Case Study No. 1: I N T E R C O

Alfonso, Eric

Basilio, Leo

Deinla, Dennis

Lapat, George

Magpantay, Mark

Silfavan, John

Talaugon, Danilo

Villaroman, Ramil

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INTERCO Case Background

Interco started out as a Shoe Company founded on December 1911

It’s business has spread to other consumer products/services through acquisitions

It is fairly conservative financially, debt level is relatively low

Interco has moved away from apparel and general retail (went from 59 % to 40 % of total sales)

Placed more emphasis on the footwear division (acquired Converse in 1986)

Placed much more emphasis on the furniture division (sales rose from 20-33% of Interco’s total sales)

Highly liquid as the current ratios are consistently over 3.5, showing that it has a plenty of cash to cover any of its current liabilities

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Interco’s Business Climate in 1988

Cheap imports hurting profitability of U.S. apparel manufacturers

Retailing industry profits reduced due to drop-off in consumer spending and deep discounting programs being offered by retailers in 1987

Apparel business are struggling, dropped in earnings from $6.7M in 1986 to $2.0M in 1988

Furniture and home furnishings prospects appear bright given favorable demographic trends in family formations

Footwear have been flourishing

October 1987 stock market crash still in rear-view mirror

Interco’s sales is growing from 4.04 % in 1987 to 13.39 % growth in 1988. Earnings is also growing from 4.51 % growth in 1987 to 13.97 % in 1988

Overall performance of the company is improving, although some divisions are not pulling their weight

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Interco’s Business Operation & Goal

Interco have four major divisions:– Apparel (e.g., London Fog)

– General retail merchandising (Central Hardware)

– Footwear (Converse, Florsheim)

– Furniture and home furnishings (Ethan Allen)

Interco’s Goal– Improve long- term sales and earnings growth

– Earn increased return on assets and equity

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Interco’s Management Concern

Interco management is concerned that their stock price is undervalued– Management felt that bad performance in apparel group is unduly dragging down Interco’s stock

price.

– Because of this “undervaluation”, Interco’s management is afraid for possible unsolicited takeover bid.

– Interco engage the services of Wasserstein, Parella & Co. to amended the Shareholder Rights Plan and adopted the golden parachute severance agreement for their senior executives making any hostile takeover of the company prohibitively expensive

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The Takeover Bid

On July 27, 1988, City Capital proposed a merger with Interco– City Capital Associates Limited Partnership was led by the Rales brothers

– The Rales brothers has been involved in multiple acquisitions of undervalued companies

City Capital offered to buy Interco’s common shares at USD64 per share

Interco’s Board expanded the role of their financial advisor, Wasserstein, Perella, & Co. to evaluate City Capital’s offer

The offer was raised to USD70 per share in the morning of August 8, 1988

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Solution – Discounted Cash Flow Valuation

Computation of beta (β)– We utilize daily Interco stock price in Exhibit 3 and the daily S&P500 stock price - same dates

– Through regression, we get a β of 1

Computation of the Required Rate of Return k– k = RFR + β(Rm -RFR)

RFR = 9.01%, 10 year treasury bonds from exhibit 14

Rm = 12.4%, internet data: 1988 S&P500 stock price

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RFR β Rm β(Rm -RFR) k

9.01% 1 12.40% 3.39% 12.40%

Solution – Discounted Cash Flow Valuation

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Furniture 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Sales Growth 7.70% 7.70% 7.70% 7.70% 7.70% 7.70% 7.70% 7.70% 7.70% 7.70% Exhibit 12

Operating Margin in % 13.1 13.21 13.32 13.43 13.54 13.66 13.77 13.88 13.99 14.10 Exhibit 12

Net sales 1,105,563 1,190,691 1,282,375 1,381,117 1,487,463 1,601,998 1,725,352 1,858,204 2,001,286 2,155,385 2,321,349 Exhibit 8

Earnings from Operation 155,981 169,416 183,996 199,816 216,982 235,606 255,813 277,734 301,514 327,310

Less: Depreciation & Interest - - - - - - - - - -

Earnings Before Tax 155,981 169,416 183,996 199,816 216,982 235,606 255,813 277,734 301,514 327,310

