Corporate Finance Project

Transcription

1 Corporate Finance Project The Entertainment/Electronics Industry May 2, 2005 Simone De Liberis Georgios Fassas Paulo Larumbe Brad Pseres Daniel Weisleder Jennifer Williams

2 Executive Summary This is a corporate finance analysis of the following companies in the Entertainment/Electronics industry: Apple Computers, Inc. Cablevision Electronic Arts Netflix Time Warner TiVo These businesses represent an industry trend of convergence between electronics and entertainment companies. Business Descriptions: Apple Apple ignited the personal computer revolution in the 1970s with the Apple II and reinvented the personal computer in the 1980s with the Macintosh. Today, Apple continues to lead the industry in innovation with its award-winning desktop and notebook computers, OS X operating system, and ilife and professional applications. Apple is also leading the digital music revolution with its ipod portable music players and itunes online music store. Cablevision Cablevision Systems Corporation was organized in 1985 and is one of the largest cable operators in the United States based on the number of subscribers. As of December 31, 2004, the company served about 2.96 million homes in the New York-metropolitan area. The business is classified into four segments: Telecommunications Services consists of the cable television business which includes basic cable, interactive digital cable, high-speed data, Voice over Internet Protocol and residential telephone services operations Rainbow this segment consists of interests in national and regional programming businesses including AMC, The Independent Film Channel, WE: Women s Entertainment, fuse and various Fox Sports regional networks Madison Square Garden this segment owns and operated the Madison Square Garden arena and the adjoining Theater at Madison Square Garden. Also included here are the New York Knicks, the New York Rangers and the New York Liberty professional sports franchises Rainbow DBS This segment operates the company s Voom direct broadcast satellite service and a suite of 21 high definition channels. The company announced in early April, 2005 that this unit would be disbanded. Electronic Arts Electronic Arts (EA) is the world's leading independent developer and publisher of interactive entertainment software for personal computers and advanced entertainment 2

3 systems such as the PlayStation 2 Computer Entertainment System, the PlayStation, Xbox video game console from Microsoft, the Nintendo GameCube and the Game Boy Advance. It was created in 1982 and, since then, EA has garnered more than 700 awards for outstanding software in the U.S. and Europe. EA markets its products worldwide under four brand logos and has over 33 product franchises that have reached more than a million unit sales worldwide, and their headquarters are located in Redwood City, California. Netflix Started in 1998, Netflix, Inc. ( Netflix ) is the largest online DVD rental service, offering unlimited DVD rentals for a monthly subscription fee. Subscribers select movies from Netflix s library of over 35,000 titles, which are then mailed free of charge via first-class mail. The basic subscription package allows subscribers to check out three DVDs at a time with no due date or late fees for a monthly fee of $ Once selections are returned via paid-postage envelopes provided by Netflix, the next selection in a subscriber s online queue is then shipped directly to the subscriber. As of 2004, Netflix had 2.6 million subscribers and held 78% share of the online DVD rental market. Netflix has more than 1000 at corporate headquarters and shipping centers. Netflix operates 29 shipping centers located throughout the United States. Netflix reaches more than 85 percent of subscribers with generally one-day delivery. On average, Netflix ships more than 3 million DVDs per week. Time Warner Time Warner Inc. is a media and entertainment company. It classifies its businesses into five areas: America Online, consisting principally of interactive services; Cable, consisting principally of interests in cable systems providing video, high-speed data and Digital Phone services; Filmed Entertainment, consisting principally of feature film, television and home video production and distribution; Networks, consisting principally of cable television and broadcast networks, and Publishing, consisting principally of magazine and book publishing. TiVo TiVo Inc. is a provider of technology and services for digital video recorders (DVRs). The Company's subscription-based TiVo service is designed to improve home entertainment by providing consumers with an easy way to record, watch and control television. The TiVo service also offers the television industry a platform for advertising, content delivery and audience research. The TiVo service requires a TiVo-enabled DVR. As of January 31, 2004, there were over 1.3 million subscriptions to the TiVo service. 3

4 A Summary of Findings Section I: Corporate Governance It would be hard to say that there is a clear pattern in all of the companies corporate governance policies: they differ both in terms of compensation to the CEO and social responsibility, as well as the number of members in the board. However, we did find a commonality among the firms when it came to percentage of insiders and members with connections to the company. The firms seem to be healthy in that respect. Section II: Stockholder Analysis The marginal investor for all of the companies is institutional. Our analysis found that some of our companies have individual investors who own a large percentage of shares outstanding. These investors exercise a considerable amount of influence over the company. Section III: Risk and Return In this section we began our quantitative analysis by computing top down and bottom up Betas for each of our companies. Our analysis indicated that the top down estimation was inaccurate due to poorly correlated regressions with high standard errors. Once we calculated reliable bottom-up Beta estimations, we used these risk measurements to compute the weighted average cost of capital for each of our firms. Section IV: Investment Returns The projects of firms in this analysis vary widely, and their returns on capital and equity and the related economic value added varied considerably over the last five years. Electronic Arts and Netflix have positive returns (one has a specialty competitive advantage and the latter was the first mover in the business model with a competitive advantage in its distribution). Apple (with a high cost of equity and capital) and Time Warner (with its large size) are both negative. Cablevision has a stockholder s deficiency because its liabilities exceed its assets. This rendered the return on equity measure meaningless. Cablevision s recent return on capital and EVA have been negative implying that the company has been destroying firm value with its projects. Section V and VI: Capital Structures Choices and Optimal Capital Structure We see significant difference in our companies market debt to capital ratio. Time Warner and Cablevision have the highest ratio, 24% and 49.17% respectively, while Apple, Netflix, EA and TiVo are closer to 0%. However, all our companies use operating leases for their financing and those (leases) aren t usually included in the debt calculations; therefore we included these numbers when we estimated our Market Value of Debt. None of the companies included in this analysis are operating at their optimal. TiVo is closer to its optimal debt ratio than the others and is over-levered while the rest are all under-levered. 4

