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CMBA ACG6175-Bear Stearns & Co. issued a report on Blockbuster

Bear Stearns & Co Bear Stearns & CoAnswer the following 10 questions, using the financial statement data from BlockbusterEntertainment 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 isreproduced in part below.Blockbuster-Entertainment (Ticker symbol: BV, Price per share: $33 ½) increased owned and franchisedvideo stores from 19 at the end of 1986 to 415 at December 31, 1988. In the same period revenuejumped 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 were25,741,549 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 canbe 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." APBOpinion 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 isusually required by the SEC) is to relate the amortization period to the nature of the businessacquired. Thus in a typical hi-tech acquisition the SEC requires goodwill to be amortized over 5 to 7years; in bank purchases, over 15 to 20 years.Other information: Eight of the eighty company-owned stores that appeared in the 1987 10-K (annualfiling with the SEC) are not on the 1988 list. The maximum term of the company’s franchiseagreements is 25 years.1) What is Blockbuster’s amortization timetable? Do you think it is appropriate?2) What would be the impact on Blockbuster’s 1988 earnings per share if 5 year amortizationwere applied to this goodwill?B) On April 20, Blockbuster announced an agreement to merge with its largest franchisee, VideoSuperstore. 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 senseto 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 werenot included in 1988 revenues?C) BV drastically slowed its depreciation (amortization) of "hit* video tapes at the start of 1988. In 1987BV depreciated its rental videotape "hits" over nine months, straight line. At the start of 1988, itswitched to a method it called "36 month accelerated.” The financial statements do not disclose howaccelerated the curve is, but do say that the company uses 150% of straight line, computed on amonthly 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 stock” videotapes?5) What was the effect on earnings per share of the change in depreciation method for “hit” tapes(assume that hit tapes made up 25% of new tape purchases, and that the average hit tapewas owned for half the year)?D) BV also sells videotapes. However, most of the sales are in bulk to new franchisees, rather than tostore customers. In 1988, 68% of sales were to franchisees. Page 1 of 10 Bear Stearns & Co6) 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. Theincome statement shows, in revenues:Royalties and other fees $8,142,000However, Note 1 to the financial statements lists:Royalties and other fees $7,590,000Area Development fees 550,000Initial franchise fees 2,415,000 The first two items total to the income statement amount, the third seems to be buried, inexplicably, inrental revenues.7) What was the effect on 1988 earnings per share, of the non-recurring items: area developmentfees and 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 afterthe above adjustments?10) What would BV’s Price/Earnings ratio be, given all of the aboveadjustments (including #3)? Page 2 of 10 Bear Stearns & CoExhibit 2Selected Excerpts: Blockbuster Entertainment Corporation 1988 Annual ReportBLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIESConsolidated Statements of OperationsFor the Years ended December 31,(in thousands, except per share data) 1988 1987 1986 $87,29941,4528,142136,893 $19,00921.5462,67343,228 $ 2,8934,2472987,438 31,34363,63815,567 15,92316,4294,162 3,5115,1522,093 26,345 6,714 (3,318) — (954) 626(2,066)92 456(569)104 228—— 24,997 6,705 (4,044) 9,499 2,615 (823) $ 15,498 $ 4,090 $(3,221) NET INCOME (LOSS) PER COMMONAND COMMON SHAREEQUIVALENT $.58 $.28 $(.34) NET INCOME (LOSS) PER COMMONAND COMMON SHAREEOUIVALENT—ASSUMING FULLDILUTION $.57 $.28 $(.34) REVENUE:Rental revenueProduct salesRoyalties and other fees OPERATING COSTS AND EXPENSES:Cost of product salesOperating expensesSelling, general, and administrativeOPERATING INCOME (LOSS)EQUITY IN LOSS OF AN AFFILIATEINTEREST INCOMEINTEREST EXPENSEOTHER INCOME, NETINCOME (LOSS) BEFORE INCOMETAXESPROVISION FOR (BENEFIT OF)INCOME TAXESNET INCOME (LOSS) — Page 3 of 10 Bear Stearns & CoExhibit 2 (Continued)BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIESConsolidated Statements of OperationsFor the Years ended December 31,(in thousands, except per share data)ASSETS1988CURRENT ASSETSCash and short term investmentsAccounts receivable, less allowancesNotes receivable from shareholdersMerchandise InventoriesOtherTotal Current AssetsVIDEOCASSETTE RENTAL INVENTORY, NETPROPERTY AND EQUIPMENT, NETINTANGIBLE ASSETS RELATING TO ACQUIREDBUSINESS, NETOTHER ASSETS 1987 $8,9595,617—17,9016,35938,836 7,1682,5967,9198,4402,39928,522 60,29447,284 16,38914,998 24,7545,599176,767 12,1492,12774,185 $3,13934,1318,1081893,65349,220 $2,18210,5872,54644548916,879 21,3031,2933,167 14,79745160 — — 2,57484,80615,124 1,80040,572(374) 101,784$176,767 41,998$74,185 LIABILITIES AND SHAREHOLDERS’ EQUITYCURRENT LIABILITIESCurrent Portion of Long Term DebtAccounts payableAccrued liabilitiesCurrent deterred income taxesAdvance payments from franchise ownersTotal Current LiabilitiesLONG TERM DEBT. LESS CURRENT PORTIONOTHER NONCURRENT LIABILITIESDEFERRED INCOME TAXESCOMMITMENTSSHAREHOLDERS’ EQUITY:Preferred Stock, $1 par value; authorized 500,000 Shares;none outstandingCommon Stock, $10 par value; authorized 40.000.000and 20,000.000 shares, respectively; issued 25,741.549and 17,995.092, respectivelyCapital In excess of par valueRetained earnings (deficit)Total Shareholders’ Equity The accompanying notes are an Integral part of these statements. Page 4 of 10 Bear Stearns & CoExhibit 2 (Continued)BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIESConsolidated Statements of OperationsFor the Years ended December 31,(in thousands, except per share data) 1988 1987 1986 $15,498 $4,090 $(3,221) 22,223 4,776 1,038 — — 954 (3,132)(9,309) (1,211)(5,068) (1,264)(3,153) 24,797 8,947 2,619 3,164(3,984)(917) (1,511)1,1381,378 2,000346346 48,340 10.263 (1,376) CASH FLOWS FROM INVESTING ACTIVITIESCollection of notes receivablePurchase of videocassette rental inventory, netPurchases of property and equipment, netUsed in acquisitionsOther 7,919(51,255)(31,224)(9,843)— —(14,281)(10,519)(2,814)(2,805) —(3,053)(4,133)—(1,174) NET CASH USED IN INVESTING ACTIVITIES (84,403) (30,449) (8,360) CASH FLOWS FROM FINANCING ACTIVITIESProceeds from the issuance of common stock, netProceeds from long term debtRepayments of long term debtOther 36,09439,847(38,807)— 17,8009,184(2,794)(238) 3,8981,400—150 NET CASH PROVIDED BY FINANCING ACTIVITIES 37,854 23,952 5,448 1,791 3,766 (4,288) 7,168 3,402 7,690 8,959 7,168 3,402 CASH FLOWS FROM OPERATING ACTIVITIESNet income (loss)Adjustments to reconcile net income (loss) to net cash from(used in operating activities)Depreciation and amortizationEquity in loss of an affiliateChanges in operating assets and liabilities,net of effects from purchase transactionsIncrease in accounts receivableIncrease in merchandise inventoriesIncrease in accounts payable and accruedliabilitiesIncrease (decrease) in advance paymentsfrom franchise ownersIncrease in other working capital items, netOtherNET CASH FLOW FROM (USED IN)OPERATING ACTIVITIES NET INCREASE (DECREASE) IN CASH AND SHORTTERM INVESTMENTCASH AND SHORT TERM INVESIMENTS, BEGINNINGOF YEARCASH AND SHORT-TERM INVESTMENTS, END OFYEAR The accompanying notes are an integral part of these statementsPage 5 of 10 Bear Stearns & CoExhibit 2 (Continued)BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIESNotes to Consolidated Financial Statements(000’s omitted in all labels except per share amounts)I. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESThe accompanying financial statements present the consolidated financial (Million and results ofoperations of the Company and its subsidiaries All material intercompany accounts and transactions havebeen eliminated in order lo maintain consistency and comparability between periods presented, certainamounts have been reclassified from the previously reported fiscal 1987 and 1986 financial statements inorder to conform to fiscal 1988 presentationThe statements of changes in shareholders’ equity, all per share data and number of common shares forall periods included in the financial statements and notes have been adjusted to reflect the two-for-onestock splits that occurred in both March and August, 1988, as more fully described in Note 7.The accompanying financial statements do not include the financial condition and results operations ofMajor Video Corp., which was acquired