Company Background

According to the 1998 Annual 10-K filing, Maxwell Shoes Co. Ltd. designs, develops and markets casual and dress footwear for women and children under several brands names which are targeted to moderate to upper moderate priced market segments. Their brand names include Mootsies Tootsies, Sam and Libby, Jones New York, Mootsies Kids, and Sam and Libby Kids, as well as licensed brands such as J.G. Hook and Dockers (R) /Khakis. They also sell discounted merchandise from closed out shoe manufacturers. In 1997, the company employed 149 people and sold primarily in the United States to women (85%) and children (15%)(Maxwell Shoes Co. Inc., 1999). Their major competitors include Brown Shoe Company, Vans Inc., and K-Swiss Inc.

Economic Assumptions

According to the Department of Commerce, in March 1998, the 1998 to 2000 forecast for the US economy was as follows (US Department of Commerce, 1999):

	1997A	1998E	1999E	2000E
Real GDP ∆%	3.9	3.4	1.95	2.45
CPI ∆%	2.3	1.6	2.65	2.95
Unemp. %	5.4	4.5	4.8	5.8

The key assumptions are continued economic growth due to high consumer confidence and healthy advances in real personal disposable income but a plateau will ensue due to a decline in the stock market caused by unfavorable political events such as events in the Middle East and the investigation of President Clinton (Department of Commerce, 1999; Standard and Poor's, 1998). Consumer spending typically comprises two thirds of Gross Domestic Product.

Industry Profile

The shoe manufacturing industry is very competitive, mature and fragmented. It is very sensitive to changes in the business cycle, as earnings rise during periods of expansion and decline during periods of recession. Rivalry is high among competitors as there are many who are attempting to differentiate, while there are low switching costs and growth is slow. The threat of new entrants are high because of a growing international market place where shoes are produced in several countries, especially in Asia where labor is cheap. The threat of substitutes are low, as there are few substitutes for footwear. The bargaining power of buyers are high since Maxwell Shoes Co. Inc, has one major buying agent to procure manufacturing of their shoes. The supplier is low in power because Maxwell Shoes Co. Inc is a large client.

Company Strategy

The source of competitive advantage is focused differentiation since they are attempting to target a niche market of women and children in the moderate to upper moderate priced footwear segment. The business strategy leverages their strong manufacturing relationships and focused brand management to increase profitability by strengthening existing footwear brands and private label brands while expanding its brand portfolio through acquisitions, licensing, and developing new brands (Maxwell Shoes Co. Inc.).

Their core competencies are their ability to design, develop and market footwear with contemporary styles at affordable prices. Their critical success factors are keeping up with the latest fashion trends, design and product development, and marketing and customer support. A major trend is more casual footwear for business attire, which the company is following.

The company's financial strategy is to finance by equity issues and they have no long-term debt, while they finance inventories and accounts receivable with trade payables and cash flow from operations. The company does not manufacture any products since they subcontract them to foreign countries, of which 94% are from one buying agent, Universal Max Trading, who procures the factory orders primarily in China. Maxwell purchases products from its foreign subcontractors in U.S. dollars to protect itself against currency fluctuations.

Assumptions of Forecast

· Factors Not Included in Forecast

The consolidating retail industry, possible future international expansion, and the consolidating footwear manufacturing industry were not included in the forecast due to a lack of data. These factors may be significant. The consolidating retail industry may result in a loss of Maxwell's customers and lower profit margins. Increased revenue and profits from international expansion in the future is possible through the acquisition of internationally well-known footwear brands. Maxwell could capitalize on the consolidating footwear industry by adding new brands appealing to a broader market.

· Sales Growth

Assumption: Sales growth will continue but will experience a reduction in the growth rate for four years (1999 to 2002) until a 10% growth rate plateaus in 2003. The growth rates are 1999: 20.4%, 2000: 17.2%, 2001: 14.1%, 2002: 11%.

Justification: At the beginning of 1998, as a result of the Asian crisis, Mr. Allan Greenspan decided to cut interest rates at one quarter of a percentage point three times, thus increasing the money supply and increasing consumer confidence. The apparel and footwear industry did better in response to the increased consumer disposable income. Sales from 1996 to 1998 grew approximately 27 % due to rapid market penetration and the broadened product assortment, however we do not think such hyper growth is sustainable under the assumption that the US economy might be at its end stage of the expansionary cycle. Although a company can continue to use its core competencies to sustain its growth, the reversion to the mean will put downward pressure on the sales growth to approximately 10% in the terminal period, which is the industry average (Market Guide 2001), therefore we use a sales growth rate to extrapolate the next five years sales.