5 Section VII: Moving to the Optimal Netflix and Electronic Arts are underleveraged and have good projects; therefore, they should move to their optimal by borrowing debt and investing in new projects. Apple and Time Warner are also underleveraged but these companies are not having good projects in which to invest. Then, Apple and Time Warner should take on debt and return money to stockholders in the form of stock buybacks. On the contrary, Tivo and Cablevision are overleveraged. Tivo should issue stock to pay back debt because it has no good opportunities to invest. Cablevision should sell assets and use the proceeds to retire debt or renegotiate its debt agreements. Section VIII: Dividend Policy& IX: A Framework for Analyzing Dividends By analyzing the 6 companies, we found that only Time Warner paid dividends (from 1998 to 2002), whereas, the other 5 companies did not paid. Retaining earnings and reinvest in profitable projects, appears to be reasonable for high growth companies like: Apple, Cablevision, EA, Netflix, and Tivo. Time Warner is not providing economic value added to its projects, therefore it should pay dividends (as it did until 1998) or buy back stocks. Section X: Valuation Our analysis of the valuation of the six companies in this report found that the market currently overvalues 5 of the companies and undervalues only one. In fact, the analysis indicates that Electronics Arts is the only company currently undervalued, while Apple, Cablevision, Netflix, Time Warner and Tivo are overvalued. On a percentage basis, Netflix is the most overvalued company (37%). We believe that the market could be overvaluing these companies because it is expecting an even higher growth in revenues. 5

6 I. Corporate Governance The Chief Executive Officer All of our companies have given their CEOs enough shares to make their goals and the firm s stay synchronized and avoid a clash of interests. Company Name Yrs as CEO Salary Bonus Stock Ownership Apple Steve Jobs 8 $1 $74,750,000 5,060,002 Cablevision James Dolan 10 $1,600,000 $2,800, ,363 Electronic Arts Lawrence Probst III 14 $627,759 $781, ,455 Netflix Reed Hastings 6 $224,615 $91,428 4,618,000 Time Warner Richard Parsons 4 $3,454,450 $9,790,000 7,500,000 Tivo Michael Ramsay 8 $343,750 $199,500 2,833,118 Among these six companies, the CEO that has the most power and influence over his firm is Reed Hastings (Netflix), who owns 7.6% of the company s shares. This high level of influenced is explained by the fact that Hastings is not just the CEO, but also the founder of Netflix. It is interesting to mention that Hastings is the only insider among Netflix six board of directors members. The CEO with the least influence is Electronic Arts Lawrence Probst, who holds only 0.21% of the company s shares. This could seem strange, since Probst is a home grown CEO he was promoted from within. However, given EA s large market cap and well divided power (no shareholder owns more than 6% of shares, including institutions), and precisely because he s not one of the founders, it is probably understandable that he doesn t have a larger percentage. The Board of Directors Company Board Size Insiders Members with Connections to the Company CEOs on Board from Other Companies Apple Cablevision Electronic Arts Netflix Time Warner Tivo We could identify some kind of trend in terms of insiders in these companies: all of them seem to be healthy in the sense that the representation of shareholder needs seem to be balanced with management power. Cablevision has the most number of insiders, yet, it also has the largest board, so in the end almost 74% of the board members are not insiders, a ratio that is even higher than Apple s, which insiders are only two, but hold more than 28% of the seats in the board which is still not too high. 6

7 In that respect, it seems like Electronic Arts board is the best, since there is only one insider (11% of the board). Yet, EA seats 5 CEOs from other companies, many from companies also dedicated to entertainment and/or electronics, while TiVo has only one. Perhaps the only clearly bad signal in all of our companies is the fact that all of Cablevision s insiders are part of the same family: the Dolan family, which is also the founding family. The negative effects of having these insiders were seen in 2003, when Chairman Charles Dolan proposed an initiative to cut the size of the board by decreasing the number of members elected by owners of publicly traded shares (Class A) from 6 to 3, therefore making the private holders (e.g, the Dolans) choose a higher percentage of the board members. However, the initiative was not approved, which confirms that our firms do have effective, healthy boards. Interaction with Financial Markets Four of our companies are traded in the New York Stock Exchange (Apple, Electronic Arts, Time Warner and Cablevision), with the first three being part of the S&P 500 index. The other two (Netflix and Tivo) are traded in the NASDAQ National Market. Reports and information on all companies is easily available through their own websites, as well as other sources in the internet. Company NASDAQ NYSE S&P Apple X X Cablevision X Electronic Arts X X Netflix X Time Warner X X Tivo X The following table summarizes the number of analysts and average daily trading volume for the previous year, for all six companies: Company No. Analysts Avg. Daily Trading Volume Apple 25 21,475,771 Cablevision 30 2,579,270 Electronic Arts 26 4,540,299 Netflix 16 1,313,675 Time Warner 17 17,426,141 TiVo 18 18,473,080 7

8 A p p l e Corporate Social Responsibility EA TW Cable Vision Netflix TiVo There is a wide spectrum in the corporate social responsibility of the companies in this analysis. Three of the most consolidated companies (Apple, Time Warner and Electronic Arts) have well established social programs, and give back to the community in different ways: donations for education, health centers, community programs, etc. Cable Vision does so, but in a less verifiable way: we had a hard time finding concrete contributions by the company, although these do exist. Finally, the two newest companies (Netflix and TiVo) haven t had the time to design and develop structured social programs; they are still in the process of building the brand and the company, but it is expected that, as these companies grow, they will implement ways to improve this conditions. Not surprisingly, Time Warner is the company with most legal issues, since it s a communications corporation and there is a considerable amount of people who will not be pleased with the comments and broadcasts, but it has also been involved in fraud scandals for artificially inflating its publicly reported advertising sales. 8