in January, 1989. This transaction, which will be accounted for asa pooling of interests, is more fully described in Note 10.Short-Term InvestmentsShort-term investments consist of interest bearing securities with interest rates ranging from 5.20% to9.13% with maturities of less than ninety days.Accounts Receivable:Accounts receivable includes an allowance for uncollectible accounts of $181,000 and $155,000 as ofDecember 31, 1988, and 1987, respectively.Merchandise Inventories:Merchandise inventories are stated at the lower of cost or market. Cost is determined on a movingaverage basis and generally includes those costs required to purchase and ready products for sale orutilization in Company-owned stores. Inventory transferred to Company-owned stores is reclassified tonon-current assets and amortized in accordance with Company policy.Videocassette Rental Inventory:Videocassettes are recorded at cost and amortized over their estimated economic life with no provisionfor salvage value. Those videocassettes which are considered base stock (“non-hits”) are amortized overthirty-six months on a straight-line basis. Beginning January 1, 1988, economics and the relatedamortization period for new release feature films, which are frequently ordered in large quantities tosatisfy initial demand (“hits”), were revised to approximate 36 months on an accelerated basis.During the six-month period ended December 31, 1987, the economic life of “hits” and relatedamortization period approximated nine months on a straight-line basis with no salvage value. TheCompany has determined that the economic useful life and related amortization for these “hits” moreclosely approximates 36 months on the accelerated basis with no provision for salvage value.Videocassette rental inventory and related amortization as of December 31, is as follows:19881987Videocassette rental inventory………………………………………$76,390$19,600Less: Accumulated amortization…………………………………….(16,096)(3,211)$60,294$16,389Amortization expense related to videocassette rental inventory was $15,659,000, $3,543,000, and$545,000 in 1988, 1987, and 1986, respectively. As videocassette rental inventory is sold or retired, theapplicable cost and accumulated amortization are eliminated from the accounts and any gain or loss isrecorded.Property and Equipment:Property and equipment is stated at cost. Depreciation and amortization is provided over the estimateduseful lives of the related assets using the straight line method. Property and equipment as of December31, consists of the following: Page 6 of 10 Bear Stearns & CoExhibit 2 (Continued)BuildingsLeasehold ImprovementFurniture and fixturesEquipment and vehiclesLess: Accumulated depreciation and amortization Life15-19 Years5-10 Years5-10 Years3-10 Years 1988$63926,37811,14114,63152,789(5,505)$47,284 1987$2896,4654,4825,29816,354(1,536)$14,938 Depreciation expense was $3,796,000, $993,000 and $492,000 in 1988, 1987 and 1986, respectively.Additions to and major improvements of property and equipment are capitalized. Maintenance and repairexpenditures are charged to expense as incurred and amounted to approximately $454,000, $191,000and $125,000 in 1988, 1987, and 1986, respectively. As property and equipment is sold or retired, theapplicable cost and accumulated depreciation or amortization are eliminated from the accounts and anygain or loss is recorded. Intangible Assets:Intangible assets relating to acquired businesses as of December 31, 1988, and 1987 consist primarily ofthe cost of purchased business in excess of market value of net assets acquired. The cost in excess ofmarket value of net assets relating to businesses acquired is being amortized on a straight-line basis overa period of 40 years. The accumulated amortization of intangible assets amounted to $769,000 in 1988and $196,000 in 1987. Revenue Recognition:Revenue from Company-owned stores is recognized at the time or rental or sale. Revenue from franchiseowners is recognized when all material services or conditions required under the franchise agreementhave been performed by the Company. The only significant commitment and obligation the Company hasunder its franchise agreements is to provide products to franchise owners. The Company derivessubstantially all of its franchise program revenue from the following sources: (1) Initial franchise fees, (2)Product sales to franchise owners, (3) Area