· Net Operating Profits after Tax

Assumption: We assume that the Net Operating Profits after tax will decline to 4.0% in the terminal period.

Justification: the financial position has been strengthening since 1996 as the company has a very liquid position, very little debt and management has been very efficient in executing their plans. This is evidenced by a high current ratio for 1998 of 7.8 times for liquidity which exceeds benchmarks of 1 to 2 times, a debt to equity of 0.15 for debt which is much less than benchmarks of 1 to 2 times, and an increasing Return on Equity of 4.4% in 1996 to 16% in 1998 for management efficiency. Furthermore the company has little financial leverage, as evidenced by no significant long debt and no bank loans outstanding. However, because of an expected economic slowing of growth and expected increase in inflation, we expect operating profit growth to slow down to 4.0%, which is less than the industry growth rate of 6% (Market Guide, 2001) since there are lower profit margins because management has higher working capital such as in Accounts Receivable and in Accounts Payable. Accounts Receivable are at 78 days while industry average is 44 days (Market Guide 2001), while Accounts Payable are 11.5 days while normal invoice terms are 30 days, and lower end products usually have lower profit margins. We also believe that price pressure from Asian competition will reduce gross profit margins and Selling General and Administrative expenses will likely increase proportionate to Sales as the company spends more on advertising to capture market share.

· Tax Rate

Assumption: Tax rates will remain at 38%. Justification: We base the tax rates on statutory rates and ignoring the one time stock options exercised in 1998 that reduced the tax rate by 5% to 33%.

· After Tax Cost of Debt

Assumption: the after tax cost of debt will be 0%. Justification: The company presently generates sufficient cash flow to finance future expansion of long-term assets, and can improve working capital to finance accounts receivable and inventories. The company currently has generated approximately $3 million per year on average for the past three years. At our assumed Sales growth rate, the company will double sales in 8 years and will require to double their long-term assets from $9.7 million to $20 million. The company could pay for this $10.3 million expansion in 4 years time with their existing cash flow of $3 million per year. While the current cost of debt is negative 5% due to the company having large cash reserves ($18 million) including marketable securities, these cash reserves will be consumed when they use it for future expansion. Inventory can be financed from accounts payable, accounts receivable could be financed with existing cash reserves of $18 million, and by improving collection procedures to bring receivables to within the industry average of 44 days (Market Guide, 2001), instead of 78 days at present, and by paying accounts payable slower such at 30 days, instead of 11 days at present.

If the company is unable to reduce existing levels of working capital, they have a line of credit with the Boston Bank of $35 million, according to the 10-K report (Maxwell Shoes Co. Inc, 1999). According to their the line of credit agreement in the 10-K report, interest rates are based on the Federal Funds Effective Rate plus 1.5%. The Federal Funds Effective Rate was 5.07% on October 31, 1998 (Ecomagic.com, 2001) so the interest rate charged on the line of credit would be 6.57%. In one years time, the rate will increase 1.06% due to an increase in inflation, as measured by the consumer price index, so this interest rate will increase to 7.63%(6.57% + 1.06%), and after tax, assuming a 38% tax rate, will be 4.73%. We expect that interest rates will remain at this level since inflation, measured by the consumer price index, will remain stable for future years.

· Beginning Net Operating Working Capital/Sales

Assumption: We assume a decrease to 20%. Justification: The company presently has a Net Operating Working Capital/Sales ratio of 25%, which has risen from 19% in 1997. The major components of Net Operating Working Capital are Accounts Receivable, Inventory and Accounts Payable. Exhibit 2 shows that the number of days outstanding for these items have been growing since 1996, suggesting that as sales increase, the proportion of Net Operating Working Capital will increase as well. Compared to industry averages, obtained from Market Guide, we find that Accounts Receivable turnover for industry is 44 days while the company's turnover is almost twice as high at 78 days - a difference of 34 days, and Inventory turnover for industry is 91 days while the company is 69 days - a difference of 21 days (Market Guide, 2001). In total, when compared to industry, we find that the company is too high in net operating working capital by approximately 13 days (34 days less 21 days), indicating that net operating working capital would be reduced to industry standards to remain competitive. This would mean that the present ratio of 25% would be reduced by approximately 20%, based on a reduction of the number of Accounts Receivable by 13 days.