9 % % % % % % % % % % % A p p l e C a b l e v i s i o n E A N e t f l i x T i m e W a r n e r T i V o II. Stockholder Analysis Insiders Institutions The diagram above shows the range of institutional holdings and also shows the range of Insider/5%+ Owners for the six companies. The stockholder composition of the six companies in our analysis varies among companies. The stockholders of our companies are all mostly Institutions with EA having the highest percentage and Netflix and TiVo having almost half of it. While Cablevision, Netflix, and TiVo have a relatively high percentage of Insider holdings, Apple, EA and Time Warner have only a small percentage. In the companies where insiders and large owners control a large proportion of stock management finds itself under more control and pressure from stockholders. The marginal investors for all companies are institutions, which are presumably well diversified. Apple Private Capital Management Inc. is the only institution holding more than 5% percent and is the marginal investor in Apple. It is a financial institution, and it is well diversified. During the last 6 months, almost 41% of total insider shares held were sold Cablevision 22% of shares are held by insiders and 5% owners, 64% of shares are held by institutions/mutual funds. Citigroup owns the highest percent at around 12.5%. Because the percent of stock held by institutions and insiders is high, the marginal investor in Cablevision is most likely the institutional investor with insider influence. Electronic Arts The company is largely owned by institutions, many of which have more than 5% of the shares, but none with enough power to call the shots on its own. (Marisco Capital 9

10 Management has only an extra 0.49% over the next largest investor, Wellington Management Co.) Close to 25% of total insider shares held have been sold during the last 6 months. Netflix Among the largest Netflix s stockholders, institutional investors hold more than 53% of Netflix s equity. These institutional and diversified investors represent Netflix s marginal investor. Reed Hastings, founder and CEO, holds almost 4 millions (7,6 %) of Netflix s outstanding stocks. Tom Dillon, Netflix s COO, detains 0.2%, and Leslie Kilgore, VP Marketing, holds 0.1% of shares. The other insiders hold 7.8% of Netflix s equity. Netflix executive managers hold a large stake of Netflix s equity. Time Warner 878 institutional holders own 73.2% of Time Warner's publicly traded stock. The majority of investors are institutional, and the marginal investor is also institutional and is CAPITAL RESEARCH & MANAGEMENT CO with a share of 7.24%. Since an institutional investor is likely to be well-diversified, the risk and return models will hold. TiVo Fidelity Management is the institution holding the greatest percentage of the total company s stock and is the marginal investor in Tivo. Fidelity Management is a financial institution that it is well diversified and trades the stock. During the last 6 months, 0.2% of total insider shares held were sold. 10

11 III. Risk and Return Deriving a Top-Down Beta A regression of the companies' historic performance relative to a market index (all regressions were run against the S&P 500 with monthly data for the past five years, with the exception of Netflix, which had less standard error when run with weekly data against the Morgan Stanley Multinational Index) illustrates the risk of each company. Electronic Time Apple Cablevisio n Arts Netflix Warner TiVo Regression Beta Intercept 2.22% 0.13% 2.36% 0.73% -0.75% 2.47% Jensen's Alpha (Excess Annual Return) 29.41% 2.76% 28.57% 48.43% -6.30% 34.90% Risk Attributed to Market Factors (R- Squared ) 26.00% 20.00% 9.00% 14.00% 57.00% 20.00% Risk Attributed to Firm-Specific Factors 74.00% 80.00% 91.00% 86.00% 43.00% 80.00% Standard Error % Range % Range The slope of the regression yields the regression Beta. This is a measure of the riskiness of the stock relative to the market. Simply stated, a Beta of 1 means the stock is exactly as risky as the overall market, while a Beta of 2 means that the stock is twice as risky as the market. Essentially, the regression compares the variance of an individual stock s returns to the returns of the market and uses that differential to provide an indication of risk. Of the companies, Time Warner has the greatest percentage of risk attributed to the market index (shown by the R-Squared value). That is because it is the most highly diversified company in the analysis, and because it is a large component of the S&P 500 (similar regression results were yielded when using the Morgan Stanley Multinational Index. The precision of this Beta estimation is represented by the standard error. The standard errors range from of low of 24% in Time Warner's case, to a high of 42% in the case of Apple. These relatively high standard errors are reason to doubt the validity of these Beta estimations. 11

12 Performance against the market: The data yielded by the regression can be used to calculate Jensen s alpha, a metric that describes how each stock performed relative to market expectations. The Risk-free rate used for the Jensen's Alpha was 2.57% 1 Apple, Netflix, and TiVO performed very well relative to the market. Time Warner also significantly underperformed against the market. The stock s R 2 indicates how much of the stock s variance can be attributed to market risk and how much can be attributed to firm specific and thus diversifiable factors. In the case of Netflix, 14% of the movement in the stock is due to market factors, while Time Warner had the highest R 2 at 57%, which makes sense because it is the most diversified company and makes up a large portion of the S&P500, the index against which the regression was run. Estimating a Bottom-up Beta While using a regression Beta to conduct analysis is legitimate option, the relatively high standard errors are cause to doubt the accuracy of this metric. An alternative technique was used to derive a Beta: the bottom-up method using the industry average betas. Levered Beta for Company = Unlevered Beta [ 1 + ( 1-t) (D/E) ] The market value of equity can be calculated using the formula below: Market Value of Equity = Stock Price * Shares Outstanding Calculating the market value of debt is slightly more involved, and can be estimated using the following formula: Market Value of Debt = Interest Expense * PVA (i,n) + Book Value of Debt * PV (i,n) Where: PVA = Present Value of Annuity Factor PV = Present Value Factor i = Cost of Borrowing n = Average Maturity of Debt The results of the calculations are summarized in the table below: ($ in thousands) Electronic Time Apple Cablevision Arts Netflix Warner TiVo Mkt. Val of Equity $29,467,000 $8,297,280 $15,580,000 $571,088 $77,483,000 $463,740 Mkt. Val of Debt $509,000 $8,024,931 $100,540 $25,767 $22,375,000 $16,391 Total Capitalization $29,976,000 $16,322,211 $15,684,050 $573, $99,858,000 $480,131 1 The average annual rate of the risk-free T-Bill over the last 5 years. 12

