Case Study Question




Not all cases mentioned below will be covered. In Spring 2012, we will discuss 13 business cases. Check Class Schedule to see which ones will be covered.
  • For each case I've created a set of study questions, which can help you FRAME and THINK about issues relevant to the case.
    • These are questions that I believe a real world investor would ponder on when analyzing a business or business situation.
    • In Wall-Street-speak, these are the "due-diligence" or "kicking the tires" questions.
    • Disclaimer: the questions serve as the basis for class discussion and are not intended to serve as endorsements or illustrations of effective or ineffective management. Put in a different way, corporate IR and legal please go away.
  • Clicking on the  symbol will lead you to a company's Wikinvest page, where you can find more recent info about the company.
    • Your primary job is to get the class thinking, and to give them the relevant information they may need.
    • These are not exam or assignment questions for you.
      • They are there to help you.
        • Coming up with the right question is much more difficult than answering it.
      • You don't need to answer all of the questions during your presentation.
      • You won't have enough time to.
    • Sometimes you won't be able to provide a definite answer at all. 
      • It is fine to make "one the one hand.. on the other hand.." type of arguments.
      • There are no CORRECT or RIGHT answers, only sensible arguments.
    • Learn to deal with imperfect and incomplete information.


A-Rod: Signing the best player in baseball 

  • The owners of Texas Rangers are shrewd businessmen, and they make financial decisions not baseball fan decisions.
    • George W. Bush invested $800k in the Rangers in 1989 and sold his stake for $15 million in 1998 - an IRR of 38%!
  • How does a super star affect a team's business and finance? 
    • More or less so in baseball vs. other professional sports?
  • What will Rodriguez bring to the team?
    • How risky is a bet on a young player?
    • How many extra tickets do you expect the Rangers to be able to sell each year if they sign A-Rod?
    • What is the change in the probability of the Rangers entering the World Series?
    • Will the franchise be worth more permanently even after A-Rod eventually leaves?
  • The contract proposed was $252 million over 10 years. That was what you read on newspaper headlines.
    • What is the real present value though?
    • Rangers need a shortstop anyway, which costs about $3 million/year.
  • The A-Rod effect:
    • We expect A-Rod to add 8 wins a season for the Rangers.
      • How many additional fans can one win bring?
        • How much revenue does one fan generate?
      • Improved chance of reaching ALCS and World Series?
        • Additional revenues?
      • Additional broadcast revenue?
      • Additional sponsorship?
      • Increased franchise value even after A-Rod leaves/retires?
        • Think Cleveland Cavaliers after LeBron James.
        • Cavalier value increased more than $220 million from 2003 to 2009.
  • Epilogue
    • Subsequently Alex Rodriguez performed much better than expected. 
    • However, Rangers' win record didn't improve.
    • Attendance was reduced by half a million.
    • Would you have bid less for A-Rod in 2000 if you were the Texas Rangers' manager?
      • Without A-Rod, Rangers would probably have performed even worse.


Tottenham Hotspur F.C. (LON: TTNM

  • Tottenham Hotspur is worth more than $400 million at the time.
  • How does a professional sports club make money?
    • Ticket sales account for less than 20% of revenues.
  • How does a better player and a larger stadium affect a soccer club's revenues, costs, and profits? 
    • Why is Manchester United and Arsenal worth more in the stock market?
      • Past 10 years data suggest that for every 1% increase in a team's season point total, revenues improve by 1.52%.
    • Three scenarios:
      • Adding a new player
      • Adding a stadium
      • Adding both a new player and a stadium
    • Is a larger stadium substitute or complement for a great player?
      • What is "synergy gain"? (You probably hear this term very frequently in financial news.)
  • Learn how to read financial statements.
    • Understand EBITDA, Depreciation, Amortization, EBIT.
    • After reading the financial statements in Exhibit 5, can you understand how Tottenham Hotspur make money?
    • Is running a soccer club any different from running Nike, General Motors, or IBM?
    • Accountant-speak
      • Players are called Intangible Fixed Assets! 
        • They are worth more than the stadium.
        • When you believe they are worth less now than when you bought them, you say "our intangible assets have been impaired"
        • When you sell/trade the players to other teams for less, you say "we realize losses on the disposal of intangible assets"
    • Why can Spartan Football Team make $27 million profit on $44 million annual revenues (a 61% net income margin!)?
      • Players are not paid market salary.
      • MSU doesn't need to pay any taxes (save 40%!).
      • Just for your information, Wolverines' net income margin is 71%, higher than ours.
  • How do we value a soccer club?
    • Free Cash Flow:
      • The club generates profits from customers (tickets, sponsorship, media contracts): EBITDA.
        • However, not all revenues are received immediately. 
        • Corporate sponsors or media companies may pay you later and Accounts Receivables are created.
      • The clubs need to spend money to keep the business running and growing: 
        • Capital expenditure (e.g., building a new stadium), stocking more inventories as sales grow, etc.
      • We state that the club has a positive Free Cash Flow if what it receives is greater than what it pays out.
      • "Free" means they can be returned to shareholders without affecting the normal operations of the business.
        • Are the proceeds from selling your home stadium "free cash flows"?
    • Discount rate
      • Why is money (and cash flow) in the future worth less in the present?
      • To compensate for your bearing the risks, how much do you expect to earn each year for investing $1 in Tottenham Hotspur (assuming that you are not emotionally attached to the club)?
    • Enterprise Value (EV)
      • The present value of future free cash flows discounted to present.
    • Shareholder Value: 
      • Deducting from EV what the company owes the debt holders, and adding back excess cash holdings (i.e. cash that the business doesn't need).
      • Share price: dividing shareholder value by the number of shares outstanding!
  • We can value any companies with the above method!


