Final Case: Friendly Cards, Inc. FINAN Lutz

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1 Final Case: Friendly Cards, Inc. FINAN 4210 Lutz Jonathan Matsen 05/01/2013

2 Problem Identification Wendy Beaumont, president of Friendly Cards, is currently faced with 3 time sensitive issues that need to me dealt with immediately. As a relatively small company in the fiercely competitive greeting card industry, Ms. Beaumont must make some quick yet intelligent decisions to ensure the continued success of her company. To be more specific, she must decide upon: The investment in equipment to enable the company to make rather than buy their own envelopes The acquisition of Creative Designs Inc., a small Midwestern manufacturer of studio cards The possibility of going to the market to raise additional equity capital in order to relieve pressure on its financial position Identification of Relevant Facts Friendly s position in the industry As of early 1988, the main issues facing the greeting card industry were: Continued industry consolidation (a decline of 15% per decade since 1954) Cyclical revenues The presence of high fixed costs Threat of Industry Consolidation Since its inception in 1978, Friendly Cards reacted to the looming threat of industry consolidation by rapidly expanding internally and through various acquisitions. These acquisitions allowed Friendly to access new markets and demographics that would have been previously unavailable to them. For example, through their acquisition of a California firm, the company gained West Coast distribution access and a more profitable form of distribution that cut out the middle-man/men (which ate away at profit margins), and a new branding opportunity through the creation of Friendly Artists. Friendly also diversified their product offerings with a full line of greeting cards (1200 designs) for the upcoming 1988 year, which was uncharacteristic of a small company. They were also active in the packaged box card market, which was a less active industry segment for giants like American Greetings (they focused more heavily on the sale of packaged cards). Friendly s presence in the packaged box segment also cut costs due to the non-return nature of the product once the package was opened, unlike the high chance of individual card returns (which were a constant source of increased costs and a headache for those in the industry). Cyclical Nature of the Industry

3 Concerning the cyclical nature of the industry, Friendly realized 30% of dollar sales by Christmas and 25% by Valentines. The remainders of sales were made-up by spring and everyday cards. Currently none of Friendly s cards were studio cards which were defined in the industry as higher fashion items. With its primary demographic of over-40 year olds, the majority of their customer base was cost conscious. All production was done in-house, but printing work could be done outside of necessary. Another key issue was the fact that Friendly currently purchases all of their envelopes from outside manufacturers. High Fixed Costs Expensive production, the need for large inventories, and long lead times were the main contributors to this particular industry quality. These costs were natural to the industry and more or less unchangeable. While these costs could not be reduced, sales costs could. The large companies used their own sales force to sell directly, while Friendly relied on its sales force of 25 employees who sold either directly to the central buyers of national chains, rack jobbers, and wholesalers. Friendly s reliance on this method of sales had a direct effect on their low profit margins. There were often two middle-men or intermediaries that were in-between the final customer and Friendly it was estimated that retail dollar sales of Friendly Cards were 3x the sales figures seen on the income statement. Friendly s Financial Issues Due to the capital-intensive nature of the operating in the industry, Friendly had always faced some sort of financial hardship. Thankfully, they had good relationships with their banks, which has contributed to their success. Facts specific to Friendly that will be useful in analyzing their current issues include A $6.25 million line a credit A borrowing rate of 2.2% above the current prime rate of 8.5% December and January were peak times of need for bank and trade credit, with low points in April where needs were 50% less The company is currently heavily debt financed, with current liabilities/equity ratio of 4.72 (it had previously reached 5.22 just a year prior!). Taking this into consideration, Ms. Beaumont is currently being urged to seek more equity capital. Her bankers are insisting that Friendly take action before the peak-borrowing season in at the end of 1988 to make sure that it will be able to comply with the following lending restrictions which will take effect in 1989: Bank loans outstanding could not exceed 85% of Friendly s A/R Total liabilities could not exceed 3x the BV of the company s net worth To remain safely within these boundaries, Ms. Beaumont would like to keep Friendly s ratio of all interest bearing debt/equity to a max of 2 to 1.