13 A p p l e C a b l e - v i s i o n E l e c t r o n i c A r t s N e t f l i x T i m e W a r n e r T i V O B o t t o m U p B e t a With market value of equity and market value of debt numbers, the formula previously mentioned can be used to lever the industry average unlevered Betas. The table below shows the results and the impact of D/E ratios on levered Betas: Electronic Time Apple Cablevision Arts Netflix Warner TiVo D/E Ratio 1.73% 0.97% 0.65% 4.50% 31.65% 3.50% Unlevered Beta Levered Beta Using industry average data adjusted on a firm specific basis for debt weightings should have more legitimacy than simply using a firm specific regression. The following chart indicates how different the results can be using either the top-down or bottom-up methods. Regression vs. Bottom-Up Betas Regression Beta Using Betas to Calculate the Cost of Capital These more reliable Betas can be used to determine the weighted average cost of capital for each company. The WACC is derived from two components: The cost of equity (Ke), and the cost of debt (Kd). These components are applied on a firm specific debt/equity ratio to come up with a weighted average cost of capital. The first step requires the calculation of the cost of equity using the following equation: 13

14 Ke = Rf + Beta* Rp Where Rf = Risk-free rate (4.28% in the calculations: long-term US treasury bond) And Rp = Risk Premium (4.84% in the calculations: geometric average premium for stock over T-Bonds from 1928 to 2004). The next step requires the calculation of the cost of debt. In order to do this, we first looked to see if the companies had any publicly traded debt in order to get a credit rating. If the company did not have publicly traded debt, we calculated the interest coverage ratio and derived a synthetic rating. Once ratings for each company had been obtained, we calculated the cost of debt as a rating dependent spread over the Treasury. With the cost of equity (Ke), and the cost of debt (Kd) derived, the WACC can be calculated using the following formula: WACC = Ke (Equity Ratio) + Kd (Debt Ratio)(1-t) The table below shows the results of the calculations: Electronic Time Apple Cablevision Arts Netflix Warner TiVo Levered Beta Cost of Equity 13.14% 12.83% 12.90% 10.57% 12.33% 10.69% Cost of Debt 3.41% 9.14% 3.36% 3.01% 3.76% 14.28% WACC 12.99% 11.01% % 10.27% 10.82% These calculations indicate that Apple has the highest cost of capital at 12.99%. TiVo has a higher cost of debt than cost of equity because it has been running operating losses for the past couple of years. The chart below portrays a graphical representation of cost of capital differentials amongst the firms. 14

15 % % % % % % % % % % % % % % A p p l e C a b l e - v i s i o n E l e c t r o n i s A r t s W A C C N e t f l i x T i m e W a r n e r T i V o Conclusion This analysis considered both regression and bottom-up Betas based on the industry unlevered betas. Bottom-up Betas will be used in calculations from this point forward because they offer a more accurate assessment of the risk associated with the firms. The weighted average cost of capital calculations for each of the firm using these Betas illustrate how various factors such as leverage and firm size and stability impact the overall cost of capital. This data will be useful in measuring investment returns, which will be discussed in the next section of the analysis. Following are the detailed calculations for each firm: Apple In February 2004, the Company retired $300 million of debt outstanding in the form of 6.5% unsecured notes. The notes were originally issued in 1994 and were sold at % of par for an effective yield to maturity of 6.51%. The Company currently has no long-term debt obligations. 15

16 Business breakdown: Product Net Sales (M) Weight Business Power Macintosh $1, % Hardware/Peripherals PowerBoo $1, % Hardware/Peripherals imac $ % Hardware/Peripherals ibook $ % Hardware/Peripherals Total Macintosh $4, % Hardware/Peripherals ipod $1, % Electronics Other Music Products $ % Software and Services Peripherals and Other $951 Hardware 11.49% Hardware/Peripherals Software $ % Software and Services Services $ % Software and Services Total net sales $8,279 Apple can be broken into three business components: Business Net Sales Weight Unlevered Beta Hardware/Peripherals $5, % 1.92 Software and Services $1, % 1.85 Electronics $1, % 1.27 Unlevered Beta = (1.92 x ) + (1.85 x ) + (1.27 x ) = 1.81 Cost of Debt Apple is rated as an AAA company with a default spread of 0.35%. Pre-tax Cost of Debt: 4.28% % = 4.63% Average tax rate: 26.44% After-tax Cost of Debt: 3.41% Debt/Equity Ratio The company has no Debt but has the following lease payments Fiscal Years 2005 $ Later years 232 Total minimum lease payments $ 617 Market Value of Debt: $509M The average payment for years is $77M. Therefore, it is reasonable to assume $232M will be paid in 3 years, $77M in each year. 16

