Business Law Chapter 5 Channel For Distributing Toys Directly Consumers Through

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channel for distributing toys is directly to consumers through catalogs. The so-called direct channels offered by the internet

and catalog sales help Mattel reduce its dependence on a few mass retailers.

Aging Population. Grandparents accounted for 14% of U.S. toy purchases in 1999. The number of grandparents is

expected to grow from 58 million in 1999 to 76 million in 2005.

Interactive Media. As children have increasing access to computers, the demand for interactive computer games is

expected to accelerate. The “high–tech” toy market segment is growing 20% annually, compared with the modest 5%

growth in the traditional toy business.

International Growth. In 1999, 44% of Mattel’s sales came from its international operations. Mattel already has

redesigned its Barbie doll for the Asian and the South American market by changing Barbie’s face and clothes.

Threats

Decreasing Demand for Traditional Toys. Children’s tastes are changing. Popular items are now more likely to include

athletic clothes and children’s software and video games rather than more traditional items such as dolls and stuffed

animals.

Distributor Returns. Distributors may return toys found to be unsafe or unpopular. A quality problem with the Cabbage

Patch Doll could cost Mattel more than $10 million in returns and in settling lawsuits.

Shrinking Target Market. Historically, the toy industry has considered their prime market to be children from birth to

age 14. Today, the top toy-purchasing years for a child range from birth to age 10.

Just-In-Time Inventory Management. Changing customer inventory practices make it difficult to accurately forecast

reorders, which has resulted in lost sales as unanticipated increases in orders could not be filled from current manufacturer

inventories.

Internal Assessment

Strengths

Mattel’s key strengths lie in its relatively low manufacturing cost position, with 85% of its toys manufactured in low–

labor-cost countries like China and Indonesia, and its established distribution channels. Moreover, licensing agreements

with Disney enable Mattel to add popular new characters to its product lines.

Weaknesses

Mattel’s Barbie and Hot Wheels product lines are mature, but the company has been slow to reposition these core

brands. The lack of technical expertise to create software–based products limits Mattel’s ability to exploit the shift away

from traditional toys to video or interactive games.

Acquisition Plan

Objectives and Strategy

Mattel’s corporate strategy is to diversify Mattel beyond the mature traditional toys segment into high-growth segments.

Mattel believed that it had to acquire a recognized brand identity in the children’s software and entertainment segment of

the toy industry, sometimes called the “edutainment” segment, to participate in the rapid shift to interactive, software-based

toys that are both entertaining and educational. Mattel believed that such an acquisition would remove some of the

seasonality from sales and broaden their global revenue base. Key acquisition objectives included building a global brand

strategy, doubling international sales, and creating a $1 billion software business by January 2001.

Defining the Target Industry

The “edutainment” segment has been experiencing strong growth predominantly in the entertainment segment. Parents

are seeing the importance of technology in the workplace and want to familiarize their children with the technology as early

as possible. In 1998, more than 40% of households had computers and, of those households with children, 70% had

educational software. As the number of homes with PCs continues to increase worldwide and with the proliferation of

video games, the demand for educational and entertainment software is expected to accelerate.

Management Preferences

Mattel was looking for an independent children’s software company with a strong brand identity and more than $400

million in annual sales. Mattel preferred not to acquire a business that was part of another competitor (e.g., Hasbro

Interactive). Mattel’s management stated that the target must have brands that complement Mattel’s business strategy and

the technology to support their existing brands, as well as to develop new brands. Mattel preferred to engage in a stock-for-

stock exchange in any transaction to maintain manageable debt levels and to ensure that it preserved the rights to all

software patents and licenses. Moreover, Mattel reasoned that such a transaction would be more attractive to potential

targets because it would enable target shareholders to defer the payment of taxes.

Potential Targets

Game and edutainment development divisions are often part of software conglomerates, such as Cendant, Electronic

Arts, and GT Interactive, which produce software for diverse markets including games, systems platforms, business

management, home improvement, and pure educational applications. Other firms may be subsidiaries of large book, CD–

ROM, or game publishers. The parent firms showed little inclination to sell these businesses at what Mattel believed were

reasonable prices. Therefore, Mattel focused on five publicly traded firms: Acclaim Entertainment, Inc., Activision, Inc.,

Interplay Entertainment Corp, The Learning Company, Inc. (TLC), and Take-Two Interactive Software. Of these, only

Acclaim, Activision, and The Learning Company had their own established brands in the games and edutainment sectors

and the size sufficient to meet Mattel’s revenue criterion.