Less: Income Tax at42.8% 66,760 72,510 78,750 85,521 92,868 100,840 109,488 118,870 129,048 140,089

Net Income 89,221 96,906 105,245 114,295 124,114 134,767 146,325 158,864 172,466 187,221

Less: Net FC Inv (Capex-Dep) 0 0 0 0 0 0 0 0 0 0 Exhibit 12

Less: Working Capital Inv 0 0 0 0 0 15,419 16,607 17,885 19,262 20,746 Exhibit 12

FCFE 89,221 96,906 105,245 114,295 124,114 119,348 129,718 140,979 153,204 166,476

PV of FCFE at 12.4% 79,378 76,704 74,115 71,608 69,181 59,186 57,232 55,338 53,502 51,724

Our assumption: Above operating margin in % is already inclusive of interest and depreciation

Solution – Discounted Cash Flow Valuation

Footwear 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Sales Growth 6.30% 6.30% 6.30% 6.30% 6.30% 6.30% 6.30% 6.30% 6.30% 6.30% Exhibit 12

Operating Margin in % 9.10 9.24 9.39 9.53 9.68 9.82 9.97 10.11 10.26 10.40 Exhibit 12

Net sales 890,411 946,507 1,006,137 1,069,523 1,136,903 1,208,528 1,284,666 1,365,600 1,451,632 1,543,085 1,640,300 Exhibit 8

Earnings from Operation 86,132 93,012 100,416 108,385 116,959 126,183 136,105 146,776 158,252 170,591

Less: Dep & Int - - - - - - - - - -

Earnings Before Tax 86,132 93,012 100,416 108,385 116,959 126,183 136,105 146,776 158,252 170,591

Less: Income Tax at42.8% 36,865 39,809 42,978 46,389 50,058 54,006 58,253 62,820 67,732 73,013

Net Income 49,268 53,203 57,438 61,996 66,900 72,177 77,852 83,956 90,520 97,578

Less: Net FC Inv (Capex-Dep) 0 0 0 0 0 0 0 0 0 0 Exhibit 12

Less: Working Capital Inv 0 0 0 0 0 9,517 10,117 10,754 11,432 12,152 Exhibit 12

FCFE 49,268 53,203 57,438 61,996 66,900 62,659 67,735 73,202 79,089 85,426

PV of FCFE at 12.4% 43,832 42,112 40,448 38,842 37,290 31,073 29,885 28,734 27,620 26,542

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Solution – Discounted Cash Flow Valuation

Apparel 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Sales Growth 7.10% 7.10% 7.10% 7.10% 7.10% 7.10% 7.10% 7.10% 7.10% 7.10% Exhibit 12

Operating Margin in % 6.40 6.47 6.53 6.60 6.67 6.73 6.80 6.87 6.93 7.00 Exhibit 12

Net sales 813,198 870,935 932,771 998,998 1,069,927 1,145,892 1,227,250 1,314,385 1,407,706 1,507,653 1,614,697 Exhibit 8

Earnings from Operation 55,740 60,319 65,268 70,615 76,393 82,635 89,378 96,663 104,531 113,029

Less: Dep & Int - - - - - - - - - -

Earnings Before Tax 55,740 60,319 65,268 70,615 76,393 82,635 89,378 96,663 104,531 113,029

Less: Income Tax at42.8% 23,857 25,817 27,935 30,223 32,696 35,368 38,254 41,372 44,739 48,376

Net Income 31,883 34,503 37,333 40,392 43,697 47,267 51,124 55,291 59,792 64,652

Less: Net FC Inv (Capex-Dep) 0 0 0 0 0 0 0 0 0 0 Exhibit 12

Less: Working Capital Inv 0 0 0 0 0 10,170 10,892 11,665 12,493 13,380 Exhibit 12

FCFE 31,883 34,503 37,333 40,392 43,697 37,097 40,232 43,626 47,298 51,272

PV of FCFE at 12.4% 28,366 27,310 26,290 25,306 24,357 18,397 17,751 17,124 16,518 15,930

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Solution – Discounted Cash Flow Valuation

Retail 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Sales Growth 7.60% 7.60% 7.60% 7.60% 7.60% 7.60% 7.60% 7.60% 7.60% 7.60% Exhibit 12