17 Market Value of Equity: $29,467M Debt/Equity: 1.73% Debt/Capital: 1.70% B L = 1.81*(1 + ( )*0.0173) = 1.83 Cost of Equity (COE): 4.28% *(4.84%) = 13.14% Cost of Capital (WACC): (0.1314)*( ) + (0.0341)*(0.0170) = 12.99% Calculating The Bottom Up Beta for Cablevision Cablevision s business breakdown from 10-k Product Weight (based on % of revenue) Business Cable Distribution High-Speed Data Services Rainbow (TV Networks) MSG (Pro Sports) 43.4% Cable TV 20.75% Cable TV 20.75% Entertainment 15.09% Entertainment Total 100% Therefore, Cablevision can be broken down into two business components: Business Weight Industry Unlevered Beta Cable TV 64.15% 1.15 Entertainment 35.85% 1.17 Bottom-up β for Cablevision Cablevision Business Weight (portion of Revenue) Industry Industry Unlevered Beta Weighted unlevered Beta Entertainment % Cable TV % Cablevision Unlevered Beta 17

18 First the unlevered beta is adjusted for cash and then a levered beta for the company is calculated: Cablevision's Levered Beta Cash Debt Equity Firm value Cash/Firm Value Unlevered β D/E Levered β 1,011,260 8,024,931 8,297,280 16,322, Cost of Debt For two of the last three years, Cablevision has had a negative operating income. Its bonds are not traded and the company is not rated. In light of this, the estimated bond rating for the company is CCC with a 10% default spread. Pre-tax Cost of Debt: 4.28% % = 14.28% Average tax rate: 36.00% After-tax Cost of Debt: (1-.36)*14.28% = 9.14% Market Value of Debt Book Value of Debt The company has the following interest-bearing debt on their books at 12/31/2004: Current Portion of Bank Debt 5,387 Current portion of collateralized indebtedness 617,476 Current portion of captial lease obligation 11,581 Bank Debt 2,484,500 Collateralized Indebtedness 935,951 Senior Notes and debentures 5,991,564 Senior subordinated Notes and debentures 746,231 Notes Payable 150,000 Capital Lease Obligation 59,982 Total Book Value of debt 11,002,672 To determine the market value of the interest-bearing debt, the following values were used: Interest expense in 2004 = 721,322 Pre-tax cost of borrowing = 14.28% The average maturity of debt was calculated as approximately 6.69 years using the following data: 18

19 Debt Distribution Amount (1) Maturity Date Today Maturity - Today (2) (1) * (2) /15/2007 5/1/ , /15/2008 5/1/2005 1, , /1/2009 5/1/2005 1, , /15/2009 5/1/2005 1, , /15/2009 5/1/2005 1, , /1/2011 5/1/2005 2,161 13, /1/2011 5/1/2005 2,161 2,147, /15/2012 5/1/2005 2,541 1,270,500 1,000 4/15/2012 5/1/2005 2,541 2,541, /1/2012 5/1/2005 2, , /1/2014 5/1/2005 3,410 1,705, /15/2016 5/1/2005 4,032 1,008, /15/2018 5/1/2005 4,673 1,401, /15/2018 5/1/2005 4,823 2,411,500 6,750 16,477,700 Weighted Average Days to Maturity = 16,477,700 / 6750 = 2,441 days Weighted Average Years to Maturity = 2,441 days / 365 days/year = 6.69 years This resulted in: Market Value of Interest-bearing Debt = 7,488,584 Operating Lease Obligations Additionally, the latest 10-k reports these upcoming operating lease obligations. Fiscal Years 103, $ , , , ,769 Later years 559,223 Debt Value of leases (PV) $ 536,347 Market Value of Equity Shares Outstanding in Market Value of (1000s) Price per Shares Equity 309,600 $ $ 8,297,280 19

20 Debt Ratios Debt/Equity = Market Value of Debt (including PV of Operating Leases)/ Market Value of Equity = (7,488, ,347) / 8,297,290 =.9672 Debt/Capital = (D / (D + E)) = (7,488, ,347) / (7,488, , ,297,290) =.4917 Equity/Capital = (E / (D + E)) = (8,297,290) / (7,488, , ,297,290) =.5083 Cost of Equity using Cablevision s Levered Beta R J = RF + b(r P ) => R J = (.0484) = 12.83% WACC: (0.4917)(.0914) + (.5083)(.1283) = 11.01% Electronics Arts Electronic Arts divides its sales by geography and by product. Since they basically produce one type of product (entertainment software for consoles), the breakdown is given by the type of hardware required to play the program: Hardware Net Sales (M$) Weight PlayStation 2 1,314, % PC 469, % Xbox 384, % Nintendo GameCube 199, % Game Boy Advance 77, % Subscription Services 49, % PlayStation 29, % EA Studio Net Product Revenue 2,525, % Co-publishing & Distribution 398, % Advertising, Programming, etc 33, % Total Net Revenue 2,957, % Business Entertainment Tech Entertainment Tech Entertainment Tech Entertainment Tech Entertainment Tech Entertainment Tech Entertainment Tech Entertainment Tech Entertainment Tech 20

21 Basically all of EA s revenues come from the same type of business: Entertainment Technology, which has an unlevered beta of Cost of Debt Electronic Arts is rated as an AAA company with a default spread of 0.35% Pre-tax Cost of Debt: 4.28% % = 4.63% Company s tax rate: 27.53% After-tax Cost of Debt: 3.36% Debt/Equity Ratio Even though the company has no debt, it does lease several facilities around the world, and has the following lease payments:(millions of US$) Fiscal Years 2005 $ Later years 35.8 Total minimum lease payments $ Market Value of Debt: $100.54M 2 Market Value of Equity: $15,580M Debt/Equity: 0.65% Debt/Capital: 0.64% Cost of Equity = 4.28% *(4.84%) = 12.90% B L = 1.78*(1 + ( )*0.0065) = 1.79 Cost of Capital = (0.129)*(0.9936) + (0.0336)*(0.0064) = 12.84% Netflix Bottom Up Betas Netflix s beta has been estimated using the average unlevered beta of the technologyentertainment industry (1.78). Netflix s unlevered beta (1.26) is the weighted average of its cash balance (it represent 29% of the firm value) and its remaining assets. By using a 2 The average payment for years is 16.88M. The NPV for those years is $73.84M. After that, I assume the company will pay $17.9M a year for two years in order to cancel the remaining $35.8M. The NPV for those two years is $26.7M. 21

