ITC2018 FINANCIAL MANAGEMENT TUTORIAL SUGGESTED SOLUTION

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1 ITC208 FINANCIAL MANAGEMENT TUTORIAL SUGGESTED SOLUTION Part a) Marks Overreliance on key management / loss of key personnel: The founding shareholders, who are also key management personnel, possess significant skills and expertise and the 2 loss of such individuals could negatively impact Netflix The market in which Netflix operates is highly competitive / Competition risk: The threat of competitors (including pirated movies) could limit the growth prospects and also 2 the ability of Netflix to increase its prices on a long term basis. Netflix's services are highly dependent on the access of internet: If internet is disrupted or not available in parts of the country, this could limit the growth prospects or the ability of 2 Netflix to generate revenues (this point addresses the availability of internet infrastructure). Netflix does not have control over the cost of internet: The providers of internet services could increase their prices, resulting in the cost of accessing Netflix's services being higher 2 and thereby limit its revenue generating abilities (this point addresses the cost of internet access to customers). Overreliance on a key service provider: Amazon Web Services is the sole provider of a critical service to Netflix. If their terms changes unfavourably towards Netflix, this could 2 negatively affect its profitability or if Amazon Web Services terminates its services to Netflix or its service is interrupted, the services of Netflix and its sustainability might be threatened. Content is acquired from overseas and thereby exposed to currency risk: The depreciation of the rand against the major currencies could resulting in Netflix incurring 2 significant costs on its content acquisition costs. Bargaining power of suppliers is high: There are limited number of experienced and reputable content providers in the world which could potentially mean that their bargaining 2 power is high. This could result in Netflix acquiring content at significant costs and therefore negatively impacting on its profitability. Failure to acquire exclusive content or quality content: Due to the competitive process of acquiring content, Netflix might fail to acquire content on an exclusive basis or quality 2 content which might then result in the company losing customers to its competitors. Susceptibility to economic condition: The services offered by Netflix might be considered to be a luxury (rather than a necessity) and therefore might be negatively impacted in times 2 of challenging economic conditions. Reputational risk: The provision of Netflix services requires the use of technology, e.g. internet access, Amazon's infrastructure, payment processing softwares (fraud risk) and other related technologies required to deliver the service; and electricity supply. The 2 disruption of such services due to IT failure and/or load shedding could result in reputational damage to the company and consequently loss of customers. The demand for Netflix's services is seasonal: Subscription services are on a monthly basis and therefore the business is prone to seasons of low demand which could result in low cash flows during those periods while the company has to incur the overheads of 2 content. In addition, Netflix might struggle to win back customers when they terminate their services (alternatively, it could be addressed as risk of low switching costs). High operating leverage: Netflix has to acquire content on a long term basis and this might result in the business being highly leverage from an operating perspective. The inability of 2 Netflix to sign up a large number of customers might negatively impact its profitability. Loss of focus on core business: Netflix's product portfolio includes a service (DVD rental) whose market is on the decline. Management's focus on the streaming services, which is 2 now Netflix's core business, might be divided and result in loss of customers. Available marks 28 Communication skills - logical argument Endunamoo Board Course 208

2 Part b) Advantages / Merits Marks Disadvantages / Pitfalls Marks Strategic action # Acquisition of a controlling interest in MTN by Netflix Strategic action #2 MTN and Netflix would enter into an exclusive 0-year partnership MTN might have a track record / experience and expertise in rolling out network infrastructure Netflix, as a listed company, might use its listed shares as a currency in order to settle the acquisition price Netflix will be acquiring a successful business in a growing market and therefore will diversify its product portfolio Over time, this option might address the issue of the cost of internet as the enlarged company might benefit from economies of scale with a larger customer base MTN has foreign operations. If its operations are consolidated into those of Netflix, opportunities for natural hedge could allow Netflix to acquire content at favourable rates No major capital investment is required at inception of the arrangement Netflix will be able to leverage the distribution network and brand of MTN to sign up new members This option is likely to require significant capital upfront, if the transaction is settled in Netflix's own cash reserves This might present the most expensive option as Netflix might be required to pay for goodwill too Netflix might lose focus on its core operations of providing streaming services (the option is too radical) Netflix will be required to invest significant capital expenditure on an ongoing basis as it rolls out network infrastructure to new markets The arrangement will require Netflix to pay a fixed fee over the term of the contract irrespective of the number of subscribers. This might prove to be expensive if the services are not well received The discounts are available to customers that are also the registered customers of MTN - customers registered with other network service providers might feel excluded and Netflix might lose their goodwill Endunamoo Board Course 208 2

