HBS Case Study : Interco 9-291-033

HBS Case Study : Interco 9-291-033

• 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
• 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)

Current Scenario

• •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

Operations

Currently has four major divisions

1. Apparel (e.g., London Fog)
2. General retail merchandising (Central Hardware)
3. Footware (Converse, Florsheim)
4. Furniture and home furnishings (Ethan Allen)

Interco's Goal

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

Concern
Interco concerned stock price may be undervalued

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

Action taken by Interco

Following 1987 crash, Interco’s 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)

Raise of new problem
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 Interco’s parts exceeds Interco’s current stock price
• Plans to sell apparel division and also sell part of footwear division, focus on home furnishing

Offer for takeover

• City Capital has accumulated 8.7% of Interco’s stock
• Ups the ante on 7/27/88: City Capital proposes a merger/takeover of Interco and offers to buy Interco’s 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 Capital’s offer.

Solution:

WACC calculation:

discount rate for Interco’s free cash flows:

10-year Treasury bond returns 9%
10-year AAA bond returns 9.5%

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 * (1+g) / (r - g)

Value of firm10 = 14*FCF10 (by assumption)

=> 14 = (1+g) / (r - g)

r = .10 => g = .027

r = .11 => g = .036

r = .12 => g = .045

r = .13 => g = .055

r = .14 => g = .064

Stock price at various discount rates

Discount rate	14 times	15 times	16 times
10.00%	$80	$84	$87
11.00%	74	77	81
12.00%	69	72	74
13.00%	64	66	69
14.00%	59	61	64

End of Interco

• •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 Interco’s 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
• 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.