Merger or Acquisition of Footwear and Mens and Womens Branded Clothing - Case Study Example

Business Project for merger/acquisition of footwear and a large designer and marketer of men’s and women’s branded clothing Table of Contents Evaluate the commercial logic of acquiring Mandrake Footwear, and discuss whether it is an appropriate target for Gear Active? 3 2 What modifications (if any) do you feel should be made to Lintons projections. Justify any further assumptions you make, and suggest how your figures could be verified. 5 3 What value does Mandrake have as an acquisition candidate? 8 4 How would you analyse possible synergies or other sources of value not reflected in Lintons base case assumptions? 12 Reference 15 1 Evaluate the commercial logic of acquiring Mandrake Footwear, and discuss whether it is an appropriate target for Gear Active? Taking a decision of acquiring a business is very difficult even under the best of circumstances. It is always better to relate with logics and other fact based techniques for developing a purchase decision of a company. The basic logics that many companies follow for taking decision for acquisition of another company are the followings. To increase market share: This is one of the most important reason for acquisition of a company by another. Acquisition of a company or a particular division of a company in the same industry always helps to increase the market share of the buyer company which can gain the market share of the target company. Gear Active is one of the most profitable footwear companies in footwear industry. But the firm’s market share is much smaller than its competitors and the management thinks that this smaller size has become the competitive advantage for the company. The company followed the strategy of deeper penetration into the market for strong brand presence. Due to increasing competition in the market the company needs to wise its market share and it might be beneficial for the company if it acquires one of its competitor or another company’s business in footwear industry. Mandrake Footwear is the brand of footwear division of Winkler Fashions which is recognized for fashionable apparels not for sport shoes and that is why the company has incurred lose in this division. But Gear Active is the brand which is known for specialist in sport shoes. So the company can acquire Mandrake footwear to its expand its footwear business and can increase its market share. To achieve Economies of Scale: The basic concept of economies of scale is that if a company achieves economies of scale that means the average cost per unit sale decreases because total cost of sales remain same or little increased but it is much lower than the extra revenue the company can gain from the expanded business. The best way to achieve economies scale especially for the smaller companies is through expansion of business by merger with or acquisition of another business in the same industry. This will increase the sales volume and simultaneously reduce the cost of sales per unit which include operating cost, distribution cost and promotional cost compared to the output or the return. As, Gear Active is a smaller company, it can achieve or even can enhance its economies of scale if it acquires Mandrake footwear. Product differentiation: Acquisition helps the buyer to increase the product differentiation by providing a wide variety of products like different design, price etc. So, Gear Active can offer wide variety of Mandrake’s designs along with their existing design and price varieties to its existing as well as new potential buyers. A better opportunity to choose from different designs and prices enhance the customers’ purchasing decisions and also selection of a brand. To increase distribution network: The footwear industry is mature and highly competitive industry. So each company has their strong distribution network like distributors and retailers. So getting new distribution medium is more difficult in a mature industry than getting the competitor’s distribution channels. So, Gear Active can get a stronger distribution channels by acquiring Mandrake and even can compete with the other existing players in the same market. This might enhance the market presence as well as the sales volume of the parent company. Apart from these three key logics, there are some other factors which influence the purchase decision of Gear Active. Acquisition is the easy way to finance an existing business. Because the acquired company anyway provide a customer base which is the key requirement for the declining company like Gear Active. By acquisition the buyer company can overcome the difficulties or weaknesses by gaining the strength area of the acquired company. Mandrake footwear has a strong supplier base as it is a subsidiary brand of a large company Winkler Fashion. This is one of the weaknesses of Gear Active so it is an opportunity for the company to get one of its competitors supplier base by which it can get supply of shoes in comparatively cheaper price and can also reduce the retail price of its own products. This might be a greater advantage for the company to with the other competitors in the same market. 2 What modifications (if any) do you feel should be made to Lintons projections. Justify any further assumptions you make, and suggest how your figures could be verified. Winkler Fashion bought Mandrake Shoes in 2008 in order to get a larger and well established distribution network of Mandrake. Management of Winkler Fashion thought that Mandrake can widen its distribution with big retailers and departmental stores. But their projected outcome from Mandrake was not effective even it has been declining the business. Despite of the financial health problem of Mandrake some of its business division had been growing very well like the men’s sport footwear and women sport footwear. Men’s casual category also has little growth but main problem came in women’s casual. It has incurred heavy loss and affected the overall business (Figure 1). So, proliferation of this brand and underperforming women’s segment of its business contributed an overall decline of Mandrake. Figure 1: 3 year Segmental Data of Mandrake Footwear (£ 000s) Gear Active was established with a mission to produce and market high quality sport shoes for tennis and golf