Editor’s note: Yesterday, Tom examined Steve Madden’s recent operating history, so reading that will give you the background for the valuation presented here.

Economic Outlook and Forecasts:

In order to properly analyze the possible acquisition of Steve Madden (SHOO), it is important to create a financial forecast to be able to figure out growth rates and determine what cash the company will generate and hence what the company is currently worth. After the subprime meltdown, credit rates rose due to an aversion to lending in the bond markets. The Federal Reserve responded by pumping money into the system to lower rates and make lending more attractive. Given the assumption that the Federal Reserve will continue to manage interest rates in a favorable manner to spur lending and encourage consumer spending, we will assume that the credit crunch in the United States is a temporary problem and consumer spending will return to the levels prior to the sub-prime lending events in the next one to two years. This means that we can assume that future revenues will grow. Along with this assumption we will assume that the cost cutting activities that lead to greater income numbers in the retail division were not one time events and the improved profit margins will stay. Over the last two quarters revenue declines in wholesale were attributed to management’s miscalculation in the trend amongst the Candies division. In order to provide a conservative valuation we are going to assume that this miscalculation could not have been prevented and we are not going to calculate any additional growth to revenues or cash.

Discounting Cash Flows:

In order to calculate the present value of Steve Madden we will discount past cash flows based off of future growth rates. The main things that are needed in order to arrive at a target price are; operating free cash flow, discount rate, future growth projections, and terminal/exit multiple.

For operating free cash flow we take the combined operating free cash flow from the previous four quarters and the subtract that number by capital expenditures from the previous four quarters. The number that we arrive at is the initial free cash flow which is $32 million.

The next question in determining present value is finding out the rate at which Steve Madden will grow free cash flow over the next five years. Given our assumption that the credit markets will continue to improve and the consumers will trend back normal spending behavior we will use the consensus analysts growth number of 15% annual growth for the next five years.

In order to find the discount rate the use of Capital Asset Pricing Model (CAPM) is used. This model is:
r = Rf + b(Rm-Rf)

Where r = discount rate, Rf = risk free return, b = Beta of security, Rm = expected market return

In this situation we will have
Rf = 4%, the rate of the 3-month T-Bill
b = 1.62
Rm = 6.6%, rate of return from S&P 500 plus dividends

Using this model we get an implied discount rate of 8.2%. The model below shows the price targets of Steve Madden by using the method described above. By using a discount rate of 8.2% we get a price target of $34.25 and a total worth of Steve Madden Company to be $687.2 million. Thus we calculate that a buyout of Steve Madden could value the firm at up to 55% above the most recent close.

The diagram below gives target prices for different discount rates and different growth estimates in order to give a range of potential valuations with different estimates:

Recommendation:

Steve Madden at its current price is definitely a candidate to be taken private. Steve Madden is currently priced using a very high discount rate. This means that the market is implying that in order to not invest in Steve Madden investors are able to buy investments that have on average outperformed the broader markets at a lower risk value. Given the analyst’s projection of Steve Madden’s growth, an LBO firm has a margin of safety in buying Steve Madden up to $34 dollars a share.

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Disclosure: Author is long SHOO.