Executive Summary The footwear industry is highly competitive industry with fairly stable profit margins. Active Gear is a profitable firm in the industry; however Active Gear is a smaller firm than many other competitors and its small size is becoming a competitive disadvantage. The rise of large retailers has also endangered Active Gear’s growth. Mercury Athletic Footwear designs and distributes athletic and casual footwear dominantly to the youth market. Mercury competes in four main 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 and post-acquisition the line may be discontinued by Active Gear. The acquisition of the Mercury Athletic division has sources of potential including an increase in Active Gear’s revenue, an increase in leverage with contract manufacturers, boosting capacity utilization and expanding its presence with retailers and distributors. Upon the review of the opportunity to acquire Mercury Athletic Footwear, the results of the financial analysis below indicate Active Gear should proceed with the acquisition.
Based on the Free Cash Flow Method, considering the financial projections and assumptions for Mercury Athletic, indicate the acquisition has a positive net present value of $112,778,000 [Present Value of Future Cash Flows (59,440,000) + Terminal Value ($276,921,000) – Purchase Price ($223,583,000)]. There are also possible synergies that could make the project even more financially favorable, which are discussed below in the analysis. Introduction John Liedtke, the head of business development for Active Gear, Inc. is responsible for developing the financial projection for the acquisition of Mercury Athletic.
Below is a summarized comparison of Active Gear and Mercury Athletics’ current operations: | Active Gear, Inc. | Mercury Athletic| 2006 Revenue| $470 million| $431 million| % of Revenue Product| 42% athletic shoe58% casual footwear| 79% athletic shoe21% casual footwear| 2006 Operating Income| | | Revenue Growth| 2-6%| 12. 5%| Average Industry Revenue Growth| 10%| 10%| Mr. Liedtke used historical performance information to project future operating income. To estimate a discount rate, Liedtke assumed the same degree of leverage (20%) for Mercury that is currently used by Athletic Gear.
Given current credit market conditions, Liedtke expected the degree of leverage to imply a cost of debt of 6%. According to the case at the time of the analysis, U. S. treasury bills with maturities of 1,5,10 and 20 years were yielding 4. 50%, 4. 69%, 4. 73% and 4. 93%, respectively. Problem Liedtke must capture, analyze, and compare an accurate body of financial data for the acquisition of Mercury. A thorough analysis of this data will further expose the strengths and weaknesses of the acquisition. In order to complete this analysis the following questions must be answered: 1. What are the cash flows? . What are the cash flows worth today? 3. What is the NPV of the acquisition? 4. To what degree does the acquisition strengthen the company as a whole? 5. What happens after 2011? 6. How or will synergies improve the value of the acquisition? Analysis Mercury Athletic’s EBIT margin for 2006 was 9. 8%. Liendke’s 2007 projected EBIT reflects a conservative increase in EBIT of 9% compared to the average industry growth rate of 10%. Based on the information given in the case, Liendke’s EBIT projections for 2007 through 2011 reflect an accurate growth in earnings for Mercury Athletic.
In order to determine the NPV of the acquisition, the first step is to calculate the free cash flows. The Earnings before Interest after Taxes (EBIAT) cash flows of Mercury’s operations was determined using the projected EBIT calculated by Liedtke minus the assumed corporate tax rate (40%). The free cash flows from Mercury’s business operations were determined using the Free Cash Flow Method (EBIT + Depreciation – ? Net Working Capital – Capital Expenditures). The free cash flows are demonstrated in the chart below: The next step was to determine the cost of debt and cost of equity.
Case assumptions made by Liedtke of a 40% corporate tax rate, 6% estimated cost of debt, and 20% leverage were used in calculating the cost of debt. The cost of debt was determined to be 3. 6% (= Debt*(1-Tax Rate). The cost equity was determined using the CAPM approach. Looking at the last 78 years, the historical S&P market returns would suggest using a 10. 5% to 11. 0% rate to project future returns. The average industry revenue growth rate in footwear is 10%. However, to be more conservative, a market return rate of 8% was used.
The risk free rate was determined to be 4. 69% using the 10 year US Treasury Bills yield given in the case footnotes on page 7 of the case. This results in a market risk premium of 3. 31%. The cost of equity was determined to be 12. 80% (Risk free rate + Beta x Market Risk Premium) (See Exhibit 1). The cost of equity and debt was used to calculate an estimate of Mercury’s Working Assumption Cost of Capital (WACC) to discount the free cash flows. Applying the cost of equity with the cost of debt resulted in a WACC of 10. 67% (See Exhibit 1). Using the discounted rate of 10. 7% results in the present value of cash flows of the acquisition is $59,440,000 (See Exhibit 1). Typically its assumed businesses will continue on in perpetuity unless information relevant to future revenue projections and returns are available. Since we can’t make specific projections about product line growth for Mercury Athletic and the projected cash flows stop at year 2011, terminal value was calculated to estimate what would happen after 2011. To calculate the terminal value, a 3% growth rate was assumed based on historical U. S. inflation.
This results in a terminal value of $276,921,000 (Cash flows in year 1 / Rate – Growth). The purchase price of the acquisition ($157,290,000) was estimated using the price per earnings ratio of a comparable company in the footwear industry given in case Exhibit 3. The price per earnings ratio was then applied to the 2006 Mercury net income. The price per earnings ratio was used because it is the most accurate reflection of the market’s view of Mercury Athletic. Surfside Footwear’s price per earnings was used as the comparable company because it has a 9. 3% EBIT margin, which is equivalent to Mercury’s 2006 EBIT margin.
The value of the acquisition ($336,361,000) minus the purchase prices ($223,583,000) yields a net present value of $112,778,000 (See Exhibit 1). Synergies could be realized after the acquisition. By adopting Active Gear’s inventory system, this will reduce the Days Sales Inventory (DSI) from 60 to 42. 5, adding potential value to the acquisition. If Mercury women’s casual line turns around with the adoption of Active Gear’s inventory system it has the potential to increase revenue growth by 3% and EBIT by 9%. If this were to occur, Active Gear could reap the rewards financially.
However, even without the possibility of synergies, the acquisition still has a positive net present value. A sensitivity analysis of the results indicates that the acquisition would remain a positive NPV project for Active Gear, using considerably different assumptions regarding Mercury’s capital structure and equity beta. The comparable company Surfside Footwear’s equity beta of 2. 68 was used as a measure of sensitivity. Using the equity beta of Surfside Footwear results in a NPV of $22,259,000 (See Exhibit 2), which reflects the risk among similar industry peers.
Changing the capital structure of Mercury Athletic also results in a positive NPV. Assuming Mercury Athletic is an all equity firm using a 0% debt capital structure, the NPV of the acquisition would be $48,968,000 (See Exhibit 3). Summary and Recommendation Given the financial projections above, Liedtke has sufficient evidence to recommend moving forward with the acquisition of Mercury Athletic. The project has a positive NPV for Athletic Gear given the conservative market risk premium used in the WACC calculation and the different assumptions made in the capital structure.
Synergies discussed above will potentially add value to the acquisition. With the successful acquisition of Mercury Athletic, Active Gear could increase revenue, increase leverage with contract manufacturers, boost capacity utilization, and expand its presence with retailers and distributors. These positive effects addresses the concerns of Active Gear executives regarding the size of the company’s operations compared to other firms in the footwear industry, resulting in a higher competitive advantage in the footwear industry.