In 1999, TLC was the second largest consumer software company in the world, behind Microsoft. TLC was the leader

in educational software, with a 42% market share, and in-home productivity software (i.e., home improvement software),

with a 44% market share. The company has been following an aggressive expansion strategy, having completed 14

acquisitions since 1994. At 68%, TLC also had the highest gross profit margin of the target companies reviewed. TLC

owned the most recognized titles and appeared to have the management and technical skills in place to handle the kind of

volume that Mattel desired. Their sales were almost $1 billion, which would enable Mattel to achieve its objective in this

“high–tech” market. Thus, TLC seemed the best suited to satisfy Mattel’s acquisition objectives.

Completing the Acquisition

Despite disturbing discoveries during due diligence, Mattel acquired TLC in a stock-for-stock transaction valued at $3.8

billion on May 13, 1999. Mattel had determined that TLC’s receivables were overstated because product returns from

distributors were not deducted from receivables and its allowance for bad debt was inadequate. A $50 billion licensing deal

also had been prematurely put on the balance sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially

exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by

the appeal of rapidly becoming a big player in the children’s software market, Mattel closed on the transaction aware that

TLC’s cash flows were overstated.

Epilogue

For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999

net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August,

just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end

the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad,

was leaving the company.

On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a

seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the

firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an

affiliate of Gores Technology Group for rights to a share of future profits. Essentially, the deal consisted of no cash upfront

and only a share of potential future revenues. In lieu of cash, Gores agreed to give Mattel 50% of any profits and part of any

future sale of TLC. In a matter of weeks, Gores was able to do what Mattel could not do in a year. Gores restructured

TLC’s seven units into three, set strong controls on spending, sifted through 467 software titles to focus on the key brands,

and repaired relationships with distributors. Gores also has sold the entertainment division and is seeking buyers for the

remainder of TLC.

Discussion Questions:

1. Why was Mattel interested in diversification?

2. What alternatives to acquisition could Mattel have considered? Discuss the pros and cons of each

alternative?

3. How might the internet affect the toy industry? What potential conflicts with customers might be

created?

4. What are the primary barriers to entering the toy industry?

5, What could Mattel have done to protect itself against risks uncovered during due diligence?

First Union Buys Wachovia Bank: A Merger of Equals?

First Union announced on April 17, 2001, that an agreement had been reached to acquire Wachovia Corporation for about

$13 billion in stock, thus uniting two fiercely independent rivals. With total assets of about $324 billion, the combination

created the fourth largest bank in the United States behind Citigroup, Bank of America, and J.P. Morgan Chase. The merger

also represents the joining of two banks with vastly different corporate cultures. Because both banks have substantial

overlapping operations and branches in many southeastern U.S. cities, the combined banks are expected to be able to add to

earnings in the first 2 years following closing. Wachovia, which is much smaller than First Union, agreed to the merger for

only a small 6% premium.

The deal is being structured as a merger of equals. That is a rare step given that the merger of equals’ framework usually

is used when two companies are similar in size and market capitalization. L. M. Baker, chair and CEO of Wachovia, will be

chair of the new bank and G. Kennedy Thompson, First Union’s chair and CEO, will be CEO and president. The name

Wachovia will survive. Of the other top executives, six will be from First Union and four from Wachovia. The board of

directors will be evenly split, with nine coming form each bank. Wachovia shareholders own about 27% of the combined

companies and received a special one-time dividend of $.48 per share because First Union recently had slashed its dividend.

To discourage a breakup, First Union and Wachovia used a fairly common mechanism called a “cross option,” which

gives each bank the right to buy a 19.9% stake in the other using cash, stock, and other property including such assets as

distressed loans, real estate, or less appealing assets. (At less than 20% ownership, neither bank would have to show the

investment on its balance sheet for financial reporting purposes.) Thus, the bank exercising the option would not only be

able to get a stake in the merged bank but also would be able to unload its least attractive assets. A hostile bidder would

have to deal with the idea that another big bank owned a chunk of the stock and that it might be saddled with unattractive

assets.

The deal structure also involved an unusual fee if First Union and Wachovia parted ways. Each bank is entitled to 6% of

the $13 billion merger value, or about $780 million in cash and stock. The 6% is about twice the standard breakup fee. The

cross-option and 6% fee were intended to discourage other last-minute suitors from making a bid for Wachovia.

