The Anatomy of a Transaction: K2 Incorporated Acquires
On January 26, 2004, K2 Inc. completed the purchase of
Fotoball USA in an all stock transaction. What follows is an attempt to
reconstruct the events prior to closing in order to illustrate how the acquisition
process discussed in Chapters 4 and 5 may have been applied in this
Industry/ Market Definition
K2 is a sporting goods equipment and accessories
manufacturer that has achieved worldwide recognition. K2’s 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 such as baseball, softball,
fishing, water sports activities, alpine skiing, snowboarding, snowshoeing,
in-line skating, and mountain biking.
The firm’s current top competitors include Adidas-Salomon,
Rollerblade, Inc., and Skis Rossignol S.A. While other sporting goods suppliers
such as Amer Group Plc, Head N.V., NIKE, Inc., Fila USA, and Reebok
International Ltd. do not currently compete in K2’s served markets, they are
well positioned to do so given their substantial brand recognition and
financial resources. Not only must K2 be concerned about existing and potential
competitors, a variety of substitute popular or “cool” sports such as horseback
riding, ice hockey, sky diving, surfing, and cross-country skiing could erode
growth in its targeted markets. The firm’s primary customers are sporting goods
retailers. Many of K2’s smaller retailers and some larger retailers are not
strongly capitalized. Adverse conditions in the sporting goods retail industry
can adversely impact the ability of retailers to purchase K2 products or could
force retailers to insist upon credit terms that involve significant risks of
nonpayment. Secondary customers include individuals, both hobbyists as well as
professionals. K2’s success is dependent on its ability to keep abreast of
changes in taste and style, and its ability to provide high-quality products at
competitive prices. The majority of K2 products are manufactured in China,
which helps to ensure cost competitiveness. However, disruptions of
international trade or shipping could adversely affect the availability or cost
of K2 products. K2’s revenue from international operations was approximately
32% of total revenue for fiscal 2002, and approximately 26% of K2’s sales are
denominated in foreign currencies. K2’s international operations are subject to
a variety of risks, including recessions in foreign economies, currency
conversion risks and currency fluctuations, limitations on repatriation of
earnings, and reduced protection of intellectual property rights in some
countries. K2 believes that the most successful sporting goods suppliers will
be those with greater resources. In addition to financial capabilities, such
resources include the ability to produce or source high-quality, low-cost
products and deliver these products on a timely basis and the ability to access
distribution channels with a broad array of products and brands. In addition,
as the influence of large sporting goods retailers grows, management believes
these retailers will prefer to rely on fewer and larger sporting goods
suppliers to help them manage the supply of products and the allocation of
K2 has a number of leading brands. Rawlings, a K2
subsidiary, is a leading supplier of baseball equipment. Worth, another
subsidiary, is a leading supplier of softball products. K2’s line of fishing
rods, Shakespeare’s Ugly Stik models, has been the best-selling fishing rods in
the United States over the past 20 years. K2 is also involved in the sports
apparel business. The company faces very stiff competition in this industry
from Nike and Reebok. K2 believes that its customer relationships are
excellent. Wal-Mart accounted for over 10% and 5% of K2’s consolidated annual
net sales and operating income, respectively, in 2003.
Despite its strong brand names, K2 is susceptible to being
duplicated. The sporting goods markets and recreational products markets are
generally highly competitive, with competition centering on product innovation,
performance and styling, price, marketing, and delivery. Competition in these
products (other than for active wear) consists of a relatively small number of
large producers, some of whom have substantially greater financial resources
than K2. K2’s relationships with the many collegiate and professional leagues
and teams cannot be easily usurped by smaller competitors that may want to
enter into these markets. It takes time for the necessary trust and confidence
to build up in these relationships. Larger competitors may have the capacity to
take away some of these relationships, but K2 has so many that the loss of one
or two will not seriously hinder its overall revenue growth. Its relatively
small size in comparison to major competitors is the firm’s primary weakness.
Historically, the firm has been able to achieve profitable growth by
introducing new products into fast-growing markets. The firm has historically
applied its core competencies of producing fiberglass and assembling structures
for manufacturing skis to new markets such as snow boarding and in-line
Mission Statement and Strategic Objectives
“K2 will accept nothing less than the best. All our efforts
are focused on reaching the summit of our industry. We will create ever better
products that raise the bar of performance and celebrate the human spirit. We
will build value by growing and succeeding where others have failed. We will
get to the top of our game.” The firm’s long-term objective is to achieve the
number one market share position in its served markets. Toward that end, K2
seeks to meet or exceed its corporate cost of capital of 15%. In addition, K2
intends to achieve sustained double-digit revenue growth, gross profit margins
above 35%, and net profit margins in excess of 5% within the next 5 years. The
firm also seeks to reduce its debt-to-equity ratio to the industry average of
25% in the next 5 years.