Crocs, Inc. (NASDAQ: CROX

  • Crocs's gross profit margins in 2006, 2007, 2008, 2009, were 57%, 59%, 32%, and 47%, respectively?
    • Why can Crocs mark up the price of a pair of plastics sandals by more than 100% of manufacturing costs? 
      • Nike manages to do that too, but on a larger scale: on 30 times the revenues of Crocs.
    • Can Crocs charge a premium price for ever?
    • Why has Crocs been losing money in the past several years despite decently high gross margins?
      • What are the costs of maintaining a premium brand?
  • How broad an appeal does Crocs have? 
    • How many pairs of sandals can Crocs expect to sell each year? 
      • Would everyone with a pair of Nike also buy a pair of Crocs? 
    • Is global warming good or bad news for Crocs?
      • Why does Crocs usually lose money in the 4th quarter (winter!)?
      • Why are the sales of Deckers Outdoors (the owner of TEVA sandal brand) less seasonal?
        • It owns the UGG (boot) brand as well, which is popular during the winter seasons.
      • How is Crocs trying to improve sales in winter. Answers: Blitzen, Boots....
  • Is Crocs selling functional footwear or is it selling a fashion brand and an image?
    • Is it just a fad? Is it just a novelty? Is it a premium brand?
    • Would you compare Crocs to established companies such as Nike, Under Armour?
    • In late 2009, Crocs changed marketing direction away from fashion and towards comfort, believing that their long-term prospects would be best served by appealing to workers who spend a lot of time on their feet.
  • Putting it all together:
    • How should we forecast Crocs's future revenue growth based on what we believe Crocs really is?
    • Why are profit margin and revenue growth the two most important value drivers for the business?
    • Why will additional growth add to Crocs stock price only if it can maintain a reasonable profit margin?
    • In the class I am going to teach you the importance of "sensitivity analysis".
  • Epilogue (please don't use this hindsight when discussing the questions above)
    • Since the 36% decline, CROX continued to fall and became almost worthless as the economic recession deepened.
    • However, if you invested in CROX in early 2009, your investment would have increased 14 times by now.
    • Would you want to get into CROX now?
  • Trivial facts:

Nike, Inc. (NYSE: NKE

You also need to read Chapter 13 of Ross, Westerfield, Jaffe's Corporate Finance textbook (included in the course pack)
  • Companies don't pay interests on equity capital. 
    • Then why does equity capital has a cost?
    • What does the "cost of equity" mean?
  • How do we estimate a business's cost of capital?
  • Is selling apparel riskier than selling footwear? 
    • How often do you need new (athletic) shoes and how often do you need new clothes?
      • "Recurring revenues" are safer for Nike.
    • How does it impact Nike's cost of capital if as management states Nike will add new lines of mid-priced shoes?
    • Is the mid-priced segment more or less risky than the high-end footwear market?
  • Is it realistic for the management to expect long-term revenue growth of  8% to 10% and earnings growth of above 15%?
  • Will risks also increase if Nike increases sales growth?
  • Is selling footwear in emerging markets riskier than selling footwear in the US?
    • Will Nike's cost of capital increase over time as it expands internationally?
  • Is cost of capital a precise value or a range of educated guesses?
    • I will teach you a Wall Street jargon that will make you sound very professional: "triangulate." 

Netflix,Inc. (NASDAQ: NFLX)  

  • How does Netflix's business model differ from traditional video rental stores? 
    • Is it more or less costly to have physical store presence? 
    • What have happened to Netflix's brick-and-mortar competitors since the start of Netflix?
      • Movie Gallery was liquidated in 2010 and Blockbuster filed for bankruptcy protection later that year.
    • Who are Netflix's new competitors?
  • Learn some important metrics in the media industry
    • Subscriber Acquisition Cost (SAC)
    • Average Revenue Per User (ARPU)
    • Attrition Rate
    • What are your best guesses on these metrics for Facebook.com?
      • Do you think Facebook is worth $50 billion (the latest valuation after Goldman Sachs' recent investment)?
        • Facebook has 500 million active users. A $50 billion valuation means one active user is worth $100 dollars for Facebook shareholders.
        • They are willing to pay you up to  $100 (i.e. subscriber acquisition cost) just for registering or staying active (i.e. lower attrition rate)!
        • So that later they can fleece you by charging you for everything (i.e. higher ARPU).
  • How does Netflix make money with "unlimited" plans? 
    • Think: how does all-you-can-eat buffet diners make money? how does membership gyms (health clubs) make money?
      • No one is able to eat a tone of food even if it is "all you can eat", and few people can occupy a treadmill for 24 hours non-stop.
    •  Is Netflix business risk more like that of a buffet diner or a gym?
      • Think: many people pay the gym membership but never go.
  • Netflix collects subscription fees from customers before paying suppliers, hence financing part of its operations for free. 
    • How does it affect the value of Netflix?
    • Can you think of any other businesses that enjoy this advantage? 

Jetblue Airways (NASDAQ: JBLU)  

  • What are JetBlue's main selling points and advantages over other airlines? 
    • Why can't its competitors imitate? Or can they?
  • Which airlines are most comparable to JetBlue?
    • Delta Airlines? Southwest Airlines? Ryanair?
    • Is it appropriate to assume that JetBlue will enjoy the same growth prospect and valuation as Southwest Airlines, the most successful low-fare airline?
    • Learn the Wall Street jargon: comparable (or just "comp").
  • Know the jargons: bake-off, quiet period, letter of intent, prospectus, comfort letter, due dilligence, book-building, red herring, road show, tombstone ads
    • I will ask you in class.
  • What are the benefits of underpricing an IPO? 
    • Benefits to whom? 
      • As the shares were 30 times over-subscribed, only less than 5% of demand was filled.
      • However, demand from "friends and family of Jetblue management and employee" were 96% filled, at the IPO price.
      • Legal? Ethical? 
    • Was JBLU underpriced at all at IPO?
      • JBLU share price doubled in the first two years, but was traded at half the IPO price by the end of 2007.
Videos of JetBlue CFO explaining the pricing of IPO can be found here.