According to a First Union filing with the Securities and Exchange Commission, Wachovia rebuffed an overture from

an unidentified bank just 24 hours before accepting First Union’s offer. Analysts identified the bank as SunTrust Bank.

SunTrust had been long considered a likely buyer of Wachovia after having pursued Wachovia unsuccessfully in late 2000.

Wachovia’s board dismissed the offer as not being in the best interests of the Wachovia’s shareholders.

The transaction brings together two regional banking franchises. In the mid-1980s, First Union was much smaller than

Wachovia. That was to change quickly, however. In the late 1980s and early 1990s, First Union went on an acquisition

spree that made it much larger and better known than Wachovia. Under the direction of now-retired CEO Edward

Crutchfield, First Union bought 90 banks. Mr. Crutchfield became known in banking circles as “fast Eddie.” However,

acquisitions of the Money Store and CoreStates Financial Corporation hurt bank earnings in late 1990s, causing First

Union’s stock to fall from $60 to less than $30 in 1999. First Union had paid $19.8 billion for CoreStates Financial in 1998

and then had trouble integrating the acquisition. Customers left in droves. Ill, Mr. Crutchfield resigned in 2000 and was

replaced by G. Kennedy Thompson. He immediately took action to close the Money Store operation and exited the credit

card business, resulting in a charge to earnings of $2.8 billion and the layoff of 2300 in 2000.

In contrast, Wachovia assiduously avoided buying up its competitors and its top executives frequently expressed shock

at the premiums that were being paid for rival banks. Wachovia had a reputation as a cautious lender.

Whereas big banks like First Union did stumble mightily from acquisitions, Wachovia also suffered during the 1990s.

Although Wachovia did acquire several small banks in Virginia and Florida in the mid-1990s, it remained a mid-tier player

at a time when the size and scope of its bigger competitors put it at a sharp cost disadvantage. This was especially true with

respect to credit cards and mortgages, which require the economies of scale associated with large operations. Moreover,

Wachovia remained locked in the Southeast. Consequently, it was unable to diversify its portfolio geographically to

minimize the effects of different regional growth rates across the United States.

In the past, big bank deals prompted a rash of buying of bank stocks, as investors bet on the next takeover in the banking

sector. Banks such as First Union, Bank of America (formerly NationsBank), and Bank One acquired midsize regional

banks at lofty premiums, expanding their franchises. They rationalized these premiums by noting the need for economies of

scale and bigger branch networks. Many midsize banks that were obvious targets refused to sell themselves without

receiving premiums bigger than previous transactions. However, things have changed.

Back in 1995 buyers of banks paid 1.94 times book value and 13.1 times after-tax earnings. By 1997, these multiples

rose to 3.4 times book value and 22.2 times after-tax earnings. However, by 2000, buyers paid far less, averaging 2.3 times

book value and 16.3 times earnings. First Union paid 2.47 times book value and 15.7 times after-tax earnings. The

declining bank premiums reflect the declining demand for banks. Most of the big acquirers of the 1990s (e.g., Wells Fargo,

Bank of America, and Bank One) now feel that they have reached an appropriate size.

Banking went through a wave of consolidation in the late 1990s, but many of the deals did not turn out well for the

acquirers’ shareholders. Consequently, most buyers were unwilling to pay much of a premium for regional banks unless

they had some unique characteristics. The First Union–Wachovia deal is remarkable in that it showed how banks that were

considered prized entities in the late 1990s could barely command any premium at all by early 2001.

Discussion Questions:

1. In your judgment, was this merger a true merger of equals? Why might this framework have been used in this

instance? Do you think it was a fair deal for Wachovia stockholders? Explain your answer.

2. Do you believe the cross option and unusual fee structure in this transaction were in the best interests of the

Wachovia shareholders? Explain your answer.

3. How did big banks during the 1990s justify paying lofty premiums for smaller, regional banks? Why do you think

their subsequent financial performance was hurt by these acquisitions?

4. What integration challenges do you believe these two banks will encounter as they attempt to consolidate

operations?

5. Speculate on why Wachovia’s management rebuffed the offer from SunTrust Banks with the ambiguous statement

that it was not in the best interests of Wachovia’s shareholders?

