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?
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.
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)?
