Pacific Wardrobe Acquires Surferdude Apparel by a Skillful Structuring of the Acquisition Plan
Pacific Wardrobe (Pacific) is a privately owned California corporation that has annual sales of $20 million and pretax profits of $2 million. Its target market is the surfwear/sportswear segment of the apparel industry. The surfwear/sportswear market consists of two segments: cutting-edge and casual brands. The first segment includes high-margin apparel sold at higher-end retail establishments. The second segment consists of brands that sell for lower prices at retail stores such as Sears, Target, and J.C. Penney. Pacific operates primarily as a U.S. importer/distributor of mainly casual sportswear for young men and boys between 10–21 years of age. Pacific’s strategic business objectives are to triple sales and pretax profits during the next 5 years. Pacific intends to achieve these objectives by moving away from the casual sportswear market segment and more into the high-growth, high-profit cutting-edge surfer segment. Because of the rapid rate at which trends change in the apparel industry, Pacific’s management believes that it can take advantage of current trends only through a well-conceived acquisition strategy.
Pacific’s Operations and Competitive Environment
Pacific imports all of its apparel from factories in Hong Kong, Taiwan, Nepal, and Indonesia. Its customers consist of major chains and specialty stores. Most customers are lower-end retail stores. Customers include J.C. Penney, Sears, Stein Mart, Kids “R” Us, and Target. No one customer accounts for more than 20% of Pacific’s total revenue. The customers in the lower-end market are extremely cost sensitive. Customers consist of those in the 10–21 years of age range who want to wear cutting-edge surf and sport styles but who are not willing or able to pay high prices. Pacific offers an alternative to the expensive cutting-edge styles. Pacific has found a niche in the young men’s and teenage boy’s sportswear market. The firm offers similar styles as the top brand names in the surf and sport industry, such as Mossimo, Red Sand, Stussy, Quick Silver, and Gotcha, but at a lower price point. Pacific indirectly competes with these top brand names by attempting to appeal to the same customer base. Few companies compete with Pacific at its level—low-cost production of “almost” cutting-edge styles.
Pacific’s Strengths and Weaknesses
Pacific’s core strengths lie in its strong vendor support in terms of quantity, quality, service, delivery, and price/cost. Pacific’s production is also scaleable and has the potential to produce at high volumes to meet peak demand periods. Additionally, Pacific also has strong financial support from local banks and a strong management team, with an excellent track record in successfully acquiring and integrating small acquisitions. Pacific also has a good reputation for high-quality products and customer service and on-time delivery. Finally, Pacific has a low cost of goods sold when compared with the competition. Pacific’s major weakness is that it does not possess any cutting-edge/trendy labels. Furthermore, its management team lacks the ability to develop trendy brands.
Acquisition Plan
Pacific’s management objectives are to grow sales, improve profit margins, and increase its brand life cycle by acquiring a cutting-edge surfwear retailer with a trendy brand image. Pacific intends to improve its operating margins by increasing its sales of trendy clothes under the newly acquired brand name, while obtaining these clothes from its own low-cost production sources. Pacific would prefer to use its stock to complete an acquisition, because it is currently short of cash and wishes to use its borrowing capacity to fund future working capital requirements. Pacific’s target debt-to-equity ratio is 3 to 1. The firm desires a friendly takeover of an existing surfwear company to facilitate integration and avoid a potential “bidding war.” The target will be evaluated on the basis of profitability, target markets, distribution channels, geographic markets, existing inventory, market brand recognition, price range, and overall “fit” with Pacific. Pacific will locate this surfwear company by analyzing the surfwear industry; reviewing industry literature; and making discrete inquiries relative to the availability of various firms to board members, law firms, and accounting firms. Pacific would prefer an asset purchase because of the potentially favorable impact on cash flow and because it is concerned about unknown liabilities that might be assumed if it acquired the stock.