22 tax rate equal to 35%, the current debt to equity ratio (4.5%) and the above computed unlevered beta, Netflix s levered beta results equal to Bottom-up β for NETFLIX Comparable firm Average Unlevered β Tax Rate Entertainment Tech (31firms) % Firm value Cash/Firm Value Unlevered β D/E Levered β Cash Debt Equity 174,461,000 25,767, ,087, ,855, Cost of Debt: Netflix has an Interest Cover Ratio (average over the last 3 years) equal to Average EBIT (1) 21,946,000 6,929,000-8,976,000 Interest Expenses (2) 170, ,000 11,972, Interest Coverage Ratio (1)/(2) Therefore, its synthetic rating is AAA with a default spread of 0.35%: Rating Default spread Risk free Pre-tax Cost of debt Tax Rate After-tax Cost of debt AAA 0.35% 4.28% 4.63% 35.00% 3.01% Pre-tax Cost of Debt: R f + Default Spread = 4.28% % = 4.63% Tax rate: 35 % After-tax Cost of Debt: 3.01% Market value of Debt: Netflix has $68,000 debt (book value). In addition, the company has the following operating lease payments: Year Commitment 2005 $ 5,946, $ 6,754, $ 3,956, $ 3,595, $ 2,639,000 Thereafter $ 6,401,000 The total amount of operating leases is $29,291,000 and its maturity (computed as a weighted average maturity of debt outstanding) is 3.43 years. Netflix has a $6,401,000 lease commitment due after Spreading this last lease commitment over 2 yrs, the NPV of the operating leases is $25,181,132. The total market value of debt is $25,767,485, adding the Market Value of interest-bearing Debt ($586,354) at the PV of operating leases. 22

23 PV Leases (1) Book Value of Debt Interest Expense Pre Tax cost of Debt Market Value of interestbearing Debt (2) Market Value of Debt (3) =(1) + (2) 25,181,132 68, , % 586,354 25,767,485 Market value of Equity: Netflix has 52,732,025 outstanding stocks. The current market price of Netflix s stock is $ Therefore, the market value of Equity is $571,087,831. β u = 1.78 * (0.71) + 0 * (0.29) = 1.26 β L = 1.26*(1 + (1 0.35)*0.045) = 1.30 Cost of Equity = Rf + β L Rp = *4.84 = 10.57% Debt/Equity= 25,767,485/ 571,087,831 = 4.5% Debt/Capital = 25,767,485/596,855,316 = 4.33% WACC = 3.01* 4.33% * 95.7% = 10.24% Time Warner: 2004 Revenue EBITDA EBIT Comparable Firms Unlevered Beta Division Value Weight Weight * Beta AOL Internet Cable Cable TV Filmed Entertainme nt TV Networks Entertainment Entertainment Publishing Publishing Total $43.65 $10.41 $ % 1.38 B L = B U *(1 + (1 t)*(d/e) = 1.38*(1 + (1 0.35)*0.3165) = 1.66 marginal tax rate, t = 35% D/E = 31.65% Cost of Debt Interest Coverage Ratio = EBIT/Interest Expense = $6714/$1533 = 4.83 estimated synthetic rating of A Actual rating = BBB Time Warner has an actual rating of BBB with a default spread of 1.50%. Pre-tax Cost of Debt: 4.28% % = 5.78% Marginal tax rate: 36% After-tax Cost of Debt: 3.76% 23

24 Market Value of Debt: $22,375M Market Value of Equity: $77,483M Debt/Equity: 31.65% Debt/Capital: 24.04% Equity/Capital: 75.94% Cost of Equity: 4.28% (4.84%) = 12.33% Cost of Capital: (0.1233)*(.7594) + (0.0376)*(.2404) = 10.27% TiVo Tivo derives revenues from three sources: TiVo service revenues: Consumers subscribe directly to the TiVo service, paying a montly or a one-time product lifetime fee. Technology revenues: Tivo possess technology supported by a portfolio of patents that enables the company to offer TiVo-enabled DVR software, hardware, and service solutions to customers like DIRECTV, Pioneer, Toshiba, Humax, and Sony. DVR hardware revenues: Tivo engages a contract manufacturer to build a number of the lower-end, less expensive TiVo enabled DVRs. Business breakdown: Business Net Sales 3 Weight Unlevered Beta Service $ % 1.17 Technology $ % 1.78 Hardware $ % 1.27 The Unlevered Beta of Tivo is equal to a weighted average of its business components unlevered betas (based on industry averages). Unlevered Beta: 1.17 x x x = 1.28 Cost of debt: Interest coverage ratio and default spread: Over the last few years the company has have negative EBIT. Therefore, an estimated bond rating for the company might be CCC and consequently it would have a 10% default spread. Pre-tax cost of debt: 4.28% + 10% = 14.28% Corporate marginal tax rate: 0% (the company has have negative operating earning all years) After tax cost of debt: 14.28% 3 January 31, 2004, in thousands. 24

25 Debt/ Equity ratio: Debt: Note payable: Book value 10,450; interest expense 731 and an average maturity of 3 years: & 1 $ (1 ' (1.1428) 731$ $ $ % Operating leases: 3 #!!!! " (1.1428) = = 8691 Year Operating Lease Discount rate Present Value Total 7700 Market value of debt: = Market value of equity: 463,740 (thousands) Cost of equity: (0.0484) = 10.69% & 16,391 # Levered Beta: 1.28 (1+ (1-0.00) $! ) = % 463,740 " Cost of Capital: (0.1069) 463,740 +(0.1428) (1-0.00) 463, ,391 16, ,740 = 10.82% + 16,391 25

