Video Store Case Study Question. Introduction. Background

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1 Video Store Case Study Question Introduction This example illustrates the use of the discounted cash-flow technique as it might apply to a video store operation. In this instance, the store has been relatively successful in the past but faces an uncertain future. The owner is faced with making a decision of either continuing operations for the next several years and then possibly liquidating the company at that time, or immediately liquidating the company. A potential sale to a prospective purchaser hasn't been ruled out either, but in valuation terms, would equate to the higher of the two values. This case study question deals in large part with the nature of the video rental industry and the key players therein. This is a critical part of any valuation analysis and may require consultation with independent industry experts depending on the circumstances and the experience of the valuator. The format of the Valuation Analysis also provides students with an abbreviated version of the content of a typical valuation report - Scope of Review, Assumptions, etc. Most reports typically consist of narrative explanation in the report itself with all supporting calculations included as schedules and/or appendices. Some of the information contained in this question (in terms of format and type of analysis completed) has been adopted from similar questions contained in prior CICBV Membership Entrance Exams. Students are cautioned to note that this example is for illustrative purposes only and does not necessarily reflect all of the steps undertaken in an actual valuation engagement or a precise valuation conclusion. Background Vince Videos Ltd. ( Vince Videos ) is an independently owned video store operation with a single outlet located in downtown Prince George, B.C. The company was initially established in 1995 by Max Beta who has been the sole shareholder since inception. Mr. Beta understands that the video rental business is under increased competition from online rental firms as well as "on-demand" services being promoted by cable and satellite TV providers. Vince Videos was once a thriving business but has more recently suffered a marked decline in profitability. He has come to you for assistance in determining whether to continue operating or to discontinue operations and liquidate all assets. Video Rental Industry When the VCR was first introduced as a consumer item, it was primarily viewed as a device for "time shifting" television shows to more convenient viewing hours. It soon became clear, however, that there was a significant market demand for pre-recorded videos. Most studio executives initially thought that consumers would prefer to buy rather than rent, and at the time, video machines were a luxury item that were only affordable by the wealthy who could easily afford to buy videos. The video machines continued to decline in price, and once it became a mass market item, middle class users tended to prefer renting rather than buying videos. Video Store Case Study Page 1

2 By the early 1990s, the purchase market became an important factor for video stores, and soon developed into two primary segments. Some videos were still primarily targeted for rental and had retail sales prices of approximately $100. The second segment was targeted for consumer purchase and videos were priced at $19.95 or less. The children's video market was also developing into a significant force where the phenomenon of "repeat viewing" became rampant. By 1993, the industry started to become dominated by the large chains. The biggest of these, Blockbuster Video, had close to 2,000 U.S. outlets and controlled about 15% of the rental market. Blockbuster is still the world s largest retailer of rentable videos, DVDs and video games and presently operates in excess of 8,000 stores world-wide, including franchise operations, in 27 different countries. The business operations are divided into 2 regions North America, based in Dallas, and International, which is managed from Uxbridge in the UK. The second-biggest chain in the U.S. was probably West Coast Video with roughly 500 outlets in the early to mid-1990s. In Canada, Rogers Video (parent company of Rogers Communications Inc.) is a dominant player in the video rental industry. In 1998 Blockbuster Video started to advertise a promotion referred to as "guaranteed in stock", which meant that if the video you wanted wasn't in stock, you would receive a coupon towards a free rental of it. This new development occurred largely due to a change in the nature of the contractual agreements between the rental stores and the distributors of videos. When the rental market was just developing during the 1980s, studios initially charged a flat wholesale price to the stores for videos targeted for the rental market at a price much higher than the marginal cost of production. This often resulted in stores economizing on their purchases which in turn often caused inefficient "queuing" by consumers for popular titles. In early 1998, however, content providers developed a different model that was based on a nominal one-time fee and then a fixed percentage of rental revenues. Stores no longer had an incentive to economize in their purchases and this essentially led to Blockbuster's guaranteed in-stock promotion. In 2004, Blockbuster promoted the elimination of late fees. 1 After several years of robust growth during the 1990s, the home video rental business appears to have peaked. According to several recent studies, total video rental revenues have flattened and/or started to decline in concert with an overall decline in consumers rating of the video store experience. Negative reactions from respondents to the studies included returning movies, short rental times, and needing to go to the store to rent the movie in the first place. The most prevalent complaint, however, was the limited selection of titles. A 1991 article published in the Wall Street Journal stated that the video market had matured with the $8 billion rental market slowing to less than 4% annual growth per year. The $3 billion sales market, however, was growing at 10% to 15% per year, with the big sellers consisting of children's videos, classic films, and special interest tapes, such as cooking and exercise videos. A number of different retailers were also entering the 1 Note that the "no late fee" promise isn't 100% accurate. Blockbuster customers have 1 week after the film's due date to return it without penalty, and after that time they are charged the cost of the movie. If they do return the film within 30 days, the charge is refunded less a restocking fee. Video Store Case Study Page 2

