Valuation and Capital Investments
Mercury Footwear 1
We think that this acquisition makes sense for AGI, for a number of reasons.
First, the Mercury product portfolio gives AGI access to growing markets that they have not had access to in the past. Specifically, Mercury’s products have become popular with a loyal market of extreme sports enthusiasts that has seen recent sales growth. This could be a nice complement to AGI’s current brand, which is associated with a prosperous, active lifestyle.
Just as importantly, there are potential synergies related to manufacturing. As mentioned in the case, there has ...view middle of the document...
Lastly, the acquisition of Mercury gives AGI access to a distribution channel (large discount retailers) that it has avoided in the past in the name of brand image. While Mercury has had to make price concessions in order to get on the shelves of these retailers, they have still enjoyed margins on certain products (i.e. men’s athletic footwear) that beat industry averages. This could be an opportunity for AGI to “test the waters” with this distribution channel to determine if it is a viable path for future growth and value creation while still maintaining a reputation for quality footwear.
Mr. Liedtke’s baseline valuation of Mercury Footware is one that is based in the right ideas but utilizes high level assumptions and imprecise rates and factors. First off, his assumption that the overhead to revenue ration will remain constant is a bit farfetched. Although growth has slowed for them a bit, there is still growth in revenues and sales without significant capital or fixed investment, thus the ration should show a slight increase. Secondly, his decision to not create debt or equity accounts on the assumed balance sheet is creating a large gap in the leverage assumptions of the firm. The leverage of the firm can be a big driver of the firm’s market value in most valuation models. The leverage of the firm determines not only market value but is a key input in determining an accurate cost of the company’s debt and equity. He instead used the leverage rate of the potential buyer (AGI), which is a completely different company in size, growth and markets.
In determining an accurate valuation of future cash flows, a company must understand its growth and discount rates (WACC). Liedtke utilizes an assumed level of leverage at 20% to match AGI which, as stated above, is an unfounded assumption. Additionally there is a market cost of debt used as a discount rate at 6% which may not be accurate for the circumstances of Mercury’s debt. The discount rate applied to Mercury should leverage one that takes into account the proportional cost of their debt and their equity. The model in the case merely accommodates debt and has no consideration for equity. To further the analysis, there has to be an assumption of extraordinary (if any) and ordinary growth for the firm in addition to his growth of 3% as assumed in the case. There needs to be more diligence put on the growth rate as a weighted average of the firms based on their current revenue streams. Once this is assumption base is built and calculated, they can then discount the future growth and terminal cash flows to appropriately estimate value.
The key to an accurate valuation is understanding the firm’s current cash flows, their growth potential (both extraordinary as well as ordinary) and their cost of doing business. These are the fundamental building blocks to understanding the viability of the firm earning money, paying its owners and creditors as well as accounting for...