26 IV. Measuring Investment Returns Investment returns can be compared to the calculated hurdle rates (cost of equity and cost of capital) as a measurement of success. Even though using accounting numbers is not the most precise method, these calculations provide telling information about each of the companies. Netflix and Electronic Arts had positive EVAs, while Apple, Cablevision, and Time Warner did not. ($ in thousands) Electronic Time Apple Cablevison Arts Netflix Warner Tivo Net Income $276,000 -$676,092 $863,000 $21,595, 000 $3,364,000 -$32,018 EBIT*(1-t) $326,000 -$279,376 $785,000 $21,946, 000 $6,165,000 -$22,480 Tax Rate (t) 26.00% 36.00% 35.00% 35.00% 35.00% 0.00% Book Value of Equity (end of previous year) $4,223,000 -$1,989,802 $3,400,000 $112,707,849 $56,213 $522,165 Book Value of Debt (end of previous year) $0 $8,501,417 $0 $63,304, 000 $25,745 $8,185 Pre-Tax Cost of Debt 4.63% 14.28% 4.63% 4.63% 5.78% 14.28% PV Operating Leases $509 $536,347 $101,000 $25,181, 132 $0 $7,700 Most Recent Yr ROE 6.54% NA 25.38% 19.16% 5.98% -6.13% ROE 5 yr avg 4.95% NA 17.64% NA % % Most Recent Yr COE 13.14% 12.83% 12.90% 10.56% 12.33% 10.69% Most Recent Yr NA $9,697,8 Equity EVA -$278,902 $424, $3,567,000 -$87,837 Most Recent Yr ROC 5.68% -1.55% 14.66% 13.03% 4.89% -3.97% Most Recent Yr WACC 12.99% 11.01% 12.84% 10.23% 10.27% 10.82% Most Recent Yr EVA -$308,774 -$1,051,923 $62,000 $4,928,3 36 -$4,410,000 -$78,458 Is this firm investing in good projects (i.e. is ROC > COC and ROE > COE?) NO NO YES YES NO NO Apple Computers, Inc., Time Warner, And TiVo These three companies are investing in bad projects; their respective ROCs are less than their WACCs and their respective ROEs less than their COEs. Cablevision 26

27 This section measures Cablevision s returns over the past three years. The following data, gleaned from the company s financial statements from those years, was used in the calculations: Year Book Value of Debt Book Value of Equity EBIT ,002,672-2,630, , ,501,417-1,989, , ,718,904-1,723, , ,006,106-1,585,906 1,848,296 Return On Capital This measure was adjusted to include operating leases: Return on Capital 2004 Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC -202, % 11,002,672-2,630, % Return on Capital 2003 Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC 429, % 8,501,417-1,989, % Return on Capital 2002 Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC -112, % 7,718,904-1,723, % It seems that Cablevision is not doing well on the projects it is investing in. The ROC is not only far below the cost of capital but it is also negative in two of the three years analyzed. Economic Value Added EVA (Economic Value Added) 2004 ROC Cost of capital Book Value of Debt Book Value of Equity EVA % 11.01% 11,002,672-2,630,334-1,051,914 EVA (Economic Value Added) 2003 ROC Cost of capital Book Value of Debt Book Value of Equity EVA 4.22% 11.01% 8,501,417-1,989, ,300 27

28 EVA (Economic Value Added) 2003 ROC Cost of capital Book Value of Debt Book Value of Equity EVA % 11.01% 7,718,904-1,723, ,312 Not surprisingly based on the ROC values calculated above, the company seems to be destroying firm value with its projects. Return on Equity Cablevision s book value of equity is consistently negative (it has a shareholder deficiency) and therefore this measure is not meaningful. Electronic Arts Since Electronic Arts requires relatively small hard assets (such as production plants) and very cheap inventory, it doesn t really need to carry much debt. This, added to the fact that the entertainment software is providing huge cash flows, give EA a good ROE/ROA. It's excess returns are sustainable as the gaming industry grows and EA has an excellent capability in game design. Netflix The ROC is measured using adjusted EBIT (adding back the interest on operating leases). ROE and ROC are much higher than the hurdle rates; thus, EVA is positive. Even though book values may not be a good measure of the investment in existing projects, Netflix s ROE and ROC suggest that the firm is investing in good projects. Even though the competition (Blockbuster, Wal-Mart and Amazon) has recently increased, Netflix could match the hurdle rates. In the near future, Netflix will enter in movie downloading technologies. The video on demand service represents a further opportunity to expand Netflix s long-term profitability. 28

29 V. Capital Structure Choices In this section, we will try to assess qualitatively and partly quantitatively the financial mix of each firm and to determine if they have too much or too little debt. Current financial mix Accounting practice doesn t treat operating leases as debt. However, since our companies use operating leases to finance their business, we have included operating leases in the total debt calculations in the following table. Apple Cablevision Electronic Netflix Time Warner TiVo Arts MV Debt Ratio 1.70% 49.17% 3.41% 4.33% 24.04% 3.41% Rating AAA (S) CCC (S) AAA (S) AAA (S) BBB (S) CCC (S) (S): synthetic rating Benefits of Debt Apple Cablevision Electronic Arts Netflix Time Warner Tax Benefit Added Discipline Apple s effective tax rate is 26% Apple is a widely held firm, however current CEO Steve Jobs owns 5M shares. Nevertheless, the use of debt as a discipline mechanism could be applicable. Cablevision s effective tax rate is 36% The company is closely held with high insider holdings. This means that debt is unlikely to add significant additional discipline to management. EA s effective tax rate is 30.1% EA is a widely held firm and there is a big discipline benefit from debt. Netflix s effective tax rate is 0 % Reed Hastings, Netflix s CEO, holds almost 4 millions (7.6 %) of Netflix s outstanding stocks. Therefore, the company doesn t need the discipline that debt provides. Warner s effective tax rate is 30.35% Because it is a large firm with a low percentage of insider holdings, the company may highly benefit from the greater discipline from debt. TiVo TiVo s effective tax-rate 0% The CEO who is the co-founder of the company has a high percentage of its stocks; therefore, the added discipline of debt is not necessarily needed. 29