McKesson HBOC Restates Revenue

McKesson Corporation, the nation’s largest drug wholesaler, acquired medical software provider HBO & Co. in a $14.1

billion stock deal in early 1999. The transaction was touted as having created the country’s largest comprehensive health

care services company. McKesson had annual sales of $18.1 billion in fiscal year 1998, and HBO & Co. had fiscal 1998

revenue of $1.2 billion. HBO & Co. makes information systems that include clinical, financial, billing, physician practice,

and medical records software. Charles W. McCall, the chair, president, and chief executive of HBO & Co., was named the

new chair of McKesson HBOC.

As one of the decade’s hottest stocks, it had soared 38–fold since early 1992. McKesson’s first attempt to acquire HBO

in mid-1998 collapsed following a news leak. However, McKesson’s persistence culminated in a completed transaction in

January 1999. In its haste, McKesson closed the deal even before an in–depth audit of HBO’s books had been completed. In

fact, the audit did not begin until after the close of the 1999 fiscal year. McKesson was so confident that its auditing firm,

Deloitte & Touche, would not find anything that it released unaudited results that included the impact of HBO shortly after

the close of the 1999 fiscal year on March 31, 1999. Within days, indications that contracts had been backdated began to

surface.

By May, McKesson hired forensic accountants skilled at reconstructing computer records. By early June, the

accountants were able to reconstruct deleted computer files, which revealed a list of improperly recorded contracts. This

evidence underscored HBO’s efforts to deliberately accelerate revenues by backdating contracts that were not final.

Moreover, HBO shipped software to customers that they had not ordered, while knowing that it would be returned. In doing

so, they were able to boost reported earnings, the company’s share price, and ultimately the purchase price paid by

McKesson.

In mid-July, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5

million for the past 3 fiscal years to correct for accounting irregularities. The company’s stock had fallen by 48% since late

April when it first announced that it would have to restate earnings. McKesson’s senior management had to contend with

rebuilding McKesson’s reputation, resolving more than 50 lawsuits, and attempting to recover $9.5 billion in market value

lost since the need to restate earnings was first announced. When asked how such a thing could happen, McKesson

spokespeople said they were intentionally kept from the due diligence process before the transaction closed. Despite not

having adequate access to HBO’s records, McKesson decided to close the transaction anyway.

Discussion Questions:

1. Why do you think McKesson may have been in such a hurry to acquire HBO without completing an appropriate

due diligence?

2. Assume an audit had been conducted and HBO’s financial statements had been declared to be in accordance with

GAAP. Would McKesson have been justified in believing that HBO’s revenue and profit figures were 100%

accurate?

3. McKesson, a drug wholesaler, acquired HBO, a software firm. How do you think the fact that the two firms were

in different businesses may have contributed to what happened?

4. Describe the measurable and non-measurable damages to McKesson’s shareholders resulting from HBO’s

fraudulent accounting activities.

The Cash Impact of Product Warranties

Reliable Appliances, a leading manufacturer of washing machines and dryers, acquired a marginal competitor, Quality–

Built, which had been losing money during the last several years. To help minimize losses, Quality-Built reduced its

quality-control expenditures and began to purchase cheaper parts. Quality–Built knew that this would hurt business in the

long run, but it was more focused on improving its current financial performance to increase the firm’s prospects for

eventual sale. Reliable Appliances saw an acquisition of the competitor as a way of obtaining market share quickly at a time

when Quality–Built’s market value was the lowest in 3 years. The sale was completed quickly at a very small premium to

the current market price.

Quality-Built had been selling its appliances with a standard industry 3-year warranty. Claims for the types of appliances

sold tended to increase gradually as the appliance aged. Quality–Built’s warranty claims’ history was in line with the

industry experience and did not appear to be a cause for alarm. Not surprisingly, in view of Quality–Built’s cutback in

quality-control practices and downgrading of purchased parts, warranty claims began to escalate sharply within 12 months

of Reliable Appliances’s acquisition of Quality-Built. Over the next several years, Reliable Appliances paid out $15 million

in warranty claims. The intangible damage may have been much higher because Reliable Appliances’s reputation had been

damaged in the marketplace.

Discussion Questions:

1. Should Reliable Appliances have been able to anticipate this problem from its due diligence of Quality-Built?

Explain how this might have been accomplished.

2. How could Reliable have protected itself from the outstanding warranty claims in the definitive agreement of

purchase and sale?

