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Bear Stearns & Co




Bear Stearns & Co;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 ?) 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?;2) What would be the impact on Blockbuster's 1988 earnings per share 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 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 tape;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.;Page 1 of 10;Bear Stearns & Co;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;fees 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 after;the above adjustments?;10) What would BV's Price/Earnings ratio be, given all of the above;adjustments (including #3)?;Page 2 of 10;Bear Stearns & Co;Exhibit 2;Selected Excerpts: Blockbuster Entertainment Corporation 1988 Annual Report;BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES;Consolidated Statements of Operations;For the Years ended December 31;(in thousands, except per share data);1988;1987;1986;$87,299;41,452;8,142;136,893;$19,009;21.546;2,673;43,228;$ 2,893;4,247;298;7,438;31,343;63,638;15,567;15,923;16,429;4,162;3,511;5,152;2,093;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;$(3,221);NET INCOME (LOSS) PER COMMON;AND COMMON SHARE;EQUIVALENT;$.58;$.28;$(.34);NET INCOME (LOSS) PER COMMON;AND COMMON SHARE;EOUIVALENT?ASSUMING FULL;DILUTION;$.57;$.28;$(.34);REVENUE;Rental revenue;Product sales;Royalties and other fees;OPERATING COSTS AND EXPENSES;Cost of product sales;Operating expenses;Selling, general, and administrative;OPERATING INCOME (LOSS);EQUITY IN LOSS OF AN AFFILIATE;INTEREST INCOME;INTEREST EXPENSE;OTHER INCOME, NET;INCOME (LOSS) BEFORE INCOME;TAXES;PROVISION FOR (BENEFIT OF);INCOME TAXES;NET INCOME (LOSS);?;Page 3 of 10;Bear Stearns & Co;Exhibit 2 (Continued);BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES;Consolidated Statements of Operations;For the Years ended December 31;(in thousands, except per share data);ASSETS;1988;CURRENT ASSETS;Cash and short term investments;Accounts receivable, less allowances;Notes receivable from shareholders;Merchandise Inventories;Other;Total Current Assets;VIDEOCASSETTE RENTAL INVENTORY, NET;PROPERTY AND EQUIPMENT, NET;INTANGIBLE ASSETS RELATING TO ACQUIRED;BUSINESS, NET;OTHER ASSETS;1987;$8,959;5,617;?;17,901;6,359;38,836;7,168;2,596;7,919;8,440;2,399;28,522;60,294;47,284;16,389;14,998;24,754;5,599;176,767;12,149;2,127;74,185;$3,139;34,131;8,108;189;3,653;49,220;$2,182;10,587;2,546;445;489;16,879;21,303;1,293;3,167;14,797;451;60;?;?;2,574;84,806;15,124;1,800;40,572;(374);101,784;$176,767;41,998;$74,185;LIABILITIES AND SHAREHOLDERS' EQUITY;CURRENT LIABILITIES;Current Portion of Long Term Debt;Accounts payable;Accrued liabilities;Current deterred income taxes;Advance payments from franchise owners;Total Current Liabilities;LONG TERM DEBT. LESS CURRENT PORTION;OTHER NONCURRENT LIABILITIES;DEFERRED INCOME TAXES;COMMITMENTS;SHAREHOLDERS' EQUITY;Preferred Stock, $1 par value, authorized 500,000 Shares;none outstanding;Common Stock, $10 par value, authorized 40.000.000;and 20,000.000 shares, respectively, issued 25,741.549;and 17,995.092, respectively;Capital In excess of par value;Retained earnings (deficit);Total Shareholders? Equity;The accompanying notes are an Integral part of these statements.;Page 4 of 10;Bear Stearns & Co;Exhibit 2 (Continued);BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES;Consolidated Statements of Operations;For 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);1,138;1,378;2,000;346;346;48,340;10.263;(1,376);CASH FLOWS FROM INVESTING ACTIVITIES;Collection of notes receivable;Purchase of videocassette rental inventory, net;Purchases of property and equipment, net;Used in acquisitions;Other;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 ACTIVITIES;Proceeds from the issuance of common stock, net;Proceeds from long term debt;Repayments of long term debt;Other;36,094;39,847;(38,807);?;17,800;9,184;(2,794);(238);3,898;1,400;?;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 ACTIVITIES;Net income (loss);Adjustments to reconcile net income (loss) to net cash from;(used in operating activities);Depreciation and amortization;Equity in loss of an affiliate;Changes in operating assets and liabilities;net of effects from purchase transactions;Increase in accounts receivable;Increase in merchandise inventories;Increase in accounts payable and accrued;liabilities;Increase (decrease) in advance payments;from franchise owners;Increase in other working capital items, net;Other;NET CASH FLOW FROM (USED IN);OPERATING ACTIVITIES;NET INCREASE (DECREASE) IN CASH AND SHORTTERM INVESTMENT;CASH AND SHORT TERM INVESIMENTS, BEGINNING;OF YEAR;CASH AND SHORT-TERM INVESTMENTS, END OF;YEAR;The accompanying notes are an integral part of these statements;Page 5 of 10;Bear Stearns & Co;Exhibit 2 (Continued);BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES;Notes to Consolidated Financial Statements;(000?s omitted in all labels except per share amounts);I. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES;The accompanying financial statements present the consolidated financial (Million and results of;operations of the Company and its subsidiaries All material intercompany accounts and transactions have;been eliminated in order lo maintain consistency and comparability between periods presented, certain;amounts have been reclassified from the previously reported fiscal 1987 and 1986 financial statements in;order to conform to fiscal 1988 presentation;The statements of changes in shareholders' equity, all per share data and number of common shares for;all periods included in the financial statements and notes have been adjusted to reflect the two-for-one;stock 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 of;Major Video Corp., which was acquired in January, 1989. This transaction, which will be accounted for as;a pooling of interests, is more fully described in Note 10.;Short-Term Investments;Short-term investments consist of interest bearing securities with interest rates ranging from 5.20% to;9.13% with maturities of less than ninety days.;Accounts Receivable;Accounts receivable includes an allowance for uncollectible accounts of $181,000 and $155,000 as of;December 31, 1988, and 1987, respectively.;Merchandise Inventories;Merchandise inventories are stated at the lower of cost or market. Cost is determined on a moving;average basis and generally includes those costs required to purchase and ready products for sale or;utilization in Company-owned stores. Inventory transferred to Company-owned stores is reclassified to;non-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 provision;for salvage value. Those videocassettes which are considered base stock (?non-hits?) are amortized over;thirty-six months on a straight-line basis. Beginning January 1, 1988, economics and the related;amortization period for new release feature films, which are frequently ordered in large quantities to;satisfy 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 related;amortization period approximated nine months on a straight-line basis with no salvage value. The;Company has determined that the economic useful life and related amortization for these ?hits? more;closely 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;1988;1987;Videocassette rental inventory???????????????;$76,390;$19,600;Less: Accumulated amortization??????????????.;(16,096);(3,211);$60,294;$16,389;Amortization 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, the;applicable cost and accumulated amortization are eliminated from the accounts and any gain or loss is;recorded.;Property and Equipment;Property and equipment is stated at cost. Depreciation and amortization is provided over the estimated;useful lives of the related assets using the straight line method. Property and equipment as of December;31, consists of the following;Page 6 of 10;Bear Stearns & Co;Exhibit 2 (Continued);Buildings;Leasehold Improvement;Furniture and fixtures;Equipment and vehicles;Less: Accumulated depreciation and amortization;Life;15-19 Years;5-10 Years;5-10 Years;3-10 Years;1988;$639;26,378;11,141;14,631;52,789;(5,505);$47,284;1987;$289;6,465;4,482;5,298;16,354;(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 repair;expenditures are charged to expense as incurred and amounted to approximately $454,000, $191,000;and $125,000 in 1988, 1987, and 1986, respectively. As property and equipment is sold or retired, the;applicable cost and accumulated depreciation or amortization are eliminated from the accounts and any;gain or loss is recorded.;Intangible Assets;Intangible assets relating to acquired businesses as of December 31, 1988, and 1987 consist primarily of;the cost of purchased business in excess of market value of net assets acquired. The cost in excess of;market value of net assets relating to businesses acquired is being amortized on a straight-line basis over;a period of 40 years. The accumulated amortization of intangible assets amounted to $769,000 in 1988;and $196,000 in 1987.;Revenue Recognition;Revenue from Company-owned stores is recognized at the time or rental or sale. Revenue from franchise;owners is recognized when all material services or conditions required under the franchise agreement;have been performed by the Company. The only significant commitment and obligation the Company has;under its franchise agreements is to provide products to franchise owners. The Company derives;substantially 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 cost;plus a mark-up. Revenue for these items is recognized when the products are shipped. In addition, they;pay a royalty based on monthly revenue and a monthly software license fee, which are recognized as;revenue when earned. Certain franchise owners pay an initial franchise fee and a non-refundable area;development fee under their franchise agreement. Revenue is recognized from these fees when the store;is opened.;Revenue included in the consolidated statements of operations from the Company?s franchise program;for the years ended December 31, is as follows;1988;1987;1986;Product Sales;$28,334;$19,163;$3,793;Royalties and other fees;7,590;2,583;298;Area development fees;552;90;-Initial franchise fees;2,415;270;-$38,891;$22,406;$4,091;Approximately 10%, 21%, and 48% of total revenue in 1988, 1987, and 1986, respectively, was derived;from one franchise owner: BLOCKBUSTER Midwest, L.P.;Income Taxes;The Company has applied Statement of financial Accounting Standards (SFAS) No. 96 ? Accounting for;Income Taxes to all years presented.;Page 7 of 10;Bear Stearns & Co;EXHIBIT 2 (Continued);2. SUPPLEMENTAL CASH FLOW INFORMATION;Supplemental cash flow information for the years ended December 31, is as follows;1988;1987;Cash received (paid) during the year for;Interest income;$578;$486;Interest expense;(2,760);(130);Income taxes;(3,338);(789);Investing activities in connection with acquisitions (none in 1986);1988;Videocassette rental inventory;$8,846;Property and equipment;5,090;Other non-current assets;572;Intangible assets relating to acquired businesses;13,093;Working 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);46;1987;$2,575;1,316;-11,992;(384);(10,290);(2,365);$2,844;3. BUSINESS COMBINATIONS;All businesses acquired through December 31, 1988, and accounted for as purchases are included in the;financial 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 as;if 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, the;Company