Operating Margin in % 6.5 6.61 6.72 6.83 6.94 7.06 7.17 7.28 7.39 7.50 Exhibit 12

Net sales 532,251 572,702 616,227 663,061 713,453 767,676 826,019 888,797 956,345 1,029,027 1,107,233 Exhibit 8

Earnings from Operation 37,226 40,739 44,572 48,753 53,311 58,280 63,697 69,601 76,034 83,043

Less: Dep & Int - - - - - - - - - -

Earnings Before Tax 37,226 40,739 44,572 48,753 53,311 58,280 63,697 69,601 76,034 83,043

Less: Income Tax at42.8% 15,933 17,436 19,077 20,866 22,817 24,944 27,262 29,789 32,542 35,542

Net Income 21,293 23,303 25,495 27,887 30,494 33,336 36,435 39,812 43,491 47,500

Less: Net FC Inv (Capex-Dep) 0 0 0 0 0 0 0 0 0 0 Exhibit 12

Less: Working Capital Inv 0 0 0 0 0 4,376 4,708 5,066 5,451 5,865 Exhibit 12

FCFE 21,293 23,303 25,495 27,887 30,494 28,961 31,726 34,745 38,040 41,635

PV of FCFE at 12.4% 18,944 18,445 17,954 17,471 16,997 14,362 13,998 13,639 13,284 12,936

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Solution – Discounted Cash Flow Valuation

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Interco 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998Sales Growth 7.20% 7.20% 7.20% 7.20% 7.20% 7.20% 7.20% 7.20% 7.20% 7.20%Operating Margin in % 9.2 9.30 9.40 9.50 9.60 9.70 9.80 9.90 10.00 10.10Net sales 3,341,423 3,580,835 3,837,510 4,112,700 4,407,747 4,724,094 5,063,287 5,426,985 5,816,970 6,235,151 6,683,579 Earnings from Operation 335,078 363,486 394,252 427,569 463,644 502,704 544,993 590,773 640,331 693,973 Earnings Before Tax 335,078 363,486 394,252 427,569 463,644 502,704 544,993 590,773 640,331 693,973 Less: Income Tax at 42.8% 143,413 155,572 168,740 182,999 198,440 215,157 233,257 252,851 274,062 297,020 Net Income 191,665 207,914 225,512 244,569 265,204 287,547 311,736 337,922 366,269 396,952 Less: Working Capital Inv 0 0 0 0 0 42,517 45,570 48,843 52,353 56,116 FCFE 191,665 207,914 225,512 244,569 265,204 245,030 266,166 289,079 313,916 340,836 PV of FCFE at 12.4% 170,520 164,570 158,808 153,227 147,825 121,513 117,433 113,471 109,627 105,897

TV11 @ 14 multiple 4,771,705 PV of TV11 @ 14 m = 1,482,554 TV11 @ 15 multiple 5,112,541 PV of TV11 @ 15 m = 1,588,450 TV11 @ 16 multiple 5,453,377 PV of TV11 @ 16 m = 1,694,347

Present Value of the Firm = P1 + P2 + P3 + P4 + P5 +P6 + P7 + P8 + P9 + P10 + TV11

Value of Firm @ TV14 2,845,445 Stock Price @41,356,847 shares = 68.80

Value of Firm @ TV15 2,951,342 Stock Price @41,356,847 shares = 71.36

Value of Firm @ TV16 3,057,238 Stock Price @41,356,847 shares = 73.92

Solution – DCF at different Discount Rates

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Interco 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 @14 @15 @16

FCFE 191,665 207,914 225,512 244,569 265,204 245,030 266,166 289,079 313,916 340,836 4,771,705 5,112,541 5,453,377

PV of FCFE at 10% Discount Rate 174,241 171,830 169,431 167,044 164,671 138,313 136,585 134,858 133,131 131,407 1,839,699 1,971,106 2,102,513

(1+k) (1+k)2 (1+k)3 (1+k)4 (1+k)5 (1+k)6 (1+k)7 (1+k)8 (1+k)9 (1+k)10

1.100 1.210 1.331 1.464 1.611 1.772 1.949 2.144 2.358 2.594

Discount RateTerminal Multiple

14 15 16

10% 81 84 88

11% 76 79 82

12% 71 73 76

13% 66 69 71

@ 10% RdValue of Firm @ TV14 = 3,361,209 , Stock Price @41,356,847 shares = 81 Value of Firm @ TV15 = 3,492,616 , Stock Price @41,356,847 shares = 84 Value of Firm @ TV16 = 3,624,024 , Stock Price @41,356,847 shares = 88