Harley-Davidson (NYSE: HOG)  

  • Why can Harley-Davidson (H-D) sell its motorcycles at much higher profit margins than its competitors? 
    • How wide is H-D's "economic moats"? 
      • Warren Buffett: I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will."
      • H-D almost went bankrupt in the 1970s after its production quality plummeted.
    • What is the value of an unique brand? 
      • Is H-D selling an image?
      • Why did H-D's finally cease to produce light weight motorcycles bearing the Harley-Davidson badge?
    • Between revenue growth and profitability which one would H-D try to protect first?
  • Is the luxury goods sector more or less affected by an economic downturn? 
    • Who buy Harleys? Who buy heavy-weight motorcycles?
      • Married males in their mid to late forties with a household income of about $84k.
    • Are they more or less affected by an economic downturn?
    • When the economy eventually comes back from a recession, will everything get back to normal? 
      • What is the normal sales level for H-D?
      • Understand what drove the increase in demand before the recession.
        • Cheap credit provided by HDFS (Harley-Davidson Financial Services)?
          • Such demand is unlikely to come back.
    • How would you incorporate economic forecasts into your company-level valuation model?
  • Forecast the long-term demand growth of H-D.
    • Learn the Wall Street jargon: "secular growth" vs. "cyclical growth".
    • Why is growth so important for H-D?
    • Previous owners account for half of all motorcycles sold.
    • "New rich" outside the traditional North American, European, and Japanese markets.
    • Police patrol market.
  • What does H-D share in common with the auto makers (GM, Ford, Chrysler)?
    • Unionization, labor strike..
    • High fixed costs: need about $1 billion to run the company regardless of sales level.
    • Heavily financing vehicles sales with consumer credits
  • Since the valuation was done in April 2008, Harley-Davidson stock has fallen 80% as of February 2009. 
    • If you bought H-D shares in April 2008, how would this affect your conviction about the trade?
    • If you shorted H-D shares in April 2008, would you consider yourselves a stock market genius? 

Spyder Active Sports 

  • The business: 
    • Should Spyder focus on a high-end niche market or sell to a broader range of people by adding lower-priced brands?
    • How did Spyder, a "sleepy little company" in 1997,  increase its annual revenues by six times to $60 million in 2004? 
      • The investments taken (e.g. marketing events, athletic endorsements, department store promotion, IT upgrades, etc)  were certainly expensive. 
        • Were they worth it?
  • Relative valuation: How much was a typical sportswear company worth in 2004? 
    • What were the typical EV/Sales and EV/EBITDA multiples?
    • Were the market conditions getting more favorable (vs. several years ago)?
  • The motives for selling the company.
    • Why did CHB Capital want to sell the company? 
    • Why did David Jacobs want to sell?
  • How will Jacobs' decision whether to sell his stakes affect CHB?
    • Note that, if both CHB (owning 37.9%) and Jacob (25.4%) sells their stakes, the new owner can have majority control of the company.
    • Investors usually are willing to pay more for being able to control a company.
  • What were the exit options for the owners?
    • Why was an IPO not practical?
    • What were the benefits and costs of selling to a strategic investor (e.g. VF Corporation) vs. a financial investor (e.g. Apax Partners)?
      • Noting Spyder's seasonal pattern in revenues, do you think Spyder would be an attractive acquisition target for Quiksilver (surfwear) or Crocs (sandals) ? Why?
    • What other non-financial considerations Jacob may have when choosing buyers?
      • Will the new owners continue to employ Jacobs and his two sons (Jake and Bill)?


Dell, Inc. (NASDAQ: DELL)  

Read both "Dell's Working Capital" and the May 2009 interview with Michael Dell. 
  • You may also want to review what you've learnt (and probably have forgotten by now) in SCM 303 and MKT 300.
  • Accounting skills: 
    • Learn how to calculate DSI, DSO, DPO, and CCC (Exhibit 2 of "Dell's Working Capital").
    • Calculate the financial ratios in Exhibit 5 of "Valuing Virtual Integration at Dell Computer".
  • What are the benefits and costs of a "build-to-order" direct sales business model? 
    • How does Dell make money with such a low profit margin (about 5% of sales, before tax)?
    • How did Dell benefit from the following two situations?
      • In 1995, Intel introduced the new and faster Pentium 120MHz processor.
      • In early 1996, computer component prices dropped 20% in one quarter, and as much as 10% in one month.
  • Why did Dell in 1990 start to sell computers again in traditional retail channels (e.g. CompUSA, Costco)? 
    • What did Dell achieve and what were the problems?
  • What did Dell do in 1993 to create a comeback from losses? 
    • How should we balance between growth and profitability? What are the trade-offs between the two?
  • How does Dell pick and choose which market segments (e.g. consumer desktop, enterprise server) to enter? 
    • Why is the ROIC of a business line so important a metric for a CEO to watch?
    • In 1995 the top computer manufacturers were IBM, CompaqPackard Bell, and Apple.
      • Where are they today?
        • Compaq sold out to Hewlett-Packard (2002), IBM to Lenovo (2005), , and Packard Bell to Acer (2008).
        • Apple has become mainly a mobile phone and MP3 player manufacturer.
      • Do you consider them as failures in the PC market?
        • The PC market has always been cut-throat competitive.
        • Smart people pursue investment returns not market share.
      • Is Dell today just a consumer PC manufacturer? 
  • Why does Dell want to know its customers' future demand as precisely as possible? 
    • Why is it so important for finance?
    • Should it concern only the supply chain management guys?

Amazon, Inc. (NASDAQ: AMZN)  

  • You may want to review the IPO jargons you've learnt in the JetBlue IPO case.
  • Why did Jeff Bezos move from New York to Seattle to start the company? 
    • What was special about Seattle?
  • How does Amazon's business model and financing model differ from Borders and Barnes & Noble?
  • How does the famous "Long Tail" business model benefit Amazon in selling books online?
    • How does the "product recommendation" feature of Amazon.com work?
    • Also think about Netflix and Pandora Radio's recommendation systems.
  • With information available in 1997, how large a business would you have expected Amazon to become? 
    • The global book market size was about $82 billion in 1997.
    • Amazon's revenues in the latest 12 months ended 12/31/2010 were $34.2 billion, vs. $15.7 million in 1996. 
    • Were investors back in 1997 too optimistic or too pessimistic?
  • Amazon was not profitable until 2002. 
    • How could a money-losing online bookseller with a revenue of $148 million be valued at $538 million at IPO?
    • Amazon was said to be in a class of ventures that have bi-modal outcomes: the company will either fail or it will grow really big.
      • Why can't it stay as a small and viable company?
  • Why did Jeff Bezos hire Joy Covey? What expertises did Covey bring to Amazon?
  • The fortunes of the three major book sellers have gone very different paths since 1997. 
    • Amazon's stock value has increased 10,000% since, while Borders has filed for bankruptcy protections recently.
    • What would you have done differently if you were CEO of Borders in 1997 and had the crystal ball to see the future?