The Downside of Earnouts

In the mid-1980s, a well-known aerospace conglomerate acquired a high-growth systems integration company by paying a

huge multiple of earnings. The purchase price ultimately could become much larger if certain earnout objectives, including

both sales and earnings targets, were achieved during the 4 years following closing. However, the buyer’s business plan

assumed close cooperation between the two firms, despite holding the system integrator as a wholly owned but largely

autonomous subsidiary. The dramatic difference in the cultures of the two firms was a major impediment to building trust

and achieving the cooperation necessary to make the acquisition successful. Years of squabbling over policies and practices

tended to delay the development and implementation of new systems. The absence of new systems made it difficult to gain

market share. Moreover, because the earnout objectives were partially defined in terms of revenue growth, many of the

new customer contracts added substantial amounts of revenue but could not be completed profitably under the terms of

these contracts. The buyer was slow to introduce new management into its wholly owned subsidiary for fear of violating the

earnout agreement. Finally, market conditions changed, and what had been the acquired company’s unique set of skills

became commonplace. Eventually, the aerospace company wrote off most of the purchase price and merged the remaining

assets of the acquired company into one of its other product lines after the earnout agreement expired.

Discussion Questions:

1. Describe conditions under which an earnout might be most appropriate.

2. In your opinion, are earnouts more appropriate for firms in certain types of industries than for others? If so, give

examples. Explain your answer.

Case Study: Sleepless in Philadelphia

Closings can take on a somewhat surreal atmosphere. In one transaction valued at $20 million, the buyer intended to

finance the transaction with $10 million in secured bank loans, a $5 million loan from the seller, and $5 million in equity.

However, the equity was to be provided by wealthy individual investors (i.e., “angel” investors) in amounts of $100,000

each. The closing took place in Philadelphia around a long conference room table in the law offices of the firm hired by the

buyer, with lawyers and business people representing the buyer, the seller, and several banks reviewing the final

documents. Throughout the day and late into the evening, wealthy investors (some in chauffeur-driven limousines) and

their attorneys would stop by to provide cashiers’ checks, mostly in $100,000 amounts, and to sign the appropriate legal

documents. The sheer number of people involved created an almost circus-like environment. Because of the lateness of the

hour, it was not possible to deposit the checks on the same day. The next morning a briefcase full of cashiers’ checks was

taken to the local bank.

Discussion Question:

1. What do you think are the major challenges faced by the buyer in financing small transactions transaction in this

manner?

Case Study: Mattel Overpays for the Learning Company

Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company (TLC), a leading developer of

software for toys, in a stock-for-stock transaction valued at $3.5 billion on May 13, 1999. Mattel had determined that

TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its

allowance for bad debt was inadequate. A $50 million licensing deal also had been prematurely put on the balance sheet.

Finally, TLC’s brands were becoming outdated. TLC had substantially exaggerated the amount of money put into research

and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the

children’s software market, Mattel closed on the transaction aware that TLC’s cash flows were overstated.

For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999

net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August,

just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end

the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad,

was leaving the company.

On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a

seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the

firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an

affiliate of Gores Technology Group (GTG) for rights to a share of future profits. Essentially, the deal consisted of no cash

upfront and only a share of potential future revenues. In lieu of cash, GTG agreed to give Mattel 50 percent of any profits

and part of any future sale of TLC. In a matter of weeks, GTG was able to do what Mattel could not do in a year. GTG

restructured TLC’s seven units into three, put strong controls on spending, sifted through 467 software titles to focus on the

key brands, and repaired relationships with distributors. GTG also sold the entertainment division.

Discussion Questions:

1. Despite being aware of extensive problems, Mattel proceeded to acquire The Learning Company. Why? What

could Mattel to better protect its interests? Be specific.

2. Why was Gore Technology Group able to do what Mattel could not do in a year.?

The Anatomy of a Transaction: K2 Incorporated Acquires Fotoball USA

Our story begins in the early 2000s. K2 is a sporting goods equipment manufacturer whose portfolio of brands includes

Rawlings, Worth, Shakespeare, Pflueger, Stearns, K2, Ride, Olin, Morrow, Tubbs and Atlas. The company’s diversified

mix of products is used primarily in team and individual sports activities, and its primary customers are sporting goods

retailers, many of which are not strongly capitalized. Historically, the firm has been able to achieve profitable growth by

introducing new products into fast-growing markets. Most K2 products are manufactured in China, which helps ensure cost

competitiveness but also potentially subjects the company to a variety of global uncertainties.