3 video sales market. McDonalds, for example sold approximately 5-6 million copies of the movie "Indiana Jones", and now both gasoline stations and supermarkets also participate in extensive promotions involving videos. New developments in the industry include competitors such as "Netflix" which allow consumers to order their video choices via the internet, as well as "movies on demand" services being advertised by the cable and satellite TV providers. Netflix was started in 1999 and now boasts 2.6 million customers. Netflix reported approximately $500 million in revenues in 2003 and is projecting more than $700 million in Future growth in the retail home video industry will be largely driven by the increasing popularity of inhome theatre systems and other enhanced viewing and sound capabilities, such as high-definition DVD. The changing video rental market has also meant that the largest chains such as Blockbuster have all but squeezed out the smaller independent stores. For example, in the U.S. in the 1990s there were in excess of 70,000 stores in the 1990s nation-wide that rented movies compared to approximately only 18,000 today. In order to compete, independent stores are being forced to offer customers something extra and/or specialize in cult films. Video store operations In Canada, Blockbuster Canada is the largest movie and game rental retailer, with approximately 410 stores in 10 provinces and over 5,000 employees. Under the current Blockbuster franchising program, Blockbuster enters into a development agreement and subsequent franchise agreement(s) with each franchisee. Each franchisee is granted the right to develop one or more stores at a permitted location or locations and is charged a development fee for each store to be opened. Franchisees are also required to pay a one-time franchisee fee and continuing royalty fees, service fees, and monthly payments for other miscellaneous items, such as maintenance of the proprietary software used to operate the store. Franchisees typically contribute additional funds for national advertising programs and are required to spend certain amounts for local advertising. Pricing and rental policies, however, are not centrally controlled, nor does Blockbuster require its franchises to purchase inventory from them. All Roger Video stores are corporately owned and operated, primarily in highly populated urban centers. For those communities that are too small to support an urban style video store, Rogers Video has an arrangement referred to as a Rogers Video dealer. This relationship is targeted primarily at owners of convenience stores, general stores, or grocery stores and essentially consists of a video rental operation within one of these existing stores. Rogers Video also provides materials, training, and support to the dealer and either shares revenues or leases the movies to the dealer as needed. In order to maximize their revenues, movie studios release their movies to different distribution channels at different points in time. The first distribution channel after theatrical release is home video (both rental and retail, including mass merchant retail) on DVD and VHS. This distribution window is typically exclusive from most other forms of non-theatrical movie distribution, such as pay-per-view and video-on-demand. The length of this exclusive distribution window for home video retailers varies, but has traditionally ranged from about 45 to 60 days, and thereafter, movies are made Video Store Case Study Page 3

