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Ability Results,” The Accounting Review (January 1977): 1“21.
3. See Robert Freeman, James Ohlson, and Stephen Penman, “Book Rate-of-Return and Pre-
diction of Earnings Changes: An Empirical Investigation,” Journal of Accounting Research (Au-
tumn 1982): 639“653.
4. See Stephen H. Penman, “An Evaluation of Accounting Rate-of-Return,” Journal of Ac-
counting, Auditing, and Finance (Spring 1991): 233“256; Eugene Fama and Kenneth French,
“Size and Book-to-Market Factors in Earnings and Returns,” Journal of Finance (March 1995):
131“156; and Victor Bernard, “Accounting-Based Valuation Methods: Evidence on the Market-
to-Book Anomaly and Implications for Financial Statements Analysis,” University of Michigan
working paper (1994). Ignoring the effects of accounting artifacts, ROEs should be driven in a
competitive equilibrium to a level approximating the cost of equity capital.
5. A “normal” profit margin is that which, when multiplied by the turnover achievable within
an industry and with a viable corporate strategy, yields a return on investment that just covers the
cost of capital. However, as mentioned above, accounting artifacts can cause returns on invest-
ment to deviate from the cost of capital for long periods, even in a competitive equilibrium.
6. When the Morgan Stanley Dean Witter analyst was making the presentation in December
1998, the actual balance sheet for 1998 was not available. Therefore, in the analyst™s report, cash
flow projections were based on projected balance sheets for both 1998 and 1999. Since we present
cash flow forecasts implied by the actual balance sheet for 1998 and the projected balance sheet
for 1999, the figures in Table 10-3 differ from the cash flow forecasts in the analyst™s report.
Prospective Analysis: Forecasting

10-21 Part 2 Business Analysis and Valuation Tools

7. See Foster (1977). A somewhat more accurate model is furnished by Brown and Rozeff, but
it requires interactive statistical techniques for estimation. Lawrence D. Brown and Michael
Rozeff, “Univariate Time Series Models of Quarterly Accounting Earnings per Share,” Journal
of Accounting Research (Spring 1979): 179“189.
8. To estimate the model, we write in terms of realized earnings (as opposed to expected earn-
ings) and move Qt-4 to the left-hand side:
Qt ’ Qt-4 = δ + φ (Qt-1 ’ Qt-5 ) + e t
We now have a regression where (Qt ’ Qt-4 ) is the dependent variable, and its lagged value”
(Qt-1 ’ Qt-5 )”is the independent variable. Thus, to estimate the equation, prior earnings data
must first be expressed in terms of year-to-year changes; the change for one quarter is then re-
gressed against the change for the most recent quarter. The intercept provides an estimate of δ,
and the slope is an estimate of φ. The equation is typically estimated using 24 to 40 quarters of
prior earnings data.
9. See O™Brien (1988).
10. See footnote 8 for a description of the estimation process. The series for the dependent vari-
able would be (0.47 “ 0.38), (0.27 “ 0.235), (0.47 “ 0.38), and so on. The series for the independent
variable would be the corresponding lagged values: (0.27 “ 0.235), (0.47 “ 0.38), (0.215 “ 0.205),
and so on.
Maxwell Shoe Company, Inc.

na McKinsey, an active investor in the stock market, was intrigued by
the following brokerage report recommendation of Maxwell Shoe Company:
Maxwell Shoe reported fourth quarter earnings per share on an operating ba-
sis of $0.33, slightly above our estimate of $0.32. Operating EPS for fiscal 1998
Business Analysis and Valuation Tools