3 Part b) Advantages / Merits Marks Disadvantages / Pitfalls Marks The package will be offered as part of a two year contract and this might allow Netflix an opportunity to achieve a high switching costs as customers will not be able easily terminate the streaming services This option does not address the issue of availability of internet in the areas that Netflix might want to pursue Due to their exclusivity nature of agreement, the growth of Netflix will be limited to the growth of MTN Netflix has limited flexibility with this option because after the termination of the arrangement, MTN might decide not to renew the arrangement or renew it at terms unfavourable to Netflix Recommendation based on candidate's argument Available marks 8 0 Maximum marks 5 9 Communication skills - logical argument 2 Endunamoo Board Course 208 3

4 Part c) Marks Revenue analysis Total revenue growth rates - Standard 8,7% ½ - Premium 32,2% ½ - DVD (20,2%) ½ Total revenue 24,4% ½ Analysed into Revenue price growth rates - Standard 6,0% ½ - Premium 2,0% ½ - DVD (5,0%) ½ Revenue volume growth rates - Standard 2,0% ½ - Premium 8,0% ½ - DVD (6,0%) ½ Total revenue mix - Standard 38,% 40,0% - Premium 58,9% 55,4% - DVD 2,9% 4,6% Commentary Revenue performance was excellent during the period, achieving a 24.4% growth in a highly competitive market is noteworthy. This total revenue growth is well above the inflation rate of 6%, indicating that revenue growth was driven by more than the inflationary impact (i.e. real growth) The Premium services experienced the highest revenue growth in FY205, at 32.2% growth relative to 8.7% experienced by the Standard service. The Premium services' growth was driven both by the increase in price as well as growth in members. The fact that Netflix was able to increase the price by more than inflation and still increased the members' subscriptions could indicate the premium or quality of the HD streaming services to its customers. On the other hand, the revenue growth of the Standard service was primarily driven by the increase in members' subscription while prices increased in line with inflation. The total revenue growth was primarily driven by the streaming services, which accounted for a combined contribution of 97.% and 95.4% of total revenue in FY205 and FY204 respectively. The DVD business performed dismally - experiencing a decline in all fronts, i.e. in total revenue, pricing and members' subscription - and this could be related to the general decline in the market. The revenue contribution of DVD business is low and brings into question why Netflix is still continuing this business as it will likely take the focus of management's attention from the core streaming services - is a matter of sentimentality? Endunamoo Board Course 208 4

5 Contribution analysis Total contribution mix per category Marks - Standard Premium DVD Total contribution Total contribution mix - Standard 29,0% 32,6% - Premium 66,2% 58,0% - DVD 4,7% 9,4% Total contribution margins - Standard 20,5% 7,% - Premium 30,3% 22,0% - DVD 43,5% 43,0% Total contribution growth rates - Standard 42,0% ½ - Premium 82,% ½ - DVD (9,3%) ½ Commentary The Premium streaming service generates the highest contribution to total contribution. Although the DVD business is a declining business, it generates the highest contribution margin relative to the streaming services. It appears that the decision to purchase DVD titles a couple of months after their release yielding positive results for Netflix as the contribution margin increased slightly from 43.0% to 43.5%. Cost of revenue analysis Total content expenses analysis Content expenses as a % of revenue 50,3% 53,4% Content expenses growth rate 7,% ½ Content expenses growth rates - Standard 7,0% ½ - Premium 9,0% ½ - DVD (8,% ½ Content expenses mix - Standard 34,5% 34,5% - Premium 63,2% 62,2% - DVD 2,3% 3,3% Commentary Endunamoo Board Course 208 5