4 sequentially available to television distribution channels. Although this order of distribution still provides some advantages to traditional home video retailers, the advantage has been diminished due to the sell-through pricing of DVDs, which has resulted in significant competition from mass merchant retailers, as movies are released for rental and sale at the same time. Retailers must choose between linear pricing and revenue-sharing terms for a given title before it is released on video. Once the retailer chooses a contractual form, they must accept the same contractual form for all units purchased for that title. Thus, the retailer makes two decisions for each title: first, they choose a contract form. Second, they choose the number of units to purchase. These contracts typically charge between $0 and $8 per unit of inventory with the retailer keeping between 40 and 60 percent of rental revenues. Movie distributors and the large chains (most notably Blockbuster, Inc.) directly negotiate revenue-sharing agreements covering most titles distributed by the upstream firm. For smaller chains and independent retailers, a third party typically aggregates their demand and negotiates and monitors revenue-sharing agreements with movie distributors on their behalf. Video retailers engage in both price and non-price strategies to manage the high demand and weekly demand variation for newly released titles. Many retailers charge a higher price for newly released films which subsequently falls by 50% or more once the title is moved from the new release display to the standard library. Some outlets also offer discounts or 2-for-1 specials on mid-week rentals. Still other outlets keep the price the same, but have shorter rental periods for the newer (and hence more popular) titles. A rule of thumb for the industry is that "about twenty percent of your movies do about eighty percent of your profit." Whether these figures are entirely accurate is debatable, but it is certainly true that the most reliable demand in movies is for the hot items of the day with the general inventory generally serving the viewers who have exhausted the current items of interest. Both company owned and franchise-operated stores typically employ an average of 14 people, including one store manager and one assistant manager. The use of specialized software specifically designed for the video industry is also common, which allows tracking and management of revenues on a video by video basis. Strategy Vince Videos has historically charged a competitive rate for its videos, usually $5.00 for new releases, and less for other titles. Mr. Beta has been able to manage the store himself up to this point, but it is being increasingly difficult to compete with the variety of other entertainment choices available to consumers. If a sale to a third party isn t feasible, Mr. Beta is also considering a liquidation of the business. (As the income statements in Appendix I indicate, the business has incurred nominal bottom-line losses in two of the last five years.) Video Store Case Study Page 4

5 Mr. Beta realizes that drastic measures are required and has decided to now deal exclusively in children videos. Prince George has an increasing number of young families moving to the community and this is where he sees the store s market niche. This is only considered a short-term solution, however, since there are strong rumours that a huge competing store is scheduled to open in the nearby area in approximately 3 years. Management Vince Videos is managed solely by Mr. Beta who only hires additional part-time staff as needed. Mr. Beta had no previous experience in the video rental industry prior to establishing Vince Videos in Financial Statements Figures I and II contains historical financial statements (income statement and balance sheet respectively) of Vince Videos for the fiscal years ending June 30, 2000 to 2004 inclusive. Other Information 1. Rates of return on fixed income investments (Illustrative only) 90 day Treasury Bill 4% Government of Canada 5 year Bonds 5% Long-term Corporate Bonds 6% Chartered Bank Prime Lending Rate 4% (Source: Bank of Canada website at 2. Stock Market Data (Illustrative only) P/E Multiple CFPS Multiple TSE 300 composite multiples 10 7 TSE small-capap subindex multiple 8 5 (Source: Bank of Canada website at [CFPS: cash-flow per share] 3. Summary of Video Rental Industry Financial Ratios (Illustrative only) Current ratio 0.8:1 1:1 Total debt: Equity 1:1 1:1 Video Store Case Study Page 5

6 (Services such as Standards and Poors generally provide a variety of industry ratios. Dedicated business valuation websites also offer this kind of analysis for sale, such as The Financial Valuation Group at In some instances, valuators calculate some comparable ratios themselves using publicly available financial statements, such as Blockbusters in this case.) 4. Forecasted information Mr. Beta has prepared cash flow forecasts for the next 5 years and according to his best estimates, Vince Videos will report the following results for the fiscal years ending : (000s) Revenues $450 $400 $250 $190 $150 Gross profit Earnings (loss) before tax (0) Based on his discussions with Mr. Beta, the CBV also estimates a residual value of $10,000 should the store liquidate after 5 more years of operations. 6. The combined federal and provincial corporate tax rate applicable to Vince Videos Ltd. is 35%. (2005) Video Store Case Study Page 6

7 FIGURE I VINCE VIDEOS LTD. INCOME STATEMENT FOR THE YEARS ENDED JUNE 30 (000s) Revenue $500 $450 $300 $350 $360 Cost of sales Gross profit (60%) (58%) (50%) (54%) (50%) Direct store Expenses Store contribution Indirect Expenses EBIT Interest on debt Earnings (loss) before tax (5) 15 (5) Income tax Net income (5) 10 (5) [Please note that operating results are for illustrative purposes only and are not necessarily representative of a typical video rental operation] Video Store Case Study Page 7