Solution – Relative Valuation

Purchase Price as Multiple of

Aquirer/TargetAnnouncement

DateAdj Aggregate Price ($million)

Net Income

Book Value

SalesOperating

Income Operating Cash Flow

Average

Furniture Manufacturing CompaniesMasco/Henredon June 3,1986 $260.90 31.6 2.6 2.1 20.3 15.8Chicago Pacific/General Mill Furniture Aug 12,1986 89.3 14.1 1.8 1 12 9.9Interco/Lane Nov 17,1986 523.7 2.8 2.8 1.6 11.1 9.6La-Z-Boy/Kincaid Dec 14,1987 63.5 22 2.1 0.8 11.7 8.1Hostorical Average 17.6 2.3 1.4 13.8 10.9 9.2City Capital offer Aug 8,1988 2,941.30 18.1 2.2 0.9 11.4 9.2 8.4

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Footwear Manufacturing CompaniesInterco/Converse July 31,1986 $202.70 37.1 1.8 0.9 24.7 18.2Reebok/Rockport Sept 18,1986 146.1 30.7 0 1.7 26 23.9Reebok/Avia March 10,1987 191 40.6 6.7 2.1 24.6 23.3Moacq/Morse Shoe June 3,1987 312.5 2.5 1.8 0.5 13 9.2Nike/Cole Haan Apr 25,1988 95 36.2 0 1.5 12.2 8.1

Hostorical Average 29.42 3.43 1.34 20.1 16.54 14.2City Capital offer Aug 8,1988 2,941.30 18.1 2.2 0.9 11.4 9.2 8.4

Solution – Relative Valuation

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Purchase Price as Multiple of

Aquirer/Target Announcement Date

Adj Aggregate Price ($million)

Net Income Book Value SalesOperating

Income Operating Cash Flow

Average

Apparel CompaniesWest Point Pepperall/Cluett, Peabody Nov 4,1985 $551.90 19.6 1.5 0.6 10.6 0.2W.Acquisition/Warnco Mar 17,1986 504.7 21 2.5 0.9 10.6 9.2Salant/Manhataan Indus Feb 2,1988 129.7 1.4 0.4Wesray/Wm Carter Apr 28,2988 157.4 1.6 0.8 24 13.7Hostorical Average 335.93 20.30 1.75 0.68 15.07 7.70 9.1City Capital offer Aug 8,1988 2,941.30 18.1 2.2 0.9 11.4 9.2 8.4

Central Hardware DivisionManagement Group/Payless Cashways June 24,1988 $1,189.40 22 2.3 0.6 13.1 9.2 9.4City Capital offer Aug 8,1988 2,941.30 18.1 2.2 0.9 11.4 9.2 8.4                 

Average 10.47375

Our Decision as the Board of Interco

Findings– Relative Valuation

The offer of City Capital, as compared to historical acquisition of the same business, is lower with an average of 10.5 vs. 8.4

– Discounted Cash Flow Valuation USD 66 per share - @ 13.0% discount rate and Terminal Value of 14 multiple

USD 74 per share - @ 12.4% discount rate and Terminal Value of 16 multiple

USD 88 per share - @ 10.0% discount rate and Terminal Value of 16 multiple

Our Decision– Decline the offer of City Capital and challenge them to submit their best proposal given above

valuation report from the consultant

– An Offer of USD 74 per Share will be considered

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Our Decision as the Board of Interco

Why shall we consider an offer of USD 74 per Share– The stock has been undervalued. In fact the value of Interco shares is always below USD50 in the

last 3 years

– It only reaches 68 a share in July when City Capital tendered their unsolicited merger proposal in July 27, 1988.

– The USD 74 per share seemed fair (+) since it is base from the prevailing S&P500 return of equity of 12.4% and at maximum assumed TV of 16 multiple.

– Selling less profitable division also poses greater risk of undervaluation.

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