K2 intends to achieve its mission and objectives by
becoming the low-cost supplier in each of its niche markets. The firm intends
to achieve a low-cost position by using its existing administrative and
logistical infrastructure to support entry into new niche segments within the
sporting goods and recreational markets, new distribution channels, new product
launches through existing distribution channels, continued aggressive cost
cutting, and to expand its global sourcing to include other low-cost countries
in addition to Mainland China.
Implementation Strategy In view of its great success in
acquiring and integrating a series of small acquisitions in recent years, K2
has 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. Consequently, K2 believes that it can accelerate its growth
strategy by seeking strategic acquisitions of other sporting goods companies
with well-established brands and with complementary distribution channels.
M&A Related Functional Strategies
Functional strategies have been developed based on an
acquisition-oriented implementation strategy. A potential target for
acquisition is a company that holds many licenses with professional sports
teams. Through its relationship with these sports teams, K2 can further promote
its long line of sporting gear and equipment. The different business functions
within K2 all have roles to play in supporting the implementation strategy.
Research & Development
K2’s R&D activities are focused on developing only the highest
quality sports equipment and apparel. The NBA, NFL, and Major League Baseball
are all potential licensing partners. To support these critical activities, the
research and development budget will be increased by 10% annually during the
next 5 years. High-quality and innovative new products can be sold into the
customer bases of firms acquired during this period.
Marketing and Sales
The licensing agreements in existence between the target
firm and its partners can be enhanced to include the many products that K2 now
offers. It must be determined whether one sales force can sell both the
products sold by K2 currently and those obtained through an acquisition. If so,
a restructuring of the current K2 sales force and that of the target firm could
result in significant cost savings. O
ther Functional Departments
he HR department is charged with the responsibility to
determine appropriate staffing requirements and the way those can be best
satisfied immediately following a merger. Potential job overlaps are expected
to contribute to significant cost savings. The finance department is charged
with quantifying the potential increase in revenue from cross selling K2 and
the target’s products into each firm’s existing customer bases and to determine
the feasibility of realizing anticipated cost synergies. Such information will
be used to determine the initial offer price for the target firm. The legal
department is responsible for determining the validity of customer and supplier
contracts; and, in conjunction with the finance department, their overall
profitability. Finally, the tax department is responsible for assessing the tax
impact an acquisition would have on K2’s operating cash flow and shareholders.
K2 has incentive systems in place to motivate employees to
work toward implementing its business strategy. Employees are awarded yearly
bonuses based on their performance throughout the year. At the end of the year,
employees working in sales are given up to 5% of the sales revenues for which
they were personally responsible. Management staff are given a bonus based on
how well their department has performed. They are given a bonus made up of 10%
of the operating income achieved by their department. This way they are motivated
not only to increase sales but to minimize costs as well.
Monitoring Systems Monitoring systems are in place to
monitor the actual performance of the firm against the business plan.
Activity-based systems monitor variables, which drive financial performance.
Such variables include customer retention, average revenue per customer, and
average revenue per dealer.
Business Plan Financials and Valuation
K2’s net revenue is projected to grow from $790 million in
2004 to $988 million in 2008 on a standalone basis. After-tax income is
expected to increase from $17.6 million to 41.2 million during the same period.
Reflecting a sharp improvement in free cash flow from ($7.6) million in 2004 to
$46 million in 2008, K2’s current valuation based on discounted cash flow
(without any new acquisitions) is $812 million or $23.79 per share.
K2’s overarching financial objective for any acquisition is
to at least earn its cost of capital, and its primary nonfinancial objectives
are to acquire a firm with well-established brands and complementary
distribution channels. More specifically, K2 is seeking a firm with a
successful franchise in the marketing and manufacturing of souvenir and
promotional products that could be easily integrated into K2’s current
After completion of a merger, K2 must successfully, among
other things, integrate the target’s sourcing and manufacturing capabilities
into K2’s sourcing and manufacturing operations, sell K2’s portfolio of
products and brands through the target’s distribution channels, increase the
target’s sales to team sports and sporting goods retailers, and develop a
licensing and cobranding program. In addition, K2 will need to retain the
management, key employees, customers, distributors, vendors, and other business
partners of both companies. It is possible that these integration efforts will
not be completed as smoothly as planned, which could have an adverse impact on
the operations of the combined company. K2 believes that given its successful
track record in acquiring and integrating businesses, its management team can
deal with these challenges.
Borrowing under K2’s existing $205 million revolving credit
facility and under its $20 million term loan, as well as potential future
financings, may substantially increase K2’s current leverage. Among other
things, such increased indebtedness could adversely affect K2’s ability to
expand its business, to market its products, to make needed infrastructure
investments, and adversely affect the cost and availability of funds from
If new shares of K2 stock are issued to pay for the target
firm, K2’s earnings per share may be diluted for an extended time period if
anticipated synergies are not realized in a timely fashion. Moreover,
overpaying for any firm could result in K2 failing to earn its cost of capital.