was $1.37. Including the final one-time tax benefit related to the company™s sec-
ondary offering, net EPS was $0.36 for the fourth quarter and $1.44 for the year.
The company™s backlog was up 10.4%, lower than previous quarters but still
very solid given the tough retail conditions. . . . We remain very positive toward
Maxwell Shoe given the brand™s performance in a challenging retail environment,
management™s execution, and its low-cost sourcing capabilities.
We are adjusting our 1999 EPS estimate to $1.50 from $1.55 due mostly to
10 higher tax rate and weighted average share count assumptions. Additionally, we
Prospective Analysis: Forecasting
are increasing our revenue estimates to $188 million from $182 million. The com-
pany is trading at only 8.0 times our fiscal 1999 estimate, which is a discount to
Shoe Com-
the industry. Additionally, the company has no debt and has about $2.00 per share
of cash on its balance sheet. We reiterate our Strong Buy rating.
S. A. Richter et al., of Tucker Anthony
& R. L. Day, December 18, 1998
This analyst report reminded McKinsey of another equally bullish evaluation of Max-
well she read a few months ago in Barron™s (see Exhibit 1). As it was becoming increas-
ingly dif¬cult to ¬nd undervaluated stocks in the current bull market, McKinsey decided
to investigate Maxwell Shoe further.

Maxwell Shoe was originally a closeout footwear business founded in 1949. It was in-
corporated as Maxwell Shoe Company, Inc. in 1976. During the late 1980s, the company
began focusing on designing, developing, and marketing full lines of branded women™s
footwear. The company went public with a listing on the NASD in 1994.
Professor Krishna G. Palepu prepared this case as the basis for class discussion rather than to illustrate either
effective or ineffective handling of an administrative situation. Copyright © 1999 by the President and Fellows of
Harvard College. Harvard Business School case 9-100-038.
1. Material in this section is drawn from Maxwell™s 1998 10-K report.

Prospective Analysis: Forecasting

10-23 Part 2 Business Analysis and Valuation Tools

In 1998 the company offered casual and dress footwear for women in the moderately
priced market segment ($20 to $90 price range) under Mootsies Tootsies, Sam & Libby,
and Jones New York brand names. The company also designed and developed private
label footwear for selected retailers under their own brand name, or under the names of
J.G. Hook or Dockers. Substantially all of the company™s products were manufactured
overseas by independent factories in low-cost locations such as China.
Maxwell sold its footwear primarily to department stores, specialty stores, catalog re-
tailers, and cable television shopping channels. In April 1997 the company entered into
Maxwell Shoe Company

a joint venture with Butler Group LLC, a wholly owned subsidiary of General Electric
Capital Corporation, to operate approximately 130 retail Sam & Libby and Jones New
York women™s footwear stores through a company called SLJ Retail. Maxwell owned
49 percent of SLJ Retail, the rest being owned by GE Capital.
Since 1987, when Maxwell ¬rst focused on its branded footwear strategy, it has re-
ported sales and pro¬t increases every year. The company attributed this ¬nancial suc-
cess to the following strengths: established brand recognition by consumers, strong
manufacturing relationships with overseas manufacturers and buying agents, emphasis
on high volume, moderately priced footwear, and comprehensive customer relationships
enhanced through electronic data interchange (EDI) systems.
The company expected to build on this competitive advantage, and grow in future by
enhancing its current brands, by increasing its private label business, and by acquiring
new brands as consolidation in the fragmented footwear industry continued.

Maxwell reported for the year ending October 21, 1998, $165.6 million in revenues and
13.3 million in pro¬ts (see Exhibit 2 for the company™s balance sheet, income statement,
and cash ¬‚ow statement for the year). The company™s revenues and pro¬ts grew at aver-
age rates of 16 percent and 24 percent during the previous three years. The correspond-
ing ¬ve-year sales and pro¬t growth rates for the footwear industry as a whole were 17
percent and 9 percent.
Until the middle of July 1998, Maxwell™s ¬nancial performance was mirrored by the
company™s stock price performance (see Exhibit 3). The company™s share price in-
creased from about $5 in 1995 to a peak of $19 by July 1998. However, in the subsequent
months, the company™s share price began to drop, ending at $11 by December 1998. An-
alysts attributed this share price decline to overall concerns with the footwear industry,
which was expected to grow at a relatively modest rate in future because of cheap im-
ports from Asia and relatively ¬‚at consumption patterns. Analysts, however, expected
Maxwell to do better than the industry because of its focus on the moderate price seg-
ment and its heavy reliance on low-cost overseas manufacturing. For example, Tucker
Anthony™s analysts stated:
Investors™ concerns rest with the challenging footwear industry, tough retail envi-
ronment and overall inventory concerns. While we believe the footwear sector will
398 Prospective Analysis: Forecasting

Prospective Analysis: Forecasting

continue to underperform as a group, we believe Maxwell™s shares currently dis-
count investor™s concerns. If the company continues to perform as we estimate, we
believe the risk/reward ratio is very attractive at the current levels.2
Ina McKinsey was wondering how she should go about evaluating the analysts™ view
that Maxwell is an undervalued stock.