8 FIGURE II VINCE VIDEOS LTD. BALANCE SHEET FOR THE YEARS ENDED JUNE 30 (000s) ASSETS Current Assets Cash $ 20 $ 13 $ 25 $ 25 $ 20 Accounts receivable Inventory and other Capital Assets $ 265 $ 240 $ 241 $239 $ 220 LIABILITIES AND S/H EQUITY Current Liabilities Bank indebtedness $ 110 $ 90 $ 90 $ 100 $ 100 Accounts payable Shareholders Equity Capital stock Retained earnings $265 $ 240 $ 241 $ 239 $ 220 [Please note that balance sheets are for illustrative purposes only and are not necessarily representative of a typical video rental operation] Video Store Case Study Page 8

9 Valuation Analysis Dear Mr. Beta: Pursuant to your request, I have prepared an analysis which provides a valuation of Vince Videos Ltd. together with my recommendation regarding liquidation versus continued operations. In preparing my valuation, I have adopted the generally accepted definition of fair market value. Fair market value is clearly defined below. The actual prices at which a transaction may occur could differ from the estimates of fair market value provided herein. Definition Fair market value is defined as the highest price available in an open and unrestricted market between informed and prudent parties acting at arm's length and under no compulsion to transact, expressed in terms of cash. Scope of Review For the purposes of this report, I have relied upon: Vince Videos financial statements and projections Public market multiples and financial market statistics Restrictions and Limitations This report is not for general circulation or publication, and should not be distributed without my prior written consent. This report is intended only for the stated purposes outlined herein. I do not assume liability for any loss incurred by parties relying on this report outside of the stated purposes. I reserve the right to make changes to my analysis and/or to update my report should any additional information become available to me subsequent to the date of this report. Assumptions In arriving at my opinion of value, I have relied upon the following major assumptions for Vince Videos as at June 30, 2005: There are no contingent or unrecorded liabilities There is no litigation pending There was no material change in the financial position since the most recent financial statement date My valuation opinion may change should I consider different assumptions. Video Store Case Study Page 9

10 Valuation Approach On the basis of my review, I consider both going concern and liquidation calculations most appropriate given Vince Video s historical and projected operations. I have further concluded that using the discounted cash flow approach is the most appropriate methodology to use in valuing all of the issued and outstanding shares of Vince Videos on a going concern basis, since the future of the operations is uncertain and cash flow is expected to vary significantly. Discounted Cash Flow Value My calculation of the discounted cash flow value of Vince Videos is contained on Schedules A-1 through A-3 and is discussed under the following headings: Summary of discounted cash flow Schedule A-1 Residual value of operations Schedule A-2 Estimate of discounted cash flow value Schedule A-3 Projected Cash Flow (Schedule A-1) On Schedule B-1, I have calculated the cash flow for the five years ended June 30, , using the projections provided by Mr. Beta. These projections have been compared to historical results and are considered reasonable. The cash flow during this period was based on the income before income tax as the ongoing capital expenditures are equal to depreciation. The result was an after tax cash flow for the five years which was then discounted at a rate of 20% to arrive at a discounted cash flow value of $44,000. Discount Rate In selecting a discount rate, I considered a number of different factors, including rates of return on other investments and stock market multiples. Details of the components include a prevailing risk free rate of 6%, plus a general equity risk premium of 6%, plus a company-specific risk premium of 8%. The "equity risk premium" is a premium that an equity investor requires versus investing in a no-risk or low-risk investment. Various studies have been completed in order to quantify this amount, but for purposes of this example it is an assumed amount. Video Store Case Study Page 10