• The target should be smaller than $100 million in market
capitalization and should have positive cash flows. Also, it should be focused
on the sports or outdoor activities market.
• The search should be conducted initially by analyzing
• The company has an experienced acquisition team in place,
which will be utilized to complete this acquisition.
• The form of payment would be new K2 nonvoting common
• The form of acquisition would be a purchase of stock.
• K2 will not consider purchases involving less than 100%
of the target’s stock.
• Only friendly takeovers will be considered.
• The target firm’s current year P/E should not exceed 20.
Potential target firms will be identified using a series of
search criteria. Potential candidates’ main line of business must be the sports
equipment market in which they are generating positive cash flows, have a
market capitalization no greater than $100 million, and possess a complementary
product offering. 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 represents 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. The fit with the Rawlings division would make both
companies stronger in the marketplace. Fotoball also has proven expertise in
licensing programs, which would assist K2 in developing additional revenue
sources for its portfolio of brands.
K2 has positioned itself as a holding company and does not
take an active management role in the businesses it acquires. The firm
generally allows acquired companies to function independently. In 2003,
Fotoball lost $3.2 million so it is anticipated that the company will be
receptive to an acquisition proposal. A stock-for-stock exchange offer would be
very attractive to the shareholders of Fotoball. The transaction is expected to
qualify as a “taxfree” reorganization for federal income tax purposes.
Additionally, most of the employees would be retained, and management would
continue running the company. Fotoball is a very young company, and many of its
investors are looking to make their profits through the growth of the stock.
The stock-for-stock offer contains a significant premium, which would be well
received considering that the company has been in the red, and it would allow
Fotoball shareholders to defer taxes until they decide to sell their stocks and
be taxed at the current 20% capital gains rate. Earn-outs would also be
included in the deal to give management incentives to run the company
effectively and meet deadlines in a timely order. The acquisition vehicle used
in the deal would be a C-type corporation. Postclosing, Fotoball would be run
as a wholly owned subsidiary of K2. This form would work best because K2 is in
the process of acquiring many companies, and it cannot actively manage all of
them. In addition, such an organizational structure would be most conducive to
a possible earn-out and the preservation of the unique culture at Fotoball.
Determining the Initial Offer Price
Valuations for both K2 Inc. and Fotoball were done using
discounted cash-free flow methods. The valuations reflect the following
anticipated synergies due to economies of scale and scope: a reduction in
selling expenses of approximately $1 million per year; a reduction in
distribution expenses of approximately $500,000 per year; and an annual
reduction in G&A expenses of approximately $470,000. The standalone value
of K2 was $23.79 per share or $812 million. The standalone value of Fotoball
was $3.97 per share or $14.3 million. Including the effects of anticipated
synergy, the estimated combined market value of the two firms is $909 million.
This represents an increase in the shareholder value of the combined firms of
$82.7 million over the sum of the standalone values of the two firms. Based on
Fotoball’s outstanding common stock float of 3.6 million shares and the current
stock price of $4.02 at that time, a minimum offer price was determined by
multiplying the current stock price by the number of shares outstanding. The
minimum offer price was $14.5 million. If K2 were to concede 100% of the value
of synergy to Fotoball, the value of the firm would be $97.2 million. However,
sharing more than 45% of synergy with Fotoball would cause a serious dilution
of earnings and significantly raise the required rate of return on this deal.
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%
of the projected combined firms’ revenues in fiscal year 2004 were expected to
come from K2, only 4% of the value of the anticipated synergy was added to the
minimum offer price to come up with an initial offer price of $17.8 million or
$4.94 per share. This represented a premium of 23% over the then current market
value of Fotoball’s stock.
Due to the synergies involved in this transaction as well as
the relatively small size of the target (Fotoball) as compared to the acquirer
(K2), it is unlikely that this merger would endanger K2’s creditworthiness or
near-term profitability. Although the contribution to earnings would be
relatively small, the addition of Fotoball would help to diversify and smooth
K2’s revenue stream, which has been subject to seasonality in the past. Because
of the projected increase in EPS, the forecasted reduction in debt-to-equity
ratio, and the smoothing of revenues, K2 does not see any adverse effects of
this transaction on its future financing capabilities.
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 will move expeditiously according to a schedule put
in place prior to closing to implement the best practices of both firms.
Immediately following closing, senior K2 managers will communicate on site, if
possible, with Fotoball customers, suppliers, and employees to allay their
immediate concerns. (This case study is adapted from a paper written by Curt
Charles, Tuukka Luolamo, Jeffrey Rathel, Ryan Komagome, and Julius Kumar,
Loyola Marymount University, April 28, 2004.)
Case Study Discussion Questions
1. How did K2’s acquisition plan objective support the
realization of its corporate mission and business plan 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?