Tiffany & Co. (NYSE: TIF)  

  • Why is the Tiffany brand valuable? 
    • Why is a diamond ring worth more in a Tiffany blue box? 
    • Why can Tiffany mark up the prices of jewelry by 100% from costs, while Blue Nile only 25%? and customers willingly paying?
  • Name five luxury retailers you know (e.g. Coach Inc.). Check their gross margins and operating margins. 
    • Do you think they are charging extorting prices? 
    • Coach e.g., marks up their hand bags by nearly 300% of costs.
  • Get the latest financial data of Tiffany from Google Finance. 
    • Is Tiffany more profitable today than two decades ago? 
    • What has contributed to the changes in ROIC? 
      • More or less efficient inventory management? 
      • Higher or lower profit margin? 
      • The increasing affluence of the rich in America? 
  • Why did Tiffany want to do an IPO after the 1986 Christmas season and not before?
  • Do you think investment banks deserve the 7% cut (known as "gross spread") they can usually earn from underwriting IPOs?
  • How do investment banks "stabilize" stock prices during IPOs? What is a "Green Shoe" provision?
  • Tiffany's stock price fell more than 40% after the Black Money stock market crash of 1987. 
    • If you were there, would you have bought Tiffany stocks at a "bargain" price? 
      • Why (or why not)? 
      • Had you bought Tiffany stocks in November 1987, you would have made a 100% return within one year. 
    • Why is Tiffany's value more affected by the general stock market conditions?
      • Would investors require higher returns for investing in businesses like Tiffany?
  • The same opportunity was presented to you again during the recent global financial crisis, when Tiffany stock again fell by more than 40%. 
    • What would you have done differently this time knowing that you had missed the opportunity in 1987?

Radio One (NASDAQ: ROIAK)  

  • What market is Radio One serving? 
    • Why is this market financially attractive?
  • Why has advertising on radios remained popular while other traditional media (e.g. print newspapers) have been losing market share?
  • How will online radio stations such as Pandora Radio and Last.fm affect traditional radio stations?
  • What is BCF? Why are the BCF multiples (e.g. Enterprise Value/BCF) good measures of radio station valuation? 
    • Why does Radio One has much higher BCF multiples than its competitors, except the Hispanic radio stations?
  • Why is an independent local station worth more in the hands of Radio One? 
    • Cost synergies? Revenue synergies?
    • What measures do you expect Radio One to take to turn around poorly-performing stations it acquires?
  • Radio One eventually paid $1.4 billion for the new stations.
    • Was it a reasonable price?
    • Radio One's revenues have been declining in the past several years. 
      • From hindsight, was Radio One too optimistic and did it overpay for the stations?
      • Is hindsight relevant?

Coke (NYSE:KO
 
vs. Pepsi (NYSE: PEP)  

  • What are the main products of PepsiCo, Inc.? 
    • Is PepsiCo just a Cola company?
    • Is it a potato chip company?
    • What company is it?
  • Why doesn't Coke want to be just a Cola company (i.e. Carbonated Soft Drink, CSD)? 
    • In terms of market potentials, what do CSDs share in common with tobaccos?
    • Why is Gatorade so important in the Cola Wars?
    • In Michigan, soft drinks are called "pop". What does the rest of the nation call soft drinks?
  • EVA (Economic Value Added) = (ROIC - WACC) * Invested Capital. 
    • What is EVA measuring?
    • Why is it important for making investment/divestment decisions?
    • Why did PepsiCo sell off its restaurant businesses ( KFC, TacoBell, and Pizza Hut) in 1997?
    • If interested, can read an essay (PDF file) by Damodaran comparing the differences between ROIC, ROC, and ROE.
  • What do "bottlers" do?
    • What are the differences between The Coca-Cola Company (NYSE: KO) and the Coca-Cola Enterprises (NYSE: CCE)?
    • Why do bottlers usually operate independently from the Cola companies, which focus on marketing and producing syrup concentrate?
    • Why do you think did Pepsi decide in 2010 to buy back and to operate again its two largest bottlers (The Pepsi Bottling Group and PepsiAmericas)?
  • Everyone knows Coca-Cola and Pepsi. Why are they still spending so much money in marketing?
    • Coke and Pepsi is able to mark up the prices of their products (i.e. syrup concentrate) a lot. Why?
    • How do they manage to sell purified tap water (Aquafina and Dasani) to us for $1/bottle?


Correction Corp of America (NYSE: CXW)  

  • Why are prisons a "growth business"?
  • Compare the private prison and the hospitality industries
    • Is the skill set of a graduate from our School of Hospitality Business useful for running a private prison?
    • What do the two industries share in common?
      • Operating metrics to watch: Number of beds available. Occupancy rate. Price per night, etc.
    • From an investor's perspective, what are the major differences between these two industries?
  • Operating margins are higher in "owned and managed" facilities vs. "managed-only" facilities
    • Why doesn't CXW exit the "managed-only" business?
    • Are the "owned and managed" facilities really more profitable in terms of ROIC?
      • Decompose CXW's ROIC using the "Modern DuPont Identity" you learnt previously.
      • From an investor's perspective, how do we trade off operating margin against capital investment needs?
  • What are the risks of investing in new facilities?
    • A hotel building can be converted into an apartment building.
      • Can you convert a prison complex into a resort?
    • Do you want a prison or a resort built near your neighborhood?
  • Does CXW perform better during economic booms or economic downturns?
    • Do you think the current dire fiscal situations in many states will have positive or negative impacts on CXW?
    • How does CXW's cyclicality affect its cost of capital?
  • What benefits does being the #1 player in the industry bring to CXW? 
  • Suppose you were the portfolio manager of MSU foundation managing the university endowments. 
    • Given the controversial nature of privatized prison business, should you avoid CXW even if you find it an attractive investment financially?


