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Valuing the Opportunity at Mercury Athletic Footwear

John Liedtke of Active Gear, Inc. is contemplating the acquisition of West Coast

Fashions’ footwear division: Mercury Athletic. The footwear industry AGI operates in is a

highly competitive market separated into several segments. The casual footwear segment has a

high volatility due to the effect of fast paced fashion trends, while the athletic segment relies

heavily on brand and quality. AGI’s simplified supply chain and products target affluent,

suburban families with classic styles and high quality that allow for high inventory turnover and

operating margins. However, its commitment to these principles and the brand’s premium image

have stunted its growth opportunities in the last couple years due to the rise of discount footwear

retailers and changes in the manufacturing infrastructure.

Discount retailers offered value to customers in a way that was inconsistent with AGI

branding, which led to the decision to resist selling through “big box” retailers. Mercury

Footwear targets a more youthful market focused on extreme sports, and attributes much of its

growth to the success they’ve had with discount retailers. An acquisition by AGI could provide

an opportunity to spread their supply chain into discount retailers without damaging current

branding. Additionally, the large international manufacturers, especially in China, increased the

leverage held over shoemakers by consolidating production outfits and reducing their clientele to

focus on higher capacity utilization projects with longer runs. The limited size of AGI has made

it difficult to maintain their negotiating position with manufacturers, but adding Mercury

products could ensure they have enough production to satisfy the manufacturers desire for longer

runs.

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1. Mercury is an appropriate acquisition target for AGI for a multitude of reasons. According to

Liedtke acquiring the firm would “roughly double Active Gear’s revenue, increase its leverage

with contract manufacturers, and expand its presence with key retailers and distributors.” AGI’s

smaller size is becoming a competitive disadvantage - growth is imperative. An expanded

business also provides AGI with leverage among their foreign contract manufacturers who are

requiring longer and larger production runs. Acquiring Mercury would improve AGI’s

negotiating position with their contractors and help maintain their efficient production network.

As a firm that has traditionally focused on athletic fashion wear and casual shoes with a

classic styling, Mercury would allow AGI to branch into a more youthful and alternative scene.

This would open up a new demographic and customer base for both brands, and allow both firms

to feed off existing distribution networks for cross- and up-selling opportunities.

2. For the most part, Liedtke’s projections seem to be based upon accurate assumptions. Liedtke

is valuing Mercury using AGI’s existing capital structure and thus uses the same discount rate

and leverage ratio as AGI’s current business. This is a safe assumption because not only should

the discount rate should reflect alternative investment opportunities for AGI, but the overall

leverage should remain the same. In terms of revenue growth rate for Mercury, Liedtke’s

assumptions also seem to hold up. Historically, from 2004 to 2006, Mercury revenue grew at an

average of 12.8% (Exhibit 4). Liedtke predicts average future revenue growth to be 5.7%

(Exhibit 6) for the next five years. The footwear industry is highly competitive and cyclical, and

has been growing rapidly for the previous few years. It is likely that will industry will slow in the

near future, making Liedtke’s 5.7% revenue growth prediction a reasonable deduction from

12.8%.

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However, Liedtke’s assumption regarding the revenue-to-overhead ratio may not be

justifiable. He states that Mercury’s historical ratio would remain the same after the acquisition,

yet Mercury is likely to conform to the existing overhead structure of AGI. The companies have

inherently different overhead structures to begin with, and it is unlikely that the

revenue-to-overhead ratio will remain the same for Mercury. It is more likely to be consistent

with AGI’s pre merger ratio.

3. Mercury’s estimated value was found using a discounted cash flow method, using base case

projections provided by Liedtke and some assumptions. Preparing the forecasted free cash flows

required us to calculate the net working capital (NWC) for the life of the project (see Appendix

A). The FCF table can be seen in Appendix B. Discounting these figures required calculating a

WACC. We used the CAPM model to find the cost of equity (Appendix D), with the 20-year

Treasury bond rate of 4.93% as our assumed risk free rate. The S&P 500 annual return rate for

2006 was 15.61%, meaning the market risk premium (r​m​ – r​f​) was 10.68%. Mercury’s levered

beta was found by un-levering the comparable firms betas and finding the median, before

re-levering that value to fit Mercury’s capital structure (Appendix E). The cost of equity was

calculated at 18.25%, with the cost of debt at 6%. Using these figures the WACC was 15.32%.

We utilized the FCF and WACC values to estimate the NPV of projected cash flows and

value Mercury using the Gordon Growth model. A long term growth rate assumption of 3% was

used to limit growth to a level that would stay in line with the broader economy. This led to a

valuation of Mercury at $247,864M (Appendix C, D and F).

4.When using the multiples of comparable firms, the enterprise value we obtained in part 3 is

conservative. The comparables method leads to enterprise values around 2x higher than what we

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obtained using the discounted cash flow method (Appendix G). This is strange because

Mercury’s profit margins are much stronger than their industry peers (14.6% vs. 13.5% EBITDA

margins, respectively). While this could simply be because size differs among competitors or the

cash flows of competitors are more stable, our DCF valuation appears to undervalue Mercury.

A sensitivity analysis, however, shows enterprise values that are relatively consistent

(Appendix H). The values are not as large as those obtained using the comparable multiple

method. This shows that the sensitivity of the WACC and LTGR assumptions does not have an

extremely significant impact on our valuation and cash flow predictions.

5. Possible synergies between AGI and Mercury could exist in both cost and revenue form. At a

basic level, once the firms merge, any redundant employees, production facilities, or machinery

could be eliminated. Consolidation of the resources of both firms would allow the merged

company to reduce overhead, labor, and fixed costs. In terms of revenue, synergies between

target markets would increase the reach and marketability of the newly merged firm. Folding

Mercury’s women’s footwear line into that of AGI’s would be an example of this spreading of

brand awareness. Furthermore, the adoption of AGI’s inventory management into Mercury’s

supply chain could greatly reduce Mercury’s DSI. This will help increase sales and operating

margins. To value this increase you could compute the amount of goods sold had Mercury had a

DSI more similar to AGI.

The impact of these synergies on our valuation could be sizeable, and should not be

ignored. The potential reduction in costs and increase in revenues could change our free cash

flow model, and thus lead to a higher valuation for Mercury.

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Appendix A.

Appendix B.

Appendix C.

Appendix D.

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Appendix E.

Appendix F.

Appendix G.

Appendix H.