development fees and (4) Royalties and other fees.Franchise owners purchase their initial tape inventory, equipment and supplies from the Company at costplus a mark-up. Revenue for these items is recognized when the products are shipped. In addition, theypay a royalty based on monthly revenue and a monthly software license fee, which are recognized asrevenue when earned. Certain franchise owners pay an initial franchise fee and a non-refundable areadevelopment fee under their franchise agreement. Revenue is recognized from these fees when the storeis opened.Revenue included in the consolidated statements of operations from the Company’s franchise programfor the years ended December 31, is as follows:198819871986Product Sales$28,334$19,163$3,793Royalties and other fees7,5902,583298Area development fees55290-Initial franchise fees2,415270-$38,891$22,406$4,091Approximately 10%, 21%, and 48% of total revenue in 1988, 1987, and 1986, respectively, was derivedfrom one franchise owner: BLOCKBUSTER Midwest, L.P.Income Taxes:The Company has applied Statement of financial Accounting Standards (SFAS) No. 96 – Accounting forIncome Taxes to all years presented. Page 7 of 10 Bear Stearns & CoEXHIBIT 2 (Continued)2. SUPPLEMENTAL CASH FLOW INFORMATIONSupplemental cash flow information for the years ended December 31, is as follows:19881987Cash received (paid) during the year for:Interest income$578$486Interest expense(2,760)(130)Income taxes(3,338)(789)Investing activities in connection with acquisitions (none in 1986):1988Videocassette rental inventory$8,846Property and equipment5,090Other non-current assets572Intangible assets relating to acquired businesses13,093Working capital other than cash acquired(4,037)Long-term debt issued and assumed(5,527)Common stock and warrants issued(8,194)Cash used in acquisitions$9,843 1986$268(45)461987$2,5751,316-11,992(384)(10,290)(2,365)$2,844 3. BUSINESS COMBINATIONSAll businesses acquired through December 31, 1988, and accounted for as purchases are included in thefinancial statements from the date of acquisition. Those businesses acquired through December 31,1988, and treated as poolings of interests have been included retroactively in the financial statements asif the companies had operated as one entity since inception.In early 1988, the Company acquired Video Library, Inc., a 42-stor retail video chain based in San Diego,Calif., for $6,380.861 in cash and 885,508 shares of common stock. In addition, during 1988, theCompany acquired four other businesses for $4,840.462 in cash and notes, and 449,889 shares of itscommon stock. The aforementioned acquisitions were accounted for under the purchase method ofaccounting.The Company’s consolidated results of operations on an unaudited pro forma basis, assuming theseacquisitions had occurred as of January 1, 1987, are as follows:Pro forma revenuePro forma net incomePro forma earnings per share 1988$144,62415,532.56 1987$61,9364,216.27 This pro forma information does not purport to be indicative of the results that actually would have beenobtained if the operations had been combined during the periods presented and is not intended to be aprojection of future results.Effective May, 1987, the Company acquired Movies To Go, Inc., a 29-store retail video chain based in St.Louis, Mo., $14,500,000 in cash, notes and warrants representing 880,000 shares of common stock. Thisacquisition was accounted for under the purchase method of accounting.In March, 1987, the Company acquired the net assets of Southern Video in exchange for 321,840 sharesof common stock of the Company. The transaction was accounted for under the pooling of interestsmethod of accounting. Page 8 of 10 Bear Stearns & CoEXHIBIT 2 (Continued)4. LONG TERM DEBTThe details relating to long term debt as of December 31 are as follows:1988 1987 $15,000 $— 6,905 9,121 Payable to a bank under an unsecured revolving credit agreement,interest at prime (8.75% at December 31, 1987), due 1989.Interest payable quarterly with principal due at maturity. — — 7,500 Payable to others, interest at various rates ranging from 6% to 14%due at various times through 1992. Monthly principal payments ofapproximately $89,000 plus interest. Secured by certain inventoriesand real estate. 