J.Crew Group (NYSE: JCG)  

Economics of the Fashion Industry
  • What's the SPA (Specialty store retailer of Private-label Apparel) business model?
    • What's the pros and cons of this business model? 
      • Compared with department stores and with catalog business, respectively.
      • Is Tiffany & Co an SPA?
    • What is the multi-channel business model?
  • The key to understanding an industry (or at least appearing to be an expert)
    • Learn some jargons: design-to-adoption ratio, UPT (unit per transaction), SKU (stock keeping unit), chief merchant, chief designer...
  • Why is the business seasonal? 
    • What are the most important months for the company?
  • How can J.Crew increase EBITDA? 
    • The answer: opening more stores, generating more revenues per store, and improving profit margin; see Table A.
    • How much did it cost to open a new store?
    • What other metrics (e.g store traffic) is J.Crew monitoring closely? How?
    • Why is EBITDA important for valuing retail businesses?
    • Why is revenue per square foot a good measure of performance in the retail industry? 
      • Why is this metric usually higher in Banana Republic stores than in Old Navy stores?
      • (Both brands are owned by GAP)
TPG's investments and attempts to turn around the company
  • What is an LBO?
  • Why did Arthur Cinadar want to sell the company to his daughter Emily Woods? 
    • Why didn't he just give the business to her?
  • Why didn't Emily Woods want to be the CEO?
  • TPG set the revenue target to be $1.3 billion by 2001. It turned out that J.Crew achieved this only in 2008 -- seven years late.
    • Why didn't things evolve as planned? 
      • Should TPG have expected the risks? Did they?
    • What are the unique risks of operating in the fashion industry?
    • What happened to the US economy  in 2000 and 2001? 
      • Why was the general economic enviroment important for consumer retail businesses?
    • Why did J.Crew halt its rapid expansion plan in 2001 and start to cut costs?
      • Do you think they could "cost-cut" their way out of the problems?
    • What were TPG's options after failing to turn around J.Crew?
  • Why are  David BondermanJames Coutler, and William Price III perfect partners in TPG? 
    • Among the three, whom do you think you are most likely to become in 25 years? 
  • Do you think that every one of the partners should have veto power in investment decisions? 
    • Do you think every partner should get equal share in profits?
Epilogue
  • TPG decided to hold onto its stake and didn't sell J.Crew to American Eagle Outfitters (AEO). 
    • J.Crew finally did an IPO in 2006 valuing the business at >$1.7 billion, more than 3  times what AEO offered for it in 2002. 
      • Did TPG make a right decision for not accepting AEO's offer? 
      • What were the main drivers for the value appreciation?
    • Today J.Crew is worth as much as AEO. 
      • Should AEO regret for not offering a higher price in 2002 and buying out a potential competitor?
    • Are there so called RIGHT decisions, without hindsight? 
      • What risks had TPG taken between 2002 and 2006?
  •  In November 2010, TPG (partnered with Leonard Green) decided to take J.Crew private again for nearly $3 billion
    • J.Crew shareholders approved the deal on March 1, 2011. 
    • Why does TPG believe that J.Crew's value is again under-appreciated by the market. 
    • What can Leonard Green & Partners bring to the table?
    • What risks is TPG taking this time?

Warner Music Group (NYSE: WMG)  

  • Learn from Exhibit 5 on how to create Powerpoint slides that communicate effectively and look professional.
    • Waterfall Charts: page 19, 24
      • On page 19, would you learn faster reading the chart or the data table?
    • Column Charts: page 14, 16, 20
    • Stack Charts: page 15, 16, 17
  • How much is 97.5 Now-FM required to pay Lady Gaga each time her songs is played?
    • Does she get paid as a performer for songs not written by herself?
    • Learn some background about the royalties system in the music industry.
    • What is a record label? What are the relations between record labels and artists?
    • How are songwriters and performing artists compensated for their work?
  • Traditionally, how does Warner Music Group (WMG) and any other major record labels make money? 
    • What are the major differences between the recorded music business and the music publishing business? 
    • Which of the two business segments is more profitable? Why?
    • What is the best-selling album of all time in the U.S.?
    • How much money does WMG collect each year for the song "Happy Birthday to You"?
  • What is the future of the music industry in the digital age and amidst rampant piracy on Internet?
    • Music industry revenues peaked in 1999 (when you were about 10 years old)
    • Read the Fast Company article "Take Us to the River"
      • What new sources of revenues are music labels pursuing?
      • Why did Goldman Sachs analyst Ingrid Chung call the digital-based revenues "river of nickels"?
    • Are live event promoters such as Live Nation threatening the home turf of the music labels?
      • Live Nation has signed Jay-Z, Madonna, U2, Robbie Williams, etc
  • Why did AOL Time Warner want to sell off its Warner Music division? 
    • What else did it want to sell?
  • Check exhibit 5. What were the main cost saving initiatives planned by THLP? 
    • What do you think would be the unintended negative consequences of cost cutting ?
  •  Why did THLP want to bring in Edgar Bronfman Jr., Providence Equity Partners and Bain Capital, as partners? 
    • THLP had enough money to do it itself. Why did it need partners?
  • Epilogue and ongoing events
    • Just one year later, In 2005, THLP brought the company public
      • Raised $500 million, mostly paid out to the private equity consortium
      • Valued the firm at $4.6 billion including net debt
    • In 2011, WMG hired Goldman Sachs as financial advisor to seek for buyers for part or the whole of the company
      • Several potential suitors have emerged, including KKR-Bertelsmann, Sony/ATV, Len Blavatnik
      • What do you think would be the most likely outcome?

Microsoft (NASDAQ: MSFT
 acquisition of Intuit (NASDAQ: INTU

  • Why pay $1.5 billion (a 100% premium) for a business with less than $200 million in annual revenues and less than $10 million in net incomes?
  • How did Microsoft eliminate the once market leaders WordPerfect (word processor) and Lotus 1-2-3 (spreadsheet software)? 
    • Many of you probably haven't heard of their names at all.
    • Have you ever heard of Prodigy, Compuserve, and American On Line? 
      • Where are they now?
  • Why didn't Microsoft develop a competing product to beat the then tiny Intuit?
  • The buyout offer made my Microsoft eventually fell through because of the Justice Department's anti-trust scrutiny. 
    • Today Intuit has become the Microsoft of its niche markets, with annual revenues of above $3.5 billion, net incomes of above $500 million, and a market cap of above $16 billion. 
      • Quicken has 80% of personal finance software market (vs. Microsoft Money's 20%).
      • QuickBooks has 95% of small business accounting software market.
      • Turbo Tax is the #1 DIY tax reporting software.
    • From hindsight, do you think Microsoft's $1.5 billion offer back in 1994 was a reasonable price to pay to eliminate a potential powerful competitor?
  • One of the richest MSU alumni sold his business to Intuit for $532 million in December 1999, three months before the Dot-Com bubble crashed.
    • Just 30 months later, he bought the business back for $64 million.
    • What's his name? What can you learn from him?
Wiki: Intuit, TurboTax, WordPerfect, Lotus 1-2-3, Prodigy, Compuserve, Scott Cook, Dan Gilbert

