Interco HBS Case Study

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IntercoHBS Case Study
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Interco Case Study

• Background
• Started out as shoe company been around a long
  time
• Business has spread to other consumer products /
  services through acquisitions
• Fairly conservative financially, debt level is
  relatively low

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Operations

• Currently has four major operating divisions
• 1. Apparel (e.g., London Fog)
• 2. General retail merchandising (Central
  Hardware)
• 3. Footware (Converse, Florsheim)
• 4. Furniture and home furnishings (Ethan Allen)

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Intercos Goals

• Improve long-term sales and earnings growth
• Earn increased return on assets and equity

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How does Interco plan to achieve these goals?

• Improve profitability of existing assets
• Divest/sell unproductive assets
• Make acquisitions that will improve
  growth/returns
• Use corporate finance!
• (adjust payout policy and debt policy to
  maximize firm value we will discuss this in
  depth later in the course)

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Recent Interco History (from 1984-88)

• 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 Intercos
  total sales)

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Economic environment in August 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
• Furniture and home furnishings prospects appear
  bright given favorable demographic trends in
  family formations (success of firms like Home
  Depot proved this ex post!)
• October 1987 stock market crash still in
  rear-view mirror

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Interco concerned stock price may be
undervalued - Why?

• Management felt that bad performance in
  apparel group is unduly dragging down Intercos
  stock price.
• Because of this undervaluation, Intercos
  management afraid may be a takeover target.

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What has Interco done to try and improve return
to shareholders (boost its stock price) and thus
deter an unwanted takeover attempt?

• Following 1987 crash, Intercos board authorized
  repurchase of 5 million shares (by end of fiscal
  1988 over 4 million shares had been repurchased
  over 10 of the equity)
• 7/15/88 Interco announces reorganization plan
• sell the apparel division that is dragging down
  rest of company
• take the money raised from this sale and return
  it to shareholders (via special dividend or
  repurchase)

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Mid 1988 things start to get interesting

• Enter stage left the cowboy(s) with the black
  hat
• Rales Brothers Washington DC businessmen
• The book on the Rales Brothers
• they buy undervalued companies with strong
  brand-names
• City Capital (formed by Rales) has Interco in it
  sights
• Thinks currently that the sum of Intercos parts
  exceeds Intercos current stock price
• Plans to sell apparel division and also sell part
  of footwear division, focus on home furnishing

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Good Guys in Black Hats?

• Corporate raiders as
• Misunderstood heroes
• Unsung protectors of the public shareholders

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• City Capital has accumulated 8.7 of Intercos
  stock
• Ups the ante on 7/27/88 City Capital proposes a
  merger/takeover of Interco and offers to buy
  Intercos stock for 64 per share (price was
  44.75 on 6/30/88)
• Morning of 8/8/88 Offer raised to 70 per share
• Offer is timed well Interco happens to have a
  Board meeting scheduled for 8/8/88.
• Board wants their financial advisor, Wasserstein,
  Perella, Co. to evaluate City Capitals offer.

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The Big Question

• Should Intercos Board accept or reject the
  offer of 70 per share that is on the table?

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Premiums Paid Analysis (Exhibit 10)

• Advantage
• Disadvantage

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Comparable Firm Analysis
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Discounted Cash Flow Analysis
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• Given the assumption presented by Wasserstein,
  Perella, Co., we can value Interco using a
  discounted cash flow methodology.
• Value Interco
• discounted first 10 free cash flows TV10 /
  (1r)10
• Value Intercos equity
• Value Interco 318.5M of debt
• Price per share of stock
• Value Intercos equity / 37.5M shares

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Are assumptions implicit in estimates reasonable?

• 1. First ten cash flows
• 2. Discount rate (WACC)
• 3. Long-term growth rate

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2. Discount Rate (WACC)

• What is appropriate discount rate for Intercos
  free cash flows?
• Exhibit 14
• 10-year Treasury bond returns 9
• 10-year AAA bond returns 9.5

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3. Long-term Growth Rate

• Given multiple applied and discount rate assumed,
  can back out the implied long-term growth rate of
  free-cash flow. Way to check if value obtained
  using market data of competitors can be justified
  by DCF analysis.
• Value of firm10 FCF11 / (r - g) FCF10 (1g)
  / (r - g)
• Value of firm10 14FCF10 (by assumption)
• ? 14 (1g) / (r - g)
• r .10 ? g .027
• r .11 ? g .036
• r .12 ? g .045
• r .13 ? g .055
• r .14 ? g .064

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Now, the rest of the story . . .

• 8/22/88 Wasserstein, Perella adjust valuation
  range to 74-87
• 9/10/88 City Capital raises offer to 72 per
  share
• 9/19/88 Board adopts restructuring plan and
  rejects 72 offer
• 10/17/88 City Capital raises offer to 74
• 10/19/88 Board declares large dividend financed
  by debt (and anticipation of proceeds from
  selling off divisions), rejects 74 offer
• 11/16/88 City Capital 74 offer expires, Interco
  stock price falls closing at 63.375
• 11/16/88 group of shareholders file lawsuit
  against Interco and its Board in connection with
  Intercos avoidance of the hostile tender offer
  by City Capital (breach of fiduciary
  responsibility)
• Under 11/88 restructuring, Interco to pay 1.42
  billion cash dividend

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Now, the end of the story . . .

• Earnings were less than forecast during 1989-1990
• Proceeds from asset sales less than anticipated
• Spring of 1990, Interco pays 18.5 million to
  settle the shareholder lawsuit
• Spring of 1990, Interco begins to work with
  creditors to restructure its debt
• 6/15/90 Interco defaulted on bond payments
• 1/24/91 Interco filed for bankruptcy and sued
  Wasserstein, Perella, Co. for negligence
• Interesting side note (footnote 2 of the case)
• Wasserstein, Perella, Co. get 1.8 million from
  Interco for its advice/services, however get a
  3.7 million bonus if City Capital rescinded
  their offer to buy Interco and Interco then put
  in place its own restructuring plan.