firm by City Capital stays in the low interval of Interco’s value range.

Interco also asked its financial advisor Wasserstein, Perella & Co.’s to evaluate the firm value.
Wasserstein provided data and the board of directors concluded that the valuation should be
higher than the Rales suggested as it should be $68-$80 range per common share. It confirmed
that the offer is not in the best interests of Interco. But based on our own calculation in Q4, the
stock price should be in $57-$65 range per common share. There is a possibility that Wasserstein
might give wrong valuation, or just did valuation only based on comparable analysis. This
indicates Interco should take the offer since $70 per share is above the current DCF valuation
instead of trying alternatives.

For the actions of Rales, it might be not a good deal for them as they pay higher value than the
value based on our internal DCF analysis. Considering that they have a strong desire to buy
Interco however, they may have a strong positive outlook for footwear and furniture divisions,
and they look like having a confidence to sell the business again to other party than the price they
paid after doing strategic restructuring.

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 Exhibit 1 Free Cash Flow Analysis of Interco (1989-1998)

Exhibit 2 Discounted Cash Flow Analysis of Interco

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 Exhibit 2 Discounted Cash Flow Analysis of Interco (Continued)

Implied
14X VT- VT+(10)=TV VT+ Firm Value Stock Price Debt Equity Stock Price
PV of FCFF @ 10% $1,496,368 $4,743,889 1,828,975 3,325,343 $80.41 318,500 3,006,843 80.18
PV of FCFF @ 11% $1,427,905 $4,743,889 1,670,724 3,098,630 $74.92 318,500 2,780,130 74.14
PV of FCFF @ 12% $1,364,045 $4,743,889 1,527,405 2,891,450 $69.91 318,500 2,572,950 68.61
PV of FCFF @ 13% $1,304,410 $4,743,889 1,397,494 2,701,905 $65.33 318,500 2,383,405 63.56

15X
PV of FCFF @ 10% $1,496,368 $5,082,738 1,959,616 3,455,984 $83.56 318,500 3,137,484 83.67
PV of FCFF @ 11% $1,427,905 $5,082,738 1,790,062 3,217,967 $77.81 318,500 2,899,467 77.32
PV of FCFF @ 12% $1,364,045 $5,082,738 1,636,506 3,000,551 $72.55 318,500 2,682,051 71.52
PV of FCFF @ 13% $1,304,410 $5,082,738 1,497,315 2,801,726 $67.75 318,500 2,483,226 66.22

16X
PV of FCFF @ 10% $1,496,368 $5,421,587 2,090,257 3,586,625 $86.72 318,500 3,268,125 87.15
PV of FCFF @ 11% $1,427,905 $5,421,587 1,909,399 3,337,304 $80.70 318,500 3,018,804 80.50
PV of FCFF @ 12% $1,364,045 $5,421,587 1,745,606 3,109,651 $75.19 318,500 2,791,151 74.43
PV of FCFF @ 13% $1,304,410 $5,421,587 1,597,136 2,901,547 $70.16 318,500 2,583,047 68.88

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 Exhibit 3 Sample Historical Returns on U.S. Stock, T. Bonds and T. Bills (1928-1987)

Annual Returns on Investments in

Year S&P 500 3-month T.Bill 10-year T. Bond
1928 43.81% 3.08% 0.84%
1929 -8.30% 3.16% 4.20%
1930 -25.12% 4.55% 4.54%
1931 -43.84% 2.31% -2.56%
1932 -8.64% 1.07% 8.79%
1933 49.98% 0.96% 1.86%
1934 -1.19% 0.32% 7.96%
1935 46.74% 0.18% 4.47%
1936 31.94% 0.17% 5.02%
1937 -35.34% 0.30% 1.38%
1938 29.28% 0.08% 4.21%
1939 -1.10% 0.04% 4.41%
1940 -10.67% 0.03% 5.40%
1941 -12.77% 0.08% -2.02%
1942 19.17% 0.34% 2.29%
1943 25.06% 0.38% 2.49%
1944 19.03% 0.38% 2.58%
1945 35.82% 0.38% 3.80%
1946 -8.43% 0.38% 3.13%
1947 5.20% 0.57% 0.92%
1948 5.70% 1.02% 1.95%
1949 18.30% 1.10% 4.66%
1950 30.81% 1.17% 0.43%
1959 12.06% 3.26% -2.65%
…
1980 31.74% 11.22% -2.99%
1981 -4.70% 14.30% 8.20%
1982 20.42% 11.01% 32.81%
1983 22.34% 8.45% 3.20%
1984 6.15% 9.61% 13.73%
1985 31.24% 7.49% 25.71%
1986 18.49% 6.04% 24.28%
1987 5.81% 5.72% -4.96%
Arithmetic Average
1928-1987 11.28% 4.33%
Risk Premium 6.95%

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 Exhibit 4 Revised Discount Cash Flow Valuation of Interco

Firm Implied Stock Stock

VT- VT+(10)=TV VT+ Value Price Debt Equity Price
14X 1,232,643 4,743,889 1,246,442 2,479,086 $59.94 318,500 2,160,586 $57.62
15X 1,232,643 5,082,738 1,335,474 2,568,117 $62.10 318,500 2,249,617 $59.99
16X 1,232,643 5,421,587 1,424,506 2,657,149 $64.25 318,500 2,338,649 $62.36

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