6 Cost of revenue analysis Content expenses represent a major expense item (accounting for c.50% of revenue) in generating revenue for Netflix The total content expense growth rate was favourably below the increase in revenue due to the following reasons: - DVD titles were not purchased immediately after their release which contributed to the cost of the DVD content expenses - However, the content expenses for streaming services which was the primary driver of the content expenses growth, increased significantly - this increase could probably be a result of exclusive streaming content acquired. - It is likely that the majority of the content expenses relate to long-term contracts with predetermined escalation rates which are likely to be in line with inflation rates. Content expenses should be investigated further to determine how much of the expenses is fixed (long-term contracts) and how much is variable (revenue sharing agreements) in order to better understand the extent of the operating leverage of Netflix as well the growth rates of the content expenses. The Premium content expenses increased by the highest percentage and contributes the highest amount to the total content expenses - this could highlight Netflix's attempt to gain customers and consequently the increase in Premium members through the acquisition exclusive and quality content. Marketing expenses Total marketing expenses analysis Marketing expenses as a % of revenue 22,7% 25,5% Marketing expenses growth rate 0,7% ½ Marketing expenses growth rates - Standard 0,0% ½ - Premium 5,0% ½ - DVD (26,5% ½ Marketing expenses mix - Standard 57,% 57,4% - Premium 40,7% 39,2% - DVD 2,3% 3,4% Commentary Although the marketing expenses grew by more than the inflation rate, the increase of 0.7% appears reasonable / appropriate given the increase in the member base and the competitive nature of the industry. Alternatively, a candidate could argue that a 0.7% increase in marketing expenses in such a highly competitive sector might not be appropriate. The growth in marketing expenses was underpinned by the following factors: - In response to a declining DVD market, it appears that management decrease the expenditure on marketing and promotions for the DVD business. - The 5% increase in the marketing expenses of the Premium service could highlight the aggressive marketing of the service and could have provided the platform for Netflix to increase the fees and volumes for such services - The Standard service accounts for the biggest contribution in marketing expenses. Endunamoo Board Course 208 6

7 Other items Technology and development - as a % of revenue 9,0% 9,0% - growth rates 24,4% ½ It appears that the expenses have remained fairly constant during the period under review and grew in line with revenue. General and administration - as a % of revenue 5,0% 4,0% - growth rates 55,5% ½ General expenses increased by more than the revenue growth rates. This needs to be investigated to better understand the reason for this as the increase is quite significant. Operating income - as a % of revenue 3,0% 8,0% - growth rates 0,% ½ The increase in operating income margin highlights the cost efficiency of management. Net interest expense - as a % of revenue 0,4% 0,4% - growth rates 24,4% ½ The increase in the net interest expense which is line with revenue could highlight that the majority of the funding is incurred to support the revenue growth. Taxation expense - effective tax rate 30,0% 28,0% - growth rates 9,8% ½ The effective tax rate in FY204 in 28% is in line with expected the income tax in South Africa. However, the 30% is higher than the expected rate and therefore this should be investigated further. Profit after tax - as a % of revenue 8,8% 5,5% - growth rates 99,4% ½ Overall The profit margin of Netflix improved during the year indicating that the overall performance of Netflix was quite good during the period. Available marks 65 Communication skills - layout and presentation Communication skills - clarity of expression Maximum marks 9 Endunamoo Board Course 208 7

8 Part d) Errors and/or omissions Mark Reason(s) The cash flows estimated incorrectly included the cash flows of CameraTek The historical financial information has been included in the estimation of free cash flow or The valuation date is 3 December 205 and therefore cash flows prior that are historical financial information which should not be included in the estimation of free cash flows No tax on operating cash flows has been provided Depreciation expense has been included in operating cash flow estimate. Amortisation expense of content library has been included in operating cash flow estimate. Interest expense has been incorrectly included in the estimation of free cash flows (DO NOT grant credit if the candidate has indicated that net interest expense has been incorrectly calculated - this is because interest income is on operating cash and cash equivalents and therefore it is correct to include in the estimation of free cash flows) Cash and cash equivalents has been erroneously omitted from the movement in working capital Investment in capital expenditure incorrectly includes acquisitions / additions only and disposals have not been taken into consideration The estimation of WACC is conceptually incorrect CameraTek's operations are different to the operations of Filmna and therefore the business likely has a different risk profile. Therefore, it might be prudent (from a principles' perspective) to value the businesses separately. Only the future cash flows should be discounted and therefore it is incorrect to include the historical financial information for FY205 The estimation of free cash flows need to be after tax cash flows Depreciation is a non-cash flow item and therefore should be excluded from operating cash flows Amortisation is a non-cash flow item and therefore should be excluded from operating cash flows Interest expense represents financing cash flows and the effective costs is incorporated in the WACC calculation Cash and cash equivalents is part of operating cash flows because the cash is not available for distribution to investors of Filmna and therefore forms part of working capital The capital expenditure policy involves disposal of PPE on an annual basis and therefore the proceeds from such disposals need to be incorporated in the estimation of free cash flows WACC needs to take into consideration the risks related to the operations of Filmna. It is unlikely that the average of the WACC of Filmna's competitors are similar to that of the company and furthermore, the listed peers are likely to have capital structure different to Filmna's Marks 2 Endunamoo Board Course 208 8