Pacific’s screening criteria for identifying potential acquisition candidates include the following:
1. Industry: Garment industry targeting young men, teens, and boys
2. Product: Cutting-edge, trendy surfwear product line
3. Size: Revenue ranging from $5 million to $10 million
4. Profit: Minimum of breakeven on operating earnings for fiscal year 1999
5. Management: Company with management expertise in brand and image building
6. Leverage: Maximum debt-to-equity ratio of 3 to 1
After a review of 14 companies, Pacific’s management determined that SurferDude best satisfied their criteria. SurferDude is a widely recognized brand in the surfer sports apparel line; it is marginally profitable, with sales of $7 million and a debt-to-equity ratio of 3 to 1. SurferDude’s current lackluster profitability reflects a significant advertising campaign undertaken during the past several years. Based on financial information provided by SurferDude, industry averages, and comparable companies, the estimated purchase price ranges from $1.5 million to $15 million. The maximum price reflects the full impact of anticipated synergy. The price range was estimated using several valuation methods.
Valuation
On a standalone basis, sales for both Pacific and SurferDude are projected to increase at a compound annual average rate of 20% during the next 5 years. SurferDude’s sales growth assumes that its advertising expenditures during the past several years created a significant brand image, thus increasing future sales and gross profit margins. Pacific’s sales growth rate reflects the recent licensing of several new apparel product lines. Consolidated sales of the combined companies are expected to grow at an annual growth rate of 25% as a result of the sales and distribution synergies created between the two companies. The discount factor was derived using different methods, such as the buildup method or the CAPM. Because this was a private company, the buildup method was utilized and then supported by the CAPM. At 12%, the specific business risk premium is assumed to be somewhat higher than the 9% historical average difference between the return on small stocks and the risk-free return as a result of the capricious nature of the highly styleconscious surfware industry. The marketability discount is assumed to be a relatively modest 20% because Pacific is acquiring a controlling interest in SurferDude. After growing at a compound annual average growth rate of 25% during the next 5 years, the sustainable long-term growth rate in SurferDude’s standalone revenue is assumed to be 8%.
The CAPM method supported the buildup method. One comparable company, Apparel Tech, had a estimated by Yahoo.Marketguide.com to be 4.74, which results in a ke of 32.07 for this comparable company. The weighted average cost of capital using a target debt-to-equity ratio of 3 to 1 for the combined companies is estimated to be 26%. The standalone values of SurferDude and Pacific assume that fixed expenses will decrease as a percentage of sales as a result of economies of scale. Pacific will outsource production through its parent’s overseas facilities, thus significantly reducing the cost of goods sold. SurferDude’s administrative expenses are expected to decrease from 25% of sales to 18% because only senior managers and the design staff will be retained. The sustainable growth rate for the terminal period for both the standalone and the consolidated models is a relatively modest 6%. Pacific believes this growth rate is reasonable considering the growth potential throughout the world. Although Pacific and SurferDude’s current market concentration resides largely in the United States, it is forecasted that the combined companies will develop a global presence, with a particular emphasis in developing markets. The value of the combined companies including synergies equals $15 million.
Developing an Initial Offer Price
Using price-to-cash flow multiples to develop an initial offer price, the target was valued on a standalone basis and a multiple of 4.51 for a comparable publicly held company called Stage II Apparel Corp. The standalone valuation, excluding synergies, of SurferDude ranges from $621,000 to $2,263,000.
Negotiating Strategy
Pacific expects to initially offer $2.25 million and close at $3.0 million. Pacific’s management believes that SurferDude can be purchased at a modest price when compared with anticipated synergy because an all-stock transaction would give SurferDude’s management ownership of between 25% and 30% of the combined companies.
Integration
A transition team consisting of two Pacific and two SurferDude managers will be given full responsibility for consolidating the businesses following closing. A senior Pacific manager will direct the integration team. Once an agreement of purchase and sale has been signed, the team’s initial responsibilitieswill beto first contact andinform employees and customers of SurferDude that operations will continue as normal until the close of the transaction. As an inducement to remain through closing, Pacific intends to offer severance packages for those SurferDude employees who will be terminated following the consolidation of the two businesses. Source: Adapted from Contino, Maria, Domenic Costa, Larui Deyhimy, and Jenny Hu, Loyola, Marymount University, MBAF 624, Los Angeles, CA, Fall 1999.
Case Study Discussion Questions
1. What were the key assumptions implicit in Pacific Wardrobe’s acquisition plan, with respect to the market, valuation, and integration effort? Comment on the realism of these assumptions.
2. Discuss some of the challenges that Pacific Wardrobe is likely to experience during due diligence.
3. Identify alternative deal structures Pacific Wardrobe might have employed in order to complete the transaction. Discuss why these might have been superior or inferior to the one actually chosen.