Bear Stearns & Co
Answer the following 10 questions, using the financial statement data from Blockbuster Entertainment Corporation. Show your work (i.e., note what numbers you’re using).
On May 9, 1989, Bear Stearns & Co. issued a report on Blockbuster Entertainment Corp., which is reproduced in part below.
Blockbuster-Entertainment (Ticker symbol: BV, Price per share: $33 ½)increased owned and franchised video stores from 19 at the end of 1986 to 415 at December 31, 1988. In the same period revenue jumped from $7.4 million to $136.9 million. Reported earnings also leaped; from $.34 per share in 1986 to $.57 per share in 1988. The stock carries an historical Price to Earnings ratio of 59, and there were 25,741,549 shares of common stock issued and outstanding as of 12/31/88.
A)Some of Blockbuster’s mergers with other video rental companies have been recorded as purchases. In a merger treated as a purchase, the price paid is first allocated to the fair values of assets that can be kicked, picked up or painted. Any excess paid for the company beyond these “fair values becomes goodwill, which Blockbuster labels “intangible assets relating to acquired businesses.” APB Opinion 17 requires that goodwill be amortized to income (expensed) over 40 years or less.
In the past, many companies automatically adopted 40 year amortization. Current practice (which is usually required by the SEC) is to relate the amortization period to the nature of the business acquired. Thus in a typical hi-tech acquisition the SEC requires goodwill to be amortized over 5 to 7 years; in bank purchases, over 15 to 20 years.
Other information: Eight of the eighty company-owned stores that appeared in the 1987 10-K (annual filing with the SEC) are not on the 1988 list. The maximum term of the company’s franchise agreements is 25 years.
1) What is Blockbuster’s amortization timetable? Do you think it is
appropriate?
Not appropriate, the industrial standard and SEC current use should apply to all firms. Blockbuster videos are a form of hi-tech, the standard amortization period this type of business structure should be the 5-7 year amortization. Blockbuster is using an outdated amortization timetable of 40 years. The effect of a longer amortization will reduce the payments and the interest to over a longer period of time resulting in a higher loan/debt liability than original balance because the additional interest will increase over the term. However, longer terms also improve cash flow leverage. In addition, the goodwill amortization must be on intangible assets, not on physical assets.
2) What would be the impact on Blockbuster’s 1988 earnings per share be if 5 year amortization were applied to this goodwill?
B)On April 20, Blockbuster announced an agreement to merge with its largest franchisee, Video Superstore. Video Superstore was Blockbuster’s largest customer for videotapes, accounting for 10% of such sales in 1988, 21% in 1987, and 48% in 1986.
Since intra-company transactions are eliminated from the financial statements (it doesn’t make sense to record sales to yourself!),these sales will disappear next year.
3) What would have been the effect on earnings per share if Video Superstore purchases were not included in 1988 revenues?
C)BV drastically slowed its depreciation (amortization) of “hit* video tapes at the start of 1988. In 1987 BV depreciated its rental videotape “hits” over nine months, straight line. At the start of 1988, it switched to a method it called “36 month accelerated. The financial statements do not disclose how accelerated the curve is, but do say that the company uses 150% of straight line, computed on a monthly basis. Thus, the resulting depreciation is as follows:
First 12 months 40%
Second 12 months 30%
Third 12 months 30%
4)Over what period does BV depreciate its “base stockvideotapes?
5)What was the effect on earnings per share of the change in depreciation method for hittapes (assume that hittapes made up 25% of new tape purchases, and that the average hittape was owned for half the year)?
D)BV also sells videotapes. However, most of the sales are in bulk to new franchisees, rather than to store customers. In 1988, 68% of sales were to franchisees.
6)What was the effect on earnings per share of these sales to franchisees?
E)BV charges franchisees various fees and discloses them in a somewhat confusing manner. The income statement shows, in revenues:
Royalties and other fees $8,142,000
However, Note 1 to the financial statements lists:
Royalties and other fees $7,590,000
Area Development fees 550,000
Initial franchise fees 2,415,000
The first two items total to the income statement amount, the third seems to be buried, inexplicably, in rental revenues.
7)What was the effect on 1988 earnings per share, of the non-recurring items: area development feesand initial franchise fees?
8)What would BV’s 1988
earnings per share be after all of the above adjustments?
9)Ignoring #3 above, what would BV’s 1988 earnings per share be after the above adjustments?
10)What would BV’s Price/Earnings ratio be, given all of the above adjustments (including #3)?