Toys "R" Us 

  • What is a Category Killer? What is a Big Box store?
  • What is "age compression"? Why are video games a threat to Toys "R" Us? 
    • Why are the Babies "R" Us division much more profitable than the Toys "R" Us division?
  • Why are mass/discount stores (e.g. Wal-Mart) threats to Toys "R" Us?
    • Why is Toys "R" Us's international division much more profitable?
  • What is "comparable-store sales" (aka same-store sales, SSS)? 
    • Why is it an important performance measure in the retail industry?
  • Why did Toys "R" Us hire Amazon.com (and later GSI Commerce) to run its online e-commerce operations?
    • Should they do it in-house instead?
  • Why was the private equity consortium willing to pay a 120% premium to acquire Toys "R" Us? 
    • How do you think could they make money out of such an expensive deal?
    • How would the company's significant real estate holdings come into play the valuation?
      • The advantages and the disadvantages of owning a large real estate portfolio?
      • Do they provide downside protections?
  • What are the advantages of the Toys "R" Us Express store format?
  • Why did private equity firm KKR need the help of Bain Capital and Vornado Realty Trust?
  • Supposed you were the portfolio manager of MSU endowments. 
    • If you knew that the LBO would create shareholders by laying off 30% of workers before Christmas, would you participate in the deal?

Dollar General (NYSE: DG)  

  • Read Chapter 16 of the "Corporate Finance" textbook (included in the course pack)
    • Understand the main benefits and costs of high debt leverage used in leveraged buyouts (LBOs)
    • Why are LBOs more commonly used for acquiring businesses operating in mature industries generating stable and predictable cash flows and having significant tangible assets that could be used as collateral?
      • For examples, Warner Music, Dollar General, Toys "R" Us
    • Why are LBOs rarely used for technology firms such as Seagate (the subject of the next case study)?
    • How can we determine the optimal capital structure of a business to trade off the tax and agency benefits of debt against expected costs of financial distress?
  • Recent events in the deep-discount retail sector:
  • Use "common-size" statements (as in Exhibit 7) to compare the financial ratios of Dollar General (DG) vs. Wal-Mart
    • Financial data for Wal-Mart are not provided in the case material. Obtain them from your financial sites of choice
    • Can you use the financial ratios to say something about the differences between the two companies'  business models?
    • How does DG make money under the shadow of "Everyday Low Price" Walmart?
      • How does DG achieve higher gross margins than Walmart by selling most items for under $10?
      • Is DG competing against big-box discounters such as Walmart and Target?
      • Is DG competing against drug chains (Walgreens, CVS) and convenience stores (7-Eleven, gas stations)?
  • In November 2009, DG was listed on NYSE again after KKR sold off some of its stake in an IPO. 
    • DG's valuation has improved by 50% during this two year in spite of he economic recession. 
    • What have contributed to DG's increased value?
      • Higher revenues? Higher profit margin? More efficient inventory management?
  • Use the most recent fiscal year data to calculate EV/EBITDA ratios of the five deep-discount chains mentioned in the case material (DG, FDO, FRED, DLTR, NDN)
    • Which stock provides the most attractive value in terms of EV/EBITDA?
    • Is it always more attractive to purchase a stock with the lowest EV/EBITDA?
  • Who are DG's target customers? 
  • Why did DG abandon the "packaway" model in 2006 in favor of inventory markdown?
    • What is the "packaway" model? 
    • DG had to write off some inventories due to this transition. 
      • Thanks to "special items" like this, reported EBITDA  was much lower in 2006.
      • Should we consider inventory markdowns a transitory one-off cost or persistent costs?
      • How should we adjust DG's reported income statements to better reflect economic reality?
  • DG planned to close 400 stores in 2007 and open 300 new stores. 
    • Why not just close 100 stores and open no new stores? 
  • Among DG's competitors, Dollar Tree Stores (DLTR)'s stock price has appreciated by 150% since 2007 while Fred's, Inc.(FRED)'s stock has barely moved.
    • What have driven DLTR's superior stock market performance and FRED's terrible one in the past several years?
    • Is now a good time to buy DLTR or FRED? Why?

Seagate Technology (NASDAQ: STX

  • Get yourself familiar with some of the recent events in the hard-disk drive (HDD) industry
    • TPG in talks to buy Seagate (STX) for $7.5 billion (October 15, 2010)
      • The talk failed because TPG couldn't convince Silver Lake, Bain Capital, or KKR to join.
    • Seagate said to have rejected a bid from Western Digital (December 2, 2010)
      • WDC made a higher offer but the talk ended because of concerns about objections from government anti-trust authorities.
    • Western Digital (WDC) purchased Hitachi's HDD unit for $4.3 billion (March 7, 2011)
      • Hitachi purchased the unit from IBM for $2.1 billion in 2003
        • The unit posted five consecutive annual operating annual losses until 2008
      • The new WDC would took away STX's #1 market leader position.
        • The new WDC would produce twice the numbers of HDDs than STX does.
          • What are the benefits of being the #1 market leader?
        • WDC would solidify its leadership position in the notebook HDD market and also become a serious contender in the enterprise HDD market
          • Why is the enterprise market more profitable than the consumer desktop market?
          • Why is the mobile (e.g. notebook) market more profitable than the desktop market? 
      • STX's stock jumped +9% upon the WDC-Hitachi announcement.
        • Why would losing the #1 position be good news for STX?
  • In 1997, about 80% of Seagate's employees were located in Asia (China, Malaysia, Singapore, Thailand)
    • How would exchange rate fluctuations affect Seagate's profitability?
    • How can Seagate hedge against currency risks?
  • Seagate was the only one vertically-integrated HDD maker
    • Seagate developed technologies in-house, manufactured most of the key components itself, and then assembled them into HDDs.
      • All the other HDD makers (e.g. Quantum, Western Digital, Maxtor) outsourced the manufacture of hardware to contract manufacturers, and didn't need to invest as much in R&D or  PP&E.
      • In Exhibit 3, can we compare the profitability of HDD makers based on their gross margin numbers? Why not?
    • What are the pros and cons of vertical integration?
      • e.g., Most auto makers focus on design and marketing, and rely on third-part auto parts suppliers for most components.
  • The market value of Seagate's VERITAS stake had come to substantially exceed Seagate's entire market cap. 
    • How could this be? Did the market consider the value of STX's HDD business as negative?
  • Why are LBOs (Leveraged Buyouts) less suitable for technology companies?
    • Why is financial distress particularly costly for an HDD manufacturer?
    • In Table A you can find a list of 7 of the largest HDD makers in 1999
      • Today only 4 are still making hard-drives. What happened to the other 3?
  • Can we use Seagate Technology stock (STX)'s beta to calculate the HDD operation's cost of capital? 
  • Why were Seagate shareholders willing to exchange its stake of 128 million Veritas shares for 109 million new Veritas shares? '
    • Since 109 is definitely less than 128, wasn't it very foolish a deal to accept?
  • In fiscal year 2008, Seagate generated $3.2 billion of gross profits and $1.5 billion of EBIT on $12.7 billion of revenues.
    • Finally meeting the management's base case revenue forecasts (made in 2000) for fiscal year 2006 (see Exhibit 8). 
      • Achieved not through organic growth, but through acquisition of Maxtor for $1.9 billion in 2006
      • And Maxtor acquire Quantum Corp's HDD business for $1 billion in 2001.
    • However, the EBIT target was achieved ahead of schedule, on significant reduced SG&A costs.
    • From hindsight, was Silverlake Partners right about the future of the HDD market?
  • Seagate's headquarters remained at Scotts Valley, California until 2010
    • However, It changed its place of incorporation to Cayman Islands in 2000, and to Ireland in 2010
    • Seagate had almost no operations in the Cayman Islands or the Republic of Ireland. Why incorporated the company there?
  • Epilogue
    • Seagate returned to stock market in 2002, selling 20% stake valuing the company at $5 billion including net debt.
    • The value of Silver Lake's stake has more than tripled in two years. 
      • The increased value can be attributed mainly to proportionate profitability improvement in Seagate's HDD business.
      • Silver Lake turned around the business drastically in two years.