11 (Students may want to reference the "Ibbotson" studies completed for the U.S. market available at 2 ) For the company-specific risk premium, the quantification is largely a matter of professional judgement. Also keep in mind that the tangible asset-backing of a company is one of the primary components to consider in determining an applicable discount rate. (All other factors being equal, a high TAB business will warrant a lower risk premium than a comparable business with a low TAB, even if both businesses potentially earn the identical revenue/cash flow stream.) In this instance, the companyspecific risk premium was selected based on consideration of: the changing nature of the video rental industry in general; the additional risks faced by Vince Videos in light of the expected direct competition in the next few years; and declining profitability in the most recent years. In summary, I chose a final discount rate of 20%. Residual value of Operations (Schedule A-2) Residual value of the operations at the end of the five year projection period must be calculated under the discounted cash flow approach. In the case of ongoing operations, the maintainable level of operations must be determined based on the projected results in the year The selection of a capitalization rate for calculating residual value is also required, taking into account the fact that the earnings used are based on projections. In this instance, however, operations are assumed to be liquidated at the end of the projection period with a residual value of $10,000. The residual value was then discounted back to the valuation date using a discount rate of 20% resulting in a residual value of $4, Here are the four primary ways to estimate the equity risk premium (Source: Video Store Case Study Page 11

12 Estimate of discounted cash flow value (Schedule A-3) On Schedule B-3, I calculated the value of Vince Videos by adding the value of the discounted cash flow and the discounted value of the residual value of the operations to arrive at a total value of $48,000. Estimate of liquidation value (Schedule A-4) Liquidation value has three important applications: (i) where a business is not a going concern and is suitable for liquidation, (ii) where a business is a going concern, but its value is closely related to liquidation value, and (iii) it is used as an aid in establishing fair market value on a going-concern basis. A "forced" liquidation assumes that the assets are sold over a short period of time without any particular effort to obtain the highest price available. An "orderly" liquidation, on the other hand, assumes a reasonable time is taken for the assets to be liquidated. In this instance, I have estimated that the liquidation value of Vince Videos on an orderly basis to be $21,000. This assumes that accounts receivable is recoverable at 90% of face value, inventory can be sold at 85% of book value, and capital assets can be sold for 60% of book value. To arrive at an approximate liquidation value, I have also deducted the estimated costs and taxes of liquidation. Final estimate of fair market value and recommendation Based on my calculations and the information provided to me, it appears that the highest fair market value is obtained by continuing to operate the store for an additional five years ($48,000) versus an immediate liquidation ($21,000). The difference may not be considered material, however, given the sensitivity of the outcome to assumptions made in this analysis as well as your perspectives and preferences for future business strategy. I would be pleased to discuss my findings with you in greater detail. Signed: CBV Business Valuator Video Store Case Study Page 12

13 Appendix A Schedule A-1 Vince Videos Summary of Discounted cash flow June 30 (000s) Income before tax $ 50 $ 30 $ 5 $ 5 $0 Income tax(35%) (17) (10) (2) (2) 0 Cash flow after tax Discount 20% Discounted cash flow Total PV $44 Video Store Case Study Page 13

14 Appendix A Schedule A-2 Vince Videos Residual value of operations June 30 year end (000s) Residual value $ 10 Discounted back to present Present value $ 4 Explanatory note: For an ongoing business operation, a residual value is calculated at the end of the forecast period and is normally computed on the basis of some sort of capitalization. (either earnings or cash flow) In the case of a finite life business, however, such as a mining operation, the residual value essentially represents a "scrap" value consisting of a sale of residual assets less clean-up costs etc. In this instance the anticipation is that the store will only operate during the forecast period and then cease operations at the end. Video Store Case Study Page 14

15 Appendix A Schedule A-3 Vince Videos Estimate of Discounted cash flow value June 30, 2004 (000s) Value of discounted cash flow (Schedule A-1) $ 44 Residual value of operation (Schedule A-2) 4 Estimate of discounted cash flow value $ 48 Video Store Case Study Page 15

16 Appendix A Schedule A-4 Vince Videos Liquidation Value June 30, 2004 year end (000s) Estimated fair market value of assets Cash $ 20 Accounts receivable $5 x 90% 4 Inventory $100 x 85% 85 Capital assets $95 x 60% 57 $166 Less: Fair market value of liabilities (total) 130 Subtotal 36 Less: Realization costs (assumed) (10) Less: Realization taxes (assumed) (5) Estimated orderly liquidation value $ 21 Video Store Case Study Page 16