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

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