Analysis The Envelope Machine Adequate information needed to calculate an appropriate WACC to discount CF s was not given, so instead an IRR for the machine s projected future cash flows was

4 Analysis The Envelope Machine Adequate information needed to calculate an appropriate WACC to discount CF s was not given, so instead an IRR for the machine s projected future cash flows was calculated assessing the economic impact of its purchase. Since the depreciation of 62,000 per year totaled the purchase price of the machine and no terminal value was given, it was assumed to have a TV of 0 at the end of year 8. Subsequently a TV was not considered in the projected cash flows. An IRR of 41% was derived from the following cash flow analysis: Since Friendly is currently in a tough financial situation, the capital needed to purchase the equipment will probably need to come from more expensive sources, such as the sale of common stock to the West Coast investors (which will be examined in more detail below). It should also be noted that the cash flows calculated in reality are reductions in the current COGS on Friendly s income statement (since they are currently paying the $1,500,000 revenue this project would generate on envelopes from outside manufacturers). Creative Designs Acquisition Building upon their previous strategy of utilizing acquisitions to sustain growth, Friendly needs to examine the economic implications of acquiring Creative Designs. There are two scenarios that need to be looked at when considering this acquisition projected cash flows and valuations with Ms. Beaumont s proposed abilities to increase sales and reduce costs and without.

5 Regardless of which scenario would actually happen, it was necessary to calculate CAPM (which required estimating CD s beta) and WACC. To estimate CD s equity beta, from Exhibit 5 was used to unlever the equity betas of the two companies, take the average, and derive a beta of 1.20 for creative designs to be used in the CAPM. Moving on to CAPM, the T-bill rate of 6.1% was used for the risk-free rate and the average of the bond rates was used for the market rate (all from Exhibit 5). Using these figures, I came up with a CAPM of 10.9% for CD. For the cost of debt I used the 11.5% number given in Exhibit 5, which stated that it was for a corporate bond of similar quality to Friendly Cards. The next step was to calculate WACC. For the D/V and E/V weights, I used the 45% debt to total number given in the case suggestions and a tax rate of 40% was used. The CAPM of 10.9% was used for the cost of equity. Using all of these numbers, I came up with a WACC of 9.06%. The following was assumed/inferred when analyzing the two scenarios Under the proposed sales increases/cost reductions Tax Rate of 40% Sales increase of 6% starting in 1989 (stated in case) 5% Reduction from 1987 COGS (stated in case), COGS after 1987 equaling 58% of yearly sales which was derived from the Exhibit 6 and dividing COGS by Net Sales from and taking the average minus the 5% proposed reduction by Ms. Beaumont 10% Reduction of non-cogs expenses starting in 1988 (stated in case), with non-cogs expenses equaling 28% of yearly sales which was derived from Exhibit 6 in the same fashion as COGS Depreciation as 13% of net fixed assets which was derived from Exhibit 6 by taking an average of depreciation cost as a percentage of net fixed assets over the years CAPEX equaling 190 each year To calculate the terminal values used to get the NPV, the Gordon Growth model was used. I used the CF in year 5 as the final CF, 6% proposed sales increase as the growth percent and the 9.06% WACC. When utilizing the above assumptions, I came up with an NPV (or firm value) of $15, Under current conditions Tax Rate of 40% Increase of sales of 9% per year which was derived from looking at Exhibit 6 and taking the average of sales growth from COGS as 61% of net sales Other expenses as 32% of net sales Depreciation as 13% of net fixed assets which was derived from Exhibit 6 by taking an average of depreciation cost as a percentage of net fixed assets over the years CAPEX equaling 190 each years