Time Inc. (NYSE, TWX)  

  • In 1989, what lines of business is Time Inc. in?
    • What bargaining chips does Time Inc. have? 
  • The strategic fits between different players in the entertainment industry
    • Exhibit 4 describes each player's involvements in different areas of the entertainment industry value chain
    • What does Paramount Communications want from Time Inc.?
    • What does Warner Communications want from Time Inc.?
    • What does Time Inc. want from a potential partner?
    • Where does Time Inc. overlap with other companies?
  • What are the main benefits of vertical integration between content producers (e.g., Warner Bros., 20th Century Fox) and cable networks (e.g., HBO, Showtime) or broadcast networks (such as ABC, NBC, Fox)?
    • Broadcast TV (over the air): 
      • The differences between TV networks and TV stations
    • Cable TV: 
      • The differences between cable networks (e.g., CNN, HBO) and cable systems (e.g., Comcast, Cox)
      • The differences between basic cable (e.g., USA, CNN, TNT) and pay cable networks (e.g., HBO, Cinemax, Showtime)
    • The differences between broadcast and cable TV
      • How do cable networks make money? 
      • How is their business model different from that of broadcast networks?
  • What potential synergies will there be for a merger between Time and Warner, and one between Time and Paramount?
  • Why does Time Inc. management desire control in the new entity Time-Warner?
    • Does managing movie/TV producers require different skills than managing writers?
    • Why is editorial independence important for print publishing business?
  • Time Inc.'s financial advisors put the intrinsic value of Time Inc. at $10.8 to $12.1 billion, and that of Warner at $11.6 to $13 billion. 
    • The combined equity value of Time-Warner (without considering any synergy benefits) thus will be $22.4 to $25.1 billion. 
      • Based on the Time-Warner stock swap deal, Time Inc. shareholders will own 41% of the combined entity after the merger.
      • The deal therefore values Time Inc. at $9.1 billion to $10.3 billion, or $160 to $181/share.
      • Can you replicate my calculations?
        • All the inputs can be found in the case material
    • Since Paramount was offering only $175/share, it wasn't that attractive after all. 
      • But Paramount's offer was in hard cash, while the "intrinsic value" of Time-Warner, calculated by the financial advisors, are just theoretical and may never be achieved. 
      • On the other hand, Paramount's offer was subject to its being able to obtain the $10 billion debt financing from banks. The cash is not that certain again.
      • Later Paramount boosted its offer to $200/share.
    • Which offer would you accept?
      • What factors do you need to consider to reach your decision?
  • Eventually, Time Inc's board met on June 16 and decided to borrow $14 billion and purchase Warner for $70/share in cash, valuing Warner Communications at $12.5 billion, the mid-point of its advisor's recommended valuation.
    • In the next fours years, Time-Warner's stock price fell to as low as $70/share. 
      • Where were the synergy benefits?
        • Today's Time-Warner is a much smaller and focused entity, having sold off its music division Warner Music, cable systems Time-Warner Cable, internet division AOL, book publishing division Time-Warner Books, and theme parks Six Flags.
      • Warner Communications' original shareholders were certainly better off regardless of what happened subsequently, walking away with hard cash after the merger. 
    • For the rest of 1990s though, Time-Warner was a star performer, cumulated with a high-profile merger with AOL in January 2000
      • And then crashed to earth after the collapse of the internet bubble just two months later
      • Hypothetically, do you think that Time Inc. shareholders may have been better off taking the $200/share offer from Paramount and getting out of the roller-coaster media business altogether?
        • We can never make decisions with the benefits of hindsight.