30 Costs of Debt Apple Cablevision Bankruptcy Risk Agency Costs Future Flexibility Apple s size, strong brand, In general, the agency costs Apple s need for Future excess cash and relatively are likely to be high for Financing Flexibility is high stable cash flows suggest Apple since not many because it operates in a dynamic that the risk of bankruptcy people know what Apple s environment that keeps evolving for this company is upcoming projects will be and no one can be certain about relatively low. about, and it s assets are the future needs of the industry mainly intangible assets as a whole nor Apple as a Cablevision is significantly over-leveraged. Its earnings are so volatile and there is significant concern as to whether the company can continue to service its sizable debt. As a result, the company is under bankruptcy threat. The agency costs are high since the success of projects in entertainment are highly unpredictable. Moreover, many of the company s assets are intangible. company. Technology and services are changing rapidly in the cable industry in particular. Cablevision should borrow less to maintain future financing flexibility. Electronic Arts Netflix EA s earnings during the last few years have been volatile, however they have been positive. Plus, it s a big company with a 16B market cap therefore the Bankruptcy risk is pretty low. Netflix s EBIT has varied widely in the past years. This high variation might indicate that the risk of bankruptcy is quite high. EA s agency costs are high because of the nature of its projects. Netflix s agency costs are high because its assets are mainly intangible assets and its projects uncertain. EA is constantly growing, its Net cash flows are decreasing therefore they have a high need for financing flexibility Netflix needs future financing flexibility because it operates in a dynamic environment that is intensively competitive and subject to rapid changes. Time Warner The firm has a low to medium volatility of earnings and cash flows, so it has a relatively low probability of bankruptcy. Its cost of bankruptcy would be primarily direct, as well as indirect in increasing its cost of capital. The agency costs are high since upcoming projects in entertainment are often not published and the outcome not predictable. Because the company is in transition due to its recent acquisition of AOL and emerging technologies vastly changing the nature of the business, it may borrow less because its future investment needs are uncertain. 30

31 TiVo We believe that the likelihood of bankruptcy for TiVo is low. TiVo has a really small debt that represents only 3.41% of the total assets. The company is currently having negative operating earnings and negative free cash flows; however, it has a huge amount of cash that can be used to service the debt. As it is for the rest of the companies we analyzed, the agency cost for TiVo seems to be significantly large as well. TiVo too needs future financing flexibility for all the reasons mentioned already. It operates in a dynamic environment that is intensively competitive and subject to rapid changes. Qualitative Judgment Based on this qualitative analysis, we expect Time Warner and Electronic Arts to have the highest debt ratio; They have potentially the largest benefits from debt and the costs aren t higher than the rest of the firms. Apple is somewhere in the middle; with large benefits but also large agency costs and a high need for flexibility. Netflix and TiVo will have no benefits from Debt and also have high costs, but no bankruptcy risk. Finally, we expect Cablevision, even though it has some benefits, to have the lowest ratio since it has high debt costs and is the only one with a high bankruptcy risk. 31

32 VI. Optimal Capital Structure In this section, we are analyzing the optimum cost of capital of each company with and without rating constraints. Quantitative analysis The following table shows each company s optimal WACC. Cablevision and TiVo are both losing money and have an optimal of 0%, while Apple s and Netflix s optimal is 10%. EA is 30% and Time Warner stands at 40%. Time Warner and EA are both mature companies. Cablevision is facing losses and has a high bankruptcy risk. The other three having the optimal WACC at 0% to 10% might reflect the fact that all three companies, it they take good projects, have the ability to grow. Debt Ratio Apple Cablevision Electronic Arts Netflix Time Warner TiVo 0% 12.94% 9.57% 12.44% 10.39% 11.07% 10.47% 10% 12.65% 11.48% 12.03% 10.07% 10.71% 12.47% 20% 14.61% 13.48% 11.68% 10.09% 10.39% 14.47% 30% 15.81% 15.48% 11.43% 11.46% 10.10% 16.47% 40% 20.29% 17.48% 13.00% 13.33% 9.91% 18.47% 50% 22.29% 19.48% 16.07% 18.70% 11.78$ 20.47% 60% 24.29% 21.48% 17.27% 20.70% 12.58% 22.47% 70% 26.29% 23.48% 18.47% 22.70% 16.47% 24.47% 80% 28.29% 25.48% 19.67% 24.70% 17.67% 26.47% 90% 30.29% 27.48% 20.87% 26.70% 18.87% 28.47% The economic value added to each company is the following: Firm Value (No Growth) Δ Value (No Growth) Firm Value (Growth) Δ Value (Growth) Δ Value/Share (No Growth) Δ Value/Share (Growth) Apple Cablevision Electronic Arts Netflix Time Warner TiVo $30,240,000 $18,829,049 $18,141,584 $607,062 $106,400,000 $495,780 $509,000 $2,507,470 $1,263,463 $10,099 $4,630,000 $15,649 $30,533,000 $19,686,210 $18,899,503 $614,893 $108,771,000 $507,726 $803,000 $3,364,631 $2,021,381 $17,930 $7,001,000 $27,595 $0.62 $8.10 $4.10 $0.19 $0.99 $0.24 $0.98 $10.87 $6.56 $0.34 $1.50 $0.43 Δ COE 0.53% -2.43% 2.13% 0.26% 1.70% -0.22% Δ WACC -0.22% -1.38% -0.86% -0.17% -0.45% -0.34% New Beta Δ Beta