928 988 1,609 — 24,442(3,139)$21,303 17,609(2,812)$14,797 Notes Payable:Payable to banks under an unsecured revolving credit agreement,interest at prime plus ¼% (10.50% as of December 31, 1988),due 1992, interest payable quarterly with principal due at maturity.Payable to former shareholders of Movies to Go, interest ratesescalating annually from 6% to prime plus 2% due 1992.Periodic annual principal payments ranging from $427,000to $2,570,000 plus interest. Capitalized lease obligations secured by furnitureand fixtures, computer equipment and vehiclesTotal long-term debtLess: Current PortionLong term debt, less current portionThe long term debt as of December 31, 1988, is due as follows:1989$3,31919902,67019913,0031992 and thereafter15,630 In June, 1988, the Company entered into a revolving credit agreement with Security Pacific NationalBank, for itself and as agent and Southeast Bank, N.A., for itself, pursuant to which the banks haveagreed to loan the Company an aggregate of $50,000,000 on an unsecured basis. No principal paymentsare required until the maturity date in 1992. Interest on current loans is the lower of the prime rate ineffect of the agent plus ¾ of one percent, depending on the aggregate principal amount of the advancesoutstanding of the London Interbank offered rate plus 1 and ¾ percent or two percent, depending uponthe aggregate principal amount of advances outstanding. There is a commitment fee of ½ percent perannum on the average unused portion of the available commitment plus ¼ percent per annum on aportion of the banks’ average daily inactive commitments and ½ percent on such part of the inactivatedcommitment when activated. There are no compensating balance requirements in connection with therevolving credit agreement. The agreement requires the Company to maintain certain financial ratios andimposes certain restrictions on, among other things, additional debt, payment of cash dividends andcapital expenditures in excess of specified amounts. Page 9 of 10 Bear Stearns & Co5. INCOME TAXESThe income tax provision (belief) for the years ended December 31, consists of the following components:1988 1987 1986 $43903734,763 $1,925802005 $(790)-(790) 4,3234134,736$9,499 58228610$2,615 (33)–(33)$(823) Current:FederalStateTotal CurrentDeferred:FederalStateTotal Deferred A reconciliation of the expected income tax provision at the U.S. federal income tax rate (34% in 1988),40% in 1987, and 46% in 1986) to the Company effective income tax provision for the years endedDecember 31, is as follows. Income tax provision (benefit) at statutory rateAmortization expense not deductible for taxTax benefits of temporary differences not recognized forfinancial reportingEffect of future lower tax rate on temporary differences, netState income taxes, net of federal income tax benefitIntercompany profit eliminations of pooled entityOther, netTotal 1988$8,499157 1987$2,68278 1986($1,860)– –786-57$9,499 -(137)108-(116)$2,615 800–16077$(823) Deferred taxes reflect the impact of “temporary differences” between the amount of assets and liabilitiesfor financial reporting purposes and such amounts as measured by tax laws and regulations. Report of Independent Public AccountantsTo BLOCKBUSTER Entertainment Corporation:We have audited the accompanying consolidated balance sheets of BLOCKBUSTER EntertainmentCorporation (a Delaware corporation) and subsidiaries as of December 31, 1986 and 1987, and therelated consolidated statements of operations, changes in shareholders’ equity and cash flows for each ofthe three years in the period ended December 31, 1988. These financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion on these financial statementsbased on our audits.We conducted our audits in accordance with generally accepted auditing standards. Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, as well as evaluating theoverall financial statement presentation. We believe that our audits provide a reasonable basis for ouropinion.In our opinion, the financial statements referred to above present fairly. In all material respects, thefinancial position of BLOCKBUSTER Entertainment Corporation and subsidiaries as of December 31,1988 and 1987, and the results of their operations and their cash flows for each of the three years in theperiod ended December 31, 1988, in conformity with generally accepted accounting principles.ARTHUR ANDERSON AND COMPANYFt. Lauderdale, Florida, Feb. 17, 1989 Page 10 of 10

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