players. And thereafter the company well recognized for its quality sport shoes. So, the main motive behind the acquisition of Mandrake should be expanding its sport footwear business. Linton needs to concentrate on the sport segment only not the casual. Because Women’s casual has very declined business since 2008 and also men’s casual has not generated that much operating revenue. Sales growth of this segment has been likely steady. So, Linton needs to do an internal reconstruction of all the segment of its business as well as Mandrake business. The positioning of these two should emphasize the sport segment not casual. Linton need to change customer brand recognition and it should be sport shoe specialist. Gear Active is famous for its quality and the casual segment of the business badly affecting the overall reputation of the business. The casual shoes have comparatively lower product life than the sport shoe. As these are the fashionable and designed footwear, the product life become shorter than the customer expectation due to the bad climate and the perception of the customer to the brand changes. So, to maintain the USP of the brand Mandrake and also Gear Active, Linton needs to divest these two casual segments of Mandrake and should invest that asset into the men’s and women’s sport footwear. By this strategy, the brand image of the company will be influenced by its historical USP i.e. the quality. Repositioning a brand to the consumer mind is not an easy task. If product differentiation affects the strength of a brand then it would beneficial to stay with the existing segment of product. Because every footwear company has these four types of product category for this reason the competition among the firms are also far more than the any other industry. So, to get competitive advantage Linton should divest the casual segment to become popular in sport footwear specialist. Figure 2: Segmental Asset -Revenue comparison of Mandrake Footwear From the three year asset-revenue comparison of different segment of Mandrake’s products it can be summarized that men’s and women’s sport footwear segment has an increasing growth and has been contributing maximum percentage of the total revenue of the company. In 2009 and 2010 women’s casual incurred heavy loss with respect to asset it had. Men’s casual also did not have much growth in revenue as well as income with compared to sport segment. So, Linton can use reorganize the assets of these two segment and use these two assets into high growth segment i.e. in sport segments. Because the growth rate of operating income is comparatively very high. Sales volume also higher these two segment which resulted substantial amount of revenue with respect to asset these two have. Linton can achieve a faster break even if it reorganizes the segments of Mandrake with respect to higher return on asset. 3 What value does Mandrake have as an acquisition candidate? In this section of the study of the study, we would find the value of Mandrake as an acquisition candidate. For the valuation of Mandrake, we would employ the discounted cash flow method. The approach used in this method is to compute the value of a company’s stock by projecting the upcoming free cash flows of the company and then discounting back those cash flows to the current date at a suitable required rate of return. This approach is beneficial for the valuation of companies that do not give out dividends on a regular basis. Owing to the infinite life of the company, the assessment is broken down into two segments: a projected period and a terminal value, which captures the value of the company for cash flows occurring after the completion of the forecasted period. The commonly considered projected period for the valuation of a company is that of five years. The cash flows generated by the company post these five years are encompassed in the terminal value of the company. For the computation of the terminal value of a company, it is assumed that the company would not benefit from any further abnormal growth. In context of an acquisition, the Free Cash flows to the firm refers to the residual cash flows that remains with the company subsequent to meeting all the operating expenditures, taxes as well as reinvestment requirements. However, the FCFF is computed prior the consideration of any interest or principal expenses pertaining to debt. Consequently, FCFF = After Tax Operating Income –Reinvestment requirements = EBIT (1- Tax Rate) + (Depreciation & Amortization – CAPEX) – Δ Working Capital The major difference in the free cash flow to equity and free cash flow to firm is that in the computation of FCFE initiates with the Net Income while the foundation in the computation of FCFF is the Operating Income. Consequently FCFE are subsequent to subtraction of interest charges whereas FCFF are prior to the inclusion of Interest expenditure. Next, one has to subtract the net debt issues while calculating FCFE; however it should not be deducted in the calculation of FCFF. In view of the fact that FCFE ensue to the equity shareholders, the FCFE is discounted by the cost of equity. On the other hand, FCFF ensues to the creditors in addition to the equity shareholders. Consequently, the FCFF has to be discounted by the weighted average cost of capital (Pinto et al, 2010). The FCFF of a company are the cash flows that are produced by the operating assets of the company, prior to the inclusion of any financing expenses. Hence, FCFF of a company is a measure of its’ operating cash flow. The free cash flows to firm accrue to all the sources of capital. The debt holders are likely to benefit from the FCFF in the form of principle and interest payment, while the equity shareholders in the form of dividends and stock repurchases. The Weighted Average Cost of Capital (WAAC) of the company is utilised as the discount rate to attain the present value of the company’s free cash flows. Thus, for the valuation of Mandrake, we need to compute its WAAC, the present value of its free cash flows during forecasted period and its terminal value. The FCFF calculation of Mandrake for the period (2009 to 2015), assuming the tax rate to be 40% is as follows: 2009 2010 2011 2012 2013 2014 2015 EBIT 31066 42299 47005 53036 57605 61686 64612 (1-t) 0.6 0.6 0.6 0.6 0.6 0.6 0.6 EBIT * (1-t) 18639.6 25379.4 