acquired four other businesses for $4,840.462 in cash and notes, and 449,889 shares of its;common stock. The aforementioned acquisitions were accounted for under the purchase method of;accounting.;The Company?s consolidated results of operations on an unaudited pro forma basis, assuming these;acquisitions had occurred as of January 1, 1987, are as follows;Pro forma revenue;Pro forma net income;Pro forma earnings per share;1988;$144,624;15,532;.56;1987;$61,936;4,216;.27;This pro forma information does not purport to be indicative of the results that actually would have been;obtained if the operations had been combined during the periods presented and is not intended to be a;projection 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. This;acquisition 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 shares;of common stock of the Company. The transaction was accounted for under the pooling of interests;method of accounting.;Page 8 of 10;Bear Stearns & Co;EXHIBIT 2 (Continued);4. LONG TERM DEBT;The 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 of;approximately $89,000 plus interest. Secured by certain inventories;and 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 ?% (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 rates;escalating annually from 6% to prime plus 2% due 1992.;Periodic annual principal payments ranging from $427,000;to $2,570,000 plus interest.;Capitalized lease obligations secured by furniture;and fixtures, computer equipment and vehicles;Total long-term debt;Less: Current Portion;Long term debt, less current portion;The long term debt as of December 31, 1988, is due as follows;1989;$3,319;1990;2,670;1991;3,003;1992 and thereafter;15,630;In June, 1988, the Company entered into a revolving credit agreement with Security Pacific National;Bank, for itself and as agent and Southeast Bank, N.A., for itself, pursuant to which the banks have;agreed to loan the Company an aggregate of $50,000,000 on an unsecured basis. No principal payments;are required until the maturity date in 1992. Interest on current loans is the lower of the prime rate in;effect of the agent plus ? of one percent, depending on the aggregate principal amount of the advances;outstanding of the London Interbank offered rate plus 1 and ? percent or two percent, depending upon;the aggregate principal amount of advances outstanding. There is a commitment fee of ? percent per;annum on the average unused portion of the available commitment plus ? percent per annum on a;portion of the banks? average daily inactive commitments and ? percent on such part of the inactivated;commitment when activated. There are no compensating balance requirements in connection with the;revolving credit agreement. The agreement requires the Company to maintain certain financial ratios and;imposes certain restrictions on, among other things, additional debt, payment of cash dividends and;capital expenditures in excess of specified amounts.;Page 9 of 10;Bear Stearns & Co;5. INCOME TAXES;The income tax provision (belief) for the years ended December 31, consists of the following components;1988;1987;1986;$4390;373;4,763;$1,925;80;2005;$(790);-(790);4,323;413;4,736;$9,499;582;28;610;$2,615;(33);--(33);$(823);Current;Federal;State;Total Current;Deferred;Federal;State;Total 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 ended;December 31, is as follows.;Income tax provision (benefit) at statutory rate;Amortization expense not deductible for tax;Tax benefits of temporary differences not recognized for;financial reporting;Effect of future lower tax rate on temporary differences, net;State income taxes, net of federal income tax benefit;Intercompany profit eliminations of pooled entity;Other, net;Total;1988;$8,499;157;1987;$2,682;78;1986;($1,860);--;--786;-57;$9,499;-(137);108;-(116);$2,615;800;--160;77;$(823);Deferred taxes reflect the impact of ?temporary differences? between the amount of assets and liabilities;for financial reporting purposes and such amounts as measured by tax laws and regulations.;Report of Independent Public Accountants;To BLOCKBUSTER Entertainment Corporation;We have audited the accompanying consolidated balance sheets of BLOCKBUSTER Entertainment;Corporation (a Delaware corporation) and subsidiaries as of December 31, 1986 and 1987, and the;related consolidated statements of operations, changes in shareholders? equity and cash flows for each of;the three years in the period ended December 31, 1988. These financial statements are the responsibility;of the Company?s management. Our responsibility is to express an opinion on these financial statements;based on our audits.;We conducted our audits in accordance with generally accepted auditing standards. Those standards;require that we plan and perform the audit to obtain reasonable assurance about whether the financial;statements are free of material misstatement. An audit includes examining, on a test basis, evidence;supporting the amounts and disclosures in the financial statements. An audit also includes assessing the;accounting principles used and significant estimates made by management, as well as evaluating the;overall financial statement presentation. We believe that our audits provide a reasonable basis for our;opinion.;In our opinion, the financial statements referred to above present fairly. In all material respects, the;financial 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 the;period ended December 31, 1988, in conformity with generally accepted accounting principles.;ARTHUR ANDERSON AND COMPANY;Ft. Lauderdale, Florida, Feb. 17, 1989;Page 10 of 10;Attachments;Blockbuster_-_Bear_Sterns_Case.pdf (91.11 KB)


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