K2’s success depends on its ability to keep abreast of changes in taste and style and to offer competitive prices. The

company’s external analysis at the time showed that the most successful sporting goods suppliers will be those with the

greatest resources, including both management talent and capital, the ability to produce or source high-quality, low-cost

products and deliver them on a timely basis, and access to distribution channels with a broad array of products and brands.

Management expected that large retailers would prefer to rely on fewer and larger sporting goods suppliers to help them

manage the supply of products and the allocation of shelf space.

The firm’s primary customers are sporting goods retailers. Many of K2’s smaller retailers and some larger retailers were

not strongly capitalized. Adverse conditions in the sporting goods retail industry could adversely impact the ability of

retailers to purchase K2 products. Secondary customers included individuals, both hobbyists as well as professionals.

The firm had a few top competitors, but there were other large sporting goods suppliers with substantial brand

recognition and financial resources with whom K2 did not compete. However, they could easily enter K2’s currently served

markets. In the company’s secondary business, sports apparel, it did face stiff competition from some of these same

suppliers, including Nike and Reebok.

K2’s internal analysis showed that the firm was susceptible to imitation, despite strong brand names, and that some

potential competitors had substantially greater financial resources than K2. One key strength was the relationships K2 had

built with collegiate and professional leagues and teams, not easily usurped. Larger competitors may have had the capacity

to take some of these away, but K2 had so many that it could withstand the loss of one or two. The primary weakness of K2

was its relatively small size in comparison to major competitors.

As a long-term, strategic objective, K2 set out to be number one in market share in the markets it served by becoming

the low-cost supplier. To that end, K2 wanted to meet or exceed its corporate cost of capital of 15 percent; achieve

sustained double-digit revenue growth, gross profit margins above 35 percent, and net profit margins in excess of 5 percent

within five years; and reduce its debt–to-equity ratio to the industry average of 25 percent in the same period. The business

strategy for meeting this objective was to become the low-cost supplier in new niche segments of the sporting goods and

recreational markets. The firm would use its existing administrative and logistical infrastructure to support entry into these

new segments, new distribution channels, and new product launches through existing distribution channels. Also, K2

planned to continue its aggressive cost cutting and expand its global sourcing to include low-cost countries other than

China.

All this required an implementation strategy. K2 decided to avoid product or market extension through partnering

because of the potential for loss of control and for creating competitors once such agreements lapse. Rather, the strategy

would build on the firm’s great success, in recent years, acquiring and integrating smaller sporting goods companies with

well-established brands and complementary distribution channels. To that end, M&A-related functional strategies were

developed. A potential target for acquisition would be a company that holds many licenses with professional sports teams.

Through its relationship with those teams, K2 could further promote its line of sporting gear and equipment.

In addition, K2 planned to increase its R&D budget by 10 percent annually over five years to focus on developing

equipment and apparel that could be offered to the customer base of firms it acquired during the period. Existing licensing

agreements between a target firm and its partners could be enhanced to include the many products K2 now offers. If

feasible, the sales force of a target firm would be merged with that of K2 to realize significant cost savings.

K2 also thought through the issue of strategic controls. The company had incentive systems in place to motivate work

towards implementing its business strategy. There were also monitoring systems to track the actual performance of the firm

against the business plan.

In its acquisition plan, K2’s overarching financial objective was to earn at least its cost of capital. The plan’s primary

non-financial objective was to acquire a firm with well-established brands and complementary distribution channels. More

specifically, K2 sought an acquisition with a successful franchise in the marketing and manufacturing of souvenir and

promotional products that could be easily integrated into K2’s current operations.

The acquisition plan included an evaluation of resources and capabilities. K2 established that after completion of a

merger, the target’s sourcing and manufacturing capabilities must be integrated with those of K2, which would also retain

management, key employees, customers, distributors, vendors and other business partners of both companies. An

evaluation of financial risk showed that borrowing under K2’s existing $205 million revolving credit facility and under its

$20 million term loan, as well as potential future financings, could substantially increase current leverage, which could –

among other things – adversely affect the cost and availability of funds from commercial lenders and K2’s ability to expand

its business, market its products, and make needed infrastructure investments. If new shares of K2 stock were issued to pay

for the target firm, K2 determined that its earnings per share could be diluted unless anticipated synergies were realized in a

timely fashion. Moreover, overpaying for any firm could result in K2 failing to earn its cost of capital.