28203 31821.6 34563 37011.6 38767.2 Capital Expenditure -1756 1284 11983 12226 13303 14258 14943 Depreciation & Amortization 8001 9506 9587 9781 10643 11406 11954 Change in Working Capital 31961 31961 -77 2648 9805 8987 5934 FCFF -3564.4 1640.4 25884 26728.6 22098 25172.6 29844.2 The WAAC of Mandrake would be used as the discount rate as this reflects the opportunity cost of the investors. The equation of WAAC can be expressed as follows: WAAC = WD KD (1 – t) + WE KE, (Source: Pinto et al, 2010) where: t is the tax rate applicable to the company. KD is the cost of debt. KE is the cost of equity, expressed as Risk free rate + Beta * Risk premium. WE and WD are the percentage of debt and equity of the company. It has been mentioned that at the time of the analysis, the yield of the UK Government bonds with maturities of 1, 5, 10 and 20 years were 4.5%, 4.59%, 4.73% and 4.93% respectively. The 20 year UK Government bond can be assumed as the Risk free rate of the region. Hence the Risk free rate for Mandrake would be 4.93%. Linton had planned to assume the same degree of gearing for Mandrake as that of Gear Active. Hence the debt percentage of the company would be taken as 20%, while the equity percentage would be 80%, and the cost of debt for the company would be 6%. The anticipated marginal tax rate for Mandrake would be 40%. Assuming that the beta of Mandrake is the average of the beta of the companies in the Footwear Industry (Exhibit 3), we compute the Mandrake’s beta to be 1.55. Additionally, assuming the market risk premium to be 3%, the Cost of Equity of Mandrake would be, K E = Risk free rate + Beta * Risk premium = 4.93 + 1.55 * 3 = 9.58% Therefore, WAAC of Mandrake = WD KD (1 – t) + WE KE = (0.20 * 0.06 * 0.60) + (0.80 * 0.096) = 0.0072 + 0.0766 = 8.38 % = 8.4% (approximately). In this case, we anticipate the Mandrake would reach a steady state after 2014, and would start growing at a stable growth rate of 1% from 2015 onwards. Therefore value of Mandrake can be represented as follows, (Source: Pinto et al, 2010) The present value of the forecasted cash flows of Mandrake for the period 2011 to 2014 would be, PV= 25884/ (1.084) + 26728.6/ (1.084) ^2 +22098/ (1.084) ^3 +25172.6/ (1.084) ^4 = 82,204.54 The terminal value of Mandrake would be [29844.2/ (0.084- 0.01)]/ (1.084) ^5 = 403300/ (1.084) ^5 = 269452.25. Therefore, value of Mandrake = 82,204.54 + 269,452.25= 351,656.78. (thousands of £). 4 How would you analyse possible synergies or other sources of value not reflected in Lintons base case assumptions? Apart from Linton’s projected case assumption, there are some possible synergies which need to analyse and consider for future projection of Mandrake’s performance. After the acquisition of Mandrake by Winkler fashions, sales have been declining because of wrong positioning strategy. WF started selling clothes through Mandrake wide network distribution and it has affected the brand positioning. So, Linton needs to reposition the brand again to make it only sports foot wear brand. Gear Active has been concentrating to its brand and inventory management since its establishment. Efficient inventory management has contributed to the brand to get competitive advantage in the industry. It has also contributed to its revenue growth and strong profit margin. The company is having lowest DSI (Daily Sales Inventory) among its competitors. Linton needs to consider the DSI status of Mandrake for making future projection of Mandrake’s performance because Mandrake’s DSI in 2010 was more than 10 days which was longest than the average DSI of the industry. This operational inefficiency of the company was due to ineffective wholesale pricing system. Mandrake has been following discounted pricing for its retail clients. The company offered discounts to the distributors to get the front shelves of popular retail chains for its product. As this industry is highly competitive and all the popular brands come into price war in order to position their products in retail outlets. Mandrake continuously offered discounted price to the retailers which influence the decline of its overall revenue. So pricing strategy directly affected the inventory system as well as the daily sales. So Linton needs to recover this operational inefficiency of the brand so that it can come up with the standard of Gear Active. Otherwise, there will be unmatched stock liquidity ratio between these two brands which might have a negative impact on the overall distribution management of the parent company. After the acquisition of Mandrake by WF, financial performance of Mandrake had been disappointing. Growing popularity of sports shoes along with the wide distribution network of WF supported the initial growth of Mandrake. So, Linton needs to consider these external factors which influenced Mandrake growth even in the sport footwear segment. Despite of this support from the parent company another two segments did not have revenue growth which include one loss making segment i.e. women’s casual footwear. Another possible synergy Linton needs to consider that Mandrake sourced all of its production from the independent contractors from all over Asia. It sourced raw materials for the production of shoes from foreign companies which increased unit cost of production. But the company was not able sale its product in higher price due to perfect competition market of shoe industry. So, there lack of effective strategy planning both in production and sales. So, there was a mismatch in the synergy between two major areas of Mandrake’s business. So, these internal strategic problems of mandrake leads to future decline of its business and can affect5 the Gear Active’s brand image. Lastly, Linton needs to incorporate mandrake’s women’s casual footwear to Gear Active’s similar segment because this segment has not been generating profit since 2009 and this category of product can’t be sold by in future as it was already in declined stage. So, it will be better to incorporate the women’s footwear segment with parent company’s similar segment. The asset of this segment can be invested in other growing segments of Mandrake. So, by this incorporation the combined business might achieve revenue growth of 3% and EBIT margin of 9%. Reference Pinto, J. E., et al, 2010. Equity Asset Valuation. John Wiley & Sons. Read More