9 No terminal value has been estimated and included The equity value has been estimated prior to deducting debt of in the company The value of the non-controlling interest of CameraTek has not been deducted Filmna appears to be a going concern and therefore the free cash flows should be estimated to perpetuity through the terminal value The discounting of the free cash flows results in the estimation of the enterprise value of the company and not the equity value. The debt of the company has to be deducted in order to establish the equity value The value of non-controlling interest represents value not attributable to the equity of the Filmna Group and therefore it should be deducted from the equity value Available marks 2 Available marks 3 Maximum marks 7 Maximum marks 7 Communication skills Layout and structure Part e) Estimation of maintainable earnings Logical argument Earnings before tax (95,46-7,452) Once-off items - Legal claim (Happy Harry and the Potters) Impairment of content (Korupt) Adjusted profit before tax Taxation expense (99 86 x 28%) (55 948) Estimated maintainable earnings Marks Estimation of P/E No information on comparable listed company with operations in content production and production of technology equipment Therefore, Wolf information would utilised as it is closest listed peer P/E of Wolf (25 / 6,25) 4,00 Adjusted for the following items (max 2) - Control premium - 00% interest in being considered + - Filma is highly reputable in the industry + - Unlisted status of Filmna (lack of marketability, restricted finance, etc.) - - Small size of Filmna relative to Wolf (in revenue terms) - - The operations of CameraTek provides revenue-diversification or present higher risk for Filmna (motivate) +/- Adjusted earnings based multiple (any reasonable figure) 4,50 Equity valuation of Filmna (R'000) ( x 4,5) Available marks 4 Maximum marks 9 Endunamoo Board Course 208 9

10 Part f) Option : Richesse Funds PMT ( 752) I 4,00% PV N 5 Currency depreciation 5% Mark Year Capital raised Repayments ( 752) ( 752) ( 752) ( 752) ( 752) Trans. costs (95) - cash flows ( 752) ( 752) ( 752) ( 752) ( 752) Exchange rate mark - for using different exchange rates (regardless of whether this is correct or not) mark - for correctly depreciating the currency 20,00 2,00 22,05 23,5 24,3 25,53 2 R- cash flows (36 794) (38 634) (40 56) (42 593) (44 73) IRR 0,5% Option 2: Rainbow Bank Effective annual interest ((+(9.75%+.25%)/2)^2-,30% Year Capital raised Repayments (32 000) (32 000) (32 000) (32 000) (32 000) Interest (8 084) (4 467) (0 850) (7 234) (3 67) Trans. costs (2 960) R- cash flows (50 084) (46 467) (42 850) (39 234) (35 67) IRR 2,0% The most cost-effective debt instrument is the foreign loan Endunamoo Board Course 208 0

11 Equity capital Use Beta of BlockBuster, since the operations of Netflix will include both movie distribution and content production following the acquisition of Filmna Group Bonus mark: An adjustment to reflect the inclusion of CameraTek, which can be considered to have a different risk profile, might be necessary Debt-equity ratio of BlockBuster (3.927bn / (8.5 x 700m)) 66,00% Unlever BlockBuster's Beta (.22 / ( + (-28%) x 66%),02 Relever BlockBuster's Beta (.0.2 x ( + (-28%) x 75%),29,22 2B Cost of equity based on CAPM 6,89% WACC Weight Cost WACC Equity capital 57,4% 6,89% 9,65% Debt capital 42,86% 0,5% 4,35% 00% 4,00% Converting debt-equity to debt ratio Debt ratio = 75 / 75 = 42,86% and Equity ratio = 00 / 75 = 57,4% Calculating the WACC correctly (answering the question) Available marks (including 2 bonus marks) 23 Communication skills - calculations are easy to follow / used tables for determining IRR of debt, etc. Maximum marks 20 Endunamoo Board Course 208