Ultimately, management set some specific preferences: the target should be smaller than $100 million in market

capitalization and should have positive cash flows, and it should be focused on the sports or outdoor activities market. The

initial search, by K2’s experienced acquisition team, would involve analyzing current competitors. The acquisition would

be made through a stock purchase – and K2 chose to consider only friendly takeovers involving 100 percent of the target’s

stock – and the form of payment would be new K2 non–voting common stock. The target firm’s current year P/E should not

exceed 20.

After an exhaustive search, K2 identified Fotoball USA as its most attractive target due to its size, predictable cash

flows, complementary product offering, and many licenses with most of the major sports leagues and college teams.

Fotoball USA represented a premier platform for expansion of K2’s marketing capabilities because of its expertise in the

industry and place as an industry leader in many sports and entertainment souvenir and promotional product categories. K2

believed the fit with the Rawlings division would make both companies stronger in the marketplace. Fotoball also had

proven expertise in licensing programs, which would assist K2 in developing additional revenue sources for its portfolio of

brands. In 2003, Fotoball had lost $3.2 million, so it was anticipated that they would be receptive to an acquisition proposal

and that a stock-for-stock exchange offer would be very attractive to Fotoball shareholders because of the anticipated high

earning growth rate of the combined firms.

Negotiations ensued, and the stock-for-stock offer contained a significant premium, which was well received. Fotoball is

a very young company and many of its investors were looking to make their profits through the growth of the stock. The

offer would allow Fotoball shareholders to defer taxes until they decided to sell their stocks and be taxed at the capital gains

rate. An earn-out was also included in the deal to give management incentives to run the company effectively and meet

deadlines in a timely order.

Valuations for both K2 and Fotoball reflected anticipated synergies due to economies of scale and scope, namely,

reductions in selling expenses of approximately $1 million per year, in distribution expenses of approximately $500,000 per

year, and in annual G&A expenses of approximately $470,000. The combined market value of the two firms was estimated

at $909 million – an increase of $82.7 million over the sum of the standalone values of the two firms.

Based on Fotoball’s outstanding common stock of 3.6 million shares, and the stock price of $4.02 at that time, a

minimum offer price was determined by multiplying the stock price by the number of shares outstanding. The minimum

offer price was $14.5 million. Were K2 to concede 100 percent of the value of synergy to Fotoball, the value of the firm

would be $97.2 million. However, sharing more than 45 percent of synergy with Fotoball would have caused a serious

dilution of earnings. To determine the amount of synergy to share with Fotoball’s shareholders, K2 looked at what portion

of the combined firms revenues would be contributed by each of the players and then applied that proportion to the

synergy. Since 96 percent of the projected combined firms revenues in fiscal year 2004 were expected to come from K2,

only 4 percent of the synergy value was added to the minimum offer price to come up with an initial offer price of $17.8

million, or $4.94 per share. That represented a premium of 23 percent over the market value of Fotoball’s stock at the time.

The synergies and the Fotoball’s relatively small size compared to K2 made it unlikely that the merger would endanger

K2’s credit worthiness or near-term profitability. Although the contribution to earnings would be relatively small, the

addition of Fotoball would help diversify and smooth K2’s revenue stream, which had been subject to seasonality in the

past.

Organizationally, the integration of Fotoball into K2 would be achieved by operating Fotoball as a wholly owned

subsidiary of K2, with current Fotoball management remaining in place. All key employees would receive retention

bonuses as a condition of closing. Integration teams consisting of employees from both firms were set to move

expeditiously according to a schedule established prior to closing the deal. The objective would be to implement the best

practices of both firms.

On January 26, 2004, K2 Inc. completed the purchase of Fotoball USA in an all-stock transaction. Immediately after,

senior K2 managers communicated (on-site, where possible) with Fotoball customers, suppliers, and employees to allay any

immediate concerns.

Discussion Questions:

1. How did K2’s acquisition plan objective support the realization of its corporate mission and strategic objectives?

2. What alternatives to M&As could K2 have employed to pursue its growth strategy? Why were the

alternatives rejected?

3. What was the role of “strategic controls” in implementing the K2 business plan?

4. How did the K2 negotiating strategy seek to meet the primary needs of the Fotoball shareholders

and employees?