RJR Nabisco (NYSE: RAI)  

  • At $31 billion (including net debt), the RJR Nabisco deal kept the largest LBO record for 17 years until 2006 when KKR participated in another deal acquiring hospital chain HCA Inc. for $33 billion.
    • Adjusted for inflation, however, the RJR Nabisco deal remains the largest in history
  • For more color, you may be interested in reading the best-selling book "Barbarians at the Gate: The Fall of RJR Nabisco" , and watching the namesake movie "Barbarians at the Gate" (Available at Netflix).
  • A Fortune article "KKR: The Sequel" (June 2005) takes stock of KKR's ups and downs in the previous two decades.
The Management Plan (Exhibit 6)
  • What does the management team (led by F. Ross Johnson) plan to do about RJR Nabisco after taking it private?
    • How will the planned changes improve the company's value?
  • Would you consider tobacco an attractive business and investment?
    • What's so attractive about selling cigarettes? 
      • How can tobacco companies consistently achieve >20% ROIC when their WACC is probably below 10%?
      • Warren Buffett: "I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."
    • Without hindsight about the legal liability issues that later surfaced, what's the main risks and threats faced by tobacco companies?
  • Why is RJR Nabisco stock out of favor in the stock market?
    • <10X P/E for RJR Nabisco stocks  v.s. >20X P/E for other foods stocks
  • Without hindsight, do you think that the Premier smokeless cigarette, which costs $1 billion to develop, will turn out to be a good investment for RJR Nabisco?
  • Philip Morris (a tobacco company, already owning General Foods) is currently bidding for Kraft Foods in order to grow its food business.
    • Considering that RJR Nabisco management intends to separate the food and tobacco divisions, it seems that Philips Morris has reached an opposite conclusion regarding the wisdom of a synergy between food and tobacco.
    • Epilogue: Philip Morris acquired Kraft Foods in December 1988, the same month KKR won the bid to take over RJR Nabisco.
The KKR Plan (Exhibit 7)
  • What may be the potential synergies between selling cigarettes and Oreo cookies?
    • Among the businesses that RJR Nabisco owned and then divested by the mid-1980s were: KFCSmirnoff Vodka, Sunkist soft drink, Canada Dry,  Sea-Land (the world's largest container shipping company), Aminoil (2nd largest independent oil and gas exploration company in the US)
    • It is interesting to note that today's Kraft Foods (and most other major packaged food company in the US) doesn't offer any beverage products
      • Kool-AidTang, Maxwell House products are powdered drink mixes, not beverage drinks
      • Kraft also divested its frozen dinner division to H.J. Heinz (1994) and frozen pizza division to Nestle (2010).
      • Recently, Kraft has decided to separate its global snack business from its North America grocery business (e.g. cheese)
        • It seems that Kraft now has learnt that there is no synergy even between cookies and cheese.
    • Are there more synergies between tobacco and foods than between dry and wet/fresh/frozen foods?
    • It is also interesting to note that both KKR and RJR Nabisco management agrees that the following divisions should be divested:
      • Del Monte (fresh fruits and vegetables, and food processing)
        • A recent sequel: In March 2011, more than two decades later, KKR acquired Del Monte Foods (now mainly a pet foods company, 2nd largest in the US) for $5.3 billion
      • Nabisco's international operations outside North America, accounting for a quarter of global sales
      • 20% ownership in ESPN network
  • Why does KKR believe that RJR Nabisco should retain a significant portion of the food business?
    • Discuss the benefits and costs of a tobacco company owning food businesses
  • What operational changes does KKR plan to make after taking the firm private?
    • Explain how KKR's plan will create more value than the management plan
  • F. Ross Johnson came from a packaged-food-industry background, yet he decided to divest the food business from RJR Nabisco
    • Would his career history (i.e., insider, knowing a lot about the food industry) lead you to believe that he may have better information than KKR?
The payout
  • Why did RJR Nabisco's board of directors choose KKR's offer?
    • Its financial advisors determined that the management group's offer had the same dollar value
  • Who came out as the greatest winner of the whole event?
    • RJR Shareholders? 
      • Their shares were bought out at a 100% premium
    • Employees
      • Employees owned 10% of the company, worth $2.4 billion at $109 per share (the price offered by KKR)
    • Henry Kravis and George Roberts?  $200 million fees
      • The two cousins chipped in only  $56 million of their own money. 
      • Most of the $3.7 billion invested by KKR came from its investors (known as "limited partners" or "co-investors").
        • Limited partners of the "1987 Fund" included Oregon Public Employee Retirement System, First Chicago Corporation Venture Capital, Washington State Investment Board, Minnesota State Board of Investment, the New York State Retirement Fund, the university endowments of Harvard University and the MIT, the corporate pension funds of Coca-Cola, Georgia-Pacific, and United Technologies
      • All told, it was estimated that KKR investors eventually lost nearly $1 billion on the RJR Nabisco deal.
      • However,  KKR general partners was not required to share losses with its investors while entitling to 20% of any gains ("carried interest")
        • In fact, KKR collected almost $200 million for transaction and management fees on the deal.
    • Lawyers and bankers advising the deal? Nearly $1 billion in fees (which was a lot of money in 1988)
    • The senior management team?
      • F. Ross Johnson received a $53 million severance package (including current and deferred payments), known as "Golden Parachute"
      • Edward Horrigan (head of tobacco operations) received $46 million
      • Each of them also owned 235,000 shares of RJR Nabisco, worth more than $25 million
Some notable subsequent events:
  • In 1991, two years later, KKR floated 60% of RJR Nabisco on the stock market
  • In 1994, KKR used its RJR Nabisco stocks to purchase the diary and pasta maker Borden Inc. for more than $4 billion including net debt
  • In 1995, RJR Nabisco spun off 19.5% of Nabisco Foods on the stock market
  • By the end of 1995, KKR has divested all of its $3.7 billion initial investments in RJR Nabisco
  • KKR failed to turn around Borden Inc. and had to shut down its food division in 2001
  • In 1999, R.J. Reynolds (the tobacco business) was spun off from RJR Nabisco
  • In 2000, Nabisco (the remaining food business) was sold to Philip Morris's Kraft Foods division
  • In 2001, Philip Morris floated 12% of its Kraft Foods division in an IPO
    • In 2007, distributed all of the remaining Kraft Foods stake to shareholders
    • Philip Morris finally became a pure-play tobacco company
    • Except the 28.7% stake in beer company SABMIller after selling the Miller business to SAB in 2002
  • In 2003, Philips Morris changed its name to Altria Group
  • After decades of diversification, Philip Morris has returned to its root
What may have driven the above decisions to separate and refocus?
  • The realization that there are no synergies between tobacco and foods after all?
  • Did these subsequent events show that F. Ross Johnson's thinking was right after all?
  • Hypothetically, given an opportunity, should RJR Nabisco have sold the Nabisco business to the eager Philip Morris back in 1989? 
    • A decision can't be made with the benefits of hindsight
    • We are constantly required to make decisions based on incomplete information
    • However, history can teach us invaluable lessons.
Ċ
Rocco Huang,
Feb 25, 2011, 5:15 PM