6 To calculate the terminal values used to get the NPV, the Gordon Growth model was used. I used the CF in year 5 as the final CF, 9% average sales increase as the growth percent and the 9.06% WACC. When utilizing the above assumptions, I came up with an NPV (or firm value) of $7, Raising additional equity funds through the West Coast Investors There are many issues to think about when considering issuing equity to raise funds. Ms. Beaumont would need to consider the fact that issuing new equity dilutes the value of previously held shares (she would own less of the company), and it is generally considered to be a more expensive form of funding (which would raise the WACC). The case also mentions that Ms. Beaumont s financial advisor, Ms. McConville, after speaking with an investment banker recommended that $8 a share is a very good deal right now. Raising equity funds within the current economic climate will be difficult for the firm due to the stock market crash at the end of Even though Friendly s shares have hit $15 dollars in the past, due to the economic climate, the investment banker says that even $8 per share is a lofty request. When taking into account the precarious situation that Friendly Cards is currently in, seriously considering issuing new equity would seem to be a good way to go. The West Coast Investors are asking to buy 200,000 common shares are $8 per share. This would infuse $1,600,000 into the firm. This extra cash would alleviate the current pressure on the debt to equity ratio as well as provide the firm with more flexibility to pursue opportunities such as the envelope-making machine. The other stipulation to the deal is that Friendly would have to pay a finders fee of $80,000 or 10,000 shares to the individual who had brought this deal to Ms. Beaumont s mind The advantages of taking this deal are that the finder s fee is only 5% of the total issue amount, which is going to be cheaper than if an investment bank did a public issue, the infusion of cash would most likely allow Friendly to meet the covenants given to them by the bank, and the uncertainty about how many securities will be sold if a public offering is held will be eliminated. The disadvantages of this deal are the loss of majority control by Ms. Beaumont (she would not be able to make unilateral decisions). She currently holds 55% of the stock, but with the new issue her portion of ownership would drop to 41%. Also, the West Coast investors would hold 26% of shares and would have a significant say in the way that the company was run. This would likely be a big issue for Ms. Beaumont who grew the company from nothing by herself. As previously mentioned, the issuance of new stock will increase their WACC due to the higher cost of equity financing (it doesn t have the tax saving benefits of debt). Due to the fact that issuing more shares will erode the value that each share has to existing stockholders, they will need to achieve a higher rate of return on their projects to ensure shareholder value does not decrease. This shouldn t be an issue considering the high rate of expected growth the company is expecting.

7 Generally speaking a company should only issue equity if they need the capital to finance growth or if they are overleveraged (which Friendly Cards currently is). Also, with a predicted sales growth of 27%, they are going to need to finance that growth with either outside financing or external funds. They have pretty much utilized debt to the greatest extent they can so the only other way to fund this growth is to insanely increase sales or issue more equity. To further drive the point that Friendly Cards is overleveraged, they have a debt-to-asset ratio of 82%, a quick ratio of.67 and a market value debt to equity ratio, of 245%. All of his suggests that they company is severely overleveraged. With such a low quick ratio they should have issues paying off short-term debt if their sales took a nosedive for some unforeseen reason. When comparing their market value debt to equity ratio of 245% with industry big players American and Gibson Greetings, 63% and 49% respectively, is particularly alarming since those companies are much larger/more diversified and would be more equipped to handle an unforeseen occurrence such as a drop in sales. On top of all the above reasons pointing to the essential acceptance of the offer, the company is essentially being forced to issue new equity by their bankers. With a debt/equity ratio forecasted to remain above 4, this would violate the stipulation that they get the ratio under 3. Recommendations Envelope Machine With a calculated IRR of 41%, it would be a very good idea for Friendly Cards to purchase the machine. It would reduce their costs and contribute to their bottom line. The only issue with purchasing the machine is the funds available to purchase it. This could easily be alleviated by the issuance of new equity. Acquisition of Creative Designs At a purchase price of $1,881,000, even if the proposed refinements to the company s sales and cost structure are not able to be achieved (both valuation situations have an NPV above the purchase price) this would be a good deal for Friendly Card to go through with. Also Creative Designs is in the business of studio cards, which Friendly is currently not producing. This would be a great addition to the existing product line and would continue the tradition of accessing new market share through acquisitions. Also, since CD is in the same business as Friendly, Ms. Beaumont s projections should be easily achievable. Issue of New Equity to West Coast Investors As can probably be seen in the analysis section, I would recommend that Friendly Cards go through with the issuance. The financial advisor, current bankers, and ratios all point to the fact that this deal will be good for the continued success of the business. The world is not perfect and

8 Ms. Beaumont will have to get over the fact that she will not have majority control of the company anymore.

Friendly Cards, Inc.

Harvard Business School 9-293-135 Rev. June 18, 1993 Friendly Cards, Inc. In early 1988, Wendy Beaumont, President of Friendly Cards, Inc., met with Amy McConville, a friend and financial consultant. They