Maxwell Shoe Company

2. “Maxwell Shoe Company,” by S.A. Richter et al., of Tucker Anthony & R. L. Day, December 18, 1998.
Prospective Analysis: Forecasting

10-25 Part 2 Business Analysis and Valuation Tools

Barron™s Article on Maxwell Shoe Company

By Rhonda Brammer
Barron™s, September 28, 1998
Maxwell Shoe Company

As somebody or other once said, Trouble is only opportunity in work clothes. Which
could be a motto of our pal Scott Black, who runs Delphi Management up in Boston. A
shrewd contrarian and ¬rst-rate value manager of the old school (yes, book and p/e do
matter), Scott talks a mile a minute, can recite vital statistics on over 100 names in his port-
folio (without crib sheets) and, here™s the amazing part, he actually gets the numbers right.
These days, many a small-cap manager is pretty glum”and no wonder, with the Rus-
sell 2000 off 15% for the year, compared with an 8% gain for the S&P 500. But, we™re
happy to report, when we checked in with Scott, he was positively upbeat.
Sure, small stocks have been “annihilated,” he concedes. Worse still, in his eyes at
least, Delphi is down 4% for the year (he hates to lose money). But the de¬nite bright spot:
“We™re buying companies”and I am talking about decent companies”at 10 and 11
times earnings.”
Which is how we got to talking about Maxwell Shoe.
Founded half a century ago, when Maxwell Blum started a closeout footwear business,
Maxwell Shoe today boasts sales of over $160 million. The company designs and mar-
kets casual and dress shoes for women”and to a lesser extent, kids”under several
brand names, carefully targeting each brand to a speci¬c segment of the market.
Shoes in the Mootsies Tootsies line, for example, which chips in almost half of revenue,
are designed to appeal to women 18 to 34. They sell for $25 to $40 a pair and might be
found at Kohl™s or Mercantile Stores. The slightly pricier Sam & Libby line”about 10% of
sales”are targeted at women 21 to 35, sell for $35“$50 a pair, and might wind up at
Rich™s or Robinson-May. The relatively upscale Jones New York brand”some 25% of rev-
enue”are designed for women over 30. A pair fetches $65 to $90 and you might see
them in the window at Macy™s or Lord & Taylor.
Most of Maxwell™s shoes are made in China, though some of the Jones New York Line
are manufactured in Spain and Italy. To leverage its offshore experience, Maxwell makes
private label shoes for others, which account for roughly the balance of sales.
Now there™s no denying, footwear is a slow-growing, ¬ercely competitive business”
one that isn™t likely to prosper in a sluggish economy. Global players, like Nike and Ree-
bok, moreover, have already been hard hit by weakness in Asia.
But there™s no reason, Black argues, that shares of Maxwell Shoe, which recently traded
over 23, should have been hammered to 12.
“People group them all together,” he shrugs. “But this is no Nike where, at the margin,
they were dependent on Japan and the Far East for their growth.”

Republished with permission of Dow Jones & Co., Inc.; permission conveyed through Copyright Clearance Center,
400 Prospective Analysis: Forecasting

Prospective Analysis: Forecasting

Indeed, Maxwell™s results sparkle.
In ¬scal ™97, ending October, sales grew by 28% to 134 million, while net rose over
50%, to $9 million, or $1.09 a share. In the ¬rst nine months, ended July, sales advanced
27%, while net climbed 44%, to $9.8 million, or $1.08 a share. For all of ¬scal ™98,
Black™s looking for $1.35“$1.40 a share.
Book value is over $8 and the company is debt-free”something Black likes. “If the
economy turns south,” he quips, “at least they live to ¬ght another day.”

Maxwell Shoe Company
Worth noting, too”at least for those who remember Maxwell from years back”is that


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