· Beginning Net Operating Long-Term Assets/Sales

Assumption: We assume this will remain the same at 4%. Justification: The company's Net Operating Long term Assets to Sales ratio is currently 4%, down from 5% in 1997. The ratio is low because the company does not manufacture, but rather subcontracts to foreign agents. Long term assets primarily consist of warehouses and trademarks, which the company will increase as sales grow. The company expects to continue subcontracting their manufacturing abroad, so they will continue to expand warehouse space and trademarks while keeping the Net Long-term Asset/Sales ratio in line with past performance at 4%.

· Net Debt at Beginning of Year / Net Capital

Assumption: This will be 0%. Justification: The company has a very low Net Debt at Beginning of the Year to Net Capital ratio, currently at -5.6%. This is because the company has virtually no long-term debt except for a minor amount of capital leases, and has been financing their growth through share issuance and cash flow from operations. According to Market Guide, the industry average for debt to equity is 0.37 to 1 (Market Guide, 2001) while the company in 1998 had a debt to equity ratio of 0.14 times. As stated earlier under after tax cost of debt, the company has sufficient cash flow to pay for expansion by increasing working capital and by acquiring additional long-term assets, so no future debt will be required. Long term assets have a useful life of between 5 years (furniture and fixtures) and 15 years for trademarks, averaging 10 years. Since cash flow can pay for a doubling of long-term assets in 4 years, there will also be sufficient cash to pay for replacement of depreciated assets, and no debt will likely be necessary.

· Cost of Equity

Assumption: We assume a 12% Cost of Equity. Justification: A company's cost of capital should be at least equal to what shareholders could invest in the market with comparable risk and return. Using Security Market Line theory, we compute the company's expected rate of return by using the following formula: k_e = k_rf + B(k_m - k_rf), where k_eis the expected rate of return, k_rf is the risk free rate of return, k_m is the market rate of return, and B is the company's beta. The risk free rate of return is represented by the 91day treasury bill rate, which is typically 5%, or 4.96% at 30 September 1998 (WESCO, 2001). The Market Rate of Return has typically averaged 12% based on the Standard and Poor 500 Index for the four years from 1996 to 1999 (Ken Reichelt 2000) and is further supported by a statement made by D. P. Wehrly in the Finance 634 - Investment Management class, concerning the average rate of return for the past 15 years in the stock market. The company's Beta is presently 0.65, based on Market Guide (Market Guide, 2001). The company's expected rate of return, or cost of equity would then be 10% (5% + 0.7(12%-5%)). However, the firm must generate a higher rate of return than the expected rate of return in order to justify reinvesting free cash flow into the firm, so we have chosen a rate of 12% which is comparable with market rate of return for higher risk companies.

Conclusion

Please refer to Exhibit 1for details of the forecast and valuation of the firm. Based on our assumptions and available data, we predict that the firm's value will be $25 per share. According to the case, Barron's determined the price to be $20 per share while it is trading in October 1998 at $11.75 per share, indicating the share price is undervalued. We would concur with Barrons assessment that Maxwell's stock should be bought, since it is undervalued.

Exhibits

1. Forecast and Valuation of Maxwell Shoes Co. Inc.

2. Key Working Capital Ratios

Bibliography

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Market Guide from Multex.com. (2001). Ratio Comparisons for Maxwell Shoes Co. Inc. to Industry. Retrieved from the World Wide Web 26 February 2001: http://yahoo.marketguide.com/mgi/ratio/a0a2C.html.

Maxwell Shoe Co. Ltd. (1999, January 26). Annual 10-K Report for Maxwell Shoes Co. Ltd, for the fiscal year ended 31 October 1998. Retrieved 24 February 2001 from the World Wide Web: http://www.sec.gov/Archives/edgar/data/918578/0000927016-99-000183.txt

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WESCO. (2001). Average 91 Day Treasury Bill Rates. Retrieved from the World Wide Web February 26, 2001: http://